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315189_1993.txt

315189

1993

ITEM 1. BUSINESS. PRODUCTS Deere & Company (Company) and its subsidiaries (collectively called John Deere) have operations which are categorized into five business segments. The Company's worldwide AGRICULTURAL EQUIPMENT segment manufactures and distributes a full range of equipment used in commercial farming -- including tractors; tillage, soil preparation, planting and harvesting machinery; and crop handling equipment. The Company's worldwide INDUSTRIAL EQUIPMENT segment manufactures and distributes a broad range of machines used in construction, earthmoving and forestry -- including backhoe loaders; crawler dozers and loaders; four-wheel-drive loaders; scrapers; motor graders; excavators; and log skidders. This segment also includes the manufacture and distribution of engines and drivetrain components for the original equipment manufacturer (OEM) market. The Company's worldwide LAWN AND GROUNDS CARE EQUIPMENT segment manufactures and distributes equipment for commercial and residential uses -- including small tractors for lawn, garden and utility purposes; riding and walk- behind mowers; golf course equipment; utility transport vehicles; snowblowers; and other outdoor power products. The products produced by the equipment segments are marketed primarily through independent retail dealer networks. The Company's CREDIT segment, which operates in the United States and Canada, purchases and finances retail notes from John Deere's equipment sales branches in the United States and Canada. The notes are acquired by the sales branches through John Deere retail dealers and originate in connection with retail sales by dealers of new John Deere equipment and used equipment. The credit segment also purchases and finances retail notes unrelated to John Deere equipment, representing primarily recreational vehicle and recreational marine product notes acquired from independent dealers of that equipment (recreational product retail notes). The credit subsidiaries also lease John Deere equipment to retail customers, finance and service unsecured revolving charge accounts acquired from merchants in the agricultural, lawn and grounds care and marine retail markets, and provide wholesale financing for recreational vehicles and John Deere engine inventories held by dealers of those products. The Company's INSURANCE AND HEALTH care segment issues policies in the United States and Canada primarily for: a general line of property and casualty insurance to John Deere and non-Deere dealers and to the general public; group life and group accident and health insurance for employees of participating John Deere dealers; group life and group accident and health insurance for employees of John Deere; life and annuity products to the general public and credit physical damage insurance in connection with certain retail sales of John Deere products financed by the credit subsidiaries. This segment also provides health management programs and related administrative services in the United States to corporate customers and employees of John Deere. The Company's worldwide agricultural, industrial and lawn and grounds care equipment operations and subsidiaries are sometimes referred to as the "Equipment Operations." The Company's credit, insurance and health care subsidiaries are sometimes referred to as "Financial Services." The Company believes that its worldwide sales of agricultural equipment during recent years have been greater than those of any other business enterprise. It also believes that John Deere is an important provider of most of the types of industrial equipment that it markets, and a leader in some size ranges. The Company also believes it is the largest manufacturer of lawn and garden tractors and provides the broadest line of grounds care equipment in North America. The John Deere enterprise has manufactured agricultural machinery since 1837. The present Company was incorporated under the laws of Delaware in 1958. MARKET CONDITIONS AND OPERATING RESULTS North American agricultural economic conditions in 1993 were generally more favorable than in 1992. Although flooding and excessively wet conditions in certain areas of the Midwest and drought conditions in parts of the Southeast resulted in an estimated 31 percent decrease in corn production and a 16 percent decline in soybean production in 1993, United States farm net cash income is expected to achieve a record level in 1993. The lower production caused grain prices to rise above 1992 levels. Livestock producers enjoyed favorable prices and profit margins during 1993 and farmers boosted their cash flow by selling inventories accumulated from record corn and soybean yields in 1992. Additionally, direct government payments to farmers are expected to increase in 1993, aiding farmers most heavily impacted by this year's flooding. Uncertainties over the passage of a new investment tax credit were resolved in 1993 as the anticipated tax credit was not included in the final tax legislation. Consequently, many United States farmers who had delayed making purchases in 1992 bought equipment this year. Sales in Canada were boosted by a special 13 month investment tax credit in effect from December 1992 to December 1993. As a result of these developments, North American retail sales of John Deere agricultural equipment were considerably higher in 1993 compared with last year. The North American general economy continued its slow expansion in 1993. In the United States, housing starts increased about five percent during the year with second-half strength overcoming a very sluggish first half. Real public construction was up slightly from the previous year's level while non-residential construction was flat. However, the cumulative effects of the rebound in economic activity were felt in 1993, as housing starts were up more than 25 percent from their 1991 level and real public construction was nine percent larger. Consequently, North American retail sales of industrial and construction machinery for both the industry and John Deere rose significantly in 1993. Consumer spending for durable goods rose briskly in 1993, and North American retail sales of John Deere lawn and grounds care equipment increased significantly. Sales were also supported by favorable moisture conditions over most areas throughout the prime selling season. However, dry conditions did emerge in portions of the Southeast and Northeast which impeded some late season buying activity. Industry retail sales of agricultural equipment in overseas markets in general remained relatively weak during 1993. However, overseas retail sales of John Deere agricultural equipment were higher in 1993 than in 1992, reflecting good acceptance of the Company's new tractors and combines. Despite recessionary conditions prevailing in most European markets and in Japan, overseas retail sales of John Deere lawn and grounds care equipment continued to expand in 1993. Overseas industrial and construction equipment markets were relatively flat in 1993 compared with 1992. Acquisitions of receivables and leases by the Company's credit subsidiaries were somewhat higher in 1993 compared with last year due primarily to growth in revolving charge accounts, leases and wholesale receivables. Although retail sales of John Deere equipment were higher in 1993, acquisitions of John Deere retail notes were down slightly compared with last year reflecting a higher level of cash purchases by John Deere customers and a more competitive financing environment, particularly during the latter part of 1993. Acquisitions of recreational product retail notes were substantially lower in 1993 due mainly to a very competitive financing market. Although relatively soft market conditions continued during 1993 in the property/casualty insurance industry, John Deere's insurance premium volumes increased in 1993 over 1992. Health care premium volumes were considerably higher in 1993 reflecting continued growth in John Deere's health care operations. Worldwide income in 1993 was $286 million or $3.70 per share before the effects of special items (accounting changes, restructuring charges and the new United States income tax law), compared with net income of $37 million or $.49 per share in 1992. However, 1993 reported results were affected by the special items described below. After the effects of the restructuring charges, the incremental expense from the accounting changes and the tax rate change, income in 1993 was $184 million or $2.39 per share. The Company incurred a worldwide net loss in 1993 of $921 million or $11.91 per share after all of the special items including the cumulative effect of the accounting changes. Additional financial information regarding each of the Company's business segments over the past three years is presented on pages 34 and 35. During the second quarter of 1993, the Company announced and initiated plans to downsize and rationalize its European operations. This resulted in a second quarter provision for restructuring charges of $80 million after income taxes or $1.03 per share ($107 million before income taxes), representing costs of employment reductions to be implemented during 1993 and the next few years. In the fourth quarter of 1993, effective November 1, 1992, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and FASB Statement No. 112, Employers' Accounting for Postemployment Benefits. These standards generally require the accrual of these benefits, which are primarily retiree health care and life insurance benefits, during the employees' years of active service. The Company elected to recognize the cumulative effect of these accounting changes as a one-time charge to earnings. The aggregate cumulative effect of adopting the new standards as of November 1, 1992 was a non-cash charge of $1,105 million after income taxes or $14.30 per share ($1,728 million before income taxes). Additionally, the adoption of these standards resulted in an incremental non-cash after-tax increase in 1993 postretirement and postemployment benefits expense of $38 million or $.49 per share ($60 million before income taxes). The incremental postretirement and postemployment benefits expense relating to the Financial Services subsidiaries was immaterial. Additional information is presented on pages 36 and 37 of the notes to the consolidated financial statements. The Omnibus Budget Reconciliation Act of 1993, which enacted an increase in the United States federal statutory income tax rate from 34 percent to 35 percent effective January 1, 1993, was signed into law during the fourth quarter of 1993. In accordance with FASB Statement No. 109, Accounting for Income Taxes, income taxes relating to previously reported United States taxable income were recalculated and the United States deferred income tax assets and liabilities as of the enactment date were revalued during the fourth quarter of 1993 using the new tax rate of 35 percent. This resulted in a credit of $16 million or $.21 per share to the provision for income taxes. This tax rate change had an immaterial effect on the Financial Services subsidiaries. Additional information is presented on page 39 of the notes to the consolidated financial statements. The Company's worldwide Equipment Operations, which exclude income from the credit, insurance and health care operations, had income of $114 million in 1993 before the effects of the previously mentioned special items, compared with a net loss of $107 million in 1992. The improved operating results for 1993 were attributable to the Company's North American equipment operations. Sales and production volumes in North America were higher this year in response to increased retail demand, and price realization improved in all of the Company's North American equipment businesses compared with 1992 as sales incentive cost levels were significantly lower. Additionally, North American productivity continued to improve during 1993. Including the incremental effect of the accounting changes, the restructuring charges and the tax rate change, the worldwide Equipment Operations' net income was $13 million in 1993. The Equipment Operations incurred a net loss of $1,085 million in 1993 after all of the special items including the cumulative effect of the accounting changes. Income of the Company's Financial Services subsidiaries before the cumulative effect of the accounting changes totaled $164 million in 1993 while net income after the accounting changes was $157 million, compared with $138 million last year. Worldwide net sales and revenues, which include net sales of equipment and revenues from the credit, insurance and health care operations, increased 11 percent to $7,754 million in 1993 compared with net sales and revenues of $6,961 million in 1992. Worldwide net sales of equipment to dealers were $6,479 million in 1993, an increase of 13 percent from sales of $5,723 million last year. The physical volume of the Company's worldwide sales to dealers increased approximately nine percent in 1993. Worldwide production tonnage of all John Deere products in 1993 was 11 percent higher than last year. For further discussion of results of operations, see the information under the caption "Management's Discussion and Analysis" on pages 24-35. EQUIPMENT OPERATIONS AGRICULTURAL EQUIPMENT Sales of agricultural equipment, particularly in the United States and Canada, are affected by total farm cash receipts, which reflect levels of farm commodity prices, acreage planted, crop yields and government payments. Sales are also influenced by general economic conditions, levels of interest rates, agricultural trends and the levels of costs associated with farming. Weather and climatic conditions can also affect buying decisions of equipment purchasers. A substantial part of new agricultural equipment sales is for replacement of equipment that is old or is less efficient than newer equipment, or both. When the farm economy is depressed, farmers tend to postpone the replacement of their existing equipment. When conditions improve, sales are stimulated by demand for replacement equipment. During the 1990's, there has been a continuation of the trend toward minimum tillage agriculture. Minimum tillage agriculture reduces soil erosion but increases the use of chemical herbicides and pesticides. Several governmental initiatives have recently been approved that may hold long-term promise for agricultural markets. The U.S., Canada, and Mexico have implemented the North American Free Trade Agreement (NAFTA) which reduces internal trade restrictions between the three countries. For some commodities and products, free trade commenced January 1, 1994. For other products which are more sensitive economically and politically, free trade will be achieved gradually over a 15 year period. U.S. corn exports to Mexico fall into this second category. The Uruguay round of the General Agreement on Tariffs and Trade (GATT) also was successfully concluded in 1993. This agreement promises to reduce agricultural export subsidies over a period of years and grant market access for many products that were previously restricted. It is the Company's belief that U.S. and Canadian farmers possess comparative advantages in the production of certain agricultural products and may benefit from the eventual implementation of this agreement. This treaty is expected to take effect July 1, 1995. Finally, the Environmental Protection Agency (EPA) agreed in December 1993 that 30 percent of the fuel used in metropolitan areas not reaching nationally established air quality guidelines should come from renewable fuel sources. While final approval has not been reached, it is widely believed that corn producers will benefit from EPA's action. Since the early 1980s, farmers have experienced cost/price pressures which have caused them to be more concerned with cost control and maximum productivity. The John Deere agricultural equipment sold in this environment is high-powered, versatile and technologically sophisticated. It is built to exacting design, materials and performance specifications for rugged usage and exposure to adverse weather conditions. Large, cost-efficient, highly-mechanized agricultural operations account for an important share of total United States farm output; 28 percent of United States farms accounted for 90 percent of agricultural produce sales in 1987 (the latest year for which data are available).(1) The large-size agricultural equipment used on such farms has been particularly important to John Deere. A large proportion of the Equipment Operations' total agricultural equipment sales in the United States is comprised of tractors over 100 horsepower and self-propelled combines. During late 1992, John Deere introduced three new tractor lines: the 5000, 6000 and 7000 series tractors selling in the 40 to 150 PTO horsepower categories. These tractors represented important changes to John Deere's product offerings. The 6000 and 7000 series tractors have many new design features including modular configuration permitting lower cost updates to respond to changing customer needs. The 5000 series tractors are manufactured in the United States and replace tractors formerly sourced from Germany. In the United States, farm commodity prices and farm income are heavily influenced by international supply and demand conditions for food and fiber products. In general, declining international stock levels boost farm commodity prices and incomes, while rising stock levels tend to depress prices and incomes. In 1993, world production of wheat and coarse grains (corn, oats, barley and sorghum) fell from the levels achieved in 1992. Production decreases were most notable in the United States, the former Soviet Union and the European Union (formerly the European Economic Community). The ending worldwide stocks of wheat are now expected by the United States Department of Agriculture ("USDA") to decrease slightly to 139.1 million metric tons ("MMT") at the end of the 1993/94 marketing year compared with 141.3 MMT one year earlier. The 139.1 MMT stock level will represent about 25 percent of annual world consumption, a stock-to-usage ratio that is well below the 33 - 34 percent range that prevailed in the mid-1980s. This ratio stood at 23 percent in 1989/90 and has been 25 or 26 percent for the past three years. Ending stocks of coarse grains are expected by the USDA to fall to 114.3 MMT at the end of the 1993/94 marketing year as consumption is expected to exceed production. This would represent 14 percent of annual world consumption. This ratio is down significantly from 1992/93 (when it was 18%), and represents the lowest level of carryover relative to usage since 1973/74.(2) For 1994, USDA has announced zero annual acreage reduction programs for all crops except cotton, which was raised from 7.5 percent in 1993 to 11 percent in 1994. Total acreage planted in 1994 is expected to rise about 9 million acres from 1993 levels. United States market share of commodity sales in world markets rose in the first three years (1986-1988) following passage of the 1985 farm bill. This resulted partly from a weaker dollar in relation to other currencies, and partly from more competitive United States commodity prices stemming from the 1985 farm bill. Thereafter, as United States carryover stocks declined and production was tempered by governmental acreage reduction programs and drought in various years, United States market shares have generally declined. Market share for United States wheat has been adversely affected by higher Canadian and European production. Direct government payments to farmers were increased significantly by the 1985 farm bill. During 1977-82, government payments represented less than two percent of United States farm cash receipts. This percentage rose to 10.5 percent in 1987 and, although still high compared to 1977-82, declined to 4.5 percent in 1991. These direct government payments, combined with lower production costs incurred by farmers and higher livestock and commodity prices, resulted in record levels of net cash income to United States farmers from 1987 to 1990. The 1990 farm bill extended the basic features of the 1985 farm bill through 1995 with two notable exceptions: (1) target prices were frozen at their 1990 levels rather than declining two to three percent annually, and (2) a "triple base" feature was incorporated into the new legislation. This feature restricts deficiency payments to 85 percent of the base traditionally paid and is expected to reduce future government outlays. Government payments are forecasted to increase to 7.0 percent of United States farm cash receipts for 1993 compared to 5.0 percent in 1992, and farm net cash income is estimated to have reached a record level in 1993.(3) The 1990 farm bill is scheduled to remain in effect through the crops grown in 1995. Seasonal patterns in retail demand for agricultural equipment result in substantial variations in the volume and mix of products sold to retail customers during various times of the year. Seasonal demand must be estimated months in advance, and equipment must be manufactured in anticipation of such demand in order to achieve efficient utilization of manpower and facilities throughout the year. The Equipment Operations incur substantial seasonal indebtedness with related interest expense to finance production and inventory of equipment, and to finance sales to dealers in advance of seasonal demand. The Equipment Operations often encourage retail sales by waiving retail finance charges during off-season periods or in other sales promotions. Sales promotions and price concessions, including waiver and reduction of finance charges, were significantly lower in 1992 and 1993 compared with extensive amounts during recent prior years. An important part of the competition within the agricultural equipment industry during the past decade has come from a diverse variety of short-line and specialty manufacturers with differing manufacturing and marketing methods. Because of industry conditions, especially consolidation among large integrated competitors, the competitive environment is undergoing important changes, and the importance of short-line and specialty manufacturers, as well as foreign suppliers, may continue to increase in the future. Outside the United States, price stabilization programs conducted by national governments or groups of national governments, such as the European Union, tend to exert substantial influence upon commodity prices and agricultural activity, insulating their agricultural sectors from changes in world market conditions and restricting imports from the United States and elsewhere. In Western Europe, the cost of such programs, international disputes with exporting nations, and international negotiations such as GATT have caused the European Union to alter and modify its Common Agricultural Policy over time. These changes have tended to lower real farm income and restrict planted and harvested acreage. As a result, agricultural machinery sales have fallen substantially in Western Europe in the last decade. Inflation, slow economic growth, changes in currency relationships and price controls have been prevalent in many of the countries in which the Equipment Operations compete outside the United States, Canada and Europe. In addition to the agricultural equipment manufactured by the Equipment Operations, a number of products are purchased from other manufacturers for resale by John Deere, including four models of small utility tractors sourced from a Japanese manufacturer. These tractors are marketed primarily in the United States and Canada. INDUSTRIAL EQUIPMENT The industrial equipment industry is broadly defined as including construction, earthmoving and forestry equipment, as well as some materials handling equipment, cranes, off-highway trucks and a variety of machines for specialized industrial applications, including uses in the mining industry. The Equipment Operations provide types and sizes of equipment that compete for approximately two-thirds of the estimated total United States market for all types and sizes of industrial equipment (other than the market for cranes and specialized mining equipment). Retail sales of John Deere industrial equipment are influenced by prevailing levels of residential, industrial and public construction and the condition of the forest products industry. Sales are also influenced by general economic conditions and the level of interest rates. United States housing starts are forecasted to have been 1.26 million units in 1993, about 4 percent higher than 1992, and 25 percent higher than 1991. Nonresidential and public construction in the United States are both expected to be unchanged in 1993 as compared to 1992, but together were up about nine percent from 1991 activity. Environmental and ecological issues slowed logging activities in various parts of the United States in 1993, while late year housing activity boosted the demand for lumber products and lumber prices rose significantly as a result of these developments. North American industry retail sales of industrial and construction machinery rose significantly in 1993 compared with 1992. John Deere industrial equipment falls into three broad categories: utility tractors and smaller earthmoving equipment, medium capacity construction and earthmoving equipment, and forestry machines. The Equipment Operations' industrial equipment business began in the late 1940s with wheel and crawler tractors of a size and horsepower range similar to agricultural tractors, utilizing common components. Through the years, the Equipment Operations substantially increased production capacity for industrial equipment, adding to the line larger machines such as crawler loaders and dozers, log skidders, motor graders, hydraulic excavators and four-wheel-drive loaders. These products incorporate technology and many major components similar to those used in agricultural equipment, including diesel engines, transmissions and sophisticated hydraulics and electronics. The Company and Hitachi Construction Machinery Co., Inc. of Japan have a joint venture for the manufacture of hydraulic excavators in the United States and for the distribution of excavators primarily in North, Central and South America. The Company also has supply agreements with Hitachi under which a broad range of industrial products manufactured by the Company in the United States, including four-wheel-drive loaders, are distributed by Hitachi in Japan and other Far East markets. In addition, Hitachi is manufacturing certain models of four-wheel-drive loaders for distribution by John Deere primarily in North, Central and South America. The Equipment Operations manufacture and distribute diesel engines and drivetrain components both for use in John Deere products and for sale to other original equipment manufacturers (OEM). LAWN AND GROUNDS CARE EQUIPMENT The line of John Deere lawn and grounds care equipment includes rear-engine riding mowers, front-engine lawn tractors and suburban tractors, lawn and garden tractors, small diesel tractors, compact utility tractors, front mowers, small utility transport vehicles, and a broad line of associated implements for mowing, tilling, snow and debris handling, aerating, and many other residential, commercial, golf and sports turf care applications. The product line also includes walk-behind mowers, snow throwers and other outdoor power products. Retail sales of lawn and grounds care products are influenced by weather conditions, consumer spending patterns and general economic conditions. Even though the recovery of the general economy has been slow, the length of the upturn, the gradual improvement in housing starts and sales of existing homes, and generally favorable weather conditions stimulated purchases of lawn and grounds care equipment in 1993. Retail sales of John Deere lawn and grounds care equipment increased significantly in 1993. ENGINEERING AND RESEARCH John Deere makes large expenditures for engineering and research to improve the quality and performance of its products, and to develop new products. Such expenditures were $270 million, or four percent of net equipment sales in 1993, and $288 million in 1992. MANUFACTURING MANUFACTURING PLANTS. In the United States and Canada, the Equipment Operations own and operate 15 factory locations, which contain approximately 29.5 million square feet of floor space. Six of the factories are devoted primarily to the manufacture of agricultural equipment, two to industrial equipment, one to engines, one to hydraulics and power train components, one to gray iron and nodular castings, three to lawn and grounds care equipment, and one to power train components manufactured mostly for OEM markets. The Equipment Operations own and operate tractor factories in Germany, Spain and Argentina; agricultural equipment factories in France, Germany and South Africa; and an engine factory in France. These overseas factories contain approximately 6.1 million square feet of floor space. The Equipment Operations also have financial interests in a combine manufacturer in Brazil, in a tractor and implement manufacturer in Mexico, in a lawn and grounds care equipment manufacturer in Germany and the Netherlands, and in a joint venture to build industrial excavators in the United States. John Deere's facilities are well maintained, in good operating condition and are suitable for their present purposes. These facilities together with planned capital expenditures are expected to meet John Deere's needs in the foreseeable future. The Equipment Operations manufacture many of the components included in their products. The principle raw materials required for the manufacture of their products are purchased from numerous suppliers. The Company believes that available sources of supply will generally be sufficient for its needs for the foreseeable future. Although the Equipment Operations depend upon outside sources of supply for a substantial amount of components, manufacturing operations are extensively integrated. Similar or common manufacturing facilities and techniques are employed in the production of components for industrial, agricultural and lawn and grounds care equipment. Although production levels in 1993 were ten percent higher than in 1992, production continues to be well below capacity levels. The Equipment Operations' manufacturing strategy involves the implementation of appropriate levels of technology and automation, so that manufacturing processes can remain viable at relatively low production levels and can be flexible enough to accommodate many of the product design changes required to meet market requirements. In order to utilize manufacturing facilities and technology more effectively, the Equipment Operations continue to pursue improvements in manufacturing processes. Manufacturing activities judged not competitively advantageous for the Equipment Operations on a long-term basis are being shifted to outside suppliers, while many of those manufacturing activities that do offer long-term competitive advantages are being restructured. Improvements include the creation of flow-through manufacturing cells which reduce costs and inventories, increase quality and require less space, and the establishment of flexible assembly lines which can handle a wider range of product mix and deliver products at the times when dealers and customers demand them. Additionally, considerable effort is being directed to manufacturing cost reduction through product design, the introduction of advanced manufacturing technology and improvements in organizational structure. The Equipment Operations are also pursuing the sale to other companies of selected parts and components which can be manufactured and supplied to third parties on a competitive basis. CAPITAL EXPENDITURES. The Equipment Operations' capital expenditures were $196 million in 1993 compared with $269 million in 1992 and $295 million in 1991. Provisions for depreciation applicable to the Equipment Operations' property, plant and equipment during these years were $222 million, $213 million and $186 million, respectively. The Equipment Operations' capital expenditures for 1994 are currently estimated to approximate $230 million. As in recent years, the 1994 expenditures will be primarily associated with new product and operations improvement programs. The future level of capital expenditures will depend on business conditions. PATENTS AND TRADEMARKS John Deere owns a significant number of patents and trademarks which have been obtained over a period of years. The Company believes that, in the aggregate, the rights under these patents and licenses are generally important to its operations, but does not consider that any patent or license or group of them is of material importance in relation to John Deere's business. MARKETING In the United States and Canada, the Equipment Operations distribute equipment and service parts through six agricultural equipment sales branches, one industrial equipment sales and administration office and one lawn and grounds care equipment sales and administration office (collectively called sales branches). In addition, the Equipment Operations operate a centralized parts distribution warehouse in coordination with several regional parts depots in the United States and Canada. The sales branches in the United States and Canada market John Deere products to approximately 3,250 retail dealers, all of which are independently owned except for one retail store owned and operated by the Company. Of these dealers, approximately 1,550 sell agricultural equipment, 382 sell industrial equipment, and 26 sell both agricultural and industrial equipment. Smaller industrial equipment is sold by nearly all of the industrial equipment dealers. Larger industrial equipment, forestry equipment and a line of light industrial equipment are sold by most of them. Lawn and grounds care equipment is sold by most John Deere agricultural equipment dealers, a few industrial equipment dealers, and about 1,300 lawn and grounds care equipment dealers, many of whom also handle competitive brands and dissimilar lines of products. Outside North America, John Deere agricultural equipment is sold to distributors and dealers for resale in over 110 countries by sales branches located in six European countries, South Africa, Argentina and Australia, by export sales branches in Europe and the United States, and by associated companies in Mexico and Brazil. Lawn and grounds care equipment sales overseas occur primarily in Europe and Australia. Outside North America, industrial equipment is sold primarily by an export sales branch located in the United States. WHOLESALE FINANCING The Equipment Operations provide wholesale financing to dealers in the United States for extended periods, to enable dealers to carry representative inventories of equipment and to encourage the purchase of goods by dealers in advance of seasonal retail demand. Down payments are not required, and interest is not charged for a substantial part of the period for which the inventories are financed. A security interest is retained in dealers' inventories, and periodic physical checks are made of dealers' inventories. Generally, terms to dealers require payments as the equipment which secures the indebtedness is sold to retail customers. Variable market rates of interest are charged on balances outstanding after certain interest-free periods, which currently are 6 to 9 months for agricultural tractors, 6 months for industrial equipment, and from 6 to 24 months for most other equipment. Financing is also provided to dealers on used equipment accepted in trade, on repossessed equipment, and on approved equipment from other manufacturers. A security interest is obtained in such equipment. Equipment dealer defaults incurred in recent years by John Deere have not been significant. In Canada, John Deere products (other than service parts and lawn and grounds care equipment) in the possession of dealers are inventories of the Equipment Operations that are consigned to the dealers. Dealers are required to make deposits on consigned equipment remaining unsold after specified periods. Sales to overseas dealers are made by the Equipment Operations' overseas and export sales branches and are, for the most part, financed by John Deere in a manner similar to that provided for sales to dealers in the United States and Canada, although maturities tend to be shorter and a security interest is not always retained in the equipment sold. Receivables from dealers, which largely represent dealer inventories, were $2.8 billion at October 31, 1993 compared with $2.9 billion at October 31, 1992 and $3.0 billion at October 31, 1991. At those dates, the ratios of worldwide net dealer receivables to fiscal year net sales were 43 percent, 51 percent and 51 percent, respectively. The highest month-end balance of such receivables during each of the past two fiscal years was $3.1 billion at April 30, 1993 and $3.3 billion at April 30, 1992. FINANCIAL SERVICES CREDIT OPERATIONS UNITED STATES AND CANADA. In the United States and Canada, the Company's credit subsidiaries finance retail sales of John Deere agricultural, industrial and lawn and grounds care equipment, used equipment accepted by dealers in trade, and a significant amount of equipment of other manufacturers. John Deere retail installment loan (and some sale) contracts (collectively called retail notes) are acquired by the sales branches through John Deere retail dealers. Criteria for acceptance of retail notes are agreed upon between the sales branches and the Company's credit subsidiaries in the United States and Canada, John Deere Capital Corporation (Capital Corporation) and John Deere Finance Limited, (collectively referred to as Credit Companies). A subsidiary of the Capital Corporation leases John Deere agricultural, industrial and lawn and grounds care equipment to United States retail customers. The credit subsidiaries also finance recreational products, primarily recreational vehicle and recreational marine product retail notes acquired from independent dealers of that equipment. The United States credit subsidiary also finances and services unsecured revolving charge accounts acquired from retail merchants in the agricultural, lawn and grounds care and marine retail markets and, additionally, provides wholesale financing for recreational vehicles and John Deere engine inventories held by dealers of those products. The credit subsidiaries intend to continue to seek additional volumes and types of non-Deere financing with the objective of broadening their base of business and increasing their autonomy. All of the retail notes acquired by the sales branches have been immediately sold by them to the Credit Companies. The Equipment Operations have been the Credit Companies' major source of business, and the Credit Companies have been the sole vehicles for retail financing by the Equipment Operations. In many cases, retail purchasers of John Deere products finance their purchases outside the John Deere organization. The Credit Companies' terms for financing equipment retail sales (other than smaller items purchased through unsecured revolving charge accounts) provide for retention of a security interest in the equipment financed. The Credit Companies' guidelines for minimum down payments, which vary with the types of equipment and repayment provisions, are generally not less than 20 percent on agricultural and industrial equipment, 10 percent on lawn and grounds care equipment used for personal use and 20 percent for recreational vehicles and marine products. Finance charges are sometimes waived for specified periods or reduced on certain products sold or leased in advance of the season of use or in other sales promotions. At the time retail notes are accepted, the Equipment Operations compensate the Credit Companies in an amount permitting them to earn approximately the normal net finance charge on the retail notes or leases for periods during which finance charges are waived or reduced. The cost is accounted for as a deduction in arriving at net sales by the Equipment Operations. Retail leases are offered to equipment users in the United States by John Deere retail dealers on behalf of the Capital Corporation. A small number of leases executed between dealers and units of local government are subsequently assigned to the sales branches, and are in turn offered to and accepted by the Capital Corporation. Leases are usually written for periods of one to six years, and in some cases contain an option permitting the customer to purchase the equipment at the end of the lease term. Retail leases are also offered in a generally similar manner to customers in Canada through a Canadian subsidiary. The Company has expressed an intention of conducting its business with the Capital Corporation on such terms that the Capital Corporation's consolidated ratio of earnings before fixed charges to fixed charges for each fiscal quarter will not be less than 1.05 to 1. For 1993, the consolidated ratio of the Capital Corporation was 1.99 to 1 (excluding the effect of the accounting changes). This arrangement is not intended to make the Company responsible for payment of the obligations of the Capital Corporation. Additional information on the Credit Companies appears under the caption "Credit Operations" on pages 30 and 31. OVERSEAS. Retail sales and financing outside of the United States and Canada are affected by a diversity of customs and regulations. The Equipment Operations retain only a minor part of the obligations arising from retail sales of their products overseas. INSURANCE AND HEALTH CARE The Company's insurance subsidiaries consist of John Deere Insurance Group, Inc. and its subsidiaries in the United States, and John Deere Insurance Company of Canada. The Insurance Group is made up of a Property/Casualty Division and a Life Division. The Property/Casualty Division insures over 4,300 dealership organizations in the United States. This program provides commercial insurance for agricultural/ industrial equipment, auto, recreational vehicle and boat dealerships. In addition, the Property/Casualty Division insures long haul trucking operations and currently insures approximately 13,000 trucks. Other specialty insurance programs include insurance on equipment utilized in forestry, construction and agricultural operations. The Group's involvement in reinsurance takes the form of a long-term business relationship with Re Capital Reinsurance Corporation as well as the ownership of approximately 44% of the outstanding shares of Re Capital Corporation, its parent company. The Life Division had nearly $6 billion of life insurance in force at October 31, 1993. Marketing efforts are focused on providing life and health insurance coverages to various commercial markets and to individuals, nationally. In 1985, the Company formed John Deere Health Care, Inc. to more fully utilize the Company's expertise in the field of health care, which was developed from efforts to control its own health care costs. John Deere Health Care, Inc. currently provides health management programs and related administrative services, either directly or through its health maintenance organization subsidiaries. Heritage National Healthplan and John Deere Family Healthplan, for companies located in Illinois, Iowa, Wisconsin and Tennessee. At October 31, 1993, 234,931 individuals were enrolled in these programs, of which 69,352 were John Deere employees, retirees and their dependents. For additional financial information on insurance and health care operations, see the material under the caption "Insurance and Health Care Operations" on pages 31 and 32. ENVIRONMENTAL MATTERS In 1990, certain Clean Air Act Amendments were adopted by Congress which require the Environmental Protection Agency (the "EPA") to study emissions from off-road engines and equipment, including virtually all of the equipment manufactured by the Company. If the EPA determines such emissions contribute to air quality problems, the EPA is required to promulgate regulations containing standards applicable to such emissions. The EPA may promulgate such regulations sometime during 1994. Although at this time management cannot assess the impact that such regulations (if promulgated) would have upon the Company, management does not believe that it is likely to be material. The Company has been designated a potentially responsible party (PRP), in conjunction with other parties, in certain government actions associated with hazardous waste sites. As a PRP, the Company has been and will be required to pay a portion of the costs of evaluation and cleanup of these sites. Management does not expect that these matters will have a material adverse effect on the consolidated financial position or operating results of the Company. EMPLOYEES At October 31, 1993, John Deere had 33,070 employees, including 24,942 employees in the United States and Canada. Unions are certified as bargaining agents for approximately 95 percent of John Deere's United States employees. Most of the Company's United States production and maintenance employees are covered by a contract with the United Automobile Workers with an expiration date of October 1, 1994. The majority of employees at John Deere facilities overseas are also represented by unions. EXECUTIVE OFFICERS OF THE REGISTRANT Following are the names and ages of the executive officers of the Company, their positions with the Company and summaries of their backgrounds and business experience. All executive officers are elected or appointed by the Board of Directors and hold office until the annual meeting of the Board of Directors following the annual meeting of stockholders in each year. NAME, AGE AND OFFICE (AT DECEMBER 31, PRINCIPAL OCCUPATION DURING LAST 1993), AND YEAR ELECTED TO OFFICE FIVE YEARS OTHER THAN OFFICE OF THE COMPANY CURRENTLY HELD Hans W. Becherer, 58, Chairman, 1990 1990 and prior, President David H. Stowe, Jr., 57, President, 1990 1990 and prior, Executive Vice President Bill C. Harpole, 59, 1990 and prior, Executive Vice President, 1990 Senior Vice President Eugene L. Schotanus, 56, 1990 and prior, Executive Vice President, 1990 Senior Vice President Joseph W. England, 53, - Senior Vice President, 1981 J. Michael Frank, 55, 1989 and prior, Senior Vice President, 1989 Vice President Bernard L. Hardiek, 53 1990 and prior, Senior Vice President, 1990 Vice President John K. Lawson, 53, 1992 and prior, Senior Vice President, 1992 Vice President Michael S. Plunkett, 56, - Senior Vice President, 1983 Pierre E. Leroy, 45, - Vice President and Treasurer, 1987 Frank S. Cottrell, 51, 1991-1993, Secretary and Vice President, Secretary and General Counsel General Counsel, 1993 1987-1991, Secretary and Associate General Counsel - ------------------------------------------------------------------------------- ITEM 2.

ITEM 2. PROPERTIES. See "Manufacturing" in Item 1. The Equipment Operations also own and operate buildings housing seven sales branches, one centralized parts depot, five regional parts depots and several transfer houses and warehouses throughout the United States and Canada. These facilities contain approximately 4.8 million square feet of floor space. The Equipment Operations also own and operate buildings housing three sales branches, one centralized parts depot and three regional parts depots in Europe. These facilities contain approximately 850,000 square feet of floor space. The Deere Administrative Center and nearby office facilities for its insurance and health care activities, all of which are owned by John Deere, together contain about 733,000 square feet of floor space. John Deere also leases office space in various locations. John Deere's obligations on these leases are not material. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Company is subject to various unresolved legal actions which arise in the normal course of its business, the most prevalent of which relate to product liability and retail credit matters. The Company and certain subsidiaries of the Capital Corporation are currently involved in legal actions relating to alleged violations of certain technical provisions of Texas consumer credit statutes in connection with John Deere Company's financing of the retail purchase of recreational vehicles and boats in that state. These actions include: a class action brought by Russell Durrett individually and on behalf of others against John Deere Company (filed in state court on February 19, 1992 and removed on February 26, 1992 to the United States District Court for the Northern District of Texas, Dallas Division), which case was certified as a class action by the court on November 6, 1992; and a class action titled DEERE CREDIT, INC. V. SHIRLEY Y. MORGAN, ET AL., originally filed on February 20 1992 and certified in the 281st Judicial District Court of Harris County, Texas, on October 12, 1993 for all persons who opt out of the federal class action. The Company and the Capital Corporation subsidiaries believe that they have substantial defenses and intend to defend the actions vigorously. Although it is not possible to predict the outcome of these unresolved legal actions and the amounts of claimed damages and penalties are large, the Company believes that these unresolved legal actions will not have a material adverse effect on the Company's consolidated financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is listed on the New York Stock Exchange, the Chicago Stock Exchange and the Frankfurt, Germany Stock Exchange. See the information concerning quoted prices of the Company's common stock and the number of stockholders in the second table and the third paragraph, and the data on dividends declared and paid per share in the first table, under the caption "Supplemental 1993 and 1992 Quarterly Information (Unaudited)" on page 47. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA FINANCIAL SUMMARY - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See the information under the caption "Management's Discussion and Analysis" on pages 24-35. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See the consolidated financial statements and notes thereto and supplementary data on pages 18-47 . ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information regarding directors in the proxy statement dated January 14, 1994 (the "proxy statement"), under the captions "Election of Directors" and "Directors Continuing in Office" is incorporated herein by reference. Information regarding executive officers is presented in Item 1 of this report under the caption "Executive officers of the registrant". ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information in the proxy statement under the captions "Option/SAR Grants in Last Fiscal Year", "Summary Compensation Table" and "Aggregate Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values" is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. The information on the security ownership of a certain beneficial owner contained in the proxy statement under the caption "Principal Holders of Voting Securities" is incorporated by reference. (b) SECURITY OWNERSHIP OF MANAGEMENT. The information on shares of common stock of the Company beneficially owned by, and under option to (i) each director and (ii) the directors and officers as a group, contained in the proxy statement under the captions "Election of Directors", "Directors Continuing in Office" and "Aggregate Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values" is incorporated herein by reference. (c) CHANGE IN CONTROL. None. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information on certain relationships and related transactions contained in the proxy statement under "Certain Business Relationships" is incorporated herein by reference. PART IV - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) FINANCIAL STATEMENTS Page Statement of Consolidated Income for the years ended 18 October 31, 1993, 1992 and 1991 Consolidated Balance Sheet, October 31, 1993 and 1992 20 Statement of Consolidated Cash Flows for the years ended 22 October 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 36 (a)(2) SCHEDULES TO CONSOLIDATED FINANCIAL STATEMENTS Schedule I - Marketable Securities - Other Investments, 52 October 31, 1993 and 1992 Schedule VIII - Valuation and Qualifying Accounts, 54 for the years ended October 31, 1993, 1992 and 1991 Schedule IX - Short-Term Borrowings, for the years ended 56 October 31, 1993, 1992 and 1991 Schedule X - Supplementary Income Statement Information, 60 for the years ended October 31, 1993, 1992 and 1991 (a)(3) EXHIBITS SEE THE "INDEX TO EXHIBITS" ON PAGES 61-63 OF THIS REPORT. Certain instruments relating to long-term borrowings constituting less than 10% of registrant's total assets, are not filed as exhibits herewith pursuant to Item 601(b)4(iii)(A) of Regulation S-K. Registrant agrees to file copies of such instruments upon request of the Commission. (b) REPORTS ON FORM 8-K. Current report on Form 8-K dated August 24, 1993 (Items 5 and 7). FINANCIAL STATEMENTS AND SCHEDULES OMITTED The following schedules for the Company and consolidated subsidiaries are omitted because of the absence of the conditions under which they are required: II, III, IV, V, VI, VII, XI, XII, XIII, and XIV. - ------------------------------------------------------------------------------- FOOTNOTES 1. Derived from data published in 1989 by the U.S. Department of Commerce - "1987 Census of Agriculture,", Vol. I Part 51, pp. 104-5. 2. U.S. Department of Agriculture, "World Grain Situation and Outlook," Foreign Agricultural Service Circular, FG-11-93, November, 1993, p.37. 3. U.S. Department of Agriculture, "Agricultural Outlook," Economic Research Service, November 1993, p.60. DEERE & COMPANY STATEMENT OF CONSOLIDATED INCOME The "Consolidated" (Deere & Company and Consolidated Subsidiaries) data in this statement conform with the requirements of FASB Statement No. 94. In the supplemental consolidating data in this statement "Equipment Operations" (Deere & Company with Financial Services on the Equity Basis) reflect the basis of consolidation described on page 36 of the notes to the consolidated financial statements. The consolidated group data in the "Equipment Operations" income statement reflect the results of the agricultural equipment, industrial equipment and lawn and grounds care equipment operations. The supplemental "Financial Services" consolidating data in this statement include Deere & Company's credit, insurance and health care subsidiaries. Transactions between the "Equipment Operations" and "Financial Services" have been eliminated to arrive at the "Consolidated" data. The information on pages 24 through 47 is an integral part of this statement. DEERE & COMPANY CONSOLIDATED BALANCE SHEET - ------------------------------------------------------------------------------- The "Consolidated" (Deere & Company and Consolidated Subsidiaries) data in this statement conform with the requirments of FASB Statement No.94. In the supplemental consolidating data in this statement "Equipment Operations" (Deere & Company with Financial Services on the Equity Bases) reflect the basis of consolidation described on page 36 of the notes to the consolidated financial statements. The supplemental "Financial Services" consolidating data in this statement include Deere & Company's credit, insurance and health care subsidiaries. Transactions between the "Equipment Operations" and "Financial Services" have been eliminated to arrive at the "Consolidated" data. The information on pages 24 through 47 is an integral part of this statement. - -------------------------------------------------------------------------------- DEERE & COMPANY STATEMENT OF CONSOLIDATED CASH FLOWS The "Consolidated" (Deere & Company and Consolidated Subsidiaries) data in this statement conform with the requirements of FASB Statement No. 94. In the supplemental consolidating data in this statement "Equipment Operations" (Deere & Company with Financial Services on the Equity Basis) reflect the basis of consolidation described on page 36 of the notes to the consolidated financial statements. The supplemental "Financial Services" consolidating data in this statement include Deere & Company's credit, insurance and health care subsidiaries. Transactions between the "Equipment Operations" and "Financial Services" have been eliminated to arrive at the "Consolidated" data. The information on pages 24 through 47 is an integral part of this statement. MANAGEMENT'S DISCUSSION AND ANALYSIS - ------------------------------------------------------------------------------- RESULTS OF OPERATIONS FOR THE YEARS ENDED OCTOBER 31, 1993, 1992 AND 1991 (UNAUDITED) - ------------------------------------------------------------------------------- BUSINESS AND SEGMENT DESCRIPTION The company's operations are categorized into five business segments described below. The company's worldwide agricultural equipment segment manufactures and distributes a full range of equipment used in commercial farming - including tractors; tillage, soil preparation, planting and harvesting machinery; and crop handling equipment. The company's worldwide industrial equipment segment manufactures and distributes a broad range of machines used in construction, earthmoving and forestry - including backhoe loaders; crawler dozers and loaders; four-wheel-drive loaders; scrapers; motor graders; excavators; and log skidders. This segment also includes the manufacture and distribution of engines and drivetrain components for the original equipment manufacturer (OEM) market. The company's worldwide lawn and grounds care equipment segment manufactures and distributes equipment for commercial and residential uses - including small tractors for lawn, garden and utility purposes; riding and walk-behind mowers; golf course equipment; utility transport vehicles; snowblowers; and other outdoor power products. The products produced by the equipment segments are marketed primarily through independent retail dealer networks. The company's credit segment, which operates in the United States and Canada, purchases and finances retail notes from John Deere's equipment sales branches in the United States and Canada. The notes are acquired by the sales branches through John Deere retail dealers and originate in connection with retail sales by dealers of new John Deere equipment and used equipment. The credit segment also purchases and finances retail notes unrelated to John Deere equipment, representing primarily recreational vehicle and recreational marine product notes acquired from independent dealers of that equipment (recreational product retail notes). The credit subsidiaries also lease John Deere equipment to retail customers, finance and service unsecured revolving charge accounts acquired from merchants in the agricultural, lawn and grounds care and marine retail markets, and provide wholesale financing for recreational vehicles and John Deere engine inventories held by dealers of those products. The company's insurance and health care segment issues policies in the United States and Canada primarily for: a general line of property and casualty insurance to John Deere and non-Deere dealers and to the general public; group life and group accident and health insurance for employees of participating John Deere dealers; group life and group accident and health insurance for employees of the company; life and annuity products to the general public and credit physical damage insurance in connection with certain retail sales of John Deere products financed by the credit subsidiaries. This segment also provides health management programs and related administrative services in the United States to corporate customers and employees of Deere & Company. Deere & Company's consolidated financial statements result from consolidation of the company's agricultural equipment, industrial equipment and lawn and grounds care equipment businesses with its Financial Services businesses (credit, insurance and health care). The consolidation procedure is explained on page 36 in the notes to the consolidated financial statements. The notes explain how the terms "Equipment Operations", "Financial Services" and "Consolidated" are used in this report to help readers understand the data presented. These terms are used in Management's Discussion and Analysis for clarification or emphasis. Net sales of service parts and accessories, which are included in the previous totals, amounted to $1,358 million in 1993, $1,260 million in 1992 and $1,243 million in 1991. 1993 COMPARED WITH 1992 (UNAUDITED) - ------------------------------------------------------------------------------- MARKET CONDITIONS North American agricultural economic conditions were generally more favorable than in 1992. Although flooding and excessively wet conditions in certain areas of the Midwest and drought conditions in parts of the Southeast resulted in an estimated 31 percent decrease in corn production and a 16 percent decline in soybean production in 1993, United States farm cash income is expected to achieve a record level in 1993. The lower production caused grain prices to rise above 1992 levels. Livestock producers enjoyed favorable prices and profit margins during 1993 and farmers boosted their cash flow by selling inventories accumulated from record corn and soybean yields in 1992. Additionally, direct government payments to farmers are expected to increase in 1993, aiding farmers most heavily impacted by this year's flooding. Uncertainties over the passage of a new investment tax credit were resolved in 1993 as the anticipated tax credit was not included in the final tax legislation. Consequently, many United States farmers who had delayed making purchases in 1992 bought equipment this year. Sales in Canada were boosted by a special 13-month investment tax credit in effect from December 1992 to December 1993. As a result of these developments, North American retail sales of John Deere agricultural equipment were considerably higher in 1993 compared with last year. The North American general economy continued its slow expansion in 1993. In the United States, housing starts increased about five percent during the year with second-half strength overcoming a very sluggish first half. Real public construction was up slightly from the previous year's level while nonresidential construction was flat. However, the cumulative effects of the rebound in economic activity were felt in 1993, as housing starts were up more than 25 percent from their 1991 level and real public construction was nine percent larger. Consequently, North American retail sales of industrial and construction machinery for both the industry and John Deere rose significantly in 1993. Consumer spending for durable goods rose briskly in 1993, and North American retail sales of John Deere lawn and grounds care equipment increased significantly. Sales were also supported by favorable moisture conditions over most areas throughout the prime selling season. However, dry conditions did emerge in portions of the Southeast and Northeast which impeded some late season buying activity. Industry retail sales of agricultural equipment in overseas markets in general remained relatively weak during 1993. However, overseas retail sales of John Deere agricultural equipment were higher in 1993 than in 1992, reflecting good acceptance of the company's new tractors and combines. Despite recessionary conditions prevailing in most European markets and in Japan, overseas retail sales of John Deere lawn and grounds care equipment continued to expand in 1993. Overseas industrial and construction equipment markets were relatively flat in 1993 compared with 1992. Acquisitions of receivables and leases by the company's credit subsidiaries were somewhat higher in 1993 compared with last year due primarily to growth in revolving charge accounts, leases and wholesale receivables. Although retail sales of John Deere equipment were higher in 1993, acquisitions of John Deere retail notes were down slightly compared with last year reflecting a higher level of cash purchases by John Deere customers and a more competitive financing environment, particularly during the latter part of 1993. Acquisitions of recreational product retail notes were significantly lower in 1993 due mainly to a very competitive financing market. Although relatively soft market conditions continued during 1993 in the property/casualty insurance industry, John Deere's insurance premium volumes increased in 1993 over 1992. Health care premium volumes were considerably higher in 1993 reflecting continued growth in the company's health care operations. OPERATING RESULTS Deere & Company's operating results before the effects of special items (restructuring charges, changes in accounting standards and tax law changes) improved significantly in 1993 as a result of substantial improvement in the company's North American equipment operations and continued strong performance of the Financial Services subsidiaries. Worldwide income in 1993 was $286 million or $3.70 per share before the effects of the special items, compared with net income of $37 million or $.49 per share in 1992. However, 1993 reported results were affected by the special items described below. After the effects of the restructuring charges, the incremental expense from the accounting changes and the tax rate change, income in 1993 was $184 million or $2.39 per share. The company incurred a worldwide net loss in 1993 of $921 million or $11.91 per share after all of the special items including the cumulative effect of the accounting changes. During the second quarter of 1993, the company announced and initiated plans to downsize and rationalize its European operations. This resulted in a second quarter provision for restructuring charges of $80 million after income taxes or $1.03 per share ($107 million before income taxes), representing costs of employment reductions to be implemented during 1993 and the next few years. The resulting restructuring should improve future overseas operating results. In the fourth quarter of 1993, effective November 1, 1992, the company adopted Financial Accounting Standards Board (FASB) Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and FASB Statement No. 112, Employers' Accounting for Postemployment Benefits. The aggregate cumulative effect of adopting the new standards as of November 1, 1992, which relate mainly to retiree health care and life insurance benefits, was a non-cash charge of $1,105 million after income taxes or $14.30 per share ($1,728 million before income taxes). Additionally, the adoption of these standards resulted in an incremental non-cash after-tax increase in 1993 postretirement and postemployment benefits expense of $38 million or $.49 per share ($60 million before income taxes). The incremental postretirement and postemployment benefits expense relating to the Financial Services subsidiaries was immaterial. Additional information is presented on pages 36, 37 and 47 of the notes to the consolidated financial statements. The Omnibus Budget Reconciliation Act of 1993, which enacted an increase in the United States federal statutory income tax rate from 34 percent to 35 percent effective January 1, 1993, was signed into law during the fourth quarter of 1993. In accordance with FASB Statement No. 109, Accounting for Income Taxes, income taxes relating to previously reported United States taxable income were recalculated and the United States deferred income tax assets and liabilities as of the enactment date were revalued during the fourth quarter of 1993 using the new tax rate of 35 percent. This resulted in a credit of $16 million or $.21 per share to the provision for income taxes. This tax rate change had an immaterial effect on the Financial Services subsidiaries. Additional information is presented on page 39 of the notes to the consolidated financial statements. The company's total worldwide net sales and revenues, which include net sales of equipment and revenues from the credit, insurance and health care operations, increased 11 percent to $7,754 million in 1993 compared with net sales and revenues of $6,961 million in 1992. Worldwide net sales of equipment to dealers were $6,479 million in 1993, an increase of 13 percent from sales of $5,723 million last year. The physical volume of the company's worldwide sales to dealers increased approximately nine percent in 1993. Worldwide production tonnage of all John Deere products in 1993 was 11 percent higher than last year. Finance and interest income decreased nine percent to $563 million in 1993 compared with $615 million last year, while insurance and health care premiums increased 12 percent to $554 million in the current year compared with $496 million in 1992. Worldwide net sales of John Deere agricultural equipment increased eight percent to $4,078 million in 1993 from last year's volume of $3,759 million. Worldwide industrial equipment net sales of $1,348 million increased 26 percent from $1,068 million last year. Net sales of lawn and grounds care equipment totaled $1,053 million in 1993 compared with $896 million last year, representing an increase of 18 percent. Net sales to dealers of John Deere equipment in the United States and Canada increased 19 percent to $4,934 million compared with $4,147 million in 1992. Net sales of equipment overseas totaled $1,545 million, a decrease of two percent compared with last year's net sales of $1,576 million. Excluding the effects of price increases and changes in currency relationships, the physical volume of overseas sales was approximately one percent higher in 1993 than in The company's worldwide Equipment Operations, which exclude income from the credit, insurance and health care operations, had income of $114 million in 1993 before the effects of the previously mentioned special items, compared with a net loss of $107 million in 1992. Including the restructuring charges, the incremental effect of the accounting changes and the tax rate change, the Equipment Operations' income was $13 million in 1993. The Equipment Operations incurred a net loss of $1,085 million in 1993 after all of the special items including the cumulative effect of the accounting changes. Income of the company's credit subsidiaries before the cumulative effect of the accounting changes totaled $122 million in 1993, while net income after the accounting changes was $118 million compared with last year's net income of $106 million. Income from insurance and health care operations before the cumulative effect of the accounting changes was $42 million in 1993, while net income after the accounting changes totaled $39 million compared with net income of $32 million last year. Additional information is presented in the discussion of "Credit Operations" and "Insurance and Health Care Operations" on pages 30 through 32. The improved operating results of the Equipment Operations in 1993 were attributable to the company's North American equipment operations. Sales and production volumes were higher this year in response to increased retail demand, and price realization improved in all of the company's North American equipment businesses compared with 1992 as sales incentive cost levels were significantly lower. Additionally, productivity continued to improve during 1993. North American sales increased 19 percent and production tonnage was 15 percent higher in 1993 than last year. However, the overseas equipment operations incurred a substantially higher net loss this year, primarily due to lower production volumes, higher cost levels and unfavorable changes in European currency relationships. Reflecting the effects of the improved North American operations, the worldwide ratio of cost of goods sold to net sales decreased to 83.1 percent in 1993 compared with 85.7 percent last year. The cost ratio of the overseas operations was significantly higher this year. The aggregate of the Equipment Operations' research and development and selling, administrative and general expenses was $4 million lower in 1993 compared with last year, primarily due to lower employment levels. After-tax results of the Equipment Operations in 1993 benefited by $33 million or $.43 per share from the reduction of inventories valued on a last-in, first-out (LIFO) basis compared to LIFO inventory benefits of $43 million or $.56 per share in 1992. Additional information is presented on page 42 of the notes to the consolidated financial statements. The 1993 income tax provision relating to the Equipment Operations, excluding the fourth quarter benefit from the United States tax rate change, was unfavorably affected by losses, including restructuring charges, recorded in taxing jurisdictions having low tax rates or where the company cannot currently record tax benefits, coupled with income realized in countries having higher income tax rates. In fiscal year 1993, the FASB issued Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, and Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. Neither Statement is expected to have a material effect on the company's net income or financial position. Additional information is presented in the "Summary of Significant Accounting Policies" on page 36. BUSINESS SEGMENT AND GEOGRAPHIC AREA RESULTS The following discussion of operating results by industry segment and geographic area relates to information beginning on page 34. Operating profit is defined as income before interest expense, foreign exchange gains and losses, income taxes and certain corporate expenses, except for the operating profit of the credit segment, which includes the effect of interest expense. Operating profit of each of the company's North American equipment operations was favorably affected by improved price realization, higher volumes and improved productivity compared with last year's results. Before the restructuring charges and the incremental expense of the accounting changes, operating profit of the worldwide agricultural equipment segment increased to $266 million in 1993 compared with $106 million in 1992. This improvement was caused primarily by an eight percent increase in worldwide agricultural equipment sales to dealers, a nine percent increase in production tonnage and a substantial decline in sales discounts and warranty costs as a percent of gross sales in 1993. Benefits from the reduction of LIFO inventories totaled $38 million this year compared with $45 million last year. Agricultural dealer receivables decreased $146 million in 1993. Including restructuring charges of $107 million and incremental expense of $36 million from the accounting changes, 1993 operating profit was $123 million. Operating profit of the North American agricultural equipment operations, excluding the incremental expense from accounting changes, was substantially higher in the current year compared with 1992 results. This resulted from a 14 percent increase in sales, a 15 percent increase in production tonnage, a significantly lower level of sales discounts and warranty costs and improved productivity. Additionally, North American agricultural dealer receivables decreased by $108 million during 1993 reflecting the strong retail demand for the company's products. Excluding the restructuring charges in 1993, the overseas agricultural equipment operations incurred a substantially larger operating loss in 1993 compared to 1992. Production was two percent lower than last year while the physical volume of overseas agricultural equipment sales to dealers increased approximately one percent in 1993. Low volumes, unfavorable changes in currency relationships and higher cost levels adversely affected the company's overseas performance during 1993. Overseas agricultural dealer receivables declined $38 million during 1993, mainly due to exchange rate fluctuations. The worldwide industrial equipment operations improved significantly in 1993, generating an operating profit of $36 million in 1993 before the incremental expense from the accounting changes, compared with a $71 million operating loss in 1992. In 1993, sales increased 26 percent, production tonnage increased 15 percent, sales discounts and warranty costs declined as a percent of gross sales and productivity improved. However, LIFO inventory benefits were $13 million this year compared with $20 million last year. Industrial dealer receivables increased by $41 million during 1993. This year's operating profit was $20 million including the incremental expense of $16 million from the accounting changes. The worldwide lawn and grounds care equipment operations had a substantially higher operating profit of $107 million in 1993 excluding the incremental expense from the accounting changes, compared with $42 million in 1992. Lawn and grounds care equipment sales to dealers increased 18 percent, production was up 13 percent, sales discounts and warranty costs were lower as a percent of gross sales in 1993 and efficiency improved this year. Lawn and grounds care dealer receivables were relatively unchanged from last year's level. Including the incremental expense of $8 million from the accounting changes, operating profit was $99 million in 1993. The combined operating profit of the credit, insurance and health care business segments increased to $247 million in 1993 from $202 million in 1992, as both segments generated higher earnings this year. Additional information on these businesses is presented in the discussion of "Credit Operations" and "Insurance and Health Care Operations" on pages 30 through 32. On a geographic basis, the United States and Canadian equipment operations had significantly higher operating profit of $432 million in 1993 before the incremental expense from the accounting changes, compared with $74 million last year. Sales to dealers increased 19 percent in 1993 and production tonnage increased 15 percent. Efficiency improved and sales discounts and warranty costs were relatively lower in all of the company's North American businesses this year. However, LIFO inventory benefits were $13 million this year compared with $65 million last year. North American dealer receivables were reduced by $75 million during 1993. This year's operating profit totaled $372 million including the incremental expense of $60 million from the accounting changes. Excluding restructuring charges, the overseas equipment operations incurred an operating loss of $23 million in 1993 compared with an operating profit of $3 million last year. Including restructuring charges of $107 million, the operating loss this year was $130 million. Sales to dealers and production tonnage were both two percent lower in 1993 while the physical volume of overseas net sales increased approximately one percent compared with 1992. As previously mentioned, 1993 results were adversely affected by low volumes, unfavorable changes in currency relationships and higher cost levels. However, benefits from the reduction of LIFO inventories totaled $38 million in 1993 compared with no benefit last year. Overseas dealer receivables decreased $33 million during the year, mainly due to exchange rate fluctuations. OUTLOOK As previously discussed, United States farm income is expected to achieve record levels in 1993 despite weather related production shortfalls of corn and soybeans. Due to the lower 1993 production and the resulting reduction in carryover stocks, a substantial increase in planted and harvested acreage of corn and soybeans is expected in 1994. While farm income will likely be lower in 1994 due mainly to lower corn and soybean marketings related to the 1993 production shortfall, next year's farm income should still be one of the highest in history. These developments, if coupled with more normal weather patterns and continuing lower levels of interest rates, are currently expected to result in 1994 North American industry retail sales of agricultural equipment being near the levels achieved in 1993. European industry retail sales of agricultural equipment are expected to continue the downward trend of recent years. The European agricultural industry remains in the midst of fundamental change as revisions to government agricultural policies, GATT negotiations and the general economic environment will likely result in lower farm incomes and crop production in 1994. The North American general economy has recovered very slowly from the 1990-91 recession, and 1994 is forecasted to be another year of moderate growth. While factors including tax increases, governmental efforts to reduce deficits, downsizing of the defense industry and recessionary conditions among many of the company's trading partners will limit general growth prospects, the lowest mortgage interest rates since the 1970s should further stimulate housing starts next year. Additionally, public construction is expected to experience moderate real growth in 1994, particularly in street, highway, bridge and sewer projects. Such development should favorably affect demand for industrial and construction equipment. Lawn and grounds care retail sales should also benefit from general economic growth and higher housing starts. Initial 1994 worldwide production schedules, in tons, are about nine percent higher than actual 1993 output. Worldwide agricultural equipment production is scheduled to be up approximately five percent from this year when dealer receivables were reduced by $146 million. Lawn and grounds care equipment production is scheduled to increase about 10 percent, and initial industrial equipment production schedules are about 17 percent higher than 1993 output. Accordingly, results of the company's Equipment Operations are currently expected to improve significantly in 1994. First quarter 1994 production tonnage is expected to be about 26 percent higher than in last year's depressed initial quarter when several of the company's factories were shut down for one- to two-week periods in addition to the normal holiday shutdowns. 1992 COMPARED WITH 1991 (UNAUDITED) MARKET CONDITIONS North American agricultural economic conditions in 1992 were generally less favorable than in 1991. Agricultural commodity prices were at favorable levels early in the fiscal year, but declined as 1992 production prospects for North American crops improved. North American grain production in 1992 increased about 16 percent over 1991 production, and grain inventories rose for most crops as commodity exports were essentially unchanged from 1991. Livestock prices reflected a similar declining trend due to increased production coupled with a sluggish general economy. Although the decline in grain prices was more than offset by higher yields and higher government payments to farmers, causing both farm cash receipts and net cash income to increase in 1992, the downward trend in market prices along with weather scares, ranging from drought concerns to early frost, and uncertainty relating to general economic conditions caused farmers to remain cautious in making new equipment purchase decisions throughout 1992. As a result of these developments, North American retail sales of agricultural equipment for both the industry and John Deere declined in 1992 compared with 1991, as retail sales of new tractors and combines decreased significantly. While the United States general economy began to emerge from recession in 1992, the overall pace of the recovery was slow and erratic. Although housing starts increased approximately 20 percent compared with 1991, that level of improvement was much lower than normally experienced during the first year of an economic recovery. Non-residential construction declined slightly during the year, continuing the contraction that began in 1987. Public construction expenditures, however, increased somewhat in 1992, assisted by funds authorized by the 1991 Surface Transportation Act. Total construction spending increased slightly in 1992 and North American retail sales of industrial equipment for the industry and John Deere were relatively unchanged from 1991 levels. Consumer spending for durable goods in North America during 1992 declined from the level in 1991 as consumers remained very cautious due to the recessionary environment. North American retail sales of John Deere lawn and grounds care equipment in 1992 were comparable to the volume in 1991. Outside the United States and Canada, retail sales of John Deere agricultural equipment were lower in 1992 than 1991, due primarily to weakness in Western Europe where recessionary pressures and economic uncertainties affected farmers in the European Economic Community. Overseas retail sales of the company's lawn and grounds care products increased significantly in 1992, mainly due to sales of SABO, a European manufacturer acquired in the fourth quarter of 1991. Overseas demand for industrial equipment increased in 1992, but remained at a relatively low level. Acquisitions of receivables and leases by the company's credit operations were lower in 1992 compared with 1991. This resulted mainly from lower retail sales of John Deere agricultural equipment as well as a more competitive financing environment for recreational products. Soft market conditions continued throughout 1992 in the property/casualty insurance industry. Large catastrophic losses also affected industry results in 1992. However, John Deere's insurance and health care premium volumes increased in 1992 compared with 1991. OPERATING RESULTS Deere & Company's operating results for 1992 reflected the effects of lower production and sales volumes in response to soft market conditions. Although price realization improved in 1992, sales incentive costs remained relatively high due to very competitive markets. The company's total worldwide net sales and revenues declined one percent to $6,961 million in 1992 compared with net sales and revenues of $7,055 million in 1991. Worldwide net sales of equipment to dealers were $5,723 million in 1992, a decrease of two percent from sales of $5,848 million in 1991. The physical volume of the company's worldwide sales to dealers decreased approximately eight percent in 1992. Worldwide production tonnage of all John Deere products in 1992 was seven percent lower than in 1991. Finance and interest income decreased six percent to $615 million in 1992 compared with $654 million in 1991, while insurance and health care premiums increased 12 percent to $496 million in 1992 compared with $444 million in 1991. Worldwide net sales of John Deere agricultural equipment decreased seven percent to $3,759 million in 1992 from a volume of $4,054 million in 1991. Worldwide industrial equipment net sales of $1,068 million increased five percent from $1,014 million in 1991. Net sales of lawn and grounds care equipment totaled $896 million in 1992 compared with $780 million in 1991, representing an increase of 15 percent resulting mainly from SABO sales. Net sales to dealers of John Deere equipment in the United States and Canada decreased five percent to $4,147 million compared with $4,349 million in 1991. Net sales of equipment overseas totaled $1,576 million, an increase of five percent compared with net sales of $1,499 million in 1991. Excluding the effects of price increases and changes in currency relationships, the physical volume of overseas sales was approximately one percent lower in 1992 than in 1991. Worldwide net income was $37 million or $.49 per share in 1992 compared with a net loss of $20 million or $.27 per share in 1991. Results in 1991 included a fourth quarter after-tax restructuring charge of $120 million or $1.58 per share, described below. The company's worldwide Equipment Operations, which exclude income from the credit, insurance and health care operations, incurred a net loss of $107 million in 1992 compared with a net loss of $132 million in 1991. Excluding the restructuring charge, 1991 worldwide net income would have been $100 million, and the Equipment Operations' net loss would have been $12 million. Net income of the company's credit subsidiaries totaled $106 million in 1992 compared with $84 million in 1991. Net income from insurance and health care operations was $32 million in 1992 compared with $28 million in 1991. Additional information is presented in the discussion of "Credit Operations" and "Insurance and Health Care Operations" on pages 30 through 32. Results of the Equipment Operations in both 1992 and 1991 were affected by low production and sales volumes in response to weak retail demand, particularly in 1992. Although sales incentive costs moderated in 1992, they remained relatively high and continued to adversely affect operating results. Reflecting the effects of lower production volumes, higher manufacturing cost levels, and a lower benefit in 1992 from the reduction of inventories valued on a last-in, first-out (LIFO) basis, the worldwide ratio of cost of goods sold to net sales increased 85.7 percent in 1992 compared with 83.9 percent in 1991. Worldwide net income and results of the Equipment Operations in 1992 and 1991 were affected by certain non-recurring or unusual items. After-tax results in 1992 and 1991 benefited by $43 million or $.56 per share and $84 million or $1.11 per share, respectively, from the reduction of LIFO inventories. During the fourth quarter of 1991, the company initiated plans to reduce costs and rationalize operations, both in North America and overseas. This resulted in a fourth quarter after-tax provision for restructuring costs of $120 million, representing costs of employment reductions and the closure of a ductile iron foundry. Additional information is presented on page 37 of the notes to the consolidated financial statements. BUSINESS SEGMENT AND GEOGRAPHIC AREA RESULTS The following discussion of operating results by industry segment and geographic area relates to information beginning on page 34. Operating profit of the worldwide agricultural equipment segment declined in 1992 to $106 million compared with $123 million in 1991. Excluding a restructuring charge of $128 million, 1991 operating profit would have been $251 million. This significant decline was caused primarily by a seven percent decrease in worldwide agricultural equipment sales to dealers and a 13 percent decrease in production tonnage. However, sales discounts and warranty costs, as a percent of gross sales, declined in 1992. Pretax benefits from the reduction of LIFO inventories totaled $45 million in 1992 compared with $102 million in 1991. Agricultural dealer receivables increased $69 million in 1992. Operating profit of the North American agricultural equipment operations was substantially lower in 1992 compared with 1991 results excluding restructuring charges. This resulted from a 15 percent decrease in production tonnage, a 10 percent decline in sales and a lower LIFO inventory benefit. However, sales discounts and warranty costs were relatively lower in 1992. North American agricultural dealer receivables increased by $34 million during 1992. The overseas agricultural equipment operations incurred an operating loss in 1992 compared with an operating profit in 1991 excluding restructuring charges. The physical volume of overseas agricultural equipment sales to dealers declined approximately seven percent in 1992 and production was eight percent lower than in 1991. Overseas agricultural dealer receivables increased $35 million during 1992. The worldwide industrial equipment operations incurred an operating loss of $71 million in 1992 compared with a $131 million loss in 1991. Last year's operating loss would have totaled $87 million excluding restructuring charges of $44 million. Production declined one percent in 1992, while sales increased five percent and sales discounts and warranty costs reflected significant improvement in 1992 from 1991 levels. Additionally, LIFO inventory benefits were $20 million in 1992 compared with $14 million in 1991. Industrial dealer receivables were reduced by $77 million during 1992. The worldwide lawn and grounds care equipment operations had an operating profit of $42 million in 1992 compared with $24 million in 1991, which included restructuring charges of $10 million. Lawn and grounds care equipment sales to dealers increased 15 percent, production was up 31 percent and sales discounts and warranty costs were lower in 1992. Results in 1992 benefited significantly from the operations of SABO. Excluding SABO production and sales for 1992, sales to dealers would have increased five percent and production would have increased 17 percent. Benefits from the reduction of LIFO inventories totaled $12 million last year while there was no benefit in 1992. Lawn and grounds care dealer receivables were relatively unchanged from the level in 1991. The combined operating profit of the credit, insurance and health care business segments increased to $202 million in 1992 from $164 million in 1991, primarily as a result of higher credit earnings. Additional information on these businesses is presented in the discussion of "Credit Operations" and "Insurance and Health Care Operations" on pages 30 through 32. On a geographic basis, the United States and Canadian equipment operations had an operating profit of $74 million in 1992 compared with a profit of $26 million in 1991. The operating profit in 1991 would have totaled $188 million excluding restructuring costs of $162 million. Sales to dealers declined five percent from 1991 and production tonnage decreased nine percent. Sales discounts and warranty costs were relatively lower in all of the company's businesses in 1992, but LIFO inventory benefits were $65 million in 1992 compared with $104 million in 1991. North American dealer receivables were reduced by $75 million during 1992. The overseas equipment operations had an operating profit of $3 million in 1992 compared with an operating loss of $10 million in 1991. However, restructuring charges of $20 million were incurred in 1991. Sales to dealers increased five percent and production tonnage was three percent lower in 1992. Additionally, benefits from the reduction of LIFO inventories totaled $24 million in 1991 compared with no benefit in 1992. As previously mentioned, 1992 results benefited significantly from the operations of SABO. The physical volume of overseas net sales declined approximately one percent compared with 1991. Overseas dealer receivables increased $64 million during 1992. CREDIT OPERATIONS Deere & Company's credit subsidiaries consist of John Deere Credit Company and its subsidiaries in the United States and John Deere Finance Limited in Canada. The credit operations bear all credit risk, net of recovery from withholdings from dealers, and perform all servicing and collection functions on retail notes and leases on John Deere products acquired by the credit subsidiaries from the Equipment Operations. The Equipment Operations receive compensation from the United States credit operations for originating retail notes and leases. The Equipment Operations are reimbursed by the credit operations for staff support and other administrative services at estimated cost, and for credit lines provided by Deere & Company based on utilization of the lines. The credit subsidiaries receive compensation from the Equipment Operations approximately equal to the normal net finance income on retail notes and leases for periods during which finance charges have been waived or reduced. Condensed combined financial information of the credit subsidiaries in millions of dollars follows: Total acquisitions of credit receivables and leases by the credit subsidiaries increased five percent during 1993 compared with acquisitions in 1992. The higher acquisitions this year resulted from an increased volume of John Deere leases, revolving charge accounts and wholesale receivables, which more than offset lower acquisitions of retail notes. During 1993, net retail notes acquired by the credit subsidiaries totaled $2,401 million, a three percent decrease compared with 1992 acquisitions of $2,470 million. Acquisitions of recreational product retail notes accounted for 10 percent of total note acquisitions in 1993 and 11 percent in 1992. Acquisitions of John Deere equipment notes were slightly lower in the current year due primarily to a higher level of cash purchases by John Deere customers and a more competitive agricultural financing environment. Acquisitions of recreational product retail notes were significantly lower in the current year, due mainly to a more competitive financing environment. The balance of revolving charge accounts financed at October 31, 1993 increased by $63 million compared with one year ago, while wholesale notes decreased by $2 million and operating leases increased by $34 million compared with October 31, 1992. The balance of net credit receivables and leases financed at October 31, 1993 totaled $3,758 million compared with $4,400 million at the end of 1992. This decrease resulted primarily from sales of retail notes during 1993 that generated net proceeds of $1,143 million. Additional information is presented on page 42. Net credit receivables and leases administered, which include receivables previously sold but still administered, amounted to $5,195 million at October 31, 1993 compared with $5,136 million at October 31, 1992. The net unpaid balance of retail notes previously sold was $1,394 million at October 31, 1993 compared with $688 million at October 31, 1992. Income of the credit operations, before the cumulative effect of adopting FASB Statement Nos. 106 and 112, was $122 million in 1993 compared with $106 million in 1992 and $84 million in 1991. On that same basis, the ratio of earnings before fixed charges to fixed charges was 1.97 to 1 in 1993, 1.74 to 1 in 1992 and 1.50 to 1 in 1991. Net income in the current year was significantly higher than in 1992 mainly because of higher securitization and servicing fee income from retail notes previously sold, lower credit losses, higher financing margins and increased gains from the sale of retail notes, which more than offset the effects of a lower volume of credit receivables and leases financed. Net income of the credit operations totaled $118 million in 1993 including the cumulative effect of the changes in accounting standards. Additional information on changes in accounting is presented on pages 36, 37 and 47 of the notes to the consolidated financial statements. Total revenues of the credit operations decreased two percent in 1993. The average balance of total net credit receivables and leases financed was seven percent lower in 1993 compared with last year, due primarily to the sale of receivables during 1993. Revenues have also been affected by the lower level of interest rates and correspondingly lower finance charges earned on the credit receivable and lease portfolio in 1993 compared with last year. These decreases in revenues were partially offset by securitization and servicing fee income from retail notes previously sold. Additionally, lower borrowing rates and a decrease in average borrowings this year resulted in a 12 percent decrease in interest expense in 1993 compared to 1992. Net income in 1992 was substantially higher than in 1991 mainly because of a higher average volume of receivables and leases financed and improved credit loss experience. Net income in 1992 also benefited from after-tax gains of $5.6 million from sales of retail notes. The average balance of total net receivables and leases financed was six percent higher in 1992 compared with 1991. However, total revenues of the credit operations decreased three percent in 1992 compared with 1991 as the average yield earned on the portfolio was lower in 1992. While revenues were affected by the lower level of interest rates and the correspondingly lower finance charges earned in 1992 compared with 1991, borrowing costs were also lower in 1992. Interest expense was down 16 percent despite the higher level of receivables and leases financed. Total credit receivable and lease amounts 60 days or more past-due were $16 million at October 31, 1993 compared with $23 million at October 31, 1992. These past-due amounts represented .34 percent of the face value of credit receivables and leases held at October 31, 1993 and .40 percent at October 31, 1992. The allowance for credit losses, which totaled $83 million at the end of 1993 and $89 million one year ago, represented 2.17 percent and 1.98 percent, respectively, of the balance of total net credit receivables and leases financed at October 31, 1993 and 1992. Deposits withheld from dealers and merchants, which are available for potential credit losses, amounted to $119 million at October 31, 1993. John Deere Capital Corporation (Capital Corporation) is a subsidiary of John Deere Credit Company. Deere & Company has expressed an intention of conducting business with the Capital Corporation on such terms that its ratio of earnings before fixed charges to fixed charges will not be less than 1.05 to 1 for each fiscal quarter. These arrangements are not intended to make Deere & Company responsible for the payment of obligations of this credit subsidiary. INSURANCE AND HEALTH CARE OPERATIONS Deere & Company's insurance subsidiaries consist of John Deere Insurance Group, Inc. and its subsidiaries in the United States, which provide life/health and property/casualty coverages to the general public nationwide, and John Deere Insurance Company of Canada. John Deere Health Care, Inc., directly or through its health maintenance organizations, provides administrative services and managed health care programs for Deere & Company and other companies located in Illinois, Iowa, Wisconsin and Tennessee. Condensed combined financial information of the insurance and health care operations in millions of dollars follows: Insurance premium revenue of $26 million in 1993, $27 million in 1992 and $30 million in 1991 and health care premium revenue of $118 million in 1993, $114 million in 1992 and $102 million in 1991 related to coverages provided to Deere & Company and its subsidiaries. Income of the insurance and health care operations, before the cumulative effect of adopting FASB Statement Nos. 106 and 112, totaled $42 million in 1993 compared with $32 million in 1992 and $28 million in 1991. The increase in 1993 net income resulted mainly from improved insurance underwriting income compared with last year which had higher loss experience, and higher health care income as a result of higher volumes and improved underwriting performance this year. Insurance and health care premiums increased 10 percent in 1993, while claims, policy benefits and other expenses increased six percent from last year. Net income of the insurance and health care operations totaled $39 million in 1993 including the cumulative effect of the changes in accounting standards. Additional information on changes in accounting is presented on pages 36, 37 and 47 of the notes to the consolidated financial statements. The increase in 1992 net income compared with 1991 resulted mainly from improved insurance income. Although underwriting income was lower, insurance earnings in 1992 benefited from higher investment income and realized capital gains on investments. Health care income increased in 1992 as a result of higher investment income. Insurance and health care premiums increased about 11 percent in 1992, while claims, policy benefits and other expenses also increased approximately 11 percent from 1991. CAPITAL RESOURCES AND LIQUIDITY (UNAUDITED) The discussion of capital resources and liquidity focuses on the balance sheet and statement of cash flows. The nature of the Company's Equipment Operations and Financial Services businesses is so different that most of the asset, liability and cash flow categories do not lend themselves to simple combination. Additionally, the fundamental differences between these businesses are reflected in different financial measurements commonly used by investors, rating agencies and financial analysts. In recognition of these differences and to provide clarity with respect to the analyses of the capital resources and liquidity of these different businesses, the following discussion has been organized to discuss separately, where appropriate, the company's Equipment Operations, Financial Services operations and the consolidated totals. EQUIPMENT OPERATIONS The company's equipment businesses are capital intensive and are subject to large seasonal variations in financing requirements for receivables from dealers and inventories. Accordingly, to the extent necessary, funds provided from operations are supplemented from external borrowing sources. Cash flows from operating activities were significantly higher in 1993 compared with 1992, mainly as a result of higher net income (excluding non-cash changes in accounting and non-cash restructuring charges accrued in 1993), a larger aggregate decrease in receivables and inventories this year and increases in accounts payable and accrued expenses compared with decreases in 1992. Cash flows from operating activities, which include dividends of $86 million received from the Financial Services subsidiaries, totaled $702 million in 1993. Proceeds from the issuance of additional common stock totaled $586 million during 1993. The aggregate amount of these cash flows was used primarily to fund a decrease in net borrowings of $504 million, an increase of $359 million in receivables from the Financial Services subsidiaries, additions to property and equipment of $197 million, the payment of dividends to stockholders of $153 million and a $31 million increase in cash and cash equivalents. Over the last three years, operating activities have provided an aggregate of $1,300 million in cash, which includes dividends of $273 million received from the Financial Services subsidiaries. Proceeds from the issuance of common stock were $590 million during this three-year period. The aggregate amount of these cash flows was used mainly to fund additions to property and equipment of $768 million, stockholders' dividends of $458 million, an increase in receivables from Financial Services subsidiaries of $436 million, acquisitions of businesses of $71 million, a decrease in net borrowings of $56 million and an increase in cash and cash equivalents of $46 million. Net dealer accounts and notes receivable result mainly from sales to dealers of equipment that is being carried in their inventories. Total dealer receivables decreased by $108 million during 1993. North American agricultural equipment dealer receivables decreased $108 million during the year, North American industrial equipment dealer receivables increased by $40 million during 1993, while North American lawn and grounds care equipment receivables declined by $7 million. Total overseas dealer receivables were $33 million lower than one year ago, due primarily to the effect of lower foreign currency exchange rates in 1993. The ratios of worldwide net dealer accounts and notes receivable to fiscal year net sales at October 31 were 43 percent in 1993, 51 percent in 1992 and 51 percent in 1991. The collection period for receivables from dealers averages less than 12 months. The percentage of receivables outstanding for a period exceeding 12 months was 11 percent at October 31, 1993 compared with 11 percent at October 31, 1992 and 16 percent at October 31, 1991. Company-owned inventories decreased by $60 million in 1993 mainly as a result of sales exceeding production levels and continued improvement in inventory management practices. Capital expenditures were $196 million in 1993 compared with $269 million in 1992 and $295 million in 1991 primarily due to lower new product expenditures. It is currently estimated that capital expenditures for 1994 will be approximately $230 million. As in recent years, the 1994 expenditures will be primarily for new product and operations improvement programs. Total interest-bearing debt of the Equipment Operations was $1,546 million at the end of 1993 compared with $2,090 million at the end of 1992 and $1,899 million at the end of 1991. The ratio of total debt to total capital (total interest-bearing debt and stockholders' equity) at the end of 1993, 1992, and 1991 was 42.6 percent, 44.1 percent and 40.1 percent, respectively. The average short-term borrowings and the weighted average interest rate incurred thereon during 1993, excluding the current portion of long-term borrowings, were $1,050 million and 6.0 percent, respectively, compared with $1,030 million and 7.2 percent, respectively, in 1992. During 1991, average short-term borrowings were $1,006 million with an average interest rate of 8.7 percent. In November 1993, the company announced that on January 4, 1994 it will redeem the $80 million balance of outstanding 8% debentures due 2002. Additional information is included in the discussion of "Long-Term Borrowings" on pages 44 through 45. In September 1993, the company issued 8,050,000 shares of common stock in a public offering. The net proceeds of $535 million were used for working capital and other general corporate purposes, including the reduction of indebtedness of the Equipment Operations and the credit subsidiaries. FINANCIAL SERVICES The Financial Services credit subsidiaries rely on their ability to raise substantial amounts of funds to finance their receivable and lease portfolios. Their primary sources of funds for this purpose are a combination of borrowings and equity capital. Additionally, the Capital Corporation periodically sells substantial amounts of retail notes in the public markets. The insurance and health care operations generate their funds through internal operations and have no external borrowings. Cash flows from the company's Financial Services operating activities were $218 million in 1993. Net cash provided by investing activities totaled $441 million in 1993, primarily due to net proceeds of $1,143 million received from the securitization and sale of receivables in the public market, which was partially offset by funds used for credit receivable and lease acquisitions which exceeded collections by $676 million. The aggregate cash provided by operating and investing activities was used for financing activities and a $90 million increase in cash and cash equivalents. Cash used for financing activities totaled $569 million in 1993, representing a net decrease in outside borrowings of $842 million and $86 million of dividends paid to the Equipment Operations, which were partially offset by an increase in payables to the Equipment Operations of $359 million. Within the Financial Services operations, the positive cash flows from insurance and health care operations were primarily invested in marketable securities. Over the past three years, the Financial Services operating activities have provided $760 million in cash. An increase in payables to the Equipment Operations has also provided $436 million during the same period. These amounts have been used mainly to fund a decrease of $387 million in net outside borrowings, $273 million of dividends to the Equipment Operations, an increase in receivables relating to asset backed securities and operating leases of $264 million, an increase of $184 million in marketable securities and an increase in cash and cash equivalents of $107 million. Marketable securities carried at cost consist primarily of debt securities held by the insurance and health care operations in support of their obligations to policyholders. The $41 million increase in 1993 resulted primarily from the continuing growth in the insurance and health care operations. Net credit receivables decreased by $676 million in 1993 compared with 1992. The discussion of "Credit Operations" on pages 30 through 31, and pages 41 through 42 of the notes to the consolidated financial statements provide detailed information on these receivables. Total interest-bearing debt of the credit subsidiaries was $2,603 million at the end of 1993 compared with $3,463 million at the end of 1992 and $3,779 million at the end of 1991. Strong capital positions for both the credit and insurance operations continued during 1993. The credit subsidiaries' ratio of total interest-bearing debt to total stockholders' equity was 3.8 to 1 at the end of 1993 compared with 4.6 to 1 at the end of 1992 and 4.9 to 1 at the end of 1991. The average short-term borrowings of the credit subsidiaries and the weighted average interest rate incurred thereon during 1993, excluding the current portion of long-term borrowings, were $1,401 million and 4.3 percent, respectively, compared with $2,150 million and 4.9 percent, respectively, in 1992. During 1991, average short-term borrowings were $2,135 million with an average interest rate of 7.3 percent. In 1993, the Capital Corporation issued $150 million of 5% notes due in 1995 and $200 million of 4-5/8% notes due in 1996. The Capital Corporation also retired $150 million of 7.4% notes due in 1993, $125 million of 9.0% debentures due in 1993 and $47 million of 7-1/2% debentures due in 1998. During 1993, the Capital Corporation issued $337 million and retired $176 million of medium-term notes. In November 1993, the Capital Corporation announced that on January 4, 1994 it will redeem the $40 million balance of outstanding 9.35% subordinated debentures due 2003. Additional information on these borrowings is included in the discussion of "Long-Term Borrowings" on pages 44 through 45. In the 1993 and 1992 fiscal years, the Capital Corporation received net proceeds of $1,143 million and $455 million, respectively, from the sale of retail notes to limited-purpose business trusts, which utilized the notes as collateral for the issuance of asset backed securities to the public. In the 1992 fiscal year, the Capital Corporation also sold retail notes to a financial institution receiving proceeds of $228 million. Retail notes were not sold by the Capital Corporation in the 1991 fiscal year. Additional sales of retail notes are expected to be made in the future. CONSOLIDATED The company maintains unsecured lines of credit with various banks in North America and overseas. Some of the lines are available to both the Equipment Operations and certain credit subsidiaries. Worldwide lines of credit totaled $3,344 million at October 31, 1993, $2,296 million of which were unused. For the purpose of computing unused credit lines, total short-term borrowings, excluding the current portion of long-term borrowings, were considered to constitute utilization. Included in the total credit lines are three long-term credit agreement commitments totaling $3,276 million. Stockholders' equity was $2,085 million at October 31, 1993 compared with $2,650 million and $2,836 million at October 31, 1992 and 1991, respectively. The decrease in 1993 was caused primarily by the net loss of $921 million resulting from the cumulative adjustment for the adoption of FASB Statement Nos. 106 and 112 described on pages 36 and 37. In addition, stockholders' equity decreased due to dividends declared of $157 million, an increase of $59 million in the minimum pension liability adjustment described under "Pension Benefits" on page 37 and a $22 million change in the cumulative translation adjustment, which were partially offset by an increase in common stock of $597 million. INDUSTRY SEGMENT AND GEOGRAPHIC AREA DATA FOR THE YEARS ENDED OCTOBER 31, 1993, 1992 AND 1991 Because of integrated manufacturing operations and common administrative and marketing support, a substantial number of allocations must be made to determine industry segment and geographic area data. Intersegment sales and revenues represent sales of components, insurance and health care premiums, and finance charges. Interarea sales represent sales of complete machines, service parts and components to units in other geographic areas. Intersegment sales and revenues are generally priced at market prices, and interarea sales are generally priced at cost plus a share of total operating profit. Overseas operations are defined to include all activities of divisions, subsidiaries and affiliated companies conducted outside the United States and Canada. Information relating to operations by industry segment in millions of dollars follows. Comments relating to this data are included in Management's Discussion and Analysis. The company views and has historically disclosed its operations as consisting of two geographic areas, the United States and Canada, and overseas, shown below. The percentages shown in the captions for net sales and revenues, operating profit (loss) and identifiable assets indicate the approximate proportion of each amount that relates to either the United States only or to the company's Europe, Africa and Middle East division, the only overseas area deemed to be significant for disclosure purposes. The percentages are based upon a three-year average for 1993, 1992 and 1991. Total exports from the United States were $961 million in 1993, $778 million in 1992 and $713 million in 1991. Exports increased in 1993 as a result of higher demand in Canada, Europe and Australia, and increased in 1992 due to higher demand in Mexico and Australia. Exports from the Europe, Africa and Middle East division were $423 million in 1993, $442 million in 1992 and $416 million in 1991. A large part of these exports were to the United States and Canada. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Following are significant accounting policies in addition to those included in other notes to the consolidated financial statements. The consolidated financial statements represent the consolidation of all companies in which Deere & Company has a majority ownership. Deere & Company records its investment in each unconsolidated affiliated company (20 to 50 percent ownership) at its related equity in the net assets of such affiliate. Other investments (less than 20 percent ownership) are recorded at cost. Unconsolidated subsidiaries and affiliates at October 31, 1993 consisted primarily of equipment affiliates in Brazil, Mexico and the United States, and a United States reinsurance affiliate. Consolidated retained earnings at October 31, 1993 include undistributed earnings of the unconsolidated affiliates of $46 million. Dividends from unconsolidated affiliates were $2 million in 1993, $2 million in 1992 and $6 million in 1991. The company's consolidated financial statements and some information in the notes and related commentary are presented in a format which includes data grouped as follows: EQUIPMENT OPERATIONS--These data include the company's agricultural equipment, industrial equipment and lawn and grounds care equipment operations with Financial Services reflected on the equity basis. Data relating to the above equipment operations, including the consolidated group data in the income statement, are also referred to as "Equipment Operations' in this report. FINANCIAL SERVICES--These data include the company's credit, insurance and health care operations. CONSOLIDATED--These data represent the consolidation of the Equipment Operations and Financial Services in conformity with Financial Accounting Standards Board (FASB) Statement No. 94. References to "Deere & Company" or "the company" refer to the entire enterprise. Sales of equipment and service parts are generally recorded by the company when they are shipped to independent dealers. Provisions for sales incentives and product warranty costs are recognized at the time of sale or at the inception of the incentive programs. There is a time lag, which varies based on the timing and level of retail demand, between the dates when the company records sales to dealers and when dealers sell the equipment to retail customers. Retail notes receivable include unearned finance income in the face amount of the notes, which is amortized into income over the lives of the notes on the effective-yield basis. Unearned finance income on variable-rate notes is adjusted monthly based on fluctuations in the base rate of a specified bank. Financing leases receivable include unearned lease income, which is equal to the excess of the gross lease receivable plus the estimated residual value over the cost of the equipment, and is recognized as revenue over the lease terms on the effective-yield basis. Rental payments applicable to equipment on operating leases are recorded as income on a straight-line method over the lease terms. Assets on operating leases are recorded at cost and depreciated on a straight-line method over the terms of the leases. Costs incurred in the acquisition of retail notes and leases are deferred and amortized into income over the expected lives of the affected receivables on the effective-yield basis. Interest charged to revolving charge account customers and on wholesale receivables is based on the balances outstanding. During 1993 and 1992, the credit subsidiaries sold retail notes to limited purpose business trusts, which utilized the notes as collateral for the issuance of asset backed securities to the public. At the time of the sales, "other receivables" from the trusts were recorded at net present value. The receivables relate to deposits made pursuant to recourse provisions and other payments to be received under the sales agreements. The receivables will be amortized to their value at maturity using the interest method. The credit subsidiaries are also compensated by the trusts for certain expenses incurred in the administration of these receivables. Securitization and servicing fee income includes both the amortization of the above receivables and reimbursed administrative expenses. Insurance and health care premiums are generally recognized as earned over the terms of the related policies. Insurance and health care claims and reserves include liabilities for unpaid claims and future policy benefits. Policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses, which vary with the production of business, are deferred and amortized over the terms of the related policies. The liability for unpaid claims and claims adjustment expenses is based on estimated costs of selling the claim using past experience adjusted for current trends. The liability for future policy benefits on traditional life insurance policies is based on the mortality, interest and withdrawal assumptions prevailing at the time the policies are issued. The liability for universal life type contracts is the total of the policyholder accumulated funds. Interest rates used in calculating future policyholder benefits and universal life account values range from four and three-quarters to 11 percent. In the fourth quarter of 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, effective November 1, 1992. Prior quarters of 1993 were restated as required by this Statement. This standard generally requires the accrual of retiree health care and other postretirement benefits during employees' years of active service. The company elected to recognize the pretax transition obligation of $1,712 million ($1,095 million or $14.17 per share net of deferred income taxes) as a one-time charge to earnings in the current year. This obligation represents the portion of future retiree benefit costs related to service already rendered by both active and retired employees up to November 1, 1992. The 1993 postretirement benefits expense and related disclosures have been determined according to the provisions of FASB Statement No. 106. For years prior to 1993, postretirement benefits were generally included in costs as covered expenses were actually incurred. The adoption of FASB Statement No. 106 resulted in an incremental pretax expense of $58 million ($37 million or $.48 per share net of deferred income taxes) compared with expense determined under the previous accounting principle. This increase in the current year expense is in addition to the previously mentioned one-time charge relating to the transition obligation. The incremental postretirement benefits expense relating to the Financial Services subsidiaries was immaterial. Additional information is presented in the discussion of "Postretirement Benefits Other Than Pensions" on pages 38 through 39, and the "Supplemental 1993 and 1992 Quarterly Information (Unaudited)" on page 47. In the fourth quarter of 1993, the company adopted FASB Statement No. 112, Employers' Accounting for Postemployment Benefits, effective November 1, 1992. This Statement requires the accrual of certain benefits provided to former or inactive employees after employment but before retirement during employees' years of active service. The company previously accrued certain disability related benefits when the disability occurred. Results for the first quarter of 1993 were restated for the cumulative pretax charge resulting from this change in accounting as of November 1, 1992 which totaled $16 million ($10 million or $.13 per share net of deferred income taxes). The adoption of FASB Statement No. 112 resulted in incremental 1993 pretax expense of $2 million ($1 million or $.01 per share net of deferred income taxes) compared with expense determined under the previous accounting principle. This increase in the current year expense is in addition to the previously mentioned one-time cumulative charge. The adoption of FASB Statement No. 112 had an immaterial effect on the Financial Services subsidiaries. Additional information is presented in the "Supplemental 1993 and 1992 Quarterly Information (Unaudited)" on page 47. In the fourth quarter of 1993, the company adopted FASB Statement No. 107, Disclosures about Fair Values of Financial Instruments. Disclosures of the fair values of financial instruments which do not approximate the carrying values in the financial statements are included in the appropriate financial statement notes. Fair values of other financial instruments approximate the carrying amounts because of the short maturities or current market interest rates of those instruments. In the second quarter of 1992, the company adopted FASB Statement No. 109, Accounting for Income Taxes. See "Income Taxes" on page 40 for further information. In December 1992, the FASB issued Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. This Statement eliminates the practice of reporting amounts for reinsured contracts net of the effects of reinsurance. The new standard will be adopted in the first quarter of the 1994 fiscal year and will not have a material effect on the company's net income or financial position. In May 1993, the FASB issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. This statement requires that the insurance and health care operations' investments in debt and equity securities be classified in the following three categories: trading, held-to-maturity or available-for-sale. Securities classified as trading securities will be carried at fair market value with unrealized gains and losses reflected in earnings. Investment securities held by the company are not considered trading securities. Debt securities that the company has the positive intent and ability to hold to maturity; except for certain changes in circumstances such as credit risk, will be classified as held to maturity and reported at amortized cost. The company currently carries its debt securities on this basis. Securities that are not categorized as either trading or held to maturity will be classified as available for sale. Securities in this category, which will include the company's equity securities, will be carried at fair market value with unrealized gains and losses excluded from earnings but shown as a separate component of stockholders' equity. The company intends to designate all but a small portion of its debt securities as held-to-maturity and, therefore, retain the current amortized cost basis of accounting. The new standard must be adopted no later than fiscal year 1995 and is not expected to have a material effect on the company's net income or financial position. Certain amounts for prior years have been reclassified to conform with 1993 financial statement presentations. RESTRUCTURING COSTS During the second quarter of 1993, the company initiated plans to downsize and rationalize its European operations. This resulted in a second quarter restructuring charge of $80 million after income taxes or $1.03 per share ($107 million before income taxes). The charge mainly represents the cost of employment reductions to be implemented during 1993 and the next few years. In 1991, the company initiated plans to reduce costs and rationalize operations, both in North America and overseas. This resulted in a 1991 restructuring charge of $120 million after income taxes or $1.58 per share ($182 million before income taxes), representing costs of employment reductions and the closure of a ductile iron foundry. PENSION BENEFITS The company has several pension plans covering substantially all of its United States employees and employees in certain foreign countries. The United States plans and significant foreign plans in Canada, Germany and France are defined benefit plans in which the benefits are based primarily on years of service and employee compensation near retirement. It is the company's policy to fund its United States plans according to the 1974 Employee Retirement Income Security Act (ERISA) and income tax regulations. In Canada and France, the company's funding is in accordance with local laws and income tax regulations, while the German pension plan is unfunded. Plan assets in the United States, Canada and France consist primarily of common stocks, common trust funds, government securities and corporate debt securities. Provisions of FASB Statement No. 87 require the company to record a minimum pension liability relating to certain unfunded pension obligations, establish an intangible asset relating thereto and reduce stockholders' equity. At October 31, 1993, this minimum pension liability was remeasured, as required by the Statement. As a result, the minimum pension liability was adjusted from $452 million at October 31, 1992 to $515 million at October 31, 1993; the related intangible asset was adjusted from $215 million to $181 million; and the amount by which stockholders' equity had been reduced was adjusted from $156 million to $215 million (net of applicable deferred income taxes of $81 million in 1992 and $119 million in 1993). The change in the minimum pension liability at October 31, 1993 resulted mainly from an increase in pension fund liabilities due to a change in mortality assumptions and the utilization of a lower discount rate. The expense of all pension plans was $151 million in 1993, $121 million in 1922 and $94 million in 1991. In 1993, pension expense increased $44 million from a change in mortality assumptions and other actuarial experience and by $6 million from utilization of a lower discount rate, which were partially offset by a reduction of $20 million resulting from favorable investment experience. In 1992, pension expense increased by $27 million due to changes in plan benefits, $18 million from the utilization of a lower discount rate and $16 million due to changes in experience and exchange rates, which were partially offset by a reduction of $34 million resulting mainly from favorable investment experience. The components of net periodic pension cost and the significant assumptions for the United States plans consisted of the following in millions of dollars and in percents: A reconciliation of the funded status of the United States plans at October 31 in millions of dollars follows: The components of net periodic pension cost and the significant assumptions for the foreign plans consisted of the following in millions of dollars and in percents: A reconciliation of the funded status of the foreign plans at October 31 in millions of dollars follows: POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The company generally provides defined benefit health care and life insurance plans for retired employees in the United States and Canada. Provisions of the benefit plans for hourly employees are in large part subject to collective bargaining. The plans for salaried employees include certain cost-sharing provisions. It is the company's policy to fund a portion of its obligations for the United States postretirement health care benefit plans under provisions of Internal Revenue Code Section 401(h). Plan assets consist primarily of common stocks, common trust funds, government securities and corporate debt securities. During the fourth quarter of 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, effective November 1, 1992. Additional information is presented in the "Summary of Significant Accounting Policies" on page 36, and the "Supplemental 1993 and 1992 Quarterly Information (Unaudited)" on page 47. The components of net periodic postretirement benefits cost of the United States and Canadian plans in 1993 consisted of the following in millions of dollars: A reconciliation of the funded status of the United States and Canadian plans at October 31, 1993 in millions of dollars follows: Actuarial assumptions used to determine 1993 costs for the United States and Canadian plans include a discount rate of 8.25 percent and a 9.7 percent expected long-term rate of return on assets. The discount rate used in determining the October 31, 1993 benefit obligations was 7.5 percent. The annual rate of increase in the per capita cost of covered health care benefits (the health care cost trend rate) was assumed to be 1.3 percent for 1994, which is lower than normal due to the effects of plan changes, particularly the migration of employees to managed care programs and company operated clinics. Subsequent to 1994, the trend rate is assumed to be 9.0 percent in 1995, decreasing gradually to 4.3 percent by the year 2001. These trend rates reflect the company's previous experience and current plans for future cost control including the effects of managed care. An increase of one percentage point in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligation as of October 31, 1993 by $241 million and the aggregate of the service and interest cost components of net periodic postretirement benefits cost for the year then ended by $25 million. INCOME TAXES The provision (credit) for income taxes by location of the taxing jurisdiction and by significant component consisted of the following in millions of dollars: Based upon location of the company's operations, the consolidated income (loss) before income taxes in the United States in 1993, 1992 and 1991 was $353 million, $49 million and $(19) million, respectively, and in foreign countries was $(80) million, $(6) million and $(7) million, respectively. Certain overseas operations are branches of Deere & Company and are therefore subject to United States as well as foreign income tax regulations. The pretax income (loss) by location and the preceding analysis of the income tax provision (credit) by taxing jurisdiction are therefore not directly related. The Omnibus Budget Reconciliation Act of 1993, which enacted an increase in the United States federal statutory income tax rate effective January 1, 1993, was signed into law during the fourth quarter of 1993. In accordance with FASB Statement No. 109, Accounting for Income Taxes, the United States deferred income tax assets and liabilities as of the enactment date were revalued during the fourth quarter of 1993 using the new tax rate of 35 percent. This resulted in a credit of $17 million or $.22 per share to the provision for income taxes. This tax rate change had an immaterial effect on the Financial Services subsidiaries. A comparison of the statutory and effective income tax provision (credit) and reasons for related differences in millions of dollars follows: In the second quarter of 1992, the company adopted FASB Statement No. 109, Accounting for Income Taxes. There was no cumulative effect of adoption or current effect on continuing operations mainly because the company had previously adopted FASB Statement No. 96, Accounting for Income Taxes, in 1988. Deferred income taxes arise because there are certain items that are treated differently for financial accounting than for income tax reporting purposes. An analysis of the deferred income tax assets and liabilities at October 31 in millions of dollars follows: At October 31, 1993, accumulated earnings in certain overseas subsidiaries and affiliates totaled $361 million for which no provision for United States income taxes or foreign withholding taxes had been made, because it is expected that such earnings will be reinvested overseas indefinitely. Determination of the amount of unrecognized deferred tax liability on these unremitted earnings is not practicable. Deere & Company files a consolidated federal income tax return in the United States which includes certain wholly-owned Financial Services subsidiaries, primarily John Deere Capital Corporation, John Deere Credit, Inc., and the health care subsidiaries. These subsidiaries account for income taxes generally as if they filed separate income tax returns. Deere & Company's insurance subsidiaries file separate federal income tax returns. During 1993, 1992 and 1991, the company recognized $4 million, $1 million and $2 million, respectively, of income tax benefits relating to tax loss and tax credit carryforwards from previous years. At October 31, 1993, certain foreign tax loss and tax credit carryforwards were available. The expiration dates and amounts in millions of dollars are as follows: 1996 - $2, $1997 - $5, 1998 - $9 and unlimited - $7. MARKETABLE SECURITIES Marketable securities are held by the insurance and health care subsidiaries. Fixed maturities, consisting of corporate bonds, government bonds and certificates of deposit, are carried at amortized cost and generally held to maturity. Equity securities, consisting of common and preferred stocks, are carried at cost. Realized gains or losses from the sales of marketable securities are based on the specific identification method. A discussion of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which could affect the carrying value of marketable securities starting in fiscal year 1995, is found on page 37 of the "Summary of Significant Accounting Policies". The value of marketable securities at October 31 in millions of dollars follows: The carrying value and market value of fixed maturities in millions of dollars follows: The contractual maturities of fixed maturities at October 31, 1993 in millions of dollars follows: Actual maturities may differ from contractual maturities because some borrowers have the right to call or prepay obligations. Proceeds from the sales of fixed maturities were $23 million in 1993, $18 million in 1992 and $34 million in 1991. Gross gains of $1 million in 1993, $1 million in 1992 and $12 million in 1991 and gross losses of none in 1993, none in 1992 and $4 million in 1991 were realized on those sales. DEALER ACCOUNTS AND NOTES RECEIVABLE Dealer accounts and notes receivable at October 31 consisted of the following in millions of dollars: At October 31, 1993 and 1992, dealer notes included above were $414 million and $397 million, respectively. Dealer accounts and notes receivable arise primarily from sales to dealers of John Deere agricultural, industrial and lawn and grounds care equipment. The company retains as collateral a security interest in the equipment associated with these receivables. Generally, terms to dealers require payments as the equipment which secures the indebtedness is sold to retail customers. Interest is charged on balances outstanding after certain interest-free periods, which range from six to nine months for agricultural tractors, six months for industrial equipment, and from six to 24 months for most other equipment. Dealer accounts and notes receivable have significant concentrations of credit risk in the agricultural, industrial and lawn and grounds care business sectors as shown above. On a geographic basis, there is not a disproportionate concentration of credit risk in any area. CREDIT RECEIVABLES Credit receivables at October 31 consisted of the following in millions of dollars: At October 31, 1993, $116 million of the net credit receivables were financed by the Equipment Operations and $3,639 million by the credit subsidiaries. Credit receivables have significant concentrations of credit risk in the agricultural, industrial, lawn and grounds care, and recreational product business sectors as shown above. On a geographic basis, there is not a disproportionate concentration of credit risk in any area. The company retains as collateral a security interest in the equipment associated with retail notes and leases. At October 31, 1993, the estimated fair value of total net credit receivables was $3,844 million compared to the carrying value of $3,755 million. The fair values of fixed-rate retail notes and financing leases were based on the discounted values of their related cash flows at current market interest rates. The fair values of variable-rate retail notes, revolving charge accounts and wholesale notes approximate the carrying amounts. Credit receivable installments, including unearned finance income, at October 31 are scheduled as follows in millions of dollars: The maximum maturities for retail notes are generally seven years for agricultural equipment, five years for industrial equipment, six years for lawn and grounds care equipment and 15 years for recreational products. The maximum term for financing leases is six years, while the maximum maturity for wholesale notes is 24 months. The company's United States credit subsidiary, John Deere Capital Corporation, received net proceeds of $1,143 million in 1993 and $455 million in 1992 from the sale of retail notes to limited-purpose business trusts, which utilized the notes as collateral for the issuance of asset backed securities to the public. The Capital Corporation and certain foreign subsidiaries also sold retail notes to other financial institutions, receiving proceeds of $5 million in 1993, $242 million in 1992 and $6 million in 1991. At October 31, 1993 and 1992, the net unpaid balances of retail notes previously sold were $1,399 million and $697 million, respectively. The company was contingently liable for recourse in the maximum amount of $113 million and $76 million at October 31, 1993 and 1992, respectively. The retail notes sold are collateralized by security interests in the related machinery sold to customers. There is a minimal amount of credit and market risk due to monthly adjustments to the sale price of a small portion of the retail notes. There is no anticipated credit risk related to nonperformance by the counterparties. At October 31, 1993 and 1992, net credit receivables administered, which include credit receivables previously sold but still administered, totaled $5,154 million and $5,092 million, respectively. The allowance for doubtful credit receivables represented 2.22 percent and 1.99 percent of credit receivables outstanding at October 31, 1993 and 1992, respectively. In addition, at October 31, 1993 and 1992, the company's credit subsidiaries had $119 million and $117 million, respectively, of deposits withheld from dealers and merchants available for potential credit losses. An analysis of the allowance for doubtful credit receivables follows in millions of dollars: Allowances for doubtful credit receivables are maintained in amounts considered appropriate in relation to the receivables and leases outstanding based on estimated collectibility and collection experience. The lower provisions in 1993 and 1992 resulted from a decrease in write-offs of uncollectible receivables and leases, particularly recreational product related notes and John Deere industrial equipment retail notes. The total "Provision for doubtful receivables" is included in the "Statement of Consolidated Cash Flows" on pages 22 and 23. OTHER RECEIVABLES Other receivables at October 31 consisted of the following in millions of dollars: Other receivables are primarily held by the Financial Services subsidiaries. The credit subsidiaries have sold retail notes to limited purpose business trusts which utilized the notes as collateral for the issuance of asset backed securities to the public. The balance of the related receivables is equal to the unamortized present value of deposits made with the trusts pursuant to recourse provisions, and other payments to be received under the sales agreements. Additional information is presented in the "Summary of Significant Accounting Policies" on page 36. EQUIPMENT ON OPERATING LEASES Operating leases arise from the lease of John Deere equipment to retail customers in the United States and Canada. Initial lease terms range from 12 to 72 months. The net value of John Deere equipment on operating leases was $195 million and $168 million at October 31, 1993 and 1992, respectively. Of these leases, at October 31, 1993, $76 million was financed by the Equipment Operations and $119 million by John Deere Credit Company. The accumulated depreciation on this equipment was $52 million and $53 million at October 31, 1993 and 1992, respectively. The corresponding depreciation expense was $29 million in 1993, $29 million in 1992 and $28 million in 1991. Future payments to be received on operating leases totaled $105 million at October 31, 1993 and are scheduled as follows: 1994--$48, 1995--$34, 1996--$15, 1997--$7 and 1998--$1. INVENTORIES Substantially all inventories owned by Deere & Company and its United States equipment subsidiaries are valued at cost on the "last-in, first-out" (LIFO) method. Remaining inventories are generally valued at the lower of cost, on the "first-in, first-out" (FIFO) basis, or market. The value of gross inventories on the LIFO basis represented 83 percent and 81 percent of worldwide gross inventories at FIFO value on October 31, 1993 and 1992, respectively. Under the LIFO inventory method, cost of goods sold ordinarily reflects current production costs thus providing a matching of current costs and current revenues in the income statement. However, when LIFO-valued inventories decline, as they did in 1993 and 1992, lower costs that prevailed in prior years are matched against current year revenues, resulting in higher reported net income. Benefits from the reduction of LIFO inventories totaled $51 million ($33 million or $.43 per share after income taxes) in 1993, $65 million ($43 million or $.56 per share after income taxes) in 1992 and $128 ($84 million or $1.11 per share after income taxes) in 1991. Raw material, work-in-process and finished goods inventories at October 31, 1993 totaled $464 million on a LIFO-value basis com- pared with $525 million one year ago. If all inventories had been valued on a FIFO basis, estimated inventories by major classification at October 31 in millions of dollars would have been as follows: PROPERTY AND DEPRECIATION Property and equipment is stated at cost, less accumulated depreciation. Property and equipment additions were $205 million in 1993 compared with $281 million in 1992. Additions for 1993 included $204 million for capital expenditures and $1 million for leased property under capital leases. Additions for 1992 included $279 million for capital expenditures and $2 million for capitalization of interest. Of the 1993 capital expenditures, $161 million were in the United States and Canada, $35 million were overseas and $8 million were incurred by the Financial Services subsidiaries. A summary of consolidated property and equipment at October 31 in millions of dollars follows: Leased property under capital leases amounting to $26 million and $29 million at October 31, 1993 and 1992, respectively, is included primarily in machinery and equipment and all other. Property and equipment expenditures for new and revised products, increased capacity and the replacement or major renewal of significant items of property and equipment are capitalized. Expenditures for maintenance, repairs and minor renewals are generally charged to expense as incurred. Depreciation amounted to $226 million in 1993, $217 million in 1992 and $190 million in 1991. Most of the company's property and equipment is depreciated using the straight-line method for financial accounting purposes. Depreciation for United States federal income tax purposes is computed using accelerated depreciation methods. It is not expected that the cost of compliance with foreseeable environmental requirements will have a material effect on the company's financial position or operating results. INTANGIBLE ASSETS Consolidated net intangible assets totaled $297 million and $338 million at October 31, 1993 and 1992, respectively. The Equipment Operations' balance of $278 million at October 31, 1993 consisted primarily of $181 million related to the minimum pension liability required by FASB Statement No. 87, and unamortized goodwill which resulted from the purchase cost of assets acquired exceeding their fair value. The intangible pension asset decreased by $34 million during 1993. Intangible assets, excluding the intangible pension asset, are being amortized over 25 years or less, and the accumulated amortization was $53 million and $47 million at October 31, 1993 and 1992, respectively. The intangible pension asset is remeasured and adjusted annually. SHORT-TERM BORROWINGS Short-term borrowings at October 31 consisted of the following in millions of dollars: All of the Financial Services short-term borrowings represent obligations of the credit subsidiaries. Unsecured lines of credit available from United States and foreign banks were $3,344 million at October 31, 1993. Some of these credit lines are available to both the Equipment Operations and certain credit subsidiaries. At October 31, 1993, $2,296 million of the worldwide lines of credit were unused. For the purpose of computing the unused credit lines, total short-term borrowings, excluding the current portion of long-term borrowings, were considered to constitute utilization. Included in the above lines of credit are three long-term committed credit agreements expiring on various dates through March 1996 in an aggregate maximum amount of $3,276 million. Each agreement is mutually extendable. Annual facility fees on the credit agreements range from 0.125 percent to 0.1875 percent. Certain of these credit agreements have various requirements of John Deere Capital Corporation, including the maintenance of its consolidated ratio of earnings before fixed charges to fixed charges at not less than 1.05 to 1 for each fiscal quarter. In addition, the Capital Corporation's ratio of senior debt to total stockholder's equity plus subordinated debt may not be more than 8 to 1 at the end of any fiscal quarter. The credit agreements also contain provisions requiring Deere & Company to maintain consolidated tangible net worth of $1,600 million according to United States generally accepted accounting principles as of October 31, 1992. The company's credit subsidiaries have entered into interest rate swap and interest cap agreements to hedge their interest rate exposure in amounts corresponding to a portion of their short-term borrowings. At October 31, 1993 and 1992, the total notional principal amounts of interest rate swap agreements were $642 million and $291 million, having rates of 3.6 percent to 10.0 percent, terminating in up to 28 months and 48 months, respectively. The total notional principal amounts of interest rate cap agreements at October 31, 1993 and 1992 were $44 million and $105 million, having capped rates of 8.0 percent to 9.0 percent, terminating in up to 15 months and 28 months, respectively. The differential to be paid or received on all swap and cap agreements is accrued as interest rates change and is recognized over the lives of the agreements. The credit and market risk under these agreements is not considered to be significant. The estimated fair value and carrying value of these interest rate swap and cap agreements were not significant at October 31, 1993. ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses at October 31 consisted of the following in millions of dollars: LONG-TERM BORROWINGS Long-term borrowings at October 31 consisted of the following in millions of dollars: All of the Financial Services long-term borrowings represent obligations of John Deere Capital Corporation. The Capital Corporation has entered into interest rate swap agreements with independent parties that change the effective rate of interest on certain long-term borrowings to a variable rate based on specified United States commercial paper rate indices. The above table reflects the effective year-end variable interest rates relating to these swap agreements. The notional principal amounts and maturity dates of these swap agreements are the same as the principal amounts and maturities of the related borrowings. In addition, the Capital Corporation has interest rate swap agreements corresponding to a portion of their fixed rate long-term borrowings. At October 31, 1993, the total notional principal amount of these interest rate swap agreements was $347 million, having variable interest rates of 3.4 percent to 3.8 percent, terminating in up to 40 months. The Capital Corporation also has interest rate swap and cap agreements associated with medium-term notes. The above table reflects the interest rates relating to these swap and cap agreements. At October 31, 1993 and 1992, the total notional principal amounts of these swap agreements were $138 million and $110 million, terminating in up to 42 months and 54 months, respectively. At October 31, 1993 and 1992, the total notional principal amounts of these cap agreements were $25 million and $125 million, terminating in up to 22 months and 34 months, respectively. A Swiss franc to United States dollar currency swap agreement is also associated with the Swiss franc bonds in the table. The credit and market risk under these agreements is not considered to be significant. At October 31, 1993, the total estimated fair value of the company's total long term borrowings was $2,658 million, comprised of $1,162 million for the Equipment Operations and $1,496 million for Financial Services. The corresponding carrying amount of total long-term borrowings was $2,548 million, comprised of $1,069 million for the Equipment Operations and $1,479 million for Financial Services. Fair values of long-term borrowings with fixed rates were based on a discounted cash flow model. Fair values of long-term borrowings that have been swapped to current variable interest rates approximate their carrying amounts. The estimated fair value and carrying value of the Capital Corporation's interest rate swap and cap agreements associated with medium-term notes were not significant at October 31, 1993. The approximate amounts of the Equipment Operations' long-term borrowings maturing and sinking fund payments required in each of the next five years in millions of dollars are as follows: 1994--$148, 1995--$18, 1996--$325, 1997-- $84 and 1998--$54. The approximate amounts of John Deere Capital Corporation's long-term borrowings maturing and sinking fund payments required in each of the next five years in millions of dollars are as follows: 1994--$405, 1995--$633, 1996--$262, 1997--$309 and 1998--$11. Certain of the company's credit agreements contain provisions requiring the maintenance of a minimum consolidated tangible net worth according to United States generally accepted accounting principles as of October 31, 1992. Under these provisions, the total consolidated retained earnings balance of $926 million at October 31, 1993 was free of restrictions as to payment of dividends or acquisition of the company's common stock. LEASES The company leases certain computer equipment, lift trucks and other property. The present values of future minimum lease payments relating to leased assets deemed to be capital leases as determined from the lease contract provisions are capitalized. Capitalized amounts are amortized over either the lives of the leases or the normal depreciable lives of the leased assets. All other leases are defined as operating leases. Lease expenses relating to operating leases are charged to rental expense as incurred. At October 31, 1993, future minimum lease payments under capital leases totaled $3 million as follows: 1994--$2, 1995--$1. Total rental expense for operating leases during 1993 was $48 million compared with $53 million in 1992 and $49 million in 1991. At October 31, 1993, future minimum lease payments under operating leases amounted to $85 million as follows: 1994--$30, 1995--$27, 1996--$17, 1997--$4, 1998--$3, later years--$4. COMMITMENTS AND CONTINGENT LIABILITIES On October 31, 1993, the company was contingently liable for recourse of approximately $113 million on credit receivables sold to financial institutions or limited purpose business trusts by both the Financial Services subsidiaries and the Equipment Operations. In addition, certain foreign subsidiaries have pledged assets with a balance sheet value of $32 million as collateral for bank advances of $2 million. Also, at October 31, 1993, the company had commitments of approximately $50 million for construction and acquisition of property and equipment. The company is subject to various unresolved legal actions which arise in the normal course of its business, the most prevalent of which relate to product liability and retail credit matters. The company and certain subsidiaries of the Capital Corporation are currently involved in legal actions relating to alleged violations of certain technical provisions of Texas consumer credit statutes in connection with John Deere Company's financing of the retail purchase of recreational vehicles and boats in that state. These actions include: a class action brought by Russell Durrett individually and on behalf of others against John Deere Company (filed in state court on February 19, 1992 and removed on February 26, 1992 to the United States District Court for the Northern District of Texas, Dallas Division), which case was certified as a class action by the court on November 6, 1992; and a class action titled Deere Credit, Inc. v. Shirley Y. Morgan, et al., originally filed on February 20, 1992, and certified in the 281st Judicial District Court of Harris County, Texas, on October 12, 1993 for all persons who opt out of the federal class action. The company and the Capital Corporation subsidiaries believe that they have substantial defenses and intend to defend the actions vigorously. Although it is not possible to predict the outcome of these unresolved legal actions and the amounts of claimed damages and penalties are large, the company believes that these unresolved legal actions will not have a material adverse effect on its consolidated financial position. CAPITAL STOCK Changes in the common stock account in 1991, 1992 and 1993 were as follows: In September 1993, the company issued 8,050,000 shares of common stock in a public offering. The net proceeds of $535 million were used for working capital and other general corporate purposes, including the reduction of indebtedness of the Equipment Operations and credit subsidiaries. The calculation of net income per share is based on the average number of shares outstanding during the year. The calculation of net income per share assuming full dilution recognizes the dilutive effect of the assumed exercise of stock appreciation rights and stock options, and conversion of convertible debentures. The calculation also reflects adjustment for interest expense relating to the convertible debentures, net of applicable income taxes. The company is authorized to issue 3,000,000 shares of preferred stock, none of which has been issued. The major changes during 1993 affecting common stock in treasury included the acquisition of 112,100 shares of treasury stock at a total cost of $6 million. In addition, 70,628 shares of treasury stock at original cost of $4 million were issued under the restricted stock plan. RESTRICTED STOCK In 1989, stockholders approved a restricted stock plan for key employees of the company. Under this plan, 750,000 shares may be granted as restricted stock. The company will establish the period of restriction for each award and hold the restricted stock during the restriction period, while the employee will receive any dividends and vote the restricted stock. No award may be made under the plan providing for restrictions that lapse after October 31, 1999. In February 1993, stockholders approved a restricted stock plan for nonemployee directors. Under this plan, 30,000 shares may be granted as restricted stock. The restrictions lapse when a director retires from the Board. Under both plans, the market value of the restricted stock at the time of grant is recorded as unamortized restricted stock compensation in a separate component of stockholders' equity. This compensation is amortized to expense evenly over the minimum periods of restriction, which is currently four years for both plans. At October 31, 1993, 444,807 shares remained available for award under both plans. Changes in the unamortized restricted stock compensation account in 1991, 1992 and 1993 were as follows: STOCK OPTIONS Options for the purchase of the company's common stock are issued to officers and other key employees under stock option plans as approved by stockholders. Options outstanding at October 31, 1993 generally become exercisable one year after the date of grant and are exercisable up to 10 years after the date of grant. The stock option plan includes authority to grant stock appreciation rights, either concurrently with the grant of options or subsequently, and to accept stock of the company in payment for shares under the options. Both incentive options and options not entitled to incentive stock option treatment (nonstatutory options) may be granted under the plan. At October 31, 1993, 4,457,902 shares remained available for the granting of options. During the last three fiscal years, changes in shares under option were as follows: For options outstanding at October 31, 1993, the average exercise price was $43.53 per share and expiration dates ranged from December 1993 to December 2002. Of the outstanding options, 261,998 may be exercised in the form of stock appreciation rights. EMPLOYEE STOCK PURCHASE AND SAVINGS PLANS The company maintains the following significant plans for eligible employees: John Deere Savings and Investment Plan, for salaried employees John Deere Stock Purchase Plan, for salaried employees John Deere Tax Deferred Savings Plan, for hourly and incentive paid employees Company contributions under these plans were $9 million in 1993, $11 million in 1992 and $22 million in 1991. RETAINED EARNINGS An analysis of the company's retained earnings follows in millions of dollars: CUMULATIVE TRANSLATION ADJUSTMENT An analysis of the company's cumulative translation adjustment follows in millions of dollars: The company has entered into foreign exchange contracts and options in order to hedge the currency exposure of certain inventory, short-term borrowings and expected inventory purchases. The foreign exchange contract gains or losses are accrued as foreign exchange rates change, and the contract premiums are amortized over the terms of the foreign exchange contracts. The option premiums and any gains are deferred and recorded as part of the cost of future inventory purchases. At October 31, 1993 and 1992, the company had foreign exchange contracts maturing in up to three months and six months for $409 million and $424 million, respectively. At October 31, 1993 and 1992, the company had options maturing in up to 24 months and 36 months for $72 million and $261 million, respectively. The credit and market risk under these agreements is not considered to be significant. At October 31, 1993, the estimated fair value and carrying value of the foreign exchange contracts and options were not significant. CASH FLOW INFORMATION For purposes of the statement of consolidated cash flows, the company considers investments with original maturities of three months or less to be cash equivalents. Substantially all of the company's short-term borrowings mature within three months or less. Cash payments for interest and income taxes consisted of the following in millions of dollars: SUPPLEMENTAL 1993 AND 1992 QUARTERLY INFORMATION (UNAUDITED) Quarterly information with respect to net sales and revenues and earnings is shown in the following schedule. Such information is shown in millions of dollars except for per share amounts. Common stock per shares prices from New York Stock Exchange composite transactions quotations follow: At October 31, 1993, there were 23,971 holders of record of the company's $1 par value common stock and 27 holders of record of the company's 5-1/2% convertible subordinated debentures due 2001. DIVIDEND A quarterly dividend of $.50 per share was declared at the Board of Director's meeting held on December 8, 1993, payable on February 1, 1994. THIS PAGE INTENTIONALLY LEFT BLANK INDEPENDENT AUDITORS' REPORT Deere & Company: We have audited the accompanying consolidated balance sheets of Deere & Company and subsidiaries as of October 31, 1993 and 1992 and the related statements of consolidated income and of consolidated cash flows for each of the three years in the period ended October 31, 1993. Our audits also included the financial statement schedules listed in the index under Part IV, Item 14(a)(2). These financial statements and financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Deere & Company and subsidiaries at October 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended October 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the Notes to the Consolidated Financial Statements, effective November 1, 1992 the company changed its method of accounting for postretirement benefits other than pensions. DELOITTE & TOUCHE December 8, 1993 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DEERE & COMPANY By: /s/ Hans W. Becherer --------------------- Hans W. Becherer Chairman and Chief Executive Officer Date: January 24, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Signature Title Date - --------- ----- ---- /s/ Hans W. Becherer Chairman, Director and ) 24 January 1994 - ----------------------- Chief Executive Officer ) Hans W. Becherer ) ) ) /s/ John R. Block Director ) - ----------------------- ) John R. Block ) ) ) /s/ Crandall C. Bowles Director ) - ----------------------- ) Crandall C. Bowles ) ) ) /s/ Owen B. Bulter Director ) - ---------------------- ) Owen B. Butler ) ) ) /s/ J. W. England Senior Vice President, ) - ---------------------- Director and Principal ) J. W. England Accounting Officer ) ) SIGNATURES - Concluded Signature Title Date - --------- ----- ---- /s/ Professor Regina Herzlinger Director ) 24 January 1994 - ------------------------------- ) Professor Regina Herzlinger ) ) /s/ Samuel C. Johnson Director ) - ------------------------------- ) Samuel C. Johnson ) ) /s/ Arthur L. Kelly Director ) - ------------------------------- ) Arthur L. Kelly ) ) /s/ A. Santamarina Director ) - ------------------------------- ) A. Santamarina ) ) /s/ E. L. Schotanus Executive Vice President, ) - ------------------------------- Director and Principal ) E. L. Schotanus Financial Officer ) ) ) /s/ D. H. Stowe, Jr. Director ) - ------------------------------- ) D. H. Stowe, Jr. ) ) /s/ John R. Walter Director ) - ------------------------------- ) John R. Walter ) DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES MARKETABLE SECURITIES -- OTHER INVESTMENTS October 31, 1993 and 1992 (In thousands of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Schedule I - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended October 31, 1993, 1992 and 1991 (In thousands of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES SHORT-TERM BORROWINGS For the Years Ended October 31, 1993, 1992 and 1991 (In thousands of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See notes on following pages - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE IX - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES SHORT-TERM BORROWINGS For the Years Ended October 31, 1993, 1992 and 1991 (In thousands of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE IX (Concluded) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE X DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended October 31, 1993, 1992 and 1991 (In thousands of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INDEX TO EXHIBITS

93675_1993.txt

93675

1993

Item 1. Business Starrett Housing Corporation was organized in New York in 1922. Through its subsidiary Levitt Corporation ("Levitt"), the Company engages in the construction and sale of single-family homes and garden apartments in the United States and Puerto Rico. See "Levitt Corporation." Over the years Starrett and its subsidiaries have constructed a wide range of office, industrial, public and institutional buildings, among the most notable being the Empire State Building, the AT&T World Headquarters, Citicorp Center, Chemical Bank World Headquarters and the New York State Javits Convention Center, and many well-known residential communities and developments, including Starrett City, Manhattan Park at Roosevelt Island and Trump Tower in New York City. The Company today is actively engaged in various construction, development, management and related businesses. See "Starrett's Construction Activities," "Development Activities" and "Management and Rental Services." Unless the context otherwise requires, references to the "Company," the "Registrant" or "Starrett" include Starrett Housing Corporation and/or one or more of its subsidiaries. Levitt Corporation Levitt's operations include sale of single family detached homes and garden apartments, development of rental apartments, mortgage banking and the development and management of senior citizen health and congregate care facilities. Housing Levitt's residential housing operations are concentrated in Florida and Puerto Rico. In Puerto Rico, Levitt believes it is the largest home builder and has been active on the island since 1960. Florida operations were started in 1978 and are currently conducted on Florida's southeast and southwest coasts. During 1993, several new sites were acquired in Florida which were opened or are scheduled for opening for sales in 1994. Although these projects are in the beginning phase of marketing, there has been a strong initial response from home-buyers to these new subdivisions. During 1994, Levitt expects an increase in sales resulting from these new subdivisions in Florida. Additionally, as the older projects are being completed, contracts are being entered into for new sites. Levitt has concentrated its significant Puerto Rican homebuilding activities in the greater San Juan area. In recent years, Puerto Rico operations have provided the majority of revenue and profits for Levitt. Levitt has a major development called Encantada and other subdivisions in the San Juan metropolitan area. Encantada is a planned unit development located in a suburb of San Juan with excellent access to schools, shopping and business centers. Encantada is planned for 2,600 homes of which more than 1,300 homes have been contracted for sale with over 1,000 deliveries as of February 28, 1994. Both single family homes and garden apartments are offered for sale at various prices in the community. The Company believes that Encantada's success can be attributed to the quality of the community, quality of the housing and the family lifestyle provided. With approximately 1,300 more homes to be sold, Encantada, together with the region's other projects, is expected to continue as an important source of revenues and profits for the Company. With the new Florida developments being introduced during 1994, Levitt's domestic operations are expected to be profitable and Puerto Rico should maintain its level of profitability. Levitt's performance in 1993 reflects the finalization of its program involving the disposition of high cost land in Virginia, New York and New Jersey as these areas were phased out. The disposition of land by selling and constructing homes at reduced prices resulted in a loss or minimal profit, but accelerated the receipt of cash from such dispositions. The disposition program has been virtually completed in 1993. Levitt's business is affected by other issues such as housing affordability, increased land costs, legislative growth restrictions, sewer and water moratoriums, possible changes in the Internal Revenue Code, including changes in Section 936 of the Internal Revenue Code relating to the taxability of corporations doing business in Puerto Rico, and increasing infrastructure demands. Levitt's backlog of homes contracted for sale at December 31, 1993 was $32,320,000 compared to $33,765,000 at December 31, 1992. Backlog consists of units which are under sales contract but where title has not yet passed, and comprises completed and uncompleted houses as well as houses where construction has not yet begun. The following table sets forth information concerning homes contracted for sale (net of cancellations during each period), housing units delivered (construction completed and title passed), and backlog: The Company's backlog at February 28, 1994 increased significantly from the amount at December 31, 1993 and February 28, 1993. This increase is attributable to the higher level of sales experienced in the Company's new projects in Florida and Puerto Rico. The backlog as of February 28, 1994 includes 23 units under contract with a contract value of $3,500,000 relating to a joint venture in which the Company has a 50% interest. After the initial contract has been received, contracts for the sale of houses may be canceled at or prior to closing for various reasons, including failure of the buyer to make the remainder of the required contract deposit or qualify for mortgage financing and default by the buyer. Levitt retains the buyer's deposit only if cancellation results from default by the buyer, except in Puerto Rico where under local law Levitt can retain only a portion of the deposit. When computing homes contracted for sale and backlog, Levitt makes no deduction for future cancellations, but nets cancellations as they occur against sales contracts. Levitt generally estimates that of the sales contracts entered into by buyers, approximately 65% have historically resulted in delivered homes. Contracts of sale are not recorded as revenues until the houses have been completed and title delivered. Levitt generally builds subdivisions on undeveloped suburban land having access to water and sewer services, although it does occasionally purchase fully developed land. Development plans must be approved by local authorities, which may take two years or more after the signing of a purchase contract. See "Regulation of the Company's Activities," page 8. Levitt provides home purchasers with warranties against construction defects for a period of up to two years from the date of purchase. In Puerto Rico there is a statutory warranty for certain construction defects which appear generally within ten years after completion. Rental Apartment Development In 1991, Levitt, in joint venture with an established apartment developer, constructed its first apartment project in Florida. This 224 unit apartment complex was completed and sold in 1992 to an institutional investor at a substantial profit. The Company and the joint venture partner have completed a second complex and have contracted to sell it to an institutional investor at a profit in 1994. A third development with Levitt's joint venture partner is scheduled to begin in the second quarter of 1994 and a fourth project is projected to begin in the last quarter of 1994. Levitt's current policy is to develop, lease and sell the apartment projects and not hold them for investment. The apartment development program is an integral part of Levitt's business and is anticipated to provide it with a continuous source of income. It is the Company's plan to develop at least one or more apartment projects each year. Mortgage Banking Levitt Mortgage Corp. ("Mortgage") is a full service mortgage lender that processes and originates loans in Puerto Rico and processes mortgage loans domestically. Mortgage is a designated approved direct endorser of FHA loans in Puerto Rico but does not service loans. In Puerto Rico, Mortgage also acts as a mortgage banker for third parties and processes and issues the mortgages it underwrites. These mortgages are sold to investors in accordance with firm purchase commitments with the investors. Mortgages are solicited through four offices in the San Juan area. Mortgage is the fifth largest mortgage banker in Puerto Rico. Health Care Facilities and Management Levitt Care Corporation ("Care") develops and manages adult congregate care ("ACLF") and assisted living facilities ("AL"). In 1987, the Company developed Northpark, a 376 unit ACLF in Hollywood, Florida. The facility was sold in 1989, and Care continues to manage it. Care is seeking to acquire existing ACLFs and AL facilities to rehabilitate and market them on a profitable basis and to develop sites for AL complexes. The facilities provide the resident, on a rental basis, meal service, weekly cleaning of the residents apartment, social activities and scheduled transportation to doctors' offices, shopping and cultural events. The rental cost of an apartment, is based on the size of the unit and the level of service required by the resident. In addition to the independent level of care in Northpark, an assisted living facility is available to the residents. This facility serves those individuals that require a greater level of care; such as assistance with bathing, dressing and eating. Management believes that the growing elderly population will increase the need for ACLF and AL facilities. Therefore, Care is seeking opportunities to expand in these areas. Development Activities In its development activities, the Company's services, in addition to those of a construction manager or general contractor, may include initial planning and development, acquisition of the property, arranging for financing and ownership of the project typically through general or limited partnerships, and providing management, consulting and related services. The Company anticipates marketing its development projects to investors or other purchasers, based principally on cash flow, capital appreciation and other non-tax considerations, and may in some instances retain ownership of such projects. In connection with its sale of projects, the Company may provide guarantees of completion and cash flow for varying periods. The Company has focused its development efforts in the areas of rental housing and projects sponsored by municipalities. The Company is proceeding with certain development projects. While the Company has generally been successful in developing such projects, these projects are in differing stages of development, and there can be no assurance that any particular project will be completed. Ownership of Partnership Interests The Company reviews from time to time projects in which it acts as a general partner or in which it has an equity interest (which for the most part have a low income tenancy subsidized in whole or in part by government-assistance programs) to determine the possibility of refinancing, resyndicating, selling, converting to condominiums, or co-oping such projects to obtain fees and other economic benefits. The Company has three projects located on the Upper West Side of Manhattan, in which it has a 50% residual partnership interest, with respect to which the Company has made application for incentives under the Low Income Housing Preservation and Resident Homeownership Act ("LIHPRHA"). LIHPRHA provides owners of certain federally subsidized projects with financial incentives in return for their agreement to continue the use of a project as affordable housing in lieu of converting the project to fair-market rentals or ownership. The financial incentives are designed to provide an owner with the approximate economic equivalent of what an owner would have received had the project discontinued its low income use and converted to a market rate rental or ownership, based upon an appraisal valuation and underwriting process set forth in the statute regulations and HUD guidelines. In May 1992, the Company commenced processing the first of its projects with the United States Department of Housing and Urban Development ("HUD"). On April 28, 1993, HUD provided the Partnership with a Value Determination Letter establishing a substantial value for the project, and in August and October 1993 HUD provided technical comments on the Plan of Action necessary to complete the processing. HUD has notified the Company that it is reversing its prior Value Determination and consequently will require the Partnership to reprocess the project, using a different formula for valuation, presently being developed by HUD. Under HUD's revised formula, the project may have a substantially diminished value. The Company disagrees with the reversal of HUD's prior Value Determination position, has so notified HUD and discussions are in process regarding this matter. In light of the foregoing, the amount of cash proceeds and profits, if any, the Company could receive for its 50% residual interest in the project as well as the time required to complete the processing is uncertain. The revised HUD position also affects processing under LIHPRHA for the two similar projects in which the Company owns a 50% residual interest located on the Upper West Side of Manhattan. If sustained, the revised HUD position will affect all New York projects of a similar nature. Starrett's Construction Activities Through its HRH Construction Corporation subsidiary ("HRH"), the Company primarily acts as construction manager in the construction of institutional, office and residential projects, most of which are located in the New York Metropolitan area. HRH builds projects either as a construction manager on a cost plus fee basis or a general contractor in which case it assumes the construction risk. The construction management and general contracting fees and other income earned by HRH during 1993, 1992 and 1991 were $4,000,000, $5,396,000 and $8,117,000, respectively. See "Segment Information," page 8. As a result of the economic slowdown, HRH has focused its activities on institutional construction and construction funded by City, State and Federal governments and is seeking to diversify into new areas of construction, all of which are subject to intense competition. In the case of projects where HRH acts as general contractor rather than construction manager (which has included projects in which the Company acts as a developer or has an ownership interest), the Company is required from time to time, as is customary in projects of this kind, to furnish payment and performance bonds assuring payment to subcontractors. The Company believes its bonding capacity is adequate for both present and projected requirements. The aggregate amount of bonds or other security the Company can obtain at any one time is dependent upon its overall financial strength. HRH's estimated backlog of fees for development work and uncompleted construction in connection with construction projects, including fees for projects where development work has begun but contracts have not yet been executed, was $8,151,000 at December 31, 1993 as compared to $8,158,000 and $9,409,000 at the end of 1992 and 1991, respectively. HRH is actively seeking to increase its backlog of business, particularly in the governmental and institutional sectors. Management and Rental Services Grenadier Realty Corp. ("Grenadier") is licensed in New York, New Jersey and Connecticut and manages many different properties with rental, condominium and cooperative residential units, commercial and retail space, and garage parking. Grenadier provides a full range of real estate management services, including on-site administration, accounting, security, maintenance, procurement, capital budgeting and owner and tenant communication programs to private owners and to governmental and institutional property owners as well as banks and thrift institutions. Grenadier operates two power plants and provides technical services for the development of energy conservation programs. In addition, Grenadier provides technical support for the implementation and operation of reliable, cost-effective electrical and mechanical building systems. Grenadier also designs security systems and provides security services to a variety of residential, commercial and industrial clients. Regulation of the Company's Activities The development business and home building industry in which the Company is engaged have, in the last several years, become subject to increased environmental, building, land use, zoning and sales regulations administered by various federal, state and local authorities, which affect construction activities as well as sales activities and other dealings with customers. Additionally, sewer moratoriums have been imposed from time to time in Puerto Rico which have caused delays in the delivery of homes to customers. The Company must obtain for its development and housing activities the approval of numerous governmental authorities which often have wide discretion in such matters. Changes in local circumstances or applicable law may necessitate applications for additional approvals or the modification of existing approvals. Compliance with these regulations has extended the time required to market projects by prolonging the time between the initiation of projects and the commencement and completion of construction. The Company is currently in various stages of securing governmental approvals for its development and homebuilding projects. Delay or inability to obtain all required approvals for a project could have a materially adverse effect on the marketability or profitability of such a project. Segment Information The Company's operations consist of (i) the development, management and ownership of real estate properties; (ii) the single-family home and garden apartment business conducted through its Levitt subsidiary; and (iii) the supplying of construction services through its HRH subsidiary. The Company groups its business into these three segments. The following table sets forth the Company's revenues and operating profit attributable to the respective segments of its operations for each of the years 1991 through 1993, and the identifiable assets attributable to the respective segments as at the end of each of those years: Operating profit is comprised of revenues less operating expenses. In computing operating profit, general corporate expenses and income taxes have not been deducted. There were no individual customers from which the Company derived 10% or more of its revenues in 1991, 1992 or 1993. Competition The construction, development and home building industries in all of the areas in which the Company operates are highly competitive, and the Company competes with major concerns as well as with smaller contractors or builders, some of whom have greater financial resources than the Company. Raw Materials and Equipment Substantially all the materials used by the Company in projects now under construction, including fixtures, appliances and systems, are readily available from many sources. The Company has from time to time experienced some shortages, delays and increased costs in connection with material shortages and increases in material prices but the Company does not believe the effect to have been significant. Employees--Labor Relations The Company directly employed, at December 31, 1993, a total of approximately 1,100 persons. The Company considers that it has satisfactory relations with the unions whose members it employs. Item 2.

Item 2. Properties The Company leases 25,000 square feet of space for its corporate offices and its main office for the construction management business, HRH, located at 909 Third Avenue in New York City. The lease for such space, which it occupied in 1973, expires in 1997. The Company also maintains a mobile field office at each of its construction sites. Levitt leases approximately 5,700 square feet of office space which it uses for its executive office and main office for its Florida homebuilding operation in Boca Raton, Florida, and also leases office space in San Juan, Puerto Rico. Item 3.

Item 3. Legal Proceedings The Company is involved in litigation and claims incident to the normal conduct of its business. Management believes that such litigation and claims will not have a materially adverse effect on the Company's business operations. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Not Applicable Executive Officers of the Company The following table sets forth the names and ages of all executive officers of the Company, the positions and offices with the Company held by each such person, and the period during which each such person has served as an executive officer. The term of office of each executive officer continues until the first meeting of the Board of Directors of the Company following the next annual meeting of shareholders, and until the election and qualification of such officer's successor. There is no family relationship between the executive officers listed above, or between such executive officers and directors. All of the executive officers except Paul Milstein have been principally engaged in his present employment for more than five years. Mr. Milstein became Chairman on January 1, 1994, and for more than five years has been active as a real estate developer and investor. PART II Item 5.

Item 5. Market for the Company's Common Equity and Related Stockholder Matters On March 16, 1994, there were 792 record holders of the Company's common stock and approximately 1,500 additional persons whose shares of Common Stock were held in street name. Such common stock is listed on the American Stock Exchange, which is the principal market on which such stock is traded. High and low sales prices on the American Stock Exchange for the Company's common stock during the last two years have been as follows: The Company paid an extraordinary dividend of $.25 per share in 1992. While the directors will consider the payment of dividends in 1994, at this time it is not anticipated that the Company will pay dividends on its common stock. Item 6.

Item 6. Selected Financial Data Starrett Housing Corporation and Subsidiaries Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 1993 Compared to 1992 During the year ended December 31, 1993 the Company had income from operations of $2,140,000 ($.34 per share) compared to $284,000 ($.04 per share) for the year ended December 31, 1992. In addition, during the year ended December 31, 1992, the Company reported an extraordinary gain net of tax of $824,000 and an accounting change of $1,287,000 or $.13 and $.20 per share, respectively, which when combined with the income from operations increased net income to $2,395,000 ($.37 per share). Earnings per share were based on average shares outstanding of 6,356,000 and 6,417,000 in 1993 and 1992, respectively. The Company's revenues increased $10,327,000 compared with the similar period in 1992. This increase was primarily attributable to an increase in revenues from the Company's Levitt division resulting from an increase in the number of houses delivered in the Company's Puerto Rico region. The increase in revenues from Levitt was offset by a decrease in revenues in the Company's development and construction management divisions in 1993. In 1992 revenues also included Levitt's Joint Venture share of the gain on the sale of a rental apartment project. Levitt's backlog of homes contracted for sale at December 31, 1993 was $32,320,000 compared to $33,765,000 at December 31, 1992. The backlog at February 28, 1994 was $63,179,000 as compared to $42,943,000 at February 28, 1993. General and administrative expenses (which were reduced for all divisions other than Grenadier which showed an overhead increase for the year) declined by $3,044,000 in 1993 following a $2,200,000 reduction in 1992 as a result of continuing cost reduction programs. Interest expense decreased by $655,000 for 1993 as compared to 1992 primarily as a result of both a decrease in borrowings and a decline in interest rates. Levitt's interest, real estate taxes and sales costs incurred with certain properties are capitalized in order to achieve better matching of costs with revenues. The Company's interest incurred on loans was $3,893,000 in 1993 and $5,964,000 in 1992, of which $2,959,000 in 1993 and $4,150,000 in 1992 was capitalized by Levitt in its operations. Levitt amortized capitalized interest of $5,802,000 in 1993 and $5,177,000 in 1992 to construction and related costs. HRH's estimated backlog of fees for development work and uncompleted construction in connection with construction projects, including fees for projects where development work has begun but contracts have not yet been executed, was $8,151,000 at December 31, 1993 as compared to $8,158,000 and $9,409,000 at the end of 1992 and 1991, respectively. HRH is actively seeking to increase its backlog of business, particularly in the governmental and institutional sectors, while at the same time continuing to reduce its overhead (overhead was reduced 21%, 25% and 20% in 1993, 1992 and 1991, respectively) to reflect the lower level of business activity. Grenadier continued its steady profitability in 1993 and has expanded its management services to private owners and institutional property owners as well as banks and thrift institutions. The Company has three projects located on the Upper West Side of Manhattan, in which it has a 50% residual partnership interest, with respect to which the Company has made application for incentives under the Low Income Housing Preservation and Resident Homeownership Act ("LIHPRHA"). On April 28, 1993, HUD provided the Partnership with a Value Determination Letter for the first of its projects establishing a substantial value for the project, and in August and October 1993 HUD provided technical comments on the Plan of Action necessary to complete the processing. HUD has notified the Company that it is reversing its prior Value Determination and consequently will require the Partnership to reprocess the project, using a different formula for valuation, presently being developed by HUD. Under HUD's revised formula, the project may have a substantially diminished value. The Company disagrees with the reversal of HUD's prior Value Determination position, has so notified HUD and discussions are in process regarding this matter. In light of the foregoing, the amount of cash proceeds and profits, if any, the Company could receive for its 50% residual interest in the project as well as the time required to complete the processing is uncertain. The revised HUD position also affects processing under LIHPRHA for the two similar projects in which the Company owns a 50% residual interest located on the Upper West Side of Manhattan. If sustained, the revised HUD position will affect all New York projects of a similar nature. See "Business - Ownership of Partnership Interests," page 6. 1992 Compared to 1991 During the year ended December 31, 1992 the Company had net income of $2,395,000 ($.37 per share) as compared with $1,384,000 ($.21 per share) in 1991. The accounting change and the extraordinary item described below added $1,287,000 and $824,000 or $.20 and $.13 per share, respectively, to net income for the year ended December 31, 1992. Earnings per share were based on average shares outstanding of 6,417,000 for 1992 and 6,495,000 for 1991. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes, which requires the Company to adjust deferred taxes for the temporary differences between the tax bases of its assets and liabilities and the amounts reported in the financial statements at enacted statutory tax rates. In September 1992, the Company repurchased a $2,600,000 outstanding mortgage loan (including accrued interest) for approximately $1,300,000, including transaction costs. The extraordinary gain, net of income tax effect, was $824,000. In October 1992, Roosevelt Island Associates ("RIA"), a partnership in which a Company subsidiary is one of several partners, defaulted on its mortgage payment obligations to the New York City Housing Development Corporation. The default was cured on January 15, 1993, by RIA entering into a bond refunding transaction with respect to its FHA insured $157,500,000 mortgage loan. This transaction resulted in an interest rate reduction to approximately 6.66%, from a prior rate of approximately 9.7%. The refinancing reduced RIA's debt service by $4,200,000 annually, thereby substantially reducing RIA's operating deficits which the Company, as a joint venture partner, has a continuing obligation to fund. As part of the refunding transaction, the Company provided cash flow guarantees to the investor partner. HRH reported a small profit for 1992. Its fee backlog decreased to $8,158,000 at December 31, 1992 as compared with $9,409,000 at the end of 1991. The Company's development activities also contributed to profits during 1992 with the recognition of $1,000,000 of income from its Livingston Plaza project, and the successful development, construction and sale by its Levitt division of a rental apartment project to a major institutional investor at a $1,800,000 profit. Grenadier continued its steady profitability in 1992. Grenadier is now providing management services to private owners and to institutional property owners as well as banks and thrift institutions. The Company's Levitt subsidiary reported income before taxes for 1992 of $864,000 as compared with a loss before taxes of $4,575,000 in 1991. The income in 1992 was before giving effect to the extraordinary gain on the repurchase of debt or the accounting change previously described. Sales in Puerto Rico increased to $48,616,000 for the year compared with $35,598,000 in 1991 and Levitt's company-wide backlog was $33,765,000 at December 31, 1992 compared with $27,043,000 for 1991. Domestically, Levitt's profitability was adversely affected by slow sales in certain of its projects. Levitt continued with its aggressive land disposition program, and in 1993 largely completed the liquidation of certain of its domestic land positions by selling and building homes at reduced prices. As a result of this program, in 1992 the Company increased its non-cash reserve by $1,810,000 to reduce the carrying value of its real estate inventory to its estimated net realizable value. Revenues increased $766,000 for the year 1992 compared with the similar period in 1991 as a result of an increase in revenues from Levitt of $10,327,000, offset principally by a decrease in revenues recognized upon the completion of a large project, Livingston Plaza in 1991, which was built and sold to The New York City Transit Authority, as well as a decrease in revenues of the Company's HRH division. General and administrative expenses (which were reduced for all divisions other than Grenadier which showed an overhead increase for the year) were reduced $2,200,000 in 1992 following a $3,000,000 reduction in 1991 as a result of continuing cost reduction programs. Interest expense decreased by $1,000,000 for 1992 as compared to 1991 primarily as a result of both a decrease in borrowings and a decline in interest rates. Levitt's interest, real estate taxes and sales costs incurred with certain properties are capitalized in order to achieve better matching of costs with revenues. The Company's interest incurred on loans was $5,964,000 in 1992 and $8,264,000 in 1991, of which $4,150,000 in 1992 and $5,314,000 in 1991 was capitalized by Levitt in its operations. Levitt amortized capitalized interest of $5,177,000 in 1992 and $4,909,000 in 1991 to construction and related costs. Cash Flow and Liquidity While the Company presently has various banking relationships, it does not have any formal lines of credit other than in connection with its Levitt subsidiary as described below. Levitt's business and earnings are substantially dependent on its ability to obtain financing on acceptable terms for it's activities. The Company has a $18,400,000 balance on a term loan, previously a revolving credit loan which was converted to a term loan in November 1991. As of December 31, 1993, the loan agreement provides for semi-annual principal payments of $1,000,000 in January and July in 1994 and 1995, a $3,000,000 payment in January 1996, a $1,000,000 payment in July 1996, a $3,000,000 payment in January 1997 and a final payment of $7,400,000 in July 1997. Levitt's Puerto Rico operations are partially financed by an unsecured $15,000,000 revolving credit facility with a Puerto Rico bank. As a result of greater than anticipated house sales in Levitt's Puerto Rico Encantada planned community in 1992 and a resultant increase in capital needed to complete such homes, Levitt obtained a short-term secured loan for $6,000,000 in June 1992. This facility was repaid in full in March 1993. In September 1993, the Puerto Rico mortgage branch operations entered into a $3,000,000 revolving credit agreement, with a Puerto Rico bank to finance the warehousing of mortgage note receivables originated by the mortgage operation. As of December 31, 1993, no amount was outstanding on its warehousing line of credit. Levitt also finances the acquisition of property for its operations on deferred payment terms provided by sellers of such property. Levitt anticipates that funds generated by operations, together with its existing credit relationships, will provide it with adequate financial resources to satisfy its operating needs and to meet its anticipated capital requirements for new projects. The timing of introducing Levitt's new projects to the market, weather conditions in certain of Levitt's regions, and traditional periods of greater customer activity have tended to create seasonal trends in Levitt's residential home building activities. Historically, the number of homes delivered has been greater in the second half of the calendar year. Net Operating Loss Carryforwards At December 31, 1993 the Company had net tax operating loss carryforwards which can be utilized against future taxable income of approximately $12,957,000 expiring in 2001 through 2008. Under current tax laws, if the aggregate voting stock owned by the Company's 5% shareholders increases over the lowest percentage owned by such shareholders during a three-year period by an amount exceeding 50% of Starrett's total voting stock, then Starrett's utilization of the net tax operating loss carryforwards could be limited to an amount per year equal to the market value of all Starrett equity securities multiplied by an adjusted federal long-term interest rate. In general, all non-5% shareholders are treated as a single 5% shareholder for the purpose of such calculations. Such an ownership change might be caused by sales of shares by the Company's shareholders, repurchases of shares by the Company, certain reorganizations, or certain other transactions. Inflation The Company believes that inflation has not had a material adverse effect upon its construction, development and management business. Levitt has from time to time been adversely affected by high interest costs and increases in material and labor costs which it has not been able to pass through entirely to home purchasers. Item 8.

Item 8. Consolidated Financial Statements and Supplementary Data See "Table of Contents to Consolidated Financial Statements and Financial Statement Schedules," page 19. Item 9.

Item 9. Disagreements on Accounting and Financial Disclosure None PART III The information called for by Items 10, 11, 12 and 13 is incorporated herein by reference from the following portions of the definitive proxy statement to be filed by the Company in connection with its 1994 Meeting of Shareholders. Item Incorporated from Item 10.

Item 10. Directors and Executive "Election of Directors" Officers of the Company Item 11.

Item 11. Executive Compensation "Compensation and Certain Transactions" Item 12.

Item 12. Security Ownership of "Information as to Certain Beneficial Stock Ownership" Owners and Management Item 13.

Item 13. Certain Relationships "Compensation and and Related Transactions Certain Transactions" PART IV Item 13. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) See the accompanying Table of Contents to Consolidated Financial Statements and Schedules and the accompanying Exhibit Index. (b) Reports on Form 8-K: The Registrant did not file any report on Form 8-K during the quarter ended December 31, 1993. TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Financial Statement Schedules, other than that listed above, are omitted because of the absence of the conditions under which they are required, or because the information required therein is set forth in the financial statements or the notes thereto. [DELOITTE & TOUCHE LETTERHEAD] INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders of Starrett Housing Corporation We have audited the consolidated financial statements and the related financial statement schedule of Starrett Housing Corporation and consolidated subsidiaries, listed in the foregoing table of contents. These consolidated financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company and its consolidated subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in note 6, the Company changed its method of accounting for income taxes effective January 1, 1992 to conform with Statement of Financial Accounting Standard No. 109. Deloitte & Touche March 21, 1994 STARRETT HOUSING CORPORATION AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED FINANCIAL POSITION December 31, 1993 and 1992 (In Thousands) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED OPERATIONS For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands Except Per Share Data) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES STATEMENTS OF STOCKHOLDERS' EQUITY For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands Except Share Data) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. Principles of Consolidation: The consolidated financial statements include the accounts of Starrett Housing Corporation (the "Company") and all of its subsidiaries. Intercompany accounts and transactions have been eliminated in the consolidated financial statements. B. Recognition of Income: The Company follows the percentage-of-completion method of recording revenues and related costs from construction contracts using the cost-to-cost method and provides currently for estimated losses on uncompleted contracts. Profits relating to sales of limited partnership interests and development fees are recognized on the percentage-of-completion method and full accrual method as appropriate. Revenue from the sale of real estate in which the Company has a continuing involvement is recognized in accordance with Statement of Financial Accounting Standards No. 66. Reflected in the deferred revenues account is that portion of the profit from the sale which is required to be deferred under the provisions of such Statement. Revenues from house sales and all related costs and expenses are recognized upon passage of title to the buyer and receipt of an adequate down payment. Revenues from cost-plus fee contracts are recognized on the basis of costs incurred during the period plus the fee earned. C. Inventory of Real Estate: Inventory of real estate is stated at the lower of cost or estimated net realizable value. Cost includes direct acquisition, development and construction costs, interest and other indirect construction costs. Estimated net realizable value is defined as an estimate of sales proceeds less all estimated costs of carrying, completing and disposing of the property. Interest is capitalized at the effective interest rates paid on borrowings for interest costs incurred on real estate inventory components during the preconstruction and planning stage and the periods that projects are under development. Capitalization of interest is discontinued if development ceases at a project. Land and improvement costs are allocated based on a method that approximates the relative sales value method. Construction costs are charged to individual homesites based on specific identification. D. Land Held for Investment: Land parcels in which the Company has no formal plans to develop or sell are classified as land held for investment. Land held for investment is carried at cost. Land parcels previously included in inventory of real estate and reclassified to land held for investment are valued at the lower of their acquisition cost or fair value at the time of transfer. The carrying value of land held for investment is evaluated for other than temporary declines in value. For the years 1993 and 1992, no adjustments for other than temporary declines were necessary. E. Rental and Other Property and Equipment: Rental and other property and equipment are carried at cost less accumulated depreciation and are depreciated using the straight-line method over the estimated useful lives of the assets which range from three to fifty years. Expenditures for maintenance and repairs are charged to expense as incurred. Costs of major renewals and betterments which extend useful lives are capitalized. F. Capitalized Costs: Mortgage interest, real estate taxes, and sales costs incurred in connection with certain properties are capitalized in order to achieve better matching of costs with revenues. Interest incurred on loans was $3,893,000 in 1993, $5,964,000 in 1992 and $8,264,000 in 1991, of which $2,959,000 in 1993, $4,150,000 in 1992 and $5,314,000 in 1991 was capitalized. Amortization of capitalized interest of $5,802,000 in 1993, $5,177,000 in 1992 and $4,909,000 in 1991 was charged to construction costs. Certain tangible costs incurred that are used directly throughout the selling period to aid in the sale of units, such as model furnishings and decorations, sales office furnishings and facilities, exhibits, displays and signage, are capitalized as deferred selling costs and amortized over the number of units to be delivered. Costs incurred during the initial and due diligence phases of a project, such as land deposits and studies, are capitalized as preacquisition costs. The unrecovered preacquisition costs are written off in the period the Company abandons development of the project. G. Income Taxes: The Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1992. The Company has reported the change in accounting for income taxes as a cumulative effect of a change in accounting method. Prior year amounts have not been restated (Note 6). H. Investments in Partnerships: Investments in partnerships in which the Company does not have a controlling interest are accounted for at cost and investments in a partnership in which the Company does have a controlling interest is accounted for on the equity method. I. Cash and Cash Equivalents: The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. J. Reclassifications: Certain prior year amounts have been reclassified in the financial statements and segment information to conform with the 1993 presentation. 2. RECEIVABLES Receivables are summarized as follows: It is expected that the receivables at December 31, 1993 as set forth above will be collected as follows: $15,198,000 in 1994, $1,610,000 in 1995, $46,000 in 1996, $51,000 in 1997, $56,000 in 1998 and $5,763,000 thereafter. At December 31, 1993, approximately $2,201,000 ($5,400,000 at December 31, 1992) of these mortgage notes receivable have been pooled into GNMA certificates which are guaranteed by the United States Government. The Company has pledged the mortgage notes as collateral to borrow funds from institutions at interest rates lower than those earned on the mortgage notes receivable and as collateral for GNMA matched payment serial notes (Note 7). The remaining mortgage notes receivable have been originated by the Company under firm commitments for sale to various third parties. The mortgage notes receivable, which result primarily from sales of homes in Puerto Rico, are payable in monthly installments and earn interest at stated interest rates which ranged from 7.5 to 12% in 1993 and 1992. 3. INVENTORY OF REAL ESTATE Inventory of real estate is summarized as follows: Due to the decline in demand for housing and the resultant weak real estate markets in New York, New Jersey, Virginia-Washington, D.C. and certain projects in Florida, the Company in 1990, implemented aggressive home sales programs to reduce land positions and thereby generate cash which can be used to invest in better yielding opportunities. The Company liquidated these land positions by selling and building homes at reduced prices. Due to the continuation of this program, the Company in 1992 increased the noncash reserve to reduce the net carrying value of inventory of real estate to its estimated net realizable value by $1,810,000. At December 31, 1993, the balance of these reserves is $725,000 (at December 31, 1992 - $2,289,000) and has been recorded as an allowance to reduce the inventory of land and land development costs. 4. RENTAL AND OTHER PROPERTY AND EQUIPMENT Rental and other property and equipment are summarized as follows: Rental properties consisted of two self storage mini-warehouse facilities which were sold for cash during 1993. 5. OTHER ASSETS Other assets are summarized as follows: 6. INCOME TAXES The Company and its domestic subsidiaries file a consolidated federal income tax return. The provision for income taxes consists of the following: Deferred income taxes result from temporary differences in the recognition of revenue and expense for tax and financial reporting purposes. The sources of these differences are primarily tax losses from limited partnerships, recognition of fee income, non-cash valuation reserves on land inventory and capitalization of interest and overhead. At December 31, 1993 the Company had a net tax operating loss carryforward, which can be utilized against future taxable income, of approximately $12,957,000 expiring in 2001 through 2008. There is no net operating loss carryforward for financial statement reporting purposes. Cash payments for income taxes during the years ended December 31, 1993, 1992 and 1991 were $2,251,000, $1,143,000 and $2,405,000, respectively. The effective tax rate was different from the statutory Federal tax rate for the following reasons: In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes ("SFAS 109"). SFAS 109 requires the Company to recognize deferred taxes for the temporary differences between the tax bases of its assets and liabilities and the amounts reported in the financial statements at enacted statutory tax rates. The Company adopted SFAS 109 as of January 1, 1992. The cumulative effect of this change is reported separately in the Statement of Consolidated Operations for the Year Ended December 31, 1992. The tax effect of each type of temporary difference that gave rise to the Company's deferred tax liability is as follows: Total deferred tax assets and liabilities were $11,709,000 and $15,817,000, respectively, at December 31, 1993 and $10,188,000 and $15,870,000, respectively, at December 31, 1992. No valuation allowance was required for deferred tax assets. 7. DEBT Notes, mortgages payable and long-term obligations are summarized as follows: (A) On December 31, 1990, the Company redeemed all of American Financial Corporation's $5.81 cumulative convertible preferred stock and issued six equal subordinated promissory notes in the aggregate principal amount of $8,800,000, maturing 1992 through 1997. The notes bear simple interest at the rate of 15% per annum. In January 1994 the third promissory note in the amount of $1,466,667 was paid. In connection with the redemption of its preferred stock, the Company also had a $4,379,000 note payable to ITT Corporation at December 31, 1992 which was paid in January 1993. (B) The Company has a balance of $18,400,000 under an unsecured bank credit facility. The terms of the agreement require the Company to maintain certain financial ratios, and restrict the payment of cash dividends under certain conditions. This facility was converted from an unsecured revolving credit loan to an unsecured term loan as of November 1991. The term loan as of December 31, 1993 which was originally $28,000,000 provides for semi-annual principal payments in January and July of $1,000,000 in 1994 and 1995, then $3,000,000 in January 1996, $1,000,000 in July 1996, $3,000,000 in January 1997 and a final payment of $7,400,000 in July 1997. (C) In June 1992, the Company amended its unsecured $15,000,000 revolving credit agreement with its Puerto Rico bank to increase the facility $6,000,000 to $21,000,000 and extended the maturity to March 1993. The additional $6,000,000 facility is secured by certain developed and undeveloped lots. At December 31, 1992, $15,000,000 and $1,436,000 were outstanding on the unsecured and secured portions of the credit facility, respectively. As of March 1993, the secured portion of the facility was repaid. In April 1993, the Company renewed the unsecured revolving portion of the credit facility for an additional three years. The agreement provides for revolving loans up to $15,000,000. Terms of the agreement require the Company's subsidiary to maintain certain financial ratios and restrict the payment of cash dividends under certain circumstances. (D) On December 31, 1993, the Company had loans totalling $2,201,000 (secured by a pledge of GNMA certificates in the same amount) through the issuance of long-term debentures by a subsidiary of a non-profit community development corporation in Puerto Rico. Both the short-term loans and debentures, which are secured by mortgage notes receivable pooled into GNMA certificates, bear interest at rates lower than the interest rates on such mortgage receivables. (E) In September 1992, the Company repurchased a $2,600,000 mortgage loan (including accrued interest) for approximately $1,300,000, including transaction costs. The Company recorded an extraordinary gain of $824,000 net of income taxes of $490,000. In September 1993, the Company's Puerto Rico mortgage branch operations entered into a $3,000,000 revolving credit agreement with a Puerto Rico bank to finance the warehousing of mortgage note receivables originated by the mortgage operation. As of December 31, 1993, no amount was outstanding on this warehousing line of credit. Notes and mortgages payable were collateralized by land inventory, land held for investment, rental properties and mortgage notes receivable with net carrying values aggregating $28,415,000 and $43,333,000 at December 31, 1993 and 1992, respectively. Debt obligations are scheduled to mature as follows: $6,496,000 in 1994, $4,207,000 in 1995, $20,513,000 in 1996, $14,287,000 in 1997, $56,000 in 1998 and $1,970,000 thereafter. Certain mortgage notes contain provisions for reducing the principal as individual homes are sold by the Company. Interest paid (net of amounts capitalized) for the years ended December 31, 1993, 1992 and 1991 was $1,362,000, $1,923,000 and $4,509,000, respectively. As of December 31, 1993, the Company had outstanding letters of credit totalling approximately $1,175,000 on which there are service charges ranging from 0.5% to 1% on the outstanding balances. The Company also had outstanding financial security bonds in the amount of $7,443,000 securing various obligations. 8. PENSION PLAN The Company and its subsidiaries have a noncontributory defined benefit pension plan (the "Plan") covering employees not represented by a union. The benefits are based on years of service and the employees' compensation over the last five years. Effective July 31, 1992, the Board of Directors amended the Plan to freeze accrued benefits for all participants. The Company will continue to fund the Plan as required, including any interest at the assumed average rate of return on Plan assets. As of December 31, 1993, the plan held fixed income securities, life insurance policies and short-term investments. Assumed average future rate of return on Plan assets was 8% for the years ended December 31, 1993 and 1992, and the projected benefit obligation was based on a 7.75% and 8% assumed discount rate at December 31, 1993 and 1992, respectively, and a 5% assumed long-term rate of compensation increase. The total pension plan cost was $880,000 in 1991. The components of net periodic pension (benefit) cost for the years ended December 31, 1993 and 1992 are as follows: The following table sets forth the Plan's funded status as of December 31, 1993 and 1992: In accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions," an additional minimum pension liability, representing the excess of accumulated benefits over plan assets and accrued pension costs, was recognized at December 31, 1993. A corresponding amount, net of income tax benefit, was recorded as a separate reduction to stockholders' equity. The Company does not provide postretirement or postemployment benefits other than pensions to employees. Therefore, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 112, "Employers' Accounting for Postemployment Benefits" have no impact on the Company's financial statements. 9. SEGMENT INFORMATION The Company's operations consist of (i) the development, management and ownership of real estate properties; (ii) the single-family home and garden apartment business conducted through its Levitt subsidiary; and (iii) the supplying of construction services through its HRH subsidiary. The Company groups its business into these three segments. The following table sets forth the Company's revenues and operating profit attributable to the respective segments of its operations for each of the years 1991 through 1993, and the identifiable assets attributable to the respective segments as at the end of each of those years: (1) Operating profit is comprised of revenues less operating expenses. In computing operating profit, general corporate expenses and income taxes have not been deducted. (2) There were no customers from which the Company derived more than 10% of its revenues in 1993, 1992 or 1991. 10. COMMITMENTS AND CONTINGENCIES Roosevelt Island Associates ("RIA"), a partnership in which a Company subsidiary is one of several partners, has provided guaranteed payments to the investor partner. The Company's share of such guarantees was $250,000 for 1993 and $465,000 for 1994 and approximately $100,000 each year until 2005, which will be paid by the Company if project cash flow is insufficient to cover these amounts. In connection with this project, the Company also provided cash flow guarantees from which it will be released if the project achieves a certain cash flow level over a specified period of time. The Company is also jointly and severally liable for $3,225,000 of a loan made in connection with a mini-warehouse facility in which it has an ownership interest. The Company's Levitt subsidiary provides for estimated warranty costs when homes are sold and continuously monitors its warranty exposure and service program. Rent expense for the years ended December 31, 1993, 1992 and 1991 was $1,004,000, $1,042,000 and $1,225,000, respectively. At December 31, 1993 the Company and its subsidiaries are committed under long-term leases expiring at various dates through 1998. The minimum rentals are $923,000 in 1994, $896,000 in 1995, $804,000 in 1996, $161,000 in 1997, and $102,000 in 1998, or an aggregate of $2,886,000. The Company is involved in litigation and claims incident to the normal conduct of its business. Management believes that such litigation and claims will not have a materially adverse effect on the Company's consolidated financial position or results of operations. 11. QUARTERLY FINANCIAL DATA (Unaudited) The quarterly financial data are set forth below (dollars in thousands, except per share amounts): (A) Includes the effect of $1,810,000 in non-cash reserves to reduce the carrying value of land to its estimated net realizable value. Certain quarterly amounts have been reclassified to conform with the annual presentation. Schedule III STARRETT HOUSING CORPORATION (Parent Company Only) CONDENSED STATEMENTS OF FINANCIAL POSITION December 31, 1993 and 1992 (In Thousands) STARRETT HOUSING CORPORATION (Parent Company Only) CONDENSED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Schedule III STARRETT HOUSING CORPORATION (Parent Company Only) CONDENSED STATEMENTS OF CASH FLOWS (In Thousands) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. STARRETT HOUSING CORPORATION Date: March 21, 1994 BY /s/ Paul Milstein -------------------------------- Paul Milstein Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date: March 21, 1994 By /s/ Paul Milstein -------------------------------- Paul Milstein, Principal Director Date: March 21, 1994 By /s/ Lewis A. Weinfeld -------------------------------- Lewis A. Weinfeld, Principal Financial and Accounting Officer Date: March 21, 1994 By /s/ Henry Benach -------------------------------- Henry Benach, Director STARRETT HOUSING CORPORATION EXHIBITS DECEMBER 31, 1993 COMMISSION FILE NUMBER 1-6736 STARRETT HOUSING CORPORATION EXHIBIT INDEX

847322_1993.txt

847322

1993

ITEM 1. BUSINESS Development and Description of Business - --------------------------------------- Information concerning the business of CRIIMI MAE Inc. (CRIIMI MAE) is contained in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and in Notes 1, 5 and 14 of the notes to the consolidated financial statements of CRIIMI MAE contained in Part IV (filed in response to Item 8 hereof), which is incorporated herein by reference. Employees - --------- CRIIMI MAE has no employees. Services are performed for CRIIMI MAE by CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) and agents retained by it. ITEM 2.

ITEM 2. PROPERTIES CRIIMI MAE does not hold title to any real estate. CRIIMI MAE indirectly holds interests in real estate through CRI Liquidating REIT, Inc.'s (CRI Liquidating) equity investment in three Participating Mortgage Investments. These investments were comprised of two components: 85% of the original investment amount was a GNMA Mortgage-Backed Security; and 15% of the original investment amount was an uninsured equity contribution to the limited partnership (a Participation) which owns the underlying property. During 1993, CRI Liquidating sold the GNMA Mortgage-Backed Securities, but retained its Participations. The aggregate carrying value of these Participations represents less than 1% of CRIIMI MAE's total consolidated assets as of December 31, 1992 and 1993. Although CRIIMI MAE does not own the related real estate, the government insured and guaranteed mortgage investments (Government Insured Multifamily Mortgages) in which CRIIMI MAE has invested are first or second liens, or are collateralized by first or second liens, on the respective residential apartment, nursing home or townhouse complexes. PART I ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Reference is made to Note 15 of the notes to the consolidated financial statements on pages 134 through 135 of the 1993 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to the security holders to be voted on during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS (a), (b) and (c) The information required in these sections is included in Selected Consolidated Financial Data on pages 22 through 26 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Reference is made to Selected Consolidated Financial Data on pages 22 through 26 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 27 through 63 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. PART II ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to pages 64 through 74 of the 1993 Annual Report to Shareholders for the consolidated financial statements of CRIIMI MAE, which are incorporated herein by reference. See also Item 14 of this report for information concerning financial statements and financial statement schedules. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a), (b), (c) and (e) The information required by Item 10 (a), (b), (c) and (e) with regard to directors and executive officers of the registrant is incorporated herein by reference to CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Securities and Exchange Commission no later than April 30, 1994. (d) There is no family relationship between any of the directors and executive officers. (f) Involvement in certain legal proceedings. None. (g) Promoters and control persons. Not applicable. PART III ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994, and Note 3 of the notes to the consolidated financial statements included in the 1993 Annual Report to Shareholders. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with management and others. Of CRIIMI MAE's five officers, two are executive officers who serve on CRIIMI MAE's Board of Directors. CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994, and Note 3 of the notes to the consolidated financial statements, included in the 1993 Annual Report to Shareholders, which contain a discussion of the amounts, fees and other compensation paid or accrued by CRIIMI MAE to the directors and executive officers and their affiliates, are incorporated herein by reference. (b) Certain business relationships. CRIIMI MAE has no business relationship with entities of which the general and limited partners of the Adviser to CRIIMI MAE are officers, directors or equity owners other than as set forth in CRIIMI MAE's 1994 Notice of PART III ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Continued Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994, which is incorporated herein by reference. (c) Indebtedness of management. None. (d) Transactions with promoters. Not applicable. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) List of documents filed as part of this report: 1 and 2. Financial Statements and Financial Statement Schedules The following financial statements are incorporated herein by reference in Item 8 from the indicated pages of the 1993 Annual Report to Shareholders: The report of CRIIMI MAE's independent accountants with respect to the above listed consolidated financial statements appears on page 64 of the 1993 Annual Report to Shareholders. All other financial statements and financial statement schedules have been omitted since the required information is included in the financial statements or the notes thereto, or is not applicable or required. (a) 3. Exhibits (listed according to the number assigned in the table in Item 601 of Regulation S-K) Exhibit No. 3 - Articles of incorporation and bylaws. d. Articles of Incorporation of CRIIMI MAE Inc. (Incorporated by reference from Exhibit 3(d) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). e. Bylaws of CRIIMI MAE Inc. (Incorporated by reference from Exhibit 3(e) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). f. Agreement and Articles of Merger between CRIIMI MAE Inc. and CRI Insured Mortgage Association, Inc. as filed with the Office of the Secretary of the State of Delaware (Incorporated by reference from Exhibit 3(f) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). g. Agreement and Articles of Merger between CRIIMI MAE Inc. and CRI Insured Mortgage Association, Inc. as filed with the State Department of Assessment and Taxation for the State of Maryland (Incorporated by reference from Exhibit 3(g) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). Exhibit No. 4 - Instruments defining the rights of security holders, including indentures. a. $85,000,000 Credit Agreement, and the exhibits thereto, dated as of October 23, 1991, between CRI Insured Mortgage Association, Inc., Signet Bank/Virginia and Westpac Banking Corporation (Incorporated by reference from Exhibit 4(g) to the Annual Report on Form 10-K for 1991). b. Collateral Pledge Agreement, and the exhibits thereto, dated as of December 31, 1991, between CRI Insured Mortgage Association, Inc., Signet Bank/Virginia, Westpac Banking Corporation and Chemical Bank (Incorporated by reference from Exhibit 4(h) to the Annual Report on Form 10-K for 1991). c. Temporary Global Note, dated as of December 31, 1991, in the aggregate amount of $19,190,625 issued by the registrant (Incorporated by reference from Exhibit 4(i) to the Annual Report on Form 10-K for 1991). d. $100,000,000 Amended and Restated Credit Agreement, and the exhibits thereto, dated as of October 23, 1991 and Amended December 22, 1992, between CRI Insured Mortgage Association, Inc., Signet Bank/Virginia and Westpac Banking Corporation (Incorporated by reference from Exhibit 4(d) to the Annual Report on Form 10-K for 1992). e. Amended and Restated Collateral Pledge Agreement, and the exhibits thereto, dated as of December 31, 1991 and amended and restated as of December 29, 1992, between CRI Insured Mortgage Association, Inc. and Chemical Bank (Incorporated by reference from Exhibit 4(e) to the Annual Report on Form 10-K for 1992). f. Amended and Restated Letter of Credit and Reimbursement Agreement and the exhibits thereto, dated as of February 9, 1993 between CRI Funding Corporation, Canadian Imperial Bank of Commerce New York Agency and National Australia Bank Limited, New York Branch (Incorporated by reference from Exhibit 4(f) to the Annual Report on Form 10-K for 1992). g. Amended and Restated Guaranty, dated as of February 9, 1993 between CRI Insured Mortgage Association, Inc., Canadian Imperial Bank of Commerce New York Agency and National Australia Bank Limited, New York Branch (Incorporated by reference from Exhibit 4(g) to the Annual Report on Form 10-K for 1992). h. Amended and Restated Loan Agreement and the exhibits thereto, dated as of February 9, 1993 between CRI Insured Mortgage Association, Inc. and CRI Funding Corporation (Incorporated by reference from Exhibit 4(h) to the Annual Report on Form 10-K for 1992). i. Second Amended and Restated Security Agreement and the exhibits thereto, dated as of February 9, 1993 between CRI Insured Mortgage Association, Inc., Canadian Imperial Bank of Commerce New York Agency and Chemical Bank (Incorporated by reference from Exhibit 4(i) to the Annual Report on Form 10-K for 1992). j. Committed Master Repurchase Agreement between Nomura Securities International, Inc. and CRI Insured Mortgage Association, Inc. dated April 30, 1993 (Incorporated by reference from Exhibit 4(j) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). k. Committed Master Repurchase Agreement Governing Purchases and Sales of Participation Certificates between Nomura Asset Capital Corporation and CRI Insured Mortgage Association, Inc. dated April 30, 1993 (Incorporated by reference from Exhibit 4(k) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). l. Committed Master Repurchase Agreement between Nomura Securities International, Inc. and CRIIMI MAE Inc. dated November 30, 1993 (filed herewith). m. Committed Master Repurchase Agreement Governing Purchases and Sales of Participation Certificates between Nomura Asset Capital Corporation and CRIIMI MAE Inc. dated November 30, 1993 (filed herewith). n. Extension and Amendment Agreement between CRI Funding Corporation, CRIIMI MAE Inc., Canadian Imperial Bank of Commerce New York Agency, National Australia Bank Limited, New York Branch, and The Fuji Bank, Ltd., New York Branch dated January 25, 1994 (filed herewith). o. Settlement Agreement between Alex J. Meloy, Trustee of the Harry Meloy Family Trust and Alan J. Hunken, Trustee of the Alan J. Hunken Retirement Plan, individually and in their capacities as representatives of certain plaintiff classes in Alex J. Meloy, et ----------------- al., v. CRI Liquidating REIT, Inc., et al., and (ii) CRI ------------------------------------------- Liquidating REIT, Inc.; CRIIMI MAE Inc.; C.R.I., Inc.; William B. Dockser; Martin C. Schwartzberg, and H. William Willoughby dated September 24, 1993 (filed herewith). Exhibit No. 10 - Material contracts. a. Revised Form of Advisory Agreement. (Incorporated by reference from Exhibit No. 10.2 to the Registration Statement). Exhibit No. 13 - Annual Report to security holders, Form 10-Q or Quarterly Report to security holders. a. 1993 Annual Report to Shareholders. Exhibit No. 21 - Subsidiaries of the registrant. a. CRI Liquidating REIT, Inc., incorporated in the state of Maryland. b. CRIIMI, Inc., incorporated in the state of Maryland. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits The list of Exhibits required by Item 601 of Regulation S-K is included in Item (a)(3) above. (d) Financial Statement Schedules See Item (a) 1 and 2 above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. CRIIMI MAE INC. February 15, 1994 /s/ William B. Dockser - --------------------- ------------------------------ DATE William B. Dockser Chairman of the Board and Principal Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: February 15, 1994 /s/ Elizabeth O. Flanagan - --------------------- --------------------------------- DATE Elizabeth O. Flanagan Chief Financial Officer and Principal Financial and Accounting Officer February 15, 1994 /s/ H. William Willoughby - --------------------- --------------------------------- DATE H. William Willoughby Director, President and Secretary February 15, 1994 /s/ Jay R. Cohen - --------------------- --------------------------------- DATE Jay R. Cohen Executive Vice President and Treasurer February 2, 1994 /s/ Frederick J. Burchill - --------------------- --------------------------------- DATE Frederick J. Burchill Executive Vice President February 2, 1994 /s/ Garrett G. Carlson, Sr. - --------------------- --------------------------------- DATE Garrett G. Carlson, Sr. Director February 10, 1994 /s/ G. Richard Dunnells - --------------------- --------------------------------- DATE G. Richard Dunnells Director February 15, 1994 /s/ Robert F. Tardio - --------------------- --------------------------------- DATE Robert F. Tardio Director CROSS REFERENCE SHEET The item numbers and captions in Parts I, II, III and IV hereof and the page and/or pages in the referenced materials where the corresponding information appears are as follows: CROSS REFERENCE SHEET EXHIBIT INDEX CRIIMI MAE INC. ANNUAL REPORT TO SHAREHOLDERS Selected Consolidated Financial Data CRIMIMI MAE INC. Selected Consolidated Financial Data - Continued CRIIMI MAE INC. Selected Consolidated Financial Data - Continued The selected consolidated statements of income data presented above for the years ended December 31, 1991, 1992 and 1993, and the consolidated balance sheet data as of December 31, 1992 and 1993, were derived from and are qualified by reference to CRIIMI MAE's consolidated financial statements which have been included elsewhere in this Annual Report to Shareholders. The consolidated statements of income data for the years ended December 31, 1989 and 1990 and the consolidated balance sheet data as of December 31, 1989, 1990 and 1991 were derived from audited financial statements not included in this Annual Report to Shareholders. This data should be read in conjunction with the consolidated financial statements and the notes thereto. (a) All financial information of CRIIMI MAE for the periods prior to the Merger (defined below) on November 27, 1989 has been presented in a manner similar to a pooling of interests, which effectively combines the historical results of the CRIIMI Funds (defined below). The dividends and net income per share amounts for the year ended December 31, 1989 have been restated based upon the weighted average shares outstanding as if the Merger had been consummated on January 1, 1989. (b) This amount does not include the special dividend of $2.31 per share paid to CRIIMI MAE shareholders of record on November 27, 1989. (c) Includes recognition of an extraordinary loss of approximately $6.6 million ($0.33 per share) resulting from the refinancing of certain notes payable. CRIIMI MAE INC. Selected Consolidated Financial Data - Continued (d) Includes net unrealized gain on mortgage investments of CRI Liquidating of approximately $29.0 million due to the implementation of Statement of Financial Accounting Standard No. 115. Market Data - ----------- On November 28, 1989, CRIIMI MAE was listed on the New York Stock Exchange (Symbol CMM). Prior to that date, there was no public market for CRIIMI MAE's shares. As of December 31, 1992 and 1993, there were 20,183,533 shares held by approximately 23,000 investors. The following table sets forth the high and low closing sales prices and the dividends per share for CRIIMI MAE shares during the periods indicated: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Background - ---------- CRIIMI MAE Inc. (CRIIMI MAE) (formerly CRI Insured Mortgage Association, Inc.), an infinite-life, actively managed real estate investment trust (REIT), is the largest REIT specializing in government insured and guaranteed mortgage investments secured by multifamily housing complexes (Government Insured Multifamily Mortgages) located throughout the United States. CRIIMI MAE's principal objectives are to provide stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages using a combination of debt and equity financing. CRIIMI MAE and its subsidiary, CRI Liquidating REIT, Inc. (CRI Liquidating), are Maryland corporations. CRIIMI MAE and CRI Liquidating were formed in 1989 to effect the merger into CRI Liquidating (the Merger) of three federally insured mortgage funds sponsored by C.R.I., Inc. (CRI), a Delaware corporation formed in 1974: CRI Insured Mortgage Investments Limited Partnership (CRIIMI I); CRI Insured Mortgage Investments II, Inc. (CRIIMI II); and CRI Insured Mortgage Investments III Limited Partnership (CRIIMI III; and, together with CRIIMI I and CRIIMI II, the CRIIMI Funds). The Merger was effected to provide certain potential benefits to investors in the CRIIMI Funds, including the elimination of unrelated business taxable income for certain tax-exempt investors, the diversification of investments, the reduction of general overhead and administrative costs as a percentage of assets and total income and the simplification of tax reporting information. In the Merger, which was approved by investors in each of the CRIIMI Funds and subsequently consummated on November 27, 1989, investors in the CRIIMI Funds received, at their option, shares of CRI Liquidating common stock or shares of CRIIMI MAE common stock. Investors in the CRIIMI Funds that received shares of CRIIMI MAE common stock became shareholders in an infinite-life, actively managed REIT having the potential to increase the size of its portfolio and enhance the returns to its shareholders. CRIIMI MAE shareholders retained their economic interests in the assets of the CRIIMI Funds which were transferred to CRI Liquidating through the issuance of one CRI Liquidating share to CRIIMI MAE for each MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued share of CRIIMI MAE common stock issued to investors in the Merger. Upon the completion of the Merger, CRIIMI MAE held a total of 20,361,807 CRI Liquidating shares, or approximately 67% of the issued and outstanding CRI Liquidating shares. Investors in the CRIIMI Funds that received shares of CRI Liquidating common stock, as well as CRIIMI MAE, became shareholders in a finite-life, self-liquidating REIT the assets of which consist primarily of Government Insured Multifamily Mortgages and other assets formerly held by the CRIIMI Funds. CRI Liquidating intends to hold, manage and dispose of its mortgage investments in accordance with the objectives and policies of the CRIIMI Funds, including disposing of any remaining mortgage investments by 1997 through an orderly liquidation. Pursuant to a Registration Rights Agreement dated November 28, 1989 between CRIIMI MAE and CRI Liquidating, CRIIMI MAE sold 3,162,500 of its CRI Liquidating shares in an underwritten public offering which was consummated in November 1993. As a result of such sale, CRIIMI MAE holds a total of 17,199,307 CRI Liquidating shares, or approximately 57% of CRI Liquidating's issued and outstanding common stock. CRIIMI MAE used approximately $4.9 million of the approximately $26.5 million in net proceeds to terminate a 9.23% interest rate swap agreement on $25 million of CRIIMI MAE's existing indebtedness and used the remaining net proceeds to purchase Government Insured Multifamily Mortgages. CRIIMI MAE and CRI Liquidating are governed by a board of directors, a majority of whom are independent directors with extensive industry related experience. The Board of Directors of CRIIMI MAE and CRI Liquidating has engaged CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) to act in the capacity of adviser to CRIIMI MAE and CRI Liquidating. The Adviser's general partner is CRI and its operations are conducted by CRI's employees. CRIIMI MAE's and CRI Liquidating's executive officers are senior executive officers of CRI. The Adviser manages CRIIMI MAE's portfolio of Government Insured Multifamily Mortgages and other assets with the goal of maximizing CRIIMI MAE's value, and conducts CRIIMI MAE's day-to-day operations. Under an advisory agreement between CRIIMI MAE and the Adviser, the Adviser and its affiliates receive certain fees and expense reimbursements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued CRIIMI MAE Investments - ---------------------- CRIIMI MAE's investment policies, which are overseen by the CRIIMI MAE Board of Directors, are intended to foster its objectives of providing stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages issued or sold pursuant to programs sponsored by the Federal Housing Administration (FHA) and the Government National Mortgage Association (GNMA). CRIIMI MAE's sources of capital include borrowings, principal distributions received on its CRI Liquidating shares, principal proceeds of CRIIMI MAE mortgage dispositions and proceeds from equity offerings. As of December 31, 1992 and 1993, CRIIMI MAE directly owned 60 and 126 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 10.1% and 8.52%, a weighted average remaining term of approximately 31 years and 34 years, and a tax basis of approximately $226 million and $499 million, respectively. As of December 31, 1992 and 1993, CRIIMI MAE indirectly owned through its subsidiary, CRI Liquidating, 73 and 63 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 9.91% and 10.03%, a weighted average remaining term of approximately 28 years and 27 years, and a tax basis of approximately $221 million and $173 million, respectively. Thus, on a consolidated basis, as of December 31, 1992 and 1993, CRIIMI MAE owned, directly or indirectly, 133 and 189 Government Insured Multifamily Mortgages, respectively. These consolidated mortgage investments (including Mortgages Held for Disposition) had a weighted average effective interest rate of approximately 9.98%, a weighted average remaining term of approximately 29 years and a tax basis of approximately $447 million, as of December 31, 1992. These amounts compare to a weighted average effective interest rate of approximately 8.95%, a weighted average remaining term of approximately 32 years and a tax basis of approximately $672 million, as of December 31, 1993. In addition, as of December 31, 1993, CRIIMI MAE had committed MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued approximately $41 million for investment in Government Insured Multifamily Mortgages or advances on FHA-Insured Loans (defined below) relating to the construction or rehabilitation of multifamily housing projects, including nursing homes and intermediate care facilities (Government Insured Construction Mortgages), to be funded by borrowings under the Commercial Paper Facility and the remaining funds available under the Master Repurchase Agreements, as defined below in "Liquidity-Corporate Borrowings". In connection with CRI Liquidating's business plan which calls for an orderly liquidation of approximately 25% of its December 31, 1993 portfolio balance each year through 1997, on February 10, 1994, CRI Liquidating sold twelve Government Insured Multifamily Mortgages resulting in net sales proceeds of approximately $48.7 million. As of the date of the sale, these twelve Government Insured Multifamily Mortgages had a weighted average effective interest rate of approximately 10.3%, a weighted average remaining term of approximately 28 years and a tax basis of approximately $34 million. This sale is expected to result in financial statement and tax basis gains of approximately $11.7 million and $14.7 million, respectively. As discussed below, CRIIMI MAE is permitted to make direct investments in primarily two categories of Government Insured Multifamily Mortgages at, near, or above par value (Near Par or Premium Mortgage Investments). FHA-Insured Loans--The first category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of Government Insured Multifamily Mortgages insured by FHA pursuant to provisions of the National Housing Act (FHA-Insured Loans). All of the FHA-Insured Loans in which CRIIMI MAE invests are insured by HUD for effectively 99% of their current face value. As part of its investment strategy, CRIIMI MAE also invests in Government Insured Construction Mortgages which involve a two-tier financing process in which a short-term loan covering construction costs is converted into a permanent loan. CRIIMI MAE also becomes the holder of the permanent loan upon conversion. The construction loan is funded in HUD-approved draws based upon the progress of construction. The construction loans are GNMA-guaranteed or insured by HUD. The construction loan generally MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued does not amortize during the construction period. Amortization begins upon conversion of the construction loan into a permanent loan, which generally occurs within a 24-month period from the initial endorsement by HUD. Mortgage-Backed Securities--The second category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of federally guaranteed mortgage-backed securities or other securities backed by Government Insured Multifamily Mortgages issued by entities other than GNMA (Mortgage-Backed Securities) and Mortgage-Backed Securities 100% guaranteed as to principal and interest by GNMA (GNMA Mortgage-Backed Securities). As of December 31, 1993, all of CRIIMI MAE's mortgage investments in this category were GNMA Mortgage-Backed Securities. The GNMA Mortgage-Backed Securities in which CRIIMI MAE invests are backed by Government Insured Multifamily Mortgages insured in whole by HUD, or insured by HUD and a coinsured lender under HUD mortgage insurance programs and the coinsurance provisions of the National Housing Act. The Mortgage-Backed Securities in which CRIIMI MAE is permitted to invest, although none have been acquired as of December 31, 1993, are backed by Government Insured Multifamily Mortgages which are insured in whole by HUD under HUD mortgage insurance programs. Generally, Government Insured Multifamily Mortgages which are purchased near, at or above par value will result in a loss if the mortgage investment is prepaid or assigned prior to maturity because the amortized cost of the mortgage investment, including acquisition costs, is approximately the same as or slightly higher than the insured amount of the mortgage investment. As of December 31, 1993, substantially all of the mortgage investments owned directly by CRIIMI MAE consisted of Government Insured Multifamily Mortgages that are Near Par or Premium Mortgage Investments. Based on current interest rates, the Adviser does not believe that the prepayment, assignment, or sale of any of CRIIMI MAE's Government Insured Multifamily Mortgages would result in a material financial statement or tax basis gain or loss. CRI Liquidating Mortgage Investments--CRI Liquidating's mortgage investments consist solely of the Government Insured Multifamily Mortgages it acquired from the CRIIMI Funds in the Merger. The CRIIMI Funds invested primarily in Government Insured MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Multifamily Mortgages issued or sold pursuant to programs of GNMA and FHA. The majority of CRI Liquidating's mortgage investments were acquired by the CRIIMI Funds at a discount to face value (Discount Mortgage Investments) on the belief that based on economic, market, legal and other factors, such Discount Mortgage Investments might be sold for cash, prepaid as a result of a conversion to condominium housing or otherwise disposed of or refinanced in a manner requiring prepayment or permitting other profitable disposition three to twelve years after acquisition by the CRIIMI Funds. Based on current interest rates, the Adviser expects that (i) the disposition of most of CRI Liquidating's Government Insured Multifamily Mortgages will result in a gain on a financial statement basis, and (ii) the disposition of any of CRI Liquidating's Government Insured Multifamily Mortgages will not result in a material loss on a financial statement basis and will result in a gain on a tax basis. Other CRIIMI MAE Mortgage Investments--In addition to investing in FHA-Insured Loans and GNMA-Mortgage Backed Securities, CRIIMI MAE's investment policies also permit CRIIMI MAE to invest in Government Insured Multifamily Mortgages which are not FHA-insured or GNMA-guaranteed (Other Insured Mortgages) and in certain other mortgage investments which are not federally insured or guaranteed (Other Multifamily Mortgages). Pursuant to CRIIMI MAE's policy, at the time of their acquisition, Other Multifamily Mortgages must have an expected yield of at least 150 basis points (1.5%) greater than the yield on Government Insured Multifamily Mortgages which could be acquired in the then current market and must meet certain other strict underwriting guidelines. The CRIIMI MAE Board of Directors has adopted a policy limiting Other Multifamily Mortgages to 20% of CRIIMI MAE's total consolidated assets. As of December 31, 1993, CRIIMI MAE had not invested or committed to invest in any Other Insured Mortgages or Other Multifamily Mortgages and CRIIMI MAE does not currently intend to invest in any Other Multifamily Mortgages for at least twelve months after the filing date of this report. CRIIMI MAE is currently exploring opportunities in connection with the sponsorship of securities offerings which involve the pooling of certain Other Multifamily Mortgages to further enhance MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued potential returns to CRIIMI MAE shareholders. Such sponsorship may also include the investment by CRIIMI MAE in the non-investment grade or unrated tranches of mortgage pools having a high current yield. As of December 31, 1993, CRIIMI MAE had not participated in the sponsorship of any such securities offerings. The Adviser does not expect that investments of this nature will exceed 5% of CRIIMI MAE's total consolidated assets for at least twelve months after the filing date of this report. Investment in Insured Mortgage Funds and Advisory Partnership--On September 6, 1991, CRIIMI MAE, through its wholly owned subsidiary CRIIMI, Inc., acquired from Integrated Resources, Inc. all of the general partnership interests in four publicly held limited partnerships known as the American Insured Mortgage Investors Funds (the AIM Funds). The AIM Funds own mortgage investments which are substantially similar to those owned by CRIIMI MAE and CRI Liquidating. CRIIMI, Inc. receives the general partner's share of income, loss and distributions (which ranges among the AIM Funds from 2.9% to 4.9%) from each of the AIM Funds. In addition, CRIIMI MAE owns indirectly a limited partnership interest in the adviser to the AIM Funds in respect of which CRIIMI MAE receives a guaranteed return each year. Acquisitions - ------------ During 1993, CRIIMI MAE directly acquired 61 Government Insured Multifamily Mortgages with an aggregate purchase price of approximately $284 million at purchase prices ranging from $0.5 million to $30.8 million, with a weighted average effective interest rate of approximately 7.56% and a weighted average remaining term of approximately 33.4 years. In addition, during 1993, CRIIMI MAE funded advances of approximately $29 million on Government Insured Construction Mortgages with a weighted average effective interest rate of approximately 8.73%. As of December 31, 1993, CRIIMI MAE had committed to acquire additional Government Insured Multifamily Mortgages and to make additional advances on and/or acquire Government Insured Construction Mortgages, totalling approximately $41 million. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued During 1993, CRIIMI MAE, and, during each of 1992 and 1993, CRI Liquidating entered into transactions in which mortgage-backed and other government agency securities were purchased. These transactions provided CRIIMI MAE with above average returns compared to its other short-term investments while maintaining the high quality of its assets and assisted in maintaining CRI Liquidating's REIT status. Some of these purchases were financed with borrowings which were nonrecourse and fully secured with the purchased mortgage-backed and other government agency securities. As of December 31, 1993, CRIIMI MAE and as of December 31, 1992 and 1993, CRI Liquidating had disposed of the mortgage-backed and other government agency securities acquired in such year and repaid the related debt. Dispositions - ------------ Dispositions result from prepayments of, defaults on and sales of Government Insured Multifamily Mortgages. Decreases in market interest rates could result in the prepayment of certain mortgage investments. CRIIMI MAE believes, however, that declining interest rates result in increased prepayments of single-family mortgages to a greater extent than mortgages on multifamily properties. This is partially due to lockouts (i.e. prepayment prohibitions), prepayment penalties or difficulties in obtaining refinancing for multifamily dwellings. However, because of the current low interest rates and HUD's current strategy of encouraging mortgagors to refinance high interest rate loans, CRIIMI MAE may experience increased prepayment levels as compared to prior years. Decreases in occupancy levels, rental rates or value of any property underlying a mortgage investment may result in the mortgagor being unable or unwilling to make required payments on the mortgage and thereby defaulting. The proceeds from the assignment (following a default) or prepayment of a Discount Mortgage Investment are expected to exceed the amortized cost of the investment. The proceeds from the assignment or prepayment of a Near Par or Premium Mortgage Investment may be slightly less than, the same as, or slightly more than, the amortized cost of the investment. The proceeds from the sale of any mortgage investment, whether a Discount Mortgage Investment or a Near Par or Premium Mortgage Investment may be slightly less than, the same MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued as, or more than the amortized cost of the investment depending on interest rates at the time of sale. On an amortized cost and tax basis, substantially all of CRIIMI MAE's mortgages are Near Par or Premium Mortgage Investments. Therefore, the proceeds from a default or prepayment of any of CRIIMI MAE's mortgage investments are expected to be slightly less than, the same as, or slightly more than the amortized cost and tax basis of such mortgages. On an amortized cost basis, as of December 31, 1993, approximately 91% of CRI Liquidating's mortgages were Discount Mortgage Investments and approximately 9% were Near Par or Premium Mortgage Investments. On a tax basis, all of CRI Liquidating's mortgages were Discount Mortgage Investments. Therefore, whether by default or prepayment, the proceeds from the disposition of CRI Liquidating's mortgage investments would, for a majority of such mortgages, be expected to exceed the tax basis of such mortgages. However, on an amortized cost basis, the proceeds from a default on, or prepayment of CRI Liquidating's Near Par or Premium Mortgage Investments would be expected to be slightly less than, the same as, or slightly more than the amortized cost. While it is not expected that CRIIMI MAE will sell any of its mortgage investments, CRI Liquidating's business plan calls for an orderly liquidation of approximately 25% of its December 31, 1993 portfolio balance per year through 1997. Therefore, to the extent mortgage investments are not otherwise disposed of, CRI Liquidating intends to sell a substantial portion of its portfolio as is necessary to effect its liquidation plan. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Historical Dispositions - ----------------------- The following table sets forth certain information concerning dispositions of Government Insured Multifamily Mortgages by CRIIMI MAE and CRI Liquidating for the past five years: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (1) CRIIMI MAE or CRI Liquidating may elect to receive insurance benefits in the form of cash when a Government Insured Multifamily Mortgage defaults. In that event, 90% of the face value of the mortgage generally is received within approximately 90 days of assignment of the mortgage to HUD and 9% of the face value of the mortgage is received upon final processing by HUD which may not occur in the same year as assignment. If CRIIMI MAE or CRI Liquidating elects to receive insurance benefits in the form of HUD debentures, 99% of the face value of the mortgage is received upon final processing by HUD. Gains from dispositions are recognized upon receipt of funds or HUD debentures and losses generally are recognized at the time of assignment. (2) Eight of the 37 assignments were sales of Government Insured Multifamily Mortgages then in default and resulted in the CRIIMI Funds, CRI Liquidating or CRIIMI MAE receiving near or above face value. (3) In connection with the Merger, CRI Liquidating recorded its investment in mortgages at the lower of cost or fair value, which resulted in an overall net write down for tax purposes. For financial statement purposes, carryover basis of accounting was used. Therefore, since the Merger, the net gain for tax purposes was greater than the net gain recognized for financial statement purposes. As a REIT, dividends to shareholders are based on tax basis income. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Liquidity - --------- CRIIMI MAE and CRI Liquidating closely monitor their cash flow and liquidity positions in an effort to ensure that sufficient cash is available for operations and debt service requirements and to continue to qualify as REITs. CRIIMI MAE and CRI Liquidating's cash receipts, which have been derived from scheduled payments of outstanding principal of and interest on, and proceeds from dispositions of, mortgage investments held by CRIIMI MAE and CRI Liquidating, plus cash receipts from interest on temporary investments, borrowings, cash received from CRIIMI MAE's interests in the AIM Funds and advisory partnership, and cash received from CRI Liquidating's investment in limited partnerships (Participations), were sufficient for the years 1991, 1992 and 1993 to meet operating, investing and financing cash requirements. It is anticipated that cash receipts will be sufficient in future years to meet similar cash requirements. Cash flow was also sufficient to provide for the payment of dividends to shareholders. As of December 31, 1993, there were no significant commitments for capital expenditures; however, as of such date, CRIIMI MAE had committed to fund additional Government Insured Construction Mortgages and acquire additional Government Insured Multifamily Mortgages totaling approximately $41.0 million. Dividends -- During 1993, CRIIMI MAE increased its quarterly dividend to $0.28 per share. Dividends totaled $1.12 per share for 1993. During the twelve consecutive quarters before 1993, CRIIMI MAE paid dividends of $0.27 per share. CRIIMI MAE's objective is to pay a stable quarterly dividend and to increase the tax basis income over time, and thereby increase the quarterly dividend. Although CRIIMI MAE's mortgage investments yield a fixed monthly mortgage payment once purchased, the cash dividends paid by CRIIMI MAE and by CRI Liquidating will vary during each year due to several factors. The factors which impact CRIIMI MAE's dividend include (i) the distributions which CRIIMI MAE receives on its CRI Liquidating shares, (ii) the Net Positive Spreads (as defined below) on borrowings under CRIIMI MAE's financing facilities, (iii) the fluctuating yields on short-term debt and the rate at which CRIIMI MAE's commercial paper rate based and London Interbank Offered Rate (LIBOR) based debt is priced, (iv) the fluctuating yields in the short-term money market MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly dividends, (v) the yield at which principal from scheduled monthly mortgage payments, mortgage dispositions and distributions from the AIM Funds and from CRI Liquidating can be reinvested, (vi) variations in the cash flow received from the AIM Funds, and (vii) changes in operating expenses. Additionally, mortgage dispositions may increase the return to the shareholders for a period, although neither the timing nor the amount can be predicted. The factors which impact CRI Liquidating's dividend include (i) yields on CRI Liquidating's mortgage investments, (ii) the reduction in the asset base and monthly mortgage payments due to monthly mortgage payments received or mortgage dispositions, (iii) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly dividends, (iv) changes in operating expenses and (v) variations in the cash flow received from the Participations. Asset/Liability Management -- CRIIMI MAE seeks to enhance the return to its shareholders through the use of leverage. Nevertheless, CRIIMI MAE's use of leverage carries with it the risk that the cost of borrowings could increase relative to the return on its mortgage investments, which could result in reduced net income or a net loss and thereby reduce the return to shareholders. A key objective of asset/liability management is to reduce interest rate risk. The Adviser continuously monitors CRIIMI MAE's outstanding borrowings in an effort to ensure that CRIIMI MAE is making optimal use of its borrowing ability based on market conditions and opportunities. Over the past four years, the Adviser has reduced CRIIMI MAE's effective borrowing rate through refinancings and new financings and the Adviser continues to evaluate opportunities to further reduce CRIIMI MAE's borrowing costs. CRIIMI MAE expects to continue to use leverage only to the extent that (i) the proceeds therefrom will be used for investments such as CRIIMI MAE's current portfolio of Government Insured Multifamily Mortgages or other high quality assets including Other Multifamily Mortgages and Other Insured Mortgages; (ii) the risk of adverse changes in interest rates is reduced by MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued the use of hedging techniques such as those currently employed by CRIIMI MAE; and (iii) the Adviser believes that after investing all funds from any specific borrowing, a Net Positive Spread (the difference between the yield on a mortgage investment acquired with borrowings and all incremental borrowing and operating expenses on a tax basis associated with the acquisition of such mortgage investment) of at least 40 basis points will be achievable. It is CRIIMI MAE's policy to borrow only when the Net Positive Spread on the borrowing is at least 40 basis points at inception of the borrowing. Such policy provides that if Net Positive Spreads of at least 40 basis points are not maintained, the annual and master servicing fees payable to the Adviser, which are calculated as a percentage of invested assets, will be reduced so that such fees, in basis points, equal the Net Positive Spread, in basis points. As of December 31, 1992 and 1993, CRIIMI MAE had a Net Positive Spread of approximately 60 and 177 basis points, respectively, on its borrowings. With respect to approximately $300.0 million of new borrowings invested or committed for investment during 1993, as of December 31, 1993, CRIIMI MAE had an average Net Positive Spread of approximately 250 basis points. CRIIMI MAE's secured financings require that its debt-to-equity ratio not exceed 2.5:1. As of December 31, 1993, CRIIMI MAE's debt-to-equity ratio, excluding approximately $41 million of borrowings committed for investment in mortgages, was 2.2:1, and its debt-to-equity ratio, including such borrowings, was 2.4:1. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Corporate Borrowings--The following table summarizes CRIIMI MAE's corporate borrowings as of December 31, 1993: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (1) Commercial Paper Facility--The following table shows commercial paper borrowing activity as of December 31, 1992 and 1993 and for the years then ended: The base issuance rate for commercial paper issued under CRIIMI MAE's commercial paper facility (the Commercial Paper Facility) ranged from 3.20% to 4.45% during the year ended December 31, 1992 and 3.15% to 3.68% during the year ended December 31, 1993, and was 4.02% and 3.41% as of December 31, 1992 and 1993, respectively. CRIIMI MAE's Commercial Paper Facility provides for the issuance of commercial paper by CRI Funding Corporation, an unaffiliated special purpose corporation, which lends the proceeds from the issuance to CRIIMI MAE. If commercial paper is not issued, the special purpose corporation may meet its obligation to MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued provide financing to CRIIMI MAE by borrowing at a rate of LIBOR plus 0.50% under a $140.0 million revolving credit facility which was established in connection with the Commercial Paper Facility. Borrowings pursuant to the Commercial Paper Facility are collateralized by a pledge of certain of CRIIMI MAE's Government Insured Multifamily Mortgages. The loan agreements contain numerous covenants which CRIIMI MAE must satisfy, including requirements that the fair value of collateral pledged must equal at least 110% of the amounts borrowed and that interest on the collateral pledged equal at least 120% of the debt service on the amounts borrowed. In addition, 60% of the Government Insured Multifamily Mortgages pledged as collateral must be GNMA-Mortgage Backed Securities. As of December 31, 1993, Government Insured Multifamily Mortgages held directly by CRIIMI MAE with a market value and face value of approximately $145.4 million and $139.7 million, respectively, were used as collateral pursuant to the Commercial Paper Facility. In February 1993, CRIIMI MAE entered into an agreement to replace a $190.0 million letter of credit which provided the credit enhancement for the Commercial Paper Facility and related revolving credit facility, with two letters of credit in the amount of $35.0 million and $155.0 million provided by National Australia Bank, Limited and Canadian Imperial Bank of Commerce (CIBC), respectively. In April 1993, the letter of credit provided by CIBC was reduced to $105.0 million. Subsequent to December 31, 1993, the special purpose corporation replaced borrowings under the Commercial Paper Facility with revolving credit loans. These revolving credit loans were scheduled to mature on January 28, 1994; however, the maturity date has been extended until February 28, 1994. CRIIMI MAE executed a Commitment Letter and Term Sheet for a revolving credit facility, dated November 24, 1993, to replace these agreements with a 30-month non-amortizing bank loan to be issued prior to the expiration date of the letter of credit agreements by lenders including the aforementioned bank group on terms substantially similar to the April 1993 Master Repurchase Agreements (defined below). While there is no assurance, CRIIMI MAE expects to close on such new revolving credit facility on or before February 28, 1994. If CRIIMI MAE is unable to consummate the loan by such MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued date, the Adviser believes that it will be able to obtain a further extension of its existing revolving credit loans. (2) Master Repurchase Agreements--On April 30, 1993, CRIIMI MAE entered into master repurchase agreements (the Master Repurchase Agreements) with Nomura Securities International, Inc. and Nomura Asset Capital Corporation (collectively, Nomura) which provide CRIIMI MAE with $350.0 million of available financing for a three-year term. CRIIMI MAE intends to seek renewal of the Master Repurchase Agreements upon expiration. Interest on such borrowings is based on the three-month LIBOR plus 0.75% or 0.50% depending on whether FHA-Insured Loans or GNMA Mortgage-Backed Securities, respectively, are pledged as collateral. For April through December 1993, the three-month LIBOR for these borrowings ranged from 3.18% to 3.50%. The value of the collateral pledged must equal at least 105% and 110% of the amounts borrowed for GNMA Mortgage-Backed Securities and FHA-Insured Loans, respectively. No more than 60% of the collateral pledged may be FHA-Insured Loans and no less than 40% may be GNMA Mortgage-Backed Securities. As of December 31, 1993, mortgage investments directly owned by CRIIMI MAE which approximate $349.4 million at market value and $342.2 million at face value, were used as collateral pursuant to certain terms of the Master Repurchase Agreements. As of December 31, 1993, CRIIMI MAE used approximately $281.7 million of the funds available under the Master Repurchase Agreements to acquire Government Insured Multifamily Mortgages and $50.0 million to repay a portion of borrowings under the Commercial Paper Facility. In addition, approximately $18.3 million of the balance of the funds available have been committed for investment in Government Insured Multifamily Mortgages or advances on Government Insured Construction Mortgages. On November 30, 1993, CRIIMI MAE entered into additional repurchase agreements with Nomura pursuant to which Nomura will provide CRIIMI MAE with an additional $150.0 million of available financing for a three-year term. The agreements provide that the funding will be utilized to purchase FHA-Insured Loans and GNMA Mortgage-Backed Securities in the event of the successful completion of the Equity Offering (described below in "Other Events"). In that event, it is contemplated that CRIIMI MAE will borrow the full $150.0 million no earlier than the consummation of MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued the Equity Offering, but no later than July 1, 1994. The terms of the $150.0 million financing arrangements are similar to the terms of the Master Repurchase Agreements entered into in April 1993. (3) Bank Term Loan--On October 23, 1991, CRIIMI MAE entered into a credit agreement with two banks for a reducing term loan facility (the Bank Term Loan) in an aggregate amount not to exceed $85.0 million, subject to certain terms and conditions. In December 1992, the credit agreement was amended to increase the reducing term loan by $15.0 million. The Bank Term Loan had an outstanding principal balance of approximately $61.7 million and $52.0 million as of December 31, 1992 and 1993, respectively. As of December 31, 1992 and 1993, the Bank Term Loan was secured by the value of 17,784,000 and 13,874,000 CRI Liquidating shares owned by CRIIMI MAE, respectively. As a result of principal payments on the Bank Term Loan in 1993, 750,000 of the 13,874,000 CRI Liquidating shares pledged as collateral were released in January 1994. The Bank Term Loan requires a quarterly principal payment based on the greater of the return of capital portion of the dividend received by CRIIMI MAE on its CRI Liquidating shares securing the Bank Term Loan or an amount to bring the Bank Term Loan to its scheduled outstanding balance at the end of such quarter. The minimum amount of annual principal payments is approximately $15.8 million, with any remaining amounts of the original $85.0 million of principal due in April 1996 and any remaining amounts of the $15.0 million of increased principal due in December 1996. The amended Bank Term Loan provides for an interest rate of 1.10% over three-month LIBOR plus an agent fee of 0.05% per year. During 1992 and 1993, three-month LIBOR for borrowings under the Bank Term Loan ranged from 3.44% to 4.50% and 3.19% to 3.59%, respectively. Hedging -- CRIIMI MAE is subject to the risk that changes in interest rates could reduce Net Positive Spreads by increasing CRIIMI MAE's borrowing costs and/or decreasing the yield on its Government Insured Multifamily Mortgages. An increase in CRIIMI MAE borrowing costs could result from an increase in short-term interest rates. To partially limit the adverse effects of rising interest rates, CRIIMI MAE has entered into a series of interest rate hedging agreements in an aggregate notional amount MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued approximately equal to all of its outstanding borrowings and commitments. To the extent CRIIMI MAE has not fully hedged its portfolio, in periods of rising interest rates CRIIMI MAE's overall borrowing costs would increase with little or no overall increase in mortgage investment income, resulting in returns to shareholders that would be lower than those available if interest rates had remained unchanged. Borrowings by CRIIMI MAE generally are hedged by swap, cap or collar agreements. As of December 31, 1993, CRIIMI MAE had in place interest rate collars on the indices underlying borrowing rates for the Commercial Paper Facility (the CP Index) with an aggregate notional amount of $115 million, a weighted average floor of 8.55% and a weighted average cap of 10.37%. An interest rate collar limits the CP Index to a maximum interest rate and also enables CRIIMI MAE to receive the benefit of a decline in the CP Index to the floor of the collar for the period of the collar. To the extent that the CP Index increases, CRIIMI MAE's overall borrowing costs would not increase until the CP Index reaches the level of the floor of the collar. At that point, CRIIMI MAE's borrowing costs would increase as the CP Index increases but only until the CP Index reaches the maximum rate provided for by the collar. As of December 31, 1993, CRIIMI MAE had in place interest rate caps on the CP Index and LIBOR underlying borrowing rates for the Commercial Paper Facility and Master Repurchase Agreements. The caps based on the CP Index have an aggregate notional amount of $50 million and a weighted average cap of 8.73%. The caps based on LIBOR have an aggregate notional amount of $300 million with a weighted average cap of 6.23%. CRIIMI MAE also had an interest rate cap with a notional amount of approximately $63 million and a cap of 6.5% on the LIBOR underlying the Bank Term Loan. An interest rate cap effectively limits CRIIMI MAE's interest rate risk on floating rate borrowings by limiting the CP Index or LIBOR, as the case may be, to a maximum interest rate for the period of the cap. To the extent the CP Index or LIBOR decrease, CRIIMI MAE's borrowing costs would decrease under such caps. To the extent the CP Index or LIBOR increase, CRIIMI MAE's borrowing costs would increase but only until the CP Index or LIBOR reaches the maximum rate provided for by the cap. As of December 31, 1993, certain cap agreements based on the three-month MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued LIBOR with a notional amount of $300 million were between approximately 2.62% and 3.13% above the current three-month LIBOR. On December 1, 1993, CRIIMI MAE paid approximately $4.9 million to terminate an interest rate swap entered into on February 8, 1990 with a notional amount of $25 million and a fixed rate of 9.23%. The termination of this swap was effective December 1, 1993. The cost to terminate the interest rate swap was expensed in the accompanying consolidated statement of income for the year ended December 31, 1993 as the underlying debt under the Commercial Paper Facility being hedged was repaid. As of December 31, 1993, CRIIMI MAE had in place no swap agreements. Current interest rates are substantially lower than when CRIIMI MAE entered into $165 million of its existing interest rate hedging agreements. As of December 31, 1993, certain collar agreements based on the CP Index with a notional amount of $115 million carried minimum interest rates which were between approximately 5.0% and 5.4% above the current CP Index. Such hedging agreements expire in 1995. While there is no assurance that any new agreements will be made, the Adviser is actively exploring alternatives to replace these hedging agreements when they expire in order to capitalize on the current low interest rate environment. As a result of minimum interest rate levels associated with the swap agreement terminated in December, 1993 and the collar agreements which expire in 1995, CRIIMI MAE incurred additional interest expense of $4.3 million, $8.1 million and $8.6 million for the years ended December 31, 1991, 1992 and 1993, respectively, of which approximately $0.8 million, $1.3 million and $1.4 million, respectively, was attributable to the terminated swap agreement. The additional interest expense amounts also include amortization of approximately $0.1 million, $0.2 million and $0.6 million, respectively, related to up-front hedging costs. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following table sets forth information relating to CRIIMI MAE's hedging agreements with respect to borrowings under the Commercial Paper Facility and Master Repurchase Agreements: (a) On May 24, 1993, CRIIMI MAE and CIBC terminated the floor on this former collar. In consideration of such termination, CRIIMI MAE paid CIBC approximately $2.3 million. This amount was deferred on the accompanying consolidated balance sheet as the underlying debt being hedged is still outstanding. This amount will be amortized for the period from May 24, 1993 through May 24, 1996. CRIIMI MAE amortized approximately $0.5 million of this deferred amount in the accompanying consolidated statements of income for the year ended December 31, 1993. (b) Approximately $4.5 million of costs were incurred in 1993 in connection with the establishment of interest rate hedges. These costs are being amortized using the effective interest method over the term of the interest rate hedge agreement for financial statement purposes and in accordance with the regulations under Internal Revenue Code Section 446 with respect to notional principal contracts for tax purposes. (c) The hedges are based either on the 30-day Commercial Paper Composite Index (CP) or three-month LIBOR. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued In addition, CRIIMI MAE entered into an interest rate hedge agreement on the Bank Term Loan to cap LIBOR at 6.5% based on the expected paydown schedule and an incremental hedge of 10.5% on the difference between the required and expected paydown schedules. As of December 31, 1993, three-month LIBOR was approximately 3.13% below the 6.5% cap. Although CRIIMI MAE expects the overall average life of its mortgage investments to exceed ten years, CRIIMI MAE's hedging agreements range in maturity from 3 to 10 years principally because of the limited availability and high cost of instruments with maturities greater than 10 years. Thus, to the extent CRIIMI MAE has not completely matched the duration of its existing mortgages to that of its existing hedges, upon the expiration of these hedges CRIIMI MAE would be fully exposed to the adverse effects of rising interest rates. The Adviser continues to actively review asset/liability hedging techniques as CRIIMI MAE's existing hedges approach their expiration dates and to monitor the duration of its hedges relative to its assets. A reduction in long-term interest rates could increase the level of prepayments of CRIIMI MAE's Government Insured Multifamily Mortgages. CRIIMI MAE's yield on mortgage investments will be reduced to the extent CRIIMI MAE reinvests the proceeds from such prepayments in new mortgage investments with effective rates which are below the rates of the prepaid mortgages. In addition, the fluctuation of long-term interest rates may affect the value of CRIIMI MAE's Government Insured Multifamily Mortgages. Although decreases in long-term rates could increase the value of CRIIMI MAE's mortgage investments, increases in such long-term rates could decrease the value of CRIIMI MAE's mortgage investments and, in certain circumstances, require CRIIMI MAE to pledge additional collateral in connection with its borrowing facilities. This would reduce CRIIMI MAE's borrowing capacity and, in an extreme case, may force CRIIMI MAE to liquidate a portion of its assets at a loss in order to comply with certain covenants under its financing facilities. CRIIMI MAE is exposed to credit loss in the event of nonperformance by the other parties to the interest rate hedge agreements should interest rates exceed the caps. However, the MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Adviser does not anticipate nonperformance by any of the counterparties, each of which has long-term debt ratings of A or above by Standard and Poor's and A2 or above by Moody's. Cash Flow--1993 versus 1992 - --------------------------- Net cash provided by operating activities increased for 1993 as compared to 1992 principally due to an increase in mortgage investment income partially offset by an increase in interest expense due primarily to mortgage acquisition activity in 1993 funded by proceeds from financings. Also contributing to the increase in cash provided by operating activities was an increase in accounts payable and accrued expenses attributable to the accrued costs incurred by CRIIMI MAE with respect to its Equity Offering of common stock, as described below in "Other Events". Partially offsetting the increase in net cash provided by operating activities for 1993 was the payment of approximately $4.9 million to terminate an interest rate swap agreement and an increase in interest expense due primarily to mortgage acquisition activity in 1993 funded by proceeds from financings. Net cash used by investing activities increased for 1993 as compared to 1992. This increase was principally due to the acquisition of Government Insured Multifamily Mortgages and advances on Government Insured Construction Mortgages of approximately $312.7 million in 1993 as compared to $31.8 million in 1992. Also contributing to the increase in cash used by investing activities was the acquisition of other short-term investments of approximately $175.3 million in 1993 as compared to approximately $66.8 million in 1992. In addition, proceeds of approximately $6.1 million were received during 1993 related to the sale of HUD debentures, as compared to the receipt of proceeds of approximately $2.3 million during the same period in 1992 related to the redemption of HUD debentures. Partially offsetting the increase in net cash used by investing activities was the receipt of approximately $167.1 million from the disposition of other short-term investments and proceeds from mortgage dispositions of approximately $93.4 million in 1993 as compared to approximately $65.5 million and $50.4 million, respectively, in 1992. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Net cash provided by financing activities increased for 1993 compared to 1992. This increase was primarily due to the receipt of net proceeds of approximately $331.7 million from the Master Repurchase Agreements, approximately $115.6 million from the financing of other short-term investments and approximately $15.0 million from an expansion of CRIIMI MAE's Bank Term Loan, partially offset by payments on short-term and long-term debt, a paydown of borrowings of commercial paper and the payment of deferred financing costs. Cash Flow--1992 versus 1991 - --------------------------- Net cash provided by operating activities increased for 1992 as compared to 1991 principally due to an increase in interest payable and a decrease in receivables and other assets compared to 1991 partially offset by a decrease in accounts payable and accrued expenses. The increase in interest payable for 1992 compared to 1991 is due to the payment in 1991 of approximately $3.0 million in interest accrued as of December 31, 1990. The decrease in receivables and other assets was attributable to the collection of the accrued interest on a mortgage which defaulted in the second half of 1991. The decrease in accounts payable and accrued expenses was due to the payment of acquisition costs incurred and accrued with respect to the acquisition of the AIM Funds in 1991. Net cash provided by investing activities decreased for 1992 as compared to 1991. This decrease resulted principally from the disposition in 1992 by CRIIMI MAE and CRI Liquidating of five Government Insured Multifamily Mortgages and the remaining 9% of two previously disposed Government Insured Multifamily Mortgages resulting in disposition proceeds aggregating approximately $50.4 million. This compares to 33 mortgage dispositions during 1991 resulting in disposition proceeds of approximately $119.0 million. Also during 1992, cash of approximately $65.5 million and approximately $2.3 million was received from the sale of other short-term investments and the redemption of HUD debentures, respectively. However, this was offset by the purchase of other short-term investments in 1992. During 1991, CRIIMI MAE and CRIIMI, Inc. paid a total of approximately $24.4 million to acquire interests in the AIM Funds and the limited partnership that serves as their adviser. In addition, CRIIMI MAE paid MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued approximately $3.7 million during 1991 for costs associated with this acquisition. This acquisition was principally funded with the proceeds from the sale of Government Insured Multifamily Mortgages. Net cash used in financing activities decreased for 1992 as compared to 1991. This decrease was primarily due to approximately $97.6 million paid in 1991 for the early extinguishment of long-term debt and the purchase of approximately $21.6 million in U.S. Treasury Securities in connection with the defeasance of long-term debt which occurred in 1991, partially offset by $85.0 million in proceeds received in 1991 from the refinancing. This decrease was also offset by an increase in principal payments on long-term debt from approximately $13.3 million during 1991 to $23.3 million in 1992. Results of Operations - --------------------- 1993 versus 1992 - ---------------- CRIIMI MAE earned approximately $23.0 million in tax basis income for 1993, a 6.4% increase from approximately $21.6 million for 1992. On a per share basis, tax basis income for 1993 increased to approximately $1.14 per share from approximately $1.07 per share for 1992. Net income for financial statement purposes was approximately $15.8 million for 1993, a 1.8% decrease from approximately $16.0 million for 1992. On a per share basis, financial statement net income for 1993 decreased to approximately $0.78 per share from $0.79 per share for 1992. Mortgage investment income increased $4.4 million or 9.4% to $50.3 million for 1993 from $45.9 million for 1992. This increase was due principally to an increase in mortgage investments, net of dispositions, resulting from acquisitions and advances on Government Insured Construction Mortgages during 1993 which were funded principally by proceeds from the Master Repurchase Agreements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Other income increased $1.4 million or 30.0% to $6.2 million for 1993 from $4.8 million for 1992. This increase was attributable primarily to approximately $175 million in other short-term investments acquired by CRIIMI MAE and CRI Liquidating during 1993, all of which were disposed of by December 31, 1993 as compared to approximately $67 million in other short-term investments acquired by CRI Liquidating during 1992, all of which were disposed of by December 31, 1992. Total income increased $5.8 million or 11.3% to $56.5 million for 1993 from $50.7 million for 1992. This increase was primarily due to the growth in mortgage investment income and other income during 1993. Interest expense increased $3.6 million or 14.8% to $28.0 million for 1993 from $24.4 million for 1992. This increase was principally a result of greater amounts borrowed during 1993 under the Master Repurchase Agreements entered into in April 1993 which provided financing of $350 million, of which approximately $331.7 million was outstanding as of December 31, 1993. This increase was partially offset by a reduction in interest rates on CRIIMI MAE's borrowings for 1993 as compared to 1992. In December 1993, CRIIMI MAE paid approximately $4.9 million to CIBC to terminate an interest rate swap entered into on February 8, 1990 with a notional amount of $25 million and a fixed rate of 9.23%. The termination of this swap was effective December 1, 1993. Other operating expenses increased $1.1 million or 32.4% to $4.6 million in 1993 from $3.5 million in 1992. This increase was attributable primarily to legal fees incurred in connection with certain litigation as described below in "Other Events." Also contributing to the increase in other operating expenses was an increase in general and administrative expenses due primarily to increased mortgage acquisition and disposition activities, the increase in costs to produce CRIIMI MAE's 1992 Annual Report to Shareholders due to its increased size and mailing costs, and the recognition of costs incurred in connection with CRIIMI MAE's reincorporation as a Maryland corporation which was effective in July 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Fees to related party are comprised of annual fees and incentive fees paid to the Adviser. The Adviser receives annual fees for managing the portfolios of CRIIMI MAE and CRI Liquidating. These fees include a base component equal to a percentage of average invested assets. In addition, fees paid to the Adviser by CRI Liquidating may include a performance based component that is referred to as the deferred component. The deferred component, which is also calculated as a percentage of average invested assets, is computed each quarter but paid (and expensed) only upon meeting certain cumulative performance goals. If these goals are not met, the deferred component accumulates, and may be paid in the future if cumulative goals are met. In addition, certain incentive fees are paid by CRIIMI MAE and CRI Liquidating on a current basis if certain performance goals are met. Fees to related party increased $0.5 million or 21.3% to $2.7 million for 1993 from $2.2 million for 1992. This increase was due primarily to an increase in annual fees and incentive fees during 1993, as discussed below. Annual fees increased $0.4 million or 20.6% to $2.5 million for 1993 from $2.1 million for 1992. This increase was primarily due to increased CRIIMI MAE mortgage assets, including advances on Government Insured Construction Mortgages. Also contributing to the increase for 1993 was the payment by CRI Liquidating in 1993, of the deferred component of the annual fee due to specific performance goals being met, which included the payment of the deferred component for the second half of 1992. Partially offsetting the increase in annual fees for 1993 was a reduction in the mortgage base, which is a component used in determining the annual fees payable by CRI Liquidating. The mortgage base has been decreasing as CRI Liquidating effects its business plan to liquidate by 1997. The CRIIMI MAE incentive fee is equal to 25% of the amount by which net income from additional mortgage investments exceeds the annual target return on equity and is payable quarterly, subject to year-end adjustment. The incentive fee increased approximately $50,000 or 30.6% to $0.2 million for 1993 from $0.2 million for 1992. This increase was primarily attributable to the fact that CRIIMI MAE's net income from additional mortgage investments exceeded the annual target return on equity during both the second and third quarters of 1993; accordingly, an incentive fee was paid MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued during those quarters. This compares to 1992 when CRIIMI MAE's net income from additional mortgage investments exceeded the annual target return on equity only in the third quarter. During 1993, CRIIMI MAE recorded a provision of $1.5 million, including $0.25 million paid in cash, in connection with the settlement of the litigation described below in "Other Events." Total expenses increased $11.7 million or 38.6% to $41.8 million for 1993 from $30.1 million for 1992. This increase was principally due to costs incurred to terminate an interest rate swap, an increase in interest expense and the recognition of a provision for settlement of litigation described below in "Other Events". Net gains on mortgage dispositions increased $1.7 million or 28.3% to $7.4 million in 1993 from $5.7 million in 1992. Gains or losses on mortgage dispositions are based on the number, carrying amounts, and proceeds of mortgage investments disposed of during the period. Gains on mortgage dispositions increased $2.0 million or 32.7% to $8.1 million in 1993 from $6.1 million in 1992. This increase was primarily due to the disposition of 17 mortgages during 1993, 11 of which resulted in gains. This compares to the disposition of seven mortgages during 1992, three of which resulted in gains. Losses on mortgage dispositions increased $0.4 million or 98.4% to $0.8 million in 1993 from $0.4 million in 1992 due to the financial statement loss of $0.5 million recognized in March 1993 as a result of the prepayment of the mortgage on Owings Manor Apartments. In November 1993, CRIIMI MAE recognized a financial statement gain of approximately $3.3 million and a tax basis gain of approximately $4.9 million in connection with the sale of 3,162,500 CRI Liquidating shares held by CRIIMI MAE. 1992 versus 1991 - ---------------- CRIIMI MAE earned approximately $21.6 million in tax basis income for 1992, a 1.9% decrease from approximately $22.0 million for 1991. On a per share basis, tax basis income for 1992 decreased to approximately $1.07 per share from approximately $1.09 per share for 1991. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Net income for financial statement purposes was approximately $16.0 million for 1992, a 78.2% increase from approximately $9.0 million for 1991. On a per share basis, financial statement net income for 1992 increased to approximately $0.79 per share from $0.45 per share for 1991. Mortgage investment income decreased $3.4 million or 6.9% to $45.9 million for 1992 from $49.3 million for 1991. This decrease was due principally to the mortgage dispositions during 1992 and 1991. Other income decreased $.2 million or 4.5% to $4.8 million for 1992 from $5.0 million for 1991. This decrease was primarily attributable to lower interest rates available for short-term investments during 1992 and the elimination on December 31, 1991, of the debt service reserve for certain notes payable, which reserve was previously invested in short-term investments. Partially offsetting this decrease was the interest earned on other short-term investments purchased by CRI Liquidating in April, July and August 1992, net of monthly option fees. In addition, this decrease in income was partially offset by an increase in income from investments in the AIM Funds and the related advisory partnership which were acquired in September 1991. Total income decreased $3.6 million or 6.7% to $50.7 million for 1992 from $54.3 million for 1991. This decrease was primarily due to a reduction in mortgage investment income and partially offset by an increase in other income during 1992. Interest expense decreased $1.4 million or 5.4% to $24.4 million for 1992 from $25.8 million for 1991. This decrease was principally a result of a reduction in both the amount of long-term debt outstanding and the interest rate thereon resulting from the refinancing on December 31, 1991 of notes payable. This decrease in interest expense on long-term debt was partially offset by an increase in interest paid or accrued on borrowings under CRIIMI MAE's Commercial Paper Facility as greater amounts were borrowed during 1992 and an increase in interest expense attributable to the seller financing of 99% of the purchase price of certain other short-term investments purchased by CRI Liquidating in July and August 1992. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Other operating expenses decreased $.3 million or 6.6% to $3.5 million in 1992 from $3.8 million in 1991. This decrease was attributable primarily to a decrease in the amortization of deferred costs resulting from the mortgage dispositions and the related reduction in the amount of capitalized deferred costs which occurred during 1992 and 1991. Fees to related party decreased $87,000 or 3.7% to $2.2 million in 1992 from $2.3 million in 1991. This decrease was due primarily to the reduction of CRI Liquidating's portfolio as a result of mortgage dispositions. Also contributing to this decrease was a reduction in the deferred component of the Adviser's annual fee paid in 1992 as a result of certain performance goals that were met for only two quarters in 1992 compared to all quarters in 1991. Partially offsetting this decrease was an increase in the annual base component resulting from CRIIMI MAE mortgage acquisitions. Net gains on mortgage dispositions increased $1.7 million or 41.6% to $5.7 million in 1992 from $4.0 million in 1991. This increase was principally due to the disposition, in 1992, of CRI Liquidating's investment in a mortgage which resulted in the recognition of a gain in 1992 totalling approximately $5.9 million. This compares to the disposition of 13 Government Insured Multifamily Mortgages during 1991 which resulted in gains totalling approximately $5.2 million. CRI Liquidating's Government Insured Multifamily Mortgages have a different tax basis than book basis because the Merger, while a taxable event, was treated in a manner similar to a pooling of interests for financial accounting purposes. Although some of the mortgage dispositions during 1992 resulted in a loss for financial statement purposes, the combined dispositions resulted in a net tax basis gain totalling approximately $11.1 million. During 1992, two properties in which CRI Liquidating holds Participations experienced operating results insufficient to pay debt service and the annual return on such Participations. CRI Liquidating recognized a loss of approximately $0.7 million with respect to the write-off of one of these Participations. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued In addition to the items discussed above, net income for 1992 increased from 1991 due, in part, to the recognition of an extraordinary loss of approximately $6.6 million in 1991 resulting from the refinancing of certain notes payable. All other costs associated with the refinancing have been included in deferred financing fees on the balance sheet and are being amortized on the effective interest method over the term of the refinancing. However, for tax purposes these deferred financing fees as well as the extraordinary loss have been capitalized and are being amortized over the term of the refinancing. REIT Status - ----------- CRIIMI MAE and CRI Liquidating have qualified and intend to continue to qualify as REITs as defined in the Internal Revenue Code and, as such, will not be taxed on that portion of their taxable income which is distributed to shareholders provided that at least 95% of such taxable income is distributed. CRIIMI MAE and CRI Liquidating intend to distribute substantially all of their taxable income and, accordingly, no provision for income taxes has been made in the accompanying consolidated financial statements. CRIIMI MAE and CRI Liquidating, however, may be subject to tax at normal corporate rates on net income or capital gains not distributed. Other Events - ------------ On March 22, 1990, a complaint was filed, on behalf of a class comprised of certain limited partners of CRIIMI III and shareholders of CRIIMI II (the Plaintiffs), in the Circuit Court for Montgomery County, Maryland against CRIIMI MAE, CRI Liquidating, CRIIMI I and its general partner, CRIIMI II, CRIIMI III and its general partner, CRI and William B. Dockser, H. William Willoughby and Martin C. Schwartzberg (the Defendants). On November 18, 1993, the Court entered an order granting final approval of a settlement agreement between the Plaintiffs and the Defendants pursuant to which CRIIMI MAE will issue to class members, including certain former limited partners of CRIIMI I, up to 2.5 million warrants, exercisable for 18 months after issuance, to purchase shares of CRIIMI MAE common stock at an exercise price of $13.17 per share. In addition, the settlement included a payment of $1.4 million for settlement administration costs and MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued the Plaintiff's attorneys' fees and expenses. Insurance provided $1.15 million of the $1.4 million cash payment, with the balance paid by CRIIMI MAE. CRIIMI MAE accrued a total provision of $1.5 million in the accompanying consolidated statements of income for the uninsured portion of the cash settlement paid by CRIIMI MAE and for the estimated value of the warrants that are expected to be issued as part of the settlement. The number of warrants to be issued is dependent on the number of class members who submit a proof of claim within 60 days of January 14, 1994 (the date the proof of claim was mailed by CRIIMI MAE). The issuance of the warrants pursuant to the settlement agreement will have no impact on CRIIMI MAE's tax basis income. Depending upon the number of warrants issued, CRIIMI MAE will record in its financial statements a non-cash expense ranging from $0 (if no warrants are issued) to $5 million (if all 2.5 million warrants are issued). Based on the Adviser's estimate of the number of warrants to be issued, CRIIMI MAE has accrued a total provision of $1.5 million (which includes the uninsured portion of the cash settlement) in the accompanying consolidated statement of income for 1993, which provision may be increased or decreased once the actual number of warrants issued is known. The Adviser estimates that the final charge (after adjustments to the provision) to net income and the increase in the number of shares of common stock outstanding as a result of the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's net income and net income per share. The exercise of the warrants will not result in a charge to CRIIMI MAE's tax basis income. Further, the Adviser believes that the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's tax basis income per share or annualized cash dividends per share because CRIIMI MAE intends to invest the proceeds from any exercise of the warrants in accordance with its investment policy to purchase Government Insured Multifamily Mortgages and other authorized investments. However, in the case of a significant decline in the yield on mortgage investments and a significant decrease in the Net Positive Spread which CRIIMI MAE could achieve on its borrowings, the exercise of the warrants may have a dilutive effect on tax basis income per share and cash dividends per share. Receipt of the proceeds from the exercise of the warrants will increase CRIIMI MAE's shareholders' equity. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued On October 19, 1993, CRIIMI MAE filed a Registration Statement on Form S-3 (Commission File No. 33-50679), expected to be amended on February 16, 1994, to register for sale to the public approximately 6.0 million shares of CRIIMI MAE's common stock (or 6.9 million shares if the underwriters exercise their overallotment option) (the Equity Offering). While there is no assurance that the Equity Offering will be consummated, it is currently expected that the sale will be completed in March 1994, subject to, among other things, such Registration Statement becoming effective and market conditions at such time. The net proceeds from the sale of the shares are estimated to be approximately $64.3 million (based on an offering price of $11.50 per share, the reported last sale price on February 11, 1994, and not including the over-allotment). Although no specific investments have as yet been selected, CRIIMI MAE intends to use such proceeds primarily for the acquisition of Government Insured Multifamily Mortgages, the purchase of interest rate hedging agreements and for other general corporate purposes, including, without limitation, working capital. It is not expected that any of the proceeds will be used to repay indebtedness of CRIIMI MAE. The costs of the Equity Offering, including professional fees, filing fees, printing costs and other items, are expected to approximate $.6 million (which was incurred or accrued as of December 31, 1993). Additionally, underwriting fees in an amount which approximates 6.0% of the gross offering proceeds are expected to be incurred. Fair Value of Financial Instruments - ----------------------------------- The following estimated fair values of CRIIMI MAE's consolidated financial instruments are presented in accordance with generally accepted accounting principles which define fair value as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. These estimated fair values, however, do not represent the liquidation value or the market value of CRIIMI MAE. In connection with CRIIMI MAE's and CRI Liquidating's implementation of Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115) as of December 31, 1993, CRIIMI MAE's MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Investment in Mortgages continues to be recorded at amortized cost; however, CRI Liquidating's Investment in Mortgages, and CRIIMI MAE's and CRI Liquidating's Mortgages Held for Disposition, are recorded at fair value as of December 31, 1993. The difference between the amortized cost and the fair value of CRI Liquidating's Government Insured Multifamily Mortgages represents the net unrealized gains on CRI Liquidating's Government Insured Multifamily Mortgages. CRIIMI MAE's share of the net unrealized gains on CRI Liquidating's Government Insured Multifamily Mortgages is reported as a separate component of shareholders' equity as of December 31, 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (A) CRI Liquidating's mortgage investments and all Mortgages Held for Disposition were accounted for at fair value on the accompanying consolidated balance sheet as of December 31, 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Investment in mortgages - ----------------------- The fair value of the Government Insured Multifamily Mortgages is based on the average of the quoted market prices from three investment banking institutions which trade insured mortgage loans as part of their day-to-day activities. Commercial paper - ---------------- The carrying amount approximates fair value because of the short maturity of the debt. Long-term debt - -------------- The carrying amount approximates fair value because the current rate on the debt is reset quarterly based on market rates. Interest rate hedge agreements - ------------------------------ The fair value of interest rate hedge agreements (used to hedge CRIIMI MAE's commercial paper and long-term debt) is the estimated amount that CRIIMI MAE would pay to terminate the agreements as of December 31, 1993, taking into account current interest rates and the current creditworthiness of the counterparties. The amount was determined based on the average of two quotes received from financial institutions which enter into these types of transactions as part of their day-to-day activities. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To the Shareholders of CRIIMI MAE Inc. We have audited the accompanying consolidated balance sheets of CRIIMI MAE Inc. (CRIIMI MAE) and its Subsidiaries as of December 31, 1992 and 1993, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 1991, 1992 and 1993. These financial statements are the responsibility of CRIIMI MAE's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of CRIIMI MAE and its Subsidiaries as of December 31, 1992 and 1993, and the consolidated results of their operations and their cash flows for the years ended December 31, 1991, 1992 and 1993, in conformity with generally accepted accounting principles. As explained in Note 2 of the notes to the consolidated financial statements, effective December 31, 1993, CRIIMI MAE and its Subsidiaries changed their method of accounting for their investment in mortgages. Washington, D.C. Arthur Andersen & Co. February 11, 1994 CRIIMI MAE INC. CONSOLIDATED BALANCE SHEETS ASSETS CRIIMI MAE INC. CONSOLIDATED BALANCE SHEETS ASSETS (Continued) The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED BALANCE SHEETS LIABILITIES AND SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF INCOME CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF INCOME (Continued) The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended December 31, 1991, 1992 and 1993 CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended December 31, 1991, 1992 and 1993 The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and the Merger CRIIMI MAE Inc. (CRIIMI MAE) (formerly CRI Insured Mortgage Association, Inc.), is an infinite-life, actively managed real estate investment trust (REIT), which specializes in government insured and guaranteed mortgage investments secured by multifamily housing complexes (Government Insured Multifamily Mortgages) located throughout the United States. CRIIMI MAE's principal objectives are to provide stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages using a combination of debt and equity financing. CRIIMI MAE and its subsidiary, CRI Liquidating REIT, Inc. (CRI Liquidating), are Maryland corporations. CRIIMI MAE and CRI Liquidating were formed in 1989 to effect the merger into CRI Liquidating (the Merger) of three federally insured mortgage funds sponsored by C.R.I., Inc. (CRI), a Delaware corporation formed in 1974: CRI Insured Mortgage Investments Limited Partnership (CRIIMI I); CRI Insured Mortgage Investments II, Inc. (CRIIMI II); and CRI Insured Mortgage Investments III Limited Partnership (CRIIMI III; and, together with CRIIMI I and CRIIMI II, the CRIIMI Funds). The Merger was effected to provide certain potential benefits to investors in the CRIIMI Funds, including the elimination of unrelated business taxable income for certain tax-exempt investors, the diversification of investments, the reduction of general overhead and administrative costs as a percentage of assets and total income and the simplification of tax reporting information. In the Merger, which was approved by investors in each of the CRIIMI Funds and subsequently consummated on November 27, 1989, investors in the CRIIMI Funds received, at their option, shares of CRI Liquidating common stock or shares of CRIIMI MAE common stock. Investors in the CRIIMI Funds that received shares of CRIIMI MAE common stock became shareholders in an infinite-life, actively managed REIT having the potential to increase the size of its portfolio and enhance the returns to its shareholders. CRIIMI MAE shareholders retained their economic interests in the assets of the CRIIMI Funds which were transferred to CRI Liquidating through CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and the Merger - Continued the issuance of one CRI Liquidating share to CRIIMI MAE for each share of CRIIMI MAE common stock issued to investors in the Merger. Upon the completion of the Merger, CRIIMI MAE held a total of 20,361,807 CRI Liquidating shares, or approximately 67% of the issued and outstanding CRI Liquidating shares. Investors in the CRIIMI Funds that received shares of CRI Liquidating common stock, as well as CRIIMI MAE, became shareholders in a finite-life, self-liquidating REIT the assets of which consist primarily of Government Insured Multifamily Mortgages and other assets formerly held by the CRIIMI Funds. CRI Liquidating intends to hold, manage and dispose of its mortgage investments in accordance with the objectives and policies of the CRIIMI Funds, including disposing of any remaining mortgage investments by 1997 through an orderly liquidation. Pursuant to a Registration Rights Agreement dated November 28, 1989 between CRIIMI MAE and CRI Liquidating, CRIIMI MAE sold 3,162,500 of its CRI Liquidating shares in an underwritten public offering which was consummated in November 1993. As a result of such sale, CRIIMI MAE holds a total of 17,199,307 CRI Liquidating shares, or approximately 57% of CRI Liquidating's issued and outstanding common stock. CRIIMI MAE used approximately $4.9 million of the approximately $26.5 million in net proceeds to terminate a 9.23% interest rate swap agreement on $25 million of CRIIMI MAE's existing indebtedness and used the remaining net proceeds to purchase Government Insured Multifamily Mortgages. CRIIMI MAE and CRI Liquidating are governed by a board of directors, a majority of whom are independent directors with extensive industry related experience. The Board of Directors of CRIIMI MAE and CRI Liquidating has engaged CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) to act in the capacity of adviser to CRIIMI MAE and CRI Liquidating. The Adviser's general partner is CRI and its operations are conducted by CRI's employees. CRIIMI MAE's and CRI Liquidating's executive officers are senior executive officers of CRI. The Adviser manages CRIIMI MAE's portfolio of Government Insured Multifamily Mortgages and other assets with the goal of maximizing CRIIMI CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MAE's value, and conducts CRIIMI MAE's day-to-day operations. Under an advisory agreement between CRIIMI MAE and the Adviser, the Adviser and its affiliates receive certain fees and expense reimbursements (see Note 3). On September 6, 1991, CRIIMI MAE, through its wholly owned subsidiary CRIIMI, Inc., acquired from Integrated Resources, Inc. (Integrated) all of the general partnership interests in four publicly held limited partnerships known as the American Insured Mortgage Investors Funds (the AIM Funds). The AIM Funds own mortgage investments which are substantially similar to those owned by CRIIMI MAE and CRI Liquidating. CRIIMI, Inc. receives the general partner's share of income, loss and distributions (which ranges among the AIM Funds from 2.9% to 4.9%) from each of the AIM Funds. In addition, CRIIMI MAE owns indirectly a limited partnership interest in the adviser to the AIM Funds in respect of which CRIIMI MAE receives a guaranteed return each year (see Note 14). CRIIMI MAE and CRI Liquidating have qualified and intend to continue to qualify as REITs under Sections 856-860 of the Internal Revenue Code. As REITs, CRIIMI MAE and CRI Liquidating do not pay taxes at the corporate level. Qualification for treatment as REITs require CRIIMI MAE and CRI Liquidating to meet certain criteria, including certain requirements regarding the nature of their ownership, assets, income and distributions of taxable income. On October 19, 1993, CRIIMI MAE filed a Registration Statement on Form S-3 (Commission File No. 33-50679), expected to be amended on February 16, 1994, to register for sale to the public approximately 6.0 million shares of CRIIMI MAE's common stock (or 6.9 million shares if the underwriters exercise their overallotment option) (the Equity Offering). While there is no assurance that the Equity Offering will be consummated, it is currently expected that the sale will be completed in March 1994, subject to, among other things, such Registration Statement becoming effective and market conditions at such time. The net proceeds from the sale of the shares are estimated to be CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS approximately $64.3 million (based on an offering price of $11.50 per share, the reported last sale price on February 11, 1994, and not including the over-allotment). Although no specific investments have as yet been selected, CRIIMI MAE intends to use such proceeds primarily for the acquisition of Government Insured Multifamily Mortgages, the purchase of interest rate hedging agreements and for other general corporate purposes, including, without limitation, working capital. It is not expected that any of the proceeds will be used to repay indebtedness of CRIIMI MAE. The costs of the Equity Offering, including professional fees, filing fees, printing costs and other items, are expected to approximate $.6 million (which was incurred or accrued as of December 31, 1993). Additionally, underwriting fees in an amount which approximates 6.0% of the gross offering proceeds are expected to be incurred. 2. Summary of Significant Accounting Policies Method of accounting - -------------------- The consolidated financial statements of CRIIMI MAE are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Reclassifications - ----------------- Certain amounts in the consolidated financial statements as of December 31, 1992 and for the years ended December 31, 1991 and 1992 have been reclassified to conform with the 1993 presentation. Cash and cash equivalents - ------------------------- Cash and cash equivalents consist of money market funds, time and demand deposits and repurchase agreements with original maturities of three months or less. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Consolidation and minority interests - ------------------------------------ The consolidated financial statements reflect the financial position, results of operations, and cash flows of CRIIMI MAE, CRI Liquidating, and CRIIMI, Inc., for all periods presented. All intercompany accounts and transactions have been eliminated in consolidation. Since CRIIMI MAE owned approximately 67%, 67% and 57% of CRI Liquidating as of December 31, 1991, 1992 and 1993, respectively, the ownership interests of the other shareholders in the equity and net income of CRI Liquidating are reflected as minority interests in the accompanying consolidated financial statements. Consolidated statements of cash flows - ------------------------------------- Since the consolidated statements of cash flows are intended to reflect only cash receipt and cash payment activity, the consolidated statements of cash flows do not reflect investing and financing activities that affect recognized assets and liabilities and do not result in cash receipts or cash payments. Such activity consisted of the following: o In July 1991, CRI Liquidating received $2,334,150 in 12 3/4% United States Department of Housing and Urban Development (HUD) debentures as proceeds from the disposition of the mortgage investment in Oak Hill Road Apartments. The proceeds from the redemption of the HUD debentures, including interest, were received in January 1992. Cash payments made for interest for the years ended December 31, 1991, 1992 and 1993 were $27,883,482, $20,826,987 and $22,448,356, respectively. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Investment in mortgages - ----------------------- In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115). This statement requires that most investments in debt and equity securities be classified into one of the following investment categories based upon the circumstances under which such securities might be sold: Held to Maturity, Available for Sale, and Trading. Generally, certain debt securities for which an enterprise has both the ability and intent to hold to maturity should be accounted for using the amortized cost method and all other securities must be recorded at their fair values. This statement, though not required to be adopted until 1994 for CRIIMI MAE and CRI Liquidating, has been adopted for the year ended December 31, 1993. CRIIMI MAE, an infinite-life entity, has the intent and ability to hold its mortgage investments until maturity. Consequently, all mortgage investments, excluding Mortgages Held for Disposition (see Note 6), have been classified as Held to Maturity and continue to be recorded at amortized cost as of December 31, 1993. CRI Liquidating intends to dispose of its existing Government Insured Multifamily Mortgages by March 31, 1997 through an orderly liquidation. In order to achieve this objective, CRI Liquidating will sell certain of its mortgage investments in addition to mortgages assigned to HUD. Consequently, the Adviser believes that the mortgage investments held by CRI Liquidating fall into the Available for Sale category (as defined by SFAS 115). As such, as of December 31, 1993, all of CRI Liquidating's mortgage investments are recorded at fair value with CRIIMI MAE's share of the net unrealized gains on CRI Liquidating's mortgage investments reported as a separate component of shareholders' equity. Subsequent increases or decreases in the fair value of Available for Sale mortgage investments shall be included as a separate component of shareholders' equity. Realized gains and losses for mortgage investments CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS classified as Available for Sale will continue to be reported in earnings, as discussed below. Prior to December 31, 1993, CRI Liquidating accounted for its mortgage investments at amortized cost. The difference between the cost and the unpaid principal balance at the time of purchase is carried as a discount or premium and amortized over the remaining contractual life of the mortgage using the effective interest method. The effective interest method provides a constant yield of income over the term of the mortgage. Mortgage investment income is comprised of amortization of the discount plus the stated mortgage interest payments received or accrued less amortization of the premium. CRIIMI MAE's consolidated investment in mortgages is comprised of Government Insured Multifamily Mortgages issued or sold pursuant to programs of the Federal Housing Administration (FHA) (FHA-Insured Loans) and mortgage-backed securities guaranteed by the Government National Mortgage Association (GNMA) (GNMA-Mortgage-Backed Securities). Payment of principal and interest on FHA-Insured Loans is insured by HUD pursuant to Title 2 of the National Housing Act. Payment of principal and interest on GNMA-Mortgage-Backed Securities is guaranteed by GNMA pursuant to Title 3 of the National Housing Act. Mortgages held for disposition - ------------------------------ At any point in time, CRI Liquidating and CRIIMI MAE may be aware of certain mortgages which have been assigned to HUD or for which the servicer has received proceeds from a prepayment. In addition, at certain times CRI Liquidating may enter into a contract to sell certain mortgages. In these cases, CRIIMI MAE and CRI Liquidating will classify these mortgages as Mortgages Held for Disposition. Mortgages Held for Disposition have been accounted for at the lower of cost or market prior to December 31, 1993, and at fair value CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS as of December 31, 1993 under the Available for Sale criteria of SFAS 115. Gains from dispositions of mortgages are recognized upon the receipt of funds or HUD debentures. Losses on dispositions of mortgages are recognized when it becomes probable that a mortgage will be disposed of and that the disposition will result in a loss. Investment in insured mortgage funds and advisory partnership - ------------------------------------------------------------- The acquisition of certain interests in the AIM Funds in September 1991 (see Note 14), including certain acquisition costs aggregating approximately $7.7 million, have been recorded under the purchase method of accounting, which provides that the investment be recorded at cost, including the acquisition costs. CRIIMI MAE is utilizing the equity method of accounting for its investment in the AIM Funds and advisory partnership, which provides for recording CRIIMI MAE's share of net earnings or losses in the AIM Funds and advisory partnership reduced by distributions from the limited partnerships and adjusted for purchase accounting amortization. The purchase price, including the deferred acquisition costs of approximately $7.7 million, was allocated among the general partner interests and the advisory partnership interest based on the partnerships' and advisory contracts' estimated fair values. The general partnership and advisory interests were assigned a total value of approximately $27 million and $5 million, respectively. Deferred costs - -------------- Included in deferred costs are mortgage selection fees, which are being paid to the Adviser of CRIIMI MAE (see Note 3) or were paid to the former general partners or adviser to the CRIIMI Funds. These deferred costs are being amortized using the effective interest method on a specific mortgage CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS basis from the date of the acquisition of the related mortgage to the expected dissolution date of CRI Liquidating or over the term of the mortgage for CRIIMI MAE (see Note 1). Upon disposition of a mortgage, the related unamortized fee is treated as part of the mortgage investment carrying value in order to measure the gain or loss on the disposition. Borrowing policy of CRI Liquidating - ----------------------------------- CRI Liquidating's Articles of Incorporation do not limit the amount or percentage of indebtedness which CRI Liquidating may incur. CRI Liquidating does not intend to incur any indebtedness, except in connection with the maintenance of its REIT status. During 1992 and 1993, CRI Liquidating entered into transactions in which it incurred debt in connection with the purchase of government guaranteed mortgage-backed securities and government insured certificates backed by project loans. This debt was nonrecourse and fully secured with the purchased government guaranteed mortgage-backed securities and government insured certificates backed by project loans. As of December 31, 1992 and 1993, CRI Liquidating disposed of these government guaranteed mortgage-backed securities and government insured certificates backed by project loans, and repaid the related debt. Interest expense is based on the seller financing of a portion of the purchase price of the other short-term investments in government guaranteed mortgage-backed securities and government insured certificates backed by project loans (see Note 7). Deferred financing costs - ------------------------ Costs incurred in connection with the establishment of CRIIMI MAE's commercial paper facility (the Commercial Paper Facility) and the issuance of long-term debt and commercial paper (see Notes 10 and 11) are amortized using the effective interest method over the terms of the borrowings. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Interest rate hedge agreements - ------------------------------ Amounts to be paid or received under interest rate hedge agreements are accrued currently and are netted for financial statement presentation purposes. Shareholders' equity - -------------------- CRIIMI MAE has authorized 60,000,000 shares of $.01 par value common stock and issued 21,184,807 shares as of December 31, 1992 and 1993. All shares issued, exclusive of the shares held in treasury, are outstanding. As of December 31, 1992 and 1993, 10,266 and 7,732 shares, respectively, were held for issuance pending presentation of predecessor units and are considered outstanding. Additionally, 25,000,000 shares of $.01 par value preferred stock are authorized; however, no shares are issued or outstanding. Income taxes - ------------ CRIIMI MAE and CRI Liquidating have qualified and intend to continue to qualify as REITs as defined in the Internal Revenue Code and, as such, will not be taxed on that portion of their taxable income which is distributed to shareholders provided that at least 95% of such taxable income is distributed. CRIIMI MAE and CRI Liquidating intend to distribute substantially all of their taxable income and, accordingly, no provision for income taxes has been made in the accompanying consolidated financial statements. CRIIMI MAE and CRI Liquidating, however, may be subject to tax at normal corporate rates on net income or capital gains not distributed. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Per share amounts - ----------------- Net income, dividends and return of capital per share amounts for 1991, 1992 and 1993 represent net income, dividends and return of capital, respectively, divided by the weighted average shares outstanding during each year. The per share amounts are based on the weighted average shares outstanding, including shares held for issuance, pending presentation of predecessor units in the CRIIMI Funds. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Transactions with Related Parties Below is a summary of the related party transactions which occurred during the years 1991, 1992 and 1993. These items are described further in the text which follows: (a) Included in the accompanying consolidated statements of income. A detailed schedule of CRI Liquidating's annual fee is reflected in the tables below. (b) These amounts are deferred on the accompanying consolidated balance sheets and amortized over the mortgage investment term. (c) Included as general and administrative expenses on the accompanying consolidated statements of income. (d) Included as income from investment in insured mortgage funds and advisory partnership, before amortization, on the accompanying consolidated statements of income. (e) Included as a reduction of investment in insured mortgage funds and advisory partnership on the accompanying consolidated balance sheets. (f) Included as a component of gains from mortgage dispositions on the accompanying consolidated statements of income. (g) As a result of reaching the carryover CRIIMI I target yield during the first and fourth quarters of 1993, CRI Liquidating paid deferred annual fees during these quarters (including $86,395 of deferred annual fees from the third and fourth quarters of 1992 which were paid during the first quarter of 1993). (h) As of June 1, 1993, pursuant to the First Amendment to the CRI Insured Mortgage Association, Inc. Advisory Agreement, CRIIMI MAE was granted the right to reduce the amounts paid to the Adviser by the difference between its guaranteed $700,000 distribution and the amount actually paid to CRIIMI MAE by CRI/AIM Investment Limited Partnership. As such, the amounts paid to the Adviser during 1993 were reduced by $101,859 which represents the difference between the guaranteed distribution for the period and the amount actually paid to CRIIMI MAE. CRIIMI MAE has entered into an agreement with the Adviser (the Advisory Agreement) under which the Adviser is obligated to present an investment program to CRIIMI MAE, to evaluate and negotiate voluntary and involuntary mortgage dispositions, provide administrative services for CRIIMI MAE and conduct CRIIMI MAE's day-to-day operations. The Advisory Agreement is for a term through November 27, 1995. The Advisory Agreement, absent a notice of termination or non-renewal, will be automatically renewed for successive three-year terms. The Advisory Agreement may be terminated solely for cause, as defined in the Advisory Agreement, by CRIIMI MAE or the Adviser. Notice of non-renewal must be given at least 180 days prior to the expiration date of the Advisory Agreement. If CRIIMI MAE terminates the Advisory Agreement other than for cause, or the Adviser terminates the Advisory Agreement for cause, in addition to compensation otherwise due, CRIIMI MAE will be required to pay the Adviser a fee equal to the Annual Fee (as described below) payable for the previous fiscal year. If the Advisory Agreement is not renewed, no termination fee will be payable. Under the Advisory Agreement, the Adviser receives compensation from CRIIMI MAE as follows: o An annual fee (the Annual Fee) for managing CRIIMI MAE's portfolio of mortgages. The Annual Fee is equal to 0.375% of average invested assets invested in Additional Mortgage Investments (defined as mortgages acquired by CRIIMI MAE after the Merger), payable quarterly. o Included in the Annual Fee shown in the preceding table is the Master Servicing Fee for overseeing the servicing of the Additional Mortgage Investments. The master servicing fee is equal to 0.025% annually of the outstanding face balance of the Additional Mortgage Investments, payable quarterly. o A mortgage selection fee for analyzing, evaluating and structuring Additional Mortgage Investments. The mortgage selection fee equals 0.75% of amounts invested in Additional Mortgage Investments. The Adviser is also entitled to receive one-half of the fees paid to CRIIMI MAE by the owner or developer of a property underlying a participating mortgage investment, provided that the interest rate on the base mortgage investment is at least equal to the prevailing market interest rate for similar base mortgage investments coupled with investments in limited partnerships. In 1991, the Adviser adopted a policy with respect to borrowings above and beyond the original $140 million Notes (see Note 11) and $140 million Commercial Paper Facility (see Note 10) which would result in a reduction in the amount of fees payable by CRIIMI MAE if Net Positive Spreads (the difference between the yield on a mortgage investment acquired with borrowings and all incremental borrowing and operating expenses on a tax basis associated with the acquisition of such mortgage investment) are not maintained: the total Annual Fee and master servicing fee of 0.40% of invested assets payable to the Adviser with respect to mortgage investments purchased with the proceeds of any particular tranche of borrowings will be reduced incrementally if CRIIMI MAE's Net Positive Spread on such tranche of borrowings falls below 0.40%, and the mortgage selection fee will be eliminated upon reinvestment of proceeds of mortgage dispositions where the mortgage investment was purchased with borrowed funds and disposed of in less than five years without providing a cumulative yield on the original mortgage investment at disposition of at least 100 basis points higher than the original yield at the date of purchase. Since the adoption of this policy, CRIIMI MAE expanded its Commercial Paper Facility (defined below) by $50 million (which expansion was paid down in 1993), increased its Bank Term Loan (defined below) by $15 million and entered into Master Repurchase Agreements (defined below) of approximately $350 million. As of December 31, 1992 and 1993, CRIIMI MAE had a Net Positive Spread of approximately 60 and 177 basis points, respectively, on its borrowings. o An incentive fee equal to 25% of the amount by which net income from Additional Mortgage Investments exceeds the annual target return on equity is payable quarterly, subject to year-end adjustment. Net income from Additional Mortgage Investments is the difference between mortgage investment income, including gains or losses on dispositions, from the mortgage investments directly invested in by CRIIMI MAE less financing costs and operating expenses, including a portion of CRIIMI MAE's general and administrative and professional expenses that the Adviser has determined to be specifically assigned to those mortgage investments. Equity for purposes of this computation is CRIIMI MAE's shareholders' equity on a tax basis. The target return on equity will be determined on a quarterly basis and will equal 1% over the average yield on Treasury Bonds maturing nearest to ten years from such quarter, as reported on a daily basis throughout such quarter, based on quotations supplied by the Federal Reserve Bank of New York, as reported by The Wall Street Journal. CRI Liquidating has also entered into an agreement with the Adviser (CRI Liquidating Advisory Agreement) under which the Adviser is obligated to evaluate and negotiate voluntary mortgage dispositions, provide administrative services for CRI Liquidating and conduct CRI Liquidating's day-to-day affairs. The terms of the CRI Liquidating Advisory Agreement are similar to CRIIMI MAE's terms. Under the CRI Liquidating Advisory Agreement, the Adviser receives compensation from CRI Liquidating as follows: o An annual fee (the CRI Liquidating Annual Fee) for managing CRI Liquidating's portfolio of mortgages. The CRI Liquidating Annual Fee is calculated separately for each of the remaining mortgage pools from the former CRIIMI Funds. With respect to CRIIMI I, the CRI Liquidating Annual Fee will equal 0.75% of average invested assets invested in mortgage investments transferred by CRIIMI I in the Merger, one-third of which will be deferred and paid on a cumulative basis only during such quarters as the carryover CRIIMI I target yield, as discussed below, is achieved on a cumulative basis. Any such deferred amounts will be paid only out of proceeds of mortgage dispositions attributable to CRIIMI I mortgage investments representing market discount. With respect to CRIIMI II, the CRI Liquidating Annual Fee will equal 0.75% of average invested assets invested in existing mortgage investments transferred by CRIIMI II in the Merger, one-fourth of which will be deferred and paid on a cumulative basis only during such quarters as the carryover CRIIMI II target yield, as discussed below, is achieved on a cumulative basis. Any such deferred amounts will be paid only out of operating income attributable to CRIIMI II mortgage investments. With respect to CRIIMI III, the CRI Liquidating Annual Fee will equal 0.25% of average invested assets invested in mortgage investments transferred by CRIIMI III in the Merger. After December 31, 1993, this fee will be reduced to 0.125% for any quarter that the carryover CRIIMI III cumulative annual fee yield, as discussed below, is not achieved. The carryover CRIIMI I target yield will be achieved during any quarter that the former CRIIMI I mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 13.33% per annum based on financial statement income. The carryover CRIIMI II target yield will be achieved during any quarter that the former CRIIMI II mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 11.66% per annum based on financial statement income. The carryover CRIIMI III cumulative annual fee yield will be achieved during any quarter, commencing after December 31, 1993, that the former CRIIMI III mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 10.89% per annum based on financial statement income. Detail of the CRI Liquidating Annual Fees for the years 1991, 1992 and 1993 is as follows: For the year ended December 31, 1991 For the year ended December 31, 1992 For the year ended December 31, 1993 o The Adviser is also entitled to certain incentive fees (the Incentive Fees) in connection with the disposition of certain mortgage investments. Like the CRI Liquidating Annual Fee, the Incentive Fees are calculated separately with respect to mortgage investments transferred in the Merger by CRIIMI I and CRIIMI II. No Incentive Fees are payable with respect to mortgage investments transferred by CRIIMI III. During any quarter in which either the carryover CRIIMI I or CRIIMI II target yields have been achieved on a cumulative basis and the Adviser has been paid any deferred amounts of the CRI Liquidating Annual Fee, the Incentive Fee will equal approximately 9.08% of net disposition proceeds representing the financial statement gain on the related CRIIMI I or CRIIMI II mortgage investments disposed of. After the carryover CRIIMI I adjusted contribution or the carryover CRIIMI II adjusted share capital has been reduced to zero, the Incentive Fee will increase to approximately 9.08% of the net disposition proceeds from the disposition of CRIIMI I or CRIIMI II mortgage investments, each determined separately. The carryover CRIIMI I adjusted contribution and the carryover CRIIMI II adjusted share capital equal the aggregate adjusted contribution of CRIIMI I investors (initial investment of investors reduced by all amounts distributed to them representing distributions of principal on their original mortgage investments other than distributions of proceeds of mortgage dispositions representing market discount that have been applied to the target yield) and the aggregate share capital of CRIIMI II investors (initial investment of investors reduced by all amounts distributed to them representing distributions of principal on their original mortgage investments other than distributions of proceeds of mortgage dispositions representing market discount that have been applied to the target yield), respectively, as of November 27, 1989, the consummation date of the Merger. Subsequent to November 27, 1989, the carryover CRIIMI I adjusted contribution and the carryover CRIIMI II adjusted share capital are reduced by all amounts of principal received from their respective former mortgage investments, whether as part of regular mortgage payments or as proceeds of mortgage dispositions, except for proceeds of mortgage dispositions representing market discount that have been applied to the respective target yield. 4. Fair Value of Financial Instruments The following estimated fair values of CRIIMI MAE's consolidated financial instruments are presented in accordance with generally accepted accounting principles which define fair value as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. These estimated fair values, however, do not represent the liquidation value or the market value of CRIIMI MAE. As of December 31, 1992, CRIIMI MAE and CRI Liquidating recorded their mortgage investments at amortized cost (excluding Mortgages Held for Disposition which were recorded at the lower of cost or market as discussed in Note 6). In connection with CRIIMI MAE's and CRI Liquidating's implementation of SFAS 115 as of December 31, 1993 (see Note 2), CRIIMI MAE's Investment in Mortgages continues to be recorded at amortized cost; however, CRI Liquidating's Investment in Mortgages and CRIIMI MAE's and CRI Liquidating's Mortgages Held for Disposition (see Note 6), are recorded at fair value as of December 31, 1993. The difference between the amortized cost and the fair value of CRI Liquidating's Government Insured Multifamily Mortgages represents the unrealized net gains on CRI Liquidating's Government Insured Multifamily Mortgages. CRIIMI MAE's share of the unrealized net gains on CRI Liquidating's Government Insured Multifamily Mortgages is reported as a separate component of shareholders' equity as of December 31, 1993. (a) CRI Liquidating's Mortgage Investments and all Mortgages Held for Disposition were accounted for at fair value on the accompanying consolidated balance sheet as of December 31, 1993 (see Note 2). The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Investment in mortgages and mortgages held for disposition - ---------------------------------------------------------- The fair value of the Government Insured Multifamily Mortgages and mortgages held for disposition are based on the average of the quoted market prices from three investment banking institutions which trade insured mortgage loans as part of their day-to-day activities. Cash and cash equivalents and accrued interest receivable - --------------------------------------------------------- The carrying amount approximates fair value because of the short maturity of these instruments. Commercial paper - ---------------- The carrying amount approximates fair value because of the short maturity of the debt. Long-term debt - -------------- The carrying amount approximates fair value because the current rate on the debt is reset quarterly based on market rates. Interest rate hedge agreements - ------------------------------ The fair value of interest rate hedge agreements (used to hedge CRIIMI MAE's commercial paper and long-term debt) is the estimated amount that CRIIMI MAE would pay to terminate the agreements as of December 31, 1992 and 1993, taking into account current interest rates and the current creditworthiness of the counterparties. The amount was determined based on the average of two quotes received from financial institutions which enter into these types of transactions as part of their day-to-day activities. 5. Investment in Mortgages CRIIMI MAE's investment policies, which are overseen by the CRIIMI MAE Board of Directors, are intended to foster its objectives of providing stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages issued or sold pursuant to programs sponsored by FHA and GNMA. CRIIMI MAE's sources of capital include borrowings, principal distributions received on its CRI Liquidating shares, principal proceeds of CRIIMI MAE mortgage dispositions and proceeds from equity offerings. As of December 31, 1992 and 1993, CRIIMI MAE directly owned 60 and 126 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 10.1% and 8.52%, a weighted average remaining term of approximately 31 years and 34 years, and a tax basis of approximately $226 million and $499 million, respectively. As of December 31, 1992 and 1993, CRIIMI MAE indirectly owned through its subsidiary, CRI Liquidating, 73 and 63 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 9.91% and 10.03%, a weighted average remaining term of approximately 28 years and 27 years, and a tax basis of approximately $221 million and $173 million, respectively. Thus, on a consolidated basis, as of December 31, 1992 and 1993, CRIIMI MAE owned, directly or indirectly, 133 and 189 Government Insured Multifamily Mortgages, respectively. These consolidated mortgage investments (including Mortgages Held for Disposition) had a weighted average effective interest rate of approximately 9.98%, a weighted average remaining term of approximately 29 years and a tax basis of approximately $447 million, as of December 31, 1992. These amounts compare to a weighted average effective interest rate of approximately 8.95%, a weighted average remaining term of approximately 32 years and a tax basis of approximately $672 million, as of December 31, 1993. In addition, as of December 31, 1993, CRIIMI MAE had committed approximately $41 million for investment in Government Insured Multifamily Mortgages or advances on FHA-Insured Loans relating to the construction or rehabilitation of multifamily housing projects, including nursing homes and intermediate care facilities (Government Insured Construction Mortgages), to be funded by borrowings under the Commercial Paper Facility and the remaining funds available under the Master Repurchase Agreements (see Notes 10 and 11). During 1993, CRIIMI MAE directly acquired 61 Government Insured Multifamily Mortgages with an aggregate purchase price of approximately $284 million at purchase prices ranging from $0.5 million to $30.8 million, with a weighted average effective interest rate of approximately 7.56% and a weighted average remaining term of approximately 33.4 years. In addition, during 1993, CRIIMI MAE funded advances of approximately $29 million on Government Insured Construction Mortgages with a weighted average effective interest rate of approximately 8.73%. As of December 31, 1993, CRIIMI MAE had committed to acquire additional Government Insured Multifamily Mortgages and to make additional advances on and/or acquire Government Insured Construction Mortgages, totalling approximately $41 million. In connection with CRI Liquidating's business plan which calls for an orderly liquidation of approximately 25% of its December 31, 1993 portfolio balance each year through 1997, on February 10, 1994, CRI Liquidating sold twelve Government Insured Multifamily Mortgages resulting in net sales proceeds of approximately $48.7 million. As of the date of the sale, these twelve Government Insured Multifamily Mortgages had a weighted average effective interest rate of approximately 10.3%, a weighted average remaining term of approximately 28 years and a tax basis of approximately $34 million. This sale is expected to result in financial statement and tax basis gains of approximately $11.7 million and $14.7 million, respectively. As discussed below, CRIIMI MAE is permitted to make direct investments in primarily two categories of Government Insured Multifamily Mortgages at, near, or above par value (Near Par or Premium Mortgage Investments). FHA-Insured Loans--The first category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of FHA-Insured Loans. All of the FHA-Insured Loans in which CRIIMI MAE invests are insured by HUD for effectively 99% of their current face value. As part of its investment strategy, CRIIMI MAE also invests in Government Insured Construction Mortgages which involve a two-tier financing process in which a short-term loan covering construction costs is converted into a permanent loan. CRIIMI MAE also becomes the holder of the permanent loan upon conversion. The construction loan is funded in HUD-approved draws based upon the progress of construction. The construction loans are GNMA-guaranteed or insured by HUD. The construction loan generally does not amortize during the construction period. Amortization begins upon conversion of the construction loan into a permanent loan, which generally occurs within a 24-month period from the initial endorsement by HUD. Mortgage-Backed Securities--The second category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of federally guaranteed mortgage-backed securities or other securities backed by Government Insured Multifamily Mortgages issued by entities other than GNMA (Mortgage-Backed Securities) and GNMA Mortgage-Backed Securities. As of December 31, 1993, all of CRIIMI MAE's mortgage investments in this category were GNMA Mortgage-Backed Securities. The GNMA Mortgage-Backed Securities in which CRIIMI MAE invests are backed by Government Insured Multifamily Mortgages insured in whole by HUD, or insured by HUD and a coinsured lender under HUD mortgage insurance programs and the coinsurance provisions of the National Housing Act. The Mortgage-Backed Securities in which CRIIMI MAE is permitted to invest, although none have been acquired as of December 31, 1993, are backed by Government Insured Multifamily Mortgages which are insured in whole by HUD under HUD mortgage insurance programs. Generally, Government Insured Multifamily Mortgages which are purchased near, at or above par value will result in a loss if the mortgage investment is prepaid or assigned prior to maturity because the amortized cost of the mortgage investment, including acquisition costs, is approximately the same as or slightly higher than the insured amount of the mortgage investment. As of December 31, 1993, substantially all of the mortgage investments owned directly by CRIIMI MAE consisted of Government Insured Multifamily Mortgages that are Near Par or Premium Mortgage Investments. Based on current interest rates, the Adviser does not believe that the prepayment, assignment, or sale of any of CRIIMI MAE's Government Insured Multifamily Mortgages would result in a material financial statement or tax basis gain or loss. CRI Liquidating Mortgage Investments--CRI Liquidating's mortgage investments consist solely of the Government Insured Multifamily Mortgages it acquired from the CRIIMI Funds in the Merger. The CRIIMI Funds invested primarily in Government Insured Multifamily Mortgages issued or sold pursuant to programs of GNMA and FHA. The majority of CRI Liquidating's mortgage investments were acquired by the CRIIMI Funds at a discount to face value (Discount Mortgage Investments) on the belief that based on economic, market, legal and other factors, such Discount Mortgage Investments might be sold for cash, prepaid as a result of a conversion to condominium housing or otherwise disposed of or refinanced in a manner requiring prepayment or permitting other profitable disposition three to twelve years after acquisition by the CRIIMI Funds. Based on current interest rates, the Adviser expects that (i) the disposition of most of CRI Liquidating's Government Insured Multifamily Mortgages will result in a gain on a financial statement basis, and (ii) the disposition of any of CRI Liquidating's Government Insured Multifamily Mortgages will not result in a material loss on a financial statement basis and will result in a gain on a tax basis. The safekeeping and servicing of the mortgage investments (excluding CRI Liquidating's investment in limited partnerships) is performed by various trustees and servicers under the terms of the Servicing Agreements. Other Investments - ----------------- In addition to investing in FHA-Insured Loans and GNMA-Mortgage Backed Securities, CRIIMI MAE's investment policies also permit CRIIMI MAE to invest in Government Insured Multifamily Mortgages which are not FHA-insured or GNMA-guaranteed (Other Insured Mortgages) and in certain other mortgage investments which are not federally insured or guaranteed (Other Multifamily Mortgages). Pursuant to CRIIMI MAE's policy, at the time of their acquisition, Other Multifamily Mortgages must have an expected yield of at least 150 basis points (1.5%) greater than the yield on Government Insured Multifamily Mortgages which could be acquired in the then current market and must meet certain other strict underwriting guidelines. The CRIIMI MAE Board of Directors has adopted a policy limiting Other Multifamily Mortgages to 20% of CRIIMI MAE's total consolidated assets. As of December 31, 1993, CRIIMI MAE had not invested or committed to invest in any Other Insured Mortgages or Other Multifamily Mortgages and CRIIMI MAE does not currently intend to invest in any Other Multifamily Mortgages for at least twelve months after the filing date of this report. CRIIMI MAE is currently exploring opportunities in connection with the sponsorship of securities offerings which involve the pooling of certain Other Multifamily Mortgages to further enhance potential returns to CRIIMI MAE shareholders. Such sponsorship may also include the investment by CRIIMI MAE in the non-investment grade or unrated tranches of mortgage pools having a high current yield. As of December 31, 1993, CRIIMI MAE had not participated in the sponsorship of any such securities offerings. The Adviser does not expect that investments of this nature will exceed 5% of CRIIMI MAE's total consolidated assets for at least twelve months after the filing date of this report. Descriptions of the mortgage investments owned, directly or indirectly by CRIIMI MAE which exceed 3% of the total carrying amount of the consolidated mortgage investments as of December 31, 1993, summarized information regarding other mortgage investments and mortgage investment income earned in 1991, 1992 and 1993, including interest earned on the disposed mortgage investments, are as follows: * As construction loans convert to permanent loans, information reported in prior periods is reclassified to the applicable permanent loan classification. ** For additional information regarding Mortgages Held for Disposition, see Note 6 of the notes to consolidated financial statements. *** Construction draws are part of a short-term financing process and are funded to cover construction costs. The construction draws are converted into a long-term permanent loan generally within a 24-month period from the initial endorsement by HUD. (A) All mortgages are collateralized by first or second liens on residential apartment, retirement home, nursing home, development land or townhouse complexes which have diverse geographic locations and are FHA-Insured Loans or GNMA Mortgage-Backed Securities. Payment of the principal and interest on FHA-Insured Loans is insured by HUD pursuant to Title 2 of the National Housing Act. Payment of the principal and interest on GNMA Mortgage-Backed Securities is guaranteed by GNMA pursuant to Title 3 of the National Housing Act. The investment in limited partnerships is not federally insured or guaranteed. (B) Principal and interest on permanent mortgages is payable at level amounts over the life of the mortgage investment. Total annual debt service payable to CRIIMI MAE and CRI Liquidating(excluding principal and interest on the mortgages classified as held for disposition) for the mortgage investments held as of December 31, 1993 is approximately $61.1 million. (C) Reconciliations of the carrying amount of CRIIMI MAE's consolidated mortgage investments for the years ended December 31, 1992 and 1993 follow: (D) Principal Amount of Loans Subject to Delinquent Principal or Interest is not presented since all required payments with respect to these FHA-Insured Loans or GNMA Mortgage-Backed Securities are current and none of these mortgages are delinquent as of December 31, 1993, except the mortgages classified as Mortgages Held for Disposition as discussed in Note 6 and the mortgages on Guinn Nursing Home and Oak Hills Nursing Home which had an aggregate face value of approximately $6.2 million as of December 31, 1993. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued Historical Dispositions - ----------------------- The following table sets forth certain information concerning dispositions of Government Insured Multifamily Mortgages by CRIIMI MAE and CRI Liquidating for the past five years: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Investment in Mortgages - Continued 5. Investment in Mortgages - Continued (1) CRIIMI MAE or CRI Liquidating may elect to receive insurance benefits in the form of cash when a Government Insured Multifamily Mortgage defaults. In that event, 90% of the face value of the mortgage generally is received within approximately 90 days of assignment of the mortgage to HUD and 9% of the face value of the mortgage is received upon final processing by HUD which may not occur in the same year as assignment. If CRIIMI MAE or CRI Liquidating elects to receive insurance benefits in the form of HUD debentures, 99% of the face value of the mortgage is received upon final processing by HUD. Gains from dispositions are recognized upon receipt of funds or HUD debentures and losses generally are recognized at the time of assignment. (2) Eight of the 37 assignments were sales of Government Insured Multifamily Mortgages then in default and resulted in the CRIIMI Funds, CRI Liquidating or CRIIMI MAE receiving near or above face value. (3) In connection with the Merger, CRI Liquidating recorded its investment in mortgages at the lower of cost or fair value, which resulted in an overall net write down for tax purposes. For financial statement purposes, carryover basis of accounting was used. Therefore, since the Merger, the net gain for tax purposes was greater than the net gain recognized for financial statement purposes. As a REIT, dividends to shareholders are based on tax basis income. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Mortgages Held for Disposition As of December 31, 1992 and 1993, the following mortgages were classified as held for disposition: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Mortgages Held for Disposition - Continued (1) Represents a CRI Liquidating mortgage investment. In connection with CRI Liquidating's implementation of SFAS 115 (see Note 2) as of December 31, 1993, all of CRI Liquidating's mortgage investments, including Mortgages Held for Disposition, were recorded at fair value. As of December 31, 1992, all of CRI Liquidating's mortgage investments classified as Mortgages Held for Disposition were recorded at the lower of cost or market. (2) Represents a CRIIMI MAE mortgage investment. As of December 31, 1992, all of CRIIMI MAE's mortgage investments classified as Mortgages Held for Disposition were recorded at the lower of cost or market. In connection with CRIIMI MAE's implementation of SFAS 115 (see Note 2) as of December 31, 1993, all of CRIIMI MAE's mortgage investments classified as Mortgages Held for Disposition were recorded at fair value. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Other Short-Term Investments During 1993, CRIIMI MAE, and, during each of 1992 and 1993, CRI Liquidating entered into transactions in which mortgage-backed and other government agency securities were purchased. These transactions provided CRIIMI MAE with above average returns compared to its other short-term investments while maintaining the high quality of its assets and assisted in maintaining CRI Liquidating's REIT status. Some of these purchases were financed with borrowings which were nonrecourse and fully secured with the purchased mortgage-backed and other government agency securities. As of December 31, 1993, CRIIMI MAE and as of December 31, 1992 and 1993, CRI Liquidating had disposed of the mortgage-backed and other government agency securities acquired in such year and repaid the related debt. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Reconciliation of Financial Statement Net Income to Tax Basis Income Reconciliations of the financial statement net income to the tax basis income for the years ended December 31, 1991, 1992 and 1993 are as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Reconciliation of Financial Statement Net Income to Tax Basis Income - Continued Differences in the financial statement net income and the tax basis income principally relate to differences in the tax bases of assets and liabilities and their related financial reporting amounts resulting from the Merger, investment in mortgages, long-term debt and deferred financing costs, investment in U.S. Treasury Securities and partnership investments. The tax basis of investment in mortgages is approximately $70.3 million less than the financial statement basis as of December 31, 1993. The tax basis of long-term debt and deferred financing costs as of December 31, 1993 was approximately $15 million and $5 million, respectively, greater than the financial statement basis. The tax basis of investments in U.S. Treasury Securities, purchased in connection with the defeasance of long-term debt (see Note 11) and netted with the defeased long-term debt for financial statement purposes, is approximately $15 million greater than the financial statement basis as of December 31, 1993. As a result of the foregoing, the nature of the dividends for income tax purposes on a per share basis is as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Summary of Quarterly Results of Operations (Unaudited) The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1991, 1992 and 1993: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Summary of Quarterly Results of Operations (Unaudited) - Continued 10. Commercial Paper The following table shows commercial paper borrowing activity as of December 31, 1992 and 1993 and for the years then ended: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Commercial Paper - Continued In May 1991, CRIIMI MAE entered into an agreement to amend the Commercial Paper Facility (defined below) which increased the funds available for borrowings from $140.0 million to $190.0 million. As of December 31, 1992 and 1993, CRIIMI MAE had borrowed a total of approximately $186.3 million and $95.3 million, respectively. The base issuance rate for commercial paper issued under CRIIMI MAE's commercial paper facility (the Commercial Paper Facility) ranged from 3.20% to 4.45% during the year ended December 31, 1992 and 3.15% to 3.68% during the year ended December 31, 1993, and was 4.02% and 3.41% as of December 31, 1992 and 1993, respectively. CRIIMI MAE's Commercial Paper Facility provides for the issuance of commercial paper by CRI Funding Corporation, an unaffiliated special purpose corporation, which lends the proceeds from the issuance to CRIIMI MAE. If commercial paper is not issued, the special purpose corporation may meet its obligation to provide financing to CRIIMI MAE by borrowing at a rate of LIBOR plus 0.50% under a $140.0 million revolving credit facility which was established in connection with the Commercial Paper Facility. Borrowings pursuant to the Commercial Paper Facility are collateralized by a pledge of certain of CRIIMI MAE's Government Insured Multifamily Mortgages. The loan agreements contain numerous covenants which CRIIMI MAE must satisfy, including CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Commercial Paper - Continued requirements that the fair value of collateral pledged must equal at least 110% of the amounts borrowed and that interest on the collateral pledged equal at least 120% of the debt service on the amounts borrowed. In addition, 60% of the Government Insured Multifamily Mortgages pledged as collateral must be GNMA- Mortgage Backed Securities. As of December 31, 1993, Government Insured Multifamily Mortgages held directly by CRIIMI MAE with a market value and face value of approximately $145.4 million and $139.7 million, respectively, were used as collateral pursuant to the Commercial Paper Facility. In February 1993, CRIIMI MAE entered into an agreement to replace a $190.0 million letter of credit which provided the credit enhancement for the Commercial Paper Facility and related revolving credit facility, with two letters of credit in the amount of $35.0 million and $155.0 million provided by National Australia Bank, Limited and Canadian Imperial Bank of Commerce (CIBC), respectively. In April 1993, the letter of credit provided by CIBC was reduced to $105.0 million. Subsequent to December 31, 1993, the special purpose corporation replaced borrowings under the Commercial Paper Facility with revolving credit loans. These revolving credit loans were scheduled to mature on January 28, 1994; however, the maturity date has been extended until February 28, 1994. CRIIMI MAE executed a Commitment Letter and Term Sheet for a revolving credit facility, dated November 24, 1993, to replace these agreements with a 30-month non-amortizing bank loan to be issued prior to the expiration date of the letter of credit agreements by lenders including the aforementioned bank group on terms substantially similar to the April 1993 Master Repurchase Agreements (defined below). While there is no assurance, CRIIMI MAE expects to close on such new revolving credit facility on or before February 28, 1994. If CRIIMI MAE is unable to consummate the loan by such date, the Adviser believes that it will be able to obtain a further extension of its existing revolving credit loans. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt The following table summarizes CRIIMI MAE's long-term debt as of December 31, 1992 and 1993: CRIIMI MAE's long-term debt matures over the next three years as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt - Continued Master Repurchase Agreements - ---------------------------- On April 30, 1993, CRIIMI MAE entered into master repurchase agreements (the Master Repurchase Agreements) with Nomura Securities International, Inc. and Nomura Asset Capital Corporation (collectively, Nomura) which provide CRIIMI MAE with $350.0 million of available financing for a three-year term. CRIIMI MAE intends to seek renewal of the Master Repurchase Agreements upon expiration. Interest on such borrowings is based on the three-month LIBOR plus 0.75% or 0.50% depending on whether FHA-Insured Loans or GNMA Mortgage-Backed Securities, respectively, are pledged as collateral. For April through December 1993, the three-month LIBOR for these borrowings ranged from 3.18% to 3.50%. The value of the collateral pledged must equal at least 105% and 110% of the amounts borrowed for GNMA Mortgage-Backed Securities and FHA-Insured Loans, respectively. No more than 60% of the collateral pledged may be FHA-Insured Loans and no less than 40% may be GNMA Mortgage-Backed Securities. As of December 31, 1993, mortgage investments directly owned by CRIIMI MAE which approximate $349.4 million at market value and $342.2 million at face value, were used as collateral pursuant to certain terms of the Master Repurchase Agreements. As of December 31, 1993, CRIIMI MAE's debt-to-equity ratio, excluding approximately $41.0 million of borrowings committed for investment in mortgages, was 2.2:1 and its debt-to-equity ratio, including such borrowings, was 2.4:1. As of December 31, 1993, CRIIMI MAE used approximately $281.7 million of the funds available under the Master Repurchase Agreements to acquire Government Insured Multifamily Mortgages and $50.0 million to repay a portion of borrowings under the Commercial Paper Facility. In addition, approximately $18.3 million of the balance of the funds available have been committed for investment in Government Insured Multifamily Mortgages or advances on Government Insured Construction Mortgages. On November 30, 1993, CRIIMI MAE entered into additional repurchase agreements with Nomura pursuant to which Nomura will CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt - Continued provide CRIIMI MAE with an additional $150.0 million of available financing for a three-year term. The agreements provide that the funding will be utilized to purchase FHA-Insured Loans and GNMA Mortgage-Backed Securities in the event of the successful completion of the Equity Offering (see Note 1). In that event, it is contemplated that CRIIMI MAE will borrow the full $150.0 million no earlier than the consummation of the Equity Offering, but no later than July 1, 1994. The terms of the $150.0 million financing arrangements are similar to the terms of the Master Repurchase Agreements entered into in April 1993. Bank Term Loan - -------------- On October 23, 1991, CRIIMI MAE entered into a credit agreement with two banks for a reducing term loan facility (the Bank Term Loan) in an aggregate amount not to exceed $85.0 million, subject to certain terms and conditions. In December 1992, the credit agreement was amended to increase the reducing term loan by $15.0 million. The Bank Term Loan had an outstanding principal balance of approximately $61.7 million and $52.0 million as of December 31, 1992 and 1993, respectively. As of December 31, 1992 and 1993, the Bank Term Loan was secured by the value of 17,784,000 and 13,874,000 CRI Liquidating shares owned by CRIIMI MAE, respectively. As a result of principal payments on the Bank Term Loan in 1993, 750,000 of the 13,874,000 CRI Liquidating shares pledged as collateral were released in January 1994. The Bank Term Loan requires a quarterly principal payment based on the greater of the return of capital portion of the dividend received by CRIIMI MAE on its CRI Liquidating shares securing the Bank Term Loan or an amount to bring the Bank Term Loan to its scheduled outstanding balance at the end of such quarter. The minimum amount of annual principal payments is approximately $15.8 million, with any remaining amounts of the original $85.0 million of principal due in April 1996 and any remaining amounts of the $15.0 million of increased principal due in December 1996. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt - Continued The amended Bank Term Loan provides for an interest rate of 1.10% over three-month LIBOR plus an agent fee of 0.05% per year. During 1992 and 1993, three-month LIBOR for borrowings under the Bank Term Loan ranged from 3.44% to 4.50% and 3.19% to 3.59%, respectively. On December 31, 1991, with the $85.0 million from the Bank Term Loan and the debt service reserve account, CRIIMI MAE repurchased approximately $97.6 million and defeased the remaining $19.2 million of the outstanding notes issued pursuant to an Indenture dated November 28, 1989 (the Notes). CRIIMI MAE purchased approximately $21.6 million of U.S. Treasury Securities to fund the principal and interest due in accordance with the original payment schedule to defease the Notes which were not repurchased. As a result of this early extinguishment of debt, CRIIMI MAE recognized an extraordinary loss of approximately $6.6 million in the accompanying consolidated statements of income for the year ended December 31, 1991. All remaining costs associated with the Bank Term Loan have been included in deferred financing fees on the accompanying balance sheet and will be amortized using the effective interest method over the life of the Bank Term Loan. However, for tax purposes these deferred financing fees as well as the extraordinary loss have been capitalized and will be amortized over the term of the Bank Term Loan. 12. Interest Rate Hedge Agreements CRIIMI MAE is subject to the risk that changes in interest rates could reduce Net Positive Spreads by increasing CRIIMI MAE's borrowing costs and/or decreasing the yield on its Government Insured Multifamily Mortgages. An increase in CRIIMI MAE borrowing costs could result from an increase in short-term interest rates. To partially limit the adverse effects of rising interest rates, CRIIMI MAE has entered into a series of interest rate hedging agreements in an aggregate notional amount approximately equal to all of its outstanding borrowings and commitments. To the extent CRIIMI MAE has not fully hedged its portfolio, in periods of rising interest rates CRIIMI MAE's CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued overall borrowing costs would increase with little or no overall increase in mortgage investment income, resulting in returns to shareholders that would be lower than those available if interest rates had remained unchanged. Borrowings by CRIIMI MAE generally are hedged by swap, cap or collar agreements. As of December 31, 1993, CRIIMI MAE had in place interest rate collars on the indices underlying borrowing rates for the Commercial Paper Facility (the CP Index) with an aggregate notional amount of $115 million, a weighted average floor of 8.55% and a weighted average cap of 10.37%. An interest rate collar limits the CP Index to a maximum interest rate and also enables CRIIMI MAE to receive the benefit of a decline in the CP Index to the floor of the collar for the period of the collar. To the extent that the CP Index increases, CRIIMI MAE's overall borrowing costs would not increase until the CP Index reaches the level of the floor of the collar. At that point, CRIIMI MAE's borrowing costs would increase as the CP Index increases but only until the CP Index reaches the maximum rate provided for by the collar. As of December 31, 1993, CRIIMI MAE had in place interest rate caps on the CP Index and LIBOR underlying borrowing rates for the Commercial Paper Facility and Master Repurchase Agreements. The caps based on the CP Index have an aggregate notional amount of $50 million with a weighted average cap of 8.73%. The caps based on LIBOR have an aggregate notional amount of $300 million with a weighted average cap of 6.23%. CRIIMI MAE also had an interest rate cap with a notional amount of approximately $63 million and a cap of 6.5% on the LIBOR underlying the Bank Term Loan. An interest rate cap effectively limits CRIIMI MAE's interest rate risk on floating rate borrowings by limiting the CP Index or LIBOR, as the case may be, to a maximum interest rate for the period of the cap. To the extent the CP Index or LIBOR decrease, CRIIMI MAE's borrowing costs would decrease under such caps. To the extent the CP Index or LIBOR increase, CRIIMI MAE's borrowing costs would increase but only until the CP Index or LIBOR reaches the maximum rate provided for by the cap. As of CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued December 31, 1993, certain cap agreements based on the three-month LIBOR with a notional amount of $300 million were between approximately 2.62% and 3.13% above the current three-month LIBOR. On December 1, 1993, CRIIMI MAE paid approximately $4.9 million to terminate an interest rate swap entered into on February 8, 1990 with a notional amount of $25 million and a fixed rate of 9.23%. The termination of this swap was effective December 1, 1993. The cost to terminate the interest rate swap was expensed in the accompanying consolidated statement of income for the year ended December 31, 1993 as the underlying debt under the Commercial Paper Facility being hedged was repaid. As of December 31, 1993, CRIIMI MAE had in place no swap agreements. Current interest rates are substantially lower than when CRIIMI MAE entered into $165 million of its existing interest rate hedging agreements. As of December 31, 1993, certain collar agreements based on the CP Index with a notional amount of $115 million carried minimum interest rates which were between approximately 5.0% and 5.4% above the current CP Index. Such hedging agreements expire in 1995. While there is no assurance that any new agreements will be made, the Adviser is actively exploring alternatives to replace these hedging agreements when they expire in order to capitalize on the current low interest rate environment. As a result of minimum interest rate levels associated with the swap agreement terminated in December, 1993 and the collar agreements which expire in 1995, CRIIMI MAE incurred additional interest expense of $4.3 million, $8.1 million and $8.6 million for the years ended December 31, 1991, 1992 and 1993, respectively, of which approximately $0.8 million, $1.3 million and $1.4 million, respectively, was attributable to the terminated swap agreement. The additional interest expense amounts also include amortization of approximately $0.1 million, $0.2 million and $0.6 million, respectively, related to up-front hedging costs. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued The following table sets forth information relating to CRIIMI MAE's hedging agreements with respect to borrowings under the Commercial Paper Facility and the Master Repurchase Agreements: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued (a) On May 24, 1993, CRIIMI MAE and CIBC terminated the floor on this former collar. In consideration of such termination, CRIIMI MAE paid CIBC approximately $2.3 million. This amount was deferred on the accompanying consolidated balance sheet as the underlying debt being hedged is still outstanding. This amount will be amortized for the period from May 24, 1993 through May 24, 1996. CRIIMI MAE amortized approximately $0.5 million of this deferred amount in the accompanying consolidated statements of income for the year ended December 31, 1993. (b) Approximately $4.5 million of costs were incurred in 1993 in connection with the establishment of interest rate hedges. These costs are being amortized using the effective interest method over the term of the interest rate hedge agreement for financial statement purposes and in accordance with the regulations under Internal Revenue Code Section 446 with respect to notional principal contracts for tax purposes. (c) The hedges are based either on the 30-day Commercial Paper Composite Index (CP) or three-month LIBOR. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued In addition, CRIIMI MAE entered into an interest rate hedge agreement on the Bank Term Loan to cap LIBOR at 6.5% based on the expected paydown schedule and an incremental hedge of 10.5% on the difference between the required and expected paydown schedules. As of December 31, 1993, three-month LIBOR was approximately 3.13% below the 6.5% cap. CRIIMI MAE is exposed to credit loss in the event of nonperformance by the other parties to the interest rate hedge agreements should interest rates exceed the caps. However, the Adviser does not anticipate nonperformance by any of the counterparties, each of which has long-term debt ratings of A or above by Standard and Poor's and A2 or above by Moody's. 13. Treasury Stock On January 12, 1990, CRIIMI MAE commenced a cash tender offer (the Tender Offer) to repurchase and to hold in treasury up to 1,000,000 outstanding CRIIMI MAE shares at $9.50 per share. The offer expired at midnight on February 12, 1990. Pursuant to the Tender Offer, CRIIMI MAE purchased and holds in treasury 1,001,274 CRIIMI MAE shares at $9.50 per share which are shown at cost on the accompanying consolidated balance sheets. Such shares could be reissued for such purposes as, among others, the acquisition of other businesses and the distribution of stock dividends. 14. Acquisition - AIM Funds Interest Effective March 1, 1991, CRIIMI MAE entered into a Purchase Agreement dated as of December 13, 1990 with Integrated and certain of its affiliates, and AIM Acquisition Corporation to acquire certain of the interests of Integrated and its affiliates in the AIM Funds sponsored by Integrated. On September 6, 1991, CRIIMI, Inc. acquired all of the general partnership interests in the AIM Funds for $23,342,591. In addition, CRIIMI MAE and CRI each invested $1,086,714 for an aggregate 20% limited partnership interest in a limited partnership which serves as the adviser to the AIM Funds. The remaining 80% of the adviser partnership is CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued owned by parties unrelated to CRIIMI MAE or CRI. The adviser partnership entered into subadvisory agreements with an affiliate of CRI under which such affiliate will perform certain services with respect to the mortgage portfolios of the AIM Funds. For its investment, CRIIMI, Inc. will receive the General Partner's share of income, loss and distributions (which ranges among the AIM Funds from 2.9%- 4.9%) from each fund and an affiliate of CRIIMI, Inc. will receive certain expense reimbursements. CRIIMI MAE is guaranteed an annual return on its investment in the adviser partnership, through the distributions it receives indirectly from the adviser partnership and a right of offset against amounts payable to its Adviser (see Note 3). Combined summarized financial information as of December 31, 1992 and 1993 and for the years ended December 31, 1991, 1992 and 1993 of the AIM Funds in which CRIIMI MAE's equity in the net income exceeds 10 percent of CRIIMI MAE's net income, is as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Combined Summarized Financial Information (Unaudited) CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Statements of Income CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15. Settlement of Litigation On March 22, 1990, a complaint was filed, on behalf of a class comprised of certain limited partners of CRIIMI III and shareholders of CRIIMI II (the Plaintiffs), in the Circuit Court for Montgomery County, Maryland against CRIIMI MAE, CRI Liquidating, CRIIMI I and its general partner, CRIIMI II, CRIIMI III and its general partner, CRI and William B. Dockser, H. William Willoughby and Martin C. Schwartzberg (the Defendants). On November 18, 1993, the Court entered an order granting final approval of a settlement agreement between the Plaintiffs and the Defendants pursuant to which CRIIMI MAE will issue to class members, including certain former limited partners of CRIIMI I, up to 2.5 million warrants, exercisable for 18 months after issuance, to purchase shares of CRIIMI MAE common stock at an exercise price of $13.17 per share. In addition, the settlement included a payment of $1.4 million for settlement administration costs and the Plaintiff's attorneys' fees and expenses. Insurance provided $1.15 million of the $1.4 million cash payment, with the balance paid by CRIIMI MAE. CRIIMI MAE accrued a total provision of $1.5 million in the accompanying consolidated statements of income for the uninsured portion of the cash settlement paid by CRIIMI MAE and for the estimated value of the warrants that are expected to be issued as part of the settlement. The number of warrants to be issued is dependent on the number of class members who submit a proof of claim within 60 days of January 14, 1994 (the date the proof of claim was mailed by CRIIMI MAE). The issuance of the warrants pursuant to the settlement agreement will have no impact on CRIIMI MAE's tax basis income. Depending upon the number of warrants issued, CRIIMI MAE will record in its financial statements a non-cash expense ranging from $0 (if no warrants are issued) to $5 million (if all 2.5 million warrants are issued). Based on the Adviser's estimate of the number of warrants to be issued, CRIIMI MAE has accrued a total provision of $1.5 million (which includes the uninsured portion of the cash settlement) in the accompanying consolidated statement of income for 1993, which provision may be increased or decreased once the actual number of warrants issued is known. The Adviser CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15. Settlement of Litigation - Continued estimates that the final charge (after adjustments to the provision) to net income and the increase in the number of shares of common stock outstanding as a result of the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's net income and net income per share. The exercise of the warrants will not result in a charge to CRIIMI MAE's tax basis income. Further, the Adviser believes that the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's tax basis income per share or annualized cash dividends per share because CRIIMI MAE intends to invest the proceeds from any exercise of the warrants in accordance with its investment policy to purchase Government Insured Multifamily Mortgages and other authorized investments. However, in the case of a significant decline in the yield on mortgage investments and a significant decrease in the Net Positive Spread which CRIIMI MAE could achieve on its borrowings, the exercise of the warrants may have a dilutive effect on tax basis income per share and cash dividends per share. Receipt of the proceeds from the exercise of the warrants will increase CRIIMI MAE's shareholders' equity. Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) (a) Includes a supplemental note in the principal balance of $268,568 with a net coupon of 9.25% and a maturity date of July 1, 1996. (b) Excludes one Mortgage Held for Disposition. Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) The following Government Insured Multifamily Mortgages were sold by CRI Liquidating on February 10, 1994: (a) Excludes two Mortgages Held for Disposition. Directors and Executive Officers The Annual Report to the Securities and Exchange Commission on Form 10-K is available to Shareholders and may be obtained by writing: Investor Services/CRIIMI MAE Inc. C.R.I., Inc. The CRI Building 11200 Rockville Pike Rockville, Maryland 20852 CRIIMI MAE Inc. shares are traded on the New York Stock Exchange under the symbol CMM.

836400_1993.txt

836400

1993

ITEM 1. BUSINESS THE COMPANY Dr Pepper/Seven-Up Companies, Inc., a Delaware corporation, is a holding company organized in 1988 whose primary asset consists of all the common stock of Dr Pepper/Seven-Up Corporation, a Delaware corporation ("DP/7UP"). Unless the context requires otherwise, the "Company" means Dr Pepper/Seven-Up Inc., together with its direct and indirect subsidiaries, and the "Holding Company" means Dr Pepper/Seven-Up Companies, Inc. As used in this document, the term "DR PEPPER" refers only to the regular DR PEPPER product while the phrases "DR PEPPER brand" and "DR PEPPER brands" refer to the line of products consisting of DR PEPPER, Diet DR PEPPER, Caffeine Free DR PEPPER and Caffeine Free Diet DR PEPPER. As used in this document, the term "7UP" refers only to the regular 7UP product while the phrases "7UP brand" and "7UP brands" refer to the line of products consisting of 7UP, Diet 7UP, CHERRY 7UP and Diet CHERRY 7UP. The Holding Company was formed in 1988 to acquire Dr Pepper Company ("Dr Pepper") and The Seven-Up Company ("Seven-Up") in a leveraged buyout transaction sponsored by Prudential-Bache Interfunding, Inc., Prudential-Bache Capital Partners I, L.P. and management. On October 28, 1992, as part of the 1992 Recapitalization (as hereinafter defined), Seven-Up merged with and into Dr Pepper (the "Merger"). DP/7UP, the surviving company, is a direct operating subsidiary of the Holding Company. 1993 PUBLIC OFFERING In February 1993, the Company completed an initial public offering (the "Offering") of 23,600,402 shares (including 2,022,089 shares sold by a selling stockholder and certain selling warrantholders) of its Common Stock resulting in net proceeds to the Company of approximately $305.9 million. The net proceeds were used to redeem approximately $115.5 million of the accreted balance of the Holding Company's Discount Notes (as hereinafter defined), reduce borrowings of approximately $82.5 million under the Credit Agreement (as hereinafter defined) and redeem all of the outstanding exchangeable Senior Preferred Stock of the Holding Company. 1992 RECAPITALIZATION On October 28, 1992, the Company completed a recapitalization transaction (the "1992 Recapitalization") to reduce interest expense, retire preferred stock and reduce associated dividend requirements and effect the Merger. As part of the 1992 Recapitalization, the Company issued $656.5 million principal amount of its 11 1/2% Senior Subordinated Discount Notes due 2002 (the "Discount Notes") resulting in gross proceeds of $375.0 million. The Company also borrowed an aggregate of $816.0 million under a credit agreement (the "Credit Agreement") among DP/7UP (as the successor company in the Merger), the Holding Company, as guarantor, and certain lenders and agents named therein, which borrowings included (i) $775.0 million under a term loan facility (the "Term Loan Facility"), and (ii) $41.0 million under a $100.0 million revolving credit facility (the "Revolving Facility"). The proceeds of the borrowings and $169.9 million of cash on hand as of October 28, 1992, were used to effect the retirement of certain indebtedness and preferred stock. On December 28, 1993, the Company modified the Credit Agreement resulting in a reduction in interest rates of approximately 1 1/2%. The amended credit line is $675.0 million, consisting of a $525.0 million Term Loan Facility and a $150.0 million Revolving Facility. PRINCIPAL PRODUCTS The Company, through DP/7UP, manufactures, markets, sells and distributes soft drink concentrates, extracts (the basic flavoring ingredients for soft drinks) and fountain syrups (concentrates or extracts with sweeteners and water added) to licensed bottlers primarily in the United States. The principal products of the Company are DR PEPPER, Diet DR PEPPER, Caffeine Free DR PEPPER, Caffeine Free Diet DR PEPPER, 7UP, Diet 7UP, CHERRY 7UP, Diet CHERRY 7UP, WELCH's carbonated soft drinks and I.B.C. soft drinks. The Company is the third largest soft drink concentrate manufacturer in the United States, with retail sales of its products estimated to represent approximately 11.4%, or $5.6 billion, of the estimated $49.1 billion 1993 United States retail soft drink industry. DP/7UP is divided into five business units: Dr Pepper USA, Seven-Up USA, Foodservice, Premier Beverages, and International. Each unit has its own selling and marketing staff fully dedicated to expanding and enhancing its brands. Soft drinks constitute one of the largest consumer food and beverage categories in the United States. The industry is considered to be non-cyclical, as sales volume has grown in each of the past ten years. The Company's business, like the concentrate and extract segment of the soft drink industry overall, is characterized by low fixed asset investment, low working capital requirements, low labor intensity, and high gross margins, all of which enable the Company to devote significant resources to the marketing support of its brands. A major competitive advantage in the industry is strong trademark recognition. Formulated in 1885, DR PEPPER is the oldest nationally distributed soft drink brand in the United States. 7UP has been a market leader in the lemon-lime category of the soft drink industry for more than 60 years. In 1993, DR PEPPER brands accounted for an estimated 6.8% of the total domestic soft drink market, up from 6.4% in 1992. Since 1986, DR PEPPER has been the number one selling non-cola and, in 1993, became the fourth largest-selling soft drink in the United States. The estimated share of the total domestic soft drink market represented by DR PEPPER increased from 5.3% in 1992 to 5.6% in 1993. 7UP brands represented an estimated 3.9% of the total domestic soft drink market in 1993, down from 4.0% in 1992. 7UP is a leader in the largest non-cola soft drink flavor category, lemon-lime, which is estimated to have accounted for 12.1% of the total 1993 domestic soft drink market. 7UP ranked as the eighth largest selling soft drink brand in 1993. 7UP is the second largest selling sugared lemon-lime brand and represents 23.8% of sales in the lemon-lime category. Diet 7UP is the number one diet lemon-lime soft drink with a 1993 share of 0.8% of the total domestic soft drink market and, in 1993, accounted for approximately 6.6% of the lemon-lime category sales volume. Dr Pepper USA represented 39.9% of the Company's 1993 net sales. Dr Pepper USA's net sales were up 7.9% in 1993 with unit sales of combined DR PEPPER brands growing at a significantly greater rate than the total domestic soft drink industry. This unit sells DR PEPPER brand concentrates to bottlers for further processing into bottle and can products that are distributed nationwide. The Company has been able to affiliate its DR PEPPER brands with what management believes are strong and aggressive bottlers. Seven-Up USA represented 30.5% of the Company's 1993 net sales. Seven-Up USA's net sales were up 3.4% in 1993 from 1992. This unit sells 7UP brand extracts to bottlers for further processing into bottle and can products that are distributed nationwide. The Foodservice Division accounted for 19.5% of the Company's 1993 net sales and was up 11.8% from 1992. This unit's brands, primarily DR PEPPER, have a significant presence in the fountain/ foodservice channel of the soft drink industry. The Company has been successful at securing foodservice distribution alongside products of both The Coca-Cola Company ("Coke") and PepsiCo, Inc. ("Pepsi"). Company brands are served in over 120,000, or approximately 16.0%, of the nation's foodservice outlets. Significant customers of the foodservice unit include McDonald's, Burger King, Taco Bell, 7-Eleven, Hardee's and Wendy's. The Company's Premier Beverages unit markets WELCH's carbonated soft drinks and markets and sells I.B.C. Root Beer and Cream Soda. Together, these brands represented 8.3% of the Company's 1993 net sales which were up 10.6% from 1992. These additional products permit the Company to offer a broad line of high-quality, non-cola options. The International unit accounted for 0.4% of the Company's net sales for 1993. At the end of 1993, the International unit had licensed bottlers to sell DR PEPPER brand products in 19 countries. In 1986, Pepsi acquired the rights to produce and market products under the 7UP trademark outside of the United States and its territories and possessions. See "Financial Information About Foreign and Domestic Operations and Export Sales". SOURCES AND AVAILABILITY OF RAW MATERIALS Substantially all of the raw materials used by the Company to manufacture its products are of a generic nature and are available from alternative suppliers. The Company does not anticipate any significant difficulties in securing adequate supplies of raw materials at acceptable prices in the future. TRADEMARKS The trademarks under which the Company markets its soft drink products are registered in the U.S. Patent and Trademark Office. Registered trademarks are protected for 10 years and can be renewed indefinitely. The DR PEPPER trademark is also registered in 90 countries. Other than its license agreements with bottlers, the Company has no material existing trademark license agreements permitting the use of its trademarks in advertising. Strong trademark recognition is a major competitive advantage in the soft drink industry. SEASONAL ASPECTS OF THE BUSINESS The Company's business is seasonal, with the second and third quarters accounting for the highest sales volume. PRACTICES RELATING TO WORKING CAPITAL The Company has significant amounts of long-term debt consisting of bank borrowings and subordinated notes. Accordingly, the Company's financial position is highly leveraged and interest payments are significant. DEPENDENCE ON SINGLE OR FEW CUSTOMERS During 1993, bottling companies owned by Pepsi accounted for 13.5% of the Company's 1993 net sales. The license agreements with such bottling companies are substantially similar to the Company's license agreements with its other bottlers. BACKLOG OF ORDERS No material backlog of orders is maintained. GOVERNMENT REGULATION The production and marketing of beverages are subject to the rules and regulations of the United States Food and Drug Administration ("FDA") and other federal, state and local health agencies. The FDA also regulates the labeling of containers. COMPETITION The soft drink business is highly competitive. The principal methods of competition in the soft drink industry are advertising campaigns, promotions, pricing, packaging and new product development. The Company competes not only with other soft drink companies for consumer acceptance but also for shelf space in supermarkets and for maximum marketing focus by the Company's licensed bottlers, all of which also bottle other soft drink brands. The Company's soft drink products compete generally with all liquid refreshments, with numerous nationally-known soft drinks such as Coca-Cola and Pepsi-Cola, and with regional producers and "private label" soft drink suppliers. SPONSORED RESEARCH AND DEVELOPMENT Research and development costs were relatively insignificant in years 1991, 1992 and 1993. COMPLIANCE WITH ENVIRONMENTAL LAWS AND REGULATIONS Compliance with statutory requirements regarding environmental quality has not had a material effect on the capital expenditures, earnings and competitive position of the Company. EMPLOYEES As of December 31, 1993, the Company (through DP/7UP) employed 952 persons, consisting of 340 individuals engaged in sales activities, 179 engaged in administrative activities, 115 engaged in financial activities, 176 engaged in production activities and 142 individuals engaged in marketing activities. No Company employees are represented by a union and the Company considers its employee relations to be good. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Dr Pepper's foreign operations generated less than 1% of the Company's net sales in years 1991, 1992 and 1993. Additionally, the Company does not expect foreign operations to be significant in the immediate future. Prior to the acquisition of Seven-Up in 1986, Philip Morris Incorporated sold the international franchise operations of Seven-Up to Pepsi. Accordingly, Pepsi holds the right to produce and sell soft drinks under the 7UP and certain associated trademarks internationally. The terms of this sale prohibit Seven-Up from distributing any of its soft drink products existing at the time of such transaction (other than I.B.C. Root Beer), as well as any products developed thereafter that are marketed under the 7UP trademark, outside of the United States and its territories and possessions. ITEM 2.

ITEM 2. PROPERTIES The Company owns, through a wholly-owned subsidiary, a state-of-the-art facility in Overland, Missouri, where it manufactures concentrates, extracts and fountain syrups. This facility is the largest soft drink concentrate, extract and syrup plant in the continental United States and produces over 150 different flavor extracts, including concentrates and syrups for the domestic operations of Cadbury Schweppes plc. The Company manufactures all of its concentrates, extracts and fountain syrups in this facility. The Company does not own or lease any other facilities for the manufacture of concentrates, extracts or fountain syrups. The Company has developed a production contingency plan with another concentrate manufacturer to produce certain of the Company's products in the event that the Overland facility were rendered inoperative. The Overland facility has substantial additional capacity available with minimal capital expenditures required. The Company leases its Dallas headquarters office building, which presently covers approximately 175,000 square feet of space. Rental payments are currently $329,000 per month, subject to escalation at stated intervals in the future. The lease expires in 1998. The Company also leases a warehouse in Dallas covering approximately 73,000 square feet of space. Rental payments approximate $21,000 per month. The Company believes that its headquarters, warehouse and production facilities are sufficient to meet its needs. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS CONTINGENCIES (A) THE COCA-COLA COMPANY ("COKE") LITIGATION On February 26, 1992, Seven-Up filed a lawsuit in the 116th Judicial District Court, Dallas County, Texas (the "State Court Suit") against Coke alleging, among other things, tortious interference with Seven-Up's existing contractual relationships with those licensed 7UP bottlers who also bottle products of Coke, and unfair competition. Coke has answered Seven-Up's complaint and has denied the allegations contained therein. Subsequently, on July 22, 1992, Seven-Up filed a lawsuit against Coke in the United States District Court for the Northern District of Texas alleging false advertising under Section 43 of the Lanham Act. These suits, which are presently in the preliminary stages of discovery, request unspecified compensatory damages and punitive damages. On March 18, 1993, Coke filed counterclaims in the State Court Suit alleging, among other things, that Seven-Up had tortiously interfered with Coke's existing contractual relationships with those licensed bottlers of Coke who are also licensed to bottle Sprite products. Additionally, Coke has alleged that Seven-Up has unlawfully interfered with Coke's prospective formation of contracts with certain licensed bottlers of Coke to distribute Sprite products. Coke's counterclaim requests unspecified compensatory damages, punitive damages and injunctive relief. DP/7UP intends to vigorously contest these allegations, but is presently unable to predict the outcome of this lawsuit. The Company does not expect that the resolution of this matter will have a material adverse effect on the Company's operating results or financial condition. (B) INTERNAL REVENUE SERVICE MATTER The Internal Revenue Service has completed its examination of Federal income tax returns of Dr Pepper and Seven-Up for the periods ended December 31, 1986, December 31, 1987 and May 19, 1988, and of the Company for the period ended December 31, 1988. The Company has been notified of proposed IRS adjustments disallowing certain deductions, including substantially all amortization of intangible assets related to the 1986 acquisitions of Dr Pepper and Seven-Up. If the adjustments are sustained, in whole or in part, the Company's net operating loss carryforwards for federal income tax purposes would be significantly reduced or eliminated. The Company is vigorously contesting the proposed adjustments. Management of the Company believes the ultimate resolution of the proposed adjustments will not have a material adverse effect on the Company's operating results or financial condition. (C) SHAREHOLDER LITIGATION On September 3, 1993, Adele Brem, a purported holder of shares of Common Stock of the Company, filed a lawsuit relating to the adoption by the Company of a Stockholders' Rights Plan (the "Rights Plan") in Delaware Chancery Court. The complaint is filed individually on behalf of the plaintiff and purportedly on behalf of all holders of Common Stock (other than the individual defendants), and names the Company and each member of its Board of Directors as defendants. In the complaint, the plaintiff alleges, among other things, that in implementing the Rights Plan, the individual defendants have wrongfully misled the shareholders and the investing community regarding the purpose and effect of the Rights Plan, have violated their fiduciary duties owed to the plaintiffs and the class, have not and are not exercising proper and independent business judgment, have acted and are acting to the detriment of the Company and its public shareholders for their own personal benefit and have pursued a course of conduct designed to entrench themselves in their positions of control within the Company. The plaintiff seeks a judgment ordering, among other things, that defendants rescind the adoption of the Rights Plan, as well as unspecified damages, attorney's fees and other relief. On September 10, 1993, Terrence Pearman, a purported holder of shares of Common Stock of the Company, filed a second lawsuit relating to the adoption by the Company of the Rights Plan in Delaware Chancery Court against the Company and each member of the Board of Directors. The complaint is filed individually on behalf of the plaintiff and purportedly on behalf of all holders of Common Stock, and makes substantially the same allegations and seeks substantially the same relief as made and sought in the lawsuit brought by Adele Brem. The Company believes that these lawsuits are without merit and that, among other things, the individual defendants have not breached any fiduciary duties in adopting the Rights Plan and that the Rights Plan is fair and in the best interests of the Company and its shareholders. (D) STEINER LITIGATION Sidney J. Steiner, the landlord under the Company's former lease covering its former headquarters facilities at 5523 East Mockingbird Lane, Dallas, Texas and Harbord Midtown, a Texas partnership, filed suit against the Company in the 95th Judicial District Court, Dallas County, Texas, on May 25, 1988 in connection with the Company's move of its corporate headquarters. The landlord has alleged that the Company breached an oral agreement to lease space in a new office building the landlord planned to construct on such premises. The landlord seeks to recover $470,000 in architectural fees and other costs claimed to have been incurred as a result of such agreement and the landlord claims to have suffered $24 million in other damages as a result of the Company's alleged breach. Additionally, on October 12, 1989, the landlord amended its complaint in this cause of action to include allegations that the Company fraudulently misrepresented the existence of asbestos in the Company's former headquarters facilities, which were purchased by the landlord and leased back to the Company in 1985. The landlord claims damages in excess of $4 million related to these new allegations. The lawsuit was dismissed without prejudice pursuant to an Agreed Order Granting Joint Motion for Non-Suit on May 18, 1992. Subsequent to filing the lawsuit, Steiner sold the property and the claim in litigation to a third party, who in turn later sold the property and the claim to another party, who became a debtor in a bankruptcy proceeding. The trustee in bankruptcy sold the claim in the lawsuit to Canco Properties ("Canco"), San Antonio, Texas, who refiled the lawsuit on January 29, 1993. By letter dated September 21, 1993, Canco claimed that additional discovery and investigation resulted in an increase in estimated damages, and now estimates their damages to be over $31.5 million with punitive damages in excess of $50 million in the aggregate. The court has set a trial date of March 14, 1994. On December 4, 1990, Steiner filed a claim with the American Arbitration Association seeking compensation for damage allegedly caused by the Company to its former corporate headquarters building during the Company's occupancy of such building as tenant under a lease agreement with Steiner. This claim was subsequently sold in the same manner as described in the immediately preceding paragraph with respect to the litigation and is now owned by Canco. Canco presently seeks damages in connection with this claim in the amount of approximately $11.5 million as well as an unspecified amount of punitive damages and attorneys' fees. An arbitration hearing with respect to this claim began on November 8, 1993 in Dallas, Texas and is expected to conclude by the end of March 1994, after which a decision by the arbitrator will be forthcoming. The Company believes that the claim alleged in the lawsuit and arbitration are without merit and intends to vigorously contest these allegations. The decision of the arbitrator, however, is binding on the parties as to those matters addressed in the arbitration. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, there were no matters submitted to a vote of security holders through the solicitation of proxies or otherwise. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock began trading on the New York Stock Exchange under the symbol "DPS" in February 1993. The high and low sales prices for the Company's Common Stock for each quarterly period within the two most recent fiscal years are as follows: The Company has not paid any dividends on its Common Stock and does not intend to pay any such dividends in the foreseeable future. See "Liquidity and Capital Resources" for a discussion of dividend payment restrictions. APPROXIMATE NUMBER OF HOLDERS OF EACH CLASS OF COMMON EQUITY The number of record holders of each class of the Company's Common Stock at February 28, 1994 is as follows: ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table presents selected consolidated financial data of the Company as of and for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. This financial data was derived from the historical consolidated financial statements of the Company. The financial data reflects the elimination of all intercompany accounts, transactions and profits among the Holding Company, Dr Pepper, Seven-Up and DP/7UP. The financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the historical consolidated financial statements of the Company and the related notes thereto. See "Index to Consolidated Financial Statements and Schedules". ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS -- YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 Net sales for the year ended December 31, 1993 increased 7.4% to $707.4 million compared to $658.7 million for the year ended December 31, 1992. All of the Company's operating units recorded net sales increases in 1993 compared to 1992, except for the International Division which was unchanged. These sales increases were primarily the result of volume increases for the Company's DR PEPPER, Diet DR PEPPER, 7UP and I.B.C. brands over the comparable period in 1992, as well as price increases on DR PEPPER, 7UP and certain other products. Cost of sales for 1993 decreased 8.0% to $116.0 million compared to $126.0 million in 1992. This decrease was primarily due to a decrease in sweetener costs somewhat offset by an increase in concentrate and syrup sales volume. Gross profit as a percentage of net sales increased from 80.9% in 1992 to 83.6% in 1993. Total operating expenses, which include marketing expense, general and administrative expense and amortization of intangible assets, increased by 9.7% to $408.4 million compared to $372.1 million in 1992. The increase was primarily due to increased marketing expenses in response to improved sales volume. The Company's general and administrative expenses increased 12.8% to $30.8 million primarily as the result of higher legal costs. Excluding this increase, general and administrative expenses as a percentage of net sales would have remained at 4.1%. The American Institute of Certified Public Accountants has recently issued Statement of Position ("SOP") 93-7 on Reporting on Advertising Costs. The SOP is effective for years beginning after June 15, 1994. The Company's adoption of the SOP is not expected to have a material effect on its operating results. As a result of the above factors, operating profit for the year ended December 31, 1993 increased 14.0% to $183.0 million compared to $160.6 million in 1992. Operating profit as a percentage of net sales increased to 25.9% in 1993 from 24.4% in 1992. Interest expense for 1993 decreased 43.1% to $85.6 million compared to $150.2 million in 1992. The decrease was due to the consummation of the 1992 Recapitalization and the Offering which together reduced outstanding borrowings and resulted in lower interest rates on borrowings. Income tax expense of $2.1 million for the year ended December 31, 1993 consists of current Federal tax expense of $1.1 million, current state tax expense of $4.0 million and a deferred Federal tax benefit of $3.0 million. In connection with the Offering, a $14.9 million extraordinary charge was recorded in 1993 which included (i) a write-off of a portion of the unamortized balance of deferred debt issuance costs related to the Credit Agreement borrowings and the Discount Notes ($6.8 million) and (ii) the premium related to the redemption of a portion of the Discount Notes ($8.1 million). In addition, a $2.0 million extraordinary charge was recorded in 1993 reflecting a write-off of a portion of the unamortized balance of deferred debt issuance costs related to the Credit Agreement borrowings. The write-off was the result of repayments of the Term Loan Facility in advance of scheduled requirements. These extraordinary items were recorded net of applicable taxes. See the following section "Results of Operations -- Year Ended December 31, 1992 Compared to Year Ended December 31, 1991" for a discussion of income taxes, extraordinary item and cumulative effect of accounting change recorded in 1992. As a result of the above factors, the Company earned $77.9 million of net income in 1993 compared to a $140.1 million net loss incurred in 1992. RESULTS OF OPERATIONS -- YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 Net sales for the year ended December 31, 1992 increased 9.6% to $658.7 million compared to $600.9 million for the year ended December 31, 1991. All of the Company's operating units recorded sales increases in 1992 compared to 1991. These increases were primarily the result of volume increases for the Company's DR PEPPER, Diet DR PEPPER, WELCH's, 7UP, Diet 7UP, CHERRY 7UP, Diet CHERRY 7UP, and I.B.C. brands over the comparable period in 1991, as well as selected price increases. Cost of sales for 1992 increased 6.1% to $126.0 million compared to $118.8 million in 1991. This increase was primarily due to an increase in concentrate and syrup sales volume. Gross profit as a percentage of net sales increased from 80.2% in 1991 to 80.9% in 1992. Total operating expenses, which include marketing expense, general and administrative expense and amortization of intangible assets, increased by 8.2% to $372.1 million compared to $344.0 million in 1991. The increase was primarily due to increased marketing expenses in response to improved sales volume. General and administrative expenses as a percentage of net sales decreased to 4.1% in 1992 from 4.4% in 1991. The Company's general and administrative expenses are comprised primarily of fixed costs. As sales volumes increase, these expenses generally represent a declining percentage of net sales. As a result of the above factors, operating profit for the year ended December 31, 1992 increased 16.2% to $160.6 million compared to $138.2 million in 1991. Operating profit as a percentage of net sales increased to 24.4% in 1992 from 23.0% in 1991. Interest expense for 1992 increased 1.5% to $150.2 million compared to $148.0 million in 1991. The increase was due to the higher accreted value of certain subordinated debt and issuance of senior notes and term loans of Dr Pepper in August 1991, somewhat offset by lower outstanding borrowings under the credit agreement of Seven-Up and lower interest rates on the Company's floating rate borrowings. Other expense for the year ended December 31, 1992 includes $6.0 million of costs associated with the Company's withdrawal of its planned public offering in July 1992. Income tax expense for the year ended December 31, 1991 consists of state and local taxes and includes a charge in lieu of taxes of $1.0 million which is offset by utilization of net operating loss carryforwards. In February 1992, the Financial Accounting Standards Board issued Statement 109, "Accounting for Income Taxes" ("Statement 109") which requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company adopted Statement 109 in the fourth quarter of 1992 and has applied the provisions of Statement 109 retroactively to January 1, 1992. The cumulative effect as of January 1, 1992 of the change in the method of accounting for income taxes is a charge to earnings of $74.8 million and has been reported separately in the 1992 consolidated statement of operations. Financial statements for periods prior to January 1, 1992 have not been restated for Statement 109. Pursuant to the deferred method under APB Opinion 11, which was applied in 1991 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. Income tax benefit of $182,000 for the year ended December 31, 1992 consists of current state tax expense of $424,000 and a deferred Federal income tax benefit of $606,000. The deferred income tax benefit includes a charge in lieu of taxes resulting from initial recognition of acquired tax benefits of $1.1 million. In connection with the 1992 Recapitalization, the Company recorded an extraordinary charge of $56.9 million consisting of a write-off of the unamortized balance of deferred debt issuance costs related to the debt retirements ($24.6 million) and premiums and fees in respect of the debt retirements ($32.3 million). In connection with the refinancing that occurred in 1991, an $18.6 million extraordinary charge was recorded representing incentive payments made to holders of the Dr Pepper Subordinated Debentures ($8.2 million), write-off of the unamortized balance of deferred debt issuance costs related to the credit agreement of Dr Pepper ($5.0 million) and the present value (assuming a discount rate of 12 3/4%) of the increase in the annual interest rate of the Dr Pepper Subordinated Debentures from 13 1/4% to 13 3/4% ($5.4 million). As a result of the above factors, the Company incurred a $140.1 million net loss in 1992 as compared to a $37.5 million net loss incurred in 1991. LIQUIDITY AND CAPITAL RESOURCES The Company believes that cash provided by operations, together with borrowings under the Revolving Facility, will be sufficient to fund its working capital requirements, capital expenditures and principal, interest and dividend requirements described below. As a result of the consummation of the 1992 Recapitalization, the Holding Company conducts its business through DP/7UP and the primary asset of the Holding Company is the common stock of DP/7UP. The Holding Company has no material operations of its own. Accordingly, the Holding Company is dependent on the cash flow of DP/7UP to meet its obligations. The Holding Company has no material obligations other than those under the Discount Notes and certain contingent obligations under the Holding Company's guarantee of DP/7UP's obligations under the Credit Agreement. Accordingly, the Holding Company is not expected to have any material need for cash until interest on the Discount Notes becomes payable in cash on May 1, 1998. The Holding Company will be required to make sinking fund payments equal to 25% of the then outstanding principal amount of the Discount Notes in each of 2000 and 2001. The Discount Notes will mature in 2002. The Credit Agreement imposes significant restrictions on the payment of dividends and the making of loans by DP/7UP to the Holding Company. The Credit Agreement does, however, allow DP/7UP to pay dividends to the Holding Company in an amount necessary to make cash interest payments on the Discount Notes, provided that such interest payments are permitted to be made at such time in accordance with the subordination provisions relating to the Discount Notes and so long as no payment default or bankruptcy default then exists under the Credit Agreement with respect to the Holding Company or DP/7UP. The Holding Company's access to the cash flow of DP/7UP is further restricted because DP/7UP may not make any dividend payments to the Holding Company unless all accumulated and unpaid dividends on the outstanding shares of the $1.375 Senior Exchangeable Preferred Stock of Dr Pepper (the "DP/7UP Preferred Stock") (and any DP/7UP preferred stock that may be issued in the future) are paid in full. In addition, the indenture governing the exchange debentures into which the DP/7UP Preferred Stock is exchangeable will limit the payment of dividends and the making of loans by DP/7UP to the Holding Company. The indenture governing the Discount Notes also imposes limits on the payment of dividends by the Holding Company. The operations of DP/7UP do not require significant outlays for capital expenditures, and its working capital requirements have historically been funded with internally generated funds. Marketing expenditures have historically been, and are expected to remain, the principal recurring use of funds for the foreseeable future. Such expenditures are, to an extent, controllable by management and are generally based on a percentage of unit sales volume. DP/7UP's other principal use of funds in the future will be the payment of principal and interest under the Credit Agreement, the payment of dividends on the outstanding shares of DP/7UP Preferred Stock and the payment of dividends to the Holding Company for purposes of making principal and interest payments on the Discount Notes. During 1993, the Company used funds provided by operations to repay $123.6 million of the principal balance under the Term Loan Facility. This amount satisfied the total required repayment for 1993 of $67.0 million with the remaining $56.6 million applied prorata toward all future required repayments. On December 28, 1993, the Company modified the Credit Agreement resulting in a reduction in interest rates of approximately 1 1/2%. The amended credit line is $675.0 million, consisting of a $525.0 million Term Loan Facility and a $150.0 million Revolving Facility. As of December 31, 1993, DP/7UP is required to repay the principal of $525.0 million under the Term Loan Facility as follows: $85.0 million in 1994, $100.0 million in 1995, $110.0 million in 1996, and $115.0 million in each of 1997 and 1998. The Revolving Facility includes an amount for letters of credit in an aggregate face amount of up to $15.0 million. At December 31, 1993, the outstanding balance of revolving loans and the aggregate face amount of letters of credit issued under the Revolving Facility were $49.0 million and $0.6 million, respectively. A total of $15.6 million of the available credit under the Revolving Facility is reserved for use to repurchase or redeem shares of DP/7UP Preferred Stock and, if not so used by September 1, 1994, is required to be used to repay borrowings under the Term Loan Facility. The Revolving Facility will mature on the earlier to occur of (i) December 31, 1998 or (ii) the date on which there are no amounts outstanding under the Term Loan Facility. The Company has entered into interest rate swap and interest rate cap agreements to satisfy certain terms of the Credit Agreement. At December 31, 1993, LIBOR-based interest rate swap agreements covered notional amounts of $350.0 million and $300.0 million expiring on December 1, 1994 and December 1, 1995, respectively. The interest rate differential to be received or paid is recognized as an adjustment to interest expense. The Company had working capital deficits of $67.2 million at December 31, 1993 and $102.2 million at December 31, 1992. The Company generally operates with a working capital deficit due to its low inventory investment and because it has a significant amount of accrued marketing expenses in current liabilities. The deficit at December 31, 1992 was significantly impacted by the use of cash on hand in connection with, and the increase in the current portion of long-term debt as a result of, the consummation of the 1992 Recapitalization. The deficit at December 31, 1993 was improved from the December 31, 1992 deficit due to the recognition of the deferred tax asset and the net increase in other working capital components as a result of the timing of cash receipts and disbursements and the seasonal nature of the business. The Company does not believe that such deficits will have a material adverse effect on the liquidity or operations of the Company. Capital expenditures totaled $1.9 million in 1992 and $3.8 million in 1993. The Credit Agreement contains numerous financial and operating covenants and prohibitions that impose limitations on the Company's liquidity, including the satisfaction of certain financial ratios and limitations on the incurrence of additional indebtedness. Through December 31, 1993, the Company has satisfied all required financial ratios. The indenture governing the Discount Notes also contains covenants that impose limitations on the Company's liquidity, including a limitation on the incurrence of additional indebtedness. The ability of the Company to meet its debt service requirements and to comply with the financial covenants in the Credit Agreement and the indenture will be dependent upon future performance, which is subject to financial, economic, competitive and other factors affecting the Holding Company and DP/7UP, many of which are beyond their control. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14, "Index to Consolidated Financial Statements and Schedules", included herein, for information required under Item 8. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements with the registrant's accountants on accounting or financial disclosure. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information for this item is incorporated by reference to the Company's Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Holding Company's 1994 Annual Meeting of Shareholders. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information for this item is incorporated by reference to the Company's Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Holding Company's 1994 Annual Meeting of Shareholders. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information for this item is incorporated by reference to the Company's Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Holding Company's 1994 Annual Meeting of Shareholders. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information for this item is incorporated by reference to the Company's Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Holding Company's 1994 Annual Meeting of Shareholders. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements See "Index to Financial Statements and Schedules" appearing after the signature pages hereof. 2. Financial Statement Schedules See "Index to Financial Statements and Schedules" appearing after the signature pages hereof. (b) Reports on Form 8-K Not applicable (c) Exhibits SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DR PEPPER/SEVEN-UP COMPANIES, INC. Date: March 16, 1994 By: /s/ JOHN R. ALBERS -------------------------------------- John R. Albers PRESIDENT AND CHIEF EXECUTIVE OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: INDEX TO FINANCIAL STATEMENTS AND SCHEDULES All other schedules are omitted as the required information is inapplicable or presented in the consolidated financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Board of Directors Dr Pepper/Seven-Up Companies, Inc.: We have audited the consolidated financial statements of Dr Pepper/Seven-Up Companies, Inc. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Dr Pepper/Seven-Up Companies, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992. KPMG Peat Marwick Dallas, Texas February 7, 1994 DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS, EXCEPT SHARES AND PER SHARE DATA) ASSETS LIABILITIES AND STOCKHOLDERS' DEFICIT See accompanying notes to consolidated financial statements. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS, EXCEPT PER SHARE DATA) See accompanying notes to consolidated financial statements. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS, EXCEPT SHARES) See accompanying notes to consolidated financial statements. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) See accompanying notes to consolidated financial statements. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Dr Pepper/Seven-Up Companies, Inc. and subsidiaries ("Company"). All significant intercompany balances and transactions have been eliminated in consolidation. (B) INVENTORIES Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. A summary of inventories at December 31, 1993 and 1992 follows (in thousands): (C) MARKETING AND ADVERTISING COSTS Marketing costs include costs of advertising, marketing and promotional programs. Prepaid advertising consists of various marketing, media and advertising prepayments, materials in inventory and production costs of future media advertising; these assets are expensed in the year used. Marketing costs, other than prepayments, are expensed in the year incurred. (D) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are recorded at cost. Depreciation is computed by the straight-line method over the estimated useful lives ranging from 3 to 10 years. Maintenance and repairs are charged to operations as incurred and expenditures for major renewals and improvements are capitalized. (E) INTANGIBLE ASSETS Franchises, goodwill, formulas, trademarks and other intangible assets are being amortized over 40 years on a straight-line basis. The Company continually reevaluates the recoverability of the carrying amount of these intangible assets based on projected undiscounted operating cash flows. (F) DEFERRED DEBT ISSUANCE COSTS Deferred debt issuance costs are amortized using the effective interest method over the life of the debt issue to which they relate. (G) INCOME TAXES Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. (H) INCOME (LOSS) PER COMMON SHARE Income (loss) per common share is based on the weighted average number of common shares and share equivalents outstanding during the year (64,621,000 in 1993, 35,533,000 in 1992 and 35,468,000 in 1991). Shares issuable in 1992 and 1991 upon exercise of stock options and warrants were antidilutive and therefore excluded from the calculation. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (I) STATEMENTS OF CASH FLOWS The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. During 1993, 1992 and 1991, the Company paid interest of $43,926,000, $85,203,000 and $75,844,000, respectively, and income taxes of $1,838,000, $1,202,000 and $552,000, respectively. (2) PROPERTY, PLANT AND EQUIPMENT A summary of property, plant and equipment and accumulated depreciation at December 31, 1993 and 1992 follows (in thousands): Depreciation expense was $2,969,000 in 1993, $2,950,000 in 1992 and $3,693,000 in 1991. (3) LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consists of the following (in thousands): (A) CREDIT AGREEMENT The Company's Credit Agreement provides for $525,000,000 of borrowings available under a Term Loan Facility and $150,000,000 of borrowings available under a Revolving Facility from a group of banks. Outstanding borrowings under the Term Loan Facility and the Revolving Facility bear interest at the lead bank's prime rate (6.0% at December 31, 1993) plus 1/4% per annum or the lead banks' average Eurodollar Rate plus 1 1/4% per annum. The Term Loan Facility requires semi-annual principal payments to maturity on December 31, 1998. The Revolving Facility will mature on the earlier to occur of December 31, 1998 or the date on which there are no amounts outstanding under the Term Loan Facility. The Company must pay an annual commitment fee of 1/2% on the unused portion of the Revolving Facility. Borrowings under the Credit Agreement are principally secured by the Company's assets, including franchise contracts relating to bottling arrangements. The carrying amount of the Credit Agreement at December 31, 1993 and 1992 approximates the fair value since the borrowings bear interest at current market rates. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (3) LONG-TERM DEBT (CONTINUED) The Credit Agreement contains certain restrictive covenants which require the Company, among other things, to satisfy certain financial ratios and restricts investments in and loans to affiliates, capital expenditures, additional debt and payment of dividends, as defined. The Company has entered into interest rate swap and interest rate cap agreements to satisfy certain terms of the Credit Agreement. At December 31, 1993, LIBOR-based interest rate swap agreements covered notional amounts of $350,000,000 and $300,000,000 expiring on December 1, 1994 and December 1, 1995, respectively. The interest rate differential to be received or paid is recognized as an adjustment to interest expense. (B) DISCOUNT NOTES The 11 1/2% Senior Subordinated Discount Notes (the "Discount Notes") had a face amount of $462,231,000 at December 31, 1993, bear interest at a rate of 11.5% per annum and are redeemable at the option of the Company at redemption prices declining annually from 104.3125% on November 1, 1997 to par on or after November 1, 2000. Interest is payable semi-annually on the Discount Notes beginning May 1, 1998. A mandatory sinking fund will retire 25% of the original principal amount in each of the years 2000 and 2001, or 50% of the issue prior to maturity. The Discount Notes mature on November 1, 2002 and are subordinate to all outstanding borrowings under the Credit Agreement. The indenture governing the Discount Notes contains covenants that impose limitations on the Company's liquidity, including a limitation on the incurrence of additional indebtedness. Based on the quoted market price for the issue, the estimated fair value of the Discount Notes is $357,651,000 and $416,883,000 at December 31, 1993 and 1992, respectively. Aggregate maturities of long-term debt for each of the five years subsequent to December 31, 1993 follows: $85,274,000 in 1994; $100,067,000 in 1995; $110,044,000 in 1996; $115,002,000 in 1997, and $164,000,000 in 1998. (4) INCOME TAXES The Company adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" (Statement 109) in the fourth quarter of 1992 and applied the provisions of Statement 109 retroactively to January 1, 1992. The cumulative effect of the change in accounting for income taxes of $74,800,000 was determined as of January 1, 1992 and is reported separately in the 1992 consolidated statement of operations. Financial statements for periods prior to January 1, 1992 have not been restated to apply the provisions of Statement 109. Income tax expense (benefit) attributable to income (loss) before extraordinary items and cumulative effect of accounting change for the years ended December 31, 1993 and 1992 consists of (in thousands): For the year ended December 31, 1993, tax benefits of $3,789,000 and $731,000 were allocated to additional paid-in capital and extraordinary item, respectively. Deferred income tax benefit for the year ended December 31, 1993 includes a charge of $2,046,000 for adjustments to deferred tax assets DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (4) INCOME TAXES (CONTINUED) and liabilities for the increase in the U.S. federal income tax rate and a benefit of $8,623,000 related to a decrease in the valuation allowance for deferred tax assets. For the year ended December 31, 1992, tax benefits of $818,000 and $1,148,000 were allocated to additional paid-in capital and goodwill, respectively. Income tax expense for the year ended December 31, 1991 consists principally of a $1,022,000 charge in lieu of taxes and state income taxes. The charge in lieu of taxes is offset by utilization of net operating loss carryforwards. Income tax expense (benefit) for the years ended December 31, 1993 and 1992 differed from the amount computed by applying the U.S. federal income tax rate of 35%, and 34%, respectively, to income (loss) before income taxes, extraordinary items and cumulative effect of accounting change as a result of the following (in thousands): The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 are presented below (in thousands): The valuation allowance for deferred tax assets as of January 1, 1992 was $76,117,000. The net change in the total valuation allowance for the years ended December 31, 1993 and 1992 was a decrease of $22,990,000 and an increase of $17,196,000, respectively. If the Company subsequently were to recognize tax benefits related to the December 31, 1993 valuation allowance for deferred tax assets, such benefits would be allocated to intangible assets (approximately $42,047,000), and income tax benefit (approximately $28,276,000). DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (4) INCOME TAXES (CONTINUED) As of December 31, 1993, the Company and its subsidiaries have approximately $269,800,000 of federal income tax loss carryforwards (see note 10) which expire in years 2001 through 2007. As a result of the Company's initial public offering and the sale of the Company's common stock by a significant shareholder, the Company is subject to an annual limitation of approximately $60,000,000 for utilizing its federal income tax loss carryforwards. (5) STOCKHOLDERS' DEFICIT (A) SHAREHOLDER RIGHTS PLAN In September 1993, the Company's Board of Directors adopted a Shareholder Rights Plan pursuant to which purchase rights were issued to holders of its common stock at the rate of one right for each share of common stock. The rights will trade with the Company's common stock until exercisable. The rights become exercisable only at the time a person or group acquires, or commences a public tender offer for, a defined percentage of the Company's common stock. Once a right becomes exercisable, the holders of the rights (other than the acquiring person or group) may purchase the Company's common stock at 50% of its then market price. The rights expire on September 13, 2003, unless earlier redeemed by the Company at a price of $.01 per right. (B) EMPLOYEE INCENTIVE PLANS The Company sponsors certain employee incentive plans under which stock options and stock awards may be granted to key officers and salaried employees of the Company. Options granted under the plans are exercisable at such times and in such amounts as determined by a committee selected by the Board of Directors of the Company. No options granted under the plans are exercisable more than ten years after the date of grant. At December 31, 1993, 2,630,000 shares were available for grant under the plans. Further information relating to options is as follows (in thousands, except per share amounts): DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (6) PENSION BENEFITS The Company has defined benefit pension plans covering substantially all of its employees. The benefits are primarily based on years of service and the employees' compensation during the last years of employment. Pension costs are funded in amounts not less than minimum statutory funding requirements nor more than the maximum amount that can be deducted for federal income tax purposes. The Company also has a nonqualified unfunded defined benefit plan covering certain executive employees. The following table sets forth the plans' funded status and amounts recognized at December 31, 1993 and 1992 (in thousands): Net pension cost includes the following components (in thousands): The assumptions used in computing the information above were as follows: (7) LEASE COMMITMENTS The Company has operating leases principally for office space, automobiles and computer equipment. Rent expense on operating leases was $6,490,000 in 1993, $6,479,000 in 1992 and $6,434,000 in 1991. The future minimum rentals under noncancellable operating leases in effect as of December 31, 1993 were $7,037,000 in 1994; $6,025,000 in 1995; $5,094,000 in 1996; $4,376,000 in 1997 and $2,532,000 in 1998. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (8) RELATED PARTY AND MAJOR CUSTOMER TRANSACTIONS In October 1993, a shareholder increased its ownership in the Company to approximately 26% of the outstanding common stock. The Company currently performs contract manufacturing for an affiliate of this shareholder. For the years 1993, 1992 and 1991, the Company received $2,025,000, $1,724,000 and $1,708,000, respectively, for such contract manufacturing services. A director of the Company also serves as a director of a company engaged in the business of bottling DR PEPPER brand and 7UP brand beverages. For the years 1993, 1992 and 1991, the Company had sales to the bottling company of $56,300,000, $52,500,000 and $46,100,000. Sales to PepsiCo, Inc. owned bottling operations accounted for 13.5%, 12.3% and 11.9% of consolidated net sales in 1993, 1992 and 1991, respectively. (9) RECAPITALIZATION TRANSACTIONS During 1993, 1992 and 1991, the Company was involved in certain significant recapitalization transactions that are described in more detail as follows: (A) 1993 PUBLIC OFFERING During early 1993, the Company completed an initial public offering of 21,578,313 shares of its common stock resulting in net proceeds to the Company of approximately $305,300,000. The net proceeds were used to redeem $115,500,000 of the accreted balance of the Discount Notes, reduce borrowings of $82,500,000 under the Credit Agreement and redeem all of the Redeemable Senior Preferred Stock. In connection with this transaction, the Company recognized an extraordinary charge of $14,300,000 resulting from the write-off of deferred debt issuance costs and the payment of premiums on the redemption of the Discount Notes. Supplementary income before extraordinary item per share for 1993, after giving effect to the redemption of the Discount Notes and the Redeemable Senior Preferred Stock and reduction in borrowings under the Credit Agreement as of the beginning of the year, was $1.46. (B) 1992 RECAPITALIZATION In 1992, the Company completed a recapitalization transaction which included the issuance of $656,509,000 principal amount (gross proceeds of $375,001,000) of the Discount Notes and borrowings of $816,000,000 under the Credit Agreement. The proceeds from the borrowings and approximately $169,900,000 of cash on hand were used to effect the retirement of certain indebtedness and preferred stock. In connection with this transaction, the Company recognized an extraordinary charge of $56,934,000 for payment of call premiums and consents to former bondholders and the write-off of the unamortized balance of deferred debt issuance costs. Additionally, the Company incurred $44,752,000 of costs related to the issuance of the Discount Notes and the Credit Agreement which is reflected as deferred debt issuance costs in the consolidated balance sheets. (C) OTHER TRANSACTIONS During the second quarter of 1992, the Company pursued a recapitalization plan which included an initial public offering of the Company's common stock. On July 1, 1992, the Company announced that it had withdrawn its offering and a charge of $6,026,000 was recorded in 1992 to reflect the costs associated with this recapitalization effort. During 1991, the Company completed a recapitalization transaction. In connection with such transaction, the Company incurred an extraordinary charge of $18,566,000 for consent payments paid DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (9) RECAPITALIZATION TRANSACTIONS (CONTINUED) to certain debenture holders, an increase in the annual interest rate on certain indebtedness and the write-off of the unamortized balance of deferred debt issuance costs related to the retirement of a previous credit agreement. (10) CONTINGENCIES (A) FORMER HEADQUARTERS The Company is a defendant in an action alleging that the Company breached an oral agreement to lease space in a new office building in connection with the Company's move of its corporate headquarters. The plaintiff also alleges that the Company fraudulently misrepresented the existence of asbestos in the Company's former corporate headquarters building. The plaintiff claims to have suffered over $31.5 million in actual damages with punitive damages in excess of $50 million. Additionally, the plaintiff filed a demand with the American Arbitration Association requesting arbitration with respect to certain damage allegedly caused by the Company to its former corporate headquarters building during the Company's occupancy of such building as a tenant. The plaintiff seeks damages in connection with this claim in the amount of approximately $11.5 million. The arbitration hearing with respect to this claim is scheduled to resume in March 1994. The decision of the arbitrator will be binding on the parties. Management of the Company intends to vigorously contest the plaintiff's allegations and believes that the resolution of these matters will not have a material adverse effect on the Company's financial condition or operating results. (B) INTERNAL REVENUE SERVICE MATTER The Internal Revenue Service is currently in the process of examining Dr Pepper Company's and The Seven-Up Company's federal income tax returns for the periods ended December 31, 1986, December 31, 1987 and May 19, 1988, and the Company's federal income tax return for the period ended December 31, 1988. The Company has been notified of proposed IRS adjustments disallowing certain deductions, including substantially all amortization of intangible assets related to the 1986 acquisition. If the adjustments are sustained, in whole or in part, the federal net operating loss carryforwards would be significantly reduced or eliminated. The Company is vigorously contesting the proposed adjustments. Management of the Company believes the ultimate resolution of the proposed adjustments will not have a material adverse effect on the Company's financial condition or operating results. (C) OTHER LITIGATION The Company's operating subsidiary, Dr Pepper/Seven-Up Corporation, is a defendant in various other lawsuits arising out of the ordinary conduct of its business. In the opinion of management, the resolution of these matters is not expected to have a material adverse effect upon the Company's financial condition or operating results. DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (11) QUARTERLY FINANCIAL DATA (UNAUDITED) SCHEDULE III DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES CONDENSED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) ASSETS See accompanying notes to condensed financial statements. SCHEDULE III DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES CONDENSED STATEMENTS OF OPERATIONS THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS, EXCEPT PER SHARE DATA) See accompanying notes to condensed financial statements. SCHEDULE III DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES CONDENSED STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) See accompanying notes to condensed financial statements. SCHEDULE III DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED FINANCIAL STATEMENTS DECEMBER 31, 1993 (1) GENERAL The accompanying condensed financial statements of Dr Pepper/Seven-Up Companies, Inc. (Company) should be read in conjunction with the consolidated financial statements of the Company included in the Company's Annual Report on Form 10-K for the year ended December 31, 1993. (2) INVESTMENTS The Company's investment in Dr Pepper/Seven-Up Corporation (DP/7UP) includes cumulative advances from DP/7UP of $13,481,000 at December 31, 1993. (3) OBLIGATIONS, GUARANTEES AND COMMITMENTS As of December 31, 1993, the Company had long-term debt of $301,427,000 in the form of 11 1/2% Senior Subordinated Discount Notes due 2002. In addition, the Company has guaranteed the obligations under the DP/7UP Credit Agreement. See note 3 to the consolidated financial statements regarding these obligations. Also see notes 6, 7 and 10 to the consolidated financial statements of the Company. SCHEDULE VII DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 See accompanying independent auditors' report. SCHEDULE VIII DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) See accompanying independent auditors' report. SCHEDULE X DR PEPPER/SEVEN-UP COMPANIES, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION CHARGED TO COSTS AND EXPENSES THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS)

771950_1993.txt

771950

1993

ITEM 1. BUSINESS GENERAL Westwood One, Inc. (the "Company" or "Westwood One") is a leading producer and distributor of nationally sponsored radio programs and believes it is the nation's second largest radio network. The Company's principal source of revenue is selling radio time to advertisers. The Company generates revenue principally by its radio networks entering into radio station affiliation agreements to obtain audience and commercial spots and then selling the audience and spots to national advertisers. The Company is strategically positioned to provide a broad range of programming and services which both deliver audience to advertisers and news, talk, sports, and entertainment programs to radio stations. The Company produces and distributes regularly scheduled news, talk, sports, and entertainment programs through its various operating radio networks: Mutual Broadcasting System, NBC Radio Networks (National Radio Network, The Source and Talknet) and Westwood One Radio. The Company's programs encompass exclusive live concerts, music and interview shows, national music countdowns, lifestyle short features, live talk shows, and sports events (principally covering the NFL, Notre Dame football and other college football and basketball games). The Company also produces and distributes special event programs, including exclusive satellite simulcasts with HBO and other cable networks. Mutual Broadcasting System, National Radio Network and Talknet are primarily adult-oriented networks, in the News, Sports, Talk and Country formats. Westwood One Radio and The Source are primarily youth-oriented networks, in the Contemporary Hit Radio ("CHR"), Album Oriented Rock ("AOR"), Country and Black formats. The Company's programs are broadcast in every radio market in the United States measured by Arbitron, the leading rating service, and are carried by Armed Forces Radio, VOA Europe and other foreign broadcast services. Westwood One, through its networks and programming, enables national advertisers to purchase advertising time and to have their commercial messages broadcast on radio stations throughout the United States, reaching demographically defined listening audiences. The Company delivers both of the major demographic groups targeted by national advertisers: the 25 to 54-year old adult market and the 12 to 34-year-old youth market. The Company currently sells advertising time to over 300 national advertisers, including each of the 25 largest network radio advertisers. Radio stations are able to obtain quality programming from Westwood One to meet their objective of attracting larger listening audiences and increasing local advertising revenue. Westwood One, through the development of internal programming as well as through acquisitions, has developed an extensive tape library of previously aired programs, interviews, live concert performances, news and special events. The Company uses its library as a major source of new programming. The tape library enhances Westwood One's future programming and revenue generating capabilities. INDUSTRY BACKGROUND RADIO BROADCASTING On January 1, 1993, there were approximately 9,750 commercial radio stations in the United States. The radio broadcast industry, however, remains highly fragmented with no broadcaster owning more than 36 radio stations. This fragmentation is due primarily to FCC limitations on multiple station ownership. A radio station selects a style of programming ("format") to attract a target listening audience and thereby attract commercial advertising directed at that audience. There are many formats from which a station may select, including news, talk, sports and various types of music and entertainment programming. The number of formats has become further segmented over recent years. For example, what once was the Rock & Roll format has now been divided into several narrower formats, including Album Oriented Rock, Adult Contemporary Music ("AC") and Contemporary Hit Radio, each with a more demographically specific audience. The increase in the number of program formats has intensified competition among stations for local advertising revenue. A radio station has two principal ways of effectively competing for these revenues. First, it can differentiate itself in its local market by selecting and successfully executing a format targeted at a particular audience thus enabling advertisers to place their commercial messages on stations aimed at audiences with certain demographic characteristics. Second, a station can broadcast special programming, sporting events or national news product, such as supplied by Westwood One, not available to its competitors within its format. National programming broadcast on an exclusive geographic basis can help differentiate a station within its market, and thereby enable a station to increase its audience and local advertising revenue. RADIO ADVERTISING Radio advertising time can be purchased on a local, regional or national basis. Local purchases allow an advertiser to select specific radio stations in chosen geographic markets for the broadcast of commercial messages. However, this process can be expensive and time-consuming, and may not permit the advertiser to select the specific program in which its advertisements will be broadcast. Local and regional purchases are typically best suited for an advertiser whose business or ad campaign is in a specific geographic area. Advertising purchased from a radio network is one method by which an advertiser targets its commercial messages to a specific demographic audience. A national advertising purchase can enable an advertiser to achieve its objective with one purchase, at a lower cost per listener, and to select a particular program environment in which its advertisements will be broadcast. In recent years the increase in the number of program formats has led to more demographically specific listening audiences, making radio an attractive, alternative medium for national advertisers. In addition, nationally broadcast news, concerts and special event programming have made radio an effective medium of reach (size of listening audiences) as well as frequency (number of exposures to the target audience). To verify audience delivery and demographic composition, specific measurement information is available to national advertisers. In the top 175 markets, the number of listeners per station is measured and published by independent rating services such as The Arbitron Ratings Co. and Statistical Research, Inc.'s RADAR. These rating services provide demographic information such as the age and sex composition of the listening audiences. Consequently, national advertisers can verify that their advertisements are being heard by their target listening audience. BUSINESS STRATEGY Westwood One's principal business is providing targeted radio audiences and commercial spots to national advertisers through its recognized programming and other network products. The Company, through its various radio networks, produces and distributes quality programming to radio stations seeking to increase their listening audience and improve local and national advertising revenue. The Company sells advertising time within its programs to national advertisers desiring to reach large listening audiences nationwide with specific demographic characteristics. In fiscal 1993 the Company developed and implemented a strategy to focus on its core radio network business and to reduce debt by divesting of all other businesses. During the year other businesses such as radio stations (WYNY-FM and KQLZ-FM) and Radio & Records were disposed. Consequently, the financial results for these businesses are reported as discontinued operations in the Company's financial statements. Additionally, in fiscal 1993 the Company completed the sale of an unconsolidated subsidiary, WNEW-AM, (reported in 1992) and sold a parcel of real estate that had been held for sale for two years. The net proceeds from all these transactions enabled the Company to reduce its debt to $60,149,000 at November 30, 1993 from $178,579,000 at November 30, 1992. Lastly, in the fourth quarter of 1993 the Company repaid its Revolving Facility and term loan with a bank by entering into a new senior debt agreement with a maximum borrowing capacity of $20,000,000. In refocusing on its core network and radio syndication business, the Company has concentrated on across-the-board cost reductions in order to improve profitability. In late fiscal 1993 the Company took a major step to enhance its future and ability to compete by entering into a definitive agreement to acquire Unistar Radio Networks, Inc. ("Unistar") for $101,300,000 along with the following additional matters in connection with the acquisition: (a) the sale by the Company to Infinity Network, Inc. ("INI"), a wholly-owned subsidiary of Infinity Broadcasting Corporation ("Infinity"), of 5,000,000 shares of the Company's Common Stock and a warrant to purchase up to an additional 3,000,000 shares of Common Stock at an exercise price of $3.00 per share, for a total purchase price of $15,000,000; (b) a Management Agreement between the Company and Infinity pursuant to which (a) the Chief Executive Officer of Infinity, currently Mel Karmazin, will become Chief Executive Officer of the Company, (b) the Chief Financial Officer of Infinity, currently Farid Suleman, will become Chief Financial Officer of the Company and (c) Infinity will manage the business and operation for an annual base fee of $2,000,000 (adjusted for inflation), an annual cash bonus payable in the event of meeting certain financial targets and additional warrants to acquire up to 1,500,000 shares of common stock exercisable at certain market prices per share. (c) a Voting Agreement providing for the reconstitution of the Board of Directors into a nine-member Board and the voting of Norman Pattiz's shares of the Company's Common Stock and Class B Stock and the shares of the Common Stock held by the Infinity subsidiary. Unistar is a producer and distributor of radio programs and 24-hour continuous play formats to radio stations nationwide. Unistar serves approximately 2,000 affiliated radio stations, and similar to Westwood One, produces and distributes regularly scheduled news, business, sports and entertainment programs through its various operating radio networks: Unistar Power Radio Network, CNN+Radio Network, Unistar Super Radio Network, CNBC Business Radio Network and Unistar Programming Network. Generally, Unistar pays the cost of producing or acquiring the broadcasting rights for its programming and pays compensation to its affiliated stations for broadcasting the programs and commercial announcements included therein. Like the Company, Unistar derives substantially all of its revenue from the sale of commercial time to national advertisers. The Company anticipates financing the acquisition ($101,300,000), repaying its current senior debt agreement ($13,648,000 at November 30, 1993) and improving its working capital with a new senior loan from a syndicate of banks in the amount of $125,000,000 and the sale of $15,000,000 of Common Stock to INI. RADIO PROGRAMMING The depth of Westwood One's programming has grown through internal expansion and through acquisition. The Company produces and distributes regularly scheduled and special syndicated programs, including exclusive live concerts, music and interview shows, national music countdowns, lifestyle short features, news broadcasts, talk programs, sporting events, and sports features. The Company controls most aspects of production of its programs, therefore being able to tailor its programs to respond to current and changing listening preferences. The Company produces both regularly scheduled short-form programs (typically 5 minutes or less) and long-form programs (typically 60 minutes or longer). Typically, the short-form programs are produced at the Company's in-house facilities located in Culver City, California, New York, New York and Arlington, Virginia. The long-form programs include shows produced entirely at the Company's in-house production facilities and recordings of live concert performances and sports events made on location. Westwood One also produces and distributes special event syndicated programs. In fiscal 1993 the Company produced and distributed numerous special event programs, including the multi-venue Country music extravaganza, Country Takes Manhattan, worldwide broadcasts of Paul McCartney Live In The New World, Zooropa 93: U2 Live From Dublin, Aerosmith Live From Brussels, the HBO simulcast of Madonna: Live Down Under "The Girlie Show", and exclusive live concert broadcasts of Tom Petty and The Heartbreakers, and Rod Stewart. Westwood One believes these broadcasts have contributed to its reputation and are an integral part of its business strategy to increase its share of the national radio network advertising market. Westwood One obtains most of the programming for its concert series by recording live concert performances of prominent recording artists. The agreements with these artists often provide the exclusive right to broadcast the concerts worldwide over the radio (whether live or pre-recorded) for a specific period of time. The Company may also obtain interviews with the recording artist and retain a copy of the recording of the concert and the interview for use in its radio programs and as additions to its extensive tape library. The agreements provide the artist with master recordings of their concerts and nationwide exposure on affiliated radio stations. In certain cases the artists may receive compensation. Westwood One's other programs are produced at its in-house production facilities. The Company determines the content and style of a program based on the target audience it wishes to reach. The Company assigns a producer, writer, narrator or host, interviewer and other personnel to record and produce the programs. Because Westwood One controls the production process, it can refine the programs' content to respond to the needs of its affiliated stations and national advertisers. In addition, the Company can alter program content in response to current and anticipated audience demand. The Company believes that its tape library is a valuable asset and significantly enhances its future programming and revenue generating capabilities. The library contains previously broadcast programs, live concert performances, interviews, daily news programs, sports and entertainment features, Capitol Hill hearings and other special events. New programs can be created and developed at a low cost by excerpting material from the library. For example, in 1993 Westwood One delved into its vast archives to bring back the sounds of the 70's and 80's for its new series The Retro Show. The Company also utilized its extensive music and interview resources for one time only specials and ongoing series such as Off The Record with Mary Turner, Classic Tracks and On The Edge. AFFILIATED RADIO STATIONS Westwood One's radio network business strategy addresses the programming needs and financial limitations of radio stations. The Company offers radio stations a wide selection of regularly scheduled and special event syndicated programming. These programs are completely produced by the Company and, therefore, the stations have no production costs. Typically, each program is offered for broadcast by the Company exclusively to one station in its geographic market, which assists the station in competing for audience share in its local marketplace. In addition, except for news programming, Westwood One's programs contain available commercial air time that the stations may sell to local advertisers. Westwood One typically distributes promotional announcements to the stations and places advertisements in trade and consumer publications to further promote the upcoming broadcast of its programs. Westwood One's networks enter into affiliation agreements with radio stations. In the case of news and current events programming, the agreements commit the station to broadcast only the advertisements associated with these programs and allows the station flexibility to have the news headlined by their newscasters. The other affiliation agreements require a station to broadcast the Company's programs and to use a portion of the program's commercial slots to air national advertisements and any related promotional spots. Radio stations in the top 200 national markets may also receive compensation for airing national advertising associated with the Company's news and current events programming. Affiliation agreements specify the number of times and the approximate time of day each program and advertisement may be broadcast. Westwood One requires that each station complete and promptly return to the Company an affidavit (proof-of-performance) that verifies the time of each broadcast. Affiliation agreements for Westwood One's entertainment programming are non-cancelable for 26 weeks and are automatically renewed for subsequent 26-week periods, if not canceled 30 days prior to the end of the existing contract term. Affiliation agreements for Westwood One's news and current events programming generally run for a period of at least one year, are automatically renewable for subsequent periods and are cancelable by either the Company or the station upon 90 days' notice. The Company has 34 people responsible for station relations and marketing its programs to radio stations. Station relationships are managed geographically to allow the marketing staff to concentrate on specific geographical regions. This enables the Company's staff to develop and maintain close, professional relationships with radio station personnel and to provide them with quick programming assistance. NATIONAL ADVERTISERS Westwood One provides national advertisers with a cost-effective way to communicate their commercial messages to large listening audiences nationwide that have specific demographic characteristics. An advertiser can obtain both frequency (number of exposures to the target audience) and reach (size of listening audience) by purchasing advertising time in the Company's programs. By purchasing time in programs directed to different formats, advertisers can be assured of obtaining high market penetration and visibility as their commercial messages will be broadcast on several stations in the same market at the same time. Westwood One generally guarantees an advertiser delivery of an audience of a specified size and demographic composition, which can be verified through independent surveys. Furthermore, advertisers receive affidavits that indicate the number of times and the time of day the advertisers' commercial messages were broadcast. The Company supports its national sponsors with promotional announcements and advertisements in trade and consumer publications. This support promotes the upcoming broadcasts of Company programs and is designed to increase the advertisers' target listening audience. The Company sells its commercial time to advertisers either as "bulk" or "flighted" purchases. Bulk purchases are long-term contracts (26 to 52 weeks) that are sold "up-front" (early advertiser commitments for national broadcast time) at discounts below prevailing market prices. Flighted purchases are contracts for a specific, short-term period of time (one to six weeks) that are sold at or above prevailing market prices. The Company's strategy for growth in advertising revenue is to increase the amount of advertising time sold on the usually more profitable flighted basis, to increase revenue of the non-RADAR rated programs, and to increase audience size for news, talk and current events programming. COMPETITION The Company operates in a very competitive environment. In marketing its programs to national advertisers, the Company directly competes with other radio networks, some of which may have greater financial resources than the Company, as well as with smaller independent radio syndication producers and distributors. In addition, Westwood One competes for advertising revenue with network television, cable television, print and other forms of communications media. The Company believes that the high quality of its programming and the strength of its station relations and advertising sales forces enable it to compete effectively with other forms of communication media. Westwood One markets its programs to radio stations, including affiliates of other radio networks, that it believes will have the largest and most desirable listening audience for each of its programs. The Company often has different programs airing on a number of stations in the same geographic market at the same time. The Company believes that in comparison with any other independent radio syndication producer and distributor or radio network it has a larger and more diversified selection of programming from which national advertisers and radio stations may choose. In addition, the Company both produces and distributes programs, thereby enabling it to respond more effectively to the demands of advertisers and radio stations. The increase in the number of program formats has led to increased competition among local radio stations for audience. As stations attempt to differentiate themselves in an increasingly competitive environment, their demand for quality programming available from outside programming sources has increased. This demand has been intensified by high operating and production costs at local radio stations and increased competition for local advertising revenue. GOVERNMENT REGULATION Radio broadcasting and station ownership are regulated by the FCC. Westwood One, as a producer and distributor of radio programs, is not subject to regulations by the FCC. EMPLOYEES On January 15, 1994, Westwood One, had 269 full-time employees, including a domestic advertising sales force of 48 people. In addition, the Company maintains continuing relationships with approximately 50 independent writers, program hosts, technical personnel and producers. Certain employees at the Mutual Broadcasting System and NBC Radio Networks are covered by collective bargaining agreements. The Company believes relations with its employees and independent contractors are good. ITEM 2.

ITEM 2. PROPERTIES The Company owns a 7,600 square-foot building in Culver City, California in which its production facilities are located; a 14,000 square-foot building and an adjacent 10,000 square-foot building in Culver City, California which contains administrative, sales and marketing offices, and storage space; and a 7,700 square-foot unoccupied building in Culver City which contained production facilities and offices for KQLZ -FM until shortly after the station was sold. In addition, the Company leases offices in New York, Chicago, Detroit, Dallas, and Arlington, Virginia. The Company believes that its facilities are more than adequate for its current level of operations and contemplates reducing its available square footage in the Culver City area. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company submitted to the Securities and Exchange Commission ("Commission") an offer of settlement arising out of a formal investigation by the Commission which has been pending since 1989. The settlement offer, which was accepted by the Commission on January 7, 1994 and an order entered on January 19, 1994, involved the Company's consent, without admitting or denying any of the findings of the Commission, to an administrative cease and desist order based upon findings that in 1987 and 1988 the Company violated antifraud and accounting provisions of the federal securities laws and the rules thereunder in its revenue recognition and accounting practices during that period. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's shareholders during the fourth quarter of the fiscal year ended November 30, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS On January 15, 1994 there were approximately 475 holders of record of the Company's Common Stock, several of which represent "street accounts" of securities brokers. Based upon the number of proxies requested by brokers in conjunction with its special shareholders' meeting on January 28, 1994, the Company estimates that the total number of beneficial holders of the Company's Common Stock exceeds 5,000. The Company's Common Stock has been traded in the over-the-counter market under the NASDAQ symbol WONE since the Company's initial public offering on April 24, 1984. The following table sets forth the range of high and low last sales prices on the NASDAQ/National Market System, as reported by NASDAQ, for the Common Stock for the fiscal quarters indicated. No cash dividend was paid on the Company's stock during fiscal 1993 or 1992. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA (IN THOUSANDS EXCEPT PER SHARE DATA) The table below summarizes selected consolidated financial data of the Company for each of the last five fiscal years: OPERATING RESULTS FOR FISCAL YEAR ENDED: BALANCE SHEET DATA AT PERIOD ENDED: - --------------- No cash dividend was paid on the Company's common stock during the five years ended November 30, 1993. Operating results for all prior periods have been reclassified to conform to the fiscal 1993 presentation for discontinued operations. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (IN THOUSANDS EXCEPT FOR SHARE AND PER SHARE AMOUNTS) In June 1993, the Company completed the sales of its two owned-and-operated radio stations, WYNY-FM and KQLZ-FM (collectively, the "Stations"), and in November 1993 Westinghouse Electric Corporation ("WEC") acquired Radio & Records and the remaining net assets of Westwood One Stations Group, Inc. ("The Group") (a subsidiary initially set up by the Company as the owner of the Stations and Radio & Records in order to collateralize loans from WEC) in complete satisfaction of The Group's remaining obligations for the principal amount of loans and accrued interest thereon owed to WEC. Accordingly, the results of the Stations and Radio & Records are classified as discontinued operations for all periods presented. The following table sets forth the consolidated statements of operations in dollars and as a percent of revenue for the three years ended November 30, 1993, 1992, and 1991, accompanied by dollar and percent comparisons covering 1993 vs 1992 and 1992 vs 1991: - --------------- NM -- not meaningful Westwood One derives substantially all of its revenue from the sale of advertising time to advertisers. Revenue decreased 2% to $99,579 in fiscal 1993 from $101,290 in fiscal 1992 and decreased 7% in fiscal 1992 from $108,586 in fiscal 1991. The decrease in revenue in fiscal 1993 was attributed to the non-recurrence of the Company's exclusive radio coverage of the 1992 Summer Olympics, partially offset by revenue growth associated with an overall increase in the market. The decrease in revenue in fiscal 1992 was primarily attributable to a 13% erosion of the national network radio revenue marketplace (according to the Radio Network Association). The decline in revenue in 1992 would have been slightly greater had the Company not had the exclusive radio coverage for the 1992 Summer Olympics. The Company's market share, based on advertising revenue reported to the Radio Network Association, was 24% in fiscal 1993 as compared to approximately 25% in fiscal 1992 and 24% in 1991. Operating costs and expenses (excluding depreciation and amortization) primarily include affiliate compensation (to radio stations in exchange for commercial spots, which the Company sells to advertisers), current period production costs of syndicated radio programs (excluding the amortization of production costs) and network administration, which typically do not vary directly with revenue, and selling expenses (including agency commissions related to advertising revenue) which often vary closely with revenue. Operating costs and expenses excluding depreciation and amortization decreased 12% to $80,918 in fiscal 1993 from $92,249 in fiscal 1992 and increased 7% in fiscal 1992 from $86,287 in fiscal 1991. The 1993 decrease is primarily due to cost reduction programs associated with affiliate compensation, programming, news and related staff expenses, the non-recurrence of the 1992 Summer Olympics, and lower agency commissions. The fiscal 1992 increase is primarily attributable to costs associated with broadcasting the 1992 Summer Olympics, a provision for contract losses and higher affiliate compensation expense, partially offset by lower syndicated music programming expense, reduced agency commissions, lower write-offs of doubtful accounts and lower transmission expense. Depreciation and amortization dropped 17% to $16,384 in 1993 from $19,661 in 1992 and dropped 11% in 1992 from $22,055 in 1991. The reductions are primarily due to lower amortization of production costs and lower write-offs resulting from fewer terminated station affiliation agreements. Corporate general and administrative expenses decreased 26% to $4,468 in fiscal 1993 from $6,017 in fiscal 1992 and decreased 3% in fiscal 1992 from $6,175 in fiscal 1991. The decrease in 1993 was attributable to across-the-board expense cuts and the non-recurrence of one-time charges from 1992. In 1992, reduced legal and consulting fees were almost offset by a one-time charge for a vested benefit related to a new executive officer's employment contract, an executive search fee and expenses associated with restructuring loan agreements. Severance and termination expenses of $2,063 in 1992 were principally due to management changes implemented to achieve future efficiencies. Operating loss decreased 88% to $2,191 in 1993 from $18,700 in 1992 after a 215% increase in 1992 from a loss of $5,931 in 1991. The 1993 significant improvement was primarily due to extensive cost reduction programs and the non-recurrence of prior year severance and termination expenses, partially offset by the non-recurrence of profit from the 1992 Summer Olympics. The increase in the 1992 operating loss occurred principally due to the profit impact of lower revenue resulting from the overall decline in the marketplace (somewhat offset by profit from the 1992 Olympics), increased operating costs and expenses excluding depreciation and amortization and significant severance and termination expenses, partially offset by lower depreciation and amortization. Interest expense was $6,551, $5,562 and $5,610 in fiscal 1993, 1992 and 1991, respectively. The 18% increase in fiscal 1993 was primarily due to restructuring expenses accompanied by an increased interest rate associated with amending the terms of the Company's bank revolving credit facility and term loan. In fiscal 1993, other income of $60 was principally comprised of investment income. In fiscal 1992 and 1991, other expense of $301 and $1,081, respectively, was due principally to provisions in 1992 and 1991 of $250 and $1,428, respectively, to write-down a parcel of real estate that was held for sale to its net realizable value, partially offset by investment income. Equity in net loss of an unconsolidated subsidiary represents the Company's share of the operating performance of WNEW-AM, which was sold in August 1992. Loss on the sale of an unconsolidated subsidiary of $6,536 in 1992 represents the provision for the sale of WNEW-AM, which closed on December 15, 1992. Loss before taxes, discontinued operations, and extraordinary gain decreased 73% to $8,682 in 1993 from $31,888 in 1992 and increased 120% in 1992 from $14,523 in 1991. The 1993 dramatic improvement was attributable to the decreased operating loss and the elimination of both the equity in net loss and loss on sale of an unconsolidated subsidiary resulting from its sale in the third quarter of fiscal 1992. The increased loss in 1992 was principally due to the increased operating loss, the loss on the sale of an unconsolidated subsidiary, and the provision for the write-down to net realizable value of a parcel of real estate. Starting in fiscal 1993 the Company no longer has deferred tax liabilities available to offset its loss from continuing operations resulting in a reduced benefit for income taxes of $10,491 in 1993. The benefit for income taxes increased 132% to $10,491 in 1992 from $4,519 in 1991, principally as a result of the change in pre-tax loss. The Company's effective tax rates in fiscal 1992 and 1991 were 33% and 31%, respectively. Loss from continuing operations decreased $12,715 to $8,682 in 1993 from $21,397 in 1992 and increased $11,393 in 1992 from $10,004 in 1991 due to changes in the pre-tax loss, partially offset by the benefit for income taxes. Loss on discontinued operations, net of income tax benefit, was $3,140 in 1993, $2,721 in 1992 and $6,778 in 1991. The 1993 loss represents the operating performance of discontinued operations through March 1, 1993. The decrease in the loss in 1992 was due to improved operating performance of WYNY-FM and Radio & Records, lower interest expense and the non-occurrence of costs associated with a 1991 format change at KQLZ-FM. The $12,087 provision for loss on disposal of discontinued operations includes estimated future costs and operating results of the discontinued assets from March 1, 1993 until the date of disposition. The Company had an extraordinary gain on the debt exchange offer in fiscal 1991, net of taxes, amounting to $25,618. In 1992, the Financial Accounting Standards Board issued FAS No. 109 "Accounting for Income Taxes". The Company will adopt the standard on December 1, 1993, and currently estimates that its deferred tax liability will be increased by approximately $2,000. The resulting expense will be recorded in the statement of operations and reported as a cumulative effect of a change in an accounting principle. LIQUIDITY AND CAPITAL RESOURCES At November 30, 1993, the Company's cash and cash equivalents were $3,868, a decrease of $2,587 from November 30, 1992. The decrease in cash of $2,587 combined with the cash provided before financing activities of $92,544 and the proceeds from the issuance of common stock of $1,507 were used to reduce outstanding borrowings by $96,638. Additionally, WEC acquired the outstanding stock of Radio & Records and the net assets of Westwood One Stations Group in complete satisfaction of the Group's remaining debt and a conversion to common stock of $2,068 face value of Senior Debentures occurred. Consequently, total debt was reduced to $60,149 at November 30, 1993, a decrease of $118,430 from $178,579 at November 30, 1992. For fiscal 1993, net cash from operating activities was $2,045, a decrease of $7,207 from fiscal 1992. The decrease was primarily attributable to higher prior year network collections associated with fourth quarter 1991 revenue and a large reduction in accounts payable and accrued liabilities primarily related to reduced interest, partially offset by improved broadcast cash flow (based on the consolidated statement of operations, calculated by subtracting from revenue, operating costs and expenses excluding depreciation and amortization) and receipt of a multi-year license fee (deferred revenue). Net cash provided by investing activities was $90,499, an increase of $101,841 over the prior year, principally due to net proceeds from the sales of two radio stations, an unconsolidated subsidiary and a parcel of real estate. Consequently, cash provided before financing activities increased by $94,634 from 1992. The Company used the assets of The Group as collateral for a revolving credit facility and for the 16% Senior Subordinated Debentures with WEC, both non-recourse to the Company, which amounted to $104,960 at November 30, 1992. In June 1993 the Company completed the sale of both radio stations and used the net proceeds to retire the 16% Debentures ($43,733) and reduce the outstanding balance of the revolving credit facility. Effective November 1, 1993, WEC acquired Radio & Records and the remaining net assets of The Group in complete satisfaction of The Group's remaining obligations for the principal amount of loans and accrued interest thereon owed to WEC. On November 22, 1993 the Company repaid its Revolving Facility and term loan by entering into a new senior debt agreement involving a revolving facility and two term loans with a maximum borrowing capacity of $20,000. At November 30, 1993, the Company had outstanding borrowings under the revolving facility of $6,648 and available borrowings of $6,352. From December 1, 1993 through January 15, 1994, holders of the Company's Senior Debentures converted $12,542 face amount of the Senior Debentures into 3,584,000 shares of the Company's common stock, reducing the outstanding amount of the Senior Debentures to $18,516. In order to finance the acquisition of Unistar (which will be accounted for as a purchase) the Company anticipates obtaining a new senior loan with a syndicate of banks in the amount of $125,000. Additionally, the Company will sell 5 million shares of Common Stock and a warrant to purchase up to an additional 3 million shares of Common Stock at an exercise price of $3.00 per share (subject to certain vesting conditions) to INI for $15,000. The proceeds will be used to acquire Unistar and repay its indebtedness ($101,300), repay the Company's current senior debt agreement, and improve working capital. Immediately following the acquisition, and as a condition to obtaining a new senior loan, the Company will also redeem its Senior Debentures. Management believes that the Company's cash, anticipated cash flow from operations and available borrowings will be sufficient to finance current and forecasted operations and debt obligations over the next 12 months. Furthermore, management believes the acquisition of Unistar will strengthen the Company's liquidity. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and the related notes and schedules of the Company are indexed on page of this Report, and attached hereto as pages through and by this reference incorporated herein. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS PART OF THIS REPORT ON FORM 10-K 1. Financial statements and schedules to be filed thereunder are indexed on page hereof. 2. Exhibits - --------------- (1) Filed as an exhibit to Registrant's registration statement on Form S-1 (File Number 2-98695) and incorporated herein by reference. (2) Filed as an exhibit to Registrant's registration statement on Form S-1 (Registration Number 33-9006) and incorporated herein by reference. (3) Filed as an exhibit to Registrant's Form 8 dated March 1, 1988 (File Number 0-13020), and incorporated herein by reference. (4) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1987 (File Number 0-13020) and incorporated herein by reference. (5) Filed as part of Registrant's September 25, 1986 proxy statement (File Number 0-13020) and incorporated herein by reference. (6) Filed as an exhibit to Registrant's current report on Form 8-K dated September 4, 1987 (File Number 0-13020) and incorporated herein by reference. (7) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1988 (File Number 0-13020) and incorporated herein by reference. (8) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1989 (File Number 0-13020) and incorporated herein by reference. (9) Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 1990 (File Number 0-13020) and incorporated herein by reference. (10) Filed as an exhibit to Registrant's application for qualification of indentures on Form T-3 which became effective and qualified on January 11, 1991 (File Number 22-20701) and incorporated herein by reference. (11) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1990 (File Number 0-13020) and incorporated herein by reference. (12) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1991 (File Number 0-13020) and incorporated herein by reference. (13) Filed as part of Registrant's March 27, 1992 proxy statement (File Number 0-13020) and incorporated herein by reference. (14) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1992 (File Number 0-13020) and incorporated herein by reference. (15) Filed as an exhibit to Registrant's June 18, 1993 Registration Statement on Form S-8. (16) Filed as part of Registrant's January 7, 1994 proxy statement (File Number 0-13020) and incorporated herein by reference. (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the fourth quarter of fiscal 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WESTWOOD ONE, INC. February 1, 1994 By NORMAN J. PATTIZ ---------------------------------- Norman J. Pattiz Chairman of the Board of Directors and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. WESTWOOD ONE, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other schedules have been omitted because they are not applicable, the required information is immaterial, or the required information is included in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF WESTWOOD ONE, INC. In our opinion, the consolidated financial statements listed in the index to consolidated financial statements and financial statement schedules on page present fairly, in all material respects, the financial position of Westwood One, Inc. and its subsidiaries at November 30, 1993 and 1992, and the results of their operations and their cash flows for each of the three fiscal years in the period ended November 30, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Century City, California February 1, 1994 WESTWOOD ONE, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation The consolidated financial statements include the accounts of all wholly-owned subsidiaries. Investments in 20 to 50 percent-owned companies are accounted for under the equity method. Revenue Recognition Revenue is recognized when commercial advertisements are broadcast. Cash Equivalents The Company considers all highly liquid instruments purchased with a maturity of less than three months to be cash equivalents. Depreciation Depreciation is computed using the straight line method over the estimated useful lives of the assets. Production Costs The Company defers a portion of its costs for recorded library material and produced radio entertainment programs with a life of longer than a year. Recorded library material includes previously broadcast programs, live concert performances, interviews, news and special events. Production costs are amortized using the straight line method over the period of expected benefit, not to exceed five years. Approximately 79% of current and deferred production costs at November 30, 1993 will be amortized by November 30, 1995. The current portion of deferred production costs represents the portion to be amortized over the next twelve months. Capitalized Station Affiliation Agreements Expenditures associated with major new affiliate agreements are capitalized and amortized starting once the affiliate's audience is included in rating service publications for use in generating advertising revenue. Capitalized station affiliation agreements exclude station affiliation agreements acquired as part of a purchase of an existing network. These expenditures, which are included in other assets, are amortized over 10 years or the period of known benefit, whichever is less. Measurement of Intangible Asset Impairment The Company periodically evaluates the carrying value of Intangible Assets. The Company considers the ability to generate positive broadcast cash flow (based on the consolidated statement of operations, calculated by subtracting from revenue, operating costs and expenses excluding depreciation and amortization) as the key factor in determining whether the assets have been impaired. To date, the Company has not experienced an impairment in any of its intangible assets. Income Taxes Deferred income taxes are provided for timing differences, resulting principally from deferred production costs. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) Earnings (Loss) per Share Net income (loss) per share is based on the weighted average number of common shares outstanding during the year. Average shares outstanding, used to compute per share figures, were as follows: Reclassification Financial statements for all prior periods have been reclassified to conform to the fiscal 1993 presentation. The principal adjustments were to include the amortization of intangible assets acquired through acquisition in arriving at an operating loss and to segregate discontinued operations. NOTE 2 -- DISCONTINUED OPERATIONS At the end of the Company's first fiscal quarter of 1993, the Company classified the results of operations from Radio & Records and its Los Angeles (KQLZ-FM) and New York (WYNY-FM) radio stations as discontinued operations. These three businesses collateralized the Company's 16% Debentures and Revolving Credit Facility with Westinghouse Electric Corporation ("WEC"). In June 1993 the Company completed the sales of its Los Angeles and New York radio stations, and used the net proceeds from the sales to retire the Company's 16% Debentures and reduce the outstanding balance of its Revolving Credit Facility. On November 1, 1993, WEC acquired the outstanding stock of Radio & Records and the net assets of Westwood One Stations Group for the outstanding balance of the Revolving Credit Facility, accrued interest and any other potential claims. Accordingly, the historical net loss of the Company's owned-and operated radio stations and Radio & Records have been reported separately from continuing operations, and the prior periods have been restated (including an allocation of interest of $7,043, $12,273, and $13,058 for fiscal 1993, 1992 and 1991, respectively). The Company made a provision for the loss on the disposition of these assets including estimated future costs and operating results from March 1, 1993 until the date of disposition, of $12,087, which includes a fourth quarter provision of $3,587 as a result of the net proceeds from the disposal of Radio & Records and the WEC agreement. Revenue from discontinued operations for fiscal 1993, 1992 and 1991 were $22,282, $36,443, and $35,764, respectively. The consolidated statements of cash flows include both continuing and discontinued operations of the Company. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 3 -- PROPERTY AND EQUIPMENT: Property and equipment is summarized as follows at: NOTE 4 -- INTANGIBLE ASSETS: Intangible assets are summarized as follows at: Station affiliation agreements are comprised of values assigned to agreements acquired as part of the purchase of radio networks and are amortized using an accelerated method over 40 years. The value of station affiliation agreements, whose period of known benefit will expire in the next twelve months, is $549 and $800 at November 30, 1993 and 1992, respectively. Goodwill represents the excess of the cost of purchased businesses over the fair value of their net assets at the date of acquisition. Intangible assets, except for acquired station affiliation agreements, are amortized on a straight-line method over 40 years. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 5 -- FINANCING ARRANGEMENTS AND LONG-TERM DEBT: Financing Arrangements In addition to long-term debt, the Company has a secured Revolving Facility in the maximum amount of $13,000 (based on a percentage of Eligible Accounts Receivable). The Revolving Facility bears interest, payable monthly, at the rate of prime plus 2.25%. At November 30, 1993, the Company owed $6,648 under this Revolving Facility and had available borrowings of $6,352. The Loan and Security Agreement for the Revolving Facility and the term notes (see below) contain provisions which require the Company to maintain minimum levels of Working Capital and Adjusted Tangible Net Worth along with a minimum current ratio. (See Note 12 -- Subsequent Events) Long-Term Debt Long-term debt consists of the following at: The Company has two Term Notes which mature on December 1, 1995 ("Note A") and December 1, 1996 ("Note B") (collectively the "Notes"). The Notes bear interest at the rate of prime plus 2.25%. Interest is payable monthly. Principal is payable monthly on each note commencing on January 1, 1994 in the amounts of $83 and $58 for Note A and Note B, respectively. (See Note 12 -- Subsequent Events). During fiscal 1993, the Company paid or exchanged the following debt instruments which were outstanding at the beginning of the year: Prime plus 1 1/2% term loan from bank, Prime plus 1 1/4% Revolving Credit Facility and 16% Senior Subordinated Debentures (See Note 2 -- Discontinued Operations). The 9% Convertible Senior Subordinated Debentures ("Senior Debentures") are unsecured and subordinated in right of payment to senior indebtedness of the Company. Interest on the Senior Debentures is payable semiannually on April 15 and October 15. The Senior Debentures are WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) convertible at any time prior to maturity, unless previously redeemed, into shares of Common Stock of the Company at the conversion price of $3.50 per share, subject to adjustment upon the occurrence of certain events. The Senior Debentures are redeemable at the option of the Company at a declining premium to par until 1996 and at par thereafter. In fiscal 1993, $2,068 of Senior Debentures were converted to Common Stock (See Note 12 -- Subsequent Events). The 6 3/4% Convertible Subordinated Debentures ("Debentures") are unsecured and subordinated in right of payment to senior indebtedness and Senior Debentures. Interest on the Debentures is payable semiannually on April 15 and October 15. The Debentures are convertible at any time prior to maturity, unless previously redeemed, into shares of Common Stock of the Company at the conversion price of $24.58 per share, subject to adjustment upon the occurrence of certain events. On January 11, 1991, the Company accepted, and, thereafter, retired $83,037 principal amount of the Debentures (84% of the then outstanding bonds) tendered pursuant to its offer to exchange its Senior Debentures for any and all of its Debentures. As a result of this transaction, the Company recorded an extraordinary gain, net of taxes, of $25,618. The aggregate maturities of long-term debt for the next five fiscal years and thereafter, pursuant to the Company's debt agreements as in effect at November 30, 1993, are as follows: NOTE 6 -- SHAREHOLDERS' EQUITY: The authorized capital stock of the Company consists of Common stock, Class B stock and Preferred stock. Common stock is entitled to one vote per share while Class B stock is entitled to 50 votes per share. In December 1992, the Company's Board of Directors authorized the issuance of 41,500 shares of common stock to an officer of the Company for services performed in fiscal 1992. In October 1990 the Company issued 267,740 shares of common stock to a company owned by the Chairman of the Board in full satisfaction of an amount owed that company for transportation services. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) As part of a settlement relating to class action lawsuits filed against the Company, it issued warrants to purchase 3,000,000 shares of the Company's common stock at $17.25 per share. The warrants expire on September 4, 1997. Warrants not exercised may be redeemable under certain circumstances at $1.00 per warrant. As part of a seven year employment agreement which commenced December 1, 1986, 112,500 shares of Class B stock were placed in escrow for the Chairman of the Board. As of November 30, 1993, all the shares were vested. NOTE 7 -- STOCK OPTIONS: The Company has stock option plans established in 1984 and 1989 which provide for the granting of options to directors, officers and key employees to purchase stock at its market value on the date the options are granted. No additional options can be granted under the 1984 Plans. There are 2,800,000 shares authorized under the 1989 Plan, as amended. Options granted generally become exercisable after one year in 25% increments per year and expire within ten years from the date of grant. The 1989 Plan will remain in existence for 10 years or until otherwise terminated by the Board of Directors. Information concerning options outstanding under the Plans is as follows: On December 1, 1986, the Chairman of the Board was granted options not covered by the Plans to acquire 525,000 shares of common stock, which vested ratably over a seven-year term or immediately upon a change in control of the Company. The options became exercisable at the fair market value of the common stock, as defined, on the date of vesting. At November 30, 1993, all the options granted are exercisable at exercise prices ranging from $1.67 to $16.31 per share. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 8 -- INCOME TAXES: Starting in fiscal 1993 the Company no longer has deferred tax liabilities available to offset its losses. The components of the (benefit) for income taxes related to continuing operations is summarized as follows: The deferred tax benefits recorded for the two years ended November 30, 1992, are attributable to the reversal of deferred taxes for timing differences, provided for in earlier years. Certain of these deferred taxes were reinstated in fiscal 1991 as a result of a tax expense of $19,828 on the extraordinary gain. A reconciliation between the Company's effective income tax rate and the U.S. statutory rate is as follows: The Company has approximately $90,000 of available U.S. net operating loss carryforwards for tax purposes. Utilization of the carryforwards is dependent upon future taxable income and they begin to expire in 2003. As a result of the Company's prior and pending debt and equity transactions, some of the Federal net operating losses may be subject to certain limitations. In 1992, the Financial Accounting Standards Board issued FAS No. 109 "Accounting for Income Taxes". The Company will adopt the standard on December 1, 1993, and currently estimates that its deferred tax liability will be increased by approximately $2,000. The resulting expense will be recorded in the statement of operations and reported as a cumulative effect of a change in an accounting principle. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 9 -- COMMITMENTS AND CONTINGENCIES: The Company has various non-cancelable, long-term operating leases for office space and equipment. In addition, the Company is committed under various contractual agreements to pay for talent, broadcast rights, research and certain digital audio transmission services. The approximate aggregate future minimum obligations under such operating leases and contractual agreements for the five years after November 30, 1993, are set forth below: NOTE 10 -- SUPPLEMENTAL CASH FLOW INFORMATION: Supplemental Information on cash flows, including amounts from discontinued operations, and non-cash transactions is summarized as follows: WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 11 -- QUARTERLY RESULTS OF OPERATIONS (UNAUDITED): The following is a tabulation of the unaudited quarterly results of operations for each of the quarters for the fiscal years ended November 30, 1993 and 1992: NOTE 12 -- SUBSEQUENT EVENTS(UNAUDITED): The Company submitted to the Commission an offer of settlement arising out of a formal investigation by the Commission which has been pending since 1989. The settlement offer, which was accepted by the Commission on January 7, 1994 and an order entered on January 19, 1994, involved the Company's consent, without admitting or denying any of the findings of the Commission, to an administrative cease and desist order based upon findings that in 1987 and 1988 the Company violated antifraud and accounting provisions of the federal securities laws and the rules thereunder in its revenue recognition and accounting practices during that period. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) From December 1, 1993 through January 15, 1994, holders of the Company's Senior Debentures converted $12,542 face amount of the Senior Debentures into 3,584,000 shares of the Company's Common Stock. On January 28, 1994 the shareholders of the Company approved and authorized the acquisition by the Company of all the issued and outstanding capital stock of Unistar Radio Networks, Inc. ("Unistar") and the assumption of $84,711 of Unistar's indebtedness for an aggregate purchase price of $101,300. The acquisition will be accounted for as a purchase and, accordingly, Unistar's results of operations will be included in the consolidated statement of operations from the date the acquisition is consummated. In order to finance the acquisition of Unistar, the Company anticipates obtaining a new senior loan with a syndicate of bank's in the amount of $125,000. Additionally, the Company will sell 5 million shares of Common Stock and a warrant to purchase up to an additional 3 million shares of Common Stock at an exercise price of $3.00 per share (subject to certain vesting conditions) to a wholly-owned subsidiary of Infinity Broadcasting Corporation for $15,000. The net proceeds will be used to acquire Unistar and repay its indebtedness ($101,300), repay the Company's current senior debt agreement, and improve working capital. Immediately following the acquisition, and as a condition to obtaining a new senior loan, the Company will also redeem its Senior Debentures. WESTWOOD ONE, INC. SCHEDULE IX CONSOLIDATED SHORT-TERM BORROWINGS (IN THOUSANDS) Notes: Short-term borrowings during the years covered by this schedule consist of loans made under various established credit lines. The average amount outstanding during each period was computed by dividing the average outstanding principal balance by 365 days. The weighted average interest rate during each period was computed by dividing the actual interest expense on such borrowings by the average amount outstanding during that period.

20164_1993.txt

20164

1993

ITEM 1. BUSINESS The registrant, Chrysler Financial Corporation and its consolidated subsidiaries (the "Company"), is a financial services organization engaged in automotive retail and wholesale financing, servicing commercial leases and loans, servicing secured small business loans, property and casualty insurance, and automotive dealership facility development and management. All of the Company's common stock is owned by Chrysler Corporation, a Delaware corporation (together with its subsidiaries, "Chrysler"). The Company, a Michigan corporation, is the continuing corporation resulting from a merger on June 1, 1967 of a financial services subsidiary of Chrysler into a newly acquired, previously unaffiliated finance company incorporated in 1926. At the end of 1993 the Company had nearly 3,100 employees and its portfolio of receivables managed totaled $28.3 billion. The Company's financial condition and liquidity improved during 1993 as it regained full access to the investment grade debt markets. In addition, the Company realized aggregate cash proceeds of $2.4 billion from the sales of certain nonautomotive assets during 1993. The sales of nonautomotive assets over the last two years have made the Company more dependent upon Chrysler. Thus, lower levels of production and sales of Chrysler products could result in a reduction in the level of finance operations of the Company. The Company's portfolio of finance receivables managed includes receivables owned and receivables serviced for others. Receivables serviced for others primarily represent sold receivables which the Company services for a fee. At December 31, 1993, receivables serviced for others accounted for 69% of the Company's portfolio of receivables managed. Total finance receivables managed at the end of each of the five most recent years were as follows: Automotive Financing. The Company conducts its automotive finance business principally through its subsidiaries Chrysler Credit Corporation, Chrysler Credit Canada Ltd., and in Mexico, Chrysler Comercial S.A. de C.V. Chrysler Credit is the major source of automobile and light duty truck wholesale (also referred to as "floor plan"), and retail financing for Chrysler dealers and their customers throughout North America. At December 31, 1993, Chrysler Credit was providing financing to approximately 2,600 Chrysler dealers who exclusively sell Chrysler products. Chrysler Credit also finances approximately 1,400 dealers who sell non-Chrysler products (either exclusively or together with Chrysler products). Chrysler Credit also offers its floor plan dealers working capital loans, real estate and equipment financing and financing plans for fleet buyers, including daily rental car companies independent of, and affiliated with, Chrysler. The automotive financing operations of Chrysler Credit Corporation and such other subsidiaries are conducted through 100 branches in the United States, Canada, Mexico and Puerto Rico. ITEM 1. BUSINESS - continued During 1993, the Company financed or leased approximately 766,000 vehicles at retail in the United States, including approximately 516,000 new Chrysler passenger cars and light duty trucks representing 25 percent of Chrysler's U.S. retail and fleet deliveries. In 1993, the average monthly payment for new vehicle retail installment sale contracts acquired in the United States was $341. The average percentage of dealer cost financed was 91 percent and the average original term was 55 months. The Company also financed at wholesale approximately 1,510,000 new Chrysler passenger cars and light duty trucks representing 75 percent of Chrysler's U.S. factory shipments in 1993. Wholesale vehicle financing accounted for 74 percent of the total automotive financing volume of the Company in 1993 and represented 16 percent of automotive finance receivables outstanding at December 31, 1993. Nonautomotive Financing. The Company has downsized its nonautomotive operations through sales and liquidations over the last several years. During 1993, the Company realized $2.4 billion of aggregate cash proceeds from the sale of substantially all of the comsumer and inventory financing businesses of Chrysler First Inc. ("Chrysler First"), and the sale of certain assets of Chrysler Capital Corporation ("Chrysler Capital"). Chrysler Capital manages commercial leases and loans to clients in over 30 industries through 16 offices throughout the United States. At December 31, 1993, Chrysler Capital managed $2.7 billion of commercial finance receivables compared to $3.2 billion at December 31, 1992. In addition, the Company managed a portfolio of secured small business loans totaling $.6 billion at December 31, 1993. Insurance. Chrysler Insurance Company and its subsidiaries ("Chrysler Insurance") provide specialized insurance coverages to automotive dealers and their customers in the United States and Canada. The property and casualty segment of Chrysler Insurance's business includes physical damage, garage liability, workers' compensation and property and contents coverage provided directly to automotive dealers. During 1993 the inventories of approximately 2,800 automotive dealerships that were financed by Chrysler Credit were insured by Chrysler Insurance. During 1993, 1,875 Chrysler and non-Chrysler automotive dealerships were insured by the Company's multi- line property and casualty insurance program known as the Pentastar Protection program. Chrysler Insurance also provides collateral protection and single interest insurance to retail automobile customers and their financing sources. Real Estate Management. Chrysler Realty Corporation ("Chrysler Realty"), which is engaged in the ownership, development and management of Chrysler automotive dealership properties in the United States, typically purchases, leases or options dealership facilities and then leases or subleases these facilities to Chrysler dealers. At December 31, 1993, Chrysler Realty controlled 923 sites (of which 297 were owned by Chrysler Realty). ITEM 1. BUSINESS - continued Funding. The Company's primary objective is to provide financing for automotive dealers and retail purchasers of Chrysler's products. The Company's liquidity improved during 1993 reflecting proceeds from nonautomotive asset sales and the Company's improved access to the capital markets. During 1993, the Company issued $2.3 billion of term debt and increased the level of short-term notes outstanding (primarily commercial paper) to $2.8 billion and repaid all borrowings outstanding under revolving credit facilities. Receivable sales continued to be a significant source of funding during 1993, as the Company realized $7.8 billion of net proceeds from the sale of automotive retail receivables compared to $5.8 billion of net proceeds from the sale of automotive and nonautomotive receivables in 1992. The Company's outstanding debt at December 31, of each of the five most recent years was as follows: ITEM 2.

ITEM 2. PROPERTIES At December 31, 1993, the following facilities were utilized by the registrant and its subsidiaries in conducting their businesses: (a) executive offices of the registrant, Chrysler Credit Corporation, Chrysler Insurance and certain other domestic subsidiaries of the registrant in Southfield, Michigan; (b) a total of 86 branches of Chrysler Credit Corporation located throughout the United States; (c) headquarters of remaining Chrysler First operations in Allentown, Pennsylvania, and a total of 3 offices of such corporation in the United States; (d) headquarters of Chrysler Capital in Stamford, Connecticut, and a total of 16 offices of such corporation in the United States; (e) headquarters of Chrysler Realty in Troy, Michigan; and (f) a total of 15 offices used as headquarters and branch offices in Canada, Mexico and Puerto Rico. All of the facilities described above were leased by the registrant. At December 31, 1993, a total of 297 automobile dealership properties generally consisting of land and improvements were owned by Chrysler Realty for lease to dealers franchised by Chrysler. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In the ordinary course of business, the registrant and its subsidiaries are parties, either as plaintiff or defendant, in various legal proceedings which are incidental to the business of such companies. The pending proceedings are not other than ordinary routine litigation and are not deemed by the registrant to be material with respect to the business of the registrant and its subsidiaries taken as a whole. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (Omitted in accordance with General Instruction J.) PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS All of the outstanding common stock of the registrant, consisting of one class of common stock, is owned by Chrysler. There is, therefore, no established public market in which such common stock is being traded. The Company did not pay cash dividends to Chrysler in 1993 and 1992. During the first quarter of 1992, the Company redeemed its remaining $75 million of preferred stock. Covenants in the Company's revolving credit agreements effectively prevent the Company from declaring or paying any dividend other than dividends payable solely in common stock of the Company, or any scheduled dividend on preferred stock issued by the Company. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Financial Condition Chrysler Financial Corporation's financial condition and liquidity improved during 1993 as it regained full access to the investment grade debt markets. During 1993, funding provided by capital market activities and the downsizing of nonautomotive operations through sales and liquidations, enabled the Company to repay all amounts outstanding under its revolving credit facilities and to provide financing support for automotive dealers and retail purchasers of Chrysler's products. The Company's portfolio of receivables managed, which includes receivables owned and receivables serviced for others, totaled $28.3 billion at December 31, 1993, down from $30.1 billion and $33.7 billion at December 31, 1992 and 1991, respectively. The decline in receivables managed primarily reflects the downsizing of the Company's nonautomotive operations. Receivables serviced for others primarily represent sold receivables which the Company services for a fee. Receivables serviced for others totaled $19.4 billion at December 31, 1993, compared to $18.3 billion and $18.4 billion at December 31, 1992 and 1991, respectively. The increase in receivables serviced for others reflects higher levels of automotive sold receivables, partially offset by the downsizing of nonautomotive operations. The Company's total allowance for credit losses, including receivables sold subject to limited recourse provisions, totaled $494 million, $573 million and $557 million at December 31, 1993, 1992 and 1991, respectively. The total allowance for credit losses as a percentage of related finance receivables outstanding was 1.78%, 1.94% and 1.74% at December 31, 1993, 1992 and 1991, respectively. The decline in credit loss reserve levels is a result of nonautomotive asset sales and an improvement in automotive credit loss experience. Total assets at December 31, 1993 declined to $14.4 billion from $17.5 billion at December 31, 1992. Total debt outstanding at December 31, 1993 was $8.4 billion compared to $11.8 billion at December 31, 1992. The Company's debt-to-equity ratio declined to 2.69 to 1 at December 31, 1993 compared to 3.92 to 1 at December 31, 1992. The decline in total assets, total debt and the debt-to-equity ratio reflects the downsizing of the Company and the use of nonautomotive asset sale proceeds to reduce the Company's outstanding indebtedness. Results of Operations Earnings before income taxes and cumulative effect of changes in accounting principles for 1993 totaled $267 million, compared to $295 million and $402 million in 1992 and 1991, respectively. The decline in 1993 earnings before income taxes and accounting changes from 1992 resulted largely from higher borrowing costs incurred under the Company's revolving credit agreements. The decline in 1992 earnings before accounting changes from the prior year was primarily due to lower levels of earning assets and increased borrowing costs incurred under the bank facilities, partially offset by lower provisions for credit losses. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) The Company's net earnings after accounting changes were $129 million, $231 million and $276 million in 1993, 1992 and 1991, respectively. Accounting changes in 1993 and 1992 negatively impact the net earnings comparisons by $81 million. Net earnings for the year ended December 31, 1993 included charges totaling $30 million from the implementation of Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", and SFAS No. 112, "Employers' Accounting for Postemployment Benefits". Net earnings for the year ended December 31, 1992 included a $51 million favorable adjustment from the adoption of SFAS No. 109, "Accounting for Income Taxes". Interest margin totaled $627 million in 1993, down 32 percent from 1992 primarily due to the sales of nonautomotive assets and higher average effective cost of borrowings incurred under the Company's bank facilities. Automotive financing income totaled $989 million in 1993, compared with $1.1 billion in 1992 and $1.4 billion in 1991. The decline in automotive financing income was primarily attributable to lower levels of earning assets and declining interest rates. Automotive financing volume totaled $59.8 billion in 1993, compared to $46.6 billion and $41.5 billion in 1992 and 1991, respectively. The increase in automotive financing volume over the last two years was largely due to higher amounts of wholesale financing provided to automotive dealers. Financing support provided in the United States for new Chrysler vehicle retail deliveries (including fleet) and wholesale vehicle sales to dealers, and the number of vehicles financed over the last three years was as follows: Interest income from the Company's nonautomotive financing operations totaled $429 million in 1993 compared with $841 million in 1992 and $1.2 billion in 1991. These nonautomotive operations had finance receivables outstanding of $2.8 billion at December 31, 1993 compared with $5.3 billion at December 31, 1992, and $7.2 billion at December 31, 1991. The decrease in nonautomotive finance receivables outstanding was due primarily to the downsizing of the Company's nonautomotive operations over the last two years. Despite improved credit ratings and lower market interest rates, the Company's average effective cost of borrowings increased during 1993 compared to a year ago. This increase was primarily due to the amortization of up-front fees and costs associated with its U.S. and Canadian revolving credit agreements commencing in August 1992. The decline in the Company's average effective cost of borrowings from 1991 to 1992 was primarily due to lower market interest rates. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) A comparison of borrowing costs is shown in the following table: Operating expenses for 1993 totaled $463 million, compared to $595 million and $614 million in 1992 and 1991, respectively. The decline in operating expenses over the last two years was primarily attributable to the downsizing of the Company's nonautomotive operations and the containment of certain automotive-related operating expenses. The Company's provision for credit losses for 1993 totaled $216 million compared to $309 million and $421 million in 1992 and 1991, respectively. The lower provision for credit losses reflects improved automotive credit loss experience and the downsizing of nonautomotive operations. The Company's depreciation and other expenses totaled $194 million in 1993, compared to $242 million and $231 million in 1992 and 1991, respectively. The decline in depreciation and other expenses from 1992 to 1993 was primarily attributable to the downsizing of nonautomotive operations. Net credit loss experience, including net losses on receivables sold subject to limited recourse provisions, for the years ended December 31, 1993, 1992 and 1991 was as follows: ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Liquidity improved during 1993 due to an improved market perception of the Company's creditworthiness, proceeds from sales of nonautomotive operations and the achievement of investment grade credit ratings. The Company's improved access to the debt markets enabled it to issue $2.3 billion of term debt and increase the level of short-term notes outstanding (primarily commercial paper) to $2.8 billion. Receivable sales continued to be a significant source of funding during 1993 as the Company realized $7.8 billion of net proceeds from the sale of automotive retail receivables, compared to $5.8 billion of net proceeds from the sale of automotive and nonautomotive retail receivables for the year ended December 31, 1992. In addition, revolving wholesale receivable sale arrangements provided funding which aggregated $4.6 billion and $4.3 billion at December 31, 1993 and 1992, respectively. During 1993 the Company realized $2.4 billion in aggregate cash proceeds from the sale of substantially all of the net assets of the consumer and inventory financing businesses of Chrysler First and the sale of certain assets of Chrysler Capital. At December 31, 1993, the Company had revolving credit facilities aggregating $5.2 billion, consisting of contractually committed U.S. credit lines of $4.7 billion expiring in August 1995, and $.5 billion of Canadian credit lines expiring in December 1995. The Company had automotive receivable sale agreements totaling $2.9 billion at December 31, 1993, consisting of a $2.5 billion U.S. automotive receivable sale agreement (of which $1.25 billion expires in September 1994 and $1.25 billion expires in September 1996), and a $.4 billion Canadian receivable sale agreement which expires in December 1995. In addition, up to $750 million of the total commitment under Chrysler's revolving credit agreement dated June 30, 1993 can be made available to the Company. As of December 31, 1993, none of the revolving credit facilities or receivables sale agreements were utilized. As of December 31, 1993, the Company had contractual debt maturities of $4.1 billion in 1994 (including $2.8 billion of short-term notes), $.6 billion in 1995, $1.0 billion in 1996, $.2 billion in 1997, $.7 billion in 1998 and $1.8 billion in years thereafter. The Company believes that cash provided by operations, receivable sales, issuance of term debt, and issuance of commercial paper backed by unused revolving credit facilities will provide sufficient liquidity in the future. New Accounting Standards In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which amends SFAS No. 5, "Accounting for Contingencies", by requiring creditors to evaluate the collectibility of both contractual interest and principal of receivables when evaluating the need for a loss accrual. The Company has not yet determined the effect of this new pronouncement on its results of operations and financial position. The Company plans to adopt SFAS No. 114 on or before January 1, 1995. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS New Accounting Standards (continued) In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. This accounting standard specifies the accounting and reporting requirements for changes in the fair values of investments in certain debt and equity securities. Based upon its initial assessment, the Company believes that the implementation of this new accounting standard will have an immaterial impact on its consolidated operating results and financial position. The Company plans to adopt this standard effective January 1, 1994, as required. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Chrysler Financial Corporation and Subsidiaries ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Chrysler Financial Corporation and Subsidiaries ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Chrysler Financial Corporation and Subsidiaries ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Chrysler Financial Corporation and Subsidiaries Notes to Consolidated Financial Statements Note 1 - Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Chrysler Financial Corporation and its domestic and foreign subsidiaries (the "Company"). All significant intercompany accounts and transactions have been eliminated in consolidation. All of the Company's common shares are owned by Chrysler Corporation (together with its subsidiaries, "Chrysler"). Prior years have been reclassified to conform with current year's classifications. Receivable Sales The Company sells significant amounts of automotive receivables acquired, in transactions subject to limited recourse provisions. The Company generally sells its receivables to a trust and remains as servicer for which it is paid a servicing fee. Normal servicing fees are earned on a level yield basis over the remaining terms of the related sold finance receivables. In a subordinated capacity, the Company retains excess servicing cash flows, a limited interest in the principal balances of the sold receivables and certain cash deposits provided as credit enhancements for investors. Gains or losses from the sale of retail receivables are recognized in the period in which such sale occurs. In determining the gain or loss for each qualifying sale of retail receivables, the investment in the sold receivable pool is allocated between the portion sold and the portion retained based on their relative fair values on the date of sale. The receivables sold are removed from the balance sheet caption "Finance receivables - net", and the Company's retained interests in such receivables are included in "Retained interests in sold receivables and other related amounts - net". Gains or losses are reflected in the consolidated statement of net earnings under the caption, "Investment and other income". Gains on sales of wholesale receivables are not material. Income Recognition Interest income from owned finance receivables is recognized using the interest method. Lending fees and certain direct loan origination costs are deferred and amortized to interest income using the interest method over the contractual terms of the finance receivables. Interest accrued on wholesale, certain lease financing and real estate receivables at the balance sheet date, is included in finance receivables. Recognition of interest income is generally suspended when a loan becomes contractually delinquent for periods ranging from 60 to 90 days. Income recognition is resumed when the loan becomes contractually current, at which time all past due interest income is recognized. Property and casualty premiums are earned on a straight-line basis over the term of their respective policies. Lease Transactions Leasing operations consist of direct finance leases of vehicles and other equipment, leveraged leases of major equipment and real estate and operating leases, all of which are accounted for in accordance with the classification of the leases. The related revenue is recorded as interest income. Dealership properties leased to others are stated at cost less accumulated depreciation of $116 million in 1993 and $108 million in 1992. Equipment leased to others is stated at cost less accumulated depreciation of $164 million in 1993 and $190 million in 1992. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 1 - Summary of Significant Accounting Policies - continued Allowance for Credit Losses An allowance for credit losses is generally established during the period in which receivables are acquired. The allowance for credit losses is maintained at a level deemed appropriate based primarily on loss experience. Other factors affecting collectibility are also evaluated, and appropriate adjustments are recorded. Retail automotive receivables not supported by a dealer guaranty are charged to the allowance for credit losses net of the estimated value of repossessed collateral at the time of repossession. Nonautomotive finance receivables are reduced to the estimated fair value of collateral when determined to be uncollectible. Cash Equivalents Temporary investments of excess borrowed funds with a maturity of less than three months when purchased are considered to be cash equivalents. Marketable Securities Marketable securities, owned by the Company's insurance subsidiaries and generally held to maturity, are carried at cost, adjusted for amortized premium or discount on bonds, plus accrued interest. Repossessed Collateral Repossessed collateral is carried at the lower of fair value less estimated selling expenses, or cost. Repossessed collateral carrying costs and gains or losses from disposition of such assets are recognized in the period incurred. Real estate owned is carried at the lower of fair value less estimated selling expenses, or cost. Fair value for real estate owned is determined by appraisal. Other factors affecting collectibility are also evaluated, and appropriate adjustments are recorded. Term Debt and Revolving Credit Fees and Costs Term debt commissions and expenses are amortized over the life of the related debt issue in relation to the outstanding principal balances. Up- front fees and costs incurred in connection with revolving credit facilities are deferred and amortized over the expected term of the facilities in relation to commitments outstanding. Costs in Excess of Net Assets Acquired Costs in excess of net assets acquired are being amortized on a straight- line basis over the remaining term of 14 years. The amount of unamortized goodwill included in "Other Assets" was $15 million and $23 million at December 31, 1993 and 1992, respectively. Off-Balance-Sheet Financial Instruments The Company enters into various interest rate exchange agreements to reduce its exposure to fluctuations in interest rates as part of its asset and liability management program. Net interest differentials to be paid or received related to interest rate exchange agreements are accrued and included as an adjustment to interest expense. The Company enters into foreign currency swap agreements to hedge exposure to debt obligations which call for repayment of principal and interest in currency other than U.S. or Canadian dollars. The underlying debt obligations are translated in the accompanying consolidated balance sheet at the contractual rate of exchange in the respective foreign currency swap agreement. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 2 - Finance Receivables and Retained Interests Outstanding balances of "Finance receivables - net" were as follows: The Company's retained interests in sold receivables and other related amounts are generally restricted and subject to limited recourse provisions. The following is a summary of amounts included in "Retained interests in sold receivables and other related amounts - net": Changes in the allowance for credit losses, including receivables sold subject to limited recourse and amounts related to "Nonautomotive assets held for sale" at December 31, 1992, were as follows: Nonearning finance receivables, including receivables sold subject to limited recourse, totaled $333 million and $735 million, at year end 1993 and 1992, respectively, which represented 1.21 percent and 2.49 percent of such receivables outstanding, respectively. In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which amends SFAS No. 5, "Accounting for Contingencies", by requiring creditors to evaluate the collectibility of both contractual interest and principal of receivables when evaluating the need for a loss accrual. The Company has not yet determined the effect of this new pronouncement on its results of operations and financial position. The Company plans to adopt SFAS No. 114 on or before January 1, 1995. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 2 - Finance Receivables and Retained Interests - continued Contractual maturities of total finance receivables at December 31, 1993 were as follows: Actual cash flow experience will vary from contractual cash flows due to future receivable sales and prepayments. The Company's investment in automotive and nonautomotive direct financing leases included in "Finance receivables - net" was as follows: The Company's investment in leveraged leases included in "Finance receivables - net" and related deferred income taxes, was as follows: In accordance with Statement of Financial Accounting Standards (SFAS) No. 13, "Accounting for Leases", the Company revised its calculations of leveraged lease cash flows to adjust for the enacted tax rate increase in 1993. This change (a) increased earnings before income taxes by $9 million, and (b) increased the provision for income taxes by $20 million, primarily due to the adjustment of the associated net deferred tax liabilities (see Note 8 - Income Taxes). ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 3 - Sales of Receivables The Company sells receivables subject to limited recourse provisions. Outstanding balances of sold finance receivables were as follows: Gains or losses from the sales of retail receivables are recognized in the period in which such sales occur. Provisions for expected credit losses are generally provided during the period in which such receivables are acquired. Since the allowance for credit losses is separately provided prior to the receivable sales, gains from receivable sales are not reduced for expected credit losses. Included in "Investment and other income" are gains before expected credit losses totaling $127 million, $146 million and $159 million for the years ended December 31, 1993, 1992 and 1991, respectively. The provision for credit losses related to such sales amounted to $135 million, $137 million and $167 million for the years ended December 31, 1993, 1992 and 1991, respectively. Note 4 - Nonautomotive Assets Held for Sale During the first quarter of 1993, the Company realized cash proceeds of $2.3 billion and a note receivable of approximately $.1 billion from the sales of certain nonautomotive assets which had been classified as "Nonautomotive assets held for sale" in the Company's consolidated balance sheet at December 31, 1992. Proceeds from these sales approximated the net carrying values of the assets sold, and were used to reduce the Company's outstanding indebtedness. Note 5 - Marketable Securities Marketable securities held by the Company's insurance subsidiaries were as follows: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 6 - Debt Short-term notes outstanding at December 31, 1993 had an average remaining term of 40 days. Average effective cost of borrowings were as follows: Debt outstanding at December 31, 1993 and 1992 was as follows: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 6 - Debt - continued Interest paid by the Company for the years ended December 31, 1993, 1992 and 1991 amounted to $847 million, $1,250 million and $1,536 million, respectively. The Company has contractual debt maturities of $4.1 billion in 1994 (including $2.8 billion of short-term notes), $.6 billion in 1995, $1.0 billion in 1996, $.2 billion in 1997, $.7 billion in 1998 and $1.8 billion in years thereafter. Interest rate exchange agreements have been entered into with major financial institutions, which are expected to fully perform under the terms of the agreements. While these agreements are generally used as hedges and are matched with specific financial instruments, they do involve a degree of interest rate risk. At December 31, 1993, the notional amount of the Company's portfolio of interest rate exchange agreements totaled $1,524 million. While notional amount is used to measure the volume of these agreements, it does not represent exposure to credit loss. The terms of the Company's foreign currency swap agreements provide for payment of foreign currency principal and interest obligations in U.S. or Canadian dollars based on the contractual exchange rate in the respective agreement. As a result, the underlying debt obligations are recorded at the contractual rate totaling $535 million at December 31, 1993. If the debt obligations had been translated at the various exchange rates in effect at December 31, 1993, the recorded amount would have been $121 million higher. Credit Facilities At December 31, 1993, the Company had credit facilities aggregating $5.2 billion, consisting of contractually committed U.S. credit lines of $4.7 billion expiring in August 1995, and $.5 billion of Canadian credit lines expiring in December 1995. At December 31, 1993, the Company had no borrowings outstanding under either of these credit facilities. The Company's U.S. revolving credit facility grants security interests in substantially all of the Company's U.S. assets and contains restrictive covenants including restrictions that effectively prevent payment of cash dividends to Chrysler. At December 31, 1993, the Company had automotive receivable sale agreements totaling $2.9 billion, consisting of a $2.5 billion U.S. automotive receivable sale agreement (of which $1.25 billion expires in September 1994 and $1.25 billion expires in September 1996), and a $.4 billion Canadian receivable sale agreement which expires in December 1995. At December 31, 1993, none of the Company's receivable sale agreements were utilized. In addition, up to $750 million of the total commitment under Chrysler's revolving credit agreement dated June 30, 1993 can be made available to the Company. As of December 31, 1993, no borrowings were outstanding under this agreement. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 7 - Reinsurance Arrangements The Company enters into various reinsurance contracts with other insurance enterprises or reinsurers to reduce the losses that may arise from catastrophes or other events. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to fulfill their obligations could result in losses to the Company. The amounts reported as "Insurance premiums earned" are net of related ceded reinsurance premiums of $46 million, $36 million and $39 million for the years ended December 31, 1993, 1992 and 1991, respectively. Amounts reported as "Insurance losses and adjustment expenses" are net of related reinsurance loss and loss adjustment expenses of $38 million, $35 million and $33 million for the years ended December 31, 1993, 1992 and 1991, respectively. Included in "Accounts payable, accrued expenses and other" are net unearned insurance premiums and net reserves for insurance losses and adjustment expenses as follows: Note 8 - Income Taxes Chrysler Financial Corporation and its U.S. subsidiaries are included in Chrysler's consolidated U.S. income tax returns. The Company's provision for income taxes is determined on a separate return basis. Under the Tax Sharing Agreement between the Company and Chrysler, U.S. income taxes have been settled substantially without regard to alternative minimum tax or limitations on utilization of net operating losses and foreign tax credits. Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." This Statement mandates use of the liability method of accounting for deferred income taxes. The principal difference between the liability method and the method previously used is that under the liability method deferred tax assets and liabilities are adjusted to reflect changes in statutory tax rates, as income adjustments, in the period such changes are enacted. At January 1, 1992, the adjustment of deferred tax assets and liabilities resulted in a favorable cumulative effect of the change in accounting principle of $51 million. Income taxes paid (recovered) by the Company for the years ended December 31, 1993, 1992 and 1991 amounted to $82 million, $172 million and $(55) million, respectively. Included in these amounts are taxes paid (recovered) from Chrysler under the Tax Sharing Agreement of $66 million, $130 million and $(83) million, in 1993, 1992 and 1991, respectively. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 8 - Income Taxes - continued The provision for income taxes in the consolidated statement of net earnings includes the following: The provision for income taxes differs from the amount of income tax determined by applying the U.S. statutory income tax rate to earnings before income taxes and cumulative effect of changes in accounting principles, as follows: The tax effected temporary differences which comprise deferred tax assets and liabilities were as follows: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 9 - Commitments and Contingent Liabilities Various legal actions are pending against Chrysler Financial Corporation and certain of its subsidiaries, some of which seek damages in large or unspecified amounts and other relief. The Company believes each proceeding constitutes routine litigation encountered in the normal course of business. Although the amount of liability at December 31, 1993 with respect to such matters cannot be determined, the Company believes the ultimate resolution of these matters will not have a material adverse effect on the Company's consolidated financial position. The Company believes that it has established reserves in an amount sufficient to cover any losses that may arise as a result of this litigation. The Company is obligated under terms of noncancelable operating leases for the majority of its office facilities and equipment, as well as for a number of dealership facilities which are subleased to Chrysler-authorized automotive dealers. These leases are generally renewable and provide that certain expenses related to the properties are to be paid by the lessee. Future minimum lease commitments under the aforementioned leases with remaining terms in excess of one year are as follows: Future minimum lease commitments have not been reduced by minimum sublease rentals of $210 million due in the future under noncancelable subleases. Rental expense for operating leases for the years ended December 31, 1993, 1992 and 1991 was $58 million, $69 million and $74 million, respectively. Sublease rentals of $42 million were received in 1993, 1992 and 1991. Chrysler currently has an unfunded pension obligation. In the event that termination liabilities with respect to Chrysler's pension plans are incurred, such liabilities would be the joint and several responsibilities of Chrysler and certain of its affiliated entities, including the Company and its subsidiaries. In the judgment of Chrysler's management, the possibility is remote that termination liabilities with respect to Chrysler's pension plans will be incurred in the foreseeable future. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 10 - Shareholder's Investment Shareholder's Investment is summarized as follows: Note 11 - Transactions with Affiliates Since 1968, the Company has had an Income Maintenance Agreement with Chrysler. The agreement provides for payments to maintain the Company's required coverage of earnings available for fixed charges at 110 percent. No payments were required pursuant to the Income Maintenance Agreement for 1993, 1992 or 1991. Gains and losses from translating assets and liabilities outside the United States to United States dollar equivalents are credited or charged to Chrysler in accordance with an agreement indemnifying the Company against losses incurred as a result of foreign risks. Pursuant to this agreement Chrysler was charged $10 million in 1993, $20 million in 1992 and was not charged in 1991. During 1993, the Company had short-term borrowings aggregating $500 million from Chrysler. All of these borrowings, including $11 million of interest expense, were repaid during the year. Certain business arrangements exist providing for guarantees from Chrysler to the Company. Pursuant to these arrangements the Company received $8 million, $56 million and $59 million in 1993, 1992 and 1991, respectively. Pursuant to an agreement between Chrysler and Chrysler Realty, the Company received fees of $25 million in 1993, and $28 million in 1992 and 1991. The fees include charges for administrative services rendered in the management of dealership land and facilities, reimbursement of holding costs on vacant facilities, reimbursement of charges by the Company to dealer tenants for rent in amounts less than the Company pays as rent on certain leased facilities and for rent in amounts less than current market rent on certain owned facilities. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 11 - Transactions with Affiliates - continued The Company provides financing related to programs sponsored by Chrysler for the sale and lease of Chrysler vehicles. Under these programs, interest rate differentials received from Chrysler are earned on a level yield basis over the term of the receivables, or if the related receivables are sold, unearned amounts are included in the calculation of gains or losses from the sale of retail receivables. In addition, the Company provides secured financing to Chrysler in the normal course of business. At December 31, 1993, $1,866 million was outstanding under these agreements. Note 12 - Employee Benefit Plans The Company's retirement programs include pension plans providing noncontributory benefits and contributory benefits. The noncontributory pension plans cover substantially all employees of Chrysler Financial Corporation and certain of its consolidated subsidiaries. Chrysler Financial Corporation and certain of its consolidated subsidiaries provide benefits based on a fixed rate for each year of service. Additionally, contributory benefits and supplemental noncontributory benefits are provided to substantially all salaried employees of Chrysler Financial Corporation and certain of its consolidated subsidiaries under the Salaried Employees' Retirement Plan. This plan provides contributory benefits based on the employee's cumulative contributions and a supplemental noncontributory benefit based on years of service and the employee's average salary during the consecutive five years in which salary was highest in the fifteen years preceding retirement. Annual payments to the pension trust fund for U.S. plans are in compliance with the Employee Retirement Income Security Act ("ERISA") of 1974, as amended. All pension trust fund assets and income accruing thereon are used solely to administer the plan and pay pension benefits. Plan assets are invested in a diversified portfolio that primarily consists of equity and debt securities. Plan assets at December 31, 1993 include 230,437 shares of Chrysler common stock. Net pension cost was $7 million for 1993, and was $8 million for 1992 and 1991. The Company provides health and life insurance benefits to substantially all of its U.S. and Canadian employees. Upon retirement from the Company, employees may become eligible for continuation of these benefits. However, benefits and eligibility rules may be modified periodically. Prior to 1993, the expense recognized for these benefits was based primarily on cash expenditures for the period. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," ("OPEB") which requires the accrual of such benefits during the years the employees provide services. The adoption of SFAS No. 106 resulted in an after-tax charge of $29 million in 1993. This one-time charge represented the immediate recognition of the OPEB transition obligation of $45 million, partially offset by $16 million of estimated tax benefits. The OPEB transition obligation is the aggregate amount that would have been accrued in the years prior to the adoption of SFAS No. 106 had this standard been in effect for those years. Implementation of SFAS No. 106 did not increase the Company's cash expenditures for postretirement benefits. Recognition of on-going expenses under OPEB will not materially affect the Company's results of operations. Effective January 1, 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This statement requires the accrual of benefits provided to former or inactive employees after employment but prior to retirement. Prior to 1993, the Company accrued for certain of these benefits at the time an employee's active service ended or expensed the benefit on the basis of cash expenditures. Adoption of this accounting standard resulted in the recognition of an after-tax charge of $1 million for the cumulative effect of this change in accounting principle. Adoption of SFAS No. 112 is not expected to materially increase annual expense recognized for these benefits, and there will be no cash impact. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 13 - Financial Instruments The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments". The estimated fair value amounts have been determined by the Company, using available market information and valuation methodologies as described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts. The carrying amounts and estimated fair values of the Company's financial instruments were as follows: The carrying value of cash and cash equivalents and accounts payable approximates market value due to the short maturity of these instruments. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 13 - Financial Instruments - continued The methods and assumptions used to estimate the fair value of financial instruments (excluding those financial instruments held for sale at December 31, 1992) are summarized as follows: Marketable Securities and Investments The fair value of marketable securities was estimated using quoted market prices. Finance Receivables - net The carrying value of variable rate finance receivables was assumed to approximate fair value since they are priced at current market rates. The fair value of fixed rate finance receivables was estimated by discounting expected cash flows using rates at which loans of similar maturities would be made as of December 31, 1993 and 1992, respectively. Retained Interests in Sold Receivables and Other Related Amounts - Net The fair values of excess servicing cash flows and other subordinated amounts due the Company arising from receivable sale transactions were estimated by discounting expected cash flows. Total Debt The fair value of public debt was estimated using quoted market prices. The fair value of other long-term debt was estimated by discounting cash flows. Interest Rate Swaps and Interest Rate Caps The fair value of the Company's existing interest rate swaps and interest rate caps was estimated by discounting net cash flows using quoted market interest rates. Foreign Currency Swap Agreements The estimated fair value of the Company's existing foreign currency swap agreements was derived by discounting expected cash flows using market exchange rates and relative market interest rates over the remaining term of the swap. The fair value estimates presented herein are based on pertinent information available as of the date of the consolidated balance sheet. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been revalued since the date of the consolidated balance sheet and, therefore, current estimates of fair value may differ significantly from the amounts presented herein. Note 14 - Revenues, Earnings and Assets by Business Segment and Geographical Area The Company provides financing and insurance products and services through the following major operating subsidiaries: Chrysler Credit Corporation - automotive retail, wholesale and fleet financing; Chrysler Capital Corporation - servicing commercial loans and leases; Chrysler First, Inc. - secured small business financing; Chrysler Insurance Company - property, casualty and other insurance; Chrysler Realty Corporation - automotive dealership facility development and management. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 14 - Revenues, Earnings and Assets by Business Segment and Geographical Area - continued Revenues, earnings and assets of finance and insurance operations are as follows: Revenues, earnings and assets by geographical area are as follows: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Note 15 - Selected Quarterly Financial Data - Unaudited Selected quarterly financial data for the years ended December 31, 1993 and 1992 are as follows: ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - continued Responsibility for Financial Reporting The Company's management is responsible for preparing the financial statements and other financial information in this Annual Report. This responsibility includes maintaining the integrity and objectivity of financial data and the presentation of the Company's results of operations and financial position in accordance with generally accepted accounting principles. The financial statements include amounts that are based on management's best estimates and judgments. The Company's financial statements have been audited by Deloitte & Touche, independent auditors. Their audits were conducted in accordance with generally accepted auditing standards and included consideration of the internal control system and tests of transactions as part of planning and performing their audits. The Company maintains a system of internal controls throughout its operations that provides reasonable assurance that its records reflect its transactions in all material respects and that significant misuse or loss of assets will be prevented. Management believes the Company's system of internal controls is adequate to accomplish these objectives on a continuous basis. The Company maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements. Management has considered the internal auditors' and Deloitte & Touche's recommendations concerning the Company's system of internal controls and has taken appropriate actions to respond to these recommendations. The Board of Directors of Chrysler Corporation, acting through its Audit Committee composed solely of nonemployee directors, is responsible for determining that management fulfills its responsibilities in the preparation of financial statements and the maintenance of internal controls. In fulfilling its responsibility, the Audit Committee recommends independent auditors to the Board of Directors for appointment by the shareholders of Chrysler Corporation. The Audit Committee also reviews the Company's consolidated financial statements and adequacy of internal controls. The Audit Committee meets regularly with management, the internal auditors and the independent auditors. Both the independent auditors and the internal auditors have full and free access to the Audit Committee, without management representatives present, to discuss the results of their audits and their views on the adequacy of internal controls and the quality of financial reporting. It is the business philosophy of the Company to obey the law and to require that its employees conduct their activities according to the highest standards of business ethics. This responsibility is characterized and reflected in various policies of the Company. A systematic program is maintained to assess compliance with these policies. /s/ John P. Tierney /s/ Timothy P. Dykstra John P. Tierney Timothy P. Dykstra Chairman of the Board Vice President and Controller INDEPENDENT AUDITORS' REPORT Shareholder and Board of Directors Chrysler Financial Corporation Southfield, Michigan We have audited the accompanying consolidated balance sheet of Chrysler Financial Corporation (a subsidiary of Chrysler Corporation) and consolidated subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of net earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Chrysler Financial Corporation and consolidated subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in the notes to the consolidated financial statements, the Company has adopted recently issued Statements of Financial Accounting Standards and, accordingly, changed its methods of accounting for postretirement benefits other than pensions and postemployment benefits in 1993, and its method of accounting for income taxes in 1992. /s/ DELOITTE & TOUCHE Detroit, Michigan January 18, 1994 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There is nothing to report with regard to this Item. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (Omitted in accordance with General Instruction J.) ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION (Omitted in accordance with General Instruction J.) ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Omitted in accordance with General Instruction J.) ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Omitted in accordance with General Instruction J.) PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: 1. Financial Statements Financial statements filed as part of this Form 10-K are listed under Part II, Item 8 of this Form 10-K. 2. Financial Statement Schedules Independent Auditors' Report on Schedules (page 57 of Form 10-K) Schedule VIII - Valuation and qualifying accounts and reserves (page 58 of Form 10-K) Schedule IX - Short-term borrowings (page 59 of Form 10-K) ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued Notes: (A) Separate Company financial statements of Chrysler Financial Corporation for the years ended December 31, 1992, 1991 and 1990 are omitted as not required under instructions contained in Regulation S-X. (B) Schedules other than those listed above have been omitted as not required under instructions contained in Regulation S-X or inapplicable. 3. Exhibits 3-A Copy of the Restated Articles of Incorporation of Chrysler Financial Corporation as adopted and filed with the Corporation Division of the Michigan Department of Treasury on October 1, 1971. Filed as Exhibit 3-A to Registration No. 2-43097 of Chrysler Financial Corporation, and incorporated herein by reference. 3-B Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on December 26, 1975, April 23, 1985 and June 21, 1985, respectively. Filed as Exhibit 3-B to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1985, and incorporated herein by reference. 3-C Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on August 12, 1987 and August 14, 1987, respectively. Filed as Exhibit 3 to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1987, and incorporated herein by reference. 3-D Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on December 11, 1987 and January 25, 1988, respectively. Filed as Exhibit 3-D to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 3-E Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on June 13, 1989 and June 23, 1989, respectively. Filed as Exhibit 3-E to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1989, and incorporated herein by reference. 3-F Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on September 13, 1989, January 31, 1990 and March 8, 1990, respectively. Filed as Exhibit 3-E to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 3-G Copy of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on March 29, 1990 and May 10, 1990. Filed as Exhibit 3-G to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended March 31, 1990, and incorporated herein by reference. 3-H Copy of the By-Laws of Chrysler Financial Corporation as amended to March 2, 1987. Filed as Exhibit 3-C to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1986, and incorporated herein by reference. 3-I Copy of the By-Laws of Chrysler Financial Corporation as amended to August 1, 1990. Filed as Exhibit 3-I to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 3-J Copy of By-Laws of Chrysler Financial Corporation as amended to January 1, 1992, and presently in effect. Filed as Exhibit 3-H to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 4-A Copy of Indenture, dated as of June 1, 1985, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-A to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. 4-B Copy of First Supplemental Indenture, dated as of June 1, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of June 1, 1985, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-B to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-C Copy of Indenture, dated as of July 15, 1985, between Chrysler Financial Corporation and Bankers Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities, J. Henry Schroder Bank & Trust Company having subsequently succeeded Banker's Trust Company as Trustee. Filed as Exhibit 4-C to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. 4-D Copy of Indenture, dated as of June 1, 1985, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-B to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 4-E Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-E to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-F Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and J. Henry Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-F to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-G Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-G to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-H Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-H to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-I Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-I to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-J Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-J to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-K Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-A to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 4-L Copy of First Supplemental Indenture, dated as of March 1, 1988, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-L to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 4-M Copy of Second Supplemental Indenture, dated as of September 7, 1990, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-M to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 4-N Copy of Third Supplemental Indenture, dated as of May 4, 1992, between Chrysler Financial Corporation and United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988 between such parties, relating to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-N to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1992, and incorporated herein by reference. 4-O Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-B to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-P Copy of First Supplemental Indenture, dated as of September 1, 1989, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed on September 13, 1989 as Exhibit 4-N to the Current Report of Chrysler Financial Corporation on Form 8-K dated September 1, 1989, and incorporated herein by reference. 4-Q Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-C to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-R Copy of First Supplemental Indenture, dated as of September 1, 1989, between Chrysler Financial Corporation and Irving Trust Company, Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed on September 13, 1989 as Exhibit 4-O to the Current Report of Chrysler Financial Corporation on Form 8-K dated September 1, 1989, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-A Copy of Income Maintenance Agreement, made December 20, 1968, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation. Filed as Exhibit 13-D to Registration Statement No. 2-32037 of Chrysler Financial Corporation, and incorporated herein by reference. 10-B Copy of Agreement, made April 19, 1971, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation, amending the Income Maintenance Agreement among such parties. Filed as Exhibit 13-B to Registration Statement No. 2-40110 of Chrysler Financial Corporation and Chrysler Corporation, and incorporated herein by reference. 10-C Copy of Agreement, made May 29, 1973, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation, further amending the Income Maintenance Agreement among such parties. Filed as Exhibit 5-C to Registration Statement No. 2-49615 of Chrysler Financial Corporation, and incorporated herein by reference. 10-D Copy of Agreement, made as of July 1, 1975, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation, further amending the Income Maintenance Agreement among such parties. Filed as Exhibit D to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1975, and incorporated herein by reference. 10-E Copy of Agreement, made June 4, 1976, between Chrysler Financial Corporation and Chrysler Corporation further amending the Income Maintenance Agreement between such parties. Filed as Exhibit 5-H to Registration Statement No. 2-56398 of Chrysler Financial Corporation, and incorporated herein by reference. 10-F Copy of Agreement, made March 27, 1986, between Chrysler Financial Corporation, Chrysler Holding Corporation (now known as Chrysler Corporation) and Chrysler Corporation (now known as Chrysler Motors Corporation) further amending the Income Maintenance Agreement among such parties. Filed as Exhibit 10-F to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1986, and incorporated herein by reference. 10-G Copy of Amended and Restated Revolving Term Credit Facility, dated as of January 17, 1993, among Chrysler Credit Canada Ltd., as the Borrower, Chrysler Financial Corporation, as the Guarantor, the several financial institutions parties thereto and Royal Bank of Canada, as Agent Bank. Filed as Exhibit 10-G to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-H Copy of Standby Receivables Purchase Agreement, dated as of January 17, 1993, among Chrysler Credit Canada, Ltd., Chrysler Financial Corporation, Royal Bank of Canada and the several other financial institutions parties thereto. Filed as Exhibit 10-H to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-I Copy of Retail Purchase and Servicing Agreement dated as of January 17, 1993 among Royal Bank of Canada, Chrysler Credit Canada Ltd., Chrysler Financial Corporation and the several other financial institutions parties thereto. Filed as Exhibit 10-I to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-J Copy of Bank Series Supplement, dated as of January 17, 1993, among Chrysler Credit Canada Ltd., Royal Bank of Canada, the several bank parties thereto and The Royal Trust Company, to the Master Custodial and Servicing Agreement, dated as of September 1, 1992. Filed as Exhibit 10-J to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-K Copy of Amendment dated as of December 1, 1992, to the Series 1992-1 Supplement dated as of February 1, 1992 among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-DDDD to the Annual Report of Chrysler Financial on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-L Copy of Series 1992-1 Supplement, dated as of February 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-YYYY to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-M Copy of Series 1992-2 Supplement, dated as of December 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Bank (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-FFFF to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-N Copy of Pooling and Servicing Agreement, dated as of January 1, 1992, among Chrysler Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and LaSalle National Bank, as Trustee, with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-QQQQ to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-O Copy of Standard Terms and Conditions of Agreement, dated as of January 1, 1992, between Chrysler Auto Receivables Company, as Seller, and Chrysler Credit Corporation, as Servicer, with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-RRRR to the Annual Report of Chrysler Financial Corporation on From 10-K for the year ended December 31, 1991, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-P Copy of Purchase Agreement, dated as of January 1, 1992, between Chrysler Financial Corporation and Chrysler Auto Receivables Company with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-SSSS to the Annual Report of Chrysler Financial Corporation on From 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-Q Copy of Sale and Servicing Agreement, dated as of January 1, 1992, among Premier Auto Trust 1992-1, as Issuer, U.S. Auto Receivables Company, as Seller, and Chrysler Credit Corporation, as Servicer, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-QQQQ to the Registration Statement of Chrysler Financial Corporation, on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-R Copy of Trust Agreement, dated as of January 1, 1992, between U.S. Auto Receivables Company and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-RRRR to the Registration Statement of Chrysler Financial Corporation on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-S Copy of Purchase Agreement, dated as of January 1, 1992, between Chrysler Financial Corporation, as Seller, and U.S. Auto Receivables Company, as Purchaser, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-SSSS to the Registration Statement of Chrysler Financial Corporation on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-T Copy of Pooling and Servicing Agreement, dated as of January 1, 1992, among Chrysler Financial Corporation, as Master Servicer, Chrysler First Business Credit Corporation, as Seller, and Security Pacific National Bank, as Trustee, with respect to U.S. Business Equity Loan Trust 1992-1. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of U.S. Business Equity Loan Trust 1992-1 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-U Copy of Series B Supplement, dated as of March 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-H to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended March 31, 1992, and incorporated herein by reference. 10-V Copy of Series C Supplement, dated as of May 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-J to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended June 30, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-W Copy of Series 1992-1 Supplement, dated as of February 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 10-YYYY to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-X Copy Indenture, dated as of March 1, 1992, between Premier Auto Trust 1992-2 and Bankers Trust Company, with respect to Premier Auto Trust 1992-2 Asset Backed Notes. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-Y Copy of a 6-3/8% Asset Backed Note with respect to Premier Auto Trust 1992-2 Asset Backed Notes. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-Z Copy Trust Agreement, dated as of March 1, 1992, between U.S. Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-2 Asset Backed Certificates. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-AA Copy Pooling and Servicing Agreement, dated as of March 1, 1992 among Chrysler Financial Corporation, as Master Servicer, Financial Acceptance Corporation, as Seller, and The First National Bank of Chicago, as Trustee, with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-BB Copy Standard Terms and Conditions of Agreement, dated as of March 1, 1992, among Chrysler Financial Corporation, as Master Servicer, Financial Acceptance Corporation, as Seller, and The First National Bank of Chicago, as Trustee, with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-CC Copy Purchase Agreement, dated as of March 1, 1992, between Chrysler First Inc. and Financial Acceptance Corporation with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-DD Copy of Indenture, dated as of May 1, 1992, between Premier Auto Trust 1992-3 and Bankers Trust Company with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-N to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-EE Copy of a 5.90% Asset Backed Note with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-FF Copy of Trust Agreement, dated as of April 1, 1992, as amended and restated as of May 1, 1992, between Premier Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-GG Copy of Receivables Purchase Agreement, dated as of April 15, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc. with respect to Canadian Auto Receivables Securitization 1992-1. Filed as Exhibit 10-IIIII to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-HH Copy of Combined and Restated Revolving Credit Agreement, dated as of July 29, 1992, among Chrysler Financial Corporation, as Borrower, Chemical Bank, as Agent and Arranger, and Swiss Bank Corporation, New York Branch, as Managing Co-Agent and Co-Arranger including as Exhibit G thereto forms of the Trust Agreement and related security documents executed and delivered concurrently therewith. Filed as Exhibit 10-A to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed August 19, 1992, and incorporated herein by reference. 10-II Copy of Second Amended and Restated Commitment Transfer Agreement, dated as of July 29, 1992, between Chrysler Financial Corporation, as Borrower, and Chemical Bank, as Agent. Filed as Exhibit 10-B to the Current Report on Form 8-K of Chrysler Financial Corporation, dated August 17, 1992 and filed August 19, 1992 and incorporated herein by reference. 10-JJ Copy of Amended and Restated Standby Receivables Purchase Agreement, dated as of September 15, 1993, among Chrysler Financial Corporation, Chrysler Credit Corporation, U.S. Auto Receivables Company, American Auto Receivables Company, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-YY to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-KK Copy of Participation and Servicing Agreement, dated as of July 29, 1992, among American Auto Receivables Company, Chrysler Credit Corporation, the Purchasers named therein, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent, with respect to the Standby Receivable Purchase Agreement. Filed as Exhibit 10-D to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed August 19, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-LL Copy of Bank Supplement, dated as of July 29, 1992, to the Pooling and Servicing Agreement, dated as of May 31, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to the Standby Receivables Purchase Agreement. Filed as Exhibit 10-E to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed on August 19, 1992, and incorporated herein by reference. 10-MM Copy of Short Term Standby Receivables Purchase Agreement, dated as of September 15, 1993, among Chrysler Financial Corporation, Chrysler Credit Corporation, U.S. Auto Receivables Company, American Auto Receivables Company, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-BBB to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-NN Copy of Participation and Servicing Agreement, dated as of September 15, 1993, among American Auto Receivables Company, Chrysler Credit Corporation, the Purchasers named therein, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-CCC to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-OO Copy of Short Term Bank Supplement, dated as of September 15, 1993, to the Pooling and Servicing Agreement, dated as of May 31, 1991, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to Short Term Standby Receivables Purchase Agreement. Filed as Exhibit 10-DDD to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-PP Copy of Receivables Purchase Agreement, dated as of August 18, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc. with respect to Canadian Auto Receivables Securitization 1992-2. Filed as Exhibit 10-OOOOO to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-QQ Copy of Indenture, dated as of September 1, 1992, between Premier Auto Trust 1992-5 and Bankers Trust Company with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-RR Copy of a 4.55% Asset Backed Note with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-SS Copy of Trust Agreement, dated as of September 1, 1992, between Premier Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-TT Copy of Series 1992-2 Supplement to the Pooling and Servicing Agreement, dated as of October 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust, Series 1992-2. Filed as Exhibit 3 to Form 8-A of Carco Auto Loan Master Trust on October 30, 1992, and incorporated herein by reference. 10-UU Copy of Master Custodial and Servicing Agreement, dated as of September 1, 1992 between Chrysler Credit Canada Ltd. and The Royal Trust Company, as Custodian. Filed as Exhibit 10-TTTTT to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-VV Copy of Trust Indenture, dated as of September 1, 1992, among Canadian Dealer Receivables Corporation and Montreal Trust Company of Canada, as Trustee. Filed as Exhibit 10-UUUUU to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-WW Copy of Loan Asset Purchase Agreement by and between NationsBank of Texas, N.A. and Chrysler First Inc., and the Subsidiaries of Chrysler First Inc. named therein, dated as of November 17, 1992, with respect to the sale of certain loan assets of Chrysler First Inc. and its subsidiaries. Filed as Exhibit 10-VVVVV to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-XX Copy of Business Asset Purchase Agreement by and among NationsBanc Financial Services Corporation and the Purchasers named therein and Chrysler First Inc. and the Sellers named therein, dated as of November 17, 1992, with respect to the sale of certain business assets of Chrysler First Inc. and its subsidiaries. Filed as Exhibit 10-WWWWW to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-YY Copy of Securitization Closing Agreement, dated as of February 1, 1993, among Chrysler Financial Corporation, certain Sellers, certain Purchasers, and certain Purchaser Parties. Filed as Exhibit 2-E to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-ZZ Copy of First Amendment to Loan Asset Purchase Agreement, dated December 30, 1992, among NationsBank of Texas, N.A. and Chrysler Financial Corporation, for and on behalf of Chrysler First Inc. and the Asset Sellers parties thereto. Filed as Exhibit 2-B to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-AAA Copy of First Amendment to Business Asset Purchase Agreement dated as of January 29, 1993 among NationsBank Financial Services Corporation, the other Purchasers parties thereto and the Sellers parties thereto and Chrysler Financial Corporation. Filed as Exhibit 2-D to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-BBB Copy of Asset Purchase Agreement, dated as of May 15, 1992, between Chrysler Capital Public Finance Corporation and Koch Financial Corporation. Filed as Exhibit 10-DDDDDD to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-CCC Copy of Asset Purchase Agreement, dated as of June 1, 1992, among General Electric Capital Corporation, Chrysler Financial Corporation, Chrysler Capital Corporation, Chrysler Asset Management Corporation and Chrysler Credit Corporation. Filed as Exhibit 10-EEEEEE to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-DDD Copy of Purchase Agreement, dated as of August 1, 1992, among General Electric Capital Corporation, Chrysler Financial Corporation, Chrysler Capital Corporation and Chrysler Asset Management Corporation. Filed as Exhibit 10-FFFFFF of the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-EEE Copy of Asset Purchase Agreement, dated as of September 30, 1992, between Chrysler Rail Transportation Corporation and United States Rail Services, a division of United States Leasing International, Inc. Filed as Exhibit 10-GGGGGG to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-FFF Copy of Asset Purchase Agreement, dated as of December 18, 1992, among Chrysler Rail Transportation Corporation, Greenbrier Transportation Limited Partnership and Greenbrier Capital Corporation. Filed as Exhibit 10-HHHHHH to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-GGG Copy of Asset Purchase Agreement, dated as of February 1, 1993, among Chrysler Rail Transportation Corporation, Chrysler Capital Transportation Services, Inc. and United States Rail Services, a division of United States Leasing International, Inc. Filed as Exhibit 10-IIIIII to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-HHH Copy of Asset Purchase Agreement between Chrysler Leaserve, Inc. (a subsidiary of General Electric Capital Auto Lease, Inc.), Chrysler Financial Corporation and Chrysler Credit Corporation, dated as of October 20, 1992, with respect to the sale of Gold Key Leases. Filed as Exhibit 10-XXXXX to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-III Copy of Servicing Agreement, dated as of October 20, 1992, between Chrysler Leaserve, Inc. (a subsidiary of General Electric Capital Auto Lease, Inc.) and Chrysler Credit Corporation, with respect to the sale of Gold Key Leases. Filed as Exhibit 10-YYYYY to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-JJJ Copy of First Amendment dated as of August 24, 1992 to the Series 1991-1 Supplement dated as of May 31, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master Trust. Filed as Exhibit 4-M to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-KKK Copy of Second Amendment dated as of August 24, 1992 to the Series 1991-2 Supplement dated as of June 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master Trust. Filed as Exhibit 4-N to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-LLL Copy of Second Amendment dated as of August 24, 1992 to the Series 1991-3 Supplement dated as of June 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master Trust. Filed as Exhibit 4-O to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-MMM Copy of First Amendment dated as of August 24, 1992 to the Series 1991-4 Supplement dated as of September 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master trust. Filed as Exhibit 4-P to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-NNN Copy of Sale and Servicing Agreement, dated as of November 1, 1992, among Premier Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Premier Auto Trust 1992-6, as Purchaser, with respect to Premier Auto Trust 1992-6. Filed as Exhibit 10-PPPPPP to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-OOO Copy of Trust Agreement, dated as of November 1, 1992, among ML Asset Backed Corporation, Premier Auto Receivables Company and Chemical Bank Delaware as Owner Trustee, with respect to Premier Auto Trust 1992-6. Filed as Exhibit 10-QQQQQQ to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-PPP Copy of Sale and Servicing Agreement, dated as of January 1, 1993, among Premier Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Premier Auto Trust 1993-1, as Purchaser, with respect to Premier Auto Trust 1993-1. Filed as Exhibit 10-RRRRRR to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-QQQ Copy of Trust Agreement, dated as of January 1, 1993, among ML Asset Backed Corporation, Premier Auto Receivables Company and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-1. Filed as Exhibit 10-SSSSSS to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-RRR Copy of Receivables Purchase Agreement, dated as of November 25, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisitions Inc. with respect to Canadian Auto Receivables Securitization 1992-3. Filed as Exhibit 10-TTTTTT to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-SSS Copy of Purchase Agreement, dated as of January 25, 1993, among Chrysler Credit Canada Ltd., Chrysler Canada Ltd., Auto 1 Limited Partnership and Chrysler Financial Corporation, with respect to Auto 1 Trust. Filed as Exhibit 10-UUUUUU to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-TTT Copy of Master Lease Agreement, dated as of January 25, 1993, among Chrysler Credit Canada Ltd., Chrysler Canada Ltd. and Auto 1 Limited Partnership, with respect to Auto 1 Trust. Filed as Exhibit 10-VVVVVV to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-UUU Copy of Amended and Restated Trust Agreement, dated as of April 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-2. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-2 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-VVV Copy of Indenture, dated as of April 1, 1993, between Premier Auto Trust 1993-2 and Bankers Trust Company, as Indenture Trustee, with respect to Premier Auto Trust 1993-2. Filed as Exhibit 4.2 of the Quarterly Report of Premier Auto Trust 1993-2 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-WWW Copy of Amended and Restated Trust Agreement, dated as of June 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-3. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-3 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-XXX Copy of Indenture, dated as of June 1, 1993, between Premier Auto Trust 1993-3 and Bankers Trust Company, as Indenture Trustee. Filed as Exhibit 4.2 to the Quarterly Report of Premier Auto Trust 1993-3 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-YYY Copy of Series 1993-1 Supplement, dated as of February 1, 1993, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 3 to the Registration Statement on Form 8-A of CARCO Auto Loan Master Trust dated March 15, 1993, and incorporated herein by reference. 10-ZZZ Copy of Receivables Purchase Agreement, made as of April 7, 1993, among Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Association Assets Acquisition Inc., with respect to CARS 1993-1. Filed as Exhibit 10-OOOO to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-AAAA Copy of Receivables Purchase Agreement, made as of June 29, 1993, among Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc., with respect to CARS 1993-2. Filed as Exhibit 10-PPPP to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-BBBB Copy of Pooling and Servicing Agreement, dated as of August 1, 1993, among Auto Receivables Corporation, Chrysler Credit Canada Ltd., Montreal Trust Company of Canada and Chrysler Financial Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-QQQQ to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-CCCC Copy of Standard Terms and Conditions of Agreement, dated as of August 1, 1993, among Auto Receivables Corporation, Chrysler Credit Canada Ltd. and Chrysler Financial Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-RRRR to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-DDDD Copy of Purchase Agreement, dated as of August 1, 1993, between Chrysler Credit Canada Ltd., and Auto Receivables Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-SSSS to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-EEEE Copy of Lease Receivables Purchase Agreement, dated as of December 23, 1992, among Chrysler Systems Leasing Inc., Chrysler Financial Corporation and Sanwa Business Credit Corporation. Filed as Exhibit 10-TTTT to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-FFFF Copy of Lease Receivables Purchase Agreement, dated September 3, 1993, among CXC Incorporated, Chrysler Systems Inc., and Chrysler Financial Corporation. Filed as Exhibit 10-UUUU to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-GGGG Copy of Lease Receivables Purchase Agreement, dated September 22, 1993, among the CIT Group/Equipment Financing, Inc., Chrysler Systems Inc., and Chrysler Financial Corporation. Filed as Exhibit 10-VVVV to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-HHHH Copy of Asset Purchase Agreement, dated as of July 31, 1993, between Chrysler Rail Transportation Corporation and General Electric Railcar Leasing Services Corporation. Filed as Exhibit 10-WWWW to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-IIII Copy of Amended and Restated Loan Agreement, dated as of June 1, 1993, between Chrysler Realty Corporation and Chrysler Credit Corporation. Filed as Exhibit 10-XXXX to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 10-JJJJ Copy of Loan Agreement, dated as of March 31, 1993, between Manatee Leasing, Inc. and Chrysler Credit Corporation. Filed as Exhibit 10-YYYY to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-KKKK Copy of Origination and Servicing Agreement, dated as of June 4, 1993, among Chrysler Leaserve, Inc., General Electric Capital Auto Lease, Inc., Chrysler Credit Corporation and Chrysler Financial Corporation. Filed as Exhibit 10-ZZZZ to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-LLLL Copy of Amended and Restated Trust Agreement, dated as of September 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical Bank Delaware, as Trustee, with respect to Premier Auto Trust 1993-5. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-5 on Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference. 10-MMMM Copy of Indenture, dated as of September 1, 1993, between Premier Auto Trust 1993-5 and Bankers Trust Company, as Indenture Trustee, with respect to Premier Auto Trust 1993-5. Filed as Exhibit 4.2 to the Quarterly Report of Premier Auto Trust 1993-5 on From 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference. 10-NNNN Copy of Asset Purchase Agreement, dated as of October 29, 1993, between Marine Asset Management Corporation and Trico Marine Assets, Inc.. Filed as Exhibit 10-CCCCC to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-OOOO Copy of Asset Purchase Agreement, dated as of December 3, 1993, between Chrysler Rail Transportation Corporation and Allied Railcar Company. 10-PPPP Copy of Secured Loan Purchase Agreement, dated as of December 15, 1993, among Chrysler Credit Canada Ltd., Leaf Trust and Chrysler Financial Corporation. 10-QQQQ Copy of Series 1993-2 Supplement, dated as of November 1, 1993, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers Traders and Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 3 to the Registration Statement on Form 8-A of CARCO Auto Loan Master Trust dated December 6, 1993, and incorporated herein by reference. 12-A Chrysler Financial Corporation and Subsidiaries Computations of Ratios of Earnings to fixed Charges. 12-B Chrysler Corporation Enterprise as a Whole Computations of Ratios of Earnings to Fixed Charges. 23 Consent of Deloitte & Touche ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - continued 24 Powers of attorney pursuant to which the signatures of certain directors of Chrysler Financial Corporation have been affixed to this Annual Report on Form 10-K. Copies of instruments defining the rights of holders of long-term debt of the registrant and its consolidated subsidiaries, other than the instruments copies of which are filed with this report as Exhibit 4-A, 4-B, 4-C, 4-D, 4-E, 4-F, 4-G, 4-H, 4-I, 4-J, 4-K, 4-L, 4-M, 4-N, 4-O, 4-P, 4-Q, and 4-R thereto, have not been filed as exhibits to this report since the amount of securities authorized under any one of such instruments does not exceed 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. The registrant agrees to furnish to the Commission a copy of each such instrument upon request. (b) The registrant filed the following reports on Form 8-K during the quarter ended December 31, 1993. Date of Report Date Filed Item Reported -------------- ---------- ------------- October 14, 1993 October 14, 1993 5 November 22, 1993 November 22, 1993 5 Financial Statements Filed -------------------------- Copy of the unaudited financial statements for Chrysler Financial Corporation and subsidiaries for the quarter ended September 30, 1993, and the related Independent Accountant's Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CHRYSLER FINANCIAL CORPORATION By /s/ JOHN P. TIERNEY John P. Tierney Chairman of the Board Date: February 4, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Principal executive officer: /s/ JOHN P. TIERNEY Chairman of the Board February 4, 1994 John P. Tierney Principal financial officer: /s/ DENNIS M. CANTWELL Vice President - Corporate February 4, 1994 Dennis M. Cantwell Finance and Development Principal accounting officer: /s/ TIMOTHY P. DYKSTRA Vice President and Controller February 4, 1994 Timothy P. Dykstra SIGNATURES (CONTINUED) Board of Directors: /s/ WILLIAM S. BISHOP* Director February 4, 1994 William S. Bishop /s/ DENNIS M. CANTWELL* Director February 4, 1994 Dennis M. Cantwell /s/ THOMAS P. CAPO* Director February 4, 1994 Thomas P. Capo /s/ ROBERT J. EATON* Director February 4, 1994 Robert J. Eaton /s/ JEREMIAH E. FARRELL* Director February 4, 1994 Jeremiah E. Farrell /s/ ROBERT A. LUTZ* Director February 4, 1994 Robert A. Lutz /s/ WILLIAM J. O'BRIEN III* Director February 4, 1994 William J. O'Brien III /s/ JOHN P. TIERNEY* Director February 4, 1994 John P. Tierney /s/ GARY C. VALADE* Director February 4, 1994 Gary C. Valade *By /s/ ROBERT A. LINK Robert A. Link Attorney-in-Fact February 4, 1994 INDEPENDENT AUDITORS' REPORT ON SCHEDULES Shareholder and Board of Directors Chrysler Financial Corporation Southfield, Michigan We have audited the consolidated financial statements of Chrysler Financial Corporation (a subsidiary of Chrysler Corporation) and consolidated subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 18, 1994; such report is included elsewhere in this Form 10-K. Our audits also included the financial statement schedules of Chrysler Financial Corporation and consolidated subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche Detroit, Michigan January 18, 1994 EXHIBIT INDEX ------------- Exhibit Number Description of Exhibit - ------- ---------------------- 3-A Copy of the Restated Articles of Incorporation of Chrysler Financial Corporation as adopted and filed with the Corporation Division of the Michigan Department of Treasury on October 1, 1971. Filed as Exhibit 3-A to Registration No. 2-43097 of Chrysler Financial Corporation, and incorporated herein by reference. 3-B Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on December 26, 1975, April 23, 1985 and June 21, 1985, respectively. Filed as Exhibit 3-B to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1985, and incorporated herein by reference. 3-C Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on August 12, 1987 and August 14, 1987, respectively. Filed as Exhibit 3 to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1987, and incorporated herein by reference. 3-D Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on December 11, 1987 and January 25, 1988, respectively. Filed as Exhibit 3-D to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 3-E Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on June 13, 1989 and June 23, 1989, respectively. Filed as Exhibit 3-E to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1989, and incorporated herein by reference. 3-F Copies of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on September 13, 1989, January 31, 1990 and March 8, 1990, respectively. Filed as Exhibit 3-E to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference. 3-G Copy of amendments to the Restated Articles of Incorporation of Chrysler Financial Corporation filed with the Department of Commerce of the State of Michigan on March 29, 1990 and May 10, 1990. Filed as Exhibit 3-G to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended March 31, 1990, and incorporated herein by reference. 3-H Copy of the By-Laws of Chrysler Financial Corporation as amended to March 2, 1987. Filed as Exhibit 3-C to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1986, and incorporated herein by reference. 3-I Copy of the By-Laws of Chrysler Financial Corporation as amended to August 1, 1990. Filed as Exhibit 3-I to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 3-J Copy of By-Laws of Chrysler Financial Corporation as amended to January 1, 1992, and presently in effect. Filed as Exhibit 3-H to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 4-A Copy of Indenture, dated as of June 1, 1985, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-A to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. 4-B Copy of First Supplemental Indenture, dated as of June 1, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of June 1, 1985, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-B to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-C Copy of Indenture, dated as of July 15, 1985, between Chrysler Financial Corporation and Bankers Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities, J. Henry Schroder Bank & Trust Company having subsequently succeeded Banker's Trust Company as Trustee. Filed as Exhibit 4-C to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. 4-D Copy of Indenture, dated as of June 1, 1985, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-B to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. 4-E Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-E to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-F Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and J. Henry Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-F to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-G Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-G to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-H Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-H to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-I Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-I to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-J Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-J to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-K Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-A to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-L Copy of First Supplemental Indenture, dated as of March 1, 1988, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-L to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 4-M Copy of Second Supplemental Indenture, dated as of September 7, 1990, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-M to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 4-N Copy of Third Supplemental Indenture, dated as of May 4, 1992, between Chrysler Financial Corporation and United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988 between such parties, relating to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-N to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1992, and incorporated herein by reference. 4-O Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-B to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-P Copy of First Supplemental Indenture, dated as of September 1, 1989, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed on September 13, 1989 as Exhibit 4-N to the Current Report of Chrysler Financial Corporation on Form 8-K dated September 1, 1989, and incorporated herein by reference. 4-Q Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-C to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-R Copy of First Supplemental Indenture, dated as of September 1, 1989, between Chrysler Financial Corporation and Irving Trust Company, Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed on September 13, 1989 as Exhibit 4-O to the Current Report of Chrysler Financial Corporation on Form 8-K dated September 1, 1989, and incorporated herein by reference. 10-A Copy of Income Maintenance Agreement, made December 20, 1968, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation. Filed as Exhibit 13-D to Registration Statement No. 2-32037 of Chrysler Financial Corporation, and incorporated herein by reference. 10-B Copy of Agreement, made April 19, 1971, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation, amending the Income Maintenance Agreement among such parties. Filed as Exhibit 13-B to Registration Statement No. 2-40110 of Chrysler Financial Corporation and Chrysler Corporation, and incorporated herein by reference. 10-C Copy of Agreement, made May 29, 1973, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation, further amending the Income Maintenance Agreement among such parties. Filed as Exhibit 5-C to Registration Statement No. 2-49615 of Chrysler Financial Corporation, and incorporated herein by reference. 10-D Copy of Agreement, made as of July 1, 1975, among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation, further amending the Income Maintenance Agreement among such parties. Filed as Exhibit D to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1975, and incorporated herein by reference. 10-E Copy of Agreement, made June 4, 1976, between Chrysler Financial Corporation and Chrysler Corporation further amending the Income Maintenance Agreement between such parties. Filed as Exhibit 5-H to Registration Statement No. 2-56398 of Chrysler Financial Corporation, and incorporated herein by reference. 10-F Copy of Agreement, made March 27, 1986, between Chrysler Financial Corporation, Chrysler Holding Corporation (now known as Chrysler Corporation) and Chrysler Corporation (now known as Chrysler Motors Corporation) further amending the Income Maintenance Agreement among such parties. Filed as Exhibit 10-F to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1986, and incorporated herein by reference. 10-G Copy of Amended and Restated Revolving Term Credit Facility, dated as of January 17, 1993, among Chrysler Credit Canada Ltd., as the Borrower, Chrysler Financial Corporation, as the Guarantor, the several financial institutions parties thereto and Royal Bank of Canada, as Agent Bank. Filed as Exhibit 10-G to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-H Copy of Standby Receivables Purchase Agreement, dated as of January 17, 1993, among Chrysler Credit Canada, Ltd., Chrysler Financial Corporation, Royal Bank of Canada and the several other financial institutions parties thereto. Filed as Exhibit 10-H to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-I Copy of Retail Purchase and Servicing Agreement dated as of January 17, 1993 among Royal Bank of Canada, Chrysler Credit Canada Ltd., Chrysler Financial Corporation and the several other financial institutions parties thereto. Filed as Exhibit 10-I to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-J Copy of Bank Series Supplement, dated as of January 17, 1993, among Chrysler Credit Canada Ltd., Royal Bank of Canada, the several bank parties thereto and The Royal Trust Company, to the Master Custodial and Servicing Agreement, dated as of September 1, 1992. Filed as Exhibit 10-J to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-K Copy of Amendment dated as of December 1, 1992, to the Series 1992-1 Supplement dated as of February 1, 1992 among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-DDDD to the Annual Report of Chrysler Financial on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-L Copy of Series 1992-1 Supplement, dated as of February 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-YYYY to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-M Copy of Series 1992-2 Supplement, dated as of December 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Bank (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-FFFF to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-N Copy of Pooling and Servicing Agreement, dated as of January 1, 1992, among Chrysler Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and LaSalle National Bank, as Trustee, with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-QQQQ to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-O Copy of Standard Terms and Conditions of Agreement, dated as of January 1, 1992, between Chrysler Auto Receivables Company, as Seller, and Chrysler Credit Corporation, as Servicer, with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-RRRR to the Annual Report of Chrysler Financial Corporation on From 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-P Copy of Purchase Agreement, dated as of January 1, 1992, between Chrysler Financial Corporation and Chrysler Auto Receivables Company with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-SSSS to the Annual Report of Chrysler Financial Corporation on From 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-Q Copy of Sale and Servicing Agreement, dated as of January 1, 1992, among Premier Auto Trust 1992-1, as Issuer, U.S. Auto Receivables Company, as Seller, and Chrysler Credit Corporation, as Servicer, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-QQQQ to the Registration Statement of Chrysler Financial Corporation, on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-R Copy of Trust Agreement, dated as of January 1, 1992, between U.S. Auto Receivables Company and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-RRRR to the Registration Statement of Chrysler Financial Corporation on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-S Copy of Purchase Agreement, dated as of January 1, 1992, between Chrysler Financial Corporation, as Seller, and U.S. Auto Receivables Company, as Purchaser, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-SSSS to the Registration Statement of Chrysler Financial Corporation on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-T Copy of Pooling and Servicing Agreement, dated as of January 1, 1992, among Chrysler Financial Corporation, as Master Servicer, Chrysler First Business Credit Corporation, as Seller, and Security Pacific National Bank, as Trustee, with respect to U.S. Business Equity Loan Trust 1992-1. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of U.S. Business Equity Loan Trust 1992-1 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-U Copy of Series B Supplement, dated as of March 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-H to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended March 31, 1992, and incorporated herein by reference. 10-V Copy of Series C Supplement, dated as of May 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-J to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-W Copy of Series 1992-1 Supplement, dated as of February 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 10-YYYY to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-X Copy Indenture, dated as of March 1, 1992, between Premier Auto Trust 1992-2 and Bankers Trust Company, with respect to Premier Auto Trust 1992-2 Asset Backed Notes. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-Y Copy of a 6-3/8% Asset Backed Note with respect to Premier Auto Trust 1992-2 Asset Backed Notes. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-Z Copy Trust Agreement, dated as of March 1, 1992, between U.S. Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-2 Asset Backed Certificates. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-AA Copy Pooling and Servicing Agreement, dated as of March 1, 1992 among Chrysler Financial Corporation, as Master Servicer, Financial Acceptance Corporation, as Seller, and The First National Bank of Chicago, as Trustee, with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-BB Copy Standard Terms and Conditions of Agreement, dated as of March 1, 1992, among Chrysler Financial Corporation, as Master Servicer, Financial Acceptance Corporation, as Seller, and The First National Bank of Chicago, as Trustee, with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-CC Copy Purchase Agreement, dated as of March 1, 1992, between Chrysler First Inc. and Financial Acceptance Corporation with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-DD Copy of Indenture, dated as of May 1, 1992, between Premier Auto Trust 1992-3 and Bankers Trust Company with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-N to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-EE Copy of a 5.90% Asset Backed Note with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-FF Copy of Trust Agreement, dated as of April 1, 1992, as amended and restated as of May 1, 1992, between Premier Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-GG Copy of Receivables Purchase Agreement, dated as of April 15, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc. with respect to Canadian Auto Receivables Securitization 1992-1. Filed as Exhibit 10-IIIII to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-HH Copy of Combined and Restated Revolving Credit Agreement, dated as of July 29, 1992, among Chrysler Financial Corporation, as Borrower, Chemical Bank, as Agent and Arranger, and Swiss Bank Corporation, New York Branch, as Managing Co-Agent and Co-Arranger including as Exhibit G thereto forms of the Trust Agreement and related security documents executed and delivered concurrently therewith. Filed as Exhibit 10-A to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed August 19, 1992, and incorporated herein by reference. 10-II Copy of Second Amended and Restated Commitment Transfer Agreement, dated as of July 29, 1992, between Chrysler Financial Corporation, as Borrower, and Chemical Bank, as Agent. Filed as Exhibit 10-B to the Current Report on Form 8-K of Chrysler Financial Corporation, dated August 17, 1992 and filed August 19, 1992 and incorporated herein by reference. 10-JJ Copy of Amended and Restated Standby Receivables Purchase Agreement, dated as of September 15, 1993, among Chrysler Financial Corporation, Chrysler Credit Corporation, U.S. Auto Receivables Company, American Auto Receivables Company, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-YY to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-KK Copy of Participation and Servicing Agreement, dated as of July 29, 1992, among American Auto Receivables Company, Chrysler Credit Corporation, the Purchasers named therein, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent, with respect to the Standby Receivable Purchase Agreement. Filed as Exhibit 10-D to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed August 19, 1992, and incorporated herein by reference. 10-LL Copy of Bank Supplement, dated as of July 29, 1992, to the Pooling and Servicing Agreement, dated as of May 31, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to the Standby Receivables Purchase Agreement. Filed as Exhibit 10-E to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed on August 19, 1992, and incorporated herein by reference. 10-MM Copy of Short Term Standby Receivables Purchase Agreement, dated as of September 15, 1993, among Chrysler Financial Corporation, Chrysler Credit Corporation, U.S. Auto Receivables Company, American Auto Receivables Company, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-BBB to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-NN Copy of Participation and Servicing Agreement, dated as of September 15, 1993, among American Auto Receivables Company, Chrysler Credit Corporation, the Purchasers named therein, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-CCC to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-OO Copy of Short Term Bank Supplement, dated as of September 15, 1993, to the Pooling and Servicing Agreement, dated as of May 31, 1991, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to Short Term Standby Receivables Purchase Agreement. Filed as Exhibit 10-DDD to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-PP Copy of Receivables Purchase Agreement, dated as of August 18, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc. with respect to Canadian Auto Receivables Securitization 1992-2. Filed as Exhibit 10-OOOOO to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-QQ Copy of Indenture, dated as of September 1, 1992, between Premier Auto Trust 1992-5 and Bankers Trust Company with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-RR Copy of a 4.55% Asset Backed Note with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-SS Copy of Trust Agreement, dated as of September 1, 1992, between Premier Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-TT Copy of Series 1992-2 Supplement to the Pooling and Servicing Agreement, dated as of October 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust, Series 1992-2. Filed as Exhibit 3 to Form 8-A of Carco Auto Loan Master Trust on October 30, 1992, and incorporated herein by reference. 10-UU Copy of Master Custodial and Servicing Agreement, dated as of September 1, 1992 between Chrysler Credit Canada Ltd. and The Royal Trust Company, as Custodian. Filed as Exhibit 10-TTTTT to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-VV Copy of Trust Indenture, dated as of September 1, 1992, among Canadian Dealer Receivables Corporation and Montreal Trust Company of Canada, as Trustee. Filed as Exhibit 10-UUUUU to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-WW Copy of Loan Asset Purchase Agreement by and between NationsBank of Texas, N.A. and Chrysler First Inc., and the Subsidiaries of Chrysler First Inc. named therein, dated as of November 17, 1992, with respect to the sale of certain loan assets of Chrysler First Inc. and its subsidiaries. Filed as Exhibit 10-VVVVV to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-XX Copy of Business Asset Purchase Agreement by and among NationsBanc Financial Services Corporation and the Purchasers named therein and Chrysler First Inc. and the Sellers named therein, dated as of November 17, 1992, with respect to the sale of certain business assets of Chrysler First Inc. and its subsidiaries. Filed as Exhibit 10-WWWWW to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-YY Copy of Securitization Closing Agreement, dated as of February 1, 1993, among Chrysler Financial Corporation, certain Sellers, certain Purchasers, and certain Purchaser Parties. Filed as Exhibit 2-E to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-ZZ Copy of First Amendment to Loan Asset Purchase Agreement, dated December 30, 1992, among NationsBank of Texas, N.A. and Chrysler Financial Corporation, for and on behalf of Chrysler First Inc. and the Asset Sellers parties thereto. Filed as Exhibit 2-B to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-AAA Copy of First Amendment to Business Asset Purchase Agreement dated as of January 29, 1993 among NationsBank Financial Services Corporation, the other Purchasers parties thereto and the Sellers parties thereto and Chrysler Financial Corporation. Filed as Exhibit 2-D to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-BBB Copy of Asset Purchase Agreement, dated as of May 15, 1992, between Chrysler Capital Public Finance Corporation and Koch Financial Corporation. Filed as Exhibit 10-DDDDDD to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-CCC Copy of Asset Purchase Agreement, dated as of June 1, 1992, among General Electric Capital Corporation, Chrysler Financial Corporation, Chrysler Capital Corporation, Chrysler Asset Management Corporation and Chrysler Credit Corporation. Filed as Exhibit 10-EEEEEE to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-DDD Copy of Purchase Agreement, dated as of August 1, 1992, among General Electric Capital Corporation, Chrysler Financial Corporation, Chrysler Capital Corporation and Chrysler Asset Management Corporation. Filed as Exhibit 10-FFFFFF of the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-EEE Copy of Asset Purchase Agreement, dated as of September 30, 1992, between Chrysler Rail Transportation Corporation and United States Rail Services, a division of United States Leasing International, Inc. Filed as Exhibit 10-GGGGGG to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-FFF Copy of Asset Purchase Agreement, dated as of December 18, 1992, among Chrysler Rail Transportation Corporation, Greenbrier Transportation Limited Partnership and Greenbrier Capital Corporation. Filed as Exhibit 10-HHHHHH to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-GGG Copy of Asset Purchase Agreement, dated as of February 1, 1993, among Chrysler Rail Transportation Corporation, Chrysler Capital Transportation Services, Inc. and United States Rail Services, a division of United States Leasing International, Inc. Filed as Exhibit 10-IIIIII to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-HHH Copy of Asset Purchase Agreement between Chrysler Leaserve, Inc. (a subsidiary of General Electric Capital Auto Lease, Inc.), Chrysler Financial Corporation and Chrysler Credit Corporation, dated as of October 20, 1992, with respect to the sale of Gold Key Leases. Filed as Exhibit 10-XXXXX to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-III Copy of Servicing Agreement, dated as of October 20, 1992, between Chrysler Leaserve, Inc. (a subsidiary of General Electric Capital Auto Lease, Inc.) and Chrysler Credit Corporation, with respect to the sale of Gold Key Leases. Filed as Exhibit 10-YYYYY to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-JJJ Copy of First Amendment dated as of August 24, 1992 to the Series 1991-1 Supplement dated as of May 31, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master Trust. Filed as Exhibit 4-M to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-KKK Copy of Second Amendment dated as of August 24, 1992 to the Series 1991-2 Supplement dated as of June 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master Trust. Filed as Exhibit 4-N to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-LLL Copy of Second Amendment dated as of August 24, 1992 to the Series 1991-3 Supplement dated as of June 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master Trust. Filed as Exhibit 4-O to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-MMM Copy of First Amendment dated as of August 24, 1992 to the Series 1991-4 Supplement dated as of September 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to Carco Auto Loan Master trust. Filed as Exhibit 4-P to the Quarterly Report on Form 10-Q of Carco Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-NNN Copy of Sale and Servicing Agreement, dated as of November 1, 1992, among Premier Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Premier Auto Trust 1992-6, as Purchaser, with respect to Premier Auto Trust 1992-6. Filed as Exhibit 10-PPPPPP to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-OOO Copy of Trust Agreement, dated as of November 1, 1992, among ML Asset Backed Corporation, Premier Auto Receivables Company and Chemical Bank Delaware as Owner Trustee, with respect to Premier Auto Trust 1992-6. Filed as Exhibit 10-QQQQQQ to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-PPP Copy of Sale and Servicing Agreement, dated as of January 1, 1993, among Premier Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Premier Auto Trust 1993-1, as Purchaser, with respect to Premier Auto Trust 1993-1. Filed as Exhibit 10-RRRRRR to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-QQQ Copy of Trust Agreement, dated as of January 1, 1993, among ML Asset Backed Corporation, Premier Auto Receivables Company and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-1. Filed as Exhibit 10-SSSSSS to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-RRR Copy of Receivables Purchase Agreement, dated as of November 25, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisitions Inc. with respect to Canadian Auto Receivables Securitization 1992-3. Filed as Exhibit 10-TTTTTT to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-SSS Copy of Purchase Agreement, dated as of January 25, 1993, among Chrysler Credit Canada Ltd., Chrysler Canada Ltd., Auto 1 Limited Partnership and Chrysler Financial Corporation, with respect to Auto 1 Trust. Filed as Exhibit 10-UUUUUU to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-TTT Copy of Master Lease Agreement, dated as of January 25, 1993, among Chrysler Credit Canada Ltd., Chrysler Canada Ltd. and Auto 1 Limited Partnership, with respect to Auto 1 Trust. Filed as Exhibit 10-VVVVVV to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-UUU Copy of Amended and Restated Trust Agreement, dated as of April 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-2. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-2 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-VVV Copy of Indenture, dated as of April 1, 1993, between Premier Auto Trust 1993-2 and Bankers Trust Company, as Indenture Trustee, with respect to Premier Auto Trust 1993-2. Filed as Exhibit 4.2 of the Quarterly Report of Premier Auto Trust 1993-2 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-WWW Copy of Amended and Restated Trust Agreement, dated as of June 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-3. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-3 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-XXX Copy of Indenture, dated as of June 1, 1993, between Premier Auto Trust 1993-3 and Bankers Trust Company, as Indenture Trustee. Filed as Exhibit 4.2 to the Quarterly Report of Premier Auto Trust 1993-3 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-YYY Copy of Series 1993-1 Supplement, dated as of February 1, 1993, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 3 to the Registration Statement on Form 8-A of CARCO Auto Loan Master Trust dated March 15, 1993, and incorporated herein by reference. 10-ZZZ Copy of Receivables Purchase Agreement, made as of April 7, 1993, among Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Association Assets Acquisition Inc., with respect to CARS 1993-1. Filed as Exhibit 10-OOOO to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-AAAA Copy of Receivables Purchase Agreement, made as of June 29, 1993, among Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc., with respect to CARS 1993-2. Filed as Exhibit 10-PPPP to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-BBBB Copy of Pooling and Servicing Agreement, dated as of August 1, 1993, among Auto Receivables Corporation, Chrysler Credit Canada Ltd., Montreal Trust Company of Canada and Chrysler Financial Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-QQQQ to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-CCCC Copy of Standard Terms and Conditions of Agreement, dated as of August 1, 1993, among Auto Receivables Corporation, Chrysler Credit Canada Ltd. and Chrysler Financial Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-RRRR to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-DDDD Copy of Purchase Agreement, dated as of August 1, 1993, between Chrysler Credit Canada Ltd., and Auto Receivables Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-SSSS to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-EEEE Copy of Lease Receivables Purchase Agreement, dated as of December 23, 1992, among Chrysler Systems Leasing Inc., Chrysler Financial Corporation and Sanwa Business Credit Corporation. Filed as Exhibit 10-TTTT to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-FFFF Copy of Lease Receivables Purchase Agreement, dated September 3, 1993, among CXC Incorporated, Chrysler Systems Inc., and Chrysler Financial Corporation. Filed as Exhibit 10-UUUU to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-GGGG Copy of Lease Receivables Purchase Agreement, dated September 22, 1993, among the CIT Group/Equipment Financing, Inc., Chrysler Systems Inc., and Chrysler Financial Corporation. Filed as Exhibit 10-VVVV to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-HHHH Copy of Asset Purchase Agreement, dated as of July 31, 1993, between Chrysler Rail Transportation Corporation and General Electric Railcar Leasing Services Corporation. Filed as Exhibit 10-WWWW to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-IIII Copy of Amended and Restated Loan Agreement, dated as of June 1, 1993, between Chrysler Realty Corporation and Chrysler Credit Corporation. Filed as Exhibit 10-XXXX to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-JJJJ Copy of Loan Agreement, dated as of March 31, 1993, between Manatee Leasing, Inc. and Chrysler Credit Corporation. Filed as Exhibit 10-YYYY to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-KKKK Copy of Origination and Servicing Agreement, dated as of June 4, 1993, among Chrysler Leaserve, Inc., General Electric Capital Auto Lease, Inc., Chrysler Credit Corporation and Chrysler Financial Corporation. Filed as Exhibit 10-ZZZZ to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-LLLL Copy of Amended and Restated Trust Agreement, dated as of September 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical Bank Delaware, as Trustee, with respect to Premier Auto Trust 1993-5. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-5 on Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference. 10-MMMM Copy of Indenture, dated as of September 1, 1993, between Premier Auto Trust 1993-5 and Bankers Trust Company, as Indenture Trustee, with respect to Premier Auto Trust 1993-5. Filed as Exhibit 4.2 to the Quarterly Report of Premier Auto Trust 1993-5 on From 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference. 10-NNNN Copy of Asset Purchase Agreement, dated as of October 29, 1993, between Marine Asset Management Corporation and Trico Marine Assets, Inc.. Filed as Exhibit 10-CCCCC to the quarterly report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-OOOO Copy of Asset Purchase Agreement, dated as of December 3, 1993, between Chrysler Rail Transportation Corporation and Allied Railcar Company. 10-PPPP Copy of Secured Loan Purchase Agreement, dated as of December 15, 1993, among Chrysler Credit Canada Ltd., Leaf Trust and Chrysler Financial Corporation. 10-QQQQ Copy of Series 1993-2 Supplement, dated as of November 1, 1993, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers Traders and Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 3 to the Registration Statement on Form 8-A of CARCO Auto Loan Master Trust dated December 6, 1993, and incorporated herein by reference. 12-A Chrysler Financial Corporation and Subsidiaries Computations of Ratios of Earnings to fixed Charges. 12-B Chrysler Corporation Enterprise as a Whole Computations of Ratios of Earnings to Fixed Charges. 23 Consent of Deloitte & Touche 24 Powers of attorney pursuant to which the signatures of certain directors of Chrysler Financial Corporation have been affixed to this Annual Report on Form 10-K.

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ITEM 1. Business -------- General Development of Business and Narrative Description of Business - --------------------------------------------------------------------- Business of BNA and Subsidiaries - -------------------------------- The Bureau of National Affairs, Inc. (BNA), is a leading publisher of specialized business, legislative, judicial, and regulatory information services. BNA was founded in 1929, and was incorporated in its present form as an employee owned company in 1947. BNA is independent, for profit, and is the oldest fully employee-owned company in the United States. BNA and its publishing subsidiaries, Tax Management Inc. and Pike & Fischer, Inc., are engaged in providing labor, legal, economic, tax, health care and other regulatory information to business, professional, and academic users. They prepare, publish, and market looseleaf subscription information services in print and compact disc formats, books, pamphlets, and research reports. Sales are made principally in the United States through field sales personnel who are supported by direct mail, space advertising, and telemarketing. Customers include lawyers, accountants, business executives, human resource professionals, health care administrative professionals, labor unions, trade associations, educational institutions, government agencies, and libraries in the United States and throughout the world. The BNA Electronic Media Division develops online databases and other electronic products from BNA services and other information, creates original electronic databases, and engages in research and development for electronic delivery of BNA information. These products are marketed through online database vendors such as Mead Data Central, West Publishing Company, Dialog, Cambridge Information Group, and others. BNA Software, a division of Tax Management Inc., develops, produces, and markets tax and financial planning software for use on personal computers. Sales are made to accountants, lawyers, tax and financial planners, and others. The products are marketed through direct mail, space advertising, and BNA field sales representatives. BNA International Inc. is the company's agent for sale of its domestic services in the United Kingdom, Europe, Africa, and Asia, and also engages in independent publishing activity, including adaptation of the company's domestic products for sales abroad. The McArdle Printing Co., Inc. provides printing services to mid-Atlantic area customers. It utilizes modern equipment and technology in printing information products for publishers, trade associations, professional societies, other non- profit organizations, financial institutions and governmental organizations. Approximately 65 percent of its business is derived from the BNA publishing companies. BNA Communications Inc. (BNAC) is engaged in the business of producing, publishing, and marketing programs for training in the Equal Employment Opportunity and safety and health related fields. The programs promote awareness, compliance, prevention, and training for managers and employees in industry and government, using audio visual and printed materials. Item 1 General Development of Business and Narrative Description --------------------------------------------------------- of Business (Continued) --------------------------- Review of Operations BNA's results for 1993 reflect the company's decision to bring to market as quickly as possible a new line of CD-ROM products to meet a growing demand for information in this exciting format and to protect its circulation base from aggressive new competition. The strategy carried a high price tag, but the enthusiastic response to the company's first CD-ROM offerings confirms the validity of the decision. The first CD-ROM product, TAX MANAGEMENT PORTFOLIOS PLUS, was launched late in 1992. It was followed in June of 1993 with BNA'S ENVIRONMENTAL LIBRARY ON CD-ROM. BNA'S HUMAN RESOURCES LIBRARY ON CD-ROM was introduced in September, and BNA's COMPENSATION & BENEFITS LIBRARY and TAX MANAGEMETN'S TAX PRACTICE SERIES ON CD-ROM came to market as the year drew to a close. Together these five products accounted for sales of over $10 million in 1993. The increasing importance of CD-ROM and other electronic products has made replacement of the company's aging editorial/production systems a high priority, and this, too, was begun in 1993. The present systems were designed for print. Their use to create electronic product is costly, slow, and cumbersome. A strong performance by the corporate investment portfolios, a banner year for BNA Software, the absence of ETSI losses, and a substantial reduction in the losses of other operations more than offset major expenses for new products, systems, and technology by the parent company, and consolidated net income rose to $11.3 million in 1993, a gain of 19.5 percent from comparable earnings of the previous year. Investment income increased by 40 percent to $6.2 million for the year. Realization of nearly $2 million in securities capital gains, which had resulted from declining market interest rates, was a major portion of the increase and is unlikely to be repeated in 1994. Despite higher cash outlays for capital expenditures, loan repayments, and repurchases of treasury shares, cash and investments increased by $10 million. With year-end cash and investment balances totalling $85 million, BNA's liquidity and financial reserves remain strong relative to the company's obligations. Expenses for 1993 included a charge of $4 million for post-retirement health care benefits. This charge is the result of a new accounting rule (SFAS 106) adopted in 1992. It is expected to increase with medical cost inflation and growth in employment rolls. Turnover in the ranks of management during the year demonstrated once again that the company has a depth of talent to match its financial strength. Vacant positions were filled from within and the business, including all of the sweeping new initiatives undertaken, advanced without missing a beat. The year saw a continued growth in total circulation units, although some of the CD-ROM sales resulted in cancellations of print services. It is not yet clear how much of an effect electronic alternatives will have on print circulation. The 1994 print renewal cycle should provide some enlightenment. Consolidated revenues exceeded $200 million for the first time in the company's history. Revenue gains were achieved by the parent company and by all of its publishing subsidiaries. A REVIEW OF 1993 OPERATIONS OF THE PARENT COMPANY AND EACH SUBSIDIARY FOLLOWS: THE BUREAU OF NATIONAL AFFAIRS, INC. Parent company revenues of $141 million in 1993 were 6.2 percent higher than in the previous year. Subscription service revenue was up by 6.9 percent. The Electronic Media Division also reported a year-to-year gain. Revenues were lower for the Book Division and for BNA PLUS. Much was accomplished during the year. Ten new services, including the parent company's first three CD-ROMs, were launched; two well-established older services, BNA POLICY AND PRACTICE SERIES and LABOR RELATIONS REPORTER, were extensively revised to reflect the current state of the law and to accommodate new material; substantial progress was made on the company's new business system to become operational in 1994; and work began in earnest on a new publishing system following a thorough study of the company's present and future needs and the available outside resources to meet these needs. New subscription sales of BNA and Tax Management services rose by 25 percent from the previous year to a record $29.3 million. BNA'S ENVIRONMENTAL LIBRARY ON CD-ROM, introduced in June, was the leading product of the year with sales of $3.5 million. The HUMAN RESOURCES LIBRARY ON CD-ROM, a fall launch, was second among top-sellers for the parent company, followed by LABOR RELATIONS REPORTER with its new AMERICANS WITH DISABILITIES CASES section and completely revised WAGE HOUR MANUAL. A major capital expenditure was made mid-year to equip the field sales force with laptop computers and CD-ROM drives so that representatives could effectively demonstrate the company's new line of electronic products. Sales & Marketing and Information Systems combined expertise and conducted intensive training programs throughout the country. Representatives embraced the new technology with astonishing speed and the results speak for themselves. The leading new print product of the year was HEALTH CARE POLICY REPORT, flagship of the new Health Care Services Division. The division acquitted itself well in its first full year of operations with sales of $1.6 million. It ended the year with three successful products and a fourth scheduled for launch in the first quarter of 1994. HEALTH CARE ELECTRONIC DATA REPORT was merged with its sister new product, HEALTH CARE POLICY REPORT, within a few months when initial sales fell short of pre-launch projections. The aggressive new product development program called for in the company's current strategic plan requires a close monitoring of performance and prompt action where a product fails to meet its circulation goals and shows little promise of achieving profitability in a reasonable period of time. Three services were terminated in the course of 1993 and subscribers were offered alternative, related services in their stead. A fourth service, BNA'S EASTERN EUROPE REPORT, was transferred to BNA International, where its chances for success are enhanced by a lower cost structure and more targeted foreign marketing. A fifth, BNA'S NATIONAL ENVIRONMENT WATCH, was given a new name and charter to appeal to a more promising market segment. It has become BNA'S ENVIRONMENT COMPLIANCE BULLETIN and is the company's first product with state- specific inserts produced by the editors through a desktop publishing system. Efforts to raise BNA's already high level of customer satisfaction remained a priority in an atmosphere of rapidly evolving needs and increasing competitive pressure. The Customer Satisfaction Committee appointed in 1992 worked effectively to heighten company-wide awareness of customer concerns and made significant progress on recommendations in the Customer Satisfaction Audit Report. Customer-oriented initiatives resulted in a better system for collecting and responding to subscriber comments, expanded service hours, and enhanced subscription retention efforts. The need for complete and accurate information about customers remained prominent in the design of the company's new business information system. BNA PLUS BNA PLUS, the company's highly regarded subscriber support arm, stepped up to new challenges presented by the addition of CD-ROM products to BNA's already formidable range of information services. Working in close partnership with the newly formed technical support group in the Information Systems Division, PLUS personnel helped to educate both subscribers and sales representatives as each new disk product appeared. More than 100,000 calls were handled in 1993, representing a 20 percent increase over the previous year. The three PLUS business units (documents, compilations, and custom research) produced revenues of $1.7 million in 1993. The combined revenue of the documents and compilations units, $1.4 million, increased 16.8 percent over 1992. Custom research revenue dropped from year-to-year as a result of a decision to convert custom environmental regulation monitoring to subscription services sold by the field sales force. ELECTRONIC MEDIA DIVISION The Electronic Media Division achieved record online revenues and profits in 1993. Revenues of $2.9 million were 7 percent greater than 1992, and operating profit was $509,000, an 18 percent increase. The Division also explored products for emerging media other than traditional online and CD-ROM, with the objective of preserving BNA's competitive position in the rapidly changing electronic environment. EMD ended the year with 292 products on seven online systems, including a new distributor, Legi-Slate. Electronic-only daily updating services were added to Legi-Slate, a subsidiary of the Washington Post Company, at mid-year. Two new online dailies, BNA's CORPORATE COUNSEL DAILY and BNA'S EMPLOYMENT POLICY & LAW DAILY, were introduced on Lexis, Westlaw, and Dialog. Other new electronic products launched in 1993 included: AMERICANS WITH DISABILITIES CASES on Lexis, Westlaw and the Human Resource Information Network (HRIN); HEALTH CARE PLOICY REPORT and MEDICARE REPORT on Lexis and HRIN; and HEALTH LAW REPORTER and DAILY ENVIRONMENT REPORT on Lexis. DAILY LABOR REPORT and UNITED STATES LAW WEEK were relaunched in a standardized coding format, while UNITED STATES LAW WEEK Section 4 -- Supreme Court Opinions -- was added to Lexis and Westlaw. EMD also worked very closely with Westlaw, which had keyed the 45-year electronic archive of U.S. PATENTS QUARTERLY, to bring that archive to BNA for use as a proprietary CD-ROM product. Through the newly created BNA Ventures, the management and staff of EMD participated in evaluating the array of joint venture, alliance, and acquisition opportunities created by the new electronic era. Through BNA Ventures, the best of these possibilities will be appropriately evaluated and pursued. BNA BOOKS With $4.4 million in revenues in 1993, the BNA Book Division nearly equalled its record-setting $4.5 million in 1992, a year that saw the publication of the third edition of DEVELOPING LABOR LAW. By mid-1993, cumulative sales of DEVELOPING LABOR LAW topped $1 million with 5,500 units sold. The Division reduced its operating loss to $166,000 in 1993, a 32 percent improvement from the previous year. One half of the Division's new products in 1993 were authored by BNA or former BNA employees. Four such products -- BNA'S DIRECTORY OF U.S. LABOR ORGANIZATIONS, BNA'S STATE ADMINISTRATIVE CODES AND REGISTERS DIRECTORY, BNA'S STATE AND FEDERAL COURT DIRECTORY, and CODES OF PROFESSIONAL RESPONSIBILITY -- won national recognition in LEGAL INFORMATION ALERT'S survey of the 50 most useful reference sources for law librarians. SUPREME COURT PRACTICE, 7TH EDITION, was released in 1993. The treatise, considered the "bible" in the field, has been published by BNA since 1950. ENVIRONMENTAL TAX HANDBOOK was produced with Tax Management Inc., and readily met with critical and commercial success. Also, the Division reached agreement with the ABA Section on Labor and Employment Law to incorporate sections of EMPLOYEE BENEFITS LAW into a new BNA CD-ROM product. The Division added to its successful Fact Sheet product line with new products on flexible spending accounts, COBRA, and the Americans with Disabilities Act. All fact sheets, including 1992's highly successful fact sheet on preventing sexual harassment, exceeded budget expectations. New technology continued to translate into immediate cost savings on the production side of the business. Approximately one quarter of the Division's titles employed desktop publishing technology in 1993, saving up to two-thirds of the average expense for traditional composition methods. By mid-year, it was clear, however, that the ambitious growth plan set out for the Book Division in 1989 needed to be modified. The Division managers met throughout the budgeting process and put together an entirely new plan for 1994 - -1996, which calls for more immediate profitability along with lower revenue growth expectations. Even greater use of BNA editorial talent and materials is contemplated under the new plan. The Division will take advantage of the company's new technologies to produce more spinoff book products and will seek to contribute more materials to CD-ROM efforts. Also, the Division will emphasize renewable products and regular supplementation in its new product development efforts. These strategies should hold the Division in good stead for the future. TAX MANAGEMENT INC. Tax Management had another record-breaking year with 1993 revenues of $38.2 million for services and BNA Software. Net income of $5.1 million made it the most profitable year ever, and the parent company was paid a $3.6 million dividend. Tax Management print and CD-ROM new service sales of $6 million exceeded 1992 sales by 53 percent. TAX PRACTICE SERIES ON CD-ROM, launched in September, was an immediate sales success, and TAX MANAGEMENT PORTFOLIOS PLUS, launched in the fall of 1992, continued to gain circulation. CD-ROM subscribers benefitted from the addition of the Internal Revenue Code, Treasury Regulations, and IRS publications, as well as IRS Forms and additional finding tools. Providing this public domain information, licensed from other vendors, increases the value of the CD-ROM services and compliments the unique benefits of Tax Management proprietary information. To accommodate market preferences, the portfolios are available in either CCH ACCESS or Folio versions. During the year, Tax Management published the equivalent of 50 new or revised portfolios, including major coverage of mergers and acquisitions, the foreign tax credit, and partnership transactions. Coverage of the 1993 tax act was unprecedented with TAX WEEKLY REPORT providing section-by-section explanations at each stage in the legislative process. Although the act affected more than 140 portfolios and 130 TAX PRACTICE SERIES chapters, updating was completed in record time. New marketing initiatives in advertising, mail promotion, and client relations also achieved outstanding results. The client relations and training unit built stronger subscriber allegiance through telephone interviews and training, while also generating sales leads for field follow-up that resulted in $275,000 in firm sales. Product Specialists also contributed to the on-going training of representatives and provided valuable information to marketing and editorial operations for product development and enhancement. BNA SOFTWARE 1993 was the most financially successful year in the history of BNA Software. Total revenues grew by 11.4 percent over the previous year, reaching $8.5 million, and the division's operating profit rose to $1.9 million, which was 21.8 percent of revenues. BNA Software capitalized on the uncertainty surrounding new tax legislation with the release of a special version of the BNA INCOME TAX SPREADSHEET incorporating the Clinton tax proposals. This pre-enactment release generated many new sales and a great deal of goodwill. BNA Software's rapid release of updates incorporating the new law as well as an aggressive customer retention program led to improved renewal rates and higher than expected year-end circulation. The major revenue-producing products for the software division continue to be the BNA INCOME TAX SPREADSHEET, the BNA ESTATE TAX SPREADSHEET, and the BNA FIXED ASSET MANAGEMENT SYSTEM. PIKE & FISCHER, INC. Pike & Fischer's net income rose to $776,000 in 1993, exceeding 1992 earnings by more than 24 percent. As a result, it was possible to pay the parent company a $600,000 dividend for 1993, $100,000 more than in any previous year. At $4.7 million, 1993 operating revenues were the highest in the company's 54- year history. While unfavorable economic conditions in the fertilizer industry resulted in a decline in revenues from the Green Markets product group, this shortfall was more than offset by increases in revenues from other Pike & Fischer publications and from editorial services contracts. Overall, operating revenues were 4 percent higher than in 1992. Although revenues moved up only slightly, careful cost management resulted in an 18 percent rise in operating profit. Operating profit exceeded $1 million for the first time, even though the company recorded more than $390,000 in non-cash amortization expenses, mostly related to the 1991 Green Markets purchase. Management's principal focus in 1993 was on improving the quality of existing publications. The most ambitious project begun in 1993 was a reengineering of Pike & Fischer's flagship telecommunications publication, RADIO REGULATION. The service's 32-year-old digest classification system was thoroughly re-examined and refined and more than 2,000 pages of reclassified digests were sent to subscribers. Subscribers also received the new DESK GUIDE TO COMMUNICATIONS LAW RESEARCH, a 400-page paperbound collection of the most important tables and indexes from fifteen volumes of the basic Radio service. Plans for a Third Series were formulated and are being refined in discussions with the Radio Advisory Board, which was established in the fall of 1992. Finally, work was started on adding a CD-ROM component to the service, for release in the first quarter of 1994. Other enhancements to existing products included the introduction of an electronic mail edition of the Green Markets newsletter to permit the publication to compete better in international markets, where fast, inexpensive delivery is essential. A GREEN MARKETS ELECTRONIC ARCHIVE containing the full text of all articles published in 1992 and 1993 made its debut at the end of the year. In addition, ADLAW BULLETIN, a newsletter designed to accompany Pike & Fischer's administrative law service and to be sold separately, was developed and launched. Pike & Fischer also produced its first electronic publication for both Windows and DOS, CABLE TV RULES ON DISK. BNA INTERNATIONAL INC. BNA International continued to reap the rewards of its restructuring and dramatically reduced the losses of previous years. The subsidiary company's after-tax loss dropped to $57,000 for 1993, compared to a loss of $535,000 in the prior year. BNAI service revenues grew to $2 million, partly as a result of acquiring BNA'S EASTERN EUROPE REPORT mid-year, but also from circulation gains for all BNAI services. Foreign sales of parent company products were marginally ahead of 1992. Demand for BNA's environmental and intellectual property services remained strong in most markets, and interest in tax and environment CD-ROM products began to grow as this technology became more widely available internationally. The drive to reduce costs and improve efficiency continued, and considerable savings were made in the editorial, production and marketing departments. BNAI relocated to new, less costly, and more functional offices in September, 1993. Although there were no new product introductions in 1993, a number of significant changes were made to existing BNAI services to improve their performance in 1994. Plans were developed to exploit an expanded market by replacing FOREIGN INVESTMENT IN THE U.S. with DIRECT INVESTMENT IN NORTH AMERICA, a more broadly focused service covering developments in the United States, Canada, and Mexico following adoption of the North American Free Trade Agreement (NAFTA). Also, a survey of WORLD PHARMACEUTICALS REPORT subscribers resulted in revisions to the format of that service, and both TAX PLANNING INTERNATIONAL and WORLD INTELLECTUAL PROPERTY REPORT were re-designed to increase their utility. Research was also carried out on the potential for a new service to be sold only outside the U.S. A positive response led to the decision to publish U.S. BUSINESS LAW REPORT in February, 1994. The new service will rely on existing BNA domestic products for source material and will be edited specifically for an international audience. The service will have the additional benefit of making BNA better known in the international markets. With its stronger financial position, BNAI is now actively turning its attention to growth. The year 1994 will be when the company completes its turnaround and identifies the new products that will generate increased revenues and profits from international markets in the future. The company's 1994 budget calls for a breakeven performance. BNA COMMUNICATIONS, INC. BNAC achieved the second highest revenue level in its history in 1993 despite a very difficult year in the training media industry. Revenues of $5.6 million from the sale of all video-based training products were 2.3 percent lower than the company record set in 1992. Results across product lines were mixed. Revenue from the company's human resources group of products increased by 4.7 percent while revenue from the safety product line dropped by 21.2 percent. While cost saving measures were instituted to help overcome the lower revenue, the company recorded a loss of $53,000 for 1993, compared to a profit in 1992 before the cumulative effects of accounting changes. The company strived aggressively to maintain and strengthen its dominant position in the EEO/AA and workforce diversity training arena. Revenue from this product line increased by nearly 5 percent in 1993 and has grown by 90 percent over the last five years. Two major new products, MYTHS VS. FACTS and A WINNING BALANCE, were released in this product line. Both have been embraced by the market and have solidified BNAC's leadership position in fair employment practice/diversity training. With the several new human resource products scheduled for release in the first half of 1994, there is every reason to expect continued growth. The decline in the company's safety program sales was attributable to a lack of regulatory activity, a difficult economy, and increased competition. Late in 1993, BNAC made a number of changes designed to reestablish its place in the safety training market. Among those changes are a newly created safety sales group, a segmented marketing program, including a separate SAFETY COMMUNICATOR newsletter, and the creation of a subscription-based, renewable safety product called SAFETY TRAINING SUBSCRIPTION PROGRAM. With its new product releases on schedule and the focus on the company's safety business that will result from a separate sales and marketing activity, BNAC is optimistic that 1994 will be a growth year -- just as five of the past six years have been. THE McARDLE PRINTING CO., INC. The McArdle Printing Company continued to operate in a commercial printing market that remained sluggish and highly competitive throughout 1993. However, both revenues and net earnings were slightly higher than in the preceding year. Operating revenues were $22.5 million, a gain of 1.3 percent from the previous year. Net income increased 1 percent to $682,000 and the subsidiary paid a $300,000 dividend to the Parent Company. BNA continued to be McArdle's largest customer in 1993. From the time the two were established as independent companies in 1947, the printing, binding and mailing of BNA publications has been McArdle's largest single source of revenue. Including a large increase in Tax Management printing produced at McArdle, BNA publications accounted for 65 percent of McArdle's operating revenue for the year. McArdle's top priority continues to be increasing revenues and fully utilizing the operating capacity it has established. A comprehensive and aggressive marketing program, combined with continuous training of the sales staff are leading efforts to accomplish this goal. During the latter part of 1993, McArdle instituted a Total Quality Management (TQM) program at the company. McArdle management is convinced that the implementation and maintenance of this program will increase quality, productivity, customer satisfaction, and employee satisfaction, on a continuous and lasting basis. McArdle's desktop printing operation was complemented by the recent addition of a Linotron Imagesetter and a DuPont black and white scanner. This new equipment further enhances the quality and productivity in both McArdle's communications and prepress operations. With the newly implemented TQM program and the further expansion of the communication system, desktop publishing, and prepress capabilities, McArdle is well positioned to meet BNA's present and future printing needs and to compete successfully in the commercial market by offering competitively priced, high quality, and on-time printing services. BNA WASHINGTON INC. BNA Washington's building and office renovation activity was heavier in 1993 than in the previous year. The major project was the reconfiguration and renovation of office space and base building upgrades required by safety and ADA compliances regulations at the company's Rockville, Maryland, facility. Many smaller relocation and office redesign projects were accomplished at BNA's downtown facilities. The projects were initiated to meet BNA's growth and operational restructuring activity and varied in size and scope. All in all, some 21 projects were undertaken and involved approximately 500 employees and 81,000 square feet of office space. BNAW successfully negotiated a contract with Caldor Corporation for the sale of the Silver Spring, Maryland, site of McArdle Printing Company's former plant, which was demolished during the summer. Settlement is contingent upon Caldor's obtaining appropriate building permits from Montgomery County for a department store and adjacent parking facilities. It is expected that Caldor will get the permits and that the sale will be concluded in late 1994 or early 1995. A long term strategic facility plan was initiated by BNAW in the latter part of the year. The objective of the plan is to evaluate BNA's long-term growth needs and to determine what options are available to meet these needs. The plan is scheduled to be completed by the end of June, 1994. BNAW's 1993 operating revenues included $1.8 million from outside tenants. PART I ------ Item 1. Business -------- General Development of Business and Narrative Description of Business Cont. - ---------------------------------------------------------------------------- The Bureau of National Affairs, Inc. ("BNA" or the "Company") operates primarily in the business information publishing industry. Operations consist of the production and marketing of information products in print and electronic form, and outside printing services. Activities in other industry segments are less than 10 percent of total revenue. As a response to customer demand, advances in technology, and competition, the Company has recently increased its efforts to publish information in the CD-ROM format. CD-ROM's allow the economical addition of value-added features such as searching capabilities and additional information content. Competition in the business information industry continues to intensify and some competitors are larger and have greater resources than BNA. The Company has invested in sales aids to help its sales force demonstrate the CD-ROM products to customers. Additionally, the Company has embarked on a plan to redesign its publishing system to more effectively produce information for electronic or print delivery. This process is expected to be developed over several years. The number of employees of BNA and its subsidiaries was 1,796 at December 31, 1993. PART I ------ Item 2.

Item 2. Properties ---------- BNA Washington Inc. owns and manages the buildings presently used by BNA and some of its Washington area subsidiaries. Principal operations are conducted in three adjacent buildings at 1227-1231 25th Street, NW, Washington, D.C. The office building at 1227 25th Street is being used primarily by BNA and also for commercial leasing. BNA also leases office space at 1250 23rd Street, NW, Washington, D.C. BNA's Circulation Department and BNA Communications Inc. operate in an owned facility at 9435 Key West Avenue, Rockville, Maryland. Pike & Fischer, Inc. leases office space for its operations at 4600 East-West Highway, Bethesda, Maryland. BNA International Inc. conducts its operations from leased offices at Heron House, 10 Dean Farrar Street, London, England. The McArdle Printing Co., Inc. owns its office and plant facilities at 800 Commerce Drive, Upper Marlboro, Maryland. Property at the former printing site in Silver Spring, Maryland is being held for investment. PART I ------ Item 3.

Item 3. Legal Proceedings ----------------- The Company is involved in certain legal actions arising in the ordinary course of business. In the opinion of management the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial statements. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- On October 6, 1993, a consent solicitation was sent to all Class A and Class B shareholders. The solicitation sought shareholders' consent to increase the authorized shares of Class B common stock by 500,000 shares, and decrease the authorized shares of Class A common stock by 500,000 shares. BNA stockholders have consented to the adoption of the amendment. As of October 29, the holders of 2,671,148 shares of Class A common stock had returned their consent forms. Of these, 2,632,673, or 79%, consented to the proposal, 31,232, or 1%, withheld consent, and 7,243, or .22%, abstained. Holders of 3,979,730 shares of Class B common stock had returned their consent forms as of October 29. Of these, 3,978,645, or 84%, consented to the proposal, 1,085, or .02%, withheld consent, and 0, or 0%, abstained. Under the laws of the State of Delaware, in which BNA is incorporated, and under BNA's Certificate of Incorporation, the affirmative consents of a majority of the 3,349,054.40 outstanding shares of Class A stock, or 1,708,018 shares, and the affirmative consents of a majority of the 4,762,546 outstanding shares of Class B stock, or 2,428,898 were required to adopt the proposed amendment. PART I ------ Item X. EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ The following persons were executive officers of The Bureau of National Affairs, Inc., at December 31, 1993. Executive officers are elected annually by the Board of Directors and serve until their successors are elected. Name Age Present position and prior experience ---- --- ------------------------------------- William A. Beltz 64 President and Chief Executive Officer Elected president and editor-in-chief in 1979 and chief executive officer in 1980. Joined BNA in 1956. John P. Boylan, Jr. 54 Vice President for Administration Elected to present position in 1986. Previously was corporate manager of data processing from 1975 to 1986. Joined BNA in 1974 after employment at Fisher-Stevens, Inc. (a former BNA subsidiary) since 1962. Robert Brooks 44 Vice President and Director of Sales and Marketing. Elected to present position in 1991. Previously General Manager of BNA Software since 1984. Joined BNA in 1974. Kathleen D. Gill 47 Vice President and Executive Editor Elected to vice president and executive editor in 1993. Previously was associate editor for business and human resources services since 1987. Joined BNA in 1970. John E. Jenc 51 Treasurer Elected to present position in 1990. Joined BNA as Controller in 1981. George J. Korphage 47 Vice President and Chief Financial Officer Elected vice president in 1988 and chief financial officer in 1989. Previously was manager of financial planning and analysis since 1985. Joined BNA in 1972. John V. Schappi 64 Vice President for Human Resources Elected to present position in 1987. Previously was associate editor for labor services since 1972. Joined BNA in 1955. (Continued) Item X. EXECUTIVE OFFICERS OF THE REGISTRANT (Continued) ------------------------------------ Name Age Present position and prior experience ---- --- ------------------------------------- John D. Stewart 78 Chairman of the Board Served as Chairman of the Board since 1970. Previously was president and editor-in- chief from 1964 to 1979, and chief executive officer from 1979 to 1980. Joined BNA in 1939. Paul N. Wojcik 45 Vice President, General Counsel, and Corporate Secretary Elected vice president and general counsel in 1988 and corporate secretary in 1989. Previously was corporate counsel and assistant corporate secretary from 1984 to 1988. Joined BNA in 1972. PART II ------- Item 5.

Item 5. Market for the Registrant's Common Stock and Related Security ------------------------------------------------------------- Holder Matters -------------- Market Information, Holders, and Dividends - ------------------------------------------ There is no established public trading market for any of BNA's three classes of stock, but the Stock Purchase and Transfer Plan provides a market in which Class A stock can be bought and sold. The Board of Directors establishes semi-annually the price at which Class A shares can be bought and sold through the Stock Purchase and Transfer Plan and declares cash dividends. In accordance with the corporation's bylaws, the price and dividends on non-voting Class B and Class C stock are the same as on Class A stock. Dividends have been paid continuously for 44 years, and they are expected to continue. As of March 1, 1994, there were 1,354 Class A shareholders, 204 Class B shareholders, and 48 Class C shareholders. The company repurchased 87,000 shares of Class B stock from retired employees or their estates in the 12 months ending March 1, 1994. Established stock price and dividends declared during 1993 and 1992 were as follows: Stock Price January 1, 1992 - March 21, 1992 $17.00 March 22, 1992 - March 27, 1993 17.50 March 28, 1993 - September 25, 1993 19.50 September 26, 1993 - December 31, 1993 20.50 Dividends Declared March 21, 1992 $ .42 September 19,1992 .42 March 27, 1993 .45 September 25, 1993 .45 The principal market for trading of voting shares of common stock of The Bureau of National Affairs, Inc., is through the Trustee of the Stock Purchase and Transfer Plan. PART II ------- Item 6.

Item 6. Selected Financial Data ----------------------- PART II ------- Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations --------------------- 1993 vs. 1992 - Consolidated Consolidated revenues of $201 million were up 4 percent from the prior year's $193 million. Excluding the cumulative effects of accounting changes recorded in 1992, consolidated net income for 1993 increased 19.5 percent to $11.3 million. This increase in comparable earnings was primarily the result of higher non-operating income, as operating profit showed a slight decline. Services (print and CD subscriptions and online products) accounted for all of the revenue increase as non-service revenues (software, outside printing, training media, books, and others) declined slightly. Service revenues amounted to 85.2 percent of consolidated revenues in 1993 and 84.6 percent in 1992, and increased 4.9 percent on higher prices and new print and CD product sales. Some of the CD sales replaced print products, but since CD products have more value- added features, they afford an opportunity for higher pricing than their print counterparts. Accordingly, while total service circulation increased only 1 percent, the annual subscription file dollar value, a more current measure of total subscription service business, increased 7.7 percent during 1993. The increase in service revenues was negatively affected by the absence of ETSI, the online network division which was sold in December, 1992. ETSI recorded revenues of $2,681,000 in 1992 and $2,472,000 in 1991. Non-service revenues amounted to $29.6 million, and declined .6 percent as higher software division sales were offset by lower sales for books, information-on-demand, training media, and printing sales to outside customers. Operating expenses increased 4.5 percent in 1993. The expense increase was mainly due to eleven new services developed and launched in 1993, including four in CD format, and higher systems development costs. Product development expenses increased 16.9 percent to $5.3 million, reflecting increased CD and print service development efforts. Operating expenses in 1993 include an identifiable $3.9 million for developing improved business and publishing systems. The overall expense increase was lessened by the absence of ETSI, which recorded operating expenses of $4,435,000 in 1992 and $4,813,000 in 1991. Operating profit declined 4 percent from 1992. The effect on operating profit from increased product and systems development expenses was mitigated by the absence of ETSI, which had a $1.8 million operating loss in 1992, and substantial improvements in the operating results for the international business unit and the tax planning software business. Non-operating income nearly doubled as investment income increased 40.3 percent to $6.2 million due to substantially higher gains on sales of securities and larger portfolio balances. Nearly $2 million in gains were recorded in 1993, an amount not expected to be matched in 1994. A net gain on disposal of assets in 1993 compared to a net loss in 1992 increased other net non-operating income $1.1 million. Earnings per share were $1.32 per share compared to $1.11 per share (before cumulative effects of accounting changes) in 1992. The consolidated federal, state, and local effective income tax rate was 28.5 percent in 1993 compared to 28.3 percent in 1992. A significant non-recurring item lowered the effective income tax rate in each year. In 1993, the effective rate was reduced 2 percent by the effect of the federal income tax rate change on net deferred tax assets. (Continued) In 1992, the effective rate was reduced 2.4 percent by a one-time realization of previously non-deductible expenses. The 1993 operating results reflect a substantial investment in developing and launching new products and in developing improved publishing and business systems. The Company is undertaking these efforts in response to customers' demand for information in an electronic format and to make operations more efficient. The development effort is ongoing and will negatively affect operating results, but management believes these expenditures are necessary to protect and enhance the Company's long-term value. Effective no later than 1994, the Company must account for the cost of providing continuing compensation and health care benefits for former employees in accordance with Statement of Financial Accounting Standards (SFAS) 112-- Employers' Accounting for Postemployment Benefits. The effect of adopting the new accounting standard has not been computed, but it is not expected to materially affect the financial position of the Company. 1992 vs. 1991 - Consolidated Results for 1992 were negatively impacted by the new accounting standards adopted during the fourth quarter. Consolidated net income before the cumulative effects of the accounting changes was $9.4 million, compared to $8.6 million in 1991, an increase of 9.5 percent. As discussed in Notes 5 and 8 to the consolidated financial statements, the Company adopted SFAS 106,--Employers' Accounting for Postretirement Benefits Other Than Pensions and SFAS 109-- Accounting for Income Taxes retroactive to January 1, 1992. The cumulative effect of these accounting changes was a net expense of $19.5 million. Annual operating expenses for 1992 also included an additional $4.3 million as a result of adopting SFAS 106. Consolidated net loss for 1992 was $10.1 million. Consolidated revenues of $193 million in 1992 increased 6.4 percent from $181.3 million in 1991. Service revenues amounted to 84.6 percent of total revenues in 1992 and 84.2 percent in 1991. Service revenues increased 6.9 percent in 1992 on higher prices and increased circulation. Seven new subscription services were launched in 1992 and subscription circulation increased 3 percent. Non- service revenues amounted to $29.8 million and increased 3.8 percent over 1991. Operating expenses increased 6.6 percent due to higher employment expenses (including accrued postretirement benefits and severance expenses), more published pages, a $1.1 million increase in identifiable product development costs, and $2 million in identifiable expenses for improved business and publishing systems. The consolidated operating profit for 1992 was $10.1 million, an increase of 3.6 percent over 1991. Overall favorable comparisons for non-operating items added to the year-to-year increase in income before cumulative effects of accounting changes. Investment income increased due to higher average portfolio balances during the year. Interest expense decreased due to lower interest rates and lower average outstanding debt. Other income (expense) was a higher net expense in 1992 compared to 1991 due to pre-tax losses recorded on the disposals of property, equipment, and a business unit. The consolidated federal, state, and local effective income tax rate was 28.3% in 1992 compared to 32.2% in 1991. The lower rate reflects the benefits realized for previously non-deductible expenses, and a higher level of tax- exempt investment income. (Continued) Segments The Company operates primarily in the business information publishing industry. Operations consist primarily of the production and marketing of information products in print and electronic form, and outside printing services. Activities in other industry segments provide less than ten percent of total revenues. Deferred Tax Assets In accordance with SFAS 109, the Company has recorded $12 million of net deferred tax assets as of year-end 1993. This amount includes $17.9 million related to the accrued postretirement benefits liability. No valuation allowance has been provided for the realization of the deferred tax assets. In assessing the realizability of the deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company has a consistent history of profitability and taxable income, and management believes this trend will continue. Factors supporting this conclusion are consistent profitable operations, a quality reputation in the markets served by the Company, a high renewal rate for subscription products, a growing deferred revenue liability (representing payments and orders for future fulfillment), and the recent successful introduction of products using new CD and electronic delivery methods. In the opinion of management, it is more likely than not that the existing deferred tax assets will be realized in future years, and no valuation allowance is necessary. Financial Resources and Cash Flows The Company maintains its financial reserves in cash and investment securities which, along with its operating cash flows, are sufficient to fund ongoing cash expenditures for operations and to support employee ownership. Cash provided from operating activities amounted to $23.5 million in 1993, $34 million in 1992, and $22.4 million in 1991. Cash flow from operations declined in 1993 due to a 5.3 percent increase in expenditures and slightly lower collections. Cash flows from operations had increased substantially in 1992 due to a one-time change in the subscription billing cycle. Cash outlays for capital expenditures were $9.1 million in 1993, compared with $5.2 million in 1992, and $17.4 million in 1991. This included equipment purchases, office furnishings, and building improvements. Capital expenditures in 1991 also reflect major renovations of older office space and equipment purchases for the new printing facility, and $1.6 million for purchased publications. Capital expenditures, are expected to be $7 million in 1994. Sales of capital stock to employees provided $2.8 million of equity capital in 1993. Dividends paid to shareholders amounted to $7.7 million in 1993, $7.1 million in 1992, and $6.9 million in 1991. Other 1993 financing expenditures included $3.2 million for debt principal repayments and $2.2 million for repurchases of Class B and Class C capital stock. (Continued) For 1994, financing requirements include $4.2 million for scheduled debt repayment and $1.1 million for known repurchases of Class B and Class C stock. With $85 million in cash and investment portfolios, the financial position and liquidity of the Company remains very strong. Should additional funding become necessary in the future, the Company has substantial debt capacity based on its operating cash flows and real estate equity which could be mortgaged. Since subscription monies are collected in advance, cash flows from operations, along with existing financial reserves and proceeds from the sales of capital stock, have been sufficient in past years to meet all operational needs, new product introductions, capital expenditures, debt repayments, and, in addition, provide funds for dividend payments and the repurchase of Class B and Class C stock tendered by shareholders. PART II ------- Item 8.

Item 8. Financial Statements and Supplementary Data ------------------------------------------- THE BUREAU OF NATIONAL AFFAIRS, INC. Consolidated Financial Statements December 31, 1993 and 1992 (With Independent Auditors' Report Thereon) INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders The Bureau of National Affairs, Inc.: We have audited the consolidated financial statements of The Bureau of National Affairs, Inc. as listed in the accompanying index in Part IV, Item 14(a)(1). In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying in- dex in Part IV, Item 14(a)(2). These consolidated financial statements and fi- nancial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Bureau of National Affairs, Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth herein. As discussed in Note 6 to the consolidated financial statements, the Company changed its method of accounting for investments to adopt the provisions of the Financial Accounting Standards Board (SFAS) 115 - Accounting for Certain Investments in Debt and Equity Securities, at December 31, 1993. s\ KPMG Peat Marwick -------------------- Washington, D. C. February 22, 1994 THE BUREAU OF NATIONAL AFFAIRS, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (In thousands of dollars) A S S E T S ----------- 1993 1992 --------- --------- CURRENT ASSETS: Cash and cash equivalents (Note 6) $ 10,982 $ 10,553 Short-term investments (Note 6) 8,804 6,883 Accounts receivable (net of allowance for doubtful accounts of $1,376 in 1993 and $984 in 1992) 41,181 34,794 Inventories (Note 9) 6,975 7,280 Prepaid expenses 2,289 2,608 Deferred selling expenses (Note 3) 24,234 18,083 --------- --------- Total current assets 94,465 80,201 --------- --------- MARKETABLE SECURITIES (Note 6) 65,265 57,651 --------- --------- PROPERTY AND EQUIPMENT, at cost (Notes 4 and 12): Land 5,176 4,933 Buildings and improvements 47,864 48,405 Furniture, fixtures and equipment 53,832 46,768 --------- --------- 106,872 100,106 Less - accumulated depreciation 45,490 38,963 --------- --------- Net property and equipment 61,382 61,143 --------- --------- DEFERRED INCOME TAXES (NOTE 8) 16,562 15,354 --------- --------- GOODWILL (Note 10) 10,175 10,488 --------- --------- OTHER ASSETS (Note 11) 3,668 4,198 --------- --------- Total assets $ 251,517 $ 229,035 ========= ========= (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (In thousands of dollars) LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ 1993 1992 --------- --------- CURRENT LIABILITIES: Accounts payable $ 15,569 $ 14,427 Employee compensation and benefits payable 13,423 11,115 Income taxes payable 38 143 Deferred income taxes (Note 8) 4,540 1,508 Current portion of long-term debt (Note 12) 4,186 7,172 Deferred subscription revenue (Note 3) 107,834 99,523 --------- --------- Total current liabilities 145,590 133,888 POSTRETIREMENT BENEFITS, less current portion (Note 5) 49,162 43,991 LONG-TERM DEBT, less current portion (Note 12) 1,332 1,534 OTHER LIABILITIES 2,949 2,974 --------- --------- Total liabilities 199,033 182,387 --------- --------- COMMITMENTS AND CONTINGENCIES (Notes 4, 13 and 14) STOCKHOLDERS' EQUITY (Notes 6 and 14): Capital stock, common, $1.00 par value - Class A - Voting; Authorized 6,700,000 shares; issued 6,478,864 shares 6,479 6,479 Class B - Nonvoting; authorized 5,300,000 shares; issued 4,919,490 shares in 1993 and 4,594,845 shares in 1992 4,919 4,595 Class C - Nonvoting; authorized 1,000,000 shares; issued 506,336 shares 506 506 Additional paid-in capital 18,423 16,298 Retained earnings 36,933 33,372 Treasury stock, at cost - 3,351,887 shares in 1993 and 3,059,364 shares in 1992 (16,360) (14,496) Net unrealized gain (loss) on marketable securities 1,614 (67) Foreign currency translation adjustment (30) (39) --------- --------- Total stockholders' equity 52,484 46,648 --------- --------- Total liabilities and stockholders' equity $ 251,517 $ 229,035 ========= ========= See accompanying notes to consolidated financial statements. THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (1) PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of The Bureau of National Affairs, Inc. (the "Parent"), and its subsidiaries (consolidated, the "Company"). The Company operates primarily in the business information publishing industry. Operations consist primarily of the production and marketing of information products in print and electronic form, and outside printing services. Activities in other industry segments provide less than 10 percent of total revenue. The Company did not derive 10 percent or more of its revenues from any one customer or government agency or from foreign sales, nor did it have 10 percent or more of its assets in foreign locations. Material intercompany transactions and balances have been eliminated. Certain prior year balances have been reclassified to conform with current year presentation. All subsidiaries are wholly-owned and fully consolidated. The net investment under the equity method of accounting as of December 31, 1993, for each operating subsidiary was as follows (in thousands of dollars): Cumulative Cost and Increase Capital (Decrease) Net Contributions in Equity Investment --------------- ---------- ------------ BNA Communications Inc. $ 3,165 $ (1,388) $ 1,777 BNA International Inc. 1 (4,136) (4,135) BNA Washington Inc. 6,436 5,220 11,656 Pike & Fischer, Inc. 1,575 1,352 2,927 Tax Management Inc. 12,139 5,982 18,121 The McArdle Printing Co., Inc. 5,800 3,473 9,273 --------- --------- --------- Total $ 29,116 $ 10,503 $ 39,619 ========= ========= ========= (2) ACQUISITIONS AND DISPOSITIONS In December 1992, the Company sold the assets of its online human resource information business division, Executive Telecom Systems International (ETSI). The sales price was $1,340,000, and consisted of cash and the transfer of ETSI's liabilities. The sale resulted in a recorded pre-tax loss of $512,000, but an after-tax gain of $64,000. ETSI's revenues were $2,681,000 in 1992, and $2,472,000 in 1991; operating expenses were $4,435,000 in 1992, and $4,813,000 in 1991. In August 1991, the Company purchased publications from McGraw-Hill, Inc., for $1,575,000 in cash and the assumption of $602,000 in subscription fulfillment obligations. The acquisition cost was assigned to assets, (Continued) THE BUREAU OF NATIONAL AFFAIRS,INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS primarily to customer lists and a non-compete agreement, based on their respective appraised values at the date of acquisition, and to goodwill. (3) RECOGNITION OF SUBSCRIPTION REVENUES AND SELLING EXPENSES Subscription revenues and related field selling and direct promotion expenses are deferred and amortized over the subscription terms, which are primarily one year. Deferred subscription revenue is classified on the balance sheet as a current item; however the fulfillment of the Company's subscription liability will use substantially less current assets than the liability amount shown. (4) DEPRECIATION AND LEASES The Company uses straight-line and accelerated methods of depreciation based on estimated useful lives ranging from 5 to 45 years for buildings and improvements and 5 to 11 years for furniture, fixtures and equipment. Depreciation expense was $8,605,000 in 1993, $7,702,000 in 1992, and $6,846,000 in 1991. Expenditures for maintenance and repairs are expensed while major replacements and improvements are capitalized. The Company has non-cancelable operating leases for office space, data processing equipment, and vehicles. Total rent expense was $3,673,000 in 1993, $3,971,000 in 1992, and $4,056,000 in 1991 (net of sublease income of $195,000, $149,000, and $103,000, respectively). As of December 31, 1993, future minimum lease commitments under non- cancelable operating leases, net of sublease rentals, were as follows (in thousands of dollars): Rental Sublease Payments Rentals Net -------- -------- ------ 1994 3,778 (228) 3,550 1995 3,378 - 3,378 1996 2,700 - 2,700 1997 2,626 - 2,626 1998 2,606 - 2,606 Thereafter 4,946 - 4,946 -------- -------- -------- Total $20,034 $ (228) $19,806 ======== ======== ======== (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (5) EMPLOYEE BENEFIT PLANS The Company has noncontributory defined benefit pension plans covering employees of the Parent and certain subsidiaries. Benefits are based on years of service and average annual compensation for the highest paid five years during the last ten years of service. The plans provide for five-year cliff vesting. The Company's funding practice is to contribute amounts, which at a minimum, satisfy forty-year funding program requirements. The Company contributed $2,914,000 to the Plan in 1993 and, because of Internal Revenue Service funding limitations, none in 1992 or 1991. Pension expense is computed on an accrual basis in accordance with financial reporting standards. Components of the net pension expense, based on the actuarial study as of January 1 for each year, were as follows (in thousands of dollars): 1993 1992 1991 -------- -------- -------- Service cost - benefits earned during the period $ 2,505 $ 2,388 $ 2,550 Interest cost 4,009 3,346 3,310 Actual return on plan assets during the year (5,904) (3,825) (6,426) Net asset gain deferred for later recognition 2,255 305 3,276 Amortization of unrecognized plan assets (93) (208) (137) Special benefits for early retirement - 275 - -------- -------- -------- Net pension expense $ 2,772 $ 2,281 $ 2,573 ======== ======== ======== (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table sets forth the funded status of the Plan and the amounts recognized in the Company's Consolidated Balance Sheets (in thousands of dollars): December 31, ------------------- 1993 1992 -------- -------- Actuarial present value of benefit obligations: Vested benefits $ 40,283 $ 32,697 Nonvested benefits 4,778 3,187 -------- -------- Accumulated benefit obligation 45,061 35,884 Projected future compensation 18,288 13,126 -------- -------- Projected benefit obligation 63,349 49,010 Plan assets at fair value 52,906 46,761 -------- -------- Projected benefit obligation in excess of plan assets 10,443 2,249 Unrecognized net asset 3,312 3,620 Unrecognized net (loss) gain (3,843) 4,659 Unrecognized prior service cost (2,442) (2,916) -------- -------- Accrued pension liability 7,470 7,612 Less - current portion 1,562 2,914 -------- -------- Long-term portion $ 5,908 $ 4,698 ======== ======== Assumed discount rate 7.0% 8.0% Assumed rate of compensation increase 5.0% 5.0% Expected long-term rate of return on assets 8.0% 8.0% Plan assets included equity securities, fixed income securities, and temporary investments. Calculations of benefit obligations as of December 31, 1993, have been estimated by an independent actuary and are subject to revision upon completion of a detailed actuarial study. In addition, some acquired subsidiaries have defined contribution pension plans and union-sponsored multi-employer pension plans. Contributions under some of these plans are at the discretion of the Board of Directors of the respective subsidiaries. Total contributions under these plans were $721,000 in 1993, $688,000 in 1992 and $636,000 in 1991. The Company also has a cash profit sharing plan based on income before taxes, as defined, covering employees of the Parent and certain subsidiaries. Profit sharing expense was $849,000 in 1993, $1,154,000 in 1992, and $1,349,000 in 1991. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In addition to providing pension benefits, the Company extends certain health care and life insurance benefits ("other postretirement benefits") to retired employees. Most of the Company's employees are eligible for these benefits if they retire while working for the Company. The Company's policy is to fund these benefits as claims and premiums are paid. Prior to 1992, the cost of postretirement benefits was charged to expense on a pay- as-you-go (cash) basis. Cash payments made by the Company for these benefits totaled $985,000 in 1993, $771,000 in 1992, and $666,000 in 1991. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions, and changed its method of accounting for postretirement benefits from a cash basis to an accrual basis. The accounting change for the benefits resulted in a one-time, non-cash expense in 1992 of $21,621,000, net of taxes of $14,079,000, for the transition obligation. The transition obligation is the actuarially determined accumulated postretirement benefit obligation as of the date of adoption of SFAS 106. In addition, the pre-tax expense for postretirement benefits for 1992 was $4,313,000 higher as a result of having adopted this method of accounting. Components of the postretirement benefit expense, based on the actuarial study as of January 1 for each year, were as follows (in thousands of dollars): 1993 1992 -------- ------- Service cost-benefits earned during the period $ 1,993 $ 2,230 Interest cost 3,073 2,854 Amortization of net gain (39) - ------- ------- Postretirement benefit expense $ 5,027 $ 5,084 ======= ======= The following table sets forth the amounts recognized in the Company's Consolidated Balance Sheets (in thousands of dollars): December 31, ------------------ 1993 1992 ------- ------- Actuarial present value of benefit obligation: Retirees $12,934 $11,043 Fully eligible active plan participants 761 1,162 Other active plan participants 22,701 24,861 ------- ------- Accumulated benefit obligation 36,396 37,066 Unrecognized net gain 7,924 3,212 ------- ------- Accrued other postretirement benefits liability 44,320 40,278 Less - current portion 1,066 985 ------- ------- Long-term portion 43,254 39,293 ======= ======= Assumed discount rate 7.0% 8.0% Assumed rate of compensation increase 5.0% 5.0% (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The December 31, 1993 accumulated benefit obligation was determined using an assumed health care cost trend rate of 10.0 percent in 1994, gradually declining to 5.0 percent per year in the year 2001 and thereafter over the projected payout period of the benefits. The effect of a one percent increase in the health care cost trend rate at December 31, 1993 would have resulted in a $6,834,000 increase in the accumulated benefit obligation and a $1,141,000 increase in the 1993 postretirement benefit expense. (6) INVESTMENTS AND INVESTMENT INCOME Cash and investments were reported as follows (in thousands of dollars): December 31, -------------------- 1993 1992 ------- ------- Cash and cash equivalents $10,982 $10,553 Short-term investments 8,804 6,883 Marketable securities 65,265 57,651 -------- -------- Total $85,051 $75,087 ======== ======== Cash equivalents consist of short-term investments, with a maturity of three months or less at the time of purchase. Short-term investments consisted of other fixed-income investments, maturing in one year or less. Marketable securities consisted of equity securities and fixed-income securities maturing in more than one year. Investment income consisted of the following (in thousands of dollars): 1993 1992 1991 ------ ------ ------ Interest income $3,581 $3,344 $3,645 Dividend income 640 369 56 Gain on sales of securities 1,969 698 240 -------- -------- -------- Total $6,190 $4,411 $3,941 ======== ======== ======= Proceeds from the sales of securities in 1993 were $156,284,000 and the gross realized gains and losses on these sales were $2,179,000 and $(210,000), respectively. Net realized gains after taxes on sales of securities included in net income amounted to $1,299,000 in 1993, $461,000 in 1992, and $158,000 in 1991. The specific identification method is used in computing realized gains and losses. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) 115 - Accounting for Certain Investments in Debt and Equity Securities. SFAS 115 requires that debt and equity securities be classified into one of three categories: held-to-maturity, available- for-sale, or trading. Held-to-maturity securities are measured at amortized cost in the Consolidated Balance Sheet and would include those securities the Company had positive intent and ability to hold until maturity. Trading securities are measured at their fair values, and include securities bought and held principally for the purpose of selling them in the near term. Available-for-sale securities are also measured at their fair values, and include investments not classified as held-to-maturity or trading. All of the Company's investments portfolio have been classified as available-for- sale and are reported at their fair values (quoted market price). Retroactive application of SFAS 115 is not permitted. Investments in fixed-income and equity securities were as follows at December 31, 1993 (in thousands of dollars): Gross Gross Amortized Unrealized Unrealized Aggregate Cost Gains Losses Fair Value --------- ---------- ---------- ----------- Equity securities $ 15,305 $ 80 $ (110) $ 15,275 U.S. Government securities 2,271 - - 2,271 Municipal bonds 50,567 2,562 ( 51) 53,078 Corporate debt 3,444 1 - 3,445 ---------- ---------- ---------- ---------- Total $ 71,587 $ 2,643 $ (161) $ 74,069 ========= ========== ========== ========== The differences between amortized cost and aggregate fair value result in unrealized gains or losses. Under SFAS 115, the net unrealized gain or loss is reported, net of tax, as a separate component of Stockholders' Equity. Prior to adopting SFAS 115, only a net unrealized loss was reported therein. The aggregate unrealized gain or loss, net of tax, was a gain of $1,614,000 and a loss of $67,000 on December 31, 1993 and 1992, respectively. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Contractual maturities of the fixed-income securities as 1993 were as follows (in thousands of dollars): Amortized Cost Fair Value -------- ---------- Within one year $ 8,778 $ 8,804 One through five years 16,634 17,345 Five through ten years 13,859 14,366 Over ten years 17,011 18,279 --------- --------- Total $ 56,282 $ 58,794 ========= ========= Prior to adopting SFAS 115, the Company's equity securities were carried at the lower of cost or market and fixed-income securities were carried at amortized cost. Marketable securities consisted of the following at December 31, 1992 (in thousands of dollars): Amortized Carrying Cost Market Amount --------- --------- --------- Equity securities $ 10,775 $ 10,674 $ 10,674 Fixed-income securities 46,977 48,300 46,977 --------- --------- --------- Total $ 57,752 $ 58,974 $ 57,651 ========= ========= ========= (7) OTHER INCOME (EXPENSE), NET Other income (expense), net was comprised of the following (in thousands of dollars): 1993 1992 1991 ------- -------- -------- Gain (loss) on sales of businesses and publications $ 311 $ (374) $ - Gain (loss) on disposals of property and equipment (8) (476) (55) -------- -------- -------- Total $ 303 $ (850) $ (55) ======== ======== ======== (8) INCOME TAXES Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) 109 - Accounting for Income Taxes, and changed its method of accounting for income taxes from the deferred method to the asset and liability method. Under the deferred method, deferred income taxes were recognized for income and expense items that were reported in different (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS years for financial reporting and income tax purposes using the tax rate applicable for the year of the calculation. Deferred tax assets and liabilities were not affected by changes in income tax rates under the deferred method. Under the asset and liability method, deferred tax assets and liabilities are recognized for future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred assets and liabilities are measured using enacted tax rates which apply to taxable income in future years when those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities for changes in tax rates will be recognized in the period that includes the enactment date. The cumulative effect of adopting SFAS 109 amounted to a one-time, non-cash tax benefit of $2,139,000 and is reported separately in the Consolidated Statements of Income for the year ended December 31, 1992. Prior years' financial statements have not been restated to apply the provisions of SFAS 109. As discussed in Note 5, the Company adopted SFAS 106 and recorded the transition obligation for other postretirement benefits. A deferred tax benefit of $14,079,000 was provided effective January 1, 1992, in conjunction with this accounting change. The total income tax expense (benefit) was allocated as follows (in thousands of dollars): 1993 1992 ------- ------- Income before taxes and cumulative effects of accounting changes $ 4,482 $ 3,718 Stockholders' Equity -- Change in: Unrealized gain/loss on marketable securities 902 34 Foreign currency translation adjustment 4 (36) -------- -------- Total $ 5,388 $ 3,716 ======== ======== (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The provision for income taxes, excluding those effects of accounting changes, consisted of the following (in thousands of dollars): 1993 1992 1991 ------- ------- ------- Taxes currently payable Federal $ 3,398 $ 6,198 $ 4,358 State and local 383 1,046 603 -------- -------- -------- 3,781 7,244 4,961 -------- -------- -------- Deferred tax provision Federal 571 (2,840) (768) State and local 130 (686) (101) -------- -------- -------- 701 (3,526) (869) -------- -------- -------- Total $ 4,482 $ 3,718 $ 4,092 ======== ======== ======== Reconciliation of the U.S. statutory rate to the Company's consolidated effective income tax rate was as follows: Percent of Pretax Income ------------------------------- 1993 1992 1991 ------- ------- ------- Federal statutory rate 35.0% 34.0% 34.0% Rate difference due to level of taxable income (1.0) - - State and local income taxes, net of Federal income tax benefit 2.0 1.8 2.6 Goodwill amortization and other nondeductible expenses 1.2 1.4 1.4 Tax-exempt interest exclusion (6.5) (5.9) (5.8) Adjustment to deferred taxes for enacted changes in tax rates (2.0) - - Dividends received exclusion (.9) (.7) (.1) Tax benefit from sale of business - (2.4) - Others, net .7 .1 .1 --------- --------- --------- Total 28.5% 28.3% 32.2% ========= ========= ========= (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The significant components of deferred income tax expense were as follows (in thousands of dollars): 1993 1992 -------- --------- Deferred tax expense (exclusive of the effects listed below) $ 1,011 $ (3,526) Adjustment to deferred taxes for enacted changes in tax rates (310) - --------- --------- Total $ 701 $ (3,526) ========= ========= For the year ended December 31, 1991, deferred income tax expense resulted from timing differences in the recognition of transactions for financial and tax reporting purposes as computed under the deferred method of accounting for income taxes. The tax effects of those timing differences totalled $(869,000) and were due to: inventory costs, $(177,000); depreciation, $191,000; deferred selling expense, $517,000; pension expense, $(828,000); annual leave, $(313,000); and other items, $(259,000). The tax effects of temporary differences that gave rise to the deferred tax assets and liabilities were as follows (in thousands of dollars): December 31, ------------------------- 1993 1992 -------- ---------- Deferred tax assets: Other postretirement benefits $ 17,870 $ 15,885 Pension expense 3,037 3,021 Annual leave 1,566 1,412 Inventories 1,443 1,898 Others 1,808 1,841 --------- --------- Total deferred tax assets 25,724 24,057 --------- --------- Deferred tax liabilities: Deferred selling expenses (9,778) (7,158) Depreciation (2,780) (2,971) Others (1,144) (82) --------- --------- Total deferred tax liabilities (13,702) (10,211) --------- --------- Net deferred tax assets $ 12,022 $ 13,846 ========= ========= In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS temporary differences become deductible. The Company has a consistent history of profitability and taxable income, and management believes that this trend will continue. Factors supporting this conclusion include consistent profitable operations, a quality reputation in the markets served by the Company, a high renewal rate for subscription products, a growing de- ferred revenue liability (representing payments and orders for future ful- fillment), and the recent successful introduction of products using new CD- ROM and electronic delivery methods. In the opinion of management, it is more likely than not that the existing deferred tax assets will be realized in future years, and no valuation allow- ance is necessary. (9) INVENTORIES Inventories, valued at the lower of cost (principally average cost method) or market, were as follows (in thousands of dollars): December 31, --------------------- 1993 1992 ------- -------- Materials and supplies $ 4,579 $ 3,888 Work in process 94 173 Finished goods 2,302 3,219 -------- -------- Total $ 6,975 $ 7,280 ======== ======== (10) GOODWILL Goodwill represents the excess of the cost of purchased publications and the capital stock of subsidiaries over the fair value of net assets at the dates of their respective acquisitions, net of accumulated amortization of $2,958,000 in 1993 and $2,645,000 in 1992. Goodwill acquired prior to November 1, 1970, in the amount of $634,000, is not being amortized because, in management's opinion, it has continuing value. Other goodwill is amortized on a straight-line basis, using forty years for the publishing acquisitions and ten years for the electronic infor- mation acquisitions. During 1992, unamortized goodwill of $37,000 was written off with the sale of ETSI's assets. Amortization expense was $313,000 for 1993, $334,000 for 1992, and $324,000 for 1991. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (11) OTHER ASSETS Other assets were as follows (in thousands of dollars): December 31, -------------------- 1993 1992 ------- ------- Amortizable assets- Customer lists $ 605 $ 1,123 Film production costs 1,599 1,218 Lease commissions 533 628 Software 7 60 Editorial service agreement 48 121 Non-compete agreements 139 358 Others - 1 -------- -------- 2,931 3,509 Notes and other receivables 737 689 -------- -------- Total $ 3,668 $ 4,198 ======== ======== Film production costs are amortized using the revenue forecast method. Other amortizable assets are expensed evenly over their respective estimated lives, ranging from 3 to 10 years. Amortization expense for these assets was as follows (in thousands of dollars): 1993 1992 1991 ------ ------ ------ Customer lists $ 518 $ 665 $ 613 Film production costs 346 297 343 Lease commissions 95 71 65 Software 56 103 163 Editorial service agreement 73 73 73 Non-compete agreements 219 220 193 Others 1 7 5 ------- ------- ------- Total $1,308 $1,436 $1,455 ======= ======= ======= Accumulated amortization for customer lists, the editorial service agreement, non-compete agreements, and other intangible assets was $4,322,000 in 1993, $3,511,000 in 1992, and $3,004,000 in 1991. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (12) LONG-TERM DEBT Long-term debt was as follows (in thousands of dollars): December 31, -------------------- 1993 1992 -------- -------- Note payable, at 3-month secondary market CD rate plus 1/2% (3.66% at December 20, 1993), due in 1994, interest payable monthly $ 4,000 $ 7,000 Note payable, 8-1/4%, due in 1999; secured by real estate; principal and interest payable $26,045 monthly 1,411 1,599 Other notes payable 107 107 --------- --------- 5,518 8,706 Less - current portion 4,186 7,172 --------- --------- Long-term portion $ 1,332 $ 1,534 ========= ========= The aggregate long-term portion at December 31, 1993, is payable as follows: 1995 - $220,000; 1996 - $239,000; 1997 - $259,000; 1998 - $281,000; and 1999 - $333,000. As of December 31, 1993, property with a cost of $4,033,000 had been pledged as collateral for the real estate debt. (13) COMMITMENTS AND CONTINGENCIES The Company has ongoing service agreements with software authors and a multi- year agreement with a key employee of one of its subsidiaries. The Company's total financial commitment related to these agreements is $1,008,000 for the year 1994. The Company is involved in certain legal actions arising in the ordinary course of business. In the opinion of management the ultimate disposition of these matters will not have a material adverse effect on the consolidated fi- nancial statements. (14) STOCKHOLDERS' EQUITY Ownership and transferability of Class A, Class B, and Class C stock are substantially restricted to employees and former employees by provisions of the Parent's certificate of incorporation and bylaws. Ownership of Class A stock, which is voting, is restricted to active employees. Class B stock and Class C stock are nonvoting. No class of stock has preference over another upon declaration of dividends or liquidation. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS During 1993, the Company's Certificate of Incorporation was amended to in- crease the authorized Class B stock shares by 500,000 shares and decrease the authorized Class A stock shares by 500,000 shares, so as to ensure that future retirees will have the option of exchanging their Class A stock for Class B stock upon retirement. The Company's commitment to employee ownership is supported by its policy to repurchase all Class B and Class C stock tendered by shareholders. As of December 31, 1993, Class B and Class C stock having a total market value of $1,132,000 are known or expected to be tendered during 1994. The Company, as a matter of policy, is also committed to repurchase any Class A stock ten- dered by shareholders to the Stock Purchase & Transfer Plan Trustee which the Trustee is unable to purchase with proceeds from the sale of Class A stock to employees. Treasury stock as of December 31, 1993 and 1992, respectively, consisted of: Class A, 3,289,445 and 2,980,591 shares; Class B, none and 23,786 shares; and Class C, 62,442 and 54,987 shares. Earnings per share have been computed based on the aggregate weighted average number of all outstanding shares of stock, which was 8,549,522 in 1993, 8,458,109 in 1992, and 8,334,816 in 1991. Financial statements of the Company's United Kingdom operations denominated in British pounds are translated into U.S. dollars at year-end exchange rates, and related gains and losses are reflected, net of taxes, directly in Stockholders' Equity in the accompanying Consolidated Balance Sheets. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION THE BUREAU OF NATIONAL AFFAIRS, INC. ------------------------------------ (In Thousands of Dollars) Year Ended December 31 ------------------------------ Item 1993 1992 1991 ---- ------- ------- ------- Maintenance and repairs $2,768 $2,784 $2,911 Depreciation and amortization of intangible assets, preoperating costs and similar deferrals 1,621 1,770 1,779 Taxes, other than payroll and income taxes 2,626 2,364 2,090 Royalties 3,380 3,297 2,946 Advertising costs 897 618 601 PART II ------- Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure -------------------- There were no changes in or disagreements with accountants on accounting and financial disclosures during the two years ended December 31, 1993 or through the date of this Form 10-K. PART III -------- Except as set forth in this Form 10-K under Part I, Item X, "EXECUTIVE OFFICERS OF THE REGISTRANT," the information required by Items 10, 11, 12, and 13, is contained in the Company's definitive Proxy Statement (the "Proxy Statement") filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, to be filed with the SEC within 120 days of December 31, 1993. Such information is incorporated herein by reference. Item 10.

Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- The information required under this Item 10 is contained in the Proxy Statement under the headings "I. ELECTION OF DIRECTORS" and "BIOGRAPHICAL SKETCHES OF NOMINEES," and is incorporated herein by reference. Information related to Executive Officers is omitted from the Proxy Statement in reliance on Instruction 3 to Regulation S-K, Item 401(b), and included as Item X of Part I of this report. Item 11.

Item 11. Executive Compensation ---------------------- The information required under this Item 11 is contained in the Proxy Statement under the headings "III. EXECUTIVE COMPENSATION" and "IV. EMPLOYEE BENEFIT PLANS" and is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Beneficial Owners and Management ------------------------------------------------------ The information required under this Item 12 is contained in the Proxy Statement under the heading "I. ELECTION OF DIRECTORS" and is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions ---------------------------------------------- The information required under this Item 13 is contained in the Proxy Statement under the heading "III. EXECUTIVE COMPENSATION" and is incorporated herein by reference. PART IV ------- Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Report on Form 8-K --------------------------------------------------------------- The following documents are filed as part of this report. (a)(1) Financial Statements: Page --------------------- ----- Report of Independent Auditors 26 Consolidated Balance Sheets as of December 31, 1993 and 1992. 28-29 Consolidated Statements of Income, Consolidated Statements of Cash Flows, and Consolidated Statements of Changes in Stockholders' Equity for each of the years ended December 31, 1993, 1992, and 1991 27,30-32 Notes to Consolidated Financial Statements 33-47 (2) Financial Statement Schedules: ------------------------------ Report of Independent Auditors as to the financial statement schedules 26 I Marketable Securities - Other Investments 48-49 V Property, Plant and Equipment 50 VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 51 VIII Valuation and Qualifying Accounts and Reserves 52 X Supplementary Income Statement Information 53 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (a)(3) Exhibits: --------- 3.1 Certificate of Incorporation, as amended* 3.2 By laws, as amended** 11 Statement re: Computation of Per Share Earnings is contained in the 1993 Consolidated Financial Statements in the Notes to Consolidated Financial Statements, Note 14, "Stockholders' Equity," at page 46 of this Form 10-K. 22 Subsidiaries of the Registrant.* 24.1 Consent of Independent Auditors for 1993, 1992, and 1991 financial statements. 28.1 Proxy Statement for the Annual Meeting of security holders to be held on April 16, 1994.3*** 28.2 Annual Report on Form 11-K related to the Company's Deferred Stock Purchase Plan for the fiscal year ended December 31, 1993*. * Filed herewith. ** Incorporated by reference to the Company's 1988 Form 10-K, Commission File Number 2-28286, filed on March 30, 1989. The exhibit numbers indicated above correspond to the exhibit numbers in that filing. *** Previously filed with the Securities and Exchange Commission. Upon written or oral request to the Company's General Counsel, a copy of any of the above exhibits will be furnished at cost. (b) Reports on Form 8-K: -------------------- No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. SIGNATURE --------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE BUREAU OF NATIONAL AFFAIRS, INC. By: s\ William A. Beltz ______________________________ William A. Beltz, President Date: 3/10/94 ______________________________ Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on dates indicated. By: s\ William A. Beltz By: s\ George J. Korphage --------------------------- ----------------------------------- William A. Beltz, George J. Korphage, President and Vice President and Chief Financial Chief Executive Officer Officer (Chief Accounting Officer) Director Director Date: 3/10/94 Date: 3/10/94 -------- -------- By: s\ Jacqueline M. Blanchard 3/10/94 By: s\ Frederick A. Schenck 3/10/94 --------------------------- ------- -------------------------- ------- Jacqueline M. Blanchard Date Frederick A. Schenck Date By: s\ Christopher R. Curtis 3/10/94 By: s\ Mary P. Swords 3/10/94 --------------------------- ------- -------------------------- ------- Christopher R. Curtis Date Mary P. Swords Date By: s\ Sandra C. Degler 3/10/94 By: s\ Daniel W. Toohey 3/10/94 --------------------------- ------- -------------------------- ------- Sandra C. Degler Date Daniel W. Toohey Date By: s\ Kathleen D. Gill 3/10/94 By: s\ Loene Trubkin 3/10/94 --------------------------- ------- -------------------------- ------- Kathleen D. Gill Date Loene Trubkin Date By: s\ John A. Jenkins 3/10/94 By: s\ Paul N. Wojcik 3/10/94 --------------------------- ------- -------------------------- ------- John A. Jenkins Date Paul N. Wojcik Date By: s\ John V. Schappi 3/10/94 --------------------------- ------- John V. Schappi Date

36270_1993.txt

36270

1993

Item 1. Business. -------- First Empire State Corporation (the "Registrant" or "First Empire (Parent)" or, together with its direct and indirect subsidiaries, the "Company") is a New York business corporation which is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the "BHCA") and under Article III-A of the New York Banking Law (the "Banking Law"). The principal executive offices of the Registrant are located at One M&T Plaza, Buffalo, New York 14240. First Empire (Parent) was incorporated in November 1969. As of December 31, 1993, the Company had consolidated total assets of $10.4 billion, deposits of $7.4 billion and stockholders' equity of $724 million. The Company had 3,655 full-time and 745 part-time employees as of December 31, 1993. At December 31, 1993, the Registrant had two wholly owned bank subsidiaries conducting business primarily in the State of New York: Manufacturers and Traders Trust Company ("M&T Bank") and The East New York Savings Bank ("East New York"). Since the beginning of 1990, the Company has experienced significant growth through federally-assisted acquisitions of assets and liabilities of failed thrift institutions and through unassisted mergers. In January and September 1990, respectively, M&T Bank, in two federally-assisted transactions, purchased selected assets and assumed selected liabilities of Monroe Savings Bank, FSB, Rochester, New York, and Empire Federal Savings Bank of America, Buffalo, New York, two institutions that had been placed in receivership. In May 1991, M&T Bank and East New York similarly purchased certain assets and assumed certain liabilities of Goldome, a Buffalo, New York savings bank, from the Federal Deposit Insurance Corporation ("FDIC"), as receiver. In July 1992, Central Trust Company and Endicott Trust Company, two banks located in Rochester and Endicott, New York, respectively, were acquired and merged with and into M&T Bank. The following table summarizes the loans and deposits acquired by the Company in these transactions at the time the transactions were consummated: Recent Acquisitions and Mergers Loans Deposits ----- -------- (In billions of dollars) Monroe Savings Bank, FSB $0.4 $0.5 Empire Federal Savings Bank of America 0.5 1.2 Goldome 1.0 2.2 Central Trust Company 0.8 1.0 Endicott Trust Company 0.2 0.3 The Company from time to time considers acquiring additional banks or thrift institutions, generally within markets it currently services or in other nearby markets. The Company has pursued such opportunities in the past, currently continues to actively review different opportunities, including the possibility of major acquisitions, and intends to continue this practice. Subsidiaries ------------ M&T Bank is a banking corporation which is incorporated under the laws of the State of New York. M&T Bank is a member of the Federal Reserve System, the FDIC and, since October 25, 1993, the Federal Home Loan Bank System. First Empire (Parent) acquired all of the issued and outstanding shares of the capital stock of M&T Bank in December 1969. The stock of M&T Bank represents a major asset of First Empire (Parent). M&T Bank operates under a charter granted by the State of New York in 1892, and the continuity of its banking business is traced to the organization of the Manufacturers and Traders Bank in 1856. The principal executive offices of M&T Bank are located at One M&T Plaza, Buffalo, New York 14240. As of December 31, 1993, M&T Bank had 122 banking offices located throughout New York State, including 106 in Western New York and in the Southern Tier of New York State, principally in Buffalo, Rochester and Endicott, 13 banking offices in the Hudson Valley region and one in New York City, plus a branch in Nassau, The Bahamas and representative offices in Albany and Syracuse. As of December 31, 1993, M&T Bank had consolidated total assets of $8.6 billion, deposits of $6.1 billion and stockholder's equity of $570 million. The deposit liabilities of M&T Bank are insured by the FDIC through either its Bank Insurance Fund ("BIF") or its Savings Association Insurance Fund ("SAIF"). Of M&T Bank's $6.1 billion in assessable deposits at December 31, 1993, 87% were assessed as BIF-insured and the remainder as SAIF-insured deposits. As a commercial bank, M&T Bank offers a broad range of financial services to a diverse base of consumers, businesses, professional clients, governmental entities and financial institutions located in its markets. Lending is focused on consumers residing in New York State and on New York-based small and medium-size businesses. M&T Bank also provides other financial services through its operating subsidiaries. East New York was acquired by First Empire (Parent) in December 1987. East New York, originally organized in 1868, is a New York-chartered capital stock savings bank, a member of the FDIC and, since October 25, 1993, a member of the Federal Home Loan Bank System. The deposit liabilities of East New York are insured by the FDIC through the BIF. The stock of East New York represents a major asset of First Empire (Parent). The principal executive offices of East New York are located at 2644 Atlantic Avenue, Brooklyn, New York 11207. Its banking business is conducted from 19 branch offices located in New York City and Nassau County, Long Island. As of December 31, 1993, East New York had total assets of $1.8 billion, deposits of $1.2 billion and stockholder's equity of $133 million. East New York takes deposits from, and offers other banking services to, a diverse base of customers located in its markets. East New York concentrates on making commercial mortgage loans which are secured by income producing properties that are primarily located throughout the metropolitan New York City area, especially apartment buildings and cooperative apartments. M&T Capital Corporation ("M&T Capital"), a wholly owned subsidiary of M&T Bank, was incorporated as a New York business corporation in January 1968. M&T Capital is a federally-licensed small business investment company operating under the provisions of the Small Business Investment Act of 1958, as amended ("SBIA"). M&T Capital provides equity capital and long-term credit to "small-business concerns", as defined by the SBIA. M&T Capital had assets of $19 million as of December 31, 1993, and recorded approximately $3.6 million of revenues in 1993. The headquarters of M&T Capital are located at One M&T Plaza, Buffalo, New York. M&T Mortgage Corporation ("M&T Mortgage") is the mortgage banking subsidiary of M&T Bank. M&T Mortgage was incorporated as a New York business corporation in November 1991. M&T Mortgage's principal activities are comprised of the origination of residential mortgages from loan production offices currently located in Columbus and Cincinnati, Ohio and Pittsburgh, Pennsylvania, and providing mortgage servicing to M&T Bank and others. M&T Mortgage had assets of $67 million as of December 31, 1993 and recorded approximately $10.1 million of revenues during 1993. The headquarters of M&T Mortgage are located at M&T Center, One Fountain Plaza, Buffalo, New York. M&T Financial Corporation ("M&T Financial"), a New York business corporation, is a wholly owned subsidiary of M&T Bank which specializes in capital-equipment leasing. M&T Financial was formed in October 1985, had assets of $86 million as of December 31, 1993 and recorded approximately $908,000 of revenues in 1993. The headquarters of M&T Financial are located at 4925 Main Street, Amherst, New York. M&T Securities, Inc. ("M&T Securities"), formerly named M&T Discount Brokerage Services, Inc. ("M&T Discount Brokerage"), is a wholly owned subsidiary of M&T Bank which was incorporated as a New York business corporation in November 1985. M&T Securities is registered as a broker/dealer under the Securities Exchange Act of 1934, as amended, and provides securities brokerage and investment advisory services. M&T Securities changed its name from M&T Discount Brokerage Services, Inc. effective as of December 1, 1993. M&T Securities recorded $446,000 of revenues during the fiscal year ended December 31, 1993. As of December 31, 1993, M&T Securities had immaterial assets, liabilities and net worth. The headquarters of M&T Securities are located at One M&T Plaza, Buffalo, New York. The Registrant and its banking subsidiaries have a number of other special-purpose or inactive subsidiaries. These other subsidiaries represented, individually and collectively, an insignificant portion of the Company's consolidated assets, net income and stockholders' equity at December 31, 1993. Lines of Business, Principal Services, Industry Segments -------------------------------------------------------- and Foreign Operations ---------------------- Commercial and retail banking, with activities incidental thereto, represents the sole significant line and/or segment of business of the Company. The Company's international activities are discussed in Note 14 of the Financial Statements filed herewith in Exhibit No. 13. The only activities that, as a class, contributed 10% or more of the sum of consolidated interest income and other income in each of the last three years were lending and investment securities transactions. The amount of income from such sources during those years is set forth on the Company's Consolidated Statement of Income filed herewith in Exhibit No. 13. Supervision and Regulation -------------------------- The banking industry is subject to extensive state and federal regulation and is undergoing significant change. In 1991, the Federal Deposit Insurance Corporation Improvement Act ("FDICIA") was enacted. FDICIA substantially amended the Federal Deposit Insurance Act ("FDI Act") and certain other statutes. Since FDICIA's enactment, the federal bank regulatory agencies have been in the process of adopting regulations to implement its statutory provisions. Most of these new regulatory provisions are now in effect, while others are being phased in over time. FDICIA and implementing regulations contain a number of substantial provisions that likely will have a significant impact on the banking industry as a whole and potentially could have a material impact upon the operations and earnings of the Company. The following discussion summarizes certain aspects of the banking laws and regulations that affect the Company. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in the state legislature, and before the various bank regulatory agencies. The likelihood and timing of any changes and the impact such changes might have on the Company are impossible to determine with any certainty. A change in applicable laws or regulations, or a change in the way such laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on the business of the Company. To the extent that the following information describes statutory or regulatory provisions, it is qualified entirely by reference to the particular statutory or regulatory provision. Bank Holding Company Regulation ------------------------------- As a registered bank holding company, the Registrant and its nonbank subsidiaries are subject to supervision and regulation under the BHCA by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") and the New York State Banking Superintendent (the "Banking Superintendent"). The Federal Reserve Board requires regular reports from the Registrant and is authorized by the BHCA to make regular examinations of the Registrant and its subsidiaries. Under the BHCA, the Registrant may not acquire direct or indirect ownership or control of more than 5% of the voting shares of any company, including a bank, without the prior approval of the Federal Reserve Board, except as specifically authorized under the BHCA. The Registrant is also subject to regulation under the Banking Law with respect to certain acquisitions of domestic banks. Under the BHCA, the Registrant, subject to the approval of the Federal Reserve Board, may acquire shares of nonbanking corporations the activities of which are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Federal Reserve Board has enforcement powers over bank holding companies and their nonbanking subsidiaries, among other things, to interdict activities that represent unsafe or unsound practices or constitute violations of law, rule, regulation, administrative orders or written agreements with a federal bank regulator. These powers may be exercised through the issuance of cease-and-desist orders, civil money penalties or other actions. Under the Federal Reserve Board's statement of policy with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit all available resources to support such institutions in circumstances where it might not do so absent such policy. Although this "source of strength" policy has been challenged in litigation, the Federal Reserve Board continues to take the position that it has authority to enforce it. For a discussion of circumstances under which a bank holding company may be required to guarantee the capital levels or performance of its subsidiary banks, see Capital Adequacy, below. The Federal Reserve also has the authority to terminate any activity of a bank holding company that constitutes a serious risk to the financial soundness or stability of any subsidiary depository institution or to terminate its control of any bank or nonbank subsidiaries. The BHCA includes a prohibition against interstate banking which can be overridden by any state which adopts a law that expressly permits out-of-state banking companies to form or acquire banks in such state. The Banking Law allows out-of-state banking companies to control New York banks if reciprocal rights are granted to New York banking companies. Most states have permitted New York banking companies to form or acquire banks located within their boundaries. Bank holding companies and their subsidiary banks are also subject to the provisions of the Community Reinvestment Act of 1977 ("CRA"). Under the terms of the CRA, the Federal Reserve Board (or other appropriate bank regulatory agency) is required, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low- and moderate-income neighborhoods. Further, such assessment is also required of any bank that has applied, among other things, to merge or consolidate with, or acquire the assets or assume the liabilities of, a federally- regulated financial institution, or to open or relocate a branch office. In the case of a bank holding company applying for approval to acquire a bank or bank holding company, the Federal Reserve Board will assess the record of each subsidiary bank of the applicant bank holding company in considering the application. The Banking Law contains provisions similar to the CRA which are applicable to New York-chartered banks. Supervision and Regulation of Bank Subsidiaries ----------------------------------------------- The Registrant's banking subsidiaries are subject to regulation, and are examined regularly, by various bank regulatory agencies: M&T Bank by the Federal Reserve Board and the Banking Superintendent and East New York by the FDIC and the Banking Superintendent. The Registrant and its direct, nonbanking subsidiaries are affiliates, within the meaning of the Federal Reserve Act, of the Registrant's subsidiary banks and their subsidiaries. As a result, the Registrant's subsidiary banks and their subsidiaries are subject to restrictions on loans or extensions of credit to, purchases of assets from, investments in, and transactions with the Registrant and its direct, nonbanking subsidiaries and on certain other transactions with them or involving their securities. Under the "cross-guarantee" provisions of the FDI Act, insured depository institutions under common control are required to reimburse the FDIC for any loss suffered by either the BIF or SAIF of the FDIC as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. Thus, any insured depository institution subsidiary of First Empire (Parent) could incur liability to the FDIC in the event of a default of another insured depository institution owned or controlled by First Empire (Parent). The FDIC's claim under the cross-guarantee provisions is superior to claims of stockholders of the insured depository institution or its holding company and to most claims arising out of obligations or liabilities owed to affiliates of the institution, but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institution. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the BIF or SAIF or both. Dividends from Bank Subsidiaries -------------------------------- M&T Bank and East New York are subject, under one or more of the banking laws, to restrictions on the amount and frequency (no more often than quarterly) of dividend declarations. Future dividend payments to the Registrant by its subsidiary banks will be dependent on a number of factors, including the earnings and financial condition of each such bank, and are subject to the limitations referred to in Note 16 to the financial statements contained in Exhibit No. 13 hereto and to other statutory powers of bank regulatory agencies. A condition precedent was interposed by the Banking Superintendent in connection with the Banking Superintendent's approval of a $41 million dividend payment by East New York to the Registrant in May 1991, which condition requires the Banking Superintendent's further approval before East New York can declare any subsequent dividends to the Registrant. The Banking Superintendent has approved dividend payments aggregating $9.5 million from East New York to the Registrant since imposing this condition. This condition precedent expired in 1994. Under FDICIA, an insured depository institution is prohibited from making any capital distribution to its owner, including any dividend, if, after making such distribution, the depository institution fails to meet the required minimum level for any relevant capital measure, including the risk-based capital adequacy and leverage standards discussed below. Capital Adequacy ---------------- The Federal Reserve Board and the FDIC have adopted risk-based capital adequacy guidelines for bank holding companies and banks under their supervision. Under the guidelines the so-called "Tier 1 capital" and "total capital" as a percentage of risk-weighted assets and certain off-balance sheet instruments must be at least 4% and 8%, respectively. The Federal Reserve Board and the FDIC have also imposed a leverage standard to supplement their risk-based ratios. This leverage standard focuses on a banking institution's ratio of Tier 1 capital to average total assets, adjusted for goodwill and certain other items. Under these guidelines, banking institutions that meet certain criteria, including excellent asset quality, high liquidity, low interest rate exposure and good earnings, and have received the highest regulatory rating must maintain a ratio of Tier 1 capital to total assets of at least 3%. Institutions not meeting these criteria, as well as institutions with supervisory, financial or operational weaknesses, along with those experiencing or anticipating significant growth are expected to maintain a Tier 1 capital to total assets ratio equal to at least 4 to 5%. As reflected in the following table, the risk-based capital ratios and leverage ratios of the Registrant, M&T Bank and East New York as of December 31, 1993 exceeded the fully phased-in risk-based capital adequacy guidelines and the leverage standard. Capital Components and Ratios at December 31, 1993 (dollars in millions) Registrant (Consolidated) M&T Bank East New York ------------- -------- ------------- Capital Components Tier 1 capital $ 715 $ 567 $ 133 Total capital 887 721 150 Risk-weighted assets and off-balance sheet instruments $7,659 $6,300 $1,364 Risk-based Capital Ratio Tier 1 capital 9.33% 8.99% 9.73% Total capital 11.58 11.45 10.98 Leverage Ratio 6.63 6.07 7.64 FDICIA required each federal banking agency, including the Federal Reserve Board, to revise its risk-based capital standards within 18 months of the enactment of the statute into law on December 19, 1991 in order to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risk of nontraditional activities, as well as reflect the actual performance and expected risk of loss on multifamily mortgages. In August 1992, the Federal Reserve Board and the FDIC issued a joint advance notice of proposed rulemaking, soliciting comments on a proposed framework for implementing these revisions. Based on comments received, the federal banking agencies in September 1993 issued proposed rules whereby exposures to interest rate risk would be measured as the effect that a specified change in market interest rates would have on the net economic value of a bank. This economic perspective considers the effect that changing market interest rates may have on the value of a bank's assets, liabilities, and off-balance-sheet positions. The banking agencies propose to measure an institution's exposure using either a standardized, supervisory model or each bank's own internal model. In either case, the results could be used in one of two ways when assessing capital adequacy for interest rate risk. One approach would be to reduce an institution's risk-based capital ratios by an amount based on the level of measured risk. The other would be to use the measured exposure as only one of several factors in assessing the need for capital. The Registrant is studying these latest proposals but cannot assess at this point the impact the proposals would have on the Company's capital requirements. Additional proposals, including proposals which concern the risks of credit concentrations and nontraditional activities are currently pending, and there is no assurance that the adoption of these or other proposals implementing FDICIA will not have an adverse impact on the Company's capital requirements. Bank regulators and legislators continue to indicate their desire to raise capital requirements applicable to banking organizations beyond their current levels. However, management is unable to predict whether and when higher capital requirements would be imposed and, if so, at what levels and on what schedule. FDICIA substantially revised the bank regulatory and funding provisions of the FDI Act and made revisions to several other federal banking statutes. Among other things, FDICIA required the federal banking agencies to take "prompt corrective action" in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized" and "critically undercapitalized". A depository institution's capital tier will depend upon where its capital levels are in relation to various relevant capital measures, which will include a risk-based capital measure and a leverage ratio capital measure, and certain other factors. Under the implementing regulations adopted by the federal banking agencies, a bank is considered "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An "adequately capitalized" bank is defined as one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier 1 risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMEL rating of 1). A bank is considered (A) "undercapitalized" if it has (i) a total risk- based capital ratio of less than 8%, (ii) a Tier 1 risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of a bank with a composite CAMEL rating of 1); (B) "significantly undercapitalized" if the bank has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier 1 risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3% and (C) "critically undercapitalized" if the bank has a ratio of tangible equity to total assets equal to or less than 2%. The Federal Reserve Board may reclassify a "well capitalized" bank as "adequately capitalized" or subject an "adequately capitalized" or "undercapitalized" institution to the supervisory actions applicable to the next lower capital category if it determines that the bank is in an unsafe or unsound condition or deems the bank to be engaged in an unsafe or unsound practice and not to have corrected the deficiency. M&T Bank and East New York currently meet the definition of "well capitalized" institutions. "Undercapitalized" depository institutions, among other things, are subject to growth limitations, are prohibited, with certain exceptions, from making capital distributions, are limited in their ability to obtain funding from a Federal Reserve Bank and are required to submit a capital restoration plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan and provide appropriate assurances of performance. If a depository institution fails to submit an acceptable plan, including if the holding company refuses or is unable to make the guarantee described in the previous sentence, it is treated as if it is "significantly undercapitalized". Failure to submit or implement an acceptable capital plan also is grounds for the appointment of a conservator or a receiver. "Significantly undercapitalized" depository institutions may be subject to a number of additional requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Moreover, the parent holding company of a significantly undercapitalized depository institution may be ordered to divest itself of the institution or of nonbank subsidiaries of the holding company. "Critically undercapitalized" institutions, among other things, are prohibited from making any payments of principal and interest on subordinated debt, and are subject to the appointment of a receiver or conservator. FDICIA directed, among other things, that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares and other standards as they deem appropriate. The Federal Reserve Board adopted such standards in 1993. FDICIA also contains a variety of other provisions that may affect the operations of the Company, including new reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions, limitations on the amount of purchased mortgage servicing rights and purchased credit card relationships includable in Tier 1 capital, and the requirement that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch. FDICIA also contains a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not "well capitalized" or are "adequately capitalized" and have not received a waiver from the FDIC. FDIC Deposit Insurance Assessments As institutions insured by the BIF and the SAIF, M&T Bank and East New York are subject to FDIC deposit insurance assessments. Under current law, as amended by FDICIA, the insurance assessment to be paid by BIF-insured institutions shall be specified in a schedule required to be issued by the FDIC that specifies, at semiannual intervals, target reserve ratios designed to increase the reserve ratio to 1.25% of estimated insured deposits (or such higher ratio as the FDIC may determine in accordance with the statute) in 15 years. FDICIA also authorizes the FDIC to impose one or more special assessments in any amounts deemed necessary to enable repayment of amounts borrowed by the FDIC from the Treasury Department. The FDIC set an assessment rate for the BIF of 0.195% for periods prior to June 30, 1991, and an assessment rate of 0.23% effective on June 30, 1991. Consistent with FDICIA, on September 15, 1992, the FDIC approved the implementation of a risk-based deposit premium assessment system under which each depository institution is placed in one of nine assessment categories based on the institution's capital classification under the prompt corrective action provisions described above, and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. The assessment rates under the new system range from 0.23% to 0.31% depending upon the assessment category into which the insured institution is placed. The new assessment system became effective January 1, 1993. It is possible that BIF assessments will be further increased and that there may be a special additional assessment. With respect to deposit insurance assessments on SAIF-insured deposits at M&T Bank (which represent approximately 13% of its total assessed deposit liabilities), under current law such assessments must be the greater of 0.15% of M&T Bank's average assessment base (as defined) or such rate as the FDIC at its sole discretion determines to be appropriate to increase (or maintain) the reserve ratio to 1.25% of estimated insured deposits (or such higher ratio as the FDIC may determine in accordance with the statute) within a reasonable period of time. Through December 31, 1993 the assessment rate could not have been less than 0.23% of the institution's average assessment base, and from January 1, 1994 through December 31, 1997 the assessment rate must not be less than 0.18% of the institution's average assessment base. The assessment rate may be higher if the FDIC, in its sole discretion, determines such higher rate to be appropriate. Effective January 1, 1993, the risk-based deposit premium assessment system described above was made applicable to SAIF- insured deposits. A significant increase in the assessment rate or a special additional assessment with respect to insured deposits could have an adverse impact on the results of operations and capital of M&T Bank or East New York. Governmental Policies --------------------- The earnings of the Company are significantly affected by the monetary and fiscal policies of governmental authorities, including the Federal Reserve Board. Among the instruments of monetary policy used by the Federal Reserve Board to implement these objectives are open-market operations in U.S. Government securities and Federal funds, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These instruments of monetary policy are used in varying combinations to influence the overall level of bank loans, investments and deposits, and the interest rates charged on loans and paid for deposits. The Federal Reserve Board frequently uses these instruments of monetary policy, especially its open-market operations and the discount rate, to influence the level of interest rates and to affect the strength of the economy, the level of inflation or the price of the dollar in foreign exchange markets. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of banking institutions in the past and are expected to continue to do so in the future. It is not possible to predict the nature of future changes in monetary and fiscal policies, or the effect which they may have on the Company's business and earnings. Competition ----------- The Company competes in offering commercial and personal financial services with other banking institutions and with firms in a number of other industries, such as thrift institutions, credit unions, personal loan companies, sales finance companies, leasing companies, securities brokers and dealers, insurance companies and retail merchandising organizations. Furthermore, diversified financial services companies are able to offer a combination of these services to their customers on a nationwide basis. As described in Bank Holding Company Regulation, above, the Banking Law allows out-of-state banking companies to control New York banks if reciprocal rights are granted to New York banking companies. No such reciprocity is required of foreign banking companies. Most states have permitted New York banking companies to form or acquire banks located within their boundaries. Moreover, it is possible that federal or state legislative initiatives may follow the legislation signed into law in New York State in June 1992 which permits a form of reciprocal interstate branching. As a result, the number of banking organizations with which the Registrant's subsidiary banks compete may grow in the future. Other Legislative Initiatives ----------------------------- From time to time, various proposals are introduced in the United States Congress and in the New York Legislature and before various bank regulatory authorities which would alter the powers of, and restrictions on, different types of banking organizations and which would restructure part or all of the existing regulatory framework for banks, bank holding companies and other financial institutions. Moreover, a number of other bills have been introduced in Congress which would further regulate, deregulate or restructure the financial services industry. It is not possible to predict whether these or any other proposals will be enacted into law or, even if enacted, the effect which they may have on the Company's business and earnings. Statistical Disclosure Pursuant to Guide 3 ------------------------------------------ See cross-reference sheet for disclosures incorporated elsewhere in this Annual Report on Form 10-K. Additional information is included in the following tables. Item 2.

Item 2. Properties. ---------- Both First Empire (Parent) and M&T Bank maintain their executive offices at One M&T Plaza in Buffalo, New York. This twenty-one story headquarters building, containing approximately 276,000 rentable square feet, is owned in fee by M&T Bank, and was completed in 1967 at a cost of approximately $17 million. First Empire (Parent), M&T Bank and their subsidiaries occupy approximately 69% of the building and the remainder is leased. At December 31, 1993, the cost of this property, net of accumulated depreciation, was $10.3 million. In September 1992, M&T Bank acquired an additional facility in Buffalo, New York with approximately 349,000 rentable square feet at a cost of approximately $12 million. This facility, known as M&T Center, is occupied by the Company's personnel and by non-affiliated tenants. At December 31, 1993, the cost of this building, including improvements made subsequent to acquisition and net of accumulated depreciation, was $16.4 million. M&T Bank also owns and occupies two separate facilities in the Buffalo area which support certain back-office and operations functions of the Company. The total square footage of these facilities approximates 213,000 square feet and their combined cost, net of accumulated depreciation, was $12.4 million. The cost, net of accumulated depreciation and amortization, of the Company's premises and equipment is detailed in Note 6 of the Financial Statements filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data". Of the 141 domestic banking offices of the Registrant's subsidiary banks, 54 are owned in fee and 87 are leased. Item 3.

Item 3. Legal Proceedings. ----------------- A number of lawsuits were pending against the Registrant and its subsidiaries at December 31, 1993. In the opinion of management, the potential liabilities, if any, arising from such litigation will not have a materially adverse impact on the Company's consolidated financial condition. Moreover, management believes that the Company has substantial defenses in such litigation, but there can be no assurance that the potential liabilities, if any, arising from such litigation will not have a materially adverse impact on the Company's consolidated results of operations in the future. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. --------------------------------------------------- Not applicable Executive Officers of the Registrant ------------------------------------ Information concerning the Registrant's executive officers is presented below as of March 1, 1994. Shown parenthetically is the year since which the officer has held the indicated position with the Registrant or its subsidiaries. In the case of each such corporation, officers' terms run until the first meeting of the board of directors after such corporation's annual meeting, and until their successors are elected and qualified. Robert G. Wilmers, age 59, is president (1988), chief executive officer (1983) and a director (1982) of the Registrant. Mr. Wilmers served as chairman of the board of the Registrant prior to its acquisition of East New York. He is chairman of the board, president and chief executive officer (1983) and a director (1982) of M&T Bank. Mr. Wilmers is a director of East New York (1988) and M&T Financial (1985). In 1980, he formed Robert G. Wilmers Associates, New York City, a private investment firm. Paul B. Murray, age 70, is chairman of the board and a director (1988) of the Registrant. He is chairman of the board (1988), president (1978), chief executive officer (1980) and a director (1962) of East New York. Mr. Murray is a director of M&T Bank (1988). William A. Buckingham, age 51, is an executive vice president (1990) of the Registrant and of M&T Bank, is in charge of its Retail Banking Division and serves as president (1992) of its Rochester Division. Mr. Buckingham held a number of management positions with Manufacturers Hanover Trust Company from 1973 to 1990, including the position of executive vice president of its branch banking division which he held immediately prior to joining the Registrant and M&T Bank. Atwood Collins, III, age 47, is the executive vice president and chief operating officer (1988) of East New York. Mr. Collins held a number of management positions with Morgan Guaranty Trust Company of New York from 1972 to 1988, including the position of senior vice president and manager of treasury operations which he held immediately prior to joining East New York. James L. Hoffman, age 54, is president (1992) of the Hudson Valley Division of M&T Bank. Mr. Hoffman served as chairman of the board, president, chief executive officer and a director (1983) of The First National Bank of Highland, which had been a wholly owned subsidiary of the Registrant prior to its merger with and into M&T Bank on February 29, 1992. Mr. Hoffman is a director of M&T Financial (1986). He served as an executive vice president of M&T Bank from 1974 to 1984. Barbara L. Laughlin, age 49, is an executive vice president (1993) of the Registrant and of M&T Bank (1990), and is in charge of its Technology and Banking Operations Division. Ms. Laughlin was executive vice president of retail banking and technology at The Seamen's Bank for Savings from June 1986 to April 1990 before joining M&T Bank. William C. Rappolt, age 48, is an executive vice president and the treasurer (1993) of the Registrant and of M&T Bank (1984), and is in charge of its Treasury Division. Mr. Rappolt is a director of M&T Financial (1985), and chairman of the board and a director of M&T Securities, Inc., formerly M&T Discount Brokerage, (1985). Robert E. Sadler, Jr., age 48, is an executive vice president (1990) of the Registrant and of M&T Bank (1983), and is in charge of its Commercial Banking Division. Mr. Sadler is chairman of the board (1987) and a director of M&T Capital (1983), chairman of the board (1989) and a director of M&T Financial (1985) and chairman of the board and a director of M&T Mortgage (1991). Harry R. Stainrook, age 57, is an executive vice president (1993) of the Registrant and of M&T Bank (1985), and is in charge of its Trust and Investment Services Division. Harry S. Tishelman, age 70, is a senior vice president of M&T Bank (1983) and a vice president of East New York (1988). Mr. Tishelman is a director of M&T Mortgage Corporation (1991). James L. Vardon, age 52, is an executive vice president and the chief financial officer (1984) of the Registrant and of M&T Bank, and is in charge of its Finance Division. Mr. Vardon is a director of M&T Capital (1984) and M&T Financial (1985). PART II ------- Item 5.

Item 5. Market for Registrant's Common Equity and Related ------------------------------------------------- Stockholder Matters. ------------------- The Registrant's common stock is traded under the symbol FES on the American Stock Exchange. See cross-reference sheet for disclosures incorporated elsewhere in this Annual Report on Form 10-K for market prices of Registrant's common stock, approximate number of common stockholders at year-end, frequency and amounts of dividends on common stock and restrictions on the payment of dividends. Item 6.

Item 6. Selected Financial Data. ------------------------ See cross-reference sheet for disclosures incorporated elsewhere in this Annual Report on Form 10-K. Item 7.

Item 7. Management's Discussion and Analysis of Financial ------------------------------------------------- Condition and Results of Operations. ----------------------------------- CORPORATE PROFILE AND SIGNIFICANT DEVELOPMENTS - ---------------------------------------------- First Empire State Corporation ("First Empire") is a regional bank holding company headquartered in Buffalo, New York with consolidated assets of $10.4 billion at December 31, 1993. First Empire and its consolidated subsidiaries are hereinafter referred to as "the Company". The Company operates principally through two wholly owned banking subsidiaries, Manufacturers and Traders Trust Company ("M&T Bank") and The East New York Savings Bank ("East New York"). M&T Bank, with total assets of $8.6 billion at December 31, 1993, is a New York-chartered commercial bank with 106 offices throughout Western New York State and New York's Southern Tier, 13 offices in New York's Hudson Valley region and offices in New York City, Albany, Syracuse and Nassau, The Bahamas. East New York, with total assets of $1.8 billion at December 31, 1993, is a New York-chartered savings bank with 19 offices in metropolitan New York City. M&T Bank's subsidiaries include M&T Mortgage Corporation, a mortgage banking company with offices in Ohio and Pennsylvania, M&T Securities, Inc., a broker/dealer, M&T Financial Corporation, an equipment leasing company, and M&T Capital Corporation, a venture capital company. In recent years, the Company has grown through a series of acquisitions of part or all of other New York State-based financial institutions. In July 1992, the Company acquired Central Trust Company of Rochester, New York ("Central Trust"), and Endicott Trust Company of Endicott, New York ("Endicott Trust"), and simultaneously merged them with and into M&T Bank. The acquisitions added approximately $1.4 billion in assets and $1.3 billion in deposits to the Company's consolidated balance sheet on the acquisition date, and brought 38 banking offices in Western New York and New York's Southern Tier into M&T Bank's branch network. In 1991 and 1990, M&T Bank and East New York also acquired selected assets and assumed selected liabilities of three failed thrift institutions in financially-assisted transactions with Federal regulators. In 1991, M&T Bank and East New York purchased approximately $1.7 billion of assets and assumed approximately $2.2 billion of deposits. In two similar transactions in 1990, M&T Bank acquired nearly $889 million in assets of the failed institutions and assumed approximately $1.7 billion of deposits. No material amounts of intangible assets were recorded in connection with these financially-assisted transactions. The 1991 and 1990 acquisitions gave M&T Bank the rights to operate 20 former branch offices of the failed thrift institutions in the Buffalo metropolitan area and 15 branch offices in the Rochester, New York area. Additionally, as part of the 1991 acquisition, East New York added 3 branches in the New York City metropolitan area. The acquisitions significantly expanded M&T Bank's market presence in both Buffalo and Rochester, despite the merger of many of the acquired branches with existing branches of M&T Bank. Each of the acquisitions has contributed to increases in net interest and fee income, as well as increased the level of operating expenses. The overall effect of the acquisitions was a significant positive contribution to the Company's net income in 1993. During the fourth quarter of 1993, M&T Bank and East New York became stockholders of the Federal Home Loan Bank of New York. The Federal Home Loan Bank of New York is part of the Federal Home Loan Bank System, a national wholesale banking network of 12 regional, stockholder-owned banks. Such memberships provide M&T Bank and East New York with access to a readily-available, relatively low-cost wholesale funding source. In response to increased consumer interest in alternative investments, three new mutual funds were added in 1993 to the Vision Group of Funds for which M&T Bank serves as investment adviser. These new funds expand the alternative investment options available to the Company's customers. OVERVIEW - -------- The Company's net income was $102.0 million or $13.87 per common share in 1993, compared to $97.9 million or $13.41 per common share in 1992 and $67.2 million or $9.32 per common share in 1991. Fully diluted earnings per common share, which assumes the full conversion of outstanding preferred stock into common, was $13.42 in 1993, $12.98 in 1992 and $9.15 in 1991. The 1992 results include $28.1 million of gains from the sales of investment securities. Excluding the after-tax impact of these gains, net income in 1992 was $81.9 million or $11.13 per common share and fully diluted earnings per share was $10.86. The securities gains realized in 1992 were the result of management's decision to adjust the Company's holdings of investment securities in response to the declining interest rate environment and the expected erosion in economic value of certain securities resulting from prepayment risk. Sales were additionally prompted by the restructuring of the Company's balance sheet in anticipation of the Central Trust and Endicott Trust acquisitions. These sales served to reduce the size of the Company's balance sheet and mitigated the impact of the acquisitions on regulatory capital ratios. The Company achieved a return on average assets in 1993 of .98%, compared to 1.03% in 1992 and .81% in 1991. The return on average common stockholders' equity was 15.61% in 1993, 17.39% in 1992 and 13.82% in 1991. Excluding the effects of the 1992 securities gains, the return on average assets in 1992 was .86%, while the return on average common stockholders' equity was 14.43%. Taxable-equivalent net interest income increased 8% in 1993 to $474.8 million, from $438.6 million in 1992. Taxable-equivalent net interest income was $337.7 million in 1991. An $823 million increase in 1993 in average earning assets resulting from loans obtained in the 1992 acquisitions and increased holdings of investment securities was the primary reason for the improved performance. Net interest income expressed as an annualized percentage of average earning assets was 4.76% in 1993, compared to 4.79% in 1992 and 4.22% in 1991. Despite a 28% decline in 1993 from the prior year-end in the level of nonperforming loans, management considered it prudent to record a provision for possible credit losses of $80.0 million in 1993, 6% lower than the $85.0 million provided in 1992. The provision for possible credit losses was $63.4 million in 1991. Caution about the timing and sustainability of economic recovery in market areas served by the Company and the unsettled commercial real estate market in the New York City metropolitan area were the primary factors affecting management's decisions in determining the provision for possible credit losses. Excluding securities gains, noninterest income for 1993 totaled $109.7 million, 12% above the $98.2 million in 1992, and 42% above the $77.2 million in 1991. Noninterest expense was $327.8 million in 1993, up 5% from $311.3 million in 1992 and 43% from $228.7 million in 1991. On December 31, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". SFAS No. 115 expands the use of fair value accounting for certain securities that the reporting enterprise does not have the positive intent or ability to hold to maturity. For securities classified as "held to maturity", SFAS No. 115 retains the use of the "amortized cost" method of accounting. The adoption of the accounting statement had no impact on reported net income, but increased the carrying value of investment securities "available for sale" by $15.8 million. This resulted in an after-tax increase in stockholders' equity of $9.1 million, or $1.33 per common share. NET INTEREST INCOME/LENDING AND FUNDING ACTIVITIES - -------------------------------------------------- As a result of growth in average earning assets, which rose $823 million or 9% to $10.0 billion, 1993 taxable-equivalent net interest income rose $36.2 million or 8% from 1992 to $474.8 million. Net interest income was $438.6 million in 1992 and $337.7 million in 1991, while average earning assets were $9.2 billion and $8.0 billion, respectively. The Company's net interest margin, expressed as an annualized percentage of average earning assets, was 4.76% in 1993, down slightly from 4.79% achieved in 1992, but up from 4.22% in 1991. The Company continued to benefit from a relatively wide net interest spread, or the difference between the yield on earning assets and the rate paid on interest-bearing liabilities, of 4.33%, up from 4.29% in 1992. The net interest spread in 1991 was 3.57%. The increased net interest spread in 1993 reflects a 56 basis point (hundredths of one percent) widening in the difference between the yield on loans and leases and the rate paid on interest-bearing deposits. Largely offsetting such increase was the impact of increases in average balances of investment securities and money-market investments, which generally yield less than loans, and short-term borrowings. Growth in average earning assets during 1993 was largely comprised of a $411 million or 6% increase in average loans. The growth in loans was driven by the full-year effect in 1993 of the July 1, 1992 acquisitions of Central Trust and Endicott Trust. Nevertheless, sluggish economic conditions in market areas served by the Company tended to hamper loan demand throughout much of 1993, particularly in the commercial sector. In addition to the increase in average loans, average investment securities grew $180 million and money-market assets rose $232 million from 1992. The current interest rate environment as reflected in the historically high spread between prime and money-market rates has been favorable to many banks. However, management believes that reductions in such spread would adversely impact the Company's net interest margin. Although not necessarily indicative of a trend, 1993's fourth quarter net interest spread of 4.14% was below that achieved in any other quarter of 1993. To help lessen the exposure to changing interest rates, the Company has entered into interest rate swaps as hedging transactions. The effects of these swaps, which had an aggregate notional amount of approximately $1.2 billion at December 31, 1993, are reflected in the yields on loans and the rates paid on interest-bearing deposits. The net effect of such swaps was to increase the Company's net interest spread by 36 basis points in 1993, 22 basis points in 1992 and 9 basis points in 1991. In general, in each interest rate swap transaction the Company is entitled to receive a fixed rate of interest and must pay a variable rate of interest based on London Inter-Bank Offer Rates ("LIBOR"). During 1993 the Company paid a weighted average variable rate of 3.32% on interest rate swaps and received a weighted average fixed rate of 6.10%. In 1992 and 1991 the weighted average variable rates paid were 4.08% and 6.10%, respectively, and the weighted average fixed rates received were 8.10% and 8.22%, respectively. Additionally, as of December 31, 1993, the Company had also entered into forward interest rate swaps with an aggregate notional amount of $475 million. These forward swaps had no effect on net income in 1993. Under the terms of the forward swaps outstanding at December 31, 1993, the Company will pay a weighted average variable rate based on LIBOR and receive a weighted average fixed rate of 5.89%. Despite average net interest-free funds rising 22% to nearly $1.4 billion in 1993, the contribution of interest-free funds to the net interest margin fell in 1993 to .43% from .50% in 1992 and .65% in 1991. A 90 basis point drop in the average cost of interest-bearing liabilities, which is used to value the contribution of interest-free funds, offset the benefit derived from the increase in funding from interest-free sources in 1993. While the acquisitions of loans in the July 1992 Central Trust and Endicott Trust transactions added significantly to the average balance of loans outstanding in 1993, the acquisitions did not materially alter the Company's mix of loans. Table 4 depicts by type, average loans outstanding for the Company in 1993, together with the percentage change in average loans by category over the past two years. Excluding home equity lines of credit, which are classified as consumer loans, approximately 63% of the Company's loans during 1993 were real estate loans, down slightly from 64% in 1992 and 67% in 1991. At the recent year-end, the Company held approximately $3.0 billion of commercial real estate loans and $1.5 billion of consumer real estate loans. Commercial real estate loans are originated by the Company predominately in the metropolitan New York City area, including properties in neighboring states generally considered to be within commuting distance of New York City, and Western New York, which includes Buffalo, Rochester and the surrounding area. Commercial real estate loans are also originated in the Hudson Valley and Southern Tier regions of New York State. The typical commercial mortgage loan originated by the Company is a fixed-rate instrument with monthly payments and a five-year balloon payment of the remaining principal at maturity. For borrowers in good standing, the terms of the loan agreement may be extended for an additional five years at the then-current market rate of interest. Table 5 depicts by geographical area the type of collateral supporting commercial real estate loans as of December 31, 1993, as well as the size of the loans outstanding. Approximately 60% of the $1.7 billion of commercial real estate loans in the metropolitan New York City area were secured by multi-family residential properties. In addition, the Company had approximately $361 million of loans secured by office space and $158 million of loans secured by retail properties in the New York City metropolitan area. The Company's experience has been that office space and, to a lesser degree, retail properties tend to experience more volatile swings in value through economic cycles. Approximately 59% of the aggregate dollar amount of New York City area loans were for $3 million or less. Commercial mortgage loans secured by properties located elsewhere in New York State were chiefly comprised of loans originated in Western New York. Given the nature of customers served in this market, collateral types tend to show greater diversity and include a significant amount of lending to customers who use the property in their trade or business, as well as real estate investors. The typical loan in this segment of the portfolio was $3 million or less. The Company normally refrains from construction lending, except when the borrower has obtained a commitment for permanent financing upon project completion. As a result, the commercial construction loan portfolio totaled only $45.4 million, or .6% of total loans as of the recent year- end. Of the $1.5 billion of real estate loans secured by one-to-four family residential properties at the 1993 year-end, approximately 80% were for properties located in New York State. At December 31, 1993, residential mortgage loans held for sale totaled $205 million. In 1992, the Company began originating residential mortgage loans in Ohio and Pennsylvania through M&T Mortgage Corporation. Most of these loans were originated for sale in the secondary market with servicing rights retained. The Company's investment securities portfolio averaged $2,173 million in 1993, up from $1,993 million in 1992 and $1,725 million in 1991. These increases occurred despite ongoing prepayments of mortgage-backed securities held in the investment portfolio, induced by the current interest rate environment, and were largely achieved through purchases of collateralized mortgage obligations ("CMOs"), other adjustable rate mortgage-backed securities and shorter-term U.S. Treasury notes. The Company considered its overall interest-rate risk profile, including the effects of interest rate swaps, when purchasing securities during 1993. The Company attempts to purchase securities which management believes provide reasonable rates of return for the prepayment risk assumed. As noted earlier, the Company adopted SFAS No. 115 on December 31, 1993 and designated approximately $2.2 billion of investment securities as "available for sale", as defined in the accounting pronouncement. The excess of estimated fair value over amortized cost, or net unrealized investment gain, for such securities was $9.1 million, net of applicable income taxes. Such amount has been included in stockholders' equity in the consolidated balance sheet as "Unrealized investment gains, net". The adoption of SFAS No. 115 had no impact on the Company's reported earnings for 1993. The average balance of money-market assets, which are comprised of interest-bearing deposits at banks, trading account assets, Federal funds sold and agreements to resell securities, was $826 million in 1993, up from $594 million a year earlier. Total money-market assets averaged $396 million in 1991. The increase in 1993 in these lower-yielding discretionary investments generally reflects investment opportunities in various short-term money-market instruments, the relative lack of alternative securities deemed attractive for longer-term investment and sluggish loan demand. Core deposits, which are comprised of noninterest-bearing demand deposits, interest-bearing transaction accounts, savings deposits and domestic time deposits under $100,000, provide the Company with a stable source of funds at generally lower interest rates than wholesale funds of similar expected maturities. Average core deposits in 1993 declined 1% to $7,178 million from $7,240 million in 1992, but, primarily due to acquisitions, grew 14% in 1992 from $6,366 million in 1991. Funding provided by core deposits totaled 72% of average earning assets in 1993, compared with 79% a year earlier and 80% in 1991. The declines in core deposits have been primarily in time deposit accounts as depositors seeking potentially higher returns continued to redeploy investment funds out of the banking system into alternative investment vehicles, such as mutual funds. An analysis of changes in the components of core deposits is presented in table 6. In addition to core deposits, the Company uses short-term borrowings from banks, securities dealers, the Federal Home Loan Bank of New York and others as sources of funding. Short-term borrowings averaged $1,922 million in 1993, $801 million above 1992's average of $1,121 million. Short-term borrowings averaged $650 million in 1991. In general, short- term borrowings have been used to fund the Company's investments in discretionary money-market assets and investment securities, and to replace deposit outflows. With regard to deposits not considered to be core deposits, domestic time deposits of $100,000 or more averaged $294 million in 1993, down 10% from $326 million in 1992 and 44% from $522 million in 1991. Average offshore deposits, which are primarily comprised of accounts with balances of $100,000 or more, amounted to $120 million in 1993, down from $130 million a year earlier and $159 million in 1991. PROVISION FOR POSSIBLE CREDIT LOSSES - ------------------------------------ The purpose of the provision is to replenish and build the Company's allowance for possible credit losses to a level necessary to maintain an adequate reserve position. In establishing the provision for possible credit losses, management considers historical loan losses incurred, the quality and size of the loan portfolios, the level of the allowance for possible credit losses and the economic climate. The provision for possible credit losses was $80.0 million in 1993, compared with $85.0 million in 1992 and $63.4 million in 1991. Net charge- offs in 1993 decreased $10.5 million to $35.8 million, while nonperforming loans also decreased to $82.3 million at December 31, 1993 from $113.6 million a year earlier. Net charge-offs totaled $44.1 million in 1991 and nonperforming loans were $89.7 million at 1991's year-end. Net charge-offs as a percentage of average loans in 1993 were .51%, compared with .70% in 1992 and .75% in 1991. Despite declines in the level of net charge-offs and nonperforming loans of 23% and 28%, respectively, management considered it prudent to record a provision for possible credit losses in 1993 which was only 6% lower than 1992 due to concerns about the unsettled commercial real estate market, in particular in the New York City metropolitan area, and the timing and sustainability of economic recovery in market areas served by the Company in general. As a result, the allowance for possible credit losses was $195.9 million or 2.70% of net loans and leases outstanding at December 31, 1993, up from $151.7 million or 2.17% at December 31, 1992 and $100.3 million or 1.66% at December 31, 1991. The decrease in net charge-offs and lower nonperforming loan levels enabled the Company to establish an allowance-to-nonperforming loan ratio of 238%. The allowance's coverage of nonperforming loans was 134% a year earlier and 112% at December 31, 1991. M&T Bank retains the contractual right to require the Federal Deposit Insurance Corporation ("FDIC") to repurchase prior to May 31, 1994 at a discount of 4% certain loans sold to M&T Bank by the FDIC from the portfolio of a failed thrift institution in the event such loans become adversely classified for regulatory purposes. As of December 31, 1993, such loans included approximately $100 million of commercial real estate loans and $249 million of consumer and residential mortgage loans. A comparative allocation of the allowance for possible credit losses for each of the past five year-ends is presented in table 10. Amounts were allocated to specific loan categories based upon management's classification of loans under the Company's internal loan grading system and estimates of potential charge-offs inherent in each category. However, as the total reserve is available to absorb losses from any loan category, amounts assigned do not necessarily indicate future losses within these categories. The increase in the allocated portion of the reserve in 1993 compared to prior years is not necessarily indicative of a deterioration of credit quality within the loan portfolio, but rather reflects certain revisions to the assumptions used to calculate the allocated portion of the reserve in 1993. Nevertheless, the unallocated portion of the reserve represents management's assessment of the overall level of credit risk in the loan portfolio over a longer time frame. Due to the size of the Company's commercial real estate loan portfolio, the Company's credit loss experience has been and will continue to be influenced by real estate prices, in particular, and overall economic conditions, in general. During 1993 the Company incurred $19.2 million of net charge-offs on commercial real estate loans, including $14.2 million on loans domiciled in the New York City metropolitan area, where declines in real estate values have been more pronounced. Nonperforming commercial real estate loans totaled $48.3 million at December 31, 1993, compared to $93.3 million a year earlier. Included in these totals were loans secured by properties in the New York City metropolitan area of $29.7 million and $49.3 million at December 31, 1993 and 1992, respectively. The Company has limited exposure to possible losses originating from concentrations of credit extended to any specific industry. No such concentration exceeded 10% of total loans outstanding at December 31, 1993. Furthermore, the Company had no exposure to lesser-developed countries, and only $1.4 million of foreign loans in total. Highly leveraged transactions, including outstanding commitments, comprised only $87.0 million or approximately 1% of loans outstanding at December 31, 1993. At December 31, 1993, repossessed assets taken in foreclosure of defaulted loans totaled $12.2 million, compared to $16.7 million and $10.4 million at year-end 1992 and 1991, respectively. OTHER INCOME - ------------ Excluding the effects of investment securities transactions, other income totaled $109.7 million in 1993, 12% above the $98.2 million earned in 1992 and 42% improved from $77.2 million in 1991. Benefiting from a full year of revenue derived from customers of the former Central Trust and Endicott Trust, along with higher revenues from securities clearing, income from trust and investment services increased 41% to $23.9 million in 1993 from $16.9 million in 1992. The 1993 result was more than double 1991's $11.8 million, also largely due to twelve months of income from former Central Trust and Endicott Trust customers and higher securities clearing revenues. Including fee income from acquired deposits, service charges on deposit accounts increased 14% to $32.3 million in 1993, while in 1992 there was a 37% increase to $28.4 million from $20.7 million in 1991. The full-year effect of the Central Trust and Endicott Trust acquisitions helped increase merchant discount and other credit card fees to $7.9 million in 1993, from $6.7 million and $5.8 million in 1992 and 1991, respectively. Trading account profits were $2.7 million in 1993, up from $1.7 million earned in 1992, but down from $5.0 million earned in 1991. Other revenues from operations were $42.9 million in 1993, down slightly from $44.5 million in 1992, but up 26% from $33.9 million in 1991. Included in other revenues from operations were gains from the sales of out-of-state loans obtained in acquisitions of $2.8 million in 1993, $6.0 million in 1992 and $5.6 million in 1991. Excluding such gains, other revenues from operations increased 4% from 1992 and 41% from 1991. Although revenues attributable to the acquisitions contributed to the improvement in 1993, the increase in other revenue from 1992 was, in large part, also due to additional income from the origination, sale and servicing of residential mortgage loans, asset management services and other loan fees. Other revenues in 1992 included $2.5 million of non- recurring earnings on options written to sell certain mortgage-backed securities. At December 31, 1993, residential mortgage loans serviced for others were approximately $2.9 billion. In 1993, the Company purchased servicing rights for approximately $395 million of residential mortgage loans. OTHER EXPENSE - ------------- Other expense totaled $327.8 million in 1993, up from $311.3 million in 1992 and $228.7 million in 1991. During 1993, the Company completed both the integration of Central Trust and Endicott Trust operations into M&T Bank and the major project to upgrade the Company's computer systems. The completion of these significant initiatives served to reduce operating expenses. However, offsetting the impact of these reduced expenses were the inclusion of a full year of ongoing operating expenses associated with the Central Trust and Endicott Trust franchises, increased processing costs associated with the additional revenues from residential mortgage banking activities and increased advertising and promotional expenses. Salaries and employee benefits expense was $154.3 million in 1993, 18% higher than the $130.8 million in 1992. Salaries and benefits expense was $103.2 million in 1991. The additional six months of expense associated with the acquired franchises of Central Trust and Endicott Trust, merit salary increases and growth in the Company's residential mortgage lending and servicing business were the primary factors contributing to the increase in 1993. Staffing requirements necessitated in large part by acquisition activity has resulted in an increase in the number of employees in recent years. The number of full-time equivalent employees was 4,028 at December 31, 1993, compared to 3,959 and 3,053 at December 31, 1992 and 1991, respectively. Nonpersonnel expenses for 1993 totaled $173.5 million, down 4% from $180.6 million in 1992. Such expenses were $125.5 million in 1991. Several significant factors in 1993 more than offset the increases in expenses associated with the 1992 acquisitions and other business growth previously noted. Most notable was a $12.1 million reduction to $4.7 million in write-downs of the carrying value of excess servicing fees and purchased mortgaged servicing rights associated with residential mortgage loans serviced for others. The amount of excess fees and purchased servicing rights recorded as assets was $17 million at December 31, 1993. As previously noted, the project to significantly upgrade the Company's major computer systems was successfully completed in 1993. Expenses associated with this project were approximately $1.0 million in 1993, compared with $9.2 million in 1992 and $4.7 million in 1991. INCOME TAXES - ------------ The provision for income taxes in 1993 was $71.5 million, up from $64.8 million in 1992 and $47.6 million in 1991. The effective tax rates were 41% in 1993 and 1991 and 40% in 1992. On August 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 into law. As part of the legislation, effective January 1, 1993, the tax rate applied to corporate taxable income in excess of $10 million was increased 1% to 35%. Under SFAS No. 109, the effects of the higher tax rate (and other changes made by the legislation) are recognized in determining financial statement income and deferred tax assets and liabilities in the period that includes the date of enactment. Accordingly, the aggregate effect of the legislation was to increase income tax expense and the effective tax rate in 1993 by approximately $792 thousand and .46%, respectively, including a $698 thousand benefit related to years prior to 1993. In the first quarter of 1992, the Company prospectively adopted SFAS No. 109 which mandates a liability method of accounting for income taxes. Such adoption did not result in any net adjustment to the Company's balance sheet and, accordingly, there was no charge in the consolidated statement of income for 1992 resulting from the change in accounting principle. INTERNATIONAL ACTIVITIES - ------------------------ The Company's investment in international assets was $62 million and $36 million at December 31, 1993 and 1992, respectively. Total offshore deposits were $189 million and $118 million at December 31, 1993 and 1992, respectively. LIQUIDITY AND INTEREST RATE SENSITIVITY - --------------------------------------- A critical element in managing a banking institution is ensuring that sufficient cash flow and liquid assets exist to satisfy demands for loans, deposit withdrawals and other corporate purposes. The Company's core deposit base has historically provided a large source of funds. Such deposits financed 68% of the Company's earning assets at December 31, 1993, compared to 83% at December 31, 1992. Consistent with the experience of other financial institutions, the Company's core deposits, both in amount and as a percentage of earning assets, have declined. Such decline has been primarily in time deposit accounts as many depositors have transferred funds out of the banking system into alternative investment vehicles, such as mutual funds. The Company supplements funding from core deposits with various wholesale funds such as Federal funds purchased and securities sold under agreements to repurchase. Additionally, during 1993 M&T Bank and East New York became stockholders of the Federal Home Loan Bank of New York. Among other things, such memberships provide a combined credit facility of approximately $500 million, secured by residential mortgage loans and investment securities. Borrowings outstanding under such credit facility were $310 million at December 31, 1993. Further, funding is available through various arrangements for unsecured short-term borrowings from a wide group of banks and other financial institutions which, while informal and sometimes reciprocal, aggregate to several times anticipated funding needs. Other sources of liquidity include maturities of money- market assets, repayments of loans and investment securities, and cash flow generated from operations. First Empire's ability to pay dividends and fund operating expenses is primarily dependent on the receipt of dividend payments from its banking subsidiaries, which are subject to various regulatory limitations. Additionally, First Empire maintains a line of credit with a commercial bank. First Empire and the Company do not currently anticipate engaging in any activity, in either the short- or long-term, which would cause a significant strain on liquidity. Management believes that available sources of funds are currently more than sufficient to meet anticipated funding needs. Table 14 reflects the effect of repricing assets and liabilities on a contractual basis, and is presented in accordance with industry practice. The cumulative repricing figures in the table represent the net position of assets and liabilities contractually subject to repricing in specific time periods, adjusted for the impact of interest rate swaps entered into as hedge transactions. Management believes this measure does not appropriately depict interest rate risk since changes in interest rates do not necessarily affect all categories of earning assets and interest- bearing liabilities equally nor, as presented in the table, on the contractual maturity or repricing date. Additionally, assessing interest rate risk from a static position fails to consider ongoing lending and deposit gathering activities as well as projected changes in balance sheet composition. In management's opinion, the foregoing interest rate sensitivity analysis does not appropriately reflect the Company's actual sensitivity to changes in the interest rate environment. Management monitors interest rate sensitivity with the aid of a computer model which takes into account typical interrelationships in the magnitude and timing of the repricing of all banking and investment products, including the effects of expected prepayments. Through analysis of such information, management believes that the Company's exposure to changing interest rates, as modified by interest rate swaps, is substantially different than the data presented in the accompanying table may imply. Management believes that the Company's net interest income would benefit from rising interest rates over a two to three year period; however, it is expected that higher interest rates would have a short-term detrimental effect on net interest income. Management closely monitors interest rate risk and stands ready to take action to mitigate the Company's exposure when circumstances deem it prudent to do so. As part of overall interest rate sensitivity management, the Company has entered into currently effective interest rate swap contracts to help balance the Company's interest rate sensitivity position. The notional amount of such contracts was approximately $1.2 billion at December 31, 1993. In general, under the terms of these swaps, the Company receives a fixed rate of interest and pays a variable rate. The swaps increased net interest income by $34.2 million and net interest margin by 34 basis points in 1993. The increase in net interest income and margin in 1992 was $20.1 million and 22 basis points, respectively. Of the interest rate swaps currently in effect, $400 million mature in the first quarter of 1996. In general, beginning in 1995, the notional amount of the remaining swaps currently in effect will decline depending on the level of interest rates or the prepayment behavior of mortgage-backed securities to which the swaps are indexed. As of December 31, 1993, the Company had also entered into several forward swaps having a notional amount of $475 million. Such forward swaps had no effect on net interest income in 1993. CAPITAL - ------- Common stockholders' equity totaled $684.0 million at December 31, 1993, compared with $586.8 million and $495.8 million at the end of 1992 and 1991, respectively. On a per share basis, common stockholders' equity was $99.43 at December 31, 1993, up from $85.79 per share a year earlier and $73.91 at December 31, 1991. Total stockholders' equity was $724.0 million or 6.99% of total assets at December 31, 1993, compared with $626.8 million or 6.54% at December 31, 1992 and $535.8 million or 5.84% at December 31, 1991. The ratio of average total stockholders' equity to average total assets was 6.45%, 6.10% and 5.96% in 1993, 1992 and 1991, respectively. Included in stockholders' equity were $9.1 million of net unrealized investment gains resulting from the Company's adoption of SFAS No. 115 on December 31, 1993. Such unrealized gains represent the amount by which fair value exceeded amortized cost for investment securities classified pursuant to SFAS No. 115 as "available for sale", net of applicable income taxes. To assess the capital adequacy of banking institutions, Federal regulators have implemented risk-based capital measures. Generally, a banking institution is required to maintain risk-based "core capital" and "total capital" ratios of at least 4% and 8%, respectively. In addition to the risk-based measures, Federal bank regulators have also implemented a minimum "leverage" ratio guideline of 3% of the quarterly average of total assets. The capital ratios of the Company and its banking subsidiaries, M&T Bank and East New York, as of December 31, 1993 are presented in table 15. Excluding the effects of realized and unrealized gains from investment securities, First Empire's rate of internal capital generation rose to 12.66% in 1993 from 11.59% in 1992 and 11.00% in 1991. As a supplement to capital additions generated from earnings, First Empire issued $40 million of cumulative convertible 9% preferred stock in March 1991. Additionally, M&T Bank issued $75 million of ten year subordinated notes in December 1992, which further strengthened the "total capital" ratios of M&T Bank and the Company. Cash dividends on common stock of $13.1 million were paid in 1993 compared with $10.8 million in 1992 and $9.3 million in 1991. In the second quarter of 1993, First Empire's quarterly common dividend rate was increased to $.50 per share from $.40. In total, dividends per common share increased to $1.90 in 1993 from $1.60 in 1992. Total dividends paid per common share were $1.40 in 1991. Dividends of $3.6 million were paid to the preferred stockholder in 1993 and 1992. Preferred stock dividends totaled $2.9 million in 1991. In December 1993 First Empire announced a plan to purchase and hold as treasury stock up to 506,930 shares of its common stock as a reserve for the possible future conversion of its 9% convertible preferred stock. Such preferred stock is convertible at any time into shares of First Empire's common stock at a conversion price of $78.90625 per share, subject to certain adjustments. First Empire has the right to redeem the preferred stock without premium on or after March 31, 1996. However, upon receipt of notification of such a planned redemption, the holder may convert the preferred stock into common shares. As of December 31, 1993, no common shares had been purchased pursuant to the plan. RECENTLY ISSUED ACCOUNTING STANDARDS NOT YET ADOPTED - ---------------------------------------------------- In May 1993 the Financial Accounting Standards Board issued SFAS No. 114 "Accounting by Creditors for Impairment of a Loan". SFAS No. 114 requires that creditors measure certain impaired loans based on the present value of expected future cash flows, discounted at the loan's effective interest rate or at the loan's observable value or the fair value of underlying collateral, if the loan is collateral-dependent. SFAS No. 114 applies to financial statements for fiscal years beginning after December 15, 1994. When adopted, SFAS No. 114 is not expected to have an adverse impact on the Company's results of operations. 33.1 FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES Table 11 MATURITY OF DOMESTIC CERTIFICATES OF DEPOSIT AND TIME DEPOSITS WITH BALANCES OF $100,000 OR MORE Dollars in thousands December 31, 1993 - ---------------------------- ----------------- Under 3 months $ 188,666 3 to 6 months 30,336 6 to 12 months 19,243 over 12 months 51,072 - ---------------------------- ----------------- Total $ 289,317 ============================ ================= Item 8.

Item 8. Financial Statements and Supplementary Data. Financial Statements and Supplementary Data consist of the financial statements as indexed and presented below and table 2 "Quarterly Trends" presented in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations". INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Accountants Consolidated Balance Sheet - December 31, 1993 and 1992 Consolidated Statement of Income - Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows - Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of First Empire State Corporation: We have audited the accompanying consolidated balance sheet of First Empire State Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements audited by us present fairly, in all material respects, the financial position of First Empire State Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 3 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 115, which changed its method of accounting for investments in debt and equity securities as of December 31, 1993. /s/ Price Waterhouse - -------------------- Price Waterhouse Buffalo, New York January 10, 1994 FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of First Empire State Corporation and subsidiaries ("the Company") conform to generally accepted accounting principles and to general practices within the banking industry. The more significant accounting policies are as follows: Consolidation The consolidated financial statements include First Empire State Corporation ("Parent Company") and its subsidiaries, all of which are wholly owned. The financial statements of the Parent Company report investments in subsidiaries under the equity method, adjusted for the impact of significant intercompany transactions, all of which are eliminated in consolidation. Certain data have been reclassified to conform with the current year presentation. Consolidated Statement of Cash Flows For purposes of this statement, cash and due from banks, Federal funds sold and agreements to resell securities are considered cash and cash equivalents. Trading account Trading account assets are stated at market value. Gains and losses on the sales of trading account assets and adjustments to market values are included in trading account profits in the Consolidated Statement of Income. Investment securities On December 31, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". As required, the provisions of SFAS No. 115 were not applied to any prior periods. Investments in debt securities are classified as held to maturity and stated at amortized cost when management has the positive intent and ability to hold such securities to maturity. Investments in other debt securities and equity securities having readily determinable fair values are classified as available for sale and stated at estimated fair value. Unrealized gains or losses related to investment securities available for sale are reflected in stockholders' equity, net of applicable income taxes. Other securities at December 31, 1993 included stock of the Federal Reserve Bank of New York and Federal Home Loan Bank of New York and are stated at cost. Amortization of premiums and accretion of discounts for investment securities available for sale and held to maturity are included in interest income. The cost basis of individual securities is written down to estimated fair value through a charge to earnings when declines in value below amortized cost are considered to be other than temporary. Realized gains and losses on the sales of investment securities are determined using the specific identification method. Prior to December 31, 1993 debt securities were carried at amortized cost when management had both the ability and intent to hold such securities to maturity. Periodic sales of these securities occurred principally as a result of reactive measures taken by management to changing business circumstances. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 1. SIGNIFICANT ACCOUNTING POLICIES, continued Investment securities, continued When it became probable that a debt security would be sold, the security was classified as held for sale. Investment securities held for sale were reported at the lower of aggregate cost or fair market value. Adjustments to the carrying value of investment securities held for sale were included in gain on sales of bank investment securities in the Consolidated Statement of Income. Equity securities were stated at the lower of cost or fair market value. Declines in value considered to be other than temporary were recognized as losses on sales of bank investment securities in the Consolidated Statement of Income. Securities not classified as held for sale at December 31, 1992 were included in other securities in the Consolidated Balance Sheet. Loans Interest income on loans is accrued on a level yield method. Loans are placed on nonaccrual status and previously accrued interest thereon is charged against income when principal or interest is delinquent 90 days, unless management determines that the loan status clearly warrants other treatment. Loan fees and certain direct loan origination costs are deferred and recognized as an interest yield adjustment over the life of the loan. Net deferred fees have been included in unearned discount on the Consolidated Balance Sheet as a reduction of loans outstanding. Loans held for sale are carried at the lower of cost or fair market value. Valuation adjustments made on these loans are included in other revenues from operations in the Consolidated Statement of Income. Allowance for possible credit losses The allowance for possible credit losses represents the amount which, in management's judgment, will be adequate to absorb credit losses from existing loans, leases and credit commitments. The adequacy of the allowance is determined by management's evaluation of the loan portfolio based on such factors as the differing economic risks associated with each loan category, the current financial condition of specific borrowers, the economic environment in which borrowers operate, any delinquency in payments, and the value of any collateral. Premises and equipment Premises and equipment are stated at cost less accumulated depreciation. Depreciation expense is computed principally using the straight-line method over the estimated useful lives of the assets. Income taxes In 1992 the Company adopted SFAS No. 109, "Accounting for Income Taxes". The provisions for SFAS No. 109 were not applied to any prior periods. Investment tax credits related to leveraged leasing property are amortized into income tax expense over the life of the lease agreement. Financial futures On occasion the Company uses interest rate futures contracts as part of its management of interest rate risk. Outstanding financial futures contracts represent future commitments and are not included in the Consolidated Balance FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 1. SIGNIFICANT ACCOUNTING POLICIES, CONTINUED Financial futures, continued Sheet. Futures contracts used in securities trading operations are marked to market and the resulting gains or losses are recognized in trading account profits. Gains and losses on futures contracts designated as hedges are amortized as an adjustment to interest income or expense over the life of the item hedged. Interest rate swap agreements For interest rate swap agreements entered into for the purpose of hedging interest rate risk, income or expense is recognized as accrued under the terms of the agreement as an adjustment to interest income or expense on the item hedged. Agreements and commitments entered into for trading purposes are marked to market with resulting gains or losses recorded in trading account profits. Earnings per common share Earnings per common share data are computed on the basis of the weighted average number of shares outstanding during the year, plus shares issuable upon the assumed exercise of outstanding common stock options. Proceeds assumed to have been received on such exercise are treated as if applied toward the repurchase of outstanding common shares in the open market during the year, as required under the "treasury stock" method of accounting. 2. ACQUISITIONS On July 1, 1992, the Company consummated the merger of Central Trust Company, Rochester, New York ("Central Trust"), and Endicott Trust Company, Endicott, New York ("Endicott Trust"), with and into Manufacturers and Traders Trust Company ("M&T Bank"), a wholly owned subsidiary of the Parent Company, simultaneous with their acquisition from Midlantic Corporation. Assets totaling approximately $1.4 billion and deposits totaling approximately $1.3 billion were acquired, for which M&T Bank paid $57.2 million in cash. The transaction, which was accounted for under the purchase method of accounting, did not create a material amount of intangible assets. The following table depicts certain proforma information as if the Central Trust and Endicott Trust acquisitions had occurred on January 1, 1991. These results combine the historical results of Central Trust and Endicott Trust into the Company's income statement and, while certain adjustments were made for the estimated impact of purchase accounting adjustments and other acquisition-related activity, they are not necessarily indicative of what would have occurred had the acquisition taken place at that time. Proforma Year ended December 31 1992 1991 ---- ---- (in thousands, except per share) Interest income $ 809,687 888,413 Other income 143,103 96,381 Net income 98,285 74,850 Earnings per common share $ 13.46 10.43 ======== ======= FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 3. INVESTMENT SECURITIES The amortized cost and estimated fair value of investment securities were as follows: FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 3. INVESTMENT SECURITIES, CONTINUED On December 31, 1993 the Company adopted SFAS No. 115 which expands the use of fair value accounting for certain investments in debt and equity securities, while retaining the use of the amortized cost method of accounting for investments in debt securities that the reporting enterprise has the positive intent and ability to hold to maturity. The adoption of SFAS No. 115 had no impact on reported net income, but increased stockholders' equity by $9.1 million. Such increase is the unrealized gain on investment securities available for sale, as defined in SFAS No. 115, net of applicable income taxes. At December 31, 1993, mortgage-backed securities included collateralized mortgage obligations with an amortized cost and market value of $1,184,026,000 and $1,182,194,000, respectively. At December 31, 1992, collateralized mortgage obligations included in mortgaged-backed securities held for investment had an amortized cost and market value of $733,489,000 and $734,585,000, respectively. The securities held for sale at December 31, 1992 were all collateralized mortgage obligations. Included in other securities at December 31, 1992 are equity securities with a cost and market value of $15,859,000 and $26,226,000, respectively. Proceeds from the sales of debt securities were $843,315,000 and $116,902,000 in 1992 and 1991, respectively. Gross realized gains and losses were $31,742,000 and $3,013,000 in 1992, respectively, and $501,000 and $28,000 in 1991, respectively. Gains recognized in 1993 consisted of appreciation in market value of investment securities held for sale at December 31, 1992. The amortized cost and estimated fair value of debt securities by contractual maturity were as follows: Estimated Amortized fair cost value --------- -------- (in thousands) December 31, 1993 Debt securities available for sale: Due in one year or less $ 5,076 5,195 Due after one year through five years 28,623 29,294 Due after five years through ten years 4,743 4,857 Due after ten years 1,451 1,485 --------- -------- 39,893 40,831 Mortgage-backed securities available for sale 2,107,283 2,110,104 --------- --------- $2,147,176 2,150,935 ========= ========= Debt securities held to maturity: Due in one year or less $ 42,855 42,944 Due after one year through five years 178,167 178,032 Due after five years through ten years 1,915 2,152 Due after ten years 394 489 --------- --------- $ 223,331 223,617 ========= ========= At December 31, 1993, investment securities with a carrying value of $1,327,289,000, including $1,202,194,000 of investment securities available for sale, were pledged to secure demand notes issued to the U.S. Treasury, borrowings from the Federal Home Loan Bank of New York, repurchase agreements and governmental deposits. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 4. LOANS AND LEASES Total gross loans and leases outstanding were comprised of the following: December 31 1993 1992 ---------- --------- (in thousands) Loans Commercial, financial, agricultural, etc. $1,419,039 1,389,893 Real estate - construction 51,384 35,831 Real estate - mortgage 4,540,177 4,422,730 Consumer 1,337,293 1,211,401 --------- --------- Total loans 7,347,893 7,059,855 --------- --------- Leases 91,166 88,662 --------- --------- Total loans and leases $7,439,059 7,148,517 ========= ========= Approximately $204.7 million of the real estate mortgage loans at December 31, 1993 were one-to-four family residential mortgage loans held for sale. The Company typically retains the mortgage servicing rights related to one- to-four family residential mortgage loans sold. One-to-four family residential mortgage loans serviced for others totaled approximately $2.9 billion at December 31, 1993 and $2.2 billion at December 31, 1992. Approximately $17.6 million of one-to-four family residential mortgage loans have been sold with recourse. The total credit loss exposure resulting from loans sold with recourse was considered negligible as of December 31, 1993. Included in the table above are nonperforming loans (loans on which interest was not being accrued, or which were ninety days or more past due or had been renegotiated at below-market interest rates) of $82,253,000 at December 31, 1993 and $113,593,000 at December 31, 1992. If nonaccrual and renegotiated loans had been accruing interest at their originally contracted terms, interest income on these loans would have amounted to $10.2 million in 1993 and $9.4 million in 1992. The actual amount included in interest income during 1993 and 1992 on these loans was $1.4 million and $1.0 million, respectively. At December 31, 1993, M&T Bank retained the contractual right to require the Federal Deposit Insurance Corporation ("FDIC") to repurchase prior to May 31, 1994, at a discount of 4% of book value, certain loans acquired on May 31, 1991 from the FDIC from the portfolio of a failed thrift institution which become adversely classified for regulatory reporting purposes. The loans on which this right is retained included approximately $100 million of commercial real estate loans, $53 million of consumer loans and $196 million of residential mortgage loans at December 31, 1993. At December 31, borrowings by directors and officers of the Parent Company and its banking subsidiaries, and by associates of such persons, exclusive of loans aggregating less than $60,000, amounted to $61,179,000 in 1993 and $61,061,000 in 1992. During 1993, new borrowings by such persons amounted to $21,015,000 (including borrowings of new directors or officers that were outstanding at the time of their election) and repayments and other deductions equaled $20,897,000. At December 31, 1993, approximately $132 million of real estate loans, primarily residential mortgage loans, were pledged to secure short-term borrowings. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 5. ALLOWANCE FOR POSSIBLE CREDIT LOSSES Changes in the allowance for possible credit losses were as follows: 1993 1992 1991 ----- ----- ----- (in thousands) Beginning balance $151,690 100,265 74,982 Provision for possible credit losses 79,958 84,989 63,412 Allowance for possible credit losses acquired - 12,749 6,000 Net charge-offs Charge-offs (46,089) (51,384) (48,494) Recoveries 10,319 5,071 4,365 ------- ------- ------- Net charge-offs (35,770) (46,313) (44,129) ------- ------- ------- Ending balance $195,878 151,690 100,265 ======= ======= ======= 6. PREMISES AND EQUIPMENT The detail of premises and equipment was as follows: December 31 1993 1992 ` -------- ------- (in thousands) Land $ 15,151 14,628 Buildings owned 89,613 84,017 Buildings under capital leases 1,773 1,773 Leasehold improvements 30,185 31,176 Furniture and equipment owned 92,544 79,600 -------- ------- 229,266 211,194 Less: accumulated depreciation and amortization Owned assets 92,819 80,879 Capital leases 1,573 1,532 -------- ------- 94,392 82,411 -------- ------- Premises and equipment, net $134,874 128,783 ======= ======= Net lease expense for all operating leases totaled $12,051,000 in 1993, $11,617,000 in 1992 and $10,008,000 in 1991. The bank subsidiaries occupy certain banking offices and use certain equipment under noncancellable operating lease agreements expiring at various dates over the next 23 years. Minimum lease payments under noncancellable operating leases are summarized as follows: Year ending December 31 (in thousands) 1994 $ 5,782 1995 7,193 1996 6,548 1997 6,820 1998 6,184 Later years 61,299 ------ $93,826 ====== Payments required under capital leases are not material. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 7. BORROWINGS The amount and interest rate of short-term borrowings were as follows: Federal funds purchased and repurchase Other agreements borrowings Total ---------- ---------- ----- (dollars in thousands) At December 31, 1993 Amount outstanding $ 1,381,335 720,332 2,101,667 Weighted-average interest rate 3.41% 2.97% 3.26% For the year ended December 31, 1993 Highest amount at a month-end $ 2,434,239 720,332 Daily-average amount outstanding 1,639,537 282,989 1,922,526 Weighted-average interest rate 3.06% 2.93% 3.04% =========== ========== ========== At December 31, 1992 Amount outstanding $ 329,161 363,530 692,691 Weighted-average interest rate 3.19% 2.49% 2.82% For the year ended December 31, 1992 Highest amount at a month-end $ 1,350,404 883,236 Daily-average amount outstanding 831,494 289,917 1,121,411 Weighted-average interest rate 3.45% 3.34% 3.42% ========== ========== ========== At December 31, 1991 Amount outstanding $ 492,887 529,543 1,022,430 Weighted-average interest rate 3.79% 3.88% 3.84% For the year ended December 31, 1991 Highest amount at a month-end $ 781,807 529,543 Daily-average amount outstanding 472,335 177,664 649,999 Weighted-average interest rate 5.67% 5.73% 5.69% ========== ========== ========== The Parent Company, M&T Bank and The East New York Savings Bank ("East New York"), a wholly owned subsidiary of the Parent Company, had available lines of credit under formal agreements at December 31, 1993 aggregating $25 million, $198 million and $310 million, respectively. Outstanding borrowings under such arrangements totaled $310 million at East New York. The Parent Company and M&T Bank had no outstanding borrowings under available lines of credit at December 31, 1993. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 7. BORROWINGS, CONTINUED Long-term borrowings at December 31, 1993 and 1992 consisted of M&T Bank's 8 1/8% subordinated notes, due December 1, 2002. Such notes are subordinate to the claims of depositors and other creditors of M&T Bank. 8. PREFERRED STOCK On March 15, 1991, the Parent Company issued and sold 40,000 shares of 9% cumulative convertible preferred stock, $1 par value, for $1,000 per share, or $40,000,000 in total. The preferred stock is convertible at any time into shares of the Parent Company's common stock at an initial conversion price of $78.90625 per share. The conversion formula provides the holder with anti-dilution protections in the event the Parent Company issues additional common stock at a price which is less than the conversion price or in the event that there are other capital changes such as common stock dividends or stock splits. The Parent Company has the right, subject to regulatory approval, to redeem the preferred stock, in whole, but not in part, on or after March 31, 1996 at a price of $40,000,000 plus accrued and unpaid dividends. The Parent Company must provide at least 45 days notice to the preferred stockholder of its intention to redeem the shares, during which time the preferred stockholder may exercise the conversion privilege. The preferred stock is not considered to be a common stock equivalent. Preferred stock dividends are deducted from net income when calculating primary earnings per common share. Fully diluted earnings per common share calculations assume that the preferred stock was converted to 506,930 shares of common stock at issuance and that no preferred stock dividends were paid. 9. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments", requires that financial institutions disclose the estimated "fair value" of their financial instruments. "Fair value" is generally defined as the price a willing buyer and a willing seller would exchange for a financial instrument in other than a distressed sale situation. Disclosures related to fair value presented herein are as of December 31, 1993 and 1992. With the exception of marketable securities, certain off-balance sheet financial instruments and one-to-four family residential mortgages originated for sale, the Company's financial instruments are not readily marketable and market prices do not exist. The Company, in attempting to comply with the provisions of SFAS No. 107, has not attempted to market its financial instruments to potential buyers, if any exist. Since negotiated prices in illiquid markets depend greatly upon the then present motivations of the buyer and seller, it is reasonable to assume that actual sales prices could vary widely from any estimate of fair value made without the benefit of negotiations. Additionally, changes in market interest rates can dramatically impact the value of financial instruments in a short period of time. The Company, in arriving at estimated fair value, primarily used calculations based upon discounted cash flows of the related financial instruments. In general, discount rates used for loan products were based upon the Company's pricing at the respective year-end. A higher discount rate was assumed with respect to estimated cash flows associated with nonaccrual loans. No value FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 9. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, CONTINUED was ascribed to existing loan put privileges (see note 4) since these rights are generally not transferable. The following table presents the book values and calculated estimates of fair value related to loans and loan commitments: Book Calculated value estimate ---------- ---------- (in thousands) December 31, 1993 Commercial loans and leases $ 1,490,745 1,490,869 Commercial real estate loans 3,019,859 3,086,602 Residential real estate loans 1,526,104 1,550,504 Consumer loans 1,224,391 1,259,579 ---------- --------- $ 7,261,099 7,387,554 ========== ========= December 31, 1992 Commercial loans and leases $ 1,459,371 1,467,377 Commercial real estate loans 2,770,300 2,828,601 Residential real estate loans 1,637,540 1,666,788 Consumer loans 1,116,593 1,159,502 ---------- --------- $ 6,983,804 7,122,268 ========== ========= SFAS No. 107 requires that the estimated fair value ascribed to noninterest-bearing deposits, savings deposits and NOW accounts be established at book value because of the customer's ability to withdraw funds immediately. Additionally, time deposit accounts are required to be revalued based upon prevailing market interest rates for similar maturity instruments. The following summarizes the results of these calculations: Book Calculated value estimate ---------- ---------- (in thousands) December 31, 1993 Noninterest-bearing deposits $ 1,052,258 1,052,258 Savings deposits and NOW accounts 4,129,673 4,129,673 Time deposits 1,982,272 2,016,376 Deposits at foreign office 189,058 189,058 ========== ========= December 31, 1992 Noninterest-bearing deposits $ 1,078,690 1,078,690 Savings deposits and NOW accounts 4,344,335 4,344,335 Time deposits 2,536,309 2,583,752 Deposits at foreign office 117,776 117,746 ========== ========= The Company believes that deposit accounts clearly have a value greater than that prescribed by SFAS No. 107. The Company feels, however, that the value associated with these deposits is greatly influenced by characteristics of the buyer, such as its ability to reduce costs of servicing the deposits and the expected deposit attrition which is customary in acquisitions. Accordingly, estimating the fair value of deposits with any degree of certainty is not practical. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 9. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, CONTINUED Due to the near maturity of short-term borrowings and money-market assets, the Company estimates that book value of these instruments approximates estimated fair value. The estimated fair value of long-term borrowings was $83,607,000 and $77,155,000, compared with a book value of $75,590,000 and $75,685,000 at December 31, 1993 and 1992, respectively. The Company does not feel the above is representative of the earnings power of the Company nor its value. The above analysis, which is inherently limited in depicting fair value, also does not consider any value associated with existing customer relationships nor the ability of the Company to create value through its loan origination, deposit gathering, or fee generating activities. Many of the fair value estimates presented herein are based upon the use of highly subjective information and assumptions and, accordingly, the results may not be precise. Management believes that fair value estimates may not be comparable between financial institutions due to the wide range of permitted valuation techniques and numerous estimates which must be made. Further, since the fair value is estimated as of the balance sheet date, the amounts actually realized or paid upon maturity or settlement of the various financial instruments could be significantly different. 10. STOCK OPTION PLAN The stock option plan allows the grant of stock options and stock appreciation rights (either in tandem with options or independently) which are exercisable over terms not exceeding ten years and one day, and at prices which may not be less than the fair market value of the common stock on the date of grant. When exercisable, the stock appreciation rights issued in tandem with stock options entitle grantees to receive cash, stock or a combination equal to the amount of stock appreciation between the dates of grant and exercise. Stock appreciation rights issued independently of stock options contain similar terms as the stock options, although upon exercise the holder is only entitled to receive cash instead of purchasing shares of the Parent Company's common stock. Of the stock options outstanding at December 31, 1993, 413,633 were granted with limited stock appreciation rights attached thereto. A summary of related activity follows: FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 10. STOCK OPTION PLAN, CONTINUED At December 31, 1993 and 1992, respectively, there were 275,670 and 390,045 shares available for future grant. A total of 1,500,000 shares were authorized under the plan. 11. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS The Company has a noncontributory defined benefit pension plan covering substantially all full-time employees. Pension benefits accrue to participants based on their level of compensation and the number of years of service. The Company contributes to the plan an amount sufficient to meet Internal Revenue Code funding standards. Net periodic pension cost (benefit) consisted of the following: 1993 1992 1991 ---- ---- ---- (in thousands) Service cost $ 3,075 2,357 1,719 Interest cost on projected benefit obligation 4,904 4,569 4,323 Actual return on assets (8,217) (6,022) (12,647) Net amortization and deferral 293 (1,601) 5,294 -------- ------- ------- Net periodic pension cost (benefit) $ 55 (697) (1,311) ======== ======= ======= FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 11. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS, CONTINUED Data relating to the funding position of the plan were as follows: 1993 1992 ---- ---- (in thousands) Vested accumulated benefit obligation $ (64,169) (50,325) Total accumulated benefit obligation (66,317) (52,462) Projected benefit obligation (81,943) (63,769) Plan assets at fair value 93,601 89,132 Plan assets in excess of projected benefit obligation 11,658 25,363 Unrecognized net asset (3,775) (4,632) Unrecognized past service cost - (1,661) Unrecognized net (gain) loss 2,775 (8,357) -------- ------- Pension asset $ 10,658 10,713 ======== ======= The discount rate used in determining the actuarial present value of the projected benefit obligation was 7.0% for 1993 and 7.5% for 1992, while the assumed rate of increase in future compensation was 5.0% for 1993 and 5.2% for 1992. The expected long-term rate of return on assets was 8.25% for 1993 and 1992. The Company also provides health care and life insurance benefits for qualified retired employees who reached the age of 55 while working for the Company. Substantially all salaried employees are covered in the plan. Net postretirement benefit cost consisted of the following: 1993 1992 1991 ---- ---- ---- (in thousands) Service cost $ 94 48 45 Interest cost on projected benefit obligation 1,094 1,057 989 Actual return on assets (364) (394) (583) Net amortization and deferral (281) (592) (361) ------- ------ ------ Net postretirement benefit cost $ 543 119 90 ======= ====== ====== Data relating to the funding position of the plan were as follows: 1993 1992 ---- ---- (in thousands) Accumulated benefit obligation Retirees $ 15,196 10,643 Actives Fully eligible 1,695 2,072 Other 1,180 731 Plan assets at fair value (8,621) (9,076) ------- ------- Accumulated benefit obligation in excess of plan assets 9,450 4,370 Unrecognized net loss (5,637) (914) Unrecognized past service cost 2,855 2,734 ------- ------- Accrued postretirement benefit cost $ 6,668 6,190 ======= ======= The Company on occasion funds a portion of these postretirement benefit obligations through contributions to a Voluntary Employee Benefit Association trust account. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 11. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS, CONTINUED The discount rate used in determining the accumulated benefit obligations was 7% for 1993 and 8% for 1992. The expected long-term rate of return on assets was 8% for both 1993 and 1992. The medical inflation rate was assumed to be 14.5% for 1993 and 15.25% for 1992, with a gradual reduction to 5.5% over twenty years. The Company's 1993 service cost, interest cost and accumulated benefit obligation, assuming a 1% increase in the medical inflation rate assumption, are depicted as follows: (in thousands) Accumulated postretirement benefit obligation $19,513 Service cost 94 Interest cost 1,168 ====== For purposes of calculating the December 31, 1993 accumulated benefit obligation for both pension and postretirement benefits, the Company revised certain mortality assumptions used to estimate the expected lives of plan participants. This change had no impact on net periodic costs for 1993, but increased the projected benefit obligation for the pension plan and the accumulated benefit obligation for the postretirement benefit plan by approximately $8.5 million and $2.3 million, respectively. 12. INCOME TAXES The components of income tax expense were as follows: 1993 1992 1991 ---- ---- ---- (in thousands) Current Federal $69,744 65,672 28,287 State and city 25,487 27,037 16,007 ------ ------ ------ Total current 95,231 92,709 44,294 ====== ====== ====== Deferred Federal (18,124) (19,919) 5,027 State and city (5,576) (7,949) (1,720) ------ ------ ------ Total deferred (23,700) (27,868) 3,307 ------ ------ ------ Total income taxes applicable to pre-tax income $71,531 64,841 47,601 ====== ====== ====== In 1992 the Company adopted SFAS No. 109, "Accounting for Income Taxes". The provisions of SFAS No. 109, which mandate a liability method of accounting for income taxes payable and receivable, were not applied for any period prior to 1992. Since the application of SFAS No. 109 did not result in any net adjustment to the Company's tax assets and liabilities, there was no charge or credit reflected in the Consolidated Statement of Income representing the cumulative effect of a change in accounting principle in 1992. The Company files a consolidated tax return which includes all subsidiaries. East New York may elect to compute its bad debt deduction for tax purposes as a percentage of taxable income. Applicable federal tax law allows qualified savings banks the option of deducting as bad debt expense 8% of their taxable income. However, failure to maintain savings bank status as defined by the Internal Revenue Code or charges to the reserve established by these deductions for other than bad debt losses would create taxable income, subject to the applicable tax rates in effect at that time. At December 31, 1993, FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 12. INCOME TAXES, CONTINUED East New York's bad debt reserve for federal tax purposes was $45,460,000. No actions are planned which would cause this reserve to become wholly or partially taxable. The portion of income tax expense attributable to gains on sales of bank investment securities was $392,000 in 1993, $12,016,000 in 1992, and $186,000 in 1991. No alternative minimum tax ("AMT") expense was recognized in any year. Total income taxes differed from the amount computed by applying the statutory federal income tax rate to pre-tax income as follows: 1993 1992 1991 ---- ---- ---- (in thousands) Income taxes at statutory rate $ 60,733 55,345 39,030 Increase (decrease) in taxes: Tax-exempt income (2,066) (3,138) (4,759) State and city income taxes, net of federal income tax effect 12,942 12,598 9,429 Thrift bad debt provision, net - - 2,361 Other (78) 36 1,540 ------- ------- ------- $ 71,531 64,841 47,601 ======= ======= ======= Deferred tax assets (liabilities) were comprised of the following at December 31: 1993 1992 ---- ---- (in thousands) Retirement benefits $ (4,904) (4,552) Leasing transactions (72,019) (71,597) Unrealized investment gains (6,657) - Gross deferred tax liabilities (83,580) (76,149) Interest on loans 7,115 6,811 Gain on sales of loans 2,207 2,571 Depreciation and amortization 3,477 2,897 Losses on loans and other assets 76,783 54,747 Postretirement and other supplemental employee benefits 5,969 5,311 Incentive compensation plans 9,247 7,282 Other 3,060 3,765 Gross deferred tax assets 107,858 83,384 -------- ------- Net deferred asset $ 24,278 7,235 ======== ======= Certain timing differences in 1991 had deferred income tax effects amounting to more than 5% of the year's income taxes computed at 34% of pre-tax income. Such differences and the related deferred tax charges (credits) were as follows: --------- (in thousands) Losses on loans and other assets $ (8,673) Leasing transactions 6,583 AMT utilization 10,034 The income tax credits shown in the Statement of Income of the Parent Company arise principally from its operating losses, before dividends from subsidiaries. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 13. OTHER INCOME AND OTHER EXPENSE The following items, which exceeded 1% of total revenues in the respective period, were included in either other revenues from operations or other costs of operations in the Consolidated Statement of Income: 1993 1992 1991 ---- ----- ---- (in thousands) Residential mortgage servicing fees $10,359 - - Gains from sales of loans - - 8,657 Professional services expense Data processing - 14,343 - Other - 5,362 - Advertising expense 9,069 - - Write-downs of mortgage servicing rights - 16,800 - ====== ====== ====== 14. INTERNATIONAL ACTIVITIES The Company engages in certain international activities consisting primarily of purchasing Eurodollar placements, collecting Eurodollar deposits and engaging in a limited amount of foreign currency trading. At December 31, 1993 and 1992, assets identified with international activities amounted to $62,419,000 and $35,653,000, respectively. 15. COMMITMENTS AND CONTINGENCIES In 1993, the Company entered into currently effective interest rate swap contracts designated for hedging purposes of $1.0 billion. At December 31, 1993, the Company had outstanding currently effective interest rate swap contracts with a notional value of approximately $1.2 billion. Under the terms of these swap agreements, the Company receives interest at a fixed rate and pays interest at a variable rate. The effects of these interest rate swap contracts are reflected in interest income on loans and leases and interest expense on time deposits in the Consolidated Statement of Income. The net effect of interest rate swaps was to increase net interest income by $34.2 million, $20.1 million and $7.6 million in 1993, 1992 and 1991, respectively. Of the interest rate swaps currently in effect, $400 million mature in the first quarter of 1996. In general, beginning in 1995, the notional amount of the remaining swaps currently in effect will decline depending on the level of interest rates or the prepayment behavior of mortgage-backed securities to which the swaps are indexed. As of December 31, 1993, the Company had also entered into forward swaps with a notional amount of $475 million. These forward interest rate swap commitments had no effect on net income. At December 31, 1992, the Company had outstanding interest rate swap contracts with a notional value of $525 million. Interest rate swap contracts are generally entered into with counterparties with substantial net worth and most contain collateral provisions protecting the at-risk party. The Company considers the credit risk inherent in these contracts to be negligible. The Company's interest rate- swap contracts had estimated market values of $15.6 million and $9.2 million at December 31, 1993 and 1992, respectively. FIRST EMPIRE STATE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS, continued 15. COMMITMENTS AND CONTINGENCIES, CONTINUED Additionally, at December 31, 1993, the Company had entered into option contracts with a face value totaling $60 million. At December 31, 1993, the Company's maximum loss exposure under these option contracts, all of which were carried for trading account purposes, was not material. In the normal course of business, various commitments and contingent liabilities are outstanding, such as commitments to extend credit guarantees and "standby" letters of credit (approximately $152,604,000 at December 31, 1993), which are not reflected in the financial statements. No material losses are expected as a result of these transactions. In the opinion of management, the potential liabilities, if any, arising from all lawsuits pending against the Company at December 31, 1993 will not have a materially adverse impact on the Company's consolidated financial condition. Moreover, management believes that the Company has substantial defenses in such litigation, but that there can be no assurance that the potential liabilities, if any, arising from such litigation will not have a materially adverse impact on the Company's consolidated results of operations in the future. 16. REGULATORY RESTRICTIONS The payment of dividends by the banking subsidiaries is restricted by various legal and regulatory limitations. Dividends by any banking subsidiary to the Parent Company are limited by the amount of earnings of the banking subsidiary in the current year and the preceding two years. For purposes of this test, at December 31, 1993, approximately $186,494,000 was available in the aggregate for payment of dividends to the Parent Company from M&T Bank without prior regulatory approval. As a result of dividends paid in prior years, East New York was not permitted to pay dividends to the Parent Company without prior regulatory approval until 1994. Banking regulations prohibit extensions of credit by the subsidiary banks to the Parent Company unless appropriately secured by assets. Securities of affiliates are not eligible as collateral for this purpose. The banking subsidiaries are required to maintain noninterest-earning reserves against deposit liabilities. During the maintenance periods that included December 31, 1993 and 1992, cash and due from banks included a daily average of $159,742,000 and $146,536,000, respectively, for such purpose. 17. PARENT COMPANY REVOLVING CREDIT AGREEMENT The Parent Company has a revolving credit agreement whereby the Parent Company may borrow up to $25,000,000 at its discretion through December 28, 1994. The agreement provides for a facility fee assessed on the entire amount of the commitment (whether or not utilized) ranging from 3/16 to 5/16 of 1% depending on the credit rating of the subordinated notes of M&T Bank. Additionally, a utilization fee of 1/8 of 1% is assessed on the daily average of outstandings under the commitment whenever such outstandings exceed 50% of the commitment. Various interest rate options exist, including a variable rate based upon the higher of the lender's prime or the Federal funds rate plus 1/4 of 1%, or a fixed rate based upon London Interbank Offer Rates. At December 31, 1993, there were no outstanding balances under such agreement. 18. PARENT COMPANY FINANCIAL STATEMENTS See other notes to financial statements. 18. PARENT COMPANY FINANCIAL STATEMENTS, CONTINUED Item 9.

Item 9. Changes In and Disagreements With Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure. None. -------------------- PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. -------------------------------------------------- The identification of the Registrant's directors is incorporated by reference to the caption "NOMINEES FOR DIRECTOR" contained in the Registrant's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, which was filed with the Securities and Exchange Commission on March 10, 1994. The identification of the Registrant's executive officers is presented under the caption "Executive Officers of the Registrant" contained in Part I of this Annual Report on Form 10-K. Disclosure of compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, by the Registrant's directors and executive officers, and persons who are the beneficial owners of more than 10% of the Registrant's common stock, is incorporated by reference to the caption "STOCK OWNERSHIP BY DIRECTORS AND EXECUTIVE OFFICERS" contained in the Registrant's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders. Item 11.

Item 11. Executive Compensation. Incorporated by reference to the ----------------------- Registrant's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, which was filed with the Securities and Exchange Commission on March 10, 1994. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and --------------------------------------------------- Management. Incorporated by reference to the Registrant's ---------- definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, which was filed with the Securities and Exchange Commission on March 10, 1994. Item 13.

Item 13. Certain Relationships and Related Transactions. Incorporated ---------------------------------------------- by reference to the Registrant's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, which was filed with the Securities and Exchange Commission on March 10, 1994. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. --------------------------------------------------------------- (a) Financial statements and financial statement schedules filed as part of this Annual Report on Form 10-K. See Part II, Item 8. "Financial Statements and Supplementary Data". The financial statement schedules required by Rule 9-07 under Regulation S-X are omitted because the required information is not applicable. (b) Reports on Form 8-K. The Registrant filed a Current Report on Form 8-K dated December 14, 1993 with the Securities and Exchange Commission on December 17, 1993 reporting that the Registrant had been authorized by the Executive Committee of its Board of Directors to purchase and hold as treasury stock up to 506,930 additional shares of the Registrant's common stock, or approximately 7.4% of those then currently outstanding, as a reserve for the possible future conversion of the shares of the 9% Convertible Preferred Stock of First Empire (Parent) into shares of the Registrant's common stock. Under this authorization, shares of common stock may be purchased from time-to-time in the open market or in privately negotiated transactions. (c) Exhibits required by Item 601 of Regulation S-K. The exhibits listed on the Exhibit Index on pages 78 and 79 of this Annual Report on Form 10-K have been previously filed, are filed herewith or are incorporated herein by reference to other filings. (d) Additional financial statement schedules. None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 16th day of March, 1994. FIRST EMPIRE STATE CORPORATION By: /s/ Robert G. Wilmers ------------------------------------ Robert G. Wilmers President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date - --------- ----- ----- Principal Executive Officers: /s/ Robert G. Wilmers - ---------------------- President and Robert G. Wilmers Chief Executive Officer 3/16/94 /s/ Paul B. Murray - ---------------------- Chairman of the Board 3/16/94 Paul B. Murray Principal Financial and Accounting Officer: /s/ James L. Vardon - ----------------------- Executive Vice President James L. Vardon and Chief Financial Officer 3/16/94 A majority of the board of directors: /s/ Brent D. Baird 3/16/94 - ------------------------------------ ------------ Brent D. Baird /s/ John H. Benisch 3/16/94 - ------------------------------------ ------------ John H. Benisch /s/ Angela Bontempo 3/16/94 - ------------------------------------ ------------ Angela Bontempo /s/ Patrick J. Callan 3/16/94 - ------------------------------------ ------------ Patrick J. Callan /s/ David N. Campbell 3/16/94 - ------------------------------------ ------------ David N. Campbell /s/ James A. Carrigg 3/16/94 - ------------------------------------ ------------ James A. Carrigg /s/ Barber B. Conable, Jr. 3/16/94 - ------------------------------------ ------------ Barber B. Conable, Jr. /s/ Richard E. Garman 3/16/94 - ------------------------------------ ------------ Richard E. Garman /s/ Roy M. Goodman 3/16/94 - ------------------------------------ ------------ Roy M. Goodman /s/ Patrick W.E. Hodgson 3/16/94 - ------------------------------------ ------------ Patrick W.E. Hodgson /s/ Lambros J. Lambros 3/16/94 - ------------------------------------ ------------ Lambros J. Lambros /s/ Wilfred J. Larson 3/16/94 - ------------------------------------ ------------ Wilfred J. Larson /s/ Paul B. Murray 3/16/94 - ------------------------------------ ------------ Paul B. Murray /s/ Jorge G. Pereira 3/16/94 - ------------------------------------ ------------ Jorge G. Pereira /s/ William C. Shanley, III 3/16/94 - ------------------------------------ ------------ William C. Shanley, III /s/ Raymond D. Stevens, Jr. 3/16/94 - ------------------------------------ ------------ Raymond D. Stevens, Jr. /s/ Peter Tower 3/16/94 - ------------------------------------ ------------ Peter Tower /s/ Richard D. Trent 3/16/94 - ------------------------------------ ------------ Richard D. Trent /s/ Samuel F. Ward 3/16/94 - ------------------------------------ ------------ Samuel F. Ward /s/ Robert G. Wilmers 3/16/94 - ------------------------------------ ------------ Robert G. Wilmers EXHIBIT INDEX 3.1 Restated Certificate of Incorporation of First Empire State Corporation dated April 19, 1989, filed by the Secretary of State of New York on April 20, 1989. Incorporated by reference to Exhibit No. 19 to the Form 10-Q for the quarter ended March 31, 1989 (File No. 1-9861). 3.2 Certificate of Amendment of the Certificate of Incorporation of First Empire State Corporation dated March 13, 1991, filed by the Secretary of State of New York on March 14, 1991. Incorporated by reference to Exhibit No. 19 to the Form 10-Q for the quarter ended March 31, 1991 (File No. 1-9861). 3.3 By-Laws of First Empire State Corporation as last amended on July 16, 1991. Incorporated by reference to Exhibit No. 3.2 to the Form 10-K for the year ended December 31, 1991 (File No. 1-9861). 4 Instruments defining the rights of security holders, including indentures. Incorporated by reference to Exhibit Nos. 3.1, 3.2, 3.3, 10.1 and 10.2 hereof. 10.1 Credit Agreement, dated as of December 30, 1993, between First Empire State Corporation and The Chase Manhattan Bank, N.A. Filed herewith. 10.2 First Empire State Corporation 1983 Stock Option Plan, as amended. Incorporated by reference to Exhibit No. 10.3 to the Form 10-K for the year ended December 31, 1991 (File No. 1-9861). 10.3 First Empire State Corporation Annual Executive Incentive Plan. Incorporated by reference to Exhibit No. 10.4 to the Form 10-K for the year ended December 31, 1992 (File No. 1 - 9861). Supplemental Deferred Compensation Agreements between Manufacturers and Traders Trust Company and: 10.4 Robert E. Sadler, Jr. and James L. Vardon, each dated as of March 7, 1985. Incorporated by reference to Exhibit Nos. (10)(d) (A) and (B), respectively, to the Form 10-K for the year ended December 31, 1984 (File No. 0-4561); 10.5 Harry R. Stainrook dated as of December 12, 1985. Incorporated by reference to Exhibit No. (10)(e)(ii) to the Form 10-K for the year ended December 31, 1985 (File No. 0-4561); 10.6 William C. Rappolt dated as of March 7, 1985. Incorporated by reference to Exhibit No. (10)(e)(iv) to the Form 10-K for the year ended December 31, 1987 (File No. 1-9861); and 10.7 William A. Buckingham dated as of August 7, 1990. Incorporated by reference to Exhibit No. 10.8 to the Form 10-K for the year ended December 31, 1990 (File No. 1-9861). 10.8 Salary Continuation Agreement, dated as of April 16, 1987, between The East New York Savings Bank and Paul B. Murray. Incorporated by reference to Exhibit No. (10)(f) to the Form 10-K for the year ended December 31, 1987 (File No. 1-9861). 10.9 Employment Agreement, dated as of December 24, 1987, among First Empire State Corporation, The East New York Savings Bank and Paul B. Murray. Incorporated by reference to Exhibit No. (10)(g) to the Form 10-K for the year ended December 31, 1987 (File No. 1-9861). 10.10 Supplemental Deferred Compensation Agreement, dated July 17, 1989, between The East New York Savings Bank and Atwood Collins, III. Incorporated by reference to Exhibit No. 10.11 to the Form 10-K for the year ended December 31, 1991 (File No. 1-9861). 11 Statement re: Computation of Earnings Per Common Share. Filed herewith. 21 Subsidiaries of the Registrant. Incorporated by reference to the caption "Subsidiaries" contained in Part I, Item 1 hereof. 23.1 Consent of Price Waterhouse re: Registration Statement No. 33- 32044. Filed herewith. 23.2 Consent of Price Waterhouse re: Registration Statement No. 33- 12207. Filed herewith. 23.3 Consent of Price Waterhouse re: Registration Statement No. 33- 58500. Filed herewith. 99.1 Annual Report of the First Empire State Corporation Retirement Savings Plan and Trust for the fiscal year ended December 31, 1993. Filed herewith. 99.2 Reconciliation of selected annual and quarterly financial data from amounts previously reported. Filed herewith. i EXHIBIT 10.1 CREDIT AGREEMENT dated as of December 30, 1993 between FIRST EMPIRE STATE CORPORATION and THE CHASE MANHATTAN BANK, N.A. ii ARTICLE 1 DEFINITIONS; ACCOUNTING TERMS. Section 1.01 Definitions. . . . . . . . . . . . . . 1 Section 1.02 Accounting Terms . . . . . . . . . . . 9 ARTICLE 2 THE CREDIT. Section 2.01 The Loans. . . . . . . . . . . . . . . 9 Section 2.02 The Note . . . . . . . . . . . . . . . 9 Section 2.03 Purpose. . . . . . . . . . . . . . . . 9 Section 2.04 Borrowing Procedures . . . . . . . . . 9 Section 2.05 Prepayments. . . . . . . . . . . . . . 10 Section 2.06 Interest Periods . . . . . . . . . . . 10 Section 2.07 Changes of Commitment. . . . . . . . . 10 Section 2.08 Certain Notices. . . . . . . . . . . . 10 Section 2.09 Minimum Amounts. . . . . . . . . . . . 11 Section 2.10 Interest . . . . . . . . . . . . . . . 11 Section 2.11 Fees . . . . . . . . . . . . . . . . . 12 Section 2.12 Payments Generally . . . . . . . . . . 12 ARTICLE 3 YIELD PROTECTION; ILLEGALITY; ETC. Section 3.01 Additional Costs . . . . . . . . . . . 13 Section 3.02 Limitation on Eurodollar Loans . . . . 14 Section 3.03 Illegality . . . . . . . . . . . . . . 14 Section 3.04 Certain Compensation . . . . . . . . . 15 ARTICLE 4 CONDITIONS PRECEDENT. Section 4.01 Documentary Conditions Precedent . . . 15 Section 4.02 Additional Conditions Precedent. . . . 16 Section 4.03 Deemed Representations . . . . . . . . 16 ARTICLE 5 REPRESENTATIONS AND WARRANTIES. Section 5.01 Incorporation, Good Standing and Due Qualification. . . . . . . . . . . . . 17 Section 5.02 Corporate Power and Authority; No Conflicts . . . . . . . . . . . . . 17 Section 5.03 Legally Enforceable Agreements . . . . 17 Section 5.04 Litigation . . . . . . . . . . . . . . 17 Section 5.05 Financial Statements . . . . . . . . . 18 Section 5.06 Ownership and Liens. . . . . . . . . . 18 Section 5.07 Taxes. . . . . . . . . . . . . . . . . 18 Section 5.08 ERISA. . . . . . . . . . . . . . . . . 19 Section 5.09 Subsidiaries and Ownership of Stock. . 19 Section 5.10 Credit Arrangements. . . . . . . . . . 19 ARTICLE 6 AFFIRMATIVE COVENANTS. Section 6.01 Maintenance of Existence . . . . . . . 19 Section 6.02 Conduct of Business. . . . . . . . . . 20 iii Section 6.03 Maintenance of Properties. . . . . . . 20 Section 6.04 Maintenance of Records . . . . . . . . 20 Section 6.05 Maintenance of Insurance . . . . . . . 20 Section 6.06 Compliance with Laws . . . . . . . . . 20 Section 6.07 Right of Inspection. . . . . . . . . . 20 Section 6.08 Reporting Requirements . . . . . . . . 20 ARTICLE 7 NEGATIVE COVENANTS. Section 7.01 Debt . . . . . . . . . . . . . . . . . 22 Section 7.02 Liens. . . . . . . . . . . . . . . . . 23 Section 7.03 Leases . . . . . . . . . . . . . . . . 24 Section 7.04 Stock of Subsidiaries Etc. . . . . . 24 Section 7.05 Transactions with Affiliates . . . . . 25 Section 7.06 Mergers, Etc . . . . . . . . . . . . . 25 Section 7.07 Sale of Assets . . . . . . . . . . . . 26 ARTICLE 8 FINANCIAL COVENANTS. Section 8.01 Minimum Tangible Net Worth . . . . . . 26 Section 8.02 Leverage Ratio . . . . . . . . . . . . 26 Section 8.03 Double Leverage. . . . . . . . . . . . 26 Section 8.04 Capital Requirements . . . . . . . . . 26 ARTICLE 9 EVENTS OF DEFAULT. Section 9.01 Events of Default. . . . . . . . . . . 27 Section 9.02 Remedies . . . . . . . . . . . . . . . 29 ARTICLE 10 MISCELLANEOUS. Section 10.01 Amendments and Waivers . . . . . . . . 30 Section 10.02 Usury. . . . . . . . . . . . . . . . . 30 Section 10.03 Expenses . . . . . . . . . . . . . . . 30 Section 10.04 Survival . . . . . . . . . . . . . . . 30 Section 10.05 Assignment; Participations . . . . . . 31 Section 10.06 Notices. . . . . . . . . . . . . . . . 31 Section 10.07 Setoff . . . . . . . . . . . . . . . . 31 Section 10.08 Jurisdiction; Immunities . . . . . . . 32 Section 10.09 Table of Contents; Headings. . . . . . 32 Section 10.10 Severability . . . . . . . . . . . . . 32 Section 10.11 Counterparts . . . . . . . . . . . . . 32 Section 10.12 Integration. . . . . . . . . . . . . . 32 Section 10.13 Governing Law. . . . . . . . . . . . . 33 CREDIT AGREEMENT dated as of December 30, 1993 between FIRST EMPIRE STATE CORPORATION, a corporation organized under the laws of New York (the "Borrower") and THE CHASE MANHATTAN BANK (NATIONAL ASSOCIATION), a national banking association organized under the laws of the United States of America (the "Bank"). The Borrower desires that the Bank extend credit as provided herein, and the Bank is prepared to extend such credit. Accordingly, the Borrower and the Bank agree as follows: ARTICLE 1. DEFINITIONS; ACCOUNTING TERMS. Section 1.01. Definitions. As used in this Agreement the following terms have the following meanings (terms defined in the singular to have a correlative meaning when used in the plural and vice versa): "Acceptable Acquisition" means any Acquisition which has been either (a) approved by the Board of Directors of the corporation which is the subject of such Acquisition, or (b) recommended by such Board to the shareholders of such corporation, or (c) is of an insolvent or failing financial institution and made at the direction or with the approval of the regulatory authority charged with administering the affairs of such institution. "Acquisition" means any transaction pursuant to which the Borrower or any of its Subsidiaries (a) acquires 5% or more of any class of the voting securities (or warrants, options or other rights to acquire such securities) of any corporation other than the Borrower or any corporation which is not then a Subsidiary of the Borrower, pursuant to a solicitation of tenders therefor, or in one or more negotiated block, market or other transactions not involving a tender offer, or a combination of any of the foregoing, or (b) makes any corporation a Subsidiary of the Borrower, or causes any such corporation to be merged into the Borrower or any of its Subsidiaries, in any case pursuant to a merger, purchase of assets or any reorganization providing for the delivery or issuance to the holders of such corporations then outstanding securities, in exchange for such securities, of cash or securities of the Borrower or any of its Subsidiaries, or a combination thereof, or (c) purchases all or substantially all of the business or assets of any corporation, provided that the Borrower and its Subsidiaries shall not be prohibited from forming de novo Subsidiaries. "Affiliate" means any Person: (a) which directly or indirectly controls, or is controlled by, or is under common control with, the Borrower or any of its Subsidiaries; (b) which directly or indirectly beneficially owns or holds 5% or more of any class of voting stock of the Borrower or any such Subsidiary; or (c) 5% or more of the voting stock of which is directly or indirectly beneficially owned or held by the Borrower or, such Subsidiary. The term "control" means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a Person, whether through the ownership of voting securities, by contract, or otherwise. "Agreement" means this Credit Agreement, as amended or supplemented from time to time. References to Articles, Sections, Exhibits, Schedules and the like refer to the Articles, Sections, Exhibits, Schedules and the like of this Agreement unless otherwise indicated. "Applicable Margin" means, with respect to (a) a Variable Rate Loan, 0%, and (b) Eurodollar Loans, the rate per annum for each rating level period set forth below: Rating Level Period Applicable Margin ------------------- ----------------- Level I Period .3750% Level II Period .5000% Level III Period .6250% Level IV Period .7500% Any change in the Applicable Margin by reason of a change in the S&P Rating or Moody's Rating shall become effective on the date of announcement or publication by the respective rating agency of a change in such rating or in the absence of such announcement or publication, on the effective date of such changed rating. "Banking Day" means any day on which commercial banks are not authorized or required to close in New York City and whenever such day relates to a Eurodollar Loan or notice with respect to any Eurodollar Loan, a day on which dealings in Dollar deposits are also carried out in the London interbank market. "Capital Lease" means any lease which has been or should be capitalized on the books of the lessee in accordance with GAAP. "Closing Date" means the date this Agreement has been executed by both the Borrower and the Bank. "Code" means the Internal Revenue Code of 1986, as amended from time to time. "Commitment" means the obligation of the Bank to make Loans under this Agreement in the aggregate principal amount of $25,000,000, as such amount may be reduced or otherwise modified from time to time. "Consolidated Capitalization" means the sum of (a) Consolidated Funded Debt and (b) Consolidated Tangible Net Worth. "Consolidated Funded Debt" means as to any Person the Funded Debt of such Person and its Consolidated Subsidiaries on a consolidated basis, as determined in accordance with GAAP. "Consolidated Subsidiary" means any Subsidiary whose accounts are or are required to be consolidated with the accounts of the Borrower in accordance with GAAP. "Consolidated Tangible Net Worth" means Tangible Net Worth of the Borrower and its Consolidated Subsidiaries on a consolidated basis, as determined in accordance with GAAP, except as otherwise provided herein. "Consolidated Total Assets" means, as to any Person, total assets of such Person and its Consolidated Subsidiaries on a consolidated basis, as determined in accordance with GAAP. "Consolidated Total Assets (RAP)" means the average total consolidated assets of the Borrower determined in accordance with Appendix A to Regulation Y. "Debt" means, with respect to any Person: (a) indebtedness of such Person for borrowed money; (b) indebtedness for the deferred purchase price of property or services (except trade payables in the ordinary course of business); (c) Unfunded Vested Liabilities of such Person (if such Person is not the Borrower, determined in a manner analogous to that of determining Unfunded Vested Liabilities of the Borrower); (d) the face amount of any outstanding letters of credit issued for the account of such Person; (e) obligations arising-under acceptance facilities; (f) guaranties, endorsements (other than for collection in the ordinary course of business) and other contingent obligations to purchase, to provide funds for payment, to supply funds to invest in any Person, or otherwise to assure a creditor against loss; (g) obligations secured by any Lien on property of such Person; and (h) obligations of such Person as lessee under Capital Leases. "Default" means any event which with the giving of notice or lapse of time, or both, would become an Event of Default. "Default Rate" means, with respect to an amount of any Loan not paid when due, a rate per annum equal to: (a) if such Loan is a Variable Rate Loan, a variable rate 1% above the rate of interest thereon (including any Applicable Margin); (b) if such Loan is a Eurodollar Loan, a fixed rate 1% above the rate of interest in effect thereon (including the Applicable Margin) at the time of default until the end of the then current Interest Period therefor and, thereafter, a variable rate 1% above the rate of interest for a Variable Rate Loan (including any Applicable Margin). "Dollars" and the sign "$" mean lawful money of the United States of America. "Equity Investments in Subsidiaries" means, as to any Person, the total common stock, Perpetual Preferred Stock, surplus and retained earnings held by such Person. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended from time to time, including any rules and regulations,promulgated thereunder. "ERISA Affiliate" means any corporation or trade or business which is a member of the same controlled group of corporations (within the meaning of Section 414(b) of the Code) as the Borrower or is under common control (within the meaning of Section 414(c) of the Code) with the Borrower. "Eurodollar Base Rate" means the rate per annum (rounded upwards if necessary to the nearest 1/16 of 1%) quoted at approximately 11:00 a.m. London time by the principal London branch of the Bank two Banking Days prior to the first day of the Interest Period for such Loan for the offering to leading banks in the London interbank market of Dollar deposits in immediately available funds, for a period, and in an amount, comparable to such Interest Period and principal amount of the Eurodollar Loan which shall be made by the Bank and outstanding during such Interest Period. "Eurodollar Loan" means any Loan when and to the extent the interest rate therefor is determined on the basis of the definition "Eurodollar Base Rate". "Event of Default" has the meaning given such term in Section 9.01. "Excluded Bank Debt" means all liabilities incurred in the ordinary course of the banking or trust business, such as deposits, letters of credit, bankers acceptances, certificates of deposit, federal funds purchases, borrowings from the Federal Reserve or Federal Home Loan Bank system, foreign exchange contracts, futures contracts and interest rate protection and swap agreements. "Facility Documents" means this Agreement and the Note. "Federal Funds Rate" means, for any day, the rate per annum (expressed on a 365/366 basis of calculation, if the rate on Variable Rate Loans is so calculated) equal to the weighted average of the rates on overnight federal funds transactions as published by the Federal Reserve Bank of New York for such day (or for any day that is not a Banking Day, for the immediately preceding Banking Day). "Fixed Rate" means, for any Eurodollar Loan, a rate per annum (rounded upwards, if necessary, to the nearest 1/100 of 1%) determined by the Bank to be equal to the sum of the quotient of (i) the Eurodollar Base Rate for such Loan for the Interest Period therefor, divided by (ii) one minus the Reserve Requirement for such Loan for such Interest Period. "Form FRY-9C Consolidated Total Assets" means the Consolidated Total Assets of the Borrower contained in the most recent quarterly report on Form FRY-9C which the Borrower files with the Federal Reserve Bank of New York. "Funded Debt" means all Debt for money borrowed which by its terms matures more than one year from the date as of which such Funded Debt is incurred, and any Debt for money borrowed maturing within one year from such date which is renewable or extendable at the option of the obligor to a date beyond one year from such date (whether or not theretofore renewed or extended), including any such indebtedness renewable or extendable at the option of the obligor under, or payable from the proceeds of other indebtedness which may be incurred pursuant to, the provisions of any revolving credit agreement or other similar agreement. "GAAP" means generally accepted accounting principles in the United States of America as in effect on the date hereof, applied on a basis consistent with those used in the preparation of the financial statements referred to in Section 5.05 (except for changes concurred in by the Borrowers independent public accountants). "Insured Subsidiary" means any "insured depositary institution" (as defined in 12 U.S.C. Section 1813(c)(2) (or any successor provision), as amended, reenacted or redesignated from time to time) that is controlled (within the meaning of 12 U.S.C. Section 1841 (or any successor provision), as amended, reenacted or redesignated from time to time). "Interest Period" means the period commencing on the date a Loan is made, and ending, as the Borrower may select pursuant to Section 2.06: (a) in the case of Variable Rate Loans, 30 days thereafter; and (b) in the case of Eurodollar Loans, on the numerically corresponding day in the first, second, third, or sixth calendar month thereafter, provided that each such Interest Period which commences on the last Banking Day of a calendar month (or on any day for which there is no numerically corresponding day in the appropriate subsequent calendar month) shall end on the last Banking Day of the appropriate calendar month. "Lending Office" means, for each type of Loan, the lending office of the Bank (or of an affiliate of the Bank) designated as such for such type of Loan on its signature page hereof or such other office of the Bank (or of an affiliate of the Bank) as the Bank may from time to time specify to the Borrower as the office by which its Loans of such type are to be made and maintained. "Level I Period" means any period during which (a) no Event of Default shall have occurred and be continuing and (b) the S&P Rating is at or above A- (or any successor rating) and the Moody's Rating is at or above A3 (or any successor rating). "Level II Period" means any period (other than a Level I Period) during which (a) no Event of Default shall have occurred and be continuing and (b) the S&P Rating is at or above BBB+ (or any successor rating) and the Moody's Rating is at or above Baa1 (or any successor rating). "Level III Period" means any period (other than a Level I Period or a Level II Period) during which (a) no Event of Default shall have occurred and be continuing and (b) the S&P Rating is at or above BBB (or any successor rating) and the Moody's Rating is at or above Baa2 (or any successor rating). "Level IV Period" means any period during which the S&P Rating is less than BBB (or any successor rating) or the Moody's Rating is less than Baa2 (or any successor rating). "Lien" means any lien (statutory or otherwise), security interest, mortgage, deed of trust, priority, pledge, charge, conditional sale, title retention agreement, financing lease or other encumbrance or similar right of others, or any agreement to give any of the foregoing. "Loan" means any loan made by the Bank pursuant to Section 2.01 and, to the extent provided therein, Section 2.10. "Moody's Rating" means, at any time, the then current rating (including any failure to rate) by Moody's Investors Service, Inc. (or any successor corporation thereto) of the subordinated debt of Manufacturers and Traders Trust Company. "Multiemployer Plan" means a Plan defined as such in Section 3(37) of ERISA to which contributions have been made by the Borrower or any ERISA Affiliate and which is covered by Title IV of ERISA. "Note" means the promissory note of the Borrower in the form of Exhibit A hereto evidencing the Loans made by the Bank hereunder. "PBGC" means the Pension Benefit Guaranty Corporation and any entity succeeding to any or all of its functions under ERISA. "Person" means an individual, partnership, corporation, business trust, joint stock company, trust, unincorporated association, joint venture, governmental authority or other entity of whatever nature. "Plan" means any employee benefit or other plan established or maintained, or to which contributions have been made, by the Borrower or any ERISA Affiliate and which is covered by Title IV of ERISA or to which Section 412 of the Code applies. "Prime Rate" means that rate of interest from time to time announced by the Bank at the Principal Office as its prime commercial lending rate. "Principal Office" means the principal office of the Bank, presently located at 1 Chase Manhattan Plaza, New York, New York 10081. "Prohibited Transaction" means any transaction set forth in Section 406 of ERISA or Section 4975 of the Code. "RAP" means regulatory accounting principles prescribed by the Board of Governors of the Federal Reserve System from time to time. "Regulation D" means Regulation D of the Board of Governors of the Federal Reserve System as the same may be amended or supplemented from time to time. "Regulation U" means Regulation U of the Board of Governors of the Federal Reserve System as the same may be amended or supplemented from time to time. "Regulatory Change" means any change after the date of this Agreement in United States federal, state, municipal or foreign laws or regulations (including Regulation D) or the adoption or. making after such date of any interpretations, directives or requests applying to a broad class of banks including the Bank of or under any United States, federal, state, municipal or foreign laws or regulations (whether or not having the force of law) by any court or governmental or monetary authority charged with the interpretation or administration thereof. "Reportable Event" means any of the events set forth in Section 4043(b) of ERISA as to which events the PBGC by regulation has not waived the requirement of Section 4043(a) of ERISA that it be notified within 30 days of the occurrence of such event, provided that a failure to meet the minimum funding standard of Section 412 of the Code or Section 302 of ERISA shall be a Reportable Event regardless of any waivers given under Section 412(d) of the Code. "Reserve Requirement" means, for any Eurodollar Loan, the average maximum rate at which reserves (including any marginal, supplemental or emergency reserves) are required to be maintained during the Interest Period for such Loan under Regulation D by member banks of the Federal Reserve System in New York City with deposits exceeding $1,000,000,000 against in the case of Eurodollar Loans, "Eurocurrency liabilities" (as such term is used in Regulation D). Without limiting the effect of the foregoing, the Reserve Requirement shall also reflect any other reserves required to be maintained by such member banks by reason of any Regulatory Change against (i) any category of liabilities which includes deposits by reference to which the Eurodollar Base Rate for Eurodollar Loans is to be determined as provided in the definition of "Eurodollar Base Rate" in this Section 1.01 or (ii) any category of extensions of credit or other assets which include Eurodollar Loans. "S&P Rating" means, at any time, the then current rating (including any failure to rate) by Standard & Poor's Corporation (or any successor corporation thereto) of the subordinated debt of Manufacturers and Traders Trust Company. "Significant Subsidiary" means each Subsidiary of the Borrower other than those inactive, special purpose and dissolving corporations listed with an asterisk on Schedule I. "Subsidiary" means, as to any Person, any corporation or other entity of which at least a majority of the securities or other ownership interests having ordinary voting power (absolutely or contingently) for the election of directors or other persons performing similar functions are at the time owned directly or indirectly by such Person. "Tangible Net Worth" means the excess of total assets over total liabilities, excluding, however, from the determination of total assets: goodwill, patents, copyrights, trademarks, tradenames, licenses, franchises, organizational expenses, treasury stock and minority interests in Subsidiaries, and unamortized debt discount. "Termination Date" means December 29, 1994; provided that if such date is not a Banking Day, the Termination Date shall be the next preceding Banking Day). "Tier I Capital" means the tier I capital of the Borrower determined in accordance with Appendix A to Regulation Y of the Board of Governors of the Federal Reserve System (or any successor provision), as amended, reenacted or redesignated from time to time). "Unfunded Vested Liabilities" means, with respect to any Plan, the amount (if any) by which the present value of all vested benefits under the Plan exceeds the fair market value of all Plan assets allocable to such benefits, as determined on the most recent valuation date of the Plan and in accordance with the provisions of ERISA for calculating the potential liability of the Borrower or any ERISA Affiliate to the PBGC or the Plan under Title IV of ERISA. "Variable Rate" means, for any day, the higher of (a) the Federal Funds Rate for such day plus 1/4 of 1% or (b) the Prime Rate for such day. "Variable Rate Loan" means any Loan when and to the extent the interest rate for such Loan is determined in relation to the Variable Rate. Section 1.02. Accounting Terms. All accounting terms not specifically defined herein shall be construed in accordance with GAAP or RAP, in the case of Section 8.02, and all financial data required to be delivered hereunder shall be prepared in accordance with GAAP or RAP. ARTICLE 2. THE CREDIT. Section 2.01. The Loans. (a) Subject to the terms and conditions of this Agreement, the Bank agrees to make loans (the "Loans") to the Borrower from time to time from and including the date hereof to but excluding the Termination Date up to but not exceeding the amount of the Commitment. The Loans may be outstanding as Variable Rate Loans or Eurodollar Loans (each a "type" of Loans). The Loans of each type shall be made and maintained at the Banks Lending Office for such type of Loans. (b) Each Loan shall be due and payable on the last day of the Interest Period therefor. Section 2.02. The Note. The Loans shall be evidenced by a single promissory note in favor of the Bank in the form of Exhibit A, dated the date of this Agreement, duly completed and executed by the Borrower. Section 2.03. Purpose. The Borrower shall use the proceeds of the Loans for general corporate purposes. Such proceeds shall not be used for the purpose, whether immediate, incidental or ultimate, of buying or carrying "margin stock" within the meaning of Regulation U, or of financing an Acquisition other than an Acceptable Acquisition. Section 2.04. Borrowing Procedures. The Borrower shall give the Bank notice of each borrowing to be made hereunder as provided in Section 2.08. Not later than 1:00 p.m. New York City time on the date of such borrowing, the Bank shall, through its Lending Office and subject to the conditions of this Agreement, make the amount of the Loan to be made by it on such day available to the Borrower, in immediately available funds, by the Bank crediting an account of the Borrower designated by the Borrower and maintained with the Bank at the Principal Office. Section 2.05. Prepayments. The Borrower shall have the right to prepay Loans at any time or from time to time; provided that: (a) the Borrower shall give the Bank notice of each such prepayment as provided in Section 2.08; and (b) Eurodollar Loans may not be prepaid, except that, if after the giving effect to any reduction or termination of the Commitment pursuant to Section 2.07, the outstanding aggregate principal amount of the Loans exceeds the aggregate amount of the Commitment, the Borrower shall pay or repay the Loans on the date of such reduction or termination in an aggregate principal amount equal to the excess, together with interest thereon accrued to the date of such payment or repayment and any amounts payable pursuant to Section 3.04 in connection therewith. Section 2.06. Interest Periods. In the case of each Loan, the Borrower shall select an Interest Period of any duration in accordance with the definition of Interest Period in Section 1.01, subject to the following limitations: (a) no Interest Period may extend beyond the Termination Date; (b) notwithstanding clause (a) above, no Interest Period for a Eurodollar Loan shall have a duration less than one month (in the case of a Eurodollar Loan), and if any such proposed Interest Period would otherwise be for a shorter period, such Interest Period shall not be available; (c) if an Interest Period would end on a day which is not a Banking Day, such Interest Period shall be extended to the next Banking Day, unless, in the case of a Eurodollar Loan, such Banking Day would fall in the next calendar month in which event such Interest Period shall end on the immediately preceding Banking Day; and (d) only five Eurodollar Loans may be outstanding at any one time. Section 2.07. Changes of Commitment. (a) The Borrower shall have the right to reduce or terminate the amount of unused Commitment at any time or from time to time, provided that: (i) the Borrower shall give notice of each such reduction or termination to the Bank as provided in Section 2.08; and (ii) each partial reduction shall be in an aggregate amount at least equal to $1,000,000. (b) The Commitment once reduced or terminated may not be reinstated. Section 2.08. Certain Notices. Notices by the Borrower to the Bank of each borrowing pursuant to Section 2.04, each prepayment pursuant to Section 2.05 and each reduction or termination of the Commitment pursuant to Section 2.07 shall be irrevocable ind shall be effective only if received by the Bank not later than 1 p.m. New York City time, and (a) in the case of borrowings and (in the case of Variable Rate Loans) prepayments of (i) Variable Rate Loans, given on the Banking Day therefor; and (ii) Eurodollar Loans, given three Banking Days prior thereto; (b) in the case of reductions or termination of the Commitment, given three Banking Days prior thereto. Each such notice shall specify the Loans to be borrowed or prepaid and the amount (subject to Section 2.09) and type of the Loans to be borrowed or prepaid and the date of borrowing or prepayment (which shall be a Banking Day). Each such notice of reduction or termination shall specify the amount of the Commitment to be reduced or terminated. Section 2.09. Minimum Amounts. Except for borrowings which exhaust the full remaining amount of the Commitment, and prepayments (in the case of Variable Rate Loans) which result in the prepayment of all Loans, each borrowing and prepayment of principal of Variable Rate Loans shall be in an amount at least equal to $1,000,000, and each borrowing of Eurodollar Loans having concurrent Interest Periods shall be at least equal to $1,000,000. Section 2.10. Interest. (a) Interest shall accrue on the outstanding and unpaid principal amount of each Loan for the period from and including the date of such Loan to but excluding the date such Loan is due, at the following rates per annum: (i) for a Variable Rate Loan, at a variable rate per annum equal to the Variable Rate plus the Applicable Margin; (ii) for a Eurodollar Loan, at a fixed rate equal to the Fixed Rate plus the Applicable Margin. If any principal amount shall not be paid when due (at stated maturity, by acceleration or otherwise), interest shall accrue on such amount from,and including such due date to but excluding the date such amount is paid in full at the Default Rate. (b) The interest rate on each Variable Rate Loan shall change when the Variable Rate changes and interest on each such Loan shall be calculated on the basis of a year of 365 (or, in the case of a leap year, 366) days for the actual number of days elapsed. The interest rate on each Eurodollar Loan shall be fixed at the applicable Fixed Rate, and interest on each Eurodollar Loan shall be calculated on the basis of a year of 360 days for the actual number of days elapsed. (c) Accrued interest shall be due and payable in arrears upon any payment of principal and on the last day of the Interest Period with respect thereto and, in the case of an Interest Period greater than three months, at three-month intervals after the first day of such Interest Period; provided that interest accruing at the Default Rate shall be due and payable from time to time on demand of the Bank. (d) Notwithstanding anything herein to the contrary, from time to time to but not including the Termination Date, the Bank may make loans to the Borrower hereunder at such other rates and on such other terms and conditions as the Bank and the Borrower may agree, and the amount of such loans shall be deemed usage of the Commitment and, to the extent provided in the next sentence, Loans hereunder. Such loans shall be entitled to the benefits of the provisions of Articles 6, 7, 8 and 9 and Sections 4.03, 10.05 and 10.07. Section 2.11. Fees. (a) A facility fee shall accrue on the amount of the Commitment then in effect (whether or not utilized) for the period from and including the date hereof to the earlier of the date the Commitment is terminated or the Termination Date at a rate per annum equal to (i) .1875% during any Level I Period or Level II Period, (ii) .2500% during any Level III Period, and (iii) .3125% during any Level IV Period. The accrued commitment fee shall be due and payable in arrears upon any reduction or termination of the Commitment and on the last day of each February, May, August and November, commencing on the first such date after the Closing Date. (b) A utilization fee shall accrue on the daily average amount of loans outstanding at a rate per annum equal to .1250% for each day on which the aggregate principal amount of Loans outstanding exceeds 50% of the Commitment. The utilization fee shall be payable in arrears upon termination of the Commitment and on the last day of each February, May, August and November. Section 2.12. Payments Generally. All payments under this Agreement or the Note shall be made in Dollars in immediately available funds not later than 1:00 p.m. New York City time on the relevant dates specified above (each such payment made after such time on such due date to be deemed to have been made on the next succeeding Banking Day) at the Principal Office for the account of the applicable Lending Office of the Bank; provided that, when a new Loan is to be made by the Bank on a date the Borrower is to repay any principal of an outstanding Loan, the Bank shall apply the proceeds thereof to the payment of the principal to be repaid and only an amount equal to the difference between the principal to be borrowed and the principal to be repaid shall be made available by the Bank to the Borrower as provided in Section 2.04 or paid by the Borrower to the Bank pursuant to this Section 2.12, as the case may be. The Bank may (but shall not be obligated to) debit the amount of any such payment which is not made by such time to any ordinary deposit account of the Borrower with the Bank. The Borrower shall, at the time of making each payment under this Agreement or the Note, specify to the Bank the principal or other amount payable by the Borrower under this Agreement or the Note to which such payment is to be applied (and in the event that it fails to so specify, or if a Default or Event of Default has occurred and is continuing, the Bank may apply such payment as it may elect in its sole discretion). If the due date of any payment under this Agreement or the Note would otherwise fall on a day which is not a Banking Day, such date shall be extended to the next succeeding Banking Day and interest shall be payable for any principal so extended for the period of such extension. ARTICLE 3. YIELD PROTECTION; ILLEGALITY; ETC. Section 3.01. Additional Costs. (a) The Borrower shall pay to the Bank from time to time on demand such amounts as the Bank may reasonably determine to be necessary to compensate it for any costs which the Bank reasonably determines are attributable to its making or maintaining any Eurodollar Loans under this Agreement or the Note or its obligation to make any such Loans hereunder, or any reduction in any amount receivable by the Bank hereunder in respect of any such Loans or such obligation (such increases in costs and reductions in amounts receivable being herein called "Additional Costs"), resulting from any Regulatory Change which: (i) changes the basis of taxation of any amounts payable to the Bank under this Agreement or the Note in respect of any of such Loans (other than taxes imposed on the overall net income of the Bank or of its Lending Office for any of such Loans by the jurisdiction in which the Principal Office or such Lending Office is located); or (ii) imposes or modifies any reserve, special deposit, deposit insurance or assessment, minimum capital, capital ratio or similar requirements relating to any extensions of credit or other assets of, or any deposits with or other liabilities of, the Bank (including any of such Loans or any deposits referred to in the definition of "Eurodollar Base Rate" in Section 1.01); or (iii) imposes any other condition affecting this Agreement or the Note (or any of such extensions of credit or liabilities). The Bank will notify the Borrower of any event occurring after the date of this Agreement which will entitle the Bank to compensation pursuant to this Section 3.01(a) as promptly as practicable after it obtains knowledge thereof and determines to request such compensation and will furnish the Borrower with a certificate setting forth the computation of the amounts requested. (b) Without limiting the effect of the foregoing provisions of this Section 3.01, in the event that, by reason of any Regulatory Change, the Bank either (i) incurs Additional Costs based on or measured by the excess above a specified level of the amount of a category of deposits or other liabilities of the Bank which includes deposits by reference to which the interest rate on Eurodollar Loans is determined as provided in this Agreement or a category of extensions of credit or other assets of the Bank which includes Eurodollar Loans or (ii) becomes subject to restrictions on the amount of such a category of liabilities or assets which it may hold, then, if the Bank so elects by notice to the Borrower, the obligation of the Bank to make Eurodollar Loans hereunder shall be suspended until the date such Regulatory Change ceases to be in effect. (c) Without limiting the effect of the foregoing provisions of this Section 3.01 (but without duplication), the Borrower shall pay to the Bank from time to time on request such amounts as the Bank may reasonably determine to be necessary to compensate the Bank for any costs which it determines are attributable to the maintenance by it or any of its affiliates pursuant to any law or regulation of any jurisdiction or any interpretation, directive or request (whether or not having the force of law and whether in effect on the date of this Agreement or thereafter) of any court or governmental or monetary authority of capital in respect of its Loans hereunder or its obligation to make Loans hereunder (such compensation to include, without limitation, an amount equal to any reduction in return on assets or equity of the Bank to a level below that which it could have achieved but for such law, regulation, interpretation, directive or request). The Bank will notify the Borrower if it is entitled to compensation pursuant to this Section 3.01(c) as promptly as practicable after it determines to request such compensation and will furnish the Borrower with a certificate setting forth the computation of the amounts requested. (d) Determinations and allocations by the Bank for purposes of this Section 3.01 of the effect of any Regulatory Change pursuant to subsections (a) or (b), or of the effect of capital maintained pursuant to subsection (c), on its costs of making or maintaining Loans or its obligation to make Loans, or on amounts receivable by, or the rate of return to, it in respect of Loans or such obligation, and of the additional amounts required to compensate the Bank under this Section 3.01, shall be conclusive, provided that such determinations and allocations are made on a reasonable basis. Section 3.02. Limitation on Eurodollar Loans. Anything herein to the contrary notwithstanding, if the Bank reasonably determines (which determination shall be conclusive absent manifest error) that: (a) quotations of interest rates for the relevant deposits referred to in the definition of "Eurodollar Base Rate" in Section 1.01 are not being provided in the relevant amounts or for the relevant maturities for purposes of determining the rate of interest for Eurodollar Loans as provided in this Agreement; or (b) the relevant rates of interest referred to in the definition of "Eurodollar Base Rate" in Section 1.01 upon the basis of which the rate of interest for Eurodollar Loans is to be determined do not adequately cover the cost to the Bank of making or maintaining such Loans; then the Bank shall give the Borrower prompt notice thereof, and so long as such condition remains in effect, the Bank shall be under no obligation to make Eurodollar Loans. Section 3.03. Illegality. Notwithstanding any other provision in this Agreement, in the event that it becomes unlawful for the Bank or its Lending Office to honor its obligation to make or maintain Eurodollar Loans hereunder and such illegality cannot be cured by selection of an alternate Lending office, then the Bank shall promptly notify the Borrower thereof and the Banks obligation to make or maintain Eurodollar Loans hereunder shall be suspended until such time as the Bank may again make and maintain such affected Loans and the Borrower shall, upon the request of the Bank on the date specified (which date may include any grace period which the Bank may be entitled to), prepay any of such Loans then outstanding together with accrued interest and any amount due under Section 3.04. Section 3.04. Certain Compensation. The Borrower shall pay to the Bank, upon the request of the Bank, such reasonable amount or amounts as shall be sufficient (in the reasonable opinion of the Bank) to compensate it for any loss, cost or expense which the Bank determines is attributable to: (a) any payment of a Eurodollar Loan on a date other than the last day of an Interest Period for such Loan (whether by reason of acceleration or otherwise); or (b) any failure by the Borrower to borrow a Eurodollar Loan to be made by the Bank on the date specified therefor in the relevant notice under Section 2.04. Without limiting the foregoing, such compensation shall include an amount equal to the excess, if any, of: (i) the amount of interest which otherwise would have accrued on the principal amount so paid or not borrowed for the period from and including the date of such payment or failure to borrow to but excluding the last day of the Interest Period for such Loan (or, in the case of a failure to borrow, to but excluding the last day of the Interest Period for such Loan which would have commenced on the date specified therefor in the relevant notice) at the applicable rate of interest for such Loan provided for herein; over (ii) the amount of interest (as reasonably determined by the Bank) the Bank would have bid in the London interbank market for Dollar deposits for amounts comparable to such principal amount and maturities comparable to such period. A determination of the Bank as to the amounts payable pursuant to this Section 3.04 shall be conclusive absent manifest error. The Bank will furnish the Borrower with a certificate setting forth the computation of the amounts requested. ARTICLE 4. CONDITIONS PRECEDENT. Section 4.01. Documentary Conditions Precedent. The obligation of the Bank to make the Loan constituting the initial borrowing is subject to the condition precedent that the Bank shall have received on or before the date of such Loan each of the following, in form and substance satisfactory to the Bank and its counsel: (a) the Note duly executed by the Borrower; (b) a certificate of the Secretary or Assistant Secretary of the Borrower, dated the Closing Date, certifying the names and true signatures of the officers of the Borrower authorized to sign the Facility Documents and the other documents to be delivered by the Borrower under this Agreement; (c) a certificate of a duly authorized officer of the Borrower, dated the Closing Date, stating that the representations and warranties in Article 5 are true and correct on such date as though made on and as of such date and that no event has occurred and is continuing which constitutes a Default or Event of Default; (d) a favorable opinion of counsel for the Borrower, dated the Closing Date, in substantially the form of Exhibit B and as to such other matters as the Bank may reasonably request. Section 4.02. Additional Conditions Precedent. The obligation of the Bank to make any Loan (including the initial Loan) shall be subject to the further conditions precedent that on the date of such Loan: (a) the following statements shall be true: (i) the representations and warranties contained in Article 5 are true and correct on and as of the date of such Loan as though made on and as of such date, provided that the representations and warranties in Section 5.04 and the final sentence of Section 5.05 need not be true and correct if after such Loan there is no net increase in the aggregate principal amount outstanding hereunder; and (ii) No Default or Event of Default has occurred and is continuing, or would result from such Loan; and (b) the Bank shall have received from the Borrower such approvals, opinions or documents as the Bank may reasonably request. Section 4.03. Deemed Representations. Each notice of a Loan and acceptance by the Borrower of the proceeds thereof shall constitute a representation and warranty that the statements contained in Section 4.02(a) are true and correct both on the date of such notice and, unless the Borrower otherwise notifies the Bank prior to such borrowing, as of the date of such Loan. ARTICLE 5. REPRESENTATIONS AND WARRANTIES. The Borrower hereby represents and warrants that: Section 5.01. Incorporation, Good Standing and Due Qualification. Each of the Borrower and its Significant Subsidiaries is duly incorporated, validly existing and in good standing under the laws of the jurisdiction of its incorporation, has the corporate power and authority to own its assets and to transact the business in which it is now engaged or proposed to be engaged, and is duly qualified as a foreign corporation and in good standing under the laws of each other jurisdiction in which such qualification is required. Section 5.02. Corporate Power and Authority; No Conflicts. The execution, delivery and performance by the Borrower of the Facility Documents have been duly authorized by all necessary corporate action and do not and will not: (a) require any consent or approval of its stockholders; (b) contravene its charter or by-laws; (c) violate any provision of, or require any filing, registration, consent or approval under, any law, rule, regulation (including, without limitation, Regulation U), order, writ, judgment, injunction, decree, determination or award presently in effect having applicability to the Borrower or any of its Significant Subsidiaries or affiliates; (d) result in a breach of or constitute a default or require any consent under any indenture or loan or credit agreement or any other agreement, lease or instrument to which the Borrower is a party or by which it or its properties may be bound or affected; (e) result in, or require, the creation or imposition of any Lien, upon or with respect to any of the properties now owned or hereafter acquired by the Borrower; or (f) cause the Borrower (or any Significant Subsidiary) to be in default under any such law, rule, regulation, order, writ, judgment, injunction, decree, determination or award or any such indenture, agreement, lease or instrument. Section 5.03. Legally Enforceable Agreements. Each Facility Document is, or when delivered under this Agreement will be, a legal, valid and binding obligation of the Borrower enforceable against the Borrower in accordance with its terms, except to the extent that such enforcement may be limited by applicable bankruptcy, insolvency and other similar laws affecting creditors rights generally. Section 5.04. Litigation. There are no actions, suits or proceedings pending or, to the knowledge of the Borrower, threatened, against or affecting the Borrower or any of its Significant Subsidiaries before any court, governmental agency or arbitrator, which may, in any one case or in the aggregate, materially adversely affect the financial condition, operations, properties or business of the Borrower or any such Significant Subsidiary or of the ability of the Borrower to perform its obligation under the Facility Documents, except the depositors, class action litigation first referenced under the caption "Legal Proceedings" in the Borrowers Annual Report on Form 10-K for the fiscal year ended December 31, 1992. Section 5.05. Financial Statements. The consolidated balance sheet of the Borrower and its Consolidated Subsidiaries as at December 31, 1992, and the related consolidated income statement and statement of cash flows and statement of changes in stockholders, equity of the Borrower and its Consolidated Subsidiaries for the fiscal year then ended, and the accompanying footnotes, together with the opinion thereon, dated January 11, 1993, of Price Waterhouse, independent certified public accountants, and the interim consolidated balance sheet of the Borrower and its Consolidated Subsidiaries as at September 30, 1993, and the related consolidated income statement and statement of cash flows and, statement of changes in stockholders equity for the nine month period then ended, copies of which have been furnished to the Bank, are complete and correct and fairly present the financial condition of the Borrower and its Consolidated Subsidiaries as at such dates and the results of the operations of the Borrower and its Consolidated Subsidiaries for the periods covered by such statements, all in accordance with GAAP consistently applied (subject to year end adjustments in the case of the interim financial statements). There are no liabilities of the Borrower or any of its Consolidated Subsidiaries, fixed or contingent, which are material but are not reflected in the financial statements or in the notes thereto, other than liabilities arising in the ordinary course of business since December 31, 1992. No information, exhibit or report furnished by the Borrower to the Bank in connection with the negotiation of this Agreement contained any material misstatement of fact or omitted to state a material fact or any fact necessary to make the statements contained therein not materially misleading. Since December 31, 1992, there has been no material adverse change in the condition (financial or otherwise), business, operations or prospects of the Borrower or any of its Significant Subsidiaries. Section 5.06. Ownership and Liens. Each of the Borrower and its Consolidated Subsidiaries has title to, or valid leasehold interests in, all of its properties and assets, real and personal, including the properties and assets, and leasehold interests reflected in the financial statements referred to in Section 5.05 (other than any properties or assets disposed of in the ordinary course of business), and none of the properties and assets owned by the Borrower or any of its Significant Subsidiaries and none of its leasehold interests is subject to any Lien, except as disclosed in such financial statements or as may be permitted hereunder. Section 5.07. Taxes. Each of the Borrower and its Significant Subsidiaries has filed all tax returns (federal, state and local) required to be filed and has paid all taxes, assessments and governmental charges and levies thereon to be due, including interest and penalties, except taxes, assessments, governmental charges and levies the validity of which is being contested in good faith by appropriate proceedings and with respect to which the Borrower or such Significant Subsidiary, as the case may be, shall have set aside on its books adequate reserves. Section 5.08. ERISA. Each of the Borrower and its Subsidiaries is in compliance in all material respects with all applicable provisions of ERISA. Neither a Reportable Event nor a Prohibited Transaction has occurred with respect to any Plan; no notice of intent to terminate a Plan has been filed nor has any Plan been terminated; no circumstance exists which constitutes grounds under Section 4042 of ERISA entitling the PBGC to institute proceedings to terminate, or appoint a trustee to administer, a Plan, nor has the PBGC instituted any such proceedings; neither the Borrower nor any ERISA Affiliate has completely or partially withdrawn under Sections 4201 or 4204 of ERISA from a Multiemployer Plan; each of the Borrower and each of its ERISA Affiliates has met its minimum funding requirements under ERISA,with respect to all of its Plans and there are no Unfunded Vested Liabilities; and neither the Borrower nor any ERISA Affiliate has incurred any liability to the PBGC under ERISA. Section 5.09. Subsidiaries and Ownership of Stock. Schedule I is a complete and accurate list of the Subsidiaries of the Borrower, showing the jurisdiction of incorporation or organization of each Subsidiary and showing the percentage of the Borrowers direct or indirect ownership of the outstanding stock or other interest of each such Subsidiary. All of the outstanding capital stock or other interest of each such Subsidiary has been validly issued, is fully paid and nonassessable and is owned by the Borrower free and clear of all Liens. Section 5.10. Credit Arrangements. Schedule II is a complete and correct list of all Debt, other than Excluded Bank Debt of the Borrower or any of its Subsidiaries the aggregate principal or face amounts of which equals or exceeds (or may equal or exceed) $1,000,000 and the aggregate principal or face amount outstanding or which may become outstanding under each such arrangement is correctly described or indicated in such Schedule. ARTICLE 6. AFFIRMATIVE COVENANTS. So long as the Note shall remain unpaid or the Bank shall have any Commitment under this Agreement, the Borrower shall: Section 6.01. Maintenance of Existence. Preserve and maintain, and cause each of its Significant Subsidiaries to preserve and maintain, its corporate existence and good standing in the jurisdiction of its incorporation, and qualify and remain qualified, and cause each of its Significant Subsidiaries to qualify and remain qualified, as a foreign corporation in each jurisdiction in which such qualification is required. Section 6.02. Conduct of Business. Continue, and cause each of its Significant Subsidiaries to continue, to engage in an efficient and economical manner in a business of the same general type as conducted by it on the date of this Agreement. Section 6.03. Maintenance of Properties. Maintain, keep and preserve, and cause each of its Significant Subsidiaries to maintain, keep and preserve, all of its properties, (tangible and intangible) necessary or useful in the proper conduct of its business in good working order and condition, ordinary wear and tear excepted. Section 6.04. Maintenance of Records. Keep, and cause each of its Significant Subsidiaries to keep, adequate records and books of account, in which complete entries will be made in accordance with GAAP, reflecting all financial transactions of the Borrower and its Significant Subsidiaries. Section 6.05. Maintenance of Insurance. Maintain, and cause each of its Significant Subsidiaries to maintain, insurance with financially sound and reputable insurance companies or associations in such amounts and covering such risks or to self insure as to the same in such amounts as are prudent, which insurance may provide for reasonable deductibility from coverage thereof. Section 6.06. Compliance with Laws. Comply, and cause each of its Significant Subsidiaries to comply, in all respects with all applicable laws, rules, regulations and orders, such compliance to include, without limitation, paying before the same become delinquent all taxes, assessments and governmental charges imposed upon it or upon its property, except when contested by appropriate proceedings upon establishment of adequate reserves. Section 6.07. Right of Inspection. At times reasonably acceptable to the Borrower, from time to time, permit the Bank or any agent or representative thereof, to examine and make copies and abstracts from the records and books of account of, and visit the properties of, the Borrower and any of its Significant Subsidiaries, and to discuss the affairs, finances and accounts of the Borrower and any such Significant Subsidiary with any of their respective officers and directors and the Borrowers independent accountants. Section 6.08. Reporting Requirements. Furnish to the Bank: (a) as soon as available and in any event within 100 days after the end of each fiscal year of the Borrower, a consolidated balance sheet of the Borrower and its Consolidated Subsidiaries as of the end of such fiscal year and a consolidated income statement and statement of cash flows and statement of changes in stockholders, equity of the Borrower and its Consolidated Subsidiaries for such fiscal year, all in reasonable detail and stating in comparative form the respective consolidated figures for the corresponding date and period in the prior fiscal year and all prepared in accordance with GAAP and as to the consolidated statements accompanied by an opinion thereon acceptable to the Bank by Price Waterhouse or other independent accountants of national standing selected by the Borrower; (b) as soon as available and in any event within 55 days after the end of each of the first three quarters of each fiscal year of the Borrower, a consolidated balance sheet of the Borrower and its Consolidated Subsidiaries as of the end of such quarter and a consolidated income statement and statement of cash flows and statement of changes in stockholders equity, of the Borrower and its Consolidated Subsidiaries for the period commencing at the end of the previous fiscal year and ending with the end of such quarter, all in reasonable detail and stating in comparative form the respective consolidated figures for the corresponding date and period in the previous fiscal year and all prepared in accordance with GAAP and certified by the chief financial officer of the Borrower (subject to year-end adjustments); (c) as soon as possible and in any event within 10 days after the Borrower knows or has reason to know of the occurrence of each Default or Event of Default, a written notice setting forth the details of such Default or Event of Default and the action which is proposed to be taken by the Borrower with respect thereto; (d) promptly after the filing or receiving thereof, copies of all reports, including annual reports, and notices which the Borrower or any Subsidiary files with or receives from the PBGC or the U.S. Department of Labor under ERISA; and as soon as possible and in any event within 10 days after the Borrower or any of its Subsidiaries knows or has reason to know that any Reportable Event or Prohibited Transaction has occurred with respect to any Plan or that the PBGC or the Borrower or any such Subsidiary has instituted or will institute proceedings under Title IV of ERISA to terminate any Plan, the Borrower will deliver to the Bank a certificate of the chief financial officer of the Borrower setting forth details as to such Reportable Event or Prohibited Transaction or Plan termination and the action the Borrower proposes to take with respect thereto; (e) promptly after the furnishing thereof, copies of any statement or report furnished to any other party pursuant to the terms of any indenture, loan or credit or similar agreement (other than agreements relating to Excluded Bank Debt) and not otherwise required to be furnished to the Bank pursuant to any other clause of this Section 6.08; (f) promptly after the sending or filing thereof, copies of all proxy statements, financial statements and reports which the Borrower sends to its stockholders, and copies of all regular, periodic and special reports, and all registration statements which the Borrower files with the Securities and Exchange Commission or any governmental authority which may be substituted therefor, or with any national securities exchange; (g) as soon as available after the end of each fiscal quarter or year of the Borrower, as the case may be, the Borrower's Forms FRY-9LP and FRY-9C, accompanied by a certificate of the chief financial officer of the Borrower to the effect that the forms present fairly the financial condition and results of operation of the Borrower (in the case of Form FRY-9LP) or the Borrower and its Subsidiaries (in the case of Form FRY-9C), in accordance with applicable bank regulatory accounting requirements. (h) such other information respecting the condition or operations, financial or otherwise, of the Borrower or any of its Subsidiaries as the Bank may from time to time reasonably request, subject to such reasonable confidentiality understanding as may be agreed between the Bank and the Borrower. ARTICLE 7. NEGATIVE COVENANTS. So long as the Note shall remain unpaid or the Bank shall have any Commitment under this Agreement, the Borrower shall not: Section 7.01. Debt. Permit any of its Subsidiaries to create, incur, assume or suffer to exist any Debt, except: (a) Debt described in Schedule II and renewals, extensions and refinancings thereof, provided that the principal amount thereof does not increase; (b) Debt of any Subsidiary to the Borrower or another such Subsidiary; (c) Debt of any such Subsidiary secured by purchase money Liens permitted by Section 7.02; (d) Debt maturing within one year of incurrence; (e) Excluded Bank Debt; and (f) Funded Debt of its Subsidiaries not in excess of 35% of Consolidated Capitalization. Section 7.02. Liens. Create, incur, assume or suffer to exist, or permit any of its Subsidiaries to create, incur, assume or suffer to exist, any Lien, upon or with respect to any of its properties, now owned or hereafter acquired, except: (a) Liens securing the Loans hereunder; (b) Liens for taxes or assessments or other government charges or levies if not yet due and payable or if due and payable if they are being contested in good faith by appropriate proceedings and for which appropriate reserves are maintained; (c) Liens imposed by law, such as mechanics, materialmen's, landlords, warehousemen's and carriers Liens, and other similar Liens, securing obligations incurred in the ordinary course of business which are not past due for more than 30 days, or which are being contested in good faith by appropriate proceedings and for which appropriate reserves have been established; (d) Liens under workmen's compensation, unemployment insurance, social security or similar legislation (other than ERISA); (e) Liens, deposits or pledges to secure the performance of bids, tenders, contracts (other than contracts for the payment of money which are excluded from the definition of Excluded Bank Debt), leases (permitted under the terms of this Agreement), public or statutory obligations, surety, stay, appeal, indemnity, performance or other similar bonds, or other similar obligations arising in the ordinary course of business; (f) judgment and other similar Liens arising in connection with court proceedings; provided that the execution or other enforcement of such Liens is effectively stayed and the claims secured thereby are being actively contested in good faith and by appropriate proceedings; (g) easements, rights-of-way, restrictions and other similar encumbrances which, in the aggregate, do not materially interfere with the occupation, use and enjoyment by the Borrower or any such Subsidiary of the property or assets encumbered thereby in the normal course of its business or materially impair the value of the property subject thereto; (h) Liens securing obligations of such a Subsidiary to the Borrower or another such Subsidiary; (i) purchase money Liens on any property hereafter acquired or the assumption of any Lien on property existing at the time of such acquisition, or a Lien incurred in connection with any conditional sale or other title retention agreement or a Capital Lease; provided that: (i) any property subject to any of the foregoing is acquired by the Borrower or any such Subsidiary in the ordinary course of its business and the Lien on any such property is created contemporaneously with such acquisition; (ii) the obligation secured by any Lien so created, assumed or existing shall not exceed 90% of the lesser of cost or fair market value as of the time of acquisition of the property covered thereby to the Borrower or such Subsidiary acquiring the same; (iii) each such Lien shall attach only to the property so acquired and fixed improvements thereon; (iv) the obligations secured by such Lien are permitted by the provisions of Section 7.01; and (j) Liens securing Excluded Bank Debt. Section 7.03. Leases. Create, incur, assume or suffer to exist, or permit any of its Subsidiaries to create, incur, assume or suffer to exist, any obligation as lessee for the rental or hire of any real or personal property, except: (a) leases existing on the date of this Agreement and any extensions or renewals thereof; (b) leases (other than Capital Leases) which do not in the aggregate require the Borrower and its Subsidiaries on a consolidated basis to make payments (including taxes, insurance, maintenance and similar expense which the Borrower or any Subsidiary is required to pay under the terms of any lease) in any fiscal year of the Borrower in excess of 1/2 of 1 % of Consolidated Total Assets; (c) Capital Leases permitted by Section 7.02. Section 7.04. Stock of Subsidiaries Etc. Sell or otherwise dispose of or permit or suffer any Lien to exist with respect to any shares of capital stock of any of its Subsidiaries which is a bank or a savings bank, except in connection with a transaction permitted under Section 7.06, or permit any Subsidiary to issue any additional shares of its capital stock, except directors qualifying shares if, after giving effect to such transaction (or assuming foreclosure upon any such Lien) the Borrower would directly or indirectly control less than 80% of the stock of such Subsidiary. Section 7.05. Transactions with Affiliates. Enter into any transaction, including, without limitation, the purchase, sale or exchange of property or the rendering of any service, with any Affiliate or permit any of its Subsidiaries to enter into any transaction including, without limitation, the purchase, sale or exchange of property or the rendering of any service, with any Affiliate, except in the ordinary course of and pursuant to the reasonable requirements of the Borrowers or such Subsidiary's business and upon fair and reasonable terms no less favorable to the Borrower or such Subsidiary than would obtain in a comparable arms length transaction with a Person not an Affiliate. Section 7.06. Mergers, Etc. Merge or consolidate with, or sell, assign, lease or otherwise dispose of (whether in one transaction or in a series of transactions) all or substantially all of its assets (whether now owned or hereafter acquired) to, any Person, or acquire all or substantially all of the assets or the business of any Person (or enter into any agreement to do any of the foregoing), or permit any of its Subsidiaries to do so, except that: (a) any such Subsidiary may merge into or transfer assets to the Borrower; (b) any Subsidiary may merge into or consolidate with or transfer assets to any other Subsidiary; (c) the Borrower may so merge or consolidate (in a transaction which does not satisfy subsections (d) or (e) below) provided that (i) the surviving Person assumes all the obligations of the Borrower hereunder, (ii) no Default or Event of Default would result therefrom, and (iii) after giving effect to such merger or consolidation the surviving Person has long term senior unsecured debt rated at least BBB+ by Standard & Poor's Corporation or at least Baa1 by Moody's Investors Service, Inc., or if the surviving Person's debt is not rated, the surviving Person's principal Subsidiary has a long term deposit rating of at least A3 from Moody's Investors Service, Inc. or at least BBB+ from Standard & Poor's Corporation; (d) the Borrower or any Subsidiary may merge or consolidate or may acquire all or a majority of the voting shares or all or a substantial portion of the assets of any Person if (i) before giving effect to any such acquisition, the Form FRY-9C Consolidated Total Assets of the Borrower will constitute no less than 70% of the sum of the Form FRY-9C Consolidated Total Assets of the Borrower and the portion of the Consolidated Total Assets to be acquired from the acquired Person, (ii) immediately after the consummation of the acquisition and after giving effect thereto, no Default or Event of Default would exist, and (iii) the Borrower or any Subsidiary is the surviving entity; and (e) the Borrower or any Subsidiary may merge or consolidate or may acquire all or a majority of the voting shares or all or a substantial portion of the assets of any Person if (i) before giving effect to any such acquisition, the Form FRY-9C Consolidated Total Assets of the Borrower will constitute no less than 50% of the sum of the Form FRY-9C Consolidated Total Assets of the Borrower and the portion of the Consolidated Total Assets to be acquired from the acquired Person and (ii) prior to the acquisition the Borrower provides the Bank with pro forma financial projections which demonstrate to the Bank's reasonable satisfaction that, before giving effect to such acquisition, the Form FRY-9C Consolidated Total Assets of the Borrower will constitute no less than 70% of the sum of the Form FRY-9C Consolidated Total Assets of the Borrower and the portion of the Consolidated Total Assets to be acquired from the acquired Person within 6 months after the consummation of the acquisition, (iii) immediately after the consummation of the acquisition and after giving effect thereto, no Default or Event of Default would exist, and (iv) the Borrower or any Subsidiary is the surviving entity. Section 7.07. Sale of Assets. Sell, lease, assign, transfer or otherwise dispose of, or permit any of its Subsidiaries to sell, lease, assign, transfer or otherwise dispose of, any of its now owned or hereafter acquired assets (including, without limitation, shares of stock and indebtedness of its Subsidiaries, receivables and leasehold interests); except: (a) for assets disposed of in the ordinary course of business; (b) the sale or other disposition of assets no longer used or useful in the conduct of its business; (c) that any such Subsidiary may sell, lease, assign, or otherwise transfer its assets to the Borrower; and (d) assets sold or otherwise disposed of for consideration equal to the fair market value of such assets where the proceeds of such disposition are either (i) received entirely in cash, or (ii) in the case of non-cash proceeds, such non-cash proceeds have a fair market value not in excess of 10% of Consolidated Capitalization. ARTICLE 8. FINANCIAL COVENANTS. So long as the Note shall remain unpaid or the Bank shall have any Commitment under this Agreement: Section 8.01. Minimum Tangible Net Worth. The Borrower shall maintain at all times a Consolidated Tangible Net Worth of not less than 80% of its Consolidated Tangible Net Worth at September 30, 1993. Section 8.02. Leverage Ratio. The Borrower shall maintain Tier I Capital at least equal to 5.5% of Consolidated Total Assets (RAP). Section 8.03. Double Leverage. The Borrower shall maintain at all times a ratio of (x) the sum of (a) its Equity Investments in Subsidiaries plus (b) its goodwill to (y) the sum of (a) its Tangible Net Worth and (b) its goodwill; of not greater than 1.25 to 1.00. Section 8.04. Capital Requirements. The Borrower will, and will cause each of its banking Subsidiaries to, maintain at all times such amount of capital as may be prescribed by the Board of Governors of the Federal Reserve System (in the case of the Borrower and any state member banking Subsidiary), the Federal Deposit Insurance Corporation (in the case of any state nonmember banking Subsidiary), or the Comptroller of the Currency (in the case of any national banking Subsidiary), as the case may be, from time to time, whether by regulation, agreement or order. The Borrower shall ensure that each Insured Subsidiary shall be "adequately capitalized" (within the meaning of 12 U.S.C. Section 1831o, as amended, reenacted or redesignated from time to time). ARTICLE 9. EVENTS OF DEFAULT. Section 9.01. Events of Default. Any of the following events shall be an "Event of Default": (a) the Borrower shall: (i) fail to pay the principal of the Note as and.when due and payable; (ii) fail to pay interest on the Note or any fee or other amount due hereunder as and when due and payable; (b) any representation or warranty made or deemed made by the Borrower in this Agreement or in any other Facility Document or which is contained in any certificate, document, opinion, financial or other statement furnished at any time under or in connection with any Facility Document shall prove to have been incorrect in any material respect on or as of the date made or deemed made; (c) the Borrower or any Subsidiary shall: (i) fail to perform or observe any term, covenant or agreement contained in Section 2.03 or Articles 7 or 8 (other than Section 7.06); or (ii) enter into a transaction or an agreement to enter into a transaction violative of Section 7.06 and fail to obtain a waiver therefor within the later of 10 days of the public announcement of such agreement or 10 days after having entered into such an agreement); or (iii) fail to perform or observe any term, covenant or agreement on its part to be performed or observed (other than the obligations specifically referred to elsewhere in this Section 9.01) in any Facility Document and such failure shall continue for 30 consecutive days; (d) the Borrower or any of its Subsidiaries shall: (i) fail to pay any indebtedness, including but not limited to indebtedness for borrowed money (other than the payment obligations described in (a) above), of the Borrower or such Subsidiary, as the case may be, or any interest or premium thereon, when due (whether by scheduled maturity, required prepayment, acceleration, demand or otherwise); or (ii) fail to perform or observe any term, covenant or condition on its part to be performed or observed under any agreement or instrument relating to any such indebtedness, when required to be performed or observed, if the effect of such failure to perform or observe is to accelerate, or to permit the acceleration of, after the giving of notice or passage of time, or both, the maturity of such indebtedness, whether or not such failure to perform or observe shall be waived by the holder of such indebtedness; or any such indebtedness shall be declared to be due and payable, or required to be prepaid (other than by a regularly scheduled required prepayment), prior to the stated maturity thereof; (e) the Borrower or any of its Subsidiaries: (i) shall generally not, or be unable to, or shall admit in writing its inability to, pay its debts as such debts become due; or (ii) shall make an assignment for the benefit of creditors, petition or apply to any tribunal for the appointment of a custodian, receiver or trustee for it or a substantial part of its assets; or (iii) shall commence any proceeding under any bankruptcy, reorganization, arrangement, readjustment of debt, dissolution or liquidation law or statute of any jurisdiction, whether now or hereafter in effect; or (iv) shall have had any such petition or application filed or any such proceeding shall have been commenced, against it, in which an adjudication or appointment is made or order for relief is entered, or which petition, application or proceeding remains undismissed for a period of 30 days or more; or (v) by any act or omission shall indicate its consent to, approval of or acquiescence in any such petition, application or proceeding or order for relief or the appointment of a custodian, receiver or trustee for all or any substantial part of its property; or (vi) shall suffer any such custodianship, receivership or trusteeship to continue undischarged for a period of 30 days or more; (f) one or more judgments, decrees or orders for the payment of money in the aggregate in excess of 5% of its Consolidated Tangible Net Worth shall be rendered against the Borrower or any of its Subsidiaries and such judgments, decrees or orders shall continue unsatisfied and in effect for a period of 30 consecutive days without being vacated, discharged, satisfied or stayed or bonded pending appeal; (g) any of the following events shall occur or exist with respect to the Borrower or any ERISA Affiliate: (i) any Prohibited Transaction involving any Plan; (ii) any Reportable Event shall occur with respect to any Plan; (iii) the filing under Section 4041 of ERISA of a notice of intent to terminate any Plan or the termination of any Plan; (iv) any event or circumstance exists which might constitute grounds entitling the PBGC to institute proceedings under Section 4042 of ERISA for the termination of, or for the appointment of a trustee to administer, any Plan, or the institution by the PBGC of any such proceedings; (v) complete or partial withdrawal under Section 4201 or 4204 of ERISA from a Multiemployer Plan or the reorganization, insolvency, or termination of any Multiemployer Plan; and in each case above, such event or condition, together with all other events or conditions, if any, could in the opinion of the Bank subject the Borrower to any tax, penalty, or other liability to a Plan, Multiemployer Plan, the PBGC, or otherwise (or any combination thereof) which in the aggregate exceed or may exceed $10,000,000; (h) any bank Subsidiary shall cease accepting deposits or making commercial loans on the instruction of any Federal or state regulatory body with authority to give such instruction; (i) any Federal or state bank regulatory authority having jurisdiction to regulate any bank Subsidiary shall notify such bank Subsidiary that such bank Subsidiary's capital stock has become impaired, or any Insured Subsidiary shall cease to be an insured bank under the Federal Deposit Insurance Act; (j) any Insured Subsidiary shall be required to enter into a capital maintenance agreement (other than in connection with an acquisition and when the duration of such agreement shall be six months or less from the time of consummation of such acquisition) or shall be required to submit a capital restoration plan of the type referred to in 12 U.S.C. Section 1831o(b)(2)(C), as amended, reenacted or redesignated from time to time (whether or not the time allowed by the appropriate Federal banking agency for the submission of such plan has been established or elapsed); (k) the Borrower shall enter into any agreement to guarantee (whether or not voluntarily) the capital of any Insured Subsidiary as part of or in connection with any agreement or arrangement with any Federal banking agency other than in connection with obtaining regulatory approval for the acquisition of such Insured Subsidiary. Section 9.02. Remedies. If any Event of Default shall occur and be continuing, the Bank may, by notice to the Borrower, (a) declare the Commitment to be terminated, whereupon the same shall forthwith terminate, and (b) declare the outstanding principal of the Note, all interest thereon and all other amounts payable under this Agreement and the Note to be forthwith due and payable, whereupon the Note, all such interest and all such amounts shall become and be forthwith due and payable, without presentment, demand, protest or further notice of any kind, all of which are hereby expressly waived by the Borrower; provided, that, in the case of an Event of Default referred to in Section 9.01(c)(ii) above, such acceleration of the Note may not occur until 30 days have elapsed from the sooner of the consummation of the transaction violative of Section 7.06 or the Bank's refusal to grant a waiver therefor; and, provided, further, that, in the case of an Event of Default referred to in Section 9.01(e) above, the Commitment shall be immediately terminated, and the Note, all interest thereon and all other amounts payable under this Agreement shall be immediately due and payable without notice, presentment, demand, protest or other formalities of any kind, all of which are hereby expressly waived by the Borrower. ARTICLE 10. MISCELLANEOUS. Section 10.01. Amendments and Waivers. No amendment or waiver of any provision of this Agreement nor consent to any departure by the Borrower therefrom, shall in any event be effective unless the same shall be in writing and signed by the Bank, and then such waiver or consent shall be effective only in the specific instance and for the specific purpose for which given. No failure on the part of the Bank to exercise, and no delay in exercising, any right hereunder shall operate as a waiver thereof or preclude any other or further exercise thereof or the exercise of any other right. The remedies herein provided are cumulative and not exclusive of any remedies provided by law. Section 10.02. Usury. Anything herein to the contrary notwithstanding, the obligations of the Borrower under this Agreement and the Note shall be subject to the limitation that payments of interest shall not be required to the extent that receipt thereof would be contrary to provisions of law applicable to the Bank limiting rates of interest which may be charged or collected by the Bank. Section 10.03. Expenses. The Borrower shall reimburse the Bank on demand for all costs, expenses, and charges (including, without limitation, fees and charges of external legal counsel for the Bank and costs allocated by its internal legal department) incurred by the Bank in connection with the performance or enforcement of this Agreement or the Note. The Borrower agrees to indemnify the Bank and its respective directors, officers, employees and agents from, and hold each of them harmless against, any and all losses, liabilities, claims, damages or expenses incurred by any of them arising out of or by reason of any investigation or litigation or other proceedings (including any threatened investigation or litigation or other proceedings) relating to any actual or proposed use of the proceeds of the Loans, including without limitation, the reasonable fees and disbursements of counsel incurred in connection with any such investigation or litigation or other proceedings (but excluding any such losses, liabilities, claims, damages or expenses incurred by reason of the gross negligence or willful misconduct of the Person to be indemnified). Section 10.04. Survival. The obligations of the Borrower under Sections 3.01, 3.04 and 10.03 shall survive the repayment of the Loans and the termination of the Commitment. Section 10.05. Assignment; Participations. This Agreement shall be binding upon, and shall inure to the benefit of, the Borrower, the Bank and their respective successors and assigns, except that the Borrower may not assign or transfer its rights or obligations hereunder. The Bank may assign, or sell participations in, all or any part of any Loan to another bank or other entity, in which event (a) in the case of an assignment, upon notice thereof by the Bank to the Borrower, the assignee shall have, to the extent of such assignment (unless otherwise provided therein), the same rights, benefits and obligations as it would have if it were the Bank hereunder; and (b) in the case of a participation, the participant shall have no rights under the Facility Documents and all amounts payable by the Borrower under Article 3 shall be determined as if the Bank had not sold such participation. The agreement executed by the Bank in favor of the participant shall not give the participant the right to require the Bank to take or omit to take any action hereunder except action directly relating to (i) the extension of a payment date with respect to any portion of the principal of or interest on any amount outstanding hereunder allocated to such participant, (ii) the reduction of the principal amount outstanding hereunder or (iii) the reduction of the rate of interest payable on such amount or any amount of fees payable hereunder to a rate or amount, as the case may be, below that which the participant is entitled to receive under its agreement with the Bank. The Bank may furnish any information concerning the Borrower in the possession of the Bank from time to time to assignees and participants (including prospective assignees and participants); provided that the Bank shall require any such prospective assignee or such participant (prospective or otherwise) to agree in writing to maintain the confidentiality of such information. Section 10.06. Notices. Unless the party to be notified otherwise notifies the other party in writing as provided in this Section, and except as otherwise provided in this Agreement, notices shall be given to the Bank and to the Borrower by ordinary mail or telex addressed to such party at its address on the signature page of this Agreement. Notices shall be effective: (a) if given by mail, 72 hours after deposit in the mails with first class postage prepaid, addressed as aforesaid; and (b) if given by telex, when the telex is transmitted to the telex number as aforesaid; provided that notices to the Bank shall be effective upon receipt. Section 10.07. Setoff. The Borrower agrees that, in addition to (and without limitation of) any right of setoff, bankers lien or counterclaim the Bank may otherwise have, the Bank shall be entitled, at its option, to offset balances (general or special, time or demand, provisional or final) held by it for the account of the Borrower at any of the Banks offices, in Dollars or in any other currency, against any amount payable by the Borrower under this Agreement or the Note which is not paid when due (regardless of whether such balances are then due to the Borrower), in which case it shall promptly notify the Borrower thereof; provided that the Banks failure to give such notice shall not affect the validity thereof. Section 10.08. Jurisdiction; Immunities. (a) The Borrower and the Bank hereby irrevocably submit to the jurisdiction of any New York State or United States Federal court sitting in New York City over any action or proceeding arising out of or relating to this Agreement or the Note, and the Borrower and the Bank hereby irrevocably agree that all claims in respect of such action or proceeding may be heard and determined in such New York State or Federal court. The Borrower irrevocably consents to the service of any and all process in any such action or proceeding by the mailing of copies of such process to the Borrower at its address specified in Section 10.06. The Borrower agrees that a final judgment in any such action or proceeding shall be conclusive and may be enforced in other jurisdictions by suit on the judgment or in any other manner provided by law. The Borrower further waives any objection to venue in such State and any objection to an action or proceeding in such State on the basis of forum non conveniens. The Borrower further agrees that any action or proceeding brought against the Bank shall be brought only in New York State or United States Federal court sitting in New York County. The Borrower waives any right it may have to jury trial. (b) Nothing in this Section 10.08 shall affect the right of the Bank to serve legal process in any other manner permitted by law or affect the right of the Bank to bring any action or proceeding against the Borrower or its property in the courts of any other jurisdictions. Section 10.09. Table of Contents; Headings. Any table of contents and the headings and captions hereunder are for convenience only and shall not affect the interpretation or construction of this Agreement. Section 10.10. Severability. The provisions of this Agreement are intended to be severable. If for any reason any provision of this Agreement shall be held invalid or unenforceable in whole or in part in any jurisdiction, such provision shall, as to such jurisdiction, be ineffective to the extent of such invalidity or unenforceability without in any manner affecting the validity or enforceability thereof in any other jurisdiction or the remaining provisions hereof in any jurisdiction. Section 10.11. Counterparts. This Agreement may be executed in any number of counterparts, all of which taken together shall constitute one and the same instrument, and any party hereto may execute this Agreement by signing any such counterpart. Section 10.12. Integration. The Facility Documents set forth the entire agreement between the parties hereto relating to the transactions contemplated thereby and supersede any prior oral or written statements or agreements with respect to such transactions. Section 10.13. Governing Law. This Agreement shall be governed by, and interpreted and construed in accordance with, the law of the State of New York. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed as of the day and year first above written. FIRST EMPIRE STATE CORPORATION By /s/ Gary S. Paul --------------------------- Gary S. Paul Senior Vice President Address for Notices: One M & T Plaza Buffalo, New York 14240 Telex No.: 91-347 Telecopier No.: 716-842-5021 THE CHASE MANHATTAN BANK (NATIONAL ASSOCIATION) By /s/ Thomas M. Houston --------------------------- Thomas M. Houston Vice President Lending Office for Variable Rate and Eurodollar Loans: The Chase Manhattan Bank, N.A. 4 Metrotech Center Brooklyn, New York Address for Notices: 1 Chase Manhattan Plaza - 5th Floor New York, New York 10081 Attn: Domestic Banking Division Telecopier No.: (212) 552-7879

40874_1993.txt

40874

1993

Item 1. Business GTE Southwest Incorporated (the Company), was incorporated in Delaware in 1926. The Company is a wholly-owned subsidiary of GTE Corporation (GTE) and provides communications services in the states of Arkansas, New Mexico, Oklahoma and Texas. The Company provides local telephone service within its franchise areas and intraLATA (Local Access Transport Area) long distance service between the Company's facilities and the facilities of other telephone companies within the Company's LATAs. InterLATA service to other points in and out of the states in which the Company operates is provided through connection with interexchange (long distance) common carriers. These common carriers are charged fees (access charges) for interconnection to the Company's local facilities. End user business and residential customers are also charged access charges for access to the facilities of the long distance carriers. The Company also earns other revenues by leasing interexchange plant facilities and providing such services as billing and collection and operator services to interexchange carriers, primarily the American Telephone and Telegraph Company (AT&T). The number of access lines served has grown steadily from 1,310,342 on January 1, 1989 to 1,641,324 on December 31, 1993. The following table denotes the access lines in the states in which the Company operates as of December 31, 1993: Access State Lines Served ----- ------------ Texas 1,403,529 Oklahoma 117,668 Arkansas 78,092 New Mexico 42,035 --------- Total 1,641,324 _________ The Company's principal line of business is providing telecommunication services. These services fall into six major classes including the Texas rate case reserve: local network, network access, long distance, the Texas rate case reserve, equipment sales and services and other. Revenues from each of these classes over the last three years are as follows: Years Ended December 31 -------------------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of Dollars) Local Network Services $ 421,004 $ 391,601 $ 363,292 % of Total Revenues 36% 33% 32% Network Access Services $ 438,046 $ 482,636 $ 475,860 % of Total Revenues 38% 41% 42% Long Distance Services $ 189,954 $ 204,708 $ 207,824 % of Total Revenues 16% 17% 18% Equipment Sales and Services $ 72,394 $ 67,125 $ 69,593 % of Total Revenues 6% 6% 6% Texas Rate Case Reserve $ (16,308) $ (25,498) $ (37,000) % of Total Revenues (1)% (2)% (3)% Other $ 57,275 $ 61,213 $ 54,459 % of Total Revenues 5% 5% 5% At December 31, 1993, the Company had 7,184 employees. The Company has written agreements with the Communications Workers of America (CWA) covering approximately 5,156 of the Company's employees. The current agreements with CWA units expire in August 1995. Telephone Competition The Company holds franchises, licenses and permits adequate for the conduct of its business in the territories which it serves. The Company is subject to regulation by the regulatory bodies of the states of Arkansas, New Mexico, Oklahoma and Texas as to its intrastate business operations and by the Federal Communications Commission (FCC) as to its interstate business operations. Information regarding the Company's activities with the various regulatory agencies and revenue arrangements with other telephone companies can be found in Note 10 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. The year was marked by important changes in the U.S. telecommunications industry. Rapid advances in technology, together with government and industry initiatives to eliminate certain legal and regulatory barriers are accelerating and expanding the level of competition and opportunities available to the Company. As a result, the Company faces increasing competition in virtually all aspects of its business. Specialized communications companies have constructed new systems in certain markets to bypass the local exchange network. Additional competition from interexchange carriers as well as wireless companies continues to evolve for both intrastate and interstate communications. During 1994, the Company will begin implementation of a re-engineering plan that will redesign and streamline processes. Implementation of its re-engineering plan will allow the Company to continue to respond aggressively to these competitive and regulatory developments through reduced costs, improved service quality, competitive prices and new product offerings. Moreover, implementation of this program will position the Company to accelerate delivery of a full array of voice, video and data services. The re-engineering program will be implemented over three years. During the year, the company continued to introduce new business and consumer services utilizing advanced technology, offering new features and pricing options while at the same time reducing costs and prices. During 1993, the FCC announced its decision to auction licenses during 1994 in 51 major markets and 492 basic trading areas across the United States to encourage the development of a new generation of wireless personal communications services (PCS). These services will both complement and compete with the Company's traditional wireline services. The Company will be permitted to fully participate in the license auctions in areas outside of GTE's existing cellular service areas. Limited participation will be permitted in areas in which GTE has an existing cellular presence. In 1992, the FCC issued a "video dialtone" ruling that allows telephone companies to transmit video signals over their networks. The FCC also recommended that Congress amend the Cable Act of 1984 to permit telephone companies to supply video programming in their service areas. Activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has continued. Various forms of alternative regulation have been adopted, which provide economic incentives to telephone service providers to improve productivity and provide the foundation for the pricing flexibility necessary to address competitive entry into the markets the Company serves. In September 1993, the FCC released an order allowing competing carriers to interconnect to the local-exchange network for the purpose of providing switched access transport services. This ruling complements similar interconnect arrangements for private line services ordered during 1992. The order encourages competition for the transport of telecommunications traffic between local exchange carriers' (LECs) switching offices and interexchange carrier locations. In addition, the order allows LECs flexibility in pricing competitive services. The GTE Consent Decree, which was issued in connection with the 1983 acquisition of GTE Sprint (since divested) and GTE Spacenet, prohibits GTE's domestic telephone operating subsidiaries from providing long distance service beyond the boundaries of the LATA. This prohibition restricts their direct provision of long distance service to relatively short distances. The degree of competition allowed in the intraLATA market is subject to state regulation. However, regulatory constraints on intraLATA competition are gradually being relaxed. In fact, some form of intraLATA competition is authorized in many of the states in which the Company provides service. These and other actions to eliminate the existing legal and regulatory barriers, together with rapid advances in technology, are facilitating a convergence of the computer, media and telecommunications industries. In addition to allowing new forms of competition, these developments are also creating new opportunities to develop interactive communications networks. The Company supports these initiatives to assure greater competition in telecommunications, provided that overall the changes allow an opportunity for all service providers to participate equally in a competitive marketplace under comparable conditions. Item 2.

Item 2. Properties The Company's property consists of network facilities (77%), company facilities (15%), customer premises equipment (6%) and other (2%). From January 1, 1989 to December 31, 1993, the Company made gross property additions of $1.3 billion and property retirements of $0.7 billion. Substantially all of the Company's property is subject to liens securing long-term debt. In the opinion of management, the Company's telephone plant is substantially in good repair. Item 3.

Item 3. Legal Proceedings This item is herein incorporated by reference to Note 10 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, filed as Exhibit 13. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters Market information is omitted since the Company's common stock is wholly-owned by GTE Corporation. Item 6.

Item 6. Selected Financial Data Reference is made to the Registrant's Annual Report to Shareholders, page 28, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the Registrant's Annual Report to Shareholders, pages 24 to 27, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 8.

Item 8. Financial Statements and Supplementary Data Reference is made to the Registrant's Annual Report to Shareholders, pages 5 to 22, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The names, ages and positions of all the directors and executive officers of the Company as of March 1, 1994 are listed below along with their business experience during the past five years. a. Identification of Directors Director Name Age Since Business Experience ---- --- -------- --------------------- John C. Appel 45 1993 State President-Texas, GTE Southwest Incorporated; former Regional Vice President-General Manager, GTE West Area; former Assistant Vice President-Business Services, GTE Telephone Operations. Kent B. Foster 50 1994 Vice Chairman of the Board of Directors of GTE Corporation, October 1993. President, GTE Telephone Operations, 1989; Director, GTE Corporation, 1992; Director, all GTE domestic telephone subsidiaries, 1993; Director, BC Telecom, Inc.; Director, Compania Anonima Nacional Telefonos de Venezuela; Director, National Bank of Texas. Richard M. Cahill 55 1994 Vice President - General Counsel of GTE Telephone Operations, 1988; Director, all GTE domestic telephone subsidiaries, 1993; Director, GTE Vantage Incorporated, 1991; Director, GTE Intelligent Network Services Incorporated, 1993. Gerald K. Dinsmore 44 1994 Senior Vice President - Finance and Planning for GTE Telephone Operations, 1994. Vice President - Finance, GTE Telephone Operations, 1993; Vice President - Intermediary Customer Markets, GTE Telephone Operations, 1991. President, South Area, GTE Telephone Operations, 1992; Director, all GTE domestic telephone subsidiaries, 1993. Michael B. Esstman 47 1991 Executive Vice President-Operations, GTE Telephone Operations, 1993; President, Central Area, GTE Telephone Operations, 1991. President, Contel Eastern Region, Telephone Operations Sector, 1983; Director, AG Communications System; Director, all GTE domestic telephone subsidiaries, 1993. Thomas W. White 47 1994 Executive Vice President of GTE Telephone Operations, 1993; Senior Vice President - General Office Staff, GTE Telephone Operations, 1989; Director, all GTE domestic telephone subsidiaries, 1993; Director, Quebec-Telephone. Directors are elected annually. The term of each director expires on the date of the next annual meeting of shareholders, which may be held on any day during March, as specified in the notice of the meeting. There are no family relationships between any of the directors or executive officers of the Company. All of the directors, with the exception of Mr. Esstman, were appointed to the board effective January 1, 1994 upon the resignation of Richard E. Bell, Joe I. Cardenas, Ingram Hartje, III, Larry C. Squires, D.V.M., Kenneth F. Teasdale and Dr. Frank Vandiver. b. Identification of Executive Officers Year Assumed Current Name Age Position Position with Company (1) ------------------ ---- -------- ------------------------- John C. Appel (2) 45 1993 President J. Bruce Cole 52 1987 State Vice President - Sales Oscar C. Gomez 47 1987 State Vice President - External Affairs Gregory D. Jacobson 42 1992 State Vice President - Finance Michael T. Metcalf (3) 47 1993 State Vice President - Human Resources William G. Mundy 44 1985 State Vice President - General Counsel Dennis F. Myers (4) 49 1993 State Vice President - Operations Barry W. Paulson (5) 42 1993 State Vice President - General Manager - Oklahoma/Arkansas Charles J. Somes (6) 48 1994 Secretary Year Assumed Current Position With Name Age Positiom GTE Telephone Operations (7) -------------------- --- --------- ---------------------------- Kent B. Foster 50 1989 President Michael B. Esstman (8) 47 1993 Executive Vice President - Operations Thomas W. White 47 1989 Executive Vice President Guillermo Amore 55 1990 Senior Vice President - International Gerald K. Dinsmore (9) 44 1993 Senior Vice President - Finance and Planning Robert C. Calafell (10) 52 1993 Vice President - Video Services A. T. Jones 54 1992 Vice President - International Brad M. Krall (11) 52 1993 Vice President - Centralized Services Don A. Hayes 56 1992 Vice President - Information Technology Richard L. Schaulin 51 1989 Vice President - Human Resources Clarence F. Bercher 50 1991 Vice President - Sales Mark S. Feighner 45 1991 Vice President - Product Management Geoff C. Gould 41 1989 Vice President - Regulatory and Governmental Affairs G. Bruce Redditt 43 1991 Vice President - Public Affairs Richard M. Cahill 55 1989 Vice President and General Counsel Leland W. Schmidt 60 1989 Vice President - Industry Affairs Paul E. Miner 49 1990 Vice President - Regional Operations Support Katherine J. Harless 43 1992 Vice President- Intermediary Markets William M. Edwards, III(12) 45 1993 Controller Each of these executive officers has been an employee of the Company or an affiliated company for the last five years. Except for duly elected officers and directors, no other employees had a significant role in decision making. All officers are appointed for a term of one year. NOTES: (1) Titles were changed from Area/Regional Vice President to State Vice President in 1993; however, the functions did not change. (2) John C. Appel was appointed President effective October 22, 1993 replacing Michael B. Esstman who was appointed Executive Vice President - Operations for GTE Telephone Operations. (3) Michael T. Metcalf was appointed State Vice President - Human Resources effective December 5, 1993 replacing Nicholas J. Doria who resigned. (4) Dennis F. Myers' title changed in 1993 from Regional Vice President - General Manager/Southwest to State Vice President - Operations. (5) Barry W. Paulson's title changed in 1993 from Regional Vice President - General Manager/Midwest to State Vice President - General Manager - Oklahoma/Arkansas. (6) Charles J.Somes was appointed Secretary replacing Jerry L. Austin who retired. (7) Position is with, and duties are performed at, the GTE Telephone Operations Headquarters in Irving, Texas. (8) Michael B. Esstman was appointed Executive Vice President - Operations effective April 25, 1993 replacing Charles A. Crain who retired on April 1, 1993. (9) Gerald K. Dinsmore was appointed Senior Vice President - Finance and Planning effective November 21, 1993, replacing John L. Hume who retired. (10) Robert C. Calafell was appointed Vice President - Video Services effective March 28, 1993. (11) Brad M. Krall was appointed Vice President - Centralized Services effective November 7, 1993. (12) William M. Edwards, III was appointed Controller effective November 7, 1993 replacing John D. Utzinger. William E. Starkey retired November 21, 1993, George N. King retired May 21, 1993, Clark W. Barlow retired August 21, 1993, James A. Spriggs retired November 18, 1993, Rex A. Timms retired November 18, 1993. William D. Wilson resigned effective November 1, 1993 to accept a new position in GTE South Incorporated and GTE North Incorporated as Area Vice President - General Manager - East. The Federal securities laws require the Company's directors and executive officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of any equity securities of the Company. To the Company's knowledge, based solely on review of the copies of such reports furnished to the Company, all persons subject to these reporting requirements filed the required reports on a timely basis except Gerald K. Dinsmore, who filed one initial statement of beneficial ownership of securities late. Mr. Dinsmore does not own, and has never owned, any shares of the Company's registered preferred stock (which is the only registered class of the Company's equity securities). Long-Term Incentive Plan - Awards in Last Fiscal Year The GTE Long-Term Incentive Plan (LTIP) provides for awards, currently in the form of stock options with tandem stock appreciation rights and cash bonuses, to participating employees. The stock options and stock appreciation rights awarded under the LTIP to the seven most highly compensated individuals in 1993 are shown in the table on page 10. Under the LTIP, performance bonuses are paid in cash based on the achievement of pre-established goals for GTE's return on equity (ROE) over a three-year award cycle. Performance bonuses are denominated in units of GTE Common Stock ("Common Stock Units") and are maintained in a Common Stock Unit Account. Executive Agreements GTE has entered into agreements (the Agreements) with Messrs. Appel, Esstman, Krall and Foster regarding benefits to be paid in the event of a change in control of GTE (a "Change in Control"). A Change in Control is deemed to have occurred if a majority of the members of the Board do not consist of members of the incumbent Board (as defined in the Agreements) or if, in any 12-month period, three or more directors are elected without the approval of the incumbent Board. An individual whose initial assumption of office occurred pursuant to an agreement to avoid or settle a proxy or other election contest is not considered a member of the incumbent Board. In addition, a director who is elected pursuant to such a settlement agreement will not be deemed a director who is elected or nominated by the incumbent Board for purposes of determining whether a Change in Control has occurred. A Change in Control will not occur in the following situations: (1) certain merger transactions in which there is at least 50% GTE shareholder continuity in the surviving corporation, at least a majority of the members of the board of directors of the surviving corporation consists of members of the Board of GTE and no person owns more than 20% (or under certain circumstances, a lower percentage, not less than 10%) of the voting power of the surviving corporation following the transaction, and (2) transactions in which GTE's securities are acquired directly from GTE. The Agreements provide for benefits to be paid in the event this individual separates from service and has a "good reason" for leaving or is terminated without "cause" within two years after a Change in Control of GTE. Good reason for leaving includes but is not limited to the following events: demotion, relocation or a reduction in total compensation or benefits, or the new entity's failure to expressly assume obligations under the Agreements. Termination for cause includes certain unlawful acts on the part of the executive or a material violation of his or her responsibilities to the Corporation resulting in material injury to the Corporation. An executive who experiences a qualifying separation from service will be entitled to receive up to two times the sum of (i) base salary and (ii) the average of his or her other percentage awards under the EIP for the previous three years. The executive will also continue to receive medical and life insurance coverage for up to two years and will be provided with financial and outplacement counseling. In addition, the Agreements with Messrs. Appel, Esstman, Krall and Foster provide that in the event of a separation from service, they will receive service credit in the following amounts: two times years of service otherwise credited if the executive has five or fewer years of credited service; 10 years if credited service is more than five and not more than 10 years; and, if the executive's credited service exceeds 10 years, the actual number of credited years of service. These additional years of service will apply towards vesting, retirement eligibility, benefit accrual and all other purposes under the Supplemental Executive Retirement Plan and the Executive Retired Life Insurance Plan. In addition, each executive will be considered to have not less than 76 points and 15 years of accredited service for the purpose of determining his or her eligibility for early retirement benefits. However, there will be no duplication of benefits. The Agreements remain in effect until the earlier of July 1 of each successive year or the date on which the executive reaches age 65, unless the Agreement is terminated earlier pursuant to its terms. The Agreements will be automatically renewed on each successive July 1 unless, not later than December 31 of the preceding year, one of the parties notifies the other that he does not wish to extend the Agreement. If a Change in Control occurs, the Agreements will remain in effect until the obligations of GTE (or its successor) under the Agreements have been satisfied. Retirement Programs Pension Plans The estimated annual benefits payable, calculated on a single life annuity basis, under GTE's defined benefit pension plans at normal retirement at age 65, based upon final average earnings and years of employment, are illustrated in the table below: PENSION PLAN TABLE Years of Service Final Average _____________________________________________________________ Earnings 15 20 25 30 35 _____________ _________ __________ __________ __________ ________ $ 150,000 $ 31,604 $ 42,138 $ 52,672 $ 63,207 $ 73,742 200,000 42,479 56,638 70,797 84,957 99,117 300,000 64,229 85,638 107,048 128,457 149,867 400,000 85,979 114,638 143,298 171,957 200,617 500,000 107,729 143,638 179,548 215,457 251,367 600,000 129,479 172,638 215,798 258,957 302,117 700,000 151,229 201,638 252,048 302,457 352,867 800,000 172,979 230,638 288,298 345,957 403,617 900,000 194,729 259,638 324,548 389,457 454,367 1,000,000 216,479 288,638 360,798 432,957 505,117 1,200,000 259,979 346,638 433,298 519,957 606,617 GTE Service Corporation, a wholly-owned subsidiary of GTE, maintains a noncontributory pension plan for the benefit of GTE employees based on years of service. Pension benefits to be paid from this plan and contributions to this plan are related to basic salary exclusive of overtime, differentials, incentive compensation (except as otherwise described) and other similar types of payment. Under this plan, pensions are computed on a two-rate formula basis of 1.15% and 1.45% for each year of service, with the 1.15% service credit being applied to that portion of the average annual salary for the five highest consecutive years that does not exceed the Social Security Integration Level (the portion of salary subject to the Federal Security Act), and the 1.45% service credit being applied to that portion of the average annual salary that exceeds said level. As of March 1, 1993, the credited years of service under the plan for Messrs. Appel, Myers, Spriggs, Esstman, Krall, Cole and Foster are 22, 32, 37, 25, 27, 29 and 23, respectively. Under Federal law, an employee's benefits under a qualified pension plan such as the GTE Service Corporation plan are limited to certain maximum amounts. GTE maintains a Supplemental Executive Retirement Plan (SERP), which supplements the benefits of any participant in the qualified pension plan by direct payment of a lump sum or by an annuity, on an unfunded basis, of the amount by which any participant's benefits under the GTE Service Corporation pension plan are limited by law. In addition, the SERP includes a provision permitting the payment of additional retirement benefits determined in a similar manner as under the qualified pension plan on remuneration accrued under management incentive plans as determined by the Executive Compensation and Organizational Structure Committee. Executive Retired Life Insurance Plan The Executive Retired Life Insurance Plan (ERLIP) provides Messrs. Appel, Myers, Spriggs, Esstman, Krall, Cole and Foster a maximum postretirement life insurance benefit of three times final base salary. Upon retirement, ERLIP benefits may be paid as life insurance or optionally, an equivalent amount may be paid as a lump sum payment equal to the present value of the life insurance amount (based on actuarial factors and the interest rate then in effect), as an annuity or as installment payments. If an optional payment method is selected, the ERLIP benefit will be based on the actuarial equivalent of the present value of the insurance amount. Directors' Compensation The current directors, all of whom are employees of GTE, are not paid any fees of renumeration, as such, for service on the Board. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners as of February 28, 1994: Name and Shares of Title Address of Beneficial Percent of Class Beneficial Owner Ownership of Class ________ ________________ _________ ________ Common Stock of GTE Corporation 6,450,000 100% GTE Southwest One Stamford Forum shares of Incorporated Stamford, Connecticut record (b) Security Ownership of Management as of December 31, 1993: Name of Director or Nominee ___________________________ Common Stock of GTE Corporation John C. Appel 5,453 All less Kent B. Foster 168,299 than 1% Richard M. Cahill 37,188 Gerald K. Dinsmore 18,503 Michael B. Esstman 54,051 Thomas W. White 83,071 _______ 366,565 ======= Executive Officers(1)(2) _________________________ John C. Appel 5,453 Dennis F. Myers 14,631 James A. Spriggs 10,574 Michael B. Esstman 54,051 Brad M. Krall 13,311 J. Bruce Cole 12,153 Kent B. Foster 168,299 _______ 278,472 ======= All directors and executive officers as a group(1)(2) 762,690 ======= (1) Includes shares acquired through participation in GTE's Consolidated Employee Stock Ownership Plan and/or the GTE Savings Plan. (2) Included in the number of shares beneficially owned by Messrs. Appel, Myers, Spriggs, Esstman, Krall, Cole and Foster and all directors and executive officers as a group are 2,333; 8,631; 7,300; 33,118; 8,832; 11,532; 115,583 and 516,250 shares, respectively, which such persons have the right to acquire within 60 days pursuant to stock options. (c) There were no changes in control of the Company during 1993. Item 13.

Item 13. Certain Relationships and Related Transactions The Company's executive officers or directors were not materially indebted to the Company or involved in any material transaction in which they had a direct or indirect material interest. None of the Company's directors were involved in any business relationships with the Company. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements - Reference is made to the Registrant's Annual Report to Shareholders, pages 5 - 22 for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Report of Independent Public Accountants. Balance Sheets - December 31, 1993 and 1992. Statements of Income for the years ended December 31, 1993-1991. Statements of Reinvested Earnings for the years ended December 31, 1993-1991. Statements of Cash Flows for the years ended December 31, 1993-1991. Notes to Financial Statements. (2) Financial Statement Schedules - Included in Part IV of this report for the years ended December 31, 1993-1991: Page(s) ------- Report of Independent Public Accountants 21 Schedules: V - Property, Plant and Equipment 22-24 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 25 VIII - Valuation and Qualifying Accounts 26 X - Supplementary Income Statement Information 27 Note: Schedules other than those listed above are omitted as not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Exhibits - Included in this report or incorporated by reference. 3 Articles of Incorporation and amended By-Laws (Exhibit 3 of the 1993 Form 10-K, File No. 1-7077). 4* Thirty-Seventh Supplemental Indenture (Exhibit 4 of the Form 10-K File No. 1-7077). Thirty-Eighth Supplemental Indenture, File No. 33-43549. 13 Annual Report to Shareholders for the year ended December 31, 1993, filed herein as Exhibit 13. (b) Reports on Form 8-K - No reports on Form 8-K were filed during the fourth quarter of 1993. * Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To GTE Southwest Incorporated: We have audited in accordance with generally accepted auditing standards, the financial statements included in GTE Southwest Incorporated's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our report on the financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes in 1992 as discussed in Note 1 to the financial statements. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Dallas, Texas January 28, 1994. GTE SOUTHWEST INCORPORATED SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) - - ----------------------------------------------------------------------------- Column A Column B --------- -------------------------------------------- Item Charged to Operating Expenses - - ----------------------------------------------------------------------------- 1993 1992 1991 ----------- ---------- ----------- Maintenance and repairs $ 207,048 $ 186,486 $ 191,939 Taxes, other than payroll and income taxes, are as follows: Real and personal property $ 38,343 $ 33,820 $ 36,643 Other 7,149 15,339 2,109 Portion of above taxes charged to plant and other accounts (4,539) (4,764) (3,368) __________ __________ __________ Total $ 40,953 $ 44,395 $ 35,384 ========== ========== ========== SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GTE SOUTHWEST INCORPORATED __________________________ (Registrant) Date March 21, 1994 By JOHN C. APPEL ________________________ JOHN C. APPEL President Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. JOHN C. APPEL - - ------------------------ President and Director March 21, 1994 JOHN C. APPEL (Principal Executive Officer) GERALD K. DINSMORE - - ------------------------ Senior Vice President - Finance March 21, 1994 GERALD K. DINSMORE and Planning and Director (Principal Financial Officer) WILLIAM M. EDWARDS, III - - ------------------------ Controller March 21, 1994 WILLIAM M. EDWARDS, III (Principal Accounting Officer) RICHARD M. CAHILL - - ------------------------ Director March 21, 1994 RICHARD M. CAHILL MICHAEL B. ESSTMAN - - ------------------------ Director March 21, 1994 MICHAEL B. ESSTMAN KENT B. FOSTER - - ------------------------ Director March 21, 1994 KENT B. FOSTER THOMAS W. WHITE - - ------------------------ Director March 21, 1994 THOMAS W. WHITE

812701_1993.txt

812701

1993

Item 1. Business: The Company: The predecessor of the Company's activated carbon business was formed in 1942. From 1968 until April 1985 it was owned and operated by the previous owner. In April 1985 the Company's predecessor business was purchased by its management in a leveraged buyout. The Company's business is currently conducted by substantially the same management that conducted the business prior to the leveraged buyout. On June 9, 1987 the Company completed its initial public offering of common stock. In May of 1988 the Company acquired Degussa AG's activated carbon and charcoal business located in Germany. The acquisition was accounted for as a purchase. The acquisition provided the Company with two additional manufacturing facilities located in Germany and strengthened its customer base. In September of 1990, the Company purchased the operating assets of TMPC, Inc. (Vara International) in order to strengthen the Company's vapor phase equipment business. Products and Services: Calgon Carbon is engaged in the production and marketing of activated carbons and related services and systems throughout the world. The Company's activities consist of four integrally related areas: (1) activated carbons--the production and sale of a broad range of untreated, impregnated or acid-washed carbons, in either powder, granular or pellet form; (2) services--the provision of carbon reactivation services, as well as on-site purification, filtration and extraction services; (3) systems--the design, assembly and sales of activated carbon purification, filtration and extraction systems; and (4) charcoal--the production and sale of charcoal to consumer markets in Europe. Markets: The Company offers its activated carbon products, equipment and services to the Industrial Process Market, and the Environmental Market and charcoal products to the Consumer Market. The following table sets forth certain data concerning the Company's total net sales by market for the past three years. Industrial Process Market: The Industrial Process Market consists of customers that use the Company's products either for purification of their own products in the manufacturing process or direct incorporation into their own product. The Industrial Process Market includes four significant sub-markets: the food market, the original equipment manufacturers market, the chemical and pharmaceutical market and a group of other sub-markets. Environmental Market: The Environmental Market consists of customers that use the Company's products to control air and water pollutants. The Environmental Market has two sub- markets, the industrial market and the municipal market. Consumer Market: The Consumer Market consists of sales of charcoal (Grillis/R/ and Der Sommer-Hit/R/) for outdoor barbecue grilling. The Company's grill charcoal is primarily sold through distributors principally in Germany. This market is weather dependent, with the majority of the sales in the spring and summer months. Sales and Marketing: The Company sells activated carbons, systems and services throughout the world. In Europe, the Company also sells charcoal. To date, in areas outside of the United States and Europe, the Company's primary activity has been the sale of activated carbons. The Company sells its products and services principally through its own direct sales force, and, to a lesser degree, through agents and distributors. The Company has a direct sales force in the United States in offices located in Pittsburgh, Pennsylvania; San Mateo, California; Carlsbad, California; Lisle, Illinois; Houston, Texas; and Bridgewater, New Jersey. The Company conducts sales in Canada through its wholly owned subsidiary which has a sales office in Mississauga, Ontario. In Europe the Company has sales offices in Brussels, Belgium; Paris, France; Manchester, England; Frankfurt, Germany; and Milan, Italy. The Company also has a network of agents and distributors that conduct sales in certain countries in Europe (including Eastern European countries), the Middle East, Africa, Latin America, the Far East, Australia and New Zealand. The following table sets forth certain data concerning total net sales to customers in geographic areas in the past three years: Refer to Note 14 to the Consolidated Financial Statements for a discussion of certain other financial information classified by major geographic areas in which the Company operates. Sales of the Company's products in Japan, South Korea, Taiwan and the People's Republic of China are conducted exclusively by Calgon Far East Co. Ltd., a joint venture in which the Company is a 50% participant. The joint venture purchases the Company's products for resale in the four designated countries. Sales to the joint venture have not been a significant portion of the Company's total net sales. The Company's products and services were purchased by approximately 3,700 active customers in 1993. Over the past three years, no single customer accounted for more than 10% of the total sales of the Company in any year. Competition: The Company has three principal competitors with respect to the production and sale of activated carbons: Norit, N.V., a Dutch Company; CECA and Atochem, USA, subsidiaries of Elf-Aquitaine, a French company; and Westvaco Corporation, a United States company. Recently, Chinese producers of coal based activated carbon and certain East Asian producers of coconut based activated carbon have entered the market on a worldwide basis and sell principally through resellers. Competition in activated carbons, systems and services is based both on price and performance. Other sources of competition for the Company's activated carbon services and systems are purification, filtration and extraction processes that do not employ activated carbons. A number of other smaller competitors engage in the production and sale of activated carbons in the United States and throughout the world. These companies compete with the Company in the sale of specific types of activated carbons, but do not generally compete with the Company in the worldwide activated carbon business. In the United States the Company competes with several small regional companies for the sale of its reactivation services and equipment. There are a number of competitors in the consumer charcoal market who are located in the Eastern European countries, Spain, Portugal and South Africa. These competitors offer inexpensive, low-quality products to the market. Capital Expenditures: In 1993, the Company invested $15.1 million for capital expenditures. The Company's 1994 capital expenditure budget approximates $21.0 million and includes equipment for adsorption service customers. The Company believes that the funds generated from operations, supplemented as necessary with funds from lines of credit and its cash reserves, will provide sufficient funds required for such capital expenditures. Raw Materials: The principal raw material purchased by the Company is bituminous coal from mines in the Appalachian Region and mines outside the United States, under annual supply contracts. The Company purchases the coal used in its Belgian production facility from a number of European and Western Hemisphere coal companies under similar arrangements. The Company purchases beech wood for its German operations through long-term contracts and on the open market, either as fresh forest wood or as off-cuts from the furniture industry. Most of the wood is sourced in Germany and the supply of wood is adequate. The Company also purchases, through long-term contracts, fly ash, a by-product of the lumber industry, that is used to produce powdered carbon at the Blue Lake, California plant. The Company purchases significant amounts of natural gas from various suppliers for use in its production facilities. In both the United States and Europe, this natural gas is purchased pursuant to various contracts with natural gas companies. The only other raw material that is purchased by the Company in significant quantities is coal tar pitch, which is used as a binder in the manufacturing process. The Company purchases coal tar pitch from various suppliers in the United States and Europe under annual supply contracts. The Company does not presently anticipate any problems in obtaining adequate supplies of any of its raw materials. Research and Development: The Company's research and development activities are conducted at a research center near Pittsburgh, Pennsylvania, under the direction of a Vice President with a staff of 70 employees. A pilot plant located near Pittsburgh is used for the production of experimental activated carbon products for testing and applications development. The principal goals of the Company's research program are maintaining the Company as a technological leader in the production and utilization of granular activated carbon, systems and services; developing new products and services; and providing technical support to the manufacturing and marketing operations of the Company. Results of the Company's new product research programs include: development of a new product line of Centaur/TM/ carbons; development of proprietary specialty activated carbons in industrial and military respirators; commercial introduction of two new solvent recovery carbons, Xtrusorb A754 and Xtrusorb 800, for acetone and toluene recovery; development of an improved potable water carbon; and development of a new process to remove mercury from hydrocarbon liquids. Research and development expenses were $6.5 million, $6.2 million and $5.9 million in 1993, 1992, and 1991, respectively. Expenses were essentially flat between 1993, 1992 and 1991, apart from inflationary cost increases. Patent and Trade Secrets: The Company possesses a substantial body of technical knowledge and trade secrets and owns 47 United States patents and 68 patents in other countries. The technology embodied in these patents, trade secrets and technical knowledge applies to all phases of the Company's business including production processes, product formulations and application engineering. The Company considers this body of technology important to the conduct of its business, although it considers no individual item material to its business. Regulatory Matters: Domestic. The Company is subject to extensive environmental laws and regulations concerning emissions to the air, discharges to waterways and the generation, handling, storage, transportation, treatment and disposal of waste materials and is also subject to other federal and state laws regarding health and safety matters. The Company believes it is presently in substantial compliance with these laws and regulations. These laws and regulations are constantly evolving and it is impossible to predict accurately the effect these laws and regulations may have on the Company in the future. The Environmental Protection Agency (EPA) has issued certain regulations under the Resource Conservation and Recovery Act (RCRA) dealing with the transportation, storage and treatment of hazardous waste that impact the Company in its carbon reactivation services. Once activated carbon supplied to a customer can no longer adsorb contaminating organic substances, it is returned to the Company's facilities for reactivation and subsequent reuse. If the substance(s) adsorbed by the spent carbon is considered hazardous, under these EPA regulations the activated carbon used in the treatment process is also considered hazardous. Therefore, a permit is required to transport the hazardous carbon to the Company's facility for reactivation. The Company possesses the necessary federal and state permits to transport hazardous waste. Once at the Company's reactivation site, the hazardous spent activated carbon is placed in temporary storage tanks. Under the EPA regulations, the Company is required to have a hazardous waste storage permit. The Company has obtained RCRA Part B permits to store hazardous waste at its Neville Island and Catlettsburg facilities. The process of reactivating the spent activated carbon, which destroys the hazardous organic substances, is subject to permitting as a thermal treatment unit under RCRA. The Company does not accept for reactivation carbons containing certain hazardous materials, including PCBs, dioxins and radioactive materials. Each of the Company's domestic production facilities has permits and licenses regulating air emissions and water discharges. All of the Company's domestic production facilities are controlled under permits issued by state and federal air pollution control entities. The Company is presently in substantial compliance with these permits. Continued compliance will require administrative control and will be subject to any new or additional standards. Europe. The Company is also subject to various environmental health and safety laws and regulations at its facilities in Belgium, England and Germany. These laws and regulations address substantially the same issues as those applicable to the Company in the United States. The Company believes it is presently in substantial compliance with these laws and regulations. Indemnification. The Company has a limited indemnification agreement with the previous owner of the Company which will fund certain liabilities in certain limited situations. Employee Relations: As of December 31, 1993, the Company employed 1,320 persons on a full-time basis, 734 of whom were salaried production, office, supervisory and sales personnel. The 275 hourly personnel in the United States are represented by the United Steelworkers of America. The current contracts with the United Steelworkers of America expire on February 1, 1996 with respect to the Pittsburgh facility and on June 6, 1996 with respect to the Catlettsburg facility. The 215 hourly personnel at the Brilon Wald and Bodenfelde plants in Germany are represented by the German Chemical Industry Union. Agreements are reached every two years between the National Chemical Union and the German Chemical Federation. The last agreement expired on November 30, 1993. At this time, no formal agreement exists with the German Chemical Federation, but a proposal is under negotiation. The 70 hourly personnel at the Company's Belgian facility are represented by two national labor organizations with contracts expiring on July 1, 1995. The Company has 26 hourly employees at its United Kingdom facility. Item 2.

Item 2. Properties: The Company owns nine production facilities, two of which are located in Pittsburgh, Pennsylvania; and one each in the following locations: Catlettsburg, Kentucky; Pearlington, Mississippi; Blue Lake, California; Feluy, Belgium; Grays, England; Brilon Wald and Bodenfelde, Germany. The Catlettsburg, Kentucky plant is the Company's largest facility, with plant operations occupying approximately 50 acres of a 226-acre site. This plant produces granular activated carbons and powdered activated carbons, acid-washes granular activated carbons and reactivates spent granular activated carbons. The Pittsburgh, Pennsylvania carbon production plant occupies a four-acre site. Operations at the plant include the reactivation of spent granular activated carbons, the impregnation of granular activated carbons, the grinding of granular activated carbons into powdered activated carbons and the production of pelletized carbon. The plant also has the capacity to produce coal-based or coconut-based granular activated carbons. The Pittsburgh, Pennsylvania equipment and assembly plant is located approximately one mile from the carbon production plant and is situated within a 16-acre site that includes 300,000 square feet under roof. The equipment and assembly plant occupies 95,000 square feet under roof, with the remaining under roof space occupied by a centralized warehouse for carbon inventory. The plant assembles fully engineered equipment for purification, filtration and extraction systems. The Pearlington, Mississippi plant occupies a site of approximately 100 acres. The plant, the construction of which was completed in 1992, has one production line that produces granular activated carbons and powdered carbons. The Blue Lake, California plant, located near the city of Eureka, occupies approximately two acres. The operations at the plant include reactivation of spent granular activated carbons and manufacturing of powdered carbon. The Feluy, Belgium plant occupies a site of approximately 21 acres located 30 miles south of Brussels, Belgium. It has one production line which manufactures granular activated carbons. In addition, operations at the plant include the reactivation of spent activated carbons used in the treatment of food products, drinking water, industrial water and the grinding of granular activated carbons into powdered activated carbons. The Grays, England plant occupies a three acre site near London, England. Operations at the plant include the reactivation of spent granular activated carbons used in food or drinking water processing operations and the impregnation of granular activated carbon. The Brilon Wald, Germany plant occupies a site of approximately 40 acres and is situated in the North Rhine-Westphalia Region. Operations at the plant include the manufacture of pellet, granular and powdered carbons, acid washing and impregnation of activated carbon. The Bodenfelde, Germany plant occupies a site of approximately 40 acres and is situated in the State of Lower Saxony. Operations at the plant include the manufacture of charcoal for the consumer market. In addition, the plant produces charcoal tar which is used by the Brilon Wald plant for the production of activated carbon. As a by-product, acetic acid of various grades is produced and sold. Item 3.

Item 3. Legal Proceedings: There are no material pending legal proceedings to which the registrant or any of its subsidiaries is a party or of which any of their property is the subject, except proceedings which arise in the ordinary course of business. In the opinion of management, any ultimate liability arising from pending litigation will not have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company . Item 4.

Item 4. Submission of Matters to a Vote of Security Holders: No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters: - -------------------------------------------------------------------------------- Common Shares and Market Information There is no established trading market for Class A stock, but such stock may be converted to common stock. Class A shares are held by four officers or directors and one prior officer and director and are subject to a voting trust. These shares have identical rights with common stock except that holders of Class A stock are entitled to 10 votes per share on matters submitted to a vote of the common shareholders. Common shares are traded on the New York Stock Exchange under the trading symbol CCC. There were 1,470 registered shareholders at year end. Quarterly Common Stock Price Ranges and Dividends Item 6.

Item 6. Selected Financial Data: - -------------------------------------------------------------------------------- Eight-Year Summary Selected Financial And Statistical Data (Dollars in thousands except per share data) (a) After extraordinary charges in 1990 and 1987 resulting from prepayment of debt obligations of $1.24 million or $.03 per share net of tax, and $.68 million or $.02 per share, net of tax, respectively. (b) Income per common share for 1987 and 1986 is based upon pro forma net income of $17.71 million and $10.69 million, respectively. (c) After a charge in 1992 of $10.65 million or $.26 per share resulting from the cumulative effect of a change in accounting principle for income taxes. (d) Year of initial public offering. (e) First full year of operations. Item 7.

Item 7. Management's Discussion and Analysis: Management's Discussion and Analysis Calgon Carbon Corporation Overview Industry Worldwide recessionary conditions continued to adversely affect the activated carbon industry during 1993. Pricing of activated carbon products was impacted by the lack of demand in relation to increased activated carbon production and reactivation capacity worldwide. The overall United States market showed a slight increase but this was offset by declines in Europe and Japan where recessionary conditions increased. Potential markets in Eastern Europe did not materialize due to lack of funds. Certain trends continue to affect the activated carbon industrial process and environmental markets. First, companies are increasing their efforts to reengineer processes to reduce waste and cost of production, thereby decreasing the demand for activated carbon and service. Second, there has been a delay of major carbon fills particularly in the municipal potable water area. The markets for equipment utilized in the application of activated carbon for water and air purification and industrial processes remain weak. Lack of bid awards and extremely competitive conditions in metal fabrication reduced pricing and lowered margins. The Company The Company experienced recessionary effects in all market and product areas. Reduced volume resulted in significant pricing pressure in most areas of the business. Potential major carbon fills in the United States potable water market did not occur in 1993. Increased activity in the European potable water market, principally by water companies in the United Kingdom offset shortfalls in the United States and other countries. As a result of decreased volume during the year, the Company effectively idled two lines at its Catlettsburg, Kentucky plant in order to control inventory levels. Hourly workers were laid off as a result of this action. In order to match the work force to present activity levels, the worldwide salaried staff was reduced 8% by the end of 1993. Based upon present conditions, the Company has taken steps and will continue to focus its efforts on improving customer satisfaction through a total quality effort. Two new product lines, Filtraform/TM/ (activated carbon in cylindrical and panel shapes) and Centaur/TM/ (activated carbon with greatly enhanced catalytic properties) have been introduced. The activated carbon activities in Germany will be operated at a level in line with their markets and will be required to self-finance investment requirements. The Company continues to believe that the potable water market has significant potential; however, development efforts will be concentrated in industrial process markets as it is anticipated that recovery from recessionary conditions will occur first in these markets. Results of Operations Consolidated net sales in 1993 declined by $28.9 million or 9.7% versus 1992. This decrease was throughout the carbon, service and equipment areas. The overall decrease was the net result of volume and price decreases due to the worldwide recession and excess capacity in the carbon industry and to the effect of unfavorable currency rate changes of $9.4 million. On a market basis, net sales to the industrial process area decreased by 12.4% while net sales in the environmental area declined by 6.2% in 1993 versus 1992. The industrial process decline occurred primarily in the original equipment manufacture and food areas due to significant non-repeat 1992 sales and product selection shifts. The decrease in the environmental market also reflected the non-repeating nature of significant 1992 municipal category sales. Net sales in 1992 decreased by $10.0 million or 3.2% from 1991. Minor increases were experienced in the carbon, service and charcoal/liquid areas offset by a nearly 30% decline in the equipment area. Currency exchange had an overall positive effect of approximately $5.2 million on 1992 sales as compared to 1991. From a market standpoint, sales into the industrial process area declined 2.7% from 1991 to 1992 and sales to the environmental area declined 4.8% for the similar period. Gross profit before depreciation as a percentage of net sales was 39.0%, 40.8% and 40.5% for 1993, 1992 and 1991, respectively. The 1993 decline from 1992 was primarily the combination of lower selling prices and customer shifts to lower margin products. The slight improvement from 1991 to 1992 can generally be attributed to a reduced level of low-margin major equipment sales and improvement in variable gross margins somewhat offset by the impact of higher fixed manufacturing costs in relation to the volume of sales. Depreciation increased by $2.0 million in 1993 versus 1992 and by $3.7 million in 1992 over 1991. The 1993 increase was principally the result of the full year's depreciation rate used for the Pearl River, Mississippi plant in 1993 versus a half year rate for 1992, its first year of operation. The 1992 increase can particularly be associated with the aforementioned start-up of this plant but also resulted from other significant capital spending. Selling, general and administrative expenses decreased by $1.9 million in 1993 versus 1992 while 1992 reflected an increase of $2.1 million over 1991. The 1993 decrease was primarily related to reduced personnel costs resulting from the year-end 1992 voluntary retirement incentive program in the United States, other worldwide staff terminations, 1993 initiated cost control programs including the absence of executive bonuses due to the Company's performance and reductions due to currency rate changes. These decreases were partially offset by inflation. The 1992 increase over 1991 was primarily due to increased sales personnel associated costs in the United States as the Company attempted to maintain momentum and market share. Research and development expenses, as a percentage of sales, were 2.4%, 2.1% and 1.9% in 1993, 1992 and 1991, respectively. Interest income increased by $0.4 million in 1993 over 1992 but decreased by $0.6 million in 1992 from 1991. The 1993 increase was due to increased investable cash resulting from moving from the previous year's borrowing position. Conversely, the decrease in 1992 versus 1991 was the result of borrowings in 1992. Interest expense decreased in 1993 by $0.4 million from 1992 and increased by $0.3 million over 1991. Both changes were the result of borrowing activity in the indicated years. The effective tax rate for 1993 was 37.8% compared to 34.9% in 1992 and 37.2% in 1991. The 1993 increase was primarily the result of the United States passage of the "Omnibus Budget Reconciliation Act of 1993" which was retroactive to January 1, 1993, which not only affected the current year's tax provision, but also required the remeasurement of the Company's deferred tax liability to revised tax rates. The 1992 change versus 1991 was the result of the Company's January 1, 1992, adoption of the Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This also resulted in an unfavorable cumulative adjustment to first quarter 1992 net income of $10.7 million. (See Note 11 to the Consolidated Financial Statements.) The Company does not believe that inflation has had a significant effect on its business during the periods discussed. Working Capital and Liquidity Net cash flows from operating activities totalled $41.1 million in 1993, $45.4 million in 1992 and $47.2 million in 1991. The Company expects to be a net generator of cash, providing sufficient funding on an annual basis for debt service, working capital, payment of dividends and a maintenance level of capital expenditures, short of any major capital expansions. During 1992 and 1991, significant capital was expended in building the Pearl River plant which had a total cost of approximately $68 million. This project is now completed. During the second quarter of 1993 the Company negotiated two new credit facilities, one with a bank in the United States and one in Germany in the amounts of $10 million and approximately $11.5 million (deutsche mark 20 million) respectively. These credit facilities have a duration of one year and "until further notice", respectively. As a result, the Company has two United States credit facilities in the amounts of $10 million each, expiring as of April 30, 1994 and May 30, 1994 and the aforementioned German credit facility. Based upon its present financial position and history of operations, it is contemplated that these credit facilities, coupled with cash flow from operations, will provide sufficient liquidity to cover its debt service and any reasonable foreseeable working capital, capital expenditure, stock repurchase and dividend requirements. In July of 1993, the board of directors authorized the purchase of up to two million shares, or approximately 5% of the Company's common stock. Purchases will be made from time to time at prices that management considers appropriate and the repurchased shares will be held as treasury stock. During the year, the Company began to purchase these shares. During this period, 153,600 shares were purchased at a cost of $1.6 million. It is the current intention of the Company to declare and pay quarterly cash dividends on its common stock. The Company has paid cash dividends since the third quarter of 1987, the quarter succeeding the one in which the Company went public. The declaration and payment of dividends is at the discretion of the Board of Directors of the Company. The declaration and payment of future dividends and the amounts thereof will be dependent upon the Company's results of operations, financial condition, cash requirements for its business, future prospects and other factors deemed relevant by the Board of Directors. Capital Expenditures and Investments Capital expenditures were $15.1 million in 1993, $24.0 million in 1992 and $70.6 million in 1991. Major expenditures in 1993 were made for production improvements at the Blue Lake, California plant ($3.2 million), a specific new product production capability at the Neville Island, Pennsylvania plant ($1.8 million) and costs associated with domestic service customer capital ($2.7 million). The 1992 and 1991 expenditure amounts included costs associated with the construction of the Pearl River prime carbon production facility. Capital expenditures for the year of 1994 are projected to be approximately $21.0 million. Item 8.

Item 8. Financial Statements and Supplementary Data: Index to Consolidated Financial Statements and Supplementary Data: Report of Independent Accountants To the Board of Directors and Shareholders of Calgon Carbon Corporation: In our opinion, the consolidated financial statements listed in the index on page 12 and Item 14.B on page 27 present fairly, in all material respects, the financial position of Calgon Carbon Corporation and its subsidiaries (the Company) at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 11 to the consolidated financial statements, in 1992 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". PRICE WATERHOUSE Pittsburgh, Pennsylvania February 10, 1994 Consolidated Statement of Income Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Consolidated Balance Sheet Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Consolidated Statement of Cash Flows Increase (decrease) in Cash and Cash Equivalents Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Consolidated Statement of Shareholders' Equity Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Notes to the Consolidated Financial Statements Calgon Carbon Corporation - -------------------------------------------------------------------------------- 1. Statement of Accounting Policies Operations The Company's operations are conducted in one business segment, the production and marketing of activated carbons and related products and services. Principles of Consolidation The consolidated financial statements include the accounts of Calgon Carbon Corporation and its wholly-owned subsidiaries, Chemviron Carbon GmbH, Calgon Carbon Canada, Inc., Chemviron Carbon Ltd., Calgon Carbon Investments Inc. and the Company's foreign sales corporation. A portion of the Company's international operations in Europe are owned directly by the Company and are operated as branches. The Company's 50% investment in Calgon Far East Co., Ltd. is accounted for by the equity method. Intercompany accounts and transactions have been eliminated. Foreign Currency Translation Substantially all assets and liabilities of the Company's international operations are translated at year-end exchange rates; income and expenses are translated at average exchange rates prevailing during the year. Translation adjustments are accumulated in a separate component of shareholders' equity, net of tax effects. Transaction gains and losses are included in income. Revenue Recognition Revenue and related costs are recognized when goods are shipped or services are rendered to customers. Inventories Inventories are carried at the lower of cost or market. Inventory costs are determined using the last in, first out (LIFO) method except at Chemviron Carbon GmbH and Calgon Carbon Canada, Inc., where cost is determined by the first in, first out (FIFO) method. Property, Plant and Equipment Property, plant and equipment expenditures are recorded at cost. Repair and maintenance costs are expensed as incurred. Depreciation for financial statement purposes is computed on the straight-line method over the estimated remaining service lives of the assets, which are from twenty to thirty years for buildings and land improvements, fifteen years for machinery and equipment and seven years for vehicles. Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." (See Note 11 to the Consolidated Financial Statements.) Pensions Substantially all U.S. employees of the Company are covered by one of three non-contributory defined benefit pension plans. It is the Company's policy to annually fund net pension cost accrued to these plans, subject to minimum and maximum amounts specified by regulations. In Europe, employees are also covered by various defined benefit pension plans or government sponsored defined contribution plans. The Company funds these plans according to local laws and practices. Statement of Cash Flows For the purpose of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. - -------------------------------------------------------------------------------- 2. Restructuring Charges The charge of $1,733,000 in the fourth quarter of 1993 consists of worldwide personnel costs associated with the voluntary retirement incentive program and other staff terminations. The first and fourth quarters of 1992 included charges of $690,000 and $4,507,000, respectively, for the restructuring of operations at the Brilon- Wald, Germany activated carbon plant, for a voluntary retirement incentive program in the United States, and for termination costs at several locations. The total restructuring costs for 1992 included $2,966,000 for employee terminations and net property and spare parts write-offs for operations at the Brilon-Wald plant. The cost of the voluntary retirement incentive program and termination payments at various locations totalled $2,231,000. - -------------------------------------------------------------------------------- 3. Inventories Approximately 62% of total inventories at December 31, 1993 are valued using the LIFO method. The LIFO carrying value of inventories exceeded the related current cost by $2,463,000 and $2,497,000 at December 31, 1993 and 1992, respectively. - -------------------------------------------------------------------------------- 4. Property, Plant and Equipment - ------------------------------------------------------------------------------- 5. Long-Term Debt Pollution Control Debt The City of Ashland, Kentucky Floating Rate Pollution Control Revenue bonds bear interest at a defined floating rate and are due October 1, 2006. During the year ended December 31, 1993, the Company paid interest on these bonds at an average rate of 3.2%. These pollution control bonds are secured by certain pollution control projects located at the Company's Big Sandy, Kentucky plant. The German pollution control loans consist of three loans, due March 31, 1997, 1998 and 2000 and have fixed interest rates of 5.0%, 6.5% and 6.0%,respectively. The German wastewater control loans consist of four loans. Three loans are due February 28, 2016 and one loan is due February 28, 2017. All four loans have a fixed interest rate of 1.5%. United States Credit Facilities The Company's two credit facilities totalling $20 million expire in April and May of 1994. The Company pays annual facility fees of one-eighth percent and one-quarter percent on the unused portion of each credit line. The facilities provide for interest rates based upon prime rates with other interest options available. As of December 31, 1993, no amounts were outstanding related to these credit facilities. German Credit Facility Chemviron Carbon GmbH has a bank credit facility which provides for borrowing up to $11,527,000. The facility has no set maturity date and is made available on an until further notice basis. No commitment fee is required on unborrowed funds. The facility bears interest at the German bank rate with other interest options available. As of December 31, 1993, the weighted average interest rate was 7.2% on loans outstanding. Restrictive Covenants The United States credit facilities' covenants impose financial restrictions on the Company, including maintaining certain ratios of total liabilities to tangible net worth and operating income to interest expense. At December 31, 1993 the Company was in compliance with all financial covenants relating to the credit facilities in the United States. The German credit facility has no covenants. Maturities of Debt The Company is obligated to make principal payments on debt outstanding at December 31, 1993 of $2,516,000 in 1994, $215,000 in 1995 and 1996, respectively, $197,000 in 1997, and $146,000 in 1998. - -------------------------------------------------------------------------------- 6. Lease Commitments The Company has entered into leases covering principally office, research and warehouse space, office equipment and vehicles. Future minimum rental payments required under all operating leases that have remaining noncancelable lease terms in excess of one year are $4,535,000 in 1994, $3,937,000 in 1995, $3,507,000 in 1996, $3,216,000 in 1997, $3,130,000 in 1998 and $20,302,000 thereafter. Total rental expenses on all operating leases were $4,996,000 , $5,075,000 and $5,125,000 for the years ended December 31, 1993, 1992 and 1991, respectively. - -------------------------------------------------------------------------------- 7. Shareholders' Equity The 12,148,508 shares of Class A stock outstanding at December 31, 1993 must be converted to common stock on a share-for-share basis when the Class A stock is released from a voting trust which terminates March 1, 1995. The common stock and the Class A stock have identical rights except that holders of Class A stock are entitled to 10 votes per share with respect to each matter submitted to a vote of the shareholders. On July 13, 1993, the Board of Directors authorized the Company to purchase up to two million shares, or approximately 5% of its common stock. Purchases will be made from time to time at prices management considers appropriate and the repurchased shares will be held as treasury stock. As of December 31, 1993, the Company had purchased 153,600 shares of its common stock at an aggregate cost of $1,615,000. At the Company's annual meeting of shareholders held in April 1990, an amendment to the Certificate of Incorporation was approved which affected the capital structure of the Company and modified the class voting rights of common shareholders. The amendment increased the number of authorized shares of common stock and Class A stock from 30,000,000 shares to 100,000,000 shares and increased the number of shares of preferred stock which the Company is authorized to issue from 1,000,000 shares to 5,000,000 shares. The amendment eliminated the common stock's separate class voting on amending or deleting any provision of Section 4 of the Certificate of Incorporation (relating to the capital stock of the Company) and amending, waiving or deleting provisions of the voting trust agreement. The amendment also permits the issuance of additional shares of Class A stock without a separate class vote of the common stock as long as the number of shares of Class A stock which would be outstanding after such issuance will not exceed 55% of the number of shares of common stock which would be outstanding immediately after such issuance. - -------------------------------------------------------------------------------- 8. 1985 Stock Option Plan The Company has an Employee Stock Option Plan for officers and other key employees of the Company. Stock options may be "nonstatutory," with a purchase price not less than 80% of fair market value on the date of the grant, or "incentive" with a purchase price of not less than 100% of the fair market value on that date. Stock appreciation rights may be granted at date of option grant or at any later date during the term of the option. There were 4,138,640 shares available for issuance under the Plan. In 1985, 2,096,000 options were granted and were exercised in 1985 and 1986. "Incentive" stock options granted since 1986 become exercisable two years after the date of grant in five equal annual installments and are no longer exercisable after the expiration of ten years from the date of grant. Transactions for 1993, 1992 and 1991 are as follows: - -------------------------------------------------------------------------------- 9. Employee Growth Sharing Plan Under the Plan, an employee growth sharing plan pool is calculated as a percentage of the increase in year-to-year pre-tax income plan pool which will be distributed to full time employees not eligible to receive a cash bonus under any other incentive plan of the Company. This plan pool may be adjusted by the Board of Directors at its sole discretion in any plan year in order to reflect any material events that would impact the calculation in either a positive or negative manner. There was no pool for distribution for the years ending December 31, 1993, 1992 and 1991. - -------------------------------------------------------------------------------- 10. Pensions The Company has a number of non-contributory defined benefit pension plans for its U.S. employees which provide benefits based upon the greater of a fixed rate per month or a percentage of average compensation. Prior service and compensation of employees formerly covered by pension plans of the previous owners of the Company's operations are considered in the determination of benefits payable under Company plans. By agreement with previous owners, benefits payable under Company plans are reduced by the benefit amounts attributable to the previous owners which are computed utilizing a 2.5% compensation increase assumption. Domestic plan assets are invested primarily in commingled equity and government security trust funds administered by a bank. Prior service cost for all plans is amortized on a straight-line basis over the remaining average service period of employees expected to receive benefits under the plans. For U.S. plans, net pension costs, amounts recognized in the balance sheet and significant assumptions are as follows: In addition to the above pension cost for the year ended December 31, 1993, the Company recognized $197,000 for pension curtailment and settlement losses associated with the voluntary retirement incentive program. There are several defined benefit plans covering certain employees of Chemviron Carbon GmbH for which the obligations are accrued but not funded in accordance with local practice. Benefits under these plans are generally based on a percentage of average compensation. The European employees in the branches and United Kingdom subsidiary participate in certain contributory defined benefit pension plans which guarantee a pension over the state pension level. These plans are funded by employee contributions calculated as a percentage of their compensation with the balance of the plan funding provided by Company contributions. Funds are managed by an insurance company under a deposit administration contract. Benefits under these plans are generally based upon a percentage of final earnings subject to an upper earnings limit. For European plans, net pension costs, amounts recognized in the balance sheet and significant assumptions are as follows: - -------------------------------------------------------------------------------- 11. Provision for Income Taxes In 1992, the Company adopted SFAS No. 109 which requires an asset and liability approach in accounting for income taxes. Under this method, deferred income taxes are provided to reflect the future tax consequences of carryforwards and differences between the tax bases of assets and liabilities and their financial bases at each year-end. The unfavorable cumulative effect of the change in accounting principle determined as of January 1, 1992 totaled $10,654,000 ($.26 per share). On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 became law. This act changed the United States tax rates retroactively to January 1, 1993. As required by SFAS No. 109, these new income tax rates resulted in a remeasurement of the liability for deferred income taxes of $456,000, increasing "Provision for income taxes". The components of the provision for income taxes were as follows: Income before income taxes for 1993, 1992 and 1991 includes $7,531,000, $9,145,000 and $17,359,000, respectively, generated by operations outside the United States. The difference between the U.S. federal statutory tax rate and the Company's effective income tax rate is as follows: (a) Computed in accordance with Accounting Principles Board Opinion No. 11. The deferred tax provision for 1991 was primarily the result of timing differences related to depreciation. Operating loss and credit carryforwards of $6,545,000 in foreign jurisdictions at December 31, 1993 have no expiration dates. The Company's U.S. income tax returns have been examined by the Internal Revenue Service through 1991. Management believes that adequate provisions for taxes have been made through December 31, 1993. The components of deferred taxes are comprised of the following: - ------------------------------------------------------------------------ 12. Other Information Repair and maintenance expenses were $20,008,000, $21,584,000 and $23,297,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Other (expense)-net includes net foreign currency transaction losses of ($486,000) and ($806,000) for the years ended December 31, 1993 and 1992, respectively, and gains of $294,000 for the year ended December 31, 1991. Also included are taxes other than on income of $1,049,000, $706,000 and $760,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Deferred taxes included in the translation adjustments for 1993, 1992 and 1991 were ($1,528,000), ($1,880,000) and ($281,000), respectively. - ------------------------------------------------------------------------ 13. Supplemental Cash Flow Information - -------------------------------------------------------------------------------- 14. Geographic Information Net sales by the Company's operations in certain geographic areas, transfers between geographic areas and income from operations for 1993, 1992 and 1991 and identifiable assets, at the end of each year, classified by major geographic areas in which the Company operates, were as follows: Transfers between geographic areas are at prices in excess of cost and the resultant income is assigned to the geographic area of manufacture. Interarea income remaining in inventories is eliminated in consolidation. - -------------------------------------------------------------------------------- Quarterly Financial Data - Unaudited (Dollars in thousands except per share data) (a) The cumulative effect of a change in accounting principle for income taxes was ($10,654,000) or ($.26) per share in the first quarter of 1992. See Note 11 to the Consolidated Financial Statements for details of the adoption of SFAS 109. Item 9.

Item 9. Disagreements with Accountants: None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant: Information concerning the directors and executive officers of the Corporation required by this item is incorporated by reference to the material appearing under the heading "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. Item 11.

Item 11. Executive Compensation: Information required by this item is incorporated by reference to the material appearing under the heading "Executive Compensation" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management: Information required by this item is incorporated by reference to the material appearing under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. Item 13.

Item 13. Certain Relationships and Related Transactions: Information required by this item is incorporated by reference to the material appearing under the heading "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K: A. Financial Statements Financial statements filed as part of this report are listed in the index to Consolidated Financial Statements and Supplementary Data on page 12. B. Financial Statement Schedules Schedule V. Property, Plant and Equipment Schedule VI. Accumulated Depreciation of Property, Plant and Equipment All other schedules are omitted because they are not applicable, not material or the required information is shown in the financial statements listed above. Note: The Registrant hereby undertakes to furnish, upon request of the Commission, copies of all instruments defining the rights of holders of long-term debt of the Registrant and its consolidated subsidiaries. The total amount of securities authorized thereunder does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. (a) Incorporated herein by reference to Exhibit 3.2 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (b) Incorporated herein by reference to Exhibit 9.1 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (c) Incorporated herein by reference to Exhibit 10.22 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (d) Incorporated herein by reference to Exhibit 9.2 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1987. (e) Incorporated herein by reference to Exhibit 22.0 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1988. (f) Incorporated herein by reference to Exhibit 3.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. (g) Incorporated herein by reference to Exhibit 10.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. * Executive compensation plans. D. Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Calgon Carbon Corporation March 4, 1994 By /s/ THOMAS A. MCCONOMY - ------------- --------------------------------------- (Date) Thomas A. McConomy President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the dates indicated. Schedule V. Property, Plant and Equipment Calgon Carbon Corporation Notes: Reference is made to the Statement of Accounting Policies in Note 1 to the Consolidated Financial Statements. (a) Includes foreign currency translation of $389,000 increase to property, plant and equipment and an increase of $31,000 from amortization of goodwill. (b) Includes foreign currency translation of ($5,496,000) decrease to property, plant and equipment and an increase of $31,000 from amortization of goodwill. (c) Includes foreign currency translation of ($5,761,000) decrease to property, plant and equipment, an increase of $92,000 from amortization of goodwill. Schedule VI. Accumulated Depreciation of Property, Plant and Equipment Calgon Carbon Corporation - -------------------------------------------------------------------------------- (a) Includes foreign currency translation effect on current year depreciation of $327,000 and $31,000 from amortization of goodwill. (b) Includes foreign currency translation effect on current year depreciation of ($1,542,000) and $31,000 from amortization of goodwill. (c) Includes foreign currency translation effect on current year depreciation of ($1,917,000) and $92,000 from amortization of goodwill. EXHIBIT INDEX Note: The Registrant hereby undertakes to furnish, upon request of the Commission, copies of all instruments defining the rights of holders of long- term debt of the Resgistrant and its consolidated subsidiaries. The total amount of securities authorized thereunder does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. (a) Incorporated herein by reference to Exhibit 3.2 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (b) Incorporated herein by reference to Exhibit 9.1 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (c) Incorporated herein by reference to Exhibit 10.22 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (d) Incorporated herein by reference to Exhibit 9.2 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1987. (e) Incorporated herein by reference to Exhibit 22.0 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1988. (f) Incorporated herein by reference to Exhibit 3.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. (g) Incorporated herein by reference to Exhibit 10.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. * Executive compensation plans. CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-8 (No. 33-34019) of Calgon Carbon Corporation of our report dated February 10, 1994 appearing on page 13 of this report on Form 10-K. PRICE WATERHOUSE 600 Grant Street Pittsburgh, Pennsylvania 15219-2793 March 14, 1994

81061_1993.txt

81061

1993

Item 1. Business Publix Super Markets, Inc. (the "Company") is based in Lakeland, Florida and was incorporated in Florida on December 27, 1921. The Company is in the business of operating retail food supermarkets in Florida, Georgia and South Carolina. The Company's supermarkets sell groceries, produce, deli, bakery, meat, seafood, housewares and health and beauty care items. In addition, some stores have pharmacy and floral departments. The Company's lines of merchandise include a variety of nationally advertised and private label brands, as well as unbranded merchandise such as produce, meat and seafood. Private label items are produced in the Company's manufacturing facilities or are manufactured for the Company by outside vendors. The Company manufactures dairy, bakery and deli products. The Company's dairy plants are located in Lakeland and Deerfield Beach, Florida. The bakery and deli plants are located in Lakeland, Florida. The Company receives the food and non-food items it distributes from many sources throughout the United States. These products are generally available in sufficient quantities to enable the Company to adequately satisfy its customers. The Company believes that its sources of supply of these products and raw materials used in manufacturing are adequate for its needs and that it is not dependent upon a single or relatively few suppliers. The Company operated 425 supermarkets at the end of 1993, compared with 400 at the beginning of the year. In 1993, 29 stores were opened, 4 stores were closed, and 13 stores were expanded or remodeled. The net increase in square footage was 1.50 million or 9.0% since 1992. All of the Company's stores are located in Florida, with the exception of 15 stores located in Georgia and one located in South Carolina. The Company entered the Georgia market in 1991 and the South Carolina market in 1993. As of year end, the Company had 5 stores under construction in South Carolina, 21 in Georgia and 14 in Florida. In 1994, the Company will continue construction of additional distribution centers in Lakeland, Florida and Lawrenceville, Georgia. The Company is engaged in a highly competitive industry. Competition, based primarily on price, quality of goods and service, convenience and product mix, is with several national and regional chains, independent stores and mass merchandisers throughout its market areas. The Company anticipates continued competitor format innovation and location additions in 1994. The influx of winter residents to Florida and increased purchases of food during the traditional Christmas and Thanksgiving holidays typically results in seasonal sales increases between November and April of each year. The Company has experienced no significant changes in the kinds of products sold or in its methods of distribution since the beginning of the fiscal year. The Company had approximately 82,000 employees at the end of 1993, compared with 73,000 at the beginning of the year. Of this total, approximately 53,000 at the end of 1993 and 47,000 at the end of 1992 were not full-time employees. The Company's research and development expenses are insignificant. Compliance by the Company with Federal, state and local environmental protection laws during 1993 had no material effect upon capital expenditures, earnings or the competitive position of the Company. Item 2.

Item 2. Properties At year end, the Company operated approximately 18.1 million square feet of retail space. The Company's stores vary in size. Current store prototypes range from 27,000 to 65,000 square feet. Stores are often located in strip shopping centers where Publix is the anchor tenant. The majority of the Company's retail stores are leased. Substantially all of these leases will expire during the next 20 years. However, in the normal course of business, it is expected that the leases will be renewed or replaced by leases on other properties. At 35 locations both the building and land are owned and at 20 other locations the buildings are owned while the land is leased. The Company supplies its retail stores from seven distribution centers located in Lakeland, Miami, Jacksonville, Sarasota, Orlando, Deerfield Beach and Boynton Beach, Florida. A new distribution center is currently under construction in Lawrenceville, Georgia. With the exception of a portion of the Miami distribution facility, the Company's corporate offices, distribution facilities and manufacturing plants are owned with no outstanding debt. All of the Company's properties are well maintained and in good operating condition, and suitable and adequate for operating its business. Item 3.

Item 3. Legal Proceedings On January 19, 1993, the Equal Employment Opportunity Commission ("EEOC") applied to the United States District Court, Southern District of Florida in Miami, for an order to show cause why an administrative subpoena previously issued by the EEOC to the Company should not be enforced (EEOC v. Publix Super Markets, Inc., Case No. 93-0091). The application, among other things, alleged that information previously supplied by the Company to the EEOC did not fully comply with the subpoena and that the EEOC was entitled to require the Company to compile additional information and produce additional documents. The matter was resolved by a Consent Order, with which the Company complied, resulting in an order on June 17, 1993 dismissing the action. This application arose out of a notice of charge issued by the EEOC on March 25, 1992, In the Matter of: Kemp v. Publix Super Markets, Inc., Charge No. ###-##-####, alleging that the Company had engaged in past violations and was engaged in continuing violations of Title VII of the Civil Rights Act, as amended, by discriminating against women with respect to job assignments and promotions because of their sex. As currently amended, the charge covers employment practices by the Company in the State of Florida as a whole. On December 6, 1993, the EEOC sought to expand the scope of its investigation to include allegations of race discrimination. The EEOC has requested the Company to compile information and produce documents relating to these allegations. The Company has objected to the expansion and the EEOC has agreed to substantial reductions in the information requested and further discussions as to additional reductions in the information requested are pending. The Company denies the allegations of the charge and the subsequent attempted expansion of the charge. The EEOC has advised that the charge does not in any respect constitute a final finding of a violation, but that the EEOC has a statutory duty to conduct a full and impartial investigation for the purpose of determining whether the facts and circumstances afford the EEOC reasonable cause to believe that the Company's employment patterns and practices constitute discrimination on the basis of sex and race. The EEOC's investigation of the charge remains at the stage of considering whether there is reasonable cause to believe the allegations of the charge. At this early stage, the likelihood of an adverse finding of the Company's liability and an estimate of the amount of any exposure for any such liability cannot be determined. The Company is also a party in various other legal claims and actions considered in the normal course of business. Management believes that the ultimate disposition of these matters will not have a material effect on the Company's financial condition. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None EXECUTIVE OFFICERS OF THE COMPANY The terms of all officers expire at the annual meeting of the Company in May 1994. PART II Item 5.

Item 5. Market for the Company's Common Stock and Related Stockholder Matters (a) Market Information* Substantially all transactions of the Company's common stock have been among the Company, its employees, former employees and various benefit plans established for the Company's employees. The market price of the Company's common stock is determined by the Board of Directors based upon appraisals prepared by an independent appraiser. The market price for 1993 was $11.50 per share until March 17, 1993, when the price decreased to $11.25 per share. In the second quarter, the price increased to $11.50 per share. In the third quarter, the price was unchanged at $11.50 per share and in the fourth quarter, the price decreased to $11.00 per share. The market price for 1992 was $9.30 per share until the second quarter when the price increased to $10.60 per share. In the third quarter, the price increased to $10.80 per share and in the fourth quarter the price increased to $11.50 per share. (b) Approximate Number of Equity Security Holders As of March 4, 1994, the approximate number of holders of record of the Company's common stock was 57,500. (c) Dividends* The Company paid cash dividends of $.08 per share of common stock in 1993 and $.08 per share in 1992. Payment of dividends is within the discretion of the Company's Board of Directors and depends on, among other factors, earnings, capital requirements and the operating and financial condition of the Company. It is expected that comparable cash dividends will be paid in the future. *Restated to give retroactive effect for 5-for-1 stock split in July 1992. Item 6.

Item 6. Five Year Summary of Selected Financial Data NOTE: Dollars are in thousands except per share amounts. All years include 52 weeks. * Restated to give retroactive effect for 5-for-1 stock split in July 1992. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Business Environment As of December 25, 1993, the Company operated 425 retail grocery stores representing approximately 18.1 million square feet of retail space. Historically, the Company's primary competition has been from national and regional chains and smaller independents located throughout its market areas. The Company has continued to experience increased competition from mass merchandisers. The products offered by these retailers include many of the same items sold by the Company. All of the Company's stores are located in Florida with the exception of 15 stores located in Georgia and one store located in South Carolina. The Company opened its first store in Georgia during the fourth quarter of 1991, four stores during 1992 and 10 additional stores during 1993. The Company opened its first store in South Carolina during the fourth quarter of 1993. The Company intends to continue to pursue vigorously new locations in Florida and other states. Liquidity and Capital Resources Operating activities continue to be the Company's primary source of liquidity. Net cash provided by operating activities was approximately $370.4 million in 1993 compared with $296.8 million in 1992 and $313.7 million in 1991. Working capital was approximately $137.2 million as of December 25, 1993 as compared with $241.2 million and $271.4 million as of December 26, 1992 and December 28, 1991, respectively. Cash and cash equivalents aggregated $199.0 million as of December 25, 1993, as compared with $293.5 million and $332.8 million as of December 26, 1992 and December 28, 1991, respectively. Capital expenditures totaled $320.2 million in 1993. These expenditures were primarily incurred in connection with the opening of 29 new stores and remodeling or expanding 13 stores which added 1.63 million square feet. Significant expenditures were incurred in the continued expansion of the Deerfield Beach, Florida facility, acquisition of a grocery warehouse in Orlando, Florida and construction of a new general merchandise warehouse in Lakeland, Florida and a new distribution center in Lawrenceville, Georgia. In addition, the Company closed four stores. Capital expenditures totaled $202.6 million in 1992. These expenditures were primarily incurred in connection with the opening of 20 new stores and remodeling or expanding 12 stores which added 1.14 million square feet. Significant expenditures were incurred in expanding the Deerfield Beach facility. In addition, the Company closed 12 stores. Capital expenditures totaled $159.0 million in 1991. These expenditures were primarily incurred in connection with the opening of 20 new stores and remodeling or expanding 11 stores which added 1.10 million square feet. In addition, the Company closed six stores. The Company hopes to open as many as 60 stores in 1994. Although real estate development is unpredictable, the Company's 1994 new store growth represents a reasonable estimate of anticipated future growth. Capital expenditures for 1994, primarily made up of new store construction, the remodeling or expanding of several existing stores and the expansion and construction of distribution facilities, are expected to be approximately $400 million. This capital program is subject to continuing change and review. The 1994 capital expenditures are expected to be financed by internally generated funds and current liquid assets. In the normal course of operations, the Company replaces stores and closes unprofitable stores. The impact of future store closings is not expected to be material. The Company is self-insured, up to certain limits, for health care, fleet liability, general liability and workers' compensation claims. Reserves are established to cover estimated liabilities for existing and anticipated claims based on actual experience including, where necessary, actuarial studies. The Company has insurance coverage for losses in excess of varying amounts. The provision for self-insured reserves was $90.1 million, $78.7 million and $56.2 million in fiscal 1993, 1992 and 1991, respectively. The Company does not believe its self-insurance program will have a material adverse impact on its future liquidity, financial condition or results of operations. The Company has committed lines of credit for $75.0 million. These lines are reviewed annually by the banks. The interest rate for these lines is at or below the prime rate. No amounts were outstanding on the lines of credit as of December 25, 1993 or December 26, 1992. Cash generated in excess of the amount needed for current operations and capital expenditures is invested in short-term and long-term investments. Short-term investments were approximately $59.8 million in 1993 compared with $50.4 million in 1992. Long- term investments, primarily comprised of tax exempt bonds and preferred stocks, were approximately $199.4 million in 1993 compared with $126.8 million in 1992. Management believes the Company's liquidity will continue to be strong. The Company currently repurchases common stock at the stockholders' request in accordance with the terms of the Company's Employee Stock Purchase Plan. The Company expects to continue to repurchase its common stock, as offered by its stockholders from time to time, at its then currently appraised value. However, such purchases are not required and the Company retains the right to discontinue them at any time. Results of Operations The Company's fiscal year ends on the last Saturday in December. Fiscal years 1993, 1992 and 1991 included 52 weeks. Sales for fiscal 1993 were $7,472.7 million as compared with $6,664.3 million in fiscal 1992, a 12.1% increase. This reflects an increase of $426.5 million or 6.4% in sales from stores that were open for all of both years (comparable stores) and sales of $381.9 million or 5.7% from the net impact of 29 new stores and four closed stores. This activity contributed a net increase of 9.0% or approximately 1.50 million square feet in retail space. Sales for fiscal 1992 were $6,664.3 million as compared with $6,139.7 million in fiscal 1991, an 8.5% increase. This reflects an increase of $283.9 million or 4.6% in sales from stores that were open for all of both years (comparable stores) and sales of $240.7 million or 3.9% from the net impact of 23 new stores and 12 closed stores. This activity contributed a net increase of 5.9% or approximately .88 million square feet in retail space. This includes the acquisition of three stores from affiliated companies and the three stores closed as a result of extensive damage caused by Hurricane Andrew. In 1992, the Company identified potential environmental problems relating to properties that are owned or leased. Other income, net includes $8.0 million which was accrued for estimated clean-up costs. On August 24, 1992, Hurricane Andrew destroyed three of the Company's stores in south Florida. Several other stores sustained varying degrees of damage but were operational within four weeks. In management's opinion, the resulting property damage and business interruption losses are substantially covered by insurance and are immaterial to the Company's financial position and operations. Cost of merchandise sold including store occupancy, warehousing and delivery expenses was approximately 78.1% of sales in 1993 as compared with 77.8% and 77.3% in 1992 and 1991, respectively. In 1993 and 1992, cost of merchandise sold increased as a percent of sales due to competitive pressures. Operating and administrative expenses, as a percent of sales, were 19.1%, 19.3% and 19.9% in 1993, 1992 and 1991, respectively. In 1993, the Company's workers' compensation expense increased approximately $17.5 million or 89% as compared to 1992 due to increases in claim payments and estimated reserves for claim payments. The significant components of operating and administrative expenses are payroll costs, employee benefits and depreciation. In August 1993, the "Omnibus Budget Reconciliation Act of 1993" became effective. The major provision of the new tax law affecting the Company is the increase in the maximum corporate income tax rate from 34% to 35%. This 1% increase in the tax rate was retroactive to January 1, 1993. Therefore, in accordance with Financial Accounting Standard No. 109, "Accounting for Income Taxes," the Company recognized an additional $3.5 million income tax expense during fiscal year 1993. In recent years, the impact of inflation on the Company's food prices continues to be lower than the overall increase in the Consumer Price Index. New Accounting Standards The Company adopted Statement 109, without restating prior years' financial statements, in the first quarter of 1993. This Standard requires a change from the deferred method to the asset and liability method of accounting for income taxes. The cumulative effect of the change in method resulted in a reduction of deferred Federal and state income taxes and an increase in net earnings of approximately $11.8 million. The Company adopted Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in the first quarter of 1993. This Standard requires that an employer's obligation for postretirement benefits be fully accrued by the date the employees attain full eligibility to receive these benefits. The Company provides certain life insurance benefits for retired employees. Employees become eligible for these benefits when they reach normal retirement age while working for the Company. The cumulative effect of the change in method resulted in a decrease in net earnings of approximately $15.3 million. At the beginning of 1993, the accumulated postretirement obligation accrued was $24.6 million. During 1993, the Company's accrual increased approximately $1.9 million in additional annual costs under the new Standard. In May 1993, the Financial Accounting Standards Board issued Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. This Standard expands the use of fair value accounting for certain debt securities that are classified as available-for-sale or trading but retains the use of the amortized cost method for investments in debt securities that the Company has the positive intent and ability to hold to maturity. The Company will prospectively adopt Statement 115 in the first quarter of 1994. This Standard is not expected to materially affect the Company's financial statements. In November 1992, the Financial Accounting Standards Board issued Financial Accounting Standard No. 112, "Employers' Accounting for Postemployment Benefits," effective for fiscal years beginning after December 15, 1993. This Standard requires the accrual of a liability for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. The Company has historically accrued postemployment benefits; therefore, the adoption of Statement 112 will not materially affect the Company's financial statements. Item 8.

Item 8. Financial Statements and Supplemental Data The Company's financial statements, together with the independent auditors' report thereon, are included in the section following Part IV of this report. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 10.

Item 10. Directors, Executive Officers, Promoters and Control Persons of the Registrant Certain information concerning the directors of the Company is incorporated by reference to pages 2 through 5 of the Proxy Statement of the Company (1994 Proxy Statement) which the Company intends to file no later than 120 days after its fiscal year end. Certain information concerning the executive officers of the Company is set forth in Part I under the caption "Executive Officers of the Company." Item 11.

Item 11. Executive Compensation Information regarding executive compensation is incorporated by reference to pages 6 through 9 of the 1994 Proxy Statement. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth, as of March 4, 1994, the information with respect to common stock ownership of all Directors, including some who are 5% or more beneficial owners, and all Officers and Directors as a group. Also, listed are others known by the Company to own beneficially 5% or more of the shares of the Company's common stock. Note references are explained on the next two pages. *Shares represent less than 1% of class (1) As used in the table on the preceding page, "beneficial ownership" means the sole or shared voting or investment power with respect to the Company's common stock. Holdings of officers include shares allocated to their individual accounts in the Company's Employee Stock Ownership Plan, over which each officer exercises sole voting power and shared investment power. In accordance with the beneficial ownership regulations, the same shares of common stock may be included as beneficially owned by more than one individual or entity. The address for all beneficial owners is 1936 George Jenkins Boulevard, Lakeland, Florida 33801. (2) Excludes shares of common stock beneficially owned by Carol Jenkins Barnett's husband, as to which Carol Jenkins Barnett disclaims beneficial ownership. (3) Hoyt R. Barnett is Trustee of the Profit Sharing Plan which is the record owner of 23,278,750 shares of common stock over which he exercises sole voting and investment power. Total shares beneficially owned excludes shares of common stock owned by Hoyt R. Barnett's wife, as to which Hoyt R. Barnett disclaims beneficial ownership. (4) Mark C. Hollis is Co-Trustee with Peoples Bank of Lakeland for 1,577,699 shares of common stock in three family trusts. The remaining shares are owned in a separate family trust over which Mark C. Hollis is Co-Trustee with his wife. As Co-Trustee, Mark C. Hollis has shared voting and investment power for these shares. (5) Howard M. Jenkins is Voting Trustee of a Voting Trust Agreement (Agreement), effective May 30, 1987, established by him, his brother and two of his sisters. The Agreement, as amended, has a ten year term and covers 45,733,983 shares of common stock, of which 13,887,305 shares are beneficially owned by Howard M. Jenkins and 14,185,405 shares are beneficially owned by Nancy E. Jenkins. The remaining shares held under the Agreement are owned by various individuals who are not beneficial owners of 5% or more of the Company's common stock. As Trustee, Howard M. Jenkins has voting power for the shares represented by the Agreement unless the stockholders of a majority of the shares direct him to vote all shares in a specified manner. In addition, Howard M. Jenkins beneficially owns 571,940 shares of common stock which are either individually owned or owned as Trustee for three trusts over which he exercises sole voting and investment power. (6) William H. Vass is Trustee of the Employee Stock Ownership Plan (ESOT) which is the record owner of 27,610,780 shares of common stock over which he has shared investment power. As Trustee, William H. Vass exercises sole voting power over 545,249 shares in the ESOT because such shares have not been allocated to participants' accounts. The ESOT participants, not William H. Vass, exercise sole voting power over all remaining shares in the ESOT. (7) Includes 50,889,530 shares of common stock owned by the Profit Sharing Plan and ESOT. (8) Includes 14,185,405 shares of common stock which are held in and subject to the Voting Trust Agreement, effective May 30, 1987, for which Howard M. Jenkins is Voting Trustee. Item 13.

Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions is incorporated by reference to pages 2 through 5 and 9 of the 1994 Proxy Statement. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial Statements and Schedules The financial statements and schedules listed in the accompanying Index to Financial Statements and Schedules are filed as part of this Annual Report on Form 10-K. (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the fourth quarter of the year ended December 25, 1993. (c) Exhibits 3(a). Articles of Incorporation of the Company, together with all amendments thereto are incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K, as amended, for the year ended December 26, 1987. Articles of Amendment of the Restated Articles of Incorporation of the Company filed with the Secretary of the State of Florida, effective June 9, 1993 is incorporated herein. 3(b). By-laws of the Company are incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K, as amended, for the year ended December 26, 1987. 9. Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 31, 1988. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective March 8, 1990, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 30, 1989. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective June 14, 1991, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 28, 1991. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective November 3, 1992, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 26, 1992. Amendment to Voting Trust Agreement dated September 12, 1986, between Howard M. Jenkins, Julia J. Fancelli, Nancy E. Jenkins and David F. Jenkins, effective February 26, 1993, is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 26, 1992. 18. Letter regarding change in accounting principle is incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K for the year ended December 26, 1992. 27. Financial Data Schedule for the year ended December 25, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PUBLIX SUPER MARKETS, INC. March 15, 1994 By: ------------------------------ Keith Billups Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. PUBLIX SUPER MARKETS, INC. Index to Financial Statements and Schedules Independent Auditors' Report Financial Statements: Balance Sheets - December 25, 1993 and December 26, 1992 Statements of Earnings - Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Statements of Stockholders' Equity - Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Statements of Cash Flows - Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Notes to Financial Statements The following supporting schedules of Publix Super Markets, Inc. for the years ended December 25, 1993, December 26, 1992 and December 28, 1991 are submitted herewith: Schedules: V - Property, Plant and Equipment VI - Accumulated Depreciation of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. INDEPENDENT AUDITORS' REPORT To The Stockholders Publix Super Markets, Inc.: We have audited the financial statements of Publix Super Markets, Inc. as listed in the accompanying index. In connection with our audits of the financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Publix Super Markets, Inc. as of December 25, 1993, and December 26, 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 25, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 1 of the notes to financial statements, the Company changed its methods of accounting for postretirement benefits and income taxes during 1993 and, during 1992 changed its method of depreciation for all newly acquired fixed assets. KPMG PEAT MARWICK Tampa, Florida March 9, 1994 PUBLIX SUPER MARKETS, INC. Balance Sheets December 25, 1993 and December 26, 1992 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Balance Sheets December 25, 1993 and December 26, 1992 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Statements of Earnings Years ended December 25, 1993, December 26, 1992 and December 28, 1991 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Statements of Stockholders' Equity Years ended December 25, 1993, December 26, 1992 and December 28, 1991 See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Statements of Cash Flows Years ended December 25, 1993, December 26, 1992 and December 28, 1991 See accompanying notes to financial statements. (Continued) PUBLIX SUPER MARKETS, INC. Statements of Cash Flows (Continued) See accompanying notes to financial statements. PUBLIX SUPER MARKETS, INC. Notes to Financial Statements December 25, 1993, December 26, 1992 and December 28, 1991 (1) Summary of Significant Accounting Policies (a) Definition of Fiscal Year The fiscal year ends on the last Saturday in December. Fiscal years 1993, 1992 and 1991 comprised 52 weeks. (b) Cash Equivalents The Company considers all liquid investments with maturities of three months or less to be cash equivalents. (c) Investments Short and long-term investments are recorded at the lower of cost or market. The Company will adopt Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," in the first quarter of 1994. This Standard is not expected to materially affect the Company's financial statements. (d) Investment in Joint Ventures The Company has invested in joint ventures to develop shopping centers. The investment in these joint ventures is accounted for using the equity method. (e) Inventories Inventories are valued at cost (principally the dollar value last-in, first-out method) including store inventories which are calculated by the retail method. (f) Property, Plant and Equipment and Depreciation Maintenance and repairs are charged to expense as incurred. Expenditures for renewals and betterments are capitalized. The gain or loss on traded items is applied to the asset accounts or reflected in income for disposed items. Prior to fiscal year 1992, depreciation was computed for financial statement purposes by the declining balance and straight-line methods. During 1992, the Company adopted the straight-line method of depreciation for all newly acquired fixed assets. Assets acquired before 1992 continue to be depreciated using prior years' depreciation methods. The change to the straight-line method of depreciation was made to conform to predominant industry practice. Use of the straight-line method of depreciation on assets placed in service in 1993 and 1992, as compared with accelerated methods, resulted in an increase in earnings before income taxes of approximately $20,800,000 and $4,743,000 and in net earnings of approximately $10,848,000 or $.05 per share and $2,514,000 or $.01 per share in 1993 and 1992, respectively. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (g) Postretirement Benefits At the beginning of fiscal year 1993, the Company adopted Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," without restating prior years' financial statements. This Standard requires that an employer's obligation for postretirement benefits be fully accrued by the date the employees attain full eligibility to receive these benefits. The cumulative effect of the change in method of accounting for postretirement benefits has been reported in the 1993 statement of earnings (note 3). (h) Self-insurance Self-insurance reserves are established for heath care, fleet liability, general liability and workers' compensation claims. These reserves are determined based on actual experience including, where necessary, actuarial studies. The Company has insurance coverage for losses in excess of varying amounts. (i) Income Taxes At the beginning of fiscal year 1993, the Company adopted Financial Accounting Standard No. 109, "Accounting for Income Taxes," without restating prior years' financial statements. This Standard requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The cumulative effect of the change in method of accounting for income taxes has been reported in the 1993 statement of earnings (note 7). In prior years, the deferred method under APB Opinion 11 was applied. Under the deferred method, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Deferred taxes are not adjusted for subsequent changes in tax rates. (j) Related Parties Historically, the Company sold merchandise, performed various services and leased equipment and fixtures from two affiliated companies. In November 1992, the Company acquired these companies (note 6). (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (2) Merchandise Inventories If the first-in, first-out method of valuing inventories had been used by the Company, inventories and current assets would have been higher than reported by approximately $83,741,000, $87,012,000 and $89,930,000 as of December 25, 1993, December 26, 1992 and December 28, 1991, respectively. Also, net earnings would have decreased by approximately $1,706,000 or less than $.01 per share in 1993 and $1,547,000 or less than $.01 per share in 1992 and $712,000 or less than $.01 per share in 1991. (3) Postretirement Benefits The Company provides life insurance benefits for salaried and hourly full-time employees. Such employees retiring from the Company on or after attaining age 55 and having ten years of credited service are entitled to postretirement life insurance benefits. The Company funds the life insurance benefits on a pay-as-you-go basis. During 1993, the Company made benefit payments of approximately $1,233,000. As discussed in Note 1, the Company adopted Statement 106 at the beginning of fiscal year 1993. The accumulated postretirement obligation accrued was $24,607,000. The cumulative effect of this accounting change decreased net earnings by approximately $15,347,000. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements The accumulated postretirement benefit obligation calculated at the beginning of fiscal year 1993 was determined using an assumed discount rate of 8% and a salary increase rate of 4%. The accumulated postretirement benefit obligation as of December 25, 1993 was determined using an assumed discount rate of 7.25% and a salary increase rate of 4%. The change in the discount rate from 8% to 7.25% increased the accumulated postretirement benefit obligation by $3,892,000 and is expected to increase annual postretirement benefit costs by $455,000, beginning in 1994. (4) Common Stock Split On May 12, 1992, the Company's stockholders approved an increase in the number of authorized shares of common stock from 60,000,000 shares to 300,000,000 shares to effect a 5-for-1 stock split. All data in the accompanying financial statements has been restated to give retroactive effect for the stock split. (5) Profit Sharing Plan and Employee Stock Ownership Trust The Company has a trusteed, noncontributory profit sharing plan for the benefit of eligible employees. The amount of the Company's contribution to the plan is determined by the Board of Directors. The contribution cannot exceed 15% of compensation paid to participants. Contributions to the plan amounted to $33,976,000 in 1993, $29,867,000 in 1992 and $28,310,000 in 1991. The Company has an Employee Stock Ownership Trust (ESOT). Annual contributions to the ESOT are determined by the Board of Directors and can be made in Company stock or cash. In 1993, the Company contributed 2,000,000 shares of its common stock to the ESOT at an appraised value resulting in an expense to the Company of $22,000,000. In 1992, the Company contributed $21,200,000 in cash to the ESOT. In 1991, the Company contributed 2,000,000 shares of its common stock to the ESOT at an appraised value resulting in an expense to the Company of $18,600,000. During 1993, 1992 and 1991, the Board of Directors approved additional contributions to the ESOT of $16,983,000, $14,923,000 and $14,126,000, respectively. The additional contributions are made to the ESOT during the subsequent year. The Company intends to continue the profit sharing plan and ESOT indefinitely; however, the right to modify, amend or terminate these plans has been reserved. In the event of termination, all amounts contributed under the plans must be paid to the participants or their beneficiaries. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (6) Acquisition In November 1992, the Company issued 611,144 shares of its common stock valued at approximately $7,028,000 for all of the outstanding common stock of two affiliated companies, Publix Food Stores, Inc. and Publix Market, Inc. The merger was accounted for as a combination of companies under common control and therefore treated in a manner similar to the pooling-of-interests method. Acquired assets of approximately $6,022,000 and liabilities of approximately $3,916,000 were recorded at historical amounts. The acquisition was considered immaterial and thus the fiscal year 1992 financial statements include the assets, liabilities, results of operations and cash flows from the acquisition date to year end. (7) Income Taxes As discussed in Note 1, the Company adopted Statement 109 at the beginning of fiscal year 1993. The cumulative effect of this accounting change resulted in a reduction of deferred Federal and state income taxes and an increase in net earnings of approximately $11,853,000. The provision for income taxes consists of the following: (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements Income tax expense amounted to $104,898,000 for 1993 (an effective rate of 36.3%), $87,222,000 for 1992 (an effective rate of 34.4%) and $82,019,000 for 1991 (an effective rate of 34.2%). The actual expense for 1993, 1992 and 1991 differs from the "expected" tax expense for those years (computed by applying the U.S. Federal corporate tax rate of 35% for 1993 and 34% for 1992 and 1991 to earnings before income taxes) as follows: The significant components of deferred income taxes and their tax effects for 1993, 1992 and 1991 are as follows: The "Omnibus Budget Reconciliation Act of 1993" included various rule changes and increased the maximum corporate income tax rate from 34% to 35%, effective January 1, 1993. The impact of the new tax law increased the Company's 1993 income tax expense by $3,484,000. This included $2,514,000 attributable to the new tax rate on current income and $970,000 resulting from an adjustment of deferred tax balances. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities as of December 25, 1993 are as follows: As of December 25, 1993, the Company had net noncurrent deferred tax liabilities of $63,409,000 and current deferred tax assets of $25,299,000. The Company expects the results of future operations to generate sufficient taxable income to allow utilization of deferred tax assets. (8) Fair Value of Financial Instruments The following methods and assumptions were used by the Company in estimating the fair value for its financial instruments: Cash and cash equivalents: The carrying amount for cash and cash equivalents approximates fair value. Investment securities: The fair value for marketable debt and equity securities are based on quoted market prices. Long-term debt, including current installments: The carrying amount for long-term debt approximates fair value based on current interest rates. The carrying amount and fair value of the Company's financial instruments as of December 25, 1993 and December 26, 1992 are as follows: (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (9) Commitments and Contingencies (a) Operating Leases The Company conducts a major portion of its retail operations from leased store and shopping center premises generally under 20 year leases. Contingent rentals paid to lessors of certain store facilities are determined on the basis of a percentage of sales in excess of stipulated minimums plus, in certain cases, reimbursement of taxes and insurance. Total rental expense, net of sublease rental income, for the years ended December 25, 1993, December 26, 1992 and December 28, 1991 is as follows: As of December 25, 1993, future minimum lease payments for all noncancelable operating leases and related subleases are as follows: The Company also owns shopping centers which are leased to tenants for fixed monthly rentals. Contingent rentals received from certain tenants are determined on the basis of a percentage of sales in excess of stipulated minimums plus, in certain cases, taxes. Contingent rentals were estimated at December 25, 1993 and are included in trade receivables. Rental income was approximately $7,624,000 in 1993, $7,034,000 in 1992 and $6,454,000 in 1991. The approximate amounts of minimum future rental payments to be received under operating leases are $5,927,000, $4,845,000, $3,985,000, $2,874,000 and $2,212,000 for the years 1994 through 1998, respectively, and $9,061,000 thereafter. (b) Lines of Credit The Company has committed lines of credit for $75,000,000 available for short-term borrowings, with interest rates at or below the prime rate. There were no amounts outstanding as of December 25, 1993 or December 26, 1992. The Company pays no fees related to these lines. (Continued) PUBLIX SUPER MARKETS, INC. Notes to Financial Statements (c) Litigation On January 19, 1993, the Equal Employment Opportunity Commission ("EEOC") applied to the United States District Court, Southern District of Florida in Miami, for an order to show cause why an administrative subpoena previously issued by the EEOC to the Company should not be enforced (EEOC v. Publix Super Markets, Inc., Case No. 93-0091). The application, among other things, alleged that information previously supplied by the Company to the EEOC did not fully comply with the subpoena and that the EEOC was entitled to require the Company to compile additional information and produce additional documents. The matter was resolved by a Consent Order, with which the Company complied, resulting in an order on June 17, 1993 dismissing the action. This application arose out of a notice of charge issued by the EEOC on March 25, 1992, In the Matter of: Kemp v. Publix Super Markets, Inc., Charge No. ###-##-####, alleging that the Company had engaged in past violations and was engaged in continuing violations of Title VII of the Civil Rights Act, as amended, by discriminating against women with respect to job assignments and promotions because of their sex. As currently amended, the charge covers employment practices by the Company in the State of Florida as a whole. On December 6, 1993, the EEOC sought to expand the scope of its investigation to include allegations of race discrimination. The EEOC has requested the Company to compile information and produce documents relating to these allegations. The Company has objected to the expansion and the EEOC has agreed to substantial reductions in the information requested and further discussions as to additional reductions in the information requested are pending. The Company denies the allegations of the charge and the subsequent attempted expansion of the charge. The EEOC has advised that the charge does not in any respect constitute a final finding of a violation, but that the EEOC has a statutory duty to conduct a full and impartial investigation for the purpose of determining whether the facts and circumstances afford the EEOC reasonable cause to believe that the Company's employment patterns and practices constitute discrimination on the basis of sex and race. The EEOC's investigation of the charge remains at the stage of considering whether there is reasonable cause to believe the allegations of the charge. At this early stage, the likelihood of an adverse finding of the Company's liability and an estimate of the amount of any exposure for any such liability cannot be determined. The Company is also a party in various legal claims and actions considered in the normal course of business. Management believes that the ultimate disposition of these matters will not have a material effect on the Company's financial condition. Schedule V PUBLIX SUPER MARKETS, INC. Property, Plant and Equipment Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) (Continued) Schedule V PUBLIX SUPER MARKETS, INC. Property, Plant and Equipment Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) Notes: (1) Fully depreciated assets written off. (2) Transfer from construction in progress. (3) Accumulated depreciation on fixed assets of acquired companies. Schedule VI PUBLIX SUPER MARKETS, INC. Accumulated Depreciation of Property, Plant and Equipment Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) Note: (1) Accumulated depreciation on fully depreciated assets written off. (2) Accumulated depreciation on fixed assets of acquired companies. Schedule VIII PUBLIX SUPER MARKETS, INC. Valuation and Qualifying Accounts Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 (Amounts in thousands) Schedule IX PUBLIX SUPER MARKETS, INC. Short-term Borrowings Years Ended December 25, 1993, December 26, 1992 and December 28, 1991 Notes: (1) Computed based on the daily balance outstanding during the year. (2) Computed by dividing interest expense for the year by the average amount outstanding for the year. PUBLIX SUPER MARKETS, INC. Index to Exhibits EXHIBIT 3A Restated Articles of Incorporation of the Company as incorporated by reference to the exhibits to the Annual Report of the Company on Form 10-K, as amended, for the year ended December 26, 1987 (restated in electronic format). Articles of Amendment of the Restated Articles of Incorporation of the Company filed with the Secretary of the State of Florida, effective June 9, 1993. EXHIBIT 27 Financial Data Schedule for the year ended December 25, 1993.

92195_1993.txt

92195

1993

Item 1. BUSINESS GENERAL Southern Indiana Gas and Electric Company (Company) is an operating public utility incorporated June 10, 1912, under the laws of the State of Indiana, engaged in the generation, transmission, distribution and sale of electric energy and the purchase of natural gas and its transportation, distribution and sale in a service area which covers ten counties in southwestern Indiana. The Company has a wholly-owned nonutility investment subsidiary, Southern Indiana Properties, Inc. (refer to Note 3 of the Notes To Consolidated Financial Statements, page 35, for further discussion). Electric service is supplied directly to Evansville and 74 other cities, towns and communities, and adjacent rural areas. Wholesale electric service is supplied to an additional nine communities. At December 31, 1993, the Company served 118,163 electric customers, and was also obligated to provide for firm power commitments to the City of Jasper, Indiana, and to maintain spinning reserve margin requirements under an agreement with the East Central Area Reliability Group (ECAR). At December 31, 1993, the Company supplied gas service to 100,398 customers in Evansville and 63 other nearby communities and their environs. Since 1986, the Company has purchased its natural gas supply requirements from numerous suppliers. During 1993, twenty-five suppliers were used; however, Texas Gas Transmission Corporation (TGTC) remained the Company's primary contract supplier. In November 1993, TGTC restructured its services so that its gas supplies are sold separately from its interstate transportation services. TGTC ceased to be a supplier of natural gas to the Company, and the Company assumed full responsibility for the purchase of all its natural gas supplies. (See subsequent reference under "Gas Business" to the restructuring of interstate pipelines.) During 1993, eighteen of the Company's major gas customers took advantage of the Company's gas transportation program to procure a portion of their gas supply needs from suppliers other than the Company. The principal industries served by the Company include aluminum smelting and recycling, aluminum sheet products, polycarbonate resin (Lexan) and plastic products, appliance manufacturing, pharmacuetical and nutritional products, automotive glass, gasoline and oil products, and coal mining. The only property the Company owns outside of Indiana is approximately eight miles of 138,000 volt electric transmission line which is located in Kentucky and which interconnects with Louisville Gas and Electric Company's transmission system at Cloverport, Kentucky. The original cost of the property is less than $425,000. The Company does not distribute any electric energy in Kentucky. LINES OF BUSINESS The percentages of operating revenues and operating income before income taxes attributable to the electric and gas operations of the Company for five years ended December 31, 1993, were as follows: ELECTRIC BUSINESS The Company supplies electric service to 118,163 customers, including 103,318 residential, 14,645 commercial, 177 industrial, 19 public street and highway lighting and four municipal customers. The Company's installed generating capacity as of December 31, 1993 was rated at 1,238,000 kilowatts (Kw). Coal-fired generating units provide 1,023,000 Kw of capacity and gas or oil-fired turbines used for peaking or emergency conditions provide 215,000 Kw. In addition, the Company has interconnections with Louisville Gas and Electric Company, Public Service Company of Indiana, Inc., Indianapolis Power & Light Company, Hoosier Energy Rural Electric Cooperative, Inc., Big Rivers Electric Corporation, and the City of Jasper, providing an ability to simultaneously interchange approximately 750,000 Kw. Record-breaking peak conditions occurred on July 28, 1993, when the Company's system summer peak load of 1,012,700 Kw was 6.5% greater than the previous record system summer peak load of 951,200 Kw established August 17, 1988. The Company's total load obligation for each of the years 1989 through 1993 at the time of the system summer peak, and the related capacity margin, are presented below. The Company's other load obligations at the time of the peak included firm power commitments to Alcoa Generating Corporation (AGC) except as noted, the City of Jasper, Indiana, and the Company's reserve margin requirements under the ECAR agreement. The all-time record system winter peak load of 771,900 Kw occurred during the 1989-1990 season on December 22, 1989, and was 10.8% greater than the 1992-1993 winter season system peak (the second highest winter peak) reached on February 18, 1993 at 696,800 Kw. The Company, primarily as agent of AGC, operates the Warrick Generating Station, a coal-fired steam electric plant which interconnects with the Company's system and provides power for the Aluminum Company of America's Warrick Operations, which includes aluminum smelting and fabricating facilities. Of the four turbine generators at the plant, Warrick Units 1, 2 and 3, with a capacity of 144,000 Kw each, are owned by AGC. Warrick Unit 4, with a rated capacity of 270,000 Kw, is owned by the Company and AGC as tenants in common, each having shared equally in the cost of construction and sharing equally in the cost of operation and in the output. The Company (a summer peaking utility) has an agreement with Hoosier Energy Rural Electric Cooperative, Inc. (Hoosier Energy) for the sale of firm power to Hoosier Energy during the annual winter heating season (November 15- March 15). The contract made available 100 Mw during the 1993-1994 winter season, and allows for a possible increase to 250 Mw by November 15, 1998. The contract will terminate March 15, 2000. Electric generation for 1993 was fueled by coal (99.8%) and natural gas (.2%). Oil was used only to light fires and stabilize flames in the coal-fired boilers and for testing of gas/oil fired peaking units. Historically, coal for the Company's Culley Generating Station and Warrick Unit 4 has been purchased from operators of nearby Indiana strip mines pursuant to long-term contracts. During 1991, the Company pursued negotiations for new contracts with these mine operators and while doing so, purchased coal from the respective operators under interim agreements. In October 1992, the Company finalized a new supply agreement effective through 1995 and retroactive to 1991, with one of the operators under which coal is supplied to both locations. Included in the agreement was a provision whereby the contract could be reopened by the Company for modification of certain coal specifications. In early 1993, the Company reopened the contract for such modifications. Effective July 1, 1993, the Company bought out the remainder of its contractual obligations with the supplier, enabling the Company to acquire lower priced spot market coal. The Company estimates the savings in coal costs during the 1991-1995 period, net of the total buyout costs, will approximate $56 million. The net savings are being passed back to the Company's electric customers through the fuel adjustment clause. The coal supplier retained the right of first refusal to supply Warrick Unit 4 and the Culley plant during the years 1996-2000. (See "Rate and Regulatory Matters" of Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 15, for further discussion of the contract buyout.) The Indiana coal used in these plants is blended by the vendor and delivered to the plants to meet quality specifications set in conformance with the requirements of the Indiana State Implementation Plan for sulfur dioxide. Approximately 1,572,000 tons of coal were used during 1993 in the generation of electricity at the Culley Station and Warrick Unit 4. (See discussion under "Environmental Matters", page 7.) For supplying the A. B. Brown Generating Station, the Company has a contested agreement, possibly extending to 1998, with an area producer. (See Item 3, LEGAL PROCEEDINGS, page 10 for discussion of litigation with this producer regarding the coal supply agreement.) The amount of coal burned at A. B. Brown Generating Station during 1993 was approximately 862,000 tons. Both units at the generating station are equipped with flue gas desulfurization equipment so that coal with a higher sulfur content can be used. There are substantial coal reserves in the southern Indiana area. The average cost of coal consumed in generating electrical energy for the years 1989 through 1993 was as follows: The Broadway Turbine Units 1 and 2, Northeast Gas Turbines and A. B. Brown Gas Turbine, when used for peaking, reserve or emergency purposes, use natural gas for fuel. Number 2 fuel oil can also be used in the Broadway Turbine Units and the Brown Gas Turbine. All metered electric rates contain a provision for adjustment in charges for electric energy to reflect changes in the cost of fuel and the net energy cost of purchased power through the operation of a fuel adjustment clause unless certain criteria contained in the regulations are not met. The principal restriction to recovery of fuel cost increases is that such recovery is not allowed to the extent that operating income for the twelve month period provided in the fuel cost adjustment filing exceeds the operating income authorized by the Indiana Utility Regulatory Commission (IURC) in the latest general rate case of the Company. During 1991-1993, this restriction did not affect the Company. As prescribed by order of the IURC, the adjustment factor is calculated based on the estimated cost of fuel and the net energy cost of purchased power in a designated future quarter. The order also provides that any over- or underrecovery caused by variances between estimated and actual cost in a given quarter will be included in the second succeeding quarter's adjustment factor. This continuous reconciliation of estimated incremental fuel costs billed with actual incremental fuel costs incurred closely matches revenues to expenses. The Company's primary goal in the area of research and development is cost savings through the use of new technologies. This is accomplished, in part, through the efforts of the Electric Power Research Institute (EPRI). In 1993, the Company paid $893,000 to EPRI to help fund research and development programs such as advanced clean coal burning technology. The Company is participating with 14 other electric utility companies, through Ohio Valley Electric Corporation (OVEC) in arrangements with the United States Department of Energy (DOE), to supply the power requirements of the DOE plant near Portsmouth, Ohio. The sponsoring companies are entitled to receive from OVEC, and are obligated to pay for the right to receive, any available power in excess of the DOE contract demand. The proceeds from the sale of power by OVEC are designed to be sufficient to meet all of its costs and to provide for a return on its common stock. During 1993, the Company's participation in the OVEC arrangements was 1.5%. The Company participates with 32 other utilities, located in eight states comprising the east central area of the United States, in the East Central Area Reliability Group, the purpose of which is to strengthen the area's electric power supply reliability. GAS BUSINESS The Company supplies natural gas service to 100,398 customers, including 91,476 residential, 8,682 commercial, 236 industrial and four public authority customers, through 2,520 miles of gas transmission and distribution lines. The Company owns and operates three underground gas storage fields with an estimated ready delivery from storage of 3.9 million Dth of gas. Natural gas purchased from the Company's suppliers is injected into these storage fields during periods of light demand which are typically periods of lower prices. The injected gas is then available to supplement the normal contract volume from the pipeline during periods of peak requirements. It is estimated that approximately 119,000 Dth of gas per day can be withdrawn from the three storage fields during peak demand periods on the system. The gas procurement practices of the Company and several of its major customers have been altered significantly during the past eight years as a result of changes in the natural gas industry. In 1985 and prior years, the Company purchased nearly its entire gas requirements from Texas Gas Transmission Corporation (TGTC) compared to 1993 when a total of 25 suppliers sold gas to the Company. In total, the Company purchased 17,270,415 Dth in 1993. Of this amount, 5,046,509 Dth, or 29%, was purchased from TGTC, which continued to be the Company's largest supplier and its major pipeline. In November 1993, TGTC restructured its services so that its gas supplies are sold separately from its interstate transportation services. TGTC ceased to be a supplier of natural gas to the Company, and the Company assumed full responsibility for the purchase of all its natural gas supplies. (See subsequent reference under "Gas Business" to the restructuring of interstate pipelines.) During 1993, eighteen of the Company's major gas customers took advantage of the Company's gas transportation program to procure a portion of their gas supply needs from suppliers other than the Company. A total of 11,370,542 Dth was transported for these major customers in 1993 compared to 9,497,059 Dth transported in 1992. The Company received fees for the use of its facilities in transporting such gas, allowing it to offset a portion of the loss of its customary sales margin with respect to these customers. (See "Rate and Regulatory Matters" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 15 of this report, for discussion of the Company's general adjustment in gas rates and for discussion of the FERC Order No. 636 which requires interstate pipelines to restructure their services so that gas supplies will be sold separately from interstate transportation services.) The all-time record send out occurred during the 1989- 1990 winter season on December 22, 1989, when 223,489 Dth of gas was delivered to the Company's customers. Of this amount, 89,614 Dth was purchased, 104,358 Dth was taken out of the Company's three underground storage fields, and 29,517 Dth was transported to customers under transportation agreements. The 1992-1993 winter season peak day send out was 189,717 Dth on February 17, 1993. The average cost per Dth of gas purchased by the Company during the past five calendar years was as follows: 1989, $2.84; 1990, $2.84; 1991, $2.71; 1992, $2.77; and 1993 $2.85. The State of Indiana has established procedures which result in the Company passing on to its customers the changes in the cost of gas sold unless certain criteria contained in the regulations are not met. The principal restriction to recovery of gas cost increases is that such recovery is not allowed to the extent that operating income for the twelve month period provided in the gas cost adjustment filing exceeds the operating income authorized by the IURC in the latest general rate case of the Company. During 1991-1993, this restriction did not affect the Company. Additionally, these procedures provide for scheduled quarterly filings and IURC hearings to establish the amount of price adjustments for a designated future quarter. The procedures also provide for inclusion in a later quarter of any variances between estimated and actual costs of gas sold in a given quarter. This reconciliation process with regard to changes in the cost of gas sold closely matches revenues to expenses. The Company's rate structure does not include a weather normalization-type clause whereby a utility would be authorized to recover the gross margin on sales established in its last general rate case, regardless of actual weather patterns. Natural gas research is supported by the Company through the Gas Research Institute in cooperation with the American Gas Association. Since passage of the Natural Gas Act of 1978, a major effort has gone into promoting gas exploration by both conventional and unconventional sources. Efforts continue through various projects to extract gas from tight gas sands, shale and coal. Research is also directed toward the areas of conservation, safety and the environment. On December 23, 1993, the Company entered into a definitive agreement to acquire Lincoln Natural Gas Company, Inc., a small gas distribution company of approximately 1,300 customers contiguous to the eastern boundary of the Company's gas service territory. The acquisition is expected to be completed by mid-1994, subject to necessary regulatory and shareholder approvals. NONUTILITY SUBSIDIARY During 1986, the Company formed a wholly-owned subsidiary, Southern Indiana Properties, Inc., which owns and/or operates certain nonutility assets. Currently included in the holdings of the subsidiary are an industrial park, investments in several leveraged-lease financing arrangements, investments in several tax oriented limited partnerships, a portfolio of financial investments (principally adjustable rate preferred stocks and municipal bonds), and other nonutility property. (See Note 3 of the Notes To Consolidated Financial Statements, page 35, for further discussion of Southern Indiana Properties, Inc.) PERSONNEL The Company's network of gas and electric operations directly involves 774 employees with an additional 190 employed at Alcoa's Warrick Power Plant. Alcoa reimburses the Company for the entire cost of the payroll and associated benefits at the Warrick Plant, with the exception of one-half of the payroll costs and benefits allocated to Warrick Unit 4, which is jointly owned by the Company and Alcoa. The total payroll and benefits for Company employees in 1993 (including all Warrick Plant employees) were $46.1 million, including $4.1 million of accrued postretirement benefits other than pensions which the Company is deferring as a regulatory asset until inclusion in rates. (See Note 1 of the Notes To Consolidated Financial Statements, page 29, for further discussion of the new financial accounting standard requiring recognition of these costs effective January 1, 1993 and related regulatory treatment.) In 1992, total payroll and benefits were $40.1 million. On July 3, 1991, the Company signed a new three-year contract with Local 702 of the International Brotherhood of Electric Workers. The contract provided for a 4% general wage increase each of the three years of the contract. Certain cost-containment measures related to health care coverage were adopted. Improvements in productivity, work practices and the pension plan are also provided. Additionally, the Company's Hoosier Division signed a three- year labor contract with Local 135 of the Teamsters, Chauffeurs, Warehousemen and Helpers effective January 14, 1992. The contract provided for a 4% general wage increase each of the first and second years of the contract and a 3.75% general wage increase the third year of the contract. Also provided are improvements in health care coverage costs, pension benefits, sick pay, work practices and productivity. CONSTRUCTION PROGRAM AND FINANCING A total of $80,109,000 was spent in 1993 on the Company's construction program, of which $68,840,000 was for the electric system, $5,772,000 for the gas system, $967,000 for common utility plant facilities, and $4,530,000 for the Demand Side Management (DSM) Program. (See "Demand Side Management" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, page 19.) Major construction project expenditures in 1993 included $49.2 million of the originally projected $115 million (including Allowance for Funds Used During Construction) Culley Unit 2 and 3 scrubber project which is scheduled to be completed by 1995. (See "Clean Air Act" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, page 18.) On May 11, 1993, the Company issued two series of adjustable rate first mortgage bonds totaling $45.0 million in connection with the sale of Warrick County, Indiana environmental improvement revenue bonds. The proceeds of the revenue bonds have been placed in trust are being used to finance a portion of the Culley scrubber project. (See "Liquidity and Capital Resources" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, page 20 for further discussion of this financing and discussion of the issuance of $110 million of first mortgage bonds used to refinance existing long-term debt.) No other securities were issued by the Company during 1993 for the purpose of funding its construction program. For 1994, construction expenditures are presently estimated to be $92.2 million which includes $8.7 million for DSM programs. Expenditures in the power production area are expected to total $55.8 million and include $41.7 million for the construction of the Culley scrubber project. The balance of the 1994 construction program consists of $14.9 million for additions and improvements to other electric system facilities, $8.1 million of additions and improvements to the gas system and $4.7 million for the final phase of the $27 million Norman P. Wagner operations complex and miscellaneous common utility plant buildings, fixtures and equipment. In keeping with the Company's objective to bring new facilities on line as needed, the construction program and amount of scheduled expenditures are reviewed periodically to factor in load growth projections, system balance requirements, environmental compliance and other considerations. As a result of this program of periodic review, construction expenditures may change in the future from the program as presented herein. For the five-year period of 1994-1998, it is estimated that construction expenditures will total about $270 million as follows: 1994 - $92 million; 1995 - $41 million; 1996 - $44 million; 1997 - $48 million; and 1998 - $45 million. This construction program reflects approximately $51 million for the Company's DSM programs and $44 million to meet the Phase I requirements of the Clean Air Act Amendments of 1990. While the Company expects the majority of the construction requirements and an estimated $48 million in debt security redemptions and other long-term obligations to be provided by internally generated funds, external financing requirements of $50-70 million are anticipated. The aforementioned amounts relating to the Company's construction program are in all cases inclusive of Allowance for Funds Used During Construction. REGULATION Operating as a public utility under the laws of Indiana, the Company is subject to regulation by the Indiana Utility Regulatory Commission as to its rates, services, accounts, depreciation, issuance of securities, acquisitions and sale of utility properties or securities, and in other respects as provided by the laws of Indiana. In addition, the Company is subject to regulation by the Federal Energy Regulatory Commission with respect to the classification of accounts, rates for its sales for resale, interconnection agreements with other utilities, and acquisitions and sale of certain utility properties as provided by the laws of the United States. See "Electric Business" and "Gas Business" for further discussion regarding regulatory matters. The Company is subject to regulations issued pursuant to federal and state laws, pertaining to air and water pollution control. The economic impact of compliance with these laws and regulations is substantial, as discussed in detail under "Environmental Matters." The Company is also subject to multiple regulations issued by both federal and state commissions under the Federal Public Utility Regulatory Policies Act of 1978. As a result of the Company's ownership of 33% of Community Natural Gas Company, the Company is a "Holding Company" as such term is defined under the Public Utility Holding Company Act of 1935 (the 1935 Act). The Company is exempt from all provisions of the 1935 Act except for the provisions of Section 9(A)(2), which pertains to acquisitions of other utilities. COMPETITION The Company does not presently compete for electric or gas customers with the other utilities within its assigned service areas. As a result of changes brought about by the National Energy Policy Act of 1992, the Company may be required to compete (or have the opportunity to compete) with other utilities and wholesale generators for sales of electricity to existing wholesale customers of the Company and other potential wholesale customers. (See subsequent reference to discussion of this recent legislation.) The Company currently competes with other utilities in connection with intersystem bulk power rates. Some of the Company's customers have, or in the future could acquire, access to energy sources other than those available through the Company. (See "Gas Business", page 4, for discussion of gas transportation.) Although federal statute allows for bypass of a local distribution (gas utility) company, Indiana law disallows bypass in most cases and the Company would likely litigate such an attempt in the Indiana courts. Additionally, the Company's geographical location in the corner of the state, surrounded on two sides by rivers, limits customers' ability to bypass the Company (by running long pipelines). There is also increasing interest in research on the development of sources of energy other than those in general use. Such competition from other energy sources has not been a material factor to the Company in the past. The Company is unable, however, to predict the extent of competition in the future or its potential effect on the Company's operations. As part of its efforts to develop a National Energy Strategy, Congress has amended the Public Utility Holding Company Act and the Federal Power Act by enacting the National Energy Policy Act of 1992 (the Act), which will affect the traditional structure of the electric utility industry. (Refer to "National Energy Policy Act of 1992" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 18 of this report, for discussion of the major changes in the electric industry effected by the Act.) ENVIRONMENTAL MATTERS The Company is currently investigating the possible existence of facilities once owned and operated by the Company, its predecessors, previous landowners, or former affiliates of the Company utilized for the manufacture of gas. Refer to "Environmental Matters" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 17 of this report, for discussion of the Company's actions regarding the investigation. The Company is subject to federal, state and local regulations with respect to environmental matters, principally air, solid waste and water quality. Pursuant to environmental regulations, the Company is required to obtain operating permits for the electric generating plants which it owns or operates and construction permits for any new plants which it might propose to build. Regulations concerning air quality establish standards with respect to both ambient air quality and emissions from the Company's facilities, including particulate matter, sulfur dioxide and nitrogen oxides. Regulations concerning water quality establish standards relating to intake and discharge of water from the Company's facilities, including water used for cooling purposes in electric generating facilities. Because of the scope and complexity of these regulations, the Company is unable to predict the ultimate effect of such regulations on its future operations, nor is it possible to predict what other regulations may be adopted in the future. The Company intends to comply with all applicable valid governmental regulations, but will contest any regulation it deems to be unreasonable or impossible to comply with or which is otherwise invalid. The implementation of federal and state regulations designed to protect the environment, including those hereinafter referred to, involves or may involve review, certification or issuance of permits by federal and state agencies. Compliance with such regulations may limit or prevent certain operations or substantially increase the cost of operation of existing and future generating installations, as well as seriously delay or increase the cost of future construction. Such compliance may also require substantial investments above those amounts stated under "Construction Program and Financing", page 5. All existing Company facilities have operating permits from the Indiana Air Board. In order to secure approval for these permits, the Company has installed electrostatic precipitators on all coal-fired units and is operating flue gas desulfurization (FGD) units to remove sulfur dioxide from the flue gas at its A. B. Brown Units 1 and 2 generating facilities. The FGD units at the Brown Station remove most of the sulfur dioxide from the flue gas emissions by way of a scrubbing process, thereby allowing the Company to burn high sulfur southern Indiana coal at the station. Under the Federal Clean Air Act (the Act), states are authorized to adopt implementation plans to fulfill the requirements of the Act. These state plans are subject to approval by the U. S. Environmental Protection Agency (EPA). In 1972, Indiana adopted stringent regulations which comprise the State Implementation Plan (SIP) for attaining ambient air standards for particulates, sulfur dioxide and nitrogen oxides. The EPA approved that part of the SIP which sets forth emission standards, fixes time schedules for compliance with such standards and designates air quality regions for the State. The SIP was revised in 1979 to reflect revision of the Act and the State submitted the revised plan to the EPA for approval. On August 10, 1986, the Sierra Club filed a lawsuit against the EPA under Civil No. NA86-194-C seeking declaratory and injunctive relief to compel the EPA to take action pursuant to the Act to reduce sulfur dioxide emissions from power plants in Indiana including the Company's Warrick Unit 4 and Culley Generating Station. In settlement of this suit, the EPA agreed that there would be a SIP for the State by November 1988. The EPA gave final approval on December 16, 1988 to the Warrick County sulfur dioxide emission limits which had been approved by the Indiana Air Pollution Control Board. The ruling provided for the reduction of sulfur dioxide emissions from the two Warrick County generating stations, Warrick and Culley, to take place in two phases. The first reduction, required by December 31, 1989, provided that sulfur dioxide emissions from all units at both stations be reduced to 5.41 lb/MMBTU from 6.00 lb/MMBTU. Under the second phase, which was effective August 1, 1991, sulfur dioxide emissions from Culley Units 1 and 2 had to be decreased to 2.79 lb/MMBTU, Culley Unit 3 was allowed to remain at 5.41 lb/MMBTU, and emissions from all units at the Warrick Generating Station had to be reduced to 5.11 lb/MMBTU. The Company is currently in compliance with these provisions. In October 1990, the U.S. Congress adopted major revisions to the Act. The revisions impose significant restrictions on future emissions of sulfur dioxide (SO2) and nitrogen oxide (NOX) from coal-burning electric generating facilities, including those owned and operated by the Company. The legislation severely affects electric utilities, especially those in the Midwest. Two of the Company's principal coal-fired facilities (A. B. Brown Units 1 and 2, totaling 500 megawatts of capacity) are presently equipped with sulfur dioxide removal equipment (scrubbers) and are not expected to be severely affected by the new legislation. However, 523 megawatts of the Company's coal- fired generating capacity will be significantly impacted by the lower emission requirements. The Company will be required to reduce total emissions from Culley Unit 3 (250 megawatts), Warrick Unit 4 (135 megawatts) and Culley Unit 2 (92 megawatts) by approximately 50% to 2.5 lb/MMBTU by January 1995 (Phase I) and to 1.2 lb/MMBTU by January 2000 (Phase II). In addition, Unit 1 at Culley Station (46 megawatts) is also subject to the 1.2 lb/MMBTU restriction by January 2000. The legislation includes various incentives to promote the installation of scrubbers on units affected by the 1995 deadline. Current regulatory policy allows for the recovery through rates of all authorized and approved pollution control expenditures. (Refer to "Clean Air Act" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 18 of this report, for discussion of the Company's Clean Air Act Compliance Plan, which was filed with the IURC on January 3, 1992 and approved October 14, 1992, and the associated estimated costs.) In connection with the use of sulfur dioxide removal equipment at the A. B. Brown Generating Station, the Company operates a solid waste landfill for the disposal of approximately 200,000 tons of residue per year from the scrubbing process. Renewal of the landfill operating permit was granted in March 1992 by the Indiana Department of Environmental Management (IDEM). The permit expires in January 1997. Additionally, IDEM granted the Company's request for modification (expansion) of the landfill, issuing the construction permit in March 1992. Under the Federal Water Pollution Control Act of 1972 and Indiana law and regulations, the Company is required to obtain permits to discharge effluents from its existing generating stations into the navigable waterways of the United States. The State of Indiana has received authorization from the EPA to administer the Federal discharge permits program in Indiana. Variances from effluent limitations may be granted by permit on a plant-by- plant basis where the utility can establish the limitations are not necessary to assure the protection of aquatic life and wildlife in and on the body of water into which the discharge is to be made. The Company has been granted National Pollution Discharge Elimination System (NPDES) permits covering miscellaneous waste water and thermal discharges for all its generating facilities to which the NPDES is applicable, namely the Culley Station, A. B. Brown Station and Warrick Unit 4. Such discharge permits are limited in time and must be renewed at five-year intervals. During 1989, the Company was granted renewed five-year permits for effluent discharge for such generating facilities, which are required to be renewed again in 1994. At present there are no known enforcement proceedings concerning water quality pending or threatened against the Company. EXECUTIVE OFFICERS OF THE COMPANY The executive officers of the Company are elected at the annual organization meeting of the Board of Directors, held immediately after the annual meeting of stockholders, and serve until the next such organization meeting, unless the Board of Directors shall otherwise determine, or unless a resignation is submitted. Item 2.

Item 2. PROPERTIES The Company's installed generating capacity as of December 31, 1993 was rated at 1,238,000 Kw. The Company's coal-fired generating facilities are: the Brown Station with 500,000 Kw of capacity, located in Posey County about eight miles east of Mt. Vernon, Indiana; the Culley Station with 388,000 Kw of capacity, and Warrick Unit 4 with 135,000 Kw of capacity. Both the Culley and Warrick Stations are located in Warrick County near Yankeetown, Indiana. The Company's gas-fired turbine peaking units are: the 80,000 Kw Brown Gas Turbine located at the Brown Station; two Broadway Gas Turbines located in Evansville, Vanderburgh County, Indiana, with a combined capacity of 115,000 Kw; and, two Northeast Gas Turbines located northeast of Evansville in Vanderburgh County, Indiana with a combined capacity of 20,000 Kw. The Brown and Broadway turbines are also equipped to burn oil. Total capacity of the Company's five gas turbines is 215,000 Kw and are generally used only for reserve, peaking or emergency purposes due to the higher per unit cost of generation. The Company's transmission system consists of 871 circuit miles of 138,000, 69,000 and 36,000 volt lines. The transmission system also includes 26 substations with an installed capacity of 3,874,724 kilovolt amperes (Kva). The electric distribution system includes 3,177 pole miles of lower voltage overhead lines and 180 trench miles of conduit containing 987 miles of underground distribution cable. The distribution system also includes 86 distribution substations with an installed capacity of 1,306,508 Kva and 45,057 distribution transformers with an installed capacity of 1,771,152 Kva. The Company owns and operates three underground gas storage fields with an estimated ready delivery from storage capability of 3.9 million Dth of gas. The Oliver Field, in service since 1954, is located in Posey County, Indiana, about 13 miles west of Evansville. The Midway Field is located in Spencer County, Indiana, about 20 miles east of Evansville near Richland, Indiana, and was placed in service in December 1966. The third field is the Monroe City Field, located in Knox County, about 10 miles east of Vincennes, Indiana. The field was placed in service in 1958. The Company's gas transmission system includes 324 miles of transmission mains, and the gas distribution system includes 2,196 miles of distribution mains. The Company's properties, but not those of its subsidiary, are subject to the lien of the First Mortgage Indenture dated as of April 1, 1932 between the Company and Bankers Trust Company, New York, as Trustee, as supplemented by various supplemental indentures, all of which are exhibits to this report and collectively referred to as the "Mortgage". Item 3.

Item 3. LEGAL PROCEEDINGS. On January 27, 1993, a coal supplier filed a complaint in the Federal District Court for the Southern District of Indiana alleging that the Company breached a coal supply contract between the Company and that supplier. The Company had notified the supplier that it would not require any delivery of coal under the contract for at least some part of 1993. The supplier claims that this action violates certain minimum purchase requirements imposed by the contract, and asked the court to require specific performance of the contract by the Company and for unspecified monetary damages. The complaint alleges that the Company is obligated to purchase coal at a minimum rate of 50,000 tons per month under the contract and at any event to purchase all of the coal consumed at the Company's A. B. Brown generating plant below 1,000,000 tons per year. The contested contract may run until December 31, 1998. The Company filed counterclaims and disputes that its actions have violated the terms of the contract. On March 26, 1993, the Company and the coal supplier agreed to resume coal shipments but with the invoiced price per ton substantially lower than the contract price and subject to final outcome of the litigation. (Refer to "Rate and Regulatory Matters" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 15 of this report, for discussion of the pricing of this coal to inventory and the associated ratemaking treatment.) On June 6, 1993, the coal supplier won a summary judgement to require the Company to take a minimum of 600,000 tons annually, more or less in equal weekly shipments. The decision cannot be appealed until resolution of other contract provisions still before the court. There are no other pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant is a party. No material legal proceedings were terminated during the fourth quarter of 1993. Item 4.

Item 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS. None PART II Item 5.

Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The principal market on which the registrant's common stock (Common Stock) is traded is the New York Stock Exchange, Inc. where the Common Stock is listed. The high and low sales prices for the stock as reported in the consolidated transaction reporting system for each quarterly period during the two most recent fiscal years are: As of February 4, 1994 there were 9,445 holders of record of Common Stock. Dividends declared and paid per share of Common Stock during the past two years were: Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION Earnings per share of $2.45 in 1993 were the highest in Company history, following 1992 earnings of $2.26. The record 1993 earnings exceeded the previous all-time high of $2.37 in 1991 by 3%. The 1993 earnings were favorably impacted by higher operating revenues due to weather-related increases in retail gas and electric sales. Greater maintenance and nonfuel-related operating expenses and fewer sales to wholesale electric customers partially offset the impact of the higher retail sales. Increased allowance for funds used during construction resulting from the Company's expanded construction program also contributed to the higher earnings. For the thirty-fifth consecutive year, the Board of Directors declared a dividend increase to common shareholders at its January 1994 meeting. Payable in March 1994, the Company's new quarterly dividend is 41-1/4cents per share, increasing the indicated annual rate to $1.65 per share. ELECTRIC OPERATIONS. The table below compares changes in operating revenues, operating expenses, and electric sales between 1993 and 1992, and between 1992 and 1991, in summary form. Higher weather-related sales to the Company's retail customers was the primary reason for the 6.3% ($15.3 million) rise in electric operating revenues. Effective October 1, 1993, the Company implemented the first step (about 1% overall) of a three-step increase in its base electric rates to recover the cost of complying with the Clean Air Act Amendments of 1990 (see "Rate and Regulatory Matters"), however, the rate increase had little impact on electric revenues during 1993. In 1992, operating revenues declined 7.9% ($20.8 million) due to fewer sales to retail and wholesale customers. Cooler winter weather and much warmer summer temperatures, when cooling degree days were 30% greater than the prior year and about 17% above normal, were responsible for the 12.1% and 6.3% increases in residential and commercial sales, respectively. Following flat sales in 1992, industrial sales rose 5.7% during the current year due to increased manufacturing activity. Total system sales were up 7.6% over 1992. The Company experienced a 3.1% overall decline in system sales in 1992 when cooling degree days were down 30%. During 1993, the Company's electric customer base grew by 1,276, or 1%, totaling 118,163 at year end. In addition to greater system sales, 1993 system revenues increased approximately $2.7 million due to the recovery of higher unit fuel costs (see subsequent discussion of changes in the cost of fuel for electric generation), following a $4.7 million reduction in electric revenues in 1992 due to lower unit costs. Changes in the cost of fuel for electric generation and purchased power are reflected in customer rates through commission approved fuel cost adjustments. Because of the current worldwide oversupply of primary aluminum and softening demand for rolled can sheet aluminum in the United States, the Aluminum Company of America (Alcoa) shut down several older potlines at various manufacturing facilities. Alcoa Generating Corporation (AGC), a wholly-owned subsidiary of Alcoa, provides the energy requirements for five potlines at Alcoa's Warrick County, Indiana facility from its Warrick Generating Station. Since 1987, the Company has provided electric energy to AGC (a wholesale customer) for a sixth potline. On July 20,1993, Alcoa shut down the oldest of the six potlines at the Warrick County manufacturing operation. The Company estimates that the decline in electric sales related to the potline for 1993 represented approximately $4.8 million in nonsystem revenues and approximately $.8 million in operating income compared to the prior year. Greater sales to other nonsystem customers, due in part to the region's warmer summer temperatures, partially offset the decline in sales to AGC. Total nonsystem sales by the Company declined 8.3% during the year. On an annual basis, the decline in revenue related to the reduced sales to AGC is estimated at $14.4 million with a corresponding $2.4 million decline in operating income. The Company anticipates that a portion of the decline in operating income will be offset in the future by increases in sales to other nonsystem customers made possible by the reduced commitment to AGC. Most sales to nonsystem customers, including AGC, are on an "as available" basis under interchange agreements which provide for significantly lower margins than sales to system customers. Due to the much warmer summer temperatures, and to the increased demand by industrial customers, a new all-time peak load obligation of 1,100 megawatts was reached on July 28, 1993. The previous record peak, 1,054 megawatts, was set in 1988. The 1992 peak of 992 megawatts was held down by the unseasonably cool summer weather. The Company's total generating capacity at the time of the 1993 peak was 1,238 megawatts, representing an 11% capacity margin. Fuel for electric generation, the most significant electric operating cost, was comparable to 1992. Slightly (2.8%) higher costs of coal per MMBtu consumed due to less favorable volume-related pricing, higher average per unit mine production costs, and the amortized cost of the buyout of one of the Company's long-term coal contracts (see "Rate and Regulatory Matters"), were offset by a decline in generation. The Company continues to pursue further reductions in coal prices as a key component of its strategy to remain a low-cost provider of electricity. The decline in 1992 fuel cost reflected a 6.2% decrease in generation and a lower average cost of coal consumed. The greater energy requirements of the Company's customers and favorably priced power were the primary reasons for the increased purchases of electricity from other utilities, up substantially (220%) during 1993. Purchased electric energy costs decreased 48% in 1992 due to fewer purchases and lower average rates paid for such power. After a 4.1% decrease in 1992, other operation expenditures rose 8.2% ($2.3 million) during the current year chiefly due to increased provisions for injuries and damages, consulting and legal expenditures related to a coal contract buyout (see "Rate and Regulatory Matters") and ongoing coal contract negotiations and litigation, and increases in various administrative and general costs. Greater production plant maintenance activity was the primary reason for the 20% ($4 million) increase in electric maintenance expense. The Company performed a scheduled major turbine generator overhaul on A.B. Brown Unit 2 during the year and completed a major overhaul on the Culley Unit 1 turbine generator begun in late 1992. The Culley Unit 1 turbine generator overhaul was the only major maintenance project during 1992, when electric maintenance expenditures were down $4.5 million. Depreciation and amortization expense increased slightly in 1993 reflecting normal additions to utility plant and the completion of the warehouse and operations building at the Company's new Norman P. Wagner Operations Center. A decline in depreciation and amortization occurred in 1992 when amortization provisions related to the deferred return on the phasein of A. B. Brown Unit 2 expired. While inflation has a significant impact on the replacement cost of the Company's facilities, under the rate-making principles followed by the Indiana Utility Regulatory Commission (IURC), under whose regulatory jurisdiction the Company is subject, only the historical cost of electric and gas plant investment is recoverable in revenues as depreciation. With the exception of adjustments for changes in fuel and gas costs and margin on sales lost under the Company's demand side management programs (see "Demand Side Management"), the Company's electric and gas rates remain unchanged until a rate application is filed and a general rate order is issued by the IURC. In addition to the impact of higher 1993 pretax income on income tax expense, the Company provided approximately $.5 million of additional federal income tax expense to reflect the higher tax rates enacted under the Omnibus Budget Reconciliation Act of 1993. (See Note1 of the Notes to Consolidated Financial Statements for further discussion.) Decreased income tax expense in 1992 was chiefly attributable to lower pretax income. The decrease in taxes other than income taxes during the current year resulted from a 1992 increase in property tax expense reflecting the general reassessment of the Company's property. GAS OPERATIONS. The following table compares changes in operating revenues, operating expenses, and gas sold and transported between 1993 and 1992, and between 1992 and 1991, in summary form. Greater sales of natural gas and higher gas costs recovered through retail rates led to an 11.5% ($7.2 million) increase in gas operating revenues. Effective August 1, the Company implemented the first step (about 4% overall) of a two-step increase in its base gas rates (see "Rate and Regulatory Matters"), however, the impact on gas revenues during 1993 was not significant. A 5.6% rise in the Company's gas sales in 1993 reflected increased sales to residential and commercial customers, up 12.8% and 10.2%, respectively. Although heating degree days during the period were about normal, they were 10% greater than those recorded in 1992. Deliveries to industrial customers under the Company's sales and transportation tariffs were up 7.6%, reflecting the increased manufacturing activity of several of the Company's largest industrial customers. In 1992, residential sales were flat and commercial sales were up only 3.1% due to milder winter weather; industrial sales and transportation volumes increased 6.7% during the same period. During 1993, 1,402 new gas customers were added to the Company's system, raising the year end total 1.4% to 100,398. On December 23, 1993, the Company entered into a definitive agreement to acquire Lincoln Natural Gas, a small gas distribution company of approximately 1,300 customers contiguous to the eastern boundary of the Company's gas service territory. The acquisition is expected to be completed by mid-1994, subject to necessary regulatory and shareholder approvals. The recovery of higher unit gas costs, up 6.1%, through retail rates in 1993 raised revenues $2.7 million following a $1.3 million increase in revenues related to the recovery of higher unit costs in the prior year. During the past two years, the market for purchase of natural gas supply has been very volatile with the average price ranging from a low of $1.34 per Dth in February 1992 to the peak of $2.58 per Dth in May 1993. Prices have declined somewhat since May but remain above the February low reflecting a general tightening of the balance between available supply and demand after several years of excess supply. Changes in the cost of gas sold are passed on to customers through IURC approved gas cost adjustments. Cost of gas sold, the major component of gas operating expenses, was up 9.7% ($4.5 million) in 1993, following a 13.2% ($5.4 million) increase in 1992. The higher costs in both 1993 and 1992 reflected the increased deliveries to customers and higher unit costs. Although the Company's primary pipeline supplier, Texas Gas Transmission Corporation (TGTC), implemented revised tariffs November 1, 1993 to reflect certain changes required by Federal Energy Regulatory Commission (FERC) Order 636, the Company's 1993 purchased gas costs were relatively unaffected by the new tariffs. As of November 1,1993, TGTC ceased to be a supplier of natural gas to the Company, and the Company assumed full responsibility for the purchase of all its natural gas supplies. (See "Rate and Regulatory Matters" for further discussion of FERC Order No. 636 and of the impact on future purchased gas costs and procurement practices of the Company.) Other operation and maintenance expenses were 31% ($3.1 million) greater than the prior year due to increased provisions for injuries and damages (see "Environmental Matters" for discussion of the Company's investigation of the possible existence of facilities utilized for the manufacture of gas), abnormally low distribution maintenance expenses in 1992, and increases in various administrative and general costs. Depreciation expense for 1993 and 1992 reflected increased gas plant additions during the past several years due to new business requirements and various improvements made to the distribution system. Partially offsetting the impact of increased gas plant additions were lower depreciation rates implemented during 1993 as a result of the Company's recent gas rate case. Income tax expense for the current year was comparable to 1992, following a substantial decrease in income tax expense in 1992 resulting from lower pretax operating income. OTHER INCOME AND INTEREST CHARGES. Other income was $2.5million greater during 1993 due to increased allowance for equity funds used during construction, resulting primarily from the construction of the Company's new sulfur dioxide scrubber. (See "Clean Air Act" for further discussion.) Following a significant increase in nonutility income in 1991, nonutility income declined in 1992. The decline was largely due to lower fees from AGC for operation of its Warrick Generating Station. Interest expense during the current year was relatively unchanged. The impact of an additional $45 million of long- term debt issued during the second quarter was offset by savings from refinancing $105 million of long-term debt in the second quarter, which reduced annual interest expense by $1 million, and by additional interest capitalized due to the increased construction program. RATE AND REGULATORY MATTERS. In November 1992, the Company petitioned the IURC requesting a general increase in gas rates, the first such adjustment since 1982. On July 21,1993, the IURC approved an overall increase of approximately 8%, or $5.5 million in revenues, in the Company's base gas rates. The increase is to be implemented in two equal steps. The first step of the rate adjustment, approximately 4%, took place August 1, 1993; the second step will become effective August 1, 1994. In addition to seeking relief for rising operating and maintenance costs and substantial investment in utility plant over the past decade, the Company sought to restructure its tariffs, make available additional services, and "unbundle" existing services to better serve its gas customers and strategically position itself to address the changes brought about by the continued deregulation of the natural gas industry. (See subsequent discussion of FERC Order No. 636 in this section.) On May 24, 1993, the Company petitioned the IURC for an adjustment in its base electric rates representing the first step in the recovery of the financing costs on its investment through March 31, 1993 in the Clean Air Act Compliance project presently being constructed at the Culley Generating Station. The majority of the costs are for the installation of a sulfur dioxide scrubber on Culley Units 2 and 3. (See "Clean Air Act" for further discussion of the project and previous approval of ratemaking treatment of the incurred costs.) On September 15,1993, the IURC granted the Company's request for a 1% revenue increase, approximately $1.8 million on an annual basis, which took effect October 1, 1993. The Company anticipates petitioning the IURC in February 1994 for a 2-3% increase for financing costs related to the project construction expenditures incurred since April 1,1993, with implementation of the new rates effective mid-1994. On December 22, 1993, the Company filed a request with the IURC for the third of the three planned general electric rate increases. This final adjustment, expected to occur in early 1995, is estimated to be 6-9% and is necessary to recover financing costs related to the balance of the project construction expenditures, costs related to the operation of the scrubber, and certain nonscrubber-related costs such as additional costs incurred for postretirement benefits other than pensions beginning in 1993 and the recovery of demand side management program expenditures (see "Demand Side Management"). Over the past several years, the Company has been actively involved in intensive contract negotiations and legal actions to reduce its coal costs and thereby lower its electric rates. During 1992, the Company was successful in negotiating a new coal supply contract with one of its major coal suppliers. The new agreement, effective through 1995, was retroactive to 1991. Included in the agreement was a provision whereby the contract could be reopened by the Company for modification of certain coal specifications. In early 1993, the Company reopened the contract for such modifications. In response, the coal supplier elected to terminate the contract enabling the Company to buy out the remainder of its contractual obligations and acquire lower priced spot market coal. The cost of the contract buyout in 1993, which was based on estimated tons of coal to be consumed during the agreement period, and related legal and consulting services, totaled approximately $18 million. The Company anticipates that $2 million in additional buyout costs for actual tons of coal consumed above the previously estimated amount may be incurred during the 1994-1995 period. On September 22, 1993, the IURC approved the Company's request to amortize all buyout costs to coal inventory during the period July 1,1993 through December 31, 1995 and to recover such costs through the fuel adjustment clause beginning February 1994. The Company estimates the savings in coal costs during the 1991-1995 period, net of the total buyout costs, will approximate $56 million. The net savings are being passed back to the Company's electric customers through the fuel adjustment clause. The Company is currently in litigation with another coal supplier in an attempt to restructure an existing contract. Under the terms of the original contract, the Company was allegedly obligated to take 600,000 tons of coal annually. In early 1993, the Company informed the supplier that it would not require shipments under the contract until later in 1993. On March 26, 1993, the Company and the supplier agreed to resume coal shipments under the terms of their original contract except the invoiced price per ton would be substantially lower than the contract price. As approved by the IURC, the Company has charged the full contract price to coal inventory for subsequent recovery through the fuel adjustment clause. The difference between the contract price and the invoice price has been deposited in an escrow account with an offsetting accrued liability which will be paid either to the Company's ratepayers or its coal supplier upon settlement of the litigation. The escrowed amount was $8,749,000 at December 31, 1993. This litigation is scheduled for trial in June of 1994. Since the litigation arose due to the Company's efforts to reduce fuel costs, management believes that any related costs should be recoverable through the regulatory ratemaking process. In late 1993, in a further effort to reduce coal costs, the Company and the supplier entered into a letter agreement, effective January 1, 1994, and until the litigation is settled, whereby the Company will purchase an additional 50,000 tons monthly above the alleged base requirements at a price lower than the original contract price for tons over 50,000 per month. In April 1992, the Federal Energy Regulatory Commission (FERC) issued Order No. 636 (the Order) which required interstate pipelines to restructure their services. In August 1992, the FERC issued Order No. 636-A which substantially reaffirmed the content of the original Order. Under the Order, the stated purpose of which is to improve the competitive structure of the natural gas pipeline industry, existing pipeline sales service was "unbundled" so that gas supplies are sold separately from interstate transportation services. This restructuring has occurred through tariff filings by pipelines after negotiations with their customers. Customers, such as the Company and ultimately its gas customers, could benefit from enhanced access to competitively priced gas supplies as well as from more flexible transportation services. Conversely, customer costs will rise because the Order requires pipelines to implement new rate design methods which shift additional demand-related costs to firm customers; additionally, the FERC has authorized the pipelines to seek recovery of certain "transition" costs associated with restructuring from their customers. On November 2, 1992, the Company's major pipeline supplier, Texas Gas Transmission Corporation (TGTC), filed a recovery implementation plan with the FERC as part of its revised compliance filing regarding the Order. On October 1, 1993, the FERC accepted, subject to certain conditions, the TGTC recovery implementation plan (the Plan). The Plan, which addresses numerous issues related to the implementation of the requirements of the Order, became effective November 1, 1993. Under new TGTC transportation tariffs, which reflect the Plan's provisions, the Company will incur additional annual demand-related charges of approximately $1.9 million. Savings from lower volume-related transportation costs will partially offset the additional charges. TGTC has not yet determined the Company's allocation of transition costs, however, an estimate of such costs and implementation of revised TGTC tariffs to recover such costs are expected during the first quarter of 1994. Due to the anticipated regulatory treatment at the state level, the Company does not expect the Order to have a detrimental effect on its financial condition or results of operations. ENVIRONMENTAL MATTERS. The Company is currently investigating the possible existence of facilities once owned and operated by the Company, its predecessors, previous landowners, or former affiliates of the Company utilized for the manufacture of gas. These facilities, if they existed, would have been operated from the 1850's through the early 1950's under industry standards then in effect. Operations at these facilities would have ceased many years ago. However, due to current environmental regulations, the Company and other responsible parties may be required to take remedial action if certain materials are found at the sites of these former facilities. The Company has just recently initiated its investigation, and preliminary assessments have not yet been performed on any sites. However, based on its research, the Company has identified the existence and general location of four sites at which contamination may be present. The Company intends to perform preliminary assessments of all four sites during 1994 and, more than likely, will perform comprehensive investigations of some, or all, of these sites to determine if remedial action is required and to estimate the extent of such action and the associated costs. The Company has notified all known insurance carriers providing coverage during the probable period of operation of these facilities of potential claims for coverage of environmental costs. The Company has not, however, recorded any receivables representing future recovery from insurance carriers. Additionally, the Company is attempting to identify all potentially responsible parties for each site. The Company has not been named a potentially responsible party by the Environmental Protection Agency for any of these sites. While the Company intends to seek recovery from other responsible parties or insurance carriers, the Company does not presently anticipate seeking recovery of these investigation costs from its ratepayers. Therefore, the Company has expensed the $.5 million of anticipated cost of performing preliminary site assessments and the more comprehensive specific site investigations of all four sites. If, however, the specific site investigations indicate that significant remedial action is required, the Company will seek recovery of all related costs in excess of amounts recovered from other potentially responsible parties or insurance carriers through rates. Although the IURC has not yet ruled on a pending request for rate recovery by another Indiana utility of such environmental costs, the IURC did grant that utility authority to utilize deferred accounting for such costs until the IURC rules on the request. NATIONAL ENERGY POLICY ACT OF 1992. In late 1992, the National Energy Policy Act of 1992 (the Act) was signed into law, enacting the first comprehensive energy legislation since the National Energy Act of 1978. Key provisions contained in the Act, specifically Title VII (Electricity), are expected to cause some of the most significant changes in the history of the electric industry. The primary purpose of Title VII is to increase competition in electric generation by enabling virtually nonregulated entities, such as exempt wholesale generators, to develop power plants, and by providing the FERC authority to require a utility to provide transmission services, including the expansion of the utility's transmission facilities necessary to provide such services, to any entity generating electricity. Although the FERC may not order retail wheeling, the transmission of electricity directly to an ultimate consumer, it may order wheeling of electricity generated by an exempt wholesale generator or another utility to a wholesale customer of a regulated utility. The changes brought about by the Act may require, or provide opportunities for, the Company to compete with other utilities and wholesale generators for sales to existing wholesale customers of the Company and other potential wholesale customers. The Company has long-term contracts with its five wholesale customers which mitigate the opportunity for other generators to provide service to them. Many observers of the electric utility industry, including major credit rating agencies, certain financial analysts, and some industry executives, have expressed an opinion that retail wheeling to large retail customers and other elements of a more competitive business environment will occur in the electric utility industry, similar to developments in the telecommunications and natural gas industries. The timing of these projected developments is uncertain. In addition, the FERC has adopted a position, generically and on a case- by-case basis, that it will pursue a more competitive, less regulated, electric utility industry. Although the Company is uncertain of the final outcome of these developments, it is committed to pursuing, and is moving rapidly to implement, its corporate strategy of positioning itself as a low-cost energy producer and the provider of high quality service to its retail as well as wholesale customers. The Company already has some of the lowest per unit administrative, operation, and maintenance costs in the nation, and is continuing its efforts to further reduce its coal costs (see previous discussion of coal contract renegotiation in "Rates and Regulatory Matters"). CLEAN AIR ACT. Revisions to federal clean air laws were enacted in 1990 which have a significant impact on all of American industry. Electric utilities, especially in the Midwest, were severely impacted by Title IV (acid rain provisions) of the Clean Air Act Amendments of 1990. Title IV mandates utilities to significantly reduce emissions of sulfur dioxide (SO2) and nitrogen oxide (NOx) from coal-burning electric generating facilities in two steps. The Company is required to reduce annual emissions of SO2 on a Company-wide basis by approximately 50% by 1995 (Phase I). By the year 2000 (PhaseII), the Company must reduce emissions of SO2 by approximately 50% from the allowed 1995 level. Since the Company's two newest coal- fired generating units, A.B. Brown Units 1 and2 (500 MW total), are equipped with SO2 removal equipment (scrubbers), the impact of the law, although significant, is not as great for the Company as for some other midwestern utilities. To meet the Phase I requirements and nearly all of the Phase II requirements, the Company's Clean Air Act Compliance Plan (the Compliance Plan), which was developed as a least-cost approach to compliance, proposed the installation of a single scrubber at the Culley Generating Station to serve both Culley Unit 2 (92MW) and Culley Unit 3 (250 MW) and the installation of state of the art low NOx burners on these two units. In January 1992, the Company filed a petition with the IURC, requesting preapproval of the Compliance Plan and proposing recovery of financing costs to be incurred during the construction period. In October 1992, the IURC approved a stipulation and settlement agreement between the Company and intervenors pertaining to the petition, which essentially granted the request. Construction of the facilities, originally projected to cost approximately $115 million including the related allowance for funds used during construction, began during 1992 with completion and testing expected to occur in late 1994. Construction costs are currently running under budget. Commercial operation will begin about January 1, 1995 to comply with requirements of the Clean Air Act Amendments of 1990. Under the settlement agreement, the maximum capital cost of the compliance plan to be recovered from ratepayers is capped at approximately $107 million, plus any related allowance for funds used during construction. The estimated cost to operate and maintain the facilities, including the cost of chemicals to be used in the process, is $4-6 million per year, beginning in 1995. By installing a scrubber, the Company was entitled to apply for extra allowances, called "extension allowances", to the federal EPA. However, because utilities applied for more extension allowances than the Act made available, the federal EPA established a lottery procedure to determine which utilities would actually receive the extension allowances. In order to ensure receipt of a majority of the extension allowances, the Company, and nearly all of the other applying utilities, formed an allowance pooling group. As a result, the Company will receive about 88,000 extension allowances, which it has sold to another party under a confidential agreement. The Company will credit the proceeds to customers over 1995-1999, reducing the rate impact of the Compliance Plan. With the addition of the scrubber, the Company expects to exceed the minimum compliance requirements of Phase I of the Clean Air Act and have available unused allowances, called "overcompliance allowances", for sale to others. Proceeds from sales of overcompliance allowances will also be passed through to customers. The scrubbing process utilized by the Culley scrubber produces a salable by-product, gypsum, a substance commonly used in wallboard and other products. In December 1993, the Company finalized negotiations for the sale of an estimated 150,000 to 200,000 tons annually of gypsum to a major manufacturer of wallboard. The agreement will enable the Company to reduce certain operating costs and to credit ratepayers with the proceeds from the sale of the gypsum, further mitigating the rate impact of the Compliance Plan. The rate impact related to the Compliance Plan, estimated to be 7-10%, is being phased in over a three year period beginning in October 1993. (See "Rate and Regulatory Matters" for further discussion.) DEMAND SIDE MANAGEMENT. In October 1991, the IURC issued an order approving expenditures by the Company for development and implementation of demand side management (DSM) programs. The primary purpose of the DSM programs is to reduce the demand on the Company's generating capacity at the time of system peak requirements, thereby postponing or avoiding the addition of generating capacity. Thus, the order of the IURC provided that the accounting and ratemaking treatment of DSM program expenditures should generally parallel the treatment of construction of new generating facilities. Most of the DSM program expenditures are being capitalized per the IURC order and will be amortized over a 15 year period beginning at the time the Company reflects such costs in its rates. The Company is requesting recovery of these costs in its general electric rate increase request filed December 22, 1993 (see "Rates and Regulatory Matters" for further discussion). In addition to the recovery of DSM program costs through base rate adjustments, the Company is collecting, through a quarterly rate adjustment mechanism, most of the margin on sales lost due to the implementation of DSM programs. The Company expects to incur costs of approximately $51 million on DSM programs during the 1994-1998 period. By 1998, approximately 108 megawatts of capacity are expected to be postponed or eliminated due to these programs. Based on the latest projections, the expenditures for DSM programs, as approved by the IURC, will total an estimated $195 million through the year 2012 and result in overall savings of $160 million to ratepayers due to deferring the construction of about 156 megawatts of new generating capacity. INTEGRATED RESOURCE PLAN. In November 1993, the Company filed with the IURC a biannual update to its Integrated Resource Plan (IRP), including the DSM program expenditures referred to above. The IRP process is a least-cost approach to determining the combination of new generating facilities and conservation and load management options that will best meet customers' future energy needs. The 1993 IRP update was the result of a nine month evaluation of detailed technology costs, customer energy use patterns, and market information, and includes natural gas conservation options not in the initial 1991 IRP. If the new IRP is approved by the IURC, the Company will implement several new DSM programs recommended by the IRP, including a residential weatherization pilot project. Supply side options recommended by the IRP include strategies to diversify the Company's natural gas suppliers, maximize the use of economical purchased power during peak usage periods, and expand the strategic use of the Company's gas storage fields. While the Company intends to aggressively utilize various DSM programs to help delay the need for additional power sources, the 1993 IRP forecasts the need of a 125 megawatt base-load generating plant in the early 21st century to meet the future electricity needs of the Company's customers. POSTEMPLOYMENT BENEFITS. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective for years beginning after December 15, 1993, which will require the Company to accrue the estimated cost of benefits provided to former or inactive employees after employment but before retirement age. Postemployment benefits include, but are not limited to, salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits (including workers' compensation), and continuation of benefits such as health care and life insurance coverage. The Company will adopt SFAS No. 112 on January 1, 1994. The impact of the new statement will not have a material impact on financial position or results of operations. LIQUIDITY AND CAPITAL RESOURCES. The Company experienced record earnings per share during 1993, and financial performance continued to be solid. Internally generated cash, bolstered by the increased retail sales, provided over 74% of the Company's construction and DSM program expenditures, despite the requirements of the Culley scrubber project. Earnings continued to be of high quality, of which 11.4% represented allowance for funds used during construction. The ratio of earnings to fixed charges (SEC method) was 3.8:1, the embedded cost of long-term debt is approximately 6.6%, and the Company's long-term debt continues to be rated AA by major credit rating agencies. The Company has access to outside capital markets and to internal sources of funds that together should provide sufficient resources to meet capital requirements. The Company does not anticipate any changes that would materially alter its current liquidity. On April 30, 1993, the Company called $84.5 million of its first mortgage bonds at a premium, plus accrued interest. The bonds called were the 8% due 2001, the 8% due 2002, the 8.35% due 2007, the 9-1/4% due 2016, and the 8-5/8% due 2017. The bonds called, having a weighted average interest rate of 8.5%, were refunded with two $45 million issues carrying interest rates of 6% and 7.6%, due 1999 and 2023, respectively. On May 11, 1993, the Company issued two series of adjustable rate first mortgage bonds in connection with the sale of Warrick County, Indiana environmental improvement revenue bonds. The proceeds of the bonds have been placed in trust and are being used to finance a portion of the Culley scrubber project. The first series of bonds was for $22.2 million due 2028, the interest rate of which is fixed at 4.65% through April 30, 1998. The second series of bonds was for $22.8 million due 2023; the interest rate of this series is fixed at 6% through maturity. On June 15, 1993, the Company retired $20 million of 8.50% first mortgage bonds maturing in June of 1993 with $20 million of 7-5/8% first mortgage bonds due 2025. The only financing activity during 1992 was in December when the Company called 75,000 shares of 8.75% series cumulative preferred stock at $102 per share, plus accrued dividends, with the issuance of 75,000 shares of 6.50% series redeemable cumulative preferred stock, at $100 per share. During the five year period 1994-1998, the Company anticipates that a total of $47.7 million of debt securities will be redeemed. Construction expenditures, including $4.5 million for DSM programs, totaled $80.1 million during 1993, compared to the $52.1 million expended in 1992. As discussed in "Clean Air Act", construction of the new scrubber continued in 1993, requiring $49.2 million. The remainder of the 1993 construction expenditures consisted of the normal replacements and improvements to gas and electric facilities. The Company expects that construction requirements for the years 1994-1998 will total approximately $270 million. Included in this amount is approximately $44 million to comply with the Clean Air Act amendments by 1995 and approximately $51 million of capitalized expenditures to develop and implement DSM programs. While the Company expects the majority of the construction program and debt redemption requirements to be provided by internally generated funds, external financing requirements of $50-70 million are anticipated. At year end, the Company had $11 million in short-term borrowings, leaving unused lines of credit and trust demand note arrangements totaling $16 million. The Company is confident that its long-term financial objectives, which include maintaining a capital structure near 45-50% long-term debt, 3-7% preferred stock, and 43-48% common equity, will continue to be met, while providing for future construction and other capital requirements. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page No. 1. Financial Statements: Report of Independent Public Accountants 23 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 24 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 25 Consolidated Balance Sheets - December 31, 1993 and 1992 26 - 27 Consolidated Statements of Capitalization - December 31, 1993 and 1992 28 Consolidated Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991 29 Notes to Consolidated Financial Statements 29 - 39 2. Supplementary Information: Selected Quarterly Financial Data 40 3. Supplemental Schedules: Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 44 - 46 Schedule VI - Accumulated Provision for Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 47 - 49 Schedule VIII - Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991 50 Schedule IX - Short-Term Borrowings 51 Schedule X - Supplementary Income Statement Information 52 Schedule XIII - Other Investments 53 All other schedules have been omitted as not applicable or not required or because the information required to be shown is included in the Consolidated Financial Statements or the accompanying Notes to Consolidated Financial Statements. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of Southern Indiana Gas and Electric Company: We have audited the consolidated balance sheets and consolidated statements of capitalization of SOUTHERN INDIANA GAS AND ELECTRIC COMPANY (an Indiana corporation) AND SUBSIDIARY as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the supplemental schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and supplemental schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southern Indiana Gas and Electric Company and Subsidiary as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1, effective January 1, 1993, the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules listed under Item 8 (3) are presented for the purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These supplemental schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois January 24, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary Southern Indiana Properties, Inc. All significant intercompany transactions and balances have been eliminated. CUSTOMER RECEIVABLES, SALES, AND TRANSPORTATION REVENUES The Company's customer receivables, gas and electric sales, and gas transportation revenues are primarily derived from supplying electricity and natural gas to a broadly diversified base of residential, commercial, and industrial customers located in a southwestern region of Indiana. The Company serves 118,163 electric customers in the city of Evansville and 74 other communities and serves 100,398 gas customers in the city of Evansville and 63 other communities. UTILITY PLANT Utility plant is stated at the historical original cost of construction. Such cost includes payroll-related costs such as taxes, pensions, and other fringe benefits, general and administrative costs, and an allowance for the cost of funds used during construction (AFUDC), which represents the estimated debt and equity cost of funds capitalized as a cost of construction. While capitalized AFUDC does not represent a current source of cash, it does represent a basis for future cash revenues through depreciation and return allowances. The weighted average AFUDC rate (before income tax) used by the Company was 10.5% in 1993, 11.5% in 1992, and 11.2% in 1991. DEPRECIATION Depreciation of utility plant is provided using the straight-line method over the estimated service lives of the depreciable plant. Provisions for depreciation, expressed as an annual percentage of the cost of average depreciable plant in service, were 4.0% for electric and 3.7 % for gas in 1993, 4.0% for electric and 3.9% for gas in 1992, and 4.0% for both electric and gas in 1991. INCOME TAXES The Company utilizes a comprehensive interperiod income tax allocation policy, providing deferred taxes on temporary timing differences. Investment tax credits recorded have been deferred and are amortized through credits to income over the lives of the related property. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". SFAS No. 109 requires an asset and liability approach for financial accounting and reporting for income taxes rather than the deferred method. The new standard requires the Company to establish deferred tax assets and liabilities, as appropriate, for all temporary differences and to adjust deferred tax balances to reflect changes in tax rates expected to be in effect during the periods the temporary differences reverse. In the first quarter of 1993, because of the effects of rate regulation, the Company recorded an increase of $4,987,000 in deferred tax assets and a decrease of $8,551,000 in deferred tax liabilities, and established a corresponding regulatory liability of $13,538,000, primarily to recognize the probable future reduction in rates to flow back to customers deferred taxes previously collected in excess of current tax rates. The adoption of this standard did not have a material impact on results of operations, cash flow, or financial position. The components of the net deferred income tax liability at January 1, 1993 and December 31, 1993 are as follows: Of the $17,668,000 increase in the net deferred income tax liability from January 1, 1993 to December 31, 1993, $11,263,000 is due to current year deferred federal and state income tax expense and the remaining $6,405,000 increase is primarily a result of the decrease in the net regulatory liability. The components of current and deferred income tax expense for the years ended December 31 are as follows: The components of deferred federal and state income tax expense for the years ended December 31 are as follows: As a result of the Omnibus Budget Reconciliation Act of 1993, signed into law on August 10, 1993, the Company provided additional income tax expense of $524,000 in 1993 to recognize the impact of the 1% increase in federal income tax rates. A reconciliation of the statutory tax rates to the Company's effective income tax rate for the years ended December 31 is as follows: PENSION PLANS The Company has trusteed, noncontributory defined benefit plans which cover eligible full-time regular employees. The plans provide retirement benefits based on years of service and the employee's highest 60 consecutive months' base compensation during the last 120 months of employment. The funding policy of the Company is to contribute amounts to the plans equal to at least the minimum funding requirements of the Employee Retirement Income Security Act of 1974 (ERISA) but not in excess of the maximum deductible for federal income tax purposes. The plans' assets as of December 31, 1993 consist of investments in interest bearing obligations and common stocks of 51% and 49%, respectively. The components of net pension cost for the years ended December 31 are as follows: Part of the pension cost is charged to construction and other accounts. The funded status of the retirement plans at December 31 is as follows: The projected benefit obligation at December 31, 1992 was determined using an assumed discount rate of 8%. Due to the decline in yields on high quality fixed income investments, a discount rate of 7% was used to determine the projected benefit obligation at December 31, 1993. For both periods, the long-term rate of compensation increases was assumed to be 5%, and the long-term rate of return on plan assets was assumed to be 8%. The transitional asset is being recognized over approximately 15, 18, and 14 years for the Salaried, Hourly, and Hoosier plans, respectively. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides certain postretirement health care and life insurance benefits for retired employees and their dependents through fully insured plans. Retired employees are eligible for lifetime medical and life insurance coverage if they retire on or after attainment of age 55, regardless of length of service. Their spouses are eligible for medical coverage until age 65. Prior to age 65, retirees are covered by the same insured health care plans provided to active employees. After attaining age 65, the retirees are covered by insured Medicare supplement plans. Additionally, the Company reimburses the retirees for Medicare Part B premiums incurred. The health care plans pay stated percentages of covered medical expenses incurred, after subtracting payments by Medicare or other providers and after a stated deductible has been met. Prior to 1993, the cost of retiree health care and life insurance benefits was recognized as insurance premiums were paid, which was consistent with current ratemaking practices. The costs for retirees totaled $670,000 and $598,000 in 1992 and 1991, respectively. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" which requires the expected cost of these benefits be recognized during the employees' years of service. The actuarial assumptions and calculations involved in determining the recognized costs closely parallel pension accounting requirements. As authorized by the Indiana Utility Regulatory Commission in a December 30, 1992 generic ruling, the Company is deferring as a regulatory asset the additional SFAS No. 106 costs accrued over the costs of benefits actually paid after date of adoption, but prior to inclusion in rates. As required by the generic order, the Company anticipates including the additional costs of the benefits in rates within four years after date of adoption of SFAS No. 106. The components of the net periodic other postretirement benefit cost for the year ended December 31, 1993, is as follows: The 1993 cost determined under the new standard includes the amortization of the discounted present value of the obligation at the adoption date, $29,400,000, over a 20 year period. Reconciliation of the accumulated postretirement benefit obligation to the accrued liability for postretirement benefits as of January 1, 1993 and December 31, 1993, is as follows: The assumptions used to develop the accumulated postretirement benefit obligation at January 1, 1993 included a discount rate of 8.5% and a health care cost trend rate applicable to gross eligible charges of 14% in 1993 declining to 6% in 2008, and remaining level thereafter. Due to the decline in yields on high quality fixed income investments and general inflation, a discount rate of 7.25% and a health care cost trend rate of 13.5% in 1994 declining to 5.5% in 2008 were used to determine the accumulated postretirement benefit obligation at December 31, 1993. The estimated cost of these future benefits could be significantly impacted by future changes in health care costs, work force demographics, interest rates, or plan changes. A 1% increase in the assumed health care cost trend rate each year would increase the aggregate service and interest costs for 1993 by $900,000 and the accumulated postretirement benefit obligation by $4,700,000. The Company currently anticipates continuing its policy of funding postretirement benefits costs other than pensions as incurred. POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits", which will require the Company to accrue the estimated cost of benefits provided to former or inactive employees after employment but before retirement. The Company will adopt SFAS No. 112 on January 1, 1994. The impact of the new statement will not have a material impact on financial position or results of operations. CASH FLOW INFORMATION For the purposes of the Consolidated Balance Sheets and the Consolidated Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. The Company, during 1993, 1992, and 1991, paid interest (net of amounts capitalized) of $18,359,000, $17,890,000, and $18,502,000, respectively, and income taxes of $10,248,000, $14,291,000, and $18,289,000, respectively. The Company is involved in several partnerships which are partially financed by partnership obligations amounting to $16,730,000 and $16,114,000 at December 31, 1993 and 1992, respectively. INVENTORIES The Company accounts for its inventories under the average cost method except for gas in underground storage which is accounted for under two inventory methods: the average cost method for the Company's Hoosier Division (formerly Hoosier Gas Corporation) and the last-in, first- out (LIFO) method for all other gas in storage. Inventories at December 31 are as follows: Based on the December 1993 price of gas purchased, the cost of replacing the current portion of gas in underground storage exceeded the amount stated on a LIFO basis by approximately $12,400,000 at December 31, 1993. OPERATING REVENUES AND FUEL COSTS Revenues include all gas and electric service billed during the year except as discussed below. All metered gas rates contain a gas cost adjustment clause which allows for adjustment in charges for changes in the cost of purchased gas. As ordered by the IURC, the calculation of the adjustment factor is based on the estimated cost of gas in a future quarter. The order also provides that any under- or overrecovery caused by variances between estimated and actual cost in a given quarter, as well as refunds from its pipeline suppliers, will be included in adjustment factors of four future quarters beginning with the second succeeding quarter's adjustment factor. All metered electric rates contain a fuel adjustment clause which allows for adjustment in charges for electric energy to reflect changes in the cost of fuel and the net energy cost of purchased power. As ordered by the IURC, the calculation of the adjustment factor is based on the estimated cost of fuel and the net energy cost of purchased power in a future quarter. The order also provides that any under- or overrecovery caused by variances between estimated and actual cost in a given quarter will be included in the second succeeding quarter's adjustment factor. The Company also collects through a quarterly rate adjustment mechanism, the margin on electric sales lost due to the implementation of demand side management programs. Reference is made to "Demand Side Management" in Management's Discussion and Analysis of Operations and Financial Condition for further discussion. The Company records monthly any under- or overrecovery as an asset or liability, respectively, until such time as it is billed or refunded to its customers. The IURC reviews for approval the adjustment clauses on a quarterly basis. The cost of gas sold is charged to operating expense as delivered to customers and the cost of fuel for electric generation is charged to operating expense when consumed. 2. REGULATORY AND OTHER MATTERS The IURC has jurisdiction over all investor-owned gas and electric utilities in Indiana. The FERC has jurisdiction over those investor-owned utilities that make wholesale energy sales. These agencies regulate the Company's utility business operations, rates, accounts, depreciation allowances, services, security issues, and the sale and acquisition of properties. On July 21, 1993, the IURC approved an overall increase of approximately 8%, or $5.5 million in revenues, in the Company's base gas rates. The increase is to be implemented in two equal steps. The first step of the rate adjustment, approximately 4%, took place August 1, 1993; the second step will become effective August 1, 1994. On May 24, 1993, the Company petitioned the IURC for an adjustment in its base electric rates representing the first step in the recovery of the financing costs on its investment through March 31, 1993 in the Clean Air Act Compliance project presently being constructed at the Culley Generating Station. The majority of the costs are for the installation of a sulfur dioxide scrubber on Culley Units 2 and 3. On September 15, 1993, the IURC granted the Company's request for a 1% revenue increase (approximately $1,800,000 on an annual basis), which took effect October 1, 1993. The Company anticipates petitioning the IURC in February 1994 for a 2-3% increase for financing costs related to project construction expenditures incurred since April 1, 1993, with implementation of the new rates effective mid-1994. On December 22, 1993, the Company filed a request with the IURC for a general electric rate increase. This adjustment, expected to occur in early 1995, is estimated to be 6-9% and is necessary to recover financing costs related to the balance of the scrubber project construction expenditures, costs related to the operation of the scrubber, and certain nonscrubber-related costs such as additional costs incurred for postretirement benefits other than pensions beginning in 1993 and the recovery of demand side management program expenditures. In April 1992, the Federal Energy Regulatory Commission (FERC) issued Order No. 636 (the Order) which required interstate pipelines to restructure their services. In August 1992, the FERC issued Order No. 636-A which substantially reaffirmed the content of the original Order. On November 2, 1992, the Company's major pipeline , Texas Gas Transmission Corporation (TGTC), filed a recovery implementation plan with the FERC as part of its revised compliance filing regarding the Order. On October 1, 1993, the FERC accepted, subject to certain conditions, the TGTC recovery implementation plan. Under the new TGTC transportation tariffs, which became effective November 1, 1993, the Company will incur additional annual demand-related charges of approximately $1.9 million. Savings from lower volume-related transportation costs will partially offset the additional charges. TGTC has not yet determined the Company's allocation of transition costs, however, an estimate of such costs and implementation of revised TGTC tariffs to recover such costs, are expected during the first quarter of 1994. Due to the anticipated regulatory treatment at the state level, the Company does not expect the Order to have a detrimental effect on its financial condition or results of operations. Over the past several years, the Company has been involved in contract negotiations and legal actions to reduce its coal costs. During 1992, the Company successfully negotiated a new coal supply contract with a major supplier which was retroactive to 1991 and effective through 1995. In 1993, the Company exercised a provision of the agreement which allowed the Company to reopen the contract for the modification of certain coal specifications. In response, the coal supplier elected to terminate the contract enabling the Company to buy out the remainder of its contractual obligations and acquire lower priced spot market coal. The cost of the contract buyout in 1993, which was based on estimated tons of coal to be consumed during the agreement period, and related legal and consulting services, totaled approximately $18 million. The Company anticipates that $2 million in additional buyout costs for actual tons of coal consumed above the previously estimated amount may be incurred during the 1994-1995 period. On September 22, 1993, the IURC approved the Company's request to amortize all buyout costs to coal inventory during the period July 1, 1993 through December 31, 1995 and to recover such costs through the fuel adjustment clause beginning February 1994. As of December 31, 1993, $13,295,000 of settlement costs paid to date had not yet been amortized to coal inventory. The Company is currently in litigation with another coal supplier in an attempt to restructure an existing contract. Under the terms of the contract, the Company was allegedly obligated to take 600,000 tons of coal annually. In early 1993, the Company informed the supplier that it would not require shipments under the contract until later in 1993. On March 26, 1993, the Company and the supplier agreed to resume coal shipments under the terms of their original contract except the invoiced price per ton would be substantially lower than the contract price. As approved by the IURC, the Company has charged the full contract price to coal inventory for subsequent recovery through the fuel adjustment clause. The difference between the contract price and the invoice price has been deposited in an escrow account with an offsetting accrued liability which will be paid to either the Company's ratepayers or its coal supplier upon resolution of the litigation. The escrowed amount was $8,749,000 at December 31, 1993. This litigation is scheduled for trial in June of 1994. Since the litigation arose due to the Company's efforts to reduce fuel costs, management believes that any related costs should be recoverable through the regulatory ratemaking process. In late 1993, in a further effort to reduce coal costs, the Company and the supplier entered into a letter agreement, effective January 1, 1994, and until the litigation is settled, whereby the Company will purchase an additional 50,000 tons monthly above the alleged base requirements at a price lower than the original contract price for tons over 50,000 per month. Reference is made to "Rate and Regulatory Matters" in Management's Discussion and Analysis of Operations and Financial Condition for further discussion. 3. SOUTHERN INDIANA PROPERTIES, INC. Southern Indiana Properties, Inc. (SIPI), a wholly- owned subsidiary, was formed to conduct nonutility investment activities while segregating such activities from the Company's regulated utility business. Net income for the years 1993, 1992, and 1991 was $2,525,000, $2,321,000, and $1,936,000, respectively, and is included in "Other, net" in the Consolidated Statements of Income. SIPI investment activities consist principally of investments in partnerships (primarily in real estate), leveraged leases, and marketable securities. SIPI is a lessor in four leveraged lease agreements under which an office building, a part of a reservoir, an interest in a paper mill, and passenger railroad cars are leased to third parties. The economic lives and lease terms vary with the leases. The total equipment and facilities cost was approximately $101,200,000 and $83,400,000 at December 31, 1993 and 1992, respectively. The cost of the equipment and facilities was partially financed by nonrecourse debt provided by lenders, who have been granted an assignment of rentals due under the leases and a security interest in the leased property, which they accept as their sole remedy in the event of default by the lessee. Such debt amounted to approximately $78,700,000 and $63,700,000 at December 31, 1993 and 1992, respectively. The Company's net investment in leveraged leases at those dates was $8,184,000 and $7,191,000, respectively, as shown: 4. SHORT-TERM FINANCING The Company has trust demand note arrangements totaling $17,000,000 with several banks, of which $11,000,000 was utilized at December 31, 1993. Funds are also borrowed from time to time from banks on a short-term basis, made available through lines of credit. These available lines of credit totaled $10,000,000 at December 31, 1993 of which none was utilized at that date. 5. LONG-TERM DEBT The annual sinking fund requirement of the Company's first mortgage bonds is 1% of the greatest amount of bonds outstanding under the Mortgage Indenture. This requirement may be satisfied by certification to the Trustee of unfunded property additions in the prescribed amount as provided in the Mortgage Indenture. The Company intends to meet the 1994 sinking fund requirement by this means and, accordingly, the sinking fund requirement for 1994 is excluded from current liabilities on the balance sheet. At December 31, 1993, $106,887,000 of the Company's utility plant remained unfunded under the Company's Mortgage Indenture. Several of the Company's partnership investments have been financed through obligations with such partnerships. Additionally, the Company's investments in leveraged leases have been partially financed through notes payable to banks. Of the amount of first mortgage bonds, notes payable, and partnership obligations outstanding at December 31, 1993, the following amounts mature in the five years subsequent to 1993: 1994 - $4,612,000; 1995 - $11,143,000; 1996 - $12,394,000; 1997 - $2,672,000; and 1998 - $16,577,000. In addition, $41,475,000 of adjustable rate pollution control series first mortgage bonds could, at the election of the bondholder, be tendered to the Company in 1994 on certain interest payment dates. If the Company's agent is unable to remarket any bonds tendered at that time, the Company would be required to obtain additional funds for payment to bondholders. For financial statement presentation purposes those bonds subject to tender in 1994 are shown as current liabilities. First mortgage bonds, notes payable, and partnership obligations outstanding and classified as long-term at December 31 are as follows: 6. CUMULATIVE PREFERRED STOCK The amount payable in the event of involuntary liquidation of each series of the $100 par value preferred stock is $100 per share, plus accrued dividends. The nonredeemable preferred stock is callable at the option of the Company as follows: 4.8% Series at $110 per share, plus accrued dividends; and 4.75% Series at $101 per share, plus accrued dividends. 7. CUMULATIVE REDEEMABLE PREFERRED STOCK On December 8, 1992, the Company issued $7,500,000 of its Cumulative Redeemable Preferred Stock to replace a like amount of 8.75% of Cumulative Preferred Stock. The new series has an interest rate of 6.50% and is redeemable at $100 per share on December 1, 2002. In the event of involuntary liquidation of this series of $100 par value preferred stock, the amount payable is $100 per share, plus accrued dividends. 8. CUMULATIVE SPECIAL PREFERRED STOCK The Cumulative Special Preferred Stock contains a provision which allows the stock to be tendered on any of its dividend payment dates. On April 1, 1992, the Company repurchased 850 shares of the Cumulative Special Preferred Stock at a cost of $85,000 as a result of a tender within the provision of the issuance. On March 8, 1991, the Company repurchased 100 shares at a cost of $10,000 as a result of the same provision. 9. COMMITMENTS AND CONTINGENCIES The Company presently estimates that approximately $90,000,000 will be expended for construction purposes in 1994, including those amounts applicable to the Company's Clean Air Act Compliance Plan and demand side management (DSM) programs. Commitments for the 1994 construction program are approximately $44,000,000 at December 31, 1993. Reference is made to "Clean Air Act" and "Demand Side Management" in Management's Discussion and Analysis of Operations and Financial Condition for discussion of the impact of the Federal Clean Air Act and implementation of the Company's DSM programs. The Company is currently investigating the possible existence of facilities once owned and operated by the Company, its predecessors, previous landowners, or former affiliates of the Company utilized for the manufacture of gas. Based on its investigations, the Company has identified the existence and general location of four sites at which contamination may be present. The Company is attempting to identify all potentially responsible parties for each site. The Company has not been named a potentially responsible party by the Environmental Protection Agency for any of these sites. While the Company intends to seek recovery from other responsible parties or insurance carriers, the Company does not presently anticipate seeking recovery of these investigation costs from its ratepayers. Therefore, the Company has expensed the $500,000 anticipated cost of performing preliminary and comprehensive specific site investigations of all four sites. If the specific site investigations indicate that significant remedial action is required, the Company will seek recovery of all related costs in excess of amounts recovered from other potentially responsible parties or insurance carriers through rates. Although the IURC has not yet ruled on a pending request for rate recovery by another Indiana utility of such environmental costs, the IURC did grant that utility authority to utilize deferred accounting for such costs until the IURC rules on the request. 10. COMMON STOCK Since 1986, the Board of Directors of the Company authorized the repurchase of up to $25,000,000 of the Corporation's common stock. As of December 31, 1993, the Company had accumulated 1,110,177 common shares with an associated cost of $24,540,000 under this plan. On January 21, 1992, the Board of Directors of the Company approved a four-for-three common stock split effective March 30, 1992. The stock split was authorized by the IURC on March 18, 1992. Average common shares outstanding, earnings per share of common stock and dividends per share of common stock as shown in the accompanying financial statements have been adjusted to reflect the split. Shares issued during 1992 as a result of the stock split were 3,923,706. No shares of common stock were issued during 1993 and 1991. Each outstanding share of the Company's stock contains a right which entitles registered holders to purchase from the Company one one-hundredth of a share of a new series of the Company's Redeemable Preferred Stock, no par value, designated as Series 1986 Preferred Stock, at an initial price of $120.00 (Purchase Price) subject to adjustment. The rights will not be exercisable until a party acquires beneficial ownership of 20% of the Company's common shares or makes a tender offer for at least 30% of its common shares. The rights expire October 15, 1996. If not exercisable, the rights in whole may be redeemed by the Company at a price of $.01 per right at any time prior to their expiration. If at any time after the rights become exercisable and are not redeemed and the Company is involved in a merger or other business combination transaction, proper provision shall be made to entitle a holder of a right to buy common stock of the acquiring company having a value of two times such Purchase Price. 11. OWNERSHIP OF WARRICK UNIT 4 The Company and Alcoa Generating Corporation (AGC), a subsidiary of Aluminum Company of America, own the 270 MW Unit 4 at the Warrick Power Plant as tenants in common. Construction of the unit was completed in 1970. The cost of constructing this unit was shared equally by AGC and the Company, with each providing its own financing for its share of the cost. The Company's share of the cost of this unit at December 31, 1993 is $30,733,000 with accumulated depreciation totaling $17,846,000. AGC and the Company also share equally in the cost of operation and output of the unit. The Company's share of operating costs is included in operating expenses in the Consolidated Statements of Income. 12. SEGMENTS OF BUSINESS The Company is primarily a public utility operating company engaged in distributing electricity and natural gas. The reportable items for electric and gas departments for the years ended December 31 are as follows: 13. TAXES OTHER THAN INCOME TAXES The items comprising property and other taxes for the years ended December 31 are as follows: 14. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND TEMPORARY INVESTMENTS The carrying amount approximates fair value because of the short maturity of those investments. The fair value of temporary investments were based on current market values. LONG-TERM DEBT The fair value of the Company's long-term debt was estimated based on the current quoted market rate of utilities with a comparable debt rating. Nonutility long- term debt was valued based upon the most recent debt financing. PARTNERSHIP OBLIGATIONS The fair value of the Company's partnership obligations was estimated based on the current quoted market rate of comparable debt. REDEEMABLE PREFERRED STOCK Fair value of the Company's redeemable preferred stock was estimated based on the current quoted market of utilities with a comparable debt rating. The carrying amount and estimated fair values of the Company's financial instruments at December 31 are as follows: At December 31, 1993 and 1992, approximately $19,100,000 and $11,200,000, respectively, represent the excess of fair value over carrying amounts of the Company's long-term debt relating to utility operations. Anticipated regulatory treatment of the excess of fair value over carrying amounts of the Company's long-term debt, if in fact settled at amounts approximating those above, would dictate that these amounts be used to reduce the Company's rates over a prescribed amortization period. Accordingly, any settlement would not result in a material impact on the Company's financial position or results of operations. Item 9.

Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Identification of Directors The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. (b) Identification of Executive Officers The information required by this item is included in Part I, Item 1. - BUSINESS on page 9, to which reference is hereby made. Item 11.

Item 11. EXECUTIVE COMPENSATION AND TRANSACTIONS The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1) The financial statements, including supporting schedules, are listed in the Index to Financial Statements, page 22, (a) 2) filed as part of this report. (a) 3) Exhibits: EX-2(a) Merger Agreement - Plan of Reorganization and Agreement of Merger, by and among: Southern Indiana Gas and Electric Company; Southern Indiana Group, Inc.; Horizon Investments, Inc.; and MPM Investment Corporation, dated August 27, 1987. (Physically filed and designated as Exhibit A in Form S-4 Registration Statement filed November 12, 1987, File No. 33-18475.) EX-3(a) Amended Articles of Incorporation as amended March 26, 1985. (Physically filed and designated in Form 10-K, for the fiscal year 1985, File No. 1-3553, as Exhibit 3-A.) Articles of Amendment of the Amended Articles of Incorporation, dated March 24, 1987. (Physically filed and designated in Form 10-K for the fiscal year 1987, File No. 1-3553, as Exhibit 3-A.) Articles of Amendment of the Amended Articles of Incorporation, dated November 27, 1992. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 3-A). EX-3(b) By-Laws as amended through December 18, 1990. (Physically filed in Form 10-K for the fiscal year 1990, File No. 1-3553, as Exhibit 3-B.) By-Laws as amended through September 22, 1993. (Physically filed herewith as EX-3(b).) EX-4(a)*Mortgage and Deed of Trust dated as of April 1, 1932 between the Company and Bankers Trust Company, as Trustee, and Supplemental Indentures thereto dated August 31, 1936, October 1, 1937, March 22, 1939, July 1, 1948, June 1, 1949, October 1, 1949, January 1, 1951, April 1, 1954, March 1, 1957, October 1, 1965, September 1, 1966, August 1, 1968, May 1, 1970, August 1, 1971, April 1, 1972, October 1, 1973, April 1, 1975, January 15, 1977, April 1, 1978, June 4, 1981, January 20, 1983, November 1, 1983, March 1, 1984, June 1, 1984, November 1, 1984, July 1, 1985, November 1, 1985, June 1, 1986. (Physically filed and designated in Registration No. 2-2536 as Exhibits B-1 and B-2; in Post-effective Amendment No. 1 to Registration No. 2-62032 as Exhibit (b)(4)(ii), in Registration No. 2-88923 as Exhibit 4(b)(2), in Form 8-K, File No. 1-3553, dated June 1, 1984 as Exhibit (4), File No. 1-3553, dated March 24, 1986 as Exhibit 4-A, in Form 8-K, File No. 1-3553, dated June 3, 1986 as Exhibit (4).) July 1, 1985 and November 1, 1985 (Physically filed and designated in Form 10-K, for the fiscal year 1985, File No. 1-3553, as Exhibit 4-A.) November 15, 1986 and January 15, 1987. (Physically filed and designated in Form 10-K, for the fiscal year 1986, File No. 1-3553, as Exhibit 4-A.) December 15, 1987. (Physically filed and designated in Form 10-K, for the fiscal year 1987, File No. 1-3553, as Exhibit 4-A.) December 13, 1990. (Physically filed and designated in Form 10-K, for the fiscal year 1990, File No. 1-3553, as Exhibit 4-A.) April 1, 1993. (Physically filed and designated in Form 8-K, dated April 13, 1993, File 1-3553, as Exhibit 4.) June 1, 1993 (Physically filed and designated in Form 8-K, dated June 14, 1993, File 1-3553, as Exhibit 4.) May 1, 1993. (Physically filed herewith as EX-4(a).) EX-10.1 Agreement, dated, January 30, 1968, for Unit No. 4 at the Warrick Power Plant of Alcoa Generating Corporation ("Alcoa"), between Alcoa and the Company. (Physically filed and designated in Registration No. 2-29653 as Exhibit 4(d)-A.) EX-10.2 Letter of Agreement, dated June 1, 1971, and Letter Agreement, dated June 26, 1969, between Alcoa and the Company. (Physically filed and designated in Registration No. 2-41209 as Exhibit 4(e)-2.) *Pursuant to paragraph (b)(4)(iii)(a) of Item 601 of Regulation S-K, the Company agrees to furnish to the Commission on request any instrument with respect to long- term debt if the total amount of securities authorized thereunder does not exceed 10% of the total assets of the Company, and has therefore not filed such documents as exhibits to this Form 10-K. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) EX-10.3 Letter Agreement, dated April 9, 1973, and agreement dated April 30, 1973, between Alcoa and the Company. (Physically filed and designated in Registration No. 2-53005 as Exhibit 4(e)-4.) EX-10.4 Electric Power Agreement (the "Power Agreement"), dated May 28, 1971, between Alcoa and the Company. (Physically filed and designated in Registration No. 2-41209 as Exhibit 4(e)-1.) EX-10.5 Second Supplement, dated as of July 10, 1975, to the Power Agreement and Letter Agreement dated April 30, 1973 - First Supplement. (Physically filed and designated in Form 12-K for the fiscal year 1975, File No. 1-3553, as Exhibit 1(e).) EX-10.6 Third Supplement, dated as of May 26, 1978, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1978 as Exhibit A-1.) EX-10.7 Letter Agreement dated August 22, 1978 between the Company and Alcoa, which amends Agreement for Sale in an Emergency of Electrical Power and Energy Generation by Alcoa and the Company dated June 26, 1979. (Physically filed and designated in Form 10-K for the fiscal year 1978, File No. 1- 3553, as Exhibit A-2.) EX-10.8 Fifth Supplement, dated as of December 13, 1978, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1979, File No. 1-3553, as Exhibit A-3.) EX-10.9 Sixth Supplement, dated as of July 1, 1979, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1979, File No. 1-3553, as Exhibit A-5.) EX-10.10 Seventh Supplement, dated as of October 1, 1979, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1979, File No. 1-3553, as Exhibit A-6.) EX-10.11 Eighth Supplement, dated as of June 1, 1980 to the Electric Power Agreement, dated May 28, 1971, between Alcoa and the Company. (Physically filed and designated in Form 10- K for the fiscal year 1980, File No. 1-3553, as Exhibit (20)-1.) EX-10.12* Agreement dated May 6, 1991 between the Company and Ronald G. Reherman for consulting services and supplemental pension and disability benefits. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A- 12.) EX-10.13* Agreement dated July 22, 1986 between the Company and A. E. Goebel regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-13.) EX-10.14* Agreement dated July 25, 1986 between the Company and Ronald G. Reherman regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-14.) EX-10.15* Agreement dated July 22, 1986 between the Company and James A. Van Meter regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-15.) EX-10.16* Agreement dated February 22, 1989 between the Company and J. Gordon Hurst regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553 as Exhibit 10-A-16.) EX-10.17* Summary description of the Company's nonqualified Supplemental Retirement Plan (Physically filed and designated in Form 10- K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-17.) * Filed pursuant to paragraph (b)(10)(iii)(A) of Item 601 of Regulation S-K. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) EX-10.18* Supplemental Post Retirement Death Benefits Plan, dated October 10, 1984. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-18.) EX-10.19* Summary description of the Company's Corporate Performance Incentive Plan. (Physically filed and designated in Form 10- K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-19.) EX-10.20* Company's Corporate Performance Incentive Plan as amended for the plan year beginning January 1, 1994. (Physically filed herewith as Exhibit 10-A-20.) * Filed pursuant to paragraph (b)(10)(iii)(A) of Item 601 of Regulation S-K. (b) Reports on Form 8-K No Form 8-K reports were filed by the Company during the fourth quarter of 1993. SCHEDULE V Page 1 of 3 SOUTHERN INDIANA GAS AND ELECTRIC COMPANY PROPERTY, PLANT AND EQUIPMENT Year 1993 SCHEDULE IX SOUTHERN INDIANA GAS AND ELECTRIC COMPANY SHORT-TERM BORROWINGS Reference is made to Note 4 of the Notes to Consolidated Financial Statements, page 35, regarding short- term borrowings. SCHEDULE X SOUTHERN INDIANA GAS AND ELECTRIC COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION Reference is made to Note 13 of the Notes to Consolidated Financial Statements, page 39, regarding taxes other than income taxes. Maintenance and depreciation, other than set forth in the "Consolidated Statements of Income," rents, advertising costs, research and development and royalties during the periods were not significant. SCHEDULE XIII SOUTHERN INDIANA GAS AND ELECTRIC COMPANY OTHER INVESTMENTS December 31, 1993 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 28, 1994 SOUTHERN INDIANA GAS AND ELECTRIC COMPANY By R. G. Reherman, Chairman, President and Chief Executive Officer BY (R. G. Reherman) R. G. Reherman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signatures Title Date R. G. Reherman Chairman, President, Chief Executive Officer (Principal Executive Officer) March 28, 1994 A. E. Goebel* Senior Vice President, Chief Financial Officer, Secretary and Treasurer (Principal Financial Officer) March 28, 1994 S. M. Kerney* Controller (Principal Accounting Officer) March 28, 1994 Melvin H. Dodson* ) ) Walter B. Emge* ) ) Robert L. Koch II* ) ) Jerry A. Lamb* ) ) Donald A. Rausch* ) Directors March 28, 1994 ) John H. Schroeder* ) ) Richard W. Shymanski*) ) Donald E. Smith* ) ) James S. Vinson* ) ) N. P. Wagner* ) *By (R. G. Reherman, Attorney-in-fact) SIGECO 10-K EXHIBIT INDEX Sequential Page Number Exhibits incorporated by reference are found on 42-44 EX-3(b) By-Laws as amended through September 22, 1993 63-79 EX-4(a) Supplemental Indentures dated May 1, 1993 81-108 EX-10.20 Company's Corporate Performance Incentive Plan as amended for the plan year beginning January 1, 1994 110-114 EX-12 Computation of ratio of earnings to fixed charges 55 EX-21 Subsidiary of the Registrant 56 EX-24 Power-of-Attorney 60-61

828530_1993.txt

828530

1993

ITEM 1. BUSINESS. GENERAL ADMIRAL FINANCIAL CORP. ("ADMIRAL") IS CURRENTLY AN INACTIVE CORPORATION, WITH NO ONGOING BUSINESS ACTIVITY. Admiral was formed in 1987 to acquire an insolvent savings and loan association in a supervisory acquisition solely with private investment funds, and without the benefit of any federal assistance payments. Admiral acquired Haven Federal Savings and Loan Association ("Haven") on June 16, 1988. Admiral had no prior operating history. Haven was a Federally chartered stock savings and loan association that had been conducting its business in Winter Haven, Florida, since 1964. In addition to its main office, Haven had four branch offices in Polk County which were located in central Florida. A large portion of the population of Polk County consists of retired persons on fixed incomes so that the operations of the Association are dependent primarily on the needs of this community and are relatively unaffected by the prosperity of any of the businesses located in its primary market area. As a result of the enactment of The Financial Institution Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the United States government retroactively applied new capital standards to Haven, declared Haven to be insolvent and in default of certain provisions of an agreement that the federal government itself had disregarded, and confiscated the net assets of Haven on March 2, 1990. Admiral's sole significant asset was its investment in Haven, and Admiral has been reduced to an inactive corporate shell. Admiral acquired Haven on June 16, 1988. The acquisition occurred through a contributed property exchange, whereby Admiral issued 8,000,000 new common shares in exchange for assets (primarily real estate and a profitable business engaged in the purchase and redemption of Florida tax sale certificates) having fair market values of approximately $40 million, subject to approximately $27 million of mortgages and other liabilities, and less approximately $1 million of fees and expenses (necessary to provide the proper forms and documentation in accordance with government rules and regulations) during the ensuing sixteen month application and negotiation process with federal regulatory authorities, for a net fair value equity contribution of approximately $12 million. Admiral then contributed virtually all of these net assets and liabilities to the capital of Haven, while simultaneously issuing an additional 987,000 new common shares of Admiral to the former Haven shareholders, in exchange for 100% of the outstanding shares of Haven in an approved "supervisory acquisition" of an insolvent thrift institution. Admiral has had substantially no assets, and no operations other than its investment in Haven, and all active business operations were carried on through Haven. Prior to the consideration of any of the equity capital contributed by Admiral in the exchange, the fair value of Haven's liabilities assumed by Admiral, plus the cost of acquisition, was determined to have exceeded the fair market value of Haven's tangible assets acquired by approximately $14,902,000, of which approximately $5,374,000 was attributable to the estimated intangible value of Haven's deposit base and approximately $548,000 to the estimated intangible value of Haven's mortgage loan servicing portfolio. The balance of approximately $8,980,000 was recorded under generally accepted accounting principles (GAAP) by Haven as excess cost over net assets acquired ("Goodwill"). The acquisition was accounted for as if it occurred on June 30, 1988. The purchase method of accounting was used to record the acquisition and, accordingly, all assets and liabilities of Haven were adjusted to their estimated fair value as of the acquisition date. By way of a Resolution (the "Agreement") dated April 26, 1988, the Federal Home Loan Bank Board ("FHLBB") approved the acquisition of control of Haven by Admiral. A condition of the Agreement authorizing the acquisition required that Admiral account for the acquisition of Haven under the "purchase" method of accounting, whereby an asset in the nature of "Supervisory Goodwill" would be calculated in accordance with the "Regulatory Accounting Principles" (RAP) then in effect. Supervisory Goodwill was realized, generally, to the extent of any previous negative net worth of the acquired insolvent thrift, plus the excess of the fair market values of the contributed assets over their respective historical costs. Haven's Supervisory Goodwill of approximately $20 million was, in accordance with the Agreement, to be amortized against future earnings over a period of twenty-five years. Also in accordance with the Agreement, Haven was credited with new capital under RAP accounting, equal to $11 million. This amount was computed by taking into account the $13 million fair market value of the net assets contributed by Admiral to Haven, less the $1 million of fees and costs incurred, and less an additional $1 million resulting from reduced valuations of certain of the contributed assets for purposes of calculating Haven's RAP equity by the appraisal division of the Federal Home Loan Bank Board. In accordance with GAAP, however, the contributed equity values reported to Admiral's shareholders was the net historical book value of $596,812, net of approximately $1.05 million of out-of-pocket professional fees, expenses, and other transaction costs associated with the supervisory acquisition, and not the appraised net fair market equity values of $13 million. As an integral part of Admiral's application to acquire Haven, Admiral filed a Business Plan of proposed operations calling for a significant growth of earning assets, and an increase in low-cost deposits and other lower-cost liabilities to refinance Haven's relatively high cost of funds. This growth was to be generated both internally, and by acquisitions of other branches and thrifts. The FHLBB Agreement approved Admiral's Business Plan. In exchange for the favorable accounting treatments regarding the Supervisory Goodwill and the resulting calculation of RAP equity, the Agreement imposed a number of conditions upon Admiral. Specifically: Admiral was required to record the supervisory acquisition transaction utilizing the "purchase" method of accounting, resulting in the recognition of the maximum amount of Supervisory Goodwill possible (approximately $20 million) under any allowable method of current accounting theory. Admiral agreed that it would cause the regulatory capital of Haven to be maintained at a level at or above the quarterly minimum regulatory capital requirement and, if necessary, infuse additional equity capital sufficient to comply with this requirement. Should Admiral default in this provision and be unable to cure the default within 90 days, the FSLIC could exercise any right or remedy available to it by law, equity, statute or regulation. In addition to the rights that were available to the FSLIC by virtue of the Agreement, whenever any savings and loan association fails to meet its regulatory capital requirement, the FHLBB and the FSLIC (or their successors) could take such actions as they deem appropriate to protect the Association, its depositors and the FSLIC. Admiral agreed that it would cause Haven to liquidate all of the contributed real estate according to a schedule specified by the FHLBB as follows: 37.5% of the market value of the properties (as determined by the FHLBB's District Appraiser) by March 31, 1989, an additional 12.5% by June 30, 1989, and an additional 12.5% during each succeeding quarter. If Admiral had defaulted in this regard, it could have been subject to forfeiture of 100% of its Haven stock. The FSLIC would have the right to vote the Haven stock, remove Haven's Board of Directors and/or dispose of the stock of Haven. Admiral acquired Haven solely with private equity capital. There were no federal assistance payments, capital assistance notes, or any other form of federal payments (which had been made available to other purchasers of insolvent thrifts), involved in the acquisition Agreement negotiations. The only element of the Agreement that Admiral specifically bargained for was the allowance of Supervisory Goodwill, with its twenty-five year amortization period, to compensate Admiral for its recapitalization of an insolvent thrift with a $15 million negative net worth on the supervisory acquisition date. For the fiscal year ended June 30, 1989, Haven experienced a "Net Interest Income" (similar to a "Gross Profit" for commercial business operations) of $1.635 million, as opposed to a Net Interest Expense of ($.163 million) for the fiscal year immediately preceding Admiral's supervisory acquisition of Haven. These results represented a significant turnaround for Haven during the first year of post- supervisory acquisition operations. Haven was successful in meeting the real estate liquidation requirements imposed by the Agreement, including any extensions of time granted thereunder. However, Haven experienced a $4.3 million erosion of its regulatory capital due to losses sustained as a result of liquidating one single, large commercial property included in the stated real estate under what can only be described as "fire sale" conditions, on the last possible day under the Agreement, in order to meet the time schedules mandated by the FHLBB in the Agreement. This loss, together with other operating losses and goodwill amortization expenses, caused Haven to fail to meet its minimum capital requirement as of March 31, 1989, and at all times thereafter. The Financial Institution Reform, Recovery and Enforcement Act of 1989 ("FIRREA") was introduced on February 5, 1989, and enacted into law on August 9, 1989. FIRREA imposed, by no later than December 7, 1989, more stringent capital requirements upon savings institutions than those previously in effect. These capital requirements were applied to Haven on a retroactive basis. Haven did not meet these new capital requirements on the date of enactment, or on the date of Haven's acquisition by Admiral. Because of certain provisions of FIRREA relating primarily to the disallowance of supervisory goodwill and certain other intangible assets in the calculation of required net capital, management estimates that Admiral would have been required under the Agreement to infuse additional capital of approximately $18 million by December 7, 1989. Had FIRREA been in effect on the date of Haven's acquisition by Admiral, Haven would have fallen short of the capital requirements by approximately $14 million, after taking into account Admiral's contribution of $11 million of new regulatory capital. Admiral did not infuse any additional capital, and the net assets of Haven were confiscated by the federal authorities on March 2, 1990. With nearly $20 million of Supervisory Goodwill on the books and only $11 million of contributed capital (thereby resulting in a negative tangible net worth in excess of $8 million, and an immediate shortfall of qualifying capital in excess of nearly $15 million) on the date of the supervisory acquisition of Haven by Admiral, Haven did not meet these new capital requirements imposed by FIRREA. The FHLBB, in a supervisory letter dated March 31, 1989, designated the Association as a "troubled institution" subject to the requirements of the office of Regulatory Activities Regulatory Bulletin 3a ("RB3a"). A troubled institution under RB3a is subject to various growth restrictions concerning deposit accounts and lending activities. Haven was directed to "shrink" its asset and deposit base, thereby assuring future operating losses. As of March 31, 1989, Haven's regulatory capital fell approximately $580,000 below its minimum regulatory capital requirement. As of June 30, 1989, Haven's regulatory capital was approximately $2.3 million below the minimum regulatory requirement. This regulatory capital deficiency was a result of the Association's substantial operating losses incurred as a result of the directive from FHLBB supervisory personnel to "shrink" the assets and deposits of Haven, and the sale of certain parcels of contributed real estate, under circumstances that could only be described as a "fire sale," at amounts which approximated predecessor cost, rather than at the substantially higher appraised values (which had previously been reviewed and approved by the appropriate regulatory authorities). In addition, due to Haven's inability to continue operations without a significant capital infusion or other source of recapitalization, the value of the Association's excess cost over net assets acquired (Goodwill) was considered permanently impaired and, accordingly, the entire balance was written off at June 30, 1989. Admiral was notified by the FHLBB on July 17, 1989, that since the regulatory capital deficiency had not been corrected, Admiral was in default of the Agreement and had 90 days (i.e., until October 18, 1989) to cure the default. Admiral management was directed to resign any positions held at Haven, Haven personnel were directed to cease communications with Admiral, and to abandon any efforts to meet the contributed real estate liquidation schedule contained in the Agreement. Admiral did not infuse the additional capital required, and the net assets of Haven were confiscated by the federal government on March 2, 1990. Due to the regulatory capital requirements imposed by FIRREA, even if Admiral were able to infuse the approximate $2.3 million June 30, 1989 regulatory capital deficiency and cure the default, the cure would have only been temporary. Because of certain provisions of FIRREA relating primarily to the treatment of intangible assets, management estimates that Admiral would have been required to infuse additional capital of approximately $18 million by the December 7, 1989 date specified by the new law. Had the FIRREA requirements been effective and fully phased in at the time of the acquisition, Haven would have had a tangible capital deficiency of approximately $18 million as of the acquisition date; and to meet the capital requirements, Admiral would have had to fund approximately $14 million, in addition to the assets which were contributed with an appraised equity value of approximately $11 million for regulatory capital purposes. As of September 30, 1989, Haven had not met the contributed real estate sale schedule. On September 27, 1989, the Association received a letter from its Supervisory Agent in which the Supervisory Agent agreed not to enforce its rights upon a default in the real estate sale schedule until November 1, 1989. The net assets of Haven were confiscated by the federal government on March 2, 1990. Because of the effects of FIRREA, and the impact of certain requirements imposed by the Federal Home Loan Bank Board ("FHLBB") and the Federal Savings and Loan insurance Corporation ("FSLIC") upon Admiral and upon the operations of Haven, Admiral's management determined that the initial economic decisions leading to the acquisition, recapitalization and operation of Haven had been frustrated by FIRREA, and the only remaining alternative available to Admiral was to sell or merge Haven, and withdraw from the savings and loan business. Once Haven was divested, Admiral would have no other operations. In the meantime, Admiral and Haven applied, immediately after the enactment of FIRREA, for relief from the requirements of the Agreement. Haven also applied for regulatory relief from sanctions imposed by FIRREA for failing to meet the minimum regulatory capital requirements. Furthermore, Admiral and Haven applied for federal assistance payments under a FIRREA relief provision which management believed was intended to be applicable to prior acquirers of insolvent thrift institutions in supervisory acquisitions, where a significant amount of "supervisory goodwill" is involved, and those acquirers were being treated by the effects of the new legislation as if they had been the persons who had caused the thrift to become insolvent in the first place. Admiral management was never notified of any action taken or hearing scheduled in connection with the various forms of relief being sought. Because of all of the circumstances enumerated above, Admiral attempted to dispose of its Haven common stock and to secure a release of its obligations under the Agreement either through a merger, an acquisition or a tender of its Haven common stock to the FHLBB or its successor in the event that the Association's applications for specific relief were not approved. The net assets of Haven were confiscated on March 2, 1990. ITEM 2.

ITEM 2. PROPERTIES. Admiral Financial Corp.'s principal office is located in Miami, Florida. The Company is currently being allowed to share, free of charge, certain office facilities and office equipment located at 825 Arthur Godfrey Road, Miami Beach, Florida 33140. Admiral does not have any lease obligations. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. As of June 30, 1993, Admiral was not involved in any material legal proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. On June 21, 1988, Admiral's common stock began trading on the National Association of Securities Dealers Automatic Quotation System (NASDAQ) under the symbol ADFC. During the year, Admiral was notified by NASDAQ that Admiral's net worth did not meet the minimum standards for listing on the NASDAQ System and that Admiral's stock would begin trading in the "over-the-counter" market after September 30, 1989, if the minimum capital standards were not met. Since September 30, 1989, Admiral's shares have been listed in the "over-the-counter" market on the OTC Bulletin Board. There is no firm currently making a market in Admiral's stock. The following table sets forth, for the periods indicated, the high and low sales prices as reported by NASDAQ. ASK BID ------------- ------------- HIGH LOW HIGH LOW ---- --- ---- --- 1992: First Quarter 0 0 0 0 Second Quarter 0 0 0 0 Third Quarter 0 0 0 0 Fourth Quarter 0 0 0 0 1993: First Quarter 0 0 0 0 Second Quarter 0 0 0 0 Third Quarter 0 0 0 0 Fourth Quarter 0 0 0 0 As of June 30, 1993, there were 492 stockholders of record. The Company has not paid cash dividends since inception. The Company anticipates that for the foreseeable future any earnings from future operations will be retained for use in its business and no cash dividends will be paid on its common stock. Declaration of dividends in the future will remain within the discretion of the Company's Board of Directors, which will review its dividend policy from time to time on the basis of the company's financial condition, capital requirements, cash flow, profitability, business outlook and other factors. ITEM 6.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA. Admiral was formed in 1987 for the purpose of effecting the Contributed Property Exchange Offer and Merger with Haven and had no prior operating history. Admiral's acquisition of Haven occurred on June 16, 1988, and has been accounted for as if it occurred on June 30, 1988. The following table sets forth selected consolidated financial data for the operations of Haven and for Admiral for the five years ended June 30, 1993. In addition, selected financial data on the financial position of Admiral is shown as of June 30, 1993, 1992, 1991, 1990, and 1989. Such information is qualified in its entirety by the more detailed information set forth in the financial statements and the notes thereto included elsewhere herein. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS Admiral was formed in 1987 and had no operations until its acquisition of Haven on June 16, 1988. The acquisition was accounted for as though it had occurred on June 30, 1988, so that the five years ended June 30, 1993 are the first years during which Admiral reported operations. Admiral's only significant asset is its investment in Haven and, therefore, the operations being reported on are primarily those of its subsidiary, the predecessor registrant Haven. COMPARISON OF YEARS ENDED JUNE 30, 1993 AND 1992 GENERAL. Net loss for 1993 was $20,193 or $0.002 per share. This compares to a net loss for 1992 of $20,194 or $0.002 per share. Admiral was inactive at June 30, 1993 and 1992. TOTAL INCOME. Admiral's gross revenues were $0 and $0 in 1993 and 1992, respectively. COMPENSATION EXPENSE. Compensation expenditures were eliminated during fiscal 1990, when all employees were terminated. Consequently, compensation expense were $0 and $0 in 1993 and 1992. TOTAL OTHER EXPENSE. Other expense includes amortization of organizational expenses of $20,194 and $20,193 in 1992 and 1993. COMPARISON OF YEARS ENDED JUNE 30, 1992 AND 1991 GENERAL. Net loss for 1992 was $20,194 or $0.002 per share. This compares to a net loss for 1991 of $21,043 or $0.002 per share. Admiral was inactive at June 30, 1992 and 1991. TOTAL INCOME. Admiral's gross revenues were $0 and $0 in 1992 and 1991, respectively. COMPENSATION EXPENSE. Compensation expenditures were eliminated during fiscal 1990, when all employees were terminated. Consequently, compensation expense were $0 and $0 in 1992 and 1991. TOTAL OTHER EXPENSE. Other expense items, including amortization of organizational expenses of $20,194 and $20,193 in 1992 and 1991, were reduced as a result of Admiral ceasing active operations during fiscal 1990, when all employees were terminated, Admiral's offices were vacated, and Admiral became inactive. Consequently, other expense decreased from $21,044 in 1991 to $20,194 in 1992. LIQUIDITY AND CAPITAL RESOURCES Admiral has been reduced to a corporate "shell," with no operations or current activity. There is no corporate liquidity, no available capital resources, and no immediately foreseeable prospects for the future improvement of Admiral's financial picture. Admiral management intends to seek a new line of business. as yet unidentified. In connection therewith, Admiral's management believes that a restructuring of Admiral may be necessary in order to raise capital for new operations, and any such restructuring may have a substantial dilutive effect upon Admiral's existing shareholders. Admiral has no ongoing commitments or obligations other than with respect to its obligations related to the acquisition of Haven. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and schedules listed in Item 14 hereof and included in this report on Pages through are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN, AND DISAGREEMENTS WITH, ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth, as of June 30, 1993, certain information with respect to the directors and executive officers continuing in office until their successors have been elected and qualified. OFFICER AND/OR DIRECTOR NAME AGE POSITION SINCE ---- --- ----------------------- ----- Wm. Lee Popham 42 Chairman of the Board, 1987 Chief Executive Officer and President Linda E. Baker 54 Director, Vice President, 1987 Secretary, and Treasurer Charles E. Fancher, Jr. 43 Director 1988 Certain background information for each director is set forth below. WM. LEE POPHAM has served as Chairman of the Board and President of Admiral since its inception in 1987. He had also served as Chairman of the Board and President of Caesar Creek Holdings, Inc. (CCH), Miami, Florida (a financial acquisition company) since June 1985, and in various other officer and director positions with several subsidiaries and affiliates of CCH, until its liquidation in December 1989. He has also served as a Director and Secretary-Treasurer of Jeanne Baker, Inc., a real estate brokerage company located in Dade County, Florida, since 1973, and has been actively employed by that Company since 1990. He previously served as President of First Atlantic Capital Corporation, Miami, Florida (an investment company) from July 1983 to May 1985. Prior thereto, he was a partner in the accounting firm of KPMG Peat Marwick, LLP, Miami, Florida, where he practiced as a Certified Public Accountant. He also served as a director of Cruise America, Inc., Miami, Florida (a recreational vehicle rental and sales corporation), which shares are traded on the American Stock Exchange, from 1984 until 1991. LINDA E. BAKER has served as Vice President, Secretary and Treasurer of Admiral since its inception in April 1987. She has also served as Vice President, Secretary and Treasurer of CCH, Miami, Florida (a financial acquisition company) from June 1985 until its liquidation in December 1989, and in various other officer and director positions with several subsidiaries and affiliates of CCH. She was Vice President and Secretary of First Atlantic Capital Corporation, Miami, Florida (an investment company) from October 1983 to June 1985. Prior thereto, she was a Manager with the accounting firm of KPMG Peat Marwick, LLP, Miami, Florida. Ms. Baker is a Certified Public Accountant and a licensed Florida real estate broker. CHARLES E. FANCHER, JR. has served as President and Chief Operating Officer of General Development Utilities, Inc., Miami, Florida (a water, waste water, and liquid propane gas utility company) since June 1991, and Vice President of Atlantic Gulf Communities Corporation (f/k/a General Development Corporation), in Miami, Florida (a real estate development company) since January 1986. Mr. Fancher was previously Senior Vice President of General Development Utilities, Inc., since January 1986. Prior thereto, he served as a Vice President of General Development Utilities, Inc. in the areas of finance and operations. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION CASH COMPENSATION The following table sets forth certain information with respect to the Chief Executive Officer, and each other executive officer of Admiral and/or Haven whose total cash compensation exceeded $100,000 during the year ended June 30, 1993. ANNUAL COMPENSATION AWARDS NAME AND -------------------------- PRINCIPAL POSITION YEAR SALARY BONUS OTHER ------------------ ---- ------ ----- ----- Wm. Lee Popham 1993 $ --- --- --- Chairman and President 1992 --- --- --- Chief Executive Officer 1991 --- --- --- INCENTIVE BONUS PLAN Admiral has a policy of paying discretionary bonuses to eligible officers and employees based upon the individual's performance. Under the plan, Admiral and its subsidiaries distribute approximately 20% of Admiral's consolidated pre-tax profits in the form of cash bonuses awarded by the Compensation Committee of the Board of Directors, based on management's recommendations and evaluations of performance. No bonuses have been paid since Admiral's inception in 1987. RETIREMENT PLAN No Admiral employee is currently covered under any form of retirement plan. In prior years, Haven employees were covered under a noncontributory trusteed pension plan, which was replaced by a contributory Section 401(k) plan for Admiral and Haven employees on March 31, 1989. Employees were permitted to contribute amounts up to 6% of their annual salary to this plan, with the employer providing matching contributions at a rate of 50% of such employee's contributions (to a maximum of 3% of such employee's salary), together with a discretionary contribution amount not exceeding 1% of covered compensation. The Section 401(k) contribution plan was suspended when the net assets of Haven were confiscated, and all Admiral employees were removed from their employment positions by the federal regulators. STOCK COMPENSATION PROGRAM The Board of Directors and shareholders of Admiral adopted the 1988 Stock Compensation Program (the "Program"), effective December 19, 1988, for the benefit of directors, officers and other employees of Admiral and its subsidiaries, including Haven, who are deemed to be responsible for the future growth of Admiral. Under the Program, Admiral has reserved 1,100,000 shares of authorized but unissued Common Stock for the future issuance of option grants. Options granted under the Program can be in the form of incentive options, compensatory options, stock appreciation rights, performance shares, or any combination thereof. There have been no grants of any rights or options to any director, officer or employee of Admiral or any affiliate. EMPLOYEE STOCK PURCHASE PLAN The Board of Directors and shareholders of Admiral approved the 1988 Employee Stock Purchase Program on December 19, 1988, enabling the directors, officers and employees of Admiral and its affiliates to acquire a proprietary interest in Admiral's Common Stock through a payroll deduction program. To date, this plan has not been implemented by Admiral. EMPLOYMENT AGREEMENTS There are no employment agreements between Admiral and any of Admiral's employees. INDEBTEDNESS OF MANAGEMENT Admiral makes no loans to its directors, officers or employees. COMPENSATION OF DIRECTORS While each Director is entitled to receive $500 plus reasonable out-of-pocket expenses for attending each meeting, each Director volunteered to suspend the receipt of all director fees due to Admiral's current financial condition, beginning with the meeting held during the third fiscal quarter of the fiscal year ended June 30, 1989. No additional compensation is paid for attendance of committee meetings. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth information regarding the beneficial ownership of Admiral's Common Stock as of June 30, 1993 by (I) each person who is known by Admiral to own beneficially 5% or more of Admiral's Common Stock, (ii) each Director and/or officer of the Company, and (iii) all Directors and executive officers of Admiral as a group. Except as indicated below, each person has sole dispositive and voting power with respect to the shares of Common Stock indicated. AMOUNT AND PERCENT NATURE OF OF NAME AND ADDRESS OF BENEFICIAL COMMON BENEFICIAL OWNER OWNERSHIP STOCK ---------------- --------- ----- Wm. Lee Popham (l) 2,119,385 19.29% 825 Arthur Godfrey Road Miami Beach, Florida 33140 Ti-Aun Plantations, N.V. 889,007 8.09% Suite 600 600 Brickell Avenue Miami, Florida 33131 David C. Popham (2) 668,651 6.09% 3166 Commodore Plaza Coconut Grove, Florida 33133 Linda E. Baker 150,120 1.37% Suite 800 2665 South Bayshore Drive Coconut Grove, Florida 33133 Charles E. Fancher, Jr. 12,000 * 2844 Chucunantah Road Coconut Grove, Florida 33133 All directors and executive officers as a group (3 persons) 2,281,505 20.77% _______________ * Less than one percent (1) Includes 63,695 shares held in a testamentary trust for members of Wm. Lee Popham's family, for which Mr. Popham disclaims beneficial ownership. Does not include any shares directly or beneficially owned by David C. Popham (his brother) or Jeanne M. Baker (his mother). (2) Includes 76,185 shares held jointly by David C. Popham and Valerie P. Popham, his wife. Also includes 119,928 shares held jointly by David C. Popham and Jeanne M. Baker, the mother of David C. Popham and Wm. Lee Popham. Does not include any shares beneficially owned by Wm. Lee Popham, the brother of David C. Popham. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Wm. Lee Popham, the Chairman and President of Admiral, was previously also the Chairman, President and controlling stockholder of CCH. Mr. Popham's mother, Jeanne M. Baker, was also a director of CCH. While CCH did not receive any fees or other compensation from Admiral or Haven during the fiscal year, CCH did receive a consulting, management and organizational fee in connection with the acquisition of Haven by Admiral of $354,286, plus expense reimbursements payable in cash during fiscal 1988. CCH and its affiliates, including Caesar Creek TSC, Ltd. (CCTSC) were liquidated in December 1989. Wm. Lee Popham, together with certain members of his family (including David C. Popham and Jeanne M. Baker) and certain affiliates including CCH and CCTSC, participated in a transaction which capitalized Admiral in order to effect the acquisition of Haven in a contributed property exchange offer. The total historical cost of the property contributed by Wm. Lee Popham, his family and affiliates in the exchange was $1,228,227, the aggregate appraised value of such contributed property was $12,586,553, and the net contribution value was $7,022,965. Mr. Popham and his family and affiliates received an aggregate of 4,330,208 shares of Admiral Common Stock in the exchange, which occurred on June 16, 1988. Linda E. Baker, a director, officer and stockholder of Admiral was also an officer, director and stockholder of CCH prior to its liquidation, as described above. She is not related to Jeanne M. Baker. In accordance with the approved supervisory acquisition Agreement, Haven was contractually obligated to pay Admiral a management fee of $25,000 per quarter for financial and operational advice, budgeting, business planning, marketing and public relations. Haven was directed by FHLBB supervisory personnel to cease in honoring this approved contractual obligation, beginning with the January 1990 payment. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ADMIRAL FINANCIAL CORP. INDEX (A)1. Admiral Financial Corp.: PAGE Statement Regarding Sec. 210.3-11 of Regulation S-K Consolidated Balance Sheets as of June 30, 1993 and 1992 Consolidated Statement of Operations for the three years ended June 30, 1993 Consolidated Statement of Stockholders' (Deficit) Equity for the three years ended June 30, 1993 Consolidated Statement of Cash Flows for the three years ended June 30, 1993 Notes to Consolidated Financial Statements (a)2. There are no financial statement schedules required to be filed by Item 8 of this Form 10-K, or by paragraph (d) of Item 14. (a)3. Exhibits (3) The Articles of Incorporation and By-Laws of Admiral are incorporated herein by reference to Exhibits 3.1 and 3.2 of Admiral's Form S-4 Registration Statement filed with the Securities and Exchange Commission on January 22, 1988. (4) A specimen copy of Admiral's common stock certificate is incorporated herein by reference to Exhibit 4.1 in Amendment No.1 of Admiral's Form S-4 Registration Statement filed with the Securities and Exchange Commission on April 5, 1988. (9) Not applicable. (10) Admiral hereby incorporates by reference the sections entitled "Appendix A - Agreement and Plan of Reorganization, as amended, dated October 26, 1987, and related Agreement and Plan of Merger, as amended" and "Contributed Property Exchange Offer" contained in Haven's Prospectus/Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934 in connection with Haven's special meeting held on June 3, 1988. (11) Not applicable. (12) Not applicable. (13) Not applicable. (16) Not applicable. (18) Not applicable. (21) Admiral's sole subsidiary has been Haven Federal Savings and Loan Association. The assets and liabilities of Haven were confiscated by the federal government on March 2, 1990. (22) Not applicable. (23) Not applicable. (24) Not applicable. (27) Financial Data Schedule attached. (28) Not applicable. (99) Not applicable. (b) No reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) The exhibits required by Item 601 of Regulation S-K are included in (a)(3) above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ADMIRAL FINANCIAL CORP. By /s/ WM. LEE POPHAM ----------------------------- Wm. Lee Popham, President and Date: September 17, 1996 Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ WM. LEE POPHAM Chairman of the Board September 17, 1996 - ---------------------------- of Directors, Chief Wm. Lee Popham Executive Officer, and Chairman and President President Principal Executive Officer /s/ LINDA E. BAKER Director, Vice President, September 17, 1996 - ---------------------------- Secretary And Treasurer Linda E. Baker Principal Financial Officer /s/ CHARLES E. FANCHER, JR. Director September 17, 1996 - ---------------------------- Charles E. Fancher, Jr. FINANCIAL STATEMENTS OF AN INACTIVE REGISTRANT Pursuant to Sec. 210.3-11 of Regulation S-X, Admiral Financial Corp. qualifies as an inactive entity, meeting all of the following conditions: (A) Gross receipts from all sources for the fiscal year are not in excess of $100,000; (B) Admiral has not purchased or sold any of its own stock, granted options therefor, or levied assessments upon outstanding stock; (C) Expenditures for all purposes for the fiscal year are not in excess of $100,000; (D) No material change in the business has occurred during the fiscal year, including any bankruptcy, reorganization, readjustment or succession or any material acquisition or disposition of plants, mines, mining equipment, mine rights or leases; and (E) No exchange upon which the shares are listed, or governmental authority having jurisdiction, requires the furnishing to it or the publication of audited financial statements. Accordingly, the attached financial statements of Admiral Financial Corp. are unaudited. ADMIRAL FINANCIAL CORP. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS ASSETS JUNE 30, 1993 JUNE 30, 1992 ------------- ------------- (Unaudited) (Unaudited) Cash $ 0 $ 0 Prepaid expenses and other assets 0 20,193 Net assets of Haven Federal Savings and Loan Association (note 2) 0 0 --------- --------- Total assets $ 0 $ 20,193 ========= ========= LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY Accrued expenses and other liabilities 23,890 $ 23,890 Net liabilities of Haven Federal Savings and Loan Association (note 2) 0 0 --------- --------- Total liabilities 23,890 23,890 Preferred stock, $.01 par value. Authorized 6,000,000 shares, none outstanding Common stock, $.001 par value, 50,000,000 shares authorized 10,987,000 shares issued 10,987 10,987 Treasury stock, 1,954 and 1,954 shares, at cost 0 0 Additional paid-in capital 680,710 680,710 Deficit (715,587) (695,394) --------- --------- Total stockholders' (deficit) equity (23,890) (3,697) --------- --------- Total liabilities and stockholders' (deficit) equity $ 0 $ 20,193 ======== ========= See accompanying notes to consolidated financial statements. ADMIRAL FINANCIAL CORP. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) YEARS ENDED JUNE 30, ------------------------------ 1993 1992 1991 ---- ---- ---- REVENUES: Interest Income $ 0 $ 0 $ 0 Other income -- -- -- ------- --------- -------- Total income 0 0 0 EXPENSES: Employee Compensation -- -- -- Other Expense 20,193 20,194 21,043 -------- --------- --------- Total expense 20,193 20,194 21,043 Loss from discontinued operation 0 0 0 (note 2) --------- --------- ---------- Net loss $ 20,193) $ (20,194) $ (21,043) ========== ========== ========== Loss per share $ (0.00) $ (0.00) $ (0.00) ========== ========== ========== Dividend per share -- -- -- ========== ========== ========== Weighted average number of shares outstanding 10,985,046 10,985,046 10,985,046 ========== ========== ========== See accompanying notes to consolidated financial statements See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements ADMIRAL FINANCIAL CORP. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1993 AND 1992 (1) ORGANIZATION AND REGULATORY MATTERS Admiral Financial Corp. ("Admiral") is inactive. On June 16, 1988, Admiral acquired Haven Federal Savings and Loan Association ("Haven"). Admiral was a newly formed savings and loan holding company that was capitalized through the contribution of various parcels of real estate, investment securities and a tax sale certificate business ("Contributed Property") recorded at its net predecessor cost of $596,812, net of transaction costs. The Association was acquired by Admiral through the exchange of common stock which was accounted for under the purchase method of accounting and, accordingly, the assets and liabilities were adjusted to their estimated fair market values as of the date of acquisition. In connection with the acquisition, the Federal Home Loan Bank Board ("FHLBB"), which was abolished by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 and was succeeded by the Office of Thrift Supervision ("OTS") of the Treasury Department, issued a resolution (the "Agreement") on April 26, 1988, requiring that Admiral must comply with certain conditions. Those conditions included a Regulatory Capital Maintenance/Dividend Agreement (the "Capital Agreement") dated June 15, 1988, by and between the Federal Savings and Loan Insurance Corporation "FSLIC" and Admiral: (a) No dividends will be paid by the Association until all of the real estate included in the Contributed Property is liquidated and the cash proceeds recorded on the Association's books. Any dividends that are a result of income from the sale of real estate are restricted to the sales price less the regulatory appraised value minus any carrying costs paid by the Association. In addition, unless prior approval has been obtained from the FHLBB, dividends paid by the Association shall be limited to 50% of its income for that fiscal year as reflected in its quarterly reports to the FHLBB, except for the fiscal year of acquisition when dividends paid by the Association shall be limited to 50% of its net income earned after the effective date of the acquisition, provided that any dividends permitted under this limitation may be deferred and paid in a subsequent year, and the payment of dividends would not reduce the regulatory capital of the Association below the required level. (b) If the Association fails to meet its regulatory capital requirements, then Admiral must infuse sufficient equity capital, in a form satisfactory to the FHLBB, into the Association during the subsequent quarter. Admiral was permitted to cure any default within 90 days. Failure to do so will allow the FSLIC to exercise its legal or equitable rights under the Capital Agreement to enforce the terms of the Capital Agreement. Admiral was deemed by the FHLBB on July 17, 1989, to have defaulted on its obligation to infuse capital under the Capital Agreement and was given until October 18, 1989, to cure such defaults. Failure to cure such default by that date would permit the FSLIC (or its successor) to seek its legal or equitable remedy as set forth in the Capital Agreement, which included specific performance or administrative or judicial enforcement proceedings. (c) Admiral shall cause the Association to liquidate all of the real estate contributed as regulatory capital within two years after consummation of the transaction according to the following schedule: at least 37.5% of the market value of the properties as determined by the FHLBB District Appraiser by the end of the third quarter after consummation and thereafter at least 12.5% each subsequent quarter. The Association shall not provide financing to facilitate the liquidation of the real estate contributed as regulatory capital without the prior written approval of the Association's Supervisory Agent. If Admiral does not meet this real estate liquidation schedule, the FSLIC shall have the right to vote the Association's stock, remove the Association's Board of Directors and/or dispose of any or all of the common stock of the Association owned by Admiral. The Association applied for relief from the requirements of the Resolution and Capital Agreement which mandate the sale of real estate in accordance with the schedule above, but was never given the opportunity for a hearing, or the benefit of a response. For regulatory purposes, the Association was required to comply with minimum regulatory capital requirements. During the year ended June 30, 1989, the Association incurred substantial operating losses and sold certain parcels of Contributed Property at amounts which approximated predecessor cost, rather than at the substantially higher regulatory appraised values. These factors contributed to the Association's failure to meet its minimum regulatory capital requirement on June 30, 1989. At June 30, 1989, such minimum regulatory capital requirement amounted to approximately $6,642,000. When an association fails to meet its regulatory capital requirement, the FHLBB and the FSLIC (and their successors) may take such actions as they deem appropriate to protect the Association; its depositors; the FSLIC; and its successor, Savings Association Insurance Fund ("SAIF"). The FHLBB, in a supervisory letter dated March 31, 1989, designated the Association as a "troubled institution" subject to the requirements of the Office of Regulatory Activities Regulatory Bulletin 3a ("RB3a"). A troubled institution under RB3a is subject to various growth restrictions concerning deposit accounts and lending activities. Admiral did not have the ability to infuse sufficient equity capital into the Association in accordance with the Agreement and Capital Agreement. Due to the inability to continue operations without a significant capital infusion or other source of recapitalization, the value of the Association's excess cost over net assets acquired was considered permanently impaired and, accordingly, was written off at June 30, 1989. On August 9, 1989, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") was signed into law. FIRREA imposed, by no later than December 7, 1989, more stringent capital requirements upon savings institutions than those currently in effect. In addition, FIRREA included provisions for changes in the Federal regulatory structure for institutions including a new deposit insurance system, increased deposit insurance premiums and restricted investment activities with respect to non-investment grade corporate debt and certain other investments. FIRREA also increases the required ratio of housing-related assets in order to qualify as an insured institution. FIRREA's provisions for new capital standards required institutions to have a minimum regulatory tangible capital equal to 1.5% of total assets and a minimum 3.0% leverage capital ratio by no later than December 7, 1989. The ability to include qualifying supervisory goodwill for purposes of the leverage capital ratio requirement will be phased out by January 1, 1995. In addition, institutions were required to meet a risk-based capital requirement. In all cases, the capital standards were also required to be no less stringent than standards applicable to national banks. Currently, national banks are required to maintain a primary capital-to-assets ratio of 5.5% and a total capital-to-assets ratio of 6.0%. The Association did not meet these new capital requirements imposed by FIRREA. The Association sought regulatory relief from sanctions imposed by FIRREA for failing to meet the minimum regulatory capital requirements, and applied for financial assistance to the FDIC. There was no response or hearing prior to the seizure of Haven. The net assets of Haven were seized by the federal government on March 2, 1990. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) BASIS OF PRESENTATION The accompanying balance sheets as of June 30, 1993 and 1992, include references to the accounts of Admiral and the net assets and net liabilities of its wholly-owned subsidiary, Haven Federal Savings and Loan Association. Due to Haven's status as a discontinued operation, as discussed in note 1, the Association's net assets, net liabilities, and net losses from operations have been presented in the aggregate. The consolidated statements of operations, stockholders' (deficit) equity and cash flows for the years prior to 1990 include the accounts of Admiral and the Association. All significant intercompany transactions have been eliminated in consolidation. (b) OFFICE PROPERTIES AND EQUIPMENT All office properties and equipment were sold when the offices of the Company were closed during the fiscal year ended June 30, 1990, and the proceeds from such sales are reflected as "other income." (c) INCOME TAXES Admiral and its wholly-owned subsidiary file a consolidated tax return. Taxes are provided on all income and expense items included in earnings, regardless of the period in which such items are recognized for tax purposes, except for income representing a permanent difference. (d) REAL ESTATE Loss from real estate operations includes rental income, operating expenses, interest expense on the related mortgages payable, gains on sales, net and provision for estimated losses to reflect subsequent declines in the net realizable value below predecessor cost. Provisions for estimated losses on real estate are charged to earnings when, in the opinion of management, such losses are probable. While management uses the best information available to make evaluations, future adjustments to the allowances may be necessary if economic con ditions change substantially from the assumptions used in making the evaluations. (e) EXCESS COST OVER NET ASSETS ACQUIRED AND OTHER INTANGIBLES The excess cost over net assets acquired was amortized by the interest method over the estimated lives of the long-term, interest-bearing assets acquired. The remaining unamortized excess cost over net assets acquired was written off at June 30, 1989 (see note 1). (g) CASH AND CASH EQUIVALENTS For the purpose of the statement of cash flows, cash and cash equivalents include the accounts of Admiral. (3) PURCHASE ACCOUNTING At June 30, 1989, the remaining unamortized excess cost over net assets acquired of $7,768,074 was written off and charged to operations (see note 1). (4) INCOME TAXES At June 30, 1993 and 1992, the Company has net operating loss carryforwards of approximately $10,447,000 and $10,426,000, respectively, for Federal income tax purposes, and $10,095,000 and $10,074,000, respectively, for state income tax purposes to offset future taxable income. These carryforwards were scheduled to expire in future years as follows: The Company has not filed its federal or Florida income tax returns for the fiscal years ended June 30, 1992, 1991 and 1990. While the confiscation of the assets and liabilities of Haven may have resulted in a taxable event, management believes that any taxable income resulting from such confiscation of assets and liabilities should not exceed the available net operating loss carryforwards. The net operating loss carryforwards expiring through 2002 were generated by the Association prior to its acquisition by Admiral Financial Corp. and have been carried over at their original amounts for income tax purposes. For financial statement purposes, these purchased loss carryforwards will not be used to offset the future tax expense of Admiral. They will be accounted for as an adjustment to equity if and when a tax benefit is realized. At June 30, 1993 and 1992, such purchased loss carryforwards remaining amounted to approximately $2,837,000 and $2,837,000, respectively. (5) DISPOSAL OF THE ASSOCIATION ASSETS AND LIABILITIES The net assets and net liabilities of Haven were confiscated by the federal government on March 2, 1990. (6) COMMITMENTS AND CONTINGENCIES Admiral is not involved in any material legal proceedings.

67646_1993.txt

67646

1993

ITEM 1. BUSINESS Allegheny Power System, Inc. (APS), incorporated in Maryland in 1925, is an electric utility holding company that derives substantially all of its income from the electric utility operations of its direct and indirect subsidiaries (Subsidiaries), Monongahela Power Company (Monongahela), The Potomac Edison Company (Potomac Edison), West Penn Power Company (West Penn), and Allegheny Generating Company (AGC). The properties of the Subsidiaries are located in Maryland, Ohio, Pennsylvania, Virginia, and West Virginia, are interconnected, and are operated as a single integrated electric utility system (System), which is interconnected with all neighboring utility systems. The three electric utility operating Subsidiaries are Monongahela, Potomac Edison, and West Penn (Operating Subsidiaries). Monongahela, incorporated in Ohio in 1924, operates in northern West Virginia and an adjacent portion of Ohio. It also owns generating capacity in Pennsylvania. Monongahela serves about 340,700 customers in a service area of about 11,900 square miles with a population of about 710,000. The seven largest communities served have populations ranging from 10,900 to 33,900. On December 31, 1993, Monongahela had 1,962 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, glass sand, natural gas, rock salt, and other natural resources. Its service area's principal industries produce coal, chemicals, iron and steel, fabricated products, wood products, and glass. There are two municipal electric distribution systems and two rural electric cooperative associations in its service area. Except for one of the cooperatives, they purchase all of their power from Monongahela. Potomac Edison, incorporated in Maryland in 1923 and in Virginia in 1974, operates in portions of Maryland, Virginia, and West Virginia. It also owns generating capacity in Pennsylvania. Potomac Edison serves about 354,300 customers in a service area of about 7,300 square miles with a population of about 782,000. The six largest communities served have populations ranging from 11,900 to 40,100. On December 31, 1993, Potomac Edison had 1,152 employees. Its service area is generally rural. Its service area's principal industries produce aluminum, cement, fabricated products, rubber products, sand, stone, and gravel. There are four municipal electric distribution systems in its service area, all of which purchase power from Potomac Edison, and six rural electric cooperatives, one of which purchases power from Potomac Edison. There are also several large federal government installations served by Potomac Edison. - 2 - West Penn, incorporated in Pennsylvania in 1916, operates in southwestern and north and south central Pennsylvania. It also owns generating capacity in West Virginia. West Penn serves about 646,700 customers in a service area of about 9,900 square miles with a population of about 1,399,000. The 10 largest communities served have populations ranging from 11,200 to 38,900. On December 31, 1993, West Penn had 2,043 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, limestone, and other natural resources. Its service area's principal industries produce steel, coal, fabricated products, and glass. There are two municipal electric distribution systems in its service area, which purchase their power requirements from West Penn, and five rural electric cooperative associations, located partly within the area, which purchase virtually all of their power through a pool supplied by West Penn and other nonaffiliated utilities. AGC, organized in 1981 under the laws of Virginia, is jointly owned by the Operating Subsidiaries as follows: Monongahela, 27%; Potomac Edison, 28%; and West Penn, 45%. AGC has no employees, and its only operating assets are a 40% undivided interest in the Bath County (Virginia) pumped- storage hydroelectric station, which was placed in commercial operation in December 1985, and its connecting transmission facilities. AGC's 840-megawatt (MW) share of capacity of the station is sold to its three parents. The remaining 60% interest in the Bath County Station is owned by Virginia Electric and Power Company (Virginia Power). APS has no employees. Its officers are employed by Allegheny Power Service Corporation (APSC), a wholly-owned subsidiary of APS. On December 31, 1993, the Subsidiaries and APSC had 6,025 employees. The Subsidiaries in the past have experienced and in the future may experience some of the more significant problems common to electric utilities in general. These include increases in operating and other expenses, difficulties in obtaining adequate and timely rate relief, restrictions on construction and operation of facilities due to regulatory requirements and environmental and health considerations, including the requirements of the Clean Air Act Amendments of 1990 (CAAA), which among other things, require a substantial annual reduction in utility emissions of sulfur dioxides and nitrogen oxides. Additional concerns include proposals to restructure and, to some extent, deregulate portions of the industry and increase competition, particularly as a result of the National Energy Policy Act of 1992 (EPACT). EPACT may increase competition by allowing the formation of Exempt Wholesale Generators (EWGs), with the approval of the FERC, and providing mandatory access to the interconnected electric grid for wholesale transactions. It further provides for expansion of the grid where constraints are determined to exist - at the expense of the requestor of such transmission service and provided necessary authority to construct such facilities can be obtained. EPACT permits utility generation facilities to qualify as EWGs and allows sales to nonaffiliated and to affiliated utilities provided state commissions approve such transactions. (See ITEM 1. SALES, ELECTRIC FACILITIES and REGULATION for a further discussion of the impact of EPACT.) - 3 - In an effort to meet the challenges of the new competitive environment in the industry, APS is considering forming a new nonutility subsidiary, subject to regulatory approval, to pursue new business opportunities which have a meaningful relationship to the core utility business. APS would also consider establishing or acquiring its own EWGs, if that is feasible, particularly in view of the possible constraints imposed by regulations under the Public Utility Holding Company Act of 1935 (PUHCA) on nonexempt public utility holding companies such as APS and its Subsidiaries. Further concerns of the industry include possible restrictions on carbon dioxide emissions, uncertainties in demand due to economic conditions, energy conservation, market competition, weather, and interruptions in fuel supply because of weather and strikes. (See ITEM 1. CONSTRUCTION AND FINANCING, RATE MATTERS, and ENVIRONMENTAL MATTERS for information concerning the effect on the Subsidiaries of the CAAA.) SALES In 1993, consolidated kilowatthour (kWh) sales to the Operating Subsidiaries' retail customers increased 3.3% from those of 1992, as a result of increases of 6.5%, 5.2% and 0.3% in residential, commercial and industrial sales, respectively. The increased Kwh sales in 1993 reflect both growth in number of customers and higher use. Consolidated revenues from residential, commercial, and industrial sales increased 11.4%, 9.8%, and 5.6%, respectively, primarily because of several rate increases effective in 1993 as described in ITEM 1. RATE MATTERS, increases in fuel and energy cost adjustment clause revenues, and increased kWh sales. Consolidated kWh sales to and revenues from nonaffiliated utilities decreased 30.2% and 25.5%, respectively, due to increased native load, decreased demand, and price competition. The System's all-time peak load of 7,153 MW occurred on January 18, 1994. The peak loads in 1993 and 1992 were 6,678 MW and 6,530 MW, respectively. The increased 1994 peak was due in part to record cold temperatures throughout the Operating Subsidiaries' service areas and would have been higher except for voluntary curtailments. The average System load (Yearly Net Power Supply divided by number of hours in the year) was 4,674 megawatthours (MWh) and 4,526 MWh in 1993 and 1992, respectively. More information concerning sales may be found in the statistical sections and ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Consolidated electric operating revenues for 1993 were derived as follows: Pennsylvania, 44.8%; West Virginia, 28.4%; Maryland, 20.2%; Virginia, 5.0%; Ohio, 1.6% (residential, 35.1%; commercial, 18.4%; industrial, 28.9%; nonaffiliated utilities, 14.9%; and other, 2.7%). The following percentages of such revenues were derived from these industries: iron and steel, 6.0%; chemicals, 3.3%; fabricated products, 3.3%; aluminum and other nonferrous metals, 3.2%; coal mines, 3.1%; cement, 1.8%; and all other industries, 8.2%. The coal mine percentage decreased in 1993 principally due to the coal strike. More information concerning the coal strike may be found in ITEM 1. FUEL SUPPLY. Revenues from each of 16 industrial customers exceeded $5 million, including one coal customer of both Monongahela and West Penn with total revenues exceeding $15 million, three steel customers with revenues exceeding $26 million each, and one aluminum customer with revenues exceeding $63 million. - 4 - During 1993, Monongahela's kWh sales to retail customers increased 0.3% as a result of increases of 6.4% and 4.7% in residential and commercial sales, respectively, and a decrease of 4.4% in industrial sales, primarily due to the coal strike and lower sales to one iron and steel customer because of increased use of its own generation. Revenues from such customers increased 9.2%, 7.8% and 0.7%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 7.8%. Monongahela's all- time peak load of 1,667 MW occurred on December 21, 1989. (For a discussion of the coal strike, See ITEM 1. FUEL SUPPLY.) Monongahela's electric operating revenues were derived as follows: West Virginia, 94.0% and Ohio, 6.0% (residential, 28.8%; commercial, 17.3%; industrial, 29.2%; nonaffiliated utilities, 13.4 %; and other, 11.3%). Revenues from each of five industrial customers exceeded $8 million, including one coal customer with revenues exceeding $13 million and one steel customer with revenues exceeding $26 million. The decreases in the revenues of these customers from 1992 levels were primarily due to the coal strike. During 1993, Potomac Edison's kWh sales to retail customers increased 6.3% as a result of increases of 8.4%, 7.1%, and 4.3% in residential, commercial, and industrial sales, respectively. Revenues from such customers increased 12.7%, 11.8%, and 11.8%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 23.1%. Potomac Edison's all-time peak load of 2,595 MW occurred on January 19, 1994. Potomac Edison's electric operating revenues were derived as follows: Maryland, 66.6%; West Virginia, 16.8%; and Virginia 16.6% (residential, 38.5%; commercial, 17.5%; industrial, 24.7%; nonaffiliated utilities, 15.2%; and other, 4.1%). Revenues from one industrial customer, the Eastalco aluminum reduction plant near Frederick, Maryland, amounted to $63.4 million (8.9% of total electric operating revenues). Minimum annual charges to Eastalco under an electric service agreement which continues through March 31, 2000, with automatic extensions thereafter unless terminated on notice by either party, were $19.3 million in 1993. Said agreement may be canceled before the year 2000 upon 90 days notice of a governmental decision resulting in a material modification of the agreement. During 1993, West Penn's kWh sales to retail customers increased 3.1% as a result of increases of 5.2%, 4.4% and 0.8% in residential, commercial, and industrial sales, respectively. Revenues from residential, commercial, and industrial customers increased 11.5%, 9.6%, and 5.4%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 24.3%. West Penn's all- time peak load of 3,068 MW occurred on January 18, 1994. - 5 - West Penn's electric operating revenues were derived as follows: Pennsylvania, 100% (residential, 33.1%; commercial, 18.0%; industrial, 28.5%; nonaffiliated utilities, 14.1%; and other, 6.3%). Revenues from each of three steel customers exceeded $10 million, including two with revenues exceeding $31 million each. On average, the Operating Subsidiaries are the lowest or among the lowest cost producers of electricity in their regions and therefore the Operating Subsidiaries' delivered power prices should compete favorably with those of potential alternate suppliers who use cost-based pricing. However, the Operating Subsidiaries are experiencing cost increases due to compliance with the CAAA and purchases from Public Utility Regulatory Policies Act of 1978 (PURPA) projects. (See page 7 for a discussion of PURPA projects, and ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings concerning PURPA capacity.) In 1993, the Operating Subsidiaries provided approximately 13.3 billion kWh of energy to nonaffiliated utility companies, of which 1.5 billion kWh were generated by the Subsidiaries and the rest were transmitted from electric systems located primarily to the west. These sales included a long-term transaction under which the Operating Subsidiaries purchased 450 MW of firm capacity and its associated energy from Ohio Edison Company for resale to Potomac Electric Power Company, both nonaffiliated utilities. The transaction began in mid-1987 and will continue through 2005, unless terminated earlier. Sales to nonaffiliated utility companies vary with the needs of those companies for imported power; the availability of System generating facilities, fuel, and regional transmission facilities; and the availability and price of competitive sources of power. System sales decreased in 1993 relative to 1992 primarily because of continued decreased demand, increased Operating Subsidiaries' native load, coal conservation because of the coal strike, and increased willingness of other suppliers to make sales at lower prices. Further decreases in kWh sales to nonaffiliated utilities are expected in 1994 and beyond. Substantially all of the revenues from kWh sales to nonaffiliated utilities are passed on to retail customers and as a result have little effect on net income. The Operating Subsidiaries reactivated a peak diversity exchange arrangement with Virginia Power effective June 1993 which continues indefinitely. The Operating Subsidiaries will annually supply Virginia Power with 200 MW during each June, July, and August, in return for which Virginia Power will supply the Operating Subsidiaries with 200 MW during each December, January, and February, at least through February 1997. Thereafter, specific amounts of annual diversity exchanges beyond those currently established are to be mutually determined no less than 34 months prior to each year for which an exchange is to take place. The total number of MWh to be delivered by each to the other over the term of the arrangement is expected to be equal. - 6 - The Operating Subsidiaries and Duquesne Light Company (Duquesne Light) in 1991 entered into an exchange arrangement under which the Operating Subsidiaries will supply Duquesne Light with up to 200 MW for a specified number of weeks, generally during each March, April, May, September, October, and November. In return, Duquesne Light will supply the Operating Subsidiaries with up to 100 MW, generally during each December, January, and February. The total number of MWh delivered by each utility to the other over the term of the arrangement is expected to be the same. West Penn supplies power to the Borough of Tarentum (Tarentum) using in part leased distribution facilities from Tarentum under a 30 year lease agreement terminating in 1996. In June 1993, Tarentum, which in that year had a load of 6.5 MW and revenues of $1.8 million, notified West Penn of its intention to exercise its option to end the lease agreement. The termination of the lease agreement and resulting transfer and sale of electric facilities will result in Tarentum becoming a municipal customer which will purchase electricity on a wholesale basis from West Penn or another supplier. The sale of electric facilities will require Pennsylvania Public Utility Commission approval. The System provides wholesale transmission services to applicants under its Federal Energy Regulatory Commission (FERC) approved Standard Transmission Service tariff. The tariff provides that such service is subordinate in priority to native load and reliability requirements of interconnected systems to avoid adverse effects on regional reliability in general and on the reliability of the Operating Subsidiaries' service to their retail and full- requirements wholesale customers in particular. (See ITEM 1. ELECTRIC FACILITIES for a discussion of stress on the System's transmission system.) Transmission services requiring special arrangements or long-term commitments have been and continue to be negotiated through mutually acceptable bilateral agreements. Substantially all of the revenues from transmission service sales are passed on to retail customers and as a result have little effect on net income. EPACT permits wholesale generators, utility-owned and otherwise, and wholesale consumers to request from System and other owners of bulk power transmission facilities a commitment to supply transmission services. Generators include nonaffiliated utilities and nonutility generators (NUG) of electricity (including classifications of generators known as Independent Power Producers (IPP) and EWGs). Consumers of wholesale power include qualifying nonaffiliated utilities or groups of utilities including the many small electric systems owned by municipalities and rural electric cooperative associations in the service areas of the Operating Subsidiaries. Many of these small systems currently purchase substantially all of their power from the Operating Subsidiaries. Under EPACT, these small systems may now seek an order from the FERC to force the Operating Subsidiaries to wheel power over the System to them from sources outside the System service area. All of the small electric wholesale customers in the Operating Subsidiaries' service areas which might avail themselves of this opportunity produced $42 million of total revenues in 1993. - 7 - Under PURPA, certain municipalities and private developers have installed, are installing or are proposing to install hydroelectric and other generating facilities at various locations in or near the Operating Subsidiaries' service areas with the intent of selling some or all of the electric capacity and energy to the Operating Subsidiaries at rates provided under PURPA and approved by appropriate state commissions. The System's total generation capacity includes 292 MW of on-line PURPA capacity. Payments for PURPA capacity and energy in 1993 totaled approximately $105 million at an average cost to the System of 5.04 cents per kWh. The System projects an additional 180 MW of PURPA capacity to come on-line in future years. In addition, lapsed purchase agreements totaling 203 MW and other PURPA complaints totaling 520 MW (none of which are included in the System's integrated resource plan as of August 20, 1993), are the subject of pending litigation. (See ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings in Pennsylvania, Maryland, and West Virginia affecting PURPA capacity.) In the future, ratings of the Operating Subsidiaries' first mortgage bonds and preferred stock may be affected by increased concern of rating agencies that purchased power contracts are a risk factor deserving consideration in assessing the credit- worthiness of electric utilities. ELECTRIC FACILITIES The following table shows the System's December 31, 1993, generating capacity, based on the maximum monthly normal seasonal operating capacity of each unit. The System-owned capacity totaled 7,991 MW, of which 7,089 MW (88.7%) are coal-fired, 840 MW (10.5%) are pumped-storage, and 62 MW (0.8%) are hydroelectric. The term "pumped-storage" refers to the Bath County station which stores energy for use principally during peak load hours by pumping water from a lower to an upper reservoir, using the most economic available electricity, generally during off-peak hours. During the generating cycle, power is produced by water falling from the upper to the lower reservoir through turbine generators. The average age of the System-owned coal-fired stations shown below, based on generating capacity at December 31, 1993, was about 23.6 years. In 1993, their average heat rate was 10,020 Btu's/kWh, and their availability factor was 87.0%. - 8 - - 9 - (a) Excludes 361 MW of West Penn oil-fired capacity, which was placed on cold reserve status as of June 1, 1983. Current plans call for the reactivation of these units within the next five years. (b) Where more than one year is listed as a commencement date for a particular source, the dates refer to the years in which operations commenced for the different units at that source. (c) The installation of flue-gas desulfurization equipment (See ITEM 1. ENVIRONMENTAL MATTERS) is expected to reduce the net generating capacity of each unit by about 3%. (d) Capacity entitlement through percentage ownership of AGC. (e) The FERC issued an annual license to West Penn for Lake Lynn for 1994. A relicensing application has been filed with the FERC for Lake Lynn and a license with a 30 to 50 year term is expected to be issued in late 1994. Potomac Edison's license for hydroelectric facilities, Dam #4 and Dam #5 will expire in 2003. Potomac Edison has received 30 year licenses, effective January 1994, for the Shenandoah, Warren, Luray and Newport projects. (f) Nonutility generating capacity available through contractual arrangements pursuant to PURPA. - 10 - SYSTEM MAP The Allegheny Power System Map (System Map), which has been omitted, provides a broad illustration of the names and approximate locations of the System's major generation and transmission facilities, both existing and under construction, in a five state region which includes portions of Pennsylvania, Ohio, West Virginia, Maryland and Virginia. Additionally, Extra High Voltage substations are displayed. By use of shading, the System Map also provides a general representation of the service areas of Monongahela (portions of West Virginia and Ohio), Potomac Edison (portions of Maryland, Virginia and West Virginia), and West Penn (portions of Pennsylvania). Power Stations shown on the System Map which appear within the Monongahela service area are Willow Island, Pleasants, Harrison, Rivesville, Albright, and Fort Martin. The single Power Station appearing within the Potomac Edison service area is R. Paul Smith. The Bath County Power Station appears on the map just south of the westernmost portion of Potomac Edison's service area formed by the borders of Virginia and West Virginia. Power Stations appearing within the West Penn service area are Armstrong, Mitchell, Hatfield's Ferry, Springdale and Lake Lynn. The System Map also depicts transmission facilities which are (i) owned solely by the Operating Subsidiaries; (ii) owned by the Operating Subsidiaries in conjunction with other utilities; or (iii) owned solely by other utilities. The transmission facilities portrayed range in capacity from 138kV to 765kV. Additionally, interconnections with other utilities are displayed. - 11 - The following table sets forth the existing miles of tower and pole transmission and distribution lines and the number of substations of the Subsidiaries as of December 31, 1993: (a) The System has a total of 5,203 miles of underground distribution lines. (b) The substations have an aggregate transformer capacity of 37,512,771 kilovoltamperes. (c) Total Bath County transmission lines, of which AGC owns an undivided 40% interest and Virginia Power owns the remainder. The System has 11 extra-high-voltage (345 kV and above) (EHV) and 29 lower-voltage interconnections with neighboring utility systems. The interregional EHV transmission system, including System facilities, continues to experience periods of heavy loading in a west-to-east direction. Increases in customer load, power transfers by the Subsidiaries and by nonaffiliated entities, and parallel flows caused by transactions to which the Operating Subsidiaries are not a party, all contribute to the heavy west-to-east power flows. In late 1992 and early 1993, a substantial amount of reactive power sources (shunt capacitors) were added to neighboring eastern utilities' EHV systems. These capacitors complement the capacitors added in 1991 and 1992 on the System and together they serve to increase transfer capability by improving voltage on the transmission system during heavy loading periods. While the additional capacitors installed by the Subsidiaries' eastern neighbors have enhanced transfer capability, the interregional transmission facilities are still expected periodically to operate up to their reliability limits; therefore, restrictions on transfers may still be necessary at times as was the case in recent years. Under certain provisions of EPACT, wholesale generators, utility-owned or otherwise, may seek from System and other owners of bulk power transmission facilities a commitment to supply power transmission services, so long as the FERC finds reliability and native load and existing contractual customers are not adversely affected (See discussion under ITEM 1. SALES and REGULATION). Such demand on the System for transmission service may add periodically to heavy power flows on the System's facilities. - 12 - The Operating Subsidiaries have, to date, provided managed contractual access to the System's transmission facilities via the provisions of their Standard Transmission Service tariff, or the terms and conditions of bilateral contracts with purchasers of transmission service. As a result of EPACT, the FERC is investigating the continued desirability of traditional methods of pricing and providing transmission service. The FERC may choose to maintain existing methods, implement new methodologies which the Operating Subsidiaries and their ratepayers may or may not find to be beneficial, or a combination thereof. The Operating Subsidiaries are participating fully in the FERC proceedings with the principal intent of safeguarding the reliability of the System's transmission facilities, and the rights and interests of its native load customers. The outcome of those deliberations cannot be predicted. RESEARCH AND DEVELOPMENT The Operating Subsidiaries spent $4.6 million, $2.7 million, and $2.8 million in 1993, 1992, and 1991, respectively, for research programs. Of these amounts, $3.2 million and $0.6 million were for Electric Power Research Institute (EPRI) dues in 1993 and 1992, respectively. The Operating Subsidiaries plan to spend approximately $7.5 million for research in 1994, with EPRI dues representing $5.9 million of that total. The Operating Subsidiaries joined EPRI, an industry- sponsored research and development institution, effective October 1, 1992, contingent upon the approval by state commissions of recovery of the dues in rates, which approval was subsequently received in all jurisdictions except Ohio and West Virginia, where the matter is pending. Ongoing participation in EPRI depends upon continued approval by state commissions of recovery of dues in rates. Dues are based on a three-year, new-member ramping formula. Independent research conducted by the Operating Subsidiaries in 1993, which will be completed or continued in 1994, concentrated on environmental protection, generating unit performance, future generating technologies, delivery systems, and customer-related research. Two U.S. Department of Energy Clean Coal Technology nitrogen oxide control projects, which the Operating Subsidiaries cofounded, have recently been completed. Based upon the results of one of the projects, retrofitting of low nitrogen oxide cell burners at the Hatfield's Ferry Power Station units has been undertaken at much lower costs than would otherwise have been required. - 13 - Research is also being directed to help address major issues facing the Operating Subsidiaries including electric and magnetic field (EMF) risk, waste disposal, greenhouse gas, client-server information system prospects, renewable resources, fuel cells, new combustion turbines and other cogeneration technologies. In addition, evaluation of technical proposals for business opportunities is also ongoing. EMF research includes monitoring work done by EPRI, Department of Energy (DOE), the Environmental Protection Agency (EPA) and other government researchers. It also includes monitoring literature, law and litigation, and standards as developed. This research enables the Operating Subsidiaries to evaluate any potential health risks to employees and customers which may exist. Research activities related to alleged global climate change include monitoring government activity, studying possible joint implementation activities in connection with the Clinton Climate Change Action Plan, and studying demand- side management, electro- technologies and possible joint implementation plans. The Operating Subsidiaries also made research grants to regional colleges and universities to encourage the development of technical resources related to current and future utility problems. CONSTRUCTION AND FINANCING Construction expenditures by the Subsidiaries in 1993 amounted to $574 million and for 1994 and 1995 are expected to aggregate $500 million and $400 million, respectively. In 1993, these expenditures included $240 million for compliance with the CAAA. The 1994 and 1995 estimated expenditures include $161 million and $53 million, respectively, to cover the costs of compliance with the CAAA. (See ITEM 1. ENVIRONMENTAL MATTERS.) Allowance for funds used during construction (AFUDC) (shown below) has been reduced for carrying charges on CAAA expenditures that are being collected through currently approved surcharges or in base rates. - 14 - * Includes allowance for funds used during construction for 1993, 1994 and 1995 of: Monongahela $5.8, $4.1 and $1.9; Potomac Edison $7.1, $5.7 and $2.7; and West Penn $8.6, $12.7 and $6.2. These construction expenditures include major capital projects at existing generating stations, including the construction of flue-gas desulfurization equipment (scrubbers) at the Harrison Power Station, upgrading distribution lines and substations, and the strengthening of the transmission and subtransmission systems. It is anticipated that the Harrison scrubber project will be completed on schedule and that the final costs will be approximately 24% below the original budget. Primary factors contributing to the reduced cost are: a) the absence of any major construction problems to date; b) financing and material and equipment costs lower than expected; and c) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. In order to avoid unnecessary and uneconomic additional outages, power station construction and long-range maintenance schedules and the expenditures associated therewith will have to be coordinated over the next several years with outages to meet the in-service dates of the new emission control facilities. - 15 - On a System basis, total expenditures for 1993, 1994, and 1995 include $270 million, $191 million, and $93 million, respectively, for construction of environmental control technology. The Operating Subsidiaries continue to study ways to reduce or meet future increases in customer demand, including aggressive demand- side management programs, new and efficient electric technologies, construction of various types and sizes of generating units and increasing the efficiency and availability of System generating facilities, reducing company electrical use and transmission and distribution losses, and where feasible and economical, acquisition of reliable long- term capacity from other electric systems and from nonutility developers. The Operating Subsidiaries are implementing demand-side management activities. Potomac Edison and West Penn are engaged in state commission supported or ordered evaluations of demand-side management programs (See ITEM 1. REGULATION for a further discussion of these programs). Several jurisdictions have adopted mechanisms which provide for recovery of the costs of such activities, some return on the related investment, the associated revenue reductions and a performance incentive, either on a current basis or through deferral to a base rate case. Current forecasts, which reflect demand-side management efforts and other considerations and assume normal weather conditions, project average annual winter and summer peak load growth rates of 1.47% and 1.28%, respectively, in the period 1994-2004. After giving effect to the reactivation of West Penn capacity in cold reserve (see page 9), peak diversity exchange arrangements described in ITEM 1. SALES above, demand- side management and conservation programs, and the capacity of an anticipated new PURPA plant, the System's integrated resource plan indicates that new System-owned generating capacity will not be required until the year 2000 or beyond. If future customer demand materially exceeds that forecast or anticipated supply-side resources do not become available or demand-side management efforts do not succeed, or under extremely adverse weather conditions, the Operating Subsidiaries may be unable at times to meet all of their customers' requirements for electric service. In connection with their construction and demand- side management programs, the Operating Subsidiaries must make estimates of the availability and cost of capital as well as the future demands of their customers that are necessarily subject to regional, national, and international developments, changing business conditions, and other factors. The construction of facilities and their cost are affected by laws and regulations, lead times in manufacturing, availability of labor, materials and supplies, inflation, interest rates, and licensing, rate, environmental, and other proceedings before regulatory authorities. As a result, future plans of the Operating Subsidiaries, as well as their projected ownership of future generating stations, are subject to continuing review and substantial change. - 16 - The Subsidiaries have financed their construction programs through internally generated funds, first mortgage bond, debenture, medium-term note and preferred stock issues, pollution control and solid waste disposal notes, instalment loans, long-term lease arrangements, equity investments by APS (or, in the case of AGC, by the Operating Subsidiaries), and, where necessary, interim short-term debt. Effective January 1994, the Operating Subsidiaries also have available a $300 million multi-year credit facility. The future ability of the Subsidiaries to finance their construction programs by these means depends on many factors, including rate levels sufficient to provide internally generated funds and adequate revenues to produce a satisfactory return on the common equity portion of the Subsidiaries' capital structures and to support their issuance of senior and other securities. APS obtains most of the funds for equity investments in the Operating Subsidiaries through the issuance and sale of its common stock publicly and through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In May 1993, Monongahela, Potomac Edison, and West Penn issued $10.68 million, $13.99 million, and $18.04 million, respectively, in solid waste disposal notes to Harrison County, West Virginia. Harrison County in turn issued $24.67 million of 6-1/4% and $18.04 million of 6.3% tax-exempt 30-year solid waste disposal revenue bonds. The Operating Subsidiaries are using the proceeds from the issuance to finance certain solid waste disposal facilities which comprise a portion of the scrubbers located at the Harrison Power Station. On November 3, 1993, the holders of more than two-thirds of the shares of APS common stock voted to split the common stock by amending the charter to reclassify each share of common stock, par value $2.50, issued or unissued, into two shares of common stock, par value $1.25 each. The stock split became effective on November 4, 1993. All references to APS common stock herein reflect the two-for-one stock split. On October 14, 1993, APS issued and sold 2,400,000 shares of its common stock in an underwritten offering with net proceeds to APS of $64.1 million, and in 1993 sold 1,364,846 shares of its common stock for $36.1 million through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In October 1993, Potomac Edison and West Penn issued and sold to APS 2,500,000 and 5,000,000 additional shares of each of their common stock, respectively, at a price of $20 per share. During 1993, the rate for West Penn's 400,000 shares of market auction preferred stock, par value $100 per share, reset approximately every 90 days at 2.62%, 2.55%, 2.595% and 2.7%. The rate set at auction on January 14, 1994, was 2.52%. In August 1993, Potomac Edison redeemed the remaining $404,600 of 4.70% Series B Preferred Stock outstanding. - 17 - In 1993, the Subsidiaries issued $651.9 million of securities having interest rates between 4.95% and 7.75%, to refund outstanding debt with rates of 7.0% to 9.75%, with an annual after-tax savings in interest cost of almost $9 million. In February 1993, Potomac Edison issued $45 million of 7-3/4%, 30-year first mortgage bonds to refund $25 million, 8-5/8% series due 2007 and $15 million, 8-5/8% series due 2003. In March 1993, West Penn issued $61.5 million of 10-year, 4.95% Pollution Control Revenue Notes to refund $30 million, 9-3/4% series due 2003 and $31.5 million, 9-1/2% series due 2003. In March 1993, AGC issued $50 million of 5- 3/4% medium-term notes due in 1998 to refund $50 million, 8% debentures due in 1997. In March 1993, Potomac Edison issued $75 million of 5-7/8% first mortgage bonds due 2000 to refund $72 million of four series due 1998-2002 with rates ranging from 7% to 8- 3/8%. In April 1993, Monongahela, Potomac Edison and West Penn issued $7.05 million, $8.6 million, and $7.75 million, respectively, in 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia. Monongalia County, in turn issued $23.4 million of 5.95%, 20-year Pollution Control Revenue Bonds to refund $23.4 million of three series due in 2013 with rates ranging from 9.375% to 9.5%. In April 1993, Monongahela issued $65 million of 5-5/8% first mortgage bonds due in 2000 to refund $60 million of three series due 1998-2002 with rates ranging from 7.5% to 8.125%. In June 1993, West Penn issued $102 million of 5-1/2% first mortgage bonds due in 1998 to refund $102 million of three series due 1997-1999 with rates ranging from 7% to 7-7/8%. Also in June 1993, West Penn issued $80 million of 6-3/8% first mortgage bonds due 2003 to refund $75 million of two series due 2001-2002 with rates of 7-5/8% and 8-1/8%. In September 1993, AGC issued $50 million of 5-5/8% debentures due 2003 and $100 million of 6-7/8% debentures due 2023 to refund $50 million, 8-3/4% debentures due 2017 and $100 million, 9-1/8% debentures due 2016. At December 31, 1993, APS had $67.5 million and Monongahela had $63.1 million outstanding in short-term debt, and AGC had $50.87 million outstanding in commercial paper and notes payable to affiliates, while Potomac Edison and West Penn had short-term investments of $4.6 million and $24.9 million, respectively. The Subsidiaries' ratios of earnings to fixed charges for the year ended December 31, 1993, were as follows: Monongahela, 3.49; Potomac Edison, 3.34; West Penn, 3.49; and AGC, 2.88. APS and the Subsidiaries' consolidated capitalization ratios as of December 31, 1993, were: common equity, 46.1%; preferred stock, 6.5%; and long- term debt, 47.4%. APS and the Subsidiaries' long-term objective is to maintain the common equity portion above 45%, reduce the long-term debt portion toward 45%, and maintain the preferred stock ratio for the balance of the capital structure. In January 1994, the Operating Subsidiaries jointly entered into an aggregate $300 million multi- year credit agreement with eighteen lenders. Each Operating Subsidiary's borrowings under the agreement are limited to its pro rata share of the stock of AGC, which stock was pledged to secure the credit agreement. The Operating Subsidiaries' percentage ownership of AGC and resulting borrowing limitations are: Monongahela 27%, $81,000,000; Potomac Edison 28%, $84,000,000; and West Penn 45%, $135,000,000. The agreement may be used as a supplement to or in lieu of public financings and short-term debt programs. - 18 - During 1994, Monongahela, Potomac Edison and West Penn plan to issue up to $50 million, $75 million, and $105 million, respectively, of new securities, consisting of both debt and preferred and common equity, for general corporate purposes, including their construction programs. In addition, the Operating Subsidiaries may engage in tax-exempt solid waste disposal financings to the extent funds are available to Harrison County from the West Virginia cap allocation. APS plans to fund Operating Subsidiaries' sales of common stock to it through the issuance of short-term debt and the sale of APS' common stock through its Dividend Reinvestment and Stock Purchase Plan and Employee Stock Ownership and Savings Plan. The Operating Subsidiaries, if economic and market conditions make it desirable, may refund during 1994 up to $550 million of first mortgage bonds, up to $100 million of preferred stock, and up to $78 million of pollution control revenue notes through tender offers or optional redemptions. FUEL SUPPLY System-operated stations burned approximately 15.7 million tons of coal in 1993. Of that amount, 67% was cleaned (6.7 million tons) or used in stations equipped with scrubbers (3.9 million tons). Use of desulfurization equipment and cleaning and blending of coal make burning local higher-sulfur coal practical, and in 1993 about 96% of the coal received at System stations came from mines in West Virginia, Pennsylvania, Maryland, and Ohio. The Operating Subsidiaries do not mine or clean any coal. All raw, clean or washed coal is purchased from various suppliers as necessary to meet station requirements. Long-term arrangements, subject to price change, are in effect and will provide for approximately 12 million tons of coal in 1994. The System depends on short-term arrangements and spot purchases for its remaining requirements. Through the year 1999, the total coal requirements of present System-operated stations are expected to be met with coal acquired under existing contracts or from known suppliers. The Operating Subsidiaries will meet the requirements of Phase I of the CAAA by installing scrubbers at Harrison Power Station. This will allow the continued use of local, high-sulfur coal there. A long-term contract for the supply of lime for use in the scrubber operation and for fixation of the scrubber byproduct has been negotiated and is expected to be signed in early 1994. It is expected that the use of lime will increase the costs of operating the station. For each of the years 1989 through 1992, the average cost per ton of coal burned was, respectively, $34.64, $35.97, $36.74 and $36.31. For the year 1993, the cost per ton decreased to $36.19, and in December 1993 the cost per ton was $36.45. - 19 - The labor agreement between the United Mine Workers of America (UMWA) and the Bituminous Coal Operators' Association (BCOA) expired on February 1, 1993. As a result, the UMWA initiated selective strikes against BCOA member companies on February 2, 1993. In late May and early June, numerous mines which serve the Operating Subsidiaries' power stations were closed down to various degrees. The UMWA and BCOA agreed to a new five year contract on December 14, 1993, and mining operations resumed at most mines during the week of December 20, 1993. The Operating Subsidiaries continued to meet customer needs during this approximately seven-month period through the use of existing low cost inventories, additional spot and substitute contract coal purchases, and some conservation measures, primarily at the Harrison Power Station. The Operating Subsidiaries own coal reserves estimated to contain about 125 million tons of high- sulfur coal recoverable by deep mining. There are no present plans to mine these reserves and, in view of economic conditions now prevailing in the coal market, the Operating Subsidiaries plan to hold the reserves as a long-term resource. RATE MATTERS Rate case decisions in Pennsylvania and Maryland were issued for West Penn and Potomac Edison in May and February, 1993. West Penn On May 14, 1993, the Pennsylvania Public Utility Commission (PUC) issued an order in West Penn's base rate case effective May 18, 1993, authorizing an increase in revenues of $61.6 million, of which $26.1 million was for recovery of carrying charges (return on investment and taxes) associated with West Penn's CAAA compliance plan through June 30, 1993. West Penn had originally filed for a base rate increase designed to produce $101.4 million. West Penn received all maintenance expenses that it had requested, and a return on equity (ROE) of 11.5%. West Penn filed a petition on January 12, 1994 with the PUC requesting authorization to accrue post in-service carrying charges on the Harrison scrubbers and to defer related depreciation and operating and maintenance expenses until they are recognized in rates. West Penn cannot predict the outcome of this proceeding. West Penn plans to file an application with the PUC on or about March 31, 1994, for a base rate increase to recover the remaining carrying charges on investment, depreciation and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the new rates will become effective on or about December 31, 1994. West Penn cannot predict the precise amount to be requested or the outcome of this proceeding. On February 20, 1992, the Commonwealth Court of Pennsylvania affirmed the PUC's December 13, 1990, decision relating to West Penn's challenge to the PUC's methodology for calculation of ROE. Three industrial customers also appealed to the Commonwealth Court that part of the PUC order which failed to allocate capacity costs of PURPA projects on a demand basis in West Penn's Energy Cost Rate. On June 25, 1992, the Commonwealth Court reversed the PUC's decision on this issue and remanded the case to the PUC for further proceedings. West Penn and other parties have negotiated a settlement on capacity costs of PURPA projects and other demand-related costs in West Penn's Energy Cost Rate, which settlement does not affect West Penn's revenues. The settlement agreement was approved by the PUC and was implemented in 1993. - 20 - Monongahela On January 18, 1994, Monongahela filed an application with the West Virginia Public Service Commission (West Virginia PSC) for a base rate increase designed to produce $61.3 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Monongahela cannot predict the outcome of this proceeding. Monongahela filed a petition on January 11, 1994, with the Public Utilities Commission of Ohio (PUCO) requesting authorization to accrue post-in-service carrying charges on the Harrison scrubbers until its investment in such scrubbers is recognized in rates. The petition also requested authorization for Monongahela to defer depreciation, and operating and maintenance expenses, including property taxes (but not including fuel costs) with respect to the scrubbers until the recovery of the deferrals can be addressed in Monongahela's next base rate case or otherwise, as the PUCO may deem appropriate. Monongahela is currently awaiting a decision on this petition. If the petition is approved, Monongahela will file its Ohio base rate case in early 1995. Potomac Edison The Maryland Public Service Commission (Maryland PSC) issued a final order in Potomac Edison's base rate case on February 24, 1993, authorizing an annual increase of $11.3 million, effective February 25, 1993, which included CAAA carrying charges through February 28, 1993. The original filing in July of 1992 was designed to produce approximately $23.0 million in additional annual revenues. Subsequent adjustments reduced this request to $17.6 million. Potomac Edison received most of the maintenance expenses that it had requested and a ROE of 11.9%. On April 30, 1993, Potomac Edison filed with the Virginia State Corporation Commission (SCC) for a rate increase designed to produce $10.0 million in additional annual revenues. The new rates went into effect on September 28, 1993, subject to refund. Hearings have been held and a final SCC decision is expected by April 1994. Potomac Edison cannot predict the outcome of this proceeding. - 21 - On January 14, 1994, Potomac Edison filed an application with the West Virginia PSC for a base rate increase designed to produce $12.2 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Potomac Edison cannot predict the outcome of this proceeding. On or about April 15, 1994, and June 30, 1994, Potomac Edison plans to file new rate cases in Maryland and Virginia, respectively. The amounts of the requested increases have not yet been determined, but they will include recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the Maryland decision will be rendered in late 1994, and the Virginia decision in mid-1995. However, in both jurisdictions, it is expected that increases will be effective in late 1994. Monongahela and Potomac Edison Pursuant to its order of December 12, 1991, approving Monongahela and Potomac Edison's plan for compliance with Phase I of the CAAA, the West Virginia PSC authorized recovery by Monongahela and Potomac Edison of $5.6 million and $1.4 million, respectively, of carrying charges on Phase I CAAA compliance costs through March 31, 1993, effective July 1, 1993. This brings the annual Phase I CAAA recovery for Monongahela and Potomac Edison to $8.7 million and $2.2 million, respectively. Pursuant to the order, Monongahela and Potomac Edison will submit requests for recovery of carrying charges through March 31, 1994, on Phase I CAAA compliance costs in the annual energy cost review proceedings with any increase to be effective July 1, 1994. The annual values of all CAAA revenues authorized in these proceedings will be removed from this collection process effective when full Phase I CAAA costs are included in base rates as a result of the 1994 rate case filings. AGC Through February 29, 1992, AGC's ROE was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties filed to reduce the ROE to 10%. Hearings were completed in June 1992, and a recommendation has been issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the other parties argue should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate filed a joint complaint with the FERC against AGC claiming that both the existing ROE of 11.53% and the ROE recommended by the ALJ of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53% with rates subject to refund beginning April 1, 1994. AGC cannot predict the outcome of these proceedings. - 22 - FERC West Penn, Potomac Edison, and Monongahela implemented settlement agreements in 1993 covering wholesale rates in effect for their municipal, co-op, and borderline agreement customers subject to the jurisdiction of the FERC. Each included carrying charges for work in progress on the scrubbers at the Harrison Power Station, additional expenses for postretirement benefits other than pensions (see below), and future automatic rate changes resulting from changes to taxes or tax rates (federal, state and local for Monongahela and West Penn, and federal for Potomac Edison). The amounts of the increases and the effective dates for West Penn, Potomac Edison, and Monongahela were $1.6 million on June 15, 1993; $1.5 million on September 15, 1993; and $0.6 million on December 1, 1993, respectively. It is anticipated that additional filings to include recovery of the remaining carrying charges on investment, depreciation, as well as all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense for each Operating Subsidiary will be made in 1994 with increases to be effective around the end of 1994. Postretirement Benefits Other Than Pensions (SFAS No. 106) The Operating Subsidiaries and APSC adopted SFAS No. 106 as of January 1, 1993. This requires all companies to accrue for the cost of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years that the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Operating Subsidiaries and APSC for retired employees and their dependents were recovered in rates on a pay-as-you-go basis. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for FERC wholesale customers effective on the rate case effective date described above under ITEM 1. RATE MATTERS, FERC. Regulatory actions have been taken by the PUCO and Virginia PSC, which indicate that substantial recovery is probable. The West Virginia PSC considers recovery of SFAS No. 106 costs on a case- by-case basis and therefore Monongahela and Potomac Edison cannot predict the outcome of such proceedings. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. Recovery of these costs in Ohio will be requested in the next base rate case which is expected to be filed in early 1995. The Operating Subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. The Operating Subsidiaries have recorded regulatory assets relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates. The Operating Subsidiaries do not anticipate that SFAS No. 106 will have a substantial effect on consolidated net income. - 23 - ENVIRONMENTAL MATTERS The operations of the Subsidiaries are subject to regulation as to air and water quality, hazardous and solid waste disposal, and other environmental matters by various federal, state, and local authorities. Meeting known environmental standards is estimated to cost the Subsidiaries about $361 million in capital expenditures over the next three years, including $254 million for compliance with Phase I of the CAAA, described below, and initial cost for anticipated compliance with Phase II. The full costs of compliance with Phase II cannot be estimated at this time, but may be substantial. Additional legislation or regulatory control requirements, if enacted, may well require modifying, supplementing, or replacing equipment at existing stations at substantial additional cost. Air Standards The Operating Subsidiaries meet applicable standards as to particulates and opacity at major stations with high-efficiency electrostatic precipitators, cleaned coal, flue-gas conditioning, and, at times, reduction of output. From time to time minor excursions of opacity normal to fossil fuel operations are experienced and are accommodated by the regulatory process. In February 1994, three notices of violation were received by the Operating Subsidiaries from the West Virginia Division of Environmental Protection (WVDEP) regarding opacity excursions for three power stations in West Virginia. The Operating Subsidiaries are working with the WVDEP to resolve the alleged violations. It is not anticipated that the alleged violations will result in substantial penalties. At the major stations (other than Mitchell Unit No. 3 and Pleasants, which have scrubbers), the Operating Subsidiaries meet current emission standards as to sulfur dioxide by using low-sulfur coal, by purchasing cleaned coal to lower the sulfur content, or by blending low-sulfur with higher sulfur coal. The CAAA, among other things, require an annual reduction in total utility emissions within the United States of 10 million tons of sulfur dioxide and two million tons of nitrogen oxides from 1980 emission levels, to be completed in two phases, Phase I and Phase II. Five coal-fired System plants are affected in Phase I and the remaining five coal-fired plants and any coal-fired plants or units reactivated in the future will be affected in Phase II. Installation of scrubbers at the Harrison Power Station is the strategy undertaken by the Operating Subsidiaries to meet the required sulfur dioxide emission reductions for Phase I (1995). Continuing studies will determine the compliance strategy for Phase II (2000). It is expected that burner modifications at all power stations will satisfy the nitrogen oxide emission reduction requirements for the acid rain (Title IV) provisions of the CAAA. Additional post-combustion controls may be mandated in Maryland and Pennsylvania for ozone nonattainment (Title I) reasons. Continuous emission monitoring equipment has been installed on all Phase I units and is being installed on Phase II units. Studies to evaluate cost effective options to comply with Phase II of the CAAA, including those which may be available from the use of Operating Subsidiaries' banked emission allowances and from the emission allowance trading market, are continuing. - 24 - In an effort to introduce market forces into pollution control, the CAAA created sulfur dioxide emission allowances. An allowance is defined as an authorization for an owner to emit one ton of sulfur dioxide into the atmosphere during or following a specified calendar year. Subject to regulatory limitations, allowances (including bonus and extension allowances) not used by an owner for its own compliance may be sold or "banked" for future use or sale. Through an industry allowance pooling agreement, the Operating Subsidiaries will receive a total of approximately 570,000 bonus and extension allowances during Phase I. These allowances are in addition to the Table A allowances of approximately 356,000 per year. As a result of EPA's 1993 auctioning of a number of Table A allowances retained from each utility's annual allotment, approximately 16,000 allowances were sold for the Operating Subsidiaries. Such auctions will be held every year for the foreseeable future and allowances sold thereby will result in a prorational allocation of revenues back to the Operating Subsidiaries. If some allowances offered at auction remain unsold, the balance will also be prorationally rebated to the utilities which contributed them. The proceeds from these auctions are expected to be relatively minimal and the Operating Subsidiaries plan to credit these proceeds against the capital cost of emission compliance activities, subject to regulatory approval. Other allowance trading activities may be undertaken by the Operating Subsidiaries once certain tax questions are answered and once studies to determine Phase II compliance strategy are completed. In 1989, the West Virginia Air Pollution Control Commission approved the construction of a cogeneration facility in the vicinity of Rivesville, West Virginia. Emissions impact modeling for that facility raised concerns about the compliance status of Monongahela's Rivesville Station with the National Ambient Air Quality Standards (NAAQS) for sulfur dioxide. Pursuant to a consent order, Monongahela agreed to collect on- site meteorological data and conduct additional dispersion modeling in order to demonstrate compliance. The modeling study and a compliance strategy recommending construction of a new "good engineering practices" (GEP) stack was submitted to the WVDEP in June 1993. Costs associated with the GEP stack are approximately $7 million. Monongahela is awaiting action by the WVDEP. - 25 - Under an EPA-approved consent order with Pennsylvania, West Penn completed construction of a GEP stack at the Armstrong Station in 1982 at a cost of over $13 million with the expectation that EPA's reclassification of Armstrong County to "attainment status" under NAAQS for sulfur dioxide would follow. As a result of the 1985 revision of its stack height rules, EPA refused to reclassify the area to attainment status. West Penn appealed the EPA's decision. In 1988, the U. S. Court of Appeals for the Third Circuit dismissed West Penn's appeal for lack of jurisdiction, stating that West Penn's request for reconsideration before EPA made EPA's denial a non-final agency action. West Penn's request for reconsideration before EPA remains pending. West Penn cannot predict the outcome of this proceeding. Water Standards Under the National Pollutant Discharge Elimination System (NPDES) permitting procedures, permits for all System-owned stations are in place. However, in proposed NPDES renewal permits for some stations which are currently being sought, some conditions are being appealed through the regulatory process since the Operating Subsidiaries believe the effluent limitations being applied are overly stringent. The Operating Subsidiaries continue to work with the appropriate state agencies to resolve these issues. In the meantime, the existing permits remain in effect during the appeal process. The EPA and states are now implementing stormwater runoff regulations for controlling discharges from industrial and municipal sources as well as construction sites. Stormwater discharges have been identified and included in NPDES renewals, but controls have not yet been required. Since the current round of permit renewals began in 1993, monitoring requirements have been imposed, with pollution reduction plans and additional control of some discharges anticipated. Pursuant to the National Groundwater Protection Strategy, which supplements existing West Virginia groundwater protection policy, West Virginia has adopted a Groundwater Protection Act. This law establishes a statewide antidegradation policy which could require the Operating Subsidiaries to undertake reconstruction of existing landfills and surface impoundments as well as groundwater remediation, and may affect herbicide use for right-of-way maintenance in West Virginia. Groundwater protection standards were approved and implemented in 1993 (based on EPA drinking water criteria) which established compliance limits which cannot be exceeded. The Operating Subsidiaries anticipate that some facilities will not be able to meet the new compliance limits. Variance requests and requests for stays of implementation have been made for all affected facilities. However, variance rules have not yet been promulgated and action on the requests has not been taken. Therefore, it is not possible to predict the difficulty and costs associated with obtaining variances. If variances are not granted, costs may be incurred by the Operating Subsidiaries for groundwater remediation. Such costs, if any, cannot be predicted at this time. - 26 - The Pennsylvania Department of Environmental Resources (PADER) developed a Groundwater Quality Protection Strategy which established a goal of nondegradation of groundwater quality. However, the strategy recognizes that there are technical and economic limitations to immediately achieving the goal and further recognizes that some groundwaters need greater protection than others. The PADER is beginning to implement the strategy by promulgating changes to the existing rules that heretofore did not consider the nondegradation goal. The full extent of the impact of the strategy on the Operating Subsidiaries cannot be anticipated at this time. In 1993, two notices of violation were received by the Operating Subsidiaries from the WVDEP regarding excursions above limits contained in NPDES permits for discharge of leachate from fly ash landfills in West Virginia. One violation notice was withdrawn by the state agency and the other was resolved without payment of substantial penalty. On January 27, 1994 and February 9, 1994, the Operating Subsidiaries received two separate notices of violation from PADER regarding excursions above limits contained in the NPDES permit for discharge of leachate from Hatfield's Ferry Power Station fly ash landfill. One violation notice was resolved without payment of substantial penalty. The Operating Subsidiaries are working with the PADER to resolve the other alleged violation. It is not anticipated that the alleged violation will result in substantial penalties. Hazardous and Solid Wastes Pursuant to the Resource Conservation and Recovery Act of 1976 and the Hazardous and Solid Waste Management Amendments of 1984 (RCRA), EPA regulates the disposal of hazardous and solid waste materials. Pennsylvania, West Virginia, Maryland, Ohio, and Virginia have also enacted hazardous and solid waste management legislation. With the installation of the scrubbers at the Harrison Power Station, approximately 2.8 million tons per year of scrubber sludge, consisting principally of limestone and ash, will be generated and disposed of in a disposal facility owned and operated by the Operating Subsidiaries. The expected capacity of the site is 30 years. Pleasants Power Station processes its scrubber sludge using a wet-fixation and slurry system, with the treated sludge disposed of in a properly permitted sludge pond. Mitchell and Harrison Power Stations process their scrubber sludge by a dry-fixation process with the stabilized sludge disposed of in a properly permitted landfill. Coal combustion byproducts from all other facilities are either sold for beneficial reuse or landfilled in properly permitted and currently adequate disposal facilities owned and operated by the Operating Subsidiaries. The Operating Subsidiaries are in the process of permitting additional capacity to meet future disposal needs. - 27 - Costs are being incurred as the Operating Subsidiaries progress with implementation of both West Virginia's and Pennsylvania's 1992 solid waste regulatory changes. A predominant portion of the costs are attributable to two major factors: 1) liner systems for new disposal sites and the expansion portion of existing disposal sites, and 2) the assessment of groundwater impacts via monitoring wells. Because past operating practices, while in compliance with then existing regulations, may not meet the current criteria, as measured by new standards, it is possible that groundwater remediation may be required at some of the Operating Subsidiaries' facilities. In addition, under West Virginia's Solid Waste Rules, it is possible that certain active disposal sites may have to be retrofitted with liner systems to address potential groundwater degradation. The draft permit renewal from WVDEP for the currently active disposal site at Albright Power Station requires, on a portion of the site, retrofitting with a new liner system with possible removal of already placed coal combustion byproducts. The Operating Subsidiaries are working to have this proposed permit condition removed; however if it is not, it is anticipated that this condition will be appealed. EPA regulations on the burning of hazardous waste in utility boilers are expected to be amended in 1994 making the practice cost prohibitive for the Operating Subsidiaries. Until such time as the regulations are amended, the Operating Subsidiaries will continue to minimize their hazardous waste and to burn small quantities of hazardous waste generated in accordance with EPA boiler and industrial furnace disposal rules. Once such regulations are amended, the low volume wastes will be disposed of in incinerators or landfills which are owned by third parties. None of the Operating Subsidiaries are required to obtain hazardous waste treatment, storage or disposal permits under RCRA. With a continued effort to reduce hazardous waste, disposal costs and potential environmental liability should be minimized. Potomac Edison has received a notice from the Maryland Department of the Environment (MDE) regarding a remediation ordered under Maryland law at a facility previously owned by Potomac Edison. The MDE has identified Potomac Edison as a potentially responsible party under Maryland law. Remediation is currently being implemented by the current owner of the facility in Frederick, Maryland. It is not anticipated that Potomac Edison's share of remediation costs, if any, will be substantial. Emerging Environmental Issues Title I of the CAAA establishes an ozone transport region consisting of 11 northeast states including Maryland and Pennsylvania. Sources within the region will be required to reduce nitrogen oxide emissions, a precursor of ozone, to a level conducive to attainment of the ambient ozone standard. The first step for Title I compliance will result in the installation of low nitrogen oxide burners and potentially overfire air at all Pennsylvania and Maryland stations by 1995. This is compatible with Title IV nitrogen oxide reduction requirements. Modeling studies being conducted by the states will determine if a second step of reductions will be necessary which could require installation of post- combustion control technologies. - 28 - Title III of the CAAA requires EPA to conduct studies of toxic air pollutants from utility plants to determine if emission controls are necessary. EPA's reports are expected to be submitted to Congress in late 1995. The impact of Titles I and III on the Operating Subsidiaries is unknown at this time. Both the CWA and the RCRA are expected to be reauthorized in 1994. It is anticipated that coal combustion byproducts will continue to be regulated as nonhazardous waste, minimizing the Operating Subsidiaries' disposal costs. An additional issue which could impact the Operating Subsidiaries and which is undergoing intense study, is the effect, if any, of electric and magnetic fields. The financial impact of this issue on the Operating Subsidiaries, if any, cannot be assessed at this time. In connection with President Clinton's Climate Change Action Plan concerning greenhouse gases, the Operating Subsidiaries expressed by letter to the DOE in August 1993, their willingness to work with the DOE on implementing voluntary, cost-effective courses of action that reduce or avoid emission of greenhouse gases. Such courses of action must take into account the unique circumstances of each participating company, such as growth requirements, fuel mix and other circumstances. Furthermore, they must be consistent with the Operating Subsidiaries' integrated resource planning process and must not have an adverse effect on competitive position in terms of costs and rates or be unacceptable to their regulators. Some 63 other utility systems submitted similar letters. REGULATION APS and the Subsidiaries are subject to the broad jurisdiction of the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935 (PUHCA). APS is also subject to the jurisdiction of the Maryland PSC as to certain of its activities. The Subsidiaries are regulated as to substantially all of their operations by regulatory commissions in the states in which they operate and also by the DOE and the FERC. In addition, they are subject to numerous other city, county, state, and federal laws, regulations, and rules. EPACT became law on October 24, 1992. This broad legislation, among other things, amends PUHCA to permit utilities subject to PUHCA to compete in the wholesale generation business with other wholesale generators which it exempts from PUHCA; to ease restrictions on financing for that purpose; and to permit investment in foreign utilities. EPACT also amends the Federal Power Act to permit the FERC to order, under specified circumstances, access to transmission systems (including those of the System) so long as it would not unreasonably impair reliability nor adversely affect its existing wholesale, retail and transmission customers. It also amends PURPA to encourage states to study and regulate various matters, including the capital structures of EWGs, integrated resource planning, and the amount of purchased power that electric utilities should have in their generation mix. EPACT also sets forth waste disposal standards, new nuclear licensing procedures, and contains provisions promoting alternate transportation fuels, research on environmental issues, and increased energy from renewables (See discussion of EPACT in ITEM 1. BUSINESS, SALES and ELECTRIC FACILITIES). - 29 - Pursuant to the requirements of Section 712 of EPACT, the Maryland, Ohio, Pennsylvania, Virginia, and West Virginia commissions issued orders regarding four broad economic and regulatory policy issues related to the purchase of wholesale power. All of the commissions decided to evaluate these issues on a case- by-case basis or within their existing regulatory framework, instead of establishing generic standards. On January 24, 1994, the Maryland PSC issued an order which instituted a proceeding for the purpose of determining whether to implement standards which, under EPACT, a state commission must consider in order to encourage integrated resource planning and investments in conservation and energy efficiency by electric utilities. The order provides for the filing of initial and reply comments and for a hearing on May 3, 1994. Potomac Edison intervened and will be submitting comments in this proceeding. Under EPACT, the FERC has initiated several proceedings, one of the most significant being the request for comments on transmission pricing, including pricing as it may apply to parallel power flows. The Operating Subsidiaries have developed and submitted a pricing philosophy intended to meet certain goals, including reliable operation of the transmission system and protection of native load customers, while promoting accurate price signals and offering third- party transmission service at the lowest reasonable rates. Other FERC initiatives included the issuance of guidelines governing open access transmission requests and rules governing the establishment of Regional Transmission Groups. The Operating Subsidiaries founded and continue to participate in, along with other utilities, an organization whose primary purpose is to develop a mutually acceptable method of resolving the inequities imposed on transmission network owners by parallel power flows. The SEC has also issued regulations and proposed regulations to implement EPACT, including the integration of EPACT with PUCHA and the effect of EPACT on nonexempt PUCHA companies such as APS and its Subsidiaries. In July 1993, the PUC directed the Bureau of Conservation, Economics and Energy Planning to develop competitive bidding regulations to replace, at least in part, the existing state PURPA regulations. In November 1993, West Penn filed a petition with the PUC requesting an Order that, pending the revision and replacement of the existing state PURPA regulations, any proceedings or orders regarding purchase by West Penn of capacity from a qualifying facility under PURPA shall be based on competitive bidding. The Office of Consumer Advocate, the Office of Small Business Advocate, the West Penn Power Industrial Intervenors, and West Penn's two largest industrial customers have intervened in support of West Penn's position. Several PURPA developers and a group purporting to represent PURPA interests have filed in opposition to certain parts of the petition. West Penn cannot predict the outcome of this proceeding. - 30 - On October 8, 1993, the West Virginia PSC issued proposed regulations concerning bidding procedures for capacity additions for electric utilities and invited comment by December 7, 1993. A number of interested parties, including Monongahela and Potomac Edison, filed comments. The West Virginia PSC has taken no further action since the filing of comments. On December 17, 1992, the PUCO issued proposed rules concerning competitive bidding for supply-side resources, transmission access for winning bidders and incentives for the recovery of the cost of purchased power. The PUCO invited comments by March 3, 1993 and reply comments by March 24, 1993. A number of interested parties, including Monongahela, submitted comments. The PUCO has taken no further action following the filing of comments. Maryland and Virginia have not mandated compulsory competitive bidding at this date. The Omnibus Budget Reconciliation Act of 1993 increased the marginal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. As a result, the Operating Subsidiaries' income tax expense for 1993 increased by about $3 million. On June 13, 1990, the Maryland PSC began an investigation to determine whether Potomac Edison's methodology for calculating avoided costs under PURPA is appropriate. On October 11, 1991, the Maryland PSC incorporated this review of avoided costs into a collaborative process already formed between its Staff, the Maryland Department of Natural Resources, Potomac Edison, Eastalco Aluminum, the Maryland Energy Administration, and the Office of People's Counsel. Although the group's primary mission was to avoid litigation by working cooperatively to develop demand- side management programs, the issue of avoided costs was addressed because avoided costs are needed for determining the cost-effectiveness of programs. These negotiations culminated in a Settlement Agreement which was signed by the six parties and filed with the Maryland PSC on October 14, 1993. The Hearing Examiner issued a proposed order accepting the Settlement Agreement on November 17, 1993. The proposed order became final on December 17, 1993, thereby concluding this proceeding. In October 1990, the PUC ordered Pennsylvania's major electric utilities, including West Penn, to file programs for demand-side management designed to reduce customer demand for electricity and to reduce the need for additional generating capacity. The PUC's order proposed that the affected utilities receive full recovery of the costs of approved programs, as well as financial incentives for implementing such programs, including recovery of lost revenues. West Penn filed its proposed programs with the PUC. On December 13, 1993, the PUC entered an order which provides for the recovery of program costs either through a surcharge or deferral to a base rate case; the recovery of revenues lost due to the implementation of demand-side management programs through a base rate case; and the award of incentives for good program performance or the assessment of penalties for poor performance. Two parties to this proceeding have petitioned the PUC for reconsideration and clarification and the Pennsylvania Industrial Energy Coalition has filed an appeal with the Commonwealth Court of Pennsylvania. West Penn cannot predict the final outcome of this proceeding. - 31 - During 1993, Potomac Edison continued its participation in the Collaborative Process for demand- side management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and Potomac Edison's largest industrial customer. Potomac Edison received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993 Potomac Edison had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. ITEM 2.

ITEM 2. PROPERTIES Substantially all of the properties of the Operating Subsidiaries are held subject to the lien securing each company's first mortgage bonds and, in many cases, subject to certain reservations, minor encumbrances, and title defects which do not materially interfere with their use. Some properties are also subject to a second lien securing certain solid waste disposal and pollution control notes. The indenture under which AGC's unsecured debentures and medium-term notes are issued, prohibits AGC, with certain limited exceptions, from incurring or permitting liens to exist on any of its properties or assets unless the debentures and medium-term notes are contemporaneously secured equally and ratably with all other indebtedness secured by such lien. Transmission and distribution lines, in substantial part, some substations and switching stations, and some ancillary facilities at power stations are on lands of others, in some cases by sufferance, but in most instances pursuant to leases, easements, permits or other arrangements, many of which have not been recorded and some of which are not evidenced by formal grants. In some cases no examination of titles has been made as to lands on which transmission and distribution lines and substations are located. Each of the Operating Subsidiaries possesses the power of eminent domain with respect to its public utility operations. (See also ITEM 1. BUSINESS and SYSTEM MAP.) - 32 - ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In 1979, National Steel Corporation (National Steel) filed suit against certain Subsidiaries in the Circuit Court of Hancock County, West Virginia, alleging damages of approximately $7.9 million as a result of an order issued by the West Virginia PSC requiring curtailment of the plaintiff's use of electric power during the United Mine Workers' strike of 1977-8. A jury verdict in favor of the defendants was rendered in June 1991. National Steel has filed a motion for a new trial, which is still pending before the Circuit Court of Hancock County. The Subsidiaries believe the motion is without merit; however, they cannot predict the outcome of this case. In 1987, West Penn entered into separate agreements with developers of four PURPA projects: Milesburg (43 MW), Burgettstown (80 MW), Shannopin (80 MW) and Point Marion (2 MW). The agreements provided for the purchase of each project's power over 30 years or more at rates generally approximating West Penn's avoided costs at the time the agreements were negotiated, as defined by PURPA. Yearly capacity payments under the four agreements would total in excess of $50 million. Each agreement was subject to prior PUC approval of the pass-through to West Penn's customers of the total cost incurred under each agreement, on a current basis. In 1987 and 1988, West Penn filed a separate petition with the PUC for each agreement requesting an appropriate PUC order, and various parties intervened. Since that time, all four agreements have been, in varying degrees, the subject of complex and continuing regulatory and judicial proceedings. During 1993, West Penn entered into a settlement agreement with Point Marion and that project has been terminated. On November 24, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Milesburg project which upheld the decision of the Commonwealth Court concerning the time frame for the calculation of avoided cost and upheld the decision that the PUC had the authority under PURPA to revise and reinstate a lapsed power purchase contract. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. On December 30, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Shannopin project which upheld the decision of the Commonwealth Court affirming the PUC's authority under PURPA to revise voluntarily negotiated power purchase contracts. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. As of December 31, 1993, petitions for allowance of an appeal of the decision of the Pennsylvania Commonwealth Court on the Burgettstown project were pending before the Pennsylvania Supreme Court. West Penn cannot predict the outcome of these proceedings. On October 28, 1993, South River Power Partners, L.P. ("South River") filed a complaint against West Penn with the PUC. The complaint seeks to require West Penn to purchase 240 MW from a proposed coal-fired PURPA project which South River proposes to build in Fayette County, Pennsylvania. South River's proposed initial price for this power would be over $0.09 per kWh. West Penn is opposing this complaint as the power is not needed and the price is in excess of avoided cost. The Pennsylvania Consumer Advocate, the Small Business Advocate, the PUC Trial Staff and various industrial customers have also intervened in opposition to the complaint. West Penn cannot predict the outcome of this proceeding. - 33 - Two previously reported complaints had been filed with the West Virginia PSC by developers of cogeneration projects in Marshall and Barbour Counties, West Virginia to require Monongahela and Potomac Edison to purchase capacity from the projects. These two cases were consolidated. The West Virginia PSC on March 5, 1993, found that: Monongahela had no need for additional capacity; Potomac Edison will need new combustion turbine generating capacity beginning in 1996; and Potomac Edison's avoided cost estimate, which is substantially below the costs sought by the developers of the projects, is reasonable. The developers have asked the West Virginia PSC to consider issues not resolved in the March 5, 1993 order. On June 25, 1993 the West Virginia PSC found that Potomac Edison had a PURPA obligation to purchase power from qualifying facilities properly interconnected to the System in Monongahela's service territory and ordered negotiations by Monongahela and Potomac Edison with the two PURPA developers. On August 9, 1993, the West Virginia PSC deconsolidated the two cases. Following the West Virginia Supreme Court's denial of a petition for review of this order, both developers requested the start of negotiations. Monongahela and Potomac Edison cannot predict the outcome of these proceedings. On November 16, 1992, Potomac Edison and the developer of a proposed cogeneration project located in Cumberland, Maryland, requested that the Maryland PSC approve an amendment to a previously approved agreement for the sale of 180 MW of capacity and associated energy from the project to Potomac Edison. The amendment provides for the relocation of the proposed project within the Cumberland area; a delay of one year in the project's earliest in-service date to October 1, 1996, without increase in the initial capacity rate (which otherwise escalates annually at one-half the rate of actual inflation); and other changes consistent with the site and in-service date modifications. The Maryland PSC commenced an investigation of the amendment in December 1992. After hearings, the parties reached a settlement which was approved by the Maryland PSC on March 17, 1993. The settlement agreement resulted in a further delay of the project's in-service date to October 1, 1999, modified the initial capacity rate with only a slight escalation, and provided that Potomac Edison would pay, and recover from customers by a surcharge, a portion of the project's costs resulting from the delay. On December 22, 1993, the Maryland PSC approved the surcharge and these costs are being recovered from customers effective January 1, 1994. As previously reported, effective March 1, 1989, West Virginia enacted a new method for calculating the Business and Occupation Tax (B & O Tax) on electricity generated in that state, which disproportionately increased the B & O Tax on shipments of electricity to other states. In 1989, West Penn, the Pennsylvania Consumer Advocate, and several West Penn industrial customers filed a joint complaint in the Circuit Court of Kanawha County, West Virginia seeking to have the B & O Tax declared illegal and unconstitutional on the grounds that it violates the Interstate Commerce Clause and the Equal Protection Clause of the federal Constitution and certain provisions of federal law that bar the states from imposing or assessing taxes on the generation or transmission of electricity that discriminate against out-of-state entities. In 1991, West Penn amended the complaint to include a 1990 increase in the rate of the B & O Tax. The trial was held in July 1993 and briefs have been filed. West Penn cannot predict the outcome of this litigation. - 34 - As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shot- gun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Operating Subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the Operating Subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at Subsidiary-operated stations were employed by third- party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Operating Subsidiaries believe potential liability of the Operating Subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the Operating Subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. On March 4, 1994, the Operating Subsidiaries received notice that the EPA had identified them as potentially responsible parties ("PRPs") under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), with respect to the Jack's Creek/Sitkin Smelting Superfund Site ("Site"). The Operating Subsidiaries are among some 880 PRPs that have been identified at the Site. EPA is planning to issue a Proposed Plan and Record of Decision in September 1994 delineating the remedy selected for the Site. At this time it is not possible to determine what liability, if any, the Operating Subsidiaries may have regarding the Site. - 35 - In 1970, the Operating Subsidiaries filed with the Federal Power Commission (FPC) an application for a license to build a 1,000-MW energy-storage facility near Davis, West Virginia. In 1977, FPC issued a license for the project, but various parties, including the State of West Virginia and the U.S. Department of Interior, filed appeals, which are now pending before the U.S. Court of Appeals for the District of Columbia. The U.S. Army Corps of Engineers (Corps) denied a dredge and fill permit for the project, which decision was appealed. The U.S. District Court for the District of Columbia decided that the Corps had no jurisdiction in the matter. The Corps filed an appeal with the U.S. Court of Appeals for the District of Columbia. In 1987, the appellate Court decided that the Corps did have jurisdiction and remanded the case to the U.S. District Court for further consideration of the Corps' denial of the permit. The U. S. Supreme Court refused to review that decision. In 1988, the U.S. District Court reversed the Corps' denial of the dredge and fill permit. The District Court's decision, which has now been appealed, found, among other things, that the Operating Subsidiaries were denied an opportunity to review and comment upon written materials and other communications used by the Corps in making its decision, and as a result the Court remanded the matter to the Corps for further proceedings. Negotiations are ongoing to settle this matter. The Operating Subsidiaries cannot predict the outcome of these proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The holders of 46,537,924 shares of common stock of APS voted at a special meeting held on November 3, 1993 to amend APS' charter to reclassify each share of common stock, par value $2.50 per share, issued or unissued, into two shares of common stock, par value $1.25 each. The holder of 259,451 shares voted against the proposal and the holders of 296,598 shares abstained. The charter amendment became effective at the close of business on November 4, 1993. The amount of APS' stated capital was not changed as a result of the amendment. The holder of the common stock of Monongahela on December 13, 1993, waived the holding of a meeting and consented in writing to the amendment of its Charter to reflect the redemption of 50,000 shares of $9.64 series cumulative preferred stock. No other company submitted matters to a vote of shareholders during the fourth quarter. - 36 - Executive Officers of the Registrants The names of the executive officers of each company, their ages, the positions they hold and their business experience during the past five years appears below: (a) All officers and directors are elected annually. - 37 - (a) All officers and directors are elected annually. - 48 - (a) All officers and directors are elected annually. - 39 - PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS APS. AYP is the trading symbol of the common stock of APS on the New York, Chicago, and Pacific Stock Exchanges. The stock is also traded on the Amsterdam (Netherlands) and other stock exchanges. As of December 31, 1993, there were 63,396 holders of record of APS' common stock. The tables below show the dividends paid and the high and low sale prices of the common stock for the periods indicated: The high and low prices in 1994 were 26-1/2 and 24-1/8 through February 3. The last reported sale on that date was at 25. Monongahela, Potomac Edison, and West Penn. The information required by this Item is not applicable as all the common stock of these Subsidiaries is held by APS. AGC. The information required by this Item is not applicable as all the common stock of AGC is held by Monongahela, Potomac Edison, and West Penn. - 40 - ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Page No. APS D-1 Monongahela D-3 Potomac D-5 West Penn D-7 AGC D-9 D-1 D-2 (a) Reflects a two-for-one common stock split effective November 4, 1993. (b) Capability available through contractual arrangements with nonutility generators. (c) Preliminary. D-3 D-3 (a) Capability available through contractual arrangements with nonutility generators. D-5 D-6 D-7 D-8 (a) Capability available through contractual arrangements with nonutility generators. D-9 - 41 - ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page No. APS M-1 Monongahela M-9 Potomac M-18 West Penn M-27 AGC M-36 M-1 APS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONSOLIDATED NET INCOME Earnings per share were $1.88 in 1993 and were $1.83 and $1.80 in 1992 and 1991. Consolidated net income was $215.8 million, $203.5 million, and $194.0 million. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. All per share amounts have been adjusted to reflect the November 4, 1993, two-for-one stock split (See Note F to the consolidated financial statements). SALES AND REVENUES KWh sales to and revenues from residential, commercial, and industrial customers are shown on page D-2. Such kWh sales increased 3.3% and 1.5% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $ 46.6 $ 9.1 Fuel and energy cost adjustment clauses (a) 57.0 37.9 Rate increases (b): Pennsylvania 25.2 5.8 Maryland 12.7 11.7 West Virginia 5.3 12.4 Virginia 2.5 1.8 Ohio 2.1 1.7 47.8 33.4 Other 6.2 .1 $157.6 $80.5 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) See ITEM 1. RATE MATTERS for further information on rate changes. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were approximately normal, cooling degree days increased 69% over 1992 and were 25% over normal, contributing to the 1993 kWh sales increases. The subsidiaries experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M -2 KWh sales to industrial customers increased .3% in 1993 and 2.9% in 1992. The relatively flat industrial sales growth in 1993 followed record industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From subsidiaries' generation 1.2 3.2 5.8 From purchased power 11.2 14.6 12.4 12.4 17.8 18.2 Revenues (in millions): From subsidiaries' generation $ 28.5 $ 91.7 $158.5 From sales of purchased power 318.2 373.8 366.5 $346.7 $465.5 $525.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by subsidiaries' generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the subsidiaries' ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989--a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $14 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M -3 OPERATING EXPENSES Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with other utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA) and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Purchased power: For resale to other utilities $280.9 $344.0 $332.7 From PURPA generation 105.2 94.0 68.9 Other 33.8 12.7 29.0 Total power purchased 419.9 450.7 430.6 Power exchanges, net (2.5) .7 (1.4) $417.4 $451.4 $429.2 The amount of power purchased from other utilities for use by subsidiaries and for resale to other utilities depends upon the availability of the subsidiaries' generating equipment, transmission capacity, and fuel, and their cost of generation and the cost of operations of other utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to other utilities is described under SALES AND REVENUES above. The cost of power purchased for use by the subsidiaries, including power from PURPA generation, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the subsidiaries' regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net income. The increases in purchases from PURPA generation reflect additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $5 million. The subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates and will be requesting recovery of substantially all of the remainder in 1994 rate cases. During 1992, the subsidiaries implemented significant changes to their benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 20% greater than 1993 amounts. M-4 Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other postemployment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The subsidiaries currently accrue for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The subsidiaries are also experiencing, and expect to continue to experience, increased expenditures due to the aging of their power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the Clean Air Act Amendments of 1990 (CAAA). Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note I to the consolidated financial statements) and the replacement of aging equipment at the subsidiaries' power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $4 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($5 million) and increased property taxes ($2 million). These increases were offset by decreased West Virginia Business and Occupation taxes (B&O taxes) due to decreased generation in that state. The 1992 increase resulted from increased property taxes ($4 million), increases in gross receipts taxes ($3 million), and increased capital stock taxes ($2 million), offset by decreased B&O taxes ($2 million). The net increase of $13 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($9 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($3 million). The net decrease in 1992 of $4 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the consolidated financial statements provides a further analysis of income tax expenses. M-5 The combined increase of $4 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. Fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the levels of short-term debt maintained by the companies. The decrease in dividends on preferred stock of subsidiaries reflects the 1992 redemption of three series totaling $25 million with dividend rates of 9.4% to 9.64% and the 1993 redemption of an additional $2 million of 4.7% to $7.16 series, offset by the 1992 sale of $40 million of market auction preferred stock with an average dividend rate of 2.6%. LIQUIDITY AND CAPITAL RESOURCES SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". System companies need cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stocks, and for their construction programs. To meet these needs, the companies have used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the companies' cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. CAPITAL REQUIREMENTS Construction expenditures for 1993 were $574 million and for 1994 and 1995 are estimated at $500 million and $400 million, respectively. These estimates include $161 million and $53 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA discussed under ITEM 1. ENVIRONMENTAL MATTERS. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for M-6 compliance with both Phase I and Phase II of the CAAA. The subsidiaries are estimating amounts of approximately $1.4 billion, which includes $482 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the subsidiaries have additional capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note G to the consolidated financial statements). INTERNAL CASH FLOWS Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $270 million in 1993. Regulatory commission orders received in Maryland, Pennsylvania, Virginia, and West Virginia provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and requested and new rate cases planned in 1994, internal generation of cash can be expected to increase. The increase in other investments reflects the 1993 cash surrender values for secured benefit plans and a related prepayment. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($54 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the subsidiaries' regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. FINANCINGS In October 1993, the Company issued 2,400,000 shares of its common stock for $64.1 million. Also during 1993, the Company issued 1,364,846 shares of common stock under its Dividend Reinvestment and Stock Purchase Plan (DRISP), and Employee Stock Ownership and Savings Plan (ESOP) for $36.1 million. During 1993 the subsidiaries issued $43 million of 6.25% to 6.3% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $634 million of debt securities having interest rates of 7% to 9.75% through the issuance of $652 million of securities having interest rates of 4.95% to 7.75%. The costs M-7 associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $44 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long-term securities. Short-term debt increased from $11.2 million in 1992 to $130.6 million in 1993. The subsidiaries canceled or postponed approximately $152 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its subsidiaries established an internal money pool whereby surplus funds of the Company and certain subsidiaries may be borrowed on a short-term basis by the Company's subsidiaries. This has contributed to the decrease in the 1993 temporary cash investment amounts. Allegheny Generating Company in 1992 replaced its $65.7 million of commercial paper with $50.9 million of money pool borrowings and $2.4 million of four-year, 6.05%-6.10% medium-term notes. Allegheny Generating Company has available an established program to replace money pool borrowings with medium-term notes or commercial paper. At December 31, 1993, unused lines of credit with banks were $149 million. In addition, a multi-year credit program was established in January 1994, which provides that the subsidiaries may borrow on a standby revolving credit basis up to $300 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the subsidiaries plan to issue about $230 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $728 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The subsidiaries may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company plans to fund the subsidiaries' sale of common stock through the issuance of short-term debt and DRISP/ESOP common stock sales. The subsidiaries anticipate that they will be able to meet their future cash needs through internal cash generation and external financings as they have in the past and possibly through alternative financing procedures. M-8 ENVIRONMENTAL MATTERS AND OTHER CONTINGENCIES In the normal course of business, the subsidiaries are subject to various contingencies and uncertainties relating to their operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note I to the consolidated financial statements. All of the state jurisdictions in which the subsidiaries operate have enacted hazardous and solid waste management legislation. While the subsidiaries do not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The subsidiaries are incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the subsidiaries. As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison, and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at subsidiary-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the subsidiaries believe potential liability of the subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. M-9 Monongahela MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $61.7 million, $58.3 million, and $54.1 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-3 and D-4 Such kWh sales increased .3% in 1993 and decreased 1.0% in 1992. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase (Decrease) from Prior Year 1993 1992 (Millions of Dollars) Increased (decreased) kWh sales $ 6.6 $(5.3) Fuel and energy cost adjustment clauses (a) 11.8 12.3 Rate increases (b): West Virginia 4.1 12.1 Ohio 2.1 1.6 6.2 13.7 Other .2 (1.3) $24.8 $19.4 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a surcharge in West Virginia for recovery of carrying charges on expenditures to comply with the Clean Air Act Amendments of 1990 (CAAA), designed to produce $3.1 million on an annual basis effective on July 1, 1992, which was increased to $8.7 million on an annual basis effective on July 1, 1993, and a rate increase in Ohio, designed to produce $3.3 million on an annual basis, which became effective on July 21, 1992. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were only 6% above normal, cooling degree days increased 54% over 1992, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-10 KWh sales to industrial customers decreased 4.4% in 1993 and .7% in 1992. The 1993 decrease was primarily due to continuing declines in sales to coal and primary metals customers. Coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. Lower sales to primary metals customers was due in part to one iron and steel customer's increased use of its own generation. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .3 1.0 1.8 From purchased power 2.8 3.6 3.1 3.1 4.6 4.9 Revenues (in millions): From Company generation $ 8.4 $ 26.7 $ 48.5 From sales of purchased power 77.6 92.9 91.5 $86.0 $119.6 $140.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWH) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The increase in other revenues in 1993 and 1992 resulted from continued increases in sales of capacity, energy, and spinning reserve to other affiliated companies because of additional capacity and energy available from new PURPA projects in both years. This increase was offset in part in 1993 by an agreement with the Federal Energy Regulatory Commission to record in 1993 about $3 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. About 90% of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on net income. M-11 Operating Expenses Fuel expenses decreased 3% in 1993 and 9% in 1992. Both decreases were primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $ 68.6 $ 85.5 $ 83.0 From PURPA generation 55.7 37.4 13.2 Other 8.1 3.1 7.2 Power exchanges, net (.6) .3 (.5) Affiliated transactions: AGC capacity charges 23.3 24.2 25.1 Energy and spinning reserve charges .5 2.8 5.3 $155.6 $153.3 $133.3 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The increases in purchases from PURPA generation reflects additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. Energy and spinning reserve charges decreased in 1993 and 1992 primarily because of additional generation available from new PURPA projects. M-12 The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, will increase future employee benefit costs for postretirement benefit expenses. The Company is currently recovering approximately 50% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 and early 1995 rate cases. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-13 Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes (B&O taxes) ($1 million) due to decreased generation in that state. The 1992 decrease resulted from decreased B&O taxes ($2 million) and prior period B&O tax adjustments ($2 million), offset somewhat by increases in gross receipts and property taxes ($2 million). The net increase of $6 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($4 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $3 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures primarily associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to decrease as the Company completes its Phase I compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used M-14 internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $141 million and for 1994 and 1995 are estimated at $103 million and $83 million, respectively. These estimates include $39 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $400 million, which includes $122 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, was about $69 million for 1993. A regulatory commission order has been received in West Virginia authorizing procedures to provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and new rate cases planned in 1994 and early 1995, internal generation of cash can be expected to increase. M-15 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($13 million). The five- year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $10.68 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $67 million of debt securities having interest rates of 7.5% to 9.5% through the issuance of $72 million of securities having interest rates of 5.625% to 5.95%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. Short-term debt, including notes payable to affiliates under the money pool, increased from $8.0 million in 1992 to $63.1 million in 1993. The Company canceled or postponed approximately $69 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $100 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $81 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $50 million of new equity securities and, if economic and market conditions make it desirable, may refinance up to $285 million of first M-16 mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. As of January 1994, the Company has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the M-17 Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of the Company. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by the Company for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-18 Potomac MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $73.5 million, $67.5 million, and $58.2 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-5 and D-6. Such kWh sales increased 6.3% and 2.0% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $24.4 $ 7.7 Fuel and energy cost adjustment clauses (a) 19.1 10.4 Rate increases (b): Maryland 12.7 11.7 Virginia 2.5 1.8 West Virginia 1.1 .3 16.3 13.8 Other 2.9 .2 $62.7 $32.1 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a rate increase in Maryland, designed to produce $11.3 million on an annual basis, which became effective on February 25, 1993, and a rate increase in Virginia, designed to produce $10.0 million on an annual basis, which became effective on September 28, 1993, subject to refund. The Maryland surcharge for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance investment of $1.7 million effective on June 4, 1992, which was increased to $3.9 million effective on December 3, 1992, was rolled into base rates effective with the February 1993 increase. Rate increases also include a CAAA surcharge in West Virginia designed to produce $.8 million on an annual basis effective July 1, 1992, which was increased to $2.2 million on an annual basis effective July 1, 1993. The increased kWh sales to residential and commercial customers in 1993 reflect both higher use and growth in number of customers. While 1993 heating degree days showed only a slight increase over 1992, and were only 7% M-19 above normal, cooling degree days increased 82% over 1992 and were 12% over normal, contributing to the 1993 kWh sales increases. The Company experienced a normal winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. KWh sales to industrial customers increased 4.3% in 1993 and 2.0% in 1992. The increase in both years occurred in almost all industrial groups, the most significant of which in 1993 was from sales to cement customers. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.0 1.8 From purchased power 3.5 4.4 3.8 3.9 5.4 5.6 Revenues (in millions): From Company generation $8.6 $27.5 $47.4 From sales of purchased power 99.5 113.6 114.3 $108.1 $141.1 $161.7 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $4 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M-20 Operating Expenses Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities, capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $87.9 $104.6 $103.7 Other 10.5 3.7 8.9 Power exchanges, net (.8) .2 (.4) Affiliated transactions: AGC capacity charges 28.0 29.6 31.3 Other affiliated capacity charges 28.4 21.9 23.4 Energy and spinning reserve charges 51.1 41.2 37.6 $205.1 $201.2 $204.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power purchased from nonaffiliates for use by the Company and affiliated energy and spinning reserve charges are mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The 1993 increase in other purchased power reflects efforts to conserve coal because of selective work stoppages by the United Mine Workers of America for most of the year. M-21 While the Company does not currently purchase generation from qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), several projects have been proposed, and an agreement has been reached with one facility to commence purchasing generation in 1999. This project and others may significantly increase the cost of power purchases passed on to customers. The increase in affiliated capacity and energy and spinning reserve charges in 1993 was due to growth of kWh sales to retail customers and an increase in affiliated energy available because of energy purchased by an affiliate from new PURPA projects in 1992 and 1993. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $1.5 million. The Company is currently recovering approximately 90% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 rate cases. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. M-22 The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes due to decreased generation in that state ($1 million). The 1992 increase was due to increased property ($1 million) and gross receipts ($1 million) taxes. The net increase of $2 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($3 million) and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million), offset by plant removal tax deductions for which deferred taxes were not provided ($1 million). The net increase in 1992 was primarily due to an increase in income before taxes. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stock, M-23 and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. During 1993, the Company continued its participation in the Collaborative Process for Demand-Side Management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and the Company's largest industrial customer. The Company received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993, the Company had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. Capital Requirements Construction expenditures for 1993 were $179 million and for 1994 and 1995 are estimated at $136 million and $106 million, respectively. These estimates include $40 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $350 million, which includes $153 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has M-24 additional annual capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $75 million in 1993. Regulatory commission orders received in all of the state jurisdictions and the FERC provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and new rate cases planned in 1994, internal generation of cash can be expected to increase. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($14 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $13.99 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $121 million of debt securities having interest rates of 7% to 9.5% through the issuance of $129 million of securities having interest rates of 5.875% to 7.75%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $9 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $36 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. M-25 At December 31, 1993, the Company had SEC authorization to issue up to $115 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $84 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $75 million of new debt securities and, if economic and market conditions make it desirable, may refinance up to $231 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-26 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in five generating plants, including four operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-27 West Penn MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Net Income Consolidated net income was $102.1 million, $98.2 million, and $101.2 million in 1993, 1992, and 1991, respectively. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases, offset in part by higher expenses. Higher retail revenues in 1992 from a surcharge to recover increases in various state taxes and greater kWh sales were more than offset by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-7 and D-8. Such kWh sales increased 3.1% and 2.7% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $15.5 $ 6.7 Fuel and energy cost adjustment clauses (a) 26.2 15.2 Rate increases (b) 25.2 5.8 Other 3.1 1.3 $70.0 $29.0 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) Reflects a base rate increase on an annual basis of about $61.6 million in Pennsylvania effective May 18, 1993, including $26.1 million for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance costs, and in 1992 also reflects a surcharge effective August 24, 1991, to recover Pennsylvania tax increases. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days remained about the same as 1992, and were only 6% below normal, cooling degree days increased 70% over 1992 and were 46% over normal, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-28 KWh sales to industrial customers increased .8% in 1993 and 6.3% in 1992. The relatively flat industrial sales growth in 1993 followed increases in industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.3 2.3 From purchased power 5.0 6.5 5.4 5.4 7.8 7.7 Revenues (in millions): From Company generation $11.5 $37.5 $62.5 From sales of purchased power 141.0 167.2 160.7 $152.5 $204.7 $223.2 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The decrease in other revenues in 1993 and 1992 resulted from continued decreases in sales of energy and spinning reserve to an affiliated company because of additional energy available to it from new PURPA projects commencing in both years. The 1993 decrease was also due in part to an agreement with the Federal Energy Regulatory Commission to record in 1993 about $6 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. Most of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. M-29 Operating Expenses Fuel expenses decreased 4% in each of the years of 1993 and 1992 primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $124.5 $153.9 $146.0 From PURPA generation 49.6 56.5 55.6 Other 15.2 5.9 12.9 Power exchanges, net (1.2) .3 (.5) Affiliated transactions: AGC capacity charges 42.3 43.5 44.1 Energy and spinning reserve charges 4.7 3.5 3.8 Other affiliated capacity charges .7 .6 .6 $235.8 $264.2 $262.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net M-30 income. The decrease in purchases from PURPA generation in 1993 was due to a planned generating outage at one PURPA project. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and in 1993 also from employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $3.1 million. The Company is currently recovering all of SFAS No. 106 expenses in rates. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 5% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-31 Depreciation expense increases resulted primarily from additions to electric plant and in 1993 also from a change in depreciation rates and net salvage amortization as a result of the May 1993 rate order. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the consolidated financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $2 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($3 million) offset in part by decreased West Virginia Business and Occupation taxes (B&O taxes) ($2 million) due to decreased generation in that state. The 1992 increase resulted from increased property and capital stock taxes ($4 million), increased B&O taxes ($1 million), and increases in gross receipts taxes ($1 million). The net increase of $7 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($6 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $4 million resulted primarily from a decrease in income before taxes. Note B to the consolidated financial statements provides a further analysis of income tax expenses. The combined increase of $.3 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the consolidated financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such M-32 as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $251 million and for 1994 and 1995 are estimated at $258 million and $208 million, respectively. These estimates include $82 million and $33 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable ruling of the Pennsylvania PUC allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $700 million, which includes $207 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the consolidated financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $119 million in 1993. A regulatory commission order has been received from the PUC which provides for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and a new rate case planned in 1994, internal generation of cash can be expected to increase. M-33 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($27 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $18.04 million of 6.30% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $246 million of debt securities having interest rates of 7% to 9.75% through the issuance of $251 million of securities having interest rates of 4.95% to 6.375%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $47 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $170 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $135 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $105 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $212 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction program, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the consolidated financial statements. Pennsylvania has enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-35 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System- operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in four generating plants, including three operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-36 AGC MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As described under Liquidity and Capital Resources, revenues are determined under a cost of service formula rate schedule. Therefore, if all other factors remain equal, revenues are expected to decrease each year due to a normal continuing reduction in the Company's net investment in the Bath County station and its connecting transmission facilities upon which the return on investment is determined. Revenues for 1993 and 1992 decreased due to a reduction in interest charges and net investment, and reduced operating expenses which are described below. Additionally, revenues for 1993 and 1992 were reduced by the recording of estimated liabilities for possible refunds pending final Federal Energy Regulatory Commission (FERC) decisions in rate case proceedings (see Liquidity and Capital Resources). The net investment (primarily net plant less deferred income taxes) decreases to the extent that provisions for depreciation and deferred income taxes exceed net plant additions. The decrease in operating expenses in 1993 resulted from a decrease in federal income taxes due to a decrease in income before taxes ($1.9 million) offset by an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($.5 million), partially offset by an increase in operation and maintenance expense. The decrease in operating expenses in 1992 resulted primarily from reduced federal income taxes because of a decrease in income before taxes, partially offset by increases in taxes other than income. The increase in taxes other than income in 1992 was due to increased property taxes. The decreases in interest on long-term debt in 1993 and 1992 were the combined result of decreases in the average amount of and interest rates on long-term debt outstanding. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company's only operating assets are an undivided 40% interest in the Bath County (Virginia) pumped-storage hydroelectric station and its connecting transmission facilities. The Company has no present plans for construction of any other major facilities. M-37 Pursuant to an agreement, the Parents buy all of the Company's capacity in the station priced under a "cost of service formula" wholesale rate schedule approved by the FERC. Under this arrangement, the Company recovers in revenues all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment. Through February 29, 1992, the Company's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. On March 1, 1990, the ROE decreased from 12% to 11.25%, and on March 1, 1991, it was increased to 11.53%. In December 1991, the Company filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. In 1993, the Company issued $50 million of 5.75% medium-term notes due 1998, $50 million of 5.625% debentures due 2003, and $100 million of 6.875% debentures due 2023 to refund $50 million 8% debentures due 1997, $50 million 8.75% debentures due 2017, and $100 million 9.125% debentures due 2016. The Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. - 42 - ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Financial Statement Schedules - All other schedules are omitted because they are not applicable or the required information is shown in the Financial Statements or Notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Power System, Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Power System, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and E to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 APS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The Company and its subsidiaries (companies) are subject to regulation by the Securities and Exchange Commission. The subsidiaries are subject to regulation by various state bodies having jurisdiction and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company and its subsidiaries are summarized below. CONSOLIDATION: The Company owns all of the outstanding common stock of its subsidiaries. The consolidated financial statements include the accounts of the Company and all subsidiary companies after elimination of intercompany transactions. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures followed by Monongahela Power Company in West Virginia, revenues include service rendered but unbilled at year end. Certain increases in rates being collected by subsidiaries are subject to final commission approvals, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used by the subsidiaries for computing AFUDC in 1993, 1992, and 1991 averaged 9.37%, 9.19%, and 8.84%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4% of average depreciable property in 1993 and 3.3% in each of the years 1992 and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INVESTMENTS: The investment in subsidiaries consolidated represents the excess of acquisition cost over book equity (goodwill) prior to 1966. Goodwill is not being amortized because, in management's opinion, there has been no reduction in its value. Other investments primarily represent the cash surrender values and prepayments of purchased life insurance contracts on certain qualifying management employees under an executive life insurance plan and a supplemental executive retirement plan (Secured Benefit Plan). Payment of future premiums will fully fund these benefits. INCOME TAXES: Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The subsidiaries have a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The subsidiaries also provide partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the subsidiaries adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the subsidiaries adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before preferred dividends and income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the subsidiaries recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $ 105 289 Unbilled revenue 38 363 Tax interest capitalized 22 236 Contributions in aid of construction 17 176 State tax loss carryback/carryforward 14 560 Other 21 658 219 282 Deferred tax liabilities: Book vs. tax plant basis differences, net 1 051 500 Other 42 122 1 093 622 Total net deferred tax liabilities 874 340 Less portion above included in current liabilities 645 Total long-term net deferred tax liabilities $ 873 695 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the subsidiaries have recorded regulatory assets for an amount equal to the $562 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $108 million increase in deferred tax assets to reflect the subsidiaries' obligation to pass such tax benefits on to their customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. NOTE C--DIVIDEND RESTRICTION: Supplemental indentures relating to most outstanding bonds of subsidiaries contain dividend restrictions under the most restrictive of which $461,539,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on their common stocks, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by a subsidiary as a capital contribution or as the proceeds of the issue and sale of shares of such subsidiary's common stock. The benefits earned to date and funded status at December 31 using a measurement date of September 30 were as follows: In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. NOTE E--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: The subsidiaries adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the subsidiaries for retired employees and their dependents were recorded in expense in the period in which they were paid and were $6,553,000 and $5,691,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost--benefits earned $ 2 000 Interest cost on accumulated postretirement benefit obligation 11 300 Actual return on plan assets (24) Amortization of unrecognized transition obligation 7 300 Other net amortization and deferral 24 SFAS No. 106 postretirement cost 20 600 Regulatory deferral (4 790) Net postretirement cost $15 810 The benefits earned to date and funded status at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $115 019 Fully eligible employees 24 135 Other employees 55 255 Total obligation 194 409 Plan assets at market value in short-term investment fund 4 646 Accumulated postretirement benefit obligation in excess of plan assets 189 763 Less: Unrecognized cumulative net loss from past experience different from that assumed 41 450 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 138 200 Postretirement benefit liability at September 30, 1993 10 113 Fourth quarter 1993 contributions and benefit payments 4 549 Postretirement benefit liability at December 31, 1993 $ 5 564 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $145,500,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $13.4 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $1.0 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for the FERC wholesale customers effective in mid-to-late 1993. Regulatory actions have been taken by the Virginia and Ohio regulatory commissions which provide support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The subsidiaries have recorded regulatory assets at December 31, 1993, of $4.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. NOTE F--STOCKHOLDERS' EQUITY: COMMON STOCK: In November 1993, the common shareholders approved a two-for-one split of the Company's common stock which was effective November 4, 1993. The stock split reduced the par value of the common stock from $2.50 per share to $1.25 per share and increased the number of authorized shares of common stock from 130,000,000 to 260,000,000. The number of common stock shares outstanding and per share information for all periods reflect the two-for-one split. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. The holders of West Penn Power Company's auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. MANDATORILY REDEEMABLE PREFERRED STOCK: The Potomac Edison Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. That subsidiary has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, The Potomac Edison Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. NOTE G--LONG-TERM DEBT: Maturities for long-term debt for the next five years are: 1994, $26,000,000; 1995, $28,000,000; 1996, $43,575,000; 1997, $48,262,000; and 1998, $185,400,000. Substantially all of the properties of the subsidiaries are held subject to the lien securing each subsidiary's first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Commercial paper borrowings issuable by Allegheny Generating Company are backed by a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. However, to the extent that funds are available from the companies, Allegheny Generating Company borrowings are made through an internal money pool as described in Note H. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $2,129,923,000 and $2,033,103,000, respectively, based on actual market prices or market prices of similar issues. NOTE H--SHORT-TERM DEBT: To provide interim financing and support for outstanding commercial paper, lines of credit have been established with several banks. The companies have fee arrangements on all of their lines of credit and no compensating balance requirements. At December 31, 1993, unused lines of credit with banks were $149,175,000. In addition to bank lines of credit, in 1992 the companies established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, a multi-year credit program was established which provides that the subsidiaries may borrow up to $300 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of notes payable to banks ($75,825,000) and commercial paper ($54,811,000) and at the end of 1992 consisted of a note payable to a bank ($11,205,000). The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. NOTE I--COMMITMENTS AND CONTINGENCIES: CONSTRUCTION PROGRAM: The subsidiaries have entered into commitments for their construction programs, for which expenditures are estimated to be $500 million for 1994 and $400 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: The companies are subject to laws, regulations, and uncertainties as to environmental matters discussed under ITEM 1. ENVIRONMENTAL MATTERS. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The subsidiaries are estimating expenditures of approximately $1.4 billion, which includes $482 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $161 million and $53 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the subsidiaries will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION: In the normal course of business, the companies become involved in various legal proceedings. The companies do not believe that the ultimate outcome of these proceedings will have a material effect on their financial position. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Monongahela Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Monongahela Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 1,500,000 shares, outstanding as follows (Note G): Monongahela NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures in West Virginia, revenues include service rendered but unbilled at year end. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 8.69%, 8.23%, and 6.17%, respectively. In accordance with FERC guidelines, the 1991 rate was based solely on borrowed funds because the Company's average outstanding short-term debt was greater than the average construction work in progress balance. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.8% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $18 043 Unbilled revenue 4 181 Tax interest capitalized 2 430 Contributions in aid of construction 2 058 Vacation pay 1 958 Advances for construction 1 601 Other 4 455 34 726 Deferred tax liabilities: Book vs. tax plant basis differences, net 205 829 Other 23 411 229 240 Total net deferred tax liabilities 194 514 Less portion above included in current liabilities 2 048 Total long-term net deferred tax liabilities $192 466 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $158 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,482,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 27% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.3 million, $8.3 million, and $8.9 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 30%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $2,390,000 and $2,029,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 478 Interest cost on accumulated postretirement benefit obligation 2 819 Actual return on plan assets (5) Amortization of unrecognized transition obligation 1 772 Other net amortization and deferral 5 SFAS No. 106 postretirement cost 5 069 Regulatory deferral (1 981) Net postretirement cost $3 088 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $32 469 Fully eligible employees 4 348 Other employees 14 664 Total obligation 51 481 Plan assets at market value in short-term investment fund 1 230 Accumulated postretirement benefit obligation in excess of plan assets 50 251 Less: Unrecognized cumulative net loss from past experience different from that assumed 14 161 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 34 059 Postretirement benefit liability at September 30, 1993 2 031 Fourth quarter 1993 contributions and benefit payments 997 Postretirement benefit liability at December 31, 1993 $ 1 034 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $35,800,000 (transition obligation), is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $3.5 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.2 million. Recovery of SFAS No. 106 costs has been authorized for FERC wholesale customers effective in December 1993. Recovery has been requested in a rate case filed in West Virginia for which a final commission decision is expected in 1994. Regulatory action has been taken by the Ohio regulatory commission which provides support that substantial recovery is probable. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million for West Virginia and Ohio where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: In September 1992, the Company issued and sold to its parent, 800,000 shares of its common stock at $50 per share. Other paid-in capital decreased $4,000 in 1992 as a result of a preferred stock redemption. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994 and 1995, none; 1996, $18,500,000; 1997, $15,500,000; and 1998, $20,100,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $65 million of 5-5/8% 7-year first mortgage bonds to refund a $10 million 8-1/8% issue due in 1999, a $30 million 7-7/8% issue due in 2002, and a $20 million 7-1/2% issue due in 1998. The Company also issued $7.05 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund a $7.05 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $485,713,000 and $461,663,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Debt: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $100 million including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $81 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of $63.1 million of notes payable to banks and at the end of 1992 consisted of money pool borrowings from affiliates of $8.03 million. The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $103 million for 1994 and $83 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $400 million, which includes $122 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $39 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 27% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of The Potomac Edison Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Potomac Edison Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Potomac NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. Revenues of $63.4 million from one industrial customer, Eastalco Aluminum Company, were 8.9% of total electric operating revenues in 1993. Certain increases in rates being collected by the Company in Virginia are subject to final commission approval, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.97%, 9.92%, and 9.93%, respectively. AFUDC is not recorded for construction applicable to the state of Virginia, where construction work in progress is included in rate base. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.6% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $17 922 Unbilled revenue 12 556 Contributions in aid of construction 10 530 Tax interest capitalized 9 056 State tax loss carryback/carryforward 5 770 Advances for construction 1 303 Other 3 279 60 416 Deferred tax liabilities: Book vs. tax plant basis differences, net 183 892 Other 10 122 194 014 Total net deferred tax liabilities 133 598 Less portion above included in current liabilities 571 Total long-term net deferred tax liabilities $133 027 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $74 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,730,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 28% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.6 million, $8.6 million, and $9.2 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 35%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long- term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,790,000 and $1,564,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 35%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 383 Interest cost on accumulated postretirement benefit obligation 3 042 Actual return on plan assets (7) Amortization of unrecognized transition obligation 1 986 Other net amortization and deferral 7 SFAS No. 106 postretirement cost 5 411 Regulatory deferral (846) Net postretirement cost $4 565 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 189 Fully eligible employees 7 741 Other employees 14 635 Total obligation 57 565 Plan assets at market value in short-term investment fund 1 375 Accumulated postretirement benefit obligation in excess of plan assets 56 190 Less: Unrecognized cumulative net loss from past experience different from that assumed 15 695 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 37 995 Postretirement benefit liability at September 30, 1993 2 500 Fourth quarter 1993 contributions and benefit payments 1 132 Postretirement benefit liability at December 31, 1993 $1 368 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $40,000,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.0 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.3 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993 and for the FERC wholesale customers effective in September 1993. Regulatory action has been taken by the Virginia regulatory commission which provides support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The Company has recorded regulatory assets at December 31, 1993, of $.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL The Company issued and sold common stock to its parent, at $20 per share, 2,500,000 shares in October 1993, 4,000,000 shares in September 1992, and 1,250,000 shares in September 1991. Other paid-in capital decreased $2,000 in 1992 as a result of preferred stock transactions. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. MANDATORILY REDEEMABLE PREFERRED STOCK: The Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. The Company has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, the Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, $16,000,000; 1995, none; 1996, $18,700,000; 1997, $800,000; and 1998, $1,800,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $45 million of 7-3/4% 30-year first mortgage bonds and $75 million of 5-7/8% 7-year first mortgage bonds to refund a $25 million 8-5/8% issue due in 2007, a $15 million 8-5/8% issue due in 2003, a $20 million 8-3/8% issue due in 2001, a $15 million 7-5/8% issue due in 1999, a $12 million 7-1/2% issue due in 2002, and a $25 million 7% issue due in 1998. The Company also issued $8.6 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund an $8.6 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $566,070,000 and $538,211,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $115 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $84 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $4.6 million and $38 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $136 million for 1994 and $106 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $350 million, which includes $153 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $40 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 28% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of West Penn Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of West Penn Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock of the Company (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 3,097,077 shares, outstanding as follows (Note G): West Penn NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries (the companies). REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.40%, 9.25%, and 9.46%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4%, 3.3%, and 3.2% of average depreciable property in 1993, 1992, and 1991, respectively. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The companies join with the parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $40 455 Unbilled revenue 21 626 Tax interest capitalized 10 750 State tax loss carryback/carryforward 8 790 Contributions in aid of construction 4 588 Other 7 416 93 625 Deferred tax liabilities: Book vs. tax plant basis differences, net 507 214 Other 8 437 515 651 Total net deferred tax liabilities 422 026 Add portion above included in current assets 1 974 Total long-term net deferred tax liabilities $424 000 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $326 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $41 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $285,914,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 45% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $12.2 million, $13.8 million, and $14.8 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Consolidated Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 25%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,907,000 and $1,721,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 25%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 939 Interest cost on accumulated postretirement benefit obligation 4 389 Actual return on plan assets (9) Amortization of unrecognized transition obligation 2 817 Other net amortization and deferral 9 SFAS No. 106 postretirement cost 8 145 Regulatory deferral (1 963) Net postretirement cost $6 182 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 748 Fully eligible employees 9 030 Other employees 18 378 Total obligation 63 156 Plan assets at market value in short-term investment fund 1 510 Accumulated postretirement benefit obligation in excess of plan assets 61 646 Less: Unrecognized cumulative net loss from past experience different from that assumed 3 362 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 53 746 Postretirement benefit liability at September 30, 1993 4 538 Fourth quarter 1993 contributions and benefit payments 1 960 Postretirement benefit liability at December 31, 1993 $2 578 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $56,600,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.3 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.4 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Pennsylvania effective in May 1993 and for the FERC wholesale customers effective in June 1993. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million relating to SFAS No. 106 costs in Pennsylvania incurred prior to the May rate order, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. The Company will seek to recover these costs in its next base rate case. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: The Company issued and sold common stock to its parent, at $20 per share, 5,000,000 shares in October 1993, and 1,750,000 shares in December 1991. Other paid-in capital decreased $145,000 in 1993 and $550,000 in 1992 as a result of the underwriting fees and commissions and miscellaneous expenses associated with the Company's sale of $40 million of preferred stock in 1992. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 per share. The holders of the Company's market auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, none; 1995, $27,000,000; 1996 and 1997, none; and 1998, $103,500,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $102 million of 5-1/2% 5-year first mortgage bonds to refund a $25 million 7% issue due in 1997, a $25 million 7-7/8% issue due in 1999, and a $52 million 7-1/8% issue due in 1998, and sold $80 million of 6-3/8% 10-year first mortgage bonds to refund a $35 million 7-5/8% issue due in 2002 and a $40 million 8-1/8% issue due in 2001. The Company also issued $7.75 million of 5.95% 20-year Pollution Control Revenue Notes to refund a $7.75 million 9-3/8% issue due in 2013, and issued $61.5 million of 10-year 4.95% Pollution Control Revenue Notes to refund a $30 million 9-3/4% series and a $31.5 million 9-1/2% series due in 2003. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $823,333,000 and $783,379,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $170 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $135 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $24.9 million and $20.9 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $258 million for 1994 and $208 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $700 million, which includes $207 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $82 million and $33 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 45% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Generating Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Generating Company (an Allegheny Power System, Inc. affiliate) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A and B to the financial statements, the Company changed its method of accounting for income taxes in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 AGC NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company was incorporated in Virginia in 1981. Its common stock is owned by Monongahela Power Company - 27%, The Potomac Edison Company - 28%, and West Penn Power Company - 45% (the Parents). The Parents are wholly-owned subsidiaries of Allegheny Power System, Inc. and are a part of the Allegheny Power integrated electric utility system. The Company is subject to regulation by the Securities and Exchange Commission (SEC) and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, and consist of a 40% undivided interest in the Bath County pumped-storage hydroelectric station and its connecting transmission facilities. The cost of depreciable property units retired plus removal costs less salvage are charged to accumulated depreciation. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 2.1% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged to operating expenses. INCOME TAXES: The Company joins with its parents and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are deferred. Prior to 1987, provisions for federal income tax were reduced by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. ACCOUNTING CHANGE: Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes. Note B - Income Taxes: Details of federal income tax provisions are: In 1993, the total provision for income taxes ($13,262,000) was less than the amount produced by applying the federal income tax statutory rate to financial accounting income before income taxes ($14,155,000), due primarily to amortization of deferred investment credit ($1,316,000). Federal income tax returns through 1989 have been examined and substantially settled. The Company adopted SFAS No. 109 as of January 1, 1993, and in doing so recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets Unamortized investment tax credit $ 28 869 Deferred tax liabilities Book vs. tax plant basis differences, net 154 565 Other 152 154 717 Total net deferred tax liabilities $125 848 It is expected the FERC will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $4 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $29 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Long-Term Debt: The Company had long-term debt outstanding as follows: The Company has a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. Amounts borrowed are guaranteed by the Parents in proportion to their equity interest. Interest rates are determined at the time of each borrowing. The revolving credit agreement serves as support for the Company's commercial paper. In addition to bank lines of credit, the Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At the end of 1993, the Company had outstanding $29,500,000 of money pool borrowings from affiliates. Maturities for long-term debt for the next five years are: 1994, 10,000,000; 1995, $1,000,000; 1996, $6,375,000; 1997, $61,462,000; and 1998, $60,000,000. The estimated fair value of debentures and medium- term notes at December 31, 1993 and 1992, was $233,445,000 and $249,850,000 respectively, based on actual market prices or market prices of similar issues. The carrying amount of commercial paper and notes payable to affiliates approximates their fair value because of the short maturity of those instruments. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Classified as long-term debt by Allegheny Generating Company (AGC). Charges for maintenance and depreciation other than amounts shown in the consolidated statement of income were not material. Charges for maintenance and depreciation other than amounts shown in the statement of income were not material. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Internal arrangement for borrowing funds on a short-term basis. - 43 - - 44 - ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE For APS and the Subsidiaries, none. - 45 - PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS APS, Monongahela, Potomac Edison, West Penn, and AGC. Reference is made to the Executive Officers of the Registrants in Part I of this report. The names, ages, and the business experience during the past five years of the directors of the System companies are set forth below: (1) See Executive Officers of the Registrants in Part I of this report for further details. (a) Eleanor Baum. Dean of the Albert Nerken School of Engineering of The Cooper Union for the Advancement of Science and Art. Director of United States Trust Company, Commissioner of the Engineering Manpower Commission, and a fellow of the Institute of Electrical and Electronic Engineers and the Society of Women Engineers. Ms. Baum filed one late report on Form 4 concerning one purchase transaction in 1993. (b) William L. Bennett. Co-Chairman, Director and Chief Executive Officer of Noel Group, Inc. Formerly, General partner, Discovery Funds, a venture capital affiliate of Rockefeller & Company, Inc. Chairman of the Board of TDX Corporation. Director of Forschner Group, Inc., Global Natural Resources Inc., Lincoln Snacks Company, Simmons Outdoor Corporation and VISX, Inc. (c) Phillip E. Lint. Retired. Formerly, partner, Price Waterhouse. (d) Edward H. Malone. Retired. Formerly, Vice President of General Electric Company and Chairman, General Electric Investment Corporation. Director of Fidelity Group of Mutual Funds, General Re Corporation, Mattel, Inc., and Corporate Property Investors, a real estate investment trust. (e) Frank A. Metz, Jr. Retired. Formerly, Senior Vice President, Finance and Planning, and Director, International Business Machines Corporation. Director of Monsanto Company and Norrell Corporation. (f) Clarence F. Michalis. Chairman of the Board of Directors of Josiah Macy, Jr. Foundation, a tax-exempt foundation for medical research and education. Director of Schroder Capital Funds Inc. (g) Steven H. Rice. Business consultant and attorney-at-law. Formerly, President and Chief Operating Officer and Director of The Seamen's Bank for Savings. Director and member of the Investment and Audit Committees of Royal Group, Inc. (The Royal Insurance Companies). Director and Vice Chairman of the Board of The Stamford (CT) Federal Savings Bank. (h) Gunnar E. Sarsten. President and Chief Operating Officer of Morrison Knudsen Corporation. Formerly, President and Chief Executive Officer of United Engineers & Constructors International, Inc., a subsidiary of the Raytheon Company, and Deputy Chairman of the Third District Federal Reserve Bank in Philadelphia. (i) Peter L. Shea. Managing director of Hydrocarbon Energy, Inc., a privately owned oil and gas development drilling and production company. - 46 - ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION During 1993, and for 1992 and 1991, the annual compensation paid by each of the System companies, APS, APSC, Monongahela, Potomac Edison, West Penn, and AGC directly or indirectly for services in all capacities to such companies to their Chief Executive Officer and each of the four most highly paid executive officers of each such company whose cash compensation exceeded $100,000 was as follows: (a) APS has no paid employees. All salaries and bonuses are paid by APSC. (b) Bonus amounts are determined and paid in April of the year in which the figure appears and are based upon performance in the prior year. (c) Amounts constituting less than 10% of the total annual salary and bonus are not disclosed. All officers did receive miscellaneous other items amounting to less than 10% of total annual salary and bonus. (d) Effective January 1, 1992, the basic group life insurance provided employees was reduced from two times salary during employment, which reduced to one times salary after 5 years in retirement, to a new plan which provides one times salary until retirement and $25,000 thereafter. Executive officers and other senior managers remain under the prior plan. In order to pay for this insurance for these executives, during 1992 insurance was purchased on the lives of each of them. Effective January 1, 1993, APS started to provide funds to pay for the future benefits due under the supplemental retirement plan (Secured Benefit Plan) as described in note (a) on p. 53. To do this, APS purchased, during 1993, life insurance on the lives of the covered executives. The premium costs of both the 1992 and 1993 policies plus a factor for the use of the money are returned to APS at the earlier of (a) death of the insured or (b) the later of age 65 or 10 years from the date of the policy's inception. The figures in this column include the present value of the executives' cash value at retirement attributable to the current year's premium payment for both the Executive Life Insurance and Secured Benefit Plans (based upon the premium, future valued to retirement, using the policy internal rate of return minus the corporation's premium payment), as well as the premium paid for the basic Group Life Insurance program plan and the contribution for the 401(k) plan. For 1993, the figure shown includes amounts representing (a) the aggregate of life insurance premiums and dollar value of the benefit to the executive officer of the remainder of the premium paid on the Group Life Insurance program and the Executive Life Insurance and Secured Benefit Plans and (b) 401(k) contributions as follows: Mr. Bergman $42,392 and $4,497; Mr. Garnett $19,509 and $4,497; Mr. Skrgic $14,181 and $4,497; Ms. Gormley $11,152 and $4,294; and Mr. Jones $8,382 and $4,497, respectively. (e) These amounts as previously reported did not include the following amounts representing the dollar value of the benefit to the executive officer of the remainder of the premium paid on the Executive Life Insurance Plan: Mr. Bergman $786; Mr. Garnett $210; Mr. Skrgic $218; Ms. Gormley $232; and Mr. Jones $519. (f) See Executive Officers of the Registrants for other positions held. (g) Although less than 10% of total annual salary and bonus, Mr. Skrgic received a $15,000 housing allowance in 1993, 1992 and 1991. (h) The incentive plan was not in effect for these officers in 1991. (i) Includes $15,000 housing allowance for both 1993 and 1992 and miscellaneous other items totaling $2,423 and $2,457 for 1993 and 1992, respectively. - 47 - - 48 - - 49 - - 50 - Summary Compensation Tables AGC Annual Compensation (a) Name All Other and Compen- Principal sation Position Year Salary($) Bonus($) ($) (a) AGC has no paid employees. - 51 - DEFINED BENEFIT OR ACTUARIAL PLAN DISCLOSURE Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) APS (b) Klaus Bergman, President* $235,270 and Chief Executive Officer (c) Stanley I. Garnett, II, 112,320 Vice President, Finance (c) Peter J. Skrgic, 126,000 Vice President (c) Kenneth M. Jones, 90,004 Vice President and Comptroller (c) Nancy H. Gormley, 78,404 Vice President (c) Monongahela Klaus Bergman, $ Chief Executive Officer (c)(d) Benjamin H. Hayes, 113,364 President Thomas A. Barlow, 70,788 Vice President Robert R. Winter, 67,896 Vice President Richard E. Myers, 67,200 Comptroller * Elected Chairman of the Board effective January 1, 1994. - 52 - Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) Potomac Edison Klaus Bergman, $ Chief Executive Officer (c)(d) Alan J. Noia, 133,200 President Robert B. Murdock, 80,677 Vice President James D. Latimer, 75,298 Vice President Thomas J. Kloc, 68,591 Comptroller West Penn Klaus Bergman, $ Chief Executive Officer (c)(d) Jay S. Pifer, 111,463 President Thomas K. Henderson, 73,127 Vice President Charles S. Ault, 71,100 Vice President Charles V. Burkley, 66,442 Comptroller Allegheny Generating Company No paid employees. - 53 - (a) Assumes present insured benefit plan and salary continue and retirement at age 65 with single life annuity. Under plan provisions, the annual rate of benefits payable at the normal retirement age of 65 are computed by adding (i) 1% of final average pay up to covered compensation times years of service up to 35 years, plus (ii) 1.5% of final average pay in excess of covered compensation times years of service up to 35 years, plus (iii) 1.3% of final average pay times years of service in excess of 35 years. Covered compensation is the average of the maximum taxable Social Security wage bases during the 35 years preceding the member's retirement, except that years before 1959 are not taken into account for purposes of this average. The final average pay benefit is based on the member's average total earnings during the highest-paid 60 consecutive calendar months or, if smaller, the member's highest rate of pay as of any July 1st. Effective July 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. The maximum amount will be reduced to $150,000 effective July 1, 1994 as a result of The Omnibus Budget Reconciliation Act of 1993. Benefits for employees retiring between 55 and 62 differ from the foregoing. Pursuant to a supplemental plan (Secured Benefit Plan), senior executives of Allegheny Power System companies who retire at age 60 or over with 40 or more years of service are entitled to a supplemental retirement benefit in an amount that, together with the benefits under the basic plan and from other employment, will equal 60% of the executive's highest average monthly earnings for any 36 consecutive months. The supplemental benefit is reduced for less than 40 years service and for retirement age from 60 to 55. It is included in the amounts shown where applicable. In order to provide funds to pay such benefits, effective January 1, 1993 the Company purchased insurance on the lives of the plan participants. The Secured Benefit Plan has been designed that if the assumptions made as to mortality experience, policy dividends, and other factors are realized, the Company will recover all premium payments, plus a factor for the use of the Company's money. All executive officers are participants in the Secured Benefit Plan. This does not include benefits from an Employee Stock Ownership and Savings Plan (ESOSP) established as a non-contributory stock ownership plan for all eligible employees effective January 1, 1976, and amended in 1984 to include a savings program. Under the ESOSP for 1993, all eligible employees may elect to have from 2% to 7% of their compensation contributed to the Plan as pre-tax contributions and an additional 1% to 6% as post-tax contributions. Employees direct the investment of these contributions into one or more of five available funds. Each System company matches 50% of the pre-tax contributions up to 6% of compensation with common stock of Allegheny Power System, Inc. Effective January 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. Effective January 1, 1994, the amount was reduced to $150,000 as a result of The Omnibus Budget Reconciliation Act of 1993. Employees' interests in the ESOSP vest immediately. Their pre-tax contributions may be withdrawn only upon meeting certain financial hardship requirements or upon termination of employment. (b) APS has no paid employees. These executives are employees of APSC. (c) See Executive Officers of the Registrants for other positions held. (d) The total estimated annual benefits on retirement payable to Mr. Bergman for services in all capacities to APS, APSC and the Subsidiaries is set forth in the table for APS. Compensation of Directors In 1993, APS directors who were not officers or employees of System companies received for all services to System companies (a) $16,000 in retainer fees, (b) $800 for each committee meeting attended, except Executive Committee meetings which are $200, and (c) $250 for each Board meeting of each company attended. Under an unfunded deferred compensation plan, a director may elect to defer receipt of all or part of his or her director's fees for succeeding calendar years to be payable with accumulated interest when the director ceases to be such, in equal annual installments, or, upon authorization by the Board of Directors, in a lump sum. - 55 - ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.

49423_1993.txt

49423

1993

ITEM 1. BUSINESS - ----------------- General Aquarion Company ("Aquarion") is a holding company whose subsidiaries are engaged both in the regulated utility business of public water supply and in various nonutility businesses. Aquarion's utility subsidiary, Bridgeport Hydraulic Company ("BHC"), and its subsidiary, Stamford Water Company ("SWC", together with BHC, the "Utilities") collect, treat and distribute water to residential, commercial and industrial customers, to other utilities for resale and for private and municipal fire protection. The Utilities provide water to customers in 22 communities with a population of approximately 492,000 people in Fairfield, New Haven and Litchfield Counties in Connecticut, including communities served by other utilities to which water is available on a wholesale basis for back-up supply or peak demand purposes through the Regional Pipeline. BHC is the largest investor-owned water company in Connecticut and, with its SWC subsidiary, is among the 10 largest investor-owned water companies in the nation. The Utilities are regulated by several Connecticut agencies, including the Connecticut Department of Public Utility Control (the "DPUC"). Aquarion is also engaged in various nonutility activities. The Company conducts an environmental testing laboratory business through its Industrial and Environmental Analysts group of subsidiaries (collectively, "IEA"). IEA performs testing to determine the nature and quantity of contamination in sampled materials, including hazardous wastes, soil, air and water. IEA provides a range of environmental analytical testing capabilities, including routine and customized analysis of organic and inorganic contaminants. IEA's testing services are conducted at six regional environmental testing laboratories in Connecticut, Florida, Illinois, Massachusetts, New Jersey and North Carolina. IEA's laboratories are subject to governmental regulation at both state and federal levels. IEA's clients include engineering consulting firms, industrial and commercial corporations and federal, state and local governmental entities. The laboratories located in North Carolina, New Jersey and Connecticut participate in the U.S. Environmental Protection Agency's Contract Laboratory Program. Aquarion owns Timco, Inc. ("Timco"), a small forest products and electricity cogeneration company based in New Hampshire. At Timco's sawmill complex, lumber is cut and packaged for sale to wholesalers and retailers. The cogeneration plant produces electricity which is sold to a public utility and low cost steam for drying the lumber and heating some of the sawmill buildings. Aquarion Company is also engaged in several small utility management service businesses through its Hydrocorp, Inc. ("Hydrocorp") and Aquarion Management Services, Inc. ("AMS") subsidiaries and owns Main Street South Corporation ("MSSC"), a small real estate subsidiary formed in 1969 to assist the Utilities in marketing surplus land. The Company was incorporated in Delaware as The Hydraulic Company in 1969 to become the parent company to BHC, a Connecticut corporation founded in 1857. The corporate name was changed to Aquarion Company in April 1991. The Company's executive offices are located at 835 Main Street, Bridgeport, Connecticut 06601-2353 and its telephone number is (203) 335-2333. Recent Developments Rates. In filing its rate application with the Connecticut Department of Public Utility Control (DPUC) in February 1993, BHC had requested a 35 percent water service rate increase designed to provide a $17,500,000 increase in annual water service revenues and a return on common equity of 12.75 percent. Prior to the final decision, BHC lowere request by a total of $1,400,000 by restructuring long-term debt to reduce annual interest costs and by reducing property taxes and other miscellaneous expenses. The request included the replacement of a construction work in progress water service rate surcharge (CWIP rate surcharge) previously granted to BHC pursuant to DPUC regulations to recover 90 percent of the carrying costs of capital used in its Easton Lake Filtration Construction Project mandated by the federal Safe Drinking Water Act of 1974 (the "SDWA"). During 1993 and 1992, BHC derived revenues of $1,937,000 and $1,532,000, respectively, from the CWIP rate surcharge. Effective August 1, 1993, the DPUC awarded BHC a 20.7 percent water service rate increase designed to provide a $10,400,000 annual increase in revenues and a 11.6 percent return on common equity. The DPUC approved a 22.5 percent water services rate increase for SWC effective August 28, 1991, designed to increase annual revenues by $2,276,000 and provide a 12.85 percent return on its common equity. Effective January 1, 1991, BHC was awarded a 15 percent rate increase designed to increase annual revenues by $6,983,000 and provide a 13.25 percent return on its common equity. There is no certainty that any given rate increase will produce the intended level of revenues or the allowed return on equity. See "Public Water Supply--Rates and Regulation." Pending Utility Acquisition. Aquarion has proposed to acquire The New Canaan Water Company and Ridgefield Water Supply Company for Aquarion common stock with a market value of $3,500,000 on or about the closing date. The acquisition and a related property exchange have been approved by the DPUC but remain contingent upon certain other regulatory approvals satisfactory to the parties. Proceedings to obtain the regulatory approvals are pending. The parties have agreed to extend their acquisition agreement and the related property exchange agreement until March 31, 1994. There is no certainty that the parties will agree to further extensions if the transaction has not closed by that time. See "Industry Segment Information." Sale of Facilities. On March 15, 1993 IEA sold its Vermont laboratory which performed qualification and certification of and consulting for high purity gas delivery systems and ultrapure water systems, as well as some microbiological testing. In addition, in October 1993 IEA sold the assets of its air testing division to TRC, Inc. of Hartford, Connecticut. See "Environmental Laboratories." Other. Native Americans who allege that they constitute the Golden Hill Paugussett Tribe of Indians (the "Paugussett Indians") have taken an appeal to the U.S. Court of Appeals for the Second Circuit for the dismissal by the U.S. District Court in Connecticut of their suit seeking to restore claimed rights to certain lands in various towns in Fairfield and New Haven Counties. Newspaper reports during 1993 indicated that they have announced plans to claim further lands, including all land in the municipalities of Monroe, Shelton and Trumbull. BHC, which has not been named as a defendant to date, owns land in these communities, including land it considers surplus. It is not possible at this time to determine whether any further suit will be filed or, if so, whether BHC will be named a defendant, nor is it possible to determine what effect, if any, the filing of any such suit might have on the marketability of real property in these communities or, should the Paugussett Indians prevail, whether there would be any effect on the operations of BHC. Utility Construction Program The Utilities are engaged in a continuing construction program mandated by legislative and regulatory requirements, as well as for infrastructure replacements. The Utilities expended $16,300,000, $21,727,000 and $13,969,000 in 1993, 1992 and 1991, respectively, for plant additions and modifications of existing plant facilities, excluding an allowance for funds used during construction ("AFUDC"). The expenditures were made primarily for installations of water mains, service connections and meters and such special projects as the Easton Lake and the Litchfield Division supply and distribution system improvements. Utility capital expenditures for 1993 aggregated $16,300,000 and budgeted expenditures for 1994, most of which management believes should not be postponed, are approximately $34,200,000. Approximately half of these expenditures will be devoted to compliance with the SDWA, which requires filtration or alternative water treatment measures for BHC's major, unfiltered surface water supplies. The total capital cost of water filtration or alternative treatment measures for such supplies through December 31, 1993 was approximately $28,400,000, of which $26,800,000 related to construction of the Easton Lake filtration facility. Management estimates that the total of such costs from 1994 through 1996 will approximate $50,000,000, without adjustment for inflation, including $15,300,000 expected to be incurred in 1994. Approximately $48,000,000 of the projected 1994 through 1996 water treatment costs will be incurred in construction of the filtration facility for the Hemlocks reservoir. The remaining $2,000,000 of estimated filtration expenditures over the next four years is budgeted for SDWA-related facilities for BHC's Lakeville and Norfolk Reservoirs. Part of the cost associated with the Hemlocks facility is expected to be offset by CWIP rate surcharges which, at the DPUC's discretion, permit the recovery of 90 percent of the carrying cost of capital used in construction of SDWA-mandated water treatment facilities. Management cannot predict whether future federal, state or local regulation may require additional capital expenditures. The Company's ability to finance its future construction programs depends in part on future rate relief and the level of CWIP rate surcharges. In light of the Company's substantial need for additional funds, the Company will need additional debt and equity capital to finance future utility construction. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources and Liquidity" and "Business--Public Water Supply--Rates and Regulation." Industry Segment Information The Company's operations are grouped into four industry segments: public water supply; environmental laboratories and utility management services; forest products; and real estate. The consolidated operating revenues of the Company for the year ended December 31, 1993 were derived from the following sources: 66 percent from public water supply, 22 percent from environmental laboratories and utility management services, 12 percent from forest products, and less than 1 percent from real estate, including both MSSC and surplus utility land sales. For additional information concerning each segment for each of the years ended December 31, 1993, 1992 and 1991, see "Note 11" of "Notes to Consolidated Financial Statements" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Public Water Supply Service Area. The Utilities are engaged in the collection, treatment and distribution of water for public and private use to residential, commercial, and industrial users, and for municipal and private fire protection services in 22 communities in parts of Fairfield, Litchfield and New Haven counties in Connecticut. The Utilities also sell, as requested, water for redistribution to customers of the First and Second Taxing Districts' Water Departments of the City of Norwalk, Connecticut, Connecticut-American Water Company, and NCWC through the Southwest Regional Pipeline in Fairfield County. The communities served by the Utilities as of December 31, 1993, have a population of approximately 492,000, and the total number of customer accounts as of that date was approximately 123,900. The Utilities' service areas, primarily residential in nature, have experienced an average growth in accounts of approximately 1 percent per year over the last ten years. Industrial use has declined significantly in that time period, and the residential characteristics of the area have changed, indicating an increase in the percentage of apartment dwellings and condominium units. Management does not anticipate any significant growth in residential consumption in the foreseeable future, and expects continued decline in industrial use. The operating revenues of the Utilities for the twelve months ended December 31, 1993 were derived from the following sources: 59 percent from residential customers, 17 percent from commercial customers, 5 percent from industrial customers, 14 percent from fire protection customers, and 5 percent from other sources. Seasonality. The business of the Utilities is subject to seasonal fluctuations and weather variations. The demand for water during the warmer months is generally greater than during the cooler months, primarily due to additional water requirements of industrial and residential cooling systems, and various private and public outdoor uses such as lawn and golf course sprinkling. From year to year and season to season, demand will vary with rainfall and temperature levels. Water Supply. Water is available from both surface and subsurface sources. During 1993, approximately 97 percent of the water supplied by the Utilities was provided by impounding reservoirs, 2 percent by producing wells and 1 percent by purchased water. As of December 31, 1993, the Utilities' reservoirs, well fields and interconnections with other water utilities had an aggregate safe daily yield of 112.3 million gallons. Safe yield is an estimate of the supply capability during an extended drought. The average daily demand for water from the Utilities in 1993 was 69.3 million gallons per day ("MGD"). The reservoirs of the Utilities have an aggregate storage capacity of 29.4 billion gallons. All of the Utilities' reservoirs and active wells are located on property owned by the Utilities. Management believes it has an adequate water supply to satisfy the current and projected needs of its customers within its territorial service area through at least the year 2040. During historical drought periods in the northeastern United States, the Utilities have been able to accommodate the needs of their own customers and to offer relief to supplement the supplies to neighboring communities by water sales to utilities with which it has pipeline interconnections. Supply and distribution needs of the Utilities undergo constant review, and the Utilities continue to explore and develop additional ground water supplies and study alternative surface water sources to meet anticipated future water requirements. The Connecticut Water Diversion Policy Act, enacted in 1982, prohibits any future diversions of surface or ground water without a permit from the DEP. Although this law "grandfathers" existing surface and ground water supplies which existed when it was enacted, any subsequent water diversion which might be effected by the Utilities is subject to a lengthy permit application process and approval by the DEP. Diversion permits granted pursuant to this law are subject to renewal when their terms, which typically run from five to ten years, expire. Rates and Regulation. The Utilities are incorporated under and operate as public water utilities by virtue of authority granted by Special Acts adopted by the Connecticut legislature (the "Acts"). These Acts have granted a non-exclusive franchise, unlimited in duration, to provide public water supply to private and public customers in designated municipalities and adjacent areas. The Acts also authorize the Utilities to lay their mains and conduits in any public street, highway, or public ground; to use the water of certain rivers, streams, or other waters in Fairfield, Litchfield and New Haven counties and from certain locations along and in the Housatonic River and its tributaries, subject to such consents and approvals as may be required by law; and to exercise the po domain in connection with lands, springs, streams or ponds and any rights or interests therein which are expedient to or necessary for furnishing public water supply. In the event of the exercise of such condemnation powers, the Utilities must pay appropriate compensation to those injuriously affected by such taking. The Utilities are subject to regulation by the DPUC, which has jurisdiction with respect to rates, service, accounting procedures, issuance of securities, dispositions of utility property and other related matters. Rates charged by each of BHC and SWC are subject to approval by the DPUC. The Utilities continually review the need for increases of water rates, and historically have sought rate relief in a timely manner in light of increases in operating costs, additional investment in utility plant and related financing costs, as well as other factors. For information concerning rate increases granted in 1993 and 1991, see "Item 1. Business. Recent Developments, Rates.", above. The DPUC may allow a surcharge to be applied to rates in order to provide a current cash return to water utilities on the major portions of CWIP applicable to facilities, including filtration plants, required for compliance with the SDWA. See "Environmental Regulations." The surcharge is adjusted quarterly, subject to DPUC approval, to reflect increased CWIP expenditures for SDWA facilities. In connection with BHC's construction of filtration facilities at its Easton Lake Reservoir, the DPUC granted BHC an initial .94 percent CWIP rate surcharge in September 1990, which amount was incrementally increased on a quarterly basis to 7.35 percent at the time new rates became effective and the Easton facility became operational and subject to general ratemaking regulations. There is no CWIP surcharge in effect at present, although BHC intends to apply for a CWIP surcharge with respect to its planned filtration facilities when appropriate. Aquarion is neither an operating utility company nor a "public service company" within the meaning of the Connecticut General Statutes and is not presently subject to general regulation by the DPUC. DPUC approval is necessary, however, before Aquarion may acquire or exercise control over any Connecticut public service company. DPUC approval is also required before any other entity can acquire or exercise, or attempt to exercise, control of Aquarion. Connecticut regulations govern the sale of water company land and treatment of land sale proceeds. See "Item 2.

ITEM 2. PROPERTIES ------------------- The Company BHC owns a 20,000 square foot headquarters building and a 44,370 square foot Operations Center in Bridgeport, and leases an additional 22,000 square feet of office, laboratory and garage space in Bridgeport for utility operations. SWC owns its 13,618 square foot headquarters and operations facility in Stamford, Connecticut. Aquarion owns nonutility land totaling approximately 99 acres in Easton and Litchfield, Connecticut. Property At December 31, 1993, BHC owned in the aggregate 11 active reservoirs and approximately 1,640 miles of water mains, of which approximately 77 miles have been laid in the past five years. In addition, SWC owned 5 active reservoirs at year end. The rights to locate and maintain water transmission and distribution mains are secured by charter, easement and permit and are generally perpetual. Water is delivered to the distribution system from four major and several smaller reservoirs and forty-two producing wells. Eight additional reservoirs are used for storage purposes and are interconnected with the distribution reservoirs. BHC owns two dual media filtration plants for treatment of its Trap Falls and Easton Lake reservoir systems, which plants have capacities of 25 and 20 MGD, respectively. SWC owns a 24 MGD rapid-sand and activated-carbon filtration plant for treatment of its entire reservoir system. BHC owns approximately 19,000 acres of real property located in Fairfield, New Haven, and Litchfield Counties, Connecticut, most of which consists of reservoirs and surrounding watershed. All but 1,360 specified acres of such property are subject to the first lien arising under the BHC Indenture securing its First Mortgage Bonds. SWC owns approximately 2,400 acres of real property located in Stamford and New Canaan, Connecticut, and in Pound Ridge and Lewisboro, New York, which consist almost exclusively of reservoirs and surrounding watershed, pumps, standpipes and building facilities. The DPHAS regulates public water company lands according to a three-tiered classification system. Class I lands cannot be sold, leased or transferred. The DPHAS may authorize a transfer or change in use of Class II lands only upon a finding that there will be no adverse impact upon the public water supply and that any use restrictions required as a condition of transfer are enforceable against subsequent owners and occupants of the lands. Class III lands, which are non-watershed, are not presently subject to regulation by the DPHAS. BHC has identified approximately 2,300 acres of land it believes are surplus to its water supply needs, and therefore would qualify as Class III land. All of this Class III land, which includes approximately 570 acres which have never been in rate base, is available for sale, although all of it may not be marketable. Up to 530 additional acres could become available if the DPHAS approves the abandonment of a former reservoir system in New Haven County and reclassifies existing watershed property as Class III land, as requested by the Company. Real property may not be sold or transferred by a water utility without the prior approval of the DPUC an with other restrictions imposed by Connecticut law. State laws and regulations govern, among other things, to whom certain water company lands may be transferred, with preference given to other water companies, the municipality in which the property is located and the State of Connecticut, in that order. Additionally, the disposition of the proceeds of any permissible sale is subject to state law. Until changed by statute in 1988, it had been the practice of the DPUC to apply gains from the sale of surplus water company land that had ever been in the rate base as an offset against operating expenses, thereby substituting profits from the sale of such land for revenues which would otherwise be provided through rates. Legislation enacted in 1988, the Equitable Sharing Statute, required the DPUC to "equitably allocate" the economic benefits of the net proceeds from the sales of Class III land which was previously in the utility's rate base between the Company's ratepayers and its shareholders. Ratepayers do not share in gains from the sale of land which has never been in rate base. The Equitable Sharing Statute was clarified by a 1990 amendment which provides that the economic benefits from the sale of former-rate-base, Class III land which promotes a perpetual public interest in open space or recreational use shall be allocated "substantially in favor" of shareholders when 25 percent or more of the land sold is to be used for open space or recreational purposes. Two decisions involving 1990 land sales, resulted in allocations of the respective gain on the sales of 75 percent and 43 percent, respectively, to BHC's shareholder. In November 1993 the DPUC gave BHC approval to sell 25.78 acres of surplus, off-watershed land in Shelton, Connecticut. BHC plans to subdivide the land into eleven building lots. BHC also received approval from the DPUC in December 1993 to sell 34.55 acres of surplus, off-watershed land in Weston, Connecticut. BHC plans to subdivide the land into ten building lots. Each case involves former rate base land, and 25 percent of the land to be sold will be conveyed to the host municipality to be preserved as open space. Under the terms of both decisions, approximately two-thirds of the net proceeds from the land sales will be allocated to shareholders and the remaining one-third allocated to ratepayers through amortization into BHC's rate base over a five year period. All such net proceeds must be used for reinvestment in utility plant. The Company leases all of its laboratory facilities, except for the Massachusetts laboratory, which it owns. Aquarion owns 50 percent of Key Partners III, a partnership which owns IEA's North Carolina laboratory and headquarters facility. The smallest of IEA's laboratories occupies approximately 6,750 square feet. The largest, located in Cary, North Carolina, occupies approximately 30,000 square feet. The Company believes that the laboratory facilities owned or leased are adequate for its present and anticipated future needs and that the amounts paid for all the leases into which it has entered are reasonable. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS -------------------------- The registrant has nothing to report for this item. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY ------------------------------------------------------------ The registrant has nothing to report for this item. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED --------------------------------------------------------------- STOCKHOLDER MATTERS ------------------- Page 45 of the Company's Annual Report to Shareholders for the year ended December 31, 1993 is incorporated by reference herein pursuant to Rule 12b-23 of the Securities and Exchange Act of 1934 (the "Act") and to Instruction G(2) to Form 10-K. Aquarion has declared and paid quarterly dividends on its common stock without interruption since its organization in 1969, and prior thereto, BHC paid dividends annually on its common stock without interruption since 1890. Dividends, when declared, are normally paid on the 30th day of January, April, July and October. The earnings of Aquarion are derived from its investments in its subsidiaries, particularly BHC. Aquarion's future ability to pay dividends to holders of its Common Stock is dependent upon the continued payment by BHC of dividends to Aquarion. BHC's ability to pay dividends will depend upon timely and adequate rate relief, compliance with restrictions under certain of the BHC debt instruments and other factors. In addition, no dividends on BHC's common stock can be paid during any period in which BHC's preferred stock dividends are in arrears. Dividends on Aquarion common stock can be paid only out of net profits and surplus of the Company. Aquarion's ability to pay dividends is further restricted by the terms of Aquarion's 8 1/2 percent unsecured Senior Notes due January 1994 , which were replaced by a 5.95% unsecured Senior Note due January 1999 and 7.8 percent unsecured Senior Notes due June 1997 (the "Aquarion Notes"). As of December 31, 1993, the applicable restrictions would have permitted payment of additional dividends on Aquarion's common stock of up to $31,000,000. While Aquarion's Board of Directors intends to continue the practice of declaring cash dividends on a quarterly basis, no assurance can be given as to future dividends or dividend rates since they will be determined in light of a number of factors, including earnings, cash flow, and Aquarion and BHC's financial requirements. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations--Capital Resources and Liquidity." ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ------------------------------------- See Page 1 ("Selected Financial Data") and Pages 44 - 45 ("Supplemental Financial Data") of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which is incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(2) to Form 10-K. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ---------------------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS ----------------------------------- See Page 1 ("Selected Financial Data") and Pages 17 - 23 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which is incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(2) to Form 10-K. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA --------------------------------------------------------- The consolidated financial statements, together with the report thereon of Price Waterhouse, dated January 31, 1994, appearing on Pages 24 - 22 and Page 1 ("Selected Financial Data") and Pages 44 - 45 ("Supplemental Financial Data") of the accompanying 1993 Annual Report to Shareholders of Aquarion Company are incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(2) to Form 10-K. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON -------------------------------------------------------------- ACCOUNTING AND FINANCIAL DISCLOSURE ----------------------------------- The registrant has nothing to report for this item. PART III. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ---------------------------------------------------------------- The information as to directors required by Item 10 is set forth at Pages 2 - 8 of the Company's Definitive Proxy Statement, dated March 21, 1994 relating to the proposed Annual Meeting of Shareholders to be held on April 26, 1994, filed with the Commission pursuant to Regulation 14a under the Act, and is incorporated by referenced herein pursuant to Rule 12b-23 of the Act and Instruction G(3) to Form 10-K. Executive Officers The executive officers of the registrant are listed below. These officers were elected to the offices indicated on April 27, 1993, except as otherwise noted, for a term expiring with the 1994 annual meeting of directors. Except as indicated, all have been with registrant and its predecessors in an executive capacity for more than five years. There are no family relationships among members of the executive officers. There were no arrangements or undertakings between any of the officers listed below and any other person pursuant to which he or she was selected as an officer. Served as Office, Business Experience Officer Executive Officer Age During Past Five Years Since ----------------- --- ------------------------ ----- Jack E. McGregor 59 President (since 1988) 1985 Chief Executive Officer (since January 1990) Chief Operating Officer (1988 to January 1990) and Executive Vice President (1985 to 1988) of the Company. Director of People's Bank and Physicians Health Services, Inc. Director and Member of Executive Committee, National Association of Water Companies. Trustee of Fairfield University and Yale-New Haven Hospital. Richard K. Schmidt, Ph.D 49 Senior Vice President 1992 (since April 1993) of the Company; President and Chief Executive Officer of IEA (since March 1992); formerly President and Chief Operating Officer (1984-1992) of Mechanical Technology, Inc. James S. McInerney 56 Senior Vice President 1989 (since April 1992) of the Company; President (since April 1991) and Chief Operating Officer (since January 1990) of BHC, and Chairman and Chief Executive Officer (since January 1990) of Stamford Water Company. Executive Vice President (1990 to April 1991) and Vice President (1989) of BHC and President, Stamford Water Company (1977 to January 1990). Mr. McInerney is a Director, President or Vice President of certain of the Company's other subsidiaries. Served as Office, Business Experience Officer Executive Officer Age During Past Five Years Since ----------------- --- ------------------------ ----- Janet M. Hansen 51 Senior Vice President 1983 (since April 1993), Chief Financial Officer (since April 1992) and Treasurer (since 1988) of the Company and Vice President (since 1989), Chief Financial Officer (since April 1991) and Treasurer (since 1985) of BHC; Mrs. Hansen is Vice President and Treasurer (since April 1991) of IEA and Chairman of the Board and Chief Executive Officer (since April 1992) of Timco. Mrs. Hansen is also Vice President, Chief Financial Officer and Treasurer of certain of the Company's other subsid- iaries. Director of Gateway Bank. Larry L. Bingaman 43 Vice President, Corporate 1990 Relations and Secretary (since April 1993); Vice President, Marketing and Communications (since 1990) of the Company; Formerly Director of Communications for United Technologies' Sikorsky Aircraft Division (1989 to June 1990). ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION ------------------------------------ Pages 8 - 13 of the Company's Definitive Proxy Statement, dated March 21, 1994, relating to the proposed Annual Meeting of Shareholders to be held on April 26, 1994, filed with the Commission pursuant to Regulation 14a under the Act are incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(3) to Form 10-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND ----------------------------------------------------------------- MANAGEMENT ---------- Pages 5 - 6 of the Company's Definitive Proxy Statement, dated March 21, 1994, relating to the proposed Annual Meeting of Shareholders to be held on April 26, 1994, filed with the Commission pursuant to Regulation 14a under the Act, are incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(3) to Form 10-K. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ------------------------------------------------------------ The registrant has nothing to report for this item. PART IV. ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON ----------------------------------------------------------------- FORM 8-K -------- a) The following documents are filed as part of this report: Page in Annual Report* ------------- (1) Consolidated Statements of Income for the three years ended December 31, 1993 24 Consolidated Balance Sheets at December 31, 1993 and 1992 25-26 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 27 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993 28 Notes to Consolidated Financial Statements 29-41 Report of Independent Accountants 42 Selected Financial Data 1 Supplemental Financial Information 44-45 * Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. ____________________ (2) Financial Statement Schedules: Report of Independent Accountants on Financial Statement Schedules, see Page hereto. Index to Additional Financial Information, see Page hereto. The Financial Statement Schedules above should be read in conjunction with the Consolidated Financial Statements in the 1993 Annual Report to Shareholders. All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. (b) Reports on Form 8-K. The Company did not file a report on Form 8-K for the fourth quarter of the year ended December 31, 1993. (c) Exhibits: Each document referred to below is incorporated by reference to the files of the Commission, unless the reference is preceded by an asterisk (*). Each management contract, compensatory plan or arrangement required to be filed as an exhibit hereto is preceded by a double asterisk (**). 3(a) Restated Certificate of Incorporation of Aquarion, as amended.(1) 3(b) By-laws of Aquarion, as amended. (6) 4(a) Rights Agreement between Aquarion and The Chase Manhattan Bank, N.A. setting forth description of Preferred Stock Purchase Rights distributed to holders of Aquarion Common Stock.(6) 10(a) First Mortgage Indenture of BHC dated June 1, 1924.(2) 10(b) Seventeenth Supplemental Mortgage of BHC dated as September 1, 1960.(2) 10(c) Nineteenth Supplemental Mortgage of BHC dated as of August 1, 1965.(1) 10(d) Twentieth Supplemental Mortgage of BHC dated as of November 1, 1968.(1) 10(e) Loan Agreement of BHC dated as of October 15, 1984.(1) 10(f) Loan and Trust Agreement as of November 1, 1984.(1) 10(g) Note Agreement of Aquarion dated December 28, 1990.(3) 10(h) Note Agreement of BHC dated January 24, 1991.(3) 10(i) Note Agreement of Aquarion dated as of May 19, 1992. **10(j) Aquarion Long-Term Incentive Plan.(1) 10(k) Joint Venture Agreement betwee Brennan, Jr., William A. Brennan and Main Street South Corporation dated February 23, 1979.(4) **10(l) Employment Agreement between Aquarion and James S. McInerney, dated June 1, 1990. **10(m) Employment Agreement between Aquarion and Janet M. Hansen dated November 1, 1992. **10(n) Agreement between Aquarion and William S. Warner dated October 15, 1989.(5) **10(o) Employment Agreement between Aquarion and Jack E. McGregor dated January 1, 1990.(5) **10(p) Form of Stock Option Award Agreement for options granted pursuant to Long-Term Incentive Plan.(5) 10(q) Purchase Agreement dated July 28, 1989 by and among Frederick T. Doane, Heike A. Doane and Aquarion.(3) 10(r) Purchase Agreement dated July 10, 1990 by and among Robert L. MacDonald and Aquarion.(3) 10(s) Stock Purchase Agreement dated November 5, 1990 between Paul B. Priest, A C Laboratories, Inc. and Aquarion.(3) 10(t) Stock Purchase Agreement dated as of December 7, 1990 between Aquarion and the sellers listed on Schedule 2. 1 thereof.(3) **10(u) Employment Agreement between Aquarion and Larry L. Bingaman dated June 11, 1990.(3) 10(v) Amendment dated September 12, 1991 to the Stock Purchase Agreement dated as of December 7, 1990.(1) 10(w) Purchase and Sale Agreement dated September 12, 1991, by and among YWC Technologies, Inc., Bird Corporation, YWC, Inc., Interim Dewatering Services, Inc., Ad+Soil, Inc. and Aquarion.(1) 10(x) Agreement for Construction Management Services dated April 18, 1991 between BHC and Gilbane Building Company.(1) **10(y) Employment Agreement between Industrial and Environmental Analysts, Inc. and Dr. Richard K. Schmidt dated April 1, 1992. **10(z) Employment Agreement between Industrial and Environmental Analysts, Inc. and David C. Houle dated September 1, 1992. 10(aa) Loan Agreement of BHC dated as of June 1, 1990.(6) 10(bb) First Mortgage Bonds, Series C and Preferred Stock, 1968 Series, Purchase Agreement of SWC dated July 1968. 10(cc) Revolving Credit Agreement dated May 14, 1993.(7) 10(dd) Loan Agreement of BHC dated as of June 1, 1993. (7) 10(ee) Forward Purchase Agreement of BHC (1994A Series) dated June 9, 1993.(7) 10(ff) Loan Agreement of SWC dated September 1, 1993. *10(gg) Loan Agreement of BHC dated December 1, 1993. *10(hh) Note Agreement of Aquarion dated January 4, 1994. *13(a) Annual Report to Shareholders for the year ended December 31, 1993. *22(a) Subsidiaries of Aquarion *24(a) Consent of Independent Accountants for Aquarion Company is contained in Report of Independent Accountants on page hereof. *25(a) Power of Attorney. ____________________ (1) Filed as part of Aquarion's Form 8 Amendment to its Form 10-Q for the quarter ended September 30, 1991, filed February 19, 1992. (2) Filed as an Exhibit to BHC's Registration Statement on Form S-1, File Number 2-23434, dated April 26, 1965. (3) Filed as part of the Annual Report of the Company on Form 10-K for the year ended December 31, 1990. (4) Filed as part of the Amendment No. 1 to the Company's Registration Statement as Form S-7, File No. 2-74305, dated November 5, 1981. (5) Filed as part of the Company's Annual Report on Form 10-K for the year ended December 31, 1989. (6) Filed as part of the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (7) Filed as part of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Aquarion Company ________________ (Registrant) Date ---- By /s/Janet M. Hansen March 23, 1994 ------------------------------------------------ Janet M. Hansen Senior Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By * March 23, 1994 ------------------------------------------------ William S. Warner Chairman of the Board of Directors and Director By * March 23, 1994 ------------------------------------------------ Jack E. McGregor President, Chief Executive Officer and Director By March 23, 1994 ------------------------------------------------ George W. Edwards, Jr. Director By ------------------------------------------------ Geoffrey Etherington Director By * March 23, 1994 ------------------------------------------------ Norwick R.G. Goodspeed Director By * March 23, 1994 ------------------------------------------------ Janet D. Greenwood Director By * March 23, 1994 ------------------------------------------------ Donald M. Halsted, Jr. Director By ------------------------------------------------ Eugene D. Jones Director By * March 23, 1994 ------------------------------------------------ Larry L. Pflieger Director By * March 23, 1994 ------------------------------------------------ G. Jackson Ratcliffe Director By * March 23, 1994 ------------------------------------------------ John A. Urquhart Director *By /s/Janet M. Hansen ------------------------------------------------ Janet M. Hansen Attorney-in-fact INDEX TO ADDITIONAL FINANCIAL INFORMATION ----------------------------------------- The consolidated financial statements, together with the report of Price Waterhouse thereon, dated January 31, 1994, appearing on Pages 24 - 45 of the accompanying 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report. With the exception of the aforementioned information and the information incorporated in Items 1, 5, 6, 7 and 8, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. The following financial information should be read in conjunction with the consolidated financial statements in such 1993 Annual Report to Shareholders. Financial Statement Schedules not included in this Form 10-K Annual Report have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. ADDITIONAL FINANCIAL INFORMATION -------------------------------- Page ---- Property, plant and equipment (Schedule V) for the years 1993, 1992 and 1991 Accumulated depreciation, depletion and amortization of property, plant and equipment (Schedule VI) for the years 1993, 1992 and 1991 Supplementary income statement information (Schedule X) for the years 1993, 1992 and 1991 REPORT OF INDEPENDENT ACCOUNTANTS ON ------------------------------------ FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Board of Directors of Aquarion Company Our audits of the consolidated financial statements referred to in our report dated January 31, 1994 appearing on Page 42 of the 1993 Annual Report to Shareholders of Aquarion Company, (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/Price Waterhouse --------------------- Price Waterhouse Stamford, Connecticut January 31, 1994 EXHIBIT 22(a) ------------- Subsidiaries of the Registrant ------------------------------ Bridgeport Hydraulic Company, incorporated in the State of Connecticut Stamford Water Company, incorporated in the State of Connecticut Main Street South Corporation, incorporated in the State of Connecticut Timco, Inc., incorporated in the State of Connecticut Hydrocorp, Inc., incorporated in the State of Delaware Industrial and Environmental Analysts, Inc., incorporated in the State of Vermont Industrial and Environmental Analysts, Inc. - Massachusetts, incorporated in the State of Massachusetts Industrial and Environmental Analysts, Inc. - New Jersey, incorporated in the State of Delaware Industrial and Environmental Analysts, Inc. - Illinois, incorporated in the State of Delaware Industrial and Environmental Analysts, Inc. - Florida,incorporated in the State of Florida SRK Holding, Inc., incorporated in the State of Connecticut THC Acquisition Corp., incorporated in the State of Delaware YWC, Inc., incorporated in the State of Connecticut Aquarion Management Services, Inc., incorporated in the State of Delaware EXHIBIT 24(a) ------------- Consent of Independent Accountants ---------------------------------- The Consent of Independent Accountants for Aquarion Company is contained in the Report of Independent Accountants on page of this Form 10-K.

814153_1993.txt

814153

1993

ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS Pro Quest, Inc. (the "Company") was incorporated under the laws of the State of Colorado on March 10, 1987. The Company was formed for the purpose of engaging in sports promotion activities and also for the purpose of evaluating, structuring and completing the merger with, or acquisition of, one or more private companies, partnerships or sole proprietorships. In evaluating merger or acquisition candidates, particular emphasis was placed on business-es engaged in sports promotion activities or other sports-related activities, though not to the total exclusion of businesses engaged in other industries. On July 6, 1987, the Company commenced a public offering of securities pursuant to a Registration Statement on Form S-18. The offering closed on July 21, 1987, after the sale of 30,000,000 units. Each unit consisted of one Common Share, par value $.0001 per share, one Class A Warrant, one Class B Warrant and one Class C Warrant. Each Class A Warrant was exercisable to purchase one Common Share at $.02 per share commencing October 4, 1987, until October 4, 1988. Each Class B Warrant was exercisable to purchase one Common Share at an exercise price of $.05 per share commencing October 4, 1987 until April 4, 1989, and each Class C Warrant was exercisable to purchase one Common Share at an exercise price of $.10 per share commencing October 4, 1987, until October 4, 1989. The Company reserved the right to extend the exercise periods of the Warrants and to reduce the exercise price by up to 50% of the initial exercise price. Total proceeds from the offering were $300,000. Commissions and offering expenses payable by the Company totaled $61,914. Net proceeds to the Company were approximately $238,086. The Company called the Class A Warrants for redemption in November, 1987. Of the 30,000,000 Class A Warrants outstanding, 10,587,450 Class A Warrants were exercised, and the remaining 19,412,4550 Class A Warrants were redeemed. As a result, the Company received $208,308 in proceeds, net of $3,441 in redemption expenses. No calls or redemptions have been made of the Class B or Class C Warrants. The Company was formed primarily to engage in sports promotion or other sports-related activities. The Company proposed to establish such activities, in part, through the merger or acquisi-tion of one or more "target" entities already engaged in such activities. Such entities were expected to consist of private companies, partnerships or sole proprietorships. For approximately eighteen (18) months following the comple-tion of the Company's public offering, management evaluated several merger or acquisition candidates. After preliminary evaluations, management identified several candidates considered to be worthy of in-depth evaluations, consisting of, among others, R. S. Specialties, Inc. ("R.S."), M & M Travel, Ltd. ("M&M"), The Leland Corporation ("Leland"), For Your Eyes Only, Inc. ("FYE"), Actoma Resources, Ltd. ("Actoma"), and Factory Outlet II dba Martial Arts Supply. After review of the candidates, the Company entered into letters of intent with each of them with a view toward completing acquisitions or mergers. However, none of the efforts were successful and the Company abandoned the prospects. In August, 1987, the Company acquired 28,000,000 shares of restricted common stock of International Medical Systems, Inc. ("IMS"). The Company also loaned $25,000 to IMS, in the form of an unsecured debenture, with interest at 9% per annum. IMS, of which Messrs. Petrucci and Crawford were officers, directors and shareholders, proposed to engage in sports-medicine activities following successful completion of a public offering. The Company abandoned its investment in IMS in 1988. The Company loss with respect to the investment was reflected in the operating statements of the Company for the fiscal year ended December 31, 1988. In January, 1988, the Company formed Pro Quest Marketing Associates, Inc., a wholly-owned subsidiary which was expected to engage in certain sales, marketing and franchising activities relating to products and services which the Company might have offered. Pro Quest Marketing Associates, Inc. engaged primarily in organizational activities. It discontinued operation in July of 1988. In May, 1988, the Company entered into a contract with a New Jersey-based investment banking firm, Financial Resources Corporation ("FRC"), which provided for such firm to locate, screen and present viable acquisition candidates to the Company. In connection with the contract, the Company paid an initial fee of $15,000. Subsequently, additional fees in the amount of $30,000 which were due under the terms of the contract were satisfied by the issuance of 34,000,000 shares of restricted common stock of the Company in exchange for the outstanding fees plus a payment of $4,000. In October, 1988 the Company terminated, for cause, the consulting contract with FRC. On November 18, 1988, the Company entered into an agreement of merger which provided for a tax-free exchange of 166,000,000 restricted shares of the Company for all of the outstanding shares of Kettenbauer Technology Corporation ("Kettenbauer"). Kettenbauer held rights to a proprietary process to purify toxic waste. The agreement was mutually rescinded in December of 1988. The Company has been inactive since December 31, 1988. For the fiscal year ended December 31, 1993, the Company had a net operating loss of $2,689 and a cumulative loss from inception of $593,574. Shareholder deficit as of December 31, 1993, was $110,029. RECENT DEVELOPMENTS The Company was "suspended" by the State of Colorado and administratively dissolved on January 1, 1993. SUBSEQUENT EVENTS The Company was reinstated by the Colorado Department of State in October of 1995. Currently, it is in Good Standing in Colorado. However, there is no trading in the shares of the Company. Effective September 30, 1994, the 33,150,000 shares of the Company issued to FRC were repurchased in exchange for cancellation of obligations of FRC to the Company and a waiver of claims between the parties. The Company will not receive any of the initial $15,000 payment of fees, however. On November 23, 1994, Stephen G. Petrucci as "Seller" and Randy Sasaki as "Purchaser" entered into a Stock Purchase Agreement ("Agreement") pursuant to which the Purchaser will acquire 27,500,000 shares of the Company from Seller. Other than as specifically described herein, the terms of the Agreement are confidential. The transaction has not closed as of March 1, 1997, although the parties have taken significant steps to complete it. There is no assurance that the transaction will close, but management believes that it will be successfully concluded by April 30, 1997. For further discussion, see Item 11 of this Form 10-K. The Purchaser has not provided to management any specific plan for his ownership of the shares of the Company. Management believes that the Purchaser will seek to require the Company to elect new management. There is no assurance that by reason of the Purchaser's ownership, the capitalization, ownership, management or operation of the Company will remain unchanged. BACKLOG Backlog is not material to an understanding of the Company's present business activities. The Company has no business and therefore is not subject to renegotiation of profits or termination of contracts or subcontracts, either at the election of the federal government or otherwise. REGULATION Compliance with federal, state and local laws does not have a material effect on the Company's present operations. The Company has not been a party to any bankruptcy, receivership, reorganization, readjusting or similar proceeding. The Company has no present operations, is not subject to seasonal variation, and is not involved in any industry segment. EMPLOYEES The Company has no employees. The president, Mr. Petrucci, from time to time performs certain legal functions on behalf of the Company at no cost to the Company. At some future date, the Board of Directors may elect to compensate Mr. Petrucci for the aforementioned services. ITEM 2.

ITEM 2. PROPERTIES The Company does not maintain a full time office. From 1989 through 1993, certain space has been provided by Mr. Petrucci at no cost to the Company. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any legal proceeding. Certain holders of accounts payable by the Company may attempt to collect amounts owed to them; however, management believes that collection of some of those amounts may be barred by applicable statute(s) of limitations. Taxes may be payable by the Company and are reflected as an obligation of the Company in its financial statements. Management knows of no efforts to date to enforce collection of those taxes; however, there is no assurance that the taxes will be avoided, forgiven or otherwise compromised or that efforts to collect them by legal proceedings or levy will not be employed. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON SHARES AND RELATED SHAREHOLDER MATTERS Trading in the stock of the Company was voluntarily suspended in November, 1988. Management does not know of any trading or private sales activity of the stock since that date, other than as specifically described in Item 11 of this Form 10-K. Prior to the suspension of trading, the Company's Common Shares were traded over-the-counter and were listed in the "pink sheets" maintained by members of the National Association of Securities Dealers, Inc. ("NASD"). At the time of the suspension of trading, the "High" Bid price per Share was $.01, and the "Low" Bid price per Share was $.0025. The number of record holders of Common Shares as of September 1, 1994 (the last date obtained by management) was approximately 215. Holders of Common Shares are entitled to receive such dividends as may be declared by the Company's Board of Directors. No dividends on the Common Shares have been paid by the Company nor does the Company anticipate that dividends can or will be paid in the foreseeable future. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table summarizes certain selected financial data for the last five (5) fiscal years ended December 31: FISCAL YEAR ENDED DECEMBER 31 INCOME (LOSS) STATEMENT 1993 1992 1991 1990 1989 - -------------------------- ---- ---- ---- ---- ---- Revenues $0 0 0 0 0 Cost and Expense 2,689 10,060 17,351 2,917 7,916 Income (Loss) from Continuing Operations ($2,689) (10,060) (17,351) (2,917) (7,916) Income (Loss from Continuing Operations per Common Share * * * * * BALANCE SHEET ---------------- Current Assets 0 0 0 0 0 Working Capital 0 0 0 0 0 Total Assets 10,551 10,551 10,551 10,551 10,551 Total Liabilities 120,580 117,891 107,831 90,480 87,563 Shareholders' Equity * * * * * Dividends Declared/Paid per Common Share 0 0 0 0 0 * LESS THAN $.01 PER SHARE ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) FINANCIAL CONDITION The Company utilized substantially all of its funds in 1987 and 1988 investigating several merger/acquisition candidates. It currently has no funds available, without debt or equity financing, to proceed with ongoing internal operations. It has been inactive since December 31, 1988. (b) RESULTS OF OPERATIONS The Company is inactive. It has had no operation(s) since December, 1988. As of that date, the Company had no Current Assets, and Total Assets (consisting entirely of office equipment and organization expenses) were $15,754. For the fiscal year ending December, 1993, the Company had a net loss of $2,689 which was the result of general and administra- tive expense and accruing interest on outstanding obligations of the Company and not a result of any operation(s). (c) EFFECT OF INFLATION Inflation and changing prices do not have a significant effect on the Company since presently it has no sales revenues or business activity. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Opinion of independent certified public accountant as of December 31, 1993 Balance Sheets, audited, as of December 31, 1993, and 1992 Consolidated Statements of Operations, audited, for the years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Stockholders' Equity (Deficit), audited, for the year ending December 31, 1993. Consolidated Statements of Cash Flow, audited, for the years ended December 31, 1993, 1992, and 1991. Schedules ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Company has had no material disagreements with its independent accountants on any matter of accounting principles or practices or financial statement disclosure since inception. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors and executive officers of the Company are listed below. Directors hold office until the next annual meeting of shareholders and until a successor is elected and qualified, or until their resignation. The Company has provided for the classification of the Board of Directors upon its expansion to six or more members. At the first annual meeting of shareholders held after such expansion, three classes of directors, as nearly equal in number as possible, will be elected to serve until the third, second, and next succeeding annual meeting, respectively. At subsequent meetings, persons being elected to fill directorships will hold office for terms expiring at the third succeeding annual meeting or upon their prior resignation or removal. Executive officers are elected by the Board of Directors to serve until their resignation or their earlier removal by the Board. Name Age Position ---- --- -------- Stephen G. Petrucci 42 President and Director Daryl K. MacCarter 47 Vice President, Secretary/ Treasurer and Director John J. Crawford 44 Director STEPHEN G. PETRUCCI. Mr. Petrucci has been President and a Director of the Company since March, 1987. He received a degree of Bachelor of Business Administration from the University of Notre Dame at South Bend, Indiana in 1973. He also received a Master of Science degree from Western Michigan University in 1977 and a Juris Doctor degree from the University of Denver, College of Law 1980. Mr. Petrucci has been licensed to practice law in the State of Colorado since 1981, and is a past member of the American, Colorado and Denver Bar Associations, the Association of Trial Lawyers of America and the Colorado Trial Lawyers Association. He has been admitted to practice before the Supreme Court of the State of Colorado since 1981 and the United States Court of Appeals for the 10th Circuit since 1983. He is currently in private practice in Denver, Colorado, concentrating in mergers and acquisitions, contract and general corporate law. DARYL K. MACCARTER, M.D. Dr. MacCarter has been Vice President, Secretary/Treasurer and a director of the Company since March, 1987. He received a Bachelor of Science degree in Pre-Medicine from Montana State University in Bozeman, Montana in 1969. He received a Master of Science degree in Pharmacology/ Physiology from the University of North Dakota, Grand Forks, North Dakota in 1972 and Doctor of Medicine degree from the University of Minnesota Medical School, Minneapolis, Minnesota in 1975. Dr. MacCarter did his internal medicine residency at Yale University Affiliated Hospitals, Waterbury, Connecticut and his Rheumatology fellowship at the University of Michigan, Ann Arbor, Michigan in 1979 through 1980. He is board certified in internal medicine and rheumatology and is a Fellow of the American College of Physicians. JOHN J. CRAWFORD. Mr. Crawford has served as a director of the Company since March, 1987. He received a Bachelor of Science degree in Psychology in 1970 from Colorado State University, Fort Collins, Colorado. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The following table sets forth information regarding compensation paid by the Company during the fiscal year ended December 31, 1993, to all officers and directors as a group. No officer or director received cash or cash-equivalent compensation of any kind. Cash Or Cash Name Of Individual Capacity In Equivalent Or Number In Group Which Served Compensation - ------------------ ------------ ------------ Stephen G. Petrucci President (CEO) $ -0- All Officers and Officers and $ -0- directors directors of the Company Through 1988, non-management Board members were paid $250 for attendance at meetings of the Board of Directors. The Company established an Incentive Stock Option Plan and a Non-Qualified Stock Option Plan, under which an aggregate of 7,000,000 Common Shares have been reserved for issuance. No options have been issued pursuant to either stock option plan of the Company. No directors have been paid fees since 1988. On November 23, 1994, Stephen G. Petrucci as "Seller" and Randy Sasaki as "Purchaser" entered into a certain Stock Purchase Agreement (the "Agreement" referred to throughout this Form 10-K). Pursuant to the Agreement, the Purchaser or his designees will acquire 27,500,000 Common Shares of stock of the Company (or approximately 20% of the outstanding common shares). The transaction contemplated by the Agreement has not closed as of March 1, 1997. The Purchaser has not provided the Company with either Forms 3, 4, or 5 or any representation(s) regarding Form 5. The filing of those Forms may be delinquent if the Purchaser under the Agreement has "beneficial ownership" as defined in those Forms and the Securities Exchange Act of 1934 and Rules and Regulations promulgated thereunder. If filing of any of the Forms was required on or after November 23, 1994, delinquencies may have occurred or currently exist: (i) Form 3 must be filed 10 days after a person becomes an officer, director, or 10% beneficial owner (or holder) of certain securities; (ii) Form 4 must be filed on or before the tenth day after the end of the month in which a reporting person acquires or disposes of the Company's securities; Form 5 must be filed on or before the 45th day after the Company's fiscal year in accordance with Rule 16a-3(f). The Purchaser under the Agreement has advised management that he will undertake to make such filings as soon as reasonably possible and in all events within the time limits set above after the closing of the transaction(s) contemplated by the Agreement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following tabulates holdings of Common Shares of the Company by each person who, at September 1, 1994, hold of record or is known by management of the Company to own beneficially more than 5% of the Common Shares of the Company and, in addition, by all officers and directors of the Company individually and as a group. The shareholders listed below have sole voting and investment power except as noted. Common Shares Percentage Of Name And Address Owned Class Owned ---------------- ------------- ------------- Stephen G. Petrucci 69,500,000 48.07% 6227 East Long Place Englewood, Colorado 80112 Daryl K. MacCarter (1) 500,000 .35% #2 Mockingbird Lane Englewood, Colorado 80111 John J. Crawford (1) -0- -0- Suite 1700 6400 S. Fiddler's Green Circle Englewood, Colorado 80111 All Directors and 70,000,000 48.42% Officers as a Group (three persons) - ------ (1) Daryl K. MacCarter and John J. Crawford will receive 500,000 and 400,000 shares, respectively, per the settlement of notes payable dated October 23, 1995 ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K PRO QUEST, INC. AND SUBSIDIARIES (A Development Stage Company) FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page ---- Independent Auditors' Report Consolidated Financial Statements: Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statement of Stockholders' (Deficit) Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Schedule V Property, Plant and Equipment Schedule VI Accumulated Depreciation and Amortization of Property, Plant and Equipment INDEPENDENT AUDITORS' REPORT TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF PRO QUEST, INC. AND SUBSIDIARIES DENVER, COLORADO We have audited the accompanying consolidated balance sheets of Pro Quest, Inc. and subsidiaries (a development stage enterprise) as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' (deficit), and cash flows for each year in the three year period ended December 31, 1993, and the schedules listed in the Index. The financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements and the schedules referred to above present fairly, in all material respects, the financial position of Pro Quest, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each year in the three year period ended December 31, 1993 in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses during its development stage and has limited capital that raises substantial doubt about the entity's ability to continue as a going concern. AJ. ROBBINS, P.C. CERTIFIED PUBLIC ACCOUNTANTS AND CONSULTANTS Denver, Colorado November 7, 1995 PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ----------------------------------- 1993 1992 ---------- --------- ASSETS ------ PROPERTY, PLANT AND EQUIPMENT, at cost, net of depreciation of $2,939 $ 10,351 $ 10,351 OTHER ASSET, organization cost 200 200 --------- --------- Total Assets $ 10,551 $ 10,551 --------- --------- --------- --------- LIABILITIES AND STOCKHOLDERS' (DEFICIT) --------------------------------------- CURRENT LIABILITIES: Accounts payable $ 65,892 $ 64,455 Accounts payable stockholder/director 7,703 7,703 Accrued expenses 18,456 17,204 Accrued salaries and taxes 12,529 12,529 Notes payable to officers/directors 16,000 16,000 -------- --------- Total Current Liabilities 120,580 117,891 -------- --------- COMMITMENTS AND CONTINGENCIES: STOCKHOLDERS' (DEFICIT): Preferred stock, 20,000,000 shares authorized, $.10 par value, no shares issued and outstanding - - Common stock, 800,000,000 shares authorized; $.0001 par value, 144,587,450 shares issued and outstanding 14,459 14,459 Additional paid-in capital 469,086 469,086 (Deficit) accumulated during the development stage (593,574) (590,885) -------- --------- Total Stockholders' (Deficit) (110,029) (107,340) -------- --------- Total Liabilities and Stockholders' (Deficit) $ 10,551 $ 10,551 -------- --------- -------- --------- SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- *Less than $.01 per share SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENT OF STOCKHOLDERS' (DEFICIT) --------------------------------------------------- SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF CASH FLOW SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Notes payable and accrued interest of $51,685 were assumed by the president for repayment of advances during 1988. SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND ACTIVITY Pro Quest, Inc. (a development stage company) (the Company) was incorporated under the laws of Colorado on March 10, 1987, initially under the name Pro Image, Inc. The Company is in the development stage as defined in Financial Accounting Standards Board Statement No. 7. The Company completed a public registration of its common stock and warrants to purchase common stock on Form S-18 during July 1987. The Company's primary activities after the conclusion of its public offering was to investigate various business acquisition opportunities. Accordingly, the Company expanded its operations and evaluated a number of businesses. Principally all of the operating expenses after September 30, 1987 related to the investigation process, but because none of the businesses ultimately proved viable for the Company, none of the costs incurred were capitalized. The Company has been inactive since 1988. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. SUBSIDIARIES A wholly-owned subsidiary company, Pro Journey, Ltd., (PJL) was formed in December 1987; however, its operations did not commence until January 1988. Activities of that company were never developed beyond attempting a merger with an existing travel agency, M & M Travel, Inc. During the second quarter of 1988, management of the Company made the decision to sell all of the outstanding common stock to the merger candidate for $100 plus partial reimbursement of costs expended by the Company of approximately $4,800. Transactions for PJL have been included in operations through the date of sale. The Company formed another wholly-owned subsidiary, Island Optics International, Inc.; however, it has had no activity since its inception on September 23, 1987. On January 1, 1988 the Company formed a wholly-owned subsidiary, Pro Quest Marketing Associates, Inc. (PQM) to develop the Company's marketing potential and locate merger and acquisition opportunities for the Company. PQM was unsuccessful in its marketing efforts, therefore, operations were terminated in July 1988 and PQM has remained inactive. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) FURNITURE AND FIXTURES Furniture and fixtures are stated at cost and depreciation is provided using the straight-line method over a seven-year useful life. The furniture and fixtures have been used rent-free by a related company that is controlled by the president of Pro Quest from January 1989 to September 1994. Depreciation expense has not been recorded during 1989, 1990, 1991, 1992, or 1993, because the furniture and fixtures were not used by the Company. In 1989, the Company wrote down the value of the assets by $5,000 to account for the obsolete telephone system and office equipment. In 1989, an officer of the Company, received equipment as settlement of accrued interest of $403. INCOME TAXES Prior to January 1, 1993, income taxes were provided on all revenue and expense items, regardless of the period in which such items are recognized for tax purposes, except for those items representing a permanent difference between pre-tax accounting income and taxable income. No income tax benefit was recorded for financial accounting purposes until realized. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 Accounting for Income Taxes (FAS 109). Under this method, deferred income taxes are recorded to reflect the tax consequences in future years of temporary differences between the tax basis of the assets and liabilities and their financial amounts at year-end. The Company provides a valuation allowance to reduce deferred tax assets to their net realizable value. For financial reporting, the start-up costs are expensed as incurred; for tax purposes they are capitalized and will be amortized over a period of five years commencing in the month when operations begin. The adoption of FAS 109 did not have a material effect on the Company's consolidated financial statements, therefore, there was no cumulative effect on this change in accounting for income taxes during prior periods. CASH EQUIVALENTS For the purposes of the statement of cash flows, the Company considers all highly liquid debt instruments with a maturity of three months or less to be cash equivalents. LOSS PER SHARE Net loss per share is calculated by dividing the net loss by the weighted average number of common shares outstanding. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) INVESTEE COMPANY In August 1987, the Company acquired a 28% interest in International Medical Systems, Inc. (IMS) for $2,800, represented by 28,000,000 shares of restricted common stock. IMS is a development stage company and presently inactive. At December 1987, the investment was carried on a cost basis because IMS planned to issue stock to the public pursuant to the filing of a registration statement on Form S-18, which should have reduced the percentage to be held by the Company to below 20 percent. During 1987, the Company loaned IMS $25,000 at 9% interest per annum. The note, originally due by May 1, 1988, was extended to May 1, 1989, and was classified as Noncurrent at December 31, 1987. No provision for loss on collectibility was provided at December 31, 1987 for any amounts advanced including accrued interest, since the Company felt it would be successful in raising funds for the investee company during 1989. IMS did not successfully complete its public offering, therefore, during 1988 the Company wrote off its $2,800 investment in IMS and $28,295 in note receivable and accrued interest from IMS. ORGANIZATION COSTS Organization costs will be amortized over a period of five years commencing in the month when operations begin. NOTE 2 - GOING CONCERN BASIS The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has a net working capital deficiency of $85,050 and an equity deficit of $69,096 at December 31, 1988. The Company has terminated several agreements for cause, although there are presently no actions at law in which the Company is defendant, it is possible that one or more of the parties to the agreements may seek legal action against the Company for the balance of the agreements (see Note 7). The Company's continuation as a going concern is dependent upon its ability to merge with another company, to generate sufficient cash flow to meet its obligations on a timely basis, to obtain financing as may be required, and to ultimately obtain profitable operations. The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts that might be necessary should the Company be unable to continue as a going concern. NOTE 3 - PUBLIC OFFERING In July 1987 the Company completed a public offering of 30,000,000 units at $.01 per unit. Each unit consisted of one common share and three warrants (A, B, and C). The net proceeds after offering costs were $238,086. Each warrant is separately detachable and transferable from the common shares, and may be converted into common shares for prices ranging from $.02 to $.10 per share, with option periods from 12 to 24 months, respectively. As of December 31, 1987, all of the A warrants were redeemed or exercised. The exercise of the A warrants resulted in the Company receiving net proceeds of $208,308 after expenses. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 4 - STOCK OPTION PLANS Effective April 1, 1987, the Company adopted an incentive stock option plan (ISO Plan) for Company executives and key employees which provides that 2,000,000 shares of common stock will be reserved for issuance to employees at an exercise price of not less than the fair market value at the date of grant of the option unless such employees own 10% or more of the outstanding shares of the Company, in which case the exercise price shall be 110% of the fair market value. All shares granted shall be granted within 10 years from the date of the ISO Plan approval. All options granted must be exercised within five years of the date granted. No optionee may be granted more than $100,000 (aggregate fair market value) in common shares unless provided for in accordance with Internal Revenue Code Regulations. Also effective on the same date as the above plan, the Company adopted a nonqualified stock option plan under which the Company has reserved 5,000,000 shares of common stock for issuance. The exercise price at the date of grant may be a minimum of 25% to a maximum of 100% of the fair market value of the underlying stock. There are restrictions on the number of shares which may be exercised during the first five years from the date of grant. To date no options have been granted under either of the above plans. NOTE 5 - RELATED PARTY TRANSACTIONS In addition to transactions discussed throughout the notes, the following are additional related party transactions: OFFICE RENTALS The Company maintained its offices in space leased by Pro Phase, a firm of which the Company's president is the sole owner. During 1988 and 1987 total sublease rentals of $12,496 and $800, respectively, were paid. There is no long-term commitment for sublease space on behalf of the Company. No rent payments were made after 1988. DEBENTURE In March 1987, the Company issued an unsecured debenture in the amount of $10,000 to an officer/director of the Company. The debenture was paid in full in 1987 with accrued interest at 9% per annum. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 5 - RELATED PARTY TRANSACTIONS (Continued) On March 30, 1988 the Company obtained two bank notes payable totaling $50,000 with 10.5% interest due On May 7, 1988. The president of the Company assumed the notes and accrued interest totalling $51,750 during July 1988 as repayment of advances made to the president by the Company. BUSINESS EVALUATION EXPENSES During 1988 and 1987, a director of the Company received $10,000 and $11,000, respectively, for consulting services related to business evaluations. During 1988, the president of the Company received $16,000 for legal services related to business evaluations. EMPLOYMENT AGREEMENT On May 1, 1987, the Company entered into a one-year employment agreement with the president for monthly salary of $1,500 expiring in April 1988. The agreement was extended through September 1988. During 1988 and 1987, the president was paid $9,000 and $17,000, respectively, under this agreement and $4,500 was recorded as accrued salary at December 31, 1988 for amounts not paid. The Company has been inactive since 1988 and did not extend the agreement beyond September 1988. STOCK ISSUED FOR SERVICES During 1987, the president of the Company received 21,000,000 shares of common stock for services rendered on behalf of the Company valued at $2,100. ADVANCES During 1988 and 1987 the president received $7,988 and $43,176, respectively, from the Company as noninterest bearing advances. The balance of $51,750 was repaid during July 1988 by assumption of notes payable. NOTES PAYABLE During September 1994, the Company redeemed 25,969,091 shares of its common stock for notes payable of approximately $3,514 which are non interest bearing and due on demand. CONTRIBUTED CAPITAL During September 1994, a stockholder contributed 7,180,909 shares of the Company's common stock to the Company. The Company subsequently cancelled the shares. NOTE 6 - INCOME TAXES There is no income tax provision or benefit at December 31, 1987 through 1993. Substantially all of the expenses incurred by the Company are not currently deductible for income tax purposes. For tax purposes, such expenses are considered to be start-up expenses are all deferred and amortized over a five-year period commencing with the month in which the Company begins operations. Accordingly, the Company has no net operating loss carryforward at December 31, 1987 through 1993. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 7 - COMMITMENTS AND CONTINGENCIES, AND SUBSEQUENT EVENTS NOTES PAYABLE The vice president and a director of the Company loaned $6,000 and $10,000, respectively, to the Company on June 30, 1988 with interest at 9%. Both notes are due on demand. Accrued interest at December 31, 1988 is $270 and $450, respectively at December 31, 1989 is $407 and $1,350, respectively, at December 31, 1990 is $947 and $2,250, respectively and at December 31, 1991 is $1,487 and $3,150, respectively. The Company did not accrue interest on the notes after 1991. On October 23, 1995 the Company negotiated for settlement of the notes including accrued interest of $7,487 and $13,150, respectively, for 400,000 and 500,000 shares its of common stock, respectively. On October 6, 1995 the Company signed a $30,000 note payable to its accounting firm for services performed during a continuous engagement from 1991 through 1995. The note is unsecured and due upon demand after April 1, 1995 with interest accruing at 12% per year. The note balance consists of prior accounts payable balance of $21,472 and fees incurred after 1994 of $8,528. ACCOUNTS PAYABLE The Company has negotiated the settlement of accounts payable of $16,017 including $752 of interest to its former accounting firm for 400,000 shares of its common stock on October 23, 1995. The Company, under a provision of Colorado state law which allows a company to write off its debt after six continuous years of no collection activities by its creditors, has written off accounts payable of $36,898 on September 30, 1995. During October 1987 the Company entered into a one-year consulting agreement with an unrelated entity for marketing services by its only employee on a half-time basis for compensation of $3,750 per month. During 1987, $11,250 was paid for such services in addition to $23,000 for severance of the employee from a previous employer. During 1988 $18,750 was paid under this agreement. In May 1988 this agreement was terminated by agreement of the parties. During March 1988 the Company entered into a 21-month employment agreement with an individual for compensation of $4,583 per month. During 1988, $18,333 was paid under this agreement. The agreement was terminated in May 1988. ADDITIONAL SECURITIES FILINGS REQUIRED The Company will be required to file additional amendments to its initial registration statement pursuant to any merger. Acquisition or exercise of stock purchase warrants could involve substantial costs and expenses on behalf of the Company. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 7 - COMMITMENTS AND CONTINGENCIES, AND SUBSEQUENT EVENTS (Continued) TERMINATION OF AGREEMENTS During the course of the Company's existence, it had entered into several significant agreements involving services to be performed on behalf of the Company and/or Pro Quest Marketing Associates, Inc. The majority of these agreements were terminated during 1988 by the Company prior to their termination, for a variety of reasons, but in all cases, for cause. Although there are presently no actions at law in which the Company is defendant, it is possible that one or more of the parties to these agreements may seek legal action against the Company for the balance of the agreements. The Company is unable to quantify the amount, if any, which others may feel is due and payable as a result of the early termination of the agreements, however, the unpaid balance of the agreements exceeds $100,000. The Company's previous public relations firm filed a complaint relative to the payment of $2,500 incurred under a services contract between the two companies. The Company was not given proper notice of this filing and a judgment in the sum of $2,500 was subsequently entered. Management believes that this judgment will be eventually concluded in the favor of Pro Quest. LETTERS OF INTENT None of the businesses for which several letters of intent were entered into during 1988 and 1987, proved to be viable merger candidates, and all funds spent on developing those opportunities during 1988 and 1987 were expensed as incurred. In October 1988, the Company entered into a letter of intent with Fred. J. Villari which provided for the taxable exchange of his majority interest in Actoma Resources, Ltd., a Vancouver public company, for an eventual controlling interest in the Company. Upon entering into a binding agreement with the hereinafter described Kettenbauer Technology Corporation, the Company rescinded this letter of intent. Another letter of intent was entered into in October 1988 with Factory Outlet II dba Martial Arts Supply. This letter of intent was also rescinded by the Company upon the signing of a binding agreement with Kettenbauer Technology Corporation. In November 1988, the Company entered into a letter of intent with Kettenbauer Technology Corporation which holds rights to a proprietary process to purify toxic waste, to acquire all of its outstanding stock for 20,000,000 shares of the Company's favor of the Kettenbauer principals. This letter of intent was superseded on November 18, 1988 by the execution of a binding agreement and plan of merger with Kettenbauer. This agreement provided for a partially antidilutive, tax-free exchange of all of the Kettenbauer outstanding common shares for 166,000,000 restricted common shares of the Company. The Company mutually rescinded this letter of intent in December 1988. The Company and its subsidiaries have been inactive since December 31, 1988. There are currently no active letters of intent outstanding. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ NOTE 7 - COMMITMENTS, CONTINGENCIES AND SUBSEQUENT EVENTS (Continued) INVESTMENT BANKING CONTRACT In May 1988, the Company entered into a contract with a New Jersey based investment banking firm, Financial Resources Corporation (FRC) which provided for such firm to locate, screen and present viable acquisition candidates to the Company. In connection with the agreement, the Company paid an initial fee of $15,000. During 1988, additional fees in the amount of $30,000 which were due under the terms of the contract were satisfied by the issuance of 34,000,000 shares of the Company's common stock in exchange for the outstanding fees plus a payment of $4,000. In October 1988 the Company terminated, for cause, the consulting agreement. The $4,000 due on the shares issued above was never paid and, in the opinion of management, there were misrepresentations and nonperformance on behalf of the investment banking firm. Demand has been made for the return of the shares plus the retainer of $15,000. At December 31, 1988, the balance due under the terms of the agreement totaled $87,500. Effective September 30, 1994, 33,150,000 shares of the Company issued hereunder were repurchased in exchange for cancellation of obligations and waiver of claims. DELINQUENT PAYROLL TAXES Taxes may be payable by the Company and are reflected as an obligation of the Company in its financial statements. Management knows of no efforts to date to enforce collection of those taxes; however, there is no assurance that the taxes will be avoided, forgiven or otherwise compromised or that efforts to collect them by legal proceedings or levy will not be employed. PRO QUEST, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE COMPANY) SCHEDULES FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PRO QUEST, INC. Date: March 31, 1997 By: /s/ STEPHEN G. PETRUCCI ------------------------- Stephen G. Petrucci President (CEO) Date: March 31, 1997 By: /s/ DARYL K. MAC CARTER ------------------------- Daryl K. MacCarter Secretary/Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated. Signature Title Date - --------- ----- ---- /s/ STEPHEN G. PETRUCCI President March 31, 1997 - ----------------------- (Principal Executive Stephen G. Petrucci Officer) & Director /s/ DARYL K. MacCARTER Vice President, March 31, 1997 - ----------------------- Secretary/Treasurer Daryl K. MacCarter & Director

77242_1993.txt

77242

1993

ITEM 2. PROPERTIES Gas. PG&W's gas system consists of approximately 2,159 miles of distribution lines, nine city gate and 67 major regulating stations and miscellaneous related and additional property. PG&W believes that its gas utility properties are adequately maintained and in good operating condition in all material respects. Continued expenditures will, however, be required with regard to PG&W's on-going valve maintenance program. See "Business-Gas Business-Valve Maintenance." Most of PG&W's gas utility properties are subject to mortgage liens securing certain funded debt. These properties are subject to a first mortgage lien pursuant to the Indenture of Mortgage and Deed of Trust dated as of March 15, 1946, as supplemented by twenty-eight supplemental indentures (collectively, the "Indenture") from PG&W to Morgan Guaranty Trust Company of New York, as Trustee, and a second mortgage lien pursuant to a Subordinate Open End Mortgage, Security Agreement, Assignment of Leases, Rents and Profits, Financing Statement and Fixture Filing, dated as of September 10, 1991 (the "Intercreditor Mortgage"), from PG&W to Swiss Bank Corporation, New York Branch ("SBC"), as Collateral Agent, which secures PG&W's obligations under the Letter of Credit Agreement dated as of December 1, 1987, as amended, between PG&W and SBC. Water. PG&W's water system consists principally of 43 active and standby reservoirs and stream intakes, ten water treatment plants, various distribution system storage tanks, approximately 1,675 miles of aqueducts and pipelines, and miscellaneous related and additional property. In addition, PG&W owns approximately 53,000 acres of land situated in northeastern Pennsylvania, approximately 70% of which is used in connection with its water utility operations. From time to time, PG&W engages in the sale of non-watershed land and other physical property. Proposed legislation in Pennsylvania, if enacted, would require water utilities to obtain the PPUC's prior approval for the transfer of any watershed land (as defined) and would require the PPUC to credit to ratepayers 50% of the net proceeds (as defined) of any sale, lease or other transfer of such land permitted by the PPUC. PG&W currently anticipates that it will realize average gross profits of approximately $600,000 per year through 1996 from sales of non-watershed land and other physical property. Sales on non-watershed lands and other physical property would not be subject to the proposed legislation; however, there can be no assurance that the proceeds ultimately received will inure exclusively to the benefits of PEI's shareholders. In PG&W's opinion, its water utility properties are adequately maintained and in good operating condition in all material respects. Continued capital expenditures will nonetheless be required for PG&W's on-going program of water main replacement and rehabilitation and other improvements to ensure the integrity of PG&W's distribution system. See "Business-Water Business-Main Replacement and Rehabilitation Program and Other Distribution System Improvements." Most of PG&W's water utility properties are subject to mortgage liens securing certain funded debt. These water utility properties are subject to a first mortgage lien pursuant to the Indenture. Additionally, certain of these properties are subject to a second mortgage lien (the "PENNVEST Mortgage") pursuant to a loan agreement, dated October 16, 1987, between PG&W and the Pennsylvania Water Facilities Loan Board and pursuant to loan agreements, dated March 3, 1989, December 3, 1992, and April 5, 1993, between PG&W and the Pennsylvania Infrastructure Investment Authority, which were primarily used to finance the construction of certain water facilities. These properties are also subject to a second or third mortgage lien (depending on whether they are subject to the PENNVEST Mortgage) pursuant to the Intercreditor Mortgage. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Construction Litigation On April 22, 1992, a complaint was filed in the Court of Common Pleas of Lackawanna County, Pennsylvania, by the Quandel Group Inc. ("Quandel") against PG&W in connection with the construction of PG&W's Brownell Water Treatment Plant. In its complaint, Quandel, the general contractor for the project, made various allegations and sought approximately $1.3 million in damages, plus interest. PG&W answered the complaint and also filed a counterclaim against Quandel seeking approximately $1.6 million in damages and expenses for failure of Quandel to complete construction of the Brownell Water Treatment Plant in a timely and proper manner. Also, PG&W joined Gannett-Fleming Water Resources Engineers, Inc. (Gannett-Fleming), the designer of the project, as an additional defendant in this action. On January 25, 1994, Quandel and PG&W reached an agreement settling Quandel's claim against PG&W and PG&W's counterclaim against Quandel on terms that had no material impact on PG&W's results of operations or financial position. Additionally, as part of this settlement, Quandel agreed to indemnify PG&W for any liability arising out of Quandel's claim against Gannett-Fleming in this action, which is still pending, or otherwise relating to the construction of the Brownell Water Treatment Plant. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, there were no matters submitted to a vote of security holders of the registrant through the solicitation of proxies or otherwise. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant's common stock is owned entirely by PEI and is not traded. The dividends per share of common stock paid by PG&W during the years ended December 31, 1992 and 1993, were as follows: [CAPTION] 1992 1993 [S] [C] [C] First quarter $ .705 $ .7100 Second quarter .670 .7100 Third quarter .705 .7100 Fourth quarter .460 .6925 Total $ 2.540 $2.8225 Information relating to restriction on the payment of dividends by PG&W is set forth in Note 7 to the Financial Statements in Item 8 of this Form 10-K. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following table expresses certain items in PG&W's Statements of Income contained in Item 8

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements of PG&W and the report of independent public accountants thereon are presented on pages 42 through 71 of this Form 10-K. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Pennsylvania Gas and Water Company: We have audited the accompanying balance sheets and statements of capitalization of Pennsylvania Gas and Water Company (the "Company") (a Pennsylvania corporation and a wholly-owned subsidiary of Pennsylvania Enterprises, Inc.) as of December 31, 1993 and 1992, and the related statements of income, common shareholder's investment, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pennsylvania Gas and Water Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 1 and 9, effective January 1, 1993, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions pursuant to standards promulgated by the Financial Accounting Standards Board. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, N.Y. March 4, 1994 PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF INCOME PENNSYLVANIA GAS AND WATER COMPANY BALANCE SHEETS PENNSYLVANIA GAS AND WATER COMPANY BALANCE SHEETS PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of the financial statements. PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF CAPITALIZATION PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF COMMON SHAREHOLDER'S INVESTMENT FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 PENNSYLVANIA GAS AND WATER COMPANY NOTES TO FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Pennsylvania Gas and Water Company ("PG&W"), a wholly-owned subsidiary of Pennsylvania Enterprises, Inc. ("PEI"), is a regulated public utility subject to the jurisdiction of the Pennsylvania Public Utility Commission ("PPUC") for rate and accounting purposes. PG&W has five wholly-owned subsidiaries: Penn Gas Development Co. and four small water companies, which have not been consolidated since they are insignificant. The equity method is used to account for PG&W's investment in these subsidiaries. Utility Plant and Depreciation. Utility plant is stated at cost, which represents the original cost of construction, including payroll, administrative and general costs, an allowance for funds used during construction, and the plant acquisition adjustments. The plant acquisition adjustments represent the difference between the cost to PG&W of plant acquired as a system and the cost of such plant when first devoted to public service, and are primarily attributable to land, water rights and goodwill. Except for approximately $340,000 recorded in 1993 with respect to water plant, the plant acquisition adjustments relate to acquisitions made prior to October 31, 1970, and thus are not required to be amortized for financial reporting purposes since PG&W believes there has been no diminution in their value. Also, such plant acquisition adjustments are not being amortized, consistent with PPUC Orders. The plant acquisition adjustments of approximately $340,000 recorded in 1993 will be amortized over a ten-year period commencing on January 1, 1994, in accordance with the PPUC's December 15, 1993, Order regarding the increase in water rates for customers in the Spring Brook Water Rate Area served by the Ceasetown and Watres Water Treatment Plants. The allowance for funds used during construction ("AFUDC") is defined as the net cost during the period of construction of borrowed funds used and a reasonable rate upon other funds when so used. Such allowance is charged to utility plant and reported as either other income, net (with respect to the cost of equity funds) or as a reduction of interest expense (with respect to the cost of borrowed funds) in the accompanying statements of income. AFUDC varies according to changes in the level of construction work in progress and in the sources and costs of capital. The weighted average rate for such allowance was approximately 9% in 1991, 7% in 1992 and 8% in 1993. PG&W provides for depreciation on a straight-line basis for gas plant and all common plant. As of December 31, 1993, depreciation was provided on a straight-line basis for approximately 61% of the water plant and on a 4% compound interest method for the remainder of the water plant. Exclusive of transportation and work equipment, the annual provision for depreciation, as related to the average depreciable original cost of utility plant, resulted in the following percentages: [CAPTION] 1991 1992 1993 [S] [C] [C] [C] Gas 2.33% 2.51% 2.49% Water 1.42 1.57 1.71 Common 7.22 6.76 8.06 The increase in the annual rate of depreciation relative to water plant in both 1992 and 1993 reflects a change from the 4% compound interest method to the straight-line method of depreciation with respect to certain of that plant, as ordered by the PPUC. Such change in method of depreciation is generally being made as PG&W is allowed to initially increase its rates for customers receiving filtered water service. Under the terms of the settlement discussed in Note 2 relative to the water rate increase approved by the PPUC on December 15, 1993, for customers in the Spring Brook Water Rate Area served by the Ceasetown and Watres Water Treatment Plants, PG&W will begin depreciating all water facilities located in the areas served by those plants on a straight-line basis effective January 1, 1994. This change is expected to increase the annual provision for depreciation by approximately $1.5 million and to increase the overall annual rate of depreciation with respect to water plant to approximately 2.21%. When depreciable property is retired, the original cost of such property is removed from the utility plant accounts and is charged, together with the cost of removal less salvage, to accumulated depreciation. No gain or loss is recognized in connection with retirements of depreciable property, other than in the case of significant involuntary conversions or extraordinary retirements. Revenues and Cost of Gas. PG&W bills its customers based on estimated or actual meter readings on a cycle basis. Gas customers and certain water customers, primarily large users, are billed monthly on a cycle that extends throughout the month. Other water customers are billed bi-monthly or quarterly on cycles that extend over the respective periods. The estimated unbilled amounts from the most recent meter reading dates through the end of the period being reported on are recorded as accrued revenues. PG&W generally passes on to its customers increases or decreases in gas costs from those reflected in its tariff charges. In accordance with this procedure, PG&W defers any current under or over-recoveries of gas costs and collects or refunds such amounts in subsequent periods. In accordance with an Order adopted by the PPUC on May 31, 1990, PG&W is recovering 90% of its total take-or-pay liabilities through the billing of a surcharge to customers generally over a four-year period beginning June 1, 1990. This surcharge is reflected as operating revenue and is offset by a corresponding charge to the cost of gas. The take-or-pay liabilities billed to PG&W, which will be recovered in future periods by means of such surcharge, are included in deferred cost of gas and supplier refunds, net. The cost of gas also includes that portion (i.e., 10%) of PG&W's take-or-pay liabilities which it has agreed to absorb in accordance with the PPUC's Order of May 31, 1990. Deferred Charges. PG&W generally accounts for and reports its costs in accordance with the economic effect of rate actions by the PPUC. To this extent, certain costs are recorded as deferred charges pending their recovery in rates. Such deferred charges include, among other amounts, deferred treatment plant costs and carrying charges as discussed in Note 2, certain pre-operating costs relative to PG&W's water treatment plants, costs associated with the Early Retirement Plan as discussed in Note 9, and certain preliminary survey and investigation costs. These amounts either relate to previously-issued orders of the PPUC or are of a nature which, in the opinion of PG&W, will be recoverable in future rates, based on past actions of the PPUC or other relevant factors. PG&W records, as deferred charges, the direct financing costs incurred in connection with the issuance of long-term debt and redeemable preferred stock and equitably amortizes such amounts over the life of such securities. Cash and Cash Equivalents. For the purposes of the statements of cash flows, PG&W considers all highly liquid debt instruments purchased, which generally have a maturity of three months or less, to be cash equivalents. Such instruments are carried at cost, which approximates market value. Income Taxes. The provision for income taxes consists of the following components: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Included in operating expenses: Currently payable - Federal $ 2,328 $ 4,664 $ 5,644 State 570 1,888 1,917 Total currently payable 2,898 6,552 7,561 Deferred, net - Federal 2,454 2,512 2,535 State 263 (503) (851) Total deferred, net 2,717 2,009 1,684 Amortization of investment tax credits (256) (256) (256) Total included in operating expenses 5,359 8,305 8,989 Included in other income, net: Currently payable - Federal 104 (29) (44) State (24) (26) (28) Total currently payable 80 (55) (72) Deferred, net - Federal (31) 39 (6) State 7 - - Total deferred, net (24) 39 (6) Total included in other income, net 56 (16) (78) Total provision for income taxes $ 5,415 $ 8,289 $ 8,911 Deferred income taxes result from timing differences in the recognition of revenues and expenses for tax and accounting purposes and, with respect to elements of operating income, are recorded consistent with the treatment allowed by the PPUC for ratemaking purposes. The source of these timing differences and the tax effect of each is as follows: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Excess of tax depreciation over depreciation for accounting purposes $ 2,441 $ 2,502 $ 3,214 Deferred treatment plant costs, net 982 585 1,458 Take-or-pay costs, net (222) (446) (1,126) Other, net (508) (593) (1,868) Total deferred taxes, net $ 2,693 $ 2,048 $ 1,678 Included in: Operating expenses $ 2,717 $ 2,009 $ 1,684 Other income, net (24) 39 (6) Total deferred taxes, net $ 2,693 $ 2,048 $ 1,678 The total provision for income taxes shown in the accompanying statements of income differs from the amount which would be computed by applying the statutory federal income tax rate to income before income taxes. The following table summarizes the major reasons for this difference: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Income before income taxes $16,545 $21,245 $25,212 Tax expense at statutory federal income tax rate $ 5,625 $ 7,223 $ 8,824 Increases (reductions) in taxes resulting from - State income taxes, net of federal income tax benefit 795 1,161 935 Allowance for equity funds used during construction and equity component of deferred treatment plant carrying charges - - (545) Amortization of investment tax credits (256) (256) (256) Other, net (749) 161 (47) Total provision for income taxes $ 5,415 $ 8,289 $ 8,911 Effective January 1, 1993, PG&W adopted the provisions of Financial Accounting Standards Board ("FASB") Statement 109, "Accounting for Income Taxes," which superseded previously issued income tax accounting standards. The adoption of FASB Statement 109 did not have a significant effect on PG&W's results of operations. In accordance with the provisions of FASB Statement 109, PG&W recorded as of January 1, 1993, an additional deferred tax liability and an asset, representing the probable future rate recovery of the previously unrecorded deferred taxes, primarily relating to certain temporary differences in the basis of utility plant which had not previously been recorded because of the regulatory rate practices of the PPUC. As of December 31, 1993, a total of $87.0 million in deferred income taxes, relating primarily to temporary differences involving utility plant and consisting of deferred tax liabilities of $95.6 million and deferred tax assets of $8.6 million, were so reflected in these financial statements in accordance with the requirements of FASB Statement 109. (2) RATE MATTERS Gas Utility Operations Annual Gas Cost Adjustment. Pursuant to the provisions of the Pennsylvania Public Utility Code, which require that the tariffs of gas distribution companies, such as PG&W, be adjusted on an annual basis to reflect changes in their purchased gas costs, the PPUC ordered PG&W to make the following changes during 1991, 1992 and 1993 to the gas costs contained in its gas tariff rates: [CAPTION] Change in Calculated Effective Rate per MCF Increase (Decrease) Date From To in Annual Revenue [S] [C] [C] [C] December 1, 1991 $3.20 $2.46 $(20,800,000) December 1, 1992 2.46 2.79 9,500,000 December 1, 1993 2.79 3.74 28,800,000 The annual changes in gas rates on account of purchased gas costs have no effect on PG&W's earnings since the change in revenue is offset by a corresponding change in the cost of gas. Recovery of Take-or-Pay Costs. On April 27, 1990, PG&W filed an application with the PPUC seeking approval to recover 90% ($13.9 million based on then current estimates) of its total take-or-pay liabilities, and $250,000 of related carrying costs, through billings to customers generally over a four-year period beginning June 1, 1990. The PPUC approved this application, effective June 1, 1990. In connection with this approval, PG&W agreed to absorb a portion of its take-or-pay liabilities. The amount to be so absorbed by PG&W is currently estimated to be $1.8 million, substantially all of which had been charged to expense as of December 31, 1993. As of December 31, 1993, PG&W had billed $14.8 million of take-or-pay costs to its customers and had deferred $1.1 million of such costs, including related carrying charges, for future billing to customers. Under terms of the PPUC's Order in respect of take-or-pay obligations, the surcharge by which PG&W bills its customers for take-or-pay costs is to be adjusted annually as of June 1 to reflect changes in PG&W's total estimated liability for take-or-pay costs (which is currently projected to be as much as $18.1 million) and the portion of such costs remaining to be recovered from its customers. In accordance therewith, the PPUC approved an adjustment in PG&W's take-or-pay surcharge effective June 1, 1993, based on the estimated $3.5 million of take-or-pay costs that remained to be collected from its customers as of such date. Water Rate Filings Scranton Area Water Rate Increases. March, 1991, Increase. On June 8, 1990, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $25.5 million in additional annual revenue. This rate increase request involved the approximately 54,700 customers at such date who would be furnished water from the one previously existing and the four new water treatment plants in the Scranton Water Rate Area. In December, 1990, PG&W and certain parties filing objections to the rate increase request reached a settlement that provided for an approximate 110% rate increase designed to produce $15.0 million of additional annual revenue to be phased-in over a two- year period under the terms of a qualified phase-in plan, pursuant to FASB Statement 92 entitled "Regulated Enterprises-Accounting for Phase-in Plans." The settlement provided that $10.2 million of the increased revenue (an approximate 75% increase in rates) was to be realized through an immediate rate increase and that the remaining $4.8 million of the increased revenue (an additional 35% increase in rates) was to be realized through another rate increase one year later (at the beginning of year two of the phase-in period). The settlement also specified that the $4.8 million in revenue that would be deferred during the first year of the phase-in period was to be collected from customers in the form of a surcharge in years two through ten of the phase-in period. By Order adopted March 22, 1991, the PPUC approved the settlement and permitted PG&W a water rate increase estimated to produce additional annual revenue of $15.0 million, effective March 23, 1991. In accordance with the accounting requirements for a qualified phase-in plan as prescribed by FASB Statement 92, PG&W recorded a $1.2 million nonrecurring charge to earnings as of December 31, 1990, representing the estimated net present value of carrying charges on the $4.8 million of revenue to be deferred in the first year of the phase-in period. This charge was required because the terms of the settlement did not provide for the billing of any carrying charges on such deferred revenue. Additionally, in accordance with the provisions of FASB Statement 92, PG&W commenced recording the entire $15.0 million increase in annual revenue allowed by the PPUC as additional revenue beginning March 23, 1991. However, pursuant to the terms of the settlement, PG&W deferred the billing of $4.7 million of the increased revenue recorded during the first year of the phase-in period (i.e., the period March 23, 1991, through March 22, 1992). The amount so deferred was $100,000 less than the $4.8 million originally estimated because of slightly lower than anticipated consumption. Effective March 23, 1992, PG&W began to bill the $4.7 million that had been so deferred by means of the surcharge that will be in effect in years two through ten of the phase-in period, and as of December 31, 1993, $871,000 had been so billed to its Scranton Water Rate Area customers. June, 1993, Increase. On September 25, 1992, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $9.9 million in additional annual revenue, to be effective November 24, 1992. This rate increase request involved the approximately 56,000 customers in PG&W's Scranton Water Rate Area at such date. On November 13, 1992, the PPUC suspended this rate increase for seven months (until June 24, 1993) in order to investigate the reasonableness of the proposed rates. By Order entered June 23, 1993, the PPUC rejected the proposed rate increase in its entirety "due to inadequate service" (i.e., water quality). However, by the same Order, the PPUC granted PG&W the alternative of a rate increase designed to produce an additional $5.0 million in annual revenue, provided that PG&W dedicate the entire increase to augment the improvements to its water distribution system until "...the demonstration by [PG&W] to [the PPUC] that it is providing adequate service." PG&W accepted this alternative and placed such $5.0 million rate increase into effect as of June 23, 1993. On August 19, 1993, the PPUC approved a settlement agreement resolving certain disputed issues relating to its June 23, 1993, Order. This settlement agreement provided, among other things, for (i) modification by the PPUC of its June 23, 1993, Order to reduce the amount of the revenue increase that it ordered be dedicated to distribution system improvements by the related income taxes and other expenses and the $319,000 additional expense for retiree health care and life insurance benefits that the PPUC allowed PG&W in its revenues (which resulted in the requirement for an additional annual expenditure for distribution system improvements by PG&W of $2.5 million), (ii) the agreement by PG&W to spend a total of $4.9 million annually (an additional $2.5 million over its actual average annual expenditure of $2.4 million during the three-year period ended June 30, 1993) for distribution system improvements in the Scranton Water Rate Area until the PPUC is satisfied that PG&W is providing adequate service, (iii) the modification by the PPUC of its June 23, 1993, Order to restore the Hollister Reservoir to PG&W's rate base, and (iv) the withdrawal by PG&W and the Office of Consumer Advocate (the "OCA") of their appeals to the Commonwealth Court of Pennsylvania regarding the PPUC's June 23, 1993, Order. Spring Brook Water Rate Increases. Nesbitt Service Area. On April 30, 1991, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $2.6 million in additional annual revenue. This rate increase request involved the approximately 14,300 customers in the Spring Brook Water Rate Area at such date who were served exclusively by the Nesbitt Water Treatment Plant. PG&W and certain parties filing objections to the rate increase request reached a settlement that provided for a $1.9 million increase in annual revenue which the PPUC approved effective January 30, 1992. However, on February 27, 1992, the PPUC granted a petition of the OCA, a complainant in the rate proceeding and a signatory to the settlement, for reconsideration and clarification of the PPUC Order which approved the settlement. As a result, the $1.9 million rate increase remains subject to further PPUC and possible appellate review. Although it cannot be certain, PG&W believes that the $1.9 million increase will not be rescinded in whole or in part or affected in any other way as a result of the OCA's petition and as of March 23, 1994, no further action had been taken by the PPUC with respect to the OCA's petition. Crystal Lake Service Area. On June 30, 1992, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $4.4 million in additional annual revenue, to be effective August 29, 1992. This rate increase request involved the approximately 5,000 customers in the Spring Brook Water Rate Area served exclusively by the Crystal Lake Water Treatment Plant, which became fully operational in August, 1992. On December 15, 1992, PG&W and certain parties filing objections to the rate increase request reached a settlement providing for an approximate 130% rate increase designed to produce $2.0 million of additional annual revenue to be phased-in over a two-year period under the terms of a qualified phase-in plan, pursuant to FASB Statement 92. The settlement further provided that $1.1 million of the increased revenue (an approximate 72% increase in rates) was to be realized through an immediate rate increase and that the remaining $900,000 in increased revenue (an additional 58% increase in rates) was to be realized through another rate increase one year later (i.e., at the beginning of year two of the phase-in period). The settlement also specified that the $900,000 in revenue that would be deferred during the first year of the phase-in period, as well as an approximate $243,000 in carrying charges, was to be collected from customers in the form of a surcharge in years three through five of the phase-in period. By Order adopted February 25, 1993, the PPUC approved the settlement effective March 9, 1993. In accordance with the provisions of FASB Statement 92, PG&W commenced recording the entire $2.0 million increase in annual revenue allowed by the PPUC as additional revenue beginning March 9, 1993, along with the related carrying charges on revenue deferred in accordance with the phase-in plan. Ceasetown and Watres Service Areas. On April 29, 1993, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $19.5 million in additional annual revenue, to be effective June 28, 1993. This rate increase request involved approximately 59,300 customers in PG&W's Spring Brook Water Rate Area, principally those customers (i) served by the Ceasetown Water Treatment Plant which was placed in service on March 31, 1993, (ii) served by the Watres Water Treatment Plant which was placed in service on September 30, 1993, (iii) served jointly by the Ceasetown and Watres Water Treatment Plants, and (iv) who are served exclusively by the Nesbitt Water Treatment Plant. On June 3, 1993, the PPUC suspended this rate increase for seven months (until January 28, 1994) by operation of law in order to institute an investigation into the reasonableness of the proposed rates. On September 23, 1993, PG&W and certain parties filing objections to the rate increase request reached a settlement providing for an overall 119% rate increase involving approximately 44,900 customers, principally those served either exclusively or jointly by the Ceasetown and Watres Water Treatment Plants, designed to produce $11.9 million of additional annual revenue to be phased-in over a two-year period under the terms of a qualified phase-in plan, pursuant to FASB Statement 92, "Regulated Enterprises-Accounting for Phase-In Plans." Under the terms of the settlement, except for approximately 200 customers who were previously served jointly by the Hillside and Nesbitt Water Treatment Plants, none of the approximately 14,600 customers now served exclusively by the Nesbitt Water Treatment Plant would receive an increase. The settlement further provided that $6.4 million of the increased revenue (an approximate 65% increase in rates) was to be realized through an immediate rate increase and that the remaining $5.5 million of the increased revenue (an additional 54% increase in rates) was to be realized through a further rate increase one year later (i.e., at the beginning of year two of the phase-in period). The settlement also specified that the $5.5 million in revenue to be deferred during the first year of the phase-in period, as well as an approximate $1.3 million in related carrying charges, is to be collected from customers in the form of a surcharge in years three through five of the phase-in period. By Order adopted December 15, 1993, the PPUC approved the settlement effective December 16, 1993. In accordance with the provisions of FASB 92, PG&W commenced recording the entire $11.9 million increase in annual revenue allowed by the PPUC as additional revenue beginning December 16, 1993, along with the related carrying charges on revenue deferred in accordance with the phase-in plan. Deferred Treatment Plant Costs and Carrying Charges. Pursuant to an Order of the PPUC entered September 5, 1990, PG&W deferred all operating expenses, including depreciation and property taxes, and the carrying charges (equivalent to the AFUDC) relative to the four new Scranton Area water treatment plants and related facilities from the dates of commercial operation of the plants until March 23, 1991, the effective date of the Scranton Area water rate increase approved by the PPUC on March 22, 1991. By its Order entered June 23, 1993, relative to the Scranton Water Rate Area, the PPUC granted PG&W's request to recover the $5.1 million of costs deferred relative to the Scranton Area water treatment plants and related facilities over a ten-year period beginning June 23, 1993. Similarly, as permitted by an Order of the PPUC entered September 24, 1992, PG&W has deferred all operating expenses, including depreciation and property taxes, and the carrying charges relative to the Crystal Lake Water Treatment Plant and related facilities from August 3, 1992 (the date of commercial operation of that plant), until March 9, 1993, the effective date of the water rate increase approved by the PPUC on February 25, 1993, for customers in PG&W's Spring Brook Water Rate Area served exclusively by the Crystal Lake Water Treatment Plant. Additionally, in accordance with an Order of the PPUC entered July 28, 1993, PG&W deferred all expenses and the carrying charges relative to the Ceasetown and Watres Water Treatment Plants and related facilities, until December 16, 1993, the effective date of the water rate increase for customers served by the Ceasetown and Watres Water Treatment Plants approved by the PPUC on December 15, 1993. As of December 31, 1993, a total of $4.6 million of costs, consisting of $424,000 of operating expenses and $745,000 of carrying charges relative to the Crystal Lake Water Treatment Plant and related facilities, and $1.7 million of operating expenses and $1.7 million of carrying charges relative to the Ceasetown and Watres Water Treatment Plants and related facilities, had been so deferred pursuant to the respective PPUC Orders permitting the deferral of such costs. As contemplated by the PPUC's Orders of September 24, 1992, and July 28, 1993, PG&W will seek recovery of the costs relative to the Crystal Lake, Ceasetown and Watres Water Treatment Plants that have been deferred pursuant to such Orders in its next rate increase request relative to the Spring Brook Water Rate Area. Although it cannot be certain, PG&W believes that the recovery of such costs will be allowed by the PPUC in future rate increases, particularly in view of the PPUC's action allowing the recovery of the costs deferred with respect to the Scranton Area water treatment plants and related facilities. (3) OTHER INCOME, NET Other income, net was comprised of the following elements: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Equity component of deferred treatment plant carrying charges $ - $ - $ 821 Allowance for equity funds used during construction - - 734 Gain on sale of non-watershed land and other property, net of related income taxes 182 102 20 Interest income on repurchase agreements, net of related income taxes 254 2 16 Interest on note to affiliate 437 133 - Net interest expense on proceeds remaining in construction fund - (23) (785) Premium on retirement/defeasance of debt - (127) (81) Other 261 (57) (165) Total $ 1,134 $ 30 $ 560 (4) COMMON STOCK Since January 1, 1991, PG&W has issued the following amounts of common stock to PEI, its parent company, in addition to shares issued in connection with PEI's Dividend Reinvestment and Stock Purchase Plan: [CAPTION] Purchase Price Date Purchased Number of Shares Per Share* Aggregate [S] [C] [C] [C] March 23, 1992 171,779 $ 40.75 $ 7.0 million June 19, 1992 137,143 $ 40.25 $ 5.5 October 27, 1993 834,000 $ 38.25 $31.9 Total 1,142,922 $44.4 million * Approximately equal to the book value of PG&W's common stock at the date of issuance. The proceeds from the shares issued on June 19, 1992, and October 27, 1993, were used to repay bank borrowings which had been incurred primarily to finance construction expenditures. The shares issued on March 23, 1992, represented capitalization of the $7.0 million contribution made by PEI to PG&W on January 30, 1992, which had been temporarily treated as an intercompany advance pending approval by the PPUC of the issuance of shares of common stock relative to such contribution. Upon its receipt, the $7.0 million contribution was also utilized to repay bank borrowings incurred primarily to finance construction expenditures. These issuances of common stock by PG&W and the related reductions in its bank borrowings acted to improve PG&W's debt/equity ratio, as well as its interest and fixed charge coverages. (5) PREFERRED STOCK Preferred Stock of PG&W Subject to Mandatory Redemption On September 16, 1988, PG&W issued 250,000 shares of its 9.50% 1988 series cumulative preferred stock, $100 par value. On December 23, 1993, PG&W redeemed 100,000 shares of the 9.50% 1988 series cumulative preferred stock at a price of $103.5625 per share (plus accrued dividends to the redemption date), which included a voluntary redemption premium of $3.5625 per share ($356,250 in the aggregate). The remaining 150,000 shares of the 9.50% 1988 series cumulative preferred stock, which are currently outstanding, are subject to mandatory redemption on December 15, 1997, at a price of $100 per share, plus unpaid dividends accrued on such shares. On December 16, 1988, PG&W issued 150,000 shares of its 8.90% cumulative preferred stock, $100 par value. The 8.90% cumulative preferred stock is subject to mandatory redemption of 18,750 shares on each of December 15, 1997, March 15, 1998, June 15, 1998, and September 15, 1998, and 75,000 shares on December 15, 1998, in each instance, at a price of $100 per share, plus unpaid dividends accrued on such shares. The holders of the 5.75% cumulative preferred stock have a noncumulative right each year to tender to PG&W and to require it to purchase at a per share price not exceeding $100, up to (a) that number of shares of the 5.75% cumulative preferred stock which can be acquired for an aggregate purchase price of $80,000 less (b) the number of such shares which PG&W may already have purchased during the year at a per share price of not more than $100. Eight hundred such shares were acquired and cancelled by PG&W in each of the three years in the period ended December 31, 1993, for an aggregate purchase price in each year of $80,000. As of December 31, 1993, the aggregate annual maturities and sinking fund requirements of PG&W's cumulative preferred stock subject to mandatory redemption for each of the next five years ending December 31, were as follows: [CAPTION] Year Amount [S] [C] 1994 $ 80,000 1995 $ 80,000 1996 $ 80,000 1997 $16,955,000 (a) 1998 $13,205,000 (b) (a) Includes the entire $15.0 million principal amount of the 9.50% 1988 series cumulative preferred stock currently outstanding and $1,875,000 of the 8.90% cumulative preferred stock, both of which are subject to redemption on December 15, 1997. (b) Includes the entire $13,125,000 principal amount of the 8.90% cumulative preferred stock that is subject to redemption during 1998. At PG&W's option, the following series of cumulative preferred stock subject to mandatory redemption may currently be redeemed at the prices indicated: [CAPTION] Current Redemption Price Series Per Share Aggregate [S] [C] [C] 5.75% $ 102.00 $ 1,958,400 8.90% $ 103.96 $15,594,000 9.50% 1988 Series $ 103.56 $15,534,375 Preferred Stock of PG&W Not Subject to Mandatory Redemption On August 18, 1992, PG&W issued 250,000 shares of its 9% cumulative preferred stock, par value $100 per share, for aggregate net proceeds of approximately $23.6 million. The 9% cumulative preferred stock is not redeemable by PG&W prior to September 15, 1997. Thereafter, it is redeemable at the option of PG&W, in whole or in part, upon not less than 30 days' notice, at $100 per share plus accrued dividends to the date of redemption and at a premium of $8 per share if redeemed from September 15, 1997, to September 14, 1998, and a premium of $4 per share if redeemed from September 15, 1998, to September 14, 1999. At PG&W's option, the 4.10% cumulative preferred stock may currently be redeemed at a redemption price of $105.50 per share or for an aggregate redemption price of $10,550,000. Dividend Information The dividends on the preferred stock of PG&W in each of the three years in the period ended December 31, 1993, were as follows: [CAPTION] Series 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] 4.10% $ 405 $ 409 $ 410 5.75% 121 117 113 8.90% 1,335 1,335 1,335 9.00% - 829 2,250 9.50% 1988 series 2,375 2,375 2,354 Total $4,236 $5,065 $6,462 Dividends on all series of PG&W's preferred stock are cumulative, and if dividends in an amount equivalent to four full quarterly dividends on all shares of preferred stock then outstanding are in default and until all such dividends have been paid, the holders of the preferred stock, voting separately as one class, shall be entitled to elect a majority of the Board of Directors of PG&W. Additionally, PG&W may not declare dividends on its common stock if any dividends on shares of preferred stock then outstanding are in default. (6) LONG-TERM DEBT Long-term debt consisted of the following components at December 31, 1992 and 1993: 8%, 1987 Series B Note. On December 23, 1987, the Luzerne County Industrial Development Authority (the "Authority") issued $30.0 million of its 8% Exempt Facilities Revenue Bonds, 1987 Series B (Pennsylvania Gas and Water Company Project) (the "1987 Series B Bonds") and in connection therewith, PG&W issued a promissory note in the principal amount of $30.0 million (its 8%, 1987 Series B Note) to PNC Bank (formerly Northeastern Bank of Pennsylvania), as trustee (the "IDA Trustee") for the 1987 Series B Bonds, as security for the 1987 Series B Bonds. The 1987 Series B Bonds mature on December 1, 2017; bear interest at an initial annual rate of 8% through November 30, 1994; are secured by a letter of credit issued by Swiss Bank Corporation, New York Branch expiring on December 20, 1994, for which the annual fee is $279,000; and on December 1, 1994, will be redeemed or, at the option of PG&W, purchased by PG&W for remarketing as of that date. Under the terms of the 1987 Series B Note, PG&W agreed to pay the debt service requirements on the 1987 Series B Bonds. 7.20% Series First Mortgage Bonds. On September 15, 1992, the Authority issued $50.0 million of its Exempt Facilities Revenue Refunding Bonds, 1992 Series A (Pennsylvania Gas and Water Company Project) (the "1992 Series A Bonds") and, in connection therewith, PG&W issued $50.0 million of its 7.20% First Mortgage Bonds to the IDA Trustee for the 1992 Series A Bonds, as security for the 1992 Series A Bonds. The proceeds from the issuance of the 1992 Series A Bonds, along with additional funds provided by PG&W, were deposited with the IDA Trustee for the Authority's $50.0 million of 8-1/2% Exempt Facilities Revenue Bonds, 1987 Series A (Pennsylvania Gas and Water Company Project) (the "1987 Series A Bonds") on September 15, 1992, for use in redeeming the 1987 Series A Bonds on October 1, 1992. The deposit of such funds acted to discharge all of PG&W's obligations with respect to its 8-1/2%, 1987 Series A Note in the principal amount of $50.0 million which had been issued to the IDA Trustee in connection with the 1987 Series A Bonds and which was subject to repayment on October 1, 1992. Under the terms of the 7.20% First Mortgage Bonds, PG&W will make payments to the IDA Trustee in amounts sufficient and at the times necessary to pay the debt service requirements on the 1992 Series A Bonds. 8.375% Series First Mortgage Bonds. On December 14, 1992, PG&W issued $30.0 million of its 8.375% Series First Mortgage Bonds due 2002. The proceeds from the issuance of these bonds were used to repay approximately $28.7 million of bank borrowings, thereby providing PG&W with additional borrowing capacity for future capital expenditures and other working capital needs. 7.125% Series First Mortgage Bonds. On December 22, 1992, the Authority issued $30.0 million of its Exempt Facilities Revenue Bonds, 1992 Series B (Pennsylvania Gas and Water Company Project) (the "1992 Series B Bonds") and, in connection therewith, PG&W issued $30.0 million of its 7.125% Series First Mortgage Bonds to the IDA Trustee for the 1992 Series B Bonds, as security for the 1992 Series B Bonds. The proceeds from the issuance of the 1992 Series B Bonds were deposited in a construction fund held by the IDA Trustee for the 1992 Series B Bonds, pending their utilization to finance the construction of various additions and improvements to PG&W's water facilities for which construction commenced subsequent to September 23, 1992. As of December 31, 1993, $12.9 million was so held by the IDA Trustee and was available to finance the future construction of qualified water facilities for PG&W. Under the terms of the 7.125% Series First Mortgage Bonds, PG&W will make payments to the IDA Trustee in amounts sufficient and at the times necessary to pay the debt service requirements on the 1992 Series B Bonds. 10% and 9-1/4% Series First Mortgage Bonds. On May 1, 1993, PG&W redeemed the $5,700,000 of its 10% Series First Mortgage Bonds due 1995 and the $3,750,000 of its 9-1/4% Series First Mortgage Bonds due 1996 then outstanding, utilizing funds from bank borrowings. The 10% Series First Mortgage Bonds were redeemed at a price of 100.42% of principal (plus accrued interest to the redemption date), which included a voluntary redemption premium aggregating $23,940. The 9-1/4% Series First Mortgage Bonds were redeemed at a price of 100.98% of principal (plus accrued interest to the redemption date), which included a voluntary redemption premium aggregating $36,750. 6.05% Series First Mortgage Bonds. On December 21, 1993, the Authority issued $19.0 million of its Exempt Facilities Revenue Refunding Bonds, 1993 Series A (Pennsylvania Gas and Water Company Project) (the "1993 Series A Bonds") and, in connection therewith, PG&W issued $19.0 million of its 6.05% Series First Mortgage Bonds to the IDA Trustee for the 1993 Series A Bonds, as security for the 1993 Series A Bonds. PG&W will make payments to the IDA Trustee pursuant to the 6.05% Series First Mortgage Bonds in amounts sufficient and at the times necessary to pay the debt service requirements on the 1993 Series A Bonds. The proceeds from the issuance of the 1993 Series A Bonds, along with additional funds provided by PG&W, were deposited with the IDA Trustee for the Authority's $19.0 million of 7% Exempt Facilities Revenue Bonds, 1989 Series A (Pennsylvania Gas and Water Company Project) (the "1989 Series A Bonds") on December 21, 1993, for use in redeeming the 1989 Series A Bonds on January 1, 1994. The deposit of such funds acted to discharge all of PG&W's obligations with respect to its 7%, 1989 Series A Note in the principal amount of $19.0 million which had been issued to the IDA Trustee in connection with the 1989 Series A Bonds and which was subject to repayment on January 1, 1994. As of December 31, 1993, the aggregate annual maturities and sinking fund requirements of long-term debt for each of the next five years ending December 31, were: [CAPTION] Year Amount [S] [C] 1994 $38,584,000 (a) 1995 $47,730,000 (b) 1996 $50,758,000 (c) 1997 $ 3,694,000 1998 $ 611,000 (a) Includes the 8%, 1987 Series B Note in the principal amount of $30.0 million due 2017, but subject to repayment or refinancing on December 1, 1994. Such amount also includes the aggregate principal amount of approximately $7.0 million relative to six water facility loans of PG&W having a weighted annual interest rate of 9.33% which were voluntarily repaid by PG&W on January 31, 1994, with bank borrowings. (b) Includes $47.0 million of bank borrowings outstanding as of December 31, 1993. (c) Includes the 9.57% Series First Mortgage Bonds in the principal amount of $50.0 million due 1996. Most of PG&W's properties are subject to mortgage liens securing certain funded debt. Additionally, PG&W's gross revenues and receipts, accounts receivable and certain of its other rights and interests are subject to liens securing various water facility loans from agencies established by the Commonwealth of Pennsylvania for the purpose of providing financial assistance to public water supply and sewage systems in the state. These liens are limited to the amount of the related loans outstanding, which aggregated $19.3 million as of December 31, 1993, and $12.1 million as of March 23, 1994, subsequent to the prepayment of certain of such loans. (7) DIVIDEND RESTRICTIONS Several of PG&W's debt instruments contain restrictions on the payment by PG&W of dividends to PEI. Under the most restrictive of these provisions, which is contained in the letter of credit agreement relating to the 1987 Series B Bonds issued by the Luzerne County Industrial Development Authority with respect to which PG&W has issued its 1987 Series B Note in the principal amount of $30.0 million, PG&W may not pay dividends to PEI of more than $12.5 million in 1994 and thereafter. In addition, provisions of such agreement and also PG&W's revolving bank credit agreement (the "Credit Agreement" as defined in Note 8 to these financial statements) prohibit PG&W from paying any dividends to PEI in the event of any default under those agreements. These restrictions are not expected to prohibit PG&W from paying a sufficient amount of dividends to PEI to permit PEI to pay its current $2.20 per share annual dividend on its common stock. In addition, the preferred stock provisions of PG&W's Restated Articles of Incorporation and the indenture of mortgage under which PG&W has issued first mortgage bonds provide for certain dividend restrictions. (8) BANK NOTES PAYABLE On April 25, 1991, PG&W entered into an agreement with the various banks with which it had previously arranged lines of credit. The purpose of the agreement was to consolidate PG&W's existing bank lines of credit to provide for uniform terms relative to its bank borrowings and to extend the due dates of such borrowings. As such, the agreement superseded PG&W's individual bank lines of credit. The aggregate amount available to PG&W in 1992 under this agreement was $45.0 million. On March 1, 1993, PG&W elected to reduce the amount so available to $35.0 million in order to reduce the commitment fee that would otherwise be payable and since no more than $35.0 million would be required by PG&W under the agreement prior to its expiration on April 30, 1993. The interest rate on borrowings under the agreement was prime. The agreement also required the payment of a commitment fee of 1/2 of 1% per annum on the average daily amount of the unused portion of the available funds. The commitment fees paid with respect to this agreement totaled $60,000 in 1991, $152,000 in 1992 and $43,000 in 1993. On April 19, 1993, PG&W entered into a revolving bank credit agreement (the "Credit Agreement") with a group of six banks under the terms of which $60.0 million is available for borrowing by PG&W. The Credit Agreement terminates on April 30, 1995, at which time any borrowings outstanding thereunder are due and payable. The interest rate on borrowings under the Credit Agreement is generally less than prime. The Credit Agreement also requires the payment of a commitment fee of 3/8 of 1% per annum on the average daily amount of the unused portion of the available funds. As of March 23, 1994, $41.0 million of borrowings were outstanding under the Credit Agreement. PG&W also has three short-term bank lines of credit with an aggregate borrowing capacity of $7.0 million which provide for borrowings at interest rates generally less than prime and mature on April 30, 1994. As of March 23, 1994, PG&W had no borrowings outstanding under the short-term bank lines of credit. The commitment fees paid with respect to these agreements totaled $70,000 in 1993. Because of limitations imposed by the terms of PG&W's preferred stock, PG&W is prohibited, without the consent of the holders of a majority of the outstanding shares of its preferred stock, from issuing more than $12.0 million of unsecured debt due on demand or within one year from issuance. PG&W had $5.7 million of unsecured debt due on demand or within one year from issuance outstanding as of December 31, 1993, which included a $3.7 million demand loan from PEI. Information relating to PG&W's bank lines of credit and borrowings under those lines of credit is set forth below: (9) POSTRETIREMENT BENEFITS Substantially all employees of PG&W are covered by PEI's trusteed, noncontributory, defined benefit pension plan. Pension benefits are based on years of service and average final salary. PG&W's funding policy is to contribute an amount necessary to provide for benefits based on service to date, as well as for benefits expected to be earned in the future by current participants. To the extent that the present value of these obligations is fully covered by assets in the trust, a contribution may not be made for a particular year. Net pension costs, including amounts capitalized, were $243,000, $333,000 and $443,000 in 1991, 1992 and 1993, respectively. The following items were the components of the net pension cost for the years 1991, 1992 and 1993: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Present value of benefits earned during the year $ 637 $ 789 $ 854 Interest cost on projected benefit obligations 2,120 2,262 2,402 Return on plan assets (3,824) (2,646) (3,127) Net amortization and deferral 1,310 (72) 314 Net pension cost $ 243 $ 333 $ 443 The discount rate used to determine the actuarial present value of the projected benefit obligations, the expected long-term rate of return on plan assets and the projected increase in future compensation levels assumed in determining the net pension cost for each of the years 1991, 1992 and 1993, were as follows: [CAPTION] [S] [C] Discount rate 8% Expected long-term rate of return on plan assets 9% Projected increase in future compensation levels 5-1/2% The funded status of the plan as of December 31, 1992 and 1993, was as follows: [CAPTION] 1992 1993 (Thousands of Dollars) [S] [C] [C] Actuarial present value of the projected benefit obligations: Accumulated benefit obligations Vested $ 21,813 $ 24,265 Nonvested 139 125 Total 21,952 24,390 Provision for future salary increases 7,746 9,769 Projected benefit obligations 29,698 34,159 Market value of plan assets, primarily invested in equities and bonds 30,963 32,471 Plan assets in excess of (less than) projected benefit obligations 1,265 (1,688) Unrecognized net transition asset as of January 1, 1986, being amortized over 20 years (2,988) (2,758) Unrecognized prior service costs 2,412 2,279 Unrecognized net (gain) loss (704) 1,710 Accrued pension cost at year-end $ (15) $ (457) In March, 1991, as part of a cost reduction program, PG&W offered an Early Retirement Plan ("ERP") to its employees who would be 60 years of age or older and have a minimum of five years of service as of April 30, 1991. Of the 79 eligible employees, 73 elected to accept this offer and retired in 1991. In accordance with FASB Statement 88 "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," PG&W recorded, as of April 30, 1991, an additional pension liability of $2.0 million, reflecting the increased costs associated with the ERP. This liability, which was included in "Other deferred credits" as of December 31, 1992 and 1993, partially offsets an asset included in "Other deferred charges," representing the probable future rate recovery of such liability. As a result, the provisions of FASB Statement 88 did not have a significant effect on PG&W's results of operations for 1991. During 1992, PG&W began amortizing the portion of the deferred charges relative to its gas operations over a 20-year period and will begin amortizing the portion relating to its water operations as such amounts are approved in rates. In addition, the deferred liability is being amortized as an offset against pension expense over a 20 year amortization period approximating the effect of including the additional pension costs related to the ERP in the present value of benefits earned during the year. In addition to pension benefits, PG&W provides certain health care and life insurance benefits for retired employees. Substantially all of PG&W's employees may become eligible for those benefits if they reach retirement age while working for PG&W. Prior to January 1, 1993, the cost of retiree health care and life insurance, which totaled $800,000 in 1991 and $870,000 in 1992, was expensed as the premiums were paid under insurance contracts. Effective January 1, 1993, PG&W adopted the provisions of FASB Statement 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The provisions of FASB Statement 106 require that PG&W record the cost of retiree health care and life insurance benefits as a liability over the employees' active service periods instead of on a benefits-paid basis as was PG&W's prior practice. The following items were the components of the net cost of postretirement benefits other than pensions for the year 1993: [CAPTION] (Thousands of Dollars) [S] [C] Present value of benefits earned during the year $ 226 Interest cost on accumulated benefit obligation 967 Return on plan assets (a) -0- Amortization of transition obligation over 20 years 617 Net cost of postretirement benefits other than pensions 1,810 Less disbursements for benefits (983) Increase in liability for postretirement benefits other than pensions $ 827 Reconciliations of the accumulated benefit obligation to the accrued liability for postretirement benefits other than pensions as of January 1, 1993, and December 31, 1993, follow: [CAPTION] January 1, December 31, 1993 1993 (Thousands of Dollars) [S] [C] [C] Accumulated benefit obligation: Retirees $ 9,878 $ 10,149 Fully eligible active employees 1,649 1,735 Other active employees 815 1,222 12,342 13,106 Plan assets at fair value (a) -0- -0- Accumulated benefit obligation in excess of plan assets 12,342 13,106 Unrecognized transition obligation (12,342) (11,725) Unrecognized net loss -0- (554) Accrued liability for postretirement benefits other than pensions $ -0- $ 827 For purposes of calculating the costs to be accrued by PG&W under FASB Statement 106, an 8% discount rate and a 5.5% projected annual increase in future compensation levels were assumed. It was also assumed that the per capita cost of covered health care benefits would increase at an annual rate of 12% in 1993 and that this rate would decrease gradually to 5.5% for the year 2003 and remain at that level thereafter. The health care cost trend rate assumption had a significant effect on the amounts accrued. To illustrate, increasing the assumed health care cost trend rate by 1 percentage point in each year would increase the transition obligation as of January 1, 1993, by approximately $723,000 and the aggregate of the service and interest cost components of the net cost of postretirement benefits other than pensions for the year 1993 by approximately $60,000. (a) As of December 31, 1993, PG&W had segregated funds totaling $182,000, pending the establishment of a qualified trust fund for a portion of its liability for postretirement benefits other than pensions, as discussed in the paragraph immediately above. The additional costs accrued pursuant to FASB Statement 106 are allocated between PG&W's gas utility and water utility operations. By Order entered June 23, 1993, relative to the rate increase request that PG&W had filed on September 25, 1992, with respect to the Scranton Water Rate Area, the PPUC allowed PG&W to recover in revenues the additional costs ($319,000 for the year 1993, based on then current estimates) that were required to be accrued pursuant to FASB Statement 106 and which were allocable to the Scranton Water Rate Area. Similarly, by Order entered December 15, 1993, relative to the rate increase request that PG&W had filed on April 29, 1993, relative to the Spring Brook Water Rate Area, the PPUC allowed PG&W to recover in revenues the additional costs ($322,000 for the year 1993 based on then current estimates) that were required to be accrued pursuant to FASB Statement 106 and which were allocable to the Spring Brook Water Rate Area. Since PG&W did not seek an increase in its base gas rates during 1993, the $407,000 ($232,000 net of related income taxes) of additional cost incurred with regard to its gas utility operations as a result of the adoption of the provisions of FASB Statement 106 was expensed. (10) CONSTRUCTION EXPENDITURES PG&W estimates the cost of its 1994 construction program will be $46.8 million. Construction of water facilities, estimated to cost $29.8 million, will be financed with the $12.9 million of proceeds from the issuance of the 1993 Series A Bonds held by the IDA Trustee as of December 31, 1993, for the benefit of PG&W, internally generated funds and borrowings under PG&W's revolving bank credit facilities, pending the periodic issuance of stock and long-term debt. Construction of gas facilities, estimated to cost $17.0 million, will be financed with internally generated funds and borrowings under PG&W's revolving bank credit facilities, pending the periodic issuance of stock and long-term debt. (11) COMMITMENTS AND CONTINGENCIES Valve Maintenance On November 16, 1993, the PPUC staff issued an Emergency Order, subsequently ratified by the PPUC (the "Emergency Order"), requiring PG&W by January 31, 1994, to survey its gas distribution system to verify the location and spacing of its gas shut off valves, to add or repair valves where needed and to establish programs for the inspection and maintenance of all such valves and the verification of all gas service line information. The Emergency Order was issued following the occurrence of two gas incidents (one concerning an explosion and the other a fire) in PG&W's service area in June and October, 1993, respectively, involving nearby gas shut off valves that had been paved over by third parties and could not be readily located due to alleged inaccurate service line records. The Emergency Order also cited four additional incidents occurring since January 31, 1991, in which shut off valves had been paved over or records were inaccurate. In connection with these incidents, the PPUC has alleged that PG&W has violated certain federal and state regulations related to gas pipeline valves. The PPUC has the authority to assess fines for such violations. The PPUC ordered PG&W to develop a plan, including a timetable, by December 30, 1993, for compliance with the terms of the Emergency Order. PG&W met the December 30, 1993, deadline for submission of this plan. However, PG&W included in such plan, a timetable, which, in effect, requested an extension of the January 31, 1994, deadline contained in the Emergency Order, which PG&W viewed as unrealistic. On February 2, 1994, the PPUC staff notified PG&W that it considers the plan submitted by PG&W "only a general plan of action to address the problem with valving in [PG&W's] system" and that the plan "is lacking in detail and more information is needed." As a result, the PPUC staff indicated that it intends to initiate an informal investigation of the matter, including PG&W's responsibility for the incidents referred to in the Emergency Order. Although it is not presently possible to determine what action the PPUC will ultimately take with respect to possible violations of law and the matters raised by the Emergency Order, PG&W does not believe that compliance with, or any liability that might result from such violations or the Emergency Order will have a material adverse effect on its financial position or results of operations. Environmental Matters PG&W, like many gas distribution companies, once utilized manufactured gas plants in connection with providing gas service to its customers. None of these plants has been in operation since 1960, and several of the plant sites are no longer owned by PG&W. Pursuant to the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), PG&W filed notices with the United States Environmental Protection Agency (the "EPA") with respect to the former plant sites. None of the sites is or was formerly on the proposed or final National Priorities List. The EPA has conducted site inspections and made preliminary assessments of each site and has concluded that no further remedial action is planned. While this conclusion does not constitute a legal prohibition against further regulatory action under CERCLA or other applicable federal or state law, PG&W does not believe that additional costs, if any, related to these manufactured gas plant sites would be material to its financial position or results of operations since environmental remediation costs generally are recoverable through rates over a period of time. On February 4, 1994, PG&W was requested by the Pennsylvania Department of Environmental Resources to perform an evaluation to determine if a pipeline owned by PG&W was the source of certain soil contamination discovered by the Pennsylvania Department of Transportation in late 1993 in an area adjacent to that pipeline at a road crossing in Jackson Township, Northumberland County, Pennsylvania. This pipeline was purchased by Scranton-Spring Brook Water Service Company ("Scranton-Spring Brook"), a predecessor of PG&W, in 1956, but was never operated by Scranton-Spring Brook or PG&W in the area in question. At this time, pending further environmental analysis and evaluation, neither the source nor the extent of the contamination is known. However, if the source of the contamination is determined to be PG&W's pipeline, PG&W would be required to perform such remediation work as is necessary and to dispose of the contaminated soil. While it cannot be certain, PG&W does not presently believe that any liability it might have with respect to such contamination would have a material adverse effect on either its financial position or results of operations. Further, if PG&W were determined to be the responsible party with respect to the subject contamination, it would seek to recover any liability it were to so incur from the former owner and operator of the pipeline and/or its successors. Additionally, to the extent it could not recover its costs from such parties, PG&W could seek authority of the PPUC to recover those costs in the rates charged to its natural gas customers. (12) INDUSTRY SEGMENTS Financial information with respect to PG&W's industry segments for the years ended December 31, 1991, 1992 and 1993 is included in Item 1 of this Form 10-K. Such industry segment information is incorporated herein as part of these Financial Statements. (13) QUARTERLY FINANCIAL DATA (UNAUDITED) [CAPTION] QUARTER ENDED March 31, June 30, September 30, December 31, 1992 1992 1992 1992 (Thousands of Dollars, Except Per Share Amounts) [S] [C] [C] [C] [C] Operating revenues $ 70,673 $ 34,000 $ 25,440 $ 61,765 Operating income 12,620 6,270 4,160 10,863 Earnings (loss) applicable to common stock 5,763 (44) (2,704) 4,876 Earnings (loss) per share of common stock (a) 1.55 (.01) (.67) 1.21 [CAPTION] QUARTER ENDED March 31, June 30, September 30, December 31, 1993 1993 1993 1993 (Thousands of Dollars, Except Per Share Amounts) [S] [C] [C] [C] [C] Operating revenues $ 78,318 $ 37,251 $ 27,959 $ 63,160 Operating income 13,315 5,672 4,762 12,407 Earnings (loss) applicable to common stock 6,827 (1,037) (1,506) 5,555 Earnings (loss) per share of common stock (a) 1.70 (.26) (.37) 1.20 (a) The total of the earnings per share for the quarters does not equal the earnings per share for the year, as shown elsewhere in Item 8 of this Form 10-K, as a result of PG&W's issuance of additional shares of common stock at various dates during the year. Because of the seasonal nature of PG&W's gas heating business, there are substantial variations in operations reported on a quarterly basis. (14) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: o Restricted funds held by trustee. The fair value of the restricted funds held by trustee has been based on the current market values of the financial instruments in which such funds have been invested. o Long-term debt. The fair value of PG&W's long-term debt has been estimated based on the current quoted market price for the portion of such debt which is publicly traded and, with respect to the portion of such debt which is not publicly traded, on the estimated borrowing rates at December 31, 1993, for long-term debt of comparable credit quality with similar terms and maturities. o Preferred stock subject to mandatory redemption. The fair value of PG&W's preferred stock subject to mandatory redemption has been estimated based on the market value as of December 31, 1993, for preferred stock of comparable credit quality with similar terms and maturities. The carrying amounts and estimated fair values of PG&W's financial instruments at December 31, 1992 and 1993, were as follows: [CAPTION] 1992 1993 Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value (Thousands of Dollars) [S] [C] [C] [C] [C] Restricted funds held by trustee $ 28,020 $ 28,016 $ 12,853 $ 12,857 Long-term debt (including current portion) 284,882 291,704 306,843 327,436 Preferred stock subject to mandatory redemption (including current portion) 42,000 43,929 31,920 33,087 PG&W believes that the regulatory treatment of any excess or deficiency of fair value relative to the carrying amounts of these items, if such items were settled at amounts approximating those above, would dictate that these amounts be used to increase or reduce its rates over a prescribed amortization period. Accordingly, any settlement would not result in a material impact on PG&W's financial position or the results of operations of either PEI or PG&W. ITEM 9.

ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following financial statements, notes to financial statements and report of independent public accountants for PG&W are presented in Item 8 of this Form 10-K. Page Report of Independent Public Accountants . . . . . . . . . . . . 42 Statements of Income for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . . 43 Balance Sheets as of December 31, 1992 and 1993. . . . . . . . . 44 Statements of Cash Flows for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . . 46 Statements of Capitalization as of December 31, 1992 and 1993. . 47 Statements of Common Shareholder's Investment for each of the three years in the period ended December 31, 1993. . . . . 48 Notes to Financial Statements. . . . . . . . . . . . . . . . . . 49 2. Financial Statement Schedules The following financial statement schedules for PG&W are filed as a part of this Form 10-K. Schedules not included have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Schedule Number Page V Property, Plant and Equipment for the three-year period ended December 31, 1993. . . . . . . . . . . . . . . . . 75 VI Accumulated Depreciation of Property, Plant and Equipment for the three-year period ended December 31, 1993. . . . 76 VIII Valuation and Qualifying Accounts for the three-year period ended December 31, 1993 . . . . . . . . . . . . . 77 X Supplementary Income Statement Information for the three-year period ended December 31, 1993. . . . . . . . 78 3. Exhibits See "Index to Exhibits" located on page 80 for a listing of all exhibits filed herein or incorporated by reference to a previously filed registration statement or report with the Securities and Exchange Commission. Schedule V Schedule VI Schedule VIII PENNSYLVANIA GAS AND WATER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE-YEAR PERIOD ENDED DECEMBER 31, 1993 [CAPTION] Year ended December 31, 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Taxes other than income taxes were as follows: State gross receipts tax $ 5,993 $ 6,715 $ 7,212 State capital stock tax 1,773 1,936 1,961 Payroll taxes 2,224 2,276 2,444 Real estate and personal property taxes 2,777 2,951 3,717 Other taxes 710 772 888 $13,477 $14,650 $16,222 Charged to: Other taxes $12,814 $14,730 $16,019 Other accounts 663 (80) 203 $13,477 $14,650 $16,222 NOTE: The amounts of maintenance and repairs, depreciation and income taxes, which are charged to accounts other than those set forth in the statements of income, are not significant. PG&W did not incur any significant costs for royalties, rents, advertising or research and development during the three- year period ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. [CAPTION] PENNSYLVANIA GAS AND WATER COMPANY (Registrant) [S] [C] [C] Date: March 23, 1994 By: /s/ Dean T. Casaday Dean T. Casaday President and Chief Executive Officer (Principal Executive Officer) Date: March 23, 1994 By: /s/ John F. Kell, Jr. John F. Kell, Jr. Vice President, Finance (Principal Financial Officer and Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. [CAPTION] Signature Capacity Date [S] [C] [C] /s/ Kenneth L. Pollock Chairman of the Board of March 23, 1994 Kenneth L. Pollock Directors /s/ William D. Davis Vice Chairman of the Board March 23, 1994 William D. Davis of Directors /s/ Dean T. Casaday Director, President and March 23, 1994 Dean T. Casaday Chief Executive Officer /s/ Robert J. Keating Director March 23, 1994 Robert J. Keating /s/ John D. McCarthy Director March 23, 1994 John D. McCarthy /s/ Kenneth M. Pollock Director March 23, 1994 /s/ Kenneth M. Pollock /s/ James A. Ross Director March 23, 1994 James A. Ross /s/ Ronald W. Simms Director March 23, 1994 Ronald W. Simms INDEX TO EXHIBITS Exhibit Number (3) Articles of Incorporation and By Laws: 3-1 Restated Articles of Incorporation of PG&W, as amended -- filed as Exhibit 3-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 3-2 By-Laws of PG&W, as amended and restated on October 17, 1991 -- filed as Exhibit 3-2 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. (4) Instruments Defining the Rights of Security Holders, Including Debentures: 4-1 Indenture of Mortgage and Deed of Trust, dated as of March 15, 1946, between Scranton-Spring Brook Water Service Company (now PG&W) and Guaranty Trust Company, as Trustee (now Morgan Guaranty Trust Company of New York) -- filed as Exhibit 2(c) to PG&W's Bond Form S- 7, Registration No. 2-55419. 4-2 Fourth Supplemental Indenture, dated as of March 15, 1952 -- filed as Exhibit 2(d) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-3 Ninth Supplemental Indenture, dated as of March 15, 1957 -- filed as Exhibit 2(e) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-4 Tenth Supplemental Indenture, dated as of September 1, 1958 -- filed as Exhibit 2(f) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-5 Twelfth Supplemental Indenture, dated as of July 15, 1960 -- filed as Exhibit 2(g) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-6 Fourteenth Supplemental Indenture, dated as of December 15, 1961 -- filed as Exhibit 2(h) to PG&W's Bond Form S-7, Registration No. 2- 55419. 4-7 Fifteenth Supplemental Indenture, dated as of December 15, 1963 -- filed as Exhibit 2(i) to PG&W's Bond Form S-7, Registration No. 2- 55419. 4-8 Sixteenth Supplemental Indenture, dated as of June 15, 1966 -- filed as Exhibit 2(j) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-9 Seventeenth Supplemental Indenture, dated as of October 15, 1967 -- filed as Exhibit 2(k) to PG&W's Bond Form S-7, Registration No. 2- 55419. 4-10 Eighteenth Supplemental Indenture, dated as of May 1, 1970 -- filed as Exhibit 2(1) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-11 Nineteenth Supplemental Indenture, dated as of June 1, 1972 -- filed as Exhibit 2(m) to PG&W's Bond Form S-7, Registration No. 2-55419. Exhibit Number 4-12 Twentieth Supplemental Indenture, dated as of March 1, 1976 -- filed as Exhibit 2(n) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-13 Twenty-first Supplemental Indenture, dated as of December 1, 1976 -- filed as Exhibit 4-16 to PG&W's Annual Report on Form 10-K for 1982, File No. 1-3490. 4-14 Twenty-second Supplemental Indenture, dated as of August 15, 1989 -- filed as Exhibit 4-22 to PG&W's Annual Report on Form 10-K for 1989, File No. 0-7812. 4-15 Twenty-third Supplemental Indenture, dated as of August 15, 1989 -- filed as Exhibit 4-23 to PG&W's Annual Report on Form 10-K for 1989, File No. 0-7812. 4-16 Twenty-fourth Supplemental Indenture, dated as of September 1, 1991, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed as Exhibit 4-3 to PEI's Common Stock Form S-2, Registration No. 33-43382. 4-17 Twenty-fifth Supplemental Indenture, dated as of September 1, 1992, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed as Exhibit 4-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 4-18 Twenty-sixth Supplemental Indenture, dated as of December 1, 1992, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed as Exhibit 4-20 to PG&W's Bond Form S-2, Registration No. 33-54278. 4-19 Twenty-seventh Supplemental Indenture, dated as of December 1, 1992, from PG&W to Morgan Guaranty Trust Company -- filed as Exhibit 4-19 to PG&W's Annual Report on Form 10-K for 1992, File No. 0-7812. 4-20 Twenty-eighth Supplemental Indenture, dated as of December 1, 1993, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed herewith. NOTE: The First, Second, Third, Fifth, Sixth, Seventh, Eighth, Eleventh and Thirteenth Supplemental Indentures merely convey additional properties to the Trustee. 4-21 Statement Affecting Class or Series of Shares with respect to 9.50% 1988 Series Cumulative Preferred Stock of PG&W -- filed as Exhibit 4-18 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, File No. 1-3490. 4-22 Statement Affecting Class or Series of Shares with respect to 8.90% Cumulative Preferred Stock of PG&W -- filed as Exhibit 4-20 to PG&W's Annual Report on Form 10-K for 1988, File No. 1-3490. Exhibit Number (10) Material Contracts: 10-1 Service Agreement for storage service under Rate Schedule LGA, dated August 6, 1974, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-3 to PG&W's Annual Report on Form 10-K for 1984, File No. 1-3490. 10-2 Service Agreement for transportation service under Rate Schedule FT, dated February 1, 1992, by and between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-4 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. 10-3 Service Agreement for storage service under Rate Schedule SS-2, dated April 1, 1990, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-8 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-4 Service Agreement for sales service under Rate Schedule FS, dated August 1, 1991, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-6 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. 10-5 Service Agreement for transportation service under Rate Schedule FT, dated August 1, 1991, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-10 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-6 Service Agreement for transportation service under Rate Schedule IT, dated January 31, 1992, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-8 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. 10-7 Service Agreement for storage service under Rate Schedule LSS, dated October 1, 1993, by and between PG&W and Transcontinental Gas Pipe Line Corporation -- filed herewith. 10-8 Service Agreement for storage service under Rate Schedule GSS, dated October 1, 1993, by and between PG&W and Transcontinental Gas Pipeline Corporation Company -- filed herewith. 10-9 Service Agreement for transportation service under Rate Schedule FTS, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-10 Service Agreement for transportation service under Rate Schedule SST, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-11 Service Agreement for storage service under Rate Schedule FSS, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-12 Service Agreement for transportation service under Rate Schedule FTS-1, dated November 1, 1993, by and between PG&W and Columbia Gulf Transmission Company -- filed herewith. Exhibit Number 10-13 Service Agreement for transportation service under Rate Schedule ITS-1, dated November 1, 1993, by and between PG&W and Columbia Gulf Transmission Company -- filed herewith. 10-14 Service Agreement for transportation service under Rate Schedule ITS, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-15 Service Agreement (Contract No. 946) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline Company -- filed as Exhibit 10-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-16 Service Agreement (Service Package No. 171) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline Company -- filed as Exhibit 10-2 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-17 Service Agreement (Service Package No. 187) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline Company -- filed as Exhibit 10-3 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-18 Service Agreement (Service Package No. 190) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline -- filed as Exhibit 10-4 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-19 Service Agreement (Contract No. 2289) for storage service under Rate Schedule FS dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline -- filed as Exhibit 10-5 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-20 Joint Venture Agreement, dated May 1, 1975, between Robert Mosbacher and Transco Exploration Company, et. al., and Exhibit "B," Ratification thereof by PG&W, dated July 11, 1975 -- filed as Exhibit 5(1) to PG&W's Bond Form S-7, Registration No. 2-55419. 10-21 Project Facilities Agreement, dated December 1, 1987, between Luzerne County Industrial Development Authority and PG&W -- filed as Exhibit 10-19 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. 10-22 Remarketing Agreement, dated December 1, 1987, among PG&W, Butcher & Singer Inc. and Dean Witter Reynolds Inc. -- filed as Exhibit 10-21 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. Exhibit Number 10-23 8% Bond Purchase Agreement, dated December 15, 1987, among Luzerne County Industrial Development Authority, PG&W, Butcher & Singer Inc. and Dean Witter Reynolds Inc. -- filed as Exhibit 10-22 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. 10-24 Bond Purchase Agreement, dated September 1, 1989, relating to PG&W's First Mortgage Bonds 9.23% Series due 1999 and First Mortgage Bonds 9.34% Series due 2019 among Allstate Life Insurance Company, Allstate Life Insurance Company of New York and PG&W -- filed as Exhibit 10-33 to PG&W's Annual Report on Form 10-K for 1989, File No. 1-3490. 10-25 Form of Bond Purchase Agreement, dated as of September 1, 1991, re: $50.0 million of 9.57% First Mortgage Bonds, due September 1, 1996, entered into between PG&W and each of the following parties: Pacific Mutual Life Insurance Company, Principal Mutual Life Insurance Company, Great West Life & Annuity Insurance Company, The Life Insurance Company of Virginia, Lutheran Brotherhood, Transamerica Life Insurance and Annuity Company and The Franklin Life Insurance Company -- filed as Exhibit 10-7 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-26 Amended and Restated Project Facilities Agreement dated as of September 1, 1992, between PG&W and the Luzerne County Industrial Development Authority -- filed as Exhibit 10-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 10-27 7.20% Bond Purchase Agreement, dated September 2, 1992, among the Luzerne County Industrial Development Authority, PG&W and Butcher & Singer, a division of Wheat First Securities Inc., as representative on behalf of itself and Legg Mason Wood Walker Incorporated -- filed as Exhibit 10-2 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 10-28 Project Facilities Agreement, dated December 1, 1992, between Luzerne County Industrial Development Authority and PG&W -- filed as Exhibit 10-29 to PG&W's Annual Report on Form 10-K for 1992, File No. 1-3490. 10-29 7.125% Bond Purchase Agreement, dated December 10, 1992, among the Luzerne County Industrial Development Authority, PG&W and Butcher & Singer, a division of Wheat First Securities Inc., as representative on behalf of itself and Legg Mason Wood Walker Incorporated -- filed as Exhibit 10-30 to PG&W's Annual Report on Form 10-K for 1992, File No. 1-3490. 10-30 Second Amended and Restated Project Facilities Agreement dated as of December 1, 1993, between PG&W and the Luzerne County Industrial Development Authority -- filed herewith. Exhibit Number 10-31 6.05% Bond Purchase Agreement, dated December 2, 1993, among the Luzerne County Industrial Development Authority, PG&W and Butcher & Singer, a division of Wheat First Securities, Inc., as representative on behalf of itself and Legg Mason Wood Walker Incorporated -- filed herewith. 10-32 Letter of Credit Agreement, dated December 1, 1987, between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-20 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. 10-33 Amendment No. 1, dated as of September 10, 1991, to December 1987 Reimbursement Agreement between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-6 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-34 Amendment No. 2, dated as of December 13, 1991 to December 1987 Reimbursement Agreement between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-15 to PEI's Common Stock Form S- 2, Registration No. 33-43382. 10-35 Amendment No. 3, dated as of May 11, 1992, to December 1987 Reimbursement Agreement between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-2 to PG&W's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-3490. 10-36 Subordinate Open End Mortgage, Security Agreement, Assignment of Leases, Rents and Profits, Financing Statement and Fixture Filing, dated as of September 10, 1991, made by PG&W, as Mortgagor, to Swiss Bank Corporation, as Collateral Agent and Mortgagee -- filed as Exhibit 10-1 to PEI's Common Stock Form S-2, Registration No. 33- 43382. 10-37 Collateral Agency and Intercreditor Agreement, dated as of September 10, 1991, among Manufacturers Hanover Trust Company (now Chemical Bank), as Bank Agency, Swiss Bank Corporation, New York Branch, First Eastern Bank, N.A., Hanover Bank, Meridian Bank, Northeastern Bank of Pennsylvania (now PNC Bank, Northeast PA), Philadelphia National Bank (now CoreStates Bank, N.A.), United Penn Bank (now Mellon Bank, N.A.), National Australia Bank, Limited, New York Branch, Swiss Bank Corporation, New York Branch, as Collateral Agent and PG&W -- filed as Exhibit 10-2 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-38 Credit Agreement, dated as of April 19, 1993, by and among PG&W, the Banks parties thereto and PNC Bank, Northeast PA, as agent, and CoreStates Bank, N.A. and NBD Bank, N.A. as Co-Agents -- filed as Exhibit 10-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 10-39 9.50% Cumulative Preferred Stock Purchase Agreement, dated December 11, 1987, between PG&W and the purchasers named therein -- filed as Exhibit 10-23 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. Exhibit Number 10-40 Recapitalization Agreement, dated September 16, 1988, between PG&W and the original purchasers of PG&W's 9.50% Cumulative Preferred Stock, pursuant to which shares of the 9.50% Cumulative Preferred Stock were exchanged for shares of PG&W's 9.50% 1988 Series Cumulative Preferred Stock -- filed as Exhibit 10-24 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, File No. 1-3490. 10-41 Form of Change in Control Agreement between PEI and certain of its Officers -- filed as Exhibit 10-34 to PG&W's Annual Report on Form 10-K for 1989, File No. 1-3490. 10-42 Agreement, dated as of March 15, 1991, by and between PEI, PG&W and Robert L. Jones -- filed as Exhibit 10-38 to PG&W's Annual Report on Form 10-K for 1990, File No. 1-3490. 10-43 Employment Agreement, dated August 30, 1991, between PEI and Dean T. Casaday -- filed as Exhibit 10-16 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-44 Supplemental Retirement Agreement, dated as of December 23, 1991, between PEI and Dean T. Casaday -- filed as Exhibit 10-17 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-45 Pennsylvania Enterprises, Inc. 1992 Stock Option Plan, effective June 3, 1992 -- filed as Exhibit A to PEI's 1993 definitive Proxy Statement, File No. 0-7812. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

20947_1993.txt

20947

1993

Item 1. Business THE CENTERIOR SYSTEM Centerior Energy is a public utility holding company and the parent company of the Operating Companies and the Service Company. Centerior was incorporated under the laws of the State of Ohio in 1985 for the purpose of enabling Cleveland Electric and Toledo Edison to affiliate by becoming wholly owned subsidiaries of Centerior. The affiliation of the Operating Companies became effective in April 1986. Nearly all of the consolidated operating revenues of the Centerior System are derived from the sale of electric energy by Cleveland Electric and Toledo Edison. The Operating Companies' combined service areas encompass approximately 4,200 square miles in northeastern and northwestern Ohio with an estimated popula- tion of about 2,600,000. At December 31, 1993, the Centerior System had 6,748 employees. Centerior Energy has no employees. Cleveland Electric, which was incorporated under the laws of the State of Ohio in 1892, is a public utility engaged in the generation, purchase, transmis- sion, distribution and sale of electric energy in an area of approximately 1,700 square miles in northeastern Ohio, including the City of Cleveland. Cleveland Electric also provides electric energy at wholesale to other elec- tric utility companies and to two municipal electric systems (directly and through AMP-Ohio) in its service area. Cleveland Electric serves approxi- mately 748,000 customers and derives approximately 75% of its total electric revenue from customers outside the City of Cleveland. Principal industries served by Cleveland Electric include those producing steel and other primary metals; automotive and other transportation equipment; chemicals; electrical and nonelectrical machinery; fabricated metal products; and rubber and plastic products. Nearly all of Cleveland Electric's operating revenues are derived from the sale of electric energy. At December 31, 1993, Cleveland Electric had 3,606 employees of which about 51% were represented by one union having a collective bargaining agreement with Cleveland Electric. Toledo Edison, which was incorporated under the laws of the State of Ohio in 1901, is a public utility engaged in the generation, purchase, transmission, distribution and sale of electric energy in an area of approximately 2,500 square miles in northwestern Ohio, including the City of Toledo. Toledo Edison also provides electric energy at wholesale to other electric utility companies and to 13 municipally owned distribution systems (through AMP-Ohio) and one rural electric cooperative distribution system in its service area. Toledo Edison serves approximately 285,000 customers and derives approximately 55% of its total electric revenue from customers outside the City of Toledo. Among the principal industries served by Toledo Edison are metal casting, forming and fabricating; petroleum refining; automotive equipment and assembly; food processing; and glass. Nearly all of Toledo Edison's operating revenues are derived from the sale of electric energy. At December 31, 1993, Toledo Edison had 1,909 employees of which about 55% were represented by three unions having collective bargaining agreements with Toledo Edison. The Service Company, which was incorporated in 1986 under the laws of the State of Ohio, is also a wholly owned subsidiary of Centerior Energy. It pro- vides management, financial, administrative, engineering, legal, governmental and public relations and other services to Centerior Energy and the Operating Companies. At December 31, 1993, the Service Company had 1,233 employees. On March 25, 1994, Centerior Energy announced plans to merge Toledo Edison into Cleveland Electric. Since Cleveland Electric and Toledo Edison affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO, the PaPUC and other regulatory authorities. The merger must be approved by Toledo Edison preferred stock share owners. Preferred stock share owners of Cleveland Electric must approve the authori- zation of additional shares of preferred stock. Upon the merger becoming effective, the outstanding shares of Toledo Edison preferred stock will be exchanged for shares of Cleveland Electric preferred stock having sub- stantially the same terms. Cleveland Electric and Toledo Edison plan to seek preferred share owner approval in the summer of 1994. The merger is expected to be effective late in 1994. See Note 15 to the Operating Companies' Financial Statements for further discussion of this matter and "3. Combined Pro Forma Condensed Financial Statements (Unaudited)" contained under Item 14. of this Report for selected historical and combined pro forma financial information of Cleveland Electric and Toledo Edison. CAPCO GROUP Cleveland Electric and Toledo Edison are members of the CAPCO Group, a power pool created in 1967 with Duquesne, Ohio Edison and Pennsylvania Power. This pool affords greater reliability and lower cost of providing electric service through coordinated generating unit operations and maintenance and generating reserve back-up among the five companies. In addition, the CAPCO Group has completed programs to construct larger, more efficient electric generating units and to strengthen interconnections within the pool. The CAPCO Group companies have placed in service nine major generating units, of which the Operating Companies have ownership or leasehold interests in seven (three nuclear and four coal-fired). Each CAPCO Group company owns, as a tenant-in-common, or leases a portion of certain of these generating units. Each company has the right to the net capability and associated energy of its respective ownership and leasehold portions of the units and is, severally and not jointly, obligated for the capital and operating costs equivalent to its respective ownership and leasehold portions of the units and the required fuel, except that the obligations of Pennsylvania Power are the joint and several obligations of that company and Ohio Edison and except that the leasehold obligations of Cleveland Electric and Toledo Edison are joint and several. (See "Operations--Fuel Supply".) For all plants but one, the company in whose service area a generating unit is located is responsible for the operation of that unit for all the owners, except for the procurement of nuclear fuel for a nuclear generating unit. The Mansfield Plant, which is located in Duquesne's service area, is operated by Pennsylvania Power. Each company owns the necessary interconnecting transmission facilities within its service area, and the other CAPCO Group companies contribute toward fixed charges and operating costs of those transmission facilities. All of the CAPCO Group companies are members of ECAR, which is comprised of 28 electric companies located in nine contiguous states. ECAR's purpose is to improve reliability of bulk power supply through coordination of planning and operation of member companies' generation and transmission facilities. CONSTRUCTION AND FINANCING PROGRAMS Construction Program The Centerior System carries on a continuous program of constructing trans- mission, distribution and general facilities and modifying existing generating facilities to meet anticipated demand for electric service, to comply with governmental regulations and to protect the environment. The Operating Companies' 1993 long-term (20-year) forecast, as filed with the PUCO (see "General Regulation--State Utility Commissions"), projects long-term annual growth rates in peak demand and kilowatt-hour sales for the Operating Companies of 1.1% and 1.4%, respectively, after demand-side management con- siderations. The Centerior System's integrated resource plan for the 1990s (which is included in the long-term forecast) combines demand-side management programs with maximum utilization of existing generating capacity to postpone the need for new generating units until the next decade. Demand-side manage- ment programs, such as energy-efficient lighting and motors, curtailable load and energy management, are expected to assist customers in achieving greater energy efficiency. Centerior plans to invest up to $35,000,000 in demand-side programs in 1994 and 1995. Operable capacity margins over the next ten years are expected to be adequate without adding generating capacity. According to the current long-term integrated resource plan, the next increment of generating capacity that the Centerior System plans to put into service will be two 136,000-kilowatt units in 2003, with additional small, short-lead-time capacity in subsequent years. The following tables show, categorized by major components, the construction expenditures by Cleveland Electric and Toledo Edison and, by aggregating them, for the Centerior System during 1991, 1992 and 1993 and the estimated cost of their construction programs for 1994 through 1998, in each case including AFUDC and excluding nuclear fuel: *Construction of Perry Unit 2 was suspended in 1985. In 1992, Cleveland Electric purchased Duquesne's ownership share of Perry Unit 2 for $3,324,000. At December 31, 1993, Centerior Energy, Cleveland Electric and Toledo Edison wrote off their investment in Perry Unit 2 (see Note 4(b)). Each company in the CAPCO Group is responsible for financing the portion of the capital costs of nuclear fuel equivalent to its ownership and leased interest in the unit in which the fuel will be utilized. See "Operations-- Fuel Supply--Nuclear" for information regarding nuclear fuel supplies and Note 6 regarding leasing arrangements to finance nuclear fuel capital costs. Nuclear fuel capital costs incurred by Cleveland Electric, Toledo Edison and the Centerior System during 1991, 1992 and 1993 and their estimated nuclear fuel capital costs for 1994 through 1998 are as follows: Financing Program Reference is made to Centerior Energy's, Cleveland Electric's and Toledo Edison's Management's Financial Analysis contained under Item 7 of this Report and to Notes 11 and 12 for discussions of the Centerior System's financing activity in 1993; debt and preferred stock redemption requirements during the 1994-1998 period; expected external financing needs during such period; re- strictions on the issuance of additional debt securities and preferred stock; short-term and long-term financing capability; and securities ratings for the Operating Companies. In the second quarter of 1994, Cleveland Electric and Toledo Edison expect to issue $46,100,000 and $30,500,000, respectively, of first mortgage bonds as collateral security for the sale by a public authority of equal principal amounts of tax-exempt bonds. The proceeds from the sales of the public authority's bonds will be used to refund $46,100,000 and $30,500,000, respec- tively, of tax-exempt bonds that were issued in 1988 and have been continu- ously remarketed on a floating rate basis. The new series of bonds will each be issued at a fixed rate of interest for the remaining term to July 1, 2023. Centerior expects to raise about $35,000,000 in 1994 from the sale of authorized but unissued common stock under certain of its employee and share owner stock purchase plans. GENERAL REGULATION Holding Company Regulation Centerior Energy is currently exempt from regulation under the Holding Company Act. The Energy Act contains, among other provisions, amendments to the Holding Company Act and the Federal Power Act. The Energy Act also adopted nuclear power licensing and related regulations, energy efficiency standards and incentives for the use of alternative transportation fuels. Amendments to the Holding Company Act create a new class of independent power producers known as "Exempt Wholesale Generators", which are exempt from the Holding Company Act corporate structure regulations and operate without SEC approval or regulation. Exempt Wholesale Generators may be owned by holding companies, electric utility companies or any other person. State Utility Commissions - ------------------------- The Operating Companies are subject to the jurisdiction of the PUCO with re- spect to rates, service, accounting, issuance of securities and other matters. Under Ohio law, municipalities may regulate rates, subject to appeal to the PUCO if not acceptable to the utility. See "Electric Rates" for a description of certain aspects of Ohio rate-making law. The Operating Companies are also subject to the jurisdiction of the PaPUC in certain respects relating to their ownership interests in generating facilities located in Pennsylvania. The PUCO is composed of five commissioners appointed by the Governor of Ohio from nominees recommended by a Public Utility Commission Nominating Council. Nominees must have at least three years' experience in one of several disci- plines. Not more than three commissioners may belong to the same political party. Under Ohio law, a public utility must file annually with the PUCO a long-term forecast of customer loads, facilities needed to serve those loads and prospective sites for those facilities. This forecast must include the following: (1) Demand Forecast--the utility's 20-year forecast of sales and peak demand, before and after the effects of demand-side management programs. (2) Integrated Resource Plan (required biennially)--the utility's projected mix of resource options to meet the projected demand. (3) Short-Term Implementation Plan and Status Report (required biennially)-- the utility's discussion of how it plans to implement its integrated resource plan over the next four years. Estimates of annual expenditures and security issuances associated with the integrated resource plan over the four-year period must also be provided. The PUCO must hold a public hearing on the long-term forecast at least once every five years to determine the reasonableness of such forecast. The PUCO and the OPSB are required to consider the record of such hearings in proceed- ings for approving facility sites, changing rates, approving security issues and initiating energy conservation programs. Ohio law also permits electric utilities under PUCO jurisdiction to submit environmental compliance plans for PUCO review and approval. Ohio law requires that the PUCO make certain statutory findings prior to approving the environmental compliance plan, which includes that the plan is a reasonable least cost strategy for compliance with air quality requirements. In 1992, the PUCO held hearings on the Operating Companies' 1992 long-term forecast and environmental compliance plan. Centerior and the parties intervening in the proceeding reached agreement on the forecast and environmental compliance plan, and the agreement was sub- sequently approved by the PUCO in February 1993. The PUCO has jurisdiction over certain transactions by companies in an elec- tric utility holding company system if it includes at least one Ohio electric utility and is exempt from regulation under Section 3(a)(1) or (2) of the Holding Company Act. An Ohio electric utility in such a holding company system, such as Centerior, must obtain PUCO approval to invest in, lend funds to, guarantee the obligations of or otherwise finance or transfer assets to any nonutility company in that holding company system, unless the transaction is in the ordinary course of business operations in which one company acts for or with respect to another company. Also, the holding company in such a hold- ing company system must obtain PUCO approval to make any investment in any nonutility subsidiaries, affiliates or associates of the holding company if such investment would cause all such capital investments to exceed 15% of the consolidated capitalization of the holding company unless such funds were provided by nonutility subsidiaries, affiliates or associates. The PUCO has a reserve capacity policy for electric utilities in Ohio stating that (i) 20% of service area peak load excluding interruptible load is an appropriate generic benchmark for an electric utility's reserve margin; (ii) a reserve margin exceeding 20% gives rise to a presumption of excess capacity, but may be appropriate if it confers a positive net present benefit to cus- tomers or is justified by unique system characteristics; and (iii) appropriate remedies for excess capacity (possibly including disallowance of costs in rates) will be determined by the PUCO on a case-by-case basis. Ohio Power Siting Board The OPSB has state-wide jurisdiction, except to the extent pre-empted by Federal law, over the location, need for and certain environmental aspects of electric generating units with a capacity of 50,000 kilowatts or more and transmission lines with a rating of at least 125 kV. Federal Energy Regulatory Commission The Operating Companies are each subject to the jurisdiction of the FERC with respect to the transmission and sale of power at wholesale in interstate com- merce, interconnections with other utilities, accounting and certain other matters. Cleveland Electric is also subject to FERC jurisdiction with respect to its ownership and operation of the Seneca Plant. Nuclear Regulatory Commission The nuclear generating units in which the Operating Companies have an interest are subject to regulation by the NRC. The NRC's jurisdiction encompasses broad supervisory and regulatory powers over the construction and operation of nuclear reactors, including matters of health and safety, antitrust considera- tions and environmental impacts. Owners of nuclear units are required to purchase the full amount of nuclear liability insurance available. See Note 5(b) for a description of nuclear in- surance coverages. Other Regulation The Operating Companies are subject to regulation by Federal, state and local authorities with regard to the location, construction and operation of certain facilities. The Operating Companies are also subject to regulation by local authorities with respect to certain zoning and planning matters. ENVIRONMENTAL REGULATION General The Operating Companies are subject to regulation with respect to air quality, water quality and waste disposal matters. Federal environmental legislation affecting the operations and properties of the Operating Companies includes the Clean Air Act, the Clean Air Act Amendments, the Clean Water Act, Superfund, and the Resource Conservation and Recovery Act. The requirements of these statutes and related state and local laws are continually changing due to the promulgation of new or revised laws and regulations and the results of judicial and agency proceedings. Compliance with such laws and regulations may require the Operating Companies to modify, supplement, abandon or replace facilities and may delay or impede construction and operation of facilities, all at costs which could be substantial. The Operating Companies expect that the impact of such costs would eventually be reflected in their respective rate schedules. Cleveland Electric and Toledo Edison plan to spend, during the period 1994-1996, $70,000,000 and $20,000,000, respectively, for pollution control facilities, including Clean Air Act Amendments compliance costs. The Operating Companies believe that they are currently in compliance in all material respects with all applicable environmental laws and regulations, or to the extent that one or both of the Operating Companies may dispute the applicability or interpretation of a particular environmental law or regula- tion, the affected company has filed an appeal or has applied for permits, revisions in requirements, variances or extensions of deadlines. Concerns have been raised regarding the possible health effects associated with electric and magnetic fields. Although scientific research as to such effects has yielded inconclusive results, additional studies are being con- ducted. If electric and magnetic fields are ultimately found to pose a health risk, the Operating Companies may be required to modify transmission and distribution lines or other facilities. Air Quality Control Under the Clean Air Act, the Ohio EPA has adopted Ohio emission limitations for particulate matter and sulfur dioxide for each of the Operating Companies' plants. The Clean Air Act provides for civil penalties of up to $25,000 per day for each violation of an emission limitation. The U.S. EPA has approved the Ohio EPA's emission limitations and the related implementation plans ex- cept for some particulate matter emissions and certain sulfur dioxide emis- sions. The U.S. EPA has adopted separate sulfur dioxide emission limitations for each of the Operating Companies' plants. In November 1990, the Clean Air Act Amendments were signed into law imposing restrictions on nitrogen oxides emissions and making sulfur dioxide emission limitations significantly more severe beginning in 1995. See Note 4(a) for a description of the Operating Companies' compliance strategy, which was in- cluded in the agreement approved by the PUCO in February 1993 in connection with the Operating Companies' 1992 long-term forecast. The Clean Air Act Amendments also require studies to be conducted on the emission of certain potentially hazardous air pollutants which could lead to additional restrictions. In 1985, the U.S. EPA issued revised regulations specifying the extent to which power plant stack height may be incorporated into the establishment of an emission limitation. Pursuant to the revised regulations, the Operating Companies submitted to the Ohio EPA information intended to support continua- tion of the stack height credit received under the previous regulations for stacks at Cleveland Electric's Avon Lake and Eastlake Plants and Toledo Edison's Bay Shore Station. The Ohio EPA has accepted the submissions and forwarded them to the U.S. EPA for approval. In January 1988, the District of Columbia Circuit Appeals Court remanded portions of the 1985 regulations to the U.S. EPA for further consideration; however, the U.S. EPA has not taken action specifically on this issue. Congress is considering legislation to reduce emissions of gases such as those resulting from the burning of coal that are thought to cause global warming. If such legislation is adopted, the cost of operating coal-fired plants could increase significantly and coal-fired generating capacity could decrease significantly. Water Quality Control The Clean Water Act requires that power plants obtain permits that contain certain effluent limitations (that is, limits on discharges of pollutants into bodies of water). It also requires the states to establish water quality standards (which could result in more stringent effluent limitations than those required under the Clean Water Act) and a permit system to be approved by the U.S. EPA. Violators of effluent limitations and water quality standards are subject to a civil penalty of up to $25,000 per day for each such violation. The Clean Water Act permits thermal effluent limitations to be established for a facility which are less stringent than those which otherwise would apply if the owner can demonstrate that such less stringent limitations are sufficient to assure the protection and propagation of aquatic and other wildlife in the affected body of water. By 1978, the Operating Companies had submitted to the Ohio EPA such demonstrations for review with respect to their Ashtabula, Avon Lake, Lake Shore, Eastlake, Acme and Bay Shore plants. The Ohio EPA has taken no action on the submittals. The Operating Companies have received NPDES permit renewals from the Ohio EPA or have applied for such renewals for all of their power plants. In those situations where a permit application is pending, the affected plant may con- tinue to operate under the expired permit while such application is pending. Any violation of an NPDES permit is considered to be a violation of the Clean Water Act subject to the penalty discussed above. In 1990, the Ohio EPA issued revised water quality standards applicable to Lake Erie and waters of the State of Ohio. Based upon these revised water quality standards, the Ohio EPA placed additional effluent limitations in their most recent NPDES permits. The revised standards also may serve as the basis for more stringent effluent limitations in future NPDES permits. Such limitations could result in the installation of additional pollution control equipment and increased operating expenses. The Operating Companies are monitoring discharges at their plants to support their position that addi- tional effluent limitations are not justified. On April 16, 1993, the U.S. EPA issued proposed rules for water quality standards applicable to all states abutting the Great Lakes, including Ohio. These states would be required to adopt state water quality standards and procedures consistent with the rules within two years of final publication. Preliminary reviews indicate that the cost of complying with these rules could be significant. However, Centerior cannot determine what impact these rules will have on its operations until such rules are issued in final form and are incorporated into Ohio regulations. Waste Disposal See "Hazardous Waste Disposal Sites" in Management's Financial Analysis contained under Item 7 of this Report and Note 4(c) for a discussion of the Operating Companies' potential involvement in certain hazardous waste disposal sites, including those subject to Superfund. See "Nuclear Units" and "Fuel Supply--Nuclear" under "Operations", below, for discussions concerning the disposal of nuclear waste. The Resource Conservation and Recovery Act exempts certain fossil fuel com- bustion waste products, such as fly ash, from hazardous waste disposal re- quirements. The Operating Companies are unable to predict whether Congress will choose to amend this exemption in the future or, if so, the costs relat- ing to any required changes in the operations of the Operating Companies. ELECTRIC RATES Under Ohio law, rate base is the original cost less depreciation of a utility's total plant adjusted for certain items. The law permits the PUCO, in its discretion, to include CWIP in rate base when a construction project is at least 75% complete, but limits the amount included to 10% of rate base ex- cluding CWIP or, in the case of a project to construct pollution control fa- cilities which would remove sulfur and nitrous oxides from flue gas emissions, 20% of rate base excluding CWIP. When a project is completed, the portion of its cost which had been included in rate base as CWIP is excluded from rate base until the revenue received due to the CWIP inclusion is offset by the revenue lost due to its exclusion. During this period of time, an AFUDC-type credit is allowed on the portion of the project cost excluded from rate base. Also, the law permits inclusion of CWIP for a particular project for a period not longer than 48 consecutive months, plus any time needed to comply with changed governmental regulations, standards or approvals. The PUCO is em- powered to permit inclusion for up to another 12 months for good cause shown. If a project is canceled or not completed within the allowable period of time after inclusion of its CWIP has started, then CWIP is excluded from rate base and any revenues which resulted from such prior inclusion are offset against future revenues over the same period of time as the CWIP was included. Current Ohio law further provides that requested rates can be collected by a public utility, subject to refund, if the PUCO does not make a decision within 275 days after the rate request application is filed. If the PUCO does not make its final decision within 545 days, revenues collected thereafter are not subject to refund. A notice of intent to file an application for a rate in- crease cannot be filed before the issuance of a final order in any prior pend- ing application for a rate increase or until 275 days after the filing of the prior application, whichever is earlier. The minimum period by which the notice of intent to file must precede the actual filing is 30 days. The test year for determining rates may not end more than nine months after the date the application for a rate increase is filed. Under Ohio law, electric rates are adjusted every six months to reflect changes in fuel costs. The PUCO reviews such adjustments annually. Any difference between actual fuel costs during a six-month period and the fuel revenues recovered in that period is deferred and is taken into account in setting the fuel recovery factor for a subsequent six-month period. The PUCO has authorized the Operating Companies to adjust their rates on a seasonal basis such that electric rates are higher in the summer. Also, under Ohio law, municipalities may regulate rates charged by a utility, subject to appeal to the PUCO if not acceptable to the utility. If municipally fixed rates are accepted by the utility, such rates are binding on both parties for the specified term and cannot be changed by the PUCO. See Note 7 and Management's Financial Analysis contained under Item 7 of this Report for information relating to the PUCO's January 1989 rate orders and the Rate Stabilization Program that was approved by the PUCO for the Operating Companies in October 1992. OPERATIONS Sales of Electricity Kilowatt-hour sales by the Operating Companies follow a seasonal pattern marked by increased customer usage in the summer for air conditioning and in the winter for heating. Historically, Cleveland Electric has experienced its heaviest demand for electric service during the summer months because of a significant air conditioning load on its system and a relatively low amount of electric heating load in the winter. Toledo Edison, although having a significant electric heating load, has experienced in recent years its heaviest demand for electric service during the summer months because of heavy air conditioning usage. The Centerior System's largest customer is a steel manufacturer which has two major steel producing facilities served by Cleveland Electric. Sales to these facilities accounted for 2.5% and 3.5% of the 1993 total electric operating revenues of Centerior Energy and Cleveland Electric, respectively. The loss of these facilities (and the resultant loss of another large customer whose primary product is purchased by the two steel producing facilities) would reduce Centerior Energy's and Cleveland Electric's net income by about $34,000,000 based on 1993 sales levels. The largest customer served by Toledo Edison is a major automobile manufac- turer. Sales to this customer accounted for 1.4% and 3.9% of the 1993 total electric operating revenues of Centerior Energy and Toledo Edison, re- spectively. The loss of this customer would reduce Centerior Energy's and Toledo Edison's net income by about $10,000,000 based on 1993 sales levels. Operating Statistics For data on operating revenues by service category, electric sales by service category, customers by service category and electric energy generation for 1983 and 1989 through 1993, see the attached Pages and for Centerior Energy, and for Cleveland Electric and and for Toledo Edison. Nuclear Units The Operating Companies' generating facilities include, among others, three nuclear units owned or leased by the CAPCO Group--Perry Unit 1, Beaver Valley Unit 2 and Davis-Besse. These three units are in commercial operation. Cleveland Electric has responsibility for operating Perry Unit 1, Duquesne has responsibility for operating Beaver Valley Unit 2 and Toledo Edison has re- sponsibility for operating Davis-Besse. Cleveland Electric and Toledo Edison own, respectively, 31.11% and 19.91% of Perry Unit 1, 24.47% and 1.65% of Beaver Valley Unit 2 and 51.38% and 48.62% of Davis-Besse. Cleveland Electric and Toledo Edison also lease, as joint lessees, another 18.26% of Beaver Valley Unit 2 as a result of a September 1987 sale and leaseback transaction (see Note 2). Davis-Besse was placed in commercial operation in 1977, and its operating license expires in 2017. Perry Unit 1 and Beaver Valley Unit 2 were placed in commercial operation in 1987, and their operating licenses expire in 2026 and 2027, respectively. As part of its January 1989 rate orders, the PUCO approved nuclear plant performance standards for the Operating Companies based on rolling three-year industry averages of operating availability for pressurized water reactors and for boiling water reactors over the 1988-1998 period. Operating availability is the ratio of the number of hours a unit is available to generate elec- tricity (whether or not the unit is operated) to the number of hours in the period, expressed as a percentage. The three-year operating availability averages of the Operating Companies' nuclear units are compared against the industry averages for the same three-year period with a resultant penalty or banked benefit. If the industry performance standards are not met, a penalty would be incurred which would require the Operating Companies to refund in- cremental replacement power costs to customers through the semiannual fuel cost rate adjustment. However, if the performance of the Operating Companies' nuclear units exceeds the industry standards, a banked benefit results which can be used to offset disallowances of incremental replacement power costs should future performance be below industry standards. The relevant industry standards for the 1991-1993 period are 78.0% for pressurized water reactors such as Davis-Besse and Beaver Valley Unit 2 and 72.8% for boiling water reactors such as Perry Unit 1. The 1991-1993 availability average for Davis-Besse and Beaver Valley Unit 2 was 87.1% and for Perry Unit 1 was 69.2%. At December 31, 1993, the total banked benefit for the Operating Companies is estimated to be between $18,000,000 and $20,000,000. All three nuclear units have received generally favorable evaluations from the NRC in their most recent SALP reviews. Each of the functional areas evaluated is rated according to three performance categories, with category 1 indicating performance substantially exceeding regulatory requirements and that reduced NRC attention may be appropriate; category 2 indicating performance above that needed to meet regulatory requirements and that NRC attention may be main- tained at normal levels; and category 3 indicating performance does not significantly exceed that needed to meet minimal regulatory requirements and that NRC attention should be increased above normal levels. The most recent review periods and SALP review scores for Perry Unit 1 and Davis-Besse are: The NRC increased its attention to Perry Unit 1 in 1993 and placed the unit on a newly created list for units identified as showing "safety performance trending downward." Centerior made specific organizational changes and developed a comprehensive course of action to improve the operating performance of Perry Unit 1. In response to this course of action, on January 27, 1994, the NRC removed Perry Unit 1 from the performance trending downward list. In 1993, the NRC revised the functional areas which comprise the SALP grading process. Plant Support is a new category which covers the areas previously covered by Security, Emergency Preparedness and Radiological Controls. The Safety Assessment/Quality Verification category is now an integral part of each category and is no longer being singled out. Beaver Valley Unit 2 is the only Centerior System unit to have been graded under the new system. Perry Unit 1 and Davis-Besse will be graded under the new system when their next SALP scores are issued. The most recent review period and SALP review scores for Beaver Valley Unit 2 are: The Operating Companies ship low-level radioactive waste produced at their nuclear plants to an offsite disposal facility which may not accept such shipments after mid-1994. The Operating Companies' ability to continue offsite disposal depends on whether the State of Ohio develops a low-level radioactive waste disposal facility within the next several years. If offsite disposal becomes unavailable, the Operating Companies have facilities to temporarily store such waste on site at each of the nuclear plants. However, the Operating Companies do not intend to store such waste on site until all available off-site options have been exhausted. See Note 4(b) for a discussion of the write-off of Perry Unit 2, and see Note 5(a) and "Outlook--Nuclear Operations" in Management's Financial Analysis contained under Item 7 of this Report for a discussion of potential risks facing Centerior and the Operating Companies as owners of nuclear generating units. Competitive Conditions General. The Operating Companies compete in their respective service areas with suppliers of natural gas to satisfy customers' energy needs with regard to heating and appliance usage. The Operating Companies also are engaged in competition to a lesser extent with suppliers of oil and liquefied natural gas for heating purposes and with suppliers of cogeneration equipment. One competitor provides steam for heating purposes and provides chilled water for cooling purposes in certain areas of downtown Cleveland. The Operating Companies also compete with municipally owned electric systems within their respective service areas. As discussed below, two of the munici- palities served by the Operating Companies, the City of Toledo and the City of Garfield Heights, are investigating the economic feasibility of establishing and operating municipally owned electric systems. A few other communities have evaluated municipalization of electric service and decided to continue service from Cleveland Electric and Toledo Edison. Officials in still other communities have indicated an interest in evaluating the municipalization issue. The Operating Companies face continuing competition from locations outside their service areas which are promoted by governmental and private agencies in attempts to influence potential and existing commercial and industrial cus- tomers to locate in their respective areas. Cleveland Electric and Toledo Edison also periodically compete with other producers of electricity for sales to electric utilities which are in the market for bulk power purchases. The Operating Companies have inter- connections with other electric utilities (see "Item 2.

Item 2. Properties GENERAL The Centerior System The wholly owned, jointly owned and leased electric generating facilities of the Operating Companies in commercial operation as of February 28, 1994 pro- vide the Centerior System with a net demonstrated capability of 5,980,000 kilowatts during the winter. These facilities include 20 generating units (3,634,000 kilowatts) at seven fossil-fired steam electric generation sta- tions; three nuclear generating units (1,856,000 kilowatts); a 351,000 kilo- watt share of the Seneca Plant; seven combustion turbine generating units (135,000 kilowatts) and one diesel generator (4,000 kilowatts). Operations at two fossil-fired generating units (320,000 kilowatts) ceased in 1993 and the units are being preserved for future use. All of the Centerior System's generating facilities are located in Ohio and Pennsylvania. The Centerior System's net 60-minute peak load of its service area for 1993 was 5,397,000 kilowatts and occurred on August 27. At the time of the 1993 peak load, the operable capacity available to serve the load was 5,998,000 kilowatts. The Centerior System's 1994 service area peak load is forecasted to be 5,250,000 kilowatts, after demand-side management considerations. The operable capacity expected to be available to serve the Centerior System's 1994 peak is 5,670,000 kilowatts. Over the 1994-1996 period, Centerior Energy forecasts its operable capacity margins at the time of the projected Centerior System peak loads to range from 7% to 9.5%. Each Operating Company owns the electric transmission and distribution facili- ties located in its respective service area. Cleveland Electric and Toledo Edison are interconnected by 345 kV transmission facilities, some portions of which are owned and used by Ohio Edison. The Operating Companies have a long- term contract with the CAPCO Group companies, including Ohio Edison, relating to the use of these facilities. These interconnection facilities provide for the interchange of power between the two Operating Companies. The Centerior System is interconnected with Ohio Edison, Ohio Power, Penelec and Detroit Edison. Cleveland Electric The wholly owned, jointly owned and leased electric generating facilities of Cleveland Electric in commercial operation as of February 28, 1994 provide a net demonstrated capability of 4,148,000 kilowatts during the winter. These facilities include 16 generating units (2,709,000 kilowatts) at five fossil- fired steam electric generation stations; its share of three nuclear generat- ing units (1,026,000 kilowatts); a 351,000 kilowatt share of the Seneca Plant; two combustion turbine generating units (58,000 kilowatts) and one diesel gen- erator (4,000 kilowatts). Operations at one fossil-fired generating unit (245,000 kilowatts) ceased in October 1993 and the unit is being preserved for future use. All of Cleveland Electric's generating facilities are located in Ohio and Pennsylvania. The net 60-minute peak load of Cleveland Electric's service area for 1993 was 3,862,000 kilowatts and occurred on July 28. The operable capacity at the time of the 1993 peak was 4,122,000 kilowatts. Cleveland Electric's 1994 service area peak load is forecasted to be 3,790,000 kilowatts, after demand- side management considerations. The operable capacity, which includes firm purchases, expected to be available to serve Cleveland Electric's 1994 peak is 4,018,000 kilowatts. Over the 1994-1996 period, Cleveland Electric forecasts its operable capacity margins at the time of its projected peak loads to range from 6% to 9%. Cleveland Electric owns the facilities located in the area it serves for transmitting and distributing power to all its customers. Cleveland Electric has interconnections with Ohio Edison, Ohio Power and Penelec. The intercon- nections with Ohio Edison provide for the interchange of electric power with the other CAPCO Group companies and for transmission of power from the tenant- in-common owned or leased CAPCO Group generating units as well as for the interchange of power with Toledo Edison. The interconnection with Penelec provides for transmission of power from Cleveland Electric's share of the Seneca Plant. In addition, these interconnections provide the means for the interchange of electric power with other utilities. Cleveland Electric has interconnections with each of the municipal systems operating within its service area. Toledo Edison The wholly owned, jointly owned and leased electric generating facilities of Toledo Edison in commercial operation as of February 28, 1994 provide a net demonstrated capability of 1,832,000 kilowatts during the winter. These facilities include six generating units (925,000 kilowatts) at three fossil- fired steam electric generation stations; its share of three nuclear generating units (830,000 kilowatts) and five combustion turbine generating units (77,000 kilowatts). Operations at one fossil-fired generating unit (75,000 kilowatts) ceased in July 1993 and the unit is being preserved for future use. All of Toledo Edison's generating facilities are located in Ohio and Pennsylvania. The net 60-minute peak load of Toledo Edison's service area for 1993 was 1,568,000 kilowatts and occurred on August 27. The operable capacity at the time of the 1993 peak was 1,874,000 kilowatts. Toledo Edison's 1994 service area peak load is forecasted to be 1,490,000 kilowatts, after demand-side management considerations. The operable capacity, which includes the effect of firm sales, expected to be available to serve Toledo Edison's 1994 peak is 1,652,000 kilowatts. Over the 1994-1996 period, Toledo Edison forecasts its operable capacity margins at the time of its projected peak loads to range from 0% to 10%. Toledo Edison owns the facilities located in the area it serves for trans- mitting and distributing power to all its customers. Toledo Edison has interconnections with Ohio Edison, Ohio Power and Detroit Edison. The in- terconnection with Ohio Edison provides for the interchange of electric power with the other CAPCO Group companies and for transmission of power from the tenant-in-common owned or leased CAPCO Group generating units as well as for the interchange of power with Cleveland Electric. In addition, these inter- connections provide the means for the interchange of electric power with other utilities. Toledo Edison has interconnections with each of the municipal systems operating within its service area. TITLE TO PROPERTY The generating plants and other principal facilities of the Operating Companies are located on land owned in fee by them, except as follows: (1) Cleveland Electric and Toledo Edison lease from others for a term of about 29-1/2 years starting on October 1, 1987 undivided 6.5%, 45.9% and 44.38% tenant-in-common interests in Units 1, 2 and 3, respectively, of the Mansfield Plant located in Shippingport, Pennsylvania. Cleveland Electric and Toledo Edison lease from others for a term of about 29-1/2 years starting on October 1, 1987 an 18.26% undivided tenant-in-common interest in Beaver Valley Unit 2 located in Shippingport, Pennsylvania. Cleveland Electric and Toledo Edison own another 24.47% interest and 1.65% interest, respectively, in Beaver Valley Unit 2 as a tenant-in- common. Cleveland Electric and Toledo Edison continue to own as a tenant-in-common the land upon which the Mansfield Plant and Beaver Valley Unit 2 are located, but have leased to others certain portions of that land relating to the above-mentioned generating unit leases. (2) Most of the facilities of Cleveland Electric's Lake Shore Plant are situated on artificially filled land, extending beyond the natural shore- line of Lake Erie as it existed in 1910. As of December 31, 1993, the cost of Cleveland Electric's facilities, other than water intake and discharge facilities, located on such artificially filled land aggregated approximately $112,026,000. Title to land under the water of Lake Erie within the territorial limits of Ohio (including artificially filled land) is in the State of Ohio in trust for the people of the State for the public uses to which it may be adapted, subject to the powers of the United States, the public rights of navigation, water commerce and fishery and the rights of upland owners to wharf out or fill to make use of the water. The State is required by statute, after appropriate pro- ceedings, to grant a lease to an upland owner, such as Cleveland Elec- tric, which erected and maintained facilities on such filled land prior to October 13, 1955. Cleveland Electric does not have such a lease from the State with respect to the artificially filled land on which its Lake Shore Plant facilities are located, but Cleveland Electric's position, on advice of counsel for Cleveland Electric, is that its facilities and occupancy may not be disturbed because they do not interfere with the free flow of commerce in navigable channels and constitute (at least in part) and are on land filled pursuant to the exercise by it of its property rights as owner of the land above the shoreline adjacent to the filled land. Cleveland Electric holds permits, under Federal statutes relating to navigation, to occupy such artificially filled land. (3) The facilities of Cleveland Electric's Seneca Plant in Warren County, Pennsylvania, are located on land owned by the United States and occupied by Cleveland Electric and Penelec pursuant to a license issued by the FERC for a 50-year period starting December 1, 1965 for the construction, operation and maintenance of a pumped-storage hydroelectric plant. (4) The water intake and discharge facilities at the electric generating plants of Cleveland Electric and Toledo Edison located along Lake Erie, the Maumee River and the Ohio River are extended into the lake and rivers under their property rights as owners of the land above the water line and pursuant to permits under Federal statutes relating to navigation. (5) The transmission systems of the Operating Companies are located on land, easements or rights-of-way owned by them. Their distribution systems also are located, in part, on interests in land owned by them, but, for the most part, their distribution systems are located on lands owned by others and on streets and highways. In most cases, permission has been obtained from the apparent owner of the property or, if the distribution system is located on streets and highways, from the apparent owner of the abutting property. Their electric underground transmission and distri- bution systems are located, for the most part, in public streets. The Pennsylvania portions of the main transmission lines from the Seneca Plant, the Mansfield Plant and Beaver Valley Unit 2 are not owned by Cleveland Electric or Toledo Edison. All Cleveland Electric and Toledo Edison properties, with certain exceptions, are subject to the lien of their respective mortgages. The fee titles which Cleveland Electric and Toledo Edison acquire as tenant- in-common owners, and the leasehold interests they have as joint lessees, of certain generating units do not include the right to require a partition or sale for division of proceeds of the units without the concurrence of all the other owners and their respective mortgage trustees and the trustees under Cleveland Electric's and Toledo Edison's mortgages. Item 3.

Item 3. Legal Proceedings Regulatory Proceedings and Suits Contesting Sulfur Dioxide Emission Limitations and Related Regulations Applicable to the Operating Companies. See "Item 1. Business--Environmental Regulation--Air Quality Control". Westinghouse Lawsuit. In April 1991, the CAPCO Group companies filed a lawsuit against Westinghouse in the United States District Court for the Western District of Pennsylvania. The suit alleges that six steam generators supplied by Westinghouse for Beaver Valley Power Station Units 1 and 2 contain serious defects, particularly defects causing tube corrosion and cracking. Steam generator maintenance costs have increased due to these defects and will likely continue to increase. The condition of the steam generators is being monitored closely. If the corrosion and cracking continue, replacement of the steam generators could be required earlier than their 40-year design life. The suit seeks monetary and corrective relief. General Electric Lawsuit. On February 2, 1994, the CAPCO Group companies announced that a settlement had been reached with General Electric regarding the lawsuit filed by the CAPCO Group companies against General Electric in August 1991. In that suit which was filed in the United States District Court in Cleveland, the CAPCO Group companies as joint owners of the Perry Plant alleged that General Electric had provided defective design information relating to the containment vessels for Perry Units 1 and 2. The CAPCO Group companies also alleged that the required corrective actions caused extensive delays and cost increases in the construction of the Perry Plant. Under the settlement agreement, General Electric will provide the CAPCO Group companies with discounts on future purchases and cash payments. The value of the settlement depends on the volume of future purchases. Because the payments will be made over a period of years and the discounts will be offered over the life of the plant, they will not have a material impact on the financial results of Centerior, Cleveland Electric and Toledo Edison in any particular year or on their financial conditions. The terms of the settlement agreement are the subject of a confidentiality agreement. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART II Item 5.

Item 5. Market for Registrants' Common Equity and Related Stockholder Matters The information regarding common stock prices and number of share owners required by this Item is not applicable to Cleveland Electric or Toledo Edison because all of their common stock is held solely by Centerior Energy. Market Information Centerior Energy's common stock is traded on the New York, Chicago and Pacific Stock Exchanges. The quarterly high and low prices of Centerior common stock (as reported on the composite tape) in 1992 and 1993 were as follows: Share Owners As of March 15, 1994, Centerior Energy had 159,506 common stock share owners of record. Dividends See Note 14 to Centerior's Financial Statements for quarterly dividend pay- ments in the last two years. See "Outlook--Common Stock Dividends" in Management's Financial Analysis contained under Item 7 of this Report for a discussion of the payment of future dividends by Centerior and the Operating Companies. At December 31, 1993, Centerior Energy had a retained earnings deficit of $523 million and capital surplus of $2 billion, resulting in an overall surplus of $1.477 billion that was available to pay dividends under Ohio law. Any current period earnings in 1994 will increase surplus under Ohio law. See Note 11(c) to Centerior's Financial Statements and Note 11(b) to the Operating Companies' Financial Statements for discussions of dividend restrictions affecting Cleveland Electric and Toledo Edison. Dividends paid in 1993 on each of the Operating Companies' outstanding series of preferred stock were fully taxable. The Operating Companies believe that all or a portion of their preferred stock dividends paid in 1994 will be a return of capital because they intend to take a deduction for the abandonment of Perry Unit 2. Item 6.

Item 6. Selected Financial Data CENTERIOR ENERGY The information required by this Item is contained on Pages and attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages and attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages and attached hereto. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CENTERIOR ENERGY The information required by this Item is contained on Pages through attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages through attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages through attached hereto. Item 8.

Item 8. Financial Statements and Supplementary Data CENTERIOR ENERGY The information required by this Item is contained on Pages and through attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages and through attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages and through attached hereto. Item 9.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrants CENTERIOR ENERGY The information required by this Item for Centerior regarding directors is incorporated herein by reference to Pages 4 through 8 of Centerior's definitive proxy statement dated March 23, 1994. Reference is also made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the executive officers of Centerior Energy. CLEVELAND ELECTRIC Set forth below are the name and other directorships held, if any, of each director of Cleveland Electric. The year in which the director was first elected to Cleveland Electric's Board of Directors is set forth in paren- thesis. Reference is made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the directors and executive officers of Cleveland Electric. The directors received no remuneration in their capacity as directors. Robert J. Farling* Mr. Farling is a director of National City Bank. (1986) Murray R. Edelman Mr. Edelman is a director of Society Bank & Trust. (1993) Fred J. Lange, Jr. (1993) *Also a director of Centerior Energy and the Service Company. TOLEDO EDISON Set forth below are the name and other directorships held, if any, of each director of Toledo Edison. The year in which the director was first elected to Toledo Edison's Board of Directors is set forth in parenthesis. Reference is made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the directors and the executive officers of Toledo Edison. The directors received no remuneration in their capacity as directors. Robert J. Farling* Mr. Farling is a director of National City Bank. (1988) Murray R. Edelman Mr. Edelman is a director of Society Bank & Trust. (1993) Fred J. Lange, Jr. (1993) *Also a director of Centerior Energy and the Service Company. Item 11.

Item 11. Executive Compensation CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON The information required by this Item for Centerior is incorporated herein by reference to the information concerning compensation of directors on Page 9 and the information concerning compensation of executive officers, stock option transactions, long-term incentive awards and pension benefits on Pages 17 through 25 of Centerior's definitive proxy statement dated March 23, 1994. The named executive officers for Centerior are included for Cleveland Electric and Toledo Edison regardless of whether they were officers of Cleveland Electric or Toledo Edison because they were key policymakers for the Centerior System in 1993. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management CENTERIOR ENERGY The following table sets forth the beneficial ownership of Centerior common stock by individual directors of Centerior, the named executive officers and all directors and executive officers of Centerior Energy and the Service Company as a group as of February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Centerior Energy and the Service Company as a group were considered to own bene- ficially 0.1% of Centerior's common stock and none of the preferred stock of Cleveland Electric and Toledo Edison. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all directors and executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Owned by the Sisters of Notre Dame. (4) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. CLEVELAND ELECTRIC Individual directors of Cleveland Electric, the named executive officers and all directors and executive officers of Cleveland Electric as a group as of March 15, 1994 beneficially owned the following number of shares of Centerior common stock on February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Cleveland Electric as a group were considered to own beneficially 0.03% of Centerior's common stock and none of Cleveland Electric's serial preferred stock. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all directors and executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. TOLEDO EDISON Individual directors of Toledo Edison, the named executive officers and all directors and executive officers of Toledo Edison as a group as of March 15, 1994 beneficially owned the following number of shares of Centerior common stock on February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Toledo Edison as a group were considered to own beneficially 0.03% of Centerior's common stock. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all other executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. Item 13.

Item 13. Certain Relationships and Related Transactions CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents Filed as a Part of the Report 1. Financial Statements: Financial Statements for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Index to Selected Financial Data; Management's Discussion and Analysis of Financial Condition and Re- sults of Operations; and Financial Statements. See Page. 2. Financial Statement Schedules: Financial Statement Schedules for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Index to Schedules. See Page S-1. 3. Combined Pro Forma Condensed Financial Statements (Unaudited): Combined Pro Forma Condensed Financial Statements (unaudited) for Cleveland Electric and Toledo Edison related to their pending merger. See Pages P-1 to P-4. 4. Exhibits: Exhibits for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Exhibit Index. See Page E-1. (b) Reports on Form 8-K During the quarter ended December 31, 1993, Centerior Energy, Cleveland Electric and Toledo Edison did not file any Current Reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CENTERIOR ENERGY CORPORATION Registrant March 30, 1994 By *ROBERT J FARLING, Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, Attorney-in-Fact SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE CLEVELAND ELECTRIC ILLUMINATING COMPANY Registrant March 30, 1994 By *ROBERT J. FARLING, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, Attorney-in-Fact SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE TOLEDO EDISON COMPANY Registrant March 30, 1994 By *ROBERT J. FARLING, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, Attorney-in-Fact REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - -------------------------------------------------------------------------------- To the Share Owners and Board of Directors of [Logo] Centerior Energy Corporation: We have audited the accompanying consolidated balance sheet and consolidated statement of preferred stock of Centerior Energy Corporation (an Ohio corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Centerior Energy Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules of Centerior Energy Corporation and subsidiaries listed in the Index to Schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cleveland, Ohio February 14, 1994 (Centerior Energy) (Centerior Energy) MANAGEMENT'S FINANCIAL ANALYSIS - -------------------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 1.5% increase in 1993 operating revenues are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $53 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential, commercial and wholesale kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. As a result, total sales increased 3.1% in 1993. Residential and commercial sales increased 4.6% and 3.1%, respectively. Industrial sales increased 1.2%. Increased sales to large automotive manufacturers, petroleum refiners and the broad-based, smaller industrial group were partially offset by lower sales to large steel industry customers. Other sales increased 5.9% because of increased sales to wholesale customers. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. The net decrease in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors increased slightly for The Toledo Edison Company (Toledo Edison) but decreased 5% for The Cleveland Electric Illuminating Company (Cleveland Electric). Operating expenses increased 13.7% in 1993. The increase in total operation and maintenance expenses resulted from the $218 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $54 million and an increase in other operation and maintenance expenses. Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. The increase in other operation and maintenance expenses resulted from higher environmental expenses, power restoration and repair expenses following a July 1993 storm in the Cleveland area, and an increase in other postretirement benefit expenses. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $583 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.8% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $77 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. As a result, total kilowatt-hour sales decreased 1.1% in 1992. Residential and commercial sales decreased 4.5% and 1.3%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales were virtually the same as in 1991 as sales increases to steel producers and auto manufacturers of 10.9% and 2.7%, respectively, offset a decline in sales to other industrial customers. Other sales increased 2.3% because of increased sales to wholesale customers. Operating revenues in 1991 included the recognition by Toledo Edison of $24 million of deferred revenues over the period of a refund to customers under a provision of its January 1989 rate order. No such revenues were reflected in 1992 as the refund period ended in December 1991. The decrease in 1992 fuel cost recovery revenues resulted from the good performance of our generating units, which in turn decreased our fuel cost factors. The weighted averages of these factors decreased approximately 3% for Cleveland Electric and Toledo Edison (Operating Companies). Operating expenses decreased 4% in 1992. Lower fuel and purchased power expense resulted from less amortization of previously deferred fuel costs than the amount amortized in 1991 and lower generation requirements stemming from less electric sales. A reduction of $17 million in other operation and maintenance expenses resulted primarily from cost-cutting measures. Federal income (Centerior Energy) (Centerior Energy) taxes decreased because of the amortization of certain tax benefits under the Rate Stabilization Program discussed in Note 7 and the effects of adopting the new accounting standard for income taxes (SFAS 109) in 1992. These decreases were partially offset by higher depreciation and amortization, caused primarily by the adoption of SFAS 109, and by higher taxes, other than federal income taxes, caused by increased Ohio property and gross receipts taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program. The federal income tax provision for nonoperating income decreased because of lower carrying charge credits and a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income decreased primarily because of lower phase-in carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, we announced a comprehensive strategic action plan to strengthen our financial and competitive position. The plan established specific objectives and was designed to guide us through the year 2001. While the plan has a long-term focus, it also required us to take some very difficult, but necessary, financial actions at that time. We reduced the quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. We also wrote off our investment in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs was $1.023 billion which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. We also recognized other one-time charges totaling $39 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $87 million after taxes representing a portion of the VTP costs. We will realize approximately $50 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of our strategic plan are to maximize share owner return from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, we will continue controlling our operation and maintenance expenses and capital expenditures, reduce our outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of our plants and take other appropriate actions. COMMON STOCK DIVIDENDS The indicated quarterly common stock dividend is $.20 per share. We believe that the new level is sustainable barring unforeseen circumstances and that the new strategic plan will provide the opportunity to grow the dividend as the objectives are achieved. Nevertheless, future dividend action by our Board of Directors will continue to be decided on a quarter-to-quarter basis after the evaluation of financial results, potential earning capacity and cash flow. The lower dividend reduces our cash outflow by about $120 million annually, which we intend to use to repay debt more quickly than would otherwise be the case. This will help improve our capitalization structure and interest coverage ratios, both of which are key measures considered by securities rating agencies in determining credit ratings. Improved credit ratings and less outstanding debt, in turn, will lower our interest costs. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are a number of rural and municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems and the expansion of an existing system. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. Cleveland Public Power continues to expand its operations into areas we have served exclusively. We have been successful in retaining most of the large industrial and commercial customers in those areas by providing economic incentive packages in exchange for sole-supplier contracts. We also have similar contracts with customers in other areas. Most of these contracts have remaining terms of one to five years. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. (Centerior Energy) (Centerior Energy) The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. Our analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS Our three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(e). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Operating Companies have been named as "potentially responsible parties" (PRPs) for three sites listed on the Superfund National Priorities List (Superfund List) and are aware of their potential involvement in the cleanup of several other sites not on such list. The allegations that the Operating Companies disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all PRPs to a particular site can be held liable on a joint and several basis. Consequently, if the Operating Companies were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $400 million. However, we believe that the actual cleanup costs will be substantially lower than $400 million, that the Operating Companies' share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Operating Companies have accrued a liability totaling $19 million at December 31, 1993 based on estimates of the costs of cleanup and their proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing pro- (Centerior Energy) (Centerior Energy) gram of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $1.4 billion. In addition, we exercised various options to redeem and purchase approximately $900 million of our securities. We raised $2.2 billion through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Operating Companies also utilized their short-term borrowing arrangements to help meet their cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for Cleveland Electric and Toledo Edison, respectively, are $791 million and $249 million for their construction programs and $715 million and $324 million for the mandatory redemption of debt and preferred stock. Cleveland Electric and Toledo Edison expect to finance internally all of their 1994 cash requirements of approximately $239 million and $109 million, respectively. About 15-20% of the Operating Companies' 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $128 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Operating Companies under their respective mortgages on the basis of property additions, cash or refundable first mortgage bonds. Under their respective mortgages, each Operating Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, Cleveland Electric and Toledo Edison would have been permitted to issue approximately $78 million and $323 million of additional first mortgage bonds, respectively. After the fourth quarter of 1994, Cleveland Electric's ability to issue first mortgage bonds is expected to increase substantially when its interest coverage ratio will no longer be affected by the write-offs recorded at December 31, 1993. As discussed in Note 11(e), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused Centerior Energy Corporation (Centerior Energy) and the Operating Companies to violate certain of those covenants. The affected creditors have waived those violations in exchange for our commitment to provide them with a second mortgage security interest on our property and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $219 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. For the next five years, the Operating Companies do not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, the Operating Companies believe that they could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Operating Companies also are able to raise funds through the sale of preference stock and, in the case of Cleveland Electric, preferred stock. Toledo Edison will be unable to issue preferred stock until it can meet the interest and preferred dividend coverage test in its articles of incorporation. Centerior Energy will continue to raise funds through the sale of common stock. The Operating Companies currently cannot sell commercial paper because of their low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. We have a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused us to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Operating Companies' needs over the next several years. The availability and cost of capital to meet our external financing needs, however, also depend upon such factors as financial market conditions and our credit ratings. Current credit ratings for both Operating Companies are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Operating Companies. (Centerior Energy) (Centerior Energy) INCOME STATEMENT CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ------------------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Centerior Energy) (Centerior Energy) CASH FLOWS CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ---------------------------------------------------------------------- (1) Interest paid (net of amounts capitalized) was $295 million, $299 million and $339 million in 1993, 1992 and 1991, respectively. Income taxes paid were $50 million, $32 million and $57 million in 1993, 1992 and 1991, respectively. (2) Increases in Nuclear Fuel and Nuclear Fuel Lease Obligations in the Balance Sheet resulting from the noncash capitalizations under nuclear fuel agreements are excluded from this statement. The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES (Centerior Energy) (Centerior Energy) STATEMENT OF PREFERRED STOCK CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) NOTES TO THE FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL Centerior Energy is a holding company with two electric utility subsidiaries, Cleveland Electric and Toledo Edison. The consolidated financial statements also include the accounts of Centerior Energy's other wholly owned subsidiary, Centerior Service Company (Service Company), and Cleveland Electric's wholly owned subsidiaries. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to Centerior Energy and the Operating Companies. The Operating Companies operate as separate companies, each serving the customers in its service area. The preferred stock, first mortgage bonds and other debt obligations of the Operating Companies are outstanding securities of the issuing utility. All significant intercompany items have been eliminated in consolidation. Centerior Energy and the Operating Companies follow the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission and adopted by The Public Utilities Commission of Ohio (PUCO). As rate-regulated utilities, the Operating Companies are subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The Service Company follows the Uniform System of Accounts for Mutual Service Companies prescribed by the Securities and Exchange Commission under the Public Utility Holding Company Act of 1935. The Operating Companies are members of the Central Area Power Coordination Group (CAPCO). Other members are Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO or on ordinances of individual municipalities. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (C) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Operating Companies defer the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Operating Companies have accrued the liability for their share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Operating Companies to recover the assessments through their fuel cost factors. (D) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Operating Companies to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $17 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Operating Companies deferred certain operating expenses and both interest and equity carrying charges pursuant to PUCO-approved rate phase-in plans for their investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Operating Companies also defer certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (Centerior Energy) (Centerior Energy) (E) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depreciable utility plant in service was 3.5% in 1993 and 3.4% in both 1992 and 1991. Effective January 1, 1991, the Operating Companies, after obtaining PUCO approval, changed their method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $36 million and increased 1991 net income $28 million (net of $8 million of income taxes) and earnings per share $.20 from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Operating Companies currently use external funding for the future decommissioning of their nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $8 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Operating Companies' share of the future decommissioning costs are $92 million in 1992 dollars for Beaver Valley Unit 2 and $223 million and $300 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Operating Companies used these estimates to increase their decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $74 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (F) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rates averaged 9.9% in 1993, 10.8% in 1992 and 10.7% in 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (G) DEFERRED GAIN AND LOSS FROM SALES OF UTILITY PLANT The sale and leaseback transactions discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant) and a net loss for the sale of Beaver Valley Unit 2. The net gain and net loss were deferred and are being amortized over the terms of leases. These amortizations and the lease expense amounts are recorded as other operation and maintenance expenses. (H) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (Centerior Energy) (Centerior Energy) (I) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (2) Utility Plant Sale and Leaseback Transactions The Operating Companies are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Operating Companies are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Operating Companies have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(e). In April 1992, nearly all of the outstanding Secured Lease Obligation Bonds (SLOBs) issued by a special purpose corporation in connection with financing the sale and leaseback of Beaver Valley Unit 2 were refinanced through a tender offer and the sale of new bonds having a lower interest rate. As part of the refinancing transaction, Toledo Edison paid $43 million as supplemental rent to fund transaction expenses and part of the tender premium. This amount has been deferred and is being amortized over the remaining lease term. The refinancing transaction reduced the annual rental expense for the Beaver Valley Unit 2 lease by $9 million. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $115 million. The amounts recorded in 1993, 1992 and 1991 as annual rental expense for the Beaver Valley Unit 2 lease were $63 million, $66 million and $72 million, respectively. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. Toledo Edison is selling 150 megawatts of its Beaver Valley Unit 2 leased capacity entitlement to Cleveland Electric. We anticipate that this sale will continue indefinitely. (Centerior Energy) (Centerior Energy) (3) Property Owned with Other Utilities and Investors The Operating Companies own, as tenants in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Operating Companies' share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Operating Companies as tenants in common with other utilities and Lessors: Depreciation for Eastlake Unit 5 has been accumulated with all other nonnuclear depreciable property rather than by specific units of depreciable property. (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of our construction program for the 1994-1998 period is $1.088 billion, including AFUDC of $48 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $222 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses will be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be about 1-2% in the late 1990s. Cleveland Electric may need to install sulfur emission control technology at one of its generating plants after 2005 which could require additional expenditures at that time. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $583 million ($425 million after taxes) for our 64.76% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Operating Companies are aware of their potential involvement in the cleanup of three sites listed on the Superfund List and several other waste sites not on such list. The Operating Companies have accrued a liability totaling $19 million at December 31, 1993 based on estimates of the costs of cleanup and their proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (Centerior Energy) (Centerior Energy) (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS Our three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), our maximum potential assessment under that plan would be $155 million (plus any inflation adjustment) per incident. The assessment is limited to $20 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, our share of such excess amount could have a material adverse effect on our financial condition and results of operations. Under these policies, we can be assessed a maximum of $25 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. We also have extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (6) Nuclear Fuel Nuclear fuel is financed for the Operating Companies through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $370 million of nuclear fuel was financed. The Operating Companies severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments of $110 million, $78 million and $46 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $14 million in 1993, $15 million in 1992 and $21 million in 1991. The estimated future lease amortization payments based on projected consumption are $111 million in 1994, $97 million in 1995, $87 million in 1996, $77 million in 1997 and $69 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plans approved by the PUCO in January 1989 rate orders for the Operating Companies. The phase-in plans were designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plans required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Operating Companies' deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plans. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 were $172 million and $705 million, respectively (totaling $598 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current (Centerior Energy) (Centerior Energy) assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in our service area by freezing base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $216 million for Cleveland Electric and $89 million for Toledo Edison over the 1996-1998 period. As part of the Rate Stabilization Program, the Operating Companies are allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988 and the deferral of Toledo Edison operating expenses equivalent to an accumulated excess rent reserve for Beaver Valley Unit 2 (which resulted from the April 1992 refinancing of SLOBs as discussed in Note 2). The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $95 million and $84 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets and the remaining lease period, or approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $46 million and $12 million, respectively. The Rate Stabilization Program also authorized the Operating Companies to defer and subsequently recover the incremental expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $96 million pursuant to this provision. Amortization and recovery of this deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying the income before taxes and preferred dividend requirements of subsidiaries by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: (Centerior Energy) (Centerior Energy) In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $90 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $90 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $619 million and deferred tax liabilities of $2.198 billion at December 31, 1993 and deferred tax assets of $563 million and deferred tax liabilities of $2.598 billion at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $309 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $108 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $171 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN We sponsor a noncontributing pension plan which covers all employee groups. Two existing plans were merged into a single plan on December 31, 1993. The amount of retirement benefits generally depends upon the length of service. Under certain circumstances, benefits can begin as early as age 55. Our funding policy is to comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, we offered the VTP, an early retirement program. Operating expenses for 1993 included $205 million of pension plan accruals to cover enhanced VTP benefits and an additional $10 million of pension costs for VTP benefits paid to retirees from corporate funds. The $10 million is not included in the pension data reported below. A credit of $81 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs (credits) for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the plan(s) at December 31, 1993 and 1992. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (Centerior Energy) (Centerior Energy) (B) OTHER POSTRETIREMENT BENEFITS We sponsor a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. We adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs totaled $9 million in 1992 and $10 million in 1991, which included medical benefits of $8 million in 1992 and $9 million in 1991. The total amount accrued for SFAS 106 costs for 1993 was $111 million, of which $5 million was capitalized and $106 million was expensed as other operation and maintenance expenses. In 1993, we deferred incremental SFAS 106 expenses totaling $96 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 are summarized as follows: At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $11 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $1 million. (C) POSTEMPLOYMENT BENEFITS In 1993, we adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect our 1993 results of operations or financial position. (10) Guarantees Cleveland Electric has guaranteed certain loan and lease obligations of two mining companies under two long-term coal purchase arrangements. Toledo Edison is also a party to one of these guarantee arrangements. This arrangement requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining companies' loan and lease obligations guaranteed by the Operating Companies was $80 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Shares sold, retired and purchased for treasury during the three years ended December 31, 1993 are listed in the following tables. (Centerior Energy) (Centerior Energy) Shares of common stock required for our stock plans in 1993 were either acquired in the open market, issued as new shares or issued from treasury stock. The Board of Directors has authorized the purchase in the open market of up to 1,500,000 shares of our common stock until June 30, 1994. As of December 31, 1993, 225,500 shares had been purchased at a total cost of $4 million. Such shares are being held as treasury stock. (B) COMMON SHARES RESERVED FOR ISSUE Common shares reserved for issue under the Employee Savings Plan and the Employee Purchase Plan were 1,962,174 and 469,457 shares, respectively, at December 31, 1993. Stock options to purchase unissued shares of common stock under the 1978 Key Employee Stock Option Plan were granted at an exercise price of 100% of the fair market value at the date of the grant. No additional options may be granted. The exercise prices of option shares purchased during the three years ended December 31, 1993 ranged from $14.09 to $17.41 per share. Shares and price ranges of outstanding options held by employees were as follows: (C) EQUITY DISTRIBUTION RESTRICTIONS The Operating Companies make cash available for the funding of Centerior Energy's common stock dividends by paying dividends on their respective common stock, which are held solely by Centerior Energy. Federal law prohibits the Operating Companies from paying dividends out of capital accounts. However, the Operating Companies may pay preferred and common stock dividends out of appropriated retained earnings and current earnings. At December 31, 1993, Cleveland Electric and Toledo Edison had $125 million and $42 million, respectively, of appropriated retained earnings for the payment of dividends. However, Toledo Edison is prohibited from paying a common stock dividend by a provision in its mortgage. (D) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $40 million in 1994, $51 million in 1995, $41 million in 1996, $31 million in 1997 and $16 million in 1998. The annual mandatory redemption provisions are as follows: * All outstanding shares to be redeemed on December 1, 2001. In June 1993, Cleveland Electric issued $100 million principal amount of Serial Preferred Stock, $42.40 Series T. The Series T stock was deposited with an agent which issued Depositary Receipts, each representing 1/20 of a share of the Series T stock. The annualized preferred dividend requirement for the Operating Companies at December 31, 1993 was $68 million. The preferred dividend rates on Cleveland Electric's Series L and M and Toledo Edison's Series A and B fluctuate based on prevailing interest rates and market conditions. The dividend rates for these issues averaged 7%, 7%, 7.41% and 8.22%, respectively, in 1993. Cleveland Electric's Series P had a 6.5% dividend rate in 1993 until it was redeemed in August 1993. (Centerior Energy) (Centerior Energy) Preference stock authorized for the Operating Companies are 3,000,000 shares without par value for Cleveland Electric and 5,000,000 shares with a $25 par value for Toledo Edison. No preference shares are currently outstanding for either company. With respect to dividend and liquidation rights, each Operating Company's preferred stock is prior to its preference stock and common stock, and each Operating Company's preference stock is prior to its common stock. (E) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, for the Operating Companies was as follows: Long-term debt matures during the next five years as follows: $87 million in 1994, $317 million in 1995, $242 million in 1996, $94 million in 1997 and $117 million in 1998. The Operating Companies issued $550 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The mortgages of the Operating Companies constitute direct first liens on substantially all property owned and franchises held by them. Excluded from the liens, among other things, are cash, securities, accounts receivable, fuel, supplies and, in the case of Toledo Edison, automotive equipment. Certain unsecured loan agreements of the Operating Companies contain covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting Centerior Energy and the Operating Companies. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused Centerior Energy and the Operating Companies to violate certain covenants contained in a Cleveland Electric loan agreement and the two reimbursement agreements. The affected creditors have waived those violations in exchange for our commitment to provide them with a second mortgage security interest on our property and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $219 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Operating Companies. Centerior Energy plans to transfer any of its borrowed funds to the Operating Companies, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The (Centerior Energy) (Centerior Energy) revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $300 million for Cleveland Electric and $150 million for Toledo Edison. The Operating Companies are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Operating Companies had no commercial paper outstanding. The Operating Companies are unable to rely on the sale of commercial paper to provide short-term funds because of their below investment grade commercial paper credit ratings. (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Operating Companies' preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $81 million, or $.56 per share, as a result of the recording of $125 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $583 million write-off of Perry Unit 2 (see Note 4(b)), the $877 million write-off of the phase-in deferrals (see Note 7) and $58 million of other charges. These adjustments decreased quarterly earnings by $1.06 billion, or $7.24 per share. Earnings for the quarter ended September 30, 1992 were increased by $41 million, or $.29 per share, as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $61 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (Centerior Energy) (Centerior Energy) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) Operating Expenses (millions of dollars) Income (Loss) (millions of dollars) NOTE: 1983 data is the result of combining and restating data for the Operating Companies. (a) Includes early retirement program expenses and other charges of $272 million in 1993. (b) Includes write-off of phase-in deferrals of $877 million in 1993, consisting of $172 million of deferred operating expenses and $705 million of deferred carrying charges. (c) In 1991, the Operating Companies adopted a change in accounting for nuclear plant depreciation, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Centerior Energy) (Centerior Energy) Investment (millions of dollars) Capitalization (millions of dollars & %) (d) Includes write-off of Perry Unit 2 of $583 million in 1993. (e) Average shares outstanding and related per share computations reflect the Cleveland Electric 1.11-for-one exchange ratio and the Toledo Edison one-for-one exchange ratio for Centerior Energy shares at the date of affiliation, April 29, 1986. (f) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Centerior Energy) (Centerior Energy) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - ---------------------------------------------------------------------- To the Share Owners of The Cleveland Electric [Logo] Illuminating Company: We have audited the accompanying consolidated balance sheet and consolidated statement of preferred stock of The Cleveland Electric Illuminating Company (a wholly owned subsidiary of Centerior Energy Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Cleveland Electric Illuminating Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purposef of forming an opinion on the basic financial statements taken as a whole. The schedules of The Cleveland Electric Illuminating Company and subsidiaries listed in the Index to Schedules are presented for purposes of complying with the Securities and Exchange Commission rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cleveland, Ohio February 14, 1994 (except with respect to the matter discussed in Note 15, as to which the date is March 25, 1994) (Cleveland Electric) (Cleveland Electric) MANAGEMENT'S FINANCIAL ANALYSIS - ---------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 0.5% increase in 1993 operating revenues for The Cleveland Electric Illuminating Company (Company) are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $36 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential, commercial and wholesale kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northeastern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. As a result, total sales increased 2.9% in 1993. Residential and commercial sales increased 4.4% and 3.1%, respectively. Industrial sales decreased 1%. Lower sales to large steel industry customers were partially offset by increased sales to large automotive manufacturers and the broad-based, smaller industrial customer group. Other sales increased 11.9% because of increased sales to wholesale customers. The net decrease in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors decreased approximately 5%. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. Operating expenses increased 12.4% in 1993. The increase in total operation and maintenance expenses resulted from the $130 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $35 million and an increase in other operation and maintenance expenses. The VTP benefit expenses consisted of $102 million of costs for the Company plus $28 million for the Company's pro rata share of the costs for its affiliate, Centerior Service Company (Service Company). Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. The increase in other operation and maintenance expenses resulted from higher environmental expenses, power restoration and repair expenses following a July 1993 storm, and an increase in other postretirement benefit expenses. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $351 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.5% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $55 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. As a result, total kilowatt-hour sales decreased 3.5% in 1992. Residential and commercial sales decreased 4.4% and 0.5%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales declined 0.4% as an 8.1% decrease in sales to the broad-based, smaller industrial customer group completely offset an 8.8% increase in sales to the larger industrial customer group. Sales to steel producers and auto manufacturers within the large industrial customer group rose 10.9% and 7%, respectively. Other sales decreased 16.1% because of decreased sales to wholesale customers and public authorities. The decrease in 1992 fuel cost recovery revenues resulted primarily because of the good performance of our generating units, which in turn decreased our fuel cost factors. The weighted averages of these factors decreased approximately 3%. Operating expenses decreased 3.6% in 1992. Lower fuel and purchased power expense resulted from lower generation requirements stemming from less electric sales and less amortization of previously deferred fuel costs than the amount amortized in 1991. Federal income taxes decreased because of the amortization of certain tax benefits under the Rate Stabilization Program discussed (Cleveland Electric) (Cleveland Electric) in Note 7 and the effects of adopting the new accounting standard for income taxes (SFAS 109) in 1992. These decreases were partially offset by higher depreciation and amortization, caused primarily by the adoption of SFAS 109, and by higher taxes, other than federal income taxes, caused by increased Ohio property and gross receipts taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program. The federal income tax provision for nonoperating income decreased because of lower carrying charge credits and a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income decreased primarily because of lower phase-in-carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, Centerior Energy Corporation (Centerior Energy), along with the Company and The Toledo Edison Company (Toledo Edison), announced a comprehensive strategic action plan to strengthen their financial and competitive positions. The Company and Toledo Edison are the two wholly owned electric utility subsidiaries of Centerior Energy. The plan established specific objectives and was designed to guide Centerior Energy and its subsidiaries through the year 2001. Several actions were taken at that time. Centerior Energy reduced its quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. The Company and Toledo Edison also wrote off their investments in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs for the Company was $691 million which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. The Company also recognized other one-time charges totaling $25 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $51 million after taxes representing a portion of the VTP costs. The Company will realize approximately $30 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of the strategic plan are to maximize share owner return on Centerior Energy common stock from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, the Company will continue controlling its operation and maintenance expenses and capital expenditures, reduce its outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of its plants and take other appropriate actions. COMMON STOCK DIVIDENDS Centerior Energy's common stock dividend has been funded in recent years primarily by common stock dividends paid by the Company. We expect this practice to continue for the foreseeable future. Centerior Energy's lower common stock dividend reduces its cash outflow by about $120 million annually which, in turn, reduces the common stock dividend demands placed on the Company. The Company intends to use the increased retained cash to repay debt more quickly than would otherwise be the case. This will help improve the Company's capitalization structure and interest coverage ratios. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are two municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems and the expansion of an existing system. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. Cleveland Public Power continues to expand its operations into areas we have served exclusively. We have been successful in retaining most of the large industrial and commercial customers in those areas by providing economic incentive packages in exchange for sole-supplier contracts. We also have similar contracts with customers in other areas. Most of these contracts have remaining terms of one to five years. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses (Cleveland Electric) (Cleveland Electric) for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. As mentioned above, we have contracts with many of our large industrial and commercial customers. We will attempt to renew those contracts as they expire which will help us compete if retail wheeling is permitted in the future. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS The Company's three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(f). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Company has been named as a "potentially responsible party" (PRP) for three sites listed on the Superfund National Priorities List (Superfund List) and is aware of its potential involvement in the cleanup of several other sites not on such list. The allegations that the Company disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all PRPs to a particular site can be held liable on a joint and several basis. Consequently, if the Company were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $250 million. However, we believe that the actual cleanup costs will be substantially lower than $250 million, that the Company's share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Company has accrued a liability totaling $13 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. (Cleveland Electric) (Cleveland Electric) Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing program of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $970 million. In addition, we exercised various options to redeem and purchase approximately $430 million of our securities. We raised $1.2 billion through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Company also utilized its short-term borrowing arrangements to help meet its cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for the Company are $791 million for its construction program and $715 million for the mandatory redemption of debt and preferred stock. The Company expects to finance internally all of its 1994 cash requirements of approximately $239 million. About 20% of the Company's 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $87 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Company under its mortgage on the basis of property additions, cash or refundable first mortgage bonds. Under its mortgage, the Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, the Company would have been permitted to issue approximately $78 million of additional first mortgage bonds. After the fourth quarter of 1994, the Company's ability to issue first mortgage bonds is expected to increase substantially when its interest coverage ratio will no longer be affected by the write-offs recorded at December 31, 1993. As discussed in Note 11(d), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused the Company, Toledo Edison and Centerior Energy to violate certain of those covenants. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Toledo Edison and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $47 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Toledo Edison. For the next five years, the Company does not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, we believe that the Company could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Company also is able to raise funds through the sale of preference and preferred stock. The Company currently cannot sell commercial paper because of its low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. The Company is a party to a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused the Company, Toledo Edison and Centerior Energy to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Company's needs over the next several years. The availability and cost of capital to meet the Company's external financing needs, however, also depend upon such factors as financial market conditions and its credit ratings. Current credit ratings for the Company are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Company. (Cleveland Electric) (Cleveland Electric) INCOME STATEMENT THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - -------------------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Cleveland Electric) (Cleveland Electric) CASH FLOWS THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - -------------------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES (Cleveland Electric) (Cleveland Electric) STATEMENT OF PREFERRED STOCK THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) NOTES TO THE FINANCIAL STATEMENTS - ---------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL The Company is an electric utility and a wholly owned subsidiary of Centerior Energy. Centerior Energy has two other wholly owned subsidiaries, Toledo Edison and the Service Company. The Company follows the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by The Public Utilities Commission of Ohio (PUCO). As a rate-regulated utility, the Company is subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The financial statements include the accounts of the Company's wholly owned subsidiaries, which in the aggregate are not material. The Company is a member of the Central Area Power Coordination Group (CAPCO). Other members are Toledo Edison, Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) RELATED PARTY TRANSACTIONS Operating revenues, operating expenses and interest charges include those amounts for transactions with affiliated companies in the ordinary course of business operations. The Company's transactions with Toledo Edison are primarily for firm power, interchange power, transmission line rentals and jointly owned power plant operations and construction. See Notes 2 and 3. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to the Company and other affiliated companies. The Service Company billed the Company $180 million, $150 million and $138 million in 1993, 1992 and 1991, respectively, for such services. (C) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (D) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Company defers the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Company has accrued a liability for its share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Company to recover the assessments through its fuel cost factors. (E) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Company to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $10 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Company deferred certain operating expenses and both interest and equity carrying charges pursuant to a PUCO-approved rate phase-in plan for its investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Company also defers certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (F) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depre- (Cleveland Electric) (Cleveland Electric) ciable utility plant in service was 3.4% in 1993, 1992 and 1991. Effective January 1, 1991, the Company, after obtaining PUCO approval, changed its method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $22 million and increased 1991 net income $17 million (net of $5 million of income taxes) from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Company currently uses external funding for the future decommissioning of its nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $4 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Company's share of the future decommissioning costs are $51 million in 1992 dollars for Beaver Valley Unit 2 and $136 million and $154 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Company used these estimates to increase its decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $41 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (G) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rate was 9.63% in 1993, 10.56% in 1992 and 10.47% in 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (H) DEFERRED GAIN FROM SALE OF UTILITY PLANT The sale and leaseback transaction discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant). The net gain was deferred and is being amortized over the term of leases. The amortization and the lease expense amounts are recorded as other operation and maintenance expenses. (I) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (J) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. (Cleveland Electric) (Cleveland Electric) Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (2) Utility Plant Sale and Leaseback Transactions The Company and Toledo Edison are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Company and Toledo Edison are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Company and Toledo Edison have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(d). As co-lessee with Toledo Edison, the Company is also obligated for Toledo Edison's lease payments. If Toledo Edison is unable to make its payments under the Beaver Valley Unit 2 and Mansfield Plant leases, the Company would be obligated to make such payments. No payments have been made on behalf of Toledo Edison to date. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $70 million. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. The Company is buying 150 megawatts of Toledo Edison's Beaver Valley Unit 2 leased capacity entitlement. We anticipate that this purchase will continue indefinitely. Purchased power expense for this transaction was $103 million, $108 million and $107 million in 1993, 1992 and 1991, respectively. The future minimum lease payments through the year 2017 associated with Beaver Valley Unit 2 aggregate $1.47 billion. (3) Property Owned with Other Utilities and Investors The Company owns, as a tenant in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Company's share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Operating Company as a tenant in common with other utilities and Lessors: Depreciation for Eastlake Unit 5 has been accumulated with all other nonnuclear depreciable property rather than by specific units of depreciable property. (Cleveland Electric) (Cleveland Electric) (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of the Company's construction program for the 1994-1998 period is $829 million, including AFUDC of $38 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $165 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses will be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be about 1-2% in the late 1990s. The Company may need to install sulfur emission control technology at one of its generating plants after 2005 which could require additional expenditures at that time. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $351 million ($258 million after taxes) for the Company's 44.85% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Company is aware of its potential involvement in the cleanup of three sites listed on the Superfund List and several other waste sites not on such list. The Company has accrued a liability totaling $13 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS The Company's three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), the Company's maximum potential assessment under that plan would be $85 million (plus any inflation adjustment) per incident. The assessment is limited to $11 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, the Company's share of such excess amount could have a material adverse effect on its financial condition and results of operations. Under these policies, the Company can be assessed a maximum of $14 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. The Company also has extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been (Cleveland Electric) (Cleveland Electric) incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (6) Nuclear Fuel Nuclear fuel is financed for the Company and Toledo Edison through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $216 million of nuclear fuel was financed for the Company. The Company and Toledo Edison severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments for the Company of $57 million, $48 million and $26 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $9 million in both 1993 and 1992 and $12 million in 1991. The estimated future lease amortization payments based on projected consumption are $63 million in 1994, $56 million in 1995, $50 million in 1996, $44 million in 1997 and $39 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plan approved by the PUCO in a January 1989 rate order for the Company. The phase-in plan was designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plan required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Company's deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plan. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 by the Company were $117 million and $519 million, respectively (totaling $433 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in the Company's service area by freezing the Company's base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $216 million over the 1996-1998 period. As part of the Rate Stabilization Program, the Company is allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988. The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $56 million and $52 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets, approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $28 million and $7 million, respectively. The Rate Stabilization Program also authorized the Company to defer and subsequently recover the incremental (Cleveland Electric) (Cleveland Electric) expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $60 million pursuant to this provision. Amortization and recovery of this deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying income before taxes by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: The Company joins in the filing of a consolidated federal income tax return with its affiliated companies. The method of tax allocation reflects the benefits and burdens realized by each company's participation in the consolidated tax return, approximating a separate return result for each company. In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $61 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $61 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $426 million and deferred tax liabilities of $1.531 billion at December 31, 1993 and deferred tax assets of $415 million and deferred tax liabilities of $1.807 billion at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $197 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $69 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $94 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN Prior to December 31, 1993, the Company and Service Company jointly sponsored a noncontributing pension plan which covered all employee groups. The plan was merged with another plan which covered the employees of Toledo Edison into a single plan on December 31, 1993. The amount of retirement benefits generally depends (Cleveland Electric) (Cleveland Electric) upon the length of service. Under certain circumstances, benefits can begin as early as age 55. The funding policy is to comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, the Company and Service Company offered the VTP, an early retirement program. Operating expenses for both companies for 1993 included $146 million of pension plan accruals to cover enhanced VTP benefits and an additional $7 million of pension costs for VTP benefits paid to retirees from corporate funds. The $7 million is not included in the pension data reported below. A credit of $66 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs (credits) for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the former plan of the Company and Service Company at December 31, 1992 with comparable information for a portion of the merged plan at December 31, 1993. The December 31, 1993 benefit obligation estimates were derived from information for the former plans. Plan assets of the merged plan were allocated based on a pro rata share of the projected benefit obligation. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (B) OTHER POSTRETIREMENT BENEFITS Centerior Energy sponsors jointly with its subsidiaries a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. The Company adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs for the Company totaled $5 million in 1992 and $6 million in 1991, which included medical benefits of $4 million in 1992 and $5 million in 1991. The total amount accrued by the Company for SFAS 106 costs for 1993 was $69 million, of which $4 million was capitalized and $65 million was expensed as other operation and maintenance expenses. In 1993, the Company deferred incremental SFAS 106 expenses totaling $60 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: These amounts included costs for the Company and a pro rata share of the Service Company's costs. The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 (Cleveland Electric) (Cleveland Electric) for the Company and its share of the Service Company's obligation are summarized as follows: The Balance Sheet classification of Other Noncurrent Liabilities at December 31, 1993 includes only the Company's accrued postretirement benefit cost of $52 million and excludes the Service Company's portion since the Service Company's total accrued cost is carried on its books. At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $7 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $0.5 million. (C) POSTEMPLOYMENT BENEFITS In 1993, the Company adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect the Company's 1993 results of operations or financial position. (10) Guarantees The Company has guaranteed certain loan and lease obligations of two mining companies under two long-term coal purchase arrangements. One of these arrangements requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining companies' loan and lease obligations guaranteed by the Company was $60 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Preferred stock shares sold and retired during the three years ended December 31, 1993 are listed in the following table. (B) EQUITY DISTRIBUTION RESTRICTIONS Federal law prohibits the Company from paying dividends out of capital accounts. However, the Company may pay preferred and common stock dividends out of appropriated retained earnings and current earnings. At December 31, 1993, the Company had $125 million of appropriated retained earnings for the payment of preferred and common stock dividends. (C) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $29 million in 1994, $40 million in 1995, $30 million in both 1996 and 1997 and $15 million in 1998. The annual preferred stock mandatory redemption provisions are as follows: * All outstanding shares to be redeemed on December 1, 2001. In June 1993, the Company issued $100 million principal amount of Serial Preferred Stock, $42.40 Series T. The Series T stock was deposited with an agent which issued (Cleveland Electric) (Cleveland Electric) Depositary Receipts, each representing 1/20 of a share of the Series T stock. The annualized preferred dividend requirement at December 31, 1993 was $47 million. The preferred dividend rates on the Company's Series L and M fluctuate based on prevailing interest rates and market conditions. The dividend rates for both issues averaged 7% in 1993. The Company's Series P had a 6.5% dividend rate in 1993 until it was redeemed in August 1993. Preference stock authorized for the Company is 3,000,000 shares without par value. No preference shares are currently outstanding. With respect to dividend and liquidation rights, the Company's preferred stock is prior to its preference stock and common stock, and its preference stock is prior to its common stock. (D) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, was as follows: Long-term debt matures during the next five years as follows: $42 million in 1994, $246 million in 1995, $151 million in 1996, $55 million in 1997 and $78 million in 1998. The Company issued $275 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The Company's mortgage constitutes a direct first lien on substantially all property owned and franchises held by the Company. Excluded from the lien, among other things, are cash, securities, accounts receivable, fuel and supplies. An unsecured loan agreement of the Company contains covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting the Company, Toledo Edison and Centerior Energy. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused the Company, Toledo Edison and Centerior Energy to violate certain covenants contained in the loan agreement and the two reimbursement agreements. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Toledo Edison and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $47 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Toledo Edison. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Company and Toledo Edison. Centerior Energy plans to transfer any of its borrowed funds to the Company and Toledo Edison, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed (Cleveland Electric) (Cleveland Electric) below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios for the Company, Toledo Edison and Centerior Energy. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $300 million for the Company. The Company and Toledo Edison are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Company had no commercial paper outstanding. The Company is unable to rely on the sale of commercial paper to provide short-term funds because of its below investment grade commercial paper credit ratings. (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Company's preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $46 million as a result of the recording of $71 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $351 million write-off of Perry Unit 2 (see Note 4(b)), the $636 million write-off of the phase-in deferrals (see Note 7) and $38 million of other charges. These adjustments decreased quarterly earnings by $716 million. Earnings for the quarter ended September 30, 1992 were increased by $26 million as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $39 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (15) Pending Merger of the Company with Toledo Edison On March 25, 1994, Centerior Energy announced that its operating utility subsidiaries, the Company and Toledo Edison, plan to merge into a single operating entity. Since the Company and Toledo Edison affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO and other regulatory authorities. The merger must be approved by share owners of Toledo Edison's preferred stock. Share owners of the Company's preferred stock must approve the authorization of additional shares of preferred stock. Share owners of Toledo Edison's preferred stock will exchange their shares for preferred stock shares of the successor corporation having substantially the same terms, while the (Cleveland Electric) (Cleveland Electric) Company's preferred stock will automatically become shares of the successor corporation. Debt holders of the merging companies will become debt holders of the successor corporation. The merging companies plan to seek preferred stock share owner approval in the summer of 1994. The merger is expected to be effective in late 1994. For the merging companies, the combined pro forma operating revenues were $2.475 billion, $2.439 billion and $2.561 billion and the combined pro forma net income (loss) was $(876) million, $276 million and $296 million for the years ended December 31, 1993, 1992 and 1991, respectively. The pro forma data is based on accounting for the merger on a method similar to a pooling of interests. The pro forma data is not necessarily indicative of the results of operations which would have been reported had the merger been in effect during those years or which may be reported in the future. The pro forma data should be read in conjunction with the audited financial statements of both the Company and Toledo Edison. (Cleveland Electric) (Cleveland Electric) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) Operating Expenses (millions of dollars) Income (Loss) (millions of dollars) Income (Loss) (millions of dollars) (a) Includes early retirement program expenses and other charges of $165 million in 1993. (b) Includes write-off of phase-in deferrals of $636 million in 1993, consisting of $117 million of deferred operating expenses and $519 million of deferred carrying charges. (c) In 1991, a change in accounting for nuclear plant depreciation was adopted, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Cleveland Electric) (Cleveland Electric) THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES (d) Includes write-off of Perry Unit 2 of $351 million in 1993. (e) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Cleveland Electric) (Cleveland Electric) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - ---------------------------------------------------------------------- To the Share Owners of The Toledo [Logo] Edison Company: We have audited the accompanying balance sheet and statement of preferred stock of The Toledo Edison Company (a wholly owned subsidiary of Centerior Energy Corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Toledo Edison Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules of The Toledo Edison Company listed in the Index to Schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cleveland, Ohio February 14, 1994 (except with respect to the matter discussed in Note 15, as to which the date is March 25, 1994) (Toledo Edison) (Toledo Edison) MANAGEMENT'S FINANCIAL ANALYSIS - -------------------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 3.1% increase in 1993 operating revenues for The Toledo Edison Company (Company) are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $17 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential and commercial kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northwestern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. Residential and commercial sales increased 5.1% and 3.2%, respectively, in 1993. Industrial sales increased 6% as a result of increased sales to large automotive manufacturers, petroleum refiners and the broad-based, smaller industrial customer group. Other sales decreased 18.4% because of fewer sales to wholesale customers. Generating plant outages and retail customer demand limited power availability for bulk power transactions. As a result, total sales decreased 2.2% in 1993. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. The net increase in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors increased about 2%. Operating expenses increased 12.6% in 1993. The increase in total operation and maintenance expenses resulted from the $88 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $19 million and a slight increase in other operation and maintenance expenses. The VTP benefit expenses consisted of $75 million of costs for the Company plus $13 million for the Company's pro rata share of the costs for its affiliate, Centerior Service Company (Service Company). Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $232 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.8% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $22 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. Total kilowatt-hour sales increased 0.2% in 1992. Residential and commercial sales decreased 4.9% and 3.8%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales increased 0.6% as increased sales to glass and metal manufacturers and to the broad-based, smaller industrial customer group offset lower sales to petroleum refining and auto manufacturing customers. Other sales increased 5.2% because of increased sales to wholesale customers. Operating revenues in 1991 included the recognition of $24 million of deferred revenues over the period of a refund to customers under a provision of a January 1989 rate order. No such revenues were reflected in 1992 as the refund period ended in December 1991. Operating expenses decreased 4.4% in 1992. A reduction of $14 million in other operation and maintenance expenses resulted primarily from cost-cutting measures. Lower fuel and purchased power expense resulted from less amortization of previously deferred fuel costs than the amount amortized in 1991. These decreases were par- tially offset by higher depreciation and amortization, caused primarily by the adoption of the new accounting (Toledo Edison) (Toledo Edison) standard for income taxes (SFAS 109) in 1992, and by higher taxes, other than federal income taxes, caused by increased Ohio property taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program discussed in Note 7. The federal income tax provision for nonoperating income decreased because of a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income increased primarily because of Rate Stabilization Program carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, Centerior Energy Corporation (Centerior Energy), along with the Company and The Cleveland Electric Illuminating Company (Cleveland Electric), announced a comprehensive strategic action plan to strengthen their financial and competitive positions. The Company and Cleveland Electric are the two wholly owned electric utility subsidiaries of Centerior Energy. The plan established specific objectives and was designed to guide Centerior Energy and its subsidiaries through the year 2001. Several actions were taken at that time. Centerior Energy reduced its quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. The Company and Cleveland Electric also wrote off their investments in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs for the Company was $332 million which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. The Company also recognized other one-time charges totaling $15 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $36 million after taxes representing a portion of the VTP costs. The Company will realize approximately $20 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of the strategic plan are to maximize share owner return on Centerior Energy common stock from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, the Company will continue controlling its operation and maintenance expenses and capital expenditures, reduce its outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of its plants and take other appropriate actions. COMMON STOCK DIVIDENDS In recent years, the Company has retained all of its earnings available for common stock. The Company has not paid a common stock dividend to Centerior Energy since February 1991. Because the Company is currently prohibited from paying a common stock dividend by a provision in its mortgage (see Note 11(b)), the Company does not expect to pay any common stock dividends in the foreseeable future. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are a number of rural and municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. We have entered into contracts with many of our (Toledo Edison) (Toledo Edison) large industrial and commercial customers which have remaining terms of one to five years. We will attempt to renew those contracts as they expire which will help us compete if retail wheeling is permitted in the future. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS The Company's three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(f). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Company is aware of its potential involvement in the cleanup of several sites. Although these sites are not on the Superfund National Priorities List, they are generally being administered by various governmental entities in the same manner as they would be administered if they were on such list. The allegations that the Company disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all "potentially responsible parties" (PRPs) to a particular site can be held liable on a joint and several basis. Consequently, if the Company were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $150 million. However, we believe that the actual cleanup costs will be substantially lower than $150 million, that the Company's share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Company has accrued a liability totaling $6 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing pro- (Toledo Edison) (Toledo Edison) gram of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $440 million. In addition, we exercised various options to redeem approximately $490 million of our securities. We raised $815 million through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Company also utilized its short-term borrowing arrangements to help meet its cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for the Company are $249 million for its construction program and $324 million for the mandatory redemption of debt and preferred stock. The Company expects to finance internally all of its 1994 cash requirements of approximately $109 million. About 15% of the Company's 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions, which will help improve the Company's capitalization structure and interest coverage ratios. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $41 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Company under its mortgage on the basis of property additions, cash or refundable first mortgage bonds. Under its mortgage, the Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, the Company would have been permitted to issue approximately $323 million of additional first mortgage bonds. As discussed in Note 11(d), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused the Company, Cleveland Electric and Centerior Energy to violate certain of those covenants. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Cleveland Electric and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $172 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Cleveland Electric. For the next five years, the Company does not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, we believe that the Company could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Company also is able to raise funds through the sale of preference stock. The Company will be unable to issue preferred stock until it can meet the interest and preferred dividend coverage test in its articles of incorporation. The Company currently cannot sell commercial paper because of its low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. The Company is a party to a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused the Company, Cleveland Electric and Centerior Energy to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Company's needs over the next several years. The availability and cost of capital to meet the Company's external financing needs, however, also depend upon such factors as financial market conditions and its credit ratings. Current credit ratings for the Company are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Company. (Toledo Edison) (Toledo Edison) INCOME STATEMENT THE TOLEDO EDISON COMPANY - ---------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Toledo Edison) (Toledo Edison) CASH FLOWS THE TOLEDO EDISON COMPANY - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) [THIS PAGE INTENTIONALLY LEFT BLANK] BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) The Toledo Edison Company (Toledo Edison) (Toledo Edison) STATEMENT OF PREFERRED STOCK THE TOLEDO EDISON COMPANY - -------------------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) NOTES TO THE FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL The Company is an electric utility and a wholly owned subsidiary of Centerior Energy. Centerior Energy has two other wholly owned subsidiaries, Cleveland Electric and the Service Company. The Company follows the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by The Public Utilities Commission of Ohio (PUCO). As a rate-regulated utility, the Company is subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The Company is a member of the Central Area Power Coordination Group (CAPCO). Other members are Cleveland Electric, Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) RELATED PARTY TRANSACTIONS Operating revenues, operating expenses and interest charges include those amounts for transactions with affiliated companies in the ordinary course of business operations. The Company's transactions with Cleveland Electric are primarily for firm power, interchange power, transmission line rentals and jointly owned power plant operations and construction. See Notes 2 and 3. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to the Company and other affiliated companies. The Service Company billed the Company $76 million, $60 million and $61 million in 1993, 1992 and 1991, respectively, for such services. (C) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO or on ordinances of individual municipalities. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (D) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Company defers the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Company has accrued a liability for its share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Company to recover the assessments through its fuel cost factors. (E) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Company to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $7 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Company deferred certain operating expenses and both interest and equity carrying charges pursuant to a PUCO-approved rate phase-in plan for its investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Company also defers certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (F) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depreciable utility plant in service was 3.6% in both 1993 and 1992 and 3.4% in 1991. Effective January 1, 1991, the Company, after obtaining PUCO approval, changed its method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $14 million and increased 1991 net (Toledo Edison) (Toledo Edison) income $11 million (net of $3 million of income taxes) from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Company currently uses external funding for the future decommissioning of its nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $4 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Company's share of the future decommissioning costs are $41 million in 1992 dollars for Beaver Valley Unit 2 and $87 million and $146 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Company used these estimates to increase its decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $34 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (G) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rate was 10.22% in 1993 and 10.96% in both 1992 and 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (H) DEFERRED GAIN AND LOSS FROM SALES OF UTILITY PLANT The sale and leaseback transactions discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant) and a net loss for the sale of Beaver Valley Unit 2. The net gain and net loss were deferred and are being amortized over the terms of leases. These amortizations and the lease expense amounts are recorded as other operation and maintenance expenses. (I) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (J) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (Toledo Edison) (Toledo Edison) (2) Utility Plant Sale and Leaseback Transactions The Company and Cleveland Electric are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Company and Cleveland Electric are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Company and Cleveland Electric have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(d). As co-lessee with Cleveland Electric, the Company is also obligated for Cleveland Electric's lease payments. If Cleveland Electric is unable to make its payments under the Mansfield Plant leases, the Company would be obligated to make such payments. No payments have been made on behalf of Cleveland Electric to date. In April 1992, nearly all of the outstanding Secured Lease Obligation Bonds (SLOBs) issued by a special purpose corporation in connection with financing the sale and leaseback of Beaver Valley Unit 2 were refinanced through a tender offer and the sale of new bonds having a lower interest rate. As part of the refinancing transaction, the Company paid $43 million as supplemental rent to fund transaction expenses and part of the tender premium. This amount has been deferred and is being amortized over the remaining lease term. The refinancing transaction reduced the annual rental expense for the Beaver Valley Unit 2 lease by $9 million. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $45 million. The amounts recorded in 1993, 1992 and 1991 as annual rental expense for the Beaver Valley Unit 2 lease were $63 million, $66 million and $72 million, respectively. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. The Company is selling 150 megawatts of its Beaver Valley Unit 2 leased capacity entitlement to Cleveland Electric. We anticipate that this sale will continue indefinitely. Revenues recorded for this transaction were $103 million, $108 million and $107 million in 1993, 1992 and 1991, respectively. The future minimum lease payments through the year 2017 associated with Beaver Valley Unit 2 aggregate $1.47 billion. (3) Property Owned with Other Utilities and Investors The Company owns, as a tenant in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Company's share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Company as a tenant in common with other utilities and Lessors: (Toledo Edison) (Toledo Edison) (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of the Company's construction program for the 1994-1998 period is $259 million, including AFUDC of $10 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $57 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses may be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be less than 2% over the ten-year period. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $232 million ($167 million after taxes) for the Company's 19.91% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Company is aware of its potential involvement in the cleanup of several hazardous waste disposal sites. The Company has accrued a liability totaling $6 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS The Company's three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), the Company's maximum potential assessment under that plan would be $70 million (plus any inflation adjustment) per incident. The assessment is limited to $9 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, the Company's share of such excess amount could have a material adverse effect on its financial condition and results of operations. Under these policies, the Company can be assessed a maximum of $11 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. The Company also has extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (Toledo Edison) (Toledo Edison) (6) Nuclear Fuel Nuclear fuel is financed for the Company and Cleveland Electric through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $154 million of nuclear fuel was financed for the Company. The Company and Cleveland Electric severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments for the Company of $52 million, $29 million and $20 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $6 million in both 1993 and 1992 and $9 million in 1991. The estimated future lease amortization payments based on projected consumption are $49 million in 1994, $42 million in 1995, $37 million in 1996, $33 million in 1997 and $30 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plan approved by the PUCO in a January 1989 rate order for the Company. The phase-in plan was designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plan required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Company's deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plan. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 by the Company were $55 million and $186 million, respectively (totaling $165 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in the Company's service area by freezing the Company's base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $89 million over the 1996-1998 period. As part of the Rate Stabilization Program, the Company is allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988 and the deferral of operating expenses equivalent to an accumulated excess rent reserve for Beaver Valley Unit 2 (which resulted from the April 1992 refinancing of SLOBs as discussed in Note 2). The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $39 million and $32 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets and the remaining lease period, or approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $18 million and $5 million, respectively. The Rate Stabilization Program also authorized the Company to defer and subsequently recover the incremental expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $37 million pursuant to this provision. Amortization and recovery of this (Toledo Edison) (Toledo Edison) deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying income before taxes by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: The Company joins in the filing of a consolidated federal income tax return with its affiliated companies. The method of tax allocation reflects the benefits and burdens realized by each company's participation in the consolidated tax return, approximating a separate return result for each company. In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $29 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $29 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $178 million and deferred tax liabilities of $649 million at December 31, 1993 and deferred tax assets of $154 million and deferred tax liabilities of $794 million at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $111 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $39 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $77 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN Prior to December 31, 1993, the Company sponsored a noncontributory pension plan which covered all employee groups. The plan was merged with another plan which covered employees of Cleveland Electric and the Service Company into a single plan on December 31, 1993. The amount of retirement benefits generally depends upon the length of service. Under certain circumstances, benefits can begin as early as age 55. The funding policy is to (Toledo Edison) (Toledo Edison) comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, the Company offered the VTP, an early retirement program. Operating expenses for 1993 included $59 million of pension plan accruals to cover enhanced VTP benefits and an additional $3 million of pension costs for VTP benefits paid to retirees from corporate funds. The $3 million is not included in the pension data reported below. A credit of $15 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the Company's former plan at December 31, 1992 with comparable information for a portion of the merged plan at December 31, 1993. The December 31, 1993 benefit obligation estimates were derived from information for the former plans. Plan assets of the merged plan were allocated based on a pro rata share of the projected benefit obligation. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (B) OTHER POSTRETIREMENT BENEFITS Centerior Energy sponsors jointly with its subsidiaries a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. The Company adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs for the Company totaled $4 million in both 1992 and 1991, which included medical benefits of $3 million in both years. The total amount accrued by the Company for SFAS 106 costs for 1993 was $42 million, of which $1 million was capitalized and $41 million was expensed as other operation and maintenance expenses. In 1993, the Company deferred incremental SFAS 106 expenses totaling $37 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: These amounts included costs for the Company and a pro rata share of the Service Company's costs. The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 (Toledo Edison) (Toledo Edison) for the Company and its share of the Service Company's obligation are summarized as follows: The Balance Sheet classification of Other Noncurrent Liabilities at December 31, 1993 includes only the Company's accrued postretirement benefit cost of $33 million and excludes the Service Company's portion since the Service Company's total accrued cost is carried on its books. At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $4 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $0.3 million. (C) POSTEMPLOYMENT BENEFITS In 1993, the Company adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect the Company's 1993 results of operations or financial position. (10) Guarantees The Company has guaranteed certain loan and lease obligations of a mining company under a long-term coal purchase arrangement. This arrangement requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining company's loan and lease obligations guaranteed by the Company was $20 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Preferred stock shares retired during the three years ended December 31, 1993 are listed in the following table. (B) EQUITY DISTRIBUTION RESTRICTIONS Federal law prohibits the Company from paying dividends out of capital accounts. However, the Company may pay dividends out of appropriated retained earnings and current earnings. At December 31, 1993, the Company had $42 million of appropriated retained earnings for the payment of preferred stock dividends. The Company is currently prohibited from paying a common stock dividend by a provision in its mortgage. (C) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $12 million in each year 1994 through 1996 and $2 million in both 1997 and 1998. The annual preferred stock mandatory redemption provisions are as follows: The annualized preferred dividend requirement at December 31, 1993 was $21 million. The preferred dividend rates on the Company's Series A and B fluctuate based on prevailing interest rates and market conditions. The dividend rates for these issues averaged 7.41% and 8.22%, respectively, in 1993. Preference stock authorized for the Company is 5,000,000 shares with a $25 par value. No preference shares are currently outstanding. With respect to dividend and liquidation rights, the Company's preferred stock is prior to its preference stock and common stock, and its preference stock is prior to its common stock. (Toledo Edison) (Toledo Edison) (D) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, was as follows: Long-term debt matures during the next five years as follows: $45 million in 1994, $71 million in 1995, $91 million in 1996 and $39 million in both 1997 and 1998. The Company issued $275 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The Company's mortgage constitutes a direct first lien on substantially all property owned and franchises held by the Company. Excluded from the lien, among other things, are cash, securities, accounts receivable, fuel, supplies and automotive equipment. Certain unsecured loan agreements of the Company contain covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting the Company, Cleveland Electric and Centerior Energy. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused the Company, Cleveland Electric and Centerior Energy to violate certain covenants contained in the two reimbursement agreements. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Cleveland Electric and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $172 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Cleveland Electric. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Company and Cleveland Electric. Centerior Energy plans to transfer any of its borrowed funds to the Company and Cleveland Electric, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios for the Company, Cleveland Electric and Centerior Energy. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $150 million for the Company. The Company and Cleveland Electric are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Company had no commercial paper outstanding. The Company is unable to rely on the sale of commercial paper to provide short-term funds because of its below investment grade commercial paper credit ratings. (Toledo Edison) (Toledo Edison) (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Company's preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $35 million as a result of the recording of $54 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $232 million write-off of Perry Unit 2 (see Note 4(b)), the $241 million write-off of the phase-in deferrals (see Note 7) and $19 million of other charges. These adjustments decreased quarterly earnings by $345 million. Earnings for the quarter ended September 30, 1992 were increased by $15 million as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $22 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (15) Pending Merger of the Company with Cleveland Electric On March 25, 1994, Centerior Energy announced that its operating utility subsidiaries, the Company and Cleveland Electric, plan to merge into a single operating entity. Since the Company and Cleveland Electric affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO and other regulatory authorities. The merger must be approved by share owners of the Company's preferred stock. Share owners of Cleveland Electric's preferred stock must approve the authorization of additional shares of preferred stock. Share owners of the Company's preferred stock will exchange their shares for preferred stock shares of the successor corporation having substantially the same terms, while Cleveland Electric's preferred stock will automatically become shares of the successor corporation. Debt holders of the merging companies will become debt holders of the successor corporation. The merging companies plan to seek preferred stock share owner approval in the summer of 1994. The merger is expected to be effective in late 1994. For the merging companies, the combined pro forma operating revenues were $2.475 billion, $2.439 billion and $2.561 billion and the combined pro forma net income (loss) was $(876) million, $276 million and $296 million for the years ended December 31, 1993, 1992 and 1991, respectively. The pro forma data is based on accounting for the merger on a method similar to a pooling of interests. The pro forma data is not necessarily indicative of the results of operations which would have been reported had the merger been in effect during those years or which may be reported in the future. The pro forma data should be read in conjunction with the audited financial statements of both the Company and Cleveland Electric. (Toledo Edison) (Toledo Edison) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) - -------------------------------------------------------------------------------- Operating Expenses (millions of dollars) - -------------------------------------------------------------------------------- Income (Loss) (millions of dollars) - -------------------------------------------------------------------------------- Income (Loss) (millions of dollars) - -------------------------------------------------------------------------------- (a) Includes early retirement program expenses and other charges of $107 million in 1993. (b) Includes write-off of phase-in deferrals of $241 million in 1993, consisting of $55 million of deferred operating expenses and $186 million of deferred carrying charges. (c) In 1991, a change in accounting for nuclear plant depreciation was adopted, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Toledo Edison) (Toledo Edison) The Toledo Edison Company - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Investment (millions of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (d) Includes write-off of Perry Unit 2 of $232 million in 1993. (e) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Toledo Edison) (Toledo Edison) S-1 S-2 S-3 S-4 S-5 S-6 S-7 S-8 S-9 S-10 S-11 S-12 S-13 S-14 S-15 S-16 S-17 S-18 S-19 S-20 S-21 S-22 S-23 S-24 S-25 S-26 S-27 S-28 S-29 S-30 S-31 THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES AND THE TOLEDO EDISON COMPANY COMBINED PRO FORMA CONDENSED FINANCIAL STATEMENTS The following pro forma condensed balance sheets and income statements give effect to the agreement between Cleveland Electric and Toledo Edison to merge Toledo Edison into Cleveland Electric. These statements are unaudited and based on accounting for the merger on a method similar to a pooling of interests. These statements combine the two companies' historical balance sheets at December 31, 1993 and December 31, 1992 and their historical income statements for each of the three years ended December 31, 1993. The following pro forma data is not necessarily indicative of the results of operations or the financial condition which would have been reported had the merger been in effect during those periods or which may be reported in the future. The statements should be read in conjunction with the accompanying notes and with the audited financial statements of both Cleveland Electric and Toledo Edison. P-1 P-2 COMBINED PRO FORMA CONDENSED INCOME STATEMENTS OF CLEVELAND ELECTRIC AND TOLEDO EDISON (Unaudited) (Millions of Dollars) P-3 NOTES TO COMBINED PRO FORMA CONDENSED BALANCE SHEETS AND INCOME STATEMENTS (Unaudited) The Pro Forma Financial Statements include the following adjustments: (A) Elimination of intercompany accounts and notes receivable and accounts and notes payable. (B) Reclassification of prepaid pension costs or pension liabilities. (C) Elimination of intercompany operating revenues and operating expenses. (D) Elimination of intercompany working capital transactions. (E) Elimination of intercompany interest income and interest expense. (R) Rounding adjustments. P-4 EXHIBIT INDEX The exhibits designated with an asterisk (*) are filed herewith. The exhibits not so designated have previously been filed with the SEC in the file indi- cated in parenthesis following the description of such exhibits and are in- corporated herein by reference. An exhibit designated with a pound sign (#) is a management contract or compensatory plan or arrangement. COMMON EXHIBITS (The following documents are exhibits to the reports of Centerior Energy, Cleveland Electric and Toledo Edison.) E-1 E-2 E-3 E-4 E-5 E-6 E-7 E-8 E-9 E-10 Pursuant to Paragraph (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Regis- trants have not filed as an exhibit to this Form 10-K any instrument with respect to long-term debt if the total amount of securities authorized there- under does not exceed 10% of the total assets of the applicable Registrant and its subsidiaries on a consolidated basis, but each hereby agrees to furnish to the Securities and Exchange Commission on request any such instruments. Pursuant to Rule 14a-3(b)(10) under the Securities Exchange Act of 1934, copies of exhibits filed by the Registrants with this Form 10-K will be fur- nished by the Registrants to share owners upon written request and upon re- ceipt in advance of the aggregate fee for preparation of such exhibits at a rate of $.25 per page, plus any postage or shipping expenses which would be incurred by the Registrants. E-11

821026_1993.txt

821026

1993

Item 1. Business The Andersons Management Corp. (The "Corporation") was formed in August 1987, principally for the purpose of providing management services to The Andersons, a partnership (the "Partnership") and to act as the Partnership's sole General Partner. The Corporation began operations in 1988 when it completed an offering of its Class A and Class B Common Shares, transferred $500,000 of offering proceeds to the Partnership as its capital investment, and became the sole General Partner of the Partnership. Ownership of the Corporation's Class A and Class B Common Shares is restricted to limited partners of The Andersons. The Corporation provides all management services to the Partnership pursuant to a Management Agreement entered into between the Partnership and the Corporation. The fee paid to the Corporation for its services is an amount equal to (a) the salaries and cost of all employee benefits, and other normal employee costs, paid or accrued on behalf of the Corporation's employees who furnish services to the Partnership, (b) reimbursable expenses incurred by the Corporation in connection with its services to the Partnership, or on the Partnership's behalf, and (c) an amount equal to $5,000 for each 1% of return on partners' capital up to a 15% annual return on partners' capital, plus $7,500 for each 1% of return on partners' capital between 15% and 25%, plus $10,000 for each 1% of return on partners' capital greater than a 25% annual return to cover that part of the Corporation's general overhead which is attributable to Partnership services and to provide an element of profit to the Corporation. In addition to the fee payable to the Corporation, the Management Agreement also provides for certain other customary terms and conditions, including termination rights, and requires the Corporation to make its books and records available to the Partnership for inspection at reasonable times. Business and Properties of the Partnership The Partnership is engaged in grain merchandising and operates grain elevator facilities located in Ohio, Michigan, Indiana and Illinois. The Partnership is also engaged in the distribution of agricultural supplies such as fertilizers, seeds and farm supplies; the operation of retail general stores; the production, distribution and marketing of lawn care products and corncob products and repairing and leasing of rail cars. For more complete information as to the Partnership's business and properties, and other information regarding the Partnership's operations, reference is made to the Partnership's Form 10-K for the year ended December 31, 1993 (the "Partnership Form 10-K"), which is filed as an exhibit hereto through incorporation by reference. Item 2.

Item 2. Properties The Corporation leases an office building located in Maumee, Ohio under a net lease expiring in 2000. The Corporation subleases approximately 80% of the building to the Partnership. See "Item 13. Certain Relationships and Related Transactions." Item 3.

Item 3. Legal Proceedings None. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters (a) Because of ownership and transferability restrictions, there is no market for the Class A and Class B Common Shares. (b) As of March 1, 1994, there were 180 holders of Class A Common Shares and 177 holders of Class B Common Shares. (c) The Corporation does not intend to pay cash dividends in the foreseeable future. Item 6.

Item 6. Selected Financial Data Year Ended December 31 1993 1992 1991 1990 1989 Management Fees $63,107,331 $57,388,268 $55,357,599 $51,581,824 $46,575,914 Net income 146,399 9,083 24,680 46,473 3,586 Net income per Class A Share 31.66 1.96 5.38 9.91 .75 Weighted average number of Class A Common Shares outstanding 4,624 4,633 4,591 4,691 4,760 As of December 31 1993 1992 1991 1990 1989 Total assets $11,432,203 $ 8,841,177 $ 8,579,945 $ 7,783,120 $ 7,185,424 Shareholders' equity 1,606,724 1,472,881 1,444,973 1,448,127 1,424,891 Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources The Corporation had cash and cash equivalents and short-term investments of approximately $1.3 million at December 31, 1993 and 1992. The largest component of the Corporation's working capital was a receivable from the Partnership. This receivable represents the costs incurred by the Corporation in providing management and labor services to the Partnership but not yet paid by the Corporation and therefore not yet collected from the Partnership. The Corporation has no short-term or long-term debt. During 1993, the Corporation offered Class A and Class B Common Shares and received $11,141 under that offering. Class A and Class B Common Shares redeemed during 1993 totalled $23,697. Management believes, given the relationship between the Corporation and the Partnership whereby the Corporation is reimbursed by the Partnership for its cost in providing management and labor services to the Partnership, and given the Corporation's cash and cash equivalents and short-term investment of $1.3 million, that the Corporation's liquidity is adequate to meet both short-term and long-term needs. Results of Operations Years ended December 31, 1993 and 1992: Net income in 1993 was $146,399, or $31.66 per Class A Common Share, compared to $9,083, or $1.96 per share in 1992. Income earned by the Corporation on its investment in the Partnership was up $51,398 in 1993 and the management fee earned by the Corporation based on the Partnership's return on equity and rent and other reimbursable expenses was up $175,185. These increases are a result of the improved 1993 operating results of the Partnership and an increase in reimbursable expenses. Federal income tax expense was up due to the increase in income. During 1993 the Corporation adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Corporation elected to recognize the accrued benefits earned by employees as of January 1, 1993 (transition obligation) prospectively, which means this cost will be recognized as a component of the net periodic postretirement benefit cost over a period of approximately 20 years. The effect of adopting the new rules increased the 1993 net periodic postretiement benefit cost by approximately $850,000 and is expected to increase future postretirement benefit costs by a like amount. This cost was included in the management fee charged to the Partnership in 1993 and, therefore, had no impact on the operating results of the Corporation. Also during 1993, as a result of lower prevailing interest rates, the Corporation decreased the discount rate used to determine its projected benefit obligation for its pension plan and for its postretirment health care benefits. The change in the discount rate, from 8% to 7.5%, is expected to increase these benefit costs in future years by approximately $365,000. Because the Corporation charges all employee benefit costs to the Partnership as part of the management fee, the change in the discount rate will not impact the future operating results of the Corporation. Years ended December 31, 1992 and 1991: Net income in 1992 was $9,083, or $1.96 per Class A Common Share, compared to $24,680, or $5.38 per share in 1991. Income earned by the Corporation on its investment in the Partnership was up $59,498 in 1992 and the management fee earned by the Corporation based on the Partnership's return on equity and rent and other reimbursable expenses was also up, both due to the improved 1992 operating results of the Partnership. Interest earned and other income decreased by $132,549, due to a 50% decrease in rental income and due to lower interest rates. The rental income decrease was a result of lower occupancy of outside tenants in the office building leased by the Corporation to the Partnership and to outside tenants. Item 8.

Item 8. Financial Statements and Supplementary Data Report of Independent Auditors Shareholders The Andersons Management Corp. We have audited the accompanying balance sheets of The Andersons Management Corp. as of December 31, 1993 and 1992, and the related statements of income, cash flows, and changes in shareholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at Item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Andersons Management Corp. at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 3 to the financial statements, in 1993 the Corporation changed its method of accounting for postretirement benefits. /s/Ernst & Young ERNST & YOUNG Toledo, Ohio February 7, 1994 The Andersons Management Corp. Statements of Income Year ended December 31 1993 1992 1991 Management fees (Note 2) $63,107,331 $57,388,268 $55,357,599 Equity in income of The Andersons 145,526 94,128 34,630 Interest earned and other income 175,925 175,947 308,496 63,428,782 57,658,343 55,700,725 Costs and expenses: Salaries, wages and benefits 62,326,184 56,782,306 54,833,991 Rent expense 731,209 726,028 715,777 General expenses 153,590 139,926 124,377 63,210,983 57,648,260 55,674,145 Income before income taxes 217,799 10,083 26,580 Federal income taxes: Current 68,500 3,800 3,700 Deferred (credit) 2,900 (2,800) (1,800) 71,400 1,000 1,900 Net income $ 146,399 $ 9,083 $ 24,680 Net income per weighted average Class A Common Share $31.66 $1.96 $5.38 Weighted average number of Class A shares outstanding 4,624 4,633 4,591 See accompanying notes. The Andersons Management Corp. Balance Sheets December 31 1993 1992 Assets Current assets: Cash and cash equivalents $ 795,379 $ 223,567 Short-term investments at cost 505,313 1,041,147 Receivable from The Andersons (Note 2) 4,173,287 2,669,529 Note and accounts receivable 3,026 51,867 Prepaid expenses (Note 3) 2,723,668 2,467,869 Total current assets 8,200,673 6,453,979 Receivable from The Andersons (Note 2) 2,413,041 1,756,451 Investment in The Andersons (Note 2) 761,839 622,659 Other 56,650 8,088 $11,432,203 $ 8,841,177 Liabilities and shareholders' equity Current liabilities: Accounts payable $ 1,149,232 $ 1,526,941 Accrued compensation and benefits 6,263,206 4,084,904 Total current liabilities 7,412,438 5,611,845 Postretirement benefits (Note 3) 2,413,041 1,756,451 Shareholders' equity: Common Shares, without par value (Note 4): Class A non-voting: Authorized--25,000 shares Issued-- 4,855 shares at stated value 1,456,405 1,456,405 Class B voting: Authorized--25,000 shares Issued--4,681 shares at stated value 4,681 4,681 Retained earnings 219,090 72,691 1,680,176 1,533,777 Less common shares in treasury, at cost--(242 and 202 Class A shares and 147 and 325 Class B shares in 1993 and 1992, respectively) (73,452) (60,896) 1,606,724 1,472,881 $11,432,203 $ 8,841,177 See accompanying notes. The Andersons Management Corp. Statements of Cash Flows Year ended December 31 1993 1992 1991 Operating activities Net income $ 146,399 $ 9,083 $ 24,680 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Amortization 264 11,145 11,145 Provision for deferred income tax (credits) 2,900 (2,800) (1,800) Equity in earnings of The Andersons in excess of cash received (Note 2) (139,180) (91,337) 15,131 Changes in operating assets and liabilities: Note and accounts receivable 45,941 52,527 9,780 Receivable from The Andersons (Note 2) (2,160,348) 732,588 (616,754) Prepaid and other assets (304,625) (841,184) (308,009) Accounts payable and accrued expenses 2,457,183 233,324 799,979 Net cash provided by (used in) operating activities 48,534 103,346 (65,848) Investing activities Sales and maturities of short-term investments 1,041,147 - - Purchases of short-term investments (505,313) (14,116) (26,661) Net cash provided by (used in) investing activities 535,834 (14,116) (26,661) Financing activities Sale of Common Shares from treasury 11,141 46,671 5,369 Purchase of Common Shares for treasury (23,697) (27,846) (33,203) Net cash provided by (used in) financing activities (12,556) 18,825 (27,834) Increase (decrease) in cash and cash equivalents 571,812 108,055 (120,343) Cash and cash equivalents at beginning of year 223,567 115,512 235,855 Cash and cash equivalents at end of year $ 795,379 $ 223,567 $ 115,512 See accompanying notes. The Andersons Management Corp. Statements of Changes in Shareholders' Equity Common Shares Retained Treasury Class A Class B Earnings Shares Balances at December 31, 1990 $1,456,405 $4,681 $ 38,928 $(51,887) Sale of 17 Class A and 119 Class B shares from treasury 5,369 Purchase of 107 Class A and 124 Class B shares for treasury (33,203) Net income for the year 24,680 Balances at December 31, 1991 1,456,405 4,681 63,608 (79,721) Sale of 150 Class A and 171 Class B shares from treasury 46,671 Purchase of 90 Class A and 54 Class B shares for treasury (27,846) Net income for the year 9,083 Balances at December 31, 1992 1,456,405 4,681 72,691 (60,896) Sale of 35 Class A and 251 Class B shares from treasury 11,141 Purchase of 75 Class A and 73 Class B shares for treasury (23,697) Net income for the year 146,399 Balances at December 31, 1993 $1,456,405 $4,681 $219,090 $(73,452) See accompanying notes. The Andersons Management Corp. Notes to Financial Statements December 31, 1993 1. Significant Accounting Policies Cash Equivalents: The Corporation considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Income Taxes: Effective January 1, 1993, the Corporation changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The impact of this change was not significant. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Temporary differences relating to costs and expenses incurred on behalf of the Partnership are passed on to the Partnership through offsetting differences in the recognition of management fees by the Corporation. Deferred tax assets of the Corporation relate primarily to temporary differences associated with the Corporations' share of Partnership net income and amounted to $17,000 and $19,900 at December 31, 1993 and 1992, respectively. Taxes paid during 1993 and 1991 amounted to $5,000 and $31,000, respectively, and tax refunds amounted to $5,900 in 1992. Net Income Per Share of Common Stock: Net income per share of Common Stock is computed based on the weighted average number of Class A Common Shares outstanding during the year. See Note 4. Reclassifications: Certain amounts in the 1992 financial statements have been reclassified to conform with the 1993 presentation. These reclassifications had no effect on net income. 2. Investment in The Andersons The Corporation is the sole general partner of The Andersons (the Partnership). As sole general partner, the Corporation provides all management and labor services required by the Partnership in its operations. In exchange for providing management services the Corporation charges the Partnership a management fee equal to: a) the salaries and cost of all employee benefits and other normal employee costs, paid or accrued for services performed by the Corporation's employees on behalf of the Partnership, b) reimbursable expenses incurred by the Corporation in connection with its services to the Partnership, or on the Partnership's behalf, and c) an amount based on an achieved level of return on partners' invested capital of the Partnership to cover the Corporation's general overhead and to provide an element of profit to the Corporation. The Corporation leases an office building under a lease that commenced on May 1, 1990. The Corporation is required to pay annual lease payments of $731,209 through 2000. The Corporation charges the Partnership rent for the space utilized in its operations, which amounted to $529,982, $516,344 and $498,699 in 1993, 1992 and 1991, respectively. The Partnership generally pays the Corporation for salaries and employee benefits as those costs are paid by the Corporation. Amounts due from the Partnership relating to postretirement benefits that will not be received within one year have been classified as a noncurrent asset. The components of the management fee and rent charged by the Corporation to the Partnership consisted of the following: Year ended December 31 1993 1992 1991 Costs and expenses: Salaries and wages $47,706,731 $43,356,247 $41,103,580 Employee benefits 14,619,453 13,426,059 13,721,230 Rent for office space and other reimbursable expenses 641,491 516,344 498,699 Achieved level of return of the Partnership 139,656 89,618 34,090 Total management fees $63,107,331 $57,388,268 $55,357,599 3. Employee Benefit Plans The Corporation sponsors several employee benefit programs which include the following: Defined Benefit Pension Plan, Retirement Savings Investment Plan, Cash Profit Sharing Plan, Management Performance Program and health insurance benefits. Substantially all permanent employees are covered by the Corporation's Defined Benefit Pension Plan. The benefits are based on the employee's highest five consecutive years of compensation during their last ten years of service. The Corporation's policy is to pay into trusteed funds each year an amount equal to the annual pension expense calculated under the Entry Age Normal method. The following table sets forth the plan's funded status and amounts recognized in the Corporation's balance sheets as of December 31, 1993 and 1992. 1993 1992 Accumulated benefit obligation, including vested benefits of $4,815,512 in 1993 and $3,536,273 in 1992 $5,159,779 $3,852,363 Projected benefit obligation for service rendered to date $ 8,222,470 $ 7,454,556 Plan assets at fair value 6,568,985 5,664,926 Projected benefit obligation in excess of plan assets 1,653,485 1,789,630 Unrecognized net asset at adoption of FAS 87, net of amortization 243,817 294,296 Unrecognized net gain (loss) 530,128 (158,736) Prior service cost (147,663) (168,739) Net pension liability recognized in balance sheet (includes current portion of $645,966 in 1993) $ 2,279,767 $ 1,756,451 Net periodic pension cost includes the following components: Year ended December 31 1993 1992 1991 Service cost - benefits earned during the period $ 1,135,948 $ 1,088,099 $ 1,020,119 Interest cost on projected benefit obligation 571,278 461,896 362,838 Return on plan assets (493,623) (331,498) (578,665) Net amortization and deferral 10,420 (32,317) 326,270 Net periodic pension cost $ 1,224,023 $ 1,186,180 $ 1,130,562 The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.5% and 4%, respectively, for 1993 and 8% and 5.5%, respectively, for 1992. The weighted average long-term rate of return on plan assets used in determining the expected return on plan assets included in net periodic pension cost was 8% for 1993, 1992 and 1991. Substantially all of the plan assets are invested in a family of mutual funds at December 31, 1993 and in equity securities and United States Government obligations at December 31, 1992. Under the Retirement Savings Investment Plan (RSIP) eligible participating employees may elect to contribute specified amounts up to the lesser of $8,994 or 15% (10% in 1992) of their gross pay on a tax-deferred basis to a trust for investment in a family of mutual funds. The Corporation contributes an amount equal to 50% of the participant's contributions, but not in excess of 3% of the participant's annual gross pay. Participants are fully vested in their contributions to the RSIP. Participants hired before January 1, 1993 vest immediately in the Corporation's matching contributions and participants hired after December 31, 1992 vest ratably over five years. The matching contributions to the RSIP amounted to $761,536, $682,099 and $661,895 in 1993, 1992 and 1991, respectively. Substantially all permanent employees are included in the Cash Profit Sharing Plan. The Plan provides for participants to receive certain percentages of their pay as various threshold levels of return on partnership capital of the Partnership are achieved. The Corporation also has a Management Performance Program for certain levels of management. Participants in the Management Performance Program are not eligible to participate in the Cash Profit Sharing Plan. The expense for profit sharing/management performance programs was $2,050,273, $1,331,260 and $488,488 for 1993, 1992 and 1991, respectively. The Corporation currently provides certain health insurance benefits to its employees, including retired employees. The Corporation has reserved the right in most circumstances to modify the benefits provided and in recent years has in fact made changes. Further changes were implemented in 1993 that will effect the benefits provided to future retirees. These changes include the minimum retirement age, years of service and a sharing in the cost of providing these benefits. In addition, the Medicare Part B reimbursement currently paid by the Corporation for retirees is being phased out over a five-year period. Effective January 1, 1993, the Corporation adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires that the cost of providing postretirement health care benefits be accrued during the employees' working career rather than recognizing the cost of these benefits as claims are paid. The Corporation has elected to recognize the accrued benefits earned by employees as of January 1, 1993 (transition obligation) prospectively, which means this cost will be recognized as a component of the net periodic postretirement benefit cost over a period of approximately 20 years. The effect of adopting the new rules increased 1993 net periodic postretirement benefit cost by approximately $850,000 to $1,255,693. Postretirement benefit costs for 1992 and 1991, which were recorded on a cash basis, have not been restated. These costs amounted to approximately $404,000 for 1992 and $471,000 for 1991. As all employee benefit costs are charged to the Partnership as described in Note 2, the change in accounting for postretirement benefit costs had no effect on the Corporation's net income. The Corporation's postretirement benefits are not funded. The status of the plan as of January 1 and December 31, 1993 is as follows: December 31, January 1, 1993 1993 Accumulated postretirement benefit obligation: Retirees $ 5,534,885 $ 5,311,584 Fully eligible active plan participants 752,975 619,988 Other active participants 3,065,722 2,480,644 9,353,582 8,412,216 Unrecognized net transition obligation (7,991,605) (8,412,216) Unrecognized net loss (582,737) - Accrued postretirement benefit cost $ 779,240 $ - Net periodic postretirement benefit cost for 1993 includes the following components: Service cost $ 181,457 Interest cost 653,625 Amortization of transition obligation 420,611 Net periodic postretirement benefit costs $ 1,255,693 The weighted average discount rate used in determining the 1993 postretirement benefit cost and the accumulated postretirement benefit obligation at January 1, 1993 was 8%. The weighted average discount rate used in determining the accumulated postretirement benefit obligation at December 31, 1993 was 7.5%. The assumed health care cost trend rate used to measure the expected cost of benefits covered by the plan was 12% in 1993, declining to 5% through the year 2000 and remaining at that level thereafter. A 1% increase in the assumed health care cost trend rate would increase the annual postretirement benefit cost by approximately $150,000 and the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $1,515,000. To partially fund self-insured health care and other employee benefits, the Corporation makes payments to a trust. Assets of the trust amounted to $2,710,395 and $2,467,869 at December 31, 1993 and 1992, respectively, and such amounts are included in prepaid expenses. 4. Description of Common Shares Common shares of the Corporation are held by limited partners of The Andersons. The holders of Class A shares are entitled to dividends, if declared, and to any surplus, earned or otherwise, of the Corporation upon liquidation or dissolution. The holders of Class B shares have sole voting power, but are not entitled to share in any dividends or surplus of the Corporation. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The Corporation's Board of Directors has overall responsibility for the management of the Corporation's affairs, including its responsibilities as General Partner of the Partnership. Therefore, the Board directs the management and operations of the Partnership, through the Corporation, as General Partner, and pursuant to the Management Agreement. Day-to-day management decisions have been delegated by the Board to the Corporation's Chief Executive Officer and various committees authorized by the Board. Under the Corporation's Code of Regulations, the Board of Directors consists of not less than 7, nor more than 21, directors. Directors serve three year terms on a staggered basis so that no more than one-third of the entire Board is subject to election each year. Holders of Class B Shares have the opportunity to vote for the election of directors at annual meetings of the Corporation's shareholders, which are scheduled no later than May 31 each year. The Corporation's officers are appointed by the Board of Directors. The executive officers and directors of the Corporation are: Name Age Position Thomas H. Anderson 70 Chairman of the Board (1) (2) Richard P. Anderson 64 Director; President and Chief Executive Officer Christopher J. Anderson 39 Vice President Business Development Group (3) Daniel T. Anderson 38 Director; General Merchandise Manager Retail Group (3) Donald E. Anderson 67 Director; Science Advisor Michael J. Anderson 42 Director; Vice President and General Manager Retail Group (2) Richard M. Anderson 37 Director; Vice President and General Manager Industrial Products Group (2) John F. Barrett 44 Director Joseph L. Braker 43 Vice President and General Manager Ag Group (3) Dale W. Fallat 49 Director; Vice President Corporate Services Richard R. George 44 Corporate Controller and Principal Accounting Officer (1) Paul M. Kraus 61 Director (2) Peter A. Machin 46 Vice President and General Manager Lawn Products Group (1) Beverly J. McBride 52 General Counsel and Corporate Secretary (2) Rene C. McPherson 69 Director (1) (2) Donald M. Mennel 75 Director (1) (3) Larry D. Rigel 52 Vice President Marketing (1) Janet M. Schoen 34 Director (2) Gary L. Smith 48 Corporate Treasurer (3) (1) Member of Nominating and Advisory Committee (2) Member of Compensation Committee (3) Member of Audit Committee Thomas H. Anderson - Held the position of Manager-Company Services of The Andersons for several years and was named Senior Partner in 1987. When the Corporation was formed in 1987, he was named Chairman of the Board. He served as a General Partner of The Andersons and a member of its Managing Committee from 1947 through 1987. Richard P. Anderson - He was Managing Partner of The Andersons from 1984 to 1987 when he was named Chief Executive Officer. Served as a General Partner of The Andersons and a member of its Managing Committee from 1947 through 1987 and has been a Director of the Corporation since its inception in 1987. He is also a director of Centerior Energy Corporation, First Mississippi Corp. and N-Viro, International Corp. Christopher J. Anderson - Began full-time employment with the Partnership in 1983. He held several positions in the Grain Group, including Planning Manager and Administrative Services Manager, until 1988 when he formed a private consulting business. He returned to the Company in 1990 in his present position. Daniel T. Anderson - Began full-time employment with The Andersons in 1979. He has served in various positions in the Retail Group since 1984, including Store Manager and Retail Operations Manager. In 1990, he assumed the position of General Merchandise Manager for the Retail Group. He was elected a Director in 1990. Donald E. Anderson - In charge of scientific research for the Partnership since 1980, he semi-retired in 1992. He served as a General Partner of The Andersons from 1947 through 1987 and has served the Corporation as a Director since its inception in 1987. Michael J. Anderson - Began his employment with The Andersons in 1978. He has served in several capacities in the Grain Group and he held the position of Vice President and General Manager Grain Group from 1990 to February 1994 when he was named Vice President and General Manager of the Retail Group. He has served as a Director of the Corporation since 1988. Richard M. Anderson - Began his employment with The Andersons in 1986 as Planning Analyst and was named the Manager of Technical Development in 1987. In 1990, he assumed his present position. He has served as a Director since 1988. John F. Barrett - He has served in various capacities at The Western and Southern Life Insurance Company, including Executive Vice President and Chief Financial Officer and President and Chief Operating Officer, and currently serves as Chief Executive Officer. He is a director of Cincinnati Bell, Inc. and Fifth Third Bancorp. He was elected a Director of the Corporation in December 1992. Joseph L. Braker - Began his employment with the Partnership in 1968. He held several positions within the Grain area and in 1988, he was named Group Vice President Grain. In 1990, he was named Vice President and General Manager Ag Products Group and in February 1994 he was named Vice President and General Manager Ag Group. He served as a General Partner of The Andersons from 1985 to 1987. Dale W. Fallat - Began his employment with The Andersons in 1967 and in 1988 was named Senior Vice President Law and Corporate Affairs. He assumed his present position in 1990. He served as a General Partner of The Andersons from 1983 through 1987 and a member of its Managing Committee in 1986 and 1987. He has served as a Director of the Corporation since its inception in 1987. Richard R. George - Began his employment with the Partnership in 1976 and has served as Controller since 1979. Paul M. Kraus - General partner in the law firm of Marshall & Melhorn. He has been a Director of the Corporation since 1988. Peter A. Machin - Began his employment with The Andersons in the Lawn Products Group in 1987 as Sales Manager of Professional Products. In 1988 he was promoted to Sales and Marketing Manager and assumed his present position in 1990. Beverly J. McBride - Began her employment with The Andersons in 1976. She has served as Assistant General Counsel, Senior Counsel and since 1987 as General Counsel and Corporate Secretary. Rene C. McPherson - He has been a Director of the Corporation since 1988 and currently serves as a director of BancOne Corporation, Dow Jones & Company, Inc., Mercantile Stores Company, Inc., Milliken & Company, and Westinghouse Electric Corporation. Donald M. Mennel - Retired Chairman of the Board and Chief Executive Officer of the Mennel Milling Company. He began a private law practice in 1986. Elected as a Director in 1990. Larry D. Rigel - Began his employment with the Partnership in 1966. From 1987 to February 1994 was in charge of the Partnership's Retail operations and currently serves as Vice President Marketing for the Company. Janet M. Schoen - A former school teacher, she is currently a full-time homemaker. She was elected a Director of the Corporation in 1990. Gary L. Smith - Began his employment with the Partnership in 1980 and has served as Treasurer since 1985. Donald E., Richard P. and Thomas H. Anderson are brothers; Paul M. Kraus is a brother-in-law. Christopher J. and Daniel T. Anderson are sons of Richard P. Anderson and Janet M. Schoen is a daughter of Thomas H. Anderson. Michael J. and Richard M. Anderson are nephews of the three brothers. Item 11.

Item 11. Executive Compensation The Corporation provides all management services to the Partnership pursuant to a Management Agreement entered into between the Partnership and the Corporation as further described under "Item 1. Business." The fee paid to the Corporation includes an amount equal to the salaries and cost of all employee benefits, and other normal employee costs, paid or accrued on behalf of the Corporation's employees who are engaged in furnishing services to the Partnership. The following table sets forth the compensation paid by the Corporation to the Chief Executive Officer and the four highest paid executive officers. Summary Compensation Table Annual Compensation All Other Name and Position Year Salary Bonus Compensation(a) Richard P. Anderson 1993 $308,333 $150,000 $4,497 President and Chief 1992 286,666 60,000 4,300 Executive Officer 1991 280,008 4,200 Thomas H. Anderson 1993 206,669 90,000 4,497 Chairman of the Board 1992 190,004 35,000 4,364 1991 185,004 4,238 Joseph L. Braker 1993 194,634 70,000 4,497 Vice President and General 1992 181,408 30,000 4,364 Manager Ag Products Group 1991 175,106 15,000 4,238 Larry Rigel 1993 162,558 15,000 4,497 Vice President and General 1992 151,924 30,000 4,364 Manager Retail Group 1991 146,876 4,238 Michael J. Anderson 1993 161,962 100,000 4,497 Vice President and General 1992 146,978 30,000 4,364 Manager Grain Group 1991 136,238 41,000 4,087 (a) Corporation's matching contributions to its 401(k) retirement plan. Pension Plan The Corporation has a Defined Benefit Pension Plan (the "Pension Plan") which covers substantially all permanent and regular part-time employees. The amounts listed in the table below are payable annually upon retirement at age 65 or older. A discount of six percent per year is applied for retirement before age 65. The pension benefits are based on a single-life annuity and have been reduced for Social Security covered compensation. The compensation covered by the Pension Plan is equal to the employees' base pay, which in the Summary Compensation Table is the executive's salary, but beginning in 1989 was limited to $200,000, adjusted for inflation, and beginning in 1994 is limited to $150,000, which will also be adjusted for inflation in future years. Each of the named executives has six years of credited service. Average Approximate Annual Retirement Benefit Based Five-Year Upon the Indicated Years of Service Compensation 5 Years 10 Years 15 Years 25 Years $ 50,000 $ 3,292 $ 6,584 $ 9,877 $ 16,461 100,000 7,042 14,084 21,127 35,211 150,000 10,792 21,584 32,377 53,961 200,000 14,542 29,084 43,627 72,711 250,000 18,292 36,584 54,877 91,461 Directors' Fees Directors who are not employees of the Corporation and who are not members of the Anderson family receive an annual retainer of $10,000. Directors who are not employees of the Corporation receive a fee of $600 for each Board Meeting attended. There are three committees of the Board of Directors: the Audit Committee; the Nominating and Advisory Committee; and the Compensation Committee. The chairman of these committees receives a retainer of $2,000 provided they are not an employee of the Corporation, and members of the committees who are not employees of the Corporation receive $400 for each meeting attended. Compensation Committee Interlocks and Insider Participation The Compensation Committee includes the following executive officers and directors: Michael J. Anderson, Richard M. Anderson, Richard P. Anderson (ex officio), Thomas H. Anderson (ex officio), Dale W. Fallat, Paul M. Kraus, Beverly J. McBride, Rene C. McPherson (chairman), and Janet M. Schoen. In addition, Charles E. Gallagher, Director of Personnel, is an ex officio member of the committee. Certain Transactions - Alshire-Columbus: The Partnership and certain of the directors and executive officers of the Corporation are limited partners in Alshire-Columbus Limited Partnership ("Alshire-Columbus"), an Ohio limited partnership, which owns the Partnership's Brice General Store in Columbus, Ohio. The store is leased to the Partnership by Alshire-Columbus at an annual base rental of $732,000. Additional rental payments are due if net sales exceed $35 million. The lease is a "net lease" and has an initial term expiring in 2000, with three five- year renewal periods and options to purchase the building, land and improvements at the end of the initial term and each renewal period. The Partnership believes that the terms of the Brice General Store lease are at least as favorable to the Partnership as terms obtainable from other third parties. The Partnership contributed the land, at its cost ($1,367,000), for its original limited partner interest. As original limited partner, the Partnership has no economic interest in the income from operations of Alshire- Columbus but will receive a preferential distribution upon any sale of the real estate equal to the cost of the land plus an amount equal to the aggregate cash distributions received by the limited partners in excess of their capital contributions. The remaining cash proceeds from any sale of the Brice General Store will be distributed to the limited partners - 75%; the Partnership, as original limited partner - 24%; and the general partner - 1%. The other limited partners of Alshire-Columbus contributed $1,450,000, representing 35 limited partnership units. None of the directors and executive officers of the Corporation or their family members own more than one limited partnership unit, except for Richard P. Anderson, who owns two units. In the aggregate, 8 3/4 units are owned by directors and executive officers of the Corporation, and their family members own an additional four units. The limited partners, other than the Partnership, have 99% of the economic interest in the income from operations of Alshire-Columbus and the general partner has a 1% economic interest. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No individual beneficially owns as much as 5% of the Voting Class B Common Shares of the Corporation. As of March 1, 1994, the descendants of the founders of the Partnership beneficially held 3,597 shares of the voting Class B Common Shares, representing 79% of the outstanding shares. (b) The following table sets forth, as of March 1, 1994, the beneficial ownership by each Director and by all Directors and Officers as a group, of the Corporation's voting Class B Common Shares: Number of Shares Percent Director Beneficially Owned of Class Richard P. Anderson 79 1.7% Thomas H. Anderson 77 1.7% Daniel T. Anderson 81 1.8% Donald E. Anderson 50 1.1% Michael J. Anderson 28 * Richard M. Anderson 62 1.4% John F. Barrett 2 * Joseph L. Braker 7 * Dale W. Fallat 19 * Paul M. Kraus 40 * Rene C. McPherson 0 * Donald M. Mennel 5 * Larry D. Rigel 24 * Janet M. Schoen 65 1.4% Directors and Officers as a group 630 13.9% * less than 1% (c) The Corporation knows of no arrangements which may at a subsequent date result in a change in control of the Corporation. Item 13.

Item 13. Certain Relationships and Related Transactions See "Item 1. Business" regarding personnel and management services provided by the Corporation to the Partnership. The management fee received by the Corporation in 1993 under the Management Agreement between the Corporation and the Partnership was $63,107,331. See Note 2 to the Corporation's Financial Statements. The office building utilized by the Partnership is leased by the Corporation from an unaffiliated lessor under a net lease expiring in 2000. The Partnership subleases approximately 80% of the building from the Corporation and pays the Corporation rent for the space it occupies. Under the terms of the sublease, the Partnership also is responsible for insurance, utilities, taxes, general maintenance, snow removal, lawn care and similar upkeep expenses for the entire building. The Corporation reimburses the Partnership for management and maintenance of the building, including the space it does not occupy. The amount paid by the Partnership to the Corporation for the portion of the building occupied by the Partnership is designed to reimburse the Corporation for its equivalent cost under the Corporation's lease. In 1993, the rental payments made by the Partnership to the Corporation, net of the reimbursement for management and maintenance of the building was $529,982, which is included in the management fee referred to in the preceding paragraph. See "Item 11. Executive Compensation - Compensation Committee Interlocks and Insider Participation - Certain Transactions - Alshire- Columbus" regarding transactions with management. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) The following financial statements of the registrant are included in Item 8: Page Report of Independent Auditors................................... 5 Statements of Income - years ended December 31, 1993, 1992 and 1991............................... 6 Balance Sheets - December 31, 1993 and 1992...................... 7 Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991............................... 8 Statements of Changes in Shareholders' Equity - years ended December 31, 1993, 1992 and 1991................... 9 Notes to Financial Statements.................................... 10 (2) The following financial statement schedules are included in 14(d): I. Marketable Securities - December 31, 1993............ 24 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (3) Exhibits: 3(a) Articles of Incorporation. (Incorporated by reference to Exhibit 3(d) in Registration Statement No. 33-16936.) 3(b) Code of Regulations. (Incorporated by reference to Exhibit 3(e) in Registration Statement No. 33-16936.) 4(a) Specimen certificate of Class A Shares. (Incorporated by reference to Exhibit 4(b)(i) in Registration Statement No. 33-16936.) 4(b) Specimen certificate of Class B Shares. (Incorporated by reference to Exhibit 4(b)(ii) in Registration Statement No. 33-16936.) 10(a) Management Performance Program.* (Incorporated by reference to Exhibit 10(a) to the Partnership's Form 10-K dated December 31, 1990, File no. 2-55070.) 10(b) Lease agreement effective May 1, 1990, between Carentmon and The Andersons Management Corp. (Incorporated by reference to Exhibit 10(b) to Registrants Form 10-K dated December 31, 1992.) * Management contract or compensatory plan. 28 Partnership Form 10-K for the year ended December 31, 1993. (Incorporated by reference to File No. 2-55070.) The Corporation agrees to furnish to the Securities and Exchange Commission a copy of any long-term debt instrument or loan agreement that it may request. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the last quarter of the year. (c) Exhibits: The exhibits listed in Item 14(a)(3) of this report, and not incorporated by reference, follow "Financial Statement Schedules" referred to in (d) below. (d) Financial Statement Schedules: The financial statement schedules listed in 14(a)(2) follow "Signatures." SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in Maumee, Ohio, on the 29th day of March, 1994. THE ANDERSONS MANAGEMENT CORP. (Registrant) By /s/Thomas H. Anderson Thomas H. Anderson Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 29th day of March, 1994. Signature Title /s/Richard P. Anderson President and Chief Executive Officer, Richard P. Anderson Officer, Director (Principal Executive and Financial Officer) /s/Richard R. George Corporate Controller Richard R. George (Principal Accounting Officer) Signature Title Signature Title /s/Daniel T. Anderson Director /s/Dale W. Fallat Director Daniel T. Anderson Dale W. Fallat /s/Donald E. Anderson Director Director Donald E. Anderson Paul M. Kraus /s/Michael J. Anderson Director Director Michael J. Anderson Rene C. McPherson /s/Richard M. Anderson Director /s/Donald M. Mennel Director Richard M. Anderson Donald M. Mennel /s/Thomas H. Anderson Director Director Thomas H. Anderson Janet M. Schoen Director John F. Barrett No proxy statement is prepared. Audited financial statements will be distributed to Shareholders at a later date. SCHEDULE I - MARKETABLE SECURITIES THE ANDERSONS MANAGEMENT CORP. December 31, 1993 Amount at Which Carried In Principal the Balance Type of Investment Amount Cost Value Sheet U.S. Government Obligations $500,000 $505,313 $505,313 $505,313

716006_1993.txt

716006

1993

Item 1. Business. (a) Yellow Corporation and its wholly-owned subsidiaries are collectively referred to as "the company". The company changed its name in 1993 from Yellow Freight System, Inc. of Delaware to Yellow Corporation. This was done to more clearly distinguish the company as a holding company of transportation services and to eliminate confusion with the name of the company's principal operating subsidiary (Yellow Freight System, Inc.). In February 1993 the company completed its acquisition of the stock of Preston Corporation (Preston). Preston is the holding company for three regional less-than-truckload (LTL) carriers serving the Northeast, Upper Midwest and Southeast United States. The 1993 financial statements include the results of Preston effective March 1, 1993. The acquisition provided $497 million of operating revenue for the company in 1993. This accounted for 21.9% of the 26.2% increase in operating revenue over 1992. (b) The operation of the company is conducted through one predominant industry segment, which is the interstate transportation of general commodity freight by motor vehicle. (c) Yellow Corporation is a holding company providing freight transportation services through its subsidiaries, Yellow Freight System, Inc. (Yellow Freight), Preston Trucking Company, Inc. (Preston Trucking), Saia Motor Freight Line, Inc. (Saia), Smalley Transportation Company (Smalley Transportation), CSI/Reeves, Inc. (CSI/Reeves), Yellow Logistics Services, Inc. (Yellow Logistics) and Yellow Technology Services, Inc. (Yellow Technology). The company employed an average of 35,000 persons in 1993. Yellow Freight is the company's principal subsidiary, and up until the company's completion of the Preston Corporation acquisition in February 1993 contributed substantially all of the company's consolidated revenue. Yellow Freight had operating revenue of $2.358 billion in 1993 (83% of the company's total revenue) and is based in Overland Park, Kansas. It is the nation's largest provider of LTL transportation services with direct service to over 35,000 points in all 50 states, Puerto Rico, Canada and Mexico. Yellow Freight services Europe via an alliance with The Royal Frans Maas Group based in the Netherlands. Preston Trucking is primarily a regional LTL carrier serving the Northeast and Upper Midwest markets of the United States. Preston Trucking had operating revenue of $338 million for the ten months ended December 31, 1993 (12% of the company's total revenue) and is headquartered in Preston, Maryland. Saia is a regional LTL carrier that provides overnight and second-day service in nine southeastern states. It had operating revenue of $102 million for the ten months ended December 31, 1993 and is based in Houma, Louisiana. Smalley Transportation is a regional carrier providing service to customers in Georgia and throughout Florida. It had operating revenue of $32 million for the ten months ended December 31, 1993 and is based in Tampa, Florida. CSI/Reeves is in the business of transporting, warehousing and distributing carpet and related products. It had operating revenue of $25 million for the ten months ended December 31, 1993 and is based in Calhoun, Georgia. Item 1. Business. (cont.) Yellow Logistics offers a full range of integrated logistics management services including transportation management, warehousing, information systems, distribution, and package design and testing. Yellow Logistics specializes in serving the chemical, retail, computer hardware, electronic and pharmaceutical industries. Its headquarters are in Overland Park, Kansas. Yellow Technology supports the company's subsidiaries - primarily Yellow Freight - with information technology. It ensures that information systems anticipate and meet customers' needs and that the systems are an integral part of the transportation process. Its headquarters are in Overland Park, Kansas. The operations of the freight transportation companies are regulated by the Interstate Commerce Commission and state regulatory bodies. Competition includes contract motor carriers, private fleets, railroads and other motor carriers. No single carrier has a dominant share of the motor freight market. The company operates in a highly price-sensitive and competitive industry, making pricing and customer service major competitive factors. Pricing discipline and cost control are critical to improving profit levels in 1994. Traditionally, rate increases have been implemented to offset increases in labor and other operating costs. These increases have been difficult to retain because of the competitive pressures on pricing. The full impact of these increases is not realized immediately as a result of pricing that is on a contract basis and can only be increased when the contract is renewed or renegotiated. Pricing pressures were extremely competitive in the first half of 1993. They moderated in the second half of the year, aided by a two percent discount rollback implemented in August 1993 at Yellow Freight. The company's subsidiaries are continuing to work toward improved account profitability and maintaining pricing stability. The Yellow operating companies have implemented rate increases of between four and five percent during the first quarter of 1994 to cover increases in operating costs. The company attempts to control operating costs by maintaining efficient operations, optimum capacity utilization and strict budgetary controls. During 1993, Yellow Freight began an extensive multi-year network development process by consolidating and realigning terminals to improve customer service and reduce costs. A charge of $18.0 million before taxes was accrued for the costs to close certain facilities and dispose of excess property. This network development will result in better use of assets, reduced overhead, improved transit times and lower freight handling costs without reducing customer service. Salaries, wages and employees' benefits decreased as a percent of revenue in 1993 despite wage and benefit increases of approximately 3% effective April 1 for employees who are members of the International Brotherhood of Teamsters (Teamsters). This is due to a wage reduction of 9% effective April 1 for employees of Preston Trucking, a small decrease in the total number of employees and a reduction in workers' compensation expense. The current labor agreement with the Teamsters expires March 31, 1994. In the second quarter of 1993, Yellow Freight reaffiliated with Trucking Management, Inc. (TMI), a multi-employer bargaining group representing the trucking industry in labor contract negotiations. Preston Trucking is also a member of TMI. TMI is currently negotiating the renewal of this contract. An agreement that allows greater operational flexibility and the opportunity to reduce costs is necessary to allow Yellow Freight and Preston Trucking to better compete in the marketplace. Item 1. Business. (cont.) In addition, Preston Trucking's wage reduction expires March 31, 1994. Preston Trucking feels it is essential to continue this wage reduction in the near future to maintain its progress toward restoring profitability. Extension of the wage reduction requires a contract provision allowing the reduction and approval of Preston's Teamster employees. The company's differentiation strategy focuses on introducing new customer services, improving existing services and providing service to new markets. Yellow Freight's revenue growth was moderate in 1993 as compared to 1992. Growth was due to increased tonnage, which grew faster than the Industrial Production Index, and contributions from new services started in 1992. Yellow Freight expects moderate revenue growth in 1994. A service which reduces transit times by a full day on traditional three, four and five-day lanes experienced good revenue growth in 1993. A guaranteed expedited service that provides shippers an economical alternative to air freight in selected markets experienced a healthy revenue growth rate in 1993 and operated at a very high on-time service ratio. The Canadian and Mexican markets continued to provide good growth for Yellow Freight in 1993. This growth is expected to continue in 1994, partly as a result of NAFTA's simplified trade provisions between those countries and the United States. Service to and from Western Europe, through an alliance with The Royal Frans Maas Group of The Netherlands is expected to grow in 1994 as a result of expanded consolidation and deconsolidation points in North America and improvements in streamlining documentation processing. Preston Trucking continued to experience declines in both revenue and tonnage after the acquisition by the company, but benefited in June 1993 from the bankruptcy of a major competitor in the Northeast. Preston Trucking opened four new terminals and increased their revenue and tonnage during the last half of the year. They expect continued revenue growth in 1994 and are planning to broaden service with a new distribution center in Ohio. The company expects to benefit from Saia's expansion into Texas and Tennessee as well as their introduction of intrastate service in Texas. Combined with Saia's strong market position and profitable operations, revenue growth in 1994 is expected to be much improved. The operations of the company are generally funded by cash flows generated from operating activities except in periods of accelerated capital spending. The company requires working capital to fund capital expenditures and pay shareholder dividends. The rapid turnover of accounts receivable, effective cash management and ready access to credit provided by commercial paper, medium-term notes and flexible banking agreements allows the company to effectively manage its working capital. It is anticipated that 1994 capital expenditures and shareholder dividends will be primarily financed through internally-generated funds. The company made commercial paper borrowings in early 1993 to fund a portion of the Preston stock acquisition ($8 million) and to repay certain Preston indebtedness ($82 million). Revisions to the medium-term note program in 1993 provided for increased amounts outstanding and longer maturity periods. During the last six months of 1993, $37 million was borrowed under the medium-term note program, primarily to replace commercial paper borrowings. Modest capital expenditures and good cash flow from operations in 1993 enabled the company to further reduce commercial paper borrowings to $25 million at December 31, 1993. Item 2.

Item 2. Properties. At December 31, 1993, the company operated 696 freight terminals located in 50 states, Puerto Rico, parts of Canada and Mexico. Of this total, 331 were owned terminals and 365 were leased, generally for terms of three years or less. The number of vehicle back-in doors totaled 19,243, of which 14,802 were at owned terminals and 4,441 were at leased terminals. The freight terminals vary in size ranging from one to three doors at small local terminals, up to 304 doors at Yellow Freight's largest consolidation and distribution terminal. Substantially all of the larger terminals, containing the greatest number of doors, are owned. In addition, the company and most of its subsidiaries own and occupy general office buildings in their headquarters city. The company also maintains a significant investment in revenue equipment. At December 31, 1993, the company's subsidiaries operated the following number of linehaul units: tractors - 4,918, 45' and 48' trailers - 7,738, and 27' and 28' trailers - 31,698. The number of city units operated were: trucks and tractors - 8,165 and trailers - 5,535. The above facilities and equipment are used in the company's predominant industry, the interstate transportation of general commodity freight. The company expects moderate growth in 1994 and has projected no significant changes to its operational capacity. A small number of facilities will be closed at Yellow Freight as part of the network development process started in 1993. Projected facility expenditures of $30 million will target expansion of existing locations and the construction or purchase of new locations to improve efficiency and enter new markets in selected areas. Equipment expenditures of $90 million are expected to consist primarily of replacement units with some expansion units at certain of the subsidiaries. Revenue equipment replacement units are expected to be approximately 70% higher than in the last three years. Other operating property expenditures of $55 million are primarily for improving efficiency through technological enhancements and advanced information systems. Item 3.

Item 3. Legal Proceedings. The information set forth under the caption "Commitments and Contingencies" in the Notes to Consolidated Financial Statements on page 32 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. None. Executive Officers of the Registrant The names, ages and positions of the executive officers of the company as of March 18, 1994 are listed below. Officers are appointed annually by the Board of Directors at their meeting which immediately follows the annual meeting of shareholders. Executive Officers of the Registrant (cont.) The terms of each officer of the company designated above are scheduled to expire April 21, 1994. The terms of each officer of the subsidiary companies are scheduled to expire on the date of the next annual meeting of shareholders of that company. No family relationships exist between any of the executive officers named above. PART II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. The information set forth under the caption "Common Stock" on page 34 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Item 6.

Item 6. Selected Financial Data. The information set forth under the caption "Financial Summary" on pages 18 and 19 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Additionally, long-term debt at December 31 for each of the last five years was as follows (in thousands): 1993 - $214,176, 1992 - $123,027, 1991 - $145,584, 1990 - $163,703, 1989 - $186,680. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. "Management's Discussion and Analysis of Financial Condition and Results of Operations," appearing on pages 14 through 17 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference under Item 14 herein. Item 8.

Item 8. Financial Statements and Supplementary Data. The financial statements and supplementary information, appearing on pages 20 through 34 of the registrant's Annual Report to Shareholders for the year ended December 31, 1993, are incorporated by reference under Item 14 herein. Item 9.

Item 9. Disagreements on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. The information regarding Directors of the registrant has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. For information with respect to the executive officers of the registrant, see "Executive Officers of the Registrant" at the end of Part I of this report. Item 11.

Item 11. Executive Compensation. This information has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. This information has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. Item 13.

Item 13. Certain Relationships and Related Transactions. This information has previously been reported in the registrant's definitive proxy statement, filed pursuant to Regulation 14A, and is incorporated by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) (1) Financial Statements The following information appearing in the 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report as Exhibit (13): With the exception of the aforementioned information, the 1993 Annual Report to Shareholders is not deemed filed as part of this report. Financial statements other than those listed are omitted for the reason that they are not required or are not applicable. The following additional financial data should be read in conjunction with the consolidated financial statements in such 1993 Annual Report to Shareholders. (a) (2) Financial Statement Schedules Schedules other than those listed are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. (a) (3) Exhibits (13) - 1993 Annual Report to Shareholders. (24) - Consent of Independent Public Accountants. The remaining exhibits required by Item 7 of Regulation S-K are omitted for the reason that they are not applicable or have previously been filed. (b) Reports on Form 8-K No reports on Form 8-K were filed for the three months ended December 31, 1993. However, on March 21, 1994, a Form 8-K was filed under Item 5, Other Events, which reported that due primarily to the impact of severe winter weather in January and February, the company expects to report a net loss in the first quarter of 1994 greater than the net loss of $.06 per share recorded in the first quarter of 1993. Severe winter weather caused significant business disruptions and higher operating expenses for both the company's largest motor carrier subsidiary, Yellow Freight System, Inc. and for Preston Trucking Company, Inc. Preston Trucking, whose operations are concentrated in the Northeast and Upper Midwest, was especially hard hit by the weather. Report of Independent Public Accountants on Financial Statement Schedules To Yellow Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Yellow Corporation and Subsidiaries' annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 31, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the method of revenue recognition in 1992, as discussed in the notes to the consolidated financial statements. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14(a)(2) are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commissions rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Kansas City, Missouri, January 31, 1994 Schedule II Yellow Corporation and Subsidiaries Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties For the Years Ended December 31, 1993, 1992 and 1991 (1) Represent an interest-free loan secured by real property, payable in annual installments from January 15, 1990 to January 15, 1996 at which time the remaining balance is due. As of December 31, 1993, Stephen P. Murphy is no longer an employee of the company. This does not affect the repayment terms of the loan. (2) Represents an interest-free loan secured by real property, payable on May 1, 2006. Schedule V Yellow Corporation and Subsidiaries Property, Plant and Equipment For the Years Ended December 31, 1993, 1992 and 1991 (1) In 1993, primarily property, plant and equipment of Preston Corporation and subsidiaries acquired in February 1993. In 1992 and 1991, foreign equity translation adjustments. Schedule VI Yellow Corporation and Subsidiaries Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment For the Years Ended December 31, 1993, 1992 and 1991 (1) Foreign equity translation adjustments. Schedule VIII Yellow Corporation and Subsidiaries Valuation and Qualifying Accounts For the Years Ended December 31, 1993, 1992 and 1991 (1) Addition from Preston Corporation and subsidiaries acquired in February 1993. (2) Primarily uncollectible accounts written off - net of recoveries. Schedule X Yellow Corporation and Subsidiaries Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991 * Less than 1% of total sales Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Yellow Corporation BY: /s/ George E. Powell III ----------------------------------- George E. Powell III March 21, 1994 President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

95395_1993.txt

95395

1993

Item 1. Business (a) General Development of Business Annual Report to Stockholders, information regarding the sale of Sundstrand Data Control Division to AlliedSignal, Inc. on pages 25, 27, 28, 36, 38 and 39, information on foreign operations and activity on pages 26-27, information regarding the restructuring of the aerospace segment on pages 26 and 36, information regarding the acquisition of the Electrical Systems Division of Westinghouse Electric Corporation on pages 26, 27, 28 and 36, information regarding the establishment of a joint venture with Labinal, Inc. on page 27, and information regarding date of incorporation on page 45. (b) Financial Information About Annual Report to Stockholders, Industry Segments information by business segment on pages 25-26, and pages 34-35. (c) Narrative Description of Business Annual Report to Stockholders, pages 6-29, information on foreign operations and activity on pages 26-27 and 34-35, information on unfilled orders on pages 27 and 46-47, information regarding the development of the auxiliary power unit products on page 27, information regarding environmental matters on pages 27 and 42-43, information regarding a significant customer on pages 27, 29 and 34, information regarding research and development expenditures on pages 29 and 42, information regarding contracts with or for the government on pages 29 and 43, information regarding materials and supplies, intellectual property rights and competition on page 45, and information regarding the number of employees on pages 46-47. (d) Financial Information About Annual Report to Stockholders, Foreign and Domestic Operations information on foreign operations and Export Sales and activity on pages 26-27 and 34-35, information regarding the acquisition of the Electrical Systems Division of Westinghouse Electric Corporation on page 27, information regarding foreign and domestic operations on pages 34- 35, and information regarding foreign earnings and assets on pages 35 and 40. Item 2.

Item 2. Properties Annual Report to Stockholders, information regarding properties on page 45. FORM 10-K ITEM NO. INCORPORATED BY REFERENCE FROM: Item 3.

Item 3. Legal Proceedings Annual Report to Stockholders, information regarding environmental matters on pages 27 and 42-43, information regarding certain government contracting matters on pages 29 and 43, and information regarding income tax matters on pages 29 and 40 except the sentence on page 40 which states "Jurisdiction of this matter now resides in the United States Court of Appeals for the Seventh Circuit" is deleted and replaced with "On February 22, 1994, the United States Court of Appeals for the Seventh Circuit affirmed the decision of the U.S. Tax Court. The Company intends to file a Motion for Rehearing challenging the correctness of the Court of Appeals' opinion." Item 4.

Item 4. Submission of Matters to a Vote (Not Applicable). of Security Holders Executive officers of the Registrant Annual Report to Stockholders, information regarding officers on page 49. PART II. Item 5.

Item 5. Market for the Registrant's Annual Report to Stockholders, Common Equity and Related information regarding restrictions Stockholder Matters on dividend payments on page 40, information regarding dividends on pages 43 and 46, information regarding Registrant's common stock price range on pages 43 and 46, information regarding the number of common stockholders on page 46, and information regarding exchange listings on page 50. Item 6.

Item 6. Selected Financial Data Annual Report to Stockholders, pages 46-47, information regarding the sale of Sundstrand Data Control Division to AlliedSignal, Inc. on pages 25, 27, 28, 36, 38 and 39, information regarding the changes in accounting standards on pages 25, 26, 27, 28, 38 and 39, information regarding the restructuring of the aerospace segment on pages 26 and 36, information regarding the acquisition of the Electrical Systems Division of Westinghouse Electric Corporation on pages 26, 27, 28 and 36, and information regarding provisions for interest for asserted tax deficiencies on page 40. Item 7.

Item 7. Management's Discussion and Annual Report to Stockholders, Analysis of Financial Condition pages 25-29. and Results of Operations Item 8.

Item 8. Financial Statements and Annual Report to Stockholders, Supplementary Data pages 30-44 and 46-47. Item 9.

Item 9. Changes in and Disagreements (Not Applicable). with Accountants on Accounting and Financial Disclosure FORM 10-K ITEM NO. INCORPORATED BY REFERENCE FROM: PART III. Item 10.

Item 10. Directors and Executive Annual Report to Stockholders, Officers of the Registrant pages 48-49; Proxy Statement, pages 3-6. Item 11.

Item 11. Executive Compensation Proxy Statement, information regarding Don R. O'Hare's consulting agreement with the Registrant on page 7, information under the caption "Compensation Committee Interlocks and Insider Participation" on page 10, and information under the captions "Summary Compensation Table," "Aggregated Option Exercises in Last Fiscal Year and Fiscal Year- End Option Values," "Retirement Plans" and "Employment Agreements" on pages 14-20. Item 12.

Item 12. Security Ownership of Certain Proxy Statement, information under Beneficial Owners and Management the caption "Voting Securities" on pages 1-2, and information under the caption "Voting Securities Held by Nominees, Directors and Officers" on page 7. Item 13.

Item 13. Certain Relationships and Proxy Statement, information under Related Transactions the caption "Loans" on page 20. PART IV. Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements Annual Report to Stockholders, the following Consolidated Financial Statements of Registrant and subsidiaries on pages 30 through 44. Consolidated Statement of Earnings for the years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992, and Consolidated Balance Sheet as of December 31, 1993 and 1992 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992, and 1991 Information by Business Segment for the years ended December 31, 1993, 1992, and 1991 Quarterly Results (Unaudited) for 1993 and 1992 Notes to Consolidated Financial Statements Management's Report Independent Auditor's Report (a) 2. Financial Statement The schedules, other than the Schedules schedules relating to amounts receivable from related parties, property, plant and equipment, accumulated depreciation and short-term borrowings, have been omitted as the required information is not applicable, or not required, or because the required information is included in the Consolidated Financial Statements or Notes to Consolidated Financial Statements. PART IV. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements Report of Independent Auditors (Ernst & Young) on the financial statements and related schedules of Registrant for the years ended December 31, 1993, 1992, and 1991. (a) 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties, for the years ended December 31, 1993, 1992, and 1991. Schedule V - Property, Plant and Equipment, for the years ended December 31, 1993, 1992, and 1991. Schedule VI - Accumulated Depreciation of Property, Plant and Equipment, for the years ended December 31, 1993, 1992 and 1991. Schedule IX - Short-term Borrowings, for the years ended December 31, 1993, 1992, and 1991. (a) 3. Exhibits (3) Articles of Incorporation and By-Laws (a) Registrant's Restated Certificate of Incorporation as effective December 19, 1991 (filed as Exhibit (3)(a) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference). (b) Registrant's By-Laws, including all amendments, as effective April 21, 1992 (filed as Exhibit (19)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-5358, and incorporated herein by reference). (4) Instruments Defining the Rights of Security Holders, including Indentures (a) Credit Agreement dated as of January 28, 1993, among Registrant and eight banking institutions including Morgan Guaranty Trust Company of New York, as Agent (filed as Exhibit (4)(a) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference). (b) Amended and Restated Rights Agreement dated December 4, 1987 and Amendment thereto dated March 5, 1990 (filed as Exhibit 4(a) and 4(b) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-5358, and incorporated herein by reference). (c) Lease dated as of December 14, 1987, between Registrant and Greyhound Real Estate Investment Six, Inc. (filed as Exhibit (4)(f) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, File No. 1- 5358, and incorporated herein by reference). (d) Note Agreement of Registrant dated May 15, 1991 (filed as Exhibit (19)(c) to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, File No. 1- 5358, and incorporated herein by reference). (e) Amendment effective December 31, 1991, to Registrant's Note Agreement dated as of May 15, 1991 (filed as Exhibit (19)(c) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference). (f) Amendment and Restatement dated May 15, 1991, of Registrant's Note Agreement dated January 18, 1980 (filed as Exhibit (19)(d) to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, File No. 1-5358, and incorporated herein by reference). (g) Amendment effective December 31, 1991, to Registrant's May 15, 1991, Amended and Restated Note Agreement (filed as Exhibit (19)(d) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference). (h) Note Agreement of Registrant dated October 31, 1991 (filed as Exhibit (4)(l) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference). (i) Note Agreement of Registrant dated December 2, 1991 (filed as Exhibit (4)(m) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference). (10) Material Contracts (a) Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant (filed as Exhibit (10)(d) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* *Management contract or compensatory plan. (b) Amendments dated August 20, 1991, and November 1, 1991, to Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant (filed as Exhibit (10)(c) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference).* (c) Amendment dated August 24, 1992, to Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant (filed as Exhibit (19)(b) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference).* (d) Amendment dated August 20, 1993, to Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant.* (e) Amended and Restated Employment Agreement dated August 7, 1990, between Registrant and Harry C. Stonecipher, Registrant's Chairman of the Board, President and Chief Executive Officer (filed as Exhibit (19)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, File No. 1-5358, and incorporated herein by reference).* (f) Agreement dated June 19, 1988, between Registrant and Paul Donovan, Registrant's Executive Vice President and Chief Financial Officer, regarding Registrant's repurchase of shares of restricted stock (filed as Exhibit (10)(h) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (g) Amended and Restated Employment Agreement dated August 18, 1992, between Registrant and Robert J. Smuland, Registrant's Executive Vice President and Chief Operating Officer, Aerospace (filed as Exhibit (19)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference).* (h) Form of Employment Agreement, including amendment thereto, between Registrant and each of Paul Donovan, Registrant's Executive Vice President and Chief Financial Officer, Berger G. Wallin, Registrant's Executive Vice President and Chief Operating Officer, Industrial, Richard M. Schilling, Registrant's Vice President and General Counsel and Secretary, and DeWayne J. Fellows, Registrant's Vice President and Controller (filed as Exhibit (10)(g) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference).* (i) Employment Agreement dated March 14, 1991, between Registrant and Gary J. Hedges, Registrant's Vice President, Personnel and Public Relations (filed as Exhibit (10)(p) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1990, File No. 1-5358, and incorporated herein by reference).* (j) Agreement dated November 16, 1989, between Registrant and Labinal, Inc. establishing a jointly owned sales company to market, sell and support auxiliary power units for commercial aerospace applications (filed as Exhibit (10)(s) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference). (k) Letter of Intent dated January 22, 1993, by and between Registrant and Rockwell International Corporation setting forth Rockwell International Corporation's intent to purchase all of the assets, business and properties, subject to certain liabilities of Sundstrand Data Control Division (filed as Exhibit (10)(k) to Registrant's Annual Report for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference).* (l) Stock, Note and Real Property Purchase Agreement dated July 14, 1993, between Registrant and AlliedSignal Inc. providing for Registrant's sale to AlliedSignal Inc. of Registrant's Data Control division (filed as Exhibit (10)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, File No. 1-5358, and incorporated herein by reference). (m) Registrant's Stock Incentive Plan effective December 1, 1992 (filed as Exhibit (10)(l) to Registrant's Annual Report for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference).* (n) Closing Agreement dated November 20, 1992, by and between Registrant and subsidiaries of Registrant and the Internal Revenue Service, in connection with the resolution of the intercompany pricing dispute for the years 1979 through 1988 (filed as Exhibit (10)(m) to Registrant's Annual Report for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference). *Management contract or compensatory plan. (o) Registrant's 1989 Restricted Stock Plan as adopted April 20, 1989, by the stockholders of Registrant (filed as Exhibit (10)(v) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (p) Registrant's 1975 Restricted Stock Plan as adopted on April 19, 1975, by the stockholders of Registrant, including all amendments through April 16, 1986 (filed as Exhibit (10)(b) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1982, File No. 1-5358, and incorporated herein by reference).* (q) Registrant's 1982 Restricted Stock Plan as adopted on April 15, 1982, by the stockholders of Registrant, including all amendments through April 16, 1986 (filed as Exhibit (10)(c) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1982, File No. 1-5358, and incorporated herein by reference).* (r) Text of resolution adopted by the Board of Directors of Registrant on April 17, 1986, amending Registrant's 1975 and 1982 Restricted Stock Plans (filed as Exhibit (10)(c) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, File No. 1-5358, and incorporated herein by reference).* (s) Text of resolution adopted by the Board of Directors of Registrant on August 7, 1990, amending Registrant's 1975, 1982, and 1989 Restricted Stock Plans (filed as Exhibit (19)(f) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, File No. 1-5358, and incorporated herein by reference).* (t) Text of resolution adopted by the Board of Directors of Registrant on November 30, 1989, and December 1, 1989, establishing an Officer Incentive Compensation Plan (filed as Exhibit (10)(cc) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (u) Text of resolution adopted by the Board of Directors of Registrant on February 19, 1991, amending Registrant's Officer Incentive Compensation Plan (filed as Exhibit (10)(hh) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, File No. 1-5358, and incorporated herein by reference).* (v) Text of resolution adopted by the Board of Directors of Registrant on July 16, 1989, adopting a Director Emeritus Retirement Plan and copy of such plan as effective July 20, 1989 (filed as Exhibit (10)(dd) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (w) Text of resolution adopted by the Board of Directors of Registrant on October 17, 1984, establishing a 1984 Elected Officers' Loan Program (filed as Exhibit (10)(i) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1984, File No. 1-5358, and incorporated herein by reference).* (x) Text of resolution adopted by the Board of Directors of Registrant on October 15, 1991, amending the 1984 Elected Officers' Loan Program (filed as Exhibit (10)(ff) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference).* (11) Computation of Fully Diluted Earnings Per Share (Unaudited) for the quarter ended December 31, 1993 and 1992, and for the year ended December 31, 1993 and 1992. (13) Annual Report to Stockholders for the year ended December 31, 1993. (21) Subsidiaries of Registrant (23) Consents of Experts and Counsel (a) Consent of Independent Auditors (Ernst & Young). (24) Powers of Attorney (99) Additional Exhibits (a) Undertakings (filed as Exhibit (28)(a) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1982, File No. 1-5358, and incorporated herein by reference). (b) Reports on Form 8-K Form 8-K dated November 22, 1993, regarding Registrant's sale to AlliedSignal, Inc. of Registrant's Data Control division, and including pro forma financial statements and notes relating thereto. *Management contract or compensatory plan. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on this 2nd day of March, 1994. SUNDSTRAND CORPORATION (Registrant) By /s/ Harry C. Stonecipher ------------------------------------- HARRY C. STONECIPHER CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Harry C. Stonecipher ) Chairman of the Board, ) President and ) Chief Executive Officer ) ) Paul Donovan ) Executive Vice President ) and Chief Financial Officer ) ) DeWayne J. Fellows ) Vice President and Controller ) ) J. P. Bolduc ) Director ) ) Gerald Grinstein ) Director ) ) Charles Marshall ) March 2, 1994 Director ) ) Klaus H. Murmann ) Director ) ) Donald E. Nordlund ) Director ) ) Don R. O'Hare ) Director ) ) Thomas G. Pownall ) Director ) ) Ward Smith ) Director ) ) Robert J. Smuland ) Director ) By: /s/ Paul Donovan ---------------------------------------------------- PAUL DONOVAN, ATTORNEY-IN-FACT REPORT OF INDEPENDENT AUDITORS To the Shareholders and Board of Directors Sundstrand Corporation We have audited the consolidated balance sheets of Sundstrand Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sundstrand Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions. /s/ ERNST & YOUNG Chicago, Illinois January 27, 1994 SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES YEAR ENDED DECEMBER 31, 1993 Dollar Amounts in Thousands SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES YEAR ENDED DECEMBER 31, 1992 Dollar Amounts in Thousands SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES YEAR ENDED DECEMBER 31, 1991 Dollar Amounts in Thousands SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (1) Dollar Amounts in Millions SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (1) Dollar Amounts in Millions SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS Dollar Amounts in Millions

793421_1993.txt

793421

1993

Item 3. Legal Proceedings. ----------------- Although FRP may be from time to time involved in various legal proceedings of a character normally incident to the ordinary course of its businesses, FRP believes that potential liability in any such pending or threatened proceedings would not have a material adverse effect on the financial condition or results of operations of FRP. FRP, through FTX, maintains liability insurance to cover some, but not all, potential liabilities normally incident to the ordinary course of its businesses as well as other insurance coverages customary in its businesses, with such coverage limits as management deems prudent. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. --------------------------------------------------- Not applicable. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. ------------------------------------------------- The information set forth under the captions "FRP Units" and "Cash Distributions", on the inside back cover of FRP's 1993 Annual Report to unitholders is incorporated herein by reference. As of March 10, 1994, there were approximately 18,606 record holders of FRP Units. Item 6.

Item 6. Selected Financial Data. ----------------------- The information set forth under the caption "Selected Financial and Operating Data" on page 13 of FRP's 1993 Annual Report to unitholders is incorporated herein by reference. FRP's ratio of earnings to fixed charges for each of the years 1989 through 1993, inclusive, was 4.8x, 16.5x, 4.4x, 1.0x and a shortfall of $233.5 million, respectively. For purposes of this calculation, earnings are income from continuing operations before fixed charges. Fixed charges are interest and that portion of rent deemed representative of interest. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ----------------------------------------------------------- IMC-AGRICO COMPANY Freeport-McMoRan Resource Partners, Limited Partnership (FRP) and IMC Fertilizer, Inc. (IMC) formed a joint venture (IMC-Agrico Company), effective July 1, 1993, for their respective phosphate fertilizer businesses, including phosphate rock and uranium. IMC-Agrico Company is governed by a policy committee having equal representation from each company and is managed by IMC. Combined annual savings of at least $95 million in production, marketing, and general and administrative costs are expected to result from this transaction, the full effect beginning by the end of the second year of operations. The operating efficiencies achievable by the joint venture should enable it to generate positive cash flow in a low-price environment, such as that experienced in 1993, and to be in a position to earn significant profits if product prices rise to historical levels. As discussed below and in Note 4 to the financial statements, significant restructuring charges were recorded in connection with this transaction. As a result of the joint venture, FRP is engaged in the phosphate rock mining, fertilizer production, and uranium oxide extraction businesses only through IMC-Agrico Company. FRP will continue to operate its sulphur and oil businesses. FRP has varying sharing ratios in IMC-Agrico Company, as discussed in Note 2 to the financial statements, which were based on the projected contributions of FRP and IMC to the cash flow of the joint venture and on an equal sharing of the anticipated savings. FRP transferred the assets it contributed to IMC-Agrico Company at their book carrying cost and proportionately consolidates its interest in IMC-Agrico Company. As a result, FRP's operating results subsequent to the formation of IMC-Agrico Company vary significantly in certain respects from those previously reported. Phosphate fertilizer realizations and unit production costs were fundamentally changed as the majority of the FRP contributed fertilizer production facilities are located on the Mississippi River, whereas the IMC contributed fertilizer production facilities are located in Florida. Fertilizer produced on the Mississippi River commands a higher sales price in the domestic market because of its proximity to markets; however, raw material transportation costs at the Florida facilities are lower for phosphate rock, partially offset by increased sulphur transportation costs. 1993 RESULTS OF OPERATIONS COMPARED WITH 1992 After discussions with the staff of the Securities and Exchange Commission (SEC), FRP is reclassifying certain expenses and accruals previously recorded in 1993 as restructuring and valuation of assets. In response to inquiries, FRP advised the SEC staff that $3.2 million originally reported as restructuring and valuation of assets represented the cumulative effect of changes in accounting principle resulting from the adoption of the new accounting policies that FRP considered preferable, as described in Note 1 to the financial statements. FRP also informed the SEC staff of the components of other charges included in the amount originally reported as restructuring and valuation of assets. FRP concluded that the reclassification and the related supplemental disclosures more accurately reflect the nature of these charges to 1993 net income in accordance with generally accepted accounting principles. These reclassifications had no impact on net income or net income per share. FRP incurred a net loss of $246.1 million ($2.37 per unit) for 1993 compared with net income of $20.2 million ($.20 per unit) for 1992. Results for 1993 were adversely impacted by charges totaling $197.3 million ($1.90 per unit) related to (a) restructuring the administrative organization at Freeport-McMoRan Inc. (FTX), the general partner of FRP (Note 4), (b) asset sales/recoverability charges (Note 4), (c) adjustments to general and administrative expenses and production and delivery costs discussed below, and (d) changes in accounting principle, discussed further in Note 1 to the financial statements. Excluding these items, 1993 earnings were lower reflecting significant decreases in phosphate fertilizer, phosphate rock, sulphur, and oil revenues, primarily due to reduced sales volumes and average market prices for these products (see Selected Financial and Operating Data). Depreciation and amortization expense declined primarily because of reduced sales volumes. The reduction in general and administrative expenses reflects the benefits from the 1993 restructuring activities, partially offset by charges resulting from the restructuring project discussed below. Interest expense increased, as no interest was capitalized subsequent to the Main Pass sulphur operations becoming operational for accounting purposes in July 1993. Restructuring Activities. During the second quarter of 1993, FTX undertook a restructuring of its administrative organization. This restructuring represented a major step by FTX to lower its costs of operating and administering its businesses in response to weak market prices of the commodities produced by its operating units. As part of this restructuring, FTX significantly reduced the number of employees engaged in administrative functions, changed its management information system (MIS) environment to achieve efficiencies, reduced its needs for office space, outsourced a number of administrative functions, and implemented other actions to lower costs. As a result of this restructuring process, which included the formation of IMC-Agrico Company, the level of FRP's administrative cost has been reduced substantially over what it would have been otherwise, which benefit will continue in the future. However, the restructuring process entailed incurring certain one-time costs by FTX, a portion of which were allocated to FRP pursuant to its management services agreement with FTX. FRP's restructuring costs totaling $33.9 million, including $22.1 million allocated from FTX based on historical allocations, consisting of the following: $15.5 million for personnel related costs; $7.0 million relating to excess office space and furniture and fixtures resulting from the staff reduction; $1.8 million relating to the cost to downsize its computing and MIS structure; $8.8 million related to costs directly associated with the formation of IMC-Agrico Company; and $.8 million of deferred charges relating to FRP's credit facility which was substantially revised in June 1993. As of December 31, 1993, the remaining accrual for these restructuring costs totaled $3.1 million. In connection with the restructuring project, FRP changed its accounting systems and undertook a detailed review of its accounting records and valuation of various assets and liabilities. As a result of this process, FRP recorded charges totaling $24.9 million, comprised of the following: (a) $10.0 million of production and delivery costs consisting of $6.3 million for revised estimates of environmental liabilities and $3.7 million primarily for adjustments in converting accounting systems, (b) $7.6 million of depreciation and amortization costs consisting of $6.5 million for estimated future abandonment and reclamation costs and $1.1 million for the write-down of miscellaneous properties, and (c) $7.3 million of general and administrative expenses consisting of $4.0 million to downsize FRP's computing and MIS structure and $3.3 million for the write-off of miscellaneous assets. Agricultural Minerals Operations FRP's agricultural minerals segment, which includes its fertilizer, phosphate rock, and sulphur businesses, reported a loss of $55.9 million on revenues of $619.3 million for 1993 compared with earnings of $18.0 million on revenues of $799.0 million for 1992. Significant items impacting the segment earnings are as follows (in millions): Agricultural minerals earnings - 1992 $ 18.0 Major increases (decreases) Sales volumes (67.4) Realizations (103.2) Other (9.1) ------ Revenue variance (179.7) Cost of sales 81.4* General and administrative and other 24.4* (73.9) ------ Agricultural minerals earnings - 1993 $(55.9) ====== - - - ------- * Includes $17.5 million in cost of sales and $7.3 million in general and administrative expenses resulting from the restructuring project discussed above. Weak industrywide demand and changes attributable to FRP's participation in IMC-Agrico Company resulted in FRP's 1993 reported sales volumes for diammonium phosphate (DAP), its principal fertilizer product, declining 17 percent from that of a year-ago. The weakness in the phosphate fertilizer market prompted IMC-Agrico Company to make strategic curtailments in its phosphate fertilizer production. However, late in the year increased export purchases contributed to a rise in market prices, helping to rekindle domestic buying interests which had been unwilling to make purchase commitments. The increased demand, coupled with low industrywide production levels, caused reduced inventory levels. Late in 1993, IMC-Agrico Company increased its production levels in response to the improving markets and projected domestic and international demand for its fertilizer products. Unit production cost, excluding $17.5 million of changes related to the restructuring project, declined from 1992 reflecting initial production efficiencies from the joint venture, reduced raw material costs for sulphur, and lower phosphate rock mining expenses, partially offset by increased natural gas costs and lower production volumes. FRP's realization for DAP was lower reflecting the near 20-year low prices realized during 1993 as well as an increase in the lower-priced Florida sales by IMC-Agrico Company. FRP believes that the outlook for 1994 is for improved prices caused by more normal market demand. Spot market prices improved from a low of nearly $100 per short ton of DAP (central Florida) in July 1993 to just over $140 per ton by year end. Industry inventories at year end were below average levels, despite a fourth quarter rebound in industry production. Export demand is expected to remain at more normal levels during the first half of 1994, with China, India, and Pakistan expected to be active purchasers. Additionally, domestic phosphate fertilizer demand is expected to benefit from increased corn acreage planted due to lower government set- asides and to increased fertilizer application rates necessitated by the widespread flooding that caused a depletion of nutrients in a number of midwestern states. FRP's proportionate share of the larger IMC-Agrico Company phosphate rock operation caused 1993 sales volumes to increase from 1992, with IMC- Agrico Company operating its most efficient facilities to minimize costs. Combined sulphur production from the Caminada and Main Pass mines increased compared with 1992; however, sales volumes declined 16 percent, primarily because of reduced purchases by IMC-Agrico Company resulting from its curtailed fertilizer production. Due to the significant decline in the market price of sulphur, FRP recorded a second-quarter 1993 noncash charge to earnings (not included in segment earnings) for the excess of capitalized cost over expected realization of its non-Main Pass sulphur assets, primarily the Caminada sulphur mine (Note 4). Due to significant improvements in Main Pass sulphur production, FRP ceased the marginally profitable Caminada operations in January 1994. The shutdown of Caminada will have no material impact on FRP's reported earnings. Although reduced global demand has forced production cutbacks worldwide, sulphur prices remain depressed. A rebound in price is not expected until demand improves. At Main Pass, sulphur production increased significantly during 1993 and achieved, on schedule, full design operating rates of 5,500 tons per day (approximately 2 million tons per year) in December 1993 and has since sustained production at or above that level. As a result of the production increases, Main Pass sulphur became operational for accounting purposes beginning July 1, 1993. Recognizing Main Pass sulphur operations in income and discontinuing associated capitalized interest did not affect cash flow, but adversely affected reported operating results. Oil Operation 1993 1992 ---- ---- Sales (barrels) 3,443,000 4,884,000 Average realized price $14.43 $15.91 Earnings (in millions) $(1.5) $4.6 Since completion of development drilling in mid-April 1993, oil production for the Main Pass joint venture (in which FRP owns a 58.3 percent interest) increased significantly, averaging over 20,000 barrels per day for December 1993. Production for 1994 is expected to approximate that of 1993 if water encroachment follows current trends, with the anticipated drilling of additional wells (estimated to cost FRP approximately $4 million) offsetting a production decline in existing wells. Due to the dramatic decline in oil prices at year-end, FRP recorded a $60.0 million charge to earnings (not included in segment earnings) reflecting the excess net book value of its Main Pass oil investment over the estimated future net cash flow to be received. Future price declines, increases in costs, or negative reserve revisions could result in an additional charge to future earnings. CAPITAL RESOURCES AND LIQUIDITY Net cash used in operating activities during 1993 was $2.9 million compared with $120.1 million net cash provided during 1992, due primarily to lower income from operations. Net cash provided by investing activities was $2.5 million compared with $209.9 million used for 1992, reflecting the reduced level of capital expenditures (following completion of Main Pass development expenditures and the cost efficiency program during 1992) and the proceeds from asset sales. Net cash provided by financing activities during 1993 was $17.8 million reflecting net borrowings of $139.0 million partially offset by lower distributions resulting from unpaid distributions to FTX since early-1992 (discussed below), compared with $93.1 million for 1992 which had a net reduction of borrowings totaling $186.2 million funded by $430.5 million in proceeds from the public sale of FRP units in February 1992. Cash flow from operations for 1992 was $120.1 million compared with $106.5 million for 1991. Net cash used in investing activities declined to $209.9 million from $346.9 million in 1991, due primarily to reduced capital expenditures. Net cash provided by financing activities declined to $93.1 million in 1992 from $243.5 million in 1991, with 1991 including net borrowings of $421.2 million. Publicly owned FRP units have cumulative rights to receive quarterly distributions of 60 cents per unit through the distribution for the quarter ending December 31, 1996 (the Preference Period) before any distributions may be made to FTX. FRP has announced that beginning with the distribution for the fourth quarter of 1993 it no longer intends to supplement distributable cash with borrowings. Therefore, FRP's future distributions will be dependent on the distributions received from IMC-Agrico Company, which will primarily be determined by prices and sales volumes of its commodities and cost reductions achieved by its combined operations, and the future cash flow of FRP's oil and sulphur operations (including reclamation expenditures related to its non-Main Pass sulphur assets). On January 21, 1994, FRP declared a distribution of 60 cents per publicly held unit ($30.3 million) and 12 cents per FTX-owned unit ($6.2 million), payable February 15, 1994, bringing the total unpaid distribution due FTX to $239.2 million. Unpaid distributions due FTX will be recoverable from future FRP cash available for quarterly distributions as discussed in Note 3 to the financial statements. The January 1994 distribution included $30.9 million received from IMC-Agrico Company for its fourth-quarter 1993 distribution (including $9.3 million from working capital reductions) and $13.0 million in proceeds from the sale of certain previously mined phosphate rock acreage. In September 1993, FTX agreed to manage for one year Fertiberia, S.L., the restructured phosphate and nitrogen fertilizer businesses of FESA Fertilizantos Espanoles, a wholly owned subsidiary of ERCROS, S.A., a Spanish conglomerate. FTX has assumed no financial obligations during this period. The goal of the management services agreement is to establish Fertiberia as a financially viable concern. If financial viability can be established, FRP has agreed to negotiate the acquisition of a controlling equity interest in Fertiberia. In June 1993, FTX amended its credit agreement in which FRP participates, extending its maturity (Note 5). As of February 1, 1994, $425.0 million was available under the credit facility. To the extent FTX and its other subsidiaries incur additional debt, the amount available to FRP under the credit facility may be reduced. FRP believes that its short- term cash requirements will be met from internally generated funds and borrowings under its existing credit facility. ENVIRONMENTAL FTX and its affiliates, including FRP, have a history of commitment to environmental responsibility. Since the 1940s, long before public attention focused on the importance of maintaining environmental quality, FTX and its affiliates have conducted preoperational, bioassay, marine ecological, and other environmental surveys to ensure the environmental compatibility of its operations. FTX's Environmental Policy commits FTX and its affiliates' operations to full compliance with local, state, and federal laws and regulations, and prescribes the use of periodic environmental audits of all domestic facilities to evaluate compliance status and communicate that information to management. FTX has access to environmental specialists who have developed and implemented corporatewide environmental programs. FTX's operating units, including FRP, continue to study and implement methods to reduce discharges and emissions. Federal legislation (sometimes referred to as "Superfund") requires payments for cleanup of certain abandoned waste disposal sites, even though such waste disposal activities were performed in compliance with regulations applicable at the time of disposal. Under the Superfund legislation, one party may, under certain circumstances, be required to bear more than its proportional share of cleanup costs at a site where it has responsibility pursuant to the legislation, if payments cannot be obtained from other responsible parties. Other legislation mandates cleanup of certain wastes at unabandoned sites. States also have regulatory programs that can mandate waste cleanup. Liability under these laws involves inherent uncertainties. FRP has received notices from governmental agencies that it is one of many potentially responsible parties at certain sites under relevant federal and state environmental laws. Further, FRP is aware of additional sites for which it may receive such notices in the future. Some of these sites involve significant cleanup costs; however, at each of these sites other large and viable companies with equal or larger proportionate shares are among the potentially responsible parties. The ultimate settlement for such sites usually occurs several years subsequent to the receipt of notices identifying potentially responsible parties because of the many complex technical and financial issues associated with site cleanup. FRP believes that the aggregation of any costs associated with these potential liabilities will not exceed amounts accrued and expects that any costs would be incurred over a period of years. FRP, through FTX, maintains insurance coverage in amounts deemed prudent for certain types of damages associated with environmental liabilities which arise from unexpected and unforeseen events and has an indemnification agreement covering certain acquired sites (Note 7). FRP has made, and will continue to make, expenditures at its operations for protection of the environment. Continued government and public emphasis on environmental issues can be expected to result in increased future investments for environmental controls, which will be charged against income from future operations. Present and future environmental laws and regulations applicable to FRP's operations may require substantial capital expenditures and may affect its operations in other ways that cannot now be accurately predicted. 1992 RESULTS OF OPERATIONS COMPARED WITH 1991 FRP reported 1992 net income of $20.2 million ($.20 per unit) compared with $15.0 million ($.18 per unit) for 1991, which included an insurance settlement gain (Note 7) of $17.7 million ($.21 per unit) and a charge of $96.8 million ($1.16 per unit) to reflect the cumulative effect of the change in accounting principle for postretirement benefits other than pensions (Note 6). Excluding the nonrecurring items, income for 1992 was lower primarily because of reduced agricultural minerals and uranium earnings, partially offset by profitable Main Pass oil operations. Revenues were virtually unchanged from 1991 with increases in oil and phosphate rock revenues partially offsetting a decrease in phosphate fertilizer revenues. Production and delivery costs as a percent of revenues declined due to increased oil production, which has lower production and delivery costs than FRP's other products. Depreciation and amortization expense rose primarily because of higher oil production, and general and administrative expenses increased due to the additional effort and support required by Main Pass. Interest costs of $19.1 million for 1992 and $23.3 million for 1991, associated primarily with Main Pass development, were capitalized. Agricultural Minerals Operations Revenues and earnings for 1992 totaled $799.0 million and $18.0 million compared with $880.5 million and $78.9 million for 1991, respectively, reflecting weak market prices for phosphate fertilizers and sulphur. However, FRP's 1992 average unit production cost for phosphate fertilizers was lower than during 1991. Significant items impacting the segment earnings are as follows (in millions): Agricultural minerals earnings - 1991 $ 78.9 Major increases (decreases) Sales volumes 27.0 Realizations (107.8) Other (.7) ------ Revenue variance (81.5) Cost of sales 41.9 General and administrative and other (21.3) ------ (60.9) ------ Agricultural minerals earnings - 1992 $ 18.0 ====== Phosphate fertilizer sales volumes were slightly lower during 1992, whereas the average realization was 13 percent lower. Phosphate fertilizer realizations declined steadily throughout 1992 because of curtailed purchases by China, the largest single fertilizer importer, and supply and demand uncertainty in Europe, the former Soviet Union, and India. Also contributing to the decline in prices were lower raw material costs, most notably for sulphur, as producers in the weakening market passed along these cost savings to buyers in an attempt to preserve market share. FRP's phosphate rock and fertilizer facilities operated at or near capacity, with the 1992 phosphate fertilizer unit production cost averaging 7 percent less than during 1991 due to reduced raw material costs for sulphur and lower phosphate rock mining expenses, despite higher natural gas costs. Unit production cost also benefited during the latter part of 1992 as FRP completed a $60.0 million capital program to improve efficiency and lower costs. Sulphur production and sales volumes for 1992 declined 8 percent and 7 percent, respectively, from 1991 as the Garden Island Bay and Grand Isle mines ceased production in 1991. However, production increased at the Caminada mine, which had a significantly lower unit production cost than either Garden Island Bay or Grand Isle had prior to depletion, resulting in an average sulphur unit production cost 7 percent lower than during 1991. FRP's 1992 sulphur realization reflects the price declines which occurred since mid-1991, as world sulphur markets were burdened by the collapse of the Soviet Union as well as by a further decline in demand in Western Europe. During 1992, several Canadian sulphur marketers built inventory rather than accept depressed prices; however, others intensified their efforts to sell into the important Tampa, Florida market. Phosphate rock production and sales benefited from the capacity expansion completed in mid-1992 at one of FRP's two operated phosphate rock mines, and also reflect the output from FRP's Central Florida Pebbledale property, where sales began in July 1991 under a mining agreement with IMC. Oil Operation 1992 1991 --------- ------- Sales (barrels) 4,884,000 350,800 Average realized price $15.91 $13.34 Earnings (in millions) $4.6 $(.6) Earnings for Main Pass, which initiated oil production in late 1991, benefited from FRP's marketing efforts, which alleviated earlier problems related to its high-sulphur oil, and high average production rates. ______________________________________ The results of operations reported and summarized above are not necessarily indicative of future operating results. Item 8.

Item 8. Financial Statements and Supplementary Data. ------------------------------------------- The financial statements of FRP, the notes thereto and the report thereon of Arthur Andersen & Co., appearing on pages 20 through 32 inclusive, of FRP's 1993 Annual Report to unitholders, are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. ----------------------------------------------------------- Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. -------------------------------------------------- FRP has no directors; instead, the general partners in FRP, FTX and FMRP Inc., perform comparable functions for FRP. In addition to the elected executive officers of FRP (the "Elected FRP Executive Officers"), certain employees of the general partners have management responsibilities with respect to FRP and are thus deemed by FRP to be executive officers of FRP (the "Designated FRP Executive Officers") for purposes of the federal securities laws. The following table shows, as of March 15, 1994, the names, ages, positions with the general partners and principal occupations of the Elected FRP Executive Officers and the Designated FRP Executive Officers (collectively, the "FRP Executive Officers"): Name Age Positions and Principal Occupations ---- --- ----------------------------------- Richard C. Adkerson 47 Senior Vice President of FTX. John G. Amato 50 General Counsel of FRP. General Counsel of FTX. Director of FMRP Inc. Richard H. Block 43 Senior Vice President - Fertilizer Operations of FRP. Senior Vice President of FTX. R. Foster Duncan 40 Senior Vice President of FRP. Thomas J. Egan 49 Senior Vice President of FTX. Robert B. Foster 50 Senior Vice President - Sulphur Operations of FRP. Charles W. Goodyear 36 Senior Vice President - Finance and Accounting and Chief Financial Officer of FRP. Senior Vice President of FTX. Director of FMRP Inc. W. Russell King 44 Senior Vice President of FTX. Rene L. Latiolais 51 President and Chief Executive Officer of FRP. Director, President, and Chief Operating Officer of FTX. Director, Chairman of the Board, and President of FMRP Inc. George A. Mealey 60 Executive Vice President of FTX. Director, President, and Chief Executive Officer of Freeport-McMoRan Copper & Gold Inc., a subsidiary of FTX. James R. Moffett 55 Director, Chairman of the Board, and Chief Executive Officer of FTX. All of the individuals above, with the exceptions of Messrs. Adkerson, Amato, Duncan and Goodyear, have served FTX or FRP in various executive capacities for at least the last five years. Until 1989, Mr. Adkerson was a partner in Arthur Andersen & Co., an independent public accounting firm, Mr. Duncan was First Vice President and Manager-Corporate Finance of Howard Weil Labouisse Friedrichs Incorporated, a brokerage firm, and Mr. Goodyear was a Vice President of Kidder, Peabody & Co. Incorporated, an investment banking firm. During the past five years and prior to that period, Mr. Amato has been engaged in the private practice of law and has served as outside counsel to FTX and FRP. All Elected FRP Executive Officers and all officers of FTX serve at the pleasure of the Board of Directors of FTX. All officers of FMRP Inc. serve at the pleasure of the Board of Directors of FMRP Inc. According to (i) the Forms 3 and 4 and any amendments thereto filed pursuant to Section 16(a) of the Securities Exchange Act of 1934 ("Section 16") and furnished to FRP during 1993 by persons subject to Section 16 at any time during 1993 with respect to securities of FRP ("FRP Section 16 Insiders"), (ii) the Forms 5 with respect to 1993 and any amendments thereto filed pursuant to Section 16 and furnished to FRP by FRP Section 16 Insiders, and (iii) the written representations from certain FRP Section 16 Insiders that no Form 5 with respect to the securities of FRP was required to be filed by such FRP Section 16 Insider, respectively, with respect to 1993, no FRP Section 16 Insider failed to file altogether or timely any Forms 3, 4, or 5 required by Section 16 with respect to the securities of FRP or to disclose on such Forms transactions required to be reported thereon. Item 11.

Item 11. Executive Compensation. ---------------------- FRP does not employ any of the FRP Executive Officers, nor does it compensate them for their services. The FRP Executive Officers are either employed or retained by FTX. The President and Chief Executive Officer of FRP, Rene L. Latiolais, is employed by FTX. The four most highly compensated FRP Executive Officers other than Mr. Latiolais are James R. Moffett, Richard H. Block, Charles W. Goodyear, and W. Russell King; they are also employed by FTX. The determination as to which FRP Executive Officers were the most highly compensated was made by reference to the total annual salary and bonus for 1993 of each of the FRP Executive Officers employed by FTX that was allocated to FRP by FTX pursuant to the FRP partnership agreement on the basis of time devoted to FRP activities. The services of all the FRP Executive Officers and the services of the other officers of FRP are provided to FRP by FTX under the FRP partnership agreement. FRP reimburses FTX at FTX's cost, including allocated overhead, for such services. All the FRP Executive Officers are compensated exclusively by FTX for their services to FRP. All the FRP Executive Officers are eligible to participate in certain FTX benefit plans and programs. The total costs to FTX for the FRP Executive Officers, including the costs borne by FTX with respect to such plans and programs, are allocated to FRP, to the extent practicable, in proportion to the time spent by such FRP Executive Officers on FRP affairs. No other payment is made by FRP to FTX for providing such compensation and benefit plans and programs to the FRP Executive Officers. Reference is made to the information set forth under the caption "Management" above and to the information set forth in Note 6 to the FRP Financial Statements. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. ----------------------------------------------- According to information furnished by the person known to FRP to be a beneficial owner of more than 5% of Partnership Units, the number of Partnership Units beneficially owned by such person as of December 31, 1993, was as follows: Number of Partnership Units Percent Beneficially of Name and Address of Person Owned Class - - - -------------------------- ----------------- ------- Freeport-McMoRan Inc. 52,170,192(a) 50.8 1615 Poydras Street New Orleans, Louisiana 70112 _________ (a) These Partnership Units consist of 18,582 FRP Depositary Units and 52,151,610 FRP Unit Equivalents. FTX has sole voting and investment power with respect to such Partnership Units. The other general partner in FRP, FMRP Inc., did not own beneficially any Partnership Units as of December 31, 1993. According to information furnished by each of the Elected FRP Executive Officers and the Designated FRP Executive Officers (collectively, the "FRP Executive Officers"), the number of FRP Depositary Units and shares of FTX common stock ("FTX Shares") beneficially owned by each of them as of December 31, 1993, was as follows: Number of Number of FRP Depositary Units FTX Shares Name of Individual Beneficially Beneficially or Identity of Group Owned(a) Owned(a) - - - -------------------- -------------------- ------------ Richard H. Block 2,184 70,661(b) Charles W. Goodyear 0 188,597(b)(c) W. Russell King 990 64,119(b) Rene L. Latiolais 539(d) 517,590(b) James R. Moffett 65,439(e) 3,313,162(b)(e) 11 FRP Executive Officers as a group, including those persons named above 76,468(f) 5,033,771(f) - - - -------- (a) Except as otherwise noted, the individuals referred to have sole voting and investment power with respect to such FRP Depositary Units and FTX Shares. With the exception of Mr. Moffett, who beneficially owns 2.3% of the outstanding FTX Shares, each of the individuals referred to holds less than 1% of the outstanding FRP Depositary Units and FTX Shares, respectively. (b) Includes FTX Shares held by the trustee under the Employee Capital Accumulation Program of FTX, as follows: Mr. Block, 11,765 FTX Shares; Mr. Goodyear, 2,113 FTX Shares; Mr. King, 9,510 FTX Shares; Mr. Latiolais, 15,191 FTX Shares; Mr. Moffett, 21,293 FTX Shares; all FRP Executive Officers as a group (10 persons), 79,188 FTX Shares. Also includes FTX Shares that could be acquired within 60 days after December 31, 1993 upon the exercise of options granted pursuant to the employee stock option plans of FTX, as follows: Mr. Block, 58,896 FTX Shares; Mr. Goodyear, 186,420 FTX Shares; Mr. King, 19,168 FTX Shares; Mr. Latiolais, 332,426 FTX Shares; Mr. Moffett, 1,764,434 FTX Shares; all FRP Executive Officers as a group (11 persons), 3,079,436 FTX Shares. (c) Includes 64 FTX Shares held in a retirement account for the benefit of Mr. Goodyear. (d) Includes 405 FRP Depositary Units held for the benefit of Mr. Latiolais by the custodian under FRP's Depositary Unit Reinvestment Plan. (e) Includes a total of 39,600 FRP Depositary Units and 214,648 FTX Shares held for the benefit of a trust with respect to which Mr. Moffett and an FRP Executive Officer, as co-trustees of such trust, have sole voting and investment power but have no beneficial interest therein. Mr. Moffett and such FRP Executive Officer disclaim beneficial ownership of such FRP Depositary Units and FTX Shares held for the benefit of such trust. Includes a total of 25,839 FRP Depositary Units and 85,140 FTX Shares held for the benefit of two trusts created by Mr. Moffett for the benefit of his two children, who are adults. An FRP Executive Officer and another individual, as co-trustees of the two trusts, have sole voting and investment power with respect to such FRP Depositary Units and FTX Shares held for the benefit of such trusts but have no beneficial interest therein. Mr. Moffett and such FRP Executive Officer disclaim beneficial ownership of such FRP Depositary Units and FTX Shares held for the benefit of such trusts. Includes a total of 88,000 FTX Shares held for the benefit of a trust created by Mr. Moffett for the benefit of an educational fund and his two children, who are adults. An FRP Executive Officer and another individual, as co-trustees of such trust, have sole voting and investment power with respect to such FTX Shares held for the benefit of such trust but have no beneficial interest therein. Mr. Moffett and such FRP Executive Officer disclaim beneficial ownership of such FTX Shares held for the benefit of such trust. (f) See notes (b) through (e) above. Includes 724 FTX Shares that may be acquired upon the conversion of 6.55% Convertible Subordinated Notes due January 15, 2001 of FTX ("FTX Notes") held in trust for the benefit of one of the FRP Executive Officers, 2,682 FTX Shares that may be acquired upon the conversion of Zero Coupon Convertible Subordinated Debentures due 2006 of FTX held in trust for the benefit of such FRP Executive Officer, and 90 FTX Shares that may be acquired upon the conversion of FTX Notes held in trust for the benefit of the spouse of such FRP Executive Officer. Includes 6 FRP Depositary Units and 1,516 FTX Shares held in trust for the benefit of one of the FRP Executive Officers, 92 FTX Shares held in trust for the benefit of the spouse of such FRP Executive Officer as to which beneficial ownership is disclaimed, and 1,000 FTX Shares held by such FRP Executive Officer as custodian as to which beneficial ownership is disclaimed. These total numbers of FRP Depositary Units and FTX Shares represent less than 1% of the outstanding FRP Depositary Units and approximately 3.5% of the outstanding FTX Shares, respectively. Item 13.

Item 13. Certain Relationships and Related Transactions. ---------------------------------------------- Reference is made to the information set forth under the caption "Management" above, to the information set forth in Item 11 above and to the information set forth in Note 6 to the FRP Financial Statements. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. --------------------------------------------------------------- (a)(1), (a)(2), and (d). Financial Statements. Reference is made to the Index to Financial Statements appearing on page hereof. (a)(3) and (c). Exhibits. Reference is made to the Exhibit Index beginning on page E-1 hereof. (b). Reports on Form 8-K. No reports on Form 8-K were filed by the registrant during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 29, 1994. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP By: FREEPORT-McMoRan INC., Its Administrative Managing General Partner By: /s/ James R. Moffett ---------------------------- James R. Moffett Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 29, 1994. /s/ Rene L. Latiolais President and Chief Executive Officer - - - ----------------------- of Freeport-McMoRan Resource Rene L. Latiolais Partners, Limited Partnership and Director of Freeport-McMoRan Inc. (Principal Executive Officer) /s/ Charles W. Goodyear Senior Vice President and Chief - - - ----------------------- Financial Officer of Freeport-McMoRan Charles W. Goodyear Resource Partners, Limited Partnership (Principal Financial Officer) /s/ Nancy D. Bonner Vice President and Controller of - - - ----------------------- Freeport-McMoRan Resource Partners, Nancy D. Bonner Limited Partnership (Principal Accounting Officer) Robert W. Bruce III* Director of Freeport-McMoRan Inc. Thomas B. Coleman* Director of Freeport-McMoRan Inc. William H. Cunningham* Director of Freeport-McMoRan Inc. Robert A. Day* Director of Freeport-McMoRan Inc. William B. Harrison, Jr.* Director of Freeport-McMoRan Inc. Henry A. Kissinger* Director of Freeport-McMoRan Inc. Bobby Lee Lackey* Director of Freeport-McMoRan Inc. Gabrielle K. McDonald* Director of Freeport-McMoRan Inc. W. K. McWilliams, Jr.* Director of Freeport-McMoRan Inc. /s/ James R. Moffett Director, Chairman of the Board - - - ----------------------- and Chief Executive Officer James R. Moffett of Freeport-McMoRan Inc. George Putnam* Director of Freeport-McMoRan Inc. B. M. Rankin, Jr.* Director of Freeport-McMoRan Inc. Benno C. Schmidt* Director of Freeport-McMoRan Inc. J. Taylor Wharton* Director of Freeport-McMoRan Inc. Ward W. Woods, Jr.* Director of Freeport-McMoRan Inc. *By: /s/ James R. Moffett ----------------------- James R. Moffett Attorney-in-Fact The financial statements of FRP, the notes thereto, and the report thereon of Arthur Andersen & Co., appearing on pages 20 through 32, inclusive, of FRP's 1993 Annual Report to unitholders are incorporated by reference. The financial statement schedules listed below should be read in conjunction with such financial statements contained in FRP's 1993 Annual Report to unitholders. Page ---- Report of Independent Public Accountants.........................F-1 III-Condensed Financial Information of Registrant................F-2 V-Property, Plant and Equipment..................................F-5 VI-Accumulated Depreciation and Amortization.....................F-6 VIII-Valuation and Qualifying Accounts...........................F-7 X-Supplementary Income Statement Information.....................F-8 Schedules other than those listed above have been omitted, since they are either not required, not applicable or the required information is included in the financial statements or notes thereof. * * * REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS We have audited, in accordance with generally accepted auditing standards, the financial statements as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 included in Freeport-McMoRan Resource Partners, Limited Partnership's annual report to unitholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index above are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules for the years ended December 31, 1993, 1992 and 1991 have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. ------------------------- Arthur Andersen & Co. New Orleans, Louisiana, January 25, 1994 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS December 31, ------------------- 1993 1992 ---- ---- (In Thousands) ASSETS Current assets: Cash and short-term investments $ 5,300 $ 7,099 Accounts receivable: Customers 6,193 50,399 Other 12,811 12,175 Inventories: Products 31,458 141,216 Materials and supplies 7,877 29,060 Prepaid expenses and other 273 22,214 ---------- ---------- Total current assets 63,912 262,163 Property, plant and equipment-net 532,927 1,074,332 Investment in IMC-Agrico Company 483,070 - Other assets 100,628 157,012 ---------- ---------- Total assets $1,180,537 $1,493,507 ========== ========== LIABILITIES AND PARTNERS' CAPITAL Current liabilities: Accounts payable and accrued liabilities $ 37,175 $ 102,366 Current portion of long-term debt - 1,575 ---------- ---------- Total current liabilities 37,175 103,941 Long-term debt, less current portion 475,900 356,563 Reclamation and mine shutdown reserves 58,896 55,152 Accrued postretirement benefits and other liabilities 116,162 118,156 Partners' capital 492,404 859,695 ---------- ---------- Total liabilities and partners' capital $1,180,537 $1,493,507 ========== ========== The footnotes contained in FRP's 1993 Annual Report to unitholders are an integral part of these statements. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF OPERATIONS The footnotes contained in FRP's 1993 Annual Report to unitholders are an integral part of these statements. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOW The footnotes contained in FRP's 1993 Annual Report to unitholders notes are an integral part of these statements. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992, and 1991 Freeport-McMoRan Resource Partners, Limited Partnership Exhibit Index Sequentially Exhibit Numbered Number Page - - - ------- ---------------- 3.1 Amended and Restated Agreement of Limited Partnership of FRP dated as of May 29, 1987 (the "FRP Partnership Agreement") among FTX, Freeport Phosphate Rock Company and Geysers Geothermal Company, as general partners, and Freeport Minerals Company, as general partner and attorney-in-fact for the limited partners, of FRP. Incorporated by reference to Exhibit B to the Prospectus dated May 29, 1987 included in FRP's Registration Statement on Form S-1, as amended, as filed with the Commission on May 29, 1987 (Registration No. 33-13513). 3.2 Amendment to the FRP Partnership Agreement dated as of April 6, 1990 effected by FTX, as Administrative Managing General Partner of FRP. Incorporated by reference to Exhibit 19.3 to the Quarterly Report on Form 10-Q of FRP for the quarter ended March 31, 1990 (the "FRP 1990 First Quarter Form 10-Q"). 3.3 Amendment to the FRP Partnership Agreement dated as of January 27, 1992 between FTX, as Administrative Managing General Partner, and FMRP Inc., as Managing General Partner, of FRP. Incorporated by reference to Exhibit 3.3 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1991 (the "FRP 1991 Form 10-K"). 3.4 Amendment to the FRP Partnership Agreement dated as of October 14, 1992 between FTX, as Administrative Managing General Partner, and FMRP Inc., as Managing General Partner, of FRP. Incorporated by reference to Exhibit 3.4 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1992 (the "FRP 1992 Form 10-K"). 3.5 Amended and Restated Certificate of Limited Partnership of FRP dated June 12, 1986 (the "FRP Partnership Certificate"). Incorporated by reference to Exhibit 3.3 to FRP's Registration Statement on Form S-1, as amended, as filed with the Commission on June 20, 1986 (Registration No. 33-5561). 3.6 Certificate of Amendment to the FRP Partnership Certificate dated as of January 12, 1989. 3.7 Certificate of Amendment to the FRP Partnership Certificate dated as of December 29, 1989. Incorporated by reference to Exhibit 19.1 to the FRP 1990 First Quarter Form 10-Q. 3.8 Certificate of Amendment to the FRP Partnership Certificate dated as of April 12, 1990. Incorporated by reference to Exhibit 19.4 to the FRP 1990 First Quarter Form 10-Q. 4.1 Deposit Agreement dated as of June 27, 1986 (the "Deposit Agreement") among FRP, The Chase Manhattan Bank, N.A. ("Chase") and Freeport Minerals Company ("Freeport Minerals"), as attorney-in-fact of those limited partners and assignees holding depositary receipts for units of limited partnership interests in FRP ("Depositary Receipts"). Incorporated by reference to Exhibit 28.4 to the Current Report on Form 8-K of FTX dated July 11, 1986. 4.2 Resignation dated December 26, 1991 of Chase as Depositary under the Deposit Agreement and appointment dated December 27, 1991 of Mellon Bank, N.A. ("Mellon") as successor Depositary, effective January 1, 1992. Incorporated by reference to Exhibit 4.5 to the FRP 1991 Form 10-K. 4.3 Service Agreement dated as of January 1, 1992 between FRP and Mellon pursuant to which Mellon will serve as Depositary under the Deposit Agreement and Custodian under the Custodial Agreement. Incorporated by reference to Exhibit 4.6 to the FRP 1991 Form 10-K. 4.4 Amendment to the Deposit Agreement dated as of November 18, 1992 between FRP and Mellon. Incorporated by reference to Exhibit 4.4 to the FRP 1992 Form 10-K. 4.5 Form of Depositary Receipt. Incorporated by reference to Exhibit 4.5 to the FRP 1992 Form 10-K. 4.6 Custodial Agreement regarding the FRP Depositary Unit Reinvestment Plan among FTX, FRP and Chase, effective as of April 1, 1987 (the "Custodial Agreement"). Incorporated by refer- ence to Exhibit 19.1 to the Quarterly Report on Form 10-Q of FRP for the quarter ended June 30, 1987. 4.7 FRP Depositary Unit Reinvestment Plan. Incorporated by reference to Exhibit 4.4 to the FRP 1991 Form 10-K. 4.8 Credit Agreement dated as of June 1, 1993 (the "FTX/FRP Credit Agreement") among FTX, FRP, the several banks which are parties thereto (the "FTX/FRP Banks") and Chemical Bank, as Agent (the "FTX/FRP Bank Agent"). 4.9 First Amendment dated as of February 2, 1994 to the FTX/FRP Credit Agreement among FTX, FRP, the FTX/FRP Banks and the FTX/FRP Bank Agent. 4.10 Second Amendment dated as of March 1, 1994 to the FTX/FRP Credit Agreement among FTX, FRP, the FTX/FRP Banks and the FTX/FRP Bank Agent. 4.11 Subordinated Indenture as of October 26, 1990 between FRP and Manufacturers Hanover Trust Company ("MHTC") as the Trustee, relating to $150,000,000 principal amount of 8 3/4% Senior Subordinated Notes due 2004 of FRP (the "Subordinated Indenture"). 4.12 First Supplemental Indenture dated as of February 15, 1994 between FRP and Chemical Bank, as Successor to MHTC, as Trustee, to the Subordinated Indenture. 10.1 Contribution Agreement dated as of April 5, 1993 between FRP and IMC (the "FRP-IMC Contribution Agreement"). Incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K of FRP dated July 15, 1993 (the "FRP July 15, 1993 Form 8-K"). 10.2 First Amendment dated as of July 1, 1993 to the FRP-IMC Contribution Agreement. Incorporated by reference to Exhibit 2.2 to the FRP July 15, 1993 Form 8-K. 10.3 Amended and Restated Partnership Agreement dated as of July 1, 1993 among IMC-Agrico GP Company, Agrico, Limited Partnership and IMC-Agrico MP Inc. Incorporated by reference to Exhibit 2.3 to the FRP July 15, 1993 Form 8-K. 10.4 Parent Agreement dated as of July 1, 1993 among IMC, FRP, FTX and IMC- Agrico. Incorporated by reference to Exhibit 2.4 to the FRP July 15, 1993 Form 8-K. 12.1 FRP Computation of Ratio of Earnings to Fixed Charges. 13.1 Those portions of the 1993 Annual Report to unitholders of FRP which are incorporated herein by reference. 18.1 Letter of Arthur Andersen & Co. concerning changes in accounting principles. 21.1 List of Subsidiaries of Freeport McMoRan Resource Partners, Limited Partnership 23.1 Consent of Arthur Andersen & Co. dated March 25, 1994. 24.1 Powers of Attorney pursuant to which this report has been signed on behalf of certain directors of FTX.

2024_1993.txt

2024

1993

Item 1. Business Ace Hardware Corporation was formally organized as a Delaware corporation in 1964. In 1973, by means of a corporate merger, it succeeded to the business of Ace Hardware Corporation, an Illinois corporation organized in 1928. Until 1973, the business now being engaged in by the Company had been conducted by the Illinois corporation. The Company's principal executive offices are located at 2200 Kensington Court, Oak Brook, Illinois 60521. Its telephone number is (708) 990-6600. The Company functions as a wholesaler of hardware and related products, and manufactures paint products. Sales of the products distributed by it are presently made primarily to individuals, partnerships or corporations who are engaged in business as retail dealers of hardware or related items and who have entered into Membership Agreements with the Company entitling them to purchase merchandise and services from the Company and to use the Company's marks as provided therein. The Company operates on a cooperative basis and distributes patronage dividends to its eligible member dealers each year in proportion to the amount of their annual purchases of merchandise from it. (See the subheading "Distribution of Patronage Dividends".) At December 31, 1993 there were 4,921 retail business outlets with respect to which such Membership Agreements had been entered into. Those States having the largest concentration of member outlets are California (approximately 10%), Illinois and Texas (approximately 7% each), Florida (approximately 5%), and Michigan and Georgia (approximately 4% each). States into which were shipped the largest percentages of the merchandise sold by the Company in 1993 are California (approximately 12%), Illinois (approximately 9%), Florida and Texas (approximately 6% each) and Michigan and Georgia (approximately 4% each). Less than 3% of the Company's sales are made to outlets located outside of the United States or its territories. Information as to the number of the Company's member outlets during each of the past three calendar years is set forth in the following table: 1993 1992 1991 Member outlets at beginning of period 4,986 5,111 5,206 New member outlets 158 183 253 Member outlets terminated 223 308 348 Member outlets at end of period 4,921 4,986 5,111 Dealers having one or more member outlets at end of period 4,045 4,134 4,266 The Company services its dealers by purchasing merchandise in quantity lots, primarily from manufacturers, by warehousing substantial quantities of said merchandise and by selling the same in smaller lots to the dealers. Most of the products that the Company distributes to its dealers from its regional warehouses are sold at a 10% markup. In 1993 warehouse sales accounted for 61.7% of total sales and bulletin sales accounted for 3.4% of total sales with the balance of 34.9% representing direct shipment, including lumber and building material sales. The proportions in which the Company's total warehouse sales were divided among the various classes of merchandise sold by it during each of the past three calendar years are as follows: Class of Merchandise 1993 1992 1991 Paint, cleaning and related supplies 19% 18% 18% Hand and power tools 14% 15% 14% Electrical supplies 12% 13% 12% Plumbing and heating supplies 15% 15% 16% General hardware 12% 12% 12% Housewares and appliances 7% 7% 8% Garden, rural equipment and related supplies 12% 11% 11% Sundry 9% 9% 9% The Company sponsors two major conventions annually (one in the Spring and one in the Autumn) at various locations. Dealers and vendors are invited to attend, and dealers generally place substantial orders for delivery during the period prior to the next convention. During the convention regular merchandise, new merchandise and seasonal merchandise for the coming season are displayed to attending dealers. Lawn and garden supplies, building materials and exterior paints are seasonal merchandise in many parts of the country, as are certain sundries such as holiday decorations. Warehouse sales involve the purchase of merchandise from the Company that is maintained in inventory by the Company at its warehouses. Direct shipment sales involve the purchase of merchandise from the Company with shipment directly from the vendors. Bulletin sales involve the purchase of merchandise from the Company pursuant to special bulletin offers by the Company. Direct shipment sales are orders placed by dealers directly with vendors, using special purchase orders. Such vendors bill the Company for such orders, which are shipped directly to dealers. The Company, in turn, bills the ordering dealers at a markup. The markup on this category of sales varies with invoice amounts in accordance with the following schedule and is exclusive of sales under the LTL Plus program discussed below. Invoice Amount Handling Charge (Markup) $ 0.00 to $ 999.99 2.00% or $1.00 whichever is greater $1,000.00 to $1,999.99 1.75% $2,000.00 to $2,999.00 1.50% $3,000.00 to $3,999.00 1.25% $4,000.00 to $4,999.00 1.00% $5,000.00 to $5,999.00 .75% $6,000.00 to $6,999.00 .50% $7,000.00 to $7,999.00 .25% $8,000.00 and over .00% Bulletin sales are made based upon notification from dealers of their participation in special bulletins offered by the Company. Generally, the Company will give notice to all members of its intention to purchase certain products for bulletin shipment and then purchases only so many of such products as the members order. When the bulletin shipment arrives at the Company, it is not warehoused, but is broken up into appropriate quantities and delivered to members who placed orders. A 6% markup is generally applied to this category of sales. An additional markup of 3% is applied on the various categories of sales of merchandise exported to certain dealers located outside of the United States and its territories and possessions. The Company maintains inventories to meet only normal resupply orders. Resupply orders are orders from members for merchandise to keep inventories at normal levels. Generally, such orders are filled within one week of receipt. Bulletin orders (which are in the nature of resupply orders) may be for future delivery. The Company does not backlog normal resupply orders and, accordingly, no significant backlog exists at any point in time. The Company also has established special sales programs for lumber and building materials products and for products assigned from time to time to an "extreme competitive price sales" classification and for products purchased from specified vendors for delivery to certain of the Company's dealers on a direct shipment basis ("LTL Plus"). Under its lumber and building materials ("LBM") program, the Company imposes no handling charge, markup or national advertising assessment on direct shipment orders for such products. The LBM program also enables the Company's dealers to purchase these products at net invoice prices which pass on to them important cost savings resulting from the Company's closely monitored lumber and building materials purchasing procedures. Additionally, the LBM program offers dealers the opportunity to order less than truckload quantities of many lumber and building materials products at economical prices under the LTL warehouse redistribution procedure which the Company has established with certain major vendors. The Store Traffic Opportunity Program ("STOP") established by the Company is a program under which certain stockkeeping units of specific products assigned to an "extreme competitive price sales" classification are offered for sale to its dealers for delivery from designated Company retail support centers. Sales under this program are made without the addition of freight charges and with such handling charge or markup (if any) of not more than 5% as shall be specified for each item. The Company's officers have authority to add items to, and to withdraw items from, the STOP program from time to time and to establish reasonable minimum or multiple item purchase requirements for the items offered under the program. No allocations or distributions of patronage dividends are made with respect to sales under the STOP program. Purchases under the STOP program are, however, deemed to be warehouse purchases or bulletin purchases, as the case may be, for purposes of calculating the forms of patronage dividend distributions. (See the subheading under this Item 1 entitled "Forms of Patronage Dividend Distributions.) The LTL Plus Program, established by the Company effective as of September, 1990 is a program under which full or partial truckloads of products are purchased by the Company's dealers from specific vendors for delivery to such dealers on a direct shipment basis. No markup, handling charge or national advertising assessment is imposed by the Company on sales under the LTL Plus Program, and the maximum amount of patronage dividends allocated or distributed to the Company's dealers with respect to their purchases of products in the LTL Plus category is .5% of such sales. (See the subheading under this Item 1 entitled "Patronage Dividend Determinations and Allocations.") The Company, in addition to conducting semi-annual and other conventions and product exhibits for its dealers, also provides them with numerous special services (on a voluntary basis and at a cost to cover its related expenses), such as inventory control systems, price and bin ticketing, and an electronic ordering system. In order for them to have on hand current pricing and other information concerning the merchandise obtainable from the Company, the Company further provides to each of its dealers either a catalogue checklist service or a microfiche film service (whichever the dealer selects), for either of which services the dealer must pay a monthly charge. The Company also provides on a full-participation basis videotapes and related materials for educational and training programs for which dealers must pay an established monthly charge. (See the subheading under this Item 1 entitled "Special Charges and Assessments.") Through its wholly-owned subsidiary, Ace Insurance Agency, Inc., the Company makes available to its dealers a Group Dealer Insurance Program under which they can purchase a package of insurance coverages, including "all risk" property insurance and business interruption, crime, liability and workers' compensation coverages, as well as medical expense coverage for their employees. AHC Realty Corporation, another wholly-owned subsidiary of the Company, provides the services of a broker to those dealers who desire to sell or seek a new location for a presently owned store or to acquire an additional store. In addition, the Company offers to its dealers retail computer systems consisting of computer equipment, maintenance service and certain software programs and services. These are marketed by the Company under its registered service mark "PACE". The Company manufactures paint and related products at a facility owned by it in Matteson, Illinois. This facility now constitutes the primary source of such products offered for sale by the Company to its dealers. It is operated as a separate Division of the Company for accounting purposes. All raw materials used by the Company to manufacture paint are purchased from outside sources. The Company has had adequate sources of raw materials, and no shortages of any materials which would materially impact operations are currently anticipated. The manufacturing of paint is seasonal to the extent that greater paint sales are found in the months of April through September. Historically, compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment have not had any material impact. The Company's business, either in hardware wholesaling or paint manufacturing activities is not dependent on any major suppliers and the Company feels that any seasonal fluctuations do not have a significant impact upon operations. For further discussion of Company's business, see "Management's Discussion and Analysis of Financial Condition and Results of Operations", in Item 7 hereof. Special Charges and Assessments The Company sponsors a national advertising program for which its dealers are currently assessed an amount equal to 1.25% of their purchases (exclusive of lumber, building materials, purchases of PACE computer systems (hardware and software), less than truckload lumber and building material program purchases and LTL Plus Program purchases as described here in above in this Item 1) from the Company during each bi-weekly period, with the current minimum annual assessment being $975.00 and with the maximum annual assessment being $4,750 for each business location of any one dealer which has become a member of the Company. The total annual amount of advertising assessments payable by any one dealer is also subject to a further maximum limit which is determined by multiplying the number of such dealer's member retail store outlets serving the general public by $4,750. In the case of a dealer whose place of business is located outside the contiguous States of the United States, the Company's management has authority to determine the extent, if any, to which such dealer shall be required to pay the annual national advertising assessment based upon its evaluation of the amount and nature of the television broadcasts received in the dealer's area. The percentage of bi-weekly purchases to be assessed for the Company's national advertising program and the amount of the maximum annual assessment for such program are both subject to being changed from time to time by action of the Board of Directors of the Company. The Company also has the authority, effective January 1, 1993 to impose a regional advertising assessment (for select geographic regions) not to exceed 2% of annual purchases with the same minimum and maximum assessments imposed by the National Advertising assessment. Each dealer must pay a low volume service charge if the dealer's purchases during the calendar year are less than the minimum purchase levels described below. Minimum purchase levels and the amount of the low volume service charge are subject to change from time to time by the Company's Board of Directors. Presently, the low volume service charge is $30.00 and applies beginning one (1) year after the granting of the membership, if the dealer's purchases from the Company (exclusive of carload lumber purchases) are less than $4,000.00 per bi-weekly billing period. If the dealer's purchases from the Company reach $104,000 during the calendar year, then the dealer receives credit on its next bi-weekly billing statement for all low volume service charges imposed on that account earlier in the same calendar year, and the account is not subject to any further low volume service charges for the rest of the calendar year. The low volume service charge is not billed on a bi-monthly basis to those accounts whose previous year's sales volume exceeded the minimum purchases level for the previous year, but the full annual low volume service charge will be billed at year end to those accounts if the minimum purchase level to avoid imposition of the charge has not been met for the current year. For the calendar year in which the first anniversary of the store's membership occurs, the $104,000 purchase requirement is pro-rated from the first billing statement after that anniversary through December 31, if less than a full calendar year. An Ace store that falls below minimum purchase levels is also subject to termination. A late payment service charge is added on any past due balance owing by a dealer to the Company for purchases of merchandise and services or for the purchase price of the capital stock of the Company subscribed for by the dealer. The late payment service charge currently in effect is an amount equal to .77% per bi-weekly statement period, except in Texas where the charge is .384% and Georgia where the charge is .692%. A past due balance is created whenever payment of the amounts shown as due on any such statement is not received by the Company within 10 days following the date of the statement. The percentage for determining the amount of the late payment service charge may be changed from time to time by the Company. Subscriptions to a retail training program consisting of video tapes and related course materials (the "S.T.A.R. Program") are mandatory for all stores located in the United States and U.S. Territories. The initial monthly assessment imposed on such stores for such subscriptions is $14.50 for each single store or parent store and $10.00 for each branch store. A single store or parent store is an initial retail outlet for which a dealer owns, or has subscribed for, one (1) share of Class A stock and forty (40) shares of Class C stock of the Company. A branch store is an additional retail outlet for which a dealer owns, or has subscribed for, fifty (50) shares of Class C stock of the Company. (See Article XXV, Section 2 of the By-laws.) Branch stores may, upon request, be granted an exemption from the monthly subscription fee. Trademark and Service Mark Registrations The names "ACE HARDWARE" and "ACE" are used extensively by the Company and by its member-dealers in connection with the promotion, advertising and marketing of products distributed by the Company. The Company also uses the names "Bright & Easy" and "Weather Shedder" for promotion of the sale of certain paints and paint primers, the name "Super Striker" for promotion of the sale of a packaged assortment containing fishing rods and lures (other than big game trolling lures) and the name "LUB-E" for the promotion of the sale of lubricant. In addition, the Company uses several service marks as an aid in the establishment and operation of stores owned and operated by its member-dealers and uses the service mark "Hardware University" for certain seminars and workshops conducted for its dealers and the service mark "PACE" for in-store computer systems which it markets for use by them in their store operations. The Company holds the following Trademark and Service Mark Registrations issued by the U.S. Patent and Trademark Office for the marks used by it for the above-described purposes: Currently the Company has a pending application before the U.S. Patent and Trademark Office for registration of "ACE RENTAL PLACE" in stylized lettering design for use in connection with the rental of equipment, merchandise and supplies. Competition The competitive conditions in the wholesale hardware industry can be characterized as intensive due to the fact that independent retailers are required to remain competitive with discount stores and chain stores such as Wal-Mart, Home Depot and Sears and with other mass merchandisers. The gradual shift of retail operations to high rent shopping center locations and the trend toward longer store hours have also intensified pressures to obtain low cost wholesale supply sources. The Company directly competes in several U.S. markets with Cotter & Company, Servistar Corporation, Hardware Wholesalers, Inc., Our Own Hardware Company, and United Hardware Distributing Co., all of which companies are also dealer-owned wholesalers. Of the aforementioned companies, only Cotter & Company, headquartered in Chicago, Illinois, has a larger sales volume than the Company. Employees The Company employs 3,405 full-time employees, of which 981 are salaried employees. Collective bargaining agreements covering one truck drivers' bargaining unit and four warehouse bargaining units are currently in effect at certain of the Company's distribution warehouses. The Company's employee relations with both union and non-union employees are considered to be good, and the Company has experienced only one employee-related work stoppage in the past five years. All employees are covered either by negotiated or non-negotiated employee benefit plans which include hospitalization, death benefits and, with few exceptions, retirement benefits. Limitations on Ownership of Stock All of the issued and outstanding shares of capital stock of the Company are owned by its dealers. Only approved retail and other dealers in hardware and related products having Membership Agreements with the Company are eligible to own or purchase shares of any class of the Company's stock. No dealer, regardless of the number of member business outlets owned or controlled by him, shall be entitled to own more than 1 share of Class A Stock, which is the only class of voting stock which can be issued by the Company. This ensures that each stockholder-dealer will have an equal voice in the management of the Company. An unincorporated person or partnership shall be deemed to be controlled by another person, partnership or corporation if 50% or more of the assets or profit shares therein are owned (i) by such other person, partnership or corporation or (ii) by the owner or owners of 50% or more of the assets or profit shares of another unincorporated business firm or (iii) by the owner or owners of 50% or more of the capital stock of an incorporated business firm. A corporation shall be deemed to be controlled by another person, partnership or corporation if 50% or more of the capital stock of said corporation is owned (i) by such person, partnership or corporation or (ii) by the owner or owners of 50% or more of the capital stock of another incorporated business firm or (iii) by the owner or owners of 50% or more of the assets or profit shares of an unincorporated business firm. Distribution of Patronage Dividends The Company operates on a cooperative basis with respect to purchases of merchandise made from it by those of its dealers who have become "members" of the Company as described below and in the Company's By-laws. In addition, the Company operates on a cooperative basis with respect to all dealers who have subscribed for shares but who have not as yet become "members" by reason of the fact that the payments made by them on account of the purchase price of their shares have not yet reached an amount equal to the $1,000 purchase price of 1 share of Class A Voting Stock. All member dealers falling into either of the foregoing classifications are entitled to receive patronage dividend distributions once each year from the Company in proportion to the amount of their annual purchases of merchandise from it. The patronage dividends distributed on wholesale warehouse, bulletin and direct shipment sales made by the Company and on total sales of products manufactured by the Paint Division represented the following percentages of each of said categories of sales during each of the past three calendar years: 1993 1992 1991 Warehouse Sales 4.94434% 5.26838% 4.99516% Bulletin Sales 2.0% 2.0% 2.0% Direct Shipment Sales 1.0% 1.0% 1.0% Paint Sales 7.9389% 8.9440% 8.6463% In addition to the dividends described above, patronage dividends are calculated separately and distributed on sales of lumber products, building material products and less-than-truckload (LTL) sales of lumber and building material products. Patronage dividends equal to .1763%, .1260% and .2098% of the total sales of these products (calculated separately by each of these three sales categories) were distributed to the Company's dealers who purchased those products in 1993, 1992 and 1991, respectively. Under the LTL Plus Program, patronage dividends are also calculated separately on sales of full or partial truckloads of products purchased by eligible dealers from specified vendors (see discussion of LTL Plus Program set forth above in this Item 1). The maximum amount of patronage dividends allocable to LTL Plus sales is .5% of such sales. The LTL Plus Program dividend was .5% of such sales for 1993, 1992 and 1991. Patronage Dividend Determinations and Allocations The amounts distributed by the Company as patronage dividends consist of its gross profits on business done with dealers who qualify for patronage dividend distributions after deducting from said gross profits a proportionate share of the Company's expenses for administration and operations. Such gross profits consist of the difference between the price at which merchandise is sold to such dealers and the cost of such merchandise to the Company. All income and expenses associated with activities not directly related to patronage transactions are excluded from the computation of patronage dividends. Generally these include profits on business done with dealers who do not qualify for patronage dividend distributions and any income (loss) realized by the Company from the disposition of property and equipment (except that, to the extent that depreciation on such assets has been deducted as an expense during the time that the Company has been operating on a cooperative basis and is recaptured in connection with such a disposition, the income derived from such recapture would be included in computing patronage dividends). The By-laws of the Company provide that, by virtue of a dealer being a "member" of the Company (that is, by virtue of his ownership of 1 share of Class A Voting Stock), he will be deemed to have consented to include in his gross income for federal income tax purposes for the dealer's taxable year in which they are received by him all patronage dividends distributed to him by the Company in connection with his purchases of merchandise from the Company. A dealer who has not yet paid an amount which at least equals the $1,000 purchase price of the 1 share of Class A Voting Stock subscribed for by him will also be required to include all patronage dividends distributed to him by the Company in his gross income for federal income tax purposes in the year in which they are received by him. This is required by virtue of a provision in the Subscription Agreement executed by him under which he expressly consents to take all such patronage dividends into his gross income for such purposes. The amount of the patronage dividends which must be included in a dealer's gross income includes both the portion of such patronage dividends received by him in cash or applied against indebtedness owing by him to the Company in accordance with Section 7 of Article XXIV of the Company's By-laws and the portion or portions thereof which he receives in shares of Class C Nonvoting Stock of the Company or in patronage refund certificates. Patronage dividends on each of the Company's three basic categories of sales (warehouse sales, bulletin sales and direct shipment sales) are allocated separately, as are patronage dividends under the LTL Plus Program. However, the maximum amount of patronage dividends allocable to LTL Plus Program sales is an amount no greater than .5% of such sales, the maximum amount of patronage dividends allocable to direct shipment sales exclusive of LTL Plus Program sales is an amount equal to 1% of such sales and the maximum amount of patronage dividends allocable to bulletin sales is an amount equal to 2% of that category of sales. All remaining patronage dividends resulting from sales made under these programs are allocated by the Company to warehouse sales. The Company feels that this allocation procedure provides a practical and understandable method for the distribution of these patronage dividends in a fair and equitable manner. Sales of lumber and building materials products are not included as part of warehouse sales, bulletin sales, or direct shipment sales for patronage dividend purposes. Patronage dividends are calculated separately and distributed to the Company's dealers with respect to their purchases within each of three sales categories involving these types of products. These three categories are (a) lumber products (other than less-than-truckload sales); (b) building materials products (other than less-than-truckload sales); and (c) less-than-truckload ("LTL") sales of lumber and building material products. Patronage dividends are also calculated separately and distributed to the Company's dealers for full and partial truckloads of products purchased under the LTL Plus Program. (See the discussion of the LTL Plus Program set forth above in this Item 1 and under the subheading "Forms of Patronage Dividend Distributions," subparagraphs 2(a)-(b) below). Any manufacturing profit realized on intracompany sales of the products manufactured by the Company's Paint Division is allocated among and distributed as patronage dividends to those member dealers who are eligible to receive patronage dividends from the Company in proportion to their respective annual dollar purchases of paint and related products manufactured by said Division. The earnings realized by the Company on wholesale sales of such products made by it to its member dealers are distributed as patronage dividends to all of its dealers who are eligible to receive patronage dividends from it as part of the patronage dividends which they receive each year with respect to the basic patronage dividend categories established for warehouse sales, bulletin sales, and direct shipment sales. Under Section 8 of Article XXIV of the Company's By-laws, if the Paint Division's manufacturing operations for any year result in a net loss, rather than a profit, to the Paint Division, such loss would be netted against the earnings realized by the Company from its other activities during the year, with the result that the earnings available from such other activities for distribution as patronage dividends for such year would be correspondingly reduced. Forms of Patronage Dividend Distributions Patronage dividend distributions will be made to the eligible and qualified member dealers of the Company in cash, shares of the Company's Class C stock and patronage refund certificates in accordance with the following plan which has been adopted by the Company's Board of Directors with respect to purchases of merchandise made by such dealers from the Company on or after January 1, 1993, and which will continue to be in effect until such time as the Board of Directors, in the exercise of their authority and discretion based upon business conditions from time to time and the requirements of the Company, shall determine that such plan should be altered or amended: 1. With respect to each store owned or controlled by each eligible and qualifying dealer, such dealer shall receive a minimum cash distribution determined as follows: (a) an amount equal to 20% of the first $5,000 of the total patronage dividends allocated for distribution each year to such dealer in connection with the purchases made for such store; (b) an amount equal to 25% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $5,000 but does not exceed $7,500; (c) an amount equal to 30% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $7,500 but does not exceed $10,000; (d) an amount equal to 35% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $10,000 but does not exceed $12,500; (e) an amount equal to 40% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $12,500. 2. The portion of the total annual distribution allocated to any such dealer for each store owned or controlled by such dealer in excess of the amount to be distributed to such dealer for such store in cash shall be distributed to him each year in the form of shares of Class C Non-voting Stock of Ace Hardware Corporation (par value $100 per share), valued at the par value thereof, until the total par value of all shares of all classes of capital stock of the corporation held by such dealer with respect to such store equals the greater of: (a) $20,000; or (b) a sum equal to the total of the following categories of purchases made by such dealer for such store during the most recent calendar year: (i) 10% of the volume of Ace manufactured paint and related products purchases, plus (ii) 3% of the volume of drop-shipment or direct purchases (excluding Ace manufactured paint and related products), plus (iii) 13% of the volume of warehouse (including STOP and excluding Ace manufactured paint and related products) and bulletin purchases, plus (iv) 4% of the volume of lumber and building material (excluding LTL) purchases, plus (v) 4% of the volume of LTL Plus purchases; provided, however, that no fractional shares of Class C Non-voting Stock shall be issued to any dealer and that any amount which would have otherwise been distributable as a fractional share of such stock shall instead be distributed to such dealer in cash. 3. The portion of the total patronage dividends allocated each year to any such dealer for each store owned or controlled by such dealer which exceeds the sum of (a) the amount to be distributed to such dealer for such store in cash pursuant to Paragraph 1. above and (b) any amount to be distributed to him in the form of shares of Class C Non-voting Stock of Ace Hardware Corporation (par value $100 per share) pursuant to Paragraph 2. above shall be distributed to such dealer in cash; provided, however, that in no event shall the total amount distributed under this plan to any such dealer for any such store in cash exceed 49.9% of the total patronage dividends allocated for such store for such year, and to the extent that any distribution to be made to any such dealer for any store pursuant to this Paragraph 3. would otherwise cause the total cash distribution to such dealer for such store to exceed 49.9% of the total patronage dividends allocated for such store for such year, the distribution to be made under this Paragraph 3. shall instead be made in the form of a non-negotiable patronage refund certificate having such a maturity date and bearing interest at such an annual rate as shall be determined by the Board of Directors prior to the issuance thereof. With certain modifications, the above Plan is applied separately in determining the form in which patronage dividends accrued with respect to sales of lumber and building materials products are distributed. In this connection the combined patronage dividends allocated annually to a store from (a) sales of lumber products (other than LTL sales) to the store, (b) sales of building materials (other than LTL sales) to the store, and (c) LTL sales to the store are used in determining the minimum cash distribution percentages to be applied under Paragraph 1 of the above Plan. A store's patronage dividends from any other sales category with respect to which patronage dividends are distributed by the Company are not taken into account in determining either the minimum portion or any additional portion of the store's patronage dividends derived from its purchases of lumber and building materials products which is to be distributed in cash. Also, Paragraphs 2 and 3 of the above Plan are applied separately to patronage dividends on lumber and building materials sales and the requirements of Paragraph 2 of the Plan shall not be deemed to have been complied with in the cases of (a) purchases of lumber products (other than LTL purchases) or (b) purchases of building materials products (other than LTL purchases) until the store's holdings of Class C Non-voting Stock of the Company resulting from patronage dividends on the Company's sales to it within the particular one of those two sales categories for which a patronage dividend distribution is to be made equal 4% of the volume of the store's purchases within such category during the most recent calendar year. However, no such special Class C Stock requirement applies to patronage dividends accrued on LTL purchases. Notwithstanding the provisions of the above-described Plan, however, under Section 7 of Article XXIV of the Company's By-laws the portion of any patronage dividends which would otherwise be distributable in cash with respect to a retail dealer outlet which is a member of the Company will instead be applied against any indebtedness owing by the dealer to the Company to the extent of such indebtedness in any case where the membership for such outlet is cancelled or terminated prior to the distribution of such patronage dividends except that an amount equal to 20% of the dealer's total annual patronage dividends for such outlet will be paid in cash if a timely request for the payment of such amount in cash is submitted to the Company by the dealer. Because of the requirement of the U. S. Internal Revenue Code that the Company withhold 30% of the annual patronage dividends distributed to member dealers of the Company whose places of business are located in foreign countries or Puerto Rico (except in the case of unincorporated Puerto Rico dealers owned by individuals who are U.S. citizens and certain dealers incorporated in Guam, American Samoa, the Northern Mariana Islands, or the U.S. Virgin Islands, if less than 25% of its stock is owned by foreign persons, and at least 65% of the Corporation's gross income for the last three years has been effectively connected with the conduct of a trade or business in such possession or in the United States), the cash portion of the annual patronage dividends of such dealers shall in no event be less than 30%. It is anticipated that the terms of any patronage refund certificates issued pursuant to Paragraph 3. of the foregoing Plan would include provisions giving the Company a first lien thereon for the amount of any indebtedness owing to it at any time by the owner of any such certificate and provisions subordinating the certificates to all the rights and claims of secured, general and bank creditors against the Company. It is further anticipated that all such patronage refund certificates will have maturity dates which will be no later than five years from the dates of issuance thereof. In order to aid the Company's dealers in acquiring and installing standardized exterior signs identifying the retail stores operated by them as member outlets supplied by the Company, the Board of Directors of the Company has authorized a program under which a dealer may borrow from the Company within a range of $100 to $20,000 the funds required for such purpose. A dealer who obtains a loan under this program may either repay the loan in twelve substantially equal payments billed on such dealer's regular by-weekly billing statement, or may execute a direction to have the portion of the dealer's annual patronage dividends which would otherwise be distributed under the above plan in a form other than cash from no more than the next three annual distributions of such dividends applied toward payment of the principal and interest on the loan. In order to aid the Company's dealers in acquiring and installing PACE and PAINTMAKER computer systems purchased from the Company, the Board of Directors of the Company has also authorized programs under which the Company will finance qualified dealers in the case of a PAINTMAKER computer, within the range of $1,000 to $15,000 repayable over a period of three (3) years, and in the case of a PACE computer, within the range of $5,000 to $50,000 repayable over a period of five (5) years for such purpose. Dealers who obtain financing from the Company for these purposes direct the Company, during the financing term, to first apply toward the principal and interest due on such loans, the patronage dividends which would otherwise be payable in the form of patronage refund certificates for each year, and then to apply the patronage dividends which would otherwise be payable for the same year in the form of the Company's Class C stock. The aforementioned signage and computer financing programs may be revised or discontinued by the Board at any time. Federal Income Tax Treatment of Patronage Dividends Both the shares of Class C Non-voting Stock and the patronage refund certificates used by the Company to pay patronage dividends that accrue to its eligible and qualifying dealers constitute "qualified written notices of allocation" within the meaning of that term as used in Sections 1381 through 1388 of the U.S. Internal Revenue Code, which specifically provide for the income tax treatment of cooperatives and their patrons and which have been in effect since 1963. The stated dollar amounts of such qualified written notices of allocation must be taken into the gross income of each of the recipients thereof for the taxable years in which they are received, not withstanding the fact that stated dollar amounts may not be received in such taxable years. In order for the Company to receive a deduction from its gross income for federal income tax purposes for the amount of any patronage dividends paid by it to a patron (that is, to one of its eligible and qualifying dealers) in the form of qualified written notices of allocation, it is necessary that the Company pay (or apply against indebtedness owing to the Company by such patron in accordance with Section 7 of Article XXIV of the Company's By-laws) not less than 20% of the total patronage dividends distributable to such patron in cash and that the patron consent to having the written notices of allocation, at their stated dollar amounts, included in his gross income for the taxable year in which they are received by him. It is also required under the Code that any patronage dividend distributions deducted by the Company on its federal income tax return with respect to business done by it with patrons during the year for which such deduction is taken must be made to the Company's patrons within 8 1/2 months after the end of such year. Dealers who have become "members" of the Company by owning 1 share of Class A Voting Stock are deemed under the U.S. Internal Revenue Code to have consented to take any written notices of allocation distributed to them into their gross income by their act of obtaining or retaining membership in the Company and by having received from the Company a written notification of the By-law provision providing that membership in the Company constitutes such consent. In accordance with another provision in the Internal Revenue Code, nonmember dealers who have subscribed for shares of the Company's stock will also be deemed to have consented, by virtue of the consent provisions included in their Subscription Agreements, to take any written notices of allocation distributed to them into their gross income. A dealer receiving a patronage refund certificate as part of the dealer's patronage dividends in accordance with the last clause of Paragraph 3 of the patronage dividend distribution plan previously described under the subheading "Forms of Patronage Dividend Distributions" in this Item 1, may be deemed to have received interest income in the form of an original issue discount to the extent of any excess of the face amount of the certificate over the present value of the stated principal and interest payments to be made by the Company under the terms of the certificate. Such income would be taxable to the dealer ratably over the term of the certificate under Section 7872(b) (2) of the U. S. Internal Revenue Code. The present value for this purpose is to be determined by using a discount rate equal to the applicable Federal rate in effect as of the day of issuance of the certificate, compounded semi-annually. The Company will be required to withhold for federal income tax on the patronage dividend distribution which is made to a payee who has not furnished his taxpayer identification number to the Company or as to whom the Company has notice of the fact that the number furnished to it is incorrect. A cooperative organization may also be required to withhold on the cash portion of each patronage dividend distribution made to a payee who becomes a member of the cooperative if the payee fails to certify to the cooperative that he is not subject to backup withholding. It is the opinion of counsel for the Company that this provision is not applicable to any patronage dividend distribution to a payee unless 50% or more of the total distribution is made in cash. Since all of the Company's patronage dividends for a given year are distributed at the same time and the Company's currently effective patronage dividend plan does not permit any store which is a member of the Company to receive more than 49.9% of its patronage dividends for the year in the form of cash, it is said counsel's further opinion that such a certification failure would ordinarily have no effect on the Company or any of its dealers. Patronage dividends distributed by a cooperative organization to its patrons who are located in foreign countries or certain U. S. possessions have been held to constitute fixed or determinable annual or periodic income on which such patrons are required to pay a tax of 30% of the amount received in accordance with the provisions of Sections 871(a)(1)(A) and 881(a) (1) of the Internal Revenue Code, as do patronage dividends distributed to patrons which are incorporated in Puerto Rico or who reside in Puerto Rico but have not become citizens of the United States. With respect to its dealers who are subject to such 30% tax, the Company is also obligated to withhold from their patronage dividends and pay over to the U. S. Internal Revenue Service an amount equal to the tax. The foregoing provisions do not apply to a corporation organized in Guam, American Samoa, the Northern Mariana Islands, or the U. S. Virgin Islands if less than 25% of its stock is owned by foreign persons and at least 65% of its gross income for the last three years has been effectively connected with the conduct of a trade or business in such possession or in the United States. The 20% minimum portion of the patronage dividends to be paid in cash to a patron with respect to whom the Company is neither required to withhold 30% of his total patronage dividend distribution nor permitted to apply such minimum portion against indebtedness owing to it by him may be insufficient depending upon the income tax bracket of each individual patron, to provide funds for the full payment of the federal income tax for which such patron will be liable as a result of the receipt of the total patronage dividends distributed to him during the year, including cash, patronage refund certificates and/or Class C Non-voting Stock. In the opinion of the Company's management, payment in cash of not less than 20% of the total patronage dividends distributable each year to the Company's eligible and qualifying dealers will not have a material adverse effect on the operations of the Company or its ability to obtain adequate working capital for the normal requirements of its business. Membership Agreement In addition to signing a Subscription Agreement for the purchase of shares of the Company's stock, each retail dealer who applies to become an Ace dealer (excluding the firms which are "International Retail Merchants" as discussed below under the subheading "International Retail Merchants" in this Item 1) must sign the Company's customary Membership Agreement. A payment of $400 must accompany the signed Membership Agreement to defray the Company's estimated costs of processing the membership application. If the application is accepted, copies of both the Membership Agreement and the Stock Subscription Agreement, signed on behalf of the Company to evidence its acceptance, are forwarded to the dealer. No royalties are payable at any time by a dealer for an outlet which the Company accepts for affiliation into its dealer network. Membership may be terminated upon various notice periods and for various reasons (including voluntary termination by either party) as prescribed in the membership agreement, except to the extent that special laws or regulations applicable to specific locations may limit the Company's right to terminate memberships, or may prescribe greater periods of notice under particular circumstances. International Retail Merchants In 1989, the Company's Board of Directors authorized the Company to affiliate International Retail Merchants, who operate retail businesses outside the United States, its territories and possessions. International Retail Merchants sign an International Retail Merchants Agreement in lieu of the Company's Regular Membership Agreement, and are generally granted a license to use certain of the Company's service marks. They do not, however, sign Stock Subscription Agreements or become shareholders of the Company by reason of their International Retail Merchants Agreements, nor do they receive distributions of patronage dividends. As of December 31, 1993, 1992 and 1991 International Retail Merchant volume with the Company accounts for less than 3% of the Company's total sales in each such year. Item 2.

Item 2. Properties The Company's general offices are located at 2200 Kensington Court, Oak Brook, Illinois 60521. Information with respect to the Company's principal properties follows: (1) Includes 35,254 square feet leased to tenant until July 31, 1996. The subject property is adjacent to the Company's general offices. (2) Includes an 80,820 sq. ft. warehouse expansion project, scheduled for completion later in 1994. (3) This land is adjacent to the Company's LaCrosse, Wisconsin warehouse. The Company also leases a fleet of transportation equipment for the primary purpose of delivering merchandise from the Company's warehouses to its dealers. Item 3.

Item 3. Legal Proceedings There are no material pending legal proceedings which either individually or in the aggregate involve claims for damages that exceed 10% of the current assets of the Company and its subsidiaries on a consolidated basis. Item 4.

Item 4. Submission To A Vote Of Security Holders None. PART II Item 5.

Item 5. Market For The Registrant's Common Equity And Related Stockhoder Matters There is no existing market for the stock of the Company and there is no expectation that any market will develop. The Company is organized and operates as a cooperative corporation, and its stock is owned exclusively by retailers of hardware and related merchandise who are members of the Company. The number of holders of record as of February 28, 1994 of each class of stock of the Company is as follows: Title of Class Number of Record Holders Class A stock, $1,000 par value 3,933 Class B stock, $1,000 par value 850 Class C stock, $100 par value 4,756 Dividends, other than patronage dividends are prohibited by the Company's Articles of Incorporation and By-laws. See the discussion of patronage dividends under Item 1. Business. Item 6.

Item 6. Selected Financial Data (A) The Company operates as a cooperative organization, and pays patronage dividends to member dealers on earnings derived from business done with such dealers. It is the practice of the Company to distribute all patronage sourced earnings in the form of patronage dividends. Earnings before patronage dividends and patronage dividends will normally be the same, except for differences caused by the timing of the recognition of certain items for income tax purposes. (B) The form in which patronage dividends are to be distributed can only be determined at the end of each year when the amount distributable to each of the member dealers is known. For the five years ended December 31, 1993, patronage dividends were payable as follows: (C) Numbered notes refer to Notes to Financial Statements, beginning on page. Item 7.

Item 7. Management's Discussion And Analysis Of Financial Condition And Results Of Operations MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Company's ability to generate cash adequate to meet its needs ("liquidity") results from internally generated funds, short-term lines of credit and long-term financings (see Notes 3 and 4 to the financial statements). These sources have been sufficient to finance the Company's seasonal and other working capital requirements and its capital expenditure programs. The Company had unused unsecured lines of credit of $69.0 million at December 31, 1993. Any borrowings under these lines of credit would bear interest at the prime rate or less. Long-term financings are arranged as determined necessary to meet the Company's capital or other requirements, with principal amount, timing and form dependent on prevailing debt markets and general economic conditions. Capital expenditures for new and improved facilities were $16.3, $34.6 and $37.9 million in 1993, 1992 and 1991, respectively. During 1993, the Company financed the $16.3 million of capital expenditures out of current and accumulated internally generated funds, and short-term and long-term borrowings. 1994 capital expenditures are anticipated to be approximately $30.9 million primarily for improvements to existing facilities. As a cooperative, the Company distributes substantially all of its patronage source earnings to its members in the form of patronage dividends, which are deductible for income tax purposes (see headings "Patronage Dividend Determinations And Allocations" and "Federal Tax Treatment of Patronage Dividends"). The 1991 capital gain from the sale and leaseback of the Los Angeles, California facility constitutes nonpatronage-sourced income and is not available for distribution as patronage dividends. The Company expects that existing and new internally generated funds, along with established lines of credit and long-term financings, will continue to be sufficient to finance the Company's patronage dividend and capital expenditure programs. Operations--1993 Compared to 1992 Net sales increased 7.9% in 1993 primarily due to increases in volume from existing dealers. Sales of basic hardware and paint merchandise (including warehouse, bulletin, and direct shipments) increased 6.8%. Lumber and building material sales experienced a higher percentage increase in 1993. Net dealer outlets decreased as set forth on page 1 as a result of increased sales and marketing efforts with existing dealers and increased competition. Gross profit increased $2,829,000 or 1.9% vs. 1992 due primarily to higher net merchandise discounts and allowances. Gross profit decreased as a percent of sales, however, due to reduced handling charges on competitively priced items and shifts in the Company's sales mix. Warehouse and distribution expenses decreased by $641,000 or 2.0% due to decreased building rental and facility costs and increased levels of warehousing costs absorbed into cost of sales, partially offset by increased personnel and equipment costs and traffic freight subsidies. Selling, general, and administration expenses increased by $5,927,000 or 12.2% due to higher personnel costs and marketing expenses partially offset by higher advertising and retail support income. Interest expense increased $1,418,000 in 1993 despite lower interest rates due to increased long-term debt resulting from the financing of planned capital expenditures and increased inventory levels. The use of both short-term borrowings and long-term financing is expected to continue to fund planned capital expenditures (see liquidity and capital resources and Notes 3 and 4 to the financial statements). Operations--1992 Compared to 1991 Net sales increased 9.8% in 1992 primarily due to increases in volume from existing dealers. Sales of basic hardware and paint merchandise (including warehouse, bulletin, and direct shipments) increased 6.9%. Lumber and building material sales experienced a higher percentage increase in 1992. Total paint sales increased 12.3%. Net dealer outlets decreased as set forth on page 1 as a result of increased sales and marketing efforts with existing dealers and increased competition. Gross profit increased $13,276,000 or 9.9% vs. 1991 but is comparable as a percentage of sales primarily due to higher net merchandise discounts and allowances and a lower LIFO provision partially offset by reduced handling charges as a percent of sales caused by a shift in the sales mix. Warehouse and distribution expenses increased by $3,310,000 or 11.4% due to higher personnel costs related to volume increases, increased building rental costs and higher 1992 start-up and closing costs incurred in conjunction with the replacement of a facility. Selling, general, and administration expenses increased by $4,013,000 or 9.0% due to higher personnel costs and marketing expenses partially offset by higher advertising income. Interest expense increased $1,370,000 in 1992 despite lower interest rates due to increased long and short-term debt resulting from the financing of planned capital expenditures and increased inventory levels. The use of both short-term borrowings and long-term financing is expected to continue to fund planned capital expenditures (see liquidity and capital resources and Notes 3 and 4 to the financial statements). Other income, net decreased $2,973,000 in 1992 due primarily to the 1991 gain on the sale of the Los Angeles facility (see Note 11 to the financial statements). Inflation and Changes in Prices The Company's business is not generally governed by contracts that establish prices substantially in advance of the receipt of goods or services. As vendors increase their prices for merchandise supplied to the Company, the Company increases the price to its dealers in an equal amount plus the normal handling charge on such amounts. In the past, these increases have provided adequate gross profit to offset the impact of inflation on operating expenses. Item 8.

Item 8. Financial Statements And Supplementary Data Financial statements and financial statement schedules covered by the report of the Company's certified public accountants are listed on Page. Item 9.

Item 9. Changes In And Disagreements With Accountants On Accounting And Financial Disclosures None. PART III Item 10.

Item 10. Directors And Executive Officers Of The Company The directors and the executive officers of the Company are: Position(s) Held Name Age and Business Experience Lawrence R. Bowman 47 Director since February 4, 1991; term expires 1995; Vice President of Owenhouse Hardware Co., Inc., Bozeman, Montana David F. Hodnik 46 Executive Vice President and Chief Operating Officer since January, 1994; Executive Vice President and Treasurer since January, 1991; Senior Vice President and Treasurer since January, 1988; Vice President--Finance and Management Information Systems and Treasurer since September, 1986; Vice President--Finance and Treasurer from December, 1982. Paul M. Ingevaldson 48 Vice President--Corporate Strategy and International Business since September, 1992; Vice President--Retail Support Services since August, 1989; Vice President--Western Region since September 1, 1988; Vice President-- Distribution since September, 1986; Vice President--Management Information Systems from October, 1985; Director of Data Processing from October, 1982. Mark Jeronimus 45 Director since June 3, 1991; term expires 1994; President of Duluth Hardware, Inc., Duluth, Minnesota. Howard J. Jung 46 Director since June 1, 1987; term expires 1996; Vice President of Ace Hardware & Home Center, Inc., Raleigh, North Carolina. Rita D. Kahle 37 Vice President--Finance since January, 1994; Vice President--Controller since January, 1992; Controller from July, 1988. John E. Kingrey 50 Director since May 17, 1992; term expires 1996; President of WK&K Corp., Wimberley, Texas. Richard E. Laskowski 52 Chairman of the Board since February 18, 1992 and Director since June 1, 1987; term expires 1995; President of Ace Hardware Home Center of Round Lake, Inc., Round Lake, Illinois. William A. Loftus 55 Senior Vice President--Marketing and Advertising since September, 1992; Senior Vice President since January 1, 1991; Vice President--Retail Support Operations since August, 1989; Vice President--Eastern Region since September 1, 1988; Vice President--Sales since October, 1983; National Sales Manager from October, 1976. Fred J. Neer 54 Vice President--Human Resources since April, 1989; Director of Human Resources from April, 1986. Ray W. Osborne 57 Director since June 6, 1988; term expires 1994; President of Cook & Sons Ace Hardware Company, Inc., Albertville, Alabama. Roger E. Peterson 56 President and Chief Executive Officer (CEO) since December, 1989; President since August, 1986; Executive Vice President from March, 1985; Vice President--Operations from December, 1982. Jon R. Weiss 58 Director since June 4, 1990; term expires 1996; President of John W. Weiss Hardware Company, Glenview, Illinois. Don S. Williams 52 Director since June 6, 1988; term expires 1994; President of Williams Lumber, Inc., Rhinebeck, New York. James R. Williams 46 Director since June 5, 1989; term expires 1995; Vice-President of Williams Ace Hardware, Inc., Wichita, Kansas. Gary R. Meyer whose term was to have expired in 1994, resigned from the Board of Directors for personal reasons in November, 1993 and no successor has yet been elected for the balance of his term. The By-laws of the Company provide that its Board of Directors shall be comprised of such number of persons, not less than 9, as shall be fixed from time to time by the Board of Directors. The By-laws also provide for three classes of directors who are to be elected for staggered 3-year terms. The By-laws provide that, except for one position on the Board which may, at the discretion of the directors, be filled by the President of the Company, no person is eligible to serve as a director unless such person is either the owner of a retail business organization holding stock in the Company or an executive officer, general partner or general manager of such a retail business organization. Such directors are referred to as "dealer directors", and are elected from geographic regions of the United States established by the Board. In accordance with the applicable procedure established by the By-laws, the following directors have been selected as nominees for reelection at the annual stockholders meeting to be held on June 6, 1994, as directors of the classes, from the regions, and for terms as indicated below: Nominee Class Region Term Don S. Williams First 1 3 years Ray W. Osborne First 3 3 years Mark Jeronimus First 9 3 years The person named below has been selected as the nominee for election to the Board for the first time at the 1994 annual meeting as director of the class, from the region, and for the term indicated. Nominee Age Class Region Term Jennifer Anderson 43 First 8 3 years Reference should be made to Article IV of the By-laws for information concerning the qualifications required for membership on the Board of Directors, the terms of directors, the limitations on the total period of time for which a director may hold office, the procedure established for the designation of Nominating Committees to select certain persons as nominees for election to the Board of Directors, and the procedure for filling vacancies on the Board for the remaining portion of unexpired terms. None of the events described under Item 401(f) of Regulation S-K occurred during the past 5 years with respect to any director of the Registrant, any nominee for membership on the Board of Directors of the Registrant or any executive or staff officer of the Registrant. Item 11.

Item 11. Executive Compensation The following information is set forth with respect to the cash compensation paid by the Company to each of the five highest paid executive officers of the Company whose cash compensation exceeded $100,000, for services rendered by them in all capacities to the Company and its subsidiaries during the fiscal year ended December 31, 1993 and the two previous fiscal years: (1) The Incentive Compensation Plan covers each of the executive officers (except Mr. Peterson). The bonus amounts awarded to participants in the Plan are determined in accordance with individual performance and achievement of corporate goals. For 1991 to 1993, the maximum incentive award for each of Messrs. Hodnik, Loftus and Ingevaldson was 18% of their respective annual salaries and for other executive officers was 15% of their annual salary for the short-term incentive awards. The short-term bonus award becomes payable to each participant as early as practicable after the end of the fiscal year. The 1993 bonus amount for Mr. Peterson was a one time incentive award as described in the Compensation Committee Report. For 1994, the maximum short-term incentive award for each executive officer is 20% of their respective salary. (2) The Company provides automobiles and prior to 1993 provided club memberships to certain of its executive officers. The Company requires them to maintain records with respect to any business automobile use. Such officers pay, both directly and by reimbursement to the Company, personal automobile expenses and personal charges at clubs. The compensation table set forth above includes the value of these items and such value for any officer did not exceed the lesser of $25,000 or 10% of the compensation reported for him in said table. (3) Includes the long-term incentive award under the Incentive Compensation Plan paid in 1993. The long-term executive award is based on corporate performance over a three year time frame. The maximum long-term incentive award for Messrs. Hodnik, Loftus, Ingevaldson, and Neer and other executive officers is 8.7% of their respective average 3 year annual salaries. The long term incentive award is determined and becomes payable to each participant as early as practicable each year if the participant is still employed by the Company on the preceding 31st of December. (4) Includes compensation for the Executive Supplemental Benefit Plan (ESBP), contributions to the Company's Profit Sharing Plan which has been in existence since January 1,1953, and contributions to the Company's Retirement Benefits Replacement Plan. The Board of Directors adopted the Executive Supplemental Benefit Plan (ESBP) in 1991. ESBP provides supplemental life insurance through a universal life insurance policy, supplemental long-term disability and supplemental retirement benefits to the executive officers. Under the supplemental retirement benefits portion of ESBP a formula equal to .02 of 1% of the total corporate annual Patronage Dividend times the number of executive officers participating determines the total annual supplemental retirement benefits under ESBP. This total sum for all executive officers allocated to the supplemental retirement benefits portion of ESBP cannot exceed $200,000 in any year. The sum is allocated, by tier, to the executive officers and placed in the cash value portion of each participant's variable annuity insurance policy as soon as practicable in each subsequent year. During the year 1993, total contributions were $14,365 for Messrs. Peterson, Hodnik and Ingevaldson and $11,485 for Mr. Neer. All active employees are eligible to participate in the Company's profit sharing plan after one year of service but those active employees covered by a collective bargaining agreement regarding retirement benefits which were the subject of good faith bargaining are not eligible if such agreement does not include them in the plan. For the year 1993, the Company contributed 10.9% of each participant's eligible compensation to the Plan. During the year 1993, $25,707 was expensed by the Company pursuant to the Plan for Messrs. Peterson, Hodnik, Loftus and Ingevaldson and $21,896 for Mr. Neer. The Company has also established a Retirement Benefits Replacement Plan covering Messrs. Peterson, Hodnik, Loftus and Ingevaldson. Effective January 1, 1994, the plan will cover all executive officers of the Company. This is an unfunded Plan under which the participants therein are eligible to receive retirement benefits equal to the amounts by which the benefits they would otherwise have been entitled to receive under the Company's Profit Sharing Plan may be reduced by reason of the limitations on contributions and benefits imposed by any current or future provisions of the U.S. Internal Revenue Code or other federal legislation. During the year 1993, amounts expensed by the Company pursuant to the Plan were $94,253 for Mr. Peterson, $31,517 for Mr. Hodnik, $17,413 for Mr. Loftus, and $9,792 for Mr. Ingevaldson. (5) As a cooperative whereby all stockholders are member dealers, the Company does not grant or issue stock awards of any kind. Messrs. Peterson, Hodnik, Loftus and Ingevaldson are employed under contracts, each dated October, 1992 for respective terms of two years, terminating December 31, 1994. The contracts provide for annual compensation effective January 1, 1994 of $800,000, $350,000, $260,000, and $232,000, respectively or such increased amount, if any, as shall be approved by the Board of Directors. The Company also maintains a Pension Plan which has been in existence since December 31, 1970. All active employees are eligible to participate in this Plan on the first January 1 that they are working for the Company but those active employees covered by a collective bargaining agreement regarding which retirement benefits were the subject of good faith bargaining are not eligible if such agreement does not include them in the plan. The Plan provides benefits at retirement at or after age 65 determined under a formula which takes into account 60% of a participant's average base pay (including overtime) during the 5 highest consecutive calendar years of his employment and his years of service prior to age 65, and under which an offset is applied for the straight life annuity equivalent of the vested portion of the participant in the amount of benefits provided for him by the Company under the Profit Sharing Plan. Examples of yearly benefits provided by the Pension Plan (prior to reduction by the Profit Sharing Plan offset) are as follows: Years of Service Remuneration 10 15 20 25 30 or more $200,000 $40,000 $60,000 $80,000 $90,000 $112,221 150,000 30,000 45,000 60,000 75,000 90,000 100,000 20,000 30,000 40,000 50,000 60,000 50,000 10,000 15,000 20,000 25,000 30,000 The amounts shown above represent straight life annuity amounts. Maximum benefits from the Pension Plan are attained after 30 years of service and attainment of age 65. The compensation covered by the Pension Plan consists of base compensation (exclusive of bonuses and non-recurring salary or wage payments) and shall not exceed $235,840 of such total remuneration paid to a participant during any plan year. Remuneration and yearly benefits under the Plan are limited, and subject to adjustment, under Sections 415(d) and 401(a)17 of the U.S. Internal Revenue Code. The present credited years of service under the Pension Plan for the currently employed executive officers named in the compensation table are as follows: Roger E. Peterson--17 years; David F. Hodnik--21 years; William A. Loftus--17 years; Paul M. Ingevaldson--14 years; Fred J. Neer--7 years. Compensation Committee Report The corporation's Executive Compensation philosophy is one that supports the Company's fundamental business strategies. Like our dealers, we stress long term measured results, focus on teamwork, accepting prudent risks, and are strongly committed to fulfilling dealer/consumer needs. Our compensation program reflects a policy of competitive performance based pay. Our competitors for Human Resources include publicly owned for profit retail corporations, privately owned for profit retail enterprises, and other national cooperatives. Each of these comparative groupings has quite a different compensation practice/philosophy. Therefore, our orientation is to be cognizant of their respective practices and pay levels, but to give greater emphasis to that which supports the needs of our dealer network. The Compensation Committee is in the process of changing the compensation mix to one which stresses the provision of more significant performance based incentives, particularly long term. 1993 salary increases for executive officers averaged 5.3% per eligible executive. Annual and long term incentive opportunities for 1993 were maintained at previous levels while both programs were increased beginning in 1994. The Committee has agreed, in principle to more substantive changes to the existing long term incentive plan. This involves selecting appropriate long term performance criteria; possibly stretching the performance period to a time frame greater than its current three year time frame, or obligating plan eligible participants to a minimum of three to five years service from date of performance award. We expect to complete these plan redesign changes in early 1994. As it relates to the President/CEO compensation, the Committee in the past has relied on providing the President/CEO with a base salary without either annual or long term incentives. The Committee's primary rationale for this was to allow the President/CEO to make objective recommendations pertaining to incentive eligible officers without the incumbrance of a personal stake associated with the same performance criteria. This too is under review and likely to change, so as to ensure the long term commitment of the President/CEO position to the longer term interest of our dealer network. The Committee also concluded that the corporation's performance results for 1993 were of such a significant milestone that a special one time incentive award to the President/CEO of $100,000 was granted. This was warranted based upon total sales exceeding $2 billion and distribution of a total patronage dividend of $59 million. Both represented excellent results for the company. The Compensation Committee approved a 19.4% salary increase for the President/CEO to take effect January 1, 1994. This was based upon comparison of CEO cash compensation at competitor enterprises and a desire to maintain Mr. Peterson's salary at a level consistent with his long-term contribution to the success of Ace and its over 4,900 retailers. The Committee also reviews the executive benefits provided to either the CEO and other senior executives. Country club memberships previously granted to some officers have been eliminated, except for the President/CEO and Chief Operating Officer. Compensation of Directors Effective January 1, 1993, and January 1, 1994, each member of the Board of Directors receives a fee of $2,300 and $2,500 per month, respectively, for their services. Effective as of the foregoing dates, Mr. Laskowski is paid a total annual fee of $80,000 and $100,000 per year, respectively, in his capacity as Chairman of the Board. Under a Deferred Director Fee Plan adopted by the Board, each director may elect to defer payment of 10% to 100% of his monthly director's fee, in 10% increments, until whichever of the following dates shall be selected by him at the time he makes such deferral election: (a) the first day of the month coinciding with or next following his 70th birthday or (b) the first day of the month coinciding with or next following such director's final day of service as a director, or (c) the first day of the month coinciding with or next following such director's 75th birthday, or (d) the first day of the month coinciding with or next following the date designated, which date must be after the date of the deferred election. Each member of the Board is also reimbursed for the amount of the travel and lodging expenses incurred by him in attending meetings of the Board and of the Committees of the Board. The expenses incurred by them in attending the semi-annual conventions and exhibits which the Company sponsors are also paid by the Company. Each member of the Board is also paid $200.00 per diem compensation for special committee meetings and nominating committee regional trips which he attends. Item 12.

Item 12. Security Ownership Of Certain Beneficial Owners And Management With the exception of Mr. Laskowski, no shares of the Company's stock were held by any of its officers. No person owns of record or is known by the Company to own beneficially more than five percent of the outstanding voting securities of the Company. The following table sets forth the shares of Class B Stock and Class C Stock of the Company held beneficially, directly or indirectly, by each director owning such shares, individually itemized, and by all officers and directors as a group, as of February 28, 1994: There are no known contractual arrangements nor any pledge of securities of the Company which may at a subsequent date result in a change in control of the Company. Item 13.

Item 13. Certain Relationships And Related Transactions No director, director nominee, executive officer, security holder who is known to the Registrant to own of record or beneficially more than five percent of any class of the Registrant's voting securities, or any member of the immediate family of any of the foregoing persons, had during the last fiscal year or is currently proposed to have any material interest, direct or indirect, in any transaction in which the amount involved exceeds $60,000.00 and to which the Registrant was or is to be a party, except that each of the directors and director nominees, purchased merchandise and services from the Registrant in the ordinary course of business on behalf of the retail hardware businesses in which they have ownership interests. None of such persons received benefits not shared by other hardware retailers supplied by the Registrant. No director or director nominee has had any business relationship which is required to be disclosed pursuant to Item 404(b) of Regulation S-K of the Securities and Exchange Commission, during the Registrant's last fiscal year nor is any such relationship proposed during the Registrant's current fiscal year. No director, director nominee, executive officer, any member of the immediate family of any of the foregoing, or any corporation or organization of which any of the foregoing is an executive officer, partner, or, directly or indirectly, the beneficial owner of ten percent or more of any class of equity securities, or any trust or other estate in which any of the foregoing has a substantial beneficial interest or as to which such person serves as a trustee or in a similar capacity, has been indebted to the Registrant or its subsidiaries at any time since the beginning of the Registrant's last fiscal year in an amount in excess of $60,000.00, except for indebtedness incurred in connection with purchases of merchandise and services made from the Registrant in the ordinary course of business by the retail hardware businesses in which the directors and director nominees have ownership interest. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules And Reports On Form 8-K. (a) 1. Financial Statements The financial statements listed in the accompanying index (page) to the financial statements are filed as part of this annual report. 2. Financial Statement Schedules The financial statement schedules listed in the accompanying index (page) to the financial statements are filed as part of this annual report. 3. Exhibits The exhibits listed on the accompanying index to exhibits (pages E-1 through E-5) are filed as part of this annual report. (b) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. ACE HARDWARE CORPORATION By RICHARD E. LASKOWSKI Richard E. Laskowski Chairman of the Board and Director DATED: March 23, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date RICHARD E. LASKOWSKI Chairman of the Board March 23,1994 Richard E. Laskowski and Director ROGER E. PETERSON President and Chief March 23, 1994 Roger E. Peterson Executive Officer DAVID F. HODNIK Executive Vice President March 23, 1994 David F. Hodnik and Chief Operating Officer RITA D. KAHLE Vice President-Finance March 23, 1994 Rita D. Kahle (Principal Financial Officer) Lawrence R. Bowman, Mark Jeronimus, Directors Howard J. Jung, John E. Kingrey, Ray W. Osborne, Don S. Williams, Jon R. Weiss and James R. Williams *By DAVID F. HODNIK David F. Hodnik *By RITA D. KAHLE March 23, 1994 Rita D. Kahle *Attorneys-in-fact Item 14(a). Index To Financial Statements And Financial Statement Schedules Page(s) Independent Auditors' Report Balance Sheets at December 31, 1993 and 1992 Statements of Earnings for each of the three years in the period ended December 31, 1993 Statements of Member Dealers' Equity for each of the three years in the period ended December 31, 1993 Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Notes to Financial Statements Financial Statement Schedules for each of the three years in the period ended December 31, 1993: V--Property, plant and equipment VI--Accumulated depreciation and amortization of property, plant and equipment VIII--Valuation and qualifying accounts -- Allowance for doubtful accounts All other schedules have been omitted because the required information is not present or is not present in amounts sufficient to require submission of the schedule or the required information is included in the financial statements or the notes thereto. INDEPENDENT AUDITORS' REPORT The Board of Directors Ace Hardware Corporation: We have audited the balance sheets of Ace Hardware Corporation as of December 31, 1993 and 1992, and the related statements of earnings, member dealers' equity, and cash flows for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Ace Hardware Corporation at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois January 31, 1994 ACE HARDWARE CORPORATION NOTES TO FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies (a) The Company and Its Business The Company operates as a wholesaler of hardware and related products, and manufactures paint products. As a dealer-owned cooperative, the Company distributes substantially all of its earnings in the form of patronage dividends to its member dealers based on their volume of merchandise purchases. (b) Cash Equivalents The Company considers all highly liquid investments with an original maturity of one month or less when purchased to be cash equivalents. (c) Receivables Receivables from dealers include amounts due from the sale of merchandise and special equipment used in the operations of dealers' businesses. Other receivables are principally amounts due from suppliers for promotional and advertising allowances. (d) Inventories Inventories are valued at the lower of cost or net realizable value. Cost is determined using the last-in, first-out method on substantially all inventories. (e) Property and Equipment Property and equipment are stated at cost less accumulated depreciation and amortization. Expenditures for maintenance, repairs and renewals of relatively minor items generally are charged to earnings. Significant improvements or renewals are capitalized. Depreciation expense is computed on both straight-line and accelerated methods based on estimated useful lives as follows: Useful Life Principal Years Depreciation Method Buildings and improvements 10-40 Straight line Warehouse equipment 5-10 Sum of years Office equipment 3-10 Various Manufacturing equipment 3-20 Straight line Transportation equipment 3-7 Straight line Leasehold improvements are generally amortized on a straight-line basis over the term of the respective leases. (f) Retirement Plans The Company has retirement plans covering substantially all non-union employees. Costs with respect to the noncontributory pension plans are determined actuarially and consist of current costs and amounts to amortize prior service costs and unrecognized gains and losses. The Company contribution under the profit sharing plan is determined annually by the Board of Directors. (2) Inventories Inventories consist primarily of merchandise inventories. Substantially all of the Company's inventory is valued on the last-in, first-out (LIFO) method; the excess of replacement cost over the LIFO value of inventory was approximately $63,615,000 and $60,806,000 at December 31, 1993 and 1992, respectively. Indirect costs, consisting primarily of warehousing costs, are absorbed as inventory costs rather than period costs. (3) Short-Term Borrowings Short-term borrowings were utilized during 1993 and 1992. The maximum amount outstanding at any month-end during the period was $91,000,000 in 1993 and $69,000,000 in 1992. The weighted average interest rate was 3.56%, 4.1%, and 6.28% for the years ended December 31, 1993, 1992 and 1991, respectively. Short term borrowings outstanding as of December 31, 1993, 1992 and 1991 were $38,500,000, $56,000,000 and $22,000,000, respectively. The aggregate unused line of credit available at December 31, 1993, 1992 and 1991 was $69,000,000, $41,500,000 and $54,500,000, respectively. The aggregate compensating balances (not legally restricted) at December 31, 1993, 1992 and 1991 were $600,000, $850,000 and $664,000, respectively. (4) Long-Term Debt Long-term debt is comprised of the following: Prime interest rates in effect were 6.0% in 1993 and ranged from 6.0% to 6.5% in 1992. Aggregate maturities of long-term debt are $10,707,000, $7,283,000, $6,965,000, $6,034,000 and $5,972,000 in 1994 through 1998, respectively. Under the most restrictive covenants of the loan agreements the Company must not permit its working capital to be less than $33,000,000 and maintain current assets of at least 110% of current liabilities. The fair value of the Company's debt based upon discounting of future cash flows did not materially vary from the carrying value of such debt as of December 31, 1993. (5) Patronage Dividends and Refund Certificates Payable The Company operates as a cooperative organization and has paid or will pay patronage dividends to member dealers on the portion of earnings derived from business done with such dealers. Patronage dividends are allocated in proportion to the volume of purchases by member dealers during the period. For the years ended December 31, 1993 and 1992, the amount of patronage dividends to be remitted in cash depends upon the level of dividends earned by each member outlet, varying from 20% on the total dividends under $5,000 and increasing by 5% on total dividends for each subsequent $2,500 earned to a maximum of 40% on total dividends exceeding $12,500. For the year ended December 31, 1991, the amount of patronage dividends to be remitted in cash depended upon the level of dividends earned by each member outlet, varying from 20% on the total dividends under $2,000 and increasing by 5% on total dividends for each subsequent $1,000 earned to a maximum of 40% on total dividends exceeding $5,000. All amounts exceeding the cash portions, as defined above, will be distributed in the form of Class C $100 par value stock, to a maximum based upon the current year's purchase volume or $20,000 ($10,000 in 1991), whichever is greater, and thereafter in a combination of additional cash and patronage refund certificates having maturity dates and bearing interest as determined by the Board of Directors. A portion of the dealer's annual patronage dividends distributed under the above plan in a form other than cash can be applied toward payment of principal and interest on any balances outstanding for approved exterior signage and in 1994 toward the payment of principal and interest on any outstanding computer equipments financing. The patronage dividend composition for 1993, 1992 and 1991 follows: Patronage dividends are allocated on a calandar year basis with issuance in the following year. The patronage refund certificates outstanding at December 31, 1993 are payable as follows: On January 1, 1993 the Company prepaid a portion of the patronage refund certificates payable on January 1, 1994. The remaining patronage refund certificates payable on January 1, 1994 and a portion of the patronage refund certificates payable on January 1, 1995 will be paid in January 1994 and accordingly, are classified as current liabilities in the accompanying December 31, 1993 balance sheet. (6) Retirement Plans The Company has defined benefit pension plans covering substantially all non-union employees. Benefits are based on years of service, highest average compensation (as defined) and the related profit sharing and primary social security benefit. Contributions to the plan are based on the Entry Age Normal, Frozen Initial Liability actuarial funding method and are limited to amounts that are currently deductible for tax reporting purposes. As of December 31, 1993, plan assets were held primarily in group annuity and guaranteed interest contracts, equities and mutual funds. Pension income for the years 1993, 1992 and 1991 included the following components: The following table sets forth the funded status of the plans and amounts recognized in the Company's Balance Sheet at December 31, 1993 and 1992 (September 30th measurement date): The weighted average discount rate and rate of increase in future compensation used in determining the actuarial present value of the projected benefit obligation was 7.5% and 6.0%, respectively, in 1993 and 1992. The related expected long-term rate of return was 8.5% in 1993 and 9% in 1992. The Company also participates in several multi-employer plans covering union employees. Amounts charged to expense and contributed to the plans totaled approximately $275,000, $426,000, and $485,000 in 1993, 1992 and 1991, respectively. The Company's profit sharing plan contribution for the years ended 1993, 1992, and 1991 was approximately $8,690,000, $7,374,000 and $6,824,000, respectively. The Company has no significant post-retirement benefit liabilities as defined under Financial Accounting Standard No. 106. (7) Income Taxes As a cooperative, the Company distributes substantially all of its patronage sourced earnings to its members in the form of patronage dividends. Accordingly, provisions for income taxes have been historically insignificant and are generally comprised primarily of state income taxes. The 1993 and 1992 provisions for federal income taxes were $177,000 and $299,000, respectively, and state income taxes were $267,000 and $126,000, repectively. As described in Note 11, the Company completed a sale and leaseback of its Los Angeles, California distribution facility in 1991. The 1991 tax provision totals $1,158,000 for federal income taxes and $236,000 for state income taxes. The Company made tax payments of $357,000, $728,000, and $5,017,000 during 1993, 1992 and 1991, respectively. (8) Member Dealers' Equity The Company's founders for many years contemplated that the ownership of the Company would eventually be with the Company's member dealers. Prior to November 30, 1976, dealers deposited monies to the Ace Dealer's Perpetuation Fund for the purpose of accumulating funds for the purchase of stock when such ownership became available. The Company registered its stock with the Securities and Exchange Commission on October 1, 1976 and existing dealers who subscribed for stock applied their deposits toward payment of such shares. The small number of dealers who did not subscribe for shares had their respective deposits refunded during 1977. The Company's classes of stock are described below: At December 31, 1993 and 1992 there were no common shares reserved for options, warrants, conversions or other rights; nor were any options granted or exercised during the two years then ended. Member dealers may subscribe for the Company's stock in various prescribed combinations. Only one share of Class A Stock may be owned by a dealer with respect to the first member retail outlet controlled by such dealer. Only four shares of Class B Stock may be owned by a dealer with respect to each retail outlet controlled by such dealer, but only if such outlet was a member of the Company on or before February 20, 1974. An appropriate number of shares of Class C Stock must be included in any subscription by a dealer in an amount to provide that such dealer has a par value of all shares subscribed for equal to $5,000 for each retail outlet. Unregistered shares of Class C Stock are also issued to dealers in connection with patronage dividends. No dividends can be declared on any shares of any class of the Company's Stock. Upon termination of the Company's membership agreement with any retail outlet, all shares of stock of the Company, held by the dealer owning or controlling such outlet, must be sold back to the Company, unless a transfer of such shares is made to another party accepted by the Company as a member dealer with respect to the same outlet. A Class A share is issued to a member dealer only when the share subscribed has been fully paid. Class B and Class C shares are only issued when all such shares subscribed with respect to a retail outlet have been fully paid. Additional Stock Subscribed in the accompanying statements represents the par value of shares subscribed, reduced by the unpaid portion. All shares of stock are currently issued and repurchased at par value, except for Class B Stock which is repurchased at twice its par value, or $2,000 per share. Upon retirement of Class B shares held in treasury, the excess of redemption price over par is allocated equally between contributed capital and retained earnings. Transactions during 1992 and 1993 affecting treasury shares follow: (9) Commitments Leased property under capital leases included under "Property and Equipment" in the balance sheets as follows: The Company rents buildings and warehouse, office and certain other equipment under operating and capital leases. At December 31, 1993 annual minimum rental commitments under leases that have initial or remaining noncancelable terms in excess of one year were as follows: Year Ending Capital Operating December 31, Leases Leases (000's omitted) 1994 $ 518 $ 8,917 1995 510 6,548 1996 271 4,982 1997 -- 3,689 1998 -- 3,110 Thereafter -- 26,191 Total minimum lease payments $1,299 $53,437 Less amount representing interest 102 Present value of total minimum lease payments $1,197 All leases expire prior to 2009. Under certain leases, the Company pays real estate taxes, insurance and maintenance expenses in addition to rental expense. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Rent expense was approximately $21,444,000, $21,073,000 and $17,753,000 in 1993, 1992 and 1991, respectively. Rent expense includes $4,282,000, $3,706,000 and $3,289,000 in contingent rentals paid in 1993, 1992 and 1991, respectively, primarily for transportation equipment mileage. (10) Supplementary Income Statement Information Gross media expense, prior to income offsets from dealers and suppliers, amounting to $48,293,000, $47,813,000 and $46,167,000 were charged to operations in 1993, 1992, and 1991, respectively. (11) Interest Expense and Other Income, Net Capitalized interest totaled $29,000, $836,000 and $417,000 in 1993, 1992 and 1991, respectively. Interest paid was $10,670,000, $9,149,000 and $6,409,000 in 1993, 1992 and 1991, respectively. In November 1991, the Company completed a sale and leaseback of its Los Angeles, California facility resulting in a gain of $2.5 million, net of $1.4 million in federal and state income taxes. The facility was leased back for a term which expired on October 31, 1992. The gain on the sale and leaseback is included in other income for the year ended December 31, 1991. The capital gain from the sale constitutes nonpatronage-sourced income and is not available for distribution as patronage dividends. INDEX TO EXHIBITS Exhibits Enclosed Description 21 Subsidiaries of the Registrant. 24 Powers of Attorney. Exhibits Incorporated by Reference 2 Not Applicable 3-A Restated Certificate of Incorporation of the Registrant dated September 18, 1974 filed as Exhibit 3-A to the Registrant's Form S-1 Registration Statement (Registration No. 2-55860) on March 30, 1976 and incorporated herein by reference. 3-B By-laws of the Registrant as amended on January 24, 1994 included as Appendix A to the Prospectus constituting a part of Post Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) filed on or about March 23, 1994 and incorporated herein by reference. 3-C Certificate of Amendment to the restated Certificate of Incorporation of the Registrant dated May 19, 1976 filed as Exhibit 3-D to Amendment No. 1 to the Registrant's Form S-1 Registration Statement (Registration No. 2-55860) on June 10, 1976 and incorporated herein by reference. 3-D Certificate of Amendment to the restated Certificate of Incorporation of the Registrant dated May 21, 1979 filed as Exhibit 3-F to Amendment No. 1 to the Registrant's Form S-1 Registration Statement (Registration No. 2-63880) on May 23, 1979 and incorporated herein by reference. 3-E Certificate of Amendment to the restated Certificate of Incorporation of the Registrant dated June 7, 1982 filed as Exhibit 3-G to the Registrant's Form S-1 Registration Statement (Registration No. 2-82460) on March 16, 1983 and incorporated herein by reference. 3-F Certificate of Amendment to the restated Certificate of Incorporation of the Registrant dated June 5, 1987 filed as Exhibit 3-F to the Registrant's Form S-1 Registration Statement (Registration No. 33-4299) on March 29, 1988 and incorporated by reference. 3-G Certificate of Amendment to the restated Certificate of Incorporation of the Registrant dated June 16, 1989 filed as Exhibit 4-G to Post Effective Amendment No. 1 to the Registrant's S-2 Registration Statement filed on or about March 20, 1990 and incorporated by reference. 4-A Specimen copy of Class B stock certificate as revised as of November, 1984, filed as Exhibit 4-A to Post-Effective Amendment No. 2 to the Registrant's Form S-1 Registration Statement (Registration No. 2-82460) on March 15, 1985 and incorporated herein by reference. 4-B Specimen copy of Patronage Refund Certificate as revised in 1988 filed as Exhibit 4-B to Post-Effective Amendment No. 2 to the Registrant's Form S-1 Registration Statement (Registration No. 33-4299) on March 29, 1988 and incorporated herein by reference. E-1 4-C Specimen copy of Class A stock certificate as revised in 1987 filed as Exhibit 4-C to Post-Effective Amendment No. 2 to the Registrant's Form S-1 Registration Statement (Registration No. 33-4299) on March 29, 1988 and incorporated herein by reference. 4-D Specimen copy of Class C stock certificate filed as Exhibit 4-I to the Registrant's Form S-1 Registration Statement (Registration No. 2-82460) on March 16, 1983 and incorporated herein by reference. 4-E Copy of current standard form of Subscription for Capital Stock Agreement to be used for dealers to subscribe for shares of the Registrant's stock in conjunction with new membership agreements submitted to the Registrant filed as Exhibit 4-L to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 4-F Copy of plan for the distribution of patronage dividends with respect to purchases of merchandise made from the Registrant on or after January 1, 1993, adopted by the Board of Directors of the Registrant on December 8, 1992, filed as Exhibit 4-M to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 9 No Exhibit 10-A Copy of Retirement Benefits Replacement Plan of the Registrant, restated as of January 1, 1989, filed as Exhibit 10-A to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-B Copy of resolutions establishing 1990 Incentive Compensation Plan for Executives and amending the 1989 Incentive Compensation Plans for Executives of the Registrant adopted by its Board of Directors on January 30, 1991 and filed as Exhibit 10-F to Post Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-27790) on March 20, 1991 and incorporated herein by reference. 10-C Copy of resolutions amending the 1990 Incentive Compensation Plans for Executives and establishing the Executive Supplemental Benefit Plans of the Registrant adopted by its Board of Directors on December 11, 1990 and filed as Exhibit 10-G to Post Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-27790) on March 20, 1991 and incorporated herein by reference. 10-D Copy of amendment to the Executive Supplemental Benefits Plan of the Registrant adopted by its Board of Directors on July 30, 1991 filed as Exhibit 10-E to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 23, 1992 and incorporated herein by reference. 10-E Copy of amendment to the Executive Supplemental Benefits Plan of the Registrant adopted by its Board of Directors on December 9, 1991 filed as Exhibit 10-F to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 23, 1992 and incorporated herein by reference. E-2 10-F Copy of amendment to the 1990 Incentive Compensation Plan for Executives of the Registrant, filed as Exhibit 10-H to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 23, 1992 and incorporated herein by reference. 10-G Copy of the "Ace Hardware Corportation Officer's (sic) Incentive Compensation Plan" as amended and restated effective January 1, 1994, filed as Exhibit 10-G to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-H Copy of Employment Agreement effective January 1, 1993 between Ace Hardware Corporation and Paul Ingevaldson filed as Exhibit 10-I to Post Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 22, 1993 and incorporated herein by reference. 10-I Copy of Employment Agreement effective January 1, 1993 between Ace Hardware Corporation and David F. Hodnik filed as Exhibit 10-J to Post Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 22, 1993 and incorporated herein by reference. 10-J Copy of Employment Agreement effective January 1, 1993 between Ace Hardware Corporation and Roger E. Peterson filed as Exhibit 10-K to Post Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 22, 1993 and incorporated herein by reference. 10-K Copy of Employment Agreement effective January 1, 1993 between Ace Hardware Corporation and William A. Loftus filed as Exhibit 10-L to Post Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 22, 1993 and incorporated herein by reference. 10-L Copy of Loan Agreement with Anne Arundel County, Maryland dated December 1, 1981 securing 15-year floating rate industrial development revenue bonds in the principal sum of $9 million held by The Northern Trust Company, Chicago, Illinois, for itself and other participating lenders filed as Exhibit 10-A-k to Post-Effective Amendment No. 3 to the Registrant's Form S-1 Registration Statement (Registration No. 2-63880) on March 9, 1982 and incorporated herein by reference. 10-M Copy of Loan Agreement with Pulaski County, Arkansas dated July 1, 1988 securing a variable rate demand Industrial Development Revenue Refunding Bond with a maturity date of February 1, 1994 in the principal sum of $8,250,000.00 filed as Exhibit 10-V to the Registrant's Form S-2 Registration Statement (Registration No. 33-27790) filed on March 28, 1989 and incorporated herein by reference. E-3 10-N Copy of Note Purchase and Private Shelf Agreement with the Prudential Insurance Company of America dated September 27, 1991 securing 8.74% Senior Series A Notes in the principal sum of $20,000,000.00 with a maturity date of July 1, 2003 filed as Exhibit 10-A-q to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 23, 1992 and incorporated herein by reference. 10-O Copy of Standard Form of Ace Hardware International Retail Merchant Agreement adopted in 1990, filed as Exhibit 10-A-q to Post Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-27790) on March 20, 1991 and incorporated herein by reference. 10-P Copy of current standard form of Ace Hardware Membership Agreement filed as Exhibit 10-P to Post-Effective Amendment No. 2 to the Registrant's form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-Q Copy of 6.89% Senior Series B notes in the aggregate principal sum of $20,000,000 issued July 29, 1992 with a maturity date of January 1, 2000 pursuant to Note Purchase and Private Shelf Agreement with the Prudential Insurance Company of America dated September 27, 1991 and filed as Exhibit 10-A-r to Post Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement on March 22, 1993 and incorporated herein by reference. 10-R Copy of 6.47% Senior Series A notes in the aggregate principal amount of $30,000,000 issued September 22, 1993 with a maturity date of June 22, 2008, and $20,000,000 Private Shelf Facility, pursuant to Note Purchase and Private Shelf Agreement with the Prudential Insurance Company of America dated as of September 22, 1993, filed as Exhibit 10-R to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-S Assignment and Assumption dated October 22, 1992 of Lease dated August 31, 1992 with MTI Vacations, Inc. filed as Exhibit 10-A-s to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 22, 1993 and incorporated herein by reference. 10-T Copy of Amendment to the Executive Supplemental Benefit Plans of the Registrant adopted by its Board of Directors on March 17, 1992 and filed as Exhibit 10-A-t to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 22, 1993 and incorporated herein by reference. 10-U Copy of Lease dated September 30, 1992 for general offices of the Registrant in Oak Brook, Illinois filed as Exhibit 10-A-u to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on March 22, 1993 and incorporated herein by reference. E-4 10-V Copy of Fourth Amendment to Executive Supplemental Benefit Plans effective January 1, 1994 filed as Exhibit 10-V to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-W Copy of Ace Hardware Corporation Deferred Director Fee Plan as amended on June 8, 1993, filed as Exhibit 10-W to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-X Copy of Ace Hardware Corporation Deferred Compensation Plan January, 1994, filed as Exhibit 10-X to Post-Effective Amendment No. 2 to the Registrants Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 11 No Exhibit. 12 No Exhibit. 13 No Exhibit. 16 Not Applicable. 18 No Exhibit. 22 Not Applicable. 23 Auditors' Consent, dated March 23, 1994, filed as Exhibit 24(a) to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) filed on or about March 23, 1994 and incorporated herein by reference. 27 No Exhibit. 28 Not Applicable. Supplemental Information to be Furnished with Reports Filed Pursuant to Section 15(d) of the Act by Registrants which have not Registered Securities Pursuant to Section 12 of the Act. As of the date of the foregoing Report, no annual report for the Registrant's year ended December 31, 1993, nor any proxy soliciting materials for the Registrant's 1994 annual meeting have been sent to security holders. Copies of such Annual Report and proxy soliciting materials will subsequently be sent to security holders and furnished to the Securities and Exchange Commission. E-5

33798_1993.txt

33798

1993

Item 1. BUSINESS (a) General Development of Business ------------------------------- Grossman's Inc. (the "Company") was first incorporated in Michigan in 1919 as E.S. Evans and Co., Inc., then was reincorporated in Delaware in 1923. In 1931 the Company's name was changed to Evans Products Company. In 1986, in conjunction with the reorganization of the Company described herein, the Company adopted the name Grossman's Inc. On March 11, 1985, Evans Products Company ("Evans") and certain of its subsidiaries filed voluntary petitions for relief under Chapter 11 of the Federal Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Florida. On November 19, 1986, the Company emerged from the Chapter 11 proceedings. Under a court approved Reorganization Plan, the following transactions took place in 1986. Substantially all of Evans' assets, other than those of the retail building materials business conducted by Evans' wholly-owned subsidiary, Grossman's Inc. ("Old Grossman's"), were transferred to Evans Asset Holding Company ("EAHC") and a trust (collectively "AHC"), each beneficially owned by the lenders to Evans and one of its subsidiaries (the "Lenders") for the purpose of liquidating such assets. Evans and its filing subsidiaries (including Old Grossman's) were discharged from substantially all of their pre-Chapter 11 petition indebtedness. All of Evans' outstanding shares of common stock and preferred stock were cancelled. Old Grossman's was then merged into Evans, which adopted the name Grossman's Inc. (the "Company"), and the Company distributed to its creditors or to a trust or reserve for unpaid and unliquidated claims, $60,000,000 of its 13% Debentures due 1991, $73,000,000 of its 14% Debentures due 1996, $105,200,000 face value of its Zero Coupon Notes, which matured and the final installment paid in January 1993, and 20,000,000 shares of its Common Stock (of which 1,859,852 shares were sold by the trust and the Company in a private placement in December, 1986). On July 31, 1987, the Company completed a public offering of 11,000,000 shares of its Common Stock. Of the shares offered, 6,131,347 shares were sold by the Company, with the net proceeds of $45,092,000 used to purchase 13% and 14% Debentures. The remaining 4,868,653 shares sold in the offering were sold by stockholders. On February 1, 1989, the Company announced that it had engaged Shearson Lehman Hutton Inc. as the Company's financial adviser to assist the Company in reviewing strategic alternatives to realize the values inherent in its business. As a result of this effort, on September 12, 1989, the Company sold the assets and business of its Moore's Division to Harcros Lumber & Building Supplies Inc., an indirect wholly-owned subsidiary of Harrisons & Crosfield plc of London, England. The Moore's Division consisted of 59 retail building materials stores and yards located in Maryland, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Virginia and West Virginia. Independent of the Shearson engagement, on August 25, 1989, the Company sold its Northwest Division, consisting of 28 retail building materials stores located in California to GNW Partners, L.P., a California limited partnership. Certain of the former management employees of the Northwest Division were partners in GNW. Net proceeds from the 1989 sales of the Moore's and Northwest Divisions totalled $105.7 million. Such proceeds were principally used for the retirement on long-term debt. In September 1993, the Company announced plans to close 22 marginally performing Eastern Division stores. The closings were completed in the fourth quarter. (b) Financial Information About Industry Segments --------------------------------------------- The Company's operations during the last three years have been entirely in the retail building materials industry. (c) Narrative Description of Business --------------------------------- Grossman's is a retailer of lumber, building materials, and other home improvement products emphasizing sales to its target customers; contractors, remodelers and serious do-it-yourselfers. The Company operates 119 stores, under the names "Grossman's", "Contractors' Warehouse" and "Mr. 2nd's Bargain Outlets", as listed in Item 2

ITEM 2. PROPERTIES The Company's stores are generally located on or adjacent to major transportation arteries to be convenient to urban and suburban markets. The Company seeks to match the size of a store to market sales potential. The typical store in smaller markets contains 49,000 square feet of selling space, 24,000 square feet under roof and the remainder in a merchandised outdoor lumber yard. In larger markets, the Company's stores may have as much as 100,000 square feet of selling space, up to 60,000 square feet of which is enclosed and the remainder in an adjacent lumber yard. Most stores have an adjacent outdoor sales area with storage buildings to dispense lumber and other building materials. The Company's dual yard stores, which cater to consumers, builders and contractors, are typically located on three or more acres of land and have approximately 45,000 square feet of building area, of which 12,000 square feet are showroom and the balance, warehouse storage. Dual yards also have large outside selling and storage areas (40,000 to 60,000 square feet) to service the contractor business. MR. 2ND'S BARGAIN OUTLET - ----------------------- MASSACHUSETTS Braintree Brighton Framingham Malden Marshfield Peabody Waltham NEW YORK Brighton Buffalo Cheektowaga East Dewitt North Syracuse Rochester Tonawanda Webster West Seneca RHODE ISLAND Central Falls Warwick The Company owns 70 of its stores and leases 49 stores, of which 22 have leases that expire without renewal or purchase options within the next ten years. Historically, leases without renewal options have been actively negotiated and renewed by the Company prior to expiration. Four leases have options for the Company to purchase the stores from the lessors at various times at an aggregate purchase price estimated to be below aggregate current market value. In 1993, a decision was made to close 22 Eastern Division stores. Closings were completed in the 1993 fourth quarter. One additional store, in Erie, Pennsylvania, was closed and sold in early 1994. Of the 22 closed locations, 11 were leased and 11 were Company-owned. Of the 11 owned properties, two were sold in early 1994, two are under agreement to be sold in 1994 and the remainder are being actively marketed. One lease was terminated in early 1994. In addition to the Company's stores, the Company owns and operates two distribution centers, a data processing center and two office facilities, one of which includes the Company's corporate office. The net book value of the Company's owned real properties as of December 31, 1993 is approximately $84.1 million. Mortgage debt of approximately $23 million is outstanding on ten of the Company's owned properties. The Company's properties are considered well maintained and are in good condition. Since 1986, the Company has invested $123.2 million in capital assets in the its Eastern and Contractors' Warehouse Division stores and distribution centers. The majority of store closings during 1987 and 1988 occurred in markets served by the divisions sold in 1989. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is a party to litigation incidental to the conduct of its business, most of which is covered by insurance and none of which is expected to have a material adverse effect on the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II No cash dividends have been paid on the Company's Common Stock since its initial issuance on November 19, 1986. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF OPERATIONS FINANCIAL CONDITION Grossman's Inc. financial condition at December 31, 1993 reflects management actions taken to improve future liquidity. Significant 1993 events affecting year end financial condition are as follows: - - Operating results in Eastern Division stores were significantly below prior year levels and current year expectations, resulting in lower than anticipated cash flows and necessitating unplanned borrowings under the Company's revolving credit agreements. - - The Company reviewed both individual store and market performance and determined that 22 Eastern Division stores should be closed and the assets redeployed. A $34.3 million store closing provision was recorded in the third quarter. - - The Company announced an agreement for the sale of its 35 acre headquarters site in Braintree, Massachusetts to Kmart Corporation. Financial reporting of the sale is being deferred until certain contingencies are resolved and the sale is consummated. - - A non-cash adjustment of $30.2 million was recorded, establishing a valuation allowance to offset deferred tax assets recorded in 1991. - - The Company entered into a new three-year revolving credit agreement, secured by receivables, inventory and certain other assets. - - A $20.5 million non-cash adjustment to stockholders' investment was recorded to reflect the difference between the accumulated pension benefit obligation and the estimated value of pension plan assets. This adjustment resulted from a reduction in the discount rate assumption used to compute actuarially the cost of the future obligation. - - Three Contractors' Warehouse stores were opened, including the first in the Midwest, and 15 Eastern Division stores were repositioned. - - The Eastern Division distribution center became fully operational, and long-term financing for the facility was finalized. Eastern Division operating returns and cash flows during the first nine months of 1993 were significantly below expectations, principally due to increased competition, concurrent with a continued stagnant Northeast economy. As a result, management actions were taken to improve operating returns, liquidity and future cash flows. During the first four months of 1993, operating performance was affected negatively by severe spring weather conditions, resulting in declines in comparable store sales during each of these months. As ground conditions dried out, operating performance normalized and the Company realized increases in comparable store sales during the balance of the second quarter. Operating performance in the second quarter exceeded the prior year level. During the third quarter, operating performance began to decline significantly in the Eastern Division. Steps taken to react to diminishing store performance, including price reductions, inventory management and promotional activities, did not counterbalance the declining operational results, particularly in those stores affected most by competition. As the quarter progressed, management performed a review of each Eastern Division store and a determination was made to close 22 marginally performing stores. A charge of $34.3 million was recorded at the end of the quarter to cover closing costs, lease expenses in eleven of the closed stores, severance and outplacement costs, inventory writedowns, other anticipated expenses and the net unrecoverable amount of property, plant and equipment. The process of closing the 22 stores was completed in the fourth quarter of 1993. One additional store was closed in early 1994. Three properties, the former Nashua, New Hampshire, Eastport, Maine and Erie, Pennsylvania stores, have been sold, the latter two in early 1994. Two additional properties are under agreement to be sold in 1994, and one lease agreement has been terminated in a favorable settlement. The remaining seven owned properties and ten leased properties continue to be marketed actively. It is anticipated that the sale of some or all of the properties will occur over a period of years, resulting in a liquidity improvement at the time of each respective sale. In a separate transaction, the Company announced an agreement to sell its 35 acre headquarters site in Braintree, Massachusetts to Kmart Corporation. The sale is contingent upon certain approvals and conditions customary in commercial real estate transactions. The purchase price is dependent upon the number of square feet finally approved by local authorities having jurisdiction over the proposed site plan. Consummating the transaction is subject to the permitting process, the timing of which cannot be predicted at this time. If the transaction is consummated, the Company expects to realize significant cash flow and a gain from the sale. Upon the sale of the site, the Company plans to relocate its offices to available space in the vicinity of its current offices. The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109. This standard requires, among other things, recognition of future tax benefits, measured by enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and net operating loss carryforwards to the extent that management assesses the utilization of such net operating loss carryforwards to be more likely than not. The statement also requires deferred tax assets to be reduced by a valuation allowance if, based on the weight of available evidence, management cannot make a determination that it is more likely than not that some portion or all of the related tax benefits will be realized. Furthermore, the statement requires that a valuation allowance be established or adjusted if a change in circumstances causes a change in judgment about the future realizability of the deferred tax assets. At December 31, 1992, the Company had recorded deferred tax assets totalling $30.2 million, with no related valuation allowance, based upon management's assessment at that time that taxable income of the Company would more likely than not be sufficient to utilize fully the net operating loss carryforwards prior to their ultimate expiration in the year 2001. At September 30, 1993, based upon unanticipated 1993 operating results and a reassessment of future expectations, the Company established a valuation allowance to reduce the carrying value of deferred tax assets to zero. The Company has not recognized any future tax benefits that may be realized from taxable losses incurred in 1993. The Company anticipates that its judgment about the future realizability of the deferred tax assets will not be amended until a sustained period of income has been achieved and is likely to continue. As a result of the charges discussed above and the Company's nine-month operating performance, at September 30, 1993, the Company was not in compliance with certain covenants contained in its revolving credit agreement and certain other loan agreements. The Company's lenders waived such defaults through December 15, 1993. On December 15, 1993, the Company entered into a loan and security agreement with BankAmerica Business Credit, Inc., which provides for borrowings up to $60 million, including letters of credit up to $15 million. Borrowings pursuant to this agreement are secured by inventories, receivables and certain other assets. At December 31, 1993, cash borrowings under this agreement totalled $23.2 million and outstanding standby letters of credit, issued in the normal course of business principally to guarantee payment of insurance obligations, totalled $11.4 million. The agreement has a three-year term, with one-year renewal periods thereafter. Interest is payable at 1% over Prime Rate (7% at December 31, 1993), with a Eurodollar option available for borrowings in excess of $5 million. The agreement contains various covenants which, among other things, require minimum levels of net worth, establish minimum interest and fixed charge coverage ratios, and establish maximum levels of capital expenditures. Other loan agreements were amended to contain similar covenants. The borrowings under the revolving credit agreement have been classified as long-term at December 31, 1993, as borrowings during 1994 are expected to remain at or above the year end 1993 level. The Company has changed its actuarial assumption for the discount rate used to value pension obligations from 9.5% to 7.0%. As a result, a non-cash adjustment of $21.9 million was recorded, reducing prepaid pension assets and establishing a $15.2 million minimum liability equal to the difference between the accumulated pension benefit obligation and the estimated value of pension plan assets. An intangible asset was established of $1.4 million, equal to unrecognized prior service cost, and a $20.5 million adjustment to stockholders' investment was recorded in accordance with Statement of Financial Accounting Standards No. 87. The minimum liability, intangible asset and adjustment to stockholders' investment will be measured annually and will change based on interest rate assumptions, changes in the benefit obligation and changes in the value of plan assets. Inventory at December 31, 1993 totalled $121.8 million, a $1.4 million decrease from the prior year end. Inventory declines as a result of Eastern Division store closings were offset by inventory in three Contractors' Warehouse stores opened during 1993 and increased lumber prices. Property, plant and equipment and capital lease obligations reflect the results of actions taken in support of three principal strategic initiatives: repositioning of Eastern Division stores to strengthen their appeal to target customers, expanding the Company's Contractors' Warehouse concept and development and installation of its Eastern Division automated, integrated replenishment system. Capital expenditures of $15.1 million and capital lease additions of $7.2 million were made principally in support of these initiatives. Subject to funds availability, management plans to continue capital expenditures in support of the Contractors' Warehouse expansion and Eastern Division replenishment system, including new register systems; however, in light of 1993 store performance, repositioning of additional Eastern Division stores will be slowed. Expansion of the Contractors' Warehouse concept continued in 1993, with a store opening in Colton, California in March and store openings in Carson, California and Cincinnati, Ohio in June. Expansion of this concept will continue in 1994 with two planned store openings in the Midwest. In addition, the Company's Mexican joint venture is scheduled to open its first store in Monterrey, Mexico in the 1994 second quarter. This store will be modeled after the Contractors' Warehouse concept. The Company also opened one Grossman's store and three Mr. 2nd's Bargain Outlet Stores during 1993. The repositioning of 15 Eastern Division stores was completed prior to the 1993 spring selling season. The Company also completed the expansion to 300,000 square feet of its Distribution Center in Manchester, Connecticut. The Company purchased and expanded the distribution facility to support the Eastern Division's new automated, integrated replenishment system, which is currently operational. In January 1993, the Company paid $10.8 million as the final installment on its Zero Coupon Notes. In February 1993, the Company entered into long-term financing of $6.1 million on the Eastern Division distribution center. Upon receipt of the loan proceeds, full payment was made on the existing two-year $4.9 million mortgage. The new mortgage has a 15 year amortization period, with the balance due at the end of ten years. The Company also received $750,000 in proceeds from two mortgage loans provided by the State of Connecticut for equipment within the distribution facility. The Company believes that existing funds, funds generated from operations, proceeds to be received from the sale of properties and funds available under the $60 million loan and security agreement will be sufficient to satisfy debt service requirements, to pay other liabilities in the normal course of business and to finance planned capital expenditures. RESULTS OF OPERATIONS 1993 COMPARED WITH 1992 The 1993 net loss of $68.3 million compares to net income of $6.2 million in 1992. Significant items affecting 1993 net income were as follows: - - Higher seasonal operating losses during the first quarter of 1993 resulting from severe weather conditions in the Northeast and West adversely affected sales. - - Staff reductions were effected in the Eastern Division, largely as a result of the continued implementation of the division's automated, integrated replenishment system. Expenses related to these reductions were recorded in the third quarter. - - Eastern Division store operating results and cash flows declined significantly in the third quarter. These results were affected negatively by Northeast economic conditions and competition. Steps taken to offset these declines were only partially successful. - - After a complete review of all stores in all markets, 22 marginally performing Eastern Division stores were closed and a store closing provision of $34.3 million was recorded in the third quarter. Store closings were completed in the fourth quarter. - - Based upon unanticipated operating losses and a reassessment of future expectations, in the third quarter, the Company established a $30.2 million valuation allowance to reduce to zero the carrying value of deferred tax assets previously established in 1991. - - Gross margin declines occurred throughout the year resulting from increases in sales to professional customers, growth in Contractors' Warehouse store sales, increasingly competitive market conditions and rising lumber prices. - - Operating income improved by $2.9 million in the fourth quarter, reflecting Eastern Division overhead reductions and increased comparable store sales in each month during the quarter. The Company's two principal operating strategies are to reposition Grossman's stores to strengthen their appeal to target customers and to grow the Contractors' Warehouse concept, both of which emphasize sales to the professional customer. During 1992, within Grossman's stores, sales growth in the professional segment offset a decline in the retail segment. In 1993, sales to the retail segment continued to decline, and the growth in professional sales was not sufficient to cover this shortfall. Sales in the first four months of 1993 were affected negatively by severe weather conditions and prolonged wet ground conditions. In May and June, both total sales and comparable store sales increased. This trend did not continue into the third quarter, when sales declines occurred in all months. Total fourth quarter sales, which included one additional week in 1993, declined in the Eastern Division, reflecting closed stores, and continued to grow in Contractors' Warehouse stores. Eastern Division comparable store sales in the fourth quarter rose by 17.2%, partially due to the transfer of professional customers from closed stores to stores continuing to operate within these markets. Contractors' Warehouse comparable store sales in the fourth quarter rose by 0.7%. Gross margin declined from 26.8% in 1992 to 25.3% in 1993. Throughout 1993, margin declines occurred as the result of the increase in sales to professional customers, who receive discounts from normal retail pricing, and the growth in Contractors' Warehouse stores, which operate at higher per store sales volume with lower gross margins and lower expenses. Margin declines were also due to competitive market conditions and rising lumber prices. Economic and competitive conditions did not fully allow these price increases to be passed on to customers. Gross profit declined from $223.4 million in 1992 to $212.9 million in 1993, reflecting the overall sales decline, partially due to closed stores, and gross margin declines. Operating losses during the first quarter, which are normal due to the seasonality of the Company's business, were high due to the severe weather conditions in the Northeast and West, the Company's two principal operating markets. In the first quarter of 1993, the operating loss was $11.3 million, compared to a $4.8 million loss in the comparable period of 1992. In the 1993 second quarter, as conditions improved, operating income of $11.7 million compared favorably to the 1992 level of $10.7 million. In the third quarter of 1993, the Company's operating income prior to recognition of store closing expense was $2.9 million, as compared to $9.8 million for the same period in 1992. The decline in operating income was principally due to declining Eastern Division store results, as previously discussed. Steps taken to react to diminishing store performance, including price reductions, inventory management and promotional activities, did not counterbalance the declining operational results, particularly in those stores affected most by competition. As the third quarter progressed, management reviewed each Eastern Division store and decided to close 22 marginally performing stores. Store closing expense of $34.3 million was recorded at the end of the quarter to cover costs related to the leases in 11 of the stores, severance and outplacement expenses, inventory write downs, other anticipated expenses and the net unrecoverable amount of property, plant and equipment. Selling and administrative expenses in 1993 approximated the 1992 level, but varied significantly by quarter, with a first quarter increase of $3.6 million, a second quarter decrease of $2.6 million, a third quarter increase of $2.2 million and a fourth quarter decrease of $3.3 million. The first quarter increase was primarily due to activities in support of strategic initiatives. Expenses related to these activities were higher in the second quarter of 1992 than in the same period in 1993, the principal reason for the second quarter decline. At the end of the second quarter, the Company announced a restructuring of the Eastern Division, largely as a result of the continued implementation of the automated, integrated replenishment system. Staff reductions were effected in the third quarter, with additional reductions anticipated when further efficiencies from the system are attained. In the third quarter of 1993, selling and administrative expenses included severance payments, outplacement services and other expenses related to the restructuring, resulting in the overall expense increase. In 1994, the Company expects the restructuring to yield continuing savings in operating expenses. The fourth quarter decline in selling and administrative expenses reflects the reduced overhead as a result of closed stores and Eastern Division staff reductions. Although selling and administrative expenses in 1994 will be favorably impacted by the Eastern Division downsizing, pension expense will rise significantly as a result of changes in assumptions used to determine actuarially the pension liability and expense. Pension expense is expected to increase from $1.8 million in 1993 to approximately $5 million in 1994. Depreciation and amortization increased by $1.8 million in 1993, related to ongoing capital spending in support of strategic initiatives. Future capital spending will continue in support of the Contractors' Warehouse expansion and Eastern Division replenishment system. Preopening expense, associated with the development, opening, expansion and modernization of stores, decreased from $3.5 million in 1992 to $630 thousand in 1993 as the result of a curtailment of the repositioning of Eastern Division stores. Remodeling of Eastern Division stores planned for the 1993 fourth quarter was not undertaken due to the poor nine-month operating results. In 1992, fourth quarter preopening expenses totalled $2.4 million. Interest expense remained relatively constant from 1992 to 1993. Interest expense savings related to the retirement of high-interest rate debt were offset by $1.3 million of interest expense on borrowings under the Company's revolving credit agreement. There were no revolving credit borrowings in 1992. At September 30, 1993, based on unanticipated operating losses and a reassessment of future expectations, the Company established a valuation allowance to reduce the carrying value of deferred tax assets to zero. Tax credits recorded earlier in 1993 were also reversed, resulting in a total provision for income taxes of $30.2 million. The Company has not recognized any future tax benefits that may be realized from taxable losses incurred in 1993. Other than the effects of rising lumber prices, as previously discussed, the Company's business was not materially affected by inflation in any of the years presented. 1992 COMPARED WITH 1991 Net income of $6.2 million for the year ended December 31, 1992 exceeded the 1991 level of $4.3 million by 45%. The earnings improvement represents a 7.1% improvement in operating income, supplemented by a reduction in interest expense and gains on the sale of real estate. An overall 0.2% decline in Eastern Division sales resulted from an 11.6% decline in retail sales, virtually offset by a 39.1% increase in professional sales. The retail segment in the Eastern Division continued to reflect the effects of a prolonged slump in the housing sector, coupled with increased competition. Western Division sales increased as the result of new store openings combined with comparable store sales increases. Gross margin decreased from 27.2% to 26.8% as a result of changes in sales mix toward lower margin professional sales. An increase in retail margin was offset by this change in mix. In 1991, aggressive promotion of the Company's private label credit card was undertaken coincident to the sale of the credit card portfolio, which reduced gross margins. Economic conditions in the Northeast housing sector affected negatively sales growth in both years. Throughout 1992, the Company continued to counter the effects of the recession and increased competition with more aggressive pricing and marketing to target customers. Sales to professionals, who receive discounts from normal retail pricing, grew as a percent of overall Eastern Division sales. Further offsetting the increase in retail gross margin was the continued growth in Contractors' Warehouse store sales as a percent of total Company sales. Also favorably impacting both retail and professional margins in 1992 was improved inventory shrinkage results throughout the chain. Selling and administrative expenses increased by $1.6 million, or 0.9%, but decreased as a percent of sales from 23.8% to 23.2%. During the first six months of 1992, operating expenses increased as a percent of sales, primarily in support of the operating strategies. During the second half of the year, the Company was successful at reducing operating expenses during a period when sales increased by 4.8%, thereby reducing selling and administrative expenses as a percent of sales. Within selling and administrative expenses, payroll expense increased by 4.8%, slightly higher than the overall sales increase and reflective of the activities in support of the Company's strategies. Advertising expense decreased by 14.6%, reflective of more targeted marketing efforts. In addition, the provision for losses on accounts receivable declined by $2.0 million, the result of continued tightened credit policies and stronger collection efforts. Depreciation and amortization increased by 4.8% in 1992, related to capital spending. Preopening expense, which included expenses related to stores scheduled for 1993 openings, totalled $3.5 million as compared to $2.3 million in 1991. Interest expense declined by $1.2 million, or 12.4%. Savings related to retirement of high-interest debt were partially offset by financing secured in the second and fourth quarter of 1991, as well as interest expense related to the $4.9 million mortgage on the Company's Eastern Division distribution center, entered into in September 1992. Included in interest expense in 1991 was $364 thousand of interest on revolving credit borrowings. There were no borrowings in 1992. Interest and other income increased by $1.0 million from 1991 to 1992, which includes net gains of $4.2 million on sales of property, less other non-operating expenses and other declines due to the receipt in 1991 of state income tax refunds, and interest income in 1991 related to the Company's private label revolving credit card accounts receivable portfolio, which was sold in May 1991. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS Stockholders and Board of Directors Grossman's Inc. We have audited the accompanying consolidated balance sheets of Grossman's Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' investment and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements are the responsibility of management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Grossman's Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respectes the information set forth therein. ERNST & YOUNG Boston, Massachusetts January 31, 1994 The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. GROSSMAN'S INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES - ---------------------------------------- Principles of Consolidation - --------------------------- The consolidated financial statements present the results of operations, financial position and cash flows of Grossman's Inc. and its subsidiaries (the "Company"). All significant intercompany balances and transactions have been eliminated. Fiscal Periods - -------------- The Company's year end is December 31. The Company records activity in quarterly accounting periods of equal length ending on the last Saturday of each quarter. Differences in amounts presented and those which would have been presented using actual quarter-end dates are not material. Fiscal year 1993 contained 53 weeks while fiscal 1992 and 1991 contained 52 weeks. The additional week in 1993 was included in the fourth quarter. Cash Equivalents - ---------------- The Company considers all highly liquid investments, with a maturity of three months or less at date of purchase, to be cash equivalents. Accounts Receivable - ------------------- The Company extends credit on open account to qualified contractors and remodelers, principally in the Northeast. Finance charge income, included in interest and other income, amounted to $587.4 thousand, $619.6 thousand and $1.5 million in 1993, 1992 and 1991, respectively. Inventories - ----------- Merchandise inventories are valued at the lower of cost, as determined by the average cost method, or market. Property, Plant and Equipment - ----------------------------- Property, plant and equipment are stated at cost and are depreciated using the straight-line method over estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life of the improvements. Ranges of useful lives by principal classification are as follows: Buildings and leasehold improvements 10 - 33 years Machinery and equipment 3 - 7 years Accrued Insurance Claims - ------------------------ The Company maintains insurance coverage for general liability and workers' compensation risks under contractual arrangements which retroactively adjust premiums for claims paid subject to specified limitations. Expenses associated with such risks are accrued as amounts required to cover incurred incidents can be estimated. NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) - ---------------------------------------------------- Leases - ------ Capital leases, those leases which transfer substantially all benefits and risk of ownership, are accounted for as the acquisition of an asset and the incurrence of an obligation. Capital lease amortization is included in depreciation and amortization expense, with the amortization period restricted to the lease term. The related obligation is amortized over the lease term at a constant periodic rate of interest. Income Taxes - ------------ The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109-Accounting for Income Taxes. Tax provisions and credits are recorded at statutory rates for taxable items included in the consolidated statements of operations regardless of the period for which such items are reported for tax purposes. Deferred income taxes are recognized for temporary differences between financial statement and income tax bases of assets and liabilities for which income tax benefits will be realized in future years. Deferred tax assets are reduced by a valuation allowance when the Company cannot make the determination that it is more likely than not that some portion or all of the related tax asset will be realized. Pension Plan - ------------ The Company sponsors a noncontributory retirement plan for the benefit of substantially all employees. The Company funds pension costs in accordance with the Employee Retirement Income Security Act. Prior service costs, the unrecognized net transition assets and gains and losses, whether realized or unrealized, are amortized on a straight-line basis over estimated average remaining service periods. Preopening Expense - ------------------ Expenses associated with the opening of new stores and facilities and the expansion or major remodeling of existing stores are expensed as incurred. Store Closing Expense - --------------------- Store closing costs, net of amounts expected to be recovered, are recorded when the decision to close a store is made. Store closing costs include estimated losses, lease payments, other expenses and the net unrecoverable amount of property, plant and equipment. Earnings Per Common Share - ------------------------- Earnings per common share are computed based on the weighted average number of common shares outstanding, less shares in treasury, plus common share equivalents attributable to stock options, when dilutive. Business Segment - ---------------- The Company operates in one business segment: the retail sale, distribution and installation of building materials and related products. NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) - ---------------------------------------------------- Classification - -------------- Certain amounts in the consolidated financial statements for prior years have been reclassified to conform to the current year presentation. Such reclassifications had no effect on previously reported results of operations. NOTE 3 - REVOLVING TERM NOTE PAYABLE - ------------------------------------ On December 15, 1993, the Company entered into a loan and security agreement with BankAmerica Business Credit, Inc., which provides for borrowings up to $60 million, including letters of credit up to $15 million. Borrowings pursuant to this agreement are secured by inventories, receivables and certain other assets. At December 31, 1993, cash borrowings under this agreement totalled $23.2 million and outstanding standby letters of credit, issued in the normal course of business principally to guarantee payment of insurance obligations, totalled $11.4 million. The agreement has a three-year term, with one-year renewal periods thereafter. Interest is payable monthly at 1% over Prime Rate (7% at December 31, 1993), with a Eurodollar option available for borrowings in excess of $5 million. The agreement also provides for a 1/2% per annum commitment fee on the average daily unused amount under $50 million. The agreement contains various covenants which, among other things, require minimum levels of net worth and establish minimum interest and fixed charge coverage ratios, establish maximum levels of capital expenditures. Upon entering into the loan and security agreement, the Company's prior revolving credit agreement with a group of banks was terminated. The maximum borrowings under the prior revolving credit agreement in 1993 and 1991 were $36 million and $13 million, respectively. The weighted average annual interest rate on such borrowings during 1993 and 1991 were 5.9% and 8.9%, respectively. There were no borrowings under the agreement in 1992. In 1986, the Company issued $105.2 million of Zero Coupon Notes. The seventh and final principal payment on the notes was made in January 1993. These noninterest bearing notes were initially discounted for financial statement purposes to yield 13% per annum. Interest on the 14% Debentures is payable semi-annually on January 1 and July 1. At any time prior to maturity, upon 30 days notice, the Company may redeem the 14% Debentures, in whole or in part, on any interest payment date, at 100% of principal (in minimum amounts of $5 million), plus a yield maintenance premium based upon quoted Treasury Constant Maturity Series yields. Mortgage notes bear interest at a weighted average rate of 10.1% and are secured by real estate and equipment with a net book value of $34.2 million at December 31, 1993. During 1993, the Company purchased $5.1 million of its 14% Debentures with no material gain or loss. During 1992, the Company purchased and retired $2.9 million of the remaining principal on its Zero Coupon Notes and $228 thousand of its 14% Debentures with no material gain or loss. In February 1993, the Company received $6.1 million of mortgage loan proceeds for its new Eastern Division distribution center. The mortgage note is amortized over 15 years, with full payment due in February 2003. Interest accrues at an annual rate of 8.8% and is payable monthly. Upon receipt of the mortgage proceeds the Company paid in full the existing $4.9 million mortgage note. The Company also received $750 thousand in proceeds from two secured loans provided by the State of Connecticut for equipment within the distribution facility at annual interest rates of 5.0% for terms between seven and ten years. NOTE 4 - LONG-TERM DEBT (CONTINUED) - ----------------------------------- The 14% Debentures, mortgage notes and certain lease agreements contain various covenants which, among other things, restrict dividends and distributions on and repurchases of Common Stock; require specified levels of net worth; limit capital expenditures; restrict liens, the incurrence of indebtedness and lease obligations; and restrict loans and investments. Under the most restrictive of these agreements, the Company had no retained earnings available for the payment of dividends at December 31, 1993. Mortgage notes due in 1994 include $8,333 thousand related to properties under agreement to be sold in 1994. Interest paid during 1993, 1992 and 1991 amounted to (in thousands) $7,639, $8,286 and $9,911, respectively. NOTE 5 - FAIR VALUE OF FINANCIAL INSTRUMENTS - -------------------------------------------- Statement of Financial Accounting Standards No. 107 - Disclosures About Fair Value of Financial Instruments requires disclosure of fair value information about financial instruments for which it is practicable to estimate fair value. The Company estimates fair values based on the following assumptions: cash and cash equivalents are reported in the balance sheet at amounts which approximate fair value; and the carrying values of the Company's long-term debt and revolving term note payable are estimated using discounted cash flow analyses, based upon the Company's current incremental borrowing rates for similar types of borrowing arrangements. NOTE 5 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) - -------------------------------------------------------- NOTE 6 - LEASE COMMITMENTS (IN THOUSANDS) - ----------------------------------------- The Company has entered into leases for certain retail locations, office space, equipment and vehicles. The fixed terms of the leases range up to seven years and, in general, leases for retail locations contain multiple renewal options for various periods between one and ten years. Certain leases contain provisions which include additional payments based upon sales performance, operating and real estate tax escalations and purchase options. Total rent expense charged to operations during 1993, 1992 and 1991 amounted to $7,615, $8,819 and $8,801, respectively. Total contingent rentals included in rent expense were $923, $999 and $969, respectively. Included in property, plant and equipment as of December 31, 1993 and 1992 is $36,359 and $37,231, respectively, of machinery and equipment under capital leases. The related accumulated amortization is $24,049 and $22,961, respectively. Capital lease additions for machinery and equipment totalled $7,238 in 1993, $2,739 in 1992 and $2,982 in 1991. NOTE 7 - SALE OF PROPERTY - ------------------------- In October 1993, the Company announced an agreement for the sale of its 35 acre headquarters site in Braintree, Massachusetts to Kmart Corporation. The sale is contingent upon certain approvals and conditions. The purchase price is dependent upon the number of square feet finally approved by local authorities having jurisdiction over the proposed site plan. Consummating the transaction is subject to the permitting process, the timing of which cannot be predicted at this time. Other contingencies customary in commercial real estate transactions also exist. If the transaction is consummated, the Company expects to realize a significant gain from this sale. NOTE 8 - STOCKHOLDERS' INVESTMENT - --------------------------------- The Company's Restated Certificate of Incorporation contains certain provisions restricting accumulations of Common Stock. Under these provisions, as modified by the Board of Directors and currently in effect, no person may acquire shares of Common Stock on or prior to December 31, 1996 (or such later date as may be fixed by the Board of Directors) if the number of shares actually and constructively owned by such person, as defined, would exceed 5% of the outstanding Common Stock on any date. Attempted acquisitions of Common Stock in excess of these limits will be null and void and all shares purportedly acquired in excess of these limits will have no rights, except the right to receive out of the proceeds of resale thereof an amount not in excess of the amount paid for such excess shares plus brokers' commissions. Such restrictions may be waived by the Board of Directors and are not applicable to an acquisition of more than 50% of the outstanding shares of Common Stock for cash pursuant to a tender offer, merger or other business combination in which all holders of Common Stock are afforded an opportunity to sell all their shares. NOTE 9 - EMPLOYEE BENEFIT PLANS - ------------------------------- The Company sponsors a noncontributory defined benefit pension plan, the Grossman's Inc. Retirement Plan (the "Retirement Plan"), which covers substantially all employees. Employees are eligible to participate in the Retirement Plan at age 21 with one year of service. Benefits through 1990 are based upon years of service multiplied by a percentage of reference earnings. Beginning in 1991, the benefit is based upon annual reference earnings. NOTE 9 - EMPLOYEE BENEFIT PLANS (CONTINUED) - ------------------------------------------- Statement of Financial Accounting Standards No. 87 ("FAS 87") requires the recognition of a minimum liability, to the extent that actuarially computed accumulated plan benefits exceed the fair value of plan assets, and the recognition of a related intangible asset, to the extent of any unfunded prior service cost. At December 31, 1993, the Company recorded an adjustment of $21,938 thousand, reducing its prepaid pension asset and establishing a minimum liability of $15,199 thousand. The increase in minimum liability in 1993 reflects a change in the discount rate assumption from 9.5% to 7.0%. An intangible asset of $1,410 thousand was also recorded, equal to unrecognized prior service cost. The difference between the minimum pension liability adjustment and the intangible asset has been charged to stockholders' investment in accordance with FAS 87. The Company also sponsors a Savings Plan for the benefit of substantially all employees. The plan provides that employees may contribute up to 14% of their compensation, with a fully vested Company match of a portion of the contribution. During 1991, the plan was amended to provide for an increase in the Company's matching contribution, suspension of profit sharing contributions and full vesting of all participants in previous profit sharing contributions by the Company. The Company contributed $574 thousand in 1993, $555 thousand in 1992 and $477 thousand in 1991 to the plan. NOTE 10 - OTHER LIABILITIES - --------------------------- Standby letters of credit which guarantee general liability and workers' compensation insurance claims are outstanding under the Company's revolving credit agreement. NOTE 11 - EMPLOYEE STOCK OPTION PLAN - ------------------------------------ The Company has a nonqualified stock option plan covering officers and other key management employees ("1986 Plan"). The plan provides for nonqualified options to purchase shares of Common Stock. On April 28, 1992, the Company's Stockholders approved an increase in the total number of shares of Common Stock of the Company that may be issued under the 1986 Plan from 2,000,000 shares to 3,750,000 shares. In April 1993, the Board of Directors approved the 1993 Key Employee Stock Option Plan ("1993 Plan") covering key management employees who are not officers of the Company. The 1993 Plan provides for nonqualified options to purchase a total of 600,000 shares of Common Stock, with a maximum of 5,000 shares per employee. The maximum number of options which may be granted in any calendar year is 300,000. NOTE 11 - EMPLOYEE STOCK OPTION PLAN (CONTINUED) - ------------------------------------------------ All options granted are ten-year nonqualified options and were granted at market value. Of the options outstanding at December 31, 1993, 200,000 were exercisable when issued, 400,000 become exercisable in three equal annual installments following the December 11, 1990 date of grant, and the balance become exercisable in four equal annual installments following the respective dates of grant. All outstanding options become exercisable upon a change in control, as defined in the option agreements. At December 31, 1993, the Company had 4,155,750 shares of Common Stock reserved for future issuance under the plans. NOTE 12 - INCOME TAXES - ---------------------- The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109-Accounting for Income Taxes ("FAS 109"). This standard requires, among other things, recognition of future tax benefits, measured by enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and net operating loss carryforwards to the extent that management assesses the utilization of such net operating loss carryforwards to be more likely than not. The statement also requires deferred tax assets to be reduced by a valuation allowance if, based on the weight of available evidence, management cannot make a determination that it is more likely than not that some portion or all of the related tax benefits will be realized. Furthermore, the statement requires that a valuation allowance be established or adjusted if a change in circumstances causes a change in judgment about the future realizability of the deferred tax assets. At December 31, 1992, the Company had recorded deferred tax assets totalling $30.2 million, with no related valuation allowance, based upon management's assessment at that time that taxable income of the Company would more likely than not be sufficient to utilize fully the net operating loss carryforwards prior to their ultimate expiration in the year 2001. At September 30, 1993, based upon unanticipated 1993 operating results and a reassessment of future expectations, the Company established a valuation allowance to reduce the carrying value of deferred tax assets to zero. The Company has not recognized any future tax benefits that may be realized from taxable losses incurred in 1993. At December 31, 1993, the Company has net operating loss carryforwards of $109 million, expiring as follows: 1998-$15 million, 1999-$28 million, 2000-$23 million, 2001-$15 million and 2008-$28 million. NOTE 12 - INCOME TAXES (CONTINUED) - ---------------------------------- NOTE 12 - INCOME TAXES (CONTINUED) - ---------------------------------- The Company's tax returns for years subsequent to 1982 have not been reviewed by the Internal Revenue Service ("IRS"). Availability of the net operating loss carryforwards might be challenged by the IRS upon review of such returns and may be limited under the Tax Reform Act of 1986 as a result of changes that may occur in the ownership of the Company's stock in the future, principally relating to a change in control. The Company believes, however, that IRS challenges that would limit the utilization of available net operating loss carryforwards are unlikely, and that the adjustments to tax liability, if any, for years through 1993 will not have a material adverse effect on the Company's financial position. Income and franchise taxes paid in 1993, 1992 and 1991 amounted to (in thousands) $920, $1,158 and $848, respectively. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. Part III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K, the information called for by this item regarding Directors is hereby incorporated by reference to the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. Information regarding the Company's Executive Officers is set forth above following Item 1 of Part I of this report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G(3) of Form 10-K, the information called for by this item is hereby incorporated by reference to the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G(3) of Form 10-K, the information called for by this item is hereby incorporated by reference to the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G(3) of Form 10-K, the information called for by this item is hereby incorporated by reference to the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1 - Index to Financial Statements Page Number in this Report -------------- Consolidated Balance Sheets December 31, 1993 and 1992........................................ 27 Consolidated Statements of Operations Years Ended December 31, 1993, 1992 and 1991...................... 29 Consolidated Statements of Cash Flows Years Ended December 31, 1993, 1992 and 1991...................... 30 Consolidated Statements of Changes in Stockholders' Investment Years Ended December 31, 1993, 1992 and 1991...................... 31 Notes to Consolidated Financial Statements.......................... 32 (a) 2 - Index to Financial Statement Schedules The following consolidated financial statement schedules of Grossman's Inc. and Subsidiaries are included in Item 14(d) and filed herewith (page numbers refer to page numbers in this Form 10-K): Schedule V - Property, Plant and Equipment....................... 56 Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment....................................... 57 Schedule VIII - Valuation and Qualifying Accounts................... 58 Schedule IX - Short-Term Borrowings............................... 58 Schedule X - Supplementary Income Statement Information......................................... 59 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, or are inapplicable, and, therefore, have been omitted. (b) Reports on Form 8-K None. (a) 3. and (c) - Exhibits Exhibit Number - ------- 2(e) Final Decree and Order Closing Cases, dated October 2, 1987, of the United States Bankruptcy Court for the Southern District of Florida, filed as Exhibit 2(e) to the Company's Form 10-Q for the quarter ended September 30, 1987, is incorporated herein by reference. 2(f) Asset Purchase Agreement between GNW Partners, L.P. and Grossman's Inc., dated June 28, 1989, without exhibits, filed as Exhibit 2(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 (File 1-542), is incorporated herein by reference. 2(g) Asset Purchase Agreement between Harcros Lumber & Building Supplies Inc. and Grossman's Inc., dated August 14, 1989, without exhibits, filed as Exhibit 2(a) to the Company's Form 8-K, dated September 12, 1989, is incorporated herein by reference. 3(a) Restated Certificate of Incorporation of the Company, as in effect November 19, 1986, filed as Exhibit 3(a) to the Company's Form 8-K, dated November 19, 1986 (File No. 1-542), is incorporated herein by reference. 3(a)-1 Resolutions adopted by the Company's Board of Directors on December 15, 1987, modifying and extending restrictions on acquisition of Common Stock under Article Ninth of Company's Restated Certificate of Incorporation, filed as Exhibit 3(a)-1 to the Company's Form 8-K, dated December 15, 1987 (File 1-542), is incorporated herein by reference. 3(a)-2 Notice to Stockholders of modification and extension of restrictions on acquisition of Common Stock pursuant to Article Ninth of Company's Restated Certificate of Incorporation, filed as Exhibit 3(a)-2 to the Company's Form 8-K, dated December 15, 1987 (File 1-542), is incorporated herein by reference. 3(a)-3 Certificate of Designation Relating to Certain Restrictions on the Acquisition of Common Stock pursuant to Article Ninth of the Company's Restated Certificate of Incorporation, filed as Exhibit 3(1)-2 to the Company's Form 8-K dated November 19, 1986 (File No. 1-542), is incorporated herein by reference. 3(a)-4 Resolutions adopted by the Company's Board of Directors on October 23, 1990 extending restrictions on acquisition of Common Stock under Article Ninth of Company's Restated Certificate of Incorporation, filed as Exhibit 3(a)-4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 3(a)-5 Notice to Stockholders of extension of restrictions on acquisition of Common Stock pursuant to Article Ninth of the Company's Restated Certificate of Incorporation, filed as Exhibit 3(a)-5 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 3(a)-6 Certificate of Designation Relating to Certain Restrictions on the Acquisition of Common Stock pursuant to Article Ninth of the Company's Restated Certificate of Incorporation, filed as Exhibit 3(a)-6 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 3(a)-7 Notice to Stockholders of extension of restrictions on acquisition of Common Stock pursuant to Article Ninth of the Company's Restated Certificate of Incorporation, filed herewith. 3(a)-8 Certificate of Designation Relating to Certain Restrictions on the Acquisition of Common Stock pursuant to Article Ninth of the Company's Restated Certificate of Incorporation, filed herewith. 3(b) By-Laws of the Company, as in effect November 19, 1986, filed as Exhibit 3(b) to the Company's Form 8-K, dated November 19, 1986 (File No. 1-542), is incorporated herein by reference. 3(b)-1 Copy of the amendments to the Grossman's Inc. By-Laws as adopted by the Board of Directors of Grossman's Inc. on December 15, 1987, filed as Exhibit 3(b)-1 to the Company's Form 8-K, dated December 15, 1987 (File 1-542), is incorporated herein by reference. 4(c) Indenture, dated January 1, 1986, from the Company to United States Trust Company of New York, as Trustee, with respect to the Company's 14% Debentures due 1996, filed as Exhibit 4(c) to the Company's Form 8-K, dated November 19, 1986 (File No. 1-542), is incorporated herein by reference. 4(c)-1 First Supplemental Indenture, dated January 1, 1987, to Indenture, dated January 1, 1986 (Exhibit 4(c) above), for the Company's 14% Debentures due 1996, filed as Exhibit 4(h) to the Company's Registration Statement on Form S-1, No. 33-15107, is incorporated herein by reference. 4(c)-2 Second Supplemental Indenture, dated March 15, 1987, to Indenture, dated January 1, 1986, for the Company's 14% Debentures due 1996 (Exhibit 4(c) above), filed as Exhibit 4(j) to the Company's Registration Statement on Form S-1, No. 33-15107, is incorporated herein by reference. 4(c)-3 Third Supplemental Indenture, dated June 15, 1987, to Indenture, dated January 1, 1986, for the Company's 14% Debentures due 1996 (Exhibit 4(c) above), filed as Exhibit 4(c)-3 to the Company's Form 8-K, dated July 15, 1988 (File No. 1-542), is incorporated herein by reference. 4(c)-4 Fourth Supplemental Indenture, dated June 15, 1987, to Indenture, dated January 1, 1986, for the Company's 14% Debentures due 1996 (Exhibit 4(c) above), filed as Exhibit 4(c)-4 to the Company's Form 8-K, dated July 15, 1988 (File No. 1-542), is incorporated herein by reference. 4(c)-5 Form of Waiver dated December 21, 1988 of certain provisions of Section 5.11 to the Indenture, dated January 1, 1986, for the Company's 14% Debentures due 1996 (Exhibit 4(c) above), filed as Exhibit 4(c)-5 to the Company's Form 8-K, dated December 13, 1988, is incorporated herein by reference. 4(c)-6 Fifth Supplemental Indenture, dated September 30, 1989, to Indenture, dated January 1, 1986, for the Company's 14% Debentures due 1996 (Exhibit 4(c) above), filed as Exhibit 4(c)-6 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-542), is incorporated herein by reference. 4(c)-7 Sixth Supplemental Indenture, dated March 1, 1990, to Indenture, dated January 1, 1986, for the Company's 14% Debentures due 1996 (Exhibit 4(c) above), filed as Exhibit 4(c)-7 to the Company's Form 10-Q for the quarter ended June 30, 1990, is incorporated herein by reference. 4(c)-8 Seventh Supplemental Indenture, dated May 17, 1991, to Indenture, dated January 1, 1986, for the Company's 14% Debentures due 1996 (Exhibit 4(c) above), filed as Exhibit 4(c)-8 to the Company's Form 10-K for the year ended December 31, 1991 (File No. 1-542), is incorporated herein by reference. 4(e)-1 Amended and Restated Registration Rights and Transfer Restriction Agreement, dated April 30, 1987, among the Company; the Common Holders, Debt Holders, Offering Committee and Custodian named therein; and Herzog, Heine Geduld Inc., filed as Exhibit 4(e)-1 to the Company's Registration Statement on Form S-1, No. 33-15107, is incorporated herein by reference. 4(m) Term Loan and Security Agreement without Exhibits and Installment Note, dated October 15, 1991, between Grossman's Inc. and Sanwa Business Credit Corporation, filed as Exhibit 4(m) to the Company's Form 10-Q for the quarter ended September 30, 1991, is incorporated herein by reference. 4(n) First Amendment, dated December 14, 1993, to Term Loan and Security Agreement between Grossman's Inc. and Sanwa Business Credit Corporation, dated October 15, 1991, filed herewith. 4(o) Loan and Security Agreement between Grossman's Inc. and BankAmerica Business Credit, Inc. dated December 15, 1993 (without exhibits), filed herewith. 10(a) Amended and Restated Employment Agreement dated September 8, 1986, among Evans Products Company, Grossman's Inc. and Maurice Grossman, filed as Exhibit 10 to the Evans Products Company Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1985 (File No. 1-542), is incorporated herein by reference. 10(a)-1 Amendment, dated April 29, 1988, to Amended and Restated Employment Agreement between Grossman's Inc. and Maurice Grossman (Exhibit 10(a) above), filed as an unnumbered exhibit to the Company's Form 8-K, dated April 28, 1988 (File No. 1-542), is incorporated herein by reference. 10(a)-2 Amendment, dated December 13, 1988, to Amended and Restated Employment Agreement, dated September 8, 1986, between Grossman's Inc. and Maurice Grossman, filed as Exhibit 10(a)-2 to the Company's Form 8-K, dated December 13, 1988, is incorporated herein by reference. 10(a)-3 Amendment, dated April 24, 1990, to Amended and Restated Employment Agreement between Grossman's Inc. and Maurice Grossman (Exhibit 10(a) above), filed as an unnumbered exhibit to the Company's Form 8-K, dated April 24, 1990 (File No. 1-542), is incorporated herein by reference. 10(a)-4 Amendment, dated November 6, 1990, to Amended and Restated Employment Agreement, between Grossman's Inc. and Maurice Grossman (Exhibit 10(a) above), filed as Exhibit 10(a)-4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 10(iii)(g) Employment Agreement, dated May 23, 1990, between Grossman's Inc. and Thomas R. Schwarz, filed as Exhibit 10(iii)(g) to the Company's Form 10-Q for the quarter ended June 30, 1990 (File No. 1-542), is incorporated herein by reference. 10(iii)(g)-1 Amendment, dated November 6, 1990, to Employment Agreement, between Grossman's Inc. and Thomas R. Schwarz (Exhibit 10(iii)(g) above), filed as Exhibit 10(iii)(g)-1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 10(iii)(h) Amended and Restated Employment Agreement, dated July 1, 1991, between Grossman's Inc. and Sydney L. Katz, filed as Exhibit 10(iii)(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-542), is incorporated herein by reference. 10(iii)(k) Amended and Restated Employment Agreement, dated July 1, 1991, between Grossman's Inc. and Robert L. Flowers, filed as Exhibit 10(iii)(k) to the Company's Annual Report on Form 10-K for year ended December 31, 1991 (File No. 1-542), is incorporated herein by reference. 10(iii)(l) Amended and Restated Employment Agreement, dated July 1, 1991, between Grossman's Inc. and Richard E. Kent, filed as Exhibit 10(iii)(l) to the Company's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-542), is incorporated herein by reference. 10(iii)(m) Employment Agreement, dated February 1, 1993, between Grossman's Inc. and Alan T. Kane, filed as an unnumbered exhibit to the Company's Form 8-K, dated February 15, 1993 (File No. 1-542), is incorporated herein by reference. 10(b) Restated and Amended Grossman's Inc./Evans Asset Holding Company General Pension Plan, filed as Exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-542), is incorporated herein by reference. 10(c) Agreement Re General Pension Plan, dated November 18, 1986, among Evans Products Company, Grossman's Inc., Evans Financial Corp., Evans Transportation Company and Evans Asset Holding Company, filed as Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-542), is incorporated herein by reference. 10(c)-1 Agreement Re Spin-off of General Pension Plan, dated January 1, 1987, among the Company, Evans Asset Holding Company, Evans Financial Corp. and Evans Transportation Company, filed as Exhibit 10(c)-1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1987 (File No. 1-542), is incorporated herein by reference. 10(c)-2 Letter, dated December 30, 1987, documenting certain understandings reached among the Company, Grossman's Inc. Retirement Plan, Evans Asset Holding Company and Evans Asset Holding Company/Grossman's Inc. General Pension Plan, regarding the proper interpretation of the Agreement Re Spin-off of General Pension Plan (Exhibit 10(c)-1 above), filed as Exhibit 10(c)-2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1987 (File No. 1-542), is incorporated herein by reference. 10(c)-3 Grossman's Inc. Retirement Plan (Effective January 1, 1987), as amended and restated effective as of January 1, 1989, filed as Exhibit 10(c)-3 to the Company's Annual Report on Form 10-K for year ended December 31, 1988 (File No. 1-542), is incorporated herein by reference. 10(c)-4 Grossman's Inc. Retirement Plan, as amended and restated as of October 2, 1989, effective as of January 1, 1989, filed as Exhibit 10(c)-4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-542), is incorporated herein by reference. 10(c)-5 Amendment, adopted October 24, 1989, to the Grossman's Inc. Retirement Plan, as amended and restated as of October 2, 1989 (Exhibit 10(c)-4 above), filed as exhibit 10(c)-5 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-542), is incorporated herein by reference. 10(c)-6 Amendment, adopted December 12, 1989, to the Grossman's Inc. Retirement Plan, as amended and restated as of October 2, 1989 (Exhibit 10(c)-4 above), filed as exhibit 10(c)-6 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-542), is incorporated herein by reference. 10(c)-7 Amendment, adopted August 1, 1990, to the Grossman's Inc. Retirement Plan, as amended and restated as of October 2, 1989, filed as Exhibit 10(c)-7 to the Company's Form 10-Q for the quarter ended September 30, 1990 (File No. 1-542), is incorporated herein by reference. 10(d) Claim Allocation Agreement, dated November 19, 1986, by and between Evans Asset Holding Company, EFC Mortgage Trust and Grossman's Inc., filed as Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-542), is incorporated herein by reference. 10(e) EPC Asset Transfer Agreement, dated November 19, 1986, among Evans Products Company, Evans Asset Holding Company, EPC Properties Company, Minneapolis Electric Steel Castings Company, Racine Steel Castings Company, RSC Properties Company, Duluth Steel Castings Company, Aberdeen Forest Products Company and Evans Engineered Products Company, filed as Exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-542), is incorporated herein by reference. 10(f) EFC Asset Transfer Agreement, dated November 19, 1986, among Evans Financial Corp. and EFC Mortgage Trust, filed as Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-542), is incorporated herein by reference. 10(g) Assumption Agreement, dated November 19, 1986, among Evans Asset Holding Company, EFC Mortgage Trust, Evans Products Company, Evans Financial Corp. and Bank of America National Trust and Savings Association, as agent, filed as Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-542), is incorporated herein by reference. 10(h) Grossman's Inc. 1986 Nonqualified Stock Option Plan, filed as Exhibit A to the Company's Proxy Statement for the 1987 Annual Meeting of Stockholders, dated September 28, 1987, is incorporated herein by reference. 10(h)-1 Amendment, dated December 11, 1990, to 1986 Nonqualified Stock Option Plan, filed as Exhibit 10(h)-1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 10(h)-2 Amendment, dated January 28, 1992, to 1986 Nonqualified Stock Option Plan, filed as Exhibit 10(h)-2 to the Company's Form 10-Q for the quarter ended March 31, 1992 (File No. 1-542), is incorporated herein by reference. 10(i) Grossman's Inc. Executive Severance Plan, filed as Exhibit 10(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (File No. 1-542), is incorporated herein by reference. 10(i)-1 Grossman's Inc. Amended and Restated Executive Severance Plan, dated August 1, 1990, filed as Exhibit 10(i)-1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 10(i)-2 Amendment, dated November 6, 1990, to Grossman's Inc. Amended and Restated Executive Severance Plan (Exhibit 10(i)-1 above), filed as Exhibit 10(i)-2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 10(m)-1 Grossman's Inc. Supplemental Executive Retirement Plan, dated January 1, 1992, filed as Exhibit 10(m)-1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-542), is incorporated herein by reference. 10(n) Grossman's Savings and Profit Sharing Plan (Effective as of May 1, 1988), dated April 29, 1988, filed as Exhibit 10(c)-4 to the Company's Form 10-Q for the quarter ended June 30, 1988, is incorporated herein by reference. 10(n)-1 Amendment, effective as of May 1, 1988, to Grossman's Savings and Profit Sharing Plan (Effective as of May 1, 1988) (Exhibit 10(n) above), dated February 28, 1989, filed as Exhibit 10(n)-1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 1-542), is incorporated herein by reference. 10(n)-2 Amendment, effective as of September 12, 1989, to Grossman's Inc. Savings and Profit Sharing Plan (Effective as of May 1, 1988) (Exhibit 10(n) above), dated October 24, 1989, filed as Exhibit 10(n)-2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 (File No. 1-542), is incorporated herein by reference. 10(n)-3 Amendment No. 3 to Grossman's Inc. Savings and Profit Sharing Plan (Effective as of May 1, 1988) (Exhibit 10(n) above), filed as Exhibit 10(n)-3 to the Company's Form 10-K for the year ended December 31, 1990 (File No. 1-542), is incorporated herein by reference. 10(n)-4 Amendment No. 4 to Grossman's Inc. Savings and Profit Sharing Plan, dated May 1, 1991, filed as Exhibit 10(n)-4 to the Company's Form 10-Q for the quarter ended March 31, 1991, is incorporated herein by reference. 10(o) Grossman's Inc. 1993 Key Employee Stock Option Plan, dated April 27, 1993, filed herewith. 11(a) Statement re computation of earnings per share, filed herewith. 22 Subsidiaries of the Company, filed as Exhibit 22 to the Company's Annual Report on Form 10-Q for the quarter ended September 30, 1991 (File No. 1-542), is incorporated herein by reference. 24(a) Consent of Ernst & Young, Independent Auditors, filed herewith. (d) Financial Statement Schedules Amounts for maintenance and repairs, depreciation and amortization of intangible assets, taxes other than payroll and income taxes, and royalties are not presented as such amounts are less than 1% of total sales and revenues. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GROSSMAN'S INC. Company Date: March 16, 1994 By /s/ Sydney L. Katz ------------------------------------- Sydney L. Katz Executive Vice President, Chief Financial Officer and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.

90185_1993.txt

90185

1993

Item 1. Business. Sigma-Aldrich Corporation engages through subsidiaries in two lines of business: the production and sale of a broad range of biochemicals, organic and inorganic chemicals, radiolabeled chemicals, diagnostic reagents, chromatography products and related products (hereinafter referred to as "chemical products"), and the manufacture and sale of metal components for strut, cable tray, pipe support and telecommunication systems and electrical enclosures (hereinafter referred to as "metal products" or "B-Line"). Its principal executive offices are located at 3050 Spruce Street, St. Louis, Missouri 63103. Sigma-Aldrich Corporation (hereinafter referred to as the "Company", which term includes all consolidated subsidiaries of the Company) was incorporated under the laws of the State of Delaware in May 1975. Effective July 31, 1975 ("Reorganization"), the Company succeeded, as a reporting company, Sigma International, Ltd., the predecessor of Sigma Chemical Company ("Sigma"), and Aldrich Chemical Company, Inc. ("Aldrich"), both of which had operated continuously for more than 20 years prior to the Reorganization. Effective December 9, 1980, B-Line Systems, Inc., previously a subsidiary of Sigma, became a subsidiary of the Company. Effective June 23, 1989, the Company purchased all of the issued and outstanding capital stock of Fluka Chemie AG ("Fluka"), a Swiss corporation, from Ciba-Geigy International AG, F. Hoffman- LaRoche & Co. Limited and eleven minority shareholders. Effective May 5, 1993, the Company acquired the net assets and business of Supelco, Inc.("Supelco"), a worldwide supplier of chromatography products used in chemical research and production, from Rohm and Haas Company. (a) Chemical Products. 1) Products: The Company distributes approximately 71,000 chemical products for use primarily in research and development, in the diagnosis of disease, and as specialty chemicals for manufacturing. In laboratory applications, the Company's products are used in the fields of biochemistry, synthetic chemistry, quality control and testing, immunology, hematology, pharmacology, microbiology, neurology, and endocrinology, and in the studies of life processes. Sigma diagnostic products are used in the detection of heart, liver and kidney diseases and various metabolic disorders. Certain of these diagnostic products are used in measuring concentrations of various naturally occurring substances in the blood, indicative of certain pathological conditions. The diagnostic products are used in manual, semi-automated and automated testing procedures. Supelco offers a full line of chromatography products and application technologies for analyzing and separating complex chemical mixtures. The line includes items for the collection and preparation of various samples for further chemical analysis, gas and liquid chromatography, reference standards and related laboratory products. Aldrich also offers approximately 38,000 esoteric chemicals as a special service to customers interested in screening them for application in many areas (such as medicine and agriculture). This area accounts for less than 1% of the Company's sales. Because of continuing developments in the field of research, there can be no assurance of a continuing market for each of the Company's products. However, through a continuing review of technical literature, along with constant communications with customers, the Company keeps abreast of the trends in research and diagnostic techniques. This information, along with its own research technology, determines the Company's development of improved and/or additional products. 2) Production and Purchasing: The Company has chemical production facilities in Milwaukee and Sheboygan, Wisconsin (Aldrich); St. Louis, Missouri (Sigma); Bellefonte, Pennsylvania (Supelco); Germany (Aldrich Chemie GmbH and Co. K.G.); Israel (Makor Chemicals Limited); Switzerland (Fluka) and the United Kingdom (Sigma Chemical Company Ltd.). A minor amount of production is done by some of the Company's other subsidiaries. Biochemicals and diagnostic reagents are primarily produced by extraction and purification from yeasts, bacteria and other naturally occurring animal and plant sources. Organic and inorganic chemicals and radiolabeled chemicals are primarily produced by synthesis. Chromatography media and columns are produced using proprietary chemical synthesis and proprietary preparation processes. Similar processes are used for filtration and sample collection processes. Of the approximately 71,000 products listed in the Sigma, Aldrich, Fluka and Supelco catalogs, the Company produced approximately 31,000 which accounted for 44% of the net sales of chemical products for the year ended December 31, 1993. The remainder of products were purchased from a large number of sources either under contract or in the open market. No one supplier accounts for as much as 10% of the Company's chemical purchases. The Company has generally been able to obtain adequate supplies of products and materials to meet its needs. Whether a product is produced by the Company or purchased from outside suppliers, it is subjected to quality control procedures, including the verification of purity, prior to final packaging. This is done by a combined staff of 201 chemists and lab technicians utilizing sophisticated scientific equipment. 3) Distribution and Sales: The Company markets its chemical products primarily through Sigma, Aldrich, Fluka and Supelco under their own trademarks and labels. Marketing of products is primarily done through the distribution of over 2,600,000 comprehensive catalogs to customers and potential customers throughout the world. This is supplemented by certain specialty catalogs, by advertising in chemical and other scientific journals, by direct mail distribution of in-house publications and special product brochures and by personal visits by technical and sales representatives with customers. For customer convenience, Sigma packages approximately 300 combinations of certain of its individual products in diagnostic kit form. A diagnostic kit will include products which, when used in a series of manual and/or automated testing procedures, will aid in detecting particular conditions or diseases. The sale of these kits is promoted by a field sales unit. Diagnostic kits accounted for less than 10% of the Company's net sales of chemical products in the year ended December 31, 1993. During the year ended December 31, 1993, products were sold to approximately 129,000 customers, including hospitals, universities, clinical laboratories as well as private and governmental research laboratories. The majority of the Company's sales are small orders in laboratory quantities averaging less than $200. The Company also makes its chemical products available in larger-than-normal laboratory quantities for use in manufacturing. Sales of these products accounted for approximately 15% of chemical sales in 1993. During the year ended December 31, 1993, no one customer and no one product accounted for more than 1% of the net sales of chemical products. Sigma, Aldrich, Fluka and Supelco encourage their customers and potential customers, wherever located, to contact them by telephone "collect" or on "toll-free" WATS lines for technical staff consultation or for placing orders. Order processing, shipping, invoicing and product inventory are computerized. Shipments are made seven days a week from St. Louis, six days a week from Milwaukee, England, Germany, Israel and Japan and five days a week from all other locations. The Company strives to ship its products to customers on the same day an order is received and carries significant inventories to maintain this policy. 4) International Operations: In the year ended December 31, 1993, approximately 50% of the Company's net sales of chemical products were to customers located in foreign countries. These sales were made directly by Sigma, Aldrich, Fluka and Supelco, through distributors and by subsidiaries organized in Australia, Belgium, Brazil, Canada, Czech Republic, England, France, Germany, Holland, Hungary, India, Israel, Italy, Japan, Mexico, Scotland, Singapore, South Korea, Spain and Switzerland. Several foreign subsidiaries also have production facilities. For sales with final destinations in a foreign market, the Company has a Foreign Sales Corporation ("FSC") subsidiary which provides the Company certain Federal income tax advantages. The effect of the tax rules governing the FSC is to lower the effective Federal income tax rate on export income. The Company intends to continue to comply with the provisions of the Internal Revenue Code relating to FSCs. The Company's foreign operations and domestic export sales are subject to currency revaluations, changes in tariff restrictions and restrictive regulations of foreign governments, among other factors inherent in these operations. The Company is unable to predict the extent to which its business may be affected in the future by these matters. During the year ended December 31, 1993, approximately 10% of the Company's domestic operations' chemical purchases were from foreign suppliers. Additional information regarding international operations is included in Note 9 to the consolidated financial statements on pages 21 and 22 of the 1993 Annual Report which is incorporated herein by reference. 5) Patents and Trademarks: The Company's patents are not material to its operations. The Company's significant trademarks are the brand names "Sigma", "Aldrich", "Fluka", "Supelco" and "B-Line" and their related logos which have various expiration dates and are expected to be renewed indefinitely. 6) Regulations: The Company engages principally in the business of selling products which are not foods or food additives, drugs, or cosmetics within the meaning of the Federal Food, Drug and Cosmetic Act, as amended (the "Act"). A limited number of the Company's products, including in-vitro diagnostic reagents, are subject to labeling, manufacturing and other provisions of the Act. The Company believes it is in compliance in all material respects with the applicable regulations. The Company believes that it is in compliance in all material respects with Federal, state and local environmental and safety regulations relating to the manufacture, sale and distribution of its products. The following are brief summaries of some of the Federal laws and regulations which may have an impact on the Company's business. These summaries are only illustrative of the extensive regulatory requirements of the Federal, state and local governments and are not intended to provide the specific details of each law or regulation. The Clean Air Act (CAA), as amended, and the regulations promulgated thereunder, regulates the emission of harmful pollutants to the air outside of the work environment. Federal or state regulatory agencies may require companies to acquire permits, perform monitoring and install control equipment for certain pollutants. The Clean Water Act (CWA), as amended, and the regulations promulgated thereunder, regulates the discharge of harmful pollutants into the waters of the United States. Federal or state regulatory agencies may require companies to acquire permits, perform monitoring and to treat waste water before discharge to the waters of the United States or a Publicly Owned Treatment Works (POTW). The Occupational Safety and Health Act of 1970 (OSHA), including the Hazard Communication Standard ("Right to Know"), and the regulations promulgated thereunder, requires the labeling of hazardous substance containers, the supplying of Material Safety Data Sheets ("MSDS") on hazardous products to customers and hazardous substances the employee may be exposed to in the workplace, the training of the employees in the handling of hazardous substances and the use of the MSDS, along with other health and safety programs. The Resource Conservation and Recovery Act of 1976 (RCRA), as amended, and the regulations promulgated thereunder, requires certain procedures regarding the treatment, storage and disposal of hazardous waste. The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund Amendments and Reauthorization Act of 1986 (SARA), and the regulations promulgated thereunder, require notification of certain chemical spills and notification to state and local emergency response groups of the availability of MSDS and the quantities of hazardous materials in the Company's possession. The Toxic Substances Control Act of 1976 (TSCA), requires reporting, testing and pre-manufacture notification procedures for certain chemicals. Exemptions are provided from some of these requirements with respect to chemicals manufactured in small quantities solely for research and development use. The Department of Transportation (DOT) has promulgated regulations pursuant to the Hazardous Materials Transportation Act, referred to as the Hazardous Material Regulations (HMR), which set forth the requirements for hazard labeling, classification and packaging of chemicals, shipment modes and other goods destined for shipment in interstate commerce. Approximately 700 products, for which sales are immaterial to the total sales of the Company, are subject to control by either the Drug Enforcement Administration ("DEA") or the Nuclear Regulatory Commission ("NRC"). The DEA and NRC have issued licenses to several Company sites to permit importation, manufacture, research, analysis, distribution and export of certain products. The Company screens customer orders involving products regulated by the NRC and the DEA to verify that a license, if necessary, has been obtained. (b) Metal Products. Components for strut, cable tray and pipe support systems are manufactured by B-Line at its facilities in Highland and Troy, Illinois; Norcross, Georgia and Reno, Nevada. Components and complete systems used to support telecommunications apparatus and cabling are manufactured and sold by B-Line through its Saunders Communications unit, which is located in Santa Fe Springs, California. Circle AW Products Company, which was acquired on June 16, 1993 and operates as a wholly-owned subsidiary of B-Line, manufactures electrical enclosures at its facilities in Portland, Oregon and Modesto, California. Strut and pipe support systems are metal frameworks and related accessories used in industry to support pipes, lighting fixtures and conduit. Strut systems can be easily assembled with bolts and spring-loaded nuts, eliminating the necessity of drilling or welding associated with other types of frameworks. B-Line manufactures and sells a wide variety of components for these systems, including steel struts rolled from coils, stamped steel fittings for interconnecting struts, shelf-supporting brackets, pipe and conduit supporting clamps, and accessories for the installation of strut systems on location. Pipe hangers are generally used in conjunction with strut systems to support heavy and light duty piping runs in the mechanical, plumbing and refrigeration industry. The principal materials used by B-Line in manufacturing are coils of steel and extruded aluminum which B-Line purchases from a number of suppliers. No one supplier is essential to B-Line's production. A limited number of components for strut and pipe support systems, including bolts and nuts and certain forged and cast components, are purchased from numerous sources and sold by B-Line as accessories to its own manufactured products. Cable tray systems are continuous networks of ventilated or solid trays used primarily in the routing of power cables and control wiring in power plant or industrial installations. The systems are generally hung from ceilings or supported by strut frameworks. Cable tray is produced from either extruded aluminum or roll-formed steel in various configurations to offer versatility to designers and installers. Non-metallic strut and cable tray products, which are used primarily in corrosive environments, are also available. Telecommunications equipment racks and cable runways are manufactured from aluminum or steel. The systems are installed in the central offices of telephone operating companies. As switching equipment is changed and upgraded, the systems are replaced. Electrical enclosures are metal enclosure boxes, generally manufactured with steel, that are used to contain and protect electric meters, fuse and circuit breaker boards and electrical panels. These products are used in industrial, commercial and residential installations. B-Line also manufactures a line of lightweight support fasteners to be used in commercial and industrial facilities to attach electrical and acoustical fixtures. B-Line sells primarily to electrical, mechanical and telecommunications wholesalers. Products are marketed directly by district sales offices and by regional sales managers through independent manufacturers' representatives. Products are shipped to customers from the Highland and Troy, Illinois; Norcross, Georgia; Reno, Nevada; Portland, Oregon; and Modesto and Santa Fe Springs, California plants, from two regional warehouses and 42 consigned stock locations. B-Line's products are advertised in trade journals and by circulation of comprehensive catalogs. (c) Competition. Substantial competition exists in all the Company's marketing and production areas. Although no comprehensive statistics are available, the Company believes it is a major supplier of organic chemicals and biochemicals for research and for diagnostic testing procedures involving enzymes and of chromatography products for analyzing and separating complex chemical mixtures. A few competitors, like the Company, offer thousands of chemicals and stock and analyze most of their products. While the Company generally offers a larger number of products, some of the Company's products are unusual and have relatively little demand. In addition, there are many competitors who offer a limited quantity of chemicals, and several companies compete with the Company by offering thousands of chemicals although few of them stock or analyze substantially all of the chemicals they offer for sale. The Company believes its B-Line subsidiary to be among the three largest producers of metal strut framing, pipe hangers and cable tray component systems, although reliable industry statistics are not available. In all product areas the Company competes primarily on the basis of customer service, quality and price. (d) Employees. The Company employed 5,110 persons as of December 31, 1993. Of these, 4,198 were engaged in production and distribution of chemical products. The B-Line subsidiary employed 912 persons. The total number of persons employed within the United States was 3,792, with the balance employed by the foreign subsidiaries. The Company employed over 1,400 persons who have degrees in chemistry, biochemistry, engineering or other scientific disciplines, including approximately 235 with Ph.D. degrees. Employees engaged in chemical production, research and distribution are not represented by any organized labor group. B-Line's production workers at the Highland and Troy, Illinois facilities are members of the International Association of Machinists and Aerospace Workers, District No. 9 (AFL-CIO). The labor agreement covering these employees expires November 12, 1995. B-Line's production workers at the Norcross, Georgia facility are members of the United Food and Commercial Workers International (AFL-CIO), Retail Clerks Union Local 1063. The labor agreement covering these employees expires June 11, 1994. (e) Back-log of Orders. The majority of orders for chemical products in laboratory quantities are shipped from inventory, resulting in no back-log of these orders. However, individual items may occasionally be out of stock. These items are shipped as soon as they become available. Some orders for larger-than-normal laboratory quantities are for future delivery. On December 31, 1993 and 1992, the back-log of firm orders and orders for future delivery of chemical products was approximately $9,100,000 and $6,800,000, respectively. The Company estimates that substantially all of the December 31, 1993, back-log will be shipped during 1994. On December 31, 1993 and 1992, B-Line had a back-log of orders amounting to $2,400,000 and $2,200,000, respectively. B-Line estimates that substantially all of the December 31, 1993, back-log will be shipped during 1994. (f) Information as to Industry Segments. Information concerning industry segments for the years ended December 31, 1993, 1992 and 1991, is located in Note 9 to the consolidated financial statements on page 21 of the 1993 Annual Report which is incorporated herein by reference. (g) Executive Officers of the Registrant Information regarding executive officers is contained in Part III, Item 10, and incorporated herein by reference. Item 2.

Item 2. Properties. The Company's primary chemical production facilities are located in St. Louis, Missouri; Milwaukee and Sheboygan, Wisconsin; Bellefonte, Pennsylvania and Buchs, Switzerland. In St. Louis, the Company owns a 320,000 square foot building used for manufacturing, a complex of buildings aggregating 349,000 square feet which is currently being used for warehousing and production, a 75,000 square foot building used for warehousing and a 30,000 square foot building used for production, quality control and packaging. A 280,000 square foot building in St. Louis is being partially utilized to provide additional quality control, packaging and warehousing capacity. Also in St. Louis, the Company owns 30 acres upon which is located a 240,000 square foot administration and distribution facility, in which its principal executive offices are located, and a 175,000 square foot diagnostic production and office building. In Milwaukee, the Company owns a 165,000 square foot building which is used for manufacturing, warehousing and offices, a 110,000 square foot building which is used for additional manufacturing and warehousing and a complex of buildings aggregating 331,000 square feet which is used primarily for warehousing and distribution. Also in Milwaukee, the Company owns a 151,000 square foot building which is used for manufacturing and warehousing, a 56,000 square foot administration facility and a 615,000 square foot building which is being renovated for use as a distribution facility. The Company also owns 515 acres in Sheboygan, Wisconsin, upon which are located multiple buildings totaling 160,000 square feet for production and packaging. Fluka owns an 11 acre site in Buchs, Switzerland, upon which are located its primary production facilities. Approximately 220,000 square feet of owned production, warehousing and office facilities are at this site. In Greenville, Illinois, the Company owns 555 acres of land for future development of biochemical production facilities. Supelco owns 72 acres near Bellefonte, Pennsylvania, upon which is located a 160,000 square foot building used for manufacturing, warehousing, research and administration. The Company's B-Line manufacturing business is conducted in Highland and Troy, Illinois; Norcross, Georgia; Reno, Nevada; Portland, Oregon; and Modesto and Santa Fe Springs, California. B-Line owns a 270,000 square foot building in Highland, a 55,000 square foot building in Troy, Illinois, a 68,000 square foot building in Portland, Oregon, a 173,000 square foot building in Reno, Nevada, and a 125,000 square foot building in Modesto, California. B-Line leases a 101,000 square foot facility in Norcross, Georgia, and an 18,000 square foot building in Santa Fe Springs, California. The Company also owns warehouse and distribution facilities containing approximately 35,000 and 8,000 square feet in Metuchen, New Jersey and Ronkonkoma, New York, respectively, and leases warehouses in Chicago, Illinois and Dallas, Texas under short-term leases. Manufacturing and warehousing facilities are also owned or leased in England, Germany, Israel, Japan, Scotland and Switzerland. Sales offices are leased in all other locations. The Company considers the properties to be well maintained, in sound condition and repair, and adequate for its present needs. The Company will continue to expand its production and distribution capabilities in select markets. Item 3.

Item 3. Legal Proceedings. There are no material pending legal proceedings. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted by the Registrant to the stockholders for a vote during the fourth quarter of 1993. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Information concerning market price of the Registrant's Common Stock and related shareholder matters for the years ended December 31, 1993 and 1992, is located on page 11 of the 1993 Annual Report which is incorporated herein by reference. As of March 4, 1994, there were 2,356 record holders of the Registrant's Common Stock. Items 6 through 8. Selected Financial Data, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Financial Statements. The information required by Items 6 through 8 is incorporated herein by reference to pages 11 - 24 of the 1993 Annual Report. See Index to Financial Statements and Schedules on page of this report. Those pages of the Company's 1993 Annual Report listed in such Index or referred to in Items 1(a)(4), 1(f) and 5 are incorporated herein by reference. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10. Directors and Executive Officers of the Registrant. Information under the captions "Nominees for Board of Directors" and "Security Ownership of Directors, Executive Officers and Principal Beneficial Owners" of the 1994 Proxy Statement is incorporated herein by reference. The executive officers of the Registrant are: Name of Executive Officer Age Positions and Offices Held ------------------------- --- -------------------------- Carl T. Cori 57 Chairman of the Board, President and Chief Executive Officer Peter A. Gleich 48 Vice President and Secretary David R. Harvey 54 Executive Vice President and Chief Operating Officer Kirk A. Richter 47 Controller Thomas M. Tallarico 49 Vice President and Treasurer There is no family relationship between any of the officers. Dr. Harvey and Mr. Richter have held the positions indicated for more than five years. Dr. Cori has been President and Chief Executive Officer of the Company for more than five years. He was elected Chairman of the Board in May 1991. Mr. Gleich has been Vice President and Secretary of the Company for more than five years. He also served as Treasurer of the Company from 1975 to May 1991. Mr. Tallarico has served as Vice President of the Company since February 1991 and as Treasurer of the Company since May 1991. He served as publisher of the St. Louis Sun Publishing Company, St. Louis, Missouri, from March 1989 to July 1990. He served as Senior Vice President and General Manager of Pulitzer Publishing Co., St. Louis Post-Dispatch, St. Louis, Missouri, from 1986 to March 1989. The present terms of office of the officers will expire when the next annual meeting of the Directors is held and their successors are elected. Item 11. Executive Compensation. Information under the captions "Director Compensation and Transactions" and "Information Concerning Executive Compensation" of the 1994 Proxy Statement is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management. Information under the caption "Security Ownership of Directors, Executive Officers and Principal Beneficial Owners" of the 1994 Proxy Statement is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions. Information under the caption "Director Compensation and Transactions" of the 1994 Proxy Statement is incorporated herein by reference. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as part of this report: 1. Financial Statements. See Index to Financial Statements on page of this report. Those pages of the Company's 1993 Annual Report listed in such Index or referred to in Items 1(a)(4), 1(f) and 5 are incorporated herein by reference. 2. Financial Statement Schedules. See Index to Financial Statement Schedules on page of this report. 3. Exhibits. See Index to Exhibits on page of this report. (b) Reports on Form 8-K: No reports on Form 8-K have been filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SIGMA-ALDRICH CORPORATION (Registrant) By /s/ Thomas M. Tallarico March 30, 1994 -------------------------------------- -------------- Thomas M. Tallarico, Vice President and Date Treasurer KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Carl T. Cori, Peter A. Gleich, David R. Harvey, Kirk A. Richter and Thomas M. Tallarico and each of them (with full power to each of them to act alone), his true and lawful attorneys-in- fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments (including post-effective amendments) to this report, and to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By /s/ Carl T. Cori March 30, 1994 -------------------------------------- -------------- Carl T. Cori, Director, Chairman of the Date Board, President and Chief Executive Officer By /s/ David R. Harvey March 30, 1994 ----------------------------------------- -------------- David R. Harvey, Director, Executive Vice Date President and Chief Operating Officer By /s/ Peter A. Gleich March 30, 1994 -------------------------------------- -------------- Peter A. Gleich, Vice President and Date Secretary By /s/ Kirk A. Richter March 30, 1994 -------------------------------------- -------------- Kirk A. Richter, Controller Date By /s/ Thomas M. Tallarico March 30, 1994 --------------------------------------- -------------- Thomas M. Tallarico, Vice President and Date Treasurer By /s/ David M. Kipnis March 30, 1994 -------------------------------------- -------------- David M. Kipnis, Director Date By /s/ Andrew E. Newman March 30, 1994 --------------------------------------- -------------- Andrew E. Newman, Director Date By /s/ Jerome W. Sandweiss March 30, 1994 --------------------------------------- -------------- Jerome W. Sandweiss, Director Date SIGMA-ALDRICH CORPORATION AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Page Number Reference Annual Report Form 10-K to Shareholders Comparative financial data for the years 1993, 1992, 1991, 1990, and 1989 11 Management's discussion of financial condition and results of operations 12 FINANCIAL STATEMENTS: Consolidated Balance Sheets December 31, 1993 and 1992 15 Consolidated statements for the years ended December 31, 1993, 1992 and 1991 Income 14 Stockholders' Equity 16 Cash Flows 17 Notes to consolidated financial statements 18 Reports of independent public accountants EX-23 FINANCIAL STATEMENT SCHEDULES: V Property, plant and equipment for the years ended December 31, 1993, 1992 and 1991 VI Accumulated depreciation of property, plant and equipment for the years ended December 31, 1993, 1992 and 1991 IX Short-term borrowings for the years ended December 31, 1993, 1992 and 1991 X Supplementary income statement information for the years ended December 31, 1993, 1992 and 1991 All other schedules are not submitted because they are not applicable, not required or because the information is included in the consolidated financial statements or notes thereto. SCHEDULE X SIGMA-ALDRICH CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, (in thousands) Charged to Costs and Expenses 1993 1992 1991 ------- ------- ------- Maintenance and repairs $10,575 $ 8,857 $ 8,902 Depreciation and amortization 32,505 28,863 26,826 Advertising 28,674 25,274 24,466 Royalties and taxes, other than payroll and income taxes, incurred during 1993, 1992 and 1991 were less than 1% of sales. INDEX TO EXHIBITS These Exhibits are numbered in accordance with the Exhibit Table of Item 6.

Item 6.01 of Regulation S-K: Exhibit Reference (3) Certificate of Incorporation and By-Laws: (a) Certificate of Incorporation and Amendments Incorporated by reference to Exhibit 3(a) of Form 10-K filed for the year ended December 31, 1991, Commission File Number 0-8135. (b) By-Laws as amended February 1993 Incorporated by reference to Exhibit 3(b) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (4) Instruments Defining the Rights of Shareholders, Including Indentures: (a) Certificate of Incorporation and Amendments See Exhibit 3(a) above. (b) By-Laws as amended February 1993 See Exhibit 3(b) above. (c) The Company agrees to furnish to the Securities and Exchange Commission upon request pursuant to Item 601(b)(4)(iii) of Regulation S-K copies of instruments defining the rights of holders of long-term debt of the Company and its consolidated subsidiaries. (10) Material Contracts: (a) Incentive Stock Bonus Plan* Incorporated by reference to Exhibit 10(a) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (b) First Amendment to Incentive Incorporated by reference to Exhibit Stock Bonus Plan* 10(b) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (c) Second Amendment to Incentive Incorporated by refence to Exhibit Stock Bonus Plan* 10(c) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (d) Share Option Plan of 1987* Incorporated by reference to Exhibit 10(d) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (e) First Amendment to Share Option Incorporated by refence to Exhibit Plan of 1987* 10(e) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (f) Employment Agreement with Carl T. Incorporated by reference to Exhibit Cori* (Similar Employment Agreements 10(f) of Form 10-K filed for the also exist with Peter A. Gleich, year ended December 31, 1992, David R. Harvey, Kirk A. Richter Commission File Number 0-8135. and Thomas M. Tallarico) (g) Letter re: Consultation Services Incorporated by reference to Exhibit with Dr. David M. Kipnis* 10(g) of Form 10-K field for the year ended December 31, 1992, Commission File Number 0-8135. (11) Statement Regarding Computation Incorporated by reference to the of Per Share Earnings information on net income per share included in Note 1 to the Company's 1993 financial statements filed as Exhibit 13 below. (13) Pages 11-24 of the Annual Report to Shareholders for the year ended December 31, 1993 (21) Subsidiaries of Registrant (23) Consent of Independent Public Accountants *Represents management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.

36377_1993.txt

36377

1993

ITEM 1. BUSINESS FIRST HAWAIIAN, INC. - First Hawaiian, Inc. (the "Corporation"), a Delaware corporation, is a registered bank holding company under the Bank Holding Company Act of 1956, as amended, and a registered savings and loan holding company under section 10 of the Homeowner's Loan Act, as amended. The Corporation, through its subsidiaries, operates a general commercial banking business and other businesses related to banking. Its principal assets are its investments in First Hawaiian Bank (the "Bank"), a State of Hawaii chartered bank; First Hawaiian Creditcorp, Inc. ("Creditcorp") and First Hawaiian Leasing, Inc. ("FHL"), each a financial services loan company; and Pioneer Federal Savings Bank ("Pioneer"), a federally chartered savings bank. The Bank, Creditcorp, FHL and Pioneer are wholly-owned subsidiaries of the Corporation. At December 31, 1993, the Corporation had consolidated total assets of $7.3 billion, total deposits of $5.2 billion and total stockholders' equity of $608.4 million. Based on assets as of June 30, 1993, the Corporation was the 76th largest bank holding company in the United States as reported in the American Banker. FIRST HAWAIIAN BANK - The Bank, the oldest financial institution in Hawaii, was established as Bishop & Co. in 1858 in Honolulu. After several corporate mergers and other changes, the Bank is now a state-chartered bank. The Bank is not a member of the Federal Reserve System. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation (the "FDIC") to the extent and subject to the limitations set forth in the Federal Deposit Insurance Act, as amended. The Bank is a full-service bank conducting a general commercial and consumer banking business and offering trust services. Its banking activities include receiving transaction, savings and time deposits for personal and commercial accounts; making commercial, agricultural, real estate and consumer loans; acting as a United States tax depository facility; providing money transfer and cash management services; selling traveler's checks, bank money orders, mutual funds and annuities; issuing letters of credit; handling domestic and foreign collections; providing safe deposit and night depository facilities; lease financing; and investing in U.S. Treasury securities and securities of other U.S. government agencies and corporations and state and municipal securities. As of December 31, 1993, the Bank had total deposits of $4.5 billion and total assets of $6.1 billion, making it the second largest bank in Hawaii. Domestic Services - The domestic operations of the Bank are carried out through its main banking office located in Honolulu, Hawaii and 58 other banking offices located throughout the State of Hawaii. Fifty-one of the offices are equipped with automatic teller machines which provide 24-hour service to customers wishing to make withdrawals from and deposits to their personal checking accounts, to transfer funds between checking and savings accounts, to make balance inquiries, to obtain interim bank statements, and to make utility and loan payments. Ten nonbranch locations provide balance inquiry and withdrawal transaction services only. The Bank is a member of the CIRRUS(R)/MasterCard(R) and Plus(R)/VISA(R) automatic teller machine networks, providing its customers with access to their funds nationwide and in selected foreign countries. Lending Activities - The Bank engages in a broad range of lending activities, including making real estate, commercial and consumer loans and leases. At December 31, 1993, the Bank's loans totalled $4.0 billion, representing 66.2% of total assets. At that date, 53.0% of the loans were residential and commercial real estate loans, 31.1% were commercial loans, 12.2% were consumer loans and 3.7% were leases. Real Estate Lending--Residential. The Bank makes residential real estate loans, including home equity loans, to enable borrowers to purchase, refinance or improve residential real property. The loans are secured by mortgage liens on the related property substantially all of which is located in Hawaii. At December 31, 1993, approximately 56% of the Bank's total real estate loans were collateralized by single-family and multi-family residences. Real Estate Lending--Commercial. In the commercial real estate area, the Bank provides construction and permanent financing for a variety of commercial developments, such as hotels, warehouses and small retail centers. In order to diversify its portfolio, the Bank also selectively participates as a lender in developments on the mainland United States, primarily on the west coast. At December 31, 1993, approximately 44% of the Bank's total real estate loans were collateralized by construction and commercial properties. Commercial Lending. The Bank is a major lender to primarily small- and medium-sized businesses (including local subsidiaries and operations of foreign companies) in Hawaii and Hawaii companies doing business overseas with particular emphasis on those companies in the Asia-Pacific region. Consumer Lending. The Bank offers many types of loans and credits to consumers. The Bank provides lines of credit, uncollateralized or collateralized, and provides various types of personal and automobile loans. The Bank also provides indirect consumer automobile financing on new and used autos by purchasing finance contracts from dealers. The Bank's Dealer Center is the largest commercial bank automobile lender in the State of Hawaii. The Bank is the largest issuer of MasterCard(R) credit cards and the second largest issuer of VISA(R) credit cards in Hawaii. International Banking Services - The Bank maintains an International Banking Division which provides international banking products and services through the Bank's branch system, international banking headquarters in Honolulu, a Grand Cayman branch, two Guam branches and a representative office in Tokyo, Japan. The Bank maintains a network of correspondent banking relationships throughout the world. The Bank's international banking activities are primarily trade-related and are concentrated in the Asia-Pacific area. The Bank has no loans to lesser developed countries. Trust Services - The Bank's Asset Management Division offers a full range of trust and investment management services. The Division provides asset management, advisory and administrative services for estates, trusts and individuals. It also acts as trustee and custodian of pension and profit sharing plans. As of December 31, 1993, the Asset Management Division had 5,913 accounts with a market value of $7.1 billion. Of this total, $4.8 billion represented assets in non-managed accounts and $2.3 billion were managed trust assets. The Asset Management Division maintains custodial accounts under which it acts as agent for customers in rendering a variety of services, including dividend and interest collection, collection under installment obligations, rent collection and property management. The Asset Management Division also acts as corporate trustee or co-trustee for bond issues totaling $2.2 billion in principal amount. FIRST HAWAIIAN CREDITCORP, INC. - Creditcorp is a financial services loan company with 11 branch offices located throughout the four major islands of the State (Oahu, Hawaii, Maui and Kauai) and a branch office in Guam. Creditcorp also has a commercial loan production office in Honolulu. The lending activities of Creditcorp are concentrated in consumer and commercial financing which are primarily collateralized by real estate. Creditcorp's primary source of funds is time and savings deposits which are insured by the FDIC to the extent and subject to the limitations set forth in the Federal Deposit Insurance Act, as amended. Creditcorp also utilizes borrowings as an additional source of funding for its loan portfolio. In that regard, Creditcorp is a member of the Federal Home Loan Bank of Seattle (the "FHLB of Seattle") which provides a central credit facility for member institutions. As of December 31, 1993, Creditcorp was required, in accordance with the rules and regulations of the FHLB of Seattle, to maintain a minimum level of capital stock ownership of $3.5 million in this regional facility. As of December 31, 1993, Creditcorp's investment in the capital stock of FHLB of Seattle totalled $6.4 million and advances from the FHLB of Seattle aggregated $35.7 million. At December 31, 1993, Creditcorp had total deposits of $350.0 million, total loans and leases of $415.0 million and total assets of $433.0 million. FIRST HAWAIIAN LEASING, INC. - FHL, a financial services loan company, finances and leases personal property and equipment and acts as an agent, broker or advisor in the leasing or financing of such property for affiliates as well as third parties. As of December 31, 1993, FHL's net investment in leases amounted to $49.3 million and total assets were $51.5 million. FHL's primary source of funds is borrowings from the Corporation and the Bank. PIONEER FEDERAL SAVINGS BANK - On August 6, 1993, the Corporation acquired for cash all of the outstanding stock of Pioneer Fed BanCorp, Inc. ("Pioneer Holdings") at a purchase price of $87 million through the merger of Pioneer Holdings with and into the Corporation ("Merger"). As a result of the Merger, Pioneer became a wholly-owned subsidiary of the Corporation (see "Note 1. Business Combinations" (page 41) in the Financial Review section of the Corporation's Annual Report 1993, which is incorporated herein by reference thereto). Pioneer is a federally chartered savings bank operating in the state of Hawaii. Pioneer, the oldest savings bank in Hawaii, was chartered in 1890 by King David Kalakaua. Presently, Pioneer maintains 19 branch offices located on the four major islands of Hawaii. At December 31, 1993, Pioneer had total assets of $650.3 million. Based on total assets at December 31, 1993, Pioneer was the fourth largest of six Savings Association Insurance Fund (the "SAIF") - insured institutions operating in Hawaii. Pioneer is primarily engaged in attracting deposits from the general public through a variety of deposit products. Together with borrowings, principally from the FHLB of Seattle, and funds from ongoing operations, these resources are invested in the origination of conventional adjustable and fixed rate, one-to-four family residential mortgages. Pioneer is also engaged in other types of mortgage lending, including home equity loans, loans on smaller multi-family projects and, to a lesser extent, in other consumer lending activities. Mortgage lending activity, both origination and purchases, has been limited to loans secured by property in the State of Hawaii. As of December 31, 1993, Pioneer was required, in accordance with the rules and regulations of the FHLB of Seattle, to maintain a minimum level of capital stock ownership of $7.2 million in this regional facility. As of December 31, 1993, Pioneer's investment in the capital stock of the FHLB of Seattle totalled $25.2 million and advances from the FHLB of Seattle aggregated $143.0 million. At December 31, 1993, Pioneer had total deposits of $399.4 million, total loans of $544.0 million and total assets of $650.3 million. HAWAII COMMUNITY REINVESTMENT CORPORATION - In an effort to support affordable housing and as part of the Bank's, Creditcorp's and Pioneer's community reinvestment program, the Bank, Creditcorp and Pioneer are members of the Hawaii Community Reinvestment Corporation (the "HCRC"). The HCRC is a consortium of local financial institutions and provides $50 million in permanent long-term financing for affordable housing projects throughout Hawaii for low and moderate income residents. The $50 million loan pool is funded by the member financial institutions who also participate pro rata in each HCRC loan. The Bank's, Creditcorp's and Pioneer's participations in these HCRC loans are included in each of these companies' loan portfolio. HURRICANE INIKI - On September 11, 1992, Hurricane Iniki struck the Island of Kauai and, to a lesser extent, the west side of the Island of Oahu, causing extensive property damage. At December 31, 1993, the Bank, Creditcorp and Pioneer held mortgages collateralizing loans of $92.2 million, $11.8 million and $37.9 million, respectively, on commercial and residential properties on Kauai that were damaged by the hurricane. All of the properties were covered by casualty insurance policies which covered not only the owner of the property, but also the lender. The Corporation does not anticipate material losses resulting from damage caused by Hurricane Iniki. As a result of Hurricane Iniki, several casualty insurers failed or refused to renew and write new homeowners' casualty insurance in Hawaii. The Bank, Creditcorp and Pioneer all require and rely upon the existence of adequate homeowners' casualty insurance on all residential properties which serve as primary collateral for loans. If homeowners' casualty insurance became generally unavailable in Hawaii, the subsidiaries of the Corporation would either be required to discontinue residential real property lending or be exposed to risk of loss if uninsured collateral were destroyed in the event of fire or other casualties. In addition, such loans would not be salable in the secondary market. However, at this time alternate homeowners' casualty insurance is available to homeowners in Hawaii, but at greater costs than before the hurricane. The Legislature of the State of Hawaii has created the Hawaii Hurricane Relief Fund to offer homeowners' insurance coverage in order to stabilize the casualty insurance market in Hawaii and to increase the availability of reasonably priced homeowners' casualty insurance. As an alternative to customer-provided insurance, the Bank, Creditcorp and Pioneer have been able to obtain "forced place" homeowners' casualty coverage through insurance policies obtained by the Bank, Creditcorp or Pioneer at the borrower's expense to cover the uninsured mortgage loan. EMPLOYEES - As of December 31, 1993, the Corporation had 3,116 full-time equivalent employees. The Bank employed 2,766 persons and nonbank subsidiaries employed 350 persons. None are represented by any collective bargaining agents and relations with employees are considered excellent. MONETARY POLICY AND ECONOMIC CONDITIONS - The earnings and growth of the Corporation are affected not only by general economic conditions, but also by the monetary policies of various governmental regulatory authorities, particularly the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). The Federal Reserve Board implements national monetary policy by its open market operations in United States Government securities, control of the discount rate, and establishment of reserve requirements against both member and nonmember financial institutions' deposits. These actions have a significant effect on the overall growth and distribution of loans, investments and deposits as well as the rates earned on loans, or paid on deposits. It is not possible to predict the effect of future changes in monetary policies upon the operating results of the Corporation. COMPETITION - Although the laws of Hawaii generally prohibit interstate banking, competition in the financial services industry is intense. Hawaii-based commercial banks, savings institutions, financial services loan companies and credit unions compete against one another. Based upon the latest available figures, total deposits of all financial institutions in Hawaii as of June 30, 1993 amounted to approximately $21 billion. The two largest bank holding companies, Bancorp Hawaii, Inc. and the Corporation accounted for 26% and 23% of total deposits, respectively. The Corporation's share of deposits includes Pioneer which was acquired on August 6, 1993. The next largest competitors were Bank of America, F.S.B. and American Savings Bank, F.S.B., with 10% and 7%, respectively, of total deposits. In addition, out-of-state mutual funds, insurance companies, brokerage firms and other financial services providers also compete for consumer and commercial business in Hawaii. Foreign (non-Hawaii) banks and other financial institutions are able to make loans in Hawaii through Edge Act facilities, finance and mortgage company subsidiaries and by loan participations with local banks. United States domestic banks and other financial institutions may make loans directly in Hawaii by qualifying as "foreign lenders" in Hawaii. Foreign banks currently conduct various banking activities in Hawaii, except for retail deposit-taking. Banks and bank holding companies organized under the laws of Pacific Ocean jurisdictions with United States dollar-based economies may acquire Hawaii banks or establish branches in Hawaii, although none has done so to date. Banks and similar financial institutions of countries other than the United States may and do have representative offices or agencies in Hawaii. Under the rules of the Office of Thrift Supervision ("OTS"), federally-chartered savings associations may open branches in, or merge with another savings association located in, any state (including Hawaii), subject to certain conditions. Hawaii has no law permitting interstate bank acquisitions or branching in Hawaii by foreign (non-Hawaii) banks. The Hawaii Legislature has previously considered and rejected broad interstate banking legislation. However, legislation has been enacted which permits the acquisition of failing state-chartered financial institutions by out-of-state financial institutions in certain limited circumstances. A bill is presently under consideration in the 1994 Hawaii State Legislature which would allow out-of-state bank holding companies to acquire Hawaii banks. Further, both the United States Senate and House of Representatives are considering proposed legislation which, if enacted, could permit non-Hawaii bank holding companies to acquire Hawaii banks or bank holding companies and, if Hawaii law permitted, to operate branches of a non-Hawaii bank in Hawaii. Whether any of the proposed state or federal legislation will be enacted, the form which such legislation may take, and its effect on the Corporation cannot be predicted at this time. SUPERVISION AND REGULATION - As a bank holding company, the Corporation is subject to the Bank Holding Company Act of 1956 and is subject to supervision by the Federal Reserve Board. In general, the Bank Holding Company Act of 1956 limits the business of bank holding companies to owning or controlling banks and engaging in such other activities as the Federal Reserve Board may determine to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Corporation is also regulated and supervised by the OTS as a savings and loan holding company by virtue of its ownership of Pioneer. The various subsidiaries of the Corporation are subject to regulation and supervision by the state banking authorities of Hawaii, the Federal Reserve Board, the FDIC, the OTS and various other regulatory agencies. Holding Company Structure. The Corporation must obtain the prior approval of the Federal Reserve Board before acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank; before merging or consolidating with another bank holding company; and before acquiring substantially all of the assets of any additional bank. The Bank Holding Company Act of 1956 also prohibits the acquisition by the Corporation of any such interest in any bank or bank holding company located in a state other than Hawaii unless the laws of the state in which such bank is located expressly authorize such acquisition. With certain exceptions, the Bank Holding Company Act of 1956 prohibits bank holding companies from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares in any company which is not a bank or a bank holding company, unless the Federal Reserve Board determines that the activities of such company are so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve Board considers, among other things, whether the performance of such activities by a bank holding company would offer benefits to the public that outweigh possible adverse effects. In addition, all acquisitions are reviewed by the Department of Justice for antitrust considerations. The Corporation is required by the Bank Holding Company Act of 1956 to file annual reports and such other reports as may be required from time to time with the Federal Reserve Board. In addition, the Federal Reserve Board performs periodic examinations of the Corporation and certain of its subsidiaries. The principal source of the Corporation's cash revenue has been dividends and interest received from the Bank and other subsidiaries of the Corporation. The Bank, Pioneer and Creditcorp are subject to regulatory limitations on the amount of dividends they may declare or pay. In addition, the payment of dividends by the Corporation is limited to an amount not greater than 50% of its consolidated net income as stipulated in the debt covenants of a certain line of credit. There are also statutory limits on the transfer of funds to the Corporation and certain of its nonbanking subsidiaries by the Bank, whether in the form of loans or other extensions of credit, investments or asset purchases. Such transfers by the Bank to the Corporation or any such nonbanking subsidiary are limited in amount to 10% of the Bank's capital and surplus, or 20% in the aggregate. Furthermore, such loans and extensions of credit are required to be collateralized in specified amounts. If, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and hearing, that such bank cease and desist from such practice. The Federal Reserve Board and the FDIC have issued policy statements which provide that, as a general matter, insured banks and bank holding companies may only pay dividends out of current operating earnings. Under Hawaii law, the Bank is prohibited from declaring or paying any dividends in excess of its retained earnings. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each subsidiary bank and to make capital injections into a troubled subsidiary bank, and the Federal Reserve Board may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank. This capital injection may be required at times when the Corporation may not have the resources to provide it. Any capital loans by the Corporation to its subsidiary bank would be subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In connection with its application to the Federal Reserve Board for authority to acquire Pioneer, the Corporation committed that Pioneer will meet all present and future minimum capital ratios adopted for savings associations by OTS or the FDIC. In the event of the bankruptcy of the Corporation, this commitment would be assumed by the bankruptcy trustee and be entitled to a priority of payment. In addition, depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989 in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. "Default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. Accordingly, in the event that any insured subsidiary of the Corporation causes a loss to the FDIC, other insured subsidiaries of the Corporation could be required to compensate the FDIC by reimbursing it for the amount of such loss. Any such obligation by the Corporation's insured subsidiaries to reimburse the FDIC would stand senior to their obligations, if any, to the Corporation. Federal Deposit Insurance Corporation Improvement Act of 1991. In December, 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which substantially revises the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. FDICIA provides for, among other things, (i) a recapitalization of the Bank Insurance Fund by increasing the FDIC's borrowing authority; (ii) annual on-site examinations of federally-insured depository institutions by banking regulators; (iii) publicly available annual financial condition and management reports for financial institutions, including audits by independent accountants; (iv) the establishment of uniform accounting standards by federal banking agencies; (v) the establishment of "prompt corrective action" standards for depository institutions based on five levels of capitalization, with more scrutiny and restrictions placed on institutions with lower levels of capital; (vi) additional grounds for the appointment of a conservator or receiver for a failed or failing depository institution; (vii) a requirement that the FDIC use the least-cost method of resolving cases of troubled institutions in order to keep the costs to insurance funds at a minimum; (viii) more comprehensive regulation and examination of foreign banks; (ix) consumer protection provisions including a Truth-in-Savings Act; (x) a requirement that the FDIC establish a risk-based deposit insurance assessment system to be in effect no later than January 1, 1994; (xi) restrictions or prohibitions on accepting brokered deposits except for institutions which significantly exceed minimum capital requirements; (xii) general restrictions on the activities as principal and equity investments of state-chartered banks to those permissible for national banks unless approved by the FDIC; and (xiii) certain limits on deposit insurance coverage. A central feature of FDICIA is the requirement that the federal banking agencies take "prompt corrective action" with respect to insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital levels applicable to such institutions (including the Bank): "well capitalized,' "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under the regulations adopted by the federal banking agencies to implement these provisions of FDICIA, a depository institution is "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An "adequately capitalized" institution is defined as one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier 1 risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMEL rating of 1). A depository institution is considered (i) "undercapitalized" if it has (A) a total risk-based capital ratio of less than 8%, (B) a Tier 1 risk-based capital ratio of less than 4% or (C) a leverage ratio of less than 4% (or 3% in the case of an institution with a CAMEL rating of 1), (ii) "significantly undercapitalized" if it has (A) a total risk-based capital ratio of less than 6%, (B) a Tier 1 risk-based capital ratio of less than 3% or (C) a leverage ratio of less than 3% and (iii) "critically undercapitalized" if it has a ratio of tangible equity to total assets equal to or less than 2%. An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a cash dividend) or paying any management fees to its holding company if the depository institution is, or would thereafter be, undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit a capital restoration plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company under such guarantee is limited to the lesser of (i) an amount equal to 5% of the depository institution's total assets at the time it became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution becomes critically undercapitalized. FDICIA also provides for increased funding of the FDIC insurance funds. In addition, the FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to the regulatory capital levels of the institution and other factors (including supervisory evaluations). There is an eight basis point spread between the highest and lowest assessment rates, so that banks classified as strongest by the FDIC are subject to a rate of .23%, and banks classified as weakest by the FDIC are subject to a rate of .31%. FDICIA also requires the federal banking agencies to prescribe standards for depository institutions and their holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, executive compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares and such other standards as the agencies deem appropriate. In November, 1993 the federal banking agencies published proposed regulations to implement these provisions of FDICIA. The proposed rules set forth general standards to be observed but for the most part do not mandate specific operating standards to be followed. At this time the Corporation believes that such rules, if adopted in their proposed form, will not have a material effect on the Corporation's operations or financial results. Capital Requirements. The Corporation and certain of its subsidiaries are subject to regulatory capital guidelines issued by the federal banking agencies. Information with respect to the applicable capital requirements is included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" (Page 32) in the Financial Review section of the Corporation's Annual Report 1993, and is incorporated herein by reference thereto. FDICIA requires each federal banking agency to revise its risk-based capital standards to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risk of nontraditional activities, as well as reflect the actual performance and expected risk of loss on multi-family mortgages. In September, 1993 the federal banking agencies issued notices of proposed rulemaking soliciting comment on proposed revisions to the risk-based capital rules to take account of interest rate risk. The notice proposes alternative approaches for determining the additional amount of capital, if any, that may be required to compensate for interest rate risk. The first approach would reduce an institution's risk-based capital ratios by an amount based on its measured exposure to interest rate risk in excess of a specified threshold. The second approach would assess the need for additional capital on a case-by-case basis, considering both the level of measured exposure and qualitative risk factors. The Corporation cannot assess at this point the impact that such proposals would have on its capital ratios. In February, 1994 the federal banking agencies issued proposed rules to revise the risk-based capital standards to take account of concentration of credit risk and the risks of nontraditional activities. The proposed rules specify that concentrations of credit risk will be considered as important factors in assessing an institution's overall capital adequacy, but did not provide for any specific adjustments to the risk-based capital standards for such risks or for the risks of nontraditional activities. STATISTICAL DISCLOSURES - Guide 3 of the "Guides for the Preparation and Filing of Reports and Registration Statements" under the Securities Act of 1933 sets forth certain statistical disclosures in the "Description of Business" section of bank holding company filings with the Securities and Exchange Commission. The statistical information requested is presented in the following tables and also in the tables shown below in the Corporation's Annual Report 1993, which tables are incorporated herein by reference thereto. The tables and information contained therein have been prepared by the Corporation and have not been audited or reported upon by the Corporation's independent accountants. Information in response to the following sections of Guide 3 is included in the Financial Review section of the Corporation's Annual Report 1993, and is incorporated herein by reference thereto: I. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential Table I-C presents the percentages of total assets and total liabilities attributable to foreign operations. For this purpose, assets attributable to foreign operations are defined as assets in foreign offices and loans and leases to and investments in customers domiciled outside the United States. Deposits received and other liabilities are classified on the basis of domicile of the creditor. FIRST HAWAIIAN, INC. AND SUBSIDIARIES TABLE I-C PERCENTAGE OF TOTAL ASSETS AND TOTAL LIABILITIES ATTRIBUTABLE TO FOREIGN OPERATIONS II. INVESTMENT SECURITIES PORTFOLIO Table II-A presents the book value of investment securities by the following major categories at year-end for the years indicated. FIRST HAWAIIAN, INC. AND SUBSIDIARIES TABLE II-A SCHEDULE OF INVESTMENT SECURITIES BY BOOK VALUE Table II-B presents the maturities of investment securities, excluding securities which have no stated maturity at December 31, 1993, and the weighted average yields (for obligations exempt from Federal income taxes on a taxable equivalent basis assuming a 35% tax rate) of such securities. The tax equivalent adjustment is made for items exempt from Federal income taxes to make them comparable with taxable items before any income taxes are applied. FIRST HAWAIIAN, INC. AND SUBSIDIARIES TABLE II-B SCHEDULE OF INVESTMENT SECURITIES BY MATURITIES AND AVERAGE YIELDS DECEMBER 31, 1993 Notes: (1) The weighted average yields were calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security. (2) Includes $98 million of securities in the following maturity categories with optional tender dates ($10 million within 1 to 5 years; $20 million within 5 to 10 years; and $68 million after 10 years). III. Loan and Lease Portfolio Table III-B presents maturity and interest rate sensitivity data for all loans and leases except real estate - residential, real estate - commercial, consumer, credit cards and lease financing at December 31, 1993. FIRST HAWAIIAN, INC. AND SUBSIDIARIES TABLE III-B LOAN AND LEASE MATURITY AND INTEREST RATE SENSITIVITY DATA DECEMBER 31, 1993 Table III-C (3) presents a summary of the Corporation's foreign outstandings to each country which exceeded 1% of total assets for the years indicated. Foreign outstandings are defined as the balances outstanding of cross-border loans, acceptances, interest-bearing deposits with other banks, other interest-bearing investments and any other monetary assets. At December 31, 1993, the Corporation's total foreign outstandings amounted to $256 million. FIRST HAWAIIAN, INC. AND SUBSIDIARIES TABLE III-C (3) FOREIGN OUTSTANDINGS TO EACH COUNTRY WHICH EXCEEDS 1% OF TOTAL ASSETS ITEM 2.

ITEM 2. PROPERTIES A subsidiary of the Bank is the sole general partner in a Hawaii limited partnership which owns all of a city block in downtown Honolulu containing 55,775 square feet. The Bank's interest in the limited partnership is 99.25%. The administrative headquarters of the Corporation and the main branch of the Bank were formerly located on a portion of the city block. The buildings were demolished and the Bank has begun construction of a modern banking center on this city block. The new headquarters building will include 418,000 square feet of gross office space, including the Bank's main branch and administrative headquarters of the Corporation and the Bank. The new building is anticipated to be completed in 1996. Commencing in March 1993, the Bank leased approximately 119,000 square feet in another office building for use as an interim administrative headquarters and main branch until completion of the new structure. The interim office building is approximately a block and a half from the old administrative headquarters and main branch. Seventeen of the Bank's offices in Hawaii are located on land owned in fee simple by the Bank. The other branches of the Bank, Pioneer and Creditcorp are situated in leasehold premises or in buildings constructed by the Bank or Creditcorp on leased land (see "Note 16. Lease Commitments" (page 50) in the Financial Review section of the Corporation's Annual Report 1993, which is incorporated herein by reference thereto). . In early 1993, the Bank completed construction of an operations center located on 125,919 square feet of land owned in fee simple by the Bank in an industrial area near downtown Honolulu. The Bank occupies all of the four-story building which is anticipated to enable the Bank to meet its projected technological requirements into the twenty-first century. The Bank is also constructing a new five-story, 75,000 square foot office building, including a branch, on property owned in fee simple in Maite, Guam to replace its Agana, Guam Branch. Completion of the building is anticipated for late 1994. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The legal proceeding brought by MasterCard International, Inc. in the United States District Court for the Southern District of New York against Dean Witter, Discover & Co. and others, in which the Bank and others were named as counterclaim defendants, which was described in the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, was settled and dismissed without the Corporation or the Bank making any payment or assuming any other obligation. The date of the dismissal of claims against the Bank was January 21, 1994. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Required information is included in "Common Stock Information" (Page 15) in the Financial Review section of the Corporation's Annual Report 1993, and is incorporated herein by reference thereto. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Required information is included in "Summary of Selected Consolidated Financial Data" (Page 16) in the Financial Review section of the Corporation's Annual Report 1993, and is incorporated herein by reference thereto. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Required information is included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" (Pages 17 through 32) in the Financial Review section of the Corporation's Annual Report 1993, and is incorporated herein by reference thereto. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following information is included in the Financial Review section of the Corporation's Annual Report 1993, which is incorporated herein by reference thereto as follows: ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Required information relating to directors is included in "Election of Directors" and "Directors Continuing in Office and Executive Officers" (Pages 3 through 9) of the Corporation's Proxy Statement, and is incorporated herein by reference thereto. EXECUTIVE OFFICERS OF THE REGISTRANT Listed below are the executive officers of the Corporation with their positions, age and business experience during the past five years: There are no family relationships among any of the executive officers of the Corporation. There is no arrangement or understanding between any such executive officer and another person pursuant to which he was elected as an officer. The term of office of each officer is at the pleasure of the Board of Directors of the Corporation. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Required information is included in "Remuneration of Directors" and "Executive Compensation" (Pages 9 through 20) of the Corporation's Proxy Statement, and is incorporated herein by reference thereto. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Required information is included in "Outstanding Shares; Voting Rights," "Election of Directors" and "Directors Continuing in Office and Executive Officers" (Pages 2 through 8) of the Corporation's Proxy Statement, and is incorporated herein by reference thereto. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Required information is included in "Certain Transactions" (Pages 20 and 21) of the Corporation's Proxy Statement, and is incorporated herein by reference thereto. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 2. Financial Statement Schedules Schedules to the consolidated financial statements required by Article 9 of Regulation S-X are not required under the related instructions, or the information is included in the consolidated financial statements, or are inapplicable, and therefore have been omitted. 3. Exhibits Exhibit 3 (i) Certificate of Incorporation - Incorporated by reference to Exhibit 3 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 as filed with the Securities and Exchange Commission. (ii) Bylaws - Incorporated by reference to Exhibit 3 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 as filed with the Securities and Exchange Commission. Exhibit 4 Instruments defining rights of security holders, including indentures. (i) Equity - Incorporated by reference to Exhibit 3(i) hereto. (ii) Debt - Indenture, dated as of August 9, 1993 between First Hawaiian, Inc. and The First National Bank of Chicago, Trustee. Exhibit 10 Material contracts (i) Lease dated September 13, 1967, as amended April 21, 1987, between the Trustees under the Will and of the Estate of Samuel M. Damon, Deceased, and First National Bank of Hawaii (predecessor of the Bank) is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 as filed with the Securities and Exchange Commission. (ii) Lease dated May 20, 1982, as amended April 23, 1987, between the Trustees under the Will and of the Estate of Samuel M. Damon, Deceased, and First Hawaiian Bank is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Forms 10-K for the fiscal years ended December 31, 1987, 1985 and 1980 as filed with the Securities and Exchange Commission. (iii) Lease Agreement dated as of December 1, 1993 between REFIRST, Inc. and First Hawaiian Bank. (iv) Construction Management, Escrow and Development Agreement dated as of December 1, 1993 among REFIRST, Inc., First Hawaiian Bank and First Fidelity Bank, N.A., Pennsylvania. (v) Ground Lease dated as of December 1, 1993 among First Hawaiian Center Limited Partnership, FH Center, Inc. and REFIRST, Inc. (vi) Stock Incentive Plan of First Hawaiian, Inc. dated November 22, 1991 is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 as filed with the Securities and Exchange Commission. (vii) Long-Term Incentive Plan of First Hawaiian, Inc. effective January 1, 1992 is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 as filed with the Securities and Exchange Commission. (viii) First Hawaiian, Inc. Supplemental Executive Retirement Plan, as amended August 18, 1988 is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 as filed with the Securities and Exchange Commission. (ix) Amendment One to First Hawaiian, Inc. Supplemental Executive Retirement Plan, effective January 1, 1992 is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 as filed with the Securities and Exchange Commission. (x) First Hawaiian, Inc. Incentive Plan for Key Executives, as amended through December 13, 1989 is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 as filed with the Securities and Exchange Commission. (xi) Directors' Retirement Plan, effective as of January 1, 1992 is incorporated by reference to Exhibit 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 as filed with the Securities and Exchange Commission. Exhibit 12 Statement re: computation of ratios. Exhibit 13 Annual report to security holders - Corporation's Annual Report 1993. Exhibit 22 Subsidiaries of the registrant. Exhibit 23 Consent of independent accountants. (b) Reports on Form 8-K - No reports on Form 8-K were filed during the last quarter of the fiscal year ended December 31, 1993. (c) Response to this item is the same as Item 14(a)3. (d) Response to this item is the same as Item 14(a)2. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST HAWAIIAN, INC. (Registrant) By /s/ HOWARD H. KARR ----------------------------------- HOWARD H. KARR EXECUTIVE VICE PRESIDENT AND TREASURER Date: March 17, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. EXHIBIT INDEX

721083_1993.txt

721083

1993

ITEM 1. BUSINESS GENERAL Smith International, Inc. ("Smith" or the "Company") is a leading downhole drilling tool manufacturer and service company, which manufactures and markets a wide range of products and services used in the drilling of oil and gas wells. Smith provides technologically advanced drill bits, and drilling and completion services to the oil and gas drilling industry. Supplying products and services to the oil and gas drilling industry represents approximately 92% of the Company's revenues, with the remainder to the mining and industrial markets. The following table sets forth the revenues attributable to continuing operations of the Company for its two major product and service groups: Beginning in March 1994, the Company will also provide drilling fluids and systems to the oil and gas drilling industry as a result of the Company's February 28, 1994 acquisition of a 64% interest in M-I Drilling Fluids Company (M-I). Information about M-I is also provided below. SALE OF DIRECTIONAL DRILLING BUSINESS On March 29, 1993, the Company sold its directional drilling systems and services (DDS) business and certain of its subsidiaries and other affiliates to Halliburton Company (Halliburton) for 6,857,000 shares of Halliburton common stock. In April 1993, the Halliburton common stock was sold for $247.7 million. As a result, the Company recorded income from discontinued operations of $73.6 million including the gain from the sale of the DDS business of $80.1 million. The gain includes provisions for various fees, expenses and taxes related to the DDS sale. The DDS business reported revenues of approximately $36.3 million in the first three months of 1993, $158.7 million in 1992 and $151.1 million in 1991. The DDS business reported operating losses of $6.5 million in the first three months of 1993, $3.0 million in 1992 and $4.6 million in 1991. The Company used a portion of the proceeds of the DDS sale to repay certain debt of the Company. For further discussion, refer to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." ACQUISITIONS OF A-Z/GRANT AND LINDSEY On December 22, 1993, the Company acquired the product line assets of A-Z International, Grant Oilfield Tools and Lindsey Completion Systems (A-Z/Grant and Lindsey) from Masex Energy Services Group, Inc. for $19.0 million in cash. A-Z/Grant and Lindsey are leading providers of downhole tools, remedial services and liner hangers to the oil and gas industry. A-Z/Grant and Lindsey reported unaudited revenues of $31.6 million in 1993, $29.0 million in 1992, and $31.0 million in 1991. The acquisition was accounted for as a purchase effective December 22, 1993. The unaudited results of A-Z/Grant and Lindsey from December 22, 1993 to December 31, 1993 were not significant to the operations of the Company. ACQUISITION OF M-I DRILLING FLUIDS COMPANY IN 1994 Effective February 28, 1994, the Company acquired a 64% interest in M-I from Dresser Industries, Inc. (Dresser) for $160 million. M-I was owned 64% by Dresser and 36% by Halliburton prior to the acquisition. M-I is a leading provider of environmentally sensitive drilling fluids and systems to the oil and gas drilling industry. The Company purchased the 64% interest in M-I using $80 million of its cash and issuing a note payable to Dresser for $80 million due on August 28, 1994. M-I reported unaudited revenues of $405.8 million in 1993, $382.6 million in 1992 and $435.5 million in 1991. With the completion of the aforementioned acquisitions, the Company has established itself as a leading supplier of expendable drilling products to the oil and gas drilling industry. On an unaudited pro forma basis, the combined total revenues of all of the Company's businesses totaled $658.1 million in 1993. INDUSTRY OVERVIEW AND BUSINESS OPERATIONS Substantially all of the Company's products and services are used in the process of drilling oil and natural gas wells. Therefore, the level of drilling activity is a useful general indicator of the demand for the products and services of the Company at any given time. The level of drilling activity is determined by a variety of factors over which the Company has no control, including the current and anticipated market price of crude oil and natural gas, the production levels of the Organization of Petroleum Exporting Countries ("OPEC") and other oil and gas producers, the regional supply and demand for oil and natural gas, the level of worldwide economic activity and the long-term effect of worldwide energy conservation measures. The worldwide average active rig count increased 2.4% from 1,673 in 1992 to 1,713 in 1993, primarily due to the 5.0% increase in the average U.S. rig count between 1992 and 1993. Overall the international active rig count increased slightly as an increase in drilling activity in Canada was partially offset by drilling declines in all major international areas except the Middle East. Management anticipates drilling activity in 1994 to approximate 1993 activity levels and intense competition to continue. Some additional drilling for natural gas is expected to occur during 1994 in the Gulf of Mexico region of the U.S. due to the increase in natural gas prices over the prior year, the decline in natural gas reserves and the general emphasis of utilizing natural gas as an environmentally preferred fuel. Management believes that the Company is well positioned to benefit from increases in worldwide oil and gas exploration drilling which may develop in 1994 and beyond and that increased drilling activity will positively impact the Company's results in the future. OTHER BACKGROUND INFORMATION On March 7, 1986, the Company, exclusive of its subsidiaries, filed for protection under Chapter 11 of the U.S. Bankruptcy Code as a result of a judgment in the amount of $205.4 million in a patent infringement case relating to a drill bit patent that has since expired. The Company initiated the bankruptcy proceedings in order to protect its assets and operations from the judgment. On December 31, 1987, the Company's plan of reorganization became effective, and since that date it has conducted its business in the ordinary course. During the reorganization, the Company completed an extensive restructuring of its internal operating divisions and sold certain of its operations in order to focus on its core businesses. Because the Company sustained its historical levels of research and engineering expenditures and maintained its share of industry revenues during this period, management believes that the Company was not adversely affected by the reorganization. Industrial Equity (Pacific) Limited, a Hong Kong Corporation ("IEP") acquired 8,754,892 shares of Common Stock, 933,468 Class A Warrants and 967,133 Class B Warrants in open market purchases beginning in October 1986 and pursuant to the Company's plan of reorganization. Pursuant to a private placement in February 1988, IEP acquired preferred stock that was subsequently converted into the Company's 8.75% Convertible Preferred Stock. In May 1989, the Board of Directors of the Company was notified by IEP that IEP wished to explore the possibility of acquiring the remaining shares of the Company that it did not own. In response to that announcement, a Special Committee of the Company's Board of Directors was formed. In July 1989, the Special Committee announced that it intended to solicit offers for the Company from third parties and "explore alternatives designed to maximize shareholder value." The Company agreed to be acquired by Dresser pursuant to an Agreement and Plan of Merger, dated November 13, 1989. On December 28, 1989, Dresser exercised its right to terminate the Merger Agreement based upon circumstances relating to obtaining clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. On March 19, 1990, the Company and IEP entered into an agreement pursuant to which the Company and IEP agreed, among other things, that IEP would sell certain of the Company's securities owned by it in a public offering. The offering was successful and closed on May 30, 1990. IEP agreed that it would not acquire any securities in excess of 5% of the Company's Common Stock on a fully diluted basis for a five year period from the closing of the offering. DRILL BITS Products. The Company's drill bits group designs, manufactures and markets drill bits used in drilling oil and gas wells and mining applications. The Company offers over 900 drill bits under the Smith Tool(TM), Smith Diamond(TM) and Smith Mining(TM) product lines. Drill bit sizes range from 5 7/8 to 28 inches in diameter for the petroleum industry and from 2 15/16 to 17 1/2 inches in diameter for the mining industry. Most bits manufactured by the Company are three-cone drill bits. The surfaces of the cones are comprised of different types of pointed structures that are referred to as "cutting structures" or "teeth." The cutting structures are either an integral part of the steel cone with a hardmetal applied surface (referred to as "milled tooth") or made of an inserted material (referred to as "insert") which is usually tungsten carbide. The Company also manufactures and markets shear bits featuring cutters made of polycrystalline diamond ("PDC") or natural diamonds. The Company manufactures PDC's for use in the Company's diamond drill bits, and has patented processes for applying diamonds to a curved surface with multiple transition layers. The Company believes that the curved surface diamond insert significantly improves the ability of diamond shear bits to drill in harder and more abrasive formations. Smith is the only oilfield equipment manufacturer that develops, manufactures and markets its own synthetic diamond materials, which provides the Company a cost and technological advantage with respect to these products. In addition, the Company's in-house diamond research, engineering and manufacturing capabilities enhance the Company's ability to develop the application of diamond technology into Smith drill bits and across other Smith product lines. These diamond enhanced products last longer and increase penetration rates, which decreases overall drilling costs in certain formations. The Company believes that its ability to develop specialized diamond inserts for specific applications will provide new business opportunities as with Diamond Enhanced Insert roller cone bits and Impax(TM) hammer bits. The cutting structures in mining bits are principally tungsten carbide inserts ("TCI"). Mining bits are typically utilized for shallow drilling to place explosives for blasting in open pit mining operations. Other mining bits using both tungsten carbide and diamond enhanced inserts have been designed for use with air driven percussion tools and are known as hammer bits. Competition. Besides the Company, Hughes Christensen (a division of Baker-Hughes, Inc.), Security (a division of Dresser), and Reed/Hycalog (a division of Camco International, Inc.) are the three major competitors in the petroleum drill bit business. While the Company and Hughes Christensen maintain the leading shares of worldwide revenues of three-cone mining drill bits, they compete with over 20 other competitors. Competition for sales of petroleum drill bits is generally based on a number of factors, including performance, quality, reliability, service, price, technological advances and breadth of products. The Company believes its quality and reliability as well as technological advances, such as the Diamond Enhanced Inserts, specialized hardmetal applications and Spinodal bearing features in its drill bits, further enhance the Company's reputation and competitive advantage. Competition for sales of mining drill bits generally is based on a number of factors, including price, performance and availability. DRILLING AND COMPLETION SERVICES Products and Services. The Company manufactures tubular drill string components within its Drilco product line. These tubular products include drill collars to provide drilling weight to the bit, Hevi-Wate(TM) drill pipe to provide stress transition between drill collars and conventional drill pipe or to provide drilling weight to the bit in horizontal drilling, connecting subs to attach drill string members of differing diameters and connections and kellys to rotate the drill string on conventional drilling rigs. The Company manufactures downhole tools which are also used in the drilling process. These downhole tools are sold or rented to the end users, and include stabilizers to centralize the drill string, reamers to maintain a uniform hole diameter and shock subs to reduce the shock and vibration that occurs in the drill string. The Company also manufactures downhole remedial tools for use in connection with the drill string for specialized drilling and workover operations within its Servco product line. These remedial tools are sold or rented to the end users, and typically include supervision services provided by the Company's employees. These remedial operations include section milling to remove a section of casing permitting the well to be re-drilled using the existing casing string, hole opening and underreaming to enlarge the wellbore for proper cementing of the casing or gravel packing, packer milling to remove production packers, conventional milling to remove wellbore obstructions, pipe cutting to remove the casing when a well is abandoned and fishing services to remove obstructions from well bores primarily during workover operations. The Company maintains field service centers which provide inspection and repair services for the Company's drill string components, customer owned tubular goods and for the Company's rental tools. These field service centers serve as the distribution points for all the Company's products, and are an important part of the Company's marketing efforts. In addition to the above, the recently acquired A-Z International and Grant Oilfield Tools provides rotating drilling heads, milling tools, Pack-Stock combination packers and whipstocks for various drilling and remedial activities, and Lindsey Completion Systems has been an industry innovator in the liner hanger, completion and cementing equipment product lines. Competition. Competition in the drilling and completion services market is primarily based on response time, reliability and price. The Company attributes its competitive position to its commitment to quality and service which is evidenced by the Company maintaining quality equipment and trained personnel at field service centers in almost every major drilling location in the world. The markets for drilling and completion services are highly fragmented. DRILLING FLUIDS OPERATIONS Products and Services. Through the acquisition of M-I, the Company will provide drilling fluids products, systems, and technical services to end users engaged in drilling oil, natural gas, and geothermal wells worldwide. Drilling fluids products and systems are used to cool and lubricate the bit during drilling operations, contain formation pressures, keep rock cuttings in suspension to remove them from the hole, and maintain the stability of the wellbore. Technical services are provided at the wellsite to ensure that the products and systems are applied effectively to optimize drilling operations. These services include well-specific products and systems during the planning phase, testing and recommending adjustments to the properties of the fluids during the drilling phase, and analyzing well results to improve the drilling of future wells. M-I is a global leader in environmentally-sensitive drilling fluids products and systems as well as equipment related to the control of fluids at the wellsite. M-I manufactures and distributes more than 200 minerals products and chemical additives at nearly 30 grinding and chemical plants strategically located near most of the world's major drilling areas. M-I offers water-base, oil-base, and synthetic-base drilling fluids systems, each comprised of a number of individual products designed to ensure that the multiple functions of the drilling fluid are met. These products include weighting agents such as barite which control formation pressures; thickening agents or viscosifiers which improve the carrying capacity of the fluid; thinners and dispersants, used to thin a drilling fluid which has become too thick from formation cuttings; and fluid loss control agents, lost circulation materials, and other products used to address formation-specific conditions. Major new products and systems introduced in the last three years include NOVADRIL, a synthetic-base drilling fluid system; MCAT(TM), a cationic water-base system; ENVIROTHERM, a high-temperature drilling fluid additive; KLA-CURE(R), an additive used in suppressing shales; and PIPE-LAX(TM) ENV, an environmentally-sensitive spotting fluid. Through its Swaco Geolograph operations, a complete line of solids control, pressure control, and rig instrumentation products are offered to the worldwide drilling market on both a sale and rental basis. Key products in the pressure control line include the D-Gasser and Super Choke which hold dominant market positions. The solid control product line of shakers, hydroclones, and centrifuges have been designed to offer operators the option to drill "dry locations", where drilling fluid waste is minimized and handled in an environmentally-safe manner. Swaco Geolograph's rig instrumentation line features the SMART Data Acquisition System, an advanced monitoring system that measures, monitors, and displays the drilling status of a well with high speed accuracy. Competition. Besides M-I, the major competitors in the worldwide drilling fluids industry are Baroid Drilling Fluids (a subsidiary of Baroid Corporation which recently merged with Dresser) and Inteq (a division of Baker-Hughes, Inc.). Together, these three companies supply products and systems to over two-thirds of the worldwide drilling fluids market. While these companies supply a majority of the market, the drilling fluids industry is highly competitive, with a significant number of smaller, locally-based competitors and foreign multinational drilling fluids suppliers. Competition within the industry is based on a number of factors, including drilling performance, quality, reliability, service, price, technological advantages, and breadth of the product line. INTERNATIONAL OPERATIONS Sales to the international oil drilling markets are a key strategic focus of Smith management, and the Company markets its products and services through its subsidiaries, joint ventures and sales agents in virtually all petroleum producing areas of the world, including Canada, the North Sea/Europe, the Middle East, Mexico, Central and South America, Asia/Pacific and Africa. As a result, 53% of the Company's total revenues from continuing operations in 1993 were generated from sales in the international markets, compared to 58% in 1992. Approximately 61% of the Company's revenues are denominated in U.S. dollars. Historically, international drilling activity has been less volatile than in the U.S. due to the relatively high costs of exploration and development programs which can only be undertaken by major oil companies, consortiums and national oil companies. These entities operate under longer term strategic priorities than do the independent drilling operators that are more common in the U.S. market. SALES AND DISTRIBUTION The Company markets its products on a worldwide basis, employing Company sales personnel and independent sales agents. Sales are directed to end users in the drilling industry including independent drilling contractors, major and independent oil companies and national oil companies. In the United States, approximately 75% of all sales are made by Company sales personnel and the remainder of which are made by independent sales agents. The Company's sales force is supported by 15 field service centers in the U.S. and Canada and 27 field service centers outside of North America. The Company considers that its worldwide sales position has been significantly enhanced by its field service centers presently maintained in Bolivia, Brazil, Canada, Colombia, France, Germany, Italy, Mexico, Norway, Singapore, Tunisia, United Kingdom, United States and Venezuela. These field service centers serve as bases for the sales force and rental tool operations and also provide an opportunity to market a wider range of the Company's products than could be marketed by a sales office. The Company's field service centers are also important factors in maintaining good customer relations since they are designed primarily for repair and maintenance of drill string components and rental tools. MANUFACTURING The Company's manufacturing operations, along with quality control support, are designed to ensure that all products and services marketed by the Company will meet standards of performance and reliability consistent with the Company's reputation in the industry. The Company lowered its fixed costs and labor costs by closing its California manufacturing facilities and relocating the manufacturing of the drill bits to Ponca City, Oklahoma and other products to Houston, Texas in 1989. This move has permitted the Company to realize significant annual savings since that date. Management estimates that the Company has available manufacturing facilities to accommodate a worldwide demand level equivalent to approximately 3,000 average active drilling rigs which compares to 1,700 average active drilling rigs estimated for 1994. In addition, the Company has entered into license agreements and joint ventures with worldwide manufacturers in order to increase its production capacity for drill bits. RAW MATERIALS The Company purchases a variety of raw materials, including alloy and stainless steel bars, tungsten carbide inserts and forgings. Generally, the Company is not dependent on any single source of supply for any of its raw materials or purchased components. The Company currently purchases 80% of the tungsten carbide inserts used as cutting structures on drill bit cones, wear pads for stabilizers and hard surface materials for mills and reamers from one supplier pursuant to a supply agreement entered into in connection with the sale of a division by the Company to that supplier. In addition, the Company has also entered into a supply agreement to purchase 80% of its U.S. forging requirements from a single supplier. The Company believes that numerous alternative supply sources are available for all of such materials. The Company also produces PDC synthetic diamonds in Provo, Utah for utilization in various Company products as well as direct customer sales. The Company believes that it enjoys a competitive advantage in the manufacture of diamond drill bits because it is the only diamond drill bit manufacturer producing its own PDC. PRODUCT DEVELOPMENT, ENGINEERING AND PATENTS The Company maintains product development and engineering departments in bit technology and downhole tool technology whose activities are directed to developing new products and processes, improving existing product lines and designing specialized products to meet customer requirements. Experimental work in metallurgy also comprises a significant portion of the work of these departments. For example, recent new product developments include: tungsten carbide insert and milled tooth Spinodal(TM) bearing roller cone bits, Diamond Enhanced Insert roller cone bits, steerable motor PDC and roller cone bits; the Smith Diamond Maxidrill(TM) products and Diamond Enhanced Impax(TM) hammer bits; the Servco Millmaster(TM) carbide cutting structure; and the Servco Bearclaw(TM) PDC underreamer. In recent years, the Company has received special meritorious awards for engineering innovations sponsored by Petroleum Engineer International magazine. One such award was for the placement of PDC on curved surfaces for rock bit cutting structure while another was for the development of a new hardfacing material for use on milled tooth drill bits. During 1991, the Company developed FDS+ Milled Tooth Rock Bits for longer life at higher rates of penetration. The Company continuously attempts to improve the quality, performance and reliability of its products in order to maintain its competitive position in the industries it serves and to develop new tools and materials to meet the evolving market needs. The Company also maintains a drill bit data base which records the performance of substantially all drill bits used in the U.S. over the last 10 years, including those manufactured by competitors. This database gives the Company the ability to monitor, among other things, drill bit failures and performance improvements with product development. Management believes this proprietary data base gives the Company a competitive advantage in the drill bit business. The Company has historically maintained its research and engineering expenditures at a high level to enable it to maintain its technological and performance leadership and broaden its product lines in the drilling tools and services industry. The Company's expenditures for research and engineering activities amounted to $6.6 million in 1993, $6.2 million in 1992 and $8.9 million in 1991. In 1993, research and engineering expenditures approximated 3.0% of revenues. Although the Company has over 650 patents and regards its patents and patent applications as important in the operation of its business, it does not believe that any significant portion of its business is materially dependent upon any single patent or group of patents or generally upon patent protection. EMPLOYEES At December 31, 1993, the Company had approximately 1,750 full time employees throughout the world. None of the Company's employees in the United States are covered by collective bargaining agreements. The Company considers its labor relations to be satisfactory. ITEM 2.

ITEM 2. PROPERTIES The principal manufacturing facilities of the Company at December 31, 1993 are shown in the table below. The Company considers its manufacturing facilities to be in good condition and adequately maintained. Due to the downturn in business in recent years, the Company's manufacturing facilities operated below capacity throughout 1993 and are continuing to operate below capacity levels. A portion of the Houston, Texas facility is currently being held for sale by the Company. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In January 1991, the Company and several of the Company's competitors were served with a federal grand jury subpoena for documents, principally concerning the Company's sales, marketing and pricing activities for tri-cone rock bits produced and sold by the Company. In June 1992, Baker Hughes entered a plea of guilty to an Information charging it with a single count of violating Section 1 of the Sherman Act for the period March through May 11, 1989 and agreed to pay a $1.0 million fine to the U.S. government. On November 23, 1993, the Company entered a plea of guilty to a violation of Section 1 of the Sherman Act for the same period and paid a fine to the U.S. government of $0.7 million. After it was served the subpoena by the grand jury, the Company was served with complaints in three civil proceedings. Each action alleged violations of Section 1 of the Sherman Act. The cases were consolidated for discovery purposes with four other cases filed against other tri-cone rock bit manufacturers, but not the Company, in the Southern District of Texas, which made allegations similar to those made against the Company. The consolidated case was captioned Red Eagle Resources Corporation, Inc., et al. v. Baker Hughes, Inc., Baker Hughes Production, Inc., Hughes Tool Company, Reed Tool Company, a/k/a/ Baker RTC, Inc., Camco International, Inc., Smith International, Inc., and Dresser Industries, Inc., Civil Action No. 91-H-627. In September 1992, the district court certified the case as a class action. The class consisted of direct purchasers of rock bits from defendants in the period September 1, 1986, through January 15, 1992. On August 27, 1993, without admitting any form of liability, the Company entered into an agreement with the plaintiffs to settle all claims against the Company. The Company recorded a special charge of $19.9 million to cover the cost of the settlement of $16.8 million and related estimated legal fees and other costs and expenses. On October 28, 1993, an order was entered which gave final approval to this settlement. Chevron USA Inc., which opted not to be part of the above mentioned class action, filed suit against the Company in the United States District Court for the Southern District of Texas, Houston Division, entitled Chevron USA Inc., acting by and through its division Chevron USA Production Company v. Baker Hughes, Inc., Reed Tool Company a/k/a Baker RTC, Inc., CAMCO International, Inc., Smith International, Inc. and Dresser Industries, Inc. Cause No. H-93-949, alleging violations of Section 1 of the Sherman Act. This case is in its early phase; little formal discovery has occurred; and docket call for the trial of this matter has been set for January 26, 1996. Management believes that the resolution of this matter will not have a material adverse effect on the Company's financial position or results of operations. Executive Life On March 4, 1992, the Company was served with a complaint in the U.S. District Court in the Central District of California, entitled Lynn Martin, Secretary of the U.S. Dept. of Labor v. Smith International, Inc., et al., Case No. CV-92-1196. The complaint alleges violations of the Employee Retirement Income Security Act of 1974 ("ERISA") arising out of the Company's purchase of annuities from Executive Life Insurance Company("Executive Life"), upon the termination of its Pension Plan in August 1985. The Department of Labor ("DOL") filed the lawsuit in order to prevent the expiration of the statute of limitations while it completed its investigation of the Company's purchase of annuities from Executive Life. In 1993, Executive Life emerged from a conservatorship proceeding in California state court. The Company believes that it properly discharged its legal responsibilities with regard to the purchase of annuities from Executive Life and, consequently, that uninsured losses of the Company, if any, resulting from the DOL claims will not be material. Superfund The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (the "Superfund Act") generally addresses remedial action at sites from which there has been a "release" of "hazardous substances." Among other things, the Superfund Act authorizes the U.S. Environmental Protection Agency (the "EPA") to take any necessary response actions at these sites and, in certain circumstances, to order those parties liable for the "release" to take response actions. The EPA may seek reimbursement of expenditures of federal funds from parties potentially liable under the Superfund Act. Relevant court decisions have interpreted the Superfund Act to impose strict, joint and several liability upon all persons liable for response costs under the statute with respect to a particular site, if the harm at such site is indivisible. The Superfund Act requires the EPA to develop a National Priorities List ("NPL") of sites which are the most deserving of prompt investigation and remediation. At present, there are approximately 1,000 sites nationwide on the NPL. The Sheridan Site. On March 31, 1987, the Sheridan Site Committee (the "Committee") filed a claim in the Company's Chapter 11 case on behalf of itself and 59 potentially responsible parties ("PRPs") at the Sheridan Disposal Services site in Hempstead, Texas, an NPL site. The claim was based on the Company's alleged liability to the claimants for "contribution and potential cost recovery for administrative and remedial work" expenses incurred and to be incurred by them in connection with the Sheridan Disposal site. On August 28, 1987, the Company reached a settlement with the Committee. The Committee agreed to withdraw its proof of claim. In return, the Company agreed to pay its allocable share of response costs incurred by the Committee, such share to be limited to the lesser of $3 million or 2.93% of actual response costs. The Company's obligations pursuant to the settlement agreement with the Committee were not discharged or affected by confirmation of the Company's plan of reorganization. The settlement agreement with the Committee further provides that payments by the Company will be made on the same basis and at the same time as they are made by members of the Committee whose members have recently agreed to enter into a judicial consent decree under which they will complete the remedies selected by EPA under its Record of Decision (the "ROD"), issued in December 1988 and supplemented in September 1989. Based upon the ROD, total remediation costs are estimated, on a preliminary basis, to be approximately $28 million. On this basis, the Company's share would be $0.8 million. On October 4, 1989, the Company entered into a Sheridan Site Trust Agreement together with 37 other PRPs, providing a mechanism for the disbursement of funds in connection with remedial action to be performed at the Sheridan Site. Remediation efforts and expenditures at the Sheridan Site will likely extend over the next five years. The OII Site. Under the Superfund Act, the EPA has been conducting various activities at the Operating Industries, Inc. ("OII") site, a disposal site on the NPL located in Monterey Park, California. The United States, on behalf of the EPA, filed a proof of claim in the Company's Chapter 11 case alleging that it had incurred approximately $8 million in response costs to date, and would continue to incur response costs in the future. Subsequently, the United States alleged that its costs had increased to over $10 million. In addition to the United States, 21 other PRPs for cleanup of the OII site also filed proofs of claim against the Company's estate for contribution or indemnity arising from any claims asserted against them by the United States for response costs. The Company objected to the claims of the United States and the PRPs. On June 14, 1988, the United States District Court entered an order approving a Stipulation and Agreement to Compromise and Settle EPA's claim against the Company's estate (the "OII Settlement Agreement"). Under the OII Settlement Agreement, the claim of the United States was allowed as an amount (approximately $150,000) sufficient to entitle the EPA to a distribution pursuant to the Company's plan of reorganization. The Company further agreed to pay its allocable share of total future site response costs at the OII site, such share, however, to be limited to the lesser of $5 million or 0.65% of future site response costs. On July 15, 1988, the District Court entered a further order withdrawing and dismissing the general unsecured claims of the 21 potentially responsible parties and their requests for payment of administrative expenses. The EPA has issued three ROD's with respect to the OII Site and remediation work under RODs I and II has commenced. The Company may be requested to make interim contributions with respect to these RODs. The EPA issued ROD III with respect to landfill gas control and landfill cover on September 30, 1990. This ROD includes net present work cost estimates for the work covering 30, 45 and 60 years of project life. The EPA has estimated the cost of this work to exceed $100 million. Because of the time span involved in the remedy, EPA is working with certain parties on a South West Early Action Plan ("SWEAP") designed to address landfill gas issues in the southwestern portion of the OII landfill, which is near several homes. The cost of the final long-term remedy for the clean-up of the OII site is presently unknown and depends on the nature and extent of contamination at the site and the remedy which is ultimately selected. The EPA is still preparing its Remedial Investigation and Feasibility Study ("RI/FS") which will examine the various alternatives for a final remedy of the site;and anticipates that the RI/FS may be completed by mid-1994. Actual remediation expenditures will likely extend for a number of years after a final remedy is selected for the site, subsequent to completion of the RI/FS. At this time, the Company is unable to determine the amount it may ultimately have to contribute to the OII site pursuant to the OII settlement agreement. This amount will range from the approximately $150,000 that the Company has already paid to the $5.0 million at which the Company's liability is capped under the OII settlement agreement. The Chemform Site. Chemform, Inc. ("Chemform"), a former wholly owned subsidiary of the Company and, subsequently, the Company itself, operated a business and held a leasehold interest in property located in Pompano Beach, Florida (the "Chemform Site") between May 14, 1976 and March 16, 1979, at which time the Company sold the Chemform business and assigned the lease. The EPA has been conducting various activities at the Chemform Site under the Superfund Act and placed the Chemform Site on the NPL on October 4, 1989. In October 1989, the Company, along with three other PRPs at the Chemform Site, entered into a consent agreement with the EPA for the preparation of an RI/FS. An Amendment to that consent agreement, which became effective on April 7, 1992, specified that the RI/FS for the Chemform Site would be addressed in two operable units: Operable Unit One addresses Site-related groundwater contamination, and Operable Unit Two addressed source and soil contamination. On September 22, 1992, the EPA issued the ROD for Operable Unit One at the Site. The ROD selected a "No Action with Monitoring" alternative, under which groundwater would be monitored quarterly for at least one year. On July 13, 1993, the Company, along with two other PRPs and the EPS, executed an Administrative Order on Consent ("AOC") and Scope of Work ("SOW") which will govern the implementation of the ROD for Operable Unit One at the Chemform Site. Under the terms of the AOC and SOW, the Company, along with two other PRPs, agree to undertake the groundwater monitoring work specified in the AOC and SOW. In the ROD, EPA estimated the costs of constructing the required groundwater wells and the cost of one year of groundwater monitoring to be approximately $0.1 million. On September 16, 1993, EPA issued the ROD for Operable Unit Two at the Chemform Site, which addresses site-related soil contamination. The ROD determined that no further Superfund action is necessary to address Operable Unit Two at the site; however, the State of Florida, as represented by the Florida Department of Environmental Protection, has not yet concurred in the ROD for Operable Unit Two. It is not known whether the State of Florida will do so, or whether any further proceedings will be required due to the State's lack of concurrence. The Company believes that the EPA will demand reimbursement of certain oversight expenses that the EPA allegedly has incurred in administering the Chemform site. The Company intends to scrutinize and, if necessary, vigorously contest any such claims made by the EPA. As of December 31, 1990, the Company recorded a $5.0 million provision for its estimated liability for clean-up of all of the Company's environmental matters that were known at that time including the estimated costs to be incurred regarding the Superfund sites discussed above. In 1993, 1992 and 1991, the Company paid for various clean-up activities and recorded additional provisions charged to continuing operations of $0.5 million, $0.4 million and $0.8 million, respectively, and a provision of $1.5 million charged to the gain on sale of DDS operations based on revised estimates of required future clean-up costs. At December 31, 1993, the remaining recorded liability for estimated future clean-up costs for the sites discussed above as well as properties currently or previously owned or leased by the Company was $3.6 million. As additional information becomes available, the Company may be required to provide for additional environmental clean-up costs for Superfund sites and for properties currently or previously owned or leased by the Company. However, the Company believes that none of its clean-up obligations will result in liabilities having a material adverse effect on the Company's consolidated financial position or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT (a) The names and ages of all executive officers of the Company, all positions and offices with the Company presently held by each person named and their business experience during the last five years are stated below. Positions, unless otherwise specified, are with the Company. (b) All officers of the Company are elected annually by the Board of Directors at the meeting of the Board of Directors regularly held immediately following the annual meeting of shareholders. They hold office until their successors are elected and qualified. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. The Common Stock of the Company is traded on the New York Stock Exchange and the Pacific Stock Exchange. The following are the high and low sale prices for the Company's Common Stock as reported on the New York Stock Exchange Composite Tape for the periods indicated. On March 4, 1994, the Company had approximately 5,380 Common Stock holders of record and the last reported closing price on the New York Stock Exchange Composite Tape was $10.50. The Company has not paid dividends on its Common Stock since the first quarter of 1986. The Company's indenture relating to its long-term debt contains covenants restricting the payment of cash dividends to the Company's common Stockholders based on net earnings and operating cash flow formulas as defined in the indenture. In addition to compliance with the indenture, the determination of the amount of future cash dividends to be declared and paid on the Common Stock, if any, will depend upon the Company's financial condition, earnings and cash flow from operations, the level of its capital expenditures, its future business prospects and other factors that the Board of Directors deem relevant. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - --------------- (a) In March 1993, the Company sold its DDS business to Halliburton resulting in income from discontinued operations of $73.6 million. This amount includes the gain from the sale of the DDS business of $80.1 million. As a result, the financial data for the periods 1989 through 1992 has been restated to report the results of the DDS business as discontinued operations. The Company used a portion of the proceeds from the DDS sale to repay its bank debt and $49.0 million of notes payable to insurance companies. The Company's remaining debt, totaling $46.0 million, is presented as long-term debt at December 31, 1993 and 1992. See Notes 2 and 6 of Notes to Consolidated Financial Statements. (b) In September 1993, the Company agreed to settle a class action civil lawsuit which alleged violations of Section 1 of the Sherman Act. As a result, the Company recorded a special charge of $19.9 million to cover the cost of the settlement and related legal fees and other costs and expenses. See Note 16 of Notes to Consolidated Financial Statements. (Notes continued on following page) (c) During the first quarter of 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." As a result of adopting SFAS No. 106, the Company recorded the total outstanding liability related to such retiree benefits of $1.3 million as the cumulative effect of a change in accounting principle in the Consolidated Statements of Operations. See Note 11 of Notes to Consolidated Financial Statements. (d) In 1991, the Company recorded $22.2 million of non-recurring charges related primarily to the restructuring of its worldwide operations in response to a decline in U.S. drilling activity. The non-recurring charges consisted of $21.2 million of charges related to the restructuring and an additional $1.0 million tax provision to reflect expected tax settlements of prior year foreign tax liabilities of certain of the Company's subsidiaries. The amount of restructuring charges related to the continuing operations of the Company of $18.4 million in 1991 was charged to income (loss) from continuing operations before interest and taxes. The amount of restructuring charges related to the DDS business of $2.8 million is recorded in the results of discontinued operations in 1991. See Notes 3 and 8 of Notes to the Consolidated Financial Statements. (e) In 1991, the Company paid off its Series B Notes totaling $44.7 million from the $50.0 million proceeds of its temporary warrant reduction offers and its issuance of 992,000 shares of additional common stock. See Notes 6 and 9 of Notes to Consolidated Financial Statements. (f) In accordance with APB No. 11, the Company recognized an extraordinary tax credit of $7.5 million in 1990 resulting from utilization of operating loss carryforwards of which approximately $5.2 million related to continuing operations. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Substantially all of the products and services of the Company are used in the process of drilling an oil or natural gas well. Consequently, drilling activity is closely followed by the oil service industry as it is an indicator of the overall market demand for the Company's products and services. Although the average active drilling rig count is one indicator of the Company's potential market, another important factor is the mix of natural gas and oil wells being drilled. During 1993, the United States average rig count increased by 5.0% from 1992 activity levels while the 1993 international average rig count increased slightly from 1992 levels. The United States drilling activity rebounded from the record low activity levels experienced during 1992 as a result of the improvement in natural gas prices experienced during 1993. Although the average international rig count did not change substantially from 1992 levels, there were significant activity changes between international drilling markets, as all international areas experienced drilling activity declines except Canada and the Middle East. Management anticipates drilling activity in 1994 to approximate 1993 activity levels and intense competition to continue. Some additional drilling for natural gas is expected to occur during 1994 in the Gulf of Mexico region of the U.S. due to the increase in natural gas prices during the prior year, the decline in natural gas reserves and the general emphasis utilizing natural gas as an environmentally preferred fuel. Management believes that the Company is well positioned to benefit from increases in worldwide oil and gas exploration drilling which may develop in 1994 and beyond and that greater drilling activity will positively impact the Company's results in the future. SALE OF DIRECTIONAL DRILLING BUSINESS On March 29, 1993, the Company sold its directional drilling systems and services (DDS) business and certain of its subsidiaries and other affiliates to Halliburton Company (Halliburton) for 6,857,000 shares of Halliburton common stock. In April 1993, the Halliburton common stock was sold for $247.7 million. As a result, the Company recorded income from discontinued operations of $73.6 million including the gain from the sale of the DDS business of $80.1 million. The gain includes provisions for various fees, expenses and taxes related to the DDS sale. The DDS business reported revenues of approximately $36.3 million in the first three months of 1993, $158.7 million in 1992 and $151.1 million in 1991. The Company used a portion of the proceeds of the DDS sale to repay certain debt of the Company. For further discussion, refer to "Liquidity and Capital Resources" below. ACQUISITIONS OF A-Z/GRANT AND LINDSEY On December 22, 1993, the Company acquired the product line assets of A-Z International, Grant Oilfield Tools and Lindsey Completion Systems (A-Z/Grant and Lindsey) from Masex Energy Services Group, Inc. for $19.0 million in cash. A-Z/Grant and Lindsey are leading providers of downhole tools, remedial services and liner hangers to the oil and gas industry. A-Z/Grant and Lindsey reported unaudited revenues of $31.6 million in 1993, $29.0 million in 1992, and $31.0 million in 1991. The acquisition was accounted for as a purchase effective December 22, 1993. The results of A-Z/Grant and Lindsey from December 22, 1993 to December 31, 1993 were not significant to the operations of the Company. ACQUISITION OF M-I DRILLING FLUIDS COMPANY IN 1994 Effective February 28, 1994, the Company acquired a 64% interest in M-I Drilling Fluids Company (M-I) from Dresser Industries, Inc. (Dresser) for $160 million. M-I was owned 64% by Dresser and 36% by Halliburton prior to the acquisition. M-I is a leading provider of environmentally sensitive drilling fluids and systems to the oil and gas drilling industry. The Company purchased the 64% interest in M-I using $80 million of its cash and issuing a note payable to Dresser for $80 million due on August 28, 1994. The acquisition will be accounted for as a purchase. M-I reported unaudited revenues of $405.8 million in 1993, $382.6 million in 1992 and $435.5 million in 1991. PRO FORMA DATA The unaudited pro forma revenues and income from continuing operations for the year ended December 31, 1993 assuming the acquisitions of A-Z/Grant and Lindsey and M-I had been made on January 1, 1993 are as follows: Refer to page 22 for a more complete presentation of the unaudited pro forma statement of income (loss) from continuing operations and unaudited pro forma balance sheet. RESULTS OF OPERATIONS Revenues The tools and equipment manufactured and the services provided by the Company fall into two major product and service groups that are marketed throughout the world. The following table sets forth the amounts and percentages of revenues by major product group and by area: Drill Bits Drill bit revenues are generated from the sale of petroleum drill bits and mining bits. Petroleum drill bit revenues increased $18.3 million or 14.4% from $127.5 million in 1992 to $145.8 million in 1993 due primarily to higher sales and improved pricing in the United States and Canada resulting from the increase in North American drilling activity and increased sales into the former Soviet Union. These increases were partially offset by reduced sales in the North Sea area due to lower drilling activity and reduced volume in Mexico and Italy. Petroleum drill bit revenues declined $18.0 million or 12.4% from $145.5 million in 1991 to $127.5 million in 1992 due primarily to the decline in worldwide drilling activity, principally in the U.S. and Canada, and price reductions resulting from competitive pressures. This decrease was partially offset by an increase of 16.0% in diamond bit sales. Mining drill bit revenues decreased $1.5 million or 8.3% from $18.0 million in 1992 to $16.5 million in 1993 due to reduced sales to Canadian iron ore producers. Mining drill bit revenues decreased $2.6 million or 12.6% from $20.6 million in 1991 to $18.0 million in 1992 due to lower domestic and export activity. Drilling and Completion Services Drilling and completion services revenues decreased $6.8 million or 10.4% from $65.2 million in 1992 to $58.4 million in 1993 due to lower international drilling activity primarily in the Europe/Africa region, the Middle East and Mexico. These declines were partially offset by increased sales in Canada. Drilling and completion services revenues decreased $20.7 million or 24.1% from $85.9 million in 1991 to $65.2 million in 1992 due to reduced worldwide drilling activity, primarily the U.S., and lower sales in Australia, the Middle East, Africa and the United Kingdom. The Company also discontinued its inspection business in the United Kingdom and closed certain service centers in the U.S. in 1992. For the periods indicated, the following table summarizes the results of continuing operations of the Company and presents results as a percentage of total revenues of the continuing operations: 1993 Versus 1992 Revenues for 1993 increased $10.0 million or 4.7% from $210.7 in 1992 to $220.7 in 1993. Revenues in the United States and Canada increased due primarily to increased drilling activity. These increases were partially offset by lower revenues outside of North America due to lower drilling activity. Domestic revenues increased $16.2 million, or 18.4%, from $88.2 million in 1992 to $104.4 million in 1993 due to a 5.0% increase in the average U.S. rig count and improved pricing. International revenues decreased by $6.2 million or 5.1% from $122.5 million in 1992 to $116.3 million in 1993 due to the 9.7% decline in international drilling activity which was partially offset by revenues in Canada and the former Soviet Union. Product sales increased $10.4 million or 6.2% from $166.6 in 1992 to $177.0 million in 1993 due primarily to the increase in drilling activity in the United States and Canada partially offset by lower sales in the North Sea, the Middle East and Mexico. Rentals, services and other revenues decreased $0.4 million or 0.9% from $44.1 million in 1992 to $43.7 million in 1993 as a result of lower drilling activity in the Europe/Africa region and the Middle East. Gross profit increased $8.4 million or 11.3% from $74.1 million in 1992 to $82.5 million in 1993. Gross profit on product sales increased $5.7 million or 8.5% from $66.9 million in 1992 to $72.6 million in 1993 due to higher sales and improved pricing in the United States and Canada. Gross profit on rentals, services and other revenues increased $2.7 million or 37.5% from $7.2 million in 1992 to $9.9 million in 1993 due to lower operating costs in the United States and Canada. Operating expenses, comprised of selling expenses and general and administrative expenses, increased by $0.1 million or 0.2% from $63.8 million in 1992 to $63.9 million in 1993. The increase was due primarily to higher variable selling expenses relating to the higher North American sales and higher legal expenses associated with the drill bit litigation. These increases were reduced by lower personnel levels due to cost reduction actions and lower foreign currency translation losses. Operating expenses as a percentage of revenues decreased from 30.3% in 1992 to 29.0% in 1993. On August 27, 1993, without admitting any form of liability, the Company entered into an agreement to settle a class action civil lawsuit pending in the federal district court in Houston. The lawsuit alleged that the Company and other defendants violated Section 1 of the Sherman Act. The Company recorded a special charge of $19.9 million to cover the cost of the settlement and related estimated legal fees and other costs and expenses. On October 28, 1993, an order was entered which gave final approval to this settlement. Interest expense decreased $4.6 million or 43.4% from $10.6 million in 1992 to $6.0 million in 1993 due to the refinancing of long-term debt in the fourth quarter of 1992 and the repayment of debt from the proceeds of the DDS sale. Interest income increased due to a higher level of short-term investments resulting from the investment of the proceeds of the DDS sale. The tax provision of $0.5 million for 1993 consists primarily of foreign taxes on income. The tax benefit of $1.0 million in 1992 relates primarily to a $2.5 million benefit related to the settlement of a U.S. tax claim with the IRS. The Company provides for U.S. taxes at the statutory rate offset by tax benefits related to the U.S. net operating loss (NOL) carryforwards, available to the Company as well as foreign taxes. During 1993, the Company adopted Statement of Financial Accounting Standard No. 109 for accounting for income taxes. The adoption did not materially affect the 1993 results. 1992 Versus 1991 Revenues for 1992 decreased $41.3 million or 16.4% from $252.0 million in 1991 to $210.7 million in 1992 due primarily to an 11.5% decline in the average worldwide rig count. International revenues decreased $19.3 million or 13.6% from $141.8 million in 1991 to $122.5 million in 1992 due primarily to lower Canadian drilling activity, lower volume in the Middle East, France, the U.K. and Australia and reduced revenues in the Far East due to increased competition and pricing pressure. Domestic revenues decreased $22.0 million, or 20.0%, from $110.2 million in 1991 to $88.2 million in 1992 due to a 16.2% decline in the average U.S. rig count and competitive pricing pressures. Product sales decreased $28.5 million or 14.6% from $195.1 million in 1991 to $166.6 million in 1992 due primarily to the decline in U.S. and Canadian drilling activity and competitive pricing pressures in the U.S. and Far East. Rentals, services and other revenues decreased $12.8 million or 22.5% from $56.9 million in 1991 to $44.1 million in 1992 due to reduced U.S. drilling activity, lower demand in Africa, Australia and the Middle East and the closing of certain service centers in the United States and the discontinuance of the inspection business in the United Kingdom. Gross profit decreased $25.9 million or 25.9% from $100.0 million in 1991 to $74.1 million in 1992. Gross profit on product sales decreased by $23.8 million or 26.2% from $90.7 million in 1991 to $66.9 million in 1992 due to lower volumes in aforementioned areas and competitive pricing pressures principally in the U.S. and Far East. Gross profit on rentals, services and other revenues decreased by $2.1 million or 22.6% from $9.3 million in 1991 to $7.2 million in 1992 due primarily to lower U.S., Australia and the United Kingdom revenue levels. Operating expenses, comprised of selling expenses and general and administrative expenses, decreased by $7.1 million or 10.0% from $70.9 million in 1991 to $63.8 million in 1992. This decrease was due primarily to lower variable selling expenses associated with reduced revenues offset by currency translation losses in 1992 compared to currency translation gains in 1991. Operating expenses as a percentage of revenues increased from 28.1% in 1991 to 30.3% in 1992. In 1991, the Company recorded $22.2 million of non-recurring charges related primarily to the restructuring of its worldwide operations in response to the decline in U.S. drilling activity. The non-recurring charges consisted primarily of $21.2 million of restructuring charges composed of $9.9 million for estimated severance and relocation costs, a writedown of $5.7 million related to fixed assets of closed and downsized locations, a provision of $3.7 million to expense certain manufacturing inefficiencies and $1.9 million related to other non-recurring restructuring charges. The Company also recorded an additional $1.0 million tax provision to reflect expected tax settlements of prior year foreign tax liabilities of certain of the Company's subsidiaries. The amount of restructuring charges related to the continuing operations of the Company of $18.4 million was charged to income from continuing operations before interest and taxes. The amount of the restructuring charges related to the DDS business in 1991 of $2.8 million was recorded in the results of discontinued operations. The $1.0 million tax provision was charged against continuing operations. Interest expense decreased $3.2 million or 23.2% from $13.8 million in 1991 to $10.6 million in 1992 due primarily to lower long-term debt resulting from the repayment of the Series B Notes in December, 1991, the refinancing of long-term debt in the fourth quarter of 1992 and lower short-term interest rates. Interest income decreased $0.5 million or 50.0% from $1.0 million in 1991 to $0.5 million in 1992 due primarily to lower short-term interest rates. The tax benefit of $1.0 million at December 31, 1992 relates primarily to a $2.5 million benefit related to the settlement of a U.S. tax claim with the IRS. See Note 8 to the Notes to Consolidated Financial Statements. The Company provides for U.S. taxes at the statutory rate offset by tax benefits related to the U.S. NOL carryforwards available to the Company as well as foreign taxes. In addition to the $1.0 million foreign tax provision discussed above, the tax provision of $2.9 million at December 31, 1991 provides for U.S. taxes at the statutory rate offset by tax credits related to the U.S. NOL carryforwards available to the Company as well as foreign taxes. During 1991, the Company adopted Statement of Financial Accounting Standard No. 96 for accounting for income taxes. The adoption did not materially affect the 1991 results. LIQUIDITY AND CAPITAL RESOURCES General The Company's cash position at December 31, 1993 totaled $101.6 million or an increase of $85.3 million from the Company's cash position at December 31, 1992. The Company's current ratio increased to 3.20 to 1 at December 31, 1993 from 1.77 to 1 at December 31, 1992. The improvement in cash and the current ratio arises due to proceeds received from the sale in 1993 of the DDS business to Halliburton offset by debt repayment of $102.6 million, payments of $19.9 million related to a litigation settlement and the payment of $19.0 million to acquire A-Z/Grant and Lindsey. The Company was required to repay its bank debt in connection with the DDS sale. The Company also granted options which expired on July 23, 1993 to its insurance company lenders for early repayment of their debt at a reduced make whole premium. On April 12, 1993, the Company used a portion of the proceeds of the DDS sale to retire its domestic credit facility totaling $37.2 million, its domestic bank term loan totaling $16.4 million and $39.0 million of notes payable with insurance companies. On July 23, 1993, the Company repaid an additional $10.0 million of notes payable with insurance companies. The Company's remaining debt totaling $46.0 million at December 31, 1993 is classified as long-term. The accompanying December 31, 1992 balance sheet has also been restated to classify the $46.0 million of debt as long-term. The Company has renegotiated its loan agreements with the insurance companies to amend certain financial covenants as well as to release the collateral under the loan indenture. The Company was in compliance with its loan covenants under the amended loan indenture at December 31, 1993. See Note 6 of the Notes to Consolidated Financial Statements. Certain of the Company's foreign subsidiaries have short-term lines of credit with various foreign banks totaling approximately $1.7 million. At December 31, 1993, the Company had borrowed $0.7 million under these lines. The majority of these lines are unsecured. The Company has annual interest requirements of approximately $4.5 million under its existing long-term debt. The Company's indenture relating to its long-term debt contains covenants restricting the payment of cash dividends to the Company's common stockholders based on net earnings and operating cash flow formulas as defined in the indenture. The Company has not paid dividends on its Common Stock since the first quarter of 1986. In addition to compliance with the covenants of the indenture, the determination of the amount of future cash dividends to be declared and paid on the Common Stock, if any, will depend upon the Company's financial condition, earnings and cash flow from operations, the level of its capital expenditures, its future business prospects and other factors that the Board of Directors deem relevant. On March 2, 1994, the Company used $80.0 million of its cash and issued a note payable totaling $80.0 million to Dresser to acquire its 64% interest in M-I. The note payable to Dresser bears interest at LIBOR +2% and is due on August 28, 1994. The Company has commitments to refinance the Dresser note payable with a $40 million term loan from its insurance company lenders and a $65 million revolving line of credit from a bank group. The term loan will bear interest at 6.02 percent and be payable over a period ending in January 1998. The revolving line of credit will be due in March 1997 and bear interest at a rate ranging from LIBOR + 3/4 percent to LIBOR +1 1/2 percent based upon the debt-to-total capitalization of the Company. Management believes that such financing will be completed by the end of March 1994. The Company believes that it has sufficient existing manufacturing capacity to meet current demand for its products and services. Projected capital expenditures in 1994, excluding M-I capital expenditures, will approximate $14 million. The Company currently expects to be able to meet its ongoing working capital and capital expenditure requirements from existing cash on hand, operating cash flow and existing credit facilities or credit facilities to be arranged as discussed above. The Company has been named as a potentially responsible party in connection with three sites on the U.S. Environmental Protection Agency's National Priorities List. At December 31, 1993, the remaining recorded liability for estimated future clean-up costs for Superfund sites as well as properties currently or previously owned or leased by the Company was $3.6 million. As additional information becomes available, the Company may be required to provide for additional environmental clean-up costs. However, the Company believes that none of its clean-up obligations will result in liabilities having a material adverse effect on the Company's consolidated financial position or results of operations. See Item 3. "Legal Proceedings -- Superfund" for further discussion. Because of its substantial foreign operations, the Company is exposed to currency fluctuations and exchange risks. The Company tries to limit these risks by matching, to the extent possible, assets and liabilities denominated in foreign currencies and using hedging instruments to cover certain unmatched positions. Inflation has not had a material effect on the Company in the last few years, and the effect is expected to be minor in the near future. In general, the Company has been able to offset most of the effects of inflation through productivity gains, cost reductions, and price increases. Net Operating Loss Carryforwards As of December 31, 1993, for U.S. tax reporting purposes, the Company had NOL carryforwards of approximately $148.5 million, expiring between 2001 and 2007, which should be available to offset future U.S. taxable income. Upon certain changes in equity ownership of the Company, however, the Company's ability to utilize its NOL carryforwards may become subject to limitation under Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"). Management believes that the application of Section 382 will not materially limit the availability of the NOL carryforwards. UNAUDITED PRO FORMA FINANCIAL STATEMENTS The following unaudited pro forma statement of income (loss) from continuing operations for the year ended December 31, 1993 presents the acquisitions of M-I and A-Z/Grant and Lindsey as though the acquisitions were effective January 1, 1993. The unaudited pro forma statement of income (loss) from continuing operations gives effect to the acquisitions under the purchase method of accounting and the assumptions included in the accompanying unaudited notes to pro forma financial statements. The unaudited pro forma statement of income (loss) from continuing operations reflect the amortization of estimated goodwill, additional depreciation expense related to the estimated write-up of fixed assets and rental tools of A-Z/Grant and Lindsey and estimated adjustments to interest, taxes and minority interest. The following unaudited pro forma balance sheet as of December 31, 1993 presents the acquisition of M-I as if the acquisition had occurred at December 31, 1993. The unaudited pro forma balance sheet reflects the acquisition under the purchase method of accounting and the assumptions included in the accompanying unaudited notes to pro forma financial statements. The unaudited pro forma balance sheet reflects only those adjustments relating to the acquisition of M-I, the consolidation of the Company's 64% interest in M-I and certain estimated asset and liability valuation adjustments anticipated to result from the Company's allocation of the purchase price to the accounts of M-I at February 28, 1994. Management has not fully evaluated all of the consequences of the acquisition of M-I including assessing the fair market value of the assets acquired and the total amount of costs that may be necessary to consolidate the operations of M-I with the Company. As a result, the current estimate of the excess of the purchase price over net assets acquired in the acquisition of M-I totaling $51.2 million has been reflected as goodwill in the unaudited pro forma balance sheet. Upon completion of these evaluations during 1994, any additional asset and liability adjustments and the adjusted excess purchase price over net assets acquired will be recorded in accordance with purchase accounting rules and principles. The unaudited pro forma financial statements are not intended to be indicative of the results that would have occurred if the acquisitions had been effective as of the dates indicated or that may be obtained in the future. The unaudited pro forma financial statements should be read in conjunction with the Consolidated Financial Statements and notes thereto of the Company included elsewhere in this Form 10-K. SMITH INTERNATIONAL, INC. UNAUDITED PRO FORMA STATEMENT OF INCOME (LOSS) FROM CONTINUING OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) See accompanying unaudited notes to pro forma financial statements. SMITH INTERNATIONAL, INC. UNAUDITED PRO FORMA BALANCE SHEET AS OF DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) See accompanying unaudited notes to pro forma financial statements. SMITH INTERNATIONAL, INC. UNAUDITED NOTES TO PRO FORMA FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) STATEMENT OF INCOME (LOSS) FROM CONTINUING OPERATIONS -- (a) To reclassify M-I freight expenses from selling expense to cost of sales to be consistent with the policies of the Company. (b) To record annual amortization of goodwill which will be amortized over 40 years (c) To record additional depreciation expense as a result of adjustments to increase the book value of the A-Z/Grant and Lindsey rental tools and property and equipment to estimated fair value and depreciate the assets over the estimated remaining lives of the respective assets. (d) To record annual amortization of debt issuance costs which will be amortized over the 4 year life of the debt. (e) To record interest expense at an interest rate of 6.0 percent on the acquisition-related debt, as refinanced (see Note j below), assuming no principal reduction. (f) To reduce interest income at an interest rate of 4.0 percent as approximately $101.5 million of the Company's cash was used to fund the acquisitions and, therefore, would not have been available to earn interest income. (g) To record additional income tax expense related to the earnings of A-Z/Grant and Lindsey, the Company's portion of M-I earnings and the effects of the aforementioned adjustments at the U.S. Alternative Minimum Tax Rate of 2.0 percent. Additional taxes would not be required because of the Company's net operating loss carryforward position. (h) Income (loss) from continuing operations is presented excluding the cumulative effect of change in accounting principle. The Smith and unaudited pro forma income (loss) from continuing operations of ($3,995) and $1,652, respectively, include the special charge for a litigation settlement of $19,900 ($0.53 per common share). The Smith and unaudited pro forma income from continuing operations excluding the litigation settlement would increase to $15,905 and $21,552, respectively, or $0.40 and $0.55 per common share, respectively. The preferred stock dividends of $868 must be deducted from the applicable income (loss) from continuing operations amounts in order to compute these amounts per common share. BALANCE SHEET -- (i) The historical balance sheet of the Company includes the accounts of A-Z/Grant and Lindsey on an estimated basis acquired by the Company on December 22, 1993 for $19.0 million. Management has not fully evaluated all of the consequences of the acquisition of A-Z/Grant and Lindsey including completing the appraisals of the assets acquired and assessing the total amount of costs that may be necessary to consolidate the operations of A-Z/Grant and Lindsey with the Company. Upon completion of these evaluations, any additional asset and liability adjustments will be recorded and the excess purchase price over net assets acquired, if any, will be recorded in accordance with purchase accounting rules and principles. (j) To record the purchase of the 64% interest in M-I using $80.0 million in cash and $80.0 million in debt. The Company has reflected $10.0 million of debt as current portion of long-term debt and $70.0 million of debt as long-term because the Company has commitments to refinance the Dresser note payable with a $40 million term loan from its insurance company lenders and a $65 million revolving line of credit from a bank group. The term loan will bear interest at a rate of 6.02 percent and be payable over a period ending in January 1998. The revolving line of credit will be due in March 1997 and bear interest at a rate ranging SMITH INTERNATIONAL, INC. UNAUDITED NOTES TO PRO FORMA FINANCIAL STATEMENTS -- (CONTINUED) from LIBOR + 3/4 percent to LIBOR +1 1/2 percent based upon the debt-to-total capitalization of the Company. Management believes that such financing will be completed by the end of March 1994. (k) To record $1.8 million of estimated acquisition costs in connection with the M-I acquisition and $0.7 million of debt issuance costs in connection with the refinanced acquisition debt. (l) To eliminate the investment in M-I of $160.0 million against the Company's estimated portion of its equity in M-I of $122.7 million with the remaining balance of $37.3 million reported tentatively as goodwill. (m) To reclassify the minority interest ownership in M-I by Halliburton of $69.0 million from shareholders' equity to minority interest. (n) To record the Company's portion of the current estimate of adjustments to asset reserves and liabilities required at the acquisition date in connection with the purchase of M-I with the corresponding adjustment recorded as goodwill. Management has not fully evaluated all of the consequences of the acquisition of M-I including assessing the fair market value of the assets acquired and the total amount of costs that may be necessary to consolidate the operations of M-I with the Company. Upon completion of a full evaluation of the Company's purchase price allocation of M-I accounts, additional adjustments may become necessary to the preliminary allocation of the purchase price. The Company expects this evaluation process will be completed in 1994. [THIS PAGE INTENTIONALLY LEFT BLANK] ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Smith International, Inc.: We have audited the accompanying consolidated balance sheets of Smith International, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Smith International, Inc. and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the accompanying index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. As discussed in Note 1 to the Notes to Consolidated Financial Statements, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 96 and SFAS No. 109 "Accounting for Income Taxes" in 1991 and 1993, respectively. In 1993, the Company also adopted SFAS No. 106 "Employers Accounting for Postretirement Benefits other than Pensions". ARTHUR ANDERSEN & CO. Houston, Texas February 9, 1994, except for the subsequent event discussed in Note 2, as to which the date is March 21, 1994 SMITH INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these financial statements. SMITH INTERNATIONAL, INC. CONSOLIDATED BALANCE SHEETS ASSETS The accompanying notes are an integral part of these financial statements. SMITH INTERNATIONAL, INC. CONSOLIDATED BALANCE SHEETS LIABILITIES AND SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these financial statements. SMITH INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. SMITH INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes are an integral part of these financial statements. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ALL DOLLAR AMOUNTS IN THE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE EXPRESSED IN THOUSANDS, EXCEPT WHERE STATED IN MILLIONS) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of the Company and all of its wholly-owned domestic and international subsidiaries. All significant intercompany accounts and transactions have been eliminated. Investments in affiliates of at least a 20% interest but not more than a 50% interest are accounted for using the equity method; all other investments are carried at cost, which does not exceed the estimated net realizable value of such investments. Cash and Cash Equivalents For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. The Company's cash balance at December 31, 1993 includes $8.8 million held in escrow or otherwise restricted. Fixed Assets Fixed assets, consisting of rental equipment and property, plant and equipment, are stated at cost. The Company computes depreciation on fixed assets using principally the straight-line method. The estimated useful lives used in computing depreciation range from 3 to 40 years for buildings, 3 to 20 years for machinery and equipment, and 3 to 7 years for rental equipment. Leasehold improvements are amortized over the lives of the leases or the estimated useful lives of the improvements, whichever is shorter. For income tax purposes, accelerated methods of depreciation are used. Cost of major renewals and betterments are capitalized as fixed assets. Expenditures for maintenance, repairs and minor improvements are charged to expense when incurred. When fixed assets are sold or retired, the remaining cost and related reserves are removed from the accounts and the resulting gain or loss is included in the results of operations. Valuation of Inventories Inventories are stated at the lower of cost or market. Cost is determined by the last-in, first-out ("LIFO") method for most domestic inventories and by the first-in, first-out ("FIFO") method for all other inventories. Inventory costs consist of materials, labor and factory overhead. Translation of Foreign Currencies The accounts of all international operations, except those described in the following paragraph, are translated to United States dollars as follows: cash, receivables and related allowances, current liabilities and long-term debt are translated at year-end exchange rates; income and expense accounts, except for cost of inventory sold and depreciation and amortization are translated at average exchange rates during the year and all other accounts are translated at historical rates. All translation adjustments resulting from the translation of these financial statements to United States dollars are charged or credited to income currently. The accounts of the Company's operations in Italy are translated to United States dollars as follows: all asset and liability accounts are translated at year-end exchange rates, and income and expense items are translated at the average exchange rates during the year. Cumulative translation adjustments resulting from the translation of the financial statements of these operations to United States dollars are recorded as a separate component of shareholders' equity. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) All foreign currency transaction gains and losses are credited or charged to income currently. Foreign Exchange Contracts From time to time, the Company enters into spot and forward contracts under foreign exchange lines as a hedge against accounts payable in foreign currencies. Market value gains and losses on such forward contracts are recognized on a monthly basis, and the resulting amounts offset foreign exchange gains or losses on the related accounts payable as payments are made. The Company also purchases foreign exchange option contracts to hedge certain operating exposures. Premiums paid under these contracts are expensed over the life of the contract. Gains arising on these options are recognized at the time the options are exercised. Income Taxes In the fourth quarter of 1991, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 96, "Accounting for Income Taxes" effective January 1, 1991. This standard changed the criteria for measuring the provision for income taxes and required that a liability approach be used to report the deferred tax liability in the consolidated balance sheet. Deferred income tax assets and liabilities arise from differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements. Deferred tax balances under this standard are determined by using the tax rate expected to be in effect when the taxes will actually be paid. Under the provisions of SFAS No. 96, the Company elected not to restate prior years' consolidated financial statements and has determined that the cumulative effect of the change in accounting for income taxes was insignificant. In the first quarter of 1993, the Company adopted SFAS No. 109 "Accounting for Income Taxes". This standard superseded SFAS No. 96, "Accounting for Income Taxes" and required an asset and liability approach for financial accounting and income tax reporting. In connection with the adoption of SFAS No. 109, the Company elected not to restate prior years' consolidated financial statements and has determined that the cumulative effect of the change in accounting for income taxes was insignificant. Earnings Per Common Share Earnings per common share are computed on the basis of the weighted average number of common shares and equivalent shares outstanding during each year after deducting preferred dividends. Earnings per common share assuming full dilution, is substantially the same as primary earnings per common share as presented for each of the three years ended December 31, 1993. As the Company incurred a net loss for the years 1992 and 1991, the equivalent shares were antidilutive for those years; therefore, the equivalent shares are not included in the average number of common shares outstanding when calculating the loss per common share in 1992 and 1991. Income (loss) per common share from discontinued operations was $1.95, $(.08) and $(.16), respectively, for the years ended December 31, 1993, 1992 and 1991. The loss per common share attributable to the change in accounting principle was $(.03) for the year ended December 31, 1993. Employee Benefits During the first quarter of 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This standard changed the criteria for recognizing the cost of postretirement benefits from the pay-as-you-go (cash) basis to the recognition of such benefits over the employee service periods. As a result of adopting this standard, the Company recorded the total outstanding liability related to such retiree benefits of $1.3 million as the cumulative effect of a change in accounting principle in the consolidated statements of operations. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 2. ACQUISITIONS AND DISPOSITIONS Sale of Directional Drilling Business On March 29, 1993, the Company sold its Directional Drilling systems and services (DDS) business and certain of its subsidiaries and other affiliates to Halliburton Company (Halliburton) for 6,857,000 shares of Halliburton common stock. In April 1993, the Halliburton common stock was sold for $247.7 million. As a result, the Company recorded income from discontinued operations of $73.6 million including the gain from the sale of the DDS business of $80.1 million. The gain includes provisions for various fees, expenses and taxes related to the DDS sale. The DDS sale consisted primarily of the inventory, rental equipment and plant and equipment of the Dyna-Drill and Datadril product lines as well as certain downhole tools used in the DDS business. In addition, the Company retained approximately $23.0 million of receivables, net of payables related to the DDS business as of the date of sale. The following table summarizes the net assets as of December 31, 1992 of the DDS business sold to Halliburton in March 1993. The consolidated statements of operations reported the net results of the DDS operations as income (loss) from discontinued operations. The DDS business reported revenues of $36.3 million in the first three months of 1993, $158.7 million in 1992 and $151.1 million in 1991. In 1991, restructuring charges relating to the DDS business totalled approximately $2.8 million (See Note 3). In determining the income (loss) from discontinued operations, interest expense of $1.3 million in 1993, $5.6 million in 1992 and $7.6 million in 1991 has been allocated to the discontinued DDS operations based on the ratio of the estimated net assets sold in relation to the sum of the Company's shareholders' equity and the aggregate of outstanding debt at the end of each period. Acquisitions of A-Z/Grant and Lindsey On December 22, 1993, the Company acquired the product line assets of A-Z International, Grant Oilfield Tools and Lindsey Completion Systems (A-Z/Grant and Lindsey) from Masex Energy Services Group, Inc. for $19.0 million in cash. A-Z/Grant and Lindsey is a leading provider of downhole tools, remedial services and liner hangers to the oil and gas industry. A-Z/Grant and Lindsey reported unaudited revenues of $31.6 million in 1993, $29.0 million in 1992, and $31.0 million in 1991. This acquisition was accounted for as a purchase effective December 22, 1993. The unaudited results of A-Z/Grant and Lindsey from December 22, 1993 to December 31, 1993, were not significant to the operations of the Company. The historical balance sheet of the Company at December 31, 1993 includes the accounts of A-Z/Grant and Lindsey on an estimated basis. Management has not fully evaluated all of the consequences of the acquisition of A-Z/Grant and Lindsey including assessing the fair market value of the assets acquired and the total amount of costs that may be necessary to consolidate the operations of A-Z/Grant and Lindsey with the Company. Upon completion of these evaluations during 1994, any additional adjustments will be recorded and the excess purchase price over net assets acquired, if any, will be recorded in accordance with purchase accounting rules and principles. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Subsequent Event -- Acquisition of M-I Drilling Fluids Company Effective February 28, 1994, the Company acquired a 64% interest in M-I Drilling Fluids Company (M-I) from Dresser Industries, Inc. (Dresser) for $160 million. M-I was owned 64% by Dresser and 36% by Halliburton prior to the acquisition. M-I is a leading provider of drilling fluids and systems to the oil and gas drilling industry. The Company purchased the 64% interest in M-I using $80 million of its cash and issuing a note payable to Dresser for $80 million due on August 28, 1994. This acquisition will be accounted for as a purchase. M-I reported unaudited revenues of $405.8 million in 1993, $382.6 million in 1992 and $435.5 million in 1991. The Company has commitments to refinance the Dresser note payable with a $40 million term loan from its insurance company lenders and a $65 million revolving line of credit from the bank group. The term loan will bear interest at a rate of 6.02 percent and be payable over a period ending in January 1998. The revolving line of credit will be due in March 1997 and bear interest at a rate ranging from LIBOR + 3/4 percent to LIBOR +1 1/2 percent based upon the debt-to-total capitalization of the Company. Management believes such financing will be completed by the end of March 1994. The unaudited pro forma revenues and income from continuing operations for the year ended December 31, 1993 assuming the acquisitions of A-Z/Grant and Lindsey and M-I had been made on January 1, 1993 are as follows: 3. RESTRUCTURING CHARGES During the fourth quarter of 1991, the Company decided to restructure certain of its worldwide operations in response to the continuing decline of U.S. oil and gas drilling activity. The restructuring consisted of closing manufacturing facilities in Mexico City and Veracruz, Mexico, closing various service locations in the U.S. as well as downsizing other worldwide operations and reducing the worldwide workforce by approximately 27%. As a result of the restructuring, the Company recorded a $21.2 million unusual charge to income from continuing operations before interest and taxes in 1991 consisting of $9.9 million for estimated severance and relocation costs, a writedown of $5.7 million related to fixed assets of closed and downsized locations, a provision of $3.7 million to expense certain manufacturing inefficiencies and $1.9 million related to other non-recurring items. 4. INVENTORIES Inventories consist of the following: SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 5. ASSETS HELD FOR SALE The Company's efforts to combine manufacturing facilities and reduce operating capacity have resulted in certain excess and/or idle assets which are classified as assets held for sale. Assets held for sale are stated at the lower of cost or estimated net realizable value as of December 31, 1993 and 1992 as follows: 6. DEBT The following summarizes the Company's short-term debt and long-term debt: On October 2, 1992, the Company refinanced substantially all of its short-term and long-term debt through a private placement of debt and a new syndicated bank credit facility. The private debt offering consisted of $95.0 million of secured long-term debt repayable over a nine year period with interest at 9.83%. The secured domestic bank facility consisted of a $20.0 million three year term loan repayable in quarterly installments and a $40.0 million revolving credit facility expiring on June 30, 1995. The Company used the proceeds of the secured long-term debt, the term loan and $19.6 million of the revolving credit facility to retire the Company's $89.4 million Series A notes due December 31, 1994 with interest at 13%, a term loan of $6.5 million with interest at prime +1 3/4%, an outstanding balance of the Company's domestic credit facility of $30.5 million and $8.2 million of international lines of credit. In connection with the DDS sale, the Company was required to repay its bank debt. The Company also granted options which expired on July 23, 1993 to its insurance company lenders for early repayment of their debt at a reduced make whole premium. On April 12, 1993, the Company used a portion of the proceeds of the DDS sale to retire its domestic credit facility totaling $37.2 million, its domestic bank term loan totaling $16.4 million and $39.0 million of notes payable with insurance companies. On July 23, 1993, the Company repaid an additional $10.0 million of notes payable with insurance companies. The Company's remaining debt totaling $46.0 million at December 31, 1993 is classified as long-term. The accompanying December 31, 1992 SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) balance sheet has also been restated to classify the $46.0 million of debt as long-term. The Company has renegotiated its loan agreements with the insurance companies to amend certain financial covenants as well as to release the collateral under the loan indenture. The Company was in compliance with its loan covenants under the amended loan indenture at December 31, 1993. Certain of the Company's foreign subsidiaries have short-term lines of credit with various foreign banks totaling approximately $1.7 million. At December 31, 1993, the Company had borrowed $0.7 million under these lines. The majority of these lines are unsecured. The Company's indenture relating to its long-term debt contains covenants restricting the payment of cash dividends to the Company's common stockholders based on net earnings and operating cash flow formulas as defined in the indenture. The Company has not paid dividends on its Common Stock since the first quarter of 1986. In addition to compliance with the covenants of the indenture, the determination of the amount of future cash dividends to be declared and paid on the Common Stock, if any, will depend upon the Company's financial condition, earnings and cash flow from operations, the level of its capital expenditures, its future business prospects and other factors that the Board of Directors deem relevant. See Note 2 for a discussion of the financing of the M-I acquisition. In July 1993, the Company entered into a swap agreement with a financial institution. Under this agreement, the Company receives a fixed rate of 4.86% on $46.0 million of borrowings and pays a floating rate based on 6 month LIBOR. Management believes that the fair market value of the swap agreement at December 31, 1993 was insignificant. Interest paid during the years ended December 31, 1993, 1992, and 1991 amounted to $9.2 million, $15.7 million, and $21.3 million, respectively. 7. FINANCIAL INSTRUMENTS The carrying values of cash and cash equivalents, receivables, accounts payable and short-term debt approximate the fair market values due to the short-term maturities of these instruments. Management believes that the carrying amount of long-term debt is not materially different from the fair value using rates currently available for debt of similar terms and maturity. The Company is a party to financial instruments described below with off balance sheet risks which it utilizes in the normal course of business to manage its exposure to fluctuations in interest rates and foreign currency exchange rates. Foreign Currency Forward Contracts and Options At December 31, 1993, the Company had outstanding foreign exchange contracts as a hedge against foreign accounts totaling $11.0 million maturing at various dates during 1994. There were no significant unrecorded gains or losses on these contracts at December 31, 1993. The Company has outstanding option contracts of $5.9 million at December 31, 1993 which expire at various dates in 1994. The Company has no loss exposure under these contracts. Interest Rate Contracts The Company utilizes an interest rate swap agreement to manage its interest rate exposure. At December 31, 1993 the fair value of the agreement was insignificant. At December 31, 1993, the Company reported as part of cash and cash equivalents $16.9 million as the carrying cost of an investment fund which utilizes financial instruments to manage its interest rate exposure. During the year ended December 31, 1993, the fund's hedge account incurred a net loss of $0.3 million reducing the fair value of the fund to $16.6 million. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 8. INCOME TAXES See Note 1 regarding changes in the method in recording income taxes during 1991 and 1993. The consolidated income tax provision (benefit) relating to continuing operations are summarized as follows: Deferred taxes are principally attributable to timing differences related to depreciation expense and net operating loss (NOL) and tax credit carryforwards. Deferred taxes also include, in 1992, the net benefit resulting from a settlement of various outstanding issues with the Internal Revenue Service related to prior year audits and offsetting claims for refunds of prior year taxes and, in 1991, the recording of a $1.0 million tax provision to reflect expected settlements of prior year foreign tax liabilities of certain of the Company's subsidiaries. In 1993 and 1991, the Company reported the tax benefit of operating loss carryforwards as a reduction in the provision for income taxes in accordance with SFAS No. 109 and SFAS No. 96, respectively. The income tax provision (benefit) computed by applying the U.S. Federal statutory rate to income (loss) from continuing operations before income taxes are reconciled to the actual tax provision (benefit) as follows: SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The components of the net deferred tax liability are as follows: For U.S. tax reporting purposes, the Company has cumulative NOL carryforwards in the amount of approximately $148.5 million. These losses were generated in 1986, 1987, 1988 and 1992 in the amounts of $12.7 million, $91.3 million, $42.3 million and $2.2 million, respectively. Losses in 1986, 1987, 1988 and 1992 are available to reduce future U.S. taxable income that may be generated through the years 2001, 2002, 2003 and 2007, respectively. Upon certain changes in equity ownership of the Company, the ability to utilize NOL carryforwards becomes subject to limitation under Section 382 of the Internal Revenue Code of 1986, as amended. In the opinion of management, the application of Section 382 will not materially limit the availability of net tax loss carryforwards. Also available to reduce future U.S. income taxes are unused alternative minimum tax credits of $2.8 million and investment tax credits of $7.3 million. The investment tax credits which expire as follows: $2.8 million in 1997, $1.8 million in 1998, $1.6 million in 1999 and $1.1 million in 2000. Income taxes paid during the years ended December 31, 1993, 1992 and 1991 amounted to $0.9 million, $4.4 million, and $7.4 million respectively. The Company's foreign subsidiaries currently have undistributed earnings of $17.8 million which if repatriated would be generally sheltered from U.S. tax by NOL carryforwards and various foreign tax credits. 9. CAPITAL STOCK Preferred Stock The Company's preferred stock carried a cumulative annual dividend of 8.75% ($2.1875 per share based on a $25 value) payable quarterly and was convertible into common stock at $8 per share, subject to certain antidilution adjustments. The Preferred Stock had a liquidation preference of $25 per share plus cash equal to any accumulated and unpaid dividends, and was redeemable at the Company's option at any time at a redemption price of $25 per share plus cash equal to any accumulated and unpaid dividends, provided that the average closing price of the common stock for the 20 trading days ending on the fifth day before mailing the notice of redemption was at least 125% of the conversion price if mailed before February 10, 1994. In June 1993, the Company called the remaining shares of preferred stock for redemption in accordance with the terms of the Certificate of Designation with regard to the preferred stock. All holders of the preferred stock surrendered their shares for conversion into 2,496,250 shares of common stock of the Company. For SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) purposes of the Consolidated Statements of Cash Flows, this conversion of preferred stock to common stock is a non-cash transaction, and, therefore, is not reflected in the Consolidated Statements of Cash Flows. As of December 31, 1993, there were no shares of the preferred stock outstanding. Common Stock Warrants and Treasury Securities In November 1991, the Company raised approximately $50.0 million in equity through its temporary warrant reduction offers and the issuance of 992,000 shares of additional common stock. In connection with the temporary warrant reduction offers, 2,758,268 Class A Warrants and 3,619,596 Class B Warrants were exercised to purchase the Company's common stock at a temporarily reduced exercise price of $5.10 per Class A Warrant and $7.35 per Class B Warrant. The proceeds were used to retire the Company's then outstanding Series B Notes and accrued interest thereon totalling $46.8 million in December, 1991. At December 31, 1993, the Company has outstanding 225,520 Class A Warrants and 1,872,205 Class B Warrants to purchase common stock exercisable until February 28, 1995 at a price of $8.28 per share and $15.00 per share, respectively. During 1990, the Company issued 300,000 shares of common stock and 451,357 Class C warrants to an international subsidiary. These Class C Warrants are exercisable until February 28, 1995 at a price of $1.00 per share. The Company has recorded these warrants at their estimated value at the date of issue of $16.125 per warrant. This transaction is reflected as treasury securities in the consolidated balance sheets and consolidated statements of shareholders' equity. In June 1993, the Board of Directors approved a stock repurchase program whereby the Company may buy up to 3 million shares of its outstanding common stock. The program contemplates that the Company may, from time to time, purchase shares in the open market. This program is funded by the Company's cash balances. As of December 31, 1993, the Company had purchased 158,400 shares of common stock under the stock repurchase program at a cost of $1.3 million. These shares are reflected as treasury securities in the Consolidated Balance Sheets and Consolidated Statements of Shareholders' Equity. The Company did not make dividend payments to common stockholders during 1993, 1992 and 1991. See Note 6. 10. EMPLOYEE STOCK OPTIONS, RESTRICTED STOCK AWARDS AND STOCK APPRECIATION RIGHTS As of December 31, 1993, the Company has outstanding stock options granted under two plans: the 1989 Long-Term Incentive Compensation Plan ("1989 Plan") and the 1982 Stock Option Plan ("1982 Plan"). No further options may be granted under the 1982 Plan. Options issued in 1982, 1983, 1984 and 1985 under the 1982 Plan were cancelled and reissued effective June of 1986 at an option price which represented the fair market value on the date of reissuance. During 1991, options under the Company's 1971 Stock Option Plan lapsed. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The options, exercisable at various dates through December 2003, are conditioned upon continued employment. A summary of stock option transactions for 1993, 1992 and 1991 are as follows: Included in the 1993 grants were stock options of 199,500 shares and 240,000 shares at exercise prices of $8.38 and $10.31, respectively. These stock options vest over a four year period from the date of grant. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Included in the 1992 grants were stock options of 257,487 shares and 20,000 shares at exercise prices of $8.38 and $9.25, respectively. Of the total $8.38 stock options, the Company granted 167,497 shares in exchange for certain Stock Appreciation Rights valued at an exercise price of $10.53 - $16.09. The stock options granted at $8.38 vest over a four year period from the date of grant. The stock options granted at $9.25 were fully vested at the date of grant. Included in the 1991 grants were restricted stock options of 80,040 shares at $2.90. These options vested over a two year period from the date of grant but lapsed during 1992. In addition, as part of the 1989 Plan, the Company granted 82,540 Stock Appreciation Rights in 1991 at an exercise price range of $10.52 - $14.73 and 80,775 Stock Appreciation Rights in 1990 at an exercise price range of $12.56 - $16.09. At December 31, 1993, there were 16,508 of these rights outstanding. These rights vest over a four year period from date of grant, and are exercisable until February 2001. Upon exercise of the rights, appreciation is paid by distributing cash or shares at the option of the Company. At December 31, 1993, there were no shares of common stock reserved under the 1989 Plan for the future granting of stock options, awarding of additional restricted stock options and/or awarding of additional Stock Appreciation Rights. 11. EMPLOYEE BENEFITS The Company has non-contributory pension plans in the U.S. and U.K. Benefit accruals under the Company's U.S. pension plan, which have been frozen since 1987, covered substantially all the U.S. employees of the Company at that date. Due to the freezing of domestic pension benefits and fully funding those benefits in 1987, a contribution was not necessary for 1992 or 1991. The following tables detail the components of pension expense for the three years ended December 31, 1993, the funded status of the plans and major assumptions used to determine these amounts: SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) For 1993, the Company reduced its discount rate related to the domestic pension plan from 8.5% to 7.0% to more accurately reflect current market trends. As a result, the projected benefit obligation exceeded the fair value of the plan's assets by $2.5 million. This amount is recorded as an additional minimum liability in the Consolidated Balance Sheets at December 31, 1993. The Company has several other pension plans covering certain international employees. Pension expense for these plans totaled $0.2 million in 1993, $0.4 million in 1992 and $0.2 million in 1991. Based on the latest available actuarial valuations, total accumulated plan benefits are $2.0 million and net assets available for benefits are $2.4 million. The Company has an Employee 401(k) Plan which allows eligible participating employees to make contributions in either a Company stock fund or any one of seven mutual funds or a combination thereof. The Company contributes for all eligible employees a percentage of their qualified compensation into the Plan. Contribution percentages range from 2% for employees under the age of 40 to 6% for employees who are 60 years of age or older. Contributions to this plan by the Company totaled approximately $1.7 million in 1993 and $2.0 million for the years ended December 31, 1992 and 1991. Effective January 1, 1990, the Company also initiated an additional plan to fund a matching contribution ranging from 0% to 100% of an individual employee's 401(k) contributions based on the Company achieving a certain level of operating income as a percentage of total revenue for the year. In 1993, the Company recorded an expense of $1.2 million for this plan. No expense was required or recorded for matching contributions for 1992 or 1991 related to this plan. The Company and its subsidiaries provide certain health care benefits for retired employees. Most of the employees who retire from the Company are eligible for these benefits. The cost of postretirement health care benefits were recognized as an expense as claims were paid in 1992 and 1991. These costs totaled approximately $0.2 million in 1992 and $0.3 million in 1991. In 1990, the Financial Accounting Standards Board ("FASB") issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." During the first quarter of 1993, the Company adopted this new standard. As a result of adopting SFAS No. 106, the Company recorded the total outstanding liability related to such retiree benefits of $1.3 million as the cumulative effect of a change in accounting principle in the consolidated statements of operations. Prior to May 1, 1993, the Company had two retiree medical coverage plans. Effective May 1, 1993 the two plans were combined into one plan, the Smith International, Inc. Retiree Medical Plan. The plan provides postretirement medical benefits to retirees and their spouses. The retiree medical plan has an annual limitation (a "cap") on the dollar amount of the Company's portion of the cost of benefits incurred by retirees under the plan. The remaining cost of benefits in excess of the cap is the responsibility of the participants. For 1993, the cap was $25,000. The cap is adjusted annually for inflation, which is currently assumed to be 4 percent. The following table sets forth the plan's funded status reconciled with the amount shown in the Company's consolidated balance sheets: SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Postretirement benefit expense recognized in income from continuing operations for the year ended December 31, 1993 is summarized as follows: The health care cost trend rate assumption can have a significant effect on the amounts reported. For measurement purposes, a 12% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993. The rate was assumed to gradually decrease to 7% for 1998 and to remain at that level thereafter. An increase of one percentage point in the health care cost trend rate would not have a material effect on either the accumulated postretirement benefit obligation or the aggregate of the service and interest cost components of the postretirement benefits expense. The weighted-average discount rates used in determining the accumulated postretirement benefit obligation for 1993 and 1992 were 7.0% and 8.0%, respectively. 12. STOCKHOLDERS' RIGHTS PLAN On June 19, 1990, the Company adopted a Stockholder Rights Plan ("the Rights Plan"). The Rights Plan provides for a dividend distribution of one preferred stock purchase right ("Right") for each outstanding share of the Company's Common Stock, to shareholders of record at the close of business on June 29, 1990. The Rights Plan is designed to deter coercive takeover tactics and to prevent an acquiror from gaining control of the Company without offering a fair price to all of the Company's shareholders. The Rights will expire on June 19, 2000. Each Right entitles shareholders to buy one-hundredth of a newly issued share of Series A Junior Participating Preferred Stock of the Company at an exercise price of $50. The Rights are exercisable only if a person or group (a) acquires beneficial ownership of 20% or more of the Common Stock or (b) acquires beneficial ownership of 1% or more of the Company's Common Stock if such person or group is a 20%-or-more shareholder on the date when the Rights dividend distribution is declared or (c) commences a tender or exchange offer which upon consummation such person or group would beneficially own 20% or more of the Common Stock of the Company. However, the Rights will not become exercisable if Common Stock is acquired pursuant to an offer for all shares which a majority of the independent directors, excluding all officers of the Company, determine to be fair to and otherwise in the best interests of the Company and its shareholders. If any person or group becomes the beneficial owner of 20% or more of the Company's Common Stock, or acquires 1% or more of the Common Stock if such person or group is a 20%-or-more shareholder on the date when the Rights dividend distribution is declared, other than (in either case) pursuant to an offer for all shares as described above, then each Right not owned by such person or group or certain related parties will entitle its holder to purchase, at the Right's then current exercise price, shares of the Company's Common Stock (or, in certain circumstances as determined by the Board, cash, other property, or other securities) having a value of twice the Right's exercise price. In addition, if, after any person becomes the beneficial owner of 20% or more of the Company's Common Stock, or acquires 1% or more of the Common Stock if such person is a 20%-or-more shareholder on the date when the Rights dividend distribution is declared, the Company is involved in the merger or other business combination transaction with another person in which its Common Stock is changed or converted, or sells 50% or more of its assets or earning power to another person, each Right will entitle its holder to purchase, at the Right's then current exercise price, shares of common stock of such other person having a value of twice the Right's exercise price. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company will generally be entitled to redeem the Rights at $.01 cents per Right at any time until the tenth business day (subject to extension) following public announcement that a person has become the beneficial owner of 20% or more of the Company's Common Stock, or acquires 1% or more of the Common Stock if a 20%-or-more shareholder on the date when the Rights dividend distribution is declared. 13. SUPPLEMENTARY INCOME STATEMENT INFORMATION Amounts charged to expense for continuing operations is as follows: 14. QUARTERLY INFORMATION (UNAUDITED) Included in third quarter of 1993 results is a special charge of $19.9 million ($0.51 per common share in the third quarter and $0.53 per common share for the full year) relating to the settlement of drill bit litigation (See Note 16). Due to the conversion of the preferred stock into common stock (See Note 9) in the second quarter of 1993, the total year income (loss) per common share amounts do not equal the sum of the quarterly income (loss) per common share amounts. SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Included in the income (loss) from continuing operations and net income (loss) for the fourth quarter of 1992 is a benefit of $2.5 million to reflect the settlement of U.S. tax issues and approval of U.S. tax refund claim for prior years. For each of the quarters in 1993 and 1992, fully diluted net income (loss) per common share was the same as the respective primary net income (loss) per common share amount. 15. INDUSTRY SEGMENTS AND INTERNATIONAL OPERATIONS The Company operates primarily in one industry segment: petroleum services. The products and services of the petroleum services segment are primarily used in the drilling of oil and gas wells. The following chart sets forth information concerning the Company's continuing domestic and international operations: SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) General corporate expenses and interest income and expense have been excluded from income from continuing operations before interest and taxes in the table above. Results of operations as reported in the accompanying consolidated financial statements include general corporate expenses of $5.9 million in 1993, $5.7 million in 1992 and $4.7 million in 1991. Transfers between geographic areas are recorded by the Company and its subsidiaries based on their various intercompany pricing agreements. United States sales include $29.9 million in 1993, $27.9 million in 1992 and $33.4 million in 1991 exported to various international markets. These markets include North Sea/Europe, Africa, Middle East, Latin America, Far East/Asia, and Canada. With the exception of North Sea/Europe, neither export nor international sales to any one of these individual markets exceeded 10% of consolidated revenues. No single customer accounts for 10% or more of consolidated revenues for the periods presented. The Company's revenues are derived principally from uncollateralized sales to customers in the oil and gas industry. This industry concentration has the potential to impact the Company's exposure to credit risk, either positively or negatively, because customers may be similarly affected by changes in economic or other conditions. The creditworthiness of this customer base is strong, and the Company has not experienced significant credit losses on such receivables. 16. COMMITMENTS AND CONTINGENT LIABILITIES Leases The Company leases certain facilities and machinery and equipment under operating leases. The Company also leases certain machinery and equipment under capital leases. At December 31, 1993 and 1992, machinery and equipment included $3.0 million and $2.5 million, respectively (before accumulated amortization of $0.7 million and $0.7 million, respectively) related to capital leases. These capital leases are recorded in other current and other long-term liabilities in the accompanying consolidated balance sheets. Future minimum payments under all non-cancellable leases having initial terms of one year or more are as follows: SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Litigation In January 1991, the Company and several of the Company's competitors were served with a federal grand jury subpoena for documents, principally concerning the Company's sales, marketing and pricing activities for tri-cone rock bits produced and sold by the Company. In June 1992, Baker Hughes entered a plea of guilty to an Information charging it with a single count of violating Section 1 of the Sherman Act for the period March through May 11, 1989 and agreed to pay a $1.0 million fine to the U.S. government. On November 23, 1993, the Company entered a plea of guilty to a violation of Section 1 of the Sherman Act for the same period and paid a fine to the U.S. government of $0.7 million. After it was served the subpoena by the grand jury, the Company was served with complaints in three civil proceedings. Each action alleged violations of Section 1 of the Sherman Act. The cases were consolidated for discovery purposes with four other cases filed against other tri-cone rock bit manufacturers, but not the Company, in the Southern District of Texas, which made allegations similar to those made against the Company. The consolidated case was captioned Red Eagle Resources Corporation, Inc., et al. v. Baker Hughes, Inc., Baker Hughes Production, Inc., Hughes Tool Company, Reed Tool Company, a/k/a/ Baker RTC, Inc., Camco International, Inc., Smith International, Inc., and Dresser Industries, Inc., Civil Action No. 91-H-627. In September 1992, the district court certified the case as a class action. The class consisted of direct purchasers of rock bits from defendants in the period September 1, 1986, through January 15, 1992. On August 27, 1993, without admitting any form of liability, the Company entered into an agreement with the plaintiffs to settle all claims against the Company. The Company recorded a special charge of $19.9 million to cover the cost of the settlement of $16.8 million and related estimated legal fees and other costs and expenses. On October 28, 1993, an order was entered which gave final approval to this settlement. Chevron USA Inc., which opted not to be part of the above mentioned class action, filed suit against the Company in the United States District Court for the Southern District of Texas, Houston Division, entitled Chevron USA Inc., acting by and through its division Chevron USA Production Company v. Baker Hughes, Inc., Reed Tool Company a/k/a Baker RTC, Inc., CAMCO International, Inc., Smith International, Inc. and Dresser Industries, Inc. Cause No. H-93-949, alleging violations of Section 1 of the Sherman Act. This case is in its early phase; little formal discovery has occurred; and docket call for the trial of this matter has been set for January 26, 1996. Management believes that the resolution of this matter will not have a material adverse effect on the Company's financial position or results of operations. On March 4, 1992, the Company was served with a complaint in the U.S. District Court in the Central District of California by the U.S. Department of Labor ("DOL"). The complaint alleges violations of the Employee Retirement Income Security Act of 1974 ("ERISA") arising out of the Company's purchase of annuities from Executive Life Insurance Company("Executive Life"), upon the termination of its Pension Plan in August 1985. The DOL filed the lawsuit in order to prevent the expiration of the statute of limitations while it completed its investigation of the Company's purchase of annuities from Executive Life. In 1993, Executive Life emerged from a conservatorship proceeding in California state court. The Company believes that it properly discharged its legal responsibilities with regard to the purchase of annuities from Executive Life and, consequently, that uninsured losses of the Company, if any, resulting from the DOL claims will not be material. The Company also is named in a number of environmental legal actions related to the conduct of its business. The major actions relate to several Superfund sites including the Sheridan Disposal Services site in Hempstead, Texas, the Operating Industries, Inc. site in Monterey Park, California and the Chemform site in Pompano Beach, Florida. The Company has notified its insurance companies of potential claims for each of the above sites and coverage has been denied. The Company reached a settlement with the Sheridan Site Committee (the Committee) with respect to the Sheridan Disposal Services site in Hempstead, Texas. The Company has agreed to pay its allocable share SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) of response costs incurred by the Committee, such share to be limited to the lesser of $3.0 million or 2.93% of actual response costs. The Company has also reached a settlement with the United States Environmental Protection Agency Region IX ("EPA") with respect to the Operating Industries, Inc. ("OII") site. The Company has agreed to pay its allocable share of total future site response costs incurred, such share to be limited to the lesser of $5.0 million or 0.65% of the future site response costs incurred. As of December 31, 1993, the Company anticipates that its ultimate liability for the Sheridan and OII sites will be substantially less than these maximum amounts. Certain environmental problems may exist at the Chemform site in Pompano Beach, Florida, which is located in a highly industrialized area. The Company held a leasehold interest in this property between May 14, 1976 and March 16, 1979. On October 4, 1989, the EPA listed the Chemform site on the National Priorities List. In October 1989, the Company and three other potential responsible parties entered into an administrative consent decree order with the EPA for the preparation of the Remedial Investigation and Feasibility Study ("RI/FS"). An amendment to the consent decree specified that the RI/FS would be addressed in two operable units: Operable Unit One addresses Site-related groundwater contamination, and Operable Unit Two addressed source and soil contamination. On September 22, 1992, EPA issued the Record of Decision ("ROD") for Operable Unit One, which selected a "No Action with Monitoring" alternative, under which groundwater will be monitored for at least one year. In the ROD, the EPA estimated the costs of constructing the required groundwater wells and the cost of one year of groundwater monitoring to be approximately $0.1 million. On September 16, 1993, EPA issued the ROD for Operable Unit Two at the Chemform Site, which addresses site-related soil contamination. The ROD determined that no further Superfund action is necessary to address Operable Unit Two at the Site; however, the State of Florida, as represented by the Florida Department of Environmental Protection, has not yet concurred in the ROD for Operable Unit Two. The Company believes that the EPA will demand reimbursement of certain oversight expenses that the EPA allegedly has incurred in administering the Chemform site. The Company intends to scrutinize and, if necessary, vigorously contest any such claims made by the EPA. As of December 31, 1990, the Company recorded a $5.0 million provision for its estimated liability for the clean-up of all of the Company's environmental matters that were known at that time including the estimated costs to be incurred regarding the Superfund sites discussed above. In 1993, 1992 and 1991, the Company paid for various clean up activities and made additional provisions, charged to continuing operations, of $0.5 million, $0.4 million and $0.8 million, respectively, and a provision of $1.5 million charged to the gain on sale of DDS operations in 1993 based on revised estimates of required future clean-up costs. At December 31, 1993, the remaining recorded liability for estimated future clean-up costs for the sites discussed above as well as for properties currently or previously owned or leased by the Company totalled $3.6 million. As additional information becomes available, the Company may be required to provide for additional environmental clean-up costs for the Superfund sites and for properties currently or previously owned or leased by the Company. The Company believes that any additional unrecorded clean-up liabilities will not have a material adverse effect on the Company's consolidated financial position or the results of its operations. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information concerning directors of the Registrant, see the information set forth following the caption "ELECTION OF DIRECTORS" in the Company's definitive proxy statement to be filed no later than 120 days after the end of the fiscal year covered by this Form 10-K (the "Proxy Statement"), which information is incorporated herein by reference. For information concerning executive officers of the Registrant, see Item 4A appearing in Part I of this Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information set forth following the caption "EXECUTIVE COMPENSATION AND OTHER INFORMATION CONCERNING EXECUTIVE OFFICERS" in the Company's Proxy Statement is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth following the captions "ELECTION OF DIRECTORS" and "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" in the Company's Proxy Statement is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth following the captions "ELECTION OF DIRECTORS" and "EXECUTIVE COMPENSATION AND OTHER INFORMATION CONCERNING EXECUTIVE OFFICERS" in the Company's Proxy Statement is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) FINANCIAL STATEMENTS All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or notes thereto. (3) EXHIBITS AND INDEX TO EXHIBITS (B) REPORTS ON FORM 8-K. No reports on Form 8-K were filed during the last quarter of the period covered by this report. SMITH INTERNATIONAL, INC. SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (AMOUNTS IN THOUSANDS) SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (AMOUNTS IN THOUSANDS) See Note 1 of Notes to Consolidated Financial Statements for discussion of depreciation methods and rates. (A) Includes $10,299 and $5,505 of rental equipment and plant and equipment, respectively, related to the acquisition of A-Z/Grant and Lindsey. (B) Foreign currency translation adjustment arising from the provisions of Statement of Financial Accounting Standards Board No. 52; see Note 1 of Notes to Consolidated Financial Statements. (C) Amounts primarily represent the reclassification of certain fixed assets to assets held for sale. SMITH INTERNATIONAL, INC. SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (AMOUNTS IN THOUSANDS) SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (AMOUNTS IN THOUSANDS) See Note 1 of Notes to Consolidated Financial Statements for discussion of depreciation methods and rates. (A) Foreign currency translation adjustment arising from the provisions of Statement of Financial Accounting Standards Board No. 52; see Note 1 of Notes to Consolidated Financial Statements. (B) Includes transfer of $61,787 and $12,696 of net book value of rental equipment and plant and equipment, respectively, to net assets of DDS business sold in 1993; see Note 2 of Notes to Consolidated Financial Statements. (C) Amount represents the reclassification of certain fixed assets to assets held for sale. SMITH INTERNATIONAL, INC. SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (AMOUNTS IN THOUSANDS) SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (AMOUNTS IN THOUSANDS) See Note 1 of Notes to Consolidated Financial Statements for discussion of depreciation methods and rates. (A) Foreign currency translation adjustment arising from the provisions of Statement of Financial Accounting Standards Board No. 52; see Note 1 of Notes to Consolidated Financial Statements. (B) Amount represents a provision to writedown certain fixed assets to their estimated net realizable value and the reclassification of such items to assets held for sale. SMITH INTERNATIONAL, INC. SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (DOLLARS IN THOUSANDS) - --------------- (1) Amount represents the reclassification of certain reserves relating to long-term receivables to trade accounts receivable. SMITH INTERNATIONAL, INC. SCHEDULE IX -- SHORT-TERM BORROWINGS (DOLLARS IN THOUSANDS) - --------------- (2) Computed by dividing short-term interest expense by average short-term borrowings. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SMITH INTERNATIONAL, INC. By: /s/ DOUGLAS L. ROCK -------------------------------- Douglas L. Rock Chief Executive Officer, President, and Chief Operating Officer March 21, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the date indicated:

81100_1993.txt

81100

1993

ITEM 1. BUSINESS THE COMPANY The Company is an investor-owned public utility incorporated in the State of Washington furnishing electric service in a territory covering approximately 4,500 square miles, principally in the Puget Sound region of Washington State. The population of the Company's service area is over 1.8 million. In December 1993, the Company had approximately 804,600 total customers, consisting of 715,600 residential, 83,900 commercial, 3,800 industrial and 1,300 other customers. For the year 1993, the Company added approximately 17,500 customers, an annual growth rate of 2.2%. Growth in total kilowatt-hour sales to consumers increased 3.0% in 1993 over 1992, due to continuing growth in the number of customers in 1993 combined with unusually mild temperatures throughout 1992. During 1993, the Company's billed revenues were derived 48% from residential customers, 34% from commercial customers, 14% from industrial customers and 4% from sales to other utilities and others. During this period, the largest single customer accounted for 3.1% of the Company's operating revenues. The average number of kilowatt-hours billed per residential customer served by the Company in 1993 was 12,674 kilowatt- hours. At December 31, 1993, the peak power resources of the Company were approximately 5,367,000 KW. The Company's historical peak load of approximately 4,615,000 KW occurred on December 21, 1990. The Company is affected by various seasonal weather patterns throughout the year and, therefore, operating revenues and associated expenses are not generated evenly during the year. Variations in energy usage by consumers do occur from season to season and from month to month within a season, primarily as a result of weather conditions. The Company normally experiences its highest energy sales in the first and fourth quarters of the year. Sales to other utilities also vary by quarters and years depending principally upon water conditions for the generation of surplus hydro- electric power, customer usage and the energy requirements of other utilities. With the implementation of the Periodic Rate Adjustment Mechanism ("PRAM") in October 1991, earnings are no longer significantly influenced, up or down, by sales of surplus electricity to other utilities or by variations in normal seasonal weather or hydro conditions. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Rate Matters") The electric utility industry in general is experiencing intensifying competitive pressures, particularly in wholesale generation and industrial customer markets. The National Energy Policy Act of 1992 was designed to increase competition in the wholesale electric generation market by easing regulatory restrictions on producers of wholesale power and by authorizing the Federal Energy Regulatory Commission ("FERC") to mandate access to electric transmission systems by wholesale power generators. The potential for increased competition at the retail level in the electric utility industry through state-mandated retail wheeling has also been the subject of legislative and administrative interest in a number of states, including the state of Washington. Electric utilities, including the Company, now face greater potential competition for resources and customers from a variety of sources, including privately owned independent power producers, exempt wholesale power generators, industrial customers developing their own generation resources, suppliers of natural gas and other fuels, other investor-owned electric utilities and municipal generators. All four of the major credit rating agencies have expressed the view that competitive developments in the electric utility industry are likely to increase business risks, with resulting pressure on utility credit quality. One of the rating agencies has stated that it is revising its financial ratio guidelines for electric utilities to reflect the changing risk profiles within the industry. These rating agency actions may result in higher capital costs and more limited access to capital markets for electric utilities, including the Company. Although the Company to date has not experienced any significant adverse impact on its business from these industry trends, the Company has taken a number of steps to prepare for a more competitive business environment. These include programs to become a lower-cost producer by improving productivity and reducing the work force. The Company is also reviewing the extent of its investment in regulatory assets that may not be readily marketable to others in a competitive marketplace. The Company is seeking state legislation to provide a firm statutory basis for recovery of demand-side management regulatory assets associated with the Company's conservation programs. During the period from January 1, 1989 through December 31, 1993, the Company made gross utility plant additions of $752 million and retirements of $84 million. Gross electric utility plant at December 31, 1993 was approximately $3.1 billion. The Company had 2,609 full-time equivalent employees on December 31, 1993. REGULATION AND RATES The Company is subject to the regulatory authority of (1) the Washington Utilities and Transportation Commission (the "Washington Commission") as to rates, accounting, the issuance of securities and certain other matters, and (2) the FERC in the transmission of electric energy in interstate commerce, the sale of electric energy at wholesale for resale, accounting and certain other matters. The Washington Commission consists of three Commissioners, each appointed for a six-year term by the Governor of the State of Washington. On September 21, 1993, the Washington Commission issued two rate orders, one regarding the Company's request for an increase in general rates, the other related to an annual rate adjustment under the PRAM. In its revised general rate request, the Company had requested a $97 million increase and in its PRAM request it had requested a first year recovery of between $27.6 and $38.1 million. The Washington Commission authorized a general rate increase of $21.9 million, reflecting increased costs of service, and collection of $35.7 million in the first year to recover previously deferred costs under the PRAM. The total increase in rates of $57.6 million was effective October 1, 1993. The Washington Commission also authorized the Company to increase rates by an additional $3.9 million effective October 1, 1993 to recognize, prospectively, the effect of the increase in the Federal corporate income tax rate from 34 to 35 percent. The general rate order also required the Company to file a case by November 1, 1993, demonstrating the prudency of its eight new power purchase contracts acquired since its last general rate case. Pending the resolution of the prudency review case, the Washington Commission ordered that the Company's new rates which became effective October 1, 1993, would be collected subject to refund to the extent this proceeding demonstrates any of those contracts to be imprudent. The Washington Commission calculated the annual revenue requirement at risk to be up to $86.1 million. The general rate case order allows a 10.5% return on common equity and 8.94% return on rate base, based on a capital structure of 47% debt, 8% preferred stock and 45% common equity. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Rate Matters.") The decrease in allowed return on equity from 12.8 percent in the last general rate case to 10.5 percent approved in the present rate case has put downward pressure on earnings since the order became effective on October 1, 1993. In addition, it will be difficult for the Company to earn its full allowed rate of return because of changes made by the rate orders in the recovery methods of certain costs. Therefore, the Company continues to place strong emphasis on its ongoing improvement efforts designed to increase operating efficiencies. POWER RESOURCES During 1993, the Company's total energy production was supplied 30% by its own resources, 27% through long-term firm contracts with several of the PUDs that own hydroelectric projects on the Columbia River, 37% from other firm purchases and 6% from non-firm purchases. The following table shows the Company's resources at December 31, 1993, and energy production during the year: Peak Power Resources at December 31, 1993 1993 Energy Production ----------------------- ---------------------- Kilowatts % Kilowatt-Hours % --------- ----- -------------- ----- (Thousands) Hydro: Company resources 309,950 5.8 1,204,164 5.7 Purchased (Columbia River PUD Contracts) 1,474,282 27.5 5,681,522 26.8 Purchased (other)(a) 829,886 15.4 3,293,131 15.5 - ---------------------------------------------------------------------------- Total Hydro 2,614,118 48.7 10,178,817 48.0 - ---------------------------------------------------------------------------- Thermal: Company resources: Coal 771,900 14.4 4,790,625 22.6 Natural gas/oil 788,150 14.7 419,522 2.0 Purchased(a) 1,191,914 22.2 5,808,724 27.4 - ---------------------------------------------------------------------------- Total Thermal 2,751,964 51.3 11,018,871 52.0 - ---------------------------------------------------------------------------- Total Capability 5,366,082 100.0% 21,197,688 100.0% ============================================================================ (a) Power received from other utilities is classified between hydro and thermal based on the character of the utility system used to supply the power or, if the power is supplied from a particular resource, the character of that resource. The Pacific Northwest depends on the accumulation of snow in the Rocky and Cascade mountain ranges to supply the region's Columbia River hydroelectric resources. The Company derives much of its power supply from the Columbia River projects. For the third consecutive winter, snowpack was substantially below normal due to dry weather. Forecasts completed in early March 1994, indicate that the projected streamflow affecting the principal hydroelectric facilities from which the Company receives power is expected to be only 82 percent of normal for the period January through July, 1994. This reduction should not have a significant impact on the Company's ability to meet customer energy demands as it has recently entered into long term contracts to buy the output of four new cogeneration projects. The Company also owns 700 MW of installed combustion turbine capacity which can be used as an alternative energy supply under certain market conditions. Substantially all cost increases of combustion turbine operation or other alternative power supplies are expected to be recovered in rates through the PRAM mechanism. Company Owned - ------------- The Company and other utilities are joint owners of four mine-mouth, coal-fired, steam-electric generating units at Colstrip, Montana, approximately 100 miles east of Billings. The Company owns a 50% interest (330,000 KW) in Units 1 and 2 and a 25% interest (350,000 KW) in Units 3 and 4. The Company's share of the output of all four Colstrip units is transmitted over two 500 KV transmission lines from Colstrip to a point of interconnection with the main Northwest transmission grid at Garrison, Montana. The owners of the Colstrip Units purchase the coal requirements for the units from Western Energy Company, an affiliate of Montana Power - one of the joint owners, under the terms of long-term coal supply agreements, with escalation provisions to cover actual mining cost increases and inflationary factors. These contracts are expected to satisfy the majority of the requirements for the units over their anticipated useful life. A contract price reopener for both the base price and adjustment provisions of the Colstrip 1 & 2 Coal Supply Agreement became effective July 30, 1991. A dispute exists between the buyers, including the Company, and the seller on this reopener. This dispute will be arbitrated in the 4th quarter of 1994, the outcome of which is not expected to have material adverse impact on the financial condition or results of operations of the Company. The Company owns a 7% interest (91,900 KW) in a coal-fired, steam-electric generating plant near Centralia, Washington, with a net capability of 1,313,000 KW. In 1991, the Company and other owners of the Centralia Project renegotiated a long-term coal supply agreement with Pacific Power & Light Company. The Company also has the following plants with an aggregate net generating capability of 1,098,100 KW: Upper Baker River hydro project (103,000 KW) constructed in 1959; Lower Baker River hydro project (71,400 KW) reconstructed in 1968; White River hydro plant (63,400 KW) constructed in 1912 with installation of the last unit in 1924; Snoqualmie Falls hydro plant (44,000 KW), half the capability of which was installed during the period 1898 to 1910 and half in 1957; two smaller hydro plants, Electron (26,400 KW) and Nooksack Falls (1,750 KW), constructed during the period 1904 to 1929; Shuffleton residual oil-fired steam-electric generating plant (85,800 KW) constructed in 1929-30; a standby internal combustion unit (2,750 KW) installed in 1969; two oil-fired combustion turbine units (28,500 KW and 67,500 KW) installed in 1972 and 1974, respectively; four combustion turbine units (89,100 KW each) installed during 1981; and two combustion turbine units (123,600 KW each) installed during 1984. The Company's combustion turbines installed in 1981 and 1984 may be fueled with natural gas or distillate oil. The Company has not entered into contracts which assure a future long-term supply or price of fuel for the Company's combustion turbines, and the future availability and prices of fuel for the Company's combustion turbines are not assured. The Company has applied to the FERC for an initial license for its existing and operating White River project and authorization to install an additional 14,000 KW generating unit. The Company also has applied for a license for a proposed 8,000 KW capacity project at Nooksack Falls to replace the existing 1,750 KW capacity unlicensed facility. The initial license for the Snoqualmie Falls project expired in December 1993, and the Company is continuing the FERC application process to relicense the project and increase its capacity from 44,000 KW to 73,000 KW. FERC has granted a license extension through December 1994, and under its present policies will continue to grant one year extensions until the relicensing process is completed. Columbia River Projects - ----------------------- The purchase of power from the Columbia River projects is generally on a "cost of service" basis under which the Company pays a proportionate part of the annual debt service and operating and maintenance costs of each project in direct ratio to the amount of power annually allocated to it. Such payments are not contingent upon the projects being operable. These projects are financed through substantially level debt service payments, and their annual costs should not vary significantly over the term of the contracts unless additional financing is required to meet the costs of major maintenance, repairs or replacements or license requirements. The average cost of power purchased from these projects is approximately 11.9 mills per KWH. As of December 31, 1993, the Company was entitled to purchase portions of the power output of the PUDs' projects as set forth in the following tabulation: Company's Annual Amount Bonds Purchasable (Approximate) Outstanding -------------------------- Contract License 12/31/93(a) % of Kilowatt Costs(b) Project Exp.Date Exp.Date (Millions) Output Capacity (Millions) - ------------------------------------------------------------------------------ Rock Island Original units(c) 2012 2029(d) $ 79.8 62.5 ) ) 507,000 $ 45.7 Additional units 2012 2029(d) 326.8 100.0 ) Rocky Reach 2011 2006(e) 186.0 38.9 504,922 15.0 Wells 2018 2012(e) 199.9 34.8 292,320 10.0 Priest Rapids 2005 2005(e) 141.2 8.0 71,760 2.1 Wanapum 2009 2005(e) 189.4 10.8 98,280 2.8 - ------------------------------------------------------------------------------ Total 1,474,282 $ 75.6 ============================================================================== (a) The contracts for purchases are generally coextensive with the term of the PUD bonds associated with the project. Under the terms of some financings, however, long-term bonds were sold to finance certain assets whose estimated useful lives extend beyond the expiration date of the power sales contracts. Of the total outstanding bonds sold for each project, the percentage of principal amount of bonds which mature beyond the contract expiration dates are: 69.3% at Rock Island; 20.1% at Rocky Reach; 59.8% at Priest Rapids; and 39.4% at Wanapum. (b) Estimated debt service and operating costs for the year 1994. The components of 1994 costs associated with the interest portion of debt service are: Rock Island, $27.78 million for all units; Rocky Reach, $5.01 million; Wells, $3.42 million; Priest Rapids, $0.68 million; and Wanapum, $1.16 million. (c) For the period July 1, 1994 through June 30, 1995, the Company will pay 76.4% of the debt service and operating costs of the original units. This percentage will decrease thereafter in approximate relationship to the Company's share of the output until it reaches 50% on July 1, 1999 (see below). (d) Under a settlement agreement, FERC granted Chelan a license for 40 years beginning January 18, 1989. (e) The Company is unable to predict whether the licenses under the Federal Power Act will be renewed to the current licensees or what effect the term of the licenses may have on the Company's contracts. - -------------------- The Company has contracted to purchase a share of the output of the original units of the Rock Island Project that equals 63.5% through June 30, 1994, decreases gradually to 50% of the output until July 1, 1999, and remains unchanged thereafter for the duration of the contract. The Company has contracted to purchase the entire output of the additional Rock Island units for the duration of the contract, except that the Company's share of output of the additional units may be reduced not in excess of 10% per year beginning July 1, 2000, to a minimum of 50% upon the exercise of rights of withdrawal by Chelan for use in its local service area. The Company has contracted to purchase a share of the output of the Rocky Reach Project that remains unchanged for the duration of the contract. Under terms of a withdrawal of power settlement, the Company's share of the output of the Wells Project is currently 34.8%. However, the Company's share of the output can be reduced to 31.3% at any time upon the exercise of withdrawal rights by Douglas County PUD. The Company has contracted to purchase a share of the output of the Priest Rapids and Wanapum projects that remains unchanged for the duration of the contracts. Seven of the eleven turbines at Rocky Reach are in the process of being replaced. Studies are currently underway that are expected to lead to the replacement of the remaining four units. Turbine replacement is planned for all ten units at Wanapum. Also, as a result of FERC Settlements, it is anticipated that installation of fish screens will be required at Rocky Reach, Rock Island, Priest Rapids and Wanapum Dams. These multi-year capital projects are expected to result in increases in annual power costs as they progress. In 1964, the Company and fifteen other utilities and agencies in the Pacific Northwest entered into a long-term coordination agreement extending until June 30, 2003. This agreement provides for the coordinated operation of substantially all of the hydroelectric power plants and reservoirs in the Pacific Northwest. Among other things, it increases the ability of the Company to meet its customers' requirements with existing resources during periods of insufficient stream flows or forced outages of equipment. Certain utilities in the northwest United States and Canada are obtaining the benefits of over 1,000,000 KW of additional power as a result of the ratification of a treaty between the United States and Canada under which Canada is providing approximately 15,500,000 acre-feet of storage on the upper Columbia River. As a result of this storage, the Company obtains firm power based upon its percentage entitlement under its Columbia River contracts, currently approximately 163,800 KW. In addition, the Company has contracted to purchase 17.5% of Canada's share of the power resulting from such storage (132,100 KW capacity and 49,500 KW average energy in the 1993-94 contract year, April 1 to March 31, which amounts decrease gradually until expiration of the contract in 2003). The Company has also contracted to purchase from BPA supplemental capacity in amounts that decrease gradually until expiration of the contract in 2003. The amount of supplemental capacity currently purchased is approximately 43,900 KW. See "ENVIRONMENT - Federal Endangered Species Act" for discussion of the fishery enhancement plan related to these projects. Contracts and Agreements with Other Utilities - --------------------------------------------- On September 17, 1985, the Company and BPA entered into a settlement agreement settling the Company's claims against BPA resulting from BPA's action in halting construction on WPPSS Nuclear Project No. 3 in which the Company has a five percent interest. The settlement includes a Settlement Exchange Agreement ("Bonneville Exchange Power Contract") under which the Company is receiving from BPA for a period of approximately 30.5 years, beginning January 1, 1987, a certain amount of power determined by a formula and depending on the equivalent annual availability factors of several surrogate nuclear plants. The power is received during the months of November through April. Under the contract, the Company is guaranteed to receive not less than 191,667 MWH in each contract year until the Company has received total deliveries of 5,833,333 MWH. BPA may request energy at times not needed by the Company during the months of September through June of each contract year. The payment to the Company for such energy would be based on the actual costs to produce such energy up to the operating and maintenance costs of the Company's oil and natural gas fired combustion turbines. The Company is entitled to receive 80,000 KW of capacity and 68,000 KW of average energy from BPA under a WPPSS Nuclear Power Unit 1 Exchange Agreement through June 30, 1996. The calculation of the cost of the energy and capacity received by the Company has been in dispute, and the Company in 1990 entered into a settlement agreement with WPPSS and BPA as to prices for the July 1, 1990 through June 30, 1996 period. These prices range between 4.3 cents and 4.842 cents per KWH and are subject to certain increases or decreases as a result of settlement of or judgment on cost sharing claims with respect to the allocation of costs among WPPSS projects. On April 14, 1983, the Company contracted to purchase the output of Grays Harbor PUD's 4% interest (52,520 KW) in the Centralia generating plant subject to withdrawal on at least 7 years' notice. Grays Harbor PUD issued such notice in 1990; therefore this contract will terminate on June 30, 1997. On April 4, 1988, the Company executed a 15-year contract for the purchase of firm energy supply from Washington Water Power Company. This agreement calls for the delivery of 100 MW of capacity and 657,000 MWH of energy from the Washington Water Power system annually (75 annual average MW). Minimum and maximum delivery rates are prescribed. Under this agreement, the energy is to be priced at Washington Water Power's average generation and transmission cost. On October 27, 1988, the Company executed a 15-year contract for the purchase of firm power and energy from Pacific Power & Light Company. Under the terms of the agreement, the Company receives 120 average MW of energy and 200 MW of peak capacity. On November 23, 1988, the Company executed an agreement to purchase surplus firm power from BPA. Under the agreement, the Company receives 150 average MW of energy and 300 MW of peak capacity from BPA between October 1 and March 31 of each contract year. The contract extends for 20 years, ending in 2008. The sale will convert to a power-for-power exchange on June 30, 2001, or earlier, if BPA provides the Company with a five-year notice that it no longer has surplus energy available to support the power sale. On October 1, 1989, the Company signed a contract with Montana Power under which Montana Power provides, from its share of Colstrip Unit 4, to the Company 71 average MW of energy (94 MW of peak capacity) over a 21-year period. On December 11, 1989, the Company executed a conservation transfer agreement with Snohomish County PUD. Snohomish County PUD, together with Mason and Lewis County PUDs, will install conservation measures in their service areas. The agreement calls for the Company to receive the power saved over the expected 20-year life of the measures. The agreement calls for BPA to deliver the conservation power to the Company from March 1, 1990 through June 30, 2001, and for Snohomish County PUD to deliver the conser- vation power for the remaining term of the agreement. Power deliveries gradually increase over the first five years of the agreement, roughly matching the installation of the conservation measures, and will reach six average MW of energy in the fifth year. Under the agreement, deliveries of conservation power will then remain at six average MW of energy throughout the term of the agreement. The Company executed an exchange agreement with Pacific Gas & Electric Company which became effective on January 1, 1992. Under the agreement, 300 MW of capacity together with 413,000 MWH of energy are exchanged every year on a unit for unit basis. No payments are made under this agreement. Pacific Gas & Electric Company is a summer peaking utility and will provide power during the months of November through February. The Company is a winter peaking utility and will provide power during the months of June through September. By giving proper notice, either party may terminate the contract for various reasons. Contracts and Agreements with Non-Utilities - ------------------------------------------- The Company has contracted to purchase the output from a number of non- utility generating resources. The Company currently has available 410 MW of capacity from gas cogeneration, 40.5 MW from small hydro generation and 28 MW from municipal solid waste and others. In addition, the Company will add 245 MW of capacity in 1994 in the form of purchased power contracts with independent producers of gas-fired cogeneration. The Company's payments under these contracts are subject to the delivery of power. (See Note 14 to the Consolidated Financial Statements for further discussion.) Other Resources - --------------- The Company offers programs designed to help new and existing customers conserve electric energy. In the residential sector, free energy audits, cash grants, and on-site inspection of cost-effective energy conservation improvements generate a significant share of KWH savings. Further energy conservation savings are realized through electric water heater programs, energy efficient lighting rebates and special programs targeted at low-income customers. The commercial and industrial energy management programs offer customers engineering audits, computerized analyses, bid design criteria, cash grants and follow-up verification for a wide variety of electrical efficiency improvements. Energy conservation measures installed in 1993 are expected to result in annualized savings of approximately 260,400 MWH. The Company's energy conservation expenditures are accumulated and amortized to expense over a ten year period at the direction of the Washington Commission. The Company's total unamortized conservation balance at December 31, 1993, was $234 million. The amount included in rate base by the Washington Commission in its September 1993 order based on expenditures through April 30, 1993, was $201 million. The Washington Commission has authorized the Company to accrue, as non-cash income, the carrying costs on energy conservation expenditures until such investments are reflected in rates. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Rate Matters.") CONSTRUCTION FINANCING The Company estimates its construction expenditures, which include energy conservation expenditures and exclude Allowance for Funds Used During Construction ("AFUDC") and Allowance for Funds Used to Conserve Energy ("AFUCE"), for 1994 and 1995 to be $261 million and $200 million, respectively. The estimate for 1994 includes a $72 million payment to BPA for capacity rights to the third AC transmission line. The Company expects to fund an average of 68% of its estimated construction expenditures (excluding AFUDC and AFUCE) in 1994 and 1995 from cash from operations (net of dividends and AFUDC), and to fund the balance through the sale of securities. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the Company's construction program.) The Company's ability to finance its future construction program is dependent upon maintaining a level of earnings sufficient to permit the sale of additional securities. In determining the type and amount of future financings, the Company may be limited by restrictions contained in its Mortgage Indenture, Articles of Incorporation and certain loan agreements. Under the most restrictive tests, at December 31, 1993, the Company could issue (i) approximately $709 million of additional first mortgage bonds or (ii) approximately $564 million of additional preferred stock at an assumed dividend rate of 7.00% or (iii) a combination thereof. ENVIRONMENT The Company's operations are subject to environmental regulation by federal, state and local authorities. Capital expenditures for environmental controls on all Company facilities are estimated at $29.4 million for the period 1994 through 1996. Due to the inherent uncertainties surrounding the development of federal and state environmental and energy laws and regulations, the Company cannot determine the impact such laws may have on its existing and future facilities. Federal Comprehensive Environmental Response, Compensation and Liability Act, and the Washington State Model Toxics Control Act - ---------------------------------------------------------------- The federal Comprehensive Environmental Response, Compensation and Liability Act (commonly referred to as the "Superfund Act") subjects certain parties to liability for remedial action at contaminated disposal sites. The Company has been named by the Environmental Protection Agency ("EPA") as a Potentially Responsible Party ("PRP") at four sites in Washington State, which are: two locations formerly operated by Northwest Transformer, Inc. at Mission-Pole and South Harkness in Whatcom County; a site formerly operated by Ross Electric, Inc. at Coal Creek in Lewis County; and a site formerly operated by Simon & Sons, Inc. in Pierce County. A settlement was reached in July 1991 with the EPA on the Simon & Sons site in which the Company paid approximately $442,000. A settlement was reached with the EPA on the Northwest Transformer/Mission-Pole site in a Consent Decree approved by Federal Court in January 1992. Current estimates of future remedial costs by the Company under that settlement are approximately $0.7 million. A settlement was reached with the EPA for the Ross Electric/Coal Creek site in a Consent Decree approved by Federal Court in February 1992. Based upon December 1993 estimates of future remedial costs, the Company's estimated share would be approximately $0.3 million. A settlement was reached with the EPA on June 7, 1992, for the Northwest Transformer/South Harkness site in an Administrative Order of Consent in which the PRPs agreed to conduct a Remedial Investigation & Feasibility Study. Based on a December 1993 estimate of future costs, the Company's share would be approximately $1.6 million. The above sites represent all significant Superfund sites currently known to the Company. There is, however, no assurance that all contaminated sites and contaminants for which the Company may have a responsibility have been identified or that remedial actions planned to date at current sites, including actions pursuant to consent decrees, will be adequate. The Company has remediated two locations at the Company's Electron Generating Station which had been contaminated with chemicals formerly used to treat wooden timbers. These sites had been listed as Priority 1 by the Washington State Department of Ecology ("WDOE") because of potential groundwater contamination. Remedial actions at these sites under provisions of the state's Model Toxics Control Act began in 1991 and were completed in 1992. A final remedial report has been filed with the WDOE. The Company is also participating in a joint research project with the Electric Power Research Institute to clean up the Snoqualmie Railroad site in the town of Snoqualmie, Washington. The site has been leased from the Company since 1959 by the non-profit Puget Sound Railway Historical Association. The contamination consists of heavy petroleum hydrocarbons which were used as lubricants for railroad equipment. The purpose of the project is to provide a field demonstration of new technologies to treat heavy molecular weight petroleum hydrocarbons in soil. Remediation of the research project was completed in February 1994. The Company has also commenced a program to test, replace and take remedial actions on certain underground storage tanks as required by federal and state laws. Remedial actions and testing of Company vehicle service facilities and storage yards have also been commenced. (See Note 14 to the Consolidated Financial Statements for further discussion of environmental obligations and the related regulatory treatment.) Federal Clean Air Act Amendments of 1990 - ---------------------------------------- The Company has an ownership interest in coal-fired, steam-electric generating plants at Centralia, Washington and Colstrip, Montana which are subject to the federal Clean Air Act Amendments of 1990 ("CAAA") and other regulatory requirements. The Centralia Project and the Colstrip Projects meet the sulfur dioxide limits of the CAAA in Phase I (1995). Pacific Power & Light Company, which operates the Centralia Project, is working on compliance plans to meet the Phase II limits in the year 2000. Montana Power, which operates the Colstrip 3 & 4 Project, is working to meet the Phase II limits in the year 2000. Under the CAAA, allowances may be used to achieve compliance. It is believed that Units 1 and 2 may have an excess of allowances above what is currently set for Phase II requirements and that Units 3 and 4 appear to have enough allowances for Phase II requirements. The Company owns combustion turbine units which are capable of being fueled by natural gas or oil. The nature of these units provides operational flexibility in meeting air emission standards. There is no assurance that in the future environmental regulations affecting sulfur dioxide or nitrogen oxide emissions may not be further restricted, and there is no assurance that restrictions on emissions of carbon dioxide or other combustion by-products may not be imposed. Federal Endangered Species Act - ------------------------------ In November 1991, the National Marine Fisheries Service ("NMFS") listed the Snake River Sockeye as an endangered species pursuant to the federal Endangered Species Act. Since the Sockeye listing, the Snake River fall and spring/summer Chinook have also been listed as threatened. In response to the listings, a team of experts was formed to develop a plan for the recovery needs of these species. In anticipation of the listings, the Northwest Power Planning Council ("NWPPC") previously developed a fishery enhancement plan which combines increased springtime flows with habitat enhancements, harvest reductions, and other measures. The spring flow augmentation portion of the plan began in 1991. The draft plan developed by the NMFS recovery team late in 1993 concludes that there is no scientific evidence that increased flows during the spring outmigration period enhance fish survival. The recovery team essentially advocates a continuation of the flows called for in the Council's program, unless or until scientific research dictates something different. When finalized, the recovery team's plan may be used by the NMFS as the recovery plan required pursuant to the Act, but there is no assurance NMFS will in fact use that plan instead of some other plan. Federal agencies which operate the Federal Columbia River Power System must consult with the NMFS to determine whether any action they undertake will unduly jeopardize the listed species. Measures recently announced by NMFS covering the period 1994 through 1998 are the result of the most recent of those consultations. In general, the measures require the federal agencies to release more water during the spring and summer for fish enhancement than is required by either the NWPPC Fish and Wildlife Program or that recommended by the draft recovery plan. The NWPPC plan and plans developed by NMFS affect the Mid-Columbia projects from which the Company purchases power on a long-term basis, and will further reduce the flexibility of the regional hydroelectric system. Although the full impacts are unknown at this time, the plan ultimately developed by NMFS could shift an amount of the Company's generation from the Mid-Columbia projects from winter periods into the spring when it is not needed for system loads, and will increase the potential for spill and loss of generation at the Mid-Columbia projects. Under the Council's plan presently in effect, in years of critical water flows, the maximum amount of generation that the company would have to transfer to the spring is limited to approximately 275,000 MWH. The Company's share of energy production from the Mid-Columbia during 1993 was approximately 5,682,000 MWH and the total production from all resources was more than 21,198,000 MWH. Other species are also proposed for listing and could further restrict system flexibility and energy production. Puget Sound Power & Light Company EXECUTIVE OFFICERS AT DECEMBER 31, 1993: Name Age Offices - ---------------- --- --------------------------------------------------- R. R. Sonstelie 48 President and Chief Executive Officer since 1992; President and Chief Operating Officer 1991-1992; President and Chief Financial Officer 1987-1991; Executive Vice President 1985-1987; Senior Vice President Finance 1983-1985; Vice President Engineering and Operations 1980-1983; Director since 1987. W. S. Weaver 49 Executive Vice President and Chief Financial Officer and Director since 1991. For more than five years prior to that time, a Partner in the law firm Perkins Coie. N. L. McReynolds 59 Senior Vice President Corporate Relations since 1987; Vice President Corporate Relations 1980-1987. R. V. Myers 60 Senior Vice President Operations since 1985; Vice President Engineering and Operations 1983-1985; Vice President Generation Resources 1980-1983. R. G. Bailey 54 Vice President Power Systems since 1980. J. W. Eldredge 43 Corporate Secretary and Controller since 1993; Controller since 1988; Manager Budgets and Performance 1987-1988; Manager General Accounting 1984-1987. W. J. Finnegan 61 Vice President since January 11, 1994; Vice President Engineering 1986-1994; Director Environmental and Resource Services 1981-1986. J. L. Henry 48 Vice President Engineering and Operating Services since January 11, 1994; Vice President Operations Services 1991-1994; Director South Central Division 1990-1991; Director Division Operations 1984-1990. C. A. Knutsen 47 Vice President Administration and Corporate Services since February 10, 1994; Vice President Corporate Planning 1989-1994; Director Strategic Planning 1987-1988; Manager Demand and Resource Evaluation Project 1986-1987. J. R. Lauckhart 45 Vice President Power Planning since 1991; Director Power Planning 1986-1991. R. E. Olson 62 Vice President Finance and Treasurer since 1987; Vice President Financial Control 1986; Vice President and Treasurer 1980-1986. G. B. Swofford 52 Vice President Divisions and Customer Services since 1991; Vice President Rates and Customer Programs 1986-1991; Director Conservation and Division Services 1980-1986. S. M. Vortman 48 Vice President Strategic Planning and Regulatory Affairs since February 10, 1994; Vice President Corporate Services 1992-1994; Director Real Estate 1990-1992; Manager Community and Economic Development 1986-1990. Officers are elected for one-year terms. ITEM 2.

ITEM 2. PROPERTIES The principal generating plants owned by the Company are described under Item 1 - "Business - Power Resources." The Company owns its transmission and distribution facilities, and various other properties. Substantially all properties of the Company are subject to the lien of the Company's Mortgage Indenture. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS See Notes 8 and 14 to the Consolidated Financial Statements. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - NONE PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is traded on the New York Stock Exchange (symbol PSD). The number of stockholders of record of the Company's common stock at December 31, 1993, was 64,622. The Company has paid dividends on its common stock each year since 1943 when such stock first became publicly held. Future dividends will be dependent upon earnings, the financial condition of the Company and other factors. Certain provisions relating to the Company's senior securities limit funds available for payment of dividends to net income available for dividends on common stock (as defined in the Company's Mortgage Indenture) accumulated after December 31, 1957, plus the sum of $7.5 million. As of December 31, 1993, the balance of earnings reinvested in the business that was not restricted as to dividends on common stock was approximately $266 million. (See Note 5 to the Consolidated Financial Statements.) Dividends paid and high and low stock prices for each quarter over the last two years were: 1993 1992 --------------------------- --------------------------- Price Range Price Range --------------- Dividends --------------- Dividends Quarter Ended High Low Paid High Low Paid - ------------- ------ ------ --------- ------ ------ --------- March 31 28-3/4 26-1/8 $.45 26-3/4 23-7/8 $.44 June 30 29-3/8 26-1/4 $.46 26-3/8 24-1/2 $.45 September 30 29-3/4 25-5/8 $.46 27-7/8 25-7/8 $.45 December 31 26-7/8 23-1/2 $.46 27-3/8 25-7/8 $.45 ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net income in 1993 was $138.3 million on operating revenues of $1.113 billion, compared to $135.7 million on operating revenues of $1.025 billion in 1992 and $132.8 million on operating revenues of $956.8 million in 1991. Income for common stock was $121.9 million, $121.8 million and $122.7 million for 1993, 1992 and 1991, respectively. Earnings per share in 1993 were $2.00 on 60.9 million weighted average common shares outstanding during the period compared to $2.16 on 56.3 million weighted average common shares in 1992 and $2.21 on 55.6 million weighted average common shares in 1991. Return on the average book value of the Company's common equity in 1993 was 11.0%, compared to 12.6% in 1992 and 13.2% in 1991. The dividend payout ratio was 91.5% in 1993, compared to 82.9% in 1992 and 79.6% in 1991. Total kilowatt-hour sales to ultimate consumers in 1993 were 19.2 billion, compared with 18.4 billion in 1992 and 18.3 billion in 1991. Kilowatt-hour sales to other utilities were 0.9 billion in 1993, 1.2 billion in 1992 and 1.9 billion in 1991. The preferred stock dividend accrual increased $2.6 million in 1993 and $3.8 million in 1992 compared to 1991 primarily due to the issuance of the 7.75% Series Preferred Stock in March 1992 and the 7.875% Series Preferred Stock in July 1992. This was partially offset by the reacquisition of the Series A Flexible Dutch Auction Rate Transferable Securities $100 Par Value Preferred Stock ("FLEX DARTS") in April 1992. The 1993 increase was also partially offset by the reacquisition of the Series B FLEX DARTS in July 1993. Lower dividend rates associated with the FLEX DARTS were also an offsetting factor during 1992. In 1991, the preferred stock dividend accrual decreased $2.4 million compared to 1990 levels. A decrease of $1.8 million was due to lower dividend rates associated with the FLEX DARTS and a decrease of $0.7 million was attributed to the reacquisition of shares of the 9.36% Series Preferred Stock. The Company reacquired 162,000 shares of its 9.36% Series Preferred Stock in March 1990 and the remaining 324,000 shares over the subsequent twelve months. Years Ending December 31 Increase (Decrease) Over Preceding Year (Dollars in Millions) 1993 1992 1991 - ----------------------------------------------------------------------- Operating revenues General rate increase $ 14.2 $ -- $ 9.1 PRAM surcharge billed 48.8 44.8 9.6 Accrual of Revenue under the PRAM - Net -- 41.5 0.7 BPA Residential Purchase and Sale Agreement (15.0) (25.1) (10.6) Sales to other utilities (6.8) (0.8) 0.4 Load and other changes 46.7 7.8 12.3 - ----------------------------------------------------------------------- Total operating revenue changes 87.9 68.2 21.5 - ----------------------------------------------------------------------- Operating expenses Purchased and interchanged power 81.5 18.2 4.0 Fuel (4.4) 11.9 0.9 Other operation expenses 5.9 9.9 16.3 Maintenance (1.8) (0.4) 5.0 Depreciation and amortization (7.2) 6.6 5.1 Taxes other than federal income taxes 6.1 4.8 (0.3) Federal income taxes 11.5 16.3 (7.9) - ----------------------------------------------------------------------- Total operating expense changes 91.6 67.3 23.1 - ------------------------------------------------------------------------ Allowance for funds used during construction ("AFUDC") 1.5 (1.0) (0.4) Other income (5.5) 12.3 3.4 Interest charges (10.3) 9.3 1.0 - ----------------------------------------------------------------------- Net income changes $ 2.6 $ 2.9 $ 0.4 ======================================================================= The following information pertains to the changes outlined in the table above: OPERATING REVENUES Revenues since October 1, 1993 increased as a result of rates authorized by the Washington Utilities and Transportation Commission (the "Washington Commission") in its general rate order issued on September 21, 1993. Revenues since October 1, 1992, increased as a result of rates authorized by the Washington Commission under the second Periodic Rate Adjustment Mechanism ("PRAM") filing. Revenues since October 1, 1991, increased as a result of rates authorized under the first PRAM filing. (See "Rate Matters.") Revenues have been reduced by virtue of the credit which the Company received through the Residential Purchase and Sale Agreement with the Bonneville Power Administration ("BPA"). This agreement enables the Company's residential and small farm customers to receive the benefits of lower-cost federal power. A related reduction is included in purchased and interchanged power expenses. Revenues in 1992 were higher as a result of the recognition of $6.7 million of revenues in September 1992 related to incentive payments authorized by the Washington Commission for meeting energy conservation targets during 1991. These revenues were collected in rates beginning October 1, 1992. Revenues from the PRAM rate adjustments and continuing load growth contributed to higher revenues in 1991. Although the Company is dependent on purchased power to meet customer demand, it may, from time to time, have energy available for sale to other utilities, depending principally upon water conditions for the generation of hydroelectric power, customer usage and the energy requirements of other utilities. OPERATING EXPENSES Purchased and interchanged power expenses increased $81.5 million in 1993. Higher purchased power expenses of $95.8 million were due to new firm power purchase contracts with PURPA (Public Utility Regulatory Policies Act) qualifying facilities and higher secondary power purchases from other utilities. This increase was partially offset by the Residential Purchase and Sale Agreement with BPA, which resulted in a reduction of $14.4 million. (See discussion of the Residential Purchase and Sale Agreement under "Operating revenues.") Purchased and interchanged power expenses increased $18.2 million in 1992. Higher purchased power expenses of $42.3 million were influenced by new firm power purchase contracts with PURPA qualifying facilities and higher costs on certain firm power purchase contracts with other utilities. The Residential Purchase and Sale Agreement with BPA resulted in a reduction of $23.9 million. Purchased and interchanged power expenses increased $4.0 million in 1991. Higher levels of purchased power accounted for a $14.3 million increase. The Residential Purchase and Sale Agreement with BPA resulted in a reduction of $10.1 million. Fuel expense decreased $4.4 million in 1993 due to decreased use of the coal-fired plants. Fuel expense increased $11.9 million in 1992 over the previous year due to increased usage of the coal-fired and gas turbine plants. Other operation expenses increased $5.9 million in 1993 due primarily to a $5.1 million increase in the amortization of conservation expenditures. Also influencing 1993 expenses was an increase of $1.8 million in steam generation expenses and a decrease of $2.3 million in administration and general expenses. Other operation expenses increased $9.9 million in 1992. Transmission expense accounted for $5.3 million of the increase. Also contributing was a $2.2 million rise in customer service expenses and a $1.5 million increase in administration and general expenses. Other operation expenses increased $16.3 million in 1991. Contributing to this increase was a $8.1 million rise in administrative and general expenses; a $3.9 million increase in customer service expenses; and a $2.2 million increase in transmission and distribution expenses. Maintenance expense in 1993 declined $1.8 million compared to 1992 due primarily to a $2.2 million decrease in distribution maintenance expense. Maintenance expense in 1992 fell $0.4 million from 1991 levels due primarily to a decrease of $2.8 million in administration and general maintenance expenses. This was partially offset by a $2.0 million increase in steam plant expense. Maintenance expense in 1991 increased $5.0 million due primarily to $2.7 million for remedial action of Company owned facilities and a $1.5 million rise in transmission and distribution maintenance expenses. Depreciation and amortization expense declined $7.2 million in 1993 compared to the prior year. This decrease was due in part to a change in depreciation rates approved by the Washington Commission staff in the second quarter of 1993 which was made retroactive to the beginning of 1993. This adjustment had the effect of decreasing depreciation expense by $10.5 million during 1993. This adjustment was partially offset by the effects of additional plant being placed into service. Depreciation and amortization expense increased $6.6 million in 1992 and $5.1 million in 1991 as a result of additional plant being placed into service. Taxes other than federal income taxes increased $6.1 million in 1993 compared to 1992. Excise and municipal taxes, which are primarily revenue- based, increased $6.1 million. Taxes other than federal income taxes increased $4.8 million in 1992. An increase in Washington State property taxes of $2.2 million accounted for much of the increase. Taxes other than federal income taxes decreased $0.3 million in 1991. Contributing to the decrease was a $1.1 million decrease in property taxes. Excise and municipal taxes contributed increases of $2.1 million and $1.1 million in 1992 and 1991, respectively. Federal income taxes on operations increased $11.5 million in 1993. The increase was due in part to higher pre-tax operating income in 1993 and an increase in the corporate tax rate from 34 to 35 percent, retroactive to January 1, 1993. Federal income taxes on operations increased $16.3 million in 1992 due to an increase in pre-tax operating income and a change in the method in which energy conservation expenditures are deducted for federal tax purposes. (See Note 11 to the Consolidated Financial Statements.) Federal income taxes on operations decreased $7.9 million in 1991 due to tax benefits associated with energy conservation expenditures and lower taxable income. AFUDC (See Note 1 to the Consolidated Financial Statements.) OTHER INCOME Other income decreased $5.5 million in 1993. The decrease was due in part to a charge totaling $1.4 million as a result of the Washington Commission's September 1993 general rate case ruling and a $1.4 million decrease in excess AFUDC over the FERC maximum allowed by the Washington Commission. Also contributing to the 1993 decrease was a non-recurring $2.3 million decrease in non-operating federal income taxes in the second quarter of 1992 as a result of an IRS settlement. Other income increased $12.3 million in 1992 over 1991 levels. This increase was due in part to an increase of $4.2 million in Allowance for Funds Used to Conserve Energy ("AFUCE"). The Washington Commission, in its April 1, 1991 order authorizing the PRAM, ordered the Company to start accruing carrying costs on energy conservation expenditures until such investments are included in ratebase. These accruals commenced in May 1991 but did not become significant until the third quarter of 1991. The AFUDC allowed by the Washington Commission in excess of the FERC maximum contributed $2.0 million to the increase over 1991. In addition, other income increased $3.8 million because of net income from subsidiaries of $1.0 million in 1992 versus losses of $2.8 million in 1991 and $1.1 million from lower non-operating federal income taxes. Other income, which increased $3.4 million in 1991, included $2.0 million due to capitalized interest expense relating to construction activities of a subsidiary. Also contributing to the increase were lower non-operating federal income taxes of $1.6 million. INTEREST CHARGES Interest charges, which consist of interest and amortization on long-term debt and other interest, decreased $10.3 million in 1993 compared to the prior year. Interest and amortization on long-term debt decreased $3.5 million. Contributing $29.1 million in reduced interest expense were 11 issues of First Mortgage Bonds totaling $510 million redeemed or retired over the previous 21 months. Partially offsetting this was $23.7 million in new interest expense associated with 22 issues of Secured Medium-Term Notes totaling $549 million issued over the previous 23 months. Other interest expense decreased $6.8 million in 1993 compared to the prior year. Much of the decrease was the result of a $5.3 million non-recurring interest charge in 1992 relating to a federal income tax assessment. Also contributing were lower average daily short-term borrowings and lower weighted average interest rates in 1993. Interest charges increased $9.3 million in 1992 compared to the prior year. Interest and amortization on long-term debt increased $4.7 million. Contributing $24.0 million of new interest expense were 19 issues of Secured Medium-Term Notes totaling $645 million issued over the previous 19 months. Partially offsetting this were $21.1 million in interest reductions from First Mortgage Bond retirements or redemptions of $451 million over the same period. Also contributing an increase of $1.5 million were the effects of three issues of fixed rate pollution control bonds that were used to refund floating rate pollution control bonds of identical amounts. Other interest expense increased $4.6 million in 1992 compared to 1991. An interest charge of $5.3 million relating to a federal income tax assessment was partially offset by lower short-term interest rates in 1992. Interest charges increased $1.0 million in 1991 compared to 1990. Interest and amortization on long-term debt increased $3.0 million. This increase included $3.9 million attributable to a First Mortgage Bond issue in October 1990. Also contributing to the increase were four issues of Secured Medium-Term Notes that added $4.6 million of interest in 1991. Partially offsetting these increases was a decrease of $1.4 million due in part to lower interest rates on pollution control bonds. In addition, the effects of bond retirements decreased interest expense by $4.2 million in 1991. Other interest expense decreased $2.0 million in 1991 compared to the prior year due to lower weighted average interest rates and lower average daily short-term borrowings. CONSTRUCTION AND FINANCING PROGRAM Current construction expenditures are primarily transmission and distribution-related, designed to meet continuing customer growth. Expenditures on energy conservation resources have also taken on increased importance in recent years as the Company seeks to manage the growth in demand for electricity. Construction expenditures, which include energy conservation expenditures and exclude AFUDC and AFUCE, were $211.5 million in 1993 and are expected to be $261 million in 1994 and $200 million in 1995. The ratio of cash from operations (net of dividends, AFUDC and AFUCE) to construction expenditures (excluding AFUDC and AFUCE) was 59.1% in 1993. The Company expects to fund an average of 68% of its total 1994 and 1995 estimated construction expenditures (excluding AFUDC and AFUCE) from cash from operations (net of dividends, AFUDC and AFUCE) and the balance through the sale of securities, the nature, amount and timing of which will be subject to market and other relevant factors. The Company made an initial payment of $8.0 million in 1993 for capacity rights to BPA's third A.C. transmission line to the southwestern United States and expects to pay the remaining cost of $72 million in 1994. Construction expenditure estimates are subject to periodic review and adjustment. In April 1991, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to $450 million principal amount of First Mortgage Bonds. The First Mortgage Bonds were issued as Secured Medium-Term Notes, Series A, in 14 separate issues. The Company issued the last of the $450 million of Secured Medium-Term Notes, Series A, in September 1992. The weighted average coupon rate of the Series A Notes was 7.84%. In October 1992, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to an additional $450 million principal amount of First Mortgage Bonds. The First Mortgage Bonds can be issued as Secured Medium-Term Notes, through underwritten offerings, pursuant to delayed delivery contracts or any combination thereof. These Secured Medium-Term Notes were designated Series B. As of February 28, 1994, the Company has issued $334 million Series B Notes having an average coupon rate of 6.82%. On February 9, 1993, the Company issued a total of $50 million principal amount of Secured Medium-Term Notes which included the following: $10 million principal amount of Secured Medium-Term Notes, Series B, due February 9, 1998, bearing interest at 6.17% per annum; $10 million principal amount of Secured Medium-Term Notes, Series B, due February 9, 2000, bearing interest at 6.61% per annum; and $30 million principal amount of Secured Medium-Term Notes, Series B, due February 10, 2003, bearing interest at 7.02% per annum. Proceeds of these issues were used to redeem $20 million principal amount of First Mortgage Bonds, 7.50% Series due 1999 and $30 million principal amount of First Mortgage Bonds, 7.75% Series due 2002, on March 8, 1993. On March 5, 1993, the Company issued a total of $20 million principal amount of Secured Medium-Term Notes which consisted of $15 million principal amount of Secured Medium-Term Notes, Series B, due March 5, 1996, bearing interest at 4.85% per annum and $5 million principal amount of Secured Medium-Term Notes, Series B, due March 5, 1998, bearing interest at 5.70% per annum. Proceeds of these issues were used to redeem $20 million principal amount of First Mortgage Bonds, 6.625% Series due 1997, on April 2, 1993. On November 29, 1993, the Company issued a total of $14 million principal amount of Secured Medium-Term Notes which consisted of $3 million principal amount of Secured Medium-Term Notes, Series B, due December 1, 2003, bearing interest at 6.20% per annum and $11 million principal amount of Secured Medium-Term Notes, Series B, due December 2, 2003, bearing interest at 6.40% per annum. Proceeds of these issues were used to pay down short-term debt. On February 1, 1994, the Company issued $55 million principal amount of Secured Medium-Term Notes, Series B, due February 1, 2024, bearing interest at 7.35% per annum. Proceeds of this issue were used to extinguish $50 million principal amount of the Company's First Mortgage Bonds, 9.625% Series due 1997. The Company redeemed $24.5 million through a tender offer completed February 7, 1994. A portfolio of U.S. Government Treasury Securities was purchased to defease the remaining $25.5 million of the bonds. On April 29, 1993, the Company issued $23.46 million principal amount of Pollution Control Revenue Refunding Bonds, 5.875% Series due 2020. The proceeds were used to refund, on April 29, 1993, $16.46 million principal amount of Pollution Control Revenue Bonds, 5.90% 1973 Series and $7.0 million principal amount of Pollution Control Revenue Bonds, 6.30% 1977 Series. In February 1992, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to $200 million of preferred stock. Either $25 par value or $100 par value preferred stock may be issued. In 1992, the Company issued an aggregate of $150 million of preferred stock from this shelf. On February 3, 1994, the Company issued $50 million, Adjustable Rate Cumulative Preferred Stock, Series B ($25 par value). The proceeds were used to retire the $40 million principal amount of its Adjustable Rate Cumulative Preferred Stock, Series A ($100 par value)and to pay down short-term debt. On July 1, 1993, the Company sold 3.45 million shares of common stock. The stock was priced at $27.875 per share and resulted in proceeds to the Company of approximately $93 million. The proceeds were used to redeem the $50 million principal amount FLEX DARTS Series B Preferred Stock on July 6, 1993 with the balance used to pay down short-term debt. Short-term borrowings from banks and the sale of commercial paper are used to provide working capital for the construction program. At December 31, 1993, the Company had in place $152 million in lines of credit with several banks, which provide liquidity support for outstanding commercial paper of $70.0 million, effectively reducing the available borrowing capacity under these lines of credit to $82.0 million. (See Note 7 to the Consolidated Financial Statements.) RATE MATTERS On September 21, 1993, the Washington Commission issued two rate orders, one regarding the Company's request for an increase in general rates, the other relating to an annual rate adjustment under the Company's Periodic Rate Adjustment Mechanism ("PRAM"). In its revised general rate request, the Company had requested a $97 million increase and in its $76.3 million PRAM request it had requested a first year recovery of between $27.6 and $38.1 million of previously deferred costs under the PRAM. The Washington Commission authorized a general rate increase of $21.9 million, reflecting increased costs of service, and collection of $35.7 million in the first year to recover previously deferred costs under the PRAM. The Washington Commission authorized full recovery of the Company's PRAM request within two years from the end of the year in which the costs were deferred. The total increase in rates of $57.6 million was effective October 1, 1993. The Washington Commission also authorized the Company to increase rates by an additional $3.9 million effective October 1, 1993 to recognize, prospectively, the effect of the increase in the Federal corporate income tax rate from 34 to 35 percent. While the Washington Commission's order allowed only $57.6 million of the total requested rate relief, an additional amount of approximately $33.1 million remains eligible for deferral and future recovery through the continued operation of the PRAM. This amount includes such items as the Tenaska purchase power contract (a 245 megawatt cogeneration facility scheduled for operation in April of 1994), costs associated with the impact of hydro conditions and costs associated with fuel costs at the Colstrip plant in Montana. The Washington Commission authorized a 10.5 percent return on common equity and a common equity component of 45 percent, compared to the Company's request for a 12.25 percent return on common equity and a 45 percent common equity component. This lower return on equity reduced the amount the Washington Commission granted by approximately $30 million. Prior to October 1, 1993, provision was made for uninsured storm damage, with the approval of the Washington Commission, on the basis of the amount of outside insurance in effect and historical losses. To the extent actual costs varied from the provision, the difference was deferred for incorporation into future rates. The general rate order terminated, prospectively, the provision for deferral of uninsured storm damage except for certain losses associated with major catastrophic events. At December 31, 1993, the Company had no insurance coverage for storm damage. The general rate order also required the Company to file a case by November 1, 1993, demonstrating the prudency of its eight new power purchase contracts acquired since its last general rate case. Pending the resolution of the prudency review case, the Washington Commission ordered that the Company's new rates, effective October 1, 1993, would be collected subject to refund to the extent this proceeding demonstrates any of those contracts to be imprudent. The Washington Commission calculated the annual revenue requirement at risk to be up to $86.1 million. This amount is the difference between the Company's power costs under the new power purchase contracts and the Washington Commission's estimated cost of purchasing equivalent power on the secondary market. The Company filed its prudency case on October 18, 1993, and expects the Washington Commission to enter a final order before October 1, 1994. The decrease in allowed return on equity from 12.8 percent in the last general rate case to 10.5 percent approved in the present rate case has put downward pressure on earnings since the order became effective on October 1, 1993. In addition, it will be difficult for the Company to earn its full allowed rate of return because of changes made by the rate orders in the recovery methods of certain costs. Therefore, the Company continues to place strong emphasis on its ongoing improvement efforts designed to increase operating efficiencies. As a regulated electric utility, the Company's financial condition is largely dependent on continued cost-recovery regulation by the Washington Commission. Adverse action by the Washington Commission in regulatory matters involving the Company, including the pending prudency review case, could adversely impact the Company's financial condition and threaten its ability to maintain the dividend on its common stock at current levels. OTHER The Company and BPA have entered into a letter of intent, subject to various conditions, regarding pursuit of construction of a joint transmission project in Whatcom and Skagit counties in northern Washington state, the northernmost portion of the Company's service territory. The joint project is intended to provide the Company and BPA with certain transfer capacity with Canadian utilities and is intended to relieve certain transmission constraints on the respective systems of BPA and the Company. The joint project would involve a combination of existing facility upgrades and new construction and is currently under environmental review. The Company's efforts in this project are preliminary in nature and, as such, the Company cannot give assurance that any construction will result. The Company also continues to seek reasonable terms for acquiring capacity rights to BPA's planned third A.C. line, which would provide additional transmission capacity between the Pacific Northwest and the Southwestern states. The Company expects to receive 371 MW of southbound capacity on the line from BPA and 284 MW of northbound capacity. The price of participation is expected to be $215 per KW for each KW of rated southbound capacity or a total capital cost of $80 million. The Company is in the process of replacing the High Molecular Weight ("HMW") underground distribution cable installed during the 1960s and 1970s. The Company installed about 4,800 miles of industrial standard HMW cable between 1964 and 1979, but the Company and other utilities have experienced increasing cable failures in recent years. The Company is continuing to analyze cable failure trends to find ways to mitigate the long term effect of cable failures on customer service, within budgetary constraints. To minimize the impact of increasing cable failures, the Company replaces an increasing amount of HMW cable each year. The Company estimates that the total cost of replacing all 4,800 miles of cable will be about $550 million over a 15 to 20-year period. With 310 miles of cable replaced to date, the Company expects to spend $66 million during the period 1994-1997 for replacement of this cable. The Company presently has no plans for major diversification outside of the electric utility field and expects revenues in the near future to be generated almost entirely by electric utility operations. Investments in and advances to subsidiaries increased $14.2 million in 1993 primarily as a result of advances to a subsidiary developing small hydro projects. The electric utility industry in general is experiencing intensifying competitive pressures, particularly in wholesale generation and industrial customer markets. The National Energy Policy Act of 1992 was designed to increase competition in the wholesale electric generation market by easing regulatory restrictions on producers of wholesale power and by authorizing the FERC to mandate access to electric transmission systems by wholesale power generators. The potential for increased competition at the retail level in the electric utility industry through state-mandated retail wheeling has also been the subject of legislative and administrative interest in a number of states, including the state of Washington. Electric utilities, including the Company, now face greater potential competition for resources and customers from a variety of sources, including privately owned independent power producers, exempt wholesale power generators, industrial customers developing their own generation resources, suppliers of natural gas and other fuels, other investor-owned electric utilities and municipal generators. All four of the major credit rating agencies have expressed the view that competitive developments in the electric utility industry are likely to increase business risks, with resulting pressure on utility credit quality. One of the rating agencies has stated that it is revising its financial ratio guidelines for electric utilities to reflect the changing risk profiles within the industry. These rating agency actions may result in higher capital costs and more limited access to capital markets for electric utilities, including the Company. Although the Company to date has not experienced any significant adverse impact on its business from these industry trends, the Company has taken a number of steps to prepare for a more competitive business environment. These include programs to become a lower-cost producer by improving productivity and reducing the work force. The Company decided in January 1994 to offer an early separation plan to all officers, senior and middle managers and eligible professional staff. Benefits offered to those electing the program include a severance package based on years of service and enhanced retirement benefits for employees over 55 years of age. The number of employees that will accept the offer is presently not known. The Company has not set any specific job reduction targets. The Company, based on studies performed, currently estimates the total severance cost will not exceed $10 million. However, the total severance cost is dependent on the number of employees ultimately accepting the plan. The accrual for costs of this program will be recognized in the first quarter of 1994. Subsequent periods' expense will benefit from the savings associated with the reduced workforce. While the program will result in a net cost to the Company in 1994, the Company expects to see net savings in 1995 and beyond. The Company is also reviewing the extent of its investment in regulatory assets that may not be readily marketable to others in a competitive marketplace. The Company is seeking state legislation to provide a firm statutory basis for recovery of demand-side management regulatory assets associated with the Company's conservation programs. For a discussion of Environmental obligations, see Note 14 to the Consolidated Financial Statements. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See index on page 35. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - NONE. PART III Part III is incorporated by reference from the Company's definitive proxy statement issued in connection with the 1993 Annual Meeting of Shareholders. Certain information regarding executive officers is set forth in Part I. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1) Financial statement schedules - see index on page 35. 2) Exhibits - see index on page 67. (b) Reports on Form 8-K: None SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PUGET SOUND POWER & LIGHT COMPANY By /s/ R. R. Sonstelie -------------------------------------- R. R. Sonstelie President and Chief Executive Officer Date: March 1, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date - --------------------------- -------------------------- --------- /s/ R. R. Sonstelie President and - --------------------------- Chief Executive Officer (R. R. Sonstelie) and Director /s/ William S. Weaver Executive Vice President and - --------------------------- Chief Financial Officer (William S. Weaver) and Director March 1, /s/ R. E. Olson Vice President Finance - --------------------------- and Treasurer (R. E. Olson) (Principal Accounting Officer) /s/ Douglas P. Beighle Director - --------------------------- (Douglas P. Beighle) /s/ Charles W. Bingham Director - --------------------------- (Charles W. Bingham) /s/ Phyllis J. Campbell Director - --------------------------- (Phyllis J. Campbell) /s/ John H. Dunkak Director - --------------------------- (John H. Dunkak III) /s/ John D. Durbin Director - --------------------------- (John D. Durbin) /s/ John W. Ellis Director - --------------------------- (John W. Ellis) /s/ Daniel J. Evans Director - --------------------------- (Daniel J. Evans) /s/ Nancy L. Jacob Director - --------------------------- (Nancy L. Jacob) Director - --------------------------- (R. Kirk Wilson) Puget Sound Power & Light Company Report of Management: March 2, 1994 The accompanying consolidated financial statements of Puget Sound Power & Light Company have been prepared under the direction of management, which is responsible for their integrity and objectivity. The statements have been prepared in accordance with generally accepted accounting principles and include amounts based on judgments and estimates by management where necessary. Management also has prepared the other information in the Form 10-K and is responsible for its accuracy and consistency with the financial statements. The Company maintains a system of internal control which, in management's opinion, provides reasonable assurance that assets are properly safeguarded and transactions are executed in accordance with management's authorization and properly recorded to produce reliable financial records and reports. The system of internal control provides for appropriate division of responsibility and is documented by written policy and updated as necessary. The Company's internal audit staff assesses the effectiveness and adequacy of the internal controls on a regular basis and recommends improvements when appropriate. Management considers the internal auditor's and independent auditor's recommendations concerning the Company's internal controls and takes steps to implement those that they believe are appropriate in the circumstances. In addition, Coopers & Lybrand, the independent auditors, have performed audit procedures deemed appropriate to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Board of Directors pursues its oversight role for the financial statements through the audit committee, which is composed solely of outside Directors. The audit committee meets regularly with management, the internal auditors and Coopers & Lybrand, jointly and separately, to review management's process of implementation and maintenance of internal accounting controls and auditing and financial reporting matters. The internal and independent auditors have unrestricted access to the audit committee. R. R. Sonstelie William S. Weaver Russel E. Olson ___________________ _______________________ ______________________ R. R. Sonstelie William S. Weaver Russel E. Olson President and Executive Vice President Vice President Finance Chief Executive and Chief Financial and Treasurer (Principal Officer Officer Accounting Officer) REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders of Puget Sound Power & Light Company We have audited the consolidated financial statements and the financial statement schedules of Puget Sound Power & Light Company listed on page 35 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As more fully discussed in Note 14 to the financial statements, the Washington Commission, in its September 21, 1993 rate orders, authorized an increase in the Company's rates effective October 1, 1993 and required the Company to file another case demonstrating the prudency of certain power purchase contracts. Pending its decision in the prudency review case, the Washington Commission ordered that the new rates would be collected subject to refund to the extent any of the contract amounts were found to be imprudent. Management of the Company believes that the power purchase contracts are prudent. The Washington Commission's decision on the case is expected in September 1994. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Puget Sound Power & Light Company as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 11 and 12, effective January 1, 1993, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. Coopers & Lybrand Seattle, Washington February 10, 1994 PUGET SOUND POWER & LIGHT COMPANY CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY THE FOREGOING REPORT OF INDEPENDENT ACCOUNTANTS CONSOLIDATED FINANCIAL STATEMENTS: Page Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991........................................36 Consolidated Balance Sheets, December 31, 1993 and 1992...................37 Consolidated Statements of Capitalization, December 31, 1993 and 1992.....39 Consolidated Statements of Earnings Reinvested in the Business for the years ended December 31, 1993, 1992 and 1991....................40 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991..................................41 Notes to Consolidated Financial Statements................................42 SCHEDULES: II. Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties for the years ended December 31, 1993, 1992 and 1991........................63 V. Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................................64 VI. Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................................65 VIII. Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991........................66 All other schedules have been omitted because of the absence of the conditions under which they are required, or because the information required is included in the financial statements or the notes thereto. Financial statements of the Company's subsidiaries are not filed herewith inasmuch as the assets, revenues, earnings and earnings reinvested in the business of the subsidiaries are not material in relation to those of the Company. Puget Sound Power & Light Company Notes To Consolidated Financial Statements - ------------------------------------------------------------------------- 1) Summary of Accounting Policies Significant accounting policies are described below. Utility Plant: The costs of additions to utility plant, including renewals and betterments, are capitalized at original cost. Costs include indirect costs such as engineering, supervision, certain taxes and pension and other benefits, and an allowance for funds used during construction. Replacements of minor items of property are included in maintenance expense. The original cost of operating property together with removal cost, less salvage, is charged to accumulated depreciation when the property is retired and removed from service. Consolidation and Investment in Subsidiaries: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Puget Energy, Inc. ("Puget Energy"). Guaranteed Collateralized Bonds were issued by Puget Energy and the net proceeds from the sale of bonds were advanced to the Company (see Note 6). Puget Energy has no independent operations. Investments in all other subsidiaries are stated on an equity basis. Operating Revenues: Operating revenues are recorded on the basis of service rendered, which includes estimated unbilled revenue and revenue accrued under the Periodic Rate Adjustment Mechanism ("PRAM"). Energy Conservation: The Company accumulates energy conservation expenditures which are amortized to expense over a ten-year period when authorized by the Washington Utilities and Transportation Commission ("Washington Commission"). The Washington Commission allows an additional overall rate of return of .90% on the Company's unamortized energy conservation expenditures and on energy conservation loans to customers made prior to January 1, 1991. Self-Insurance: Prior to October 1, 1993, provision was made for uninsured storm damage, comprehensive liability, industrial accidents and catastrophic property losses, with the approval of the Washington Commission, on the basis of the amount of outside insurance in effect and historical losses. To the extent actual costs varied from the provision, the difference was deferred for incorporation into future rates. The amount deferred and included in other long-term assets at December 31, 1993, was approximately $26.8 million. In its September 21, 1993 order, the Washington Commission terminated, prospectively, the provision for deferral of uninsured storm damage except for certain losses associated with major catastrophic events. The Washington Commission in its order did provide for recovery annually of $2.8 million in deferred storm damage costs in retail rates, beginning October 1, 1993. The order also terminated the provision for deferral of other uninsured losses retroactively, resulting in an after-tax writeoff in 1993 of $2.0 million. At December 31, 1993, the Company had no insurance coverage for storm damage. Depreciation and Amortization: For financial statement purposes, the Company provides for depreciation on a straight-line basis. The depreciation of automobiles, trucks, power operated equipment and tools is allocated to asset and expense accounts based on usage. With the Washington Commission's approval, the Company reduced its depreciation rates in 1993. This adjustment had the effect of reducing depreciation expense by $10.5 million during 1993. The annual depreciation provision stated as a percent of average original cost of depreciable utility plant was 3.1% in 1993 and 3.4% for 1992 and 1991. The Company's investments in terminated generating projects are being amortized on a straight-line basis over ten years for regulatory purposes (included in operating income as "Depreciation and amortization"). Amounts recoverable through rates related to investments in terminated generating projects and the Bonneville Exchange Power Contract were adjusted to their present value in prior years in accordance with Statement of Financial Accounting Standards No. 90. These adjustments result in reduced net amortization expense over the recovery periods, the effect of which is included in miscellaneous income in the amount, net of federal income tax expense, of $2.7 million, $3.6 million and $4.5 million for 1993, 1992 and 1991, respectively. Federal Income Taxes: The Company normalizes, with the approval of the Washington Commission, certain items. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109. (See Note 11.) Allowance for Funds Used During Construction: The Allowance for Funds Used During Construction ("AFUDC") represents the cost of both the debt and equity funds used to finance utility plant additions during the construction period. The amount of AFUDC recorded in each accounting period varies depending principally upon the level of construction work in progress and the AFUDC rate used. AFUDC is capitalized as a part of the cost of utility plant and is credited as a non-cash item to other income and interest charges currently. Cash inflow related to AFUDC does not occur until these charges are reflected in rates. The AFUDC rate allowed by the Washington Commission is the Company's authorized rate of return, which was 10.22% effective January 30, 1990, 10.16% effective October 1, 1991 and 8.94% effective October 1, 1993. To the extent this rate exceeds the maximum AFUDC rate calculated using the Federal Energy Regulatory Commission ("FERC") formula, the Company capitalizes the excess as a deferred asset, crediting miscellaneous income. The amounts included in income were: $2,309,000 for 1993; $3,680,000 for 1992 and $1,686,000 for 1991. Allowance For Funds Used to Conserve Energy: Beginning in April 1991, the Washington Commission authorized the Company to capitalize, as part of energy conservation costs, related carrying costs calculated at a rate established by the Washington Commission. This Allowance for Funds Used to Conserve Energy ("AFUCE") has been credited as a non-cash item to miscellaneous income in the amount of $4,276,000 in 1993, $4,454,000 in 1992 and $767,000 in 1991. Cash inflow related to AFUCE occurs when these charges are reflected in rates. Periodic Rate Adjustment Mechanism: In April 1991, the Washington Commission issued an order establishing a PRAM designed to operate as an interim rate adjustment mechanism between tri-annual general rate cases. Under the PRAM, the Company is allowed to request annual rate adjustments, on a prospective basis, to reflect changes in certain costs as set forth in the PRAM order. Also, under terms of the order, recovery of certain costs is decoupled from levels of electricity sales. Rates established for the PRAM period are subject to future adjustment based on actual customer growth and variations in certain costs, principally those affected by hydro and weather conditions. To the extent revenue billed to customers varies from amounts allowed under the methodology established in the PRAM order, the difference is accumulated, without interest, for rate recovery which will be established in the next PRAM hearing. In its September 21, 1993 order, the Washington Commission approved the Company's latest PRAM filing. A receivable of approximately $85.0 million was recorded at December 31, 1993 under this methodology. Amounts expected to be collected within one year have been included in current assets. Other: The carrying amount of cash, which includes temporary investments with maturities of 3 months or less, is considered to be a reasonable estimate of fair value. Debt premium, discount and expenses are amortized over the life of the related debt. Certain costs have been deferred for amortization in subsequent years, as it is considered probable that such costs will be recovered through future rates. Earnings Per Common Share: Earnings per common share have been computed based on the weighted average number of common shares outstanding. On January 15, 1991, the Board of Directors declared a dividend of one preference share purchase right (a "Right") on each outstanding common share of the Company. The dividend was distributed on January 25, 1991, to shareholders of record on that date. The Rights will be exercisable only if a person or group acquires 10 percent or more of the Company's common stock or announces a tender offer which, if consummated, would result in ownership by a person or group of 10 percent or more of the common stock. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Preference Stock, $50 par value per share, at an exercise price of $45, subject to adjustments. The description and terms of the Rights are set forth in a Rights Agreement between the Company and The Chase Manhattan Bank, N.A., as Rights Agent. The Rights expire on January 25, 2001, unless earlier redeemed by the Company. In February 1992, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to $200 million of preferred stock. Either $25 par value or $100 par value preferred stock may be issued. On March 25, 1992, the Company issued $75 million, 7.75% Series, $100 par value Preferred Stock. The proceeds were used to retire $50 million principal amount of its Flexible Dutch Auction Rate Transferable Securities, $100 par value Preferred Stock ("FLEX DARTS"), Series A and to pay down short-term debt. On July 21, 1992, the Company issued $75 million, 7.875% Series, $25 par value Preferred Stock. The proceeds of this issue were used to pay down short-term debt. The 7.875% Series may be redeemed after July 14, 1997 at $25 per share plus accrued dividends. On July 1, 1993, the FLEX DARTS Series B were redeemed with the proceeds from the sale of the Company's common stock. The weighted average dividend rate for Series B was 3.30% for 1993, 3.60% for 1992 and 5.49% for 1991. The weighted average dividend rate for Series A was 4.18% in the first three months of 1992 and 5.28% for 1991. On February 3, 1994, the Company issued $50 million, Adjustable Rate Cumulative Preferred Stock ("ARPS"), Series B ($25 par value). The proceeds were used to retire the $40 million principal amount of its ARPS Series A ($100 par value). The weighted average dividend rate for the ARPS Series A was 7.00% for 1993, 7.17% for 1992 and 7.59% for 1991. For each quarterly period, dividends on the ARPS Series B, determined in advance of such period, will be set at 83% of the highest of three interest rates as defined in the Statement of Relative Rights and Preferences for ARPS Series B. The dividend rate for any dividend period will in no event be less than 4% per annum or greater than 10% per annum. Dividends from the date of issuance through May 14, 1994 will be payable at the rate of 5.24% per annum. The Company may redeem the ARPS Series B at any time on not less than 30 days notice at $27.50 per share on or prior to February 1, 1999, and at $25 per share thereafter, plus in each case accrued dividends to the date of redemption; provided however, that no shares shall be redeemed prior to February 1, 1999, if such redemption is for the purpose or in anticipation of refunding such share at an effective interest or dividend cost to the Company of less than 5.37% per annum. 3) Preferred Stock Subject to Mandatory Redemption The Company is required to deposit funds annually in a sinking fund sufficient to redeem the following number of shares of each series at $100 per share plus accrued dividends: 4.84% Series and 4.70% Series, 3,000 shares each; 8% Series, 6,000 and 1,000 shares through 2003 and 2004, respectively; and 7.75% Series, 37,500 shares on each February 15, commencing on February 15, 1998. Previous requirements have been satisfied by delivery of reacquired shares. At December 31, 1993, there were 13,939 shares of the 4.84% Series, 2,594 shares of the 4.70% Series and 704 shares of the 8% Series acquired by the Company and available for future sinking fund requirements. Upon involuntary liquidation, all preferred shares are entitled to their par value plus accrued dividends. The preferred stock subject to mandatory redemption (see Note 2) may also be redeemed by the Company at the following redemption prices per share plus accrued dividends: 4.84% Series, $102; 4.70% Series, $101; and 8% Series, $101. The 7.75% Series may be redeemed by the Company, subject to certain restrictions, at $106.72 per share plus accrued dividends through February 15, 1995 and at per share amounts which decline annually to a price of $100 after February 15, 2007. The preferred stock subject to mandatory redemption is estimated to have a fair value of $93.7 million or 100.6% of face value as of December 31, 1993. The fair value of preferred stock subject to mandatory redemption is estimated based on dealer quotes. 4) Additional Paid-in Capital 1993 1992 1991 - ----------------------------------------------------------------------------- (Dollars in Thousands) Balance at beginning of year $243,874 $198,733 $198,819 Excess of proceeds over stated values of: Common stock issued to trustee of employee investment plan 2,234 1,046 -- Common stock issued under the stock purchase and dividend reinvestment plan 24,584 10,841 -- Common stock sold to the public 61,669 37,950 -- Par value over(under) cost of reacquired preferred stock 612 579 (86) Issue costs of common stock (3,035) (1,950) -- Issue costs of preferred stock (16) (3,325) -- - ----------------------------------------------------------------------------- Balance at end of year $329,922 $ 243,874 $198,733 ============================================================================= 5) Earnings Reinvested in the Business Earnings reinvested in the business unrestricted as to payment of cash dividends on common stock approximated $266 million at December 31, 1993, under the provisions of the most restrictive covenants applicable to preferred stock and long-term debt contained in the Company's Articles of Incorporation and indentures. The adjustments made to the carrying value of costs associated with the terminated generating projects and Bonneville Exchange Power as a result of Statement of Financial Accounting Standards No. 90 and the disallowance of certain terminated generating project costs by the Washington Commission do not impact the amount of earnings reinvested in the business for purposes of payment of dividends on common stock under the terms of the aforementioned Articles and indentures. (See Note 1.) 6) Long-Term Debt First Mortgage Bonds and Guaranteed Collateralized Bonds - -------------------------------------------------------- First Mortgage Bonds at December 31: Series Due 1993 1992 Series Due 1993 1992 - --------------------------------------------------------------------------- (Dollars in Thousands) (Dollars in Thousands) 4.00% 1993 $ -- $ 40,000 9.14% 2001 $ 30,000 $ 30,000 4.75% 1994 15,000 15,000 7.75% 2002 -- 30,000 8.25% 1995 100,000 100,000 7.85% 2002 30,000 30,000 5.25% 1996 20,000 20,000 7.07% 2002 27,000 27,000 4.85% 1996 15,000 -- 7.15% 2002 5,000 5,000 6.625% 1997 -- 20,000 7.625% 2002 25,000 25,000 7.875% 1997 100,000 100,000 7.02% 2003 30,000 -- 9.625% 1997 50,000 50,000 6.20% 2003 3,000 -- 6.17% 1998 10,000 -- 6.40% 2003 11,000 -- 5.70% 1998 5,000 -- 7.70% 2004 50,000 50,000 8.83% 1998 25,000 25,000 8.06% 2006 46,000 46,000 7.50% 1999 -- 20,000 8.14% 2006 25,000 25,000 6.50% 1999 16,500 16,500 7.75% 2007 100,000 100,000 6.65% 1999 10,000 10,000 8.40% 2007 10,000 10,000 6.41% 1999 20,500 20,500 8.59% 2012 5,000 5,000 7.25% 1999 50,000 50,000 8.20% 2012 30,000 30,000 6.61% 2000 10,000 -- - --------------------------------------------------------------------------- Total First Mortgage Bonds $874,000 $900,000 =========================================================================== Guaranteed Collateralized Bonds at December 31: Series Due 1993 1992 Series Due 1993 1992 (Dollars in Thousands) (Dollars in Thousands) 8.05% 1993 $ -- $ 8,000 8.45% 1996 $ 8,000 $ 8,000 8.15% 1994 8,000 8,000 9.375% 2017 -- 114,000 8.30% 1995 8,000 8,000 - --------------------------------------------------------------------------- Total Guaranteed Collateralized Bonds $ 24,000 $146,000 =========================================================================== The Company has unconditionally guaranteed all payments of principal and premium, if any, and interest on each series of the Guaranteed Collateralized Bonds of Puget Energy issued in 1986. The guarantee of the Company with respect to each series of the Guaranteed Collateralized Bonds is backed by a related series of the Company's First Mortgage Bonds. Each related series of First Mortgage Bonds has been issued to the trustee for the Guaranteed Collateralized Bonds and so long as payment is made on the Guaranteed Collateralized Bonds no payment is due with respect to the related series of First Mortgage Bonds. Substantially all properties owned by the Company are subject to the lien of the First Mortgage Bonds. In February 1994, the Company extinguished $50 million principal amount of First Mortgage Bonds, 9.625% Series due 1997. The Company redeemed $24.5 million through a tender offer. A portfolio of U.S. Government Treasury Securities was purchased to defease the remaining $25.5 million of the bonds. The defeased bonds will be called on October 15, 1995. Pollution Control Revenue Bonds In June 1986, the Company entered into an agreement with the City of Forsyth, Montana, (the "City") borrowing $115 million obtained by the City from the sale of Customized Purchase Pollution Control Revenue Refunding Bonds due in 2012 (1986 Series) issued to finance the pollution control facilities of Colstrip Units 3 and 4. In April 1987, the Company entered into an agreement with the City, borrowing $23.4 million obtained by the City from the sale of Customized Purchase Pollution Control Revenue Refunding Bonds due December 1, 2016, (1987 Series) issued to finance additional pollution control facilities of Colstrip Unit 4. On August 7, 1991, the Company refunded $27.5 million of the 1986 Series and the entire $23.4 million of the 1987 Series with two new series of bonds, consisting of $27.5 million principal amount of a 7.05% Series due 2021 and $23.4 million principal amount of a 7.25% Series due 2021. In March 1992, the Company refunded the remaining $87.5 million of the 1986 Series with a new series at a rate of 6.80%, maturing in 2022. Each new series of bonds is collateralized by a pledge of the Company's First Mortgage Bonds, the terms of which match those of the pollution control bonds. No payment is due with respect to the related series of First Mortgage Bonds, so long as payment is made on the pollution control bonds. On April 29, 1993, the Company issued $23.46 million Pollution Control Revenue Refunding Bonds, 5.875% 1993 Series due 2020. The proceeds were used to refund $16.46 million Pollution Control Revenue Bonds, 5.90% 1973 Series and $7 million Pollution Control Revenue Bonds, 6.30% 1977 Series. Long-Term Debt Maturities and Sinking Fund Requirements - -------------------------------------------------------- The principal amounts of long-term debt maturities and sinking fund require- ments for the next five years are as follows: 1994 1995 1996 1997 1998 (Dollars in Thousands) Maturities of long-term debt $ 23,000 $108,000 $ 43,000 $150,000 $ 40,000 - ---------------------------------------------------------------------------- Sinking fund requirements $ 200 $ 200 $ -- $ -- $ -- - ---------------------------------------------------------------------------- The sinking fund requirement for the First Mortgage Bonds may be met by substitution of certain credits as provided in the indentures. The fair value of outstanding bonds including current maturities is estimated to be $1.126 billion or 106.2% of face value as of December 31, 1993. The fair value of long-term bonds is estimated based on quoted market prices. 7) Short-Term Debt The Company has short-term borrowing arrangements which include a $100 million line of credit with six major banks, a $50 million line of credit with four banks and a $2 million line with another three banks. The agreements provide the Company with the ability to borrow at different interest rate options. For the $100 million and $50 million lines of credit, the options are: (1) the higher of the prime rate or the Federal Funds rate plus 1/2 of 1 percent or (2) the bank Certificate of Deposit rate plus 1/2 of 1 percent or (3) the Eurodollar rate plus 3/8 of 1 percent. These Credit Agreements require an availability fee of 1/5 of 1% per annum on the unused loan commitment. Borrowings on the $2 million credit line are at the prime rate and compensating balances of 2-1/2% are required. In addition, the Company has agreements with several banks to borrow on an uncommitted, as available, basis at money-market rates quoted by the banks. There are no costs, other than interest, for these arrangements. The Company also uses commercial paper to fund its short-term borrowing requirements. At December 31: 1993 1992 1991 - ------------------------------------------------------------------------ (Dollars in Thousands) Short-term borrowings outstanding Bank notes $ 79,300 $ 69,800 $ 40,500 Commercial paper notes $ 70,006 $ 20,650 $ 71,289 Weighted average interest rate 3.49% 4.37% 5.49% Unused lines of credit (a) $152,000 $152,000 $153,000 During the year ended December 31: Maximum aggregate short-term borrowings $149,306 $146,158 $111,789 Average daily short-term borrowings (b) $ 55,244 $ 81,509 $ 59,931 Weighted average interest rate (c) 3.40% 4.15% 6.35% - ------------------------------------------------------------------------ (a) Provides liquidity support for outstanding commercial paper in the amount of $70.0 million, $20.7 million and $71.3 million for 1993, 1992 and 1991, respectively, effectively reducing the available borrowing capacity under these credit lines to $82.0 million, $131.3 million and $81.7 million, respectively. (b) The sum of dollar days of outstanding borrowings divided by actual days in period. (c) Actual accrued interest during the period divided by average daily borrowings. The carrying value of short-term debt is considered to be a reasonable estimate of fair value. 8) Investment in Bonneville Exchange Power Contract The Company has a five percent interest, as a tenant in common with three other investor-owned utilities and Washington Public Power Supply System ("WPPSS"), in the WPPSS Unit 3 project. Unit 3 is a partially constructed 1,240,000 kilowatt nuclear generating plant at Satsop, Washington, which is in a state of extended construction delay instituted by the Bonneville Power Administration ("BPA") and WPPSS in 1983. Under the terms of a settlement agreement (the "Settlement Agreement"), which includes a Settlement Exchange Agreement ("Bonneville Exchange Power Contract") between the Company and BPA dated September 17, 1985, the Company is receiving electric power (the "Bonneville Exchange Power") from the federal power system resources marketed by the BPA for a period of approximately 30.5 years which commenced January 1, 1987. The Settlement Agreement settled the claims of the Company against WPPSS and BPA relating to the construction delay of the WPPSS Unit 3 project. In its general rate case order issued on January 17, 1990, the Washington Commission found that all WPPSS Unit 3/Bonneville Exchange Power costs had been prudently incurred. Under terms of the order, approximately two-thirds or $97 million of the investment in Bonneville Exchange Power is included in rate base and amortized on a straight-line basis over the remaining life of the contract (amortization is included in "Purchased and interchanged power"). The remainder of the Company's investment is being recovered in rates over ten years, without a return during the recovery period. The related amortization is included in "Depreciation and amortization," pursuant to a FERC accounting order. Several issues in the litigation relating to WPPSS Unit 3, including claims on behalf of WPPSS Unit 5 against the Company and the other Unit 3 owners seeking recovery of certain common costs, have not been settled by the Settlement Agreement. The claims with respect to WPPSS Unit 3 and Unit 5 common costs, made in the United States District Court for the Western District of Washington, arise out of the fact that Unit 3 and Unit 5 were being constructed adjacent to each other and were planned to share certain costs. Unit 3 is in a state of extended construction delay and Unit 5 was terminated prior to completion. In 1989, the Company and other parties submitted arguments and affidavits to the United States District Court, in response to an order of the court, on the proper basis or bases upon which costs should have been allocated between Unit 3 and Unit 5 under the WPPSS Unit 4 and 5 Bond Resolution. On October 5, 1990, the District Court ruled that certain cost allocations between Unit 3 and Unit 5 (and between WPPSS Unit 1 and Unit 4) were improper. The District Court determined that principles of incremental cost sharing were not applied and, as a result, Unit 4 and Unit 5 apparently bore more than their fair and equitable share of construction costs. The District Court granted the motion by the trustee for WPPSS Unit 4 and Unit 5 bondholders for an accounting of all uses of WPPSS Unit 4 and Unit 5 bond proceeds to determine, among other things, the extent of improper allocation of such costs. In January 1991, the United States Court of Appeals for the Ninth Circuit granted the Company and others permission to appeal on an interlocutory basis from the District Court's orders. In February 1992, the Court of Appeals ruled on the District Court's October 5, 1990 order and held that principles of incremental cost sharing were not required and remanded the matter to the District Court for further proceedings. The ultimate resolution of these issues is not expected to have a material adverse impact on the financial condition or operations of the Company. 9) Supplementary Income Statement Information 1993 1992 1991 - ---------------------------------------------------------------------- (Dollars in Thousands) Taxes: Real estate and personal property $ 29,354 $ 30,839 $29,023 State business 40,102 35,798 33,709 Municipal, occupational and other 23,064 21,136 20,887 Payroll 9,664 9,517 8,933 Other 3,462 5,300 4,316 - ---------------------------------------------------------------------- Total taxes $105,646 $102,590 $96,868 - ---------------------------------------------------------------------- Charged to: Tax expense $100,598 $ 94,466 $89,640 Other accounts, including construction work in progress 5,048 8,124 7,228 - ---------------------------------------------------------------------- Total taxes $105,646 $102,590 $96,868 ====================================================================== See "Consolidated Statements of Income" for maintenance and depreciation expense. Advertising, research and development expenses and amortization of intangibles are not significant. The Company pays no royalties. 10) Leases The Company classifies leases as operating or capital leases. Capitalized leases are not material. The Company treats all leases as operating leases for ratemaking purposes as required by the Washington Commission. Rental and lease payments for the years ended December 31, 1993, 1992 and 1991 were approximately $14,016,000, $13,773,000 and $12,945,000, respectively. At December 31, 1993, future minimum lease payments for noncancelable leases are $8,279,000 for 1994, $8,211,000 for 1995, $8,158,000 for 1996, $8,194,000 for 1997, $7,934,000 for 1998 and in the aggregate $39,225,000 thereafter. 11) Federal Income Taxes The details of federal income taxes ("FIT") are as follows: 1993 1992 1991 - --------------------------------------------------------------------------- Charged to Operating Expense: (Dollars in Thousands) Current $56,908 $67,762 $54,004 Deferred investment tax credits - net (2,118) (4,018) (4,258) Deferred - net 29,180 8,705 6,434 - --------------------------------------------------------------------------- Total FIT charged to operations $83,970 $72,449 $56,180 =========================================================================== Charged to Miscellaneous Income: Current $(3,665) $(5,207) $(2,985) Deferred 3,087 2,596 2,175 - --------------------------------------------------------------------------- Total FIT charged to miscellaneous income $ (578) $(2,611) $ (810) =========================================================================== Total FIT $83,392 $69,838 $55,370 =========================================================================== The following is a reconciliation of the difference between the amount of FIT computed by multiplying pre-tax book income by the statutory tax rate, and the amount of FIT in the Consolidated Statements of Income: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) - --------------------------------------------------------------------------- FIT at the statutory rate $77,602 $69,890 $63,970 - --------------------------------------------------------------------------- Increase (Decrease): Depreciation expense deducted in the financial statements in excess of tax depreciation, net of depreciation treated as a temporary difference 4,698 5,295 4,754 AFUDC included in income in the financial statements but excluded from taxable income (2,563) (2,438) (2,112) Investment tax credit amortization (2,118) (4,018) (4,264) Amortization of Pebble Springs and Skagit/ Hanford projects, deducted for financial statements but not deducted for income tax purposes, net of amount treated as a temporary difference 1,465 1,748 1,748 Energy conservation expenditures, net 5,608 (1,245) (11,635) Other (1,300) 606 2,909 - --------------------------------------------------------------------------- Total FIT $83,392 $69,838 $55,370 =========================================================================== Effective tax rate 37.6% 34.0% 29.4% =========================================================================== The following are the principal components of FIT as reported: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) - --------------------------------------------------------------------------- Current FIT $53,243 $62,555 $51,019 =========================================================================== Deferred FIT - other: Conservation tax settlement (257) (22,645) -- Periodic rate adjustment mechanism (PRAM) 14,959 14,321 228 Deferred taxes related to insurance reserves 1,409 596 4,282 Terminated generating projects (5,735) (6,647) (6,647) Reversal of Statement No. 90 present value adjustments 1,477 2,374 3,096 Residential Purchase and Sale Agreement, net 4,136 2,491 (1,008) Normalized tax benefits of the accelerated cost recovery system 19,839 21,237 15,693 Energy conservation program (2,938) (3,360) (3,662) Other (623) 2,934 (3,373) - --------------------------------------------------------------------------- Total deferred FIT - other $32,267 $11,301 $ 8,609 =========================================================================== Deferred investment tax credits - net of amortization $(2,118) $(4,018) $(4,258) - ---------------------------------------------------------------------------- Total FIT $83,392 $69,838 $55,370 =========================================================================== Deferred tax amounts shown above result from temporary differences for tax and financial statement purposes. Deferred tax provisions are not recorded in the income statement on certain temporary differences for tax and financial statement purposes because they are not allowed for ratemaking purposes. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement No. 109"). Statement No. 109 requires recording deferred tax balances, at the currently enacted tax rate, for all temporary differences between the book and tax bases of assets and liabilities, including temporary differences for which no deferred taxes had been previously provided because of use of flow- through tax accounting for rate-making purposes. Under the provision of Statement No. 109, the Company recorded at the date of adoption an additional deferred tax liability of approximately $272 million. Because of prior, and expected future, ratemaking treatment for differences resulting from flow- through tax accounting, a corresponding regulatory asset for income taxes recoverable through future rates of $272 million was also established at the date of adoption. At December 31, 1993, the balance of this asset is $281 million. The cumulative effect on net income for the current period from adoption of Statement No. 109 was not significant. Adoption is not expected to significantly impact income tax expense in the future. The Company has reclassified as liabilities deferred income taxes previously netted with plant and other property and investments of $196 million in 1992. The deferred tax liability at December 31, 1993 is comprised of amounts related to the following types of temporary differences (thousands of dollars): Utility plant $425,210 PRAM 29,885 Energy conservation charges 44,548 Contributions in aid of construction (21,814) Bonneville Exchange Power 18,968 Other 31,868 ------- Total $528,665 ======== The total of $529 million consists of deferred tax liabilities of $559 million net of deferred tax assets of $30 million. In 1992, the Company reached an agreement with the Internal Revenue Service (the "Service") settling a number of issues. As part of the agreement, the Company agreed to accept the Service's position that energy conservation expenditures should be capitalized for tax purposes and deducted over the book life of the asset. Acceptance of the Service's position had no effect on net income because the Company obtained an accounting order from the Washington Commission with respect to additional tax expense associated with the settlement. The net income impact of other elements of the settlement was approximately $1.4 million. 12) Retirement Benefits The Company has a noncontributory defined benefit pension plan covering substantially all of its employees. The benefit formula is a function of both years of service and the average of the five highest consecutive years of basic earnings within the last ten years of employment. The Company funds pension cost using the "frozen entry-age" actuarial cost method. Through September 30, 1993, in accordance with the methodology confirmed in the January 17, 1990 general rate order from the Washington Commission, the Company has recognized pension costs for ratemaking and financial statement purposes using a formula based on a multi-year average of actual contributions to the plan. Effective October 1, 1993, because of a change in methodology made by the Washington Commission in its September 21, 1993 rate order, the Company's pension costs for financial statement purposes are determined in accordance with the provisions of Statement of Financial Accounting Standards No. 87, "Accounting for Pensions." Net pension costs for 1993, 1992 and 1991, including $1,440,000 for 1993, $811,000 for 1992 and $741,000 for 1991 which were charged to construction and other asset accounts, were comprised of the following components: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) Service cost (benefits earned during the period) $ 6,952 $ 6,492 $ 5,919 Interest cost on projected benefit obligation 14,676 13,743 12,510 Actual return on plan assets (21,786) (9,426) (31,492) Net amortization and deferral 5,121 (5,470) 17,826 - --------------------------------------------------------------------------- Net pension costs under FASB Statement No. 87 4,963 5,339 4,763 - --------------------------------------------------------------------------- Regulatory adjustment (2,083) (3,575) (2,999) - --------------------------------------------------------------------------- Net pension costs $ 2,880 $ 1,764 $ 1,764 =========================================================================== Funded Status of Plan At December 31: 1993 1992 - --------------------------------------------------------------------------- (Dollars in Thousands) Actuarial present value of benefit obligations: Vested $(151,399) $(125,019) Nonvested (1,090) (616) - ---------------------------------------------------------------------------- Accumulated benefit obligation (152,489) (125,635) Effect of future compensation levels (53,998) (51,072) - --------------------------------------------------------------------------- Total projected benefit obligation (206,487) (176,707) Plan assets at market value 214,580 191,776 - --------------------------------------------------------------------------- Plan assets in excess of projected benefit obligation 8,093 15,069 Unrecognized net gain due to variance between assumptions and experience (14,344) (26,145) Prior service cost 11,232 12,249 Transition asset as of January 1, 1986, being amortized on a straight-line basis over 18 years (4,194) (4,614) Regulatory adjustment, cumulative 7,453 5,370 - --------------------------------------------------------------------------- Prepaid pension cost recognized in long-term assets on balance sheet $ 8,240 $ 1,929 =========================================================================== Assumptions used for the above calculations are as follows: settlement (discount) rate for 1993 - 7.5%, for 1992 and 1991 - 8.5%; rate of annual compensation increase for 1993 - 5.5%, for 1992 and 1991 - 6%; and long-term rate of return on assets for 1993 - 8.5%, for 1992 and 1991 - 9%. Plan assets consist primarily of U.S. Government securities, corporate debt and equity securities. Effective October 1, 1991, the Company's Board of Directors approved supplemental retirement plans for officer and director level employees. Expenses for this plan for 1993, 1992 and 1991 were $651,000, $606,000 and $148,500, respectively. At December 31, 1993, a minimum liability and an intangible asset of $1,732,000 related to this plan are included in the financial statements. In addition to providing pension benefits, the Company provides certain health care and life insurance benefits for retired employees. Substantially all of the Company's employees may become eligible for those benefits if they reach normal retirement age while working for the Company. These benefits are provided through an insurance company whose premiums are based on the benefits paid during the year. The Company recognized the cost of providing those benefits by expensing $2,025,000 and $2,095,000 for the years 1992 and 1991, respectively. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("Statement No. 106") which requires the costs associated with postretirement benefits to be accrued during the working careers of active employees. The Company is recognizing the impact of Statement No. 106 by amortizing its transition obligation of $24.9 million to expense over 20 years. The resulting 1993 annual cost under Statement No. 106 is approximately $3.8 million. In the rate order issued by the Washington Commission on September 21, 1993, the Washington Commission approved adoption of accrual accounting for postretirement benefits. For rate purposes, the difference between accrual and pay-as-you-go accounting will be phased in over five years. The Washington Commission's calculation of Statement No. 106 costs for rate purposes is lower than the Company's cost. In 1993, the expense recognized for postretirement benefits was $2.8 million, including $.5 million disallowed by the Washington Commission which was expensed. An additional $1.0 million was deferred under provisions of the Washington Commission's five year phase-in plan. 13) Employee Investment Plan The Company has a qualified employee Investment Plan under which employee salary deferrals and after-tax contributions are used to purchase several different investment fund options. The Company makes a monthly contribution equal to 55% of the basic contribution of each participating employee. The basic contribution is limited to 6% of the employee's eligible earnings. All Company contributions are used to purchase Company common stock on the open market or directly from the Company. The Company contributions to the plan were $3,520,000, $3,317,000 and $3,129,000 for the years 1993, 1992 and 1991, respectively. The shareholders have authorized the issuance of up to 1,000,000 shares of common stock under the plan, of which 959,142 were issued through December 31, 1993. The employee Investment Plan eligibility requirements are set forth in the plan documents. 14) Commitments and Contingencies Commitments For the twelve months ended December 31, 1993, approximately 27% of the Company's energy output was obtained at an average cost of approximately 11.9 mills per KWH through long-term contracts with several of the Washington public utility districts ("PUDs") owning hydroelectric projects on the Columbia River. The purchase of power from the Columbia River projects is generally on a "cost-of-service" basis under which the Company pays a proportionate part of the annual cost of each project in direct ratio to the amount of power allocated to it. Such payments are not contingent upon the projects being operable. These projects are financed through substantially level debt service payments, and their annual costs should not vary significantly over the term of the contracts unless additional financing is required to meet the costs of major maintenance, repairs or replacements or license requirements. The Company's share of the costs and the output of the projects is subject to reduction due to various withdrawal rights of the districts and others over the lives of the contracts. As of December 31, 1993, the Company was entitled to purchase portions of the power output of the PUDs' projects as set forth in the following tabulation: Company's Annual Amount Bonds Purchasable (Approximate) Outstanding -------------------------- Contract License 12/31/93(a) % of Kilowatt Costs(b) Project Exp.Date Exp.Date (Millions) Output Capacity (Millions) - ----------------------------------------------------------------------------- Rock Island Original units 2012 2029 $79.8 62.5 ) ) 507,000 $ 45.7 Additional units 2012 2029 326.8 100.0 ) Rocky Reach 2011 2006(c) 186.0 38.9 504,922 15.0 Wells 2018 2012(c) 199.9 34.8 292,320 10.0 Priest Rapids 2005 2005(c) 141.2 8.0 71,760 2.1 Wanapum 2009 2005(c) 189.4 10.8 98,280 2.8 - ----------------------------------------------------------------------------- Total 1,474,282 $ 75.6 ============================================================================= (a) The contracts for purchases are generally coextensive with the term of the PUD bonds associated with the project. Under the terms of some financings, however, long-term bonds were sold to finance certain assets whose estimated useful lives extend beyond the expiration date of the power sales contracts. Of the total outstanding bonds sold for each project, the percentage of principal amount of bonds which mature beyond the contract expiration dates are: 69.3% at Rock Island; 20.1% at Rocky Reach; 59.8% at Priest Rapids; and 39.4% at Wanapum. (b) Estimated debt service and operating costs for the year 1994. The components of 1994 costs associated with the interest portion of debt service are: Rock Island, $27.78 million for all units; Rocky Reach, $5.01 million; Wells, $3.42 million; Priest Rapids, $0.68 million; and Wanapum, $1.16 million. (c) The Company is unable to predict whether the licenses under the Federal Power Act will be renewed to the current licensees or what effect the term of the licenses may have on the Company's contracts. The Company's estimated payments for power purchases from the Columbia River projects are $75.6 million for 1994, $77.0 million for 1995, $77.7 million for 1996, $80.5 million for 1997, $84.3 million for 1998 and in the aggregate $1.044 billion thereafter through 2012. The Company also has numerous long-term firm purchased power contracts with other utilities and non-utility generators in the region. These contracts have varying terms and may include escalation and termination provisions. The Company is not obligated to make payments under these contracts unless power is delivered. The Company's estimated payments for firm power purchases from other utilities and non-utility generators, which includes the expected addition of 245 MW of capacity during 1994 in the form of a purchased power contract with an independent producer of gas-fired cogeneration, are $361.5 million for 1994, $409.6 million for 1995, $424.0 million for 1996, $427.7 million for 1997, $446.3 million for 1998 and in the aggregate $6.885 billion thereafter through 2012. Total purchased power contracts provided the Company with approximately 13.5 million, 12.7 million and 13.7 million MWH of firm energy at a cost of approximately $353.5 million, $274.6 million and $230.6 million for the years 1993, 1992 and 1991, respectively. The following table indicates the Company's percentage ownership and the extent of the Company's investment in jointly-owned generating plants in service at December 31, 1993: Energy Company's Plant in Accumulated Source Ownership Service Depreciation Project (Fuel) Share (%) (Millions) (Millions) Centralia Coal 7 $ 25.7 $ 15.3 Colstrip 1 & 2 Coal 50 177.4 81.0 Colstrip 3 & 4 Coal 25 440.3 119.2 Financing for a participant's ownership share in the projects is provided for by such participant. The Company's share of related operating and maintenance expenses is included in corresponding accounts in the Consolidated Statements of Income. Certain purchase commitments have been made in connection with the Company's construction program. Contingencies The Company is subject to environmental regulation by federal, state and local authorities. The Company has been named a Potentially Responsible Party by the Environmental Protection Agency at four sites. The Company is participating along with others in remedial action at various sites in the Pacific Northwest at which it is an alleged contributor of certain wastes. Based on the best estimates available at this time, the Company anticipates future costs for environmental remediation at all sites will approximate $4.4 million which was recorded as an accrued liability at December 31, 1993. On April 1, 1992, the Washington Commission issued an order regarding the treatment of costs incurred by the Company for certain sites under its environmental remediation program. The order authorizes the Company to accumulate and defer prudently incurred cleanup costs paid to third parties for recovery in rates established in future rate proceedings. The Company believes a significant portion of its past and future environmental remediation costs are recoverable from either insurance companies, third parties, or under the Washington Commission's order. At December 31, 1993, the recoverable amount for these costs is approximately $11.3 million. In its September 21, 1993 general rate order, the Washington Commission required the Company to file a case by November 1, 1993, demonstrating the prudency of its eight new power purchase contracts acquired since its last general rate case. Pending the resolution of the prudency review case, the Washington Commission ordered that the Company's new rates, effective October 1, 1993, would be collected subject to refund to the extent this proceeding demonstrates any of those contracts to be imprudent. The Washington Commission calculated the annual revenue requirement at risk to be up to $86.1 million. This amount is the difference between the Company's power costs under the new power purchase contracts and the Washington Commission's estimated cost of purchasing equivalent power on the secondary market. The Company filed its prudency case on October 18, 1993, and expects the Washington Commission to enter a final order before October 1, 1994. Revenues reported as of December 31, 1993 which are at risk under the prudency review case are approximately $19.7 million. The extent to which refunds, if any, are necessary is subject to the determination of the Washington Commission. However, based on the nature and terms of the contracts and existing regulatory precedents, management believes that these contracts are prudent and that the ultimate resolution of the review will not have a material adverse impact on the financial condition or results of operations of the Company. Other contingencies, arising out of the normal course of the Company's business, exist at December 31, 1993. The ultimate resolution of these issues is not expected to have a material adverse impact on the financial condition or results of operations of the Company. 15) Supplemental Quarterly Financial Data (Unaudited) The following amounts are unaudited but, in the opinion of the Company, include all adjustments necessary for a fair presentation of the results of operations for the interim periods. Annual amounts are not generated evenly by quarter during the year due to the seasonal nature of the utility business. 1993 Quarter Ended March 31 June 30 Sept. 30 Dec. 31 - ------------------------------------------------------------------------ (Dollars in Thousands except per share amounts) Operating revenues $323,974 $237,617 $230,178 $321,109 Operating income $ 72,922 $ 43,039 $ 35,505 $ 59,514 Other income $ 3,718 $ 4,614 $ 3,536 $ 1,712 Net income $ 54,682 $ 26,213 $ 18,071 $ 39,361 Earnings per common share $ 0.86 $ 0.37 $ 0.23 $ 0.56 - ------------------------------------------------------------------------ 1992 Quarter Ended March 31 June 30 Sept. 30 Dec. 31 - ------------------------------------------------------------------------ (Dollars in Thousands except per share amounts) Operating revenues $280,202 $240,643 $219,221 $284,904 Operating income $ 67,818 $ 51,557 $ 35,717 $ 59,579 Other income $ 3,765 $ 6,294 $ 4,627 $ 2,517 Net income $ 48,032 $ 29,538 $ 17,987 $ 40,163 Earnings per common share $ 0.83 $ 0.47 $ 0.25 $ 0.62 - ------------------------------------------------------------------------ 16) Consolidated Statement of Cash Flows For purposes of the Statement of Cash Flows, the Company considers all temporary investments to be cash equivalents. These temporary cash investments are securities held for cash management purposes, having maturities of three months or less. The net change in current assets and current liabilities for purposes of the Statement of Cash Flows excludes short-term debt, current maturities of long-term debt and the current portion of PRAM accrued revenues. The following provides additional information concerning cash flow activities: Year Ended December 31: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) Changes in certain current assets and current liabilities: Accounts receivable $ (5,050) $(13,848) $12,474 Deferred energy costs -- (20) 119 Unbilled revenues (14,410) (15,081) 16,217 Materials and supplies 1,054 (1,338) (2,840) Prepayments and Other 5,809 (6,346) (677) Accounts payable 10,731 (5,948) 9,624 Accrued expenses and Other 11,511 3,274 (9,018) - --------------------------------------------------------------------------- Net change in certain current assets and current liabilities $ 9,645 $(39,307) $25,899 =========================================================================== Cash payments: Interest (net of capitalized interest) $80,646 $97,242 $86,114 Income taxes $32,585 $76,050 $61,256 - --------------------------------------------------------------------------- 17) Subsequent Event In furtherance of its ongoing program to manage costs effectively and remain competitive with other energy providers, the Company decided in January 1994 to offer an early separation plan to all officers, senior and middle managers and eligible professional staff. Benefits offered to those electing the program include a severance package based on years of service and enhanced retirement benefits for employees over 55 years of age. The number of employees that will accept the offer is presently not known. The Company has not set any specific job reduction targets. The Company, based on studies performed, currently estimates the total severance cost will not exceed $10 million. However, the total severance cost is dependent on the number of employees ultimately accepting the plan. The accrual for costs of this program will be recognized in the first quarter of 1994. PUGET SOUND POWER & LIGHT COMPANY SCHEDULE II. Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties - --------------------------------------------------------------------------- Column A Column B Column C Column D Column E Ending Beginning Balance Name of Debtor Balance Additions Deletions Non-Current - ---------------------------- --------- --------- --------- ----------- Year Ended December 31, 1993 Bill E. Covin (a) $262,000 $ 21,000 -- $283,000 - --------------------------------------------------------------------------- Year Ended December 31, 1992 Bill E. Covin (a) $589,000 $ 23,000 $350,000 $262,000 - --------------------------------------------------------------------------- Year Ended December 31, 1991 Bill E. Covin (a) $545,000 $ 44,000 -- $589,000 - --------------------------------------------------------------------------- (a) Note receivable at 8.06% interest, due March 31, 1995. Puget Sound Power & Light Company Schedule VIII. Valuation and Qualifying Accounts and Reserves - ----------------------------------------------------------------------------- (Dollars in Thousands) - ----------------------------------------------------------------------------- Column A Column B Column C Column D Column E - ----------------------------------------------------------------------------- Additions Balance at Charged to Balance Beginning Costs and at End of Period Expenses Deductions of Period Year Ended December 31, 1993 - ---------------------------- Accounts deducted from assets on balance sheet: Allowance for doubtful accounts receivable $ 488 $ 2,799 $ 2,764 $ 523 - ----------------------------------------------------------------------------- Reserves: Accumulated provision for self-insurance $ 87 $13,634(A) $13,721(A) $ -- ============================================================================= Year Ended December 31, 1992 - ---------------------------- Accounts deducted from assets on balance sheet: Allowance for doubtful accounts receivable $ 531 $ 1,981 $ 2,024 $ 488 - ----------------------------------------------------------------------------- Reserves: Accumulated provision for self-insurance $ 792 $ 4,610(A) $ 5,315(A) $ 87 ============================================================================= Year Ended December 31, 1991 - ---------------------------- Accounts deducted from assets on balance sheet: Allowance for doubtful accounts receivable $ 569 $ 2,954 $ 2,992 $ 531 Reserves: Accumulated provision for self-insurance $ 900 $16,047(A) $16,155(A) $ 792 ============================================================================= Note (A): Includes charges of $10.3 million in 1993, $1.8 million in 1992 and $12.5 million in 1991 which were transferred to a deferred asset account. EXHIBIT INDEX Certain of the following exhibits are filed herewith. Certain other of the following exhibits have heretofore been filed with the Commission and are incorporated herein by reference. 3-a Restated Articles of Incorporation of the Company. (Exhibit 1.2 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 3-b Restated Bylaws of the Company. (Exhibit 4-b to Registration No. 33-18506) 4.1 Fortieth through Seventy-fifth Supplemental Indentures defining the rights of the holders of the Company's First Mortgage Bonds. (Exhibit 2- d to Registration No. 2-60200; Exhibit 4-c to Registration No. 2-13347; Exhibits 2-e through and including 2-k to Registration No. 2-60200; Exhibit 4- h to Registration No. 2-17465; Exhibits 2-l, 2-m and 2-n to Registration No. 2-60200; Exhibits 2-m to Registration No. 2-37645; Exhibit 2-o through and including 2-s to Registration No. 2-60200; Exhibit 5-b to Registration No. 2- 62883; Exhibit 2-h to Registration No. 2-65831; Exhibit (4)-j-1 to Registration No. 2-72061; Exhibit (4)-a to Registration No. 2-91516; Exhibit (4)-b to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393; Exhibits (4)(a) and (4)(b) to Company's Current Report on Form 8-K, dated April 22, 1986; Exhibit (4)a to Company's Current Report on Form 8-K, dated September 5, 1986; Exhibit (4)-b to Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, Commission File No. 1-4393; Exhibit (4)-c to Registration No. 33-18506; Exhibit (4)-b to Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-4393; Exhibit (4)-b to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393; Exhibits (4)-b and (4)-c to Registration No. 33-45916; Exhibit (4)-c to Registration No. 33-50788; Exhibit (4)-a to Registration No. 33-53056; and Exhibit 4.3 to Registration No. 33-63278.) 4.2 Credit Agreement dated as of December 1, 1991, among the Company and various banks named therein, Seattle-First National Bank as Agent. (Exhibit (4)-d to Registration No. 33-45916) 4.3 Credit Agreement dated as of December 1, 1991, among the Company and various banks named therein, Bank of New York as Agent. (Exhibit (4)-e to Registration No. 33-45916) 4.4 Final form of Indenture dated as of November 1, 1986, among Puget Energy, the Company, and The First National Bank of Boston, as Trustee. (Exhibit 4-a to Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, Commission File No. 1-4393) 4.5 Final form of Pledge Agreement dated November 1, 1986, between the Company and The First National Bank of Boston, as Trustee. (Exhibit 4-c to Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, Commission File No. 1-4393) 4.6 Rights Agreement, dated as of January 15, 1991, between the Company and The Chase Manhattan Bank, N.A., as Rights Agent. (Exhibit 2.1 to Registration Statement on Form 8-A filed on January 17, 1991, Commission File No. 1-4393) 4.7 Pledge Agreement dated August 1, 1991, between the Company and The First National Bank of Chicago, as Trustee. (Exhibit (4)-j to Registration No. 33-45916) 4.8 Loan Agreement dated August 1, 1991, between the City of Forsyth, Rosebud County, Montana and the Company. (Exhibit (4)-k to Registration No. 33-45916) 4.9 Statement of Relative Rights and Preferences for the Adjustable Rate Cumulative Preferred Stock, Series B ($25 Par Value). (Exhibit 1.1 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.10 Statement of Relative Rights and Preferences for the Series A Flexible Dutch Auction Rate Transferable Securities $100 Par Value Preferred Stock. (Exhibit 1.3 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.11 Statement of Relative Rights and Preferences for the Series B Flexible Dutch Auction Rate Transferable Securities $100 Par Value Preferred Stock. (Exhibit 1.4 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.12 Statement of Relative rights and Preferences for the Preference Stock, Series R, $50 Par Value. (Exhibit 1.5 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.13 Statement of Relative Rights and Preferences for the 7 3/4% Series Preferred Stock Cumulative, $100 Par Value. (Exhibit 1.6 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.14 Statement of Relative Rights and Preferences for the 7 7/8% Series Preferred Stock Cumulative, $25 Par Value. (Exhibit 1.7 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) *4.15 Pledge Agreement, dated as of March 1, 1992, by and between the Company and and Chemical Bank relating to a series of first mortgage bonds. *4.16 Pledge Agreement, dated as of April 1, 1993, by and between the Company and The First National Bank of Chicago, relating to a series of first mortgage bonds. 10.1 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rock Island Project. (Exhibit 13-b to Registration No. 2-24262) 10.2 First Amendment, dated as of October 4, 1961, to Power Sales Contract between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 13-d to Registration No. 2-24252) 10.3 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 13-e to Registration No. 2-24252) 10.4 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Priest Rapids Development. (Exhibit 13-j to Registration No. 2-24252) 10.5 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Wanapum Development. (Exhibit 13-n to Registration No. 2-24252) 10.6 First Amendment, dated February 9, 1965, to Power Sales Contract between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-p to Registration No. 2-24252) 10.7 First Amendment, executed as of February 9, 1965, to Reserved Share Power Sales Contract between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-r to Registration No. 2-24252) 10.8 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-u to Registration No. 2-24252) 10.9 Pacific Northwest Coordination Agreement, executed as of September 15, 1964, among the United States of America, the Company and most of the other major electrical utilities in the Pacific Northwest. (Exhibit 13-gg to Registration No. 2-24252) 10.10 Contract dated November 14, 1957, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 4-1-a to Registration No. 2-13979) 10.11 Power Sales Contract, dated as of November 14, 1957, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 4-c-1 to Registration No. 2-13979) 10.12 Power Sales Contract, dated May 21, 1956, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Priest Rapids Project. (Exhibit 4-d to Registration No. 2-13347) 10.13 First Amendment to Power Sales Contract dated as of August 5, 1958, between the Company and Public Utility District No. 2 of Grant County, Washington, relating to the Priest Rapids Development. (Exhibit 13-h to Registration No. 2-15618) 10.14 Power Sales Contract dated June 22, 1959, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Wanapum Development. (Exhibit 13-j to Registration No. 2- 15618) 10.15 Reserve Share Power Sales Contract dated June 22, 1959, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Priest Rapids Project. (Exhibit 13-k to Registration No. 2- 15618) 10.16 Agreement to Amend Power Sales Contracts dated July 30, 1963, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Wanapum Development. (Exhibit 13-1 to Registration No. 2-21824) 10.17 Power Sales Contract executed as of September 18, 1963, between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-r to Registration No. 2- 21824) 10.18 Reserved Share Power Sales Contract executed as of September 18, 1963, between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13- s to Registration No. 2-21824) 10.19 Exchange Agreement dated April 12, 1963, between the United States of America, Department of the Interior, acting through the Bonneville Power Administrator and Washington Public Power Supply System and the Company, relating to the Hanford Project. (Exhibit 13-u to Registration 2- 21824) 10.20 Replacement Power Sales Contract dated April 12, 1963, between the United States of America, Department of the Interior, acting through the Bonneville Power Administrator and the Company, relating to the Hanford Project. (Exhibit 13-v to Registration No. 2-21824) 10.21 Contract covering undivided interest in ownership and operation of Centralia Thermal Plant, dated May 15, 1969. (Exhibit 5-b to Registration No. 2-3765) 10.22 Construction and Ownership Agreement dated as of July 30, 1971, between The Montana Power Company and the Company. (Exhibit 5-b to Registration No. 2-45702) 10.23 Operation and Maintenance Agreement dated as of July 30, 1971, between The Montana Power Company and the Company. (Exhibit 5-c to Registration No. 2-45702) 10.24 Coal Supply Agreement, dated as of July 30, 1971, among The Montana Power Company, the Company and Western Energy Company. (Exhibit 5-d to Registration No. 2-45702) 10.25 Power Purchase Agreement with Washington Public Power Supply System and the Bonneville Power Administration dated February 6, 1973. (Exhibit 5-e to Registration No. 2-49029) 10.26 Ownership Agreement among the Company, Washington Public Power Supply System and others dated September 17, 1973. (Exhibit 5-a-29 to Registration No. 2-60200) 10.27 Contract dated June 19, 1974, between the Company and P.U.D. No. 1 of Chelan County. (Exhibit D to Form 8-K dated July 5, 1974 10.28 Restated Financing Agreement among the Company, lessee, Chrysler Financial Corporation, owner, Nevada National Bank and Bank of Montreal (California), trustee, dated December 12, 1974 pertaining to a combustion turbine generating unit trust. (Exhibit 5-a-35 to Registration No. 2-60200) 10.29 Restated Lease Agreement between the Company, lessee, and the Bank of California, and National Association, lessor, dated December 12, 1974 for one combustion generating unit. (Exhibit 5-a-36 to Registration No. 2-60200) 10.30 Financing Agreement Supplement and Amendment among the Company, lessee, Chrysler Financial Corporation, owner, The Bank of California, National Association, trustee, Pacific Mutual Life Insurance Company, Bankers Life Company, and The Franklin Life Insurance Company, lenders, dated as of March 26, 1975, pertaining to a combustion turbine generating unit trust. (Exhibit 5-a-37 to Registration No. 2-60200) 10.31 Lease Agreement Supplement and Amendment between the Company, lessee, and The Bank of California, National Association, lessor, dated as of March 26, 1975 for one combustion turbine generating unit. (Exhibit 5-a- 38 to Registration No. 2-60200) 10.32 Exchange Agreement executed August 13, 1964, between the United States of America, Columbia Storage Power Exchange and the Company, relating to Canadian Entitlement. (Exhibit 13-ff to Registration No. 2-24252) 10.33 Loan Agreement dated as of December 1, 1980 and related documents pertaining to Whitehorn turbine construction trust financing. (Exhibit 10.52 to Annual Report on Form 10-K for the fiscal year ended December 31, 1980, Commission File No. 1-4393) 10.34 Letter Agreement dated March 31, 1980, between the Company and Manufacturers Hanover Leasing Corporation. (Exhibit b-8 to Registration No. 2-68498) 10.35 Coal Supply Agreement for Colstrip 3 and 4, dated as of July 2, 1980; Amendment No. 1 to Coal Supply Agreement, dated as of July 10, 1981; and Coal Transportation Agreement dated as of July 10, 1981. (Exhibit 20-a to Quarterly Report on Form 10-Q for the quarter ended September 30, 1981, Commission File No. 1-4393) 10.36 Residential Purchase and Sale Agreement between the Company and the Bonneville Power Administration, effective as of October 1, 1981. (Exhibit 20-b to Quarterly Report on Form 10-Q for the quarter ended September 30, 1981, Commission File No. 1-4393) 10.37 Letter of Agreement to Participate in Licensing of Creston Generating Station, dated September 30, 1981. (Exhibit 20-c to Quarterly Report on Form 10-Q for the quarter ended September 30, 1981, Commission File No. 1-4393) 10.38 Power sales contract dated August 27, 1982 between the Company and Bonneville Power Administration. (Exhibit 10-a to Quarterly Report on Form 10-Q for the quarter ended September 30, 1982, Commission File No. 1- 4393) 10.39 Agreement executed as of April 17, 1984, between the United States of America, Department of the Interior, acting through the Bonneville Power Administration, and other utilities relating to extension energy from the Hanford Atomic Power Plant No. 1. (Exhibit (10)-47 to Annual Report on Form 10-K for the fiscal year ended December 31, 1984, Commission File No. 1- 4393) 10.40 Agreement for the Assignment of Output from the Centralia Thermal Project, dated as of April 14, 1983, between the Company and Public Utility District No. 1 of Grays Harbor. (Exhibit (10)-48 to Annual Report on Form 10-K for the fiscal year ended December 31, 1984, Commission File No. 1-4393) 10.41 Settlement Agreement and Covenant Not to Sue executed by the United States Department of Energy acting by and through the Bonneville Power Administration and the Company dated September 17, 1985. (Exhibit (10)-49 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.42 Agreement to Dismiss Claims and Covenant Not to Sue dated September 17, 1985 between Washington Public Power Supply System and the Company. (Exhibit (10)-50 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.43 Irrevocable Offer of Washington Public Power Supply System Nuclear Project No. 3 Capability for Acquisition executed by the Company, dated September 17, 1985. (Exhibit A of Exhibit (10)-50 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1- 4393) 10.44 Settlement Exchange Agreement ("Bonneville Exchange Power Contract") executed by the United States of America Department of Energy acting by and through the Bonneville Power Administration and the Company, dated September 17, 1985. (Exhibit B of Exhibit (10)-50 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1- 4393) 10.45 Settlement Agreement and Covenant Not to Sue between the Company and Northern Wasco County People's Utility District, dated October 16, 1985. (Exhibit (10)-53 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.46 Settlement Agreement and Covenant Not to Sue between the Company and Tillamook People's Utility District, dated October 16, 1985. (Exhibit (10)-54 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.47 Settlement Agreement and Covenent Not to Sue between the Company and Clatskanie People's Utility District, dated September 30, 1985. (Exhibit (10)-55 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.48 Stipulation and Settlement Agreement between the Company and Muckleshoot Tribe of the Muckleshoot Indian Reservation, dated October 31, 1986. (Exhibit (10)-55 to Annual Report on Form 10-K for the fiscal year ended December 31, 1986, Commission File No. 1-4393) 10.49 Transmission Agreement dated April 17, 1981, between the Bonneville Power Administration and the Company (Colstrip Project). (Exhibit (10)-55 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.50 Transmission Agreement dated April 17, 1981, between the Bonneville Power Administration and Montana Intertie Users (Colstrip Project). (Exhibit (10)-56 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.51 Ownership and Operation Agreement dated as of May 6, 1981, between the Company and other Owners of the Colstrip Project (Colstrip 3 and 4). (Exhibit (10)-57 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.52 Colstrip Project Transmission Agreement dated as of May 6, 1981, between the Company and Owners of the Colstrip Project. (Exhibit (10)-58 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.53 Common Facilities Agreement dated as of May 6, 1981, between the Company and Owners of Colstrip 1 and 2, and 3 and 4. (Exhibit (10)-59 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.54 Agreement for the Purchase of Power dated as of October 29, 1984, between South Fork II, Inc. and the Company (Weeks Falls Hydroelectric Project). (Exhibit (10)-60 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.55 Agreement for the Purchase of Power dated as of October 29, 1984, between South Fork Resources, Inc. and the Company (Twin Falls Hydroelectric Project). (Exhibit (10)-61 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.56 Agreement for Firm Purchase Power dated as of January 4, 1988, between the City of Spokane, Washington, and the Company (Spokane Waste Combustion Project). (Exhibit (10)-62 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.57 Agreement for Evaluating, Planning and Licensing dated as of February 21, 1985 and Agreement for Purchase of Power dated as of February 21, 1985 between Pacific Hydropower Associates and the Company (Koma Kulshan Hydroelectric Project). (Exhibit (10)-63 to Annual Report on Form 10- K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.58 Power Sales Agreement dated as of August 1, 1986, between Pacific Power & Light Company and the Company. (Exhibit (10)-64 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.59 Agreement for Purchase and Sale of Firm Capacity and Energy dated as of August 1, 1986 between The Washington Water Power Company and the Company. (Exhibit (10)-65 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.60 Amendment dated as of June 1, 1968, to Power Sales Contract between Public Utility District No. 1 of Chelan County, Washington and the Company (Rocky Reach Project). (Exhibit (10)-66 to Annual Report on Form 10- K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.61 Coal Supply Agreement dated as of October 30, 1970, between the Washington Irrigation & Development Company and the Company and other Owners of the Centralia Thermal Project (Centralia Generating Plant). (Exhibit (10)- 67 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.62 Interruptible Natural Gas Service Agreement dated as of May 14, 1980, between Cascade Natural Gas Corporation and the Company (Whitehorn Combustion Turbine). (Exhibit (10)-68 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.63 Interruptible Natural Gas Service Agreement dated as of January 31, 1983, between Cascade Natural Gas Corporation and the Company (Fredonia Generating Station). (Exhibit (10)-69 to Annual Report on Form 10- K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.64 Interruptible Gas Service Agreement dated May 14, 1981, between Washington Natural Gas Company and the Company (Fredrickson Generating Station). (Exhibit (10)-70 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.65 Settlement Agreement dated April 24, 1987, between Public Utility District No. 1 of Chelan County, the National Marine Fisheries Service, the State of Washington, the State of Oregon, the Confederated Tribes and Bands of the Yakima Indian Nation, Colville Indian Reservation, Umatilla Indian Reservation, the National Wildlife Federation and the Company (Rock Island Project). (Exhibit (10)-71 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.66 Amendment No. 2 dated as of September 1, 1981, and Amendment No. 3 dated September 14, 1987, to Coal Supply Agreement between Western Energy Company and the Company and the other Owners of Colstrip 3 and 4. (Exhibit (10)-72 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.67 Amendatory Agreement No. 1 dated August 27, 1982, and Amendatory Agreement No. 2 dated August 27, 1982, to the Power Sales Contract between the Company and the Bonneville Power Administration dated August 27, 1982. (Exhibit (10)-73 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.68 Transmission Agreement dated as of December 30, 1987, between the Bonneville Power Administration and the Company (Rock Island Project). (Exhibit (10)-74 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.69 Agreement for Purchase and Sale of Firm Capacity and Energy between The Washington Water Power Company and the Company dated as of January 1, 1988. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1988, Commission File No. 1-4393) 10.70 Amendment dated as of August 10, 1988, to Agreement for Firm Purchase Power dated as of January 4, 1988, between the City of Spokane, Washington, and the Company (Spokane Waste Combustion Project).(Exhibit (10)- 76 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.71 Agreement for Firm Power Purchase dated October 24, 1988, between Northern Wasco People's Utility District and the Company (The Dalles Dam North Fishway). (Exhibit (10)-77 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.72 Agreement for the Purchase of Power dated as of October 27, 1988, between Pacific Power & Light Company (PacifiCorp) and the Company. (Exhibit (10)-78 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.73 Agreement for Sale and Exchange of Firm Power dated as of November 23, 1988, between the Bonneville Power Administration and the Company. (Exhibit (10)-79 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.74 Agreement for Firm Power Purchase, dated as of February 24, 1989, between Sumas Energy, Inc. and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1989, Commission File No. 1-4393) 10.75 Settlement Agreement, dated as of April 27, 1989, between Public Utility District No. 1 of Douglas County, Washington, Portland General Electric Company, PacifiCorp, The Washington Water Power Company and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q the for quarter ended September 30, 1989, Commission File No. 1-4393) 10.76 Agreement for Firm Power Purchase (Thermal Project), dated as of June 29, 1989, between San Juan Energy Company and the Company. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, Commission File No. 1-4393) 10.77 Agreement for Verification of Transfer, Assignment and Assumption, dated as of September 15, 1989, between San Juan Energy Company, March Point Cogeneration Company and the Company. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, Commission File No. 1-4393) 10.78 Power Sales Agreement between The Montana Power Company and the Company, dated as of October 1, 1989. (Exhibit (10)-4 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, Commission File No. 1- 4393) 10.79 Conservation Power Sales Agreement dated as of December 11, 1989, between Public Utility District No. 1 of Snohomish County and the Company. (Exhibit (10)-87 to Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-4393) 10.80 Memorandum of Understanding dated as of January 24, 1990, between the Bonneville Power Administrator and The Washington Public Power Supply System, Portland General Electric Company, Pacific Power & Light Company, The Montana Power Company, and the Company. (Exhibit (10)-88 to Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-4393) 10.81 Amendment No. 1 to Agreement for the Assignment of Power from the Centralia Thermal Project dated as of January 1, 1990, between Public Utility District No. 1 of Grays Harbor County, Washington, and the Company. (Exhibit (10)-89 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.82 Preliminary Materials and Equipment Acquisition Agreement dated as of February 9, 1990, between Northwest Pipeline Corporation and the Company. (Exhibit (10)-90 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.83 Amendment No. 1 to the Colstrip Project Transmission Agreement dated as of February 14, 1990, among the Montana Power Company, The Washington Water Power Company, Portland General Electric Company, PacifiCorp and the Company. (Exhibit (10)-91 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.84 Settlement Agreement dated as of February 27, 1990, among United States of America Department of Energy acting by and through the Bonneville Power Administrator, the Washington Public Power Supply System, and the Company. (Exhibit (10)-92 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.85 Amendment No. 1 to the Fifteen-Year Power Sales Agreement dated as of April 18, 1990, between Pacificorp and the Company. (Exhibit (10)-93 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.86 Settlement Agreement dated as of October 1, 1990, among Public Utility District No. 1 of Douglas County, Washington, the Company, Pacific Power and Light Company, The Washington Water Power Company, Portland General Electric Company, the Washington Department of Fisheries, the Washington Department of Wildlife, the Oregon Department of Fish and Wildlife, the National Marine Fisheries Service, the U.S. Fish and Wildlife Service, the Confederated Tribes and Bands of the Yakima Indian Nation, the Confederated Tribes of the Umatilla Reservation, and the Confederated Tribes of the Colville Reservation. (Exhibit (10)-95 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.87 Agreement for Firm Power Purchase dated July 23, 1990, between Trans-Pacific Geothermal Corporation, a Nevada corporation, and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.88 Agreement for Firm Power Purchase dated July 18, 1990, between Wheelabrator Pierce, Inc., a Delaware corporation, and the Company. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.89 Agreement for Firm Power Purchase dated September 26, 1990, between Encogen Northwest, L.P., A Delaware Corporation and the Company. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.90 Agreement for Firm Power Purchase (Thermal Project) dated December 27, 1990, among March Point Cogeneration Company, a California general partnership comprising San Juan Energy Company, a California corporation; Texas-Anacortes Cogeneration Company, a Delaware corporation; and the Company. (Exhibit (10)-4 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.91 Agreement for Firm Power Purchase dated March 20, 1991, between Tenaska Washington, Inc. a Delaware corporation, and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.92 Letter Agreement dated April 25, 1991, between Sumas Energy, Inc., and the Company, to amend the Agreement for Firm Power Purchase dated as of February 24, 1989. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.93 Amendment dated June 7, 1991, to Letter Agreement dated April 25, 1991, between Sumas Energy, Inc., and the Company. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.94 Amendatory Agreement No. 3, dated August 1, 1991, to the Pacific Northwest Coordination Agreement, executed September 15, 1964, among the United States of America, the Company and most of the other major electrical utilities in the Pacific Northwest. (Exhibit (10)-4 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.95 Amendment dated July 11, 1991, to the Agreement for Firm Power Purchase dated September 26, 1990, between Encogen Northwest, L.P., a Delaware limited partnership and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-4393) 10.96 Agreement between the 40 parties to the Western Systems Power Pool (the Company being one party) dated July 27, 1991. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-4393) 10.97 Memorandum of Understanding between the Company and the Bonneville Po wer Administration dated September 18, 1991. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-4393) 10.98 Amendment of Seasonal Exchange Agreement, dated December 4, 1991, between Pacific Gas and Electric Company and the Company. (Exhibit (10)-107 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.99 Capacity and Energy Exchange Agreement, dated as of October 4, 1991, between Pacific Gas and Electric Company and the Company. (Exhibit (10)-108 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.100 Intertie and Network Transmission Agreement, dated as of October 4, 1991, between Bonneville Power Administration and the Company. (Exhibit (10)-109 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.101 Amendatory Agreement No. 4, executed June 17, 1991, to the Power Sales Agreement dated August 27, 1982, between the Bonneville Power Administration and the Company. (Exhibit (10)-110 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.102 Amendment to Agreement for Firm Power Purchase, dated as of September 30, 1991, between Sumas Energy, Inc. and the Company. (Exhibit (10)-112 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.103 Centralia Fuel Supply Agreement, dated as of January 1, 1991, between Pacificorp Electric Operations and the Company and other Owners of the Centralia Steam-Electric Power Plant. (Exhibit (10)-113 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.104 Agreement for Firm Power Purchase dated August 10, 1992, between Pyrowaste Corporation, Puget Sound Pyroenergy Corporation and the Company. (Exhibit (10)-114 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.105 Memorandum of Termination dated August 31, 1992, between Encogen Northwest, L.P. and the Company. (Exhibit (10)-115 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.106 Agreement Regarding Security dated August 31, 1992, between Encogen Northwest, L.P. and the Company. (Exhibit (10)-116 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.107 Consent and Agreement dated December 15, 1992, between the Company, Encogen Northwest, L.P. and The First National Bank of Chicago, as collateral agent. (Exhibit (10)-117 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.108 Subordination Agreement dated December 17, 1992, between the Company, Encogen Northwest, L.P., Rolls-Royce & Partners Finance Limited and The First National Bank of Chicago. (Exhibit (10)-118 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1- 4393) 10.109 Letter Agreement dated December 18, 1992, between Encogen Northwest, L.P. and the Company regarding arrangements for the application of insurance proceeds. (Exhibit (10)-119 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.110 Guaranty of Ensearch Corporation in favor of the Company dated December 15, 1992. (Exhibit (10)-120 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.111 Letter Agreement dated October 12, 1992, between Tenaska Washington Partners, L.P. and the Company regarding clarification of issues under the Agreement for Firm Power Purchase. (Exhibit (10)-121 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.112 Consent and Agreement dated October 12, 1992, between the Company, and The Chase Manhattan Bank, N.A., as agent. (Exhibit (10)-122 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.113 Settlement Agreement dated December 29, 1992, between the Company and the Bonneville Power Administration (BPA) providing for power purchase by BPA. (Exhibit (10)-123 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) *10-114 Contract with W. S. Weaver, Executive Vice President & Chief Financial Officer, dated April 24, 1991. *(12)-a Statement setting forth computation of ratios of earnings to fixed charges (1989 through 1993). *(12)-b Statement setting forth computation of ratios of earnings to combined fixed charges and preferred stock dividends (1989 through 1993). (21) List of subsidiaries. (Exhibit 22 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) *(23) Consent of accountants. _________________________________ *Filed herewith.

100783_1993.txt

100783

1993

ITEM 1. BUSINESS GENERAL Union Camp Corporation is a Virginia corporation resulting from a merger in 1956 of Union Bag and Paper Corporation and Camp Manufacturing Company, Incorporated. Predecessor businesses were started in 1861 and 1887, respectively. As used in this Report, the terms "Union Camp" and the "Company" mean Union Camp Corporation and its subsidiaries unless the context otherwise requires. Union Camp's principal business segments are the manufacture and sale of paper and paperboard, packaging products and wood products and the production and sale of chemicals, including flavors and fragrances. Information about developments during 1993 relating to Union Camp's business appears in the following portions of the Union Camp 1993 Annual Report and is incorporated by reference in this Item 1: the text under the caption "Packaging Group" on pages 4 and 5, page 6 other than the text after the first sentence of the carryover paragraph, page 8 other than the second paragraph, and page 9; the text under the caption "Fine Paper" on page 10, page 11 other than the carryover paragraph, and the second paragraph on page 13; the text under the caption "Chemical Group" on pages 14, 15 and 16; the text under the caption "Overseas" on page 18 other than the last sentence in the third paragraph and the carryover paragraph and the text on page 19 other than the carryover sentence from page 18; the text under the caption "Wood Products" on page 20; and the text under the caption "Wood and Land Resources" in the first two paragraphs on page 22 and the last paragraph on page 23. Information about the Company's research and development activities appears under the caption "Research and Development Costs" in Note 1 of Notes to Consolidated Financial Statements on page 35 of the Union Camp 1993 Annual Report and is incorporated by reference in this Item 1. Revenue, operating profits and other financial data for the principal business segments and for the foreign and domestic operations and the dollar amounts of export sales of Union Camp for the years ended December 31, 1993, 1992 and 1991 appear in Note 14 of Notes to Consolidated Financial Statements on page 40 of the Union Camp 1993 Annual Report and are incorporated by reference in this Item 1. The international operations of Union Camp and its subsidiaries are subject to the risks of doing business abroad, including currency fluctuations, foreign government regulation and changes in political environments. During 1993, Union Camp's consolidated sales and operating profit were generated primarily by domestic operations. PAPER AND PAPERBOARD Union Camp's Fine Paper Division produces bleached paper and paperboard and its Kraft Paper and Board Division produces unbleached paper and paperboard. Those products are its largest contributors to profits. Union Camp's total production of bleached and unbleached paper and paperboard in 1993 was approximately 3,327,000 tons, of which about 59% was unbleached and 41% was bleached. The Company operates four large paper mills at Savannah, Georgia, Prattville, Alabama, Franklin, Virginia and Eastover, South Carolina. They are fully integrated in that all pulp required to support paper manufacturing is produced at the mill sites. Combined operating capacity is estimated to be approximately 3.5 million tons in 1994. The Savannah, Georgia mill produces unbleached kraft linerboard and paper, including saturating kraft, a specialized paper which is used by others as a backing material for decorative and industrial laminates. Unbleached kraft paper is used primarily in the manufacture of retail bags and sacks and multiwall bags and unbleached kraft linerboard is used primarily in the manufacture of corrugated shipping containers (see the next section entitled "Packaging Products"). There are six operational machines at the Savannah mill. The two paper machines at the Prattville, Alabama unbleached kraft mill produce kraft linerboard. In 1993, the Company converted about 66% of its unbleached kraft linerboard and paper production into packaging products and sold essentially all of the rest to others for conversion into similar products. The Franklin, Virginia mill produces bleached uncoated free sheet which is sold to others in roll and sheet form for conversion into envelopes, forms and tablets. Bleached uncoated free sheet offset and business papers, also produced in roll and sheet form, are sold through wholesale distributors to commercial printers and office end users. The Franklin mill also produces coated and uncoated bleached bristol grades which are sold to others for a variety of end uses, such as greeting cards, book covers and file folders. There are four paper machines and two board machines at this mill. During 1993, and as part of a $165 million modernization program, Union Camp began construction of an approximately $100 million office paper recycling (deink) facility at the Franklin, Virginia mill. The recycling facility is described on page 29 of the Union Camp 1993 Annual Report in the fourth and sixth sentences of the second paragraph under the caption "Capital Expenditures" and that text is incorporated by reference in this Item 1. The Eastover, South Carolina mill produces bleached uncoated free sheet which, like the Franklin product, is sold to others in roll and sheet form for the same end uses. The two-machine Eastover mill has an excess of pulp capacity which is used together with an on-site pulp dryer to produce bleached pulp for sale to others in domestic and international markets. In 1993, Union Camp sold about 26% of its bleached paper and paperboard production in converted or sheet form. This includes approximately 2% converted by its own plants into folding cartons, bags, and stationery. The four integrated mills use sulfate pulping chemistry, also referred to as the kraft process. Both hardwood and pine timber are used at all four mills. Approximately 22% of the Company's wood pulp production utilizes timber harvested from lands owned or controlled by the Company. Timber use at the Prattville and Savannah mills is supplemented with recycled waste paper acquired from others and the Company's converting plants (see the next section entitled "Packaging Products"). PACKAGING PRODUCTS From its mill production of paper and paperboard, Union Camp makes bags and sacks and corrugated and solid fibre containers. Union Camp produces paper bags such as grocery bags and grocer sacks used to package food, merchandise bags for dry goods items, multiwall bags used to package cement, insulation, feed, fertilizer, clay, pet food, chemical and mineral products and specialty bags used in packaging charcoal, produce, sugar, flour, seed, coffee, microwaveable popcorn and other miscellaneous items. Union Camp also produces high density plastic bags for various retail packaging applications and low density plastic products for industrial applications including stretch packaging and plastic shipping sacks. In addition, the flexible packaging plant in Asheville, North Carolina produces extrusion coated and laminated substrates as well as printed labels for the composite can industry. Union Camp produces corrugated and solid fibre containers used to ship and store canned, bottled and packaged products for a wide variety of customers, including food processors and textile, furniture, chemical and automotive manufacturers. Other packaging products include folding cartons, on which Union Camp does high quality gravure and lithographic printing, which are used for shelf packaging in retail stores. In addition, corrugated containers are produced by wholly-owned, consolidated subsidiaries in Spain, the Canary Islands, the Republic of Ireland and Puerto Rico. A corrugated container manufacturing plant in Chile, which is owned by a majority owned consolidated subsidiary of Union Camp, serves that country's fresh fruit exporters and the country's expanding industrial base. WOOD PRODUCTS Union Camp produces southern pine lumber, plywood and particleboard. Its wood products mills have the capacity to produce 470,000,000 board feet of lumber, 235,000,000 square feet (3/8" basis) of plywood and 96,000,000 square feet (3/4" basis) of particleboard annually. Union Camp's wood products mills produced at 100% of capacity in 1993. Its wood products are used in home construction and industrial markets such as furniture, cabinets and fixtures. The wood products mills also produce significant quantities of wood chips for use in Union Camp's papermaking operations. CHEMICAL GROUP The Chemical Group consists of two operating units: Chemical Products Division and Bush Boake Allen. The Chemical Products Division produces a variety of wood-based and non- wood-based chemicals. Wood-based chemicals, which are by-products of pulp mill operations, include tall oil and turpentine chemicals. Tall oil is a mixture of rosin and fatty acids which are by-products of the pulping process. Tall oil rosins are converted into rosin-based resins and fatty acids are converted into dimer acids and polyamide resins. These products are used in coatings, adhesives, printing inks, paper sizing and oil field chemicals. Non-wood-based chemicals, which are complementary to Union Camp's pulp-derived tall oil fatty acids, are produced by converting vegetable oils into a variety of esters and other derivatives. These are sold primarily for use in cosmetics, lubricants, plastics, surfactants and rubber. The Chemical Products Division has five processing facilities, three of which are in the United States and two of which are in England. Bush Boake Allen is a producer of flavors (including essential oils, seasonings and spice extracts) and fragrance and aroma chemicals. The flavor products impart a desired taste and smell to a broad range of products, including soft drinks, confections, dietary foods, snack foods, dairy products, pharmaceuticals and alcoholic beverages. The fragrance products are used in a wide variety of household items, including soaps, detergents, air fresheners, toiletries and related products. The flavor and fragrance compounds are sold primarily to major consumer product companies which use these products in conjunction with other natural and synthetic ingredients to make their products more appealing to consumers. The aroma chemicals produced by Bush Boake Allen are primarily used by major multinational consumer product manufacturers as fragrance raw materials or are used by Bush Boake Allen in its own fragrance compounds. Bush Boake Allen has developed a broad-based global presence with operations in 35 countries in North and South America, Europe, Asia, Australia, The Middle East and Africa. CAPITAL EXPENDITURES Information about Union Camp's 1993 and estimated 1994 capital expenditures appears on page 29 of the Union Camp 1993 Annual Report in the text under the caption "Capital Expenditures" and is incorporated by reference in this Item 1. MARKETING Most of Union Camp's sales, other than its chemical sales, are made in the United States east of the Rocky Mountains, through a variety of distribution methods. Paper and paperboard are sold both directly to converters and through merchants. Packaging materials are sold directly to the industrial and agricultural trades, primarily by Union Camp sales representatives and to a lesser extent through distributors. In addition, retail bags and wrappings are sold both directly to national chain stores and through paper merchants and wholesale grocers to independent retail outlets. Wood products are sold through building supply dealers and directly to industrial users. Union Camp chemicals are sold worldwide with most sales being made to customers in the United States and European Economic Community countries. Through various English and other overseas subsidiaries and related companies of Bush Boake Allen, Union Camp sells in the worldwide markets for flavors and fragrances and related products. Chemical products generally are sold directly to industrial users and to a lesser extent through agents and distributors. During 1993, Union Camp's chemical exports from the United States were about 6% of the total chemical sales of Union Camp and its subsidiaries. In addition, approximately 51% of such total chemical sales originated from the production facilities of subsidiaries located outside the United States. In 1993, Union Camp sold in the export market approximately 14% of its production of paper and paperboard. LAND DEVELOPMENT AND HOUSING Union Camp's real estate subsidiary, The Branigar Organization, Inc., is engaged in the development and sale of land for recreational and residential uses in Georgia and North Carolina. Another subsidiary, Transtates Properties Incorporated, is developing sites for commercial properties at highway interchanges in Georgia and South Carolina. COMPETITION All of Union Camp's products are sold in highly competitive markets in which there are many large and well-established companies, of which Union Camp is one. Competition in each of Union Camp's markets is based on price, quality of product, service and production innovation. TIMBER RESOURCES The basic raw material for Union Camp's business is timber, a renewable resource. Union Camp controls approximately 1,575,000 acres of timberlands in Georgia, Alabama, Virginia, Florida, North Carolina and South Carolina, of which approximately 1,544,000 acres are owned and the balance is held under long-term leases. In 1993, Union Camp obtained approximately 28% of its total timber requirements from its own timberlands and purchased the balance from others. Union Camp operates its timberlands on a sustained yield basis. As Union Camp obtains timber from natural stands of its trees, Union Camp replaces the harvested woodlands with a "plantation" reforestation program. Union Camp began reforestation on its timberlands in the mid-1950's and now has approximately 925,000 acres in plantation growth. It planted about 42,000 acres under the plantation program in 1993 and expects to plant approximately 42,000 acres in 1994. These plantation programs result in increased yield per acre. The current growing cycle for most of Union Camp's plantations averages between 22 and 25 years. Union Camp anticipates that for the foreseeable future there will be an adequate supply of timber for its operations from its own lands and other sources. ENVIRONMENTAL PROTECTION ACTIVITIES Union Camp is committed to complying with applicable environmental protection control laws and to assuring that its operations protect public health and safety. Wastewater treatment facilities and/or atmospheric emission control equipment at various Union Camp locations, which currently comply with applicable restrictions, may have to be upgraded to comply with new limitations that may be imposed when federal and state permits are renewed and as regulations are promulgated implementing revisions to federal and state air and water pollution control laws. The development of new analytical capability, over a thousand times more sensitive than previously available, revealed minute, trace amounts of dioxin in the pulp, sludge and wastewater of bleached kraft pulp mills in 1985. This discovery led to intensive studies of the health effects of exposure to these trace amounts and, simultaneously, efforts to reduce the minute quantity of this unwanted by-product which is formed during the bleaching process. The Company believes that human exposure to dioxin in the trace concentrations found in the Company's treated wastewater does not cause any health problem. The basis for the Company's statement that human health problems are not caused by the trace quantities of dioxin discharged with its treated wastewater is its internal technical evaluation of various studies and reports concerning dioxin and the known effects from exposure. Meanwhile, Union Camp's continuing research and development efforts in water conservation methods led to the development of a new bleaching process which has important environmental advantages and, as a collateral benefit, virtually eliminates dioxin. In general terms, C-Free(TM) pulp is produced in this new bleaching process developed by Union Camp, through use of ozone as a primary bleaching agent instead of elemental chlorine, which is used in most conventional operations. This development, including related bleaching process improvements in the use of oxygen and in various extraction steps, resulted in the issuance of twelve patents, with eighteen additional patents currently pending. The most significant environmental achievements of this process are dramatic reductions in chlorinated organics, including dioxin and chloroform, and the ability to recycle most of the bleach plant's wastewater, which is not possible when using chlorine because of its corrosive nature. Following is a list of pollutants and the amount each is reduced by the Company's new bleaching process as compared to conventional bleaching processes. These data are based on extensive laboratory and pilot plant testing and measurements at the Company's Franklin mill where a commercial ozone bleaching line has been installed. The Company has installed this new process on one of the bleaching lines at its Franklin, Virginia mill and the process is available for licensing by others in the industry. Union Camp invested approximately $23 million in environmental control facilities in 1993 and approximately $163 million over the past five years. The five year figure includes environmental control elements of a large modernization and expansion program completed in 1991. Over the next two years, it is estimated that environmental control expenditures will average approximately 9% of projected capital spending. Environmental control expenditures divert capital and may increase operating and financing costs. To that extent, they have an adverse impact on earnings. During the next several years, the cost of compliance with environmental control laws will depend upon the application of existing and new regulations and on revisions to existing statutes. Union Camp believes such costs will not adversely affect its competitive position within the paper and chemical industries since most paper and chemical companies have similar air, water and solid waste disposal concerns. To the extent the current dioxin controversy has an adverse effect on the U.S. bleached kraft pulp industries, Union Camp believes it will not be competitively disadvantaged because it believes it has lower than average dioxin production due to the extensive use of oxygen instead of chlorine bleaching at both its bleached kraft mills, and because of its discovery, introduction and commercialization of the proprietary process for producing C-Free(TM) pulp. EMPLOYEES Union Camp and its subsidiaries employ approximately 19,000 people, approximately 42% of whom are represented by 69 unions under collective bargaining agreements. Contracts involving approximately 2,608 hourly employees were negotiated during 1993 and contracts involving approximately 3,301 hourly employees are subject to renegotiation and renewal in 1994. Union Camp believes that its relationship with its employees is favorable and it has not experienced a strike at any major facility since mid-1974. ITEM 2.

ITEM 2. PROPERTIES Union Camp's mills and plants, domestic and foreign, are at the locations listed below and primarily produce the items described in the heading for each group. Union Camp's corporate headquarters is in Wayne, New Jersey and its principal research facilities are located in its corporate technology center in Princeton, New Jersey. Except for a few facilities which in the aggregate are not material, Union Camp owns all of the following mills and plants, in some cases subject to financing leases or similar arrangements. PAPER AND PAPERBOARD INDUSTRY SEGMENT Paper and Paperboard The four paper mills located at the sites listed below are the Company's principal facilities. Reference is made to Item 1 of this Report for information regarding their general character, including the products they produce, their productive capacity and the extent of utilization. Eastover, South Carolina Franklin, Virginia Prattville, Alabama Savannah, Georgia Paper Finishing The three converting plants listed below are part of the Company's Fine Paper Division. They convert large rolls of paper produced by the division into folio sheets for commercial printers and office size sheets for home and business use. Franklin, Virginia Normal, Illinois Sumter, South Carolina PACKAGING PRODUCTS INDUSTRY SEGMENT Paper Bags The plants listed below produce paper grocery bags and sacks including shopping bags which are sold principally to retailers, mass merchandisers, department stores and fast food restaurants. Richmond, Virginia Savannah, Georgia The plants listed below produce multiwall bags of various substrates for products such as cement, seed, feed, pet food, sugar, cookies and popcorn. Denton, Texas Seymour, Indiana Hanford, California Sibley, Iowa Hazleton, Pennsylvania Spartanburg, South Carolina Monticello, Arkansas Tifton, Georgia St. Louis, Missouri Plastic Products The plants listed below produce polyethylene packaging and roll stock for packaging a variety of agricultural and industrial products and such consumer items as ice, salt, tissues and disposable diapers. Griffin, Georgia Monticello, Arkansas Tomah, Wisconsin The plant listed below produces single ply plastic bags for sale to retailers. Shelbyville, Kentucky Specialty Flexible Packaging The plant listed below produces extrusion coated and laminated substrates as well as printed labels for the composite can industry. Asheville, North Carolina Corrugated Containers The plants listed below use a corrugator to manufacture corrugated sheets by gluing a fluted paperboard material called medium between two or more flat facings of linerboard. These corrugated sheets are then sold or made into boxes or corrugated containers in a separate operation at these plants. Ashbourne, Republic of Ireland Lafayette, Louisiana Atlanta, Georgia Lakeland, Florida Auburn, Maine La Laguna, Tenerife, Spain Bayamon, Puerto Rico Las Palmas de Gran Canaria, Spain Centerville, Ohio Morristown, Tennessee Chicago, Illinois Newtown, Connecticut Cleveland, Ohio Rancagua, Chile Decatur, Alabama Richmond, Virginia Denver, Colorado San Antonio, Texas Gandia, Spain Savannah, Georgia Houston, Mississippi Spartanburg, South Carolina Kalamazoo, Michigan Trenton, New Jersey Kansas City, Missouri Washington, Pennsylvania Finishing The plants listed below use equipment that converts corrugated sheets into boxes or laminates a printed sheet of paper to one panel of a box or applies a wax coating to a finished box. Conway, Arkansas Eaton Park, Florida Edinburgh, Texas Flint, Michigan Kansas City, Missouri Statesboro, Georgia Graphics The first two plants listed below use a process that adheres medium to a single linerboard sheet to produce singleface and then glues a printed label to the singleface. These sheets are then made into boxes at these plants. The remaining facility produces printed rolls of linerboard prior to the manufacture of corrugated sheets. Conway, Arkansas Stockton, California Savannah, Georgia Solid Fibre Products The plant listed below manufactures solid fibre sheets by gluing two or more flat linerboard sheets together. These solid fibre sheets are then made into boxes or solid fibre containers in a separate operation. Lancaster, Pennsylvania Folding Cartons and Gravure Printing The plants listed below produce folding cartons with high quality gravure and lithographic printing which are used to package cosmetics, toiletries, pharmaceutical and food products. Clifton, New Jersey Englewood, New Jersey Moonachie, New Jersey WOOD PRODUCTS INDUSTRY SEGMENT Lumber The chip and/or saw mills listed below produce wood chips, small timbers and/or dimension lumber. Chapman, Alabama Folkston, Georgia Franklin, Virginia Meldrim, Georgia Opelika, Alabama Seaboard, North Carolina Plywood The plants listed below produce veneer and/or plywood panels for sale primarily for industrial applications including furniture, truck trailers and sound equipment. Chapman, Alabama Thorsby, Alabama Particleboard The plant listed below uses wood shavings and other wood residues to produce particleboard which is cut to size and sold primarily to the furniture industry. Franklin, Virginia CHEMICAL INDUSTRY SEGMENT The Chemical industry segment has two operating units, Bush Boake Allen and the Chemical Products Division. The facilities listed below are part of the Bush Boake Allen unit which produces aroma chemicals, flavors, fragrances, essential oils, spices and seasonings. The process used and products produced by each facility are shown below. The chemical processing facilities listed below are part of the Chemical Products Division which produces a variety of wood-based and non- wood-based chemicals. Shown below are the principal products of each facility. In addition, in the Chemical industry segment, Union Camp has small consolidated subsidiary manufacturing (compounding and mixing) facilities at the following locations: Kingston, Jamaica; Auckland, New Zealand; Istanbul, Turkey; Knislinge, Sweden; Bangkok, Thailand; LaSalle, Canada and Bogor, Indonesia. The aggregate 1993 revenue from these small facilities was approximately $19.9 million. Also see Item 1 for a discussion of Union Camp's timberland holdings used in Union Camp's Paper and Paperboard and Wood Products industry segments. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company believes there are no pending legal proceedings to which Union Camp or any of its subsidiaries is a party which will have a material adverse effect on the financial position or results of operations of the Company and its subsidiaries taken as a whole. While Union Camp has been designated a potentially responsible party at a number of hazardous waste sites pursuant to the Comprehensive Environmental Response and Compensation Liability Act and similar state laws, the Company believes that its designation and the pending legal proceedings will not have a material adverse effect on the financial position or results of operations of the Company and its subsidiaries taken as a whole. The bases for the Company's opinion include: (i) the Company's experience defending or settling similar matters, the opinions of counsel representing the Company in such matters and an assessment, to the extent possible, of the claims made against and the defenses available to the Company; and (ii) in the case of environmental claims, an analysis of reasonable estimates, to the extent possible, of the cost of site investigation studies and remedial activities and the existence of other financially viable, potentially responsible parties. No credit has been assumed for any potential insurance reimbursement to the Company when the availability of the insurance coverage is not established. The Company is unable to estimate environmental costs/liabilities for several reasons. In some cases, it has not been established that the Company is a potentially responsible party. In other cases, it is uncertain whether the Company will seek, be offered or accept a de minimis settlement with payment of a premium over otherwise estimated liability in order to secure full release. In many instances, the cost of remediation is speculative because remedial investigations and feasibility studies have not yet been contracted for, have not been completed or, alternatively, have been completed but acceptable remediation has not been chosen. Some settled cases also have "reopeners" for contamination discovered after full implementation of the clean-up remedy. Finally, insurance reimbursement is usually uncertain until matters are finally resolved. In September, 1993, a Company facility in Jacksonville, Florida received a Notice of Violation (the "NOV") from the United States Environmental Protection Agency (the "EPA") alleging violation of the EPA's rules governing the burning of a hazardous waste in boilers (the Boiler and Industrial Furnace Rules or "BIF Rules") in connection with the burning by this Jacksonville facility of various turpentine fractions as fuels. In response to the NOV, the Company met with the EPA in November, 1993 to support the facility's position that burning turpentine fractions is not covered by the BIF Rules because the materials burned are not wastes, but historically have been sold as products or burned as fuel when the product's fuel value exceeded its market value. If it is required to comply with the BIF Rules, the Company estimates that it would incur capital expenditures of approximately $200,000. While the EPA has not instituted any enforcement action and has not sought penalties in connection with the NOV issued to the Company, there can be no assurances that it will not ultimately be determined that the BIF Rules apply or that the EPA will not seek penalties for past violations. The Company remains a defendant in 89 suits filed in federal court in Alabama between October 1990 and January 1992 in which construction workers allege they were exposed to asbestos while performing work at various plant sites throughout Alabama and elsewhere. The many defendants named in each of these suits include owners of the premises where the work was being done, asbestos manufacturers whose equipment was being installed, distributors of asbestos containing products, insurance companies, and a safety equipment manufacturer. Union Camp is included in the premises owner category of defendants. Union Camp was named as a defendant in two law suits brought in Texas state court during the third quarter of 1992 and as a defendant in a third lawsuit brought in Texas state court during the fourth quarter of 1993; approximately 4,000 plaintiffs are currently parties to these law suits. The plaintiffs are, for the most part, construction workers resident in Alabama who allege they were exposed to asbestos while performing work at various plant sites in Alabama. These cases are similar to the 89 cases in the paragraph immediately above. Approximately 50 defendants have been named in the cases in Texas. They include asbestos manufacturers, distributors of asbestos-containing products, insurance companies, a manufacturer of safety equipment, parties who allegedly misrepresented the dangers of asbestos exposure, and the owners of the premises where the plaintiffs allege they were working when they were exposed to asbestos. Union Camp is included in the premises owner category of defendants. The Company does not believe that these pending legal proceedings in Alabama and Texas are material. An estimate of potential liability cannot be made at this time. In its Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, the Company previously reported that a subsidiary of the Company was added as a defendant in approximately 7,000 asbestos-related cases which had been pending in Mississippi state court for several years. During the third quarter of 1991, this subsidiary was named as a defendant in additional asbestos-related consolidated actions so that the total number of such cases was over 7,000. During the second quarter of 1992, the subsidiary was named in additional similar consolidated actions so that it is a defendant in excess of 10,000 such cases. The subsidiary was named in these cases because it allegedly was part of the chain of distribution of asbestos-containing products to facilities where the plaintiffs worked. The period of alleged exposure is 1930 through the present. The subsidiary did not manufacture asbestos or asbestos-containing products. Approximately 80 defendants have been named in each of these suits, including asbestos manufacturers, distributors, an insurance company and a manufacturer of safety equipment. In late March 1993, the Company's subsidiary reached agreement to settle approximately 10,500 of these cases, with the settlement being funded by the Company's insurance carrier. This subsidiary remains a defendant in approximately 2,500 cases of which approximately 450 were filed in April 1993. An estimate of potential liability cannot be made at this time. However, the Company does not believe that these pending legal proceedings are material to it. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS Not applicable. EXECUTIVE OFFICERS OF UNION CAMP The executive officers of Union Camp as of March 1, 1994 were as follows: The Company's Articles of Incorporation provide that the Board of Directors shall be divided into three classes, as nearly equal in size as possible. Each year the directors of one class are elected to serve terms of three years. Executive officers are elected for one year and until their successors are elected. There are no family relationships among directors and executive officers. All of the executive officers listed above have held their present positions or other executive offices with Union Camp for the past five years, except as follows. Mr. McClelland became President and Chief Operating Officer in December 1989. He had been an Executive Vice President since November 1988. Prior to that time, he had been a Director and Executive Vice President of International Paper Company and President and Chief Executive Officer of Hammermill Paper Company (a subsidiary of International Paper Company). Mr. Reed was named Vice Chairman of the Board and Chief Financial Officer in April 1993. Previously he had been an Executive Vice President and Chief Financial Officer. Mr. Barney became Vice President and Treasurer in December 1992. Previously, he was the Treasurer since November 1988. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information in response to the disclosure requirements specified by this Item 5 appears under the captions and on the pages of the Union Camp 1993 Annual Report indicated below and is incorporated by reference in this Item 5. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Information in response to the disclosure requirements specified by this Item 6 appears on pages 42 and 43 of the Union Camp 1993 Annual Report and is incorporated by reference in this Item 6. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information in response to the disclosure requirements specified by this Item 7 appears in the text under the caption "Financial Review" on pages 26 to 30 of the Union Camp 1993 Annual Report and is incorporated by reference in this Item 7. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information in response to the disclosure requirements specified by this Item 8 appears on pages 32 to 40 of the Union Camp 1993 Annual Report and is incorporated by reference in this Item 8. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information in response to the disclosure requirements specified by this Item 10, with respect to (i) the directors of Union Camp, appears under the caption "Proposal 1 - Election of Directors" on pages 1 to 5 of the Union Camp 1994 Proxy Statement, (ii) the executive officers of Union Camp, appears under the caption "Executive Officers of Union Camp" in Part I of this Annual Report on Form 10-K and (iii) Section 16(a) of the Securities Exchange Act of 1934, as amended, appears under the caption "Section 16(a) Reporting" on page 18 of the Union Camp 1994 Proxy Statement. Such information is incorporated by reference in this Item 10. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information in response to the disclosure requirements specified by this Item 11 appears under the captions "Board of Directors and Committees", "Executive Compensation", "Retirement Plans" and "Severance Arrangements" on pages 6 to 7, 9 to 12, 16 to 17 and 17 to 18, respectively, of the Union Camp 1994 Proxy Statement. Such information is incorporated by reference in this Item 11. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in response to the disclosure requirements specified by this Item 12 appears under the captions "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management as of December 31, 1993" on pages 8 and 9 of the Union Camp 1994 Proxy Statement and is incorporated by reference in this Item 12. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in response to the disclosure requirements specified by this Item 13 appears in the first footnote under the caption "Proposal 1 - Election of Directors" on page 5 of the Union Camp 1994 Proxy Statement and is incorporated by reference in this Item 13. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Index of financial statements The following financial statements are included at the indicated page in the Union Camp 1993 Annual Report and are incorporated by reference in this Annual Report on Form 10-K: (2) The following schedules, for the three years ended December 31, 1993, to the Financial Statements are included beginning at the indicated page in this Annual Report on Form 10-K: All schedules other than those indicated above are omitted because of the absence of the conditions under which they are required or because the required information is set forth in the financial statements and their notes. (3) All exhibits, including those incorporated by reference. (b) Reports on Form 8-K. No Current Report on Form 8-K was filed by the Registrant during the quarter ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE TOWNSHIP OF WAYNE, AND STATE OF NEW JERSEY, ON THE 28TH DAY OF MARCH, 1994. UNION CAMP CORPORATION By /s/ RAYMOND E. CARTLEDGE (Raymond E. Cartledge) Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities stated below on March 28, 1994. SCHEDULE V SCHEDULE VI UNION CAMP CORPORATION AND CONSOLIDATED SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PLANT AND EQUIPMENT; AND COST OF COMPANY TIMBER HARVESTED For the Years Ended December 31, 1993, 1992 and 1991 (thousands of dollars) SCHEDULE VIII SCHEDULE IX UNION CAMP CORPORATION AND CONSOLIDATED SUBSIDIARIES SHORT-TERM BORROWINGS For The Years Ended December 31, 1993, 1992 and 1991 (thousands of dollars) SCHEDULE X UNION CAMP CORPORATION AND CONSOLIDATED SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992 and 1991 (thousands of dollars)

766829_1993.txt

766829

1993

Item 1. Business. (a) General Development of Business. SJW Corp. (the "Company"), incorporated in California on February 8, 1985, is a holding company with three wholly-owned subsidiaries, San Jose Water Company ("Water Company"), SJW Land Company and Western Precision, Inc. ("WP"). The Water Company, with headquarters at 374 West Santa Clara Street, San Jose, California 95196, was incorporated under the laws of the State of California in 1931, succeeding a business founded in 1866. The Water Company is a public utility in the business of providing water service to a population of approximately 913,000 in an area comprising about 134 square miles in the metropolitan San Jose area. SJW Land Company was incorporated in October, 1985. WP was acquired on December 31, 1992 through an exchange of stock between the Company and the shareholders of WP, formerly the Roscoe Moss Company. Roscoe Moss Company was incorporated on March 22, 1927. At December 31, 1993, WP held 549,976 shares, or approximately 9.7%, of common stock of California Water Service Company. WP also operates a precision mechanical parts manufacturing facility located in Sunnyvale, California, and Austin, Texas. Regulation and Rates. The Water Company's rates, service and other matters affecting its business are subject to regulation by the Public Utilities Commission of the State of California ("CPUC"). Ordinarily, there are two types of rate increases, general and offset. The purpose of the latter is generally to compensate utilities for increases in specific expenses, such as those for purchased water or power. The most recent general rate case decision authorized an initial increase followed by two annual step increases designed to maintain the authorized return on equity over a three-year period. General rate applications are normally filed and processed during the last year covered by the most recent rate case in an attempt to avoid regulatory lag. Pursuant to Section 792.5 of the Public Utilities Code, a balancing account is to be kept for all expense items for which revenue offsets have been authorized. A separate balancing account must be maintained for each offset expense item. The purpose of a balancing account is to track the under collection or over collection associated with expense changes and the revenue authorized by the CPUC to offset those expense changes. At December 31, 1993 the balancing account had a net under collected balance to be offset of $734,000. (See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations"). (b) Financial Information about Industry Segments. For the years ended December 31, 1993, 1992 and 1991 the Company had only one business segment. Approximately 95% of the Company's revenue and 92% of the Company's net income in 1993 were generated by the Water Company. There were no significant changes in 1993 in the type of products produced or services rendered by the Water Company, or in its markets or methods of distribution. (c) Narrative Description of Business. (1) (i) General. The principal business of the Water Company consists of the production, purchase, storage, purification, distribution and retail sale of water. The Water Company provides water service to customers in portions of the cities of Cupertino and San Jose and in the cities of Campbell, Monte Sereno, Saratoga and the Town of Los Gatos, and adjacent unincorporated territory, all in the County of Santa Clara in the State of California. It distributes water to customers in accordance with accepted water utility methods, which include pumping from storage and gravity feed from high elevation reservoirs. (1) (iii) Water Supply. The Water Company's water supply is obtained from wells, surface runoff or diversion and by purchases from the Santa Clara Valley Water District (the "District"). Surface supplies, which during a year of normal rainfall satisfy about 8% of the Water Company's current annual needs, provide from approximately 1% of its water supply in a dry year to approximately 14% in a wet year. In dry years the decrease in water from surface runoff and diversion and the corresponding increase in purchased and pumped water increases production costs substantially. From April 1, 1990, and continuing through March 14, 1993, the Water Company implemented mandatory water rationing programs. From April 1, 1990 through April 28, 1991, the objective was a 20% reduction in usage from comparable periods in 1987. From April 29, 1991 through April 30, 1992, the objective was a 25% reduction in usage from 1987 levels. From May 1, 1992 through March 14, 1993 the objective was a 15% reduction in usage from 1987 levels. Effective March 14, 1993 the Water Company terminated its mandatory water rationing plan and instituted a voluntary conservation plan intended to reduce usage 15% from 1987 levels. The Water Company has notified the CPUC of its intention to establish a memorandum account to record revenue lost due to voluntary conservation programs. Groundwater levels in 1993 climbed to their highest level in 6 years reflecting the impact of the last rainfall season. Santa Clara Valley Water District's reservoir storage of 102,000 acre feet (60% of capacity) was reported on January 11, 1994. (See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations.") Until 1989, the Water Company had never found it necessary to impose mandatory water rationing. Except in a few isolated cases when service had been interrupted or curtailed because of power or equipment failures, construction shutdowns or other operating difficulties, the Water Company had not at any prior time in its history interrupted or imposed mandatory curtailment of service to any type or class of customer. (1) (iv) Franchises. The Water Company holds such franchises or permits in the communities it serves as it judges necessary to operate and maintain its facilities in the public streets. (1) (v) Seasonal Factors. Water sales are seasonal in nature. The demand for water, especially by residential customers, is generally influenced by weather conditions. The timing of precipitation and climatic conditions can cause seasonal water consumption by residential customers to vary significantly. (1) (x) Competition and Condemnation. The Water Company is a public utility regulated by the CPUC and operates within a service area approved by the CPUC. The laws of the State of California provide that no other investor owned public utility may operate in the Water Company's service area without first obtaining from the CPUC a certificate of public convenience and necessity. Past experience shows such a certificate will be issued only after demonstrating the Water Company's service in such area is inadequate. California law also provides that whenever a public agency constructs facilities to extend utility service to the service area of a privately owned public utility (like the Water Company), such an act constitutes the taking of property and is conditioned upon payment of just compensation to the private utility. Under the constitution and statutes of the State of California, municipalities, water districts and other public agencies have been authorized to engage in the ownership and operation of water systems. Such agencies are empowered to condemn properties operated by privately owned public utilities upon payment of just compensation and are further authorized to issue bonds (including revenue bonds) for the purpose of acquiring or constructing water systems. To the Company's knowledge, no municipality, water district or other public agency has pending any action to condemn any part of the Water Company's system. (1) (xii) Environmental Matters. The Water Company maintains procedures to produce potable water in accordance with all applicable county, state and federal environmental rules and regulations. Additionally, the Water Company is subject to environmental regulation by various other governmental authorities. (See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations.") (1) (xiii) Employees As of December 31, 1993, the Water Company had 274 employees, of whom 53 were executive, administrative or supervisory personnel, and of whom 221 were members of unions. The Water Company has two-year collective bargaining agreements expiring December 31, 1994 with the Utility Workers of America, representing the majority of employees and the International Union of Operating Engineers, representing certain employees in the engineering department. Both groups are affiliated with the AFL-CIO. As of December 31, 1993, WP had 50 nonunion employees. (d) Financial Information about Foreign and Domestic Operations and Export Sales. Substantially all of the Company's revenue and expense are derived from operations located in the County of Santa Clara in the State of California. Item 2.

Item 2. Properties. The properties of the Water Company consist of a unified system of water production, storage, purification and distribution located in the County of Santa Clara in the State of California. In general, the property is comprised of franchise rights, water rights, necessary rights-of-way, approximately 7,000 acres of land held in fee (which is primarily nondevelopable watershed), impounding reservoirs with a capacity of approximately 2.256 billion gallons, diversion facilities, wells, distribution storage of approximately 240 million gallons and all water facilities, equipment and other property necessary to supply its customers. The Water Company maintains all of its properties in good operating condition in accordance with customary proper practice for a water utility. The Water Company's well pumping stations have a production capacity of approximately 226.7 million gallons per day and the present capacity for taking purchased water is approximately 105 million gallons per day. The gravity water collection system has a physical delivery capacity of approximately 25 million gallons per day. During 1993, a maximum and average of 189 million gallons and 117 million gallons of water per day, respectively, were delivered to the system. The Water Company holds all its principal properties in fee, subject to current tax and assessment liens, rights-of-way, easements, and certain minor clouds or defects in title which do not materially affect their use and to the lien of the indenture securing its first mortgage bonds, of which there were outstanding at December 31, 1993, $6,000,000 (including current maturities) in principal amount. SJW Land Company owns approximately 8 acres of property adjacent to the Water Company's general office facilities and another approximately 36 undeveloped acres in the San Jose Metropolitan area. The 8 acres adjacent to the Water Company are used as surface parking facilities and generate substantially all SJW Land Company's revenue. WP leases the facilities in which it operates and does not own any real estate. Item 3.

Item 3. Legal Proceedings. The Company has been named as a defendant in a lawsuit filed in Superior Court in Santa Clara County, California, seeking unspecified damages and other relief resulting from water entering a customer's premises. In 1992, a large standby fire service pipeline ruptured, flooding a title company's basement. The Company maintains the failed pipeline was the property of the building owner and that the Company is not liable for any damage. The case is in the preliminary stages of discovery and the Company intends to defend its position vigorously. The Company's insurer has reserved its rights to deny coverage, but is defending the Company. The outcome of this litigation cannot be predicted. Other than the matter described above, there are no material legal proceedings pending or known to be contemplated to which the Company is a party or to which any of its properties is subject, other than ordinary routine litigation incidental to the business conducted by the Company. For a description of CPUC proceedings see the section entitled "Regulation and Rates" in Item 1. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. At the Annual Meeting of Shareholders of the Company held on April 15, 1993, the Company's shareholders voted in favor of: (i) the election of eight directors to the Company's Board of Directors and (ii) the approval of KPMG Peat Marwick as independent auditors of the Company for 1993. The number of votes for, against, as well as the number of abstentions and broker nonvotes as to each matter approved at the Annual Meeting of the Shareholders were as follows: PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. (a) Market Information. (1) (i) Exchange The Company's common stock is traded on the American Stock Exchange under the symbol SJW. (1) (ii) High and Low Sales Prices The information required by this item as to the high and low sales prices for the Company's common stock for each quarter in the 1993 and 1992 fiscal years is contained in the section captioned "Market price range of stock" in the tables set forth in Note 12 of "Notes to Consolidated Financial Statements" in Part II, Item 8.

Item 8. (b) Holders. There were 1,663 record holders of the Company's common stock on February 6, 1994 (record date for the first quarter 1994 dividend). (c) Dividends. Quarterly dividends have been paid on the Company's and its predecessor's common stock for 201 consecutive quarters and the quarterly rate has been increased during each of the last 26 years. The information required by this item as to the cash dividends paid on common stock in 1993 and 1992 is contained in the section captioned "Dividends per share" in the tables set forth in Note 12 of "Notes to consolidated Financial Statements" in Part II, Item 8. The 1993 source of supply expenditures relate to spillway relocation and filter plant modernization, and represent items which are nonrecurring in nature. The Company expects to spend approximately $60 million on capital expenditures over the next five years. The Company's actual capital expenditures may vary from projected due to changes in the expected demand for services, weather patterns, actions by governmental agencies and general economic conditions. Annual additions to utility plant normally exceed Company- financed additions by several million dollars because certain new facilities are constructed using advances from developers and contributions in aid of construction. Most of the Company's distribution system has been constructed over the last forty years. Expenditure levels for renewal and modernization of this part of the system will grow at an increasing rate as these components reach the end of their useful lives. Additionally, in most cases replacement cost will significantly exceed the cost of the retired asset due to increases in the cost of goods and services. SOURCES OF CAPITAL The Company's ability to finance future construction programs and sustain dividend payments depends on its ability to attract external financing and maintain or increase internally generated funds. The level of future earnings and the related cash flow from operations is dependent, in large part, upon the timing and outcome of regulatory proceedings. Over the past five years the Company has paid to its shareholders, in the form of dividends, an average of 66% of its net income. The remaining earnings have been invested in the Company. Capital requirements not funded by the reinvested earnings are expected to be funded through external financing in the form of unsecured senior notes or a commercial bank line of credit. As of December 31, 1993, the Company had available $15 million of unused short-term bank line of credit, $2.6 million of cash, cash equivalents and short-term investments and over $50 million of borrowing capacity under the terms of the first mortgage bond trust indentures and senior note agreements. The Company expects to fund future capital requirements from the same sources and in the same relative proportions as in recent years. The Company's financing activity is designed to achieve a capital structure consistent with regulatory guidelines - approximately 50% debt and 50% equity. In 1993, the Company redeemed its $2,500,000 Series L, 4.625% first mortgage bond at maturity and made sinking fund payments on other series totaling $245,000. The Company also redeemed, prior to maturity, Series Q, R, S, T, U, V, Y and Z first mortgage bonds at principal. To fund the redemption, $30,000,000 of Series B unsecured 30-year senior notes were issued. As a result of this financing the Company's weighted average cost of debt is 8.23%. The Company intends to retire all remaining first mortgage bonds by 1998 and satisfy all future long-term financing needs with senior notes. Results of Operations 1993 COMPARED WITH 1992 The consolidated results of operations for the year ended December 31, 1993, include, for the first time, the results of Western Precision, Inc. (formerly the Roscoe Moss Company) which was acquired on December 31, 1992. Operating revenue for 1993 increased $5,936,000 or 7% over 1992 due to:(1) the inclusion of Western Precision, Inc. operating revenue, $4,292,000; (2) decreased rates and revenue adjustments of ($3,133,000); (3) increased usage, $4,251,000; (4) increased customers, $328,000; and (5) SJW Land Company increased parking revenue, $198,000. Operation expense increased $5,099,000 or 7% over 1992 due to the inclusion of Western Precision, Inc. operating expense of $4,370,000 and increased production. The operating expense increase associated with increased production was largely offset by increased production of lower cost surface water. Dividend income in 1993 results from the acquisition on December 31, 1992, of 549,976 common shares of California Water Service Company. The effective income tax rate for 1993 was 41% compared to 43% in 1992. See Note 6 of the Notes To Consolidated Financial Statements for the reconciliation of the book income tax provision to the amount computed by applying the federal statutory rate to income before income taxes. Interest on long-term debt, including capitalized interest, increased $848,000 or approximately 19% over 1992 due primarily to the issuance of Series A and B senior notes. Total water delivered to the system in 1993 was 43 billion gallons, up 3 billion gallons, or 7%, from 1992. The sources of supply in 1993 and 1992, respectively, were: 48% and 47% for purchased water; 40% and 45% for well water; and 12% and 8% for surface water. 1992 COMPARED WITH 1991 Operating revenue for 1992 increased $12,828,000 or 17% over 1991. The increase is attributable to: (1) increased rates, $14,576,000; (2) water conservation revenue adjustments of ($7,066,000); (3) increased usage, $5,184,000; and (4) increased customers, $134,000. For the year ended December 31, 1992, the Company recorded revenues of $1,857,000 related to a CPUC order authorizing the Company to recover sales lost due to mandatory water rationing. Operation expenses increased $8,287,000 or 18% over 1991 due primarily to increases in the rates for pump taxes and purchased water and increased production. Higher production costs associated with increased production were partially offset by increased supplies of lower cost surface water. The effective income tax rate for 1992 was 43% compared to 42% in 1991. See Note 6 of the Notes To Consolidated Financial Statements for the reconciliation of the book income tax provision to the amount computed by applying the federal statutory rate to income before income taxes. Interest on long-term debt, including capitalized interest, increased $496,000 or approximately 13 % over 1991 due primarily to the issuance of Series A senior notes and Series AA first mortgage bonds. Total water delivered to the system in 1992 was 40 billion gallons, up 4 billion gallons, or 7%, from 1991. The sources of supply in 1992 and 1991, respectively, were: 47% and 56% for purchased water; 45% and 38% for well water; and 8% and 6% for surface water. Factors That May Affect Future Results REGULATION Principally all the operating revenue of the Company results from the sale of water at rates approved by the California Public Utilities Commission (CPUC). The CPUC sets rates that are intended to provide revenue sufficient to recover operating expense and produce a reasonable return on common equity. The Company's most recent rate case decision authorizes the Company to earn a return on common equity of 11.75% in 1992, 1993 and 1994. In recent general rate case proceedings, the CPUC staff has recommended rates of return on common equity lower than 11%. The Company elected to defer, from January 1, 1994 to July 1, 1995, the filing of its next general rate application. If the application is filed on July 1, 1995, the Company should receive a decision in early 1996. The Company implemented its step rate increase on January 1, 1993, which was designed to produce a $213,000 increase in revenue. An advice letter was filed in November, 1993 for the 1994 step rate increase in the amount of $293,000, to be effective January 1, 1994. Both step rate increases were authorized in the Company's general rate case granted in December 1991 and were designed to maintain the Company's rate of return on common equity at the 11.75% authorized level. Because the Company elected to defer filing of its general rate case application it will not receive additional step rate increases until the next general rate case decision is rendered. The recovery of revenue lost due to voluntary water conservation subsequent to the termination of mandatory rationing on March 14, 1993, has not been recorded by the Company due to uncertainty of collection. Recovery of voluntary water conservation revenue losses will be determined in the next general rate case. The Company filed an advice letter in November 1993 requesting a rate increase in the amount of $892,000 for construction costs of the Austrian Dam Spillway in excess of those previously approved in rates. The Company expects to receive this special rate increase in 1994. ENVIRONMENTAL MATTERS The Company's operations are subject to pollution control and water quality control regulations issued by the United States Environmental Protection Agency (EPA), the California Department of Health Services and the California Regional Water Quality Control Board. Additionally, the Company is subject to environmental laws and regulations administered by other state and local regulatory agencies. Under the federal Safe Drinking Water Act (SDWA), the Company is subject to regulation by the EPA of the quality of water it sells and treatment techniques it uses to make the water potable. The EPA promulgates nationally applicable maximum contaminant levels (MCLs) for "contaminants" found in drinking water. The Company is currently in compliance with all MCLs promulgated to date. The EPA has continuing authority, however, to issue additional regulations under the SDWA, and Congress amended the SDWA in July 1986 to require the EPA, within a three-year period, to promulgate MCLs for over 80 chemicals. The EPA has been unable to meet the three-year deadline, but has established MCLs for many of these chemicals and has proposed additional MCLs. The Company has implemented monitoring activities and installed specific water treatment improvements enabling it to comply with existing MCLs. Of all of the regulations being considered under the current SDWA, the Disinfection By-Product Rule is anticipated to have the most significant impact on water utilities. Due to be released for public comment in March 1994, this rule will impose more stringent monitoring requirements and drinking water standards for by-products formed during the disinfection of water. The Santa Clara Valley Water District, whose imported surface water represents approximately 45% of the Company's supply, projects that compliance with this regulation could, by the year 2000, cost over $100 million in capital improvements and an additional $3 million per year in operating expenses. If incurred, these costs would be passed along to the Company in the form of higher rates for purchased water and pump taxes. The Company would seek a rate increase, via an advice letter filing, to recover the additional costs. The Company's surface and groundwater sources are generally of a higher quality than the imported water supplies and are not expected to require extensive modifications of existing treatment processes. To comply with the State Total Coliform Regulation, disinfection of Company wells is being phased in over the next five years. Three of the Company's key groundwater production stations were equipped with hypochlorinators during 1993, with six more installations planned in 1994. The EPA is expected to mandate disinfection of all groundwater supplies by 1999. In addition to SDWA, other environmental regulations are becoming increasingly important in water system operations. The Santa Clara County Toxic Gas Ordinance became effective in 1993 requiring the elimination of chlorine gas disinfection systems or the installation of complete containment systems to control accidental chlorine gas discharges. The Company has begun to replace existing chlorine gas disinfection systems at its water treatment plants with hypochlorinators which accomplish disinfection with liquid sodium hypochlorite. These facilities are scheduled for completion in early 1994. Other state and local environmental regulations apply to Company operations and facilities. These regulations relate primarily to the handling, storage and disposal of hazardous materials. The Company is currently in compliance with state and local regulations governing underground storage tanks, disposal of hazardous wastes, non-point source discharges, and the warning provisions of the California Safe Drinking Water and Toxic Enforcement Act of 1986. Future regulation may require increased monitoring, disinfection of underground water supplies, more stringent performance standards for treatment plants, aeration of Company wells and procedures to reduce levels of disinfection by-products. The Company is actively participating in proceedings currently before the CPUC which seek to establish mechanisms for recovery of government-mandated environmental compliance costs. There are limited regulatory mechanisms and procedures available to the Company for the recovery of such costs and there can be no assurance that such costs will be fully recovered. NONREGULATED SUBSIDIARIES Western Precision, Inc. (formerly the Roscoe Moss Company), acquired on December 31, 1992, operates a high-precision mechanical parts manufacturing operation and owns 549,976 shares of California Water Service Company. The manufacturing operation is not expected to materially impact cash flow or the consolidated results of operations. The investment in California Water Service Company is expected to produce 1994 pre-tax dividend income and cash flow of approximately $1 million. SJW Land Company constructed surface parking facilities to serve the 20,000 seat San Jose Arena which is located adjacent to the parking facilities. The Company expects the machine shop operation and the parking facilities to account for less than 5% of consolidated net income in 1994. The impact of inflation on the Company's operating and construction costs has been moderate during the five year period ended December 31, 1993. For rate-making purposes depreciation expense and rate of return calculations are based on the historical cost of investments in utility plant. Historically, the cost of replacing utility plant has been included in rate base when the expenditure was made. The Water Company expects to continue to earn on the historical cost of utility plant, as adjusted for rate of return calculations. Item 8. Financial Statements and Supplementary Data. Financial Statements: Independent Auditors' Report - ---------------------------- To the Shareholders and Board of Directors of SJW Corp.: We have audited the consolidated financial statements of SJW Corp. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SJW Corp. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" and changed its method of accounting for investments to adopt the provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" at December 31, 1993. As discussed in Note 7, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" in 1992. KPMG Peat Marwick San Jose, California January 21, 1994 SJW CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except share data) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements include the accounts of SJW Corp. and its wholly owned subsidiaries (the Company). Intercompany transactions and balances have been eliminated. The Company's principal subsidiary, San Jose Water Company (the Water Company), is a regulated California water utility. The Water Company's accounting policies comply with the applicable uniform system of accounts prescribed by the California Public Utilities Commission (CPUC) and conform to generally accepted accounting principles for rate regulated public utilities. Utility Plant - The cost of additions, replacements and betterments to utility plant is capitalized. The amount of interest capitalized in 1993, 1992 and 1991 was $769, $407 and $50, respectively. Construction in progress was $3,233 in 1993 and $9,689 in 1992. Depreciation is computed using the straight-line method over the estimated service lives of the assets. The cost of utility plant retired, including retirement costs (less salvage), is charged to accumulated depreciation, and no gain or loss is recognized. Nonutility Property - Nonutility property is recorded at cost and consists primarily of land, parking facilities and machine shop equipment. Cash and Equivalents - Substantially all of the Company's cash is invested in interest bearing debt instruments. The Company considers certain highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents are stated at cost plus accrued interest, which approximates fair value. Selected investments are considered temporary investments rather than cash equivalents based on their intended use. Investment in California Water Service Company - The Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" effective December 31, 1993. Under this Statement the Company's investment in California Water Service Company is reported at quoted market price, with the unrealized gain excluded from earnings and reported as a separate component of shareholders' equity. The adoption of Statement No. 115 resulted in increases in: Investment in California Water Service Company, $3,850; Deferred income taxes, $1,579; and common shareholders' equity, $2,271. At December 31, 1992, the Company's investment in California Water Service Company was reported at cost. Other Assets - Debt reacquisition costs are amortized over the term of the new debt. Debt issuance costs are amortized over the life of each issue. The excess cost over fair market value of net assets acquired is recorded as goodwill and amortized over the periods estimated to be benefited, not exceeding 40 years. Income Taxes - Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards No. 109. "Accounting for Income Taxes." Prior year financial statements have not been restated to apply the provisions of Statement No. 109, which require a change from the deferred method of accounting for income taxes to the asset and liability method of accounting for income taxes. Under Statement No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases, and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The adoption of Statement No. 109 had the effect of increasing net deferred tax liabilities by $8.5 million and of effecting corresponding $5.0 million and $3.5 million increases in investment in California Water Service Company and regulatory asset at January 1, 1993. Management believes the increase is net deferred tax liabilities recorded as a result of adopting Statement No. 109 will be recovered through future rates and has recorded a regulatory asset for this probable future revenue. As a result of recording a net regulatory asset, there was no material effect on the consolidated results of operations. Prior to the adoption of Statement No. 109 the company accounted for income taxes using the deferral method. To the extent permitted by the CPUC, investment tax credits resulting from utility plant additions are deferred and amortized over the estimated useful lives of the related property. Advances for Construction and Contributions in Aid of Construction - Advances for construction received after 1981 are being refunded ratably over 40 years. Prior customer advances are refunded based on 22% of related revenues. Estimated refunds for 1994 are $1,500. Contributions in aid of construction represent funds received from developers that are not refundable under CPUC regulations. Depreciation applicable to utility plant constructed with these contributions is charged to contributions in aid of construction. Customer advances and contributions in aid of construction received subsequent to 1986 generally must be included in federal taxable income. Beginning in 1992, contributions and advances were also included in state taxable income. Taxes paid relating to contributions and advances are recorded as deferred tax assets for financial reporting purposes and amortized over 40 years for advances, and over the life of the related asset for contributions. Revenue - Revenue includes amounts billed to customers, unbilled amounts based on estimated usage from the latest meter reading to the end of the year and recoverable net revenue losses resulting from water conservation programs. Conservation fees are amounts billed to customers whose actual water usage exceeded their allocated usage under the water conservation programs. To the extent authorized by the CPUC, the Company has used conservation fees to offset revenue lost and expenses incurred relating to conservation programs. Included in 1993 operating revenue is $1,200 relating to the recovery of prior years' conservation expenses. Operating revenue includes $327 in 1993, $1,900 in 1992 and $8,900 in 1991 related to recoverable net revenue lost due to conservation programs. Earnings Per Share - Per share data are calculated using net income divided by the weighted average number of shares outstanding during the year, excluding in 1993, contingently returnable shares. NOTE 2. TEMPORARY INVESTMENTS Temporary investments consist primarily of variable rate tax-exempt bonds and are stated at cost plus accrued interest that approximates fair value. Included in other income for 1993, 1992 and 1991 was $181, $401 and $151, respectively, of interest income. NOTE 3. CAPITALIZATION The Company is authorized to issue 176,407 shares of preferred stock. In connection with the acquisition described in Note 9, the sellers agreed to return a portion of the common shares received in the transaction in the event the acquired enterprise does not achieve a three-year earnings target. Shares of common stock issued and outstanding include 13,754 and 21,181 shares contingently returnable to the Company as of December 31, 1993 and 1992, respectively. Additionally, 5,020 shares of common stock were returned to the Company in 1993 as the result of a purchase price adjustment of the acquired entity. NOTE 4. LINE OF CREDIT The Water Company has an unsecured bank line of credit allowing aggregate short-term borrowings of up to $15,000. This line of credit bears interest at variable rates and expires April 30, 1995. NOTE 5. During 1993, the Company issued $30,000 in Series B senior notes and retired, ahead of scheduled maturity dates, first mortgage bonds Series Q, R, S, T, U, V, Y and Z totaling $22,503. Additionally, the Company exchanged Series C senior notes for $10,000 of Series AA first mortgage bonds. First mortgage bonds and senior notes are obligations of the Water Company. Maturities of long-term debt, including sinking fund requirements, amount to $2,000 in 1994, $1,500 in 1995, $1,000 in 1996, and $1,500 in 1997. Substantially all utility plant is pledged as collateral for first mortgage bonds. Senior notes are unsecured. All of the Company's debt is privately placed. The fair value of long-term debt, including current maturities, as of December 31, 1993, was approximately $78,500 based on the amount of essentially risk-free assets the Company would have to place in trust to extinguish these obligations. NOTE 6. The components of income tax expense were: The components of the net deferred tax liability as of December 31 were as follows: NOTE 7. EMPLOYEE BENEFIT PLANS Pension Plans - The Company sponsors noncontributory defined benefit pension plans. Benefits under the plans are based on an employee's years of service and highest consecutive three years of compensation. The Company's policy is to contribute the net periodic pension cost calculated under generally accepted accounting principles to the extent it is tax deductible. The Company has a Supplemental Executive Retirement Plan which is a defined benefit plan under which the Company will pay supplemental pension benefits to key executives in addition to amounts received under the Company's retirement plans. The annual cost of this plan has been included in the determination of the net periodic pension cost shown below. The plan, which is unfunded, had a projected benefit obligation of $887 and $599 as of December 31, 1993, and 1992, respectively, and net periodic pension cost of $139 and $7 for 1993 and 1992, respectively. Expense recognized in 1993 and 1992 amounted to $200. The difference between the net periodic postretirement benefit cost shown above and the amount recognized in the accompanying consolidated financial statements is recoverable in future rates and has been recorded as a regulatory asset. Benefits paid were $70, $71 and $67 in 1993, 1992 and 1991, respectively. Expense recognized in 1991 equaled benefits paid. For measurement purposes, a 12% annual increase in the per capita cost of covered health care benefits was assumed for 1994; this increase was assumed to decrease gradually to 6% by 2008 and remain at that level thereafter. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7% for 1993 and 8% for 1992. In determining the net periodic postretirement benefit cost an 8% discount rate was used for all years presented. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by 1% each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $160 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $18. NOTE 8. COMMITMENTS The Company purchases water from the Santa Clara Valley Water District (SCVWD). Delivery schedules for purchased water are based on a contract year beginning July 1 and are negotiated every three years under terms of a master contract with SCVWD expiring in 2051. The Company is obligated to purchase a minimum of 90% of the delivery schedule. The amount of water purchased in any year may not be less than 95% of the highest amount agreed to be purchased in any year of the current three-year schedule. Based on current prices and estimated deliveries, the Company expects to purchase at least $18,000 of water from SCVWD in each contract year ending June 30, 1994, through 1996. The Company also has operating lease commitments amounting to approximately $170 each year through 1996. NOTE 9. ACQUISITION On December 31, 1992, the Company acquired Roscoe Moss Company (subsequently renamed Western Precision, Inc.) through the exchange of shares of Company stock for all of the shares of the Roscoe Moss Company. The Roscoe Moss Company was the Company's principal stockholder, and as a result of the exchange, the Company acquired a high-precision mechanical parts manufacturing operation and 549,976 shares of California Water Service Company (CWS). The former Roscoe Moss Company shareholders received Company shares issued in the exchange. The acquisition was accounted for as a purchase for financial reporting purposes and the investment in CWS was included in the 1992 consolidated balance sheet at fair value net of taxes. The fair value of the investment in CWS at December 31, 1992, was $18,200. The following unaudited proforma summary presents the consolidated results of operations as if the acquisition had occurred at the beginning of the period and does not purport to be indicative of results that may occur in the future: NOTE 10. NOTE 11. CONTINGENCY The Company has been named as a defendant in a lawsuit filed in Superior Court in Santa Clara County, California, seeking unspecified damages and other relief resulting from water entering a customer's premises. In 1992, a large standby fire service pipeline ruptured, flooding a title company's basement. The Company maintains the failed pipeline was the property of the building owner and that the Company is not liable for any damage. Plaintiffs are seeking unspecified damages. The case is in the preliminary stages of discovery and the Company intends to defend its position vigorously. The Company's insurer has reserved its rights to deny coverage, but is defending the Company. The outcome of this litigation cannot be predicted. NOTE 12. SJW CORP. Property, Plant and Equipment Years ended December 31, 1993, 1992, and 1991 Notes: (1) See Note 1 of the Notes to Consolidated Financial Statements for a summary of the Company's significant utility plant and depreciation accounting policies. As to columns omitted, the answer is "None." The provisions for depreciation in 1993, 1992 and 1991 were equivalent to 2.5%, 2.4% and 2.4%, respectively, of the average depreciable utility plant in service. Depreciation of plant and equipment was recorded in the amount of $7,558,565 for 1993, $7,055,555 for 1992 and $6,608,717 for 1991 excluding $10,621 of amortization of intangibles. In conformity with the Uniform System of Accounts for Water Utilities prescribed by the CPUC, contributions in aid of construction has been charged with depreciation of $715,140 in 1993, $685,062 in 1992 and $633,320 in 1991; and the transportation clearing account has been charged $271,271 in 1993, $264,839 in 1992 and $250,969 in 1991. Amounts charged initially to the transportation clearing account have been distributed to the appropriate operating, administrative, maintenance, utility plant and other accounts. (2) Represents difference between net additions to construction work in progress and amounts transferred upon completion to classified fixed capital accounts in the same column. (3) Nonutility property acquired through stock exchange with Roscoe Moss Company. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. DIRECTORS OF THE REGISTRANT A brief biography of each nominee (including the nominee's business experience during the past 5 years) is set forth below. All nominees are currently directors of the Corporation and have served in such capacity since the Corporation was organized in 1985, except Mr. Gibson who has served since 1986, Mr. DiNapoli who has served since 1989, Mr. Toeniskoetter who has served since 1991 and Mr. Cali who has served since 1992. All nominees are also directors of San Jose Water Company, a wholly-owned public utility water corporation subsidiary of the Corporation. It is the Corporation's intention to appoint all persons elected as directors of the Corporation at the annual meeting to be directors of San Jose Water Company for a concurrent term. MARK L. CALI, Attorney at Law, with the firm, Ropers, Majeski, Kohn, Bentley, Wagner and Kane. Prior to his present employment Mr. Cali attended Santa Clara University Law School. Mr. Cali, age 28, has served as a director of San Jose Water Company since 1992. J. PHILIP DiNAPOLI, Attorney at Law, Chairman of Citation Insurance Company (Worker's Compensation specialty carrier) and Comerica California Inc. (California bank holding company); he serves as a director of Comerica, Inc. (bank holding company) and Comerica Bank-California (bank); he is also the owner of DiNapoli Development Company (real estate development company). Mr. DiNapoli, age 54, is a member of the Audit Committee and has served as a director of the San Jose Water Company since 1989. Mr. DiNapoli is a general partner of a partnership which owned, through another general partnership, certain real estate in San Jose, California. In 1993, a nonrecourse loan to the partnership secured by the real estate was declared in default and the lender put the property in receivership and foreclosed on the property. This property was only one of many real estate investments of Mr. DiNapoli and was not material in relation to his total net worth. DREW GIBSON, President of the Gibson Speno Company (real estate development and investment company) and President of the Gibson Speno Management Company (management company). He also serves as a director of Comerica California Inc. (California bank holding company) and its subsidiary Comerica Bank-California (bank). Mr. Gibson, age 51, is a member of the Audit and Compensation Committees and has served as a director of San Jose Water Company since 1986. RONALD R. JAMES, President Emeritus of the San Jose Chamber of Commerce (business promotion organization), formerly President and Chief Executive Officer of the Chamber. Mr. James, age 65, is a member of the Executive, Audit and Compensation Committees and has served as a director of San Jose Water Company since 1974. GEORGE E. MOSS, Vice Chairman of the Board of Roscoe Moss Manufacturing Company (manufacturer of steel water pipe and well casing). Mr. Moss was formerly President of the Roscoe Moss Company (holding company). Mr. Moss, age 62, is a member of the Compensation Committee and has served as a director of San Jose Water Company since 1984. ROSCOE MOSS, JR., Chairman of the Board of Roscoe Moss Manufacturing Company (manufacturer of steel water pipe and well casing). Mr. Moss was formerly Chairman of the Board of Roscoe Moss Company (holding company). Mr. Moss, age 64, is a member of the Corporation's Executive and Compensation Committees. Mr. Moss serves as a director of California Water Service Company and has served as a director of San Jose Water Company since 1980. CHARLES J. TOENISKOETTER, President of Toeniskoetter & Breeding Inc. (construction and real estate development company). Mr. Toeniskoetter, age 49, is a member of the Audit Committee and has served as a director of San Jose Water Company since 1991. J.W. WEINHARDT, President and Chief Executive Officer of the Corporation; President and Chief Executive Officer of San Jose Water Company. Mr. Weinhardt, age 62, is a member of the Corporation's Executive Committee and has served as a director of San Jose Water Company since 1975. Mr. Weinhardt also serves as a director of SJNB Financial Corp. and its subsidiary San Jose National Bank. Nominees Roscoe Moss, Jr. and George Moss are brothers. Other than the family relationship described in the preceding sentence, no nominee has any family relationship with any other nominee or with any executive officer. In the unanticipated event that a nominee is unable or declines to serve as a director at the time of the annual meeting, proxies will be voted for any nominee named by the present Board of Directors to fill the vacancy. As of the date of this Proxy Statement, the Corporation is not aware of any nominee who is unable or will decline to serve as a director. No nominee is or has been employed in his principal occupation or employment during the past 5 years by a corporation, other than Mr. Weinhardt whose employment relationship with San Jose Water Company is described above and Mr. George Moss and Mr. Roscoe Moss, Jr. whose former employment relationship with the Roscoe Moss Company (now Western Precision, Inc.), a subsidiary of the corporation is described above. The Corporation and San Jose Water Company pay their non-employee directors annual retainers of $2,400 and $12,000, respectively. In addition, all directors of the Corporation and San Jose Water Company are paid $600 for each Board or committee meeting attended. Upon ceasing to serve as a director of the Corporation or San Jose Water Company, as the case may be, directors or their estate are currently entitled to receive from the respective corporation a benefit equal to the annual retainer paid to its directors. This benefit will be paid for the number of years the director served on the board up to a maximum of 10 years. The Board of Directors has an Executive Committee, an Executive Compensation Committee and an Audit Committee. The Audit Committee reviews the results of the annual audit, the financial statements, any supplemental management information submitted by the auditors, and internal accounting and control procedures. It also recommends the selection of auditors to the Corporation's shareholders. The Compensation Committee reviews and recommends to the Board of Directors appropriate compensation for executive officers of the corporation. There is no standing nominating committee. During 1993, there were 4 regular meetings of the Board of Directors and 3 regular meetings of the Audit Committee and 1 meeting of the Executive Compensation Committee. All directors attended at least 75% of all Board and applicable committee meetings. No executive officer has any family relationship to any other executive officer or director. No executive officer is appointed for any set term. There are no agreements or understandings between any executive officer and any other person pursuant to which he was selected as an officer, other than those with directors or officers of the Company acting solely in their capacities as such. Compliance With Section 16(a) of the Exchange Act. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the American Stock Exchange. Officers, directors and greater than ten percent shareholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such reports received by it, or written representations from certain reporting persons that no other reports were required during 1993, the Company believes that during 1993 all officers, directors and greater than ten percent beneficial owners were in compliance with all Section 16(a) filing requirements, except that one report, covering a purchase of 500 shares, was filed late by Mr. DiNapoli. Item 11.

Item 11. Executive Compensation. The following table contains certain summary information regarding the cash compensation paid by the Corporation and its subsidiaries for each of the corporations last three completed fiscal years to the President and Chief Executive Officer and to each other executive officer whose total annual salary and bonus exceeded $100,000. The foregoing table does not include benefits provided under San Jose Water Company's Retirement Plan (The "Retirement Plan") or Supplemental Executive Retirement Plan (SERP). All employees of San Jose Water Company participate in the Retirement Plan. Although subject to adjustment to comply with Internal Revenue Code requirements, the plan's regular benefit formula provides for a monthly retirement benefit equal to 1.6% of the employee's average monthly compensation for each year of credited service. Compensation means the employee's regular salary prior to reduction under the Deferral Plan. The plan also contains a minimum benefit formula which, although also subject to adjustment, provides for a monthly retirement benefit equal up to 55% of the employee's average compensation for the highest 36 consecutive months of compensation less 50% of primary social security benefits. This minimum monthly benefit is reduced by 1/30th for each year of credited service less than 30 years. Benefits vest after 5 years of service or at age 65; there are provisions for early retirement. In addition, in 1992, the Board of Directors of San Jose Water Company adopted a nonqualified, unfunded Supplemental Executive Retirement Plan (SERP) for certain executives and officers of the Water Company. It is intended that the SERP in combination with the Retirement Plan will provide the covered executives and officers with a total retirement benefit commensurate with executives and officers of other comparable private water utilities. A minimum of twenty years of service is required for vesting in the SERP. The amounts contributed to the Retirement Plan by San Jose Water Company to fund retirement benefits with respect to any individual employee cannot be readily ascertained. The following table sets forth combined estimated retirement benefits, payable as a straight life annuity, assuming retirement at age 65 using the minimum benefit formula and the SERP: COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Mr. Drew Gibson, a director and member of the Corporation's Compensation Committee is a partner in the Gibson Speno Company which was compensated for consulting services as disclosed under Transactions with Management. No member of the Compensation Committee is a former or current officer or employee of the Company or any of its subsidiaries. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. The following sets forth, as of January 1, 1994, the beneficial ownership of shares of the outstanding Common Stock of the Corporation by each director or nominee to the Board, each beneficial owner of more than 5% of the common stock, the four most highly compensated executive officers and the executive officers of the Corporation as a group. Each nominee has sole voting and sole investment power with respect to the shares of the Corporation's stock listed below (or shares such powers with his spouse). Item 13.

Item 13. Certain Relationships and Related Transactions. Transactions with Management SJW Land Company and San Jose Water Company, subsidiaries of the Corporation, retained Gibson Speno Company, of which Mr. Gibson a director of the Corporation, is a partner, to perform certain consulting services during the year 1993. The Gibson Speno Company was paid $44,039 for consulting services and reimbursed $73,171 for actual costs related to construction of facilities for SJW Land Company. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) (1) Financial Statements All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. (3) Exhibits required to be filed by Item 601 of Regulation S-K. See Exhibit Index on pages 45 through 46 of this document. The exhibits filed herewith are attached hereto (except as noted) and those indicated on the Exhibit Index which are not filed herewith were previously filed with the Securities and Exchange Commission as indicated. (b) Report on Form 8-K. Current Report on Form 8-K filed on January 11, 1993 responding to Item 5, Other Events (related to the Company's acquisition of Roscoe Moss Company on December 31, 1992). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. In accordance with the Securities and Exchange Commission's requirements, the Company will furnish copies of any exhibit upon payment of a 30 cents per page fee. To order any exhibit(s), please advise the Secretary, SJW Corp., 374 West Santa Clara Street, San Jose, CA 95196, as to the exhibit(s) desired. On receipt of your request, the Secretary will provide to you the cost of the specific exhibit(s). The Secretary will forward the requested exhibits upon receipt of the required fee.

88204_1993.txt

88204

1993

Item 1. Business Sealed Air Corporation (together with its subsidiaries, the "Company") is engaged primarily in the manufacture and sale of a wide variety of protective and specialty packaging materials and systems. The Company's operations are conducted primarily in North America, Europe and the Far East, and its products are distributed in these areas as well as in other parts of the world. Information by geographic area, including net sales, operating profit and identifiable assets, for each of the three years in the period ended December 31, 1993 appears in Note 4 of the Notes to Consolidated Financial Statements, which are contained in the Company's 1993 Annual Report to Stockholders. Such Note is incorporated herein by reference. Products The Company's principal protective and specialty packaging products are engineered products, surface protection and other cushioning products, and food packaging products. Certain of these products are also produced for non-packaging applications. The Company also manufactures and sells certain other products discussed below. The net sales contributed by each class of product for each of the five years in the period ended December 31, 1993 appears in the table under the caption "Selected Financial Data" in the Company's 1993 Annual Report to Stockholders, which data is incorporated herein by reference. Engineered Products The Company's engineered products include its Instapak(R) polyurethane foam packaging systems, specialty polyethylene foams for packaging and non-packaging uses, and Korrvu(R) suspension packaging. Instapak(R) Systems Instapak(R) polyurethane foam packaging systems consist of proprietary blends of polyurethane chemicals and specially designed dispensing equipment, certain features of which are patented. The Company also manufactures a line of Instamate(R) polyolefin films, which are high-performance plastic films designed for use with Instapak(R) packaging systems. Most of the Company's net sales from Instapak(R) systems are attributable to the sale of the polyurethane chemicals and polyolefin films used in the systems installed at customer locations. Instapak(R) chemicals, films and equipment are marketed as integrated packaging systems to provide protective packaging for a wide variety of products, including computer, electronic, office, medical and communications equipment, compressors and motors, furniture and spare parts, and void-fill packaging of office supplies, books, cosmetics and other small products for distribution. Instapak(R) systems are also used to produce polyurethane foams used in certain non-packaging applications, including Instapak(R)-Floral, a foam introduced in 1993 for use as a design base for artificial flower arrangements. An Instapak(R) packaging system allows a customer to create protective cushions for products of any shape and thus to tailor its protective packaging to its individual products and needs. When Instapak(R) chemicals are mixed together and dispensed, they expand up to 200 times their liquid volume within seconds after they are dispensed to form a foam cushion. Because Instapak(R) chemicals expand significantly in volume only when mixed together, the storage space required for the chemicals before use is very low. The Company purchases chemicals from various suppliers, including major chemical companies, and blends these chemicals according to its own proprietary formulations. The Company offers its Instapak(R) customers a family of protective packaging foams, ranging from low-density foams used for light cushioning and void-fill applications to heavy-duty foams used for blocking and bracing heavy items. The Company produces a number of dispensing equipment models for low, medium and high volume use and maintains an ongoing program to develop new equipment models to meet evolving customer needs. Hand-held equipment models range from low-volume single station systems to microprocessor-controlled multiple station systems. The Company also offers its high speed Instapacker(TM) automated system and its VersaPacker(TM) system, a bench-top version of the Instapacker(TM) system, both of which produce ready-to-use foam cushions consisting of Instamate(R) film bags filled with Instapak(R) foam. Generally, customers may either buy or lease equipment from the Company for use with Instapak(R) systems. The Instapak(R) foam-in-place process generally involves either dispensing liquid chemicals into a container and separating the product being packaged from the rising foam cushion with Instamate(R) film or producing foam-filled Instamate(R) film bags that are inserted into the container with the product being packaged. Once the container is closed and sealed, the expanding foam cushion fills the box and completes the package for shipment. The foam cushions either encapsulate the product in its container or, in the case of foam-filled bags, can be used as top or bottom cushions or as a void-fill material to restrain the product in its shipping container. Customers are also able to produce pre-formed Instapak(R) foam cushions for use in packaging a wide range of products. The Company offers assistance to its customers in producing, or in preparing the molds used to produce, such pre- formed cushions. The Company offers Instamolder(TM) semi- automated cushion molding equipment that produces Instapak(R) cushions using the Instapacker(TM) system. Specialty Polyethylene Foams The Company manufactures and sells extruded plank foams and Polylam(R) laminated foams for packaging and non-packaging applications. Extruded plank foam is offered in varying densities and thicknesses up to 4 inches. Polylam(R) foam is produced in various densities and laminated into thicknesses ranging up to 6 inches. These polyethylene foams are generally sold to fabricators and converters for packaging and non- packaging applications in which a clean, non-abrasive material is required with such properties as shock absorption, vibration dampening, thermal insulation or buoyancy. These foams can be produced in various colors and are available in anti-static and flame-retardant forms. In packaging applications, these foams are fabricated into a wide range of protective packaging shapes, forms and die-cuts for designed packages in which a clean, attractive appearance and cushioning or blocking and bracing performance is needed. Non-packaging applications for specialty foams include construction, automotive, sporting and athletic equipment products. During 1993, the Company introduced post- consumer recycled content into certain of its specialty polyethylene foam product lines. Korrvu(R) Suspension Packaging The Company is engaged in the development, manufacture and sale of Korrvu(R) suspension packaging, which is covered by certain patents. A Korrvu(R) package suspends the product to be packaged in the air space of its shipping container between two strong, flexible low-slip films. Surface Protection and Other Cushioning Products The Company's surface protection and other cushioning products include air cellular cushioning materials, protective and durable mailers, thin polyethylene foams, paper packaging products, automated packaging systems and certain other packaging products. Air Cellular Cushioning Materials The Company manufactures and markets air cellular cushioning materials primarily under the trademarks AirCap(R) and PolyCap(R). These materials consist of air bubbles encapsulated between two layers of plastic film, each containing a barrier layer to retard air loss, that form a pneumatic cushion to protect products from damage through shock or vibration during shipment. The Company's PolyCap(R) R line of air cellular cushioning material is similar to AirCap(R) cushioning in construction except that its plastic film contains a lighter barrier layer. The Company's air cellular cushioning materials are used by a wide variety of end users, including both manufacturers and retailers. AirCap(R) cushioning is used primarily to protect a wide variety of lightweight and medium-weight delicate items, such as instruments, electronic components and glassware, that have no limitation on their shipping and shelf-life cycles. PolyCap(R) R cushioning is used primarily for a wide variety of lightweight products that have a relatively short shipping and shelf-life cycle. The Company also markets anti-static and flame-retardant forms of its air cellular cushioning materials. The Company's air cellular cushioning materials are produced in various forms, including continuous rolls, perforated rolls and sheets, depending on customer preference. These materials can be used alone or laminated to other materials such as paper or cardboard. They are also available in bag form (marketed under the trademark Bubblebags(R)), primarily used to provide product protection to small parts. The Company's air cellular cushioning materials can be varied in the size, shape and spacing of their encapsulated air bubbles and the thickness of the plastic to provide specific types of performance in protective packaging and cushioning. Since the beginning of 1993, the Company has broadened the use of post-industrial and post- consumer recycled polyethylene resin content in its Aircap(R) and Polycap(R) R product lines. The Company also manufactures and sells adhesive-coated air cellular cushioning material under the trademark Bubble Mask(R) and cohesive air cellular cushioning material under the trademark Cold Seal(R) AirCap(R). Polypride(TM) air cellular materials, added to the Company's product line in 1993, are multi-web materials with high tensile strength used primarily as furniture wrapping. Protective and Durable Mailers The Company manufactures and markets a variety of protective and durable mailers that are made in several standard sizes and are used for mailing or shipping a wide variety of items for which clean, lightweight preconstructed protective packages are desirable. They can provide the user with significant postage savings, ease of use and enhanced product protection relative to other types of mailers and shipping containers. The Company's protective mailers include lightweight, tear-resistant, heat-sealable mailers marketed under the trademark Jiffylite(R) that are lined with air cellular cushioning material. The Company's Jiffylite(R) R line of mailers are made from recycled kraft paper and the Company's PolyCap(R) R air cellular cushioning materials. These products also include the widely used Jiffy(TM) padded mailers made from recycled kraft paper padded with macerated recycled newspaper, Jiffy(TM) reinforced mailers, which are highly tear resistant and moisture retardant, Jiffy(TM) utility mailers, which are low-cost, lightweight mailers without padding, and Jiffy(TM) Rigi Bag(R) mailers, which are rigid mailers without padding that are well suited for products such as books and photographs. The Company also manufactures and markets Jiffy(TM) foam-lined mailers and Jiffy(TM) floppy disk mailers, which are lined with thin polyethylene foam. During 1993, the Company increased the recycled content of the kraft paper used in many of these mailer lines and introduced post-consumer recycled content into the foam lining of certain foam mailer products. During 1993, the Company expanded its mailer product line with its acquisition of the Shurtuff(R) durable plastic mailer product line. These mailers, which are produced from coextruded polyethylene film, are lightweight, water-resistant, tamper-evident and puncture-proof and are used by a wide range of customers, including air courier, mail order, banking, security and office supply services. Thin Polyethylene Foams In addition to the specialty polyethylene foams described previously, the Company manufactures thin polyethylene foams in roll or sheet form in low, medium and special densities, in flat, ribbed or bag form and in a number of colors and thicknesses up to one-half inch. The Company also sells thin polyethylene foam that has anti-static properties and foam laminate products in which the foam is laminated to paper, polyethylene film or other substrates for specialized applications. The Company's Quicksilver(TM) polyethylene film and foam laminates have cohesive properties for masking and other applications. During 1993, the Company introduced post-consumer recycled content into certain of its thin polyethylene foam product lines. Low-density thin polyethylene foam manufactured by the Company is marketed primarily in the United States, Canada and Europe under the trademark Cell-Aire(R) and is used primarily for surface protection and light-duty cushioning. Medium-density thin polyethylene foam is marketed in the United States under the trademark Cellu-Cushion(R) as a cushioning material to protect products from damage through shock or vibration during shipment. The Company also manufactures special density polyethylene foams for a variety of packaging and non-packaging applications. Paper Packaging Products The Company manufactures recycled kraft, tissue and creped paper in the United States. Some of such paper is used as a raw material in the manufacture of the Company's protective mailer and food packaging products or sold to unaffiliated customers. The Company also manufactures and sells paper packaging products under the trademarks Kushion Kraft(R), Custom Wrap(TM), Jiffy(TM) Padwrap(R), and Void Kraft(TM) for industrial surface protection, furniture surface protection, moving and storage blankets, and for use as cushioning or void fill in various packaging applications. Packaging Systems The Company produces and markets the Instasheeter(TM) high-speed converting system, designed for on-line packaging applications, which automatically converts the Company's flexible packaging materials, including air cellular cushioning materials, thin polyethylene foam and paper packaging materials, described above, into sheets of a pre-selected size and quantity. The Company also produces and markets the Accu-Cut(TM) converting system, an economical system for converting the Company's flexible packaging materials in off-line packaging applications. The Company's Jiffy Packer(TM) high-speed dunnage system, which is marketed in Europe under the name Paper Boy(TM) and in Japan under the name EcoPacker(TM), produces paper dunnage material on site from the Company's 3-ply Void Kraft(TM) recycled kraft paper. During 1993, the Company introduced a benchtop version of the Jiffy Packer(TM) system. During 1993, the Company began selling its VoidPak(TM) inflatable packaging system, which consists of a compact, portable inflator and self-sealing inflatable plastic bags, available in several sizes. When inflated, the bags can be used in a wide range of void fill applications, and they can be deflated and re-inflated for reuse. Other Packaging Products The Company participates in a joint venture called PolyMask Corporation with Minnesota Mining and Manufacturing Company ("3M") that manufactures and sells protective tapes consisting of adhesive-coated polyethylene films marketed by 3M. These products are used primarily for protecting the surfaces of polished metal, glass, plastic and other materials from abrasion during fabrication, handling and shipping. This joint venture is accounted for using the equity method. Food Packaging Products The Company manufactures in the United States and the Netherlands and sells in the United States, Canada, the Far East, Europe and other areas certain food packaging products, including primarily Dri-Loc(R) absorbent pads, certain features of which are covered by U.S. patents. The Company has also introduced other absorbent pads that utilize the features of its Dri-Loc(R) pads, including the Company's Pad-Loc(TM) pad for the poultry processor industry. These products are used in meat, fish and poultry trays to absorb excess fluids. The Company's Dri-Loc(R) pads consist of two layers of polyethylene film sealed on all four sides which enclose a layer of fluffed virgin wood-pulp fibers. On one side, the layer of film has tiny holes that permit fluids to be absorbed and retained by the enclosed fibers. The Company believes that Dri- Loc(R) pads are more effective and aesthetically attractive than conventional absorbent pads. The Company also manufactures conventional padding, sold as individual pads and in roll stock form for use by converters and processors to prepad trays. This padding consists of layers of bleached crepe tissue with one or two outer layers of polyethylene film. The Company also sells supermarket display case liners, which are similar in construction to conventional padding, under the trademark Cellu Liner(TM). Other Products The Company's other products consist primarily of loose-fill polystyrene packaging, products that control static electricity, and recreation and energy conservation products. Subsidiaries of the Company in Hong Kong, Malaysia, Mexico, Singapore and Taiwan produce loose-fill polystyrene packaging for sale under the trademark Mic-Pac(TM) to customers in those countries. In addition to air cellular cushioning materials and polyethylene foam with anti-static properties, the Company sells other products related to the elimination and neutralization of static electricity, including conductive shielding bags, floor mats, worktable coverings, and wrist and foot straps. Static control products, which are sold primarily in the United States and the Far East, are used principally by manufacturers of static-sensitive microelectronic devices. Subsidiaries of the Company in Canada and Europe manufacture translucent air cellular material similar to AirCap(R) cushioning that is fabricated into solar pool covers. In the United States, the Company manufactures and sells solar heating systems for swimming pools that use thermostatically controlled pumps to circulate pool water through plastic solar collector panels. Foreign Operations The Company has subsidiaries in Canada, England, France, Italy, Mexico, Spain and Sweden that manufacture certain of its surface protection and other cushioning products, a subsidiary in the Netherlands that produces Instapak(R) chemicals, Instamate(R) films and Dri-Loc(R) pads, a 50%-owned joint venture in Canada that manufactures specialty and thin polyethylene foams, and a subsidiary in Germany that manufactures Korrvu(R) suspension packaging. Together with a sales and marketing subsidiary in Belgium, these subsidiaries market most of the Company's products in Canada, Mexico and Europe. During 1993, the Company introduced its Instapak(R) products into Mexico, established two new manufacturing operations for air cellular cushioning materials in Europe, and expanded the sale of Dri-Loc(R) food packaging products in Europe and the Far East. Subsidiaries of the Company in Hong Kong, Japan, Malaysia, Singapore and Taiwan are engaged primarily in the marketing of Instapak(R) products in those countries and other countries in the Far East. Certain of these subsidiaries also produce or market certain of the Company's other protective packaging products. A new subsidiary was established in early 1994 in Korea to market Instapak(R) and other products in that country. The Company has foreign licensees that manufacture certain of its surface protection and other cushioning products in Australia, Chile, England, Germany, Italy, Japan, South Africa and Sweden. Licensing revenues are not material to the Company's consolidated financial statements. During 1993, 1992 and 1991, foreign net sales represented approximately 27%, 30% and 32%, respectively, of the Company's total net sales, while operating profit from foreign operations represented approximately 20%, 25% and 32%, respectively, of the Company's total operating profit. For a discussion of the factors affecting these changes in foreign net sales and operating profit, see Management's Discussion and Analysis of Results of Operations and Financial Condition, which appears in the Company's 1993 Annual Report to Stockholders and is incorporated by reference into Item 7 of this Annual Report on Form 10-K. In maintaining its foreign operations, the Company runs the risks inherent in such operations, including those of currency fluctuations. Marketing, Distribution and Customers The Company employs several hundred sales and account representatives in the countries in which it has operations who market the Company's products through a large number of distributors, fabricators and converters as well as directly to end users. In the United States and certain other countries, the Company has separate sales and marketing groups for its engineered products, its surface protection and other cushioning products, its food packaging products and certain of its other products. These groups often work together to develop market opportunities for the Company's products. To assist its marketing efforts and to provide specialized customer services, the Company maintains packaging laboratories in many of its United States and foreign facilities. These laboratories are staffed by professional packaging engineers and equipped with drop-testing and other equipment used to develop and test cost-effective package designs to meet the particular protective packaging requirements of each customer. Certain of these laboratories also design and construct molds for Instapak(R) packaging customers who prefer to use preformed foam cushions. The Company has no material long-term contracts for the distribution of its protective packaging products. In 1993, no customer or affiliated group of customers accounted for as much as 5% of the Company's consolidated net sales. Raw Materials The raw materials utilized in the Company's operations generally have been readily available on the open market and are purchased from several suppliers, reprocessed from scrap generated in the Company's manufacturing operations or obtained through participation in recycling programs. The principal raw materials used in the Company's operations include polyethylene resins and films, polyurethane chemicals, and paper and wood pulp products (including recycled or reprocessed paper products, resins, films and chemicals) and blowing agents used in foam products. Product Development The Company incurred expenses of $9,168,000 related to Company-sponsored research and development in 1993 compared with $9,414,000 during 1992 and $9,876,000 during 1991. The Company maintains a continuing effort to develop new products based on its existing product lines as well as new packaging and non- packaging applications for its products. The Company also maintains ongoing efforts to add or increase recycled or reprocessed content in its product lines. Patents and Licenses The Company is the owner or licensee of a number of United States and foreign patents and patent applications that relate to certain of its products, manufacturing processes and equipment. While some of these patents and licenses, as well as certain trademarks which the Company owns, offer some protection and competitive advantage for the Company's products and their manufacture, the Company believes that its success depends primarily on its marketing, engineering and manufacturing skills and on its research and product technology. Competition The Company's engineered products and its surface protection and other cushioning products compete with similar products made by others and with a number of other packaging materials, including various forms of paper packaging products, expanded plastics, corrugated die cuts, loosefill packaging materials, and, for protective mailers, also with envelopes, reinforced bags, boxes and other containers and various corrugated materials. Heavy-duty applications of the Company's engineered products also compete with various types of molded foam plastics, fabricated foam plastics and mechanical shock mounts and with wood blocking and bracing systems. Certain firms producing competing products are well established and may have greater financial resources than the Company. Competition for most of the Company's protective packaging products is based primarily on packaging performance characteristics, service and price. As discussed below under "Environmental Matters," the Company is also subject to competitive factors affecting packaging materials that are based upon customers' environmental preferences. Because of the light but bulky nature of the Company's air cellular, polyethylene foam and protective mailer products, significant freight savings may be realized by locating manufacturing facilities for these products near markets. To realize the benefit of such savings, the Company has facilities for manufacturing these products in various locations in proximity to major markets in North America and Europe. The Company believes that it is the leading manufacturer of air cellular cushioning materials containing a barrier layer and polyurethane foam packaging systems in the geographic areas in which it sells these products. There are a number of competing manufacturers of food packaging products in the United States, Canada and Europe. The Company believes that its Dri-Loc(R) products have a competitive advantage over conventional pads because of their efficiency and aesthetic appearance. Conventional pads and display case liners compete primarily on the basis of price, absorbency and service. The Company believes it is one of the leading suppliers of meat, fish and poultry absorbent pads to supermarkets and poultry processors in the United States. Environmental Matters The Company, like other manufacturers, is subject to various laws, rules and regulations in the countries, jurisdictions and localities in which it operates regulating the discharge of materials into the environment or otherwise relating to the protection of the environment. The Company believes that compliance with current environmental laws and regulations has not had a material effect on the Company's capital expenditures or financial position. In response to the United States Clean Air Act Amendments of 1990 and regulations thereunder, which prohibit the sale of packaging foams manufactured with chlorofluorocarbons ("CFCs") and hydrochlorofluorocarbons ("HCFCs") in the United States after the end of 1993, and the Montreal Protocol, as amended, during 1993 the Company completely eliminated the use of CFC and HCFC blowing agents in its polyurethane and polyethylene foam products and processes. The Company's capital expenditures for environmentally related projects related to such transition have not been material. In some jurisdictions in which the Company's packaging products are sold or used, laws and regulations have been adopted or proposed that seek to regulate, among other things, recycled or reprocessed content, sale or disposal of packaging materials. In addition, customer demand has increased during the last few years for packaging materials that are viewed as being "environmentally responsible" and that minimize the generation of solid waste. While these issues have become a competitive factor in the marketplace for packaging materials, the Company maintains active programs designed to comply with these laws and regulations, to monitor their evolution, and to meet such customer demand. The Company believes that its protective packaging materials offer superior packaging protection, enabling customers to achieve lower package cube and weight using the Company's protective packaging materials than with many alternative packaging methods, thereby reducing the disposal of damaged products as well as the generation of packaging waste. Because the Company offers both plastic-based and paper-based protective packaging materials, customers can select the protective packaging materials that they consider to best meet their performance and cost needs and environmental preferences. A number of the Company's product lines incorporate recycled or reprocessed content, and the Company maintains ongoing efforts to add or increase recycled or reprocessed content in many of its product lines. The Company also supports its customers' interests in eliminating waste by offering or participating in collection programs for certain of the Company's products or product packaging and for materials used in certain of the Company's products, including a program with Dow Chemical Company aimed at recovering and recycling polyethylene materials from customers, an Instapak(R) foam return program with return sites throughout the United States, collection programs for packaging materials in Germany and elsewhere in Europe, and local newspaper collection programs to obtain materials used to produce Jiffy(TM) padded mailers and certain other products. Whenever possible, materials collected through these collection programs are reprocessed and either reused in the Company's operations or offered to other manufacturers for use in other products. Certain of the Company's protective packaging products can be reused and, as an alternative to recycling or disposal in solid waste landfills, are suitable fuel sources for waste-to-energy conversion facilities. Employees At December 31, 1993, the Company had approximately 2,750 employees, with approximately 250 employees covered by collective bargaining agreements. The Company believes that its employee relations are satisfactory. Item 2.

Item 2. Properties The Company's products are manufactured at twenty-two locations in the United States, three other locations in North America, including facilities in Puerto Rico, Canada and Mexico, nine locations in Europe, including facilities in England, France, Germany, Italy, the Netherlands, Spain and Sweden, and four locations in the Far East, including facilities in Hong Kong, Malaysia, Singapore and Taiwan. In the United States, the Company's Instapak(R) products are manufactured at a facility in Connecticut and its surface protection and other cushioning products, its food packaging products and certain of its other products are manufactured at facilities in California, Illinois, Massachusetts, Mississippi, New Jersey, New York, North Carolina, Pennsylvania and Texas. The Company occupies other facilities containing sales, technical or administrative offices at several locations in the United States and abroad and maintains sales offices in Belgium and Japan. The Company owns twenty-one of its manufacturing facilities, certain of which are owned subject to mortgages or similar financing arrangements. The balance of the Company's manufacturing facilities are located in leased premises. The Company's manufacturing facilities are located in general purpose buildings in which the Company's specialized machinery for the manufacture of one or more products is contained. Item 3.

Item 3. Legal Proceedings In December 1992, the United States Environmental Protection Agency ("EPA") issued a unilateral administrative order under Section 106 of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), to the Company and approximately sixteen other persons, including several major corporations, whom it alleged to be potentially responsible parties ("PRPs"), ordering the listed PRPs to undertake certain interim remedial actions at a National Priorities List site known as the Skinner Landfill in West Chester, Ohio (the "Site"). The Company understands that the EPA designated the Company as a PRP for the Site based on the EPA's allegation that the Company is a successor to a company that the EPA alleges disposed of wastes at the Site in the years 1958 through 1963. Based upon the information currently available about the Site, the Company believes that there is no basis for the EPA's position that the Company should be properly designated as a PRP with respect to the Site, and accordingly the Company advised the EPA that it did not intend to comply with the order. To the Company's knowledge, the EPA has not yet determined whether to commence an action to attempt to enforce the order against the Company. However, the Company believes, based upon the available information about the Site, that it had sufficient cause not to comply with the order, and the Company intends to defend its position should such an action be commenced. The Company is also involved in various lawsuits and administrative and other proceedings (including environmental proceedings relating to superfund sites and other alleged clean- up obligations) incidental to its business. The Company believes that the outcome of any such lawsuits or other proceedings (including the environmental matter described above) will not have a material adverse effect on its consolidated financial statements. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the Company's stockholders during the fourth quarter of 1993. Executive Officers of the Registrant The information appearing in the following table sets forth the current position or positions held by each executive officer of the Company, his age as of March 15, 1994, the year in which he first was elected to his current position and the year in which he first was elected an officer of the Company: Name and Age as of First Elected to First Elected Current Position March 15, 1994 Current Position an Officer T. J. Dermot Dunphy 61 1971 1971 President, Chief Executive Officer and Director Elmer N. Funkhouser III 52 1984 1982 Senior Vice President William V. Hickey 49 1990 1980 Senior Vice President- Finance Warren H. McCandless 53 1991 1990 Senior Vice President Dale Wormwood 59 1991 1989 Senior Vice President Peter B. Ayrton 59 1992 1992 Vice President James A. Bixby 50 1990 1990 Vice President Bruce A. Cruikshank 51 1990 1990 Vice President Jean-Luc Debry 48 1992 1992 Vice President Robert A. Pesci 48 1990 1990 Vice President Horst Tebbe 53 1986 1986 Vice President Robert M. Grace, Jr. 47 1981 1981 General Counsel and Secretary All of the Company's officers serve at the pleasure of the Board of Directors. All officers have been employed by the Company or its subsidiaries for more than five years. In December 1989, Mr. Funkhouser entered into an agreement with the U.S. Department of Justice pursuant to which he pled guilty to a misdemeanor charge relating to willful disclosure of a false document prepared and filed by a former employee of the Company with the U.S. Department of the Treasury. There are no family relationships among any of the Company's officers or directors. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The information appearing under the caption "Common Stock Information" in the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. Item 6.

Item 6. Selected Financial Data The information appearing under the caption "Selected Financial Data" in the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information appearing under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data Interim Financial Information (Unaudited) The information appearing under the caption "Interim Financial Information (Unaudited)" in the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. Financial Statements and Schedules See Index to Consolidated Financial Statements and Schedules on page of this Annual Report on Form 10-K. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There has been no change in the independent auditors of the Company's financial statements during 1992 or 1993 or subsequent thereto. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Part of the information required in response to this Item is set forth in Part I of this Annual Report on Form 10-K under the caption "Executive Officers of the Registrant," and the balance will be set forth in the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders under the caption "Information Concerning Nominees." All such information is incorporated herein by reference. Item 11.

Item 11. Executive Compensation The information required in response to this Item will be set forth in the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders under the caption "Directors' Compensation" and under the subheadings "Summary Compensation Table" and "Compensation Committee Interlocks and Insider Participation" under the caption "Executive Compensation," and such information is incorporated herein by reference. Such incorporated information does not include the information under the subheadings "Report of Organization and Compensation Committee on Executive Compensation" and "Common Stock Performance Comparison" under the caption "Executive Compensation" in such Proxy Statement. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information required in response to this Item will be set forth in the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders under the caption "Voting Securities," and such information is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions Not applicable. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed as a part of this Annual Report on Form 10-K: (i) Financial Statements and Financial Statement Schedules See Index to Consolidated Financial Statements and Schedules on page herein. (ii) Exhibits Exhibit Description Number 3.1 Unofficial Composite Certificate of Incorporation of the Company as currently in effect. (Exhibit (2)(B) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1992, File No. 1-7834, is incorporated herein by reference.) 3.2 Amendment to the By-Laws of the Company adopted on December 16, 1993. 3.3 By-Laws of the Company as currently in effect. 4 Indenture dated as of July 1, 1989 between the Company and The First National Bank of Boston, as Trustee. (Exhibit 4.1 to the Company's Registration Statement on Form S-2, Registration No. 33-28940, is incorporated herein by reference.) 10.1 Contingent Stock Plan of the Company, as amended. (Exhibit 4(c) to the Company's Registration Statement on Form S-8, Registration No. 33-41734, is incorporated herein by reference.)* 10.2 Restricted Stock Plan for Non-Employee Directors of the Company. (Exhibit A to the Company's Proxy Statement for the annual meeting held on May 17, 1991, File No. 1-7834, is incorporated herein by reference.)* 10.3 Revolving Credit Agreement between United Jersey Bank and the Company dated March 10, 1994. 13 Portions of the Company's 1993 Annual Report to Stockholders that are incorporated by reference into this Annual Report on Form 10-K. 22 Subsidiaries of the Company. 24 Consent of KPMG Peat Marwick. *Compensatory plan or arrangement of management required to be filed as an exhibit to this report on Form 10-K. (b) Reports on Form 8-K: The Company did not file any reports on Form 8-K during the fiscal quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SEALED AIR CORPORATION (Registrant) Date: March 22, 1994 By T. J. DERMOT DUNPHY T. J. Dermot Dunphy President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date By T. J. DERMOT DUNPHY March 22, 1994 T. J. Dermot Dunphy President and Director (Principal Executive Officer) By WILLIAM V. HICKEY March 22, 1994 William V. Hickey Senior Vice President-Finance (Principal Financial Officer and Principal Accounting Officer) By JOHN K. ARMSTRONG March 22, 1994 John K. Armstrong Director By JOHN K. CASTLE March 22, 1994 John K. Castle Director By LAWRENCE R. CODEY March 22, 1994 Lawrence R. Codey Director By CHARLES F. FARRELL, JR. March 22, 1994 Charles F. Farrell, Jr. Director By DAVID FREEMAN March 22, 1994 David Freeman Director By SHIRLEY A. JACKSON March 22, 1994 Shirley A. Jackson Director By ALAN H. MILLER March 22, 1994 Alan H. Miller Director By R. L. SAN SOUCIE March 22, 1994 R. L. San Soucie Director Page SEALED AIR CORPORATION CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Years ended December 31, 1993, 1992 and 1991 Page SEALED AIR CORPORATION AND SUBSIDIARIES Index to Consolidated Financial Statements and Schedules Page Independent Auditors' Report * Financial Statements: Consolidated Statements of Earnings for the years ended December 31, 1993, 1992 and 1991 * Consolidated Balance Sheets - December 31, 1993 and 1992 * Consolidated Statements of Shareholders' Equity (Deficit) for the years ended December 31, 1993, 1992 and 1991 * Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 * Notes to Consolidated Financial Statements * Independent Auditors' Report on Schedules Schedules: V - Property, Plant and Equipment VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-Term Borrowings X - Supplementary Income Statement Information ______________________________ *The information required appears on pages 17 through 30 of the Company's 1993 Annual Report to Stockholders and is incorporated by reference into this Annual Report on Form 10-K. All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. Page Independent Auditors' Report on Schedules The Board of Directors and Shareholders Sealed Air Corporation: Under date of January 19, 1994, we reported on the consolidated balance sheets of Sealed Air Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. S/KPMG Peat Marwick KPMG Peat Marwick Short Hills, New Jersey January 19, 1994 Page Page Page Page Page

16906_1993.txt

16906

1993

Item 1. Business General Canal Electric Company (the Company) is a wholesale electric generating company organized in 1902 under the laws of the Commonwealth of Massachu- setts. The Company assumed its present corporate name in 1966 after the sale to an affiliated company of its electric distribution and transmission properties together with the right to do business in the territories served. The Company is a wholly-owned subsidiary of Commonwealth Energy System ("System"), which together with its subsidiaries is collectively referred to as "the system." The Company's generating station is located in Sandwich, Massachusetts at the eastern end of the Cape Cod Canal. The station consists of two oil- fired steam electric generating units: Canal Unit 1, with a rated capacity of 569 MW, wholly-owned by the Company; and Canal Unit 2, with a rated capacity of 580 MW, jointly-owned by the Company and Montaup Electric Company (Montaup) (an unaffiliated company). Canal Unit 2 is operated by the Company under an agreement with Montaup which provides for the equal sharing of output, fixed charges and operating expenses. Canal Units 1 and 2 commenced operation in 1968 and in 1976, respectively. The Company also has a 3.52% interest in the Seabrook 1 nuclear power plant located in Seabrook, New Hampshire, to provide for a portion of the capacity and energy needs of Cambridge Electric Light Company (Cambridge) and Commonwealth Electric Company (Commonwealth Electric), each of which are retail distribution companies and wholly-owned subsidiaries of the System. The plant has a rated capacity of 1,150 MW. For additional information pertaining to the Company's relationship with the system's retail distribution companies, together with more extensive disclosures on the Company's participation in the Seabrook plant and with other sources of power procurement, refer to the "Power Contracts" and "Power Supply Commitments and Support Agreements" sections of this Item 1 and Note 5 of Notes to Financial Statements filed under Item 8 of this report. New England Power Pool The Company, together with other electric utility companies in the New England area, is a member of the New England Power Pool (NEPOOL), which was formed in 1971 to provide for the joint planning and operation of electric systems throughout New England. NEPOOL operates a centralized dispatching facility to ensure reliability of service and to dispatch the most economically available generating units of the member companies to fulfill the region's energy requirements. This concept is accomplished by use of computers to monitor and forecast load requirements and provide for economic dispatching of generation. In the past, this has required that Canal Unit 1 operate whenever possible since it is one of the most efficient oil-fired units in the country. Canal Unit 2 CANAL ELECTRIC COMPANY is designed for cycling operation which provides for economic changes in unit load permitting reduced generation during nights and weekends when demand is lowest. It has performed as one of New England's most efficient units in this type of service. The Company and the System's other electric subsidiaries are also members of the Northeast Power Coordinating Council (NPCC), an advisory organization which includes the major power systems in New England and New York plus the provinces of Ontario and New Brunswick in Canada. NPCC establishes criteria and standards for reliability and serves as a vehicle for coordination in the planning and operation of these systems in enhancing reliability. Regulation The Company is a "public utility" within the meaning of Part II of the Federal Power Act and is subject to regulations thereunder by the FERC as to rates, accounting and other matters. The Company is subject to regulation by the DPU as to the issuance of securities. Fuel Supply (a) Oil Effective July 1, 1993, the Company executed a twenty-two month contract with Coastal Oil New England, Inc. (Coastal) for the purchase of residual fuel oil. The contract provides for delivery of a set percentage of the Company's fuel requirement, the balance (a maximum of 20%) to be met by spot purchases or by Coastal at the discretion of the Company. Energy Supply and Credit Corporation (ESCO Massachusetts, Inc.) operates the Company's oil terminal and manages the purchase, receipt and payment of oil under assignment of the Company's supply contracts to ESCO Massachusetts, Inc. Oil in the terminal's shore tanks is held in inventory by ESCO Massachusetts, Inc. and delivered upon demand to the Company's day tanks. Fuel oil storage facilities at the Canal site have a capacity of 1,199,000 barrels, representing approximately 60 days of normal operation of the two units. During 1993, ESCO maintained an average daily inventory of 583,000 barrels of fuel oil which represents 30 days of normal operation of the two units. This supply is maintained by tanker deliveries approximately every ten to fifteen days. For a discussion on the cost of fuel oil, refer to "Management's Discussion and Analysis of Results of Operations" filed under Item 7 of this report. (b) Nuclear Fuel The nuclear fuel contract and inventory information for Seabrook 1 has been furnished to the Company by North Atlantic Energy Services Corporation (NAESCO), the plant manager responsible for operation of the unit. CANAL ELECTRIC COMPANY The supply of fuel for nuclear generating plants generally involves the acquisition of uranium concentrates, its conversion to uranium hexafluoride, enrichment, fabrication of the nuclear fuel assemblies and, after its use in the reactor, its storage as spent fuel until final disposal by the federal government. Seabrook's requirement for each of these fuel components are 100% covered through 1999 by existing contracts. There are no spent fuel reprocessing or disposal facilities currently operating in the United States. Instead, commercial nuclear electric gener- ating units operating in the United States are required to retain high level wastes and spent fuel on-site. As required by the Nuclear Waste Policy Act of 1982 (the Act), as amended, the joint-owners entered into a contract with the Department of Energy for the transportation and disposal of spent fuel and high level radioactive waste at a national nuclear waste repository. Owners or generators of spent nuclear fuel or its associated wastes are required to bear all of the costs for such transportation and disposal through payment of a fee of approximately 1 mill/KWH based on net electric generation to the Nuclear Waste Fund. Under the Act, a temporary storage facility for nuclear waste was anticipated to be in operation by 1998; a reassessment of the project's schedule requires extending the completion date of the permanent facility until at least 2010. Seabrook 1 is currently licensed for enough on-site storage to accommodate all spent fuel expected to be accumulated through the year 2010. Power Contracts The Company is a party to substantially identical life-of-the-unit power contracts with Boston Edison Company, Montaup Electric Company and New England Power Company (unaffiliated utilities), under which each is severally obligated to purchase one-quarter of the capacity and energy of Canal Unit 1. Commonwealth Electric and Cambridge are jointly obligated to purchase the remaining one-quarter of the unit's capacity and energy. Similar contracts are in effect between the Company and Commonwealth Electric and Cambridge under which those companies are jointly obligated to purchase the Company's entire share of the capacity and energy of Canal Unit 2. The price of power is based on a two-part rate consisting of a demand charge and an energy charge. The demand charge covers all expenses except fuel costs and includes recovery of the original investment. It also provides for any adjustments to that investment over the economic lives of the units. The energy charge is based on the cost of fuel and is billed to each purchaser in proportion to its purchase of power. Purchasers are billed monthly. The power contracts are on file with the FERC. The Company's participation in various power arrangements is accomplished through the use of a Capacity Acquisition and Disposition Agreement (Agreement), a vehicle whereby bulk electric power is procured by the Company at the request of and for resale to its affiliates Commonwealth Electric and Cambridge. The Agreement allows the Company to act as agent for Commonwealth Electric and/or Cambridge in the procurement of additional capacity, or, to sell a portion of each company's entitlement in Unit 2. Exchange agreements are in place with several utilities whereby, in certain circumstances, it is possible to exchange capacity so that the mix of power improves the pricing for dispatch for both the seller and purchaser. Commonwealth Electric and Cambridge thus secure cost savings for their respective customers by planning for bulk power supply on a single system CANAL ELECTRIC COMPANY basis. This Agreement, which has been accepted for filing as a rate schedule by the FERC, enables the Company to recover costs incurred in connection with any unit covered by such Agreement whether or not the unit becomes operational. Power contracts are in place, whereby the Company bills Commonwealth Electric and Cambridge for certain costs associated with units subject to this Agreement. Commonwealth Electric and Cambridge, in turn, bill those charges to retail customers through rates subject to DPU regulation. In accordance with applicable provisions of the Agreement, when a source of power satisfactory to Commonwealth Electric and/or Cambridge has been identified, a document, hereafter referred to as a Capacity Acquisition or Disposition Commitment (Commitment), referencing such source of power and binding the parties thereto to the terms of the Agreement is created. Currently, Commitments are in effect for Seabrook 1, Phase I and Phase II of the Hydro-Quebec Project, varying amounts of power acquired from Northeast Utilities (NU), a 50 MW exchange with Central Vermont Public Service and a 20 MW exchange with New England Power Company through October 1993, increased to 50 MW through April 1997. Power Supply Commitments and Support Agreements In response to solicitations by NU and other utilities, the Company, on behalf of Commonwealth Electric and Cambridge, agreed to purchase entitlements through short-term contracts in various selected generating units. The contracts with NU cover the purchase of varying amounts of power through October 1994. These and other bulk electric power purchases are necessary in order to fulfill the system's NEPOOL obligation and for the Company to acquire and deliver electric generating capacity to meet Commonwealth Electric and Cambridge requirements. For additional information, refer to "Transactions with Affiliates" in Note 1 of Notes to Financial Statements and to "Management's Discussion and Analysis of Results of Operations" filed under Items 8 and 7, respectively, of this report. The Company is party to support agreements for Phase I and Phase II of the Hydro-Quebec Project and is thereby obligated to pay its share of operating and capital costs for Phase II over a 25 year period ending in 2015. Future minimum lease payments for Phase II have an estimated present value of $14.2 million at December 31, 1993. In addition, the Company has an equity interest in Phase II which amounted to $3.9 million in 1993 and $4.2 million in 1992. Construction and Financing Information concerning the Company's financing and construction programs is contained in Note 5 of Notes to Financial Statements filed under Item 8 of this report. Environmental Matters The Company is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. These laws and regulations affect, among other things, the siting and operation of generating facilities, and will continue to impact future operations, capital costs and construction schedules. CANAL ELECTRIC COMPANY The federal Clean Air Act, as amended, and certain state laws and regulations impose restrictions on air emissions. Some of these restrictions will become effective in 1995, and others by the year 2000. These laws and regulations have a particular impact on the cost of electric generating operations. As part of its emission reduction program, the Company has been burning more lower-sulphur content fuel oil at this plant. In addition, in October 1993, the Company reached an agreement with Montaup Electric Company (50% owner of Unit 2) and Algonquin Gas Transmission Company to build a natural gas pipeline that will serve Unit 2, subject to regulatory approvals. Unit 2 will be modified to burn gas in addition to oil. The project will improve air quality on Cape Cod, enable the plant to exceed the stringent 1995 air quality standards established by the Massachusetts Department of Environmental Protection and will also strengthen the Company's bargaining position as it seeks to secure the lowest-cost fuel for its customers. Plant conversion and pipeline construction are expected to be completed in 1996. Following the issuance of an environmental consent order in May 1993, the plant was subject to an intensive 26 week review by the Massachusetts Department of Environmental Protection. The on-site inspection of the plant ended in December 1993, with the plant meeting all state requirements. The plant will remain under state supervision and will be subject to unannounced emissions checks in order to ensure that the highest standards of air quality are maintained. Employees The Company has 124 regular employees, 88 (71%) are represented by the Utility Workers' Union of America, A.F.L.-C.I.O. The existing collective bargaining agreement expires on May 31, 1997. Employee relations have generally been satisfactory. Item 2.

Item 2. Properties The Company operates a generating station located at the eastern end of the Cape Cod Canal in Sandwich, Massachusetts. The station consists of two oil-fired steam electric generating units: Canal Unit 1 with a rated capacity of 569 MW, wholly-owned by the Company; and Canal Unit 2, with a rated capacity of 580 MW, jointly-owned by the Company and Montaup Electric Company, a wholly-owned subsidiary of Eastern Utilities Associates. In addition, the Company has a 3.52% joint-ownership interest (40.5 MW of capacity) in Seabrook 1. Refer to Note 3 of Notes to Financial Statements filed under Item 8 of this report for encumbrances relative to the Company's property. Item 3.

Item 3. Legal Proceedings The Company is subject to legal claims and matters arising from its normal course of business, including its ownership interest in the Seabrook plant. CANAL ELECTRIC COMPANY PART II. Item 5.

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters (a) Principal Market Not applicable. The Company is a wholly-owned subsidiary of Commonwealth Energy System. (b) Number of Shareholders at December 31, 1993 One (c) Frequency and Amount of Dividends Declared in 1993 and 1992 1993 1992 Per Share Per Share Declaration Date Amount Declaration Date Amount January 28, 1993 $ 4.35 February 24, 1992 $ 3.15 April 26, 1993 2.65 April 27, 1992 2.85 July 26, 1993 2.62 July 20, 1992 2.50 October 18, 1993 2.50 October 19, 1992 3.00 December 29, 1993 8.54 $11.50 $20.66 Reference is made to Note 6 of Notes to Financial Statements filed under Item 8 of this report for restrictions against the payment of cash dividends. (d) Future dividends may vary depending upon the Company's earnings and capital requirements as well as financial and other conditions existing at that time. CANAL ELECTRIC COMPANY Item 7.

Item 7. Management's Discussion and Analysis of Results of Operations The following is a discussion of certain significant factors which have affected operating revenues, expenses and net income during the periods included in the accompanying statements of income and is presented to facilitate an understanding of the results of operations. This discussion should be read in conjunction with the Notes to Financial Statements filed under Item 8

Item 8. Financial Statements and Supplementary Data The Company's financial statements required by this item are filed herewith on pages 14 through 32 of this report. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None CANAL ELECTRIC COMPANY Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Canal Electric Company: We have audited the accompanying balance sheets of CANAL ELECTRIC COMPANY, (a Massachusetts corporation and wholly-owned subsidiary of Commonwealth Energy System) as of December 31, 1993 and 1992, and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Canal Electric Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 7 to the financial statements, effective January 1, 1993, the Company changed its method of accounting for costs associated with postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Arthur Andersen & Co. Boston, Massachusetts, February 17, 1994. CANAL ELECTRIC COMPANY INDEX TO FINANCIAL STATEMENTS AND SCHEDULES PART II. FINANCIAL STATEMENTS Balance Sheets at December 31, 1993 and 1992 Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and Notes to Financial Statements PART IV. SCHEDULES III Investments In, Equity Earnings of, and Dividends Received From Related Parties for the Years Ended December 31, 1993, 1992 and 1991 V Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 VI Accumulated Depreciation of Property, Plant and Equipment and Amortization of Nuclear Fuel for the Years Ended December 31, 1993, 1992 and 1991 IX Short-Term Borrowings for the Years Ended December 31, 1993, 1992 and SCHEDULES OMITTED All other schedules are not submitted because they are not applicable or required or because the required information is included in the financial statements or notes thereto. CANAL ELECTRIC COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS 1993 1992 (Dollars in Thousands) PROPERTY, PLANT AND EQUIPMENT, at original cost $404 768 $402 595 Less - Accumulated depreciation and amortization 137 720 124 062 267 048 278 533 Add - Construction work in progress 2 501 1 625 Nuclear fuel in process 1 641 155 271 190 280 313 LEASED PROPERTY, net (Note 8) 14 150 14 868 INVESTMENTS Equity in corporate joint venture 3 861 4 170 CURRENT ASSETS Cash 12 446 Accounts receivable - Affiliated companies 12 215 11 754 Other 9 549 9 497 Unbilled revenues 659 883 Inventories, at average cost Electric production fuel oil 663 2 496 Materials and supplies 1 471 1 460 Prepaid taxes - Income 720 - Property 891 872 Other 1 472 1 086 27 652 28 494 DEFERRED CHARGES (Notes 1, 5 and 7) Seabrook 1 9 002 9 931 Seabrook 2 6 937 8 792 Other 11 509 11 454 27 448 30 177 $344 301 $358 022 CANAL ELECTRIC COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 CAPITALIZATION AND LIABILITIES 1993 1992 (Dollars in Thousands) CAPITALIZATION Common Equity - Common stock, $25 par value - Authorized - 2,328,200 shares Outstanding - 1,523,200 shares, wholly-owned by Commonwealth Energy System (Parent) $ 38 080 $ 38 080 Amounts paid in excess of par value 8 321 8 321 Retained earnings (Note 6) 48 151 64 498 94 552 110 899 Long-term debt, including premiums, less current sinking fund requirements (Note 3) 88 446 98 478 182 998 209 377 CAPITAL LEASE OBLIGATIONS (Note 8) 13 575 14 270 CURRENT LIABILITIES Interim Financing - (Note 3) Notes payable to banks 28 000 19 350 Advances from affiliates 8 310 3 720 36 310 23 070 Other Current Liabilities - Current sinking fund requirements 1 110 1 108 Accounts payable - Affiliated companies 1 829 2 015 Other 15 244 16 149 Accrued taxes - Local property and other 923 934 Income 460 730 Capital lease obligations (Note 8) 575 598 Accrued interest and other 3 547 2 268 23 688 23 802 59 998 46 872 DEFERRED CREDITS Accumulated deferred income taxes 70 854 70 487 Unamortized investment tax credits 13 360 14 075 Other 3 516 2 941 87 730 87 503 COMMITMENTS AND CONTINGENCIES (Note 5) $344 301 $358 022 The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) ELECTRIC OPERATING REVENUES (Note 1) Sales to affiliated companies $133 060 $144 214 $160 454 Sales to non-affiliated companies 70 000 77 451 83 374 203 060 221 665 243 828 OPERATING EXPENSES Fuel used in production 82 624 95 948 99 474 Electricity purchased for resale (Note 1) 27 977 28 847 31 343 Other operation 23 694 27 019 37 606 Maintenance 14 561 12 797 16 393 Depreciation 13 361 15 019 14 895 Amortization 3 423 3 423 (1 230) Taxes - Income (Note 2) 8 893 11 749 11 617 Local property 2 720 3 392 2 748 Payroll and other 790 686 697 178 043 198 880 213 543 OPERATING INCOME 25 017 22 785 30 285 OTHER INCOME Allowance for equity funds used during construction - 1 827 - Other, net 300 3 952 1 302 300 5 779 1 302 INCOME BEFORE INTEREST CHARGES 25 317 28 564 31 587 INTEREST CHARGES Long-term debt 9 267 9 403 9 416 Other interest charges 989 1 791 3 361 Allowance for borrowed funds used during construction (61) (1 977) (168) 10 195 9 217 12 609 NET INCOME $ 15 122 $ 19 347 $ 18 978 The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY STATEMENTS OF RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) Balance at beginning of year $64 498 $62 668 $60 445 Add (Deduct) Net income 15 122 19 347 18 978 Cash dividends on common stock (31 469) (17 517) (16 755) Balance at end of year $48 151 $64 498 $62 668 The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) OPERATING ACTIVITIES Net income $ 15 122 $ 19 347 $ 18 978 Effects of non-cash items - Depreciation and amortization 20 333 22 138 17 488 Deferred income taxes 1 445 3 950 3 866 Investment tax credits (715) (744) (729) Allowance for equity funds used during construction - (1 827) - Earnings from corporate joint venture (573) (620) (1 195) Dividends from corporate joint venture 882 822 277 Change in working capital, exclusive of cash and interim financing - Accounts receivable (513) 1 304 3 087 Unbilled revenues 224 (193) 176 Accrued income taxes, net (990) 1 313 (2 710) Local property and other taxes, net (30) (526) 326 Accounts payable and other 1 603 (2 491) (1 103) All other operating items, net (2 326) (2 988) 1 405 Net cash from operating activities 34 462 39 485 39 866 INVESTING ACTIVITIES Additions to property, plant and equipment (exclusive of AFUDC) - (6 574) (5 474) (4 889) Allowance for borrowed funds used during construction (61) (1 977) (168) Net cash used for investing activities (6 635) (7 451) (5 057) FINANCING ACTIVITIES Proceeds from (payment of) short-term borrowings 8 650 (13 850) (16 800) Proceeds from (payment of) affiliate borrowings 4 590 215 (1 085) Payment of dividends (31 469) (17 517) (16 755) Long-term debt issue refunded (9 300) - - Retirement of long-term debt through sinking funds (732) (436) (327) Net cash used for financing activities (28 261) (31 588) (34 967) Net increase (decrease) in cash (434) 446 (158) Cash at beginning of period 446 - 158 Cash at end of period $ 12 $ 446 $ - The accompanying notes are an integral part of these financial statements. CANAL ELECTRIC COMPANY NOTES TO FINANCIAL STATEMENTS (1) Significant Accounting Policies (a) General and Regulatory Canal Electric Company (the Company) is a wholly-owned subsidiary of Commonwealth Energy System. The parent company is referred to in this report as the "System" and together with its subsidiaries is referred to as "the system." The Company is regulated as to rates, accounting and other matters by various authorities including the Federal Energy Regulatory Commission (FERC) and the Massachusetts Department of Public Utilities (DPU). The System is an exempt holding company under the provisions of the Public Utility Holding Company Act of 1935 and, in addition to its investment in the Company, has interests in other utility companies and several non-regulated companies. The Company has established various regulatory assets in cases where the DPU and/or the FERC have permitted, or are expected to permit, recovery of specific costs over time. At December 31, 1993, principal regulatory assets included in deferred charges were $15.5 million for abandonment and nonconstruction costs related to the Seabrook project and $7.3 million related to deferred income taxes. (b) Reclassifications Certain prior year amounts are reclassified from time to time to conform with the presentation used in the current year's financial statements. (c) Transactions with Affiliates Transactions between the Company and other system companies include purchases and sales of electricity, including the Company's acquisition and resale of capacity entitlements and related energy generated by certain units of other New England utilities. The Company functions as the principal supplier of electric generation capacity for and on behalf of affiliates Cambridge Electric Light Company (Cambridge) and Commonwealth Electric Company (Commonwealth Electric) including abandonment and nonconstruction costs related to the Seabrook project. In addition, payments for management, accounting, data processing and other services are made to affiliate COM/Energy Services Company. Transactions with other system companies are subject to review by the FERC and the DPU. The Company's operating revenues included the following intercompany amounts for the periods indicated: Period Ended Electricity Sales Seabrook Units December 31, (Canal Units) Purchased Power and Other (Dollars in Thousands) 1993 $53 174 $31 777 $48 109 1992 60 440 32 592 51 182 1991 65 756 36 337 58 361 CANAL ELECTRIC COMPANY (d) Other Major Customers The Company is a wholesale electric generating company which sells power under life-of-the-unit contracts, approved by FERC to Boston Edison Company, Montaup Electric Company and New England Power Company, (unaffiliated utilities). Each utility is obligated to purchase one-quarter of the capacity and energy of Canal Unit 1. (e) Equity Method of Accounting The Company uses the equity method of accounting for its 3.8% invest- ment in the New England/Hydro-Quebec Phase II transmission facilities due, in part, to its ability to exercise significant influence over operating and financial policies of the entity. Under this method, it records as income the proportionate share of the net earnings of this project with a corre- sponding increase in the carrying value of the investment. The investment amount is reduced as cash dividends are received. For further information on this investment, refer to Schedule III in Part IV of this report. (f) Depreciation and Nuclear Fuel Amortization Depreciation is provided using the straight-line method at rates intended to amortize the original cost and the estimated cost of removal less salvage of properties over their estimated economic lives. The Company's composite depreciation rate, based on average depreciable property in service, was 3.47% in 1993 and 3.92% in 1992 and 1991. The depreciable life of Unit 1 was extended from 1996 to 2002 and resulted in a decrease in depreciation expense of approximately $1.7 million in 1993. The cost of nuclear fuel is amortized to fuel expense based on the quantity of energy produced. Nuclear fuel expense also includes a provision for the costs associated with the ultimate disposal of the spent nuclear fuel. (g) Maintenance Expenditures for repairs of property and replacement and renewal of items determined to be less than units of property are charged to maintenance expense. Additions, replacements and renewals of property considered to be units of property, are charged to the appropriate plant accounts. Upon retirement, accumulated depreciation is charged with the original cost of property units and the cost of removal net of salvage. (h) Allowance for Funds Used During Construction Under applicable rate-making practices, the Company is permitted to include an allowance for funds used during construction (AFUDC) as an element of its depreciable property costs. This allowance is based on the amount of construction work in progress that is not included in the rate base on which the Company earns a return. An amount equal to the AFUDC capitalized in the current period is reflected in the accompanying Statements of Income. While AFUDC does not provide funds currently, these amounts are recoverable in revenues over the service life of the constructed property. CANAL ELECTRIC COMPANY The Company develops rates based upon its current cost of capital and used a compound rate of 3.75% in 1993, 4.75% in 1992 and 6.5% in 1991. (2) Income Taxes For financial reporting purposes, the Company provides federal and state income taxes on a separate return basis. However, for federal income tax purposes, the Company's taxable income and deductions are included in the consolidated income tax return of the System and it makes tax payments or receives refunds on the basis of its tax attributes in the tax return in accordance with applicable regulations. The following is a summary of the provisions for income taxes for the years ended December 31, 1993, 1992 and 1991: 1993 1992 1991 (Dollars in Thousands) Federal: Current $ 7 192 $ 7 636 $ 7 454 Deferred 1 476 3 506 2 890 Investment tax credits (715) (744) (729) 7 953 10 398 9 615 State: Current 1 181 1 147 1 366 Deferred (31) 1 048 976 1 150 2 195 2 342 9 103 12 593 11 957 Amortization of regulatory liability relating to deferred income taxes - (604) - Total $ 9 103 $11 989 $11 957 Federal and state income taxes charged to: Operating expense $ 8 893 $11 749 $11 617 Other income 210 240 340 $ 9 103 $11 989 $11 957 Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). SFAS No. 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect in the year in which the differences are expected to reverse. CANAL ELECTRIC COMPANY Accumulated deferred income taxes consisted of the following in 1993 and 1992: 1993 1992 (Dollars in Thousands) Liabilities Property-related $78 571 $75 948 Seabrook nonconstruction 6 017 8 175 All other 1 497 1 477 86 085 85 600 Assets Investment tax credit 8 623 8 733 Regulatory liability 5 189 4 903 All other 2 047 1 957 15 859 15 593 Accumulated deferred income taxes, net $70 226 $70 007 The net year-end deferred income tax liability above is net of a current deferred tax asset of $628,000 in 1993 and $480,000 in 1992 which was included in prepaid income taxes in the accompanying Balance Sheets. The following table, detailing the significant timing differences for 1991 which resulted in deferred income taxes, is required to be disclosed pursuant to accounting standards for income taxes in effect prior to adoption of SFAS No. 109: (Dollars in Thousands) Seabrook nonconstruction costs $ 1 179 Recovery of Seabrook 2 (826) Accelerated depreciation for tax purposes 4 308 Capitalized interest during construction (698) Seabrook 2 accretion 340 Other (437) Deferred income tax provision $ 3 866 The total income tax provision set forth on the previous page represents 38% in 1993 and 1992, and 39% in 1991 of income before such taxes. The following table reconciles the statutory federal income tax rate CANAL ELECTRIC COMPANY to these percentages: 1993 1992 1991 Federal statutory rate 35% 34% 34% Increase (Decrease) from statutory rate: State tax net of federal tax benefit 3 5 5 Amortization of investment tax credits (3) (2) (2) Allowance for equity funds used during construction - (2) - Tax versus book depreciation 5 4 3 Other (2) (1) (1) Effective federal tax rate 38% 38% 39% As a result of the Revenue Reconciliation Act of 1993, the Company's federal income tax rate increased to 35% effective January 1, 1993. (3) Long-Term Debt and Interim Financing (a) Long-Term Debt Long-term debt outstanding, exclusive of current sinking fund requirements and related premiums, collateralized by substantially all of the Company's property, is as follows: Original Balance December 31, Issue 1993 1992 (Dollars in Thousands) First Mortgage Bonds - Series A, 7%, due 1996 $19 000 $ 4 560 $ 5 320 Series B, 8.85%, due 2006 35 000 34 650 34 650 Series D, 11 1/8%, due 2007 9 300 - 9 300 Series E, 7 3/8%, due 2020 10 000 10 000 10 000 Series F, 9 7/8%, due 2020 40 000 40 000 40 000 $89 210 $99 270 The Series A First Mortgage Bonds require an annual sinking fund payment of $760,000 with an option to retire an additional $95,000 per quarter. The Series B First and General Mortgage Bonds require an annual sinking fund payment of $350,000. The requirement may be met by payment, repurchase of bonds or certification of an amount of property additions equal to 60% of bondable property (as that term is defined in the indenture). The Company expects to certify additional bondable property in lieu of making sinking fund payments on these bonds. The Series E and Series F First and General Mortgage Bonds were issued in conjunction with The Industrial Development Authority of the State of New Hampshire issuing Solid Waste Disposal Bonds and Pollution Control Bonds, CANAL ELECTRIC COMPANY respectively. The bonds were issued pursuant to a Loan and Trust Agreement dated December 1, 1990 among the Authority, the Company and the First National Bank of Boston, the Trustee. (b) Notes Payable to Banks The Company and other system companies maintain both committed and uncommitted lines of credit for the financing of their construction programs, on a short-term basis, and for other corporate purposes. As of December 31, 1993, system companies had $115 million of committed lines of credit that will expire at varying intervals in 1994. These lines are normally renewed upon expiration and require annual fees of up to .1875% of the individual line. At December 31, 1993, the uncommitted lines of credit totaled $70 million. Interest rates on the outstanding borrowings generally are at an adjusted money market rate. The Company's notes payable to banks totaled $28,000,000 and $19,350,000 at December 31, 1993 and 1992, respectively. (c) Advances from Affiliates At December 31, 1993 the Company had no notes payable to the System. The Company had short-term notes payable to the System totaling $2,840,000 at December 31, 1992. These notes are written for a term of eleven months and twenty-nine days. Interest is at the prime rate (6% at December 31, 1992) and is adjusted for changes in the rate during the term of the notes. The Company is a member of the COM/Energy Money Pool (the Pool), an arrangement among the subsidiaries of the System, whereby short-term cash surpluses are used to help meet the short-term borrowing needs of the utility subsidiaries. In general, lenders to the Pool receive a higher rate of return than they otherwise would on such investments, while borrowers pay a lower interest rate than that available from banks. At December 31, 1993 and 1992, the Company had borrowings from the Pool totaling $8,310,000 and $880,000, respectively. (d) Disclosures About Fair Value of Financial Instruments As required by Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the fair value of certain financial instruments included in the accompanying Balance Sheets as of December 31, 1993 and 1992 are as follows: 1993 1992 (Dollars in Thousands) Carrying Fair Carrying Fair Value Value Value Value Long-Term Debt $89 556 $104 325 $99 586 $109 586 The carrying amount of cash, notes payable to banks and advances from affiliates approximates the fair value because of the short maturity of these financial instruments. CANAL ELECTRIC COMPANY The estimated fair value of long-term debt is based upon quoted market prices of the same or similar issues or on the current rates offered for debt with the same remaining maturity. The fair values shown above do not purport to represent the amounts at which those obligations would be settled. (4) Supplemental Disclosures of Cash Flow Information The Company's supplemental information concerning cash flow activities is as follows: 1993 1992 1991 (Dollars in Thousands) Interest paid (net of capitalized amounts) $ 9 704 $ 8 464 $12 529 Income taxes paid 9 467 8 123 11 072 (5) Commitments and Contingencies (a) Construction The Company is engaged in a continuous construction program presently estimated at $64.8 million for the five-year period 1994 through 1998. Of that amount, $13.2 million is estimated for 1994. The Company's program is subject to periodic review and revision. (b) Seabrook Nuclear Power Plant The system's 3.52% interest in the Seabrook nuclear power plant is owned by the Company to provide for a portion of the capacity and energy needs of Cambridge and Commonwealth Electric. The Company is recovering 100% of its Seabrook 1 investment through a power contract with Cambridge and Commonwealth Electric pursuant to FERC approval. Pertinent information with respect to the Company's joint-ownership interest in Seabrook 1 and information relating to operating expenses which are included in the accompanying financial statements are as follows: 1993 1992 (Dollars in Thousands) Utility plant-in-service $233 140 $233 651 Nuclear fuel 18 514 17 083 Accumulated depreciation and amortization (34 771) (25 382) Construction work in progress 881 623 $217 764 $225 975 CANAL ELECTRIC COMPANY 1993 1992 1991 (Dollars in Thousands) Operating expenses: Fuel $ 3 853 $ 3 952 $ 4 337 Other operation 4 580 5 705 9 239 Maintenance 893 1 508 1 601 Depreciation 6 522 6 426 7 214 Amortization 1 319 1 320 (3 333) $17 167 $18 911 $19 058 Plant capacity (MW) 1,150 In-service date 1990 Canal's share: Operating license Percent interest 3.52% expiration date 2026 Entitlement (MW) 40.5 The Company and the other joint-owners have established a Seabrook Nuclear Decommissioning Financing Fund to cover post-operational decommissioning costs. For the years 1993, 1992 and 1991, the Company paid $259,000, $235,000 and $181,000, respectively, as its share of the cost of this fund. The estimated cost to decommission the plant is $366 million. The Company's share, less its share of the market value of the decommissioning trust, would amount to approximately $11.6 million. (c)Power Contracts In response to solicitations made to NEPOOL member companies by Northeast Utilities (NU) and other utilities, the Company, on behalf of Commonwealth Electric and Cambridge, agreed to purchase entitlements through short-term contracts. These power contracts have been entered into with NU to purchase varying amounts of power through October 1994. These and other bulk electric power purchases are necessary in order to fulfill the system's NEPOOL obligation and for the Company to acquire and deliver electric generating capacity to meet Commonwealth Electric and Cambridge requirements. (d)Environmental Matters The Company is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. These laws and regulations affect, among other things, the siting and operation of electric generating and transmission facilities and can require the installation of expensive air and water pollution control equipment. These regulations have had an impact upon the Company's operations in the past and will continue to have an impact upon future operations, capital costs and construction schedules of major facilities. (6) Dividend Restriction At December 31, 1993, approximately $43,415,000 of retained earnings was restricted against the payment of cash dividends by terms of the Indenture of Trust securing long-term debt. CANAL ELECTRIC COMPANY (7) Employee Benefit Plans (a) Pension The Company has a noncontributory pension plan covering substantially all regular employees who have attained the age of 21 and have completed a year of service. Pension benefits are based on an employee's years of service and compensation. The Company makes monthly contributions to the plan consistent with the funding requirements of the Employee Retirement Income Security Act of 1974. Components of pension expense were as follows: 1993 1992 1991 (Dollars in Thousands) Service cost $ 384 $ 319 $ 343 Interest cost 960 799 676 Return on plan assets (1 741) (1 138) (2 119) Net amortization and deferral 913 386 1 508 Total pension expense 516 366 408 Transfers from affiliates, net 145 181 172 Less: Amounts capitalized and other 160 150 147 Net pension expense $ 501 $ 397 $ 433 The following economic assumptions were used to measure year-end obliga- tions and the estimated pension expense for the subsequent year: 1993 1992 1991 Discount rate 7.25% 8.50% 8.50% Assumed rate of return 8.50 8.50 8.50 Rate of increase in future compensation 4.50 5.50 5.50 Pension expense reflects the use of the projected unit credit method which is also the actuarial cost method used in determining future funding of the plan. The funded status of the Company's pension plan (using a measurement date of December 31) is as follows: 1993 1992 (Dollars in Thousands) Accumulated benefit obligation: Vested $ (9 333) $(6 525) Nonvested (1 614) (914) $(10 947) $(7 439) Projected benefit obligation $(13 668) $(9 898) Plan assets at fair market value 12 906 11 257 Projected benefit obligation less (greater) than plan assets (762) 1 359 Unamortized transition obligation 138 156 Unrecognized prior service cost 532 370 Unrecognized gain (248) (2 174) Accrued pension cost $ (340) $ (289) CANAL ELECTRIC COMPANY Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect pension expense in future years. The increase in the accumulated benefit obligation and the projected benefit obligation from December 31, 1992 to December 31, 1993 was primarily due to a reduction of the discount rate in light of current interest rates. (b) Other Postretirement Benefits Through December 31, 1992, the Company provided postretirement health care and life insurance benefits to all eligible retired employees. Employees became eligible for these benefits if their age plus years of service at retirement equaled 75 or more provided, however, that such service was performed for the Company or another subsidiary of the System. As of January 1, 1993, the Company eliminated postretirement health care benefits for those non-bargaining employees who were less than 40 years of age or had less than 12 years of service at that date. Under certain circumstances, eligible employees are now required to make contributions for postretirement benefits. Certain bargaining employees are also participating under these new eligibility requirements. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No.106). This new standard requires the accrual of the expected cost of such benefits during the employees' years of service and the recognition of an actuarially determined postretirement benefit obligation earned by existing retirees. The assumptions and calculations involved in determining the accrual and the accumulated postretirement benefit obligation (APBO) closely parallel pension accounting requirements. The cumulative effect of implementation of SFAS No. 106 as of January 1, 1993 was approximately $5 million which is being amortized over twenty years. Prior to 1993, the cost of postretirement benefits was recognized as the benefits were paid. The cost of retiree medical care and life insurance benefits under the traditional pay-as-you-go method totaled $131,000 in 1992 and $112,000 in 1991. In 1993, the Company began making contributions to various voluntary employee beneficiary association (VEBA) trusts that were established pursuant to section 501(c)9 of the Internal Revenue Code (the Code). The Company also made contributions to a sub-account of its pension plan pursuant to section 401(h) of the Code to satisfy a portion of its postretirement benefit obligation. The Company contributed approximately $684,000 to these trusts during 1993. The net periodic postretirement benefit cost for the year ended CANAL ELECTRIC COMPANY December 31, 1993 included the following components: (Dollars in Thousands) Service cost $ 169 Interest cost 428 Return on plan assets (35) Amortization of transition obligation over 20 years 249 Net amortization and deferral 1 Total postretirement benefit cost 812 Less: Amounts capitalized and other 536 Net postretirement benefit cost $ 276 The funded status of the Company's postretirement benefit plan using a measurement date of December 31, 1993 is as follows: (Dollars in Thousands) Accumulated postretirement benefit obligation: Retirees $ (2 596) Active participants (2 735) (5 331) Plan assets at fair market value 636 Projected postretirement benefit obligation greater than plan assets (4 695) Unamortized transition obligation 4 722 Unrecognized gain (27) $ - In determining its estimated APBO and the funded status of the plan, the Company assumed a discount rate of 7.25%, an expected long-term rate of return on plan assets of 8.5%, and a medical care cost trend rate of 9%, which gradually decreases to 5% in the year 2007 and remains at that level thereafter. The estimate also reflects a trend rate of 14.9% for reimbursement of Medicare Part B premiums which decreases to 5% by 2007 and a dental care trend rate of 5% in all years. A one percent change in the medical trend rate would have a $100,000 impact on the Company's annual expense (interest component-$60,000; service cost-$40,000) and would change the accumulated benefit obligation by approximately $755,000. Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect postretirement benefit expense in future years. (c) Savings Plan The Company has an Employees Savings Plan that provides for Company contributions equal to contributions by eligible employees up to four percent of each employee's compensation rate. Effective January 1, 1993, the rate was increased to five percent for those employees no longer eligible for postretirement benefits other than pensions. The Company's contribution was $234,000 in 1993, $197,000 in 1992 and $185,000 in 1991. CANAL ELECTRIC COMPANY (8) Lease Obligations The Company leases equipment and office space under arrangements that are classified as operating leases. These lease agreements are for terms of one year or longer. Leases currently in effect contain no provisions which prohibit the Company from entering into future lease agreements or obligations. The Company has entered into support agreements with other participating New England utilities for 3.8% of the Hydro-Quebec Phase II transmission facilities and makes monthly support payments to cover depreciation and interest costs. Future minimum lease payments, by period and in the aggregate, of capital leases and non-cancelable operating leases consisted of the following at December 31, 1993: Operating Leases Capital Leases (Dollars in Thousands) 1994 $ 438 $ 2 100 1995 372 2 036 1996 359 1 975 1997 359 1 912 1998 359 1 851 Beyond 1998 1 076 23 970 Total future minimum lease payments $2 963 33 844 Less:Estimated interest element included therein 19 694 Estimated present value of future minimum lease payments $14 150 Total rent expense for all operating leases, except those with terms of a month or less, amounted to $438,000 in 1993 and $452,000 in 1992 and 1991. There were no contingent rentals and no sublease rentals for the years 1993, 1992 and 1991. CANAL ELECTRIC COMPANY PART IV. Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Index to Financial Statements Financial statements and notes thereto of the Company together with the Report of Independent Public Accountants, are filed under Item 8 of this report and listed on the Index to Financial Statements and Schedules (page 15). (a) 2. Index to Financial Statement Schedules Filed herewith at page(s) indicated are financial statement schedules of the Company: Schedule III - Investments in, Equity Earnings of, and Dividends Received from Related Parties - Years Ended December 31, 1993, 1992 and 1991 (page 42). Schedule V - Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (pages 43-45). Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (page 46). Schedule IX - Short-Term Borrowings - Years Ended December 31, 1993, 1992 and 1991 (page 47). (a) 3. Exhibits: Notes to Exhibits - a. Unless otherwise designated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Securities and Exchange Commission file numbers indicated in parentheses. b. If applicable, as designated by an asterisk, certain documents previously filed by the Company have been disposed of by the Commission pursuant to its Records Control Schedule and are hereby being refiled by the Company. c. The following is a glossary of Commonwealth Energy System and subsidiary companies' acronyms that are used throughout the following Exhibit Index: CES.................... Commonwealth Energy System CE..................... Commonwealth Electric Company CEL.................... Cambridge Electric Light Company CEC.................... Canal Electric Company NBGEL.................. New Bedford Gas and Edison Light Company CANAL ELECTRIC COMPANY Exhibit Index Exhibit 3. Articles of incorporation and by-laws. 3.1. Articles of incorporation of CEC (Exhibit 1 to CEC's 1990 Form 10- K, File No. 2-30057). 3.2. By-laws of CEC, as amended (Exhibit 2 to the CEC 1990 Form 10-K, File No. 2-30057). Exhibit 4. Instruments defining the rights of security holders, including indentures 4.2.1 Indenture of Trust and First Mortgage between CEC and State Street Bank and Trust Company, Trustee, dated October 1, 1968 (Exhibit 4(b) to the CEC Form S-1, File No. 2-30057). 4.2.2 First and General Mortgage Indenture between CEC and Citibank, N.A., Trustee, dated September 1, 1976 (Exhibit 4(b)(2) to the CEC Form S-1, File No. 2-56915). 4.2.3 First Supplemental dated October 1, 1968 with State Street Bank and Trust Company, Trustee, dated September 1, 1976 (Exhibit 4(b)(3) to the CEC Form S-1, File No. 2-56915). 4.2.4 Second Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1983 (Exhibit 1 to the CEC 1983 Form 10-K, File No. 2-30057). 4.2.5 Third Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 3 to the CEC 1990 Form 10-K, File No. 2-30057). 4.2.6 Fourth Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 4 to the CEC 1990 Form 10-K, File No. 2-30057). Exhibit 10. Material Contracts 10.1 Power contracts. 10.1.1 Power contracts between CEC and NBGEL and CEL dated December 1, 1965 (Exhibit 13(a)(1-4) to the CEC Form S-1, File No. 2-30057). 10.1.2.1 Agreement between CEC and Montaup Electric Company (MEC) for use of common facilities by Canal Units I and II and for allocation of related costs, executed October 14, 1975 (Exhibit 1 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.2.2 Agreement between CEC and MEC for joint-ownership of Canal Unit II, executed October 14, 1975 (Exhibit 2 to the CEC 1985 Form 10-K, File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.2.3 Agreement between CEC and MEC for lease relating to Canal Unit II, executed October 14, 1975 (Exhibit 3 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.3 Contract between CEC, NBGEL and CEL, affiliated companies, for the sale of specified amounts of electricity from Canal Unit 2 dated January 12, 1976 (Exhibit 7 to the CES Form 10-K for 1985, File No. 1-7316). 10.1.4 Power contract, as amended to February 28, 1990, superceding the Power Contract dated September 1, 1986 and amendment dated June 1, 1988, between CEC (seller) and CE and CEL (purchasers) for seller's entire share of the Net Unit Capability of Seabrook 1 and related energy (Exhibit 1 to the CEC Form 10-Q (March 1990), File No. 2- 30057). 10.1.5 Purchase and Sale Agreement together with an implementing Addendum dated December 31, 1981 between CEC and CE for the purchase and sale of the CE 3.52% joint-ownership interest in the Seabrook units, dated January 2, 1981 (Exhibit 1 to the Company's Form 8-K (January 13, 1982), File No. 2-30057). 10.1.6 Agreement for Joint-Ownership, Construction and Operation of the New Hampshire Nuclear Units (Seabrook) dated May 1, 1973 and filed by NBGEL as Exhibit 13(N) on Form S-1 dated October 1973, File No. 2-49013, and as amended below: 10.1.6.1 First through Fifth Amendments to 10.1.6 dated May 24, 1974, June 21, 1974, September 25, 1974, October 25, 1974, and January 31, 1975, respectively (Exhibit 13(m) to the NBGEL Form S-1 (November 7, 1975), File No. 2-54995). 10.1.6.2 Sixth through Eleventh Amendments to 10.1.6 dated April 18, 1979, April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979 and December 15, 1979, respectively (Exhibit 1 to the CEC 1989 Form 10- K, File No. 2-30057). 10.1.6.3 Twelfth and Thirteenth Amendments to 10.1.6 dated May 16, 1980 and December 31, 1980, respectively ((Exhibit 1 and 2 to the CE Form 10-Q (June 1982), File No. 2-7749). 10.1.6.4 Fourteenth Amendment to 10.1.6 dated June 1, 1982 (Exhibit 3 to the CE Form 10-Q (June 1982), File No. 2-7749). 10.1.6.5 Fifteenth and Sixteenth Amendments to 10.1.6 dated April 27, 1984 and June 15, 1984, respectively (Exhibit 1 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.6.6 Seventeenth Amendment to 10.1.6 dated March 8, 1985 (Exhibit 1 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.6.7 Eighteenth Amendment to 10.1.6 dated March 14, 1986 (Exhibit 1 to the CEC Form 10-Q (March 1986), File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.6.8 Nineteenth Amendment to 10.1.6 dated May 1, 1986 (Exhibit 1 to the CEC Form 10-Q (June 1986), File No. 2-30057). 10.1.6.9 Twentieth Amendment to 10.1.6 dated September 19, 1986 (Exhibit 1 to the CEC Form 10-K for 1986, File No. 2-30057). 10.1.6.10 Twenty-First Amendment to 10.1.6 dated November 12, 1987 (Exhibit 1 to the CEC Form 10-K for 1987, File No. 2-30057). 10.1.6.11 Twenty-Second Amendment and Settlement Agreement to 10.1.6 dated January 13, 1989 (Exhibit 4 to the CEC 1988 Form 10-K, File No. 2- 30057). 10.1.7 Resolutions proposed by Merrill Lynch Capital Markets and adopted by the Joint-Owners of the Seabrook Nuclear Project regarding Project financing, dated May 14, 1984 (Exhibit 1 to the CEC Form 10-Q (March 1984), File No. 2-30057). 10.1.8 Interim Agreement to Preserve and Protect the Assets of and Investment in the New Hampshire Nuclear Units by and between CEC, PSNH and other Participants dated April 27, 1984 (Exhibit 2 to the CEC Form 10-Q (June 1984), File No.2-30057). 10.1.9 Agreement for Seabrook Project Disbursing Agent establishing Yankee Atomic Electric Company as the disbursing agent under the Joint- Ownership Agreement, dated May 23, 1984 (Exhibit 4 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.9.1 First Amendment to 10.1.9 dated March 8, 1985 (Exhibit 2 to the CEC Form 10-Q (March 1985),File No.2-30057). 10.1.9.2 Second through Fifth Amendments to 10.1.9 dated May 20, 1985, June 18, 1985, January 2, 1986 and November 12, 1987, respectively, (Exhibit 4 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.10 Capacity Acquisition Agreement between CEC, CEL and CE dated September 25, 1980 (Exhibit 1 to the CEC 1991 Form 10-K, File No. 2-30057). 10.1.10.1 Supplement to 10.1.10 consisting of three Capacity Acquisition Commitments each dated May 7, 1987, concerning Phases I and II of the Hydro-Quebec Project and electricity acquired from Connecticut Light and Power Company (CL&P) (Exhibit 1 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.10.2 Supplements to 10.1.10 consisting of two Capacity Acquisition Commitments each dated October 31, 1988, concerning electricity acquired from Western Massachusetts Electric Company and/or CL&P for periods ranging from November 1, 1988 to October 31, 1994 (Exhibit 2 to the CEC Form 10-Q (September 1989), File No. 2- 30057). CANAL ELECTRIC COMPANY 10.1.10.3 Amendment to 10.1.10 as amended, and restated, June 1, 1993, henceforth referred to as the Capacity Acquisition and Disposition Agreement, whereby CEC, as agent, in addition to acquiring power may also sell bulk electric power which CEL and/or CE owns or otherwise has the right to sell (Exhibit 1 to the CEC Form 10-Q (September 1993), File No. 2-30057). 10.1.10.4 Capacity Disposition Commitment dated June 25, 1993 by and between CEC (Unit 2) and CE for the sale of a portion of CE's entitlement in Unit 2 to Green Mountain Power Corporation (Exhibit 1 to the CEC Form 10-Q (September 1993), File No. 2-30057). 10.1.11 Termination Supplement between CEC, CE and CEL for Seabrook Unit 2, dated December 8, 1986 (Exhibit 3 to the CEC Form 10-K for 1986, File No. 2-30057). 10.1.12 Agreement, dated September 1, 1985, With Respect To Amendment of Agreement With Respect To Use Of Quebec Interconnection, dated December 1, 1981, among certain NEPOOL utilities to include Phase II facilities in the definition of "Project" (Exhibit 1 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.12.1 Amendatory Agreement No.3 with Respect to Use of Quebec Interconnection dated December 1, 1981, as amended to June 1, 1990, among certain NEPOOL utilities (Exhibit 1 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.13 Preliminary Quebec Interconnection Support Agreement - Phase II among certain New England electric utilities dated June 1, 1984 (Exhibit 6 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.13.1 First through Third Amendments to 10.1.13 as amended March 1, 1985, January 1, 1986 and March 1, 1987, respectively (Exhibit 1 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.13.2 Fifth through Seventh Amendments to 10.1.13 as amended October 15, 1987, December 15, 1987 and March 1, 1988, respectively (Exhibit 1 to the CEC Form 10-Q (June 1988), File No. 2-30057). 10.1.13.3 Fourth and Eighth Amendments to 10.1.13 as amended July 1, 1987 and August 1, 1988, respectively (Exhibit 3 to the CEC Form 10-Q (September 1988), File No. 2-30057). 10.1.13.4 Ninth and Tenth Amendments to 10.1.13 as amended November 1, 1988 and January 15, 1989, respectively (Exhibit 2 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.13.5 Eleventh Amendment to 10.1.13 as amended November 1, 1989 (Exhibit 4 to the CEC 1989 Form 10-K, File No. 2-30057). 10.1.13.6 Twelfth Amendment to 10.1.13 as amended April 1, 1990 (Exhibit 1 to the CEC Form 10-Q (June 1990) File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.14 Agreement to Preliminary Quebec Interconnection Support Agreement - Phase II among Public Service Company of New Hampshire (PSNH), New England Power Co. (NEP) , Boston Edison Co. (BECO), and CEC whereby PSNH assigns a portion of its interests under the original Agreement to the other three parties, dated October 1, 1987 (Exhibit 2 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.15 Phase II Equity Funding Agreement for New England Hydro Transmission Electric Company, Inc. (New England Hydro) (Massachusetts), dated June 1, 1985, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.16 Phase II Equity Funding Agreement for New England Hydro Transmission Corporation (New Hampshire Hydro), dated June 1, 1985, between New Hampshire Hydro and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.16.1 Amendment No. 1 to 10.1.16 as amended May 1, 1986 (Exhibit 6 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.16.2 Amendment No. 2 to 10.1.16 as amended September 1, 1987 (Exhibit 3 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.17 Phase II Massachusetts Transmission Facilities Support Agreement, dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 7 dated May 1, 1986 through January 1, 1989, respectively, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.18 Phase II New Hampshire Transmission Facilities Support Agreement, dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 8 dated May 1, 1986 through January 1, 1989, respectively, between New Hampshire Hydro and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.19 Phase II New England Power AC Facilities Support Agreement dated June 1, 1985, between New England Power and certain NEPOOL utilities (Exhibit 6 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.19.1 Amendments Nos. 1 and 2 to 10.1.19 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.19.2 Amendments Nos. 3 and 4 to 10.1.19 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (September 1987), File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.20 Phase II BECO AC Facilities Support Agreement, dated June 1, 1985, between BECO and certain NEPOOL utilities (Exhibit 7 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.20.1 Amendments Nos. 1 and 2 to 10.1.20 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 2 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.20.2 Amendments Nos. 3 and 4 to 10.1.20 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 4 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.21 Agreement Authorizing Execution of Phase II Firm Energy Contract, dated September 1, 1985, among certain NEPOOL utilities in regard to participation in the purchase of power from Hydro Quebec (Exhibit 8 to the CEC Form 10-Q (September 1985), File No. 2- 30057). 10.1.22 Agreement to Share Certain Costs Associated with the Tewksbury- Seabrook Transmission Line, by and among certain NEPOOL utilities, amending participants, dated May 8, 1986 (Exhibit 2 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.23 Power Contract between CEC (seller) and CE and CEL (purchasers) dated August 14, 1989 whereby purchasers agree to purchase the capacity and energy from seller's "Slice-of-System" entitlement from CL&P from November 1, 1989 to October 31, 1994 (Exhibit 1 to the CEC Form 10-Q (September 1989), File No. 2-30057). 10.1.23.1 Power Sale Agreement dated November 1, 1988, by and between CEC (buyer) and CL&P (seller) whereby buyer will purchase generating capacity totaling 250 MW from various seller's units ("Slice of System") for the term of November 1, 1989 to October 31, 1994 (Exhibit 3 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.24 Purchase Agreement dated March 1, 1991, by and between CEC (seller) and Central Vermont Public Service Corporation (CVPS) whereby CVPS will purchase 50 MW of capacity from CEC Unit 2 for the term of March 1, 1991 to October 31, 1995 (Exhibit 1 to the CEC Form 10-Q (June 1991), File No. 2-30057). 10.1.25 Power Sale Agreement dated March 1, 1991, by and between CEC (purchaser) and CVPS (seller) whereby buyer will purchase 50 MW of capacity from seller's units (25 MW from Vermont Yankee and 25 MW from Merrimack 2) for the term of March 1, 1991 to October 31, 1995 (Exhibit 2 to the CEC Form 10-Q (June 1991), File No. 2-30057). CANAL ELECTRIC COMPANY 10.1.26 Power Exchange Contract, dated March 24, 1993, between New England Power Company (NEP) and CEC for an exchange of unit capacity in which NEP will purchase 20 MW of CEC's Unit 2 capacity in exchange for CEC's purchase of 20 MW of NEP's Bear Swamp Units 1 and 2 (10 MW per unit) commencing May 31, 1993 through April 28, 1997 and NEP will purchase 50 MW of CEC's Unit 2 capacity in exchange for CEC's purchase of 50 MW of NEP's Bear Swamp Units 1 and 2 (25 MW per unit) commencing November 1, 1993 through April 28, 1997 (Exhibit 1 to the CEC Form 10-Q (March 1993), File No. 2-30057). 10.2 Other agreements. 10.2.1 Employees Savings Plan of Commonwealth Energy System and Subsidiary Companies as amended and restated as of January 1, 1993 (Exhibit 2 to the CES Form 10-Q (September 1993), File No. 1-7316). 10.2.2 Pension Plan for Employees of Commonwealth Energy System and Subsidiary Companies as amended and restated January 1, 1993 (Exhibit 1 to the CES Form 10-Q (September 1993), File No.1-7316). 10.2.3 New England Power Pool Agreement (NEPOOL) dated September 1, 1971 as amended through August 1, 1977, between NEGEA Service Corp. as agent for CEL, CEC, NBGEL, and various other electric utilities operating in New England, together with amendments dated August 15, 1978 and January 31, 1979 and February 1, 1980 (Exhibit 5(c)(13) to the CES Form S-16 (April 1980), File No. 2-64731). 10.2.3.1 Thirteenth Amendment to 10.2.3 as amended September 1, 1981 (Exhibit 5 to the CES Form 10-K for 1981, File No. 1-7316). 10.2.3.2 Fourteenth through Twentieth Amendments to 10.2.3 as amended December 1, 1981, June 1, 1982, June 15, 1983, October 1, 1983, August 1, 1985, August 15, 1985 and September 1, 1985, respectively (Exhibit 4 to the CES Form 10-Q (September 1985), File No. 1-7316). 10.2.3.3 Twenty-first Amendment to the New England Power Pool Agreement dated September 1, 1971, as amended January 1, 1986 (Exhibit 1 to the CES Form 10-Q (March 1986), File No. 1-7316). 10.2.3.4 Twenty-second Amendment to 10.2.3 as amended to September 1, 1986 (Exhibit 1 to the CES Form 10-Q (September 1986), File No. 1-7316). 10.2.3.5 Twenty-third Amendment to 10.2.3 as amended to April 30, 1987 (Exhibit 1 to the CES Form 10-Q (June 1987), File No. 1-7316). 10.2.3.6 Twenty-fourth Amendment to 10.2.3 as amended to March 1, 1988 (Exhibit 1 to the CES Form 10-K for 1987, File No. 1-7316). 10.2.3.7 Twenty-fifth Amendment to 10.2.3 as amended to May 1, 1988 (Exhibit 1 to the CES Form 10-Q (March 1988), File No. 1-7316). 10.2.3.8 Twenty-sixth Amendment to 10.2.3 as amended to March 15, 1989 (Exhibit 1 to the CES Form 10-Q (March 1989), File No. 1-7316). CANAL ELECTRIC COMPANY 10.2.3.9 Twenty-seventh Amendment to 10.2.3 as amended to October 1, 1990 (Exhibit 3 to the CES 1990 Form 10-K, File No. 1-7316). 10.2.4 Fuel Supply, Facilities Lease and Operating Contract by and between on the one side, ESCO (Massachusetts), Inc. and Energy Supply & Credit Corporation on the other side and CEC dated February 1, 1985 (Exhibit 1 to the CEC Form 10-K for 1984, File No. 2-30057). 10.2.4.1 Amendments Nos. 1 and 2 to 10.2.4 as amended July 1, 1986 and November 15, 1989, respectively (Exhibit 3 to the CEC 1989 Form 10-K, File No. 2-30057). 10.2.5 Oil Supply Contract by and between CEC (buyer) and Carey Energy Fuels Corporation (seller) for a portion of CEC's requirements of No. 6 residual fuel oil, dated July 1, 1991 (Exhibit 3 to the CEC Form 10-Q (June 1991), File No. 2-30057). 10.2.6 Assignment Agreement between CEC and ESCO (Massachusetts), Inc. (ESCO-Mass) and Energy Supply and Credit Corporation whereby CEC assigns to ESCO-Mass rights and obligations under the Supply Contract with Carey Energy Fuels Corporation, dated July 1, 1991 (Exhibit 4 to the CEC Form 10-Q (June 1991), File No. 2-30057). 10.2.7 Assignment and Sublease Agreement and CEC's Consent of Assignment thereto whereby ESCO-Mass assigns its rights and obligations under Part II of the Resupply Agreement dated February 1, 1985 to ESCO Terminals Inc., dated June 4, 1985 (Exhibit 4 to the CEC Form 10-Q (June 1985), File No. 2-30057). (b) Reports on Form 8-K No reports on Form 8-K were filed during the three months ended December 31, 1993. SCHEDULE IX CANAL ELECTRIC COMPANY SHORT-TERM BORROWINGS (a) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) Maximum Weighted Month-End Average Weighted Category of Average Amount Amount Average Aggregate Balance Interest Outstanding Outstanding Interest Short-Term at End Rate at End During During the Rate During Borrowings of Period of Period the Period Period(b) the Period(c) December 31, 1993 Notes Payable to Banks $28 000 3.2% $28 000 $14 142 3.4% Notes Payable to System $ - - $ 2 840 $ 543 6.0% COM/Energy Money Pool $ 8 310 3.2% $ 8 310 $ 3 224 3.2% December 31, 1992 Notes Payable to Banks $19 350 4.3% $33 300 $26 083 4.0% Notes Payable to System $ 2 840 6.0% $ 6 185 $ 3 341 6.3% COM/Energy Money Pool $ 880 3.4% $ 2 490 $ 1 356 3.7% December 31, 1991 Notes Payable to Banks $33 200 5.4% $42 875 $35 523 6.3% Notes Payable to System $ 2 570 6.5% $ 2 700 $ 1 458 7.6% COM/Energy Money Pool $ 935 4.6% $ 3 240 $ 2 143 5.8% (a) Refer to Note 3 of Notes to Financial Statements filed under Item 8 of this report for the general terms of each category of short-term borrowings. (b) The average amount outstanding during the period is determined by averaging the level of month-end principal balances outstanding for the prior thirteen-month period ending December 31. (c) The weighted average interest rate during the period is determined by averaging the interest rates in effect on all loans transacted for the twelve-month period ended December 31. CANAL ELECTRIC COMPANY FORM 10-K DECEMBER 31, 1993 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CANAL ELECTRIC COMPANY (Registrant) By: WILLIAM G. POIST William G. Poist, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Principal Executive Officers: WILLIAM G. POIST March 30, 1994 William G. Poist, Chairman of the Board and Chief Executive Officer R. D. WRIGHT March 28, 1994 Russell D. Wright, President and Chief Operating Officer Principal Financial Officer: JAMES D. RAPPOLI March 30, 1994 James D. Rappoli Financial Vice President and Treasurer Principal Accounting Officer: JOHN A. WHALEN March 28, 1994 John A. Whalen, Comptroller A majority of the Board of Directors: WILLIAM G. POIST March 30, 1994 William G. Poist, Director R. D. WRIGHT March 28, 1994 Russell D. Wright, Director JAMES D. RAPPOLI March 30, 1994 James D. Rappoli, Director

766701_1993.txt

766701

1993

ITEM 1. BUSINESS. ORGANIZATION Capstead Mortgage Corporation ("CMC," or together with its special-purpose finance subsidiaries and certain other entities, the "Company") was incorporated on April 15, 1985 in the state of Maryland and commenced operations in September 1985. The Company operates as a mortgage conduit which purchases and securitizes various types of single-family residential mortgage loans. In addition, the Company has formed a mortgage servicing unit to function as the primary mortgage servicer and master servicer for loans and servicing rights acquired by the Company. The Company offers investors the opportunity to participate in the income generated from servicing and investing in mortgage loans, securitization activities and other portfolio strategies. CMC, and its qualified real estate investment trust ("REIT") subsidiaries, have elected to be taxed as a REIT and intend to continue to do so. As a result of this election, CMC is not taxed at the corporate level on taxable income distributed to stockholders, provided that certain REIT qualification tests are met. Certain other subsidiaries, which are consolidated for financial reporting purposes, are not consolidated for federal income tax purposes because such entities were not established as REITs or qualified REIT subsidiaries. All taxable income of these subsidiaries is subject to federal and state income taxes, where applicable. CONDUIT OPERATIONS The Company offers to buy many different types of mortgage loan products. The products include (i) fixed-rate mortgage loans which have a fixed rate of interest for the life of the loan, (ii) adjustable-rate mortgage ("ARM") loans which provide for a periodic adjustment of the mortgage interest rate based on a specified margin over a specific financial index, and (iii) 5/25 mortgage loans which provide for an initial interest rate that adjusts one time, approximately five years following origination ("5/25 Mortgage Loans"). The Company purchases mortgage loans from mortgage banking companies, savings banks, commercial banks, credit unions, mortgage brokers and other financial intermediaries ("Correspondents") throughout the United States. Correspondents must meet certain financial and performance requirements before they are approved to participate in the Company's Correspondent Program. A purchase and sale agreement is executed with each Correspondent that provides for recourse against the Correspondent in the event of fraud or misrepresentation in the process by which a mortgage loan is originated. The Company has developed purchase guidelines for the acquisition of mortgage loans based on the anticipated requirements of its mortgage pool insurers, and management's assessment of the criteria used by nationally recognized statistical rating organizations ("Rating Agencies") to analyze the quality of the collateral pledged to mortgage-backed securities issued by the Company. The Company does not itself underwrite the mortgage loan, but instead relies on the credit review and analysis of its mortgage pool insurers (primarily General Electric Mortgage Insurance Company). Each mortgage loan purchased is required to have a commitment for insurance from a mortgage pool insurer. Detailed purchase guidelines are provided to all Correspondents in the Company's Sellers Guide. The principal amount of mortgage loans acquired by the Company at the time of origination generally range from $203,150 to $650,000 per loan. Substantially all of the mortgage loans acquired by the Company comply with the underwriting criteria of the mortgage securities programs sponsored by the Federal Home Loan Mortgage Corporation ("FHLMC") and the Federal National Mortgage Association ("FNMA"), except that their original outstanding principal amounts generally exceed the maximum permissible amount ($203,150, effective January 1, 1993) for such programs ("Nonconforming Mortgage Loans"). The average loan purchased in 1993 had an original principal balance of approximately $312,000. Commitments are issued and obligate the Company to purchase mortgage loans from the Correspondent for a specific period of time (typically 10 to 90 days), in a specific aggregate principal amount and bearing a specified mortgage interest rate and price. The Company currently issues three types of commitments: mandatory, optional and best efforts. The Company receives a fee on optional and best effort commitments, but not on mandatory commitments. However, if a Correspondent fails to deliver a loan subject to a mandatory commitment, the Correspondent is obligated to pay the Company the difference between the yield the Company would have obtained on the mortgage loan and the yield available on similar mortgage loans subject to mandatory commitments issued at the time of such failure to deliver, plus a penalty. MORTGAGE LOAN PORTFOLIO The Company purchases mortgage loans from Correspondents on a daily basis. The loans purchased are warehoused in the mortgage loan portfolio awaiting determination of the long-term investment strategy to which the loan will be directed. Periodically, mortgage loans are pledged to secure the issuance of collateralized mortgage obligations ("CMOs"), publicly-offered, multi-class mortgage pass-through certificates ("MPCs"), or AAA-rated private mortgage pass- through securities ("Mortgage Pass-Throughs") by the Company's special-purpose finance subsidiaries. The Company utilizes repurchase agreements to finance the acquisition of mortgage loans. A repurchase agreement is a form of short-term financing pursuant to which the Company pledges mortgage loans in consideration for the advance of funds at short-term interest rates generally tied to LIBOR. The Company earns the difference between the mortgage interest rate and the interest rate it owes on the short-term borrowings for the term of the repurchase transaction, typically 30 to 60 days. As noted above, the Company obtains a commitment by a mortgage pool insurer to issue a mortgage pool insurance policy that will cover losses due to mortgagor default in amounts generally ranging from 7% to 15% of the aggregate principal amount of the mortgage loans comprising such pool. The mortgage pool insurance is generally not in force during the warehousing of the mortgage loan, but instead is activated at the time the mortgage loans are pledged as collateral for a CMO, MPC or Mortgage Pass-Through unless an investor in the former securitizations is willing to assume the credit risk for the entire issuance (a "senior/subordinate" structure). The Company expects to use such senior/subordinate structures extensively in 1994. During the warehousing period, typically a period of 30 to 90 days, the Company retains the full risk that the mortgage loan may default. Certain other risks are also not covered during the warehousing period. These include bankruptcy and special hazards which are not covered by standard hazard insurance policies (e.g. earthquakes), as well as fraud or misrepresentation in the origination of the mortgage loan. Defaults on mortgage loans during the warehousing period, if linked to fraud or misrepresentation, may be mitigated by the Correspondent's obligation to repurchase such mortgage loan. However, to the extent the Correspondent does not perform the repurchase obligation, the Company may incur a loss. For a discussion of effects of interest rate changes on the Company's mortgage loan portfolio, see the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 49 and page 50 under the caption "Management's Discussion and Analysis - Effects of Interest Rate Changes." MORTGAGE PASS-THROUGH PORTFOLIO The Company's long-term investment strategy includes the securitization of ARM loans and 5/25 Mortgage Loans into Mortgage Pass-Throughs. This investment strategy primarily makes use of ARM loans which, because of their adjustable interest rates, are more likely to retain value in a rising interest rate environment. At the time mortgage loans are pledged as collateral for Mortgage Pass-Throughs, the mortgage pool insurance policy is activated. The level of coverage under any such mortgage pool insurance policy is determined by one or more Rating Agencies, and is at a level necessary to allow the insured pool of mortgage loans, or the securities such pools are pledged to secure, to be AAA-rated. At such time, the Company also insures or reserves against bankruptcy and special hazard risks, and reduces its exposure to losses from fraud or misrepresentation in the origination of the mortgage loan. The Company utilizes repurchase agreements to finance the Mortgage Pass-Through portfolio. The formation of Mortgage Pass-Throughs greatly enhances the quality of the underlying mortgage loans, thus enabling the Company to reduce its borrowing costs below the level paid on non-rated loans, thereby enhancing the interest spread. For discussion of effects of interest rate changes on the Company's Mortgage Pass-Through portfolio, see the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 49 and 50 under the caption "Management's Discussion and Analysis - Effects of Interest Rate Changes." AGENCY SECURITIES PORTFOLIO The Company also invests in fixed-rate agency securities (the "agency securities portfolio") which consists of mortgage-backed securities guaranteed by government sponsored entities such as FNMA, Government National Mortgage Association or FHLMC. Because agency securities are the most widely traded mortgage-backed securities, unique financing opportunities exist in the marketplace that enable investors to achieve very attractive interest rate spreads on the financing of such assets. For discussion of effects of interest rate changes on the Company's agency securities portfolio, see the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 49 and 50 under the caption "Management's Discussion and Analysis - Effects of Interest Rate Changes." CMO INVESTMENT PORTFOLIO AND RELATED SECURITIZATION ACTIVITY The Company's long-term investment strategy also includes the securitization of fixed-rate and 5/25 Mortgage Loans, whereby such loans are pledged as collateral for the issuance of CMOs or MPCs. Most of the Company's CMOs are structured as financings in which the Company recognizes economic gains or losses over the term of the collateral. MPCs and some CMOs are structured as sales. Such sales preserve capital by limiting the amount invested in a securitization, but at the same time may make quarterly income more volatile than in the past because of the recognition of transactional gains or losses. Beginning the fall of 1992, the Company has generally elected Real Estate Mortgage Investment Conduit ("REMIC") status for tax purposes. Each series of CMOs consists of multiple classes of bonds, each having its own maturity. MPCs are structured in a similar fashion except that technically, investors do not purchase bonds subject to an indenture; rather, they purchase certificates evidencing undivided interests in a trust that owns the underlying mortgage loans. The segmentation of CMOs into classes of bonds with varying maturities along with mortgage pool insurance and other credit enhancements provided to make all or most of the CMO bonds AAA-rated enables the Company to issue the CMO classes with shorter scheduled maturities and lower interest rates than the underlying mortgage loans. Each of these factors contributes to a positive difference ("Interest Spread") between the payments received on the mortgage loans pledged to secure such CMOs and the payments made on the CMOs issued. Because the shorter-term classes of CMO bonds typically bear lower rates of interest than longer-term classes, the Interest Spread on a CMO is typically greatest in the early years of the CMO. As the mortgage loans are repaid and the shorter-term classes of CMO bonds are retired, the average interest cost of the CMOs outstanding increases. Thus, the Interest Spread will decline over time. The right to receive the Interest Spread, along with the non-cash amortization of collateral and bond premiums and discounts is referred to as the "CMO Residual". CMO structures have evolved in recent years such that the Interest Spread portion of CMO Residuals have been virtually eliminated by the formation of additional CMO securities including various forms of interest-only and/or principal-only securities. Interest-only securities represent ownership in an undivided interest in interest payments on the underlying securities. Principal-only securities represent ownership in an undivided interest in principal payments on the underlying securities. Since the fall of 1992 the Company typically has sold the CMO Residuals and retained for its CMO Investment portfolio certain of the interest-only and/or principal-only securities formed in connection with CMO and MPC issuances. Interest-only and principal-only securities that are held by the Company in the CMO Investment portfolio are carried at the present value of the future cash flows expected to be received during the remaining terms of the investments, discounted at a constant effective yield. Income recognized is the excess of cash received over the reduction of the carrying value. In a falling interest rate environment, prepayments on the underlying mortgage collateral generally will be high and the Company could incur losses on investments in interest-only securities. This happened during 1993. Conversely, in periods of rising interest rates, interest-only securities will tend to perform very favorably because the underlying mortgage collateral will generally prepay at slower rates. This has been the Company's experience thus far in 1994. Principal-only securities react differently to changes in interest rates. Lower interest rates result in the recovery of this investment more rapidly thus increasing yields. During periods of rising rates, it takes longer for the Company to recover its investments thus lowering yields. Principal-only securities retained by the Company generally represent a much smaller investment than interest-only investments. The Company may, from time-to-time, issue CMOs collateralized by ARM loans. CMOs collateralized by ARM loans typically consist of one or more classes of bonds having a maturity equal to the life of the underlying collateral. As the interest rate received on the underlying collateral adjusts to changes in short- term interest rates, the interest rate paid on the CMO adjusts by the corresponding amount, thus the positive Interest Spread will remain relatively constant over time. At the time the loans are pledged for issuance of a CMO or MPC, the mortgage pool insurance policy generally is activated. At such time, the Company also insures or reserves against bankruptcy and special hazard risks, and reduces its exposure to losses from fraud or misrepresentation in the origination of the mortgage loan. Recently, the Company has issued CMOs with the senior/subordinate structure where investors assume the credit risk by purchasing subordinate classes of the securitization. The Company also has the option to retain certain of the subordinate classes for its CMO Investment portfolio. The yield on subordinate securities reflects risk assumed and, therefore, the Company will not need to increase its provision for losses. The issuance of CMOs typically eliminates the Company's short-term financing risk associated with the mortgage loans that are pledged as collateral for such CMOs (except in the case of any class of CMOs having a variable interest rate collateralized by fixed-rate mortgage loans), as well as the risk that the market value of such mortgage loans will decline. This is because each series of CMOs is structured to be fully repaid out of the principal and interest payments on the underlying mortgage loans, including reinvestment proceeds, regardless of fluctuations in the market value of such mortgage loans. For a discussion of effects of interest rate changes on the Company's CMO investment portfolio, see the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 49 and page 50 under the caption "Management's Discussion and Analysis - Effects of Interest Rate Changes." SERVICING OPERATIONS - -------------------- The Company formed its mortgage servicing unit early in 1993, and as of December 31, 1993, serviced and master serviced mortgage loan portfolios of $2.4 billion and $4.4 billion, respectively. This growth was accomplished primarily by retaining servicing rights on mortgage loans purchased during the year and master servicing rights on mortgage loans placed into securitizations during the year. FNMA and FHLMC servicing approvals have been obtained so that the Company can service conforming loans guaranteed by these government sponsored entities and the Company has committed to bulk acquisitions of servicing rights for both conforming and non-conforming mortgage loan portfolios totaling $1.6 billion to be completed in early 1994. Mortgage loan servicing includes collecting and accounting for payments of principal and interest from borrowers, remitting such payments to investors, holding escrow funds for payment of mortgage-related expenses such as taxes and insurance, making advances to cover delinquent payments, inspecting the mortgage premises as required, contacting delinquent mortgagors, supervising foreclosures and property dispositions in the event of unremedied defaults, and generally administering the loans. The Company receives fees for servicing residential mortgage loans ranging generally from .25% to .38% per annum on the declining principal balances of the loans. Servicing fees are collected by the Company out of monthly mortgage payments. For a discussion of effects of interest rate changes on the Company's servicing operations investment portfolio, see the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 49 and page 50 under the caption "Management's Discussion and Analysis - Effects of Interest Rate Changes." OTHER INVESTMENT STRATEGIES The Company may enter into other short- or long-term investment strategies as the opportunities arise. COMPETITION In purchasing and pooling mortgage loans and in purchasing other mortgage- related assets, the Company competes with savings banks, commercial banks, mortgage and investment bankers, conduits, insurance companies, other lenders, FNMA and FHLMC, many of whom may have greater financial resources than the Company. The competition for loan servicing is equally diverse. Mortgage banking companies, savings banks and commercial banks all engage in servicing mortgage loans, some for others and some for their own portfolio. Additionally, in issuing CMOs or other mortgage-backed securities, the Company will face competition from other issuers of these securities and the securities themselves will compete with other investment opportunities available to prospective purchasers. An increase in the purchasing of long-term mortgage loans by others may reduce the Company's ability to compete in the purchase of such loans and may reduce the yields available to the Company. In addition, if FHLMC and FNMA were to increase the dollar amount limitation on loans they are permitted to purchase (currently $203,150), they would be able to purchase a greater percentage of mortgage loans in the secondary market than they currently are permitted to acquire, and the Company's ability to maintain or increase its current acquisition levels could be adversely affected. REGULATION AND RELATED MATTERS The Company's mortgage servicing unit is subject to the rules and regulations of FNMA and FHLMC with respect to securitizing and servicing mortgage loans. In addition, there are other Federal and state statutes and regulations affecting such activities. Moreover, the Company is required annually to submit audited financial statements to FNMA and FHLMC and each regulatory entity has its own financial requirements. The Company's affairs are also subject to examination by FNMA and FHLMC at all times to assure compliance with applicable regulations, policies and procedures. Many of the aforementioned regulatory requirements are designed to protect the interests of consumers, while others protect the owners or insurers of mortgage loans. Failure to comply with these requirements can lead to loss of approved status, termination of servicing contracts without compensation to the servicer, demands for indemnification or loan repurchases, class action lawsuits and administrative enforcement actions. EMPLOYEES Until becoming fully self-administered on October 1, 1993, the Company was managed by Capstead Advisers, Inc. (the "Manager"), a wholly-owned subsidiary of Lomas Mortgage USA, Inc. ("LMUSA"), who provided all executive and administrative personnel required by the Company under the terms of a management agreement. The Company only had one employee, its Chairman and Chief Executive Officer. See the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 38 under the caption "Notes to Consolidated Financial Statements - Note K - Management and Non-Competition Agreements." As of December 31, 1993, the Company had 83 full-time employees. FEDERAL INCOME TAX As used herein, "Capstead REIT" refers to CMC and the entities that are consolidated with CMC for federal income tax purposes. Capstead REIT has elected to be taxed as a REIT for federal income tax purposes and intends to continue to do so. As a result of this election, Capstead REIT will not be taxed at the corporate level on taxable income distributed to stockholders, provided that certain REIT qualification tests are met. If Capstead REIT fails to qualify as a REIT in any taxable year, it would be subject to federal income tax at regular corporate rates and would not receive a deduction for dividends paid to stockholders. If this were the case, the amount of after-tax earnings available for distribution to stockholders would decrease substantially. CMC owns all of the issued and outstanding preferred stock of certain other subsidiaries. These subsidiaries are not included in Capstead REIT for federal income tax purposes, but are included with CMC for financial reporting purposes. All taxable income of these subsidiaries is subject to federal and state income taxes, where applicable. Capstead REIT's taxable income will include earnings of these subsidiaries only upon payment to Capstead REIT by dividend of such earnings. To qualify as a REIT, Capstead REIT must meet certain income, asset, distribution, and ownership tests. The following is a summary of the qualifications. GROSS INCOME TESTS. There are three percentage tests relating to the sources of a company's gross income which must be satisfied for each taxable year. First, at least 75% of the company's gross income must be real property related income, which includes interest on loans secured by mortgages on real property and commitment fees earned in connection with such mortgage loans. Second, at least 95% of the company's gross income must be derived from items of income that qualify under the 75% test or from dividends, interest or gain from the sale or disposition of stock or other securities. Third, gains from the sale of stock (or other securities) held for less than one year, gains from sales of property (other than foreclosure property) held primarily for sale and gains on the sale of real property, including interests in mortgages on real property held for less than four years must represent less than 30% of the company's gross income. If a company fails to satisfy one or both of the 75% or 95% gross income tests for any taxable year, it may nevertheless qualify as a REIT for such year if it is entitled to relief under certain provisions of the Code. These relief provisions are available if the company can establish that its failure to meet such tests is due to reasonable cause and not due to willful neglect. It is not possible to state whether in all circumstances Capstead REIT would be entitled to the benefit of these relief provisions. If these relief provisions apply, a 100% tax is imposed upon the greater of the amounts by which the company failed the 75% test or the 95% test. If the relief provisions are inapplicable to a particular set of circumstances involving Capstead REIT, such company will not qualify as a REIT. There are no comparable relief provisions which could mitigate the consequences of a failure to satisfy the 30% income test. ASSET TESTS. At the close of each quarter of its taxable year, Capstead REIT must satisfy certain tests regarding its assets. First, at least 75% of the value of the respective company's total assets must be represented by interests in real property, interests in mortgages on real property, shares in other real estate investment trusts, cash, cash items and government securities. Second, of the investments in securities not included in the foregoing, the value of any one issuer's securities owned by the company may not exceed 5% of the value of the company's total assets and the company may not own more than 10% of any one issuer's outstanding voting securities. Certain relief provisions apply with respect to these asset tests. If the asset tests are not met and the relief provisions cannot be satisfied by, or are inapplicable to, Capstead REIT, Capstead REIT will not qualify as a REIT. REITs are permitted to hold assets in subsidiaries which are and have been 100% owned by the REIT at all times during the period such subsidiaries existed ("qualified REIT subsidiaries"). For federal income tax purposes, all of the assets, liabilities and items of income, deduction and credit of a qualified REIT subsidiary are attributed to its parent. DISTRIBUTION REQUIREMENTS. In order to qualify for certain benefits of REIT status in any taxable year, including the deduction for dividends paid to shareholders, a REIT is required to distribute to its stockholders dividends in an amount at least equal to the sum of (i) 95% of its annual REIT taxable income exclusive of net capital gain and prior to any deduction for dividends paid plus (ii) 95% of its net after-tax income, if any, from foreclosure property minus (iii) the amount, if any, of certain noncash income in excess of 5% of its REIT taxable income exclusive of any net capital gain and prior to any deduction for dividends paid. Any income not distributed is subject to tax at regular corporate rates. Distributions declared before the time of filing of the company's tax return for the taxable year and paid not later than the first regular dividend payment following declaration will be deemed paid in such taxable year for purposes of the distribution test. A nondeductible excise tax equal to 4% will be imposed on the company for each calendar year to the extent that dividends declared and distributed or deemed distributed before December 31 are less than the sum of (i) 85% of the company's "ordinary income" plus (ii) 95% of the company's capital gain net income plus (iii) income not distributed in earlier years minus (iv) distributions in excess of income in earlier years and (v) any amount of REIT taxable income for such year. Failure to distribute 95% of REIT taxable income would disqualify a company from certain benefits of REIT status. Under certain circumstances a company may correct a failure to meet the distribution requirements by paying "deficiency dividends" to stockholders in a later year. It is the present intent of Capstead REIT to pay "deficiency dividends" if necessary to retain the benefits of their status as REITs. If a REIT recognizes net income from the sale or disposition of property (other than foreclosure property) held primarily for sale rather than investment, such income will be subject to a 100% penalty tax. This rule will not apply to real estate assets of a REIT that have been held for four years or more if (i) the REIT makes seven or fewer sales of such property during the taxable year or (ii) the aggregate adjusted bases of all the property sold during the taxable year does not exceed 10% of the adjusted bases of all the REIT's assets at the beginning of the REIT's taxable year. Certain other requirements may also need to be satisfied. STOCK OWNERSHIP TESTS. In order for a company to qualify as a REIT the Company's shares must be held by at least 100 stockholders during approximately 9/10 of the taxable year and during the last half of each taxable year not more than 50% (in value) of the company's outstanding stock may be owned directly or indirectly by five or fewer individuals. The company must demand written statements each year from the record holders of designated percentages of its shares disclosing the actual owners of such shares. A list of those persons failing or refusing to comply with such demand must be maintained as a part of the company's records. Federal income tax regulations further require that a stockholder failing or refusing to comply with the company's written demand must submit with his or her tax returns a similar statement disclosing the actual ownership of the company shares and certain other information. SPECIAL CONSIDERATIONS - TAX-EXEMPT AND CERTAIN OTHER INVESTORS For CMOs issued after December 31, 1991, pursuant to regulations not yet published, the portion of any dividend paid to stockholders attributable to "excess inclusion income" on the retained residual interests in such CMOs would be subject to certain rules. Such rules include (i) the characterization of excess inclusion income as unrelated business income for tax-exempt stockholders (including employee benefit plans and individual retirement accounts) and (ii) the inability of a stockholder to offset excess inclusion income with net operating losses (subject to certain exceptions applicable to thrift institutions). Generally, tax-exempt entities are subject to federal income tax on excess inclusion income and other unrelated business income in excess of $1,000 per year. Excess inclusion income is generally taxable income with respect to a residual interest in excess of a specified return on investment in the residual interest. In some cases, all taxable income with respect to a residual interest may be considered excess inclusion income. Until regulations or other guidance is issued, Capstead REIT will use methods it believes are appropriate for calculating the amount of excess inclusion income, if any it recognizes from CMOs issued after December 31, 1991, and allocating any excess inclusion income to its stockholders. Excess inclusion rules will most likely not apply to any CMO issued by any subsidiary of CMC on or before December 31, 1991. The Company's exposure for CMOs issued subsequent to that has been limited by the prepayment performance of these investments and the fact that beginning in the fall of 1992 the Company generally has sold the related CMO Residuals. A REIT is subject to tax on the portion of any "excess inclusion income" allocable to any shareholder which is a "disqualified organization" as defined in the REMIC provisions of the Code. If the ownership of CMC shares by any such organization would subject Capstead REIT to any tax on such income, such shares shall be immediately redeemable at the option of CMC. See "Description of CMC Capital Stock." The foregoing is general in character. Reference should be made to the pertinent Code Sections and the Regulations issued thereunder for a comprehensive statement of applicable federal income tax consequences. ITEM 2.

ITEM 2. PROPERTIES. The Company's operations are conducted primarily in Dallas, Texas on properties leased by the Company. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. At December 31, 1993 there were no material pending legal proceedings, outside the normal course of business, to which the Company or its subsidiaries were a party or of which any of their property was the subject. ITEM 4.

ITEM 4. RESULTS OF SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required by this item is included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 41 under the caption "Note Q - Market and Dividend Information," and is incorporated herein by reference, pursuant to General Instruction G(2). ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information required by this item is included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on page 42 under the caption "Selected Financial Data," and is incorporated herein by reference, pursuant to General Instruction G(2). ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required by this item is included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on pages 43 through 50 under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations," and is incorporated herein by reference, pursuant to General Instruction G(2). ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by this item is included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on pages 23 through 41, and is incorporated herein by reference, pursuant to General Instruction G(2). ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by this item is included in the Registrant's definitive Proxy Statement dated March 14, 1994 on pages 3 through 6 under the captions "Election of Directors" and "Executive Officers," and is incorporated herein by reference, pursuant to General Instruction G(3). ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information required by this item is included in the Registrant's definitive Proxy Statement dated March 14, 1994 on pages 6 through 13 under the captions "Executive Compensation," and "Report of the Compensation Committee on Executive Compensation" and is incorporated herein by reference, pursuant to General Instruction G(3). ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is included in the Registrant's definitive Proxy Statement dated March 14, 1994 on page 15 under the caption "Security Ownership of Certain Beneficial Owners and Management," and is incorporated herein by reference, pursuant to General Instruction G(3). ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this item is included in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 on pages 38 and 39 under the caption "Notes to Consolidated Financial Statements - Note K - Management and Non-Competition Agreements" and " - Note L - Transactions with Affiliates of the Former Manager" and is incorporated herein by reference, pursuant to General Instruction G(2). PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Documents filed as part of this report: 1. The following financial statements of the Company, included in the 1993 Annual Report to Stockholders, are incorporated herein by reference: - ---------------- * Incorporated herein by reference from the Company's Annual Report to Stockholders for the year ended December 31, 1993. 3. Exhibits: - ------------------ (1) Incorporated by reference to the Company's Registration Statement on Form S-11 (No. 2-97182) dated September 5, 1985. (2) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. (3) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (4) Incorporated by reference to the Company's Registration Statement on Form S-8 (No. 33-40016) dated April 29, 1991. (5) Incorporated by reference to the Company's Registration Statement on Form S-8 (No. 33-40017) dated April 29, 1991. (6) Incorporated by reference to Amendment No. 1 on Form 8 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (7) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. (8) Incorporated by reference to Amendment No. 1 of the Company's Registration Statement on Form S-4 (No. 33-31260) dated October 27, 1992. (9) Incorporated by reference to the Company's Registration Statement on Form S-3 (No. 33-62212) dated May 6, 1993. * Filed herewith. (b) Reports on Form 8-K: None. (c) Exhibits - The response to this section of ITEM 14 is submitted as a separate section of this report. (d) Financial Statement Schedules - The response to this section of ITEM 14 is submitted as a separate section of this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CAPSTEAD MORTGAGE CORPORATION REGISTRANT Date: March 29, 1994 By /s/ ANDREW F. JACOBS ----------------------------------- Andrew F. Jacobs Senior Vice President and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated below and on the dates indicated. /s/ RONN K. LYTLE Principal Executive March 29, 1994 - ------------------------------- Officer and Director (Ronn K. Lytle) /s/ ANDREW F. JACOBS Principal Financial March 29, 1994 - ------------------------------- and Accounting Officer (Andrew F. Jacobs) /s/ J. MICHAEL CORNWALL Director March 29, 1994 - ------------------------------- (J. Michael Cornwall) /s/ DAVID G. FOX Director March 29, 1994 - ------------------------------- (David G. Fox) /s/ BEVIS LONGSTRETH Director March 29, 1994 - ------------------------------ (Bevis Longstreth) /s/ PAUL M. LOW Director March 29, 1994 - ------------------------------- (Paul M. Low) /s/ HARRIET E. MIERS Director March 29, 1994 - ------------------------------- (Harriet E. Miers) /s/ CHARLES B. MULLINS, M.D. Director March 29, 1994 - ------------------------------- (Charles B. Mullins, M.D.) /s/ WILLIAM R. SMITH Director March 29, 1994 - ------------------------------- (William R. Smith) /s/ LEWIS T. SWEET, JR. Director March 29, 1994 - ------------------------------- (Lewis T. Sweet, Jr.) /s/ MARTIN TYCHER Director March 29, 1994 - ------------------------------- (Martin Tycher) PORTIONS OF THE ANNUAL REPORT ON FORM 10-K ITEMS 14(A)(1), (2) AND (3) FINANCIAL STATEMENT SCHEDULES AND EXHIBITS YEAR ENDED DECEMBER 31, 1993 CAPSTEAD MORTGAGE CORPORATION DALLAS, TEXAS SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES * Loss on sale of foreclosed properties and charge-offs of other mortgage securities. SCHEDULE IX - SHORT-TERM BORROWINGS CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES (1) Notes payable consisted of borrowings under the Company's revolving lines of credit with commercial banks. (2) Repurchase agreements consisted of borrowings from investment banks with terms typically not longer than 160 days with no provisions for extension of maturity. (3) Dollar repurchase agreements consisted of borrowings from investment banks with mortgage-backed securities as collateral and terms typically not longer than 60 days. (4) The average amount outstanding during the period was computed by dividing the total of the monthly weighted average outstanding principal balances by 12 months. (5) The weighted average interest rate during the period was computed by dividing the total of the monthly weighted average interest rates by 12 months. SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES DECEMBER 31, 1993 See accompanying Notes to Schedule XII on the following page. NOTES TO SCHEDULE XII CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES (1) The portfolio at December 31, 1993 consisted of single-family, conventional, first mortgage loans. Principal amount of mortgage loans in the portfolio totaling $900,936,000, or 36%, are adjustable-rate loans; and $318,319,000, or 13%, are 30 year mortgage loans with one rate or payment change five years from origination. The remaining $1,251,829,000, or 51%, are fixed- rate level payment loans. (2) The basis for valuing the mortgage loan portfolio for tax purposes is the same as that used for financial reporting. (3) Reconciliation of mortgage loans: (4) Consists of all mortgage loans delinquent 60 days or more. Note that of this total, $46,527,000 is covered by mortgage pool insurance which effectively limits the Company's exposure to loss. NOTES TO SCHEDULE XII - CONTINUED CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES (5) The geographic distribution of the Company's portfolio at December 31, 1993 was as follows: EXHIBIT INDEX - ------------------ (1) Incorporated by reference to the Company's Registration Statement on Form S-11 (No. 2-97182) dated September 5, 1985. (2) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. (3) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (4) Incorporated by reference to the Company's Registration Statement on Form S-8 (No. 33-40016) dated April 29, 1991. (5) Incorporated by reference to the Company's Registration Statement on Form S-8 (No. 33-40017) dated April 29, 1991. (6) Incorporated by reference to Amendment No. 1 on Form 8 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (7) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. (8) Incorporated by reference to Amendment No. 1 of the Company's Registration Statement on Form S-4 (No. 33-31260) dated October 27, 1992. (9) Incorporated by reference to the Company's Registration Statement on Form S-3 (No. 33-62212) dated May 6, 1993. * Filed herewith.

30547_1993.txt

30547

1993

Item 1. Business (a) General description of business The Registrant and its subsidiary (herein referred to collectively as the "Company") manufacture and sell a diversified line of business forms and related services for commercial and industrial use, including, without limitation, continuous and unit-set business forms, forms-related services, pressure-sensitive labels, envelopes, and other specialties. The Company's products are primarily sold through its direct sales force. The Company has sales offices, manufacturing facilities, Business Service Centers, and warehouses throughout the United States and in Puerto Rico. Business Service Centers combine a warehousing facility with a computerized forms management system for customers. 1. The industry is maturing. Factors influencing this include a move away from paper-based information systems by larger companies, smaller companies moving away from unit sets, the use of laser printers moving users to cut sheet in place of continuous forms, and slow economic growth. The competitive environment consists of about 600 companies, with the ten largest accounting for more than half the market. There is over-capacity and consequent pricing pressures. Other non-forms companies are also affecting the market by offering substitute products and systems. They include software systems and more sophisticated user-friendly printing equipment. Distribution is through direct sales, distributor sales and mail order channels. 2. No single customer accounts for more than 10% of the Company's consolidated net sales. 3. The amount of backlog of orders is not material in terms of annual sales volume. 4. The Company's principal raw material is paper, which is purchased in a wide variety of sizes, colors, widths and weights. Other raw materials include printing ink, lithographic plate material, rubber and chemicals. The Company has a policy of purchasing raw materials from several major suppliers and believes paper and other raw materials will be sufficiently available in 1994. 5. The Company holds no material patents, licenses, franchises or concessions. The Company believes that its performance is substantially dependent upon its engineering, manufacturing and marketing abilities. 6. The Company continues to be involved in research activities relating to development of new products and improvement of existing products (none of which is customer sponsored). The Company does not regard either the number of people involved in or amounts expended on research activities to be significant in relation to annual sales volume. 7. Compliance with federal, state and local provisions governing the discharge of materials into the environment has not had and, it is anticipated, will not have any material effect on the Company's capital expenditures, earnings or competitive position. 8. The number of persons employed was 2,036 as of October 30, 1993. 9. The Company's principal line of business is not subject to significant seasonal variations. 10. The Company's business is in a single industry segment, and only the business forms class of product exceeds 10% of total sales. 11. No material part of net sales is derived from foreign customers. Item 2.

Item 2. Properties The Baltimore, Maryland facility is being marketed for sale. All facilities are in good condition, and total production capacity is considered to be adequate for current needs. The Company also leases space in various locations for sales offices and for warehousing, as indicated in the note to consolidated financial statements entitled "Lease Commitments." Item 3.

Item 3. Legal Proceedings The Company is not a party to, nor is its property subject, to any material pending legal proceedings. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters Duplex common stock is traded on the American Stock Exchange. As of October 30, 1993, the Company had 1,451 common shareholders of record, excluding beneficial owners whose stock was held in nominee name. The following table sets forth, for fiscal years ended October 30, 1993, and October 31, 1992, the range of high and low closing sales prices for the Company's common stock, as well as the dividends paid per share for each year. Item 6.

Item 6. Selected Financial Data Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Net sales for 1993 were $258.9 million, or 4% less than the $270.1 million reported for 1992. About 2% of 1992's sales were attributable to it being a 53-week year, versus the normal 52-week year. In 1992, sales decreased 5% from the $285.3 million in 1991, which in turn was 4% less than the $297.7 million in 1990. For the last three years, business conditions have been difficult. Industry sales data for manifold business forms show a sales decline from 1990 to 1991 of 2%, and from 1991 to 1992 of 3%. For 1992 to 1993, the industry forecast is for a decrease of 2%. Certain segments of the forms-related market, however, continue to provide steady growth. This Includes forms management services, preprinted cut sheets, and pressure-sensitive labels. In response to this maturing market, the Company has taken significant steps to adjust its manufacturing capacity, reorganize and change its management team, retrain its sales force and improve its focus for functioning in this highly competitive marketplace. This is expected to result in a gain of market share. The Company continued to reduce its dependence on commodity products while focusing on custom forms, pressure-sensitive labels, and value-added services. Strategic alliances were developed to supplement product offerings and improve margins. The sales of continuous stock forms, a commodity-type product, were down 20% in 1993. This product, in combination with the extra week in 1992, accounted for most of 1993's sales decline. The sales of continuous stock forms were down 19% in 1992, in comparison with 1991. In 1993, sales of continuous stock forms represented slightly less than 11% of total revenues. Average selling price increases are very difficult to determine for the Company's various products. However, inflation is estimated to have had minimal impact on sales in the past three years. Paper is the Company's primary raw material, and it accounts for a significant percentage of the cost of most business forms. In 1993, the cost of white paper was volatile throughout the year, as it had been in 1992 and 1991. The LIFO provision was a credit in 1993, 1992, and 1991, respectively, of $.1 million, $.7 million, and $2.0 million. The gross profit percentage in 1993 was affected by a midyear increase in paper prices. It was 24.7%, 25.3%, and 25.7%, for 1993, 1992, and 1991, respectively. The closing of two plants in May of 1993, and subsequent increased utilization of the remaining plants, allowed the Company to hold manufacturing expense percentages despite a decline in manufactured sales. As part of a strategy to expand product and service capabilities and improve margins, the Company is developing a program of partnering for procurement of products the Company cannot produce and/or are not cost-competitive. Out-sourcing represented 18% and 15% of sales in 1993 and 1992, respectively. This is expected to increase and should have a positive effect on gross profit in the future. In 1993, selling and administrative expenses were $61.0 million, down $2.1 million or 3%, from the $63.1 million reported in 1992. Administrative expenses in the second half of 1993 were lower because of a corporate restructuring which reduced administrative staffing by approximately 30%. In 1992, selling and administrative expenses of $63.1 million were also down from the $64.6 million in 1991. Earnings in 1993, 1992, and 1991 were reduced by a pretax restructuring charge of $1.5 million, $7.0 million, and $2.0 million, respectively. This represents the cost associated with reducing administrative expenses, closing plants, consolidating distribution facilities, and the scaling back of other operations. These actions reflect the impact of the weak economy and excess capacity in the business forms industry. Savings from these cost-reduction efforts are expected to exceed the charges. Lower interest rates in 1993 and 1992 resulted in reduced interest expense and investment income. In 1993, miscellaneous income increased due to the gain on sale of real estate and equipment associated with the closing of certain plants. The sum of other income and expense items was income of $.9 million, $.6 million, and $.1 million, respectively, in 1993, 1992, and 1991. The effective tax rate was 35% in 1993, compared to a credit of 57% in 1992, and a charge of 37% in 1991. See Notes to the Consolidated Financial Statements for a reconciliation of effective income tax rates to the statutory rate. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Adoption resulted in an increase of $1.0 million and $.13 per share in income in the first quarter of 1993. This was attributable to a reduction in deferred tax rates to the current, lower, federal tax rate. Net earnings (loss) were $2.5 million, ($.6) million, and $4.3 million in 1993, 1992, and 1991, respectively. Earnings (loss) as a percentage of sales were .9% in 1993, compared with (.2%) in 1992 and 1.5% in 1991. Liquidity and Capital Resources Working capital was $83.4 million at the end of fiscal 1993, as compared with $77.5 million and $81.4 million at the end of fiscal 1992 and 1991, respectively. The current ratio remained strong at 4.3 to 1 at the end of 1993, despite the fact that net cash of $1.3 million was used in operations. In 1992 and 1991, cash was provided by operations in the amounts of $10.2 million and $16.3 million, respectively. A significant factor in the 1993 use was strong billings at the end of the fourth quarter resulting in an increase in Accounts and Notes Receivable. Receivables increased to $76.0 million at the end of fiscal 1993, as compared to $68.0 million and $71.4 million at the end of fiscal 1992 and 1991, respectively. It is projected that operations will provide cash in fiscal 1994. Capital expenditures, dividend, and working capital requirements of the Company for the past seven years have been generated internally. The Company has made no short-term borrowings over the past 13 years. Long-term debt as a percentage of total capitalization was 6% at the end of fiscal year 1993, as compared with 7% and 8% for the previous two years. No long-term financings are planned for 1994. Stockholders' equity at October 30, 1993, was $117.3 million, as compared with $114.4 million at the end of fiscal 1992. At the end of fiscal year 1993, equity per common share was $15.24. Capital expenditures in 1993 were $3.7 million, compared to $4.9 million and $7.6 million in 1992 and 1991, respectively. Dividend and Common Stock Data No cash dividends were paid in fiscal 1993, as compared to $3.7 million and $5.4 million in 1992 and 1991, respectively. Duplex common stock is traded on the American Stock Exchange. As of October 30, 1993, the Company had 1,451 common shareholders of record, excluding beneficial owners whose stock was held in nominee name. Item 8.

Item 8. Financial Statements and Supplementary Data Listed below are the financial statements included in this part of the Annual Report on Form 10-K: (a) Financial Statements REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Stockholders of Duplex Products Inc. We have audited the accompanying consolidated balance sheet of Duplex Products Inc. and Subsidiary as of October 30, 1993, and October 31, 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for the years ended October 30, 1993, October 31, 1992, and October 26, 1991. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Duplex Products Inc. and Subsidiary at October 30, 1993, and October 31, 1992, and the consolidated results of their operations and their consolidated cash flows for the years ended October 30, 1993, October 31, 1992, and October 26, 1991, in conformity with generally accepted accounting principles. As discussed in the income tax footnote, the Company changed its method of accounting for income taxes for the year ended October 30, 1993. Grant Thornton Chicago, Illinois December 2, 1993 DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEET OCTOBER 30 AND OCTOBER 31, DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEET - CONTINUED OCTOBER 30 AND OCTOBER 31, LIABILITIES AND STOCKHOLDERS' EQUITY The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED STATEMENT OF EARNINGS YEARS ENDED OCTOBER 30, OCTOBER 31 AND OCTOBER 26, The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED OCTOBER 26, 1991, OCTOBER 31, 1992, AND OCTOBER 30, 1993 The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED OCTOBER 30, OCTOBER 31 AND OCTOBER 26, The accompanying notes are an integral part of this statement. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS OCTOBER 30, 1993, AND OCTOBER 31, 1992 SUMMARY OF ACCOUNTING POLICIES The Company is in the business of manufacturing and marketing continuous and unit set business forms, forms-related services, pressure-sensitive labels, envelopes, and other specialties. The Company's significant accounting policies, which have been applied in the preparation of the accompanying consolidated financial statements, follow. The Company's fiscal year ends on the last Saturday in October. The fiscal years ended October 30, 1993, October 31, 1992, and October 26, 1991 were comprised of fifty-two, fifty-three and fifty-two weeks, respectively. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary after elimination of intercompany transactions and balances. The Company recognizes sales for custom-made business forms upon customer acceptance and completion of the manufacturing process. Stock form sales are recognized at the time of shipment to the customer. The Company considers all highly liquid debt instruments purchased with a maturity of three months and less to be cash equivalents. The Company currently provides for doubtful receivables. The allowances for doubtful receivable account balances were $800,000 and $900,000 at October 30, 1993, and October 31, 1992, respectively. The Company values its inventories at the lower of cost or market, with cost for substantially all of its inventories being based on the last-in, first-out (LIFO) method. Property, plant and equipment are valued at cost. Depreciation and amortization are provided for in amounts sufficient to relate the costs of depreciable assets to operations over their estimated useful lives or the terms of leases, which approximate the lives of the leased property. The Company primarily uses the straight-line method of depreciation for financial reporting purposes and accelerated methods for tax reporting purposes. Earnings per share is computed on the basis of the weighted average number of common shares outstanding during the year. Certain reclassifications have been made to the 1992 and 1991 financial statements to conform them to the 1993 presentation. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993, AND OCTOBER 31, 1992 INVENTORIES If the Company had used the first-in, first-out (FIFO) method of inventory accounting instead of the last-in, first-out (LIFO) method, inventories would have been $8,334,000, $8,389,000 and $9,091,000 higher at October 30, 1993, October 31, 1992, and October 26, 1991, respectively. Use of the FIFO method would have decreased earnings before income taxes by $55,000 in 1993, increased the loss before income tax credits by $702,000 in 1992 and decreased earnings before income taxes by $2,027,000 in 1991. Inventories, by classification determined by the first-in, first-out (FIFO) cost method, are as follows: It is not practicable to separate the LIFO inventory into its components (raw materials, work-in-process and finished goods) because the dollar value LIFO method is used. ACCRUED EXPENSES - OTHER The accrued expenses - other consist of the following items as of year-end: DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993, AND OCTOBER 31, 1992 ACCRUED EXPENSES - OTHER - CONTINUED The Financial Accounting Standards Board issued its Statement No. 112, "Employers' Accounting for Postemployment Benefits," in November, 1992, which is effective for fiscal years beginning after December 15, 1993. The Financial Accounting Standards Board issued its Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in December, 1990, which is effective for fiscal years beginning after December 15, 1992. Adoption of these standards is not expected to materially affect the Company's financial statements. LONG-TERM OBLIGATIONS Long-term obligations consist of the following: Prime rate at October 30, 1993 was 6%. Principal payments due on the long-term debt, exclusive of the capitalized lease, for the five years subsequent to October 30, 1993 are: 1994 - $1,212,000; 1995 - $872,000; 1996 - $883,000; 1997 - $895,000; 1998 - $600,000. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993, AND OCTOBER 31, 1992 LEASE COMMITMENTS The Company has entered into operating leases for certain plant and office facilities and equipment which expire over the next eight years. In most cases, management expects that, in the normal course of business, leases will be renewed or replaced by other leases. Rental expenses for operating leases were $6,110,000 in fiscal 1993, $6,021,000 in fiscal 1992, and $6,715,000 in fiscal 1991. At October 30, 1993, the Company was obligated under capitalized and operating leases to make future minimum lease payments as follows: PROFIT SHARING PLANS The Employees' Savings and Profit Sharing Plan provides for contributions from both the Company and eligible employees. Company contributions are voluntary and at the discretion of the Board of Directors. Any annual contribution by the Company cannot exceed 15% of earnings before deducting the contribution and federal income taxes. The Company has made no provision for a profit sharing contribution in 1993 and 1992. The provision amounted to $500,000 in 1991. DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 KEY EMPLOYEE BENEFIT PLANS For key executives, the Company has established the following: restricted stock purchase plan, stock appreciation rights plan, incentive stock option plan and supplemental executive retirement plan. During 1993, 60,700 common shares previously issued under the restricted stock purchase plan were repurchased at a cost of $852,000. During 1992, 16,100 common shares were issued under the plan at a purchase price of $25,000, and 15,800 common shares previously issued under the plan were repurchased at a cost of $241,000. During 1991, 23,500 common shares were issued under the plan at a purchase price of $35,000. Compensation expense related to the plan is charged to income over periods earned and amounted to $187,000, $330,000 and $312,000 in 1993, 1992 and 1991, respectively. There was no activity in the stock appreciation rights plan during the three years ended October 30, 1993. During 1993, incentive stock options for 75,000 shares were issued. No incentive stock options were granted, exercised or cancelled for the years ended October 31, 1992 and October 26, 1991. At October 30, 1993, options for 2,700 and 75,000 common shares were outstanding at an exercise price of $11.875 and $11.375, respectively. At October 30, 1993, 178,000 common shares were available for offering to key executives under the three plans. During 1989, the Company adopted an unfunded supplemental executive retirement plan for certain key executives. The plan provides for benefits which supplement those provided by the Company's other retirement plans. At October 30, 1993, the projected benefit obligation of the plan totalled $1,160,000, all of which has been recognized. The expense for this plan was $140,000, $221,000 and $205,000 in 1993, 1992 and 1991, respectively. wwwDUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 INCOME TAXES Through October 31, 1992, the Company accounted for income taxes under Accounting Principles Board Opinion (APB) No. 11. In February, 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" which supersedes the provisions of APB 11. SFAS 109 changes the Company's method of accounting for income taxes from the deferred method required under APB 11 to the asset and liability method. The objective of the asset and liability method is to establish deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The cumulative effect of the change in the method of accounting for income taxes was to increase net earnings $1,000,000. Prior year's financial statements have not been restated to apply the provisions of SFAS 109. The provision for income taxes consists of the following: DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 INCOME TAXES - CONTINUED The tax effects of existing temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets as of October 30, 1993 were as follows: The effective tax rate was 34.8% in 1993, (57.2)% in 1992 and 36.8% in 1991. The differences between the amounts recorded and the amounts computed by applying the U.S. federal statutory rates of 34.0% in 1993, 1992 and 1991 are explained as follows: DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 SHAREHOLDERS' RIGHTS PLAN On June 8, 1989, the Board of Directors adopted a Shareholders' Rights Plan to deter coercive takeover tactics and to prevent an acquirer from gaining control of the Company without offering a fair price to all of the Company's stockholders. Under the plan, stockholders of record on June 23, 1989 received a dividend distribution of one right for each outstanding share of the Company's common stock. If an acquiring person becomes the beneficial owner of, or commences a tender or exchange offer for, 25% or more of the Company's outstanding common stock, each right will entitle the holder (other than such acquiring person) to purchase a unit consisting of one one-hundredth of a share of Series A preferred stock, $1.00 par value, for $80.00 per unit. In addition, if an acquiring person becomes the beneficial owner of more than 30% of the Company's outstanding common stock, or upon the occurrence of certain other events, each right will entitle the holder (other than such acquiring person) to receive, upon exercise, common stock of the Company having a value equal to two times the exercise price of the right or $160.00. If the Company is acquired in a merger or other business combination in which the Company would not be the surviving corporation, or if 50% or more of the Company's assets or earning power is sold or transferred, each holder shall have the right to receive, upon exercise, common stock of the acquiring corporation having a value equal to two times the exercise price of the right or $160.00. The Company may redeem the rights in whole for $.05 per right, under certain circumstances. The rights expire on June 23, 1999. PREFERRED STOCK The Company's capitalization includes the following authorized preferred stock, none of which has been issued: 1,000,000 shares of $1 par value cumulative convertible preferred stock 150,000 shares of $1 par value Series A convertible preferred stock DUPLEX PRODUCTS INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED OCTOBER 30, 1993 AND OCTOBER 31, 1992 RESTRUCTURING COST In the second quarter of fiscal 1993, a provision of $1,500,000 was made to cover the cost associated with corporate staff reductions. In the fourth quarter of fiscal 1992, a provision of $7,000,000 was made to cover the cost associated with closing two additional manufacturing plants and the scaling back of other operations. In the fourth quarter of fiscal 1991, a provision of $2,000,000 was made to cover the cost associated with closing a plant in Florida and consolidation in distribution operations. QUARTERLY FINANCIAL RESULTS (UNAUDITED) Item 9.

Item 9. Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Certain information regarding directors of the Company is incorporated herein by reference to the descriptions on pages 2 and 3 under "Election of Directors" of the Company's 1994 Proxy Statement. The names, ages and positions of all the executive officers of the Company as of January 21, 1994 are listed below, along with their business experience during the past five years. Officers are appointed annually by the Board of Directors at the meeting of directors immediately following the Annual Meeting of Shareholders. There are no family relationships among these officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. Item 11.

Item 11. Executive Compensation Information regarding executive compensation is incorporated by reference to the material under the caption "Executive Compensation" on pages 4 through 8 of the Company's 1994 Proxy Statement. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Information regarding security ownership of certain beneficial owners and management is incorporated herein by reference to the material under the caption "Election of Directors" on pages 2 and 3, and under the caption "Beneficial Ownership of Common Stock By Certain Persons" on page 10 of the Company's 1994 Proxy Statement. Item 13.

Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions is incorporated herein by reference to the material "Business Affiliations and Securities Ownership of Nominees for Director and Directors Whose Terms Continue" on pages 2 and 3 of the Company's 1994 Proxy Statement. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K The following documents are filed as a part of this report: (a)(1) Financial statements The consolidated financial statements of the Company are included in Part II, Item 8 of this report. (a)(2) Schedules All other schedules have been omitted for the reason that they are not applicable or not required. (b) Reports on Form 8-K: None. (c) Exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index which is incorporated herein by reference. Grant Thorton [Letterhead] REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON SCHEDULES Board of Directors Duplex Products Inc. In connection with our audit of the consolidated financial statements of Duplex Products Inc. and Subsidiary, referred to in our report dated December 2, 1993, we have also audited Schedules V, VI, and VIII as of October 30, 1993, and for each of the three years in the period then ended. In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein. /s/ GRANT THORNTON GRANT THORNTON Chicago, Illinois December 2, 1993 Schedule V Duplex Products Inc. and Subsidiary PROPERTY, PLANT, AND EQUIPMENT Depreciation for financial reporting purposes is based on estimated useful lives of assets, which are as follows: Land improvements 5 to 10 years Buildings and improvements 5 to 40 years Machinery and equipment 3 to 15 years Furniture and fixtures 5 to 15 years Leasehold improvements Lives of leases Automotive equipment 4 to 5 years Schedule VI Duplex Products Inc. and Subsidiary ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Schedule VIII Duplex Products Inc. and Subsidiary VALUATION AND QUALIFYING ACCOUNTS AND RESERVES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DUPLEX PRODUCTS INC. (Registrant) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. EXHIBITS FILED WITH SECURITIES AND EXCHANGE COMMISSION Number and Description of Exhibit 3. Articles of Incorporation - Duplex Products Inc.* 11. Computation of Earnings per Share 22. Subsidiary 24. Consent of Independent Certified Public Accountants * Document has heretofore been filed with the Commission and is incorporated by reference.

73124_1993.txt

73124

1993

Item 1 - -Business NORTHERN TRUST CORPORATION Northern Trust Corporation is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended. The Corporation was organized in Delaware in 1971 and on December 1 of that year became the owner of all of the outstanding capital stock, except directors' qualifying shares, of The Northern Trust Company (Bank), an Illinois banking corporation located in the Chicago financial district. The Corporation also owns three other banks in the Chicago metropolitan area, a bank in each of Florida, Arizona, California and Texas, and various other nonbank subsidiaries, including a securities brokerage firm and a futures commission merchant. The Corporation expects that although the operations of other subsidiaries will be of increasing significance, the Bank will in the foreseeable future continue to be the major source of the Corporation's assets, revenues and net income. Except where the context otherwise requires, the term "Corporation" refers to Northern Trust Corporation and its consolidated subsidiaries. At December 31, 1993, the Corporation had consolidated total assets of approximately $16.9 billion and stockholders' equity of $1.2 billion. At June 30, 1993 the Corporation was the third largest bank holding company headquartered in Illinois and the 40th largest in the United States, based on consolidated total assets of approximately $16.3 billion on that date. THE NORTHERN TRUST COMPANY The Bank was founded by Byron L. Smith in 1889 to provide banking and trust services to the public. Currently in its one hundred and fifth year, the Bank's growth has come from internal sources rather than through merger or acquisition. At December 31, 1993, the Bank had consolidated assets of approximately $13.5 billion. At June 30, 1993, the Bank was the third largest bank in Illinois and the 38th largest in the United States, based on consolidated total assets of approximately $13.1 billion on that date. At December 31,1993 the Bank had seven active wholly owned subsidiaries: The Northern Trust International Banking Corporation, NorLease, Inc., The Northern Trust Safe Deposit Company, MFC Company, Inc., Nortrust Nominees Ltd., The Northern Trust Company U.K. Pension Plan Limited and The Northern Trust Company, Canada. The Northern Trust International Banking Corporation, located in New York, was organized under the Edge Act for the purpose of conducting international business. NorLease, Inc. was established by the Bank to enable it to broaden its leasing and leasing-related lending activities. The Northern Trust Safe Deposit Company was established in order to offer safe deposit facilities to the public. MFC Company, Inc. holds properties that are received from the Bank in connection with certain problem loans. Nortrust Nominees Ltd., located in London, is a U.K. trust corporation organized to hold U.K. real estate for fiduciary accounts. The Northern Trust Company U.K. Pension Plan Limited was established in connection with the pension plan for the Bank's London branch. The Northern Trust Company, Canada was established to offer institutional trust products and services to Canadian entities. OTHER NORTHERN TRUST CORPORATION SUBSIDIARIES The Corporation has three banking subsidiaries in the Chicago metropolitan area: Northern Trust Bank/O'Hare N.A., Northern Trust Bank/DuPage, and Northern Trust Bank/Lake Forest N.A. At December 31, 1993, the three Illinois banking subsidiaries had nine office locations with combined total assets of approximately $1.5 billion. The Corporation's Florida banking subsidiary, Northern Trust Bank of Florida N.A., is headquartered in Miami and at December 31, 1993, had fifteen offices located throughout Florida, with total assets of approximately $1.3 billion. The Corporation's Arizona banking subsidiary, Northern Trust Bank of Arizona N.A., is headquartered in Phoenix and at December 31, 1993 had total assets of approximately $214 million and serviced clients from four office locations. The Corporation has a Texas banking subsidiary, Northern Trust Bank of Texas N.A., headquartered in Dallas. It had four office locations and total assets of $152 million at December 31, 1993. The Corporation has one banking subsidiary in California, Northern Trust Bank of California N.A., headquartered in Santa Barbara. At December 31, 1993, it had six office locations and total assets of $141 million. The Corporation has several nonbank subsidiaries. Among them are Northern Trust Services, Inc., which provides management consulting services to nonaffiliated financial institutions. Northern Trust Securities, Inc. provides full brokerage services to clients of the Bank and the Corporation's other banking and trust subsidiaries and selectively underwrites general obligation tax-exempt securities. Northern Futures Corporation is a futures commission merchant. Northern Investment Corporation holds certain investments, including a loan made to a developer of a property in which - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- the Bank is the principal tenant. The Northern Trust Company of New York provides security clearance services for all nondepository eligible securities held by trust, agency, and fiduciary accounts administered by the Corporation's subsidiaries. Berry, Hartell, Evers & Osborne, Inc. is an investment management firm in San Francisco. Northern Trust Cayman International, Ltd. provides fiduciary services to clients residing outside of the U.S. CORPORATION'S INTERNAL ORGANIZATION The Corporation is organized into three principal business units: Corporate Financial Services and Personal Financial Services report to President and Chief Operating Officer William A. Osborn, who also heads the Commercial Banking and Corporate Management Services unit. In addition, the Corporation's Risk Management Unit focuses on financial and risk management. The following is a brief summary of the Corporation's business activities. CORPORATE FINANCIAL SERVICES John S. Sutfin, Vice Chairman of the Corporation, is head of Corporate Financial Services (CFS) which encompasses domestic and global custody trust- related services for securities traded in the United States and foreign markets, as well as securities lending, asset management, and cash management services. Master Trust/Master Custody is the principal product of CFS in the United States. Global Custody, the extension of domestic Master Custody to securities traded in markets foreign to the client, has been provided primarily through the Bank's London branch and Banque Scandinave en Suisse (BSS), in which the Bank has an investment of approximately 21%. The Corporation expects to transition most accounts custodied at BSS to the London branch during 1994. Related foreign exchange activities are conducted at the London branch. As measured by number of clients, the Corporation is a leading provider of Master Trust/Master Custody services in various market segments. At December 31, 1993 total assets under administration were $426.5 billion. The major market segments served are Corporate ERISA (pension and profit sharing funds subject to regulation under the Employment Retirement Income Security Act of 1974); public funds; taxable asset portfolios (foundations, endowments and insurance companies); and international asset portfolios (global assets of domestic and foreign institutions). To broaden the services provided to the defined contribution market, the Corporation signed a definitive agreement in December 1993 to acquire Hazlehurst & Associates, Inc., a privately-held retirement benefit plan services company based in Atlanta, Georgia. Hazlehurst's well established capabilities in retirement plan design, participant record keeping, and actuarial and consulting services will complement the Corporation's custody, fiduciary and investment management capabilities. The agreement is expected to close in the second quarter of 1994 subject to the approval of Hazlehurst shareholders and to regulatory approval. CFS also includes a correspondent trust market segment which provides custody, systems and investment services to smaller bank trust departments. Trust operations, The Northern Trust Company of New York and The Northern Trust Company, Canada are also included in CFS. PERSONAL FINANCIAL SERVICES Services to individuals is another major dimension of the Corporation's trust business. Barry G. Hastings, Vice Chairman of the Corporation, is head of Personal Financial Services (PFS) which encompasses personal trust and investment management services, estate administration, personal banking and mortgage lending. The Corporation's personal trust strategy combines private banking and trust services to targeted high net worth individuals in rapidly growing areas of wealth concentration. PFS is one of the largest bank managers of personal trust assets in the United States, with total assets under administration of $50.0 billion at December 31, 1993. The Corporation has created a broad national presence in the delivery of specialized private banking and personal trust services through the Bank and a network of banking subsidiaries located in Florida, Arizona, California, Texas and suburban Chicago. These full service banking subsidiaries are predominantly private banking and personal trust oriented and are included in PFS. In December 1993 the Corporation entered into a definitive agreement to acquire Beach One Financial Services, Inc., parent of The Beach Bank of Vero Beach in Florida. The agreement is expected to close in the third quarter of 1994 subject to the approval of Beach One shareholders and to regulatory approval. The Northern Trust Safe Deposit Company, Berry, Hartell, Evers & Osborne, Inc., and Northern Trust Securities, Inc. are also part of PFS. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- COMMERCIAL BANKING AND CORPORATE MANAGEMENT SERVICES Commercial Banking is headed by Gregg D. Behrens, Executive Vice President of the Bank. Commercial Banking offers a full range of banking services through the Bank and places special emphasis on developing institutional relationships in three target markets: middle market and small business companies in the Chicago and Midwest area, large domestic corporations, and financial institutions (both domestic and international). Credit services are administered in three groups: a Metropolitan Group, a Special Industries Group, and a Corporate and Correspondent Group. NorLease, Inc. and The Northern Trust International Banking Corporation are also part of Commercial Banking. Corporate Management Services (CMS), headed by J. David Brock, Executive Vice President of the Corporation, encompasses the treasury management products and services offered by the Corporation. This business serves the treasury needs of major corporations and financial institutions by providing products and services to accelerate cash collections, control disbursement outflows, and generate information to manage their cash positions. Treasury management products and services, including lockbox collection, controlled disbursement products and electronic banking, are developed and marketed in the Banking Services Group within CMS. CMS also includes banking operations and building management. RISK MANAGEMENT UNIT The Risk Management Unit, headed by Senior Executive Vice President and Chief Financial Officer Perry R. Pero, includes the Credit Policy function and the Bank's Treasury Department. The Credit Policy function is described fully on pages 16 to 17 of this report. The Treasury Department is responsible for managing the Bank's wholesale funding and interest rate risk, as well as the portfolio of interest rate risk management instruments under the direction of the Corporate Asset and Liability Policy Committee. It is also responsible for the investment portfolios of the Corporation and the Bank and provides investment advice and management services to the subsidiary banks. The Risk Management Unit also includes the Corporate Controller, Corporate Treasurer and Economic Research functions. GOVERNMENT POLICIES The earnings of the Bank, other banking subsidiaries, and the Corporation are affected by numerous external influences, principally general economic conditions, both domestic and international, and actions that the United States and foreign governments and their central banks take in managing their economies. These general conditions affect all of the Corporation's businesses, as well as the quality and volume of the loan and investment portfolios. An important regulator of domestic economic conditions is the Board of Governors of the Federal Reserve System, which has the general objective of promoting orderly economic growth in the United States. Implementation of this objective is accomplished by its open market operations in United States government securities, the discount rate at which member banks may borrow from Federal Reserve Banks and changes in the reserve requirements for deposits. The policies adopted by the Federal Reserve may strongly influence interest rates and hence what banks earn on their loans and investments and what they pay on their savings and time deposits and other purchased funds. Fiscal policies in the United States and abroad also affect the composition and use of the Corporation's resources. COMPETITION The Corporation's principal business strategy is to provide quality financial services to targeted market segments in which it believes it has a competitive advantage and favorable growth prospects. As part of this strategy, the Corporation seeks to deliver a level of service to its clients that distinguishes it from its competitors. The Corporation emphasizes the development and growth of recurring sources of fee-based income and is one of only eight major bank holding companies in the United States that generates more revenues from fee-based services than from net interest income. The Corporation seeks to develop and expand its recurring fee-based revenue by identifying selected market niches and providing a high level of individualized service to its clients in such markets. The Corporation also seeks to preserve its asset quality through established credit review procedures and to maintain a conservative balance sheet. Finally, the Corporation seeks to maintain a strong management team with senior officers having broad experience and long tenure with the Corporation. Active competition exists in all principal areas in which the subsidiaries of the Corporation are presently engaged. The Corporate and Personal Financial Services business units compete with domestic and foreign financial institutions, trust companies, financial companies, personal loan companies, mutual funds and investment advisors. The Corporation is a leading provider of Master Trust/Master Custody services and has the leading market share in the Chicago area personal trust market. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The Commercial Banking and Corporate Management Services business unit competes with domestic and foreign financial institutions, finance companies and leasing companies. Its products also face increased competition due to the general trend among corporations and other institutions to rely more upon direct access to the credit and capital markets (such as through the direct issuance of commercial paper) and less upon commercial banks and other traditional financial intermediaries. The chief local competitors of the Bank for trust and banking business are Continental Bank N.A., The First National Bank of Chicago and its affiliate American National Bank and Trust Company of Chicago, Harris Trust and Savings Bank, and LaSalle National Bank. The chief national competitors of the Bank for Master Trust/Master Custody services are Mellon Bank Corporation, State Street Boston Corporation, Bankers Trust New York Corporation, Chase Manhattan Corporation and Bank of New York Company, Inc. REGULATION AND SUPERVISION The Corporation is a bank holding company subject to the Bank Holding Company Act of 1956, as amended (Act), and to regulation by the Board of Governors of the Federal Reserve System. The Act limits the activities which may be engaged in by the Corporation and its nonbanking subsidiaries to those so closely related to banking or managing or controlling banks as to be a proper incident thereto. Also, under section 106 of the 1970 amendments to the Act and the Federal Reserve Board's regulations, a bank holding company, as well as certain of its subsidiaries, is prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provision of any property or services. The Act also prohibits bank holding companies from acquiring substantially all the assets of or owning more than 5% of the voting shares of any bank or nonbanking company which is not already majority owned without prior approval of the Board of Governors. No application to acquire shares or assets of a bank located outside the state in which the operations of a bank holding company's banking subsidiaries are principally conducted may be approved by the Federal Reserve Board unless such acquisition is specifically authorized by a statute of the state in which the bank to be acquired is located. Illinois law permits bank holding companies located in any state of the United States to acquire banks or bank holding companies located in Illinois subject to regulatory determinations that the laws of the other state permit Illinois bank holding companies to acquire banks and bank holding companies within that state on qualifications and conditions not unduly restrictive compared to those imposed by Illinois law. Subject to these regulatory determinations, the Corporation may acquire banks and bank holding companies in such states, and bank holding companies in those states may acquire banks and bank holding companies in Illinois. Applicable laws also permit the Corporation to acquire banks or bank holding companies in Arizona, California, Texas, Florida and certain other states. Illinois law permits an Illinois bank holding company to acquire banks anywhere in the state. Illinois legislation also now allows Illinois banks to open branches anywhere within Illinois. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) amended the Act to authorize the Federal Reserve Board to allow bank holding companies to acquire any savings association (whether healthy, failed or failing) and removed "tandem operations" restrictions, which previously prohibited savings associations from being operated in tandem with a bank holding company's other subsidiaries. As a result, bank holding companies, including the Corporation, now have expanded opportunities to acquire thrift institutions. Under FIRREA, an insured depository institution which is commonly controlled with another insured depository institution shall generally be liable for any loss incurred, or reasonably anticipated to be incurred, by the Federal Deposit Insurance Corporation (FDIC) in connection with the default of such commonly controlled institution, or for any assistance provided by the FDIC to such commonly controlled institution, which is in danger of default. The term "default" is defined to mean the appointment of a conservator or receiver for such institution. Thus, any of the Corporation's banking subsidiaries could incur liability to the FDIC pursuant to this statutory provision in the event of a loss suffered by the FDIC in connection with any of the Corporation's other banking subsidiaries (whether due to a default or the provision of FDIC assistance). Although neither the Corporation nor any of its nonbanking subsidiaries may be assessed for such loss under FIRREA, the Corporation has agreed to indemnify each of its banking subsidiaries, other than the Bank, for any payments a banking subsidiary may be liable to pay to the FDIC pursuant to the provisions of FIRREA. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The Bank is a member of the Federal Reserve System, its deposits are insured by the FDIC and it is subject to regulation by both these entities, as well as by the Illinois Commissioner of Banks and Trust Companies. The Bank is also a member of and subject to the rules of the Chicago Clearinghouse Association, and is registered as a government securities dealer in accordance with the Government Securities Act of 1986. As a government securities dealer its activities are subject to the rules and regulations of the Department of the Treasury. The Bank is registered as a transfer agent with the Federal Reserve and is therefore subject to the rules and regulations of the Federal Reserve. The Corporation's national bank subsidiaries are members of the Federal Reserve System and the FDIC and are subject to regulation by the Comptroller of the Currency. Northern Trust Bank/DuPage, a state chartered institution that is not a member of the Federal Reserve System, is regulated by the FDIC and the Illinois Commissioner of Banks and Trust Companies. The Corporation's nonbanking affiliates are all subject to examination by the Federal Reserve. In addition, The Northern Trust Company of New York is subject to regulation by the Banking Department of the State of New York. Northern Futures Corporation is registered as a futures commission merchant with the Commodity Futures Trading Commission, is a member of the National Futures Association, the Chicago Board of Trade and the Board of Trade Clearing Corporation, and is a clearing member of the Chicago Mercantile Exchange. Northern Trust Securities, Inc. is registered with the Securities and Exchange Commission and is a member of the National Association of Securities Dealers, Inc., and, as such, is subject to the rules and regulations of both these bodies. Berry, Hartell, Evers & Osborne, Inc. is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940 and is subject to that Act and the rules and regulations of the Commission promulgated thereunder. Various other subsidiaries and branches conduct business in other states and foreign countries and, therefore, may be subject to their regulations and restrictions. The Corporation and its subsidiaries are affiliates within the meaning of the Federal Reserve Act so that the banking subsidiaries are subject to certain restrictions with respect to loans to the Corporation or its nonbanking subsidiaries and certain other transactions with them or involving their securities. Information regarding dividend restrictions on the Corporation's banking subsidiaries is incorporated herein by reference to Note 12 titled Restrictions on Subsidiary Dividends and Loans or Advances on page 53 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. Under the FDIC's risk-based insurance assessment system, each insured bank is placed in one of nine risk categories based on its level of capital and other relevant information. Each insured bank's insurance assessment rate is then determined by the risk category in which it has been classified by the FDIC. There is an eight basis point spread between the highest and lowest assessment rates, so that banks classified as strongest by the FDIC are subject to a rate of .23%, and banks classified as weakest by the FDIC are subject to a rate of .31%. The FDIC is prohibited from lowering the average assessment rate below .23% until the Bank Insurance Fund (Fund) has reached a reserve ratio of 1.25%. The FDIC currently estimates the Fund will achieve the designated reserve ratio in the first half of 2002. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statutes. In general, FDICIA subjects banks to significantly increased regulation and supervision. Among other things, FDICIA requires federal bank regulatory authorities to take "prompt corrective action" with respect to banks that do not meet minimum capital requirements, and imposes certain restrictions upon banks which meet minimum capital requirements but are not "well capitalized" for purposes of FDICIA. FDICIA and the regulations adopted under it establish five capital categories as follows, with the category for any institution determined by the lowest of any of these ratios: *3% for banks with the highest CAMEL (supervisory) rating. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- An insured depository institution may be deemed to be in a capitalization category that is lower than is indicated by the capital position reflected on its statement of condition if it receives an unsatisfactory rating by its examiners with respect to its assets, management, earnings or liquidity. Although a bank's capital categorization thus depends upon factors other than the statement of condition ratios in the table above, the Corporation has set capital goals for each of its subsidiary banks that would allow each bank to meet the minimum ratios that are one of the conditions for it to be considered to be well capitalized. At December 31, 1993, the Bank and each of the Corporation's other subsidiary banks met or exceeded these goals. The Corporation's capital ratios are disclosed and discussed on page 39 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. Under FDICIA, a bank that is not well capitalized is generally prohibited from accepting or renewing brokered deposits and offering interest rates on deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited); in addition, "pass-through" insurance coverage may not be available for certain employee benefit accounts. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized banks are subject to limitations on growth and are required to submit a capital restoration plan, which must be guaranteed by the institution's parent company. Institutions that fail to submit an acceptable plan, or that are significantly undercapitalized, are subject to a host of more drastic regulatory restrictions and measures. FDICIA directs that each federal banking agency prescribe standards for depository institutions or depository institutions' holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses and other standards as they deem appropriate. Many regulations implementing these directives have been proposed and adopted by the agencies. FDICIA also contains a variety of other provisions that may affect the operations of a bank, including new reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions and a requirement that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch. STAFF The Corporation and its subsidiaries employed 6,259 full-time equivalent officers and staff members as of December 31, 1993, approximately 4,600 of whom were employed by the Bank. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- STATISTICAL DISCLOSURES The following statistical disclosures, included in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, are incorporated herein by reference. - -------------------------------------------------------------------------------- Additional statistical information as to the Corporation on a consolidated basis is set forth below. INVESTMENT SECURITIES REMAINING MATURITY AND AVERAGE YIELD OF INVESTMENT SECURITIES (Yield on a taxable equivalent basis giving effect of the federal and state tax rates) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LOANS AND LEASES BY TYPE Loans were classified based on credit risk exposure for 1993, 1992, 1991 and 1990. Loan breakdowns prior to 1990 were based on industry classifications defined by the Federal Reserve. - -------------------------------------------------------------------------------- REMAINING MATURITY OF SELECTED LOANS AND LEASES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- AVERAGE DEPOSITS BY TYPE - -------------------------------------------------------------------------------- AVERAGE RATES PAID ON TIME DEPOSITS BY TYPE - ------------------------------------------------------------------------------- REMAINING MATURITY OF TIME DEPOSITS $100,000 AND MORE - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- PURCHASED FUNDS - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CHANGES IN NET INTEREST INCOME Note: Changes not due only to volume changes or rate changes are included in the change due to volume column. - -------------------------------------------------------------------------------- INTERNATIONAL OPERATIONS (BASED ON OBLIGOR'S DOMICILE) See also Note 20 titled International Operations on pages 57 and 58 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, which is incorporated herein by reference. SELECTED AVERAGE ASSETS AND LIABILITIES ATTRIBUTABLE TO INTERNATIONAL OPERATIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PERCENT OF INTERNATIONAL RELATED AVERAGE ASSETS AND LIABILITIES TO TOTAL CONSOLIDATED AVERAGE ASSETS - -------------------------------------------------------------------------------- RESERVE FOR CREDIT LOSSES RELATING TO INTERNATIONAL OPERATIONS The Securities and Exchange Commission requires the Corporation to disclose a reserve for credit losses that is applicable to international operations. The above table has been prepared in compliance with this disclosure requirement and is used in determining international operating performance. In 1989, $51.5 million and in 1990 the remaining $13.1 million of the reserve designated for loans to less developed countries was transferred to the general unallocated portion of the reserve for credit losses. The amounts shown in the table should not be construed as being the only amounts that are available for international loan charge-offs, since the entire reserve for credit losses is available to absorb losses on both domestic and international loans. In addition, these amounts are not intended to be indicative of future charge-off trends. - -------------------------------------------------------------------------------- DISTRIBUTION OF INTERNATIONAL LOANS AND DEPOSITS BY TYPE - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CREDIT RISK MANAGEMENT OVERVIEW The Credit Policy function reports to the Chief Financial Officer. Credit Policy provides a system of checks and balances for the Corporation's diverse credit-related activities by establishing and monitoring all credit-related policies and practices throughout the Corporation and ensuring their uniform application. These activities are designed to ensure that credit exposure is diversified on an industry and client basis, thus lessening the overall credit risk to the Corporation. Individual credit authority within the Commercial Banking and Personal Financial Services business units is limited to specified amounts and maturities. Credit decisions involving commitment exposure in excess of the specified individual limits are submitted to the appropriate Group Credit Approval Committee (Committee). Each Committee is chaired by the executive in charge of the area and has a Credit Policy officer as a voting participant. Each Committee's credit approval authority is specified, based on commitment levels, credit ratings and maturities. Credits involving commitment exposure in excess of these group credit limits require, dependent upon the internal credit rating, the approval of the Credit Policy Credit Approval Committee, the head of Credit Policy, or the business unit head. Credit Policy established the Counterparty Risk Management Committee in order to manage the Corporation's counterparty risk more effectively. This committee has sole credit authority for exposure to all foreign banks, certain domestic banks which Credit Policy deems to be counterparties and which do not have commercial credit relationships within the Corporation, and other organizations which Credit Policy deems to be counterparties. Under the auspices of Credit Policy, country exposure limits are reviewed and approved on a country-by-country basis. As part of the Corporation's ongoing credit granting process, internal credit ratings are assigned to each client and credit before credit is extended, based on creditworthiness. Credit Policy performs a semi-annual review of selected significant credit exposures which is designed to identify at the earliest possible stages clients who might be facing financial difficulties. Internal credit ratings are also reviewed during this process. Above average risk loans, which will vary from time to time, receive special attention by both lending officers and Credit Policy. This approach allows management to take remedial action in an effort to deal with potential problems. An integral part of the Credit Policy function is a monthly formal review of all past due and potential problem loans to determine which credits, if any, need to be placed on nonaccrual status or charged off. The provision is reviewed quarterly to determine the amount necessary to maintain an adequate reserve for credit losses. The Corporation's management of credit risk is reviewed by various bank regulatory agencies. The Corporation's independent auditors also perform a review of credit-related procedures, the loan portfolio and other extensions of credit, and the reserve for credit losses as part of their audit of the Corporation's annual financial statements. ALLOCATION OF THE RESERVE FOR CREDIT LOSSES The reserve for credit losses is established and maintained on an overall portfolio basis. However, bank disclosure guidelines issued by the Securities and Exchange Commission request management to furnish a breakdown of the reserve for credit losses by loan category. Thus, in accordance with these disclosure guidelines, breakdowns are provided for the major domestic and foreign loan categories as follows: Allocated Reserve. Credit Policy estimates the amount that is necessary to provide for potential losses relating to specific nonperforming loans. The allocated portion of the reserve totaled $0.2 million at December 31, 1993, which related entirely to specific nonperforming loans. Total nonperforming loans were $27.3 million at December 31, 1993. Unallocated Reserve. The unallocated portion of the reserve is available for unknown losses that are inherent not only in the loan portfolio, but also in other extensions of credit. While the unallocated portion serves to cover specific groups of loans and other extensions of credit that entail higher than average risk, it is considered a general reserve available to absorb all credit- related losses. The unallocated portion of the reserve totaled $145.3 million at December 31, 1993 compared with $134.5 million at December 31, 1992. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- In connection with management's assessment of the unallocated portion of the reserve for credit losses at December 31, 1993, the following groups of loans with specific risk elements were considered: . Management's ongoing review process identified loans with above average credit risk, including nonperforming loans with no specific reserve allocation, which totaled $336.3 million at December 31, 1993. Management assigns risk factors of either 5% to 10% or 5% to 20% to loan categories in this group and ascribed $16.8 million to $49.7 million of the unallocated reserve to this group. . Another risk group identified is composed of commercial real estate loans. Management believes that this group, which totaled $369.4 million at December 31, 1993 (not including $137.1 million of loans with above average credit risk just described), represented a general risk factor of 5% to 10% at year-end and accordingly $18.5 million to $36.9 million of the unallocated reserve was ascribed to this group of loans. . Another risk group identified is composed of highly leveraged credit transactions (HLTs). At December 31, 1993, HLTs, as defined by bank regulatory agencies and not included in the groups of loans discussed above, totaled $42.0 million. Management assigned a general risk factor of 3% to 5% and ascribed $1.3 million to $2.1 million of the unallocated reserve to HLTs. Based on this analysis, $36.6 million to $88.7 million of the unallocated portion of the reserve for credit losses at December 31, 1993 has been ascribed to the above three groups of loans. Management believes the amount of the remaining reserve is adequate to cover both the remaining loan portfolio and other credit-related activities. As required by the Securities and Exchange Commission, the breakdown of the reserve for credit losses at December 31, 1989 through 1993 is presented below. RESERVE FOR CREDIT LOSSES - -------------------------------------------------------------------------------- Loan categories as a percent of total loans as of December 31, 1989 through 1993, are presented below. LOAN CATEGORY TO TOTAL LOANS Loans were classified based on credit risk exposure for 1993, 1992, 1991 and 1990. Loan breakdowns for 1989 were based on industry classifications defined by the Federal Reserve. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The information presented in the Credit Risk Management" section should be read in conjunction with the following information that is incorporated herein by reference to the Corporation's Annual Report to Stockholders for the year ended December 31, 1993: In addition, the following schedules on page 15 of this Form 10-K should be read in conjunction with the Credit Risk Management section: Reserve for Credit Losses Relating to International Operations Distribution of International Loans and Deposits by Type - -------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- INTEREST RATE SENSITIVITY ANALYSIS As described in the Management's Discussion and Analysis of Financial Condition and Results of Operations, in the section titled Liquidity and Rate Sensitivity on pages 37 through 39 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, rate sensitivity arises when interest rates on assets change in a different time period or in a different proportion from that of interest rates on liabilities. The objective of interest rate sensitivity management is to prudently structure the balance sheet so that movements of interest rates on assets and liabilities (adjusted for off-balance sheet hedges) are highly correlated and produce a reasonable net interest margin even in periods of volatile interest rates. Proactive rate sensitivity management for the Corporation is presently focused on the Bank. Other subsidiary banks and foreign offices of the Bank operate under policies that limit the risk of a significant mismatch in their interest sensitivity gap. The Corporate Asset and Liability Policy Committee meets at least monthly to review and determine these rate sensitivity policies. Rate sensitivity management procedures consist of performing net interest income simulations as well as monitoring assets and liabilities that are rate-sensitive within 90 days, 182 days and one year. As a matter of policy, a reasonable balance of rate-sensitive assets and liabilities on a cumulative one year basis is maintained, thus minimizing the risk related to a sustained change in interest rates. Because of daily volatility in our balance sheet items, day-to-day interest sensitivity gaps are not necessarily indicative of the desired position at a specific time or the average experience in the surrounding time period. A negative rate sensitivity gap generally indicates a timing mismatch in that more liabilities than earning assets will be repriced within the period. The economic impact of creating a negative rate sensitivity position depends on the magnitude of actual changes in interest rates relative to the anticipated interest rates. If mismatches are created in a market that anticipates rising interest rates, but the actual increase in rates is lower than expected, net interest income is enhanced by taking the negative rate sensitivity gap. As a result of positions taken as of December 31, 1993, the Corporation's net interest income would be enhanced by not only a decline in interest rates but also by a modest increase. The table below reflects the Corporation's consolidated rate sensitivity position at December 31, 1993. INTEREST RATE SENSITIVITY ANALYSIS - -------------------------------------------------------------------------------- Allocations were made to specific interest sensitivity periods based primarily on the earlier of the repricing or maturity date, with the exception of the net noninterest-related funds component. In this case, the temporary difference between the actual volume at December 31, 1993 and the trend volume was allocated to the "91 Days or Less" interest sensitivity period. The trend volume of net noninterest-related funds was allocated to the "Not Rate Sensitive Within One Year" category. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The following unaudited Consolidated Statement of Condition and Consolidated Statement of Income for The Northern Trust Company were prepared in accordance with generally accepted accounting principles and are provided here for informational purposes. These financial statements should be read in conjunction with the footnotes accompanying the consolidated financial statements of the Corporation, included in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, and incorporated herein by reference on page 24 of this report. THE NORTHERN TRUST COMPANY CONSOLIDATED STATEMENT OF CONDITION - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- THE NORTHERN TRUST COMPANY CONSOLIDATED STATEMENT OF INCOME - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SUPPLEMENTAL ITEM--EXECUTIVE OFFICERS OF THE REGISTRANT DAVID W. FOX Mr. Fox was elected Chairman of the Board of the Corporation and the Bank on April 17, 1990, and Chief Executive Officer of the Corporation and the Bank on December 19, 1989. He held the title of President of the Corporation and the Bank from 1987 through 1993. Mr. Fox, 62, joined the Bank in 1955. J. DAVID BROCK Mr. Brock became an Executive Vice President of the Corporation and the Bank in April 1990. He was Deputy Head of the Subsidiary Banks Group from 1987 to 1989. Currently he is head of Corporate Management Services. Mr. Brock, 49, joined the Bank in 1966. ROBERT G. DEDERICK Mr. Dederick returned to the Corporation and the Bank as an Executive Vice President and Chief Economist in October 1983, after serving as Undersecretary of Commerce for Economic Affairs at the Department of Commerce from 1981 to 1983. Mr. Dederick, 64, first joined the Bank in 1964. DAVID L. EDDY Mr. Eddy became a Senior Vice President of the Corporation and the Bank and Treasurer of the Corporation in 1986. Mr. Eddy, 57, joined the Bank in 1960. BARRY G. HASTINGS Mr. Hastings was elected Vice Chairman of the Corporation and the Bank effective January 1, 1994, and is currently head of Personal Financial Services. He was a Senior Executive Vice President of the Corporation and the Bank from 1992 through 1993 and prior to that time had served as an Executive Vice President of the Bank since 1987, and of the Corporation since 1990. Mr. Hastings, 46, began his career with the Corporation in 1974. JOHN V. N. MCCLURE Mr. McClure was appointed an Executive Vice President of the Corporation and the Bank effective February 15, 1994, and is currently responsible for Strategic Planning and Marketing. Previously, he served as head of the Private Banking Division of Personal Financial Services from 1989 to 1991. He had been a Senior Vice President of the Bank since 1986 and of the Corporation since 1991. Mr. McClure, 42, joined the Bank in 1973. WILLIAM A. OSBORN Mr. Osborn was elected President and Chief Operating Officer of the Corporation and the Bank effective January 1, 1994. He was a Senior Executive Vice President of the Corporation and the Bank from 1992 through 1993 and prior to that time had served as an Executive Vice President of the Bank since 1987, and of the Corporation since 1989. Mr. Osborn, 46, began his career with the Bank in 1970. PERRY R. PERO Mr. Pero is Chief Financial Officer of the Corporation and the Bank and Cashier of the Bank. Mr. Pero is also head of the Risk Management Unit and Chairman of the Corporate Asset and Liability Policy Committee. He became a Senior Executive Vice President of the Corporation and the Bank in 1992 after serving as an Executive Vice President of the Corporation and the Bank since 1987. He was Chairman of the Credit Policy Committee from 1984 to 1988. Mr. Pero, 54, joined the Bank in 1964. JOHN H. ROBINSON Mr. Robinson was appointed Controller of the Bank in 1981 and of the Corporation in 1985. He has been a Senior Vice President of the Bank since 1984 and of the Corporation since 1985. Mr. Robinson, 59, joined the Bank in 1960. PETER L. ROSSITER Mr. Rossiter was appointed General Counsel of the Corporation and the Bank in April 1993. He joined the Corporation and the Bank in 1992 as an Executive Vice President and Associate General Counsel. Mr. Rossiter, 45, had been a partner in the law firm of Schiff Hardin & Waite from 1979 to 1992. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- JOHN S. SUTFIN Mr. Sutfin was elected Vice Chairman of the Corporation and the Bank effective January 1, 1994, and is currently head of Corporate Financial Services. He was a Senior Executive Vice President of the Corporation and the Bank from 1992 through 1993. He was Chief Financial Officer of the Corporation and the Bank in 1987 and 1988. He became an Executive Vice President of the Corporation and the Bank in 1982. Mr. Sutfin, 54, joined the Bank in 1961. WILLIAM S. TRUKENBROD Mr. Trukenbrod was appointed an Executive Vice President of the Corporation and the Bank effective February 15, 1994, and is currently Chairman of the Credit Policy Committee. Previously, he served as head of the U.S. Corporate Group of Commercial Banking from 1987 to 1992. He had been a Senior Vice President of the Bank since 1980 and of the Corporation since 1992. Mr. Trukenbrod, 54, joined the Bank in 1962. There is no family relationship between any of the above executive officers and directors. The positions of Chairman of the Board and Chief Executive Officer, President and Vice Chairman are elected annually by the Board of Directors at the first meeting of the Board of Directors held after each annual meeting of stockholders. The other officers are appointed annually. Officers continue to hold office until their successors are duly elected or unless removed by the Board. ITEM 2

ITEM 2 - -PROPERTIES The executive offices of the Corporation and the Bank are located at 50 South LaSalle Street in the financial district of Chicago. This Bank-owned building is occupied by various divisions of the Corporation's business units and the Bank's safe deposit and leasing companies. Financial services are provided by the Bank at this location. Adjacent to this building are two office buildings in which the Bank leases approximately 316,000 square feet of space for staff divisions of the business units. The Bank also leases approximately 112,000 square feet of a building at 125 South Wacker Drive in Chicago for computer facilities, banking operations and personal banking services. Financial services are also provided by the Bank at two other Chicago area locations, one of which is owned and one of which is leased. In April 1994, the Bank is planning to open a branch office in a leased facility in Highland Park, Illinois. The Bank's trust and banking operations are located in a 465,000 square foot facility at 801 South Canal Street in Chicago. The building is owned by a developer and leased by the Corporation. Space for the Bank's London branch, Edge Act subsidiary and The Northern Company, Canada are leased. The Corporation's other subsidiaries operate from forty locations in Florida, Illinois, Arizona, California, New York and Texas. Of these locations, nine are owned and thirty-one are leased. Detailed information regarding the addresses of these locations can be found on pages 70 and 71 in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, which is incorporated herein by reference. The Corporation believes that the facilities which are owned or leased are suitable and adequate for its business needs. For additional information relating to the Corporation's properties and lease commitments, refer to Note 6 titled Buildings and Equipment and Note 7 titled Lease Commitments on page 50 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, which is incorporated herein by reference. ITEM 3

ITEM 3 - -LEGAL PROCEEDINGS The information called for by this item is incorporated herein by reference to Note 15 titled Contingent Liabilities on page 55 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. In late November, 1993, the U.S. Department of Justice informed the Corporation that the Department is investigating the mortgage lending practices of the Bank and the Corporation's three other Illinois banking subsidiaries, as part of its responsibility to investigate possible discrimination on the basis of race or national origin under the Equal Credit Opportunity Act and the Fair Housing Act. The Corporation intends to cooperate fully in the investigation and has so informed the Department of Justice. ITEM 4

ITEM 4 - -SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART II ITEM 5

ITEM 5 - -MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information called for by this item is incorporated herein by reference to the section of the Consolidated Financial Statistics titled Common Stock Dividend and Market Price on pages 66 and 67 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. Information regarding dividend restrictions of the Corporation's banking subsidiaries is incorporated herein by reference to Note 12 titled Restrictions on Subsidiary Dividends and Loans or Advances on page 53 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 6

ITEM 6 - -SELECTED FINANCIAL DATA The information called for by this item is incorporated herein by reference to the table titled Summary of Selected Financial Data on page 24 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 7

ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information called for by this item is incorporated herein by reference to Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 24 through 39 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 8

ITEM 8 - -FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements of the Corporation and its subsidiaries included in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, are incorporated herein by reference. The section titled Quarterly Financial Data on pages 66 and 67 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, is incorporated herein by reference. ITEM 9

ITEM 9 - -CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART III ITEM 10

ITEM 10 - -DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by Item 10, relating to Directors and Nominees for election to the Board of Directors, is incorporated herein by reference to pages 2 through 5 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. The information called for by Item 10 relating to Executive Officers is set forth in Part I of this Annual Report on Form 10K. ITEM 11

ITEM 11 - -EXECUTIVE COMPENSATION The information called for by this item is incorporated herein by reference to pages 8 and 9 and pages 10 through 16 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. ITEM 12

ITEM 12 - -SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by this item is incorporated herein by reference to pages 6 through 8 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. ITEM 13

ITEM 13 - -CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by this item is incorporated herein by reference to page 9 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART IV Item 14

Item 14 - -Exhibits, Financial Statement Schedules, and Reports on Form 8K Item 14(a)(1) and (2)--Northern Trust Corporation and Subsidiaries List of Financial Statements and Financial Statement Schedules The following financial information is submitted in Item 1 for informational purposes only: Financial Information of The Northern Trust Company (Bank Only): Unaudited Consolidated Statement of Condition--December 31, 1993 and 1992. Unaudited Consolidated Statement of Income--Years Ended December 31, 1993, 1992 and 1991. The following consolidated financial statements of the Corporation and its subsidiaries are submitted in Item 8: Consolidated Financial Statements of Northern Trust Corporation and Subsidiaries: Consolidated Statement of Condition--December 31, 1993 and 1992. Consolidated Statement of Income--Years Ended December 31, 1993, 1992 and 1991. Statement of Changes in Stockholders' Equity--Years Ended December 31, 1993, 1992 and 1991. Consolidated Statement of Cash Flows--Years Ended December 31, 1993, 1992 and 1991. The following financial information is submitted in Item 8: Financial Statements of Northern Trust Corporation (Parent Company Only): Statement of Condition--December 31, 1993 and 1992. Statement of Income--Years Ended December 31, 1993, 1992 and 1991. Statement of Changes in Stockholders' Equity--Years Ended December 31, 1993, 1992 and 1991. Statement of Cash Flows--Years Ended December 31, 1993, 1992 and 1991. The Notes to Financial Statements as of December 31, 1993, submitted in Item 8, pertain to the Bank only information, consolidated financial statements and parent company only information listed above. The Report of Independent Public Accountants submitted in Item 8 pertains to the consolidated financial statements and parent company only information listed above. Financial statement schedules have been omitted for the reason that they are not required or are not applicable. ITEM 14(a)3--EXHIBITS The exhibits listed on the Exhibit Index beginning on page 28 of this Form 10K are filed herewith or are incorporated herein by reference to other filings. ITEM 14(b)--REPORTS ON FORM 8K No reports on Form 8-K were filed by the Corporation during the quarter ended December 31, 1993. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Form 10-K Report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 15,1994 Northern Trust Corporation (Registrant) By: David W. Fox ----------------------------------- DAVID W. FOX Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Form 10-K Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Signature Title --------- ----- David W. Fox Chairman of the Board, --------------------------- David W. Fox Chief Executive Officer and Director Perry R. Pero Senior Executive Vice President --------------------------- Perry R. Pero and Chief Financial Officer John H. Robinson Senior Vice President and Controller --------------------------- John H. Robinson (Chief Accounting Officer) -------- Worley H. Clark Director Robert S. Hamada Director Barry G. Hastings Director Robert A. Helman Director Arthur L. Kelly Director Ardis Krainik Director Robert D. Krebs Director Frederick A. Krehbiel Director ---- By: Peter L. Rossiter ------------------------- William G. Mitchell Director Peter L. Rossiter Attorney-in-Fact William A. Osborn Director William A. Pogue Director Harold B. Smith Director William D. Smithburg Director John S. Sutfin Director Bide L. Thomas Director --------- Date: March 15,1994 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT INDEX The following Exhibits are filed herewith or are incorporated herein by reference. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- *Prior Filings (File No. 0-5965, except as noted) ------------------------------------------------ (1) Annual Report on Form 10-K for the year ended December 31, 1992 (2) Registration Statement on Form S-4 dated February 10, 1994 (Reg. No. 33-52219) (3) Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 (4) Quarterly Report on Form 10-Q for the quarter ended September 30, 1986 (5) Annual Report on Form 10-K for the year ended December 31, 1986 (6) Annual Report on Form 10-K for the year ended December 31, 1988 (7) Form 8-K dated January 26, 1989 (8) Annual Report on Form 10-K for the year ended December 31, 1989 (9) Form 8-A dated October 30, 1989 (10) Annual Report on Form 10-K for the year ended December 31, 1990 (11) Annual Report on Form 10-K for the year ended December 31, 1991 (12) Quarterly Report on Form 10-Q for the quarter ended March 31,1992 (13) Form 8-K dated February 20, 1991 Upon written request to Peter L. Rossiter, Secretary, Northern Trust Corporation, 50 South LaSalle Street, Chicago, Illinois 60675, copies of exhibits listed above are available to Northern Trust Corporation stockholders by specifically identifying each exhibit desired in the request. Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the Corporation hereby agrees to furnish the Commission, upon request, any instrument defining the rights of holders of long-term debt of the Corporation not filed as an exhibit herein. No such instrument authorizes long-term debt securities in excess of 10% of the total assets of the Corporation and its subsidiaries on a consolidated basis. - --------------------------------------------------------------------------------

46080_1993.txt

46080

1993

ITEM 1. BUSINESS -------- (a) General Development of Business ------------------------------- The Company designs, manufactures and markets a diverse line of toy products and related items including games and puzzles, preschool, boys' action and girls' toys, dolls, plush products and infant products, including infant apparel, throughout the world. The Company also licenses various tradenames, characters and other property rights for use in connection with the sale by others of noncompeting toys and non-toy products. Except as expressly indicated or unless the context otherwise requires, as used herein, the "Company" means Hasbro, Inc., a Rhode Island corporation organized on January 8, 1926, and its subsidiaries. (b) Description of Business Products -------------------------------- The Company designs, manufactures and markets a diverse line of toy products and related items categorized for marketing purposes as follows: (i) Infant and Preschool -------------------- The Playskool line of products is specifically designed for preschool children, toddlers and infants. The Playskool toy line includes such well known products as Lincoln Logs(R), Tinkertoys(R), Mr. Potato Head(R), In-Line Skates, Play-Doh(R), Raggedy Ann(R) and Raggedy Andy(R) rag dolls, Magic Tea Party(TM), the "Busy" line of toys and electronic items including Alphie(R) II, Talking Barney(R) and Teddy Ruxpin(R). The line also includes toys utilizing the "Sesame Street(R)" character motifs sold domestically and internationally by the Company under licenses from The Children's Television Workshop. New items for 1994 include the Playskool Dollhouse Stable, Magic Smoking Grill(TM), Cool Tools(TM) and 4 in 1 Busy(TM) Center. Playskool's line of infant and juvenile items consists of products for very young children, including the Pur(R) line of silicone nipples and pacifiers, bibs and other infant accessories such as the Hugger(R) toothbrush, a full line of health care and safety products, Tommee Tippee(TM) training cups and feeding items, water-filled teething rings, soft toys, rattles, inflatable and squeeze toys and infant apparel including the Scootees(R) line of soft shoes for babies. New products in 1994 include the 1-2-3 High Chair(TM). (ii) Promotional Brands ------------------ The Hasbro Toy product line includes innovative new products, traditional classics and contemporary favorites for both boys and girls. In the girls' toy category it offers items including the Cabbage Patch Kids(R) family of dolls and accessories, and the Puppy Surprise(R) line of products. In boys' toys it offers such products as G.I. Joe(R), The TransFormers(R) and the Tonka(R) line of trucks and vehicles, including the Electronic Talk'n Play(TM) Fire Truck(TM). It also offers activity items for both girls and boys including Fashion Plates(R), Fashion Faces(TM), the Fantastic Flowers(R) flower making machine and the Real Power Toolshop(TM). Among its new introductions for 1994 in the girls' line are the Fantastic Sticker Maker(TM), Treasure Rocks(TM) and the Make-up Beauty(TM) doll. In boys' toys, new introductions include the Stargate(TM) and Street Fighter(TM) action figures. Kenner Products offers a wide range of products. A leader in toys tied to entertainment properties, Kenner's offerings for 1994 include The Shadow(TM), Jurassic Park(TM), Batman(R), Aliens(TM) and Predator(TM) action figures and accessories, as well as Shaq Attack(TM) and Starting Lineup(R) sports action figures. Other boys' toys include the CLAW(TM) monster vehicles, Carzillas(TM) motorized vehicles and the Nerf(R) line of soft action play equipment. For girls, Kenner markets Baby Check-Up(R), Baby All Gone(R) and the Baby Sitters Club(R) dolls, Beethoven's 2nd(TM) plush pups and the Littlest Pet Shop(TM) figures and playsets. In addition, Kenner offers a selection for at home activity play including the E Z 2 Do(TM) line of items, the Spirograph(R) family of products, the Colorblaster(TM) series of design toys and the classic Easy Bake(R) Oven. (iii) Games ----- Milton Bradley manufactures and sells quality games and puzzles, including board, strategy and word games, skill and action games and travel games. It maintains a diversified line of more than 200 games and puzzles for children and adults. Its staple items include Battleship(R), The Game of Life(R), Scrabble(R), Chutes and Ladders(R), Candy Land(R), Lite-Brite(R), Trouble(R), Mousetrap(R), Operation(R), Hungry Hungry Hippos(R), Connect Four(R), Twister(R) and Big Ben(R) Puzzles. The Company also manufactures and sells games for the entire family, including such games as Yahtzee(R), Parcheesi(R), Aggravation(R), Jenga(R) and Scattergories(R). Games added to the Milton Bradley line for 1994 include 13 Dead End Drive(TM), Don't Get Rattled(TM) and Slobberin' Sam(TM). Parker Brothers markets a full line of games for families, children and adults. Its classic line of family board games includes Monopoly(R), Clue(R), Sorry!(R), Risk(R), Boggle(R), Ouija(R) and Trivial Pursuit(R). Some of these classics have been in the Parker Brothers' line for more than 50 years. The Company also markets traditional card games such as Mille Bornes(R), Rook(R), Rack-O(R), Old Maid and Go Fish. Its line of travel games includes travel editions of Monopoly(R) Junior, Clue(R), Sorry!(R) and Boggle(R) Jr. New to the Parker Brothers' line in 1994 are Willy Go Boom(TM), Swinging Snakes(TM), Bottle Topps(R) and, in the electronic talking game line, Sounds of Fun(TM), a new item featuring licensed characters from Disney's The Lion King. (iv) International ------------- The Company conducts its international operations through subsidiaries which sell a representative range of the products marketed in the United States together with some items which are sold only internationally. Products sold by subsidiaries in the United Kingdom, The Netherlands, Germany, France, Italy, Spain, Portugal, Belgium, Austria, Switzerland, Hungary and Greece are manufactured at plants located in Ireland, The Netherlands and Spain and also supplied by a Hong Kong subsidiary. In early 1994, the Company announced the planned closure of its manufacturing operation in The Netherlands with the transfer of its production to plants in Ireland and Spain. Certain products sold by the Canadian subsidiary are assembled in Canada, although the U.S. and Mexican operations and a Hong Kong subsidiary supply some component parts as well as finished goods. The Mexican marketing unit sells products supplied primarily by the domestic operations and a Hong Kong subsidiary. The Company also has a manufacturing operation in Mexico which supplies certain products, primarily for distribution through the North American operations. The New Zealand and Australian subsidiaries sell products manufactured by the New Zealand unit and also supplied by a Hong Kong subsidiary. The Company also markets certain products, primarily supplied by a Hong Kong subsidiary, in Japan, Hong Kong, Taiwan, China and other areas in the Far East. A Hong Kong subsidiary sources product for the Company's U.S. and foreign operations working primarily through unrelated manufacturers in various Far East countries. The Company also has small investments in joint ventures in India and The Peoples Republic of China which manufacture and sell products to both the Company and non-affiliated customers. In early 1993, the Company established a new Hong Kong subsidiary which markets directly to retailers a line of high quality, low priced toys, games and related products, primarily on a direct import basis. In addition, certain toy products are licensed to other toy companies to manufacture and sell product in selected foreign markets where the Company does not otherwise have a presence. Working Capital Requirements ---------------------------- The Company's shipments of products are greater in each of the third and fourth quarters than shipments in each of the first and second quarters. During the past several years, the Company has experienced a gradual shift in its revenue pattern wherein the second half of the year has grown in significance to its overall business and within that half, the fourth quarter has become more prominent and the Company expects this trend to continue. Production has been financed historically by means of short-term borrowings which reach peak levels during September through November of each year when receivables also generally reach peak levels. The toy business is also characterized by customer order patterns which vary from year to year largely because of differences each year in the degree of consumer acceptance of a product line, product availability, marketing strategies and inventory levels of retailers and differences in overall economic conditions. As a result, comparisons of unshipped orders on any date with those at the same date in a prior year are not necessarily indicative of sales for that entire given year. In addition, as more retailers move to just- in-time inventory management practices, fewer orders are being placed in advance of shipment and more orders, when placed, are for immediate delivery. The Company's unshipped orders at March 11, 1994 and March 12, 1993 were approximately $205,000,000 and $265,000,000, respectively. Also, it is a general industry practice that orders are subject to amendment or cancellation by customers prior to shipment. The backlog at any date in a given year can be affected by programs the Company may employ to induce its customers to place orders and accept shipments early in the year. This method is a general industry practice. The programs the Company is employing to promote sales in 1994 are not substantially different from those employed in 1993. As part of the traditional marketing strategies of the toy industry, many sales made early in the year are not due for payment until the fourth quarter, thus making it necessary for the Company to borrow significant amounts pending collection of these receivables. The Company relies on internally generated funds and short-term borrowing arrangements, including commercial paper, to finance its working capital needs. Currently, the Company has available to it unsecured lines of credit, which it believes are adequate, of approximately $1,550,000,000 including a $500,000,000 revolving credit agreement with a group of banks which is also used as a back-up to commercial paper issued by the Company. Research and Development ------------------------ The Company's business is based to a substantial extent on the continuing development of new products and the redesigning of existing items for continuing market acceptance. In 1993, 1992 and 1991, approximately $125,566,000, $109,655,000 and $78,983,000, respectively, were incurred on activities relating to the development, design and engineering of new products and their packaging (including items brought to the Company by independent designers) and to the improvement or modification of ongoing products. Much of this work is performed by the Company's staff of designers, artists, model makers and engineers. In addition to its own staff, the Company deals with a number of independent toy designers for whose designs and ideas the Company competes with many other toy manufacturers. Rights to such designs and ideas, when acquired by the Company, are usually exclusive under agreements requiring the Company to pay the designer a royalty on the Company's net sales of the item. These designer royalty agreements in some cases provide for advance royalties and minimum guarantees. The Company also produces a number of toys under trademarks and copyrights utilizing the names or likenesses of Sesame Street, Walt Disney, Barney(R) and other familiar movie, television and comic strip characters. Licensing fees are paid as a royalty on the Company's net sales of the item. Licenses for the use of characters are generally exclusive for specific products or product lines in specified territories. In many instances, advance royalties and minimum guarantees are required by character license agreements. Marketing and Sales ------------------- The Company's products are sold nationally and internationally to a broad spectrum of customers including wholesalers, distributors, chain stores, discount stores, mail order houses, catalog stores, department stores and other retailers, large and small. The Company and its subsidiaries employ their own sales forces which account for nearly all of the sales of their products. Remaining sales are generated by independent distributors who sell the Company's products principally in areas of the world where the Company does not otherwise maintain a presence. The Company maintains showrooms in New York and selected other major cities world-wide as well as at most of its subsidiary locations. In the United States and Canada, the Company had more than 2,000 customers, most of which are wholesalers, distributors or large chain stores, although there has been significant consolidation at the retail level over the last several years. In other countries, the Company has in excess of 20,000 customers, many of which are individual retail stores. During 1993, sales to the Company's two largest customers represented 20% and 11%, respectively, of consolidated net revenues. The Company advertises its toy and game products extensively on television. The Company generally advertises selected items in its product groups in a manner designed to promote the sale of other specific items in those product groups. Each year, the Company introduces its new products at its New York City showroom at the time of the American International Toy Fair in February. It also introduces some of its products to major customers during the last half of the prior year. In 1993, the Company spent approximately $383,918,000 in advertising, promotion and marketing programs compared to $377,219,000 in 1992 and $325,282,000 in 1991. Manufacturing and Importing --------------------------- The Company manufactures its products in facilities within the United States and various foreign countries (see "Properties"). Most of its toy products are manufactured from basic raw materials such as plastic and cardboard which are readily available. The Company's manufacturing process includes injection molding, blow molding, metal stamping, printing, box making, assembly and wood processing. The Company purchases certain components and accessories used in its toys and some finished items from domestic manufacturers as well as from manufacturers in the Far East, which is the largest manufacturing center of toys in the world, and other foreign countries. The Company believes that the manufacturing capacity of its facilities and the supply of components, accessories and completed products which it purchases from unaffiliated manufacturers is adequate to meet the foreseeable demand for the products which it markets. The Company's reliance on external sources of manufacturing can be shifted, over a period of time, to alternative sources of supply for products it sells, should such changes be necessary. However, if the Company is prevented from obtaining products from a substantial number of its current Far East suppliers due to political, labor and other factors beyond its control, the Company's operations would be disrupted while alternative sources of product were secured. In addition, the loss by the People's Republic of China of "most favored nation" trading status as granted by the United States, could significantly increase the cost of the Company's products imported into the United States from China The Company makes its own tools and fixtures but purchases dies and molds principally from independent domestic and foreign sources. Several of the Company's domestic production departments operate on a two-shift basis and its molding departments operate on a continuous basis through most of the year. Competition ----------- The Company's business is highly competitive. The Company competes with several large and hundreds of small domestic and foreign manufacturers in such areas as design, development and marketing of product. The Company is the largest toy company in the world. Employees --------- The Company employs approximately 12,500 persons worldwide, approximately 8,000 of whom are located in the United States. Trademarks, Copyrights and Patents ---------------------------------- The Company's products are protected, for the most part, by registered trademarks, copyrights and patents to the extent that such protection is available and meaningful. The loss of such rights concerning any particular product would not have a material adverse effect on the Company's business, although the loss of such protection for a number of significant items might have such an effect. Government Regulation --------------------- The Company's toy products sold in the United States are subject to the provisions of the Consumer Product Safety Act (the "CPSA"), The Federal Hazardous Substances Act (the "FHSA") and the regulations promulgated thereunder. The CPSA empowers the Consumer Product Safety Commission (the "CPSC") to take action against hazards presented by consumer products, including the formulation and implementation of regulations and uniform safety standards. The CPCS has the authority to seek to declare a product "a banned hazardous substance" under the CPSA and to ban it from commerce. The CPSC can file an action to seize and condemn an "imminently hazardous consumer product" under the CPSA and may also order equitable remedies such as recall, replacement, repair or refund for the product. The FHSA provides for the repurchase by the manufacturer of articles which are banned. Similar laws exist in some states and cities and in Canada, Australia and Europe. The Company maintains a laboratory which has testing and other procedures intended to maintain compliance with the CPSA and FHSA. Notwithstanding the foregoing, there can be no assurance that all of the Company's products are or will be hazard free. While the Company neither has had any material product recalls nor knows of any currently, should any such problem arise, it could have an effect on the Company depending on the product and could affect sales of other products. The Children's Television Act of 1990 and the rules promulgated thereunder by the Federal Communications Commission as well as the laws of certain foreign countries place certain limitations on television commercials during children's programming. (c) Financial Information About Foreign and Domestic Operations ----------------------------------------------------------- and Export Sales ---------------- The information required by this item is included in note 16 of Notes to Consolidated Financial Statements in Exhibit 13 to this Report and is incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES ---------- Lease Square Type of Expiration Location Use Feet Possession Dates - -------- --- ------ ---------- ---------- Rhode Island - ------------ Pawtucket Executive Offices & Product Development 343,000 Owned(1) -- Pawtucket Marketing Office 23,000 Owned -- Pawtucket Manufacturing 306,500 Owned -- Central Falls Manufacturing 261,500 Owned -- West Warwick Warehouse 402,000 Leased 1994 East Providence Administrative & Sales Offices 120,000 Leased 1994 Massachusetts - ------------- East Longmeadow Office, Manufacturing & Warehouse 1,147,500 Owned -- East Longmeadow Office, Manufacturing & Warehouse 254,400 Owned -- East Longmeadow Warehouse 500,000 Leased 1998 Beverly Office 100,000 Owned -- Salem Manufacturing & Warehouse 344,000 Owned -- Danvers Warehouse 125,000 Leased 1996 Holyoke Warehouse 15,000 Leased 1994 New Jersey - ---------- Northvale Office & Manufacturing 75,000 Leased 2002 Wayne Manufacturing 65,000 Leased 1995 New York - -------- New York Office & Showroom 70,300 Leased 2000 New York Office & Showroom 32,300 Leased 1999 Arcade Manufacturing 15,000 Leased 1998 Amsterdam Manufacturing 297,400 Owned -- Orangeburg Warehouse 51,000 Leased 2002 Ohio - ---- Cincinnati Office 161,000 Leased 2007 Cincinnati Warehouse 33,000 Leased 1999 Lease Square Type of Expiration Location Use Feet Possession Dates - -------- --- ------ ---------- ---------- Pennsylvania - ------------ Lancaster Warehouse 150,000 Owned(2) -- South Carolina - -------------- Easley Manufacturing 31,500 Leased 1997 Easley Manufacturing 75,000 Owned -- Easley Manufacturing 29,000 Owned -- Texas - ----- El Paso Manufacturing & Warehouse 373,000 Owned -- El Paso Manufacturing & Warehouse 487,000 Leased 1998 El Paso Warehouse 48,800 Leased 1994 Vermont - ------- Fairfax Manufacturing 43,000 Owned -- Washington - ---------- Seattle Office & Warehouse 125,100 Leased(3) 1994 Australia - --------- Rydalmere Office & Warehouse 68,000 Leased 1994 Rydalmere Office & Warehouse 22,300 Leased 1994 Austria - ------- Vienna Office 2,505 Leased 1997 Belgium - ------- Brussels Office & Showroom 16,700 Leased 1995 Canada - ------ Montreal Office, Manufacturing & Showroom 133,900 Leased 1997 Montreal Warehouse 88,100 Leased 1997 Boucherville Warehouse 110,000 Leased 1994 Mississauga Sales Office & Showroom 16,300 Leased 1998 Peoples Republic of China - ------------------------- Guangzhou Warehouse 32,900 Leased 1994 Guangzhou Manufacturing 22,900 Leased 1995 Lease Square Type of Expiration Location Use Feet Possession Dates - -------- --- ------ ---------- ---------- England - ------- Uxbridge Office & Showroom 94,500 Leased 2013 Coalville Office & Warehouse 141,200 Owned -- France - ------ Le Bourget du Lac Office, Manufacturing & Warehouse 108,300 Owned -- Savoie Technolac Office 33,500 Owned -- Pantin Office 20,900 Leased 2001 Creutzwald Warehouse 108,700 Owned -- Germany - ------- Fuerth Office & Warehouse 28,400 Owned -- Soest Warehouse 78,800 Owned -- Dietzenbach Office 30,400 Leased 1998 Greece - ------ Athens Office & Warehouse 134,400 Leased 1995 Zakynthos Island Manufacturing 57,500 Owned -- Athens Office 26,900 Leased 1995 Hong Kong - --------- Kowloon Office 36,700 Leased 1994 Kowloon Office & Warehouse 14,900 Leased 1994 Harbour City Office 11,000 Leased 1996 Hungary - ------- Budapest Office 3,700 Leased 1996 Ireland - ------- Waterford Office, Manufacturing & Warehouse 184,400 Owned -- Italy - ----- Milan Office & Showroom 12,100 Leased 1998 Japan - ----- Tokyo Office 10,800 Leased 1995 Lease Square Type of Expiration Location Use Feet Possession Dates - -------- --- ------ ---------- ---------- Malaysia - ------- Selangor Darul Ehsan Office 6,800 Leased 1995 Mexico - ------ Tijuana Office & Manufacturing 144,000 Leased 1995 Tijuana Warehouse 45,000 Leased 1994 Tijuana Warehouse 69,800 Leased 1994 Reyna Office 61,000 Leased 1996 Espana Warehouse 53,700 Leased 1996 Venados Warehouse 59,100 Leased 1995 The Netherlands - --------------- Ter Apel Office, Manufacturing & Warehouse 139,300 Owned -- Utrecht Sales Office & Showroom 17,000 Leased 1996 Emmen Warehouse 40,800 Leased 1994 Emmen Warehouse 21,500 Leased 1994 New Zealand - ----------- Auckland Office, Manufacturing & Warehouse 110,900 Leased 2005 Singapore - --------- Singapore Office & Warehouse 12,900 Leased 1994 Spain - ----- Valencia Office, Manufacturing & Warehouse 115,100 Leased 1999 Valencia Office 46,300 Leased 1995 Valencia Manufacturing & Warehouse 161,700 Leased 1997 Valencia Warehouse 94,400 Owned -- Valencia Warehouse 38,700 Leased 1994 Valencia Warehouse 43,000 Leased 1996 Switzerland - ----------- Mutschellen Office & Warehouse 23,400 Leased 1994 Taiwan - ------ TPE County Warehouse 9,800 Leased 1996 Wales - ----- Newport Warehouse 76,000 Leased 2003 Newport Warehouse 52,000 Owned -- (1) Although this property is leased pursuant to industrial revenue bond financing, the Company has an option to purchase the property for $1 at any time upon making all rental and other payments required under terms of the lease. (2) In addition, the Company owns an additional 316,000 square feet at this location which is not currently being utilized and is included in the unused property noted below. (3) In addition, at this location the Port of Seattle operates a 400,000 square foot distribution facility pursuant to an agreement with the Company. In addition to the above listed facilities, the Company either owns or leases various other properties approximating 200,000 square feet which are utilized in its operations. The Company also either owns or leases an aggregate of approximately 650,000 square feet not currently being utilized in its operations. Most of these properties are being leased, subleased or offered for sublease or sale. A portion of this space not used in the Company's operations represent facilities used by the Tonka Corporation units prior to their acquisition by the Company and integration into its existing operations. The foregoing properties consist, in general, of brick, cinder block or concrete block buildings which the Company believes are in good condition and well maintained. The Company is continuing the renovation of its principal offices in Pawtucket, Rhode Island. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS ----------------- The Company is currently proceeding with an environmental clean-up at its former manufacturing facility in Lancaster, Pennsylvania. This facility, a portion of which is being utilized for limited warehousing operations in 1994, was acquired in 1986 from the CBS Toys Division of CBS Inc. (CBS) in conjunction with the purchase of rights to selected products formerly marketed by CBS. CBS has acknowledged its responsibility with respect to some areas of contamination and some of the remedial actions needed to facilitate this clean- up, but has not yet funded any of these obligations. The Company believes that CBS has full responsibility and is engaged in legal action against CBS to recover all of the costs associated with the environmental clean-up. While it is impossible to assure the outcome of the court action, the Company believes that it will prevail. The Consolidated Financial Statements reflect, pursuant to Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, certain costs that the Company expects to ultimately recover from CBS. Preston Robert Tisch, a director of the Company, is also a director of CBS and President and Co-Chief Executive Officer of Loews Corporation, a major shareholder of CBS. By virtue of the foregoing, Mr. Tisch may be deemed to have an interest adverse to the Company with respect to the above-described action. The Company is party to certain other legal proceedings involving routine litigation incidental to the Company's business, none of which, individually or in the aggregate, is deemed to be material. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- None. EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------ The following persons are the executive officers of the Company and its subsidiaries and divisions. Such executive officers are elected annually. The position and office listed below are the principal position(s) and office(s) held by such person with the Company, subsidiary or divisions employing such person. The persons listed below generally also serve as officers and directors of the Company's various subsidiaries at the request and convenience of the Company. Period Serving in Current Name Age Position and Office Held Position - ---- --- ------------------------ ---------- Alan G. Hassenfeld (1) 45 Chairman of the Board, President and Chief Executive Officer Since 1989 Barry J. Alperin (2) 53 Vice Chairman Since 1990 George R. Ditomassi, Jr.(3) 59 Chief Operating Officer, Games and International Since 1990 Alfred J. Verrecchia (4) 51 Chief Operating Officer, Domestic Toy Operations Since 1990 John T. O'Neill (5) 49 Executive Vice President and Chief Financial Officer Since 1989 Norman C. Walker (6) 55 Executive Vice President and President, International Since 1990 Lawrence H. Bernstein (7) 51 Executive Vice President and President, Hasbro Toy Since 1989 Dan D. Owen (8) 45 President, Playskool Since 1990 Bruce L. Stein (9) 39 President, Kenner Products Since 1990 Robert F. S. Wann (10) 43 President, Parker Brothers Since 1992 E. David Wilson (11) 56 President, Milton Bradley Since 1990 Richard B. Holt (12) 52 Senior Vice President and Controller Since 1992 Period Serving in Current Name Age Position and Office Held Position - ---- --- ------------------------ ---------- Donald M. Robbins (13) 58 Senior Vice President General Counsel and Corporate Secretary Since 1992 Phillip H. Waldoks (14) 41 Senior Vice President- Corporate Legal Affairs Since 1992 Russell L. Denton (15) 49 Vice President and Treasurer Since 1989 (1) Prior thereto, President and Chief Operating Officer. (2) Prior thereto, Co-Chief Operating Officer from 1989 to 1990; prior thereto, Executive Vice President. (3) Prior thereto, Group Vice President and President, Milton Bradley. (4) Prior thereto, Co-Chief Operating Officer from 1989 to 1990; prior thereto, Executive Vice President and President, Hasbro Manufacturing Services Division. (5) Prior thereto, Senior Vice President - Finance, Chief Financial Officer and Treasurer during 1989; prior thereto, Senior Vice President - Finance and Chief Financial Officer. (6) Prior thereto, Senior Vice President and President - European Operations. (7) Prior thereto, Senior Vice President - Sales. (8) Prior thereto, Senior Vice President - Sales, Playskool. (9) Prior thereto, Executive Vice President - Marketing and Design, Kenner Products. (10) Prior thereto, Chief Operating Officer, Parker Brothers from 1991 to 1992; prior thereto, Executive Vice President - Marketing and R & D, Playskool from 1990 to 1991; prior thereto, Senior Vice President - Marketing, Playskool. (11) Prior thereto, Senior Vice President - Sales, Milton Bradley. (12) Prior thereto, Vice President and Controller. (13) Prior thereto, Vice President/General Counsel and Secretary. (14) Prior thereto, Vice President - Corporate Legal Affairs. (15) Prior thereto, independent financial consultant. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED ----------------------------------------------------- STOCKHOLDER MATTERS ------------------- The information required by this item is included in Market for the Registrant's Common Equity and Related Stockholder Matters in Exhibit 13 to this Report and is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ----------------------- The information required by this item is included in Selected Financial Data in Exhibit 13 to this Report and is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ----------------------------------------------------------- AND RESULTS OF OPERATIONS ------------------------- The information required by this item is included in Management's Review in Exhibit 13 to this Report and is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- The information required by this item is included in Financial Statements and Supplementary Data in Exhibit 13 to this Report and is incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ----------------------------------------------------------- AND FINANCIAL DISCLOSURE ------------------------ None. PART III ITEMS 10, 11, 12 and 13. The information required by these items is included in registrant's definitive proxy statement for the 1994 Annual Meeting of Shareholders and is incorporated herein by reference, except that the sections under the headings (a) "Comparison of Five Year Cumulative Total Shareholder Return Among Hasbro, S&P 500 and Russell 1000 Consumer Discretionary Economic Sector" and accompanying material and (b) "Report of the Compensation and Stock Option Committee of the Board of Directors" in the definitive proxy statement shall not be deemed "filed" with the Securities and Exchange Commission or subject to Section 18 of the Securities Exchange Act of 1934. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K --------------------------------------------------------------- (a) Financial Statements, Financial Statement Schedules and Exhibits ---------------------------------------------------------------- (1) Financial Statements -------------------- Included in PART II of this report: Independent Auditors' Report Consolidated Balance Sheets at December 26, 1993 and December 27, 1992 Consolidated Statements of Earnings for the Three Fiscal Years Ended in December 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity for the Three Fiscal Years Ended in December 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Three Fiscal Years Ended in December 1993, 1992 and 1991 Notes to Consolidated Financial Statements (2) Financial Statement Schedules ----------------------------- Included in PART IV of this Report: Report on Financial Statement Schedules of Independent Certified Public Accountants For the Three Fiscal Years Ended in December 1993, 1992 and 1991: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts and Reserves Schedule IX - Short-Term Borrowings Schedules other than those listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. (3) Exhibits -------- The Company will furnish to any shareholder, upon written request, any exhibit listed below upon payment by such shareholder to the Company of the Company's reasonable expenses in furnishing such exhibit. Exhibit - ------- 3. Articles of Incorporation and Bylaws (a) Restated Articles of Incorporation of the Company. (Incorporated by reference to Exhibit (c)(2) to the Company's Current Report on Form 8-K, dated July 15, 1993, File No. 1-6682.) (b) Amended and Restated Bylaws of the Company. (Incorporated by reference to Exhibit (c)(3) to the Company's Current Report on Form 8-K, dated July 15, 1993, File No. 1-6682.) 4. Instruments defining the rights of security holders, including indentures. (a) Revolving Credit Agreement, dated as of June 22, 1992, among the Company, certain banks (the "Banks"), and The First National Bank of Boston, as agent for the Banks (the "Agent"). (Incorporated by reference to Exhibit 4(a) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (b) Subordination Agreement, dated as of June 22, 1992, among the Company, certain subsidiaries of the Company, and the Agent. (Incorporated by reference to Exhibit 4(b) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) 10. Material Contracts (a) Agreement and Plan of Merger, dated January 31, 1991, by and among the Company, HIAC III Corp., a subsidiary of the Company ("Sub") and Tonka Corporation ("Tonka"). (Incorpo- rated by reference to Exhibit (c)(1) to the Company's Tender Offer Statement on Schedule 14D-1, dated February 6, 1991, relating to the Common Stock of Tonka.) (b) Amendment, dated April 17, 1991 to Agreement and Plan of Merger among the Company, Sub and Tonka. (Incorporated by reference to Exhibit (c)(4) to Amendment No. 9 to the Company's Tender Offer Statement on Schedule 14D-1, dated April 18, 1991, relating to the Common Stock of Tonka.) (c) Letter Agreement, dated April 29, 1991, among the Company, Sub and Tonka. (Incorporated by reference to Exhibit (c)(8) to Amendment No. 11 to the Company's Tender Offer Statement on Schedule 14D-1, dated April 29, 1991, relating to the Common Stock of Tonka.) (d) Shareholder Rights Agreement, dated May 17, 1983, between Warner Communications Inc. ("Warner") and the Company. (Incorporated by reference to Exhibit 3 to the Statement on Schedule 13D, dated May 17, 1983, relating to the Company's Common Stock.) (e) Amendment No. 1 to Shareholder Rights Agreement, dated as of December 1, 1985, between Warner and the Company. (Incorporated by reference to Exhibit 9(b) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 29, 1985, File No. 1-6682.) (f) Exchange Agreement, dated as of December 1, 1985, between the Company and Warner. (Incorporated by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 29, 1985, File No. 1-6682.) (g) Lease between Hasbro Canada Inc. (formerly named Hasbro Industries (Canada) Ltd.) and Central Toy Manufacturing Co. ("Central Toy"), dated December 23, 1976. (Incorporated by reference to Exhibit 10.15 to the Company's Registration Statement on Form S-14, File No. 2-92550.) (h) Lease between Hasbro Canada Inc. and Central Toy, together with an Addendum thereto, each dated as of May 1, 1987. (Incorporated by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1987, File No. 1-6682.) Executive Compensation Plans and Arrangements (i) Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-8, File No. 2-78018.) (j) Amendment No. 1 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(l) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 28, 1986, File No. 1-6682.) (k) Amendment No. 2 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(n) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1987, File No. 1-6682.) (l) Amendment No. 3 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 25, 1988, File No. 1-6682.) (m) Amendment No. 4 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(s) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1989, File No. 1-6682.) (n) Form of Incentive Stock Option Agreement for incentive stock options. (Incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1987, File No. 1-6682.) (o) Form of Non Qualified Stock Option Agreement under the Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(q) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 25, 1988, File No. 1-6682.) (p) Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10.10 to the Company's Registration Statement on Form 14, File No. 2-92550.) (q) Amendment No. 1 to Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10(j) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 28, 1986, File No. 1-6682.) (r) Amendment No. 2 to Non Qualified Stock Option Plan. (Incorporated by reference to Appendix A to the Company's definitive proxy statement for its 1987 Annual Meeting of Shareholders, File No. 1-6682.) (s) Amendment No. 3 to Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10(l) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1989, File No. 1-6682.) (t) Form of Stock Option Agreement (For Employees) under the Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10(t) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (u) 1992 Stock Incentive Plan (Incorporated by reference to Appendix A to the Company's definitive proxy statement for its 1992 Annual Meeting of Shareholders, File No. 1-6682.) (v) Form of Stock Option Agreement (For Employees) under the 1992 Stock Incentive Plan. (Incorporated by reference to Exhibit 10(v) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (w) Form of Stock Option Agreement (For Participants in the Long Term Incentive Program) under the 1992 Stock Incentive Plan. (Incorporated by reference to Exhibit 10(w) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (x) Form of Employment Agreement, dated July 5, 1989, between the Company and seven executive officers of the Company. (Incorporated by reference to Exhibit 10(v) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1989, File No. 1-6682.) (y) Change in Control Agreement dated as of December 13, 1990 between Tonka and Bruce L. Stein. (Incorporated by reference to Exhibit 10.2 to Tonka's Annual Report on Form 10-K for the Fiscal Year Ended December 29, 1990, File No. 1-4683.) (z) Letter Agreement between Tonka and Bruce L. Stein, dated March 21, 1994. (aa) Hasbro, Inc. Retirement Plan for Directors. (Incorporated by reference to Exhibit 10(x) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 30, 1990, File No. 1-6682.) (bb) Form of Director's Indemnification Agreement. (Incorporated by reference to Appendix B to the Company's definitive proxy statement for its 1988 Annual Meeting of Shareholders, File No. 1-6682.) (cc) Hasbro, Inc. Deferred Compensation Plan for Non-Employee Directors. (dd) Hasbro, Inc. Stock Option Plan for Non-Employee Directors. (Incorporated by reference to Appendix A to the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, File No. 1-6682.) (ee) Hasbro, Inc. Senior Management Annual Performance Plan. (Incorporated by reference to Appendix B to the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, File No.1-6682.) 11. Statement re computation of per share earnings 12. Statement re computation of ratios 13. Selected information contained in Annual Report to Shareholders 22. Subsidiaries of the registrant 24. Consents of experts and counsel (a) Consent of KPMG Peat Marwick. The Company agrees to furnish the Securities and Exchange Commission, upon request, a copy of each agreement with respect to long-term debt of the Company, the authorized principal amount of which does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K ------------------- A current report on Form 8-K dated February 10, 1994 was filed to announce the Company's results of the quarter and year ended December 26, 1993. Consolidated statements of earnings (without notes) for the quarter and year ended December 26, 1993 and December 27, 1992 and consolidated condensed balance sheets (without notes) as of said dates were also filed. (c) Exhibits -------- See (a)(3) above (d) Financial Statement Schedules ----------------------------- See (a)(2) above INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Hasbro, Inc.: Under date of February 8, 1994, we reported on the consolidated balance sheets of Hasbro, Inc. and subsidiaries as of December 26, 1993 and December 27, 1992 and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the fiscal years in the three-year period ended December 26, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related supporting schedules listed in Item 14 (a)(2). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such schedules when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ KPMG Peat Marwick Providence, Rhode Island February 8, 1994 SCHEDULE V HASBRO, INC. AND SUBSIDIARIES Property, Plant and Equipment Fiscal Years Ended in December (Thousands of Dollars) Balance at Translation Balance Beginning of Disposals/ Adjustments at End of Description Year Additions Retirements and Other(a) Year - ----------- ------------ --------- ----------- ------------ --------- Land and improvements $ 13,585 1,022 (1,195) (1,402) $ 12,010 Buildings and improvements 170,220 22,062 (4,339) 770 188,713 Machinery and equipment 150,851 33,282 (7,527) (3,556) 173,050 ------- ------- ------- ------- ------- $334,656 56,366 (13,061) (4,188) $373,773 ======= ======= ======= ======= ======= Tools, dies and molds $ 28,485 43,426 (32,627)(b) (72) $ 39,212 ======= ======= ======= ======= ======= Land and improvements $ 13,548 1,556 (1,235) (284) $ 13,585 Buildings and improvements 160,604 11,773 (7,255) 5,098 170,220 Machinery and equipment 122,074 44,167 (13,748) (1,642) 150,851 -------- ------- ------- ------- ------- $296,226 57,496 (22,238) 3,172 $334,656 ======= ======= ======= ======= ======= Tools, dies and molds $ 28,819 32,935 (33,593)(b) 324 $ 28,485 ======= ======= ======= ======= ======= Land and improvements $ 8,586 446 (3) 4,519 $ 13,548 Buildings and improvements 129,607 11,061 (2,375) 22,311 160,604 Machinery and equipment 101,307 16,650 (8,003) 12,120 122,074 ------- ------- ------- ------- ------- $239,500 28,157 (10,381) 38,950 $296,226 ======= ======= ======= ======= ======= Tools, dies and molds $ 13,335 27,847 (26,742)(b) 14,379 $ 28,819 ======= ======= ======= ======= ======= (a) 1992 includes $8,665 and $1,746 of buildings and improvements and machinery and equipment, respectively, relating to the gross-up of assets acquired in prior business combinations as required by SFAS 109. 1992 also includes $622 and $415 of machinery and equipment and tools, dies and molds, respectively, of acquired companies. 1991 includes $4,434, $21,789, $12,449 and $14,549 of land and improvements, buildings and improvements, machinery and equipment and tools, dies and molds, respectively, of acquired company. (b) Primarily represents amortization which is credited directly against the cost of the assets. SCHEDULE VI HASBRO, INC. AND SUBSIDIARIES Accumulated Depreciation and Amortization of Property, Plant and Equipment Fiscal Years Ended in December (Thousands of Dollars) Balance at Balance Beginning of Disposals/ Translation at End of Description Year Additions Retirements Adjustments Year - ----------- ------------ --------- ----------- ----------- ---------- Land improvements $ 638 121 - (6) $ 753 Buildings and improvements 42,734 11,601 (2,536) (877) 50,922 Machinery and equipment 68,429 20,933 (5,787) (2,068) 81,507 ------- ------- ------- ------- ------- $111,801 32,655 (8,323) (2,951) $133,182 ======= ======= ======= ======= ======= Land improvements $ 533 118 (9) (4) $ 638 Buildings and improvements 39,184 7,534 (3,327) (657) 42,734 Machinery and equipment 60,136 20,842 (11,134) (1,415) 68,429 ------- ------- ------- ------- ------- $ 99,853 28,494 (14,470) (2,076) $111,801 ======= ======= ======= ======= ======= Land improvements $ 418 119 (3) (1) $ 533 Buildings and improvements 32,012 9,453 (1,551) (730) 39,184 Machinery and equipment 51,216 16,210 (7,038) (252) 60,136 ------- ------- ------- ------- ------- $ 83,646 25,782 (8,592) (983) $ 99,853 ======= ======= ======= ======= ======= SCHEDULE VIII HASBRO, INC. AND SUBSIDIARIES Valuation and Qualifying Accounts and Reserves Fiscal Years Ended in December (Thousands of Dollars) Provision Balance at Charged to Write-Offs Balance Beginning of Costs and Other Allowances at End of Year Expenses Additions(a) Taken(b) Year ------------ ---------- ------------ ----------- --------- Valuation accounts deducted from assets to which they apply - for doubtful accounts receivable: 1993 $52,200 13,078 - (11,078) $54,200 ====== ====== ====== ====== ====== 1992 $60,500 10,674 - (18,974) $52,200 ====== ====== ====== ====== ====== 1991 $43,100 15,024 29,285 (26,909) $60,500 ====== ====== ====== ====== ====== (a) Doubtful accounts reserve of acquired company. (b) Includes write-offs, recoveries of previous write-offs and translation adjustments. SCHEDULE IX HASBRO, INC. AND SUBSIDIARIES Short-Term Borrowings Fiscal Years Ended in December (Thousands of Dollars) Weighted Weighted Average Average Average Interest Maximum Amount Interest Category of Balance Rate Amount Outstanding Rate Short-Term at End at End Outstanding During During Borrowings(b) of Year of Year During Year Year (a) Year (a) - ------------- ------- -------- ----------- ----------- -------- Bank $ 62,242 9.0% $182,588 $152,004 7.6% ======= ==== ======= ======= ==== Commercial Paper - - $385,160 $134,944 3.4% ======= ==== ======= ======= ==== Bank (b) $ 64,174 11.8% $401,956 $254,036 6.8% ======= ==== ======= ======= ==== Commercial Paper - - $154,748 $ 65,704 3.7% ======= ==== ======= ======= ==== Bank (b) $186,084 8.5% $568,391 $238,410 7.5% ======= ==== ======= ======= ==== Commercial Paper - - $332,278 $135,384 6.1% ======= ==== ======= ======= ==== (a) Computed daily. (b) Includes short-term borrowings (none at end of 1992 and $150,000 at end of 1991) classified as long-term debt reflecting the Company's ability and intent to refinance such borrowings on a long-term basis. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HASBRO, INC. (Registrant) By: /s/Alan G. Hassenfeld Date: March 25, 1994 ------------------------- --------------- Alan G. Hassenfeld Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date - --------- ----- ---- /s/Alan G. Hassenfeld - ---------------------------- Chairman of the Board, March 25, 1994 Alan G. Hassenfeld President,Chief Executive Officer and Director (Principal Executive Officer) /s/John T. 0'Neill - ---------------------------- Executive Vice President March 25, 1994 John T. 0'Neill and Chief Financial Officer (Principal Financial and Accounting Officer) /s/Barry J. Alperin - ---------------------------- Director March 25, 1994 Barry J. Alperin /s/Alan R. Batkin - ---------------------------- Director March 25, 1994 Alan R. Batkin /s/George R. Ditomassi, Jr. - ---------------------------- Director March 25, 1994 George R. Ditomassi, Jr. /s/Harold P. Gordon - ---------------------------- Director March 25, 1994 Harold P. Gordon /s/Alex Grass - ---------------------------- Director March 25, 1994 Alex Grass /s/Sylvia K. Hassenfeld - ---------------------------- Director March 25, 1994 Sylvia K. Hassenfeld /s/Claudine B. Malone - ---------------------------- Director March 25, 1994 Claudine B. Malone /s/James R. Martin - ---------------------------- Director March 25, 1994 James R. Martin /s/Norma T. Pace - ---------------------------- Director March 25, 1994 Norma T. Pace /s/E. John Rosenwald, Jr. - ---------------------------- Director March 25, 1994 E. John Rosenwald, Jr. /s/Carl Spielvogel - ---------------------------- Director March 25, 1994 Carl Spielvogel /s/Henry Taub - ---------------------------- Director March 25, 1994 Henry Taub /s/Preston Robert Tisch - ---------------------------- Director March 25, 1994 Preston Robert Tisch /s/Alfred J. Verrecchia - ---------------------------- Director March 25, 1994 Alfred J. Verrecchia HASBRO, INC. Annual Report on Form 10-K for the Year Ended December 26, 1993 Exhibit Index Exhibit - ------- 3. Articles of Incorporation and Bylaws (a) Restated Articles of Incorporation of the Company. (Incorporated by reference to Exhibit (c)(2) to the Company's Current Report on Form 8-K, dated July 15, 1993, File No. 1-6682.) (b) Amended and Restated Bylaws of the Company. (Incorporated by reference to Exhibit (c)(3) to the Company's Current Report on Form 8-K, dated July 15, 1993, File No. 1-6682.) 4. Instruments defining the rights of security holders, including indentures. (a) Revolving Credit Agreement, dated as of June 22, 1992, among the Company, certain banks (the "Banks"), and The First National Bank of Boston, as agent for the Banks (the "Agent"). (Incorporated by reference to Exhibit 4(a) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (b) Subordination Agreement, dated as of June 22, 1992, among the Company, certain subsidiaries of the Company, and the Agent. (Incorporated by reference to Exhibit 4(b) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) 10. Material Contracts (a) Agreement and Plan of Merger, dated January 31, 1991, by and among the Company, HIAC III Corp., a subsidiary of the Company ("Sub") and Tonka Corporation ("Tonka"). (Incorpo- rated by reference to Exhibit (c)(1) to the Company's Tender Offer Statement on Schedule 14D-1, dated February 6, 1991, relating to the Common Stock of Tonka.) (b) Amendment, dated April 17, 1991 to Agreement and Plan of Merger among the Company, Sub and Tonka. (Incorporated by reference to Exhibit (c)(4) to Amendment No. 9 to the Company's Tender Offer Statement on Schedule 14D-1, dated April 18, 1991, relating to the Common Stock of Tonka.) (c) Letter Agreement, dated April 29, 1991, among the Company, Sub and Tonka. (Incorporated by reference to Exhibit (c)(8) to Amendment No. 11 to the Company's Tender Offer Statement on Schedule 14D-1, dated April 29, 1991, relating to the Common Stock of Tonka.) (d) Shareholder Rights Agreement, dated May 17, 1983, between Warner Communications Inc. ("Warner") and the Company. (Incorporated by reference to Exhibit 3 to the Statement on Schedule 13D, dated May 17, 1983, relating to the Company's Common Stock.) (e) Amendment No. 1 to Shareholder Rights Agreement, dated as of December 1, 1985, between Warner and the Company. (Incorporated by reference to Exhibit 9(b) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 29, 1985, File No. 1-6682.) (f) Exchange Agreement, dated as of December 1, 1985, between the Company and Warner. (Incorporated by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 29, 1985, File No. 1-6682.) (g) Lease between Hasbro Canada Inc. (formerly named Hasbro Industries (Canada) Ltd.) and Central Toy Manufacturing Co. ("Central Toy"), dated December 23, 1976. (Incorporated by reference to Exhibit 10.15 to the Company's Registration Statement on Form S-14, File No. 2-92550.) (h) Lease between Hasbro Canada Inc. and Central Toy, together with an Addendum thereto, each dated as of May 1, 1987. (Incorporated by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1987, File No. 1-6682.) Executive Compensation Plans and Arrangements (i) Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-8, File No. 2-78018.) (j) Amendment No. 1 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(l) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 28, 1986, File No. 1-6682.) (k) Amendment No. 2 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(n) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1987, File No. 1-6682.) (l) Amendment No. 3 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 25, 1988, File No. 1-6682.) (m) Amendment No. 4 to Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(s) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1989, File No. 1-6682.) (n) Form of Incentive Stock Option Agreement for incentive stock options. (Incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1987, File No. 1-6682.) (o) Form of Non Qualified Stock Option Agreement under the Employee Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10(q) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 25, 1988, File No. 1-6682.) (p) Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10.10 to the Company's Registration Statement on Form 14, File No. 2-92550.) (q) Amendment No. 1 to Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10(j) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 28, 1986, File No. 1-6682.) (r) Amendment No. 2 to Non Qualified Stock Option Plan. (Incorporated by reference to Appendix A to the Company's definitive proxy statement for its 1987 Annual Meeting of Shareholders, File No. 1-6682.) (s) Amendment No. 3 to Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10(l) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1989, File No. 1-6682.) (t) Form of Stock Option Agreement (For Employees) under the Non Qualified Stock Option Plan. (Incorporated by reference to Exhibit 10(t) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (u) 1992 Stock Incentive Plan (Incorporated by reference to Appendix A to the Company's definitive proxy statement for its 1992 Annual Meeting of Shareholders, File No. 1-6682.) (v) Form of Stock Option Agreement (For Employees) under the 1992 Stock Incentive Plan. (Incorporated by reference to Exhibit 10(v) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (w) Form of Stock Option Agreement (For Participants in the Long Term Incentive Program) under the 1992 Stock Incentive Plan. (Incorporated by reference to Exhibit 10(w) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1992, File No. 1-6682.) (x) Form of Employment Agreement, dated July 5, 1989, between the Company and seven executive officers of the Company. (Incorporated by reference to Exhibit 10(v) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1989, File No. 1-6682.) (y) Change in Control Agreement dated as of December 13, 1990 between Tonka and Bruce L. Stein. (Incorporated by reference to Exhibit 10.2 to Tonka's Annual Report on Form 10-K for the Fiscal Year Ended December 29, 1990, File No. 1-4683.) (z) Letter Agreement between Tonka and Bruce L. Stein, dated March 21, 1994. (aa) Hasbro, Inc. Retirement Plan for Directors. (Incorporated by reference to Exhibit 10(x) to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 30, 1990, File No. 1-6682.) (bb) Form of Director's Indemnification Agreement. (Incorporated by reference to Appendix B to the Company's definitive proxy statement for its 1988 Annual Meeting of Shareholders, File No. 1-6682.) (cc) Hasbro, Inc. Deferred Compensation Plan for Non-Employee Directors. (dd) Hasbro, Inc. Stock Option Plan for Non-Employee Directors. (Incorporated by reference to Appendix A to the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, File No. 1-6682.) (ee) Hasbro, Inc. Senior Management Annual Performance Plan. (Incorporated by reference to Appendix B to the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, File No.1-6682.) 11. Statement re computation of per share earnings 12. Statement re computation of ratios 13. Selected information contained in Annual Report to Shareholders 22. Subsidiaries of the registrant 24. Consents of experts and counsel (a) Consent of KPMG Peat Marwick.

740868_1993.txt

740868

1993

ITEM 1. BUSINESS GENERAL The registrant, an Indiana corporation (hereinafter, the "Company"), is the leading independent designer, manufacturer and supplier of window systems to the combined automobile, light truck and van, bus, heavy truck and recreational vehicle markets in North America. The Company's window systems include various types of automotive windshields; rear, vent, quarter, push out and sliding windows; and window regulator systems, latches, door frames and related components. The Company also manufactures door systems for military and recreational vehicles and injection molded thermoplastic products and other products primarily for sale to the automotive industry. The Company's products are sold to major North American transportation original equipment manufacturers ("OEMs") including Ford, Chrysler, General Motors, AutoAlliance International, Inc. (a joint venture between Ford and Mazda), Mitsubishi, Nissan, Fleetwood, Winnebago, Navistar, Paccar (Peterbilt and Kenworth trucks) and the manufacturers of virtually all of the intra and intercity buses in the United States and Canada. BUSINESS STRATEGY The Company's business objective is to expand profitably its position as the leading independent supplier of window systems to the combined automotive, light truck and van, bus, heavy truck and recreational vehicle markets in North America. It also intends to broaden its product offerings to these markets, as well as expand its capabilities to complementary markets. Continued focus on achieving recognition as a world class manufacturer is a key component of this strategy. The Company continually strives for world class status through technical innovation, quality excellence, cost competitiveness and strategic alliances and acquisitions. Technical Innovation. The Company's most significant innovative achievement has been the development of reaction injection molded ("RIM") modular windows in the mid-1980's. This value-added product resulted from a long internal development effort and accounted for 35% of net sales in 1993. In recent years, as automotive OEMs increasingly shifted design, innovation, quality and product improvement responsibility to their suppliers, the Company increased its research, engineering and development expenditures (from $2.7 million in 1989 to $7.9 million in 1993), including the addition of an advanced design group and Company-wide computer-aided design capability. The Company has also added more sophisticated program management and complex manufacturing information systems. The Company's capabilities now include prototype and product development, specification testing and manufacturing engineering assistance. This has resulted in increased opportunities for the Company to participate earlier in the product planning process and to add value by furnishing engineering and design services and providing a broader range of parts required for vehicle assembly. Quality Excellence. The Company emphasizes a continuous improvement philosophy to its employees on all facets of operations including product quality. As a result of its commitment to quality, the Company has achieved Q1 and Pentastar quality ratings at its key manufacturing plants from Ford and Chrysler, respectively, and has received quality awards from Fleetwood (a recreational vehicle OEM), Nissan and other OEMs. At the corporate technical center, engineers examine the Company's and its competitors' products to evaluate alternative designs, suggest marketing opportunities and solve potential production problems, all of which serve to improve and maintain the Company's stringent quality standards. Competitive Cost. The Company strives to achieve a competitive cost to its customers through its emphasis on quality excellence and its involvement in the early stages of product development. The Company is a highly reliable and timely supplier able to meet its customers' demanding delivery requirements, while constantly focusing on reducing OEM inventory levels. Strategic Alliances. In 1986, Ford entered into a supply agreement (the "Supply Agreement") with the Company. Pursuant to the Supply Agreement, Ford agreed to purchase from the Company at least 70% of the requirements by dollar volume of Ford and Ford Canada for modular framed glass parts using RIM and polyvinyl chloride ("PVC") technology, commencing with the 1990 model year. Ford's purchase obligations are contingent upon the Company being competitive as to technology, quality, service, price and delivery. The Supply Agreement, which is currently scheduled to expire at the end of the 1998 model year, has been complemented by a supply agreement between Ford and the Company dated January 31, 1994 (the "1994 Supply Agreement"), which extends through the 1998 calendar year and which provides for Ford to purchase 100% of its requirements for those parts currently supplied by the Company (including parts other than modular windows), subject to specified annual price reductions. Since 1990, the Company has and is continuing to supply at least 70% of Ford's requirements for modular framed glass, which have predominately been modular windows using RIM technology. The Company works closely with Ford during the development and production by Ford of new products utilizing parts supplied by the Company, and net sales to Ford have increased from $26.7 million in 1985 to $373.1 million in 1993. The Company also benefits from an exclusive purchase and supply agreement with H.S. Die & Engineering of Grand Rapids, Michigan. H.S. Die supplies the molds (i.e., tooling) to the Company necessary to manufacture modular windows. Working closely with OEMs and H.S. Die, the Company is able to move rapidly from design to finished tooling for modular windows. As a result of this alliance, preproduction lead-times on new programs have been decreased by more than a year, which was demonstrated in Ford's development of the recently introduced Mustang model. Another strategic alliance links the Company with Schade KG, a modular and conventional window and door systems supplier located in Plettenberg, Germany. Pursuant to a Reciprocal Technology License and Cooperative Venture Agreement, both companies have cooperated in developing new business proposals. Schade helped the Company develop technical capabilities in PVC modular windows. The Company produces PVC windows for the Chrysler New Yorker at its Kentucky manufacturing facility and has been sourced to supply PVC windows for certain 1995 Mitsubishi and Nissan models. In addition, technology acquired from the Company's alliance with Schade has enabled the Company to supply door frames for General Motors's 1994 Saturn Coupe. In 1992, the Company formed a joint venture with Pollone S.A., a Brazilian automotive parts supplier, for the purpose of supplying encapsulated window assemblies to South American automakers. Located near Sao Paulo, Brazil, the joint venture, Pollexco, is owned 49% by the Company and 51% by Pollone, S.A. Production of products for Autolatina, a joint venture between Ford and Volkswagen, began in late 1993. Strategic Acquisitions. In acquisitions, the Company seeks processes, products or markets which complement the Company's existing businesses. The Company added high volume conventional window capacity to its product line as a result of a 1986 acquisition from Irvin Industries. In the mid-1980's, Ford--initially the Company's only RIM window customer--started its own subsidiary to manufacture RIM windows in Fulton, Kentucky. In 1986, the Company acquired Ford's RIM window subsidiary and manufacturing facility. In 1988, the Company acquired Nyloncraft, Inc., which manufactures injection molded thermoplastic products primarily for the automotive industry. Nyloncraft also supplies plastic components to six of the Company's manufacturing facilities. In 1990, the Company acquired the window regulator business operated by Hoover Universal, Inc., a subsidiary of Johnson Controls, Inc. The Company's technical capabilities, in particular the corporate technical center, have enabled it to redesign several products, reduce operating expenses and improve overall operations in the newly-acquired window regulator business. MARKET DESCRIPTION AND INDUSTRY FACTORS Automotive Market General. The overall market for new cars and light trucks in North America is large and cyclical, with average annual growth of 1% to 2%. However, considerable growth or decline routinely occurs within specific product segments or model lines. In particular, light truck sales have grown rapidly over the last 15 years as compared to the demand for cars. This growth in light truck demand primarily reflects the increased use of mini-vans and sport utility vehicles. The Company believes it will continue to be well-positioned as a supplier of window systems to OEMs in this higher growth market segment. Changing Supplier Policies. Several developments have substantially altered the competitive environment for automotive suppliers, including consolidation among suppliers and increased outsourcing of key components by OEMs. During the 1980s, Ford, Chrysler and General Motors began to reduce their supplier base, focusing on long-term sole-source contracts with more capable suppliers. Increasingly, the criteria for selection include not only cost, quality and responsiveness, but also certain full-service capabilities including design, engineering and project management support. OEMs now have rigorous programs for evaluating and rating suppliers which encompass quality, cost control, reliability of delivery, new technology implementation, engineering competence, continuous improvement programs and overall management. Under these programs, each facility operated by a supplier is evaluated independently. The suppliers who obtain superior ratings are favorably considered for new business; those who do not may continue their existing contracts, but normally do not receive additional business. As a result, these new supplier policies have sharply reduced the number of component suppliers. In the 1990's, OEM supply agreements have incorporated productivity provisions which specify annual price reductions which may be offset by product improvements, manufacturing improvements and/or various other mutually agreed upon methods. Transplants. Over the last ten years, Japanese manufactured vehicles have gained an increasing share of the North American market. In addition, a growing percentage of such vehicles are being made at North American operations of Japanese manufacturers ("Transplants"). Transplants receive component parts from a variety of sources including suppliers in Japan, Japanese suppliers who establish U.S. facilities and existing U.S. component suppliers. Because of the current market share of the Transplants, supplying them is an attractive opportunity. To date, the Company has been selected to supply window systems for certain Nissan, Mazda and Mitsubishi models manufactured in North America. The Company has also been selected to supply fixed vent windows for the new BMW model scheduled to be built in South Carolina in 1995. Non-Automotive Market The market for heavy trucks in North America is cyclical, and the Company believes it is well positioned to take advantage of supply opportunities which arise as aging fleets are replaced with new models. The availability of federally funded programs and the price of gasoline and diesel fuel are factors which affect the demand for intracity buses purchased for municipal mass transit systems. The market for recreational vehicles is influenced significantly by the strength of the economy and the level of consumer discretionary spending. Recent growth trends in the sale of recreational vehicles have been positive. PRODUCTS The Company designs, engineers, manufactures and supplies plastic and metal framed window assemblies, manual and power glass regulator systems and injection molded thermoplastic products principally for North American car, light truck and van, heavy truck, bus, military and recreational vehicle OEMs. The Company does not manufacture or sell primary glass. Modular Window Systems. The Company's modular, plastic framed windows are value-added parts because clips, weatherstripping and bright trim are attached during the molding process. The module-manufacturing processes used by the Company give the OEM designers great flexibility in window shape, sealing and aerodynamics. The module supplied to the OEM also lowers its parts inventory, reduces part weight and reduces assembly efforts. The Company produces modular windshields and rear windows, as well as fixed quarter, sliding and push out modular windows. The Company utilizes RIM technology and also PVC injection molding technology to manufacture modular windows. In RIM technology, liquids are mixed and fed into a mold that holds glass, framing and fastening components. The mixture polymerizes, and the completed module is removed, trimmed, cleaned, inspected and packed for shipment. In PVC injection molding, solid plastic subjected to high temperature and pressure flows in liquid form into the mold where it reverts without chemical reaction to a solid. Conventional Windows. The Company also produces conventionally framed window assemblies utilizing painted cold-rolled steel, stainless steel, rubber and/or aluminum. The glass or plastic glazed window assemblies supplied for mass transit systems have durable aluminum frames and non-leak weatherstripping. The Company supplies a wide variety of conventional windows to car, light truck and heavy truck OEMs, including pivoting wing ventilator windows, fixed and movable quarter windows and swing-out and sliding windows. The Company's flush-mount recreational vehicle windows seal tightly and feature independent sliding screens, removable storm windows and an anti-theft locking mechanism. Window Regulator Systems. The Company supplies manual and electrically powered versions of regulators (the mechanisms for lifting and lowering windows) for front and rear side windows and tailgate windows. The Company stresses safety, weight, glass stability, window system integration, parts reduction and enhanced vehicle design flexibility in its window regulators. Injection Molded Thermoplastic Products. The Company's Nyloncraft division manufactures injection molded inside and outside door handles, door latch components, fan shrouds, airspring pistons, window crank handles and a variety of other custom engineered products. The Company molds parts from nylons, polyesters, acetal and other engineered thermoplastic materials. Door Systems. The Company designs and manufactures preassembled doors for Class A motorhomes and ballistic door/window systems for the Hummer tactical military vehicle. The Company's preassembled door systems improve the OEMs' installation productivity and assist in design flexibility. CUSTOMERS AND MARKETING The Company supplies its products primarily to Ford, Chrysler and General Motors. Historical sales of the Company by customer group are set forth below. The loss of Ford, Chrysler or General Motors as a customer would have a material adverse effect on the Company. Sales of the Company's products to OEMs are made directly by the Company's sales and engineering personnel located at the Company's offices in the Detroit area and Elkhart, Indiana. Through these sales and engineering offices, the Company services its OEM customers and manages its continuing programs of product design improvement and development. The Company's customers award contracts that normally cover parts to be supplied for a particular vehicle model. Such contracts typically extend over the life of the model, which is generally four to seven years. The primary risk to the Company is that an OEM will produce fewer units of a model than anticipated. In addition, the Company competes for new business to supply parts for successor models and therefore runs the risk that the OEM will not select the Company to produce parts on a successor model. In order to reduce its reliance on any one model, the Company produces parts for a broad cross- section of both new and more mature models. The Company has been chosen as a supplier on a variety of generally successful car, light truck and van models. The following table presents a summary of the 1994 and 1995 models for which the Company is producing or will produce component parts. COMPANY 1994/1995 MODELS Ford Escort, Explorer, Taurus, Sable, Aerostar, Windstar, Ranger, Continental, Cougar, Mark VIII, Bronco, Thunderbird, Town Car, Econoline, Crown Victoria, Grand Marquis, Mustang, Probe, Villager, F-Series Truck Chrysler LHS, LeBaron, Fifth Avenue, Imperial, Cherokee, Wrangler, Comanche, Voyager, Avenger, Sebring, Concorde, Intrepid, Vision, New Yorker, Dakota, Ram Truck, Ram Van/Wagon, Talon General Motors Cavalier, Sunbird, Vandura Van, APV Mini-Van, S-10 Truck, Saturn Coupe, Saturn Station Wagon Nissan Quest, Sentra GS, Nissan Truck Mazda MX6 Mitsubishi Eclipse Based on its ability to service its OEM customers' needs effectively, the Company believes it will be able to maintain its position on most existing models, while also expanding into new models as further consolidation in the OEM supplier base occurs. The Company believes that the presence of Transplants represents an attractive growth opportunity over the next decade. The Company is currently supplying products for Mazda, Nissan and Mitsubishi models. The Company believes that it is favorably positioned to increase its business with the Transplants because of the Company's reputation for technical innovation, quality excellence, reliability and competitive cost. In the non-automotive markets, the Company sells various types of conventional window systems to North American OEMs of medium and heavy trucks, recreational vehicles and buses. The Company is the dominant supplier of wing ventilator windows for medium and heavy trucks manufactured in the United States and Canada. The Company's customers include Navistar, Freightliner, Volvo GM Heavy Truck Corp., Mack Truck, Paccar (Kenworth and Peterbilt models) and Ford. The Company supplies aluminum framed window systems to Fleetwood and Winnebago, the leading recreational vehicle OEMs in North America, as well as a number of other recreational vehicle manufacturers. The Company is the dominant supplier of metal framed window systems to intra and intercity bus OEMs. The Company also manufactures preassembled doors for certain recreational vehicle OEMs and door systems for the Hummer tactical military vehicle. The Company maintains separate sales and engineering groups at its corporate offices in Elkhart, Indiana to service these non-automotive markets. The Company has received "Supplier of the Year" and "Master of Quality" awards from Fleetwood and Freightliner, respectively, as well as recognition for quality and delivery accomplishments from other non-automotive OEMs. The Company believes that its cost competitiveness, quality excellence and design and engineering capabilities obtained in the automotive supply markets enable it to compete effectively in non-automotive markets as well. COMPETITION The Company operates in a highly competitive environment in each of its markets. The number of the Company's competitors in the automotive markets is expected to decrease due to the supplier consolidation resulting from changing OEM policies. The Company's major competitors include Donnelly Corporation, Libbey-Owens-Ford Co., Guardian Industries, Dura, Inc., Rockwell International, Hehr International, OEM internal operations and a large number of smaller operations. The Company principally competes for new business both at the beginning of the development of new models and upon the redesign of existing models by its major customers. New model development generally begins two to four years prior to the marketing of such models to the public. Once a producer has been designated to supply parts to a new program, an OEM will generally continue to purchase those parts from the designated producer for the life of the program. Competitive factors in the market for the Company's products include product quality, design and engineering competence, customer service, product mix, new product innovation, cost and timely delivery. The Company believes that its business strategy allows it to compete effectively in the markets for its products. The Company believes that it is well-positioned to succeed in this highly competitive supplier environment. The Company's size, emphasis on quality, customer service orientation, manufacturing expertise and technological leadership all contribute to the Company's success in the transportation supply industry. RESEARCH, ENGINEERING AND DEVELOPMENT The Company expended approximately $5.2 million, $5.5 million and $7.9 million on research, engineering and development during 1991, 1992 and 1993, respectively. These increased expenditures have improved significantly the Company's capacity to provide complete engineering and design services to support its product lines. The Company also has a corporate technical center in Elkhart, Indiana for basic research and development, as well as a large engineering and design staff in the Detroit area which works closely with automotive OEMs during all phases of new product development and production. FOREIGN OPERATIONS In addition to its domestic facilities described below, the Company owns a manufacturing facility in Aurora, Ontario, Canada and leases a manufacturing facility in Juarez, Mexico. The financial information concerning the Canadian operations of the Company is set forth in Notes 10 and 11 to the Company's Consolidated Financial Statements included elsewhere herein. EMPLOYEES The Company employs a total of approximately 3,500 persons, of whom approximately 20% are covered by collective bargaining agreements. The Company believes its relationship with its employees is good. ENVIRONMENTAL MATTERS The Company believes it is in substantial compliance with federal, state, local and foreign laws regarding discharge of materials into the environment and does not anticipate any material adverse effect on its future earnings, capital expenditures or competitive position as a result of compliance with such laws. For a discussion of potential environmental liabilities, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Liquidity and Capital Resources" and Note 8 to the Company's Consolidated Financial Statements included elsewhere herein. ITEM 2.

ITEM 2. PROPERTIES The Company operates 11 manufacturing facilities, all of which are in good condition. The Company manufactures framed window assemblies at its Elkhart, Jacksonville, LaGrange, Aurora, Lawrenceburg, Fulton and Toledo manufacturing facilities. Injection molded thermoplastic parts are manufactured at the Bowling Green and Mishawaka facilities. Window regulator systems, latches and related components are manufactured at the Jacksonville, Pikeville and Juarez, Mexico facilities. Except as noted below, the Company owns all of these facilities. Approximate Building Size Location (in square feet) Elkhart 270,000 (1) Jacksonville, Florida 260,000 LaGrange, Indiana 140,000 Aurora, Ontario (Canada) 120,000 Lawrenceburg, Tennessee 150,000 Fulton, Kentucky 80,000 (2) Bowling Green, Kentucky 32,000 Mishawaka, Indiana 120,000 (3) Toledo, Ohio 61,000 (4) Pikeville, Tennessee 101,900 (5) Juarez, Mexico 15,000 (6) _________________________________ (1) Approximately 35,000 square feet of this facility houses the Company's executive offices and approximately 140,000 square feet of the facility are used in manufacturing. (2) The Company leases the Fulton, Kentucky facility pursuant to a lease which expires in 1994. The Company is entitled to extend the term of the lease for six (6) additional terms of three (3) years each and may, at its option, purchase the facility at any time during the lease. (3) The Company leases the Mishawaka, Indiana facility pursuant to a lease which expires in 1998. The Company is entitled to extend the term of such lease until 2003 and may, at its option, purchase such facility at any time during the term of the lease. (4) The Company leases the Toledo, Ohio facility pursuant to a lease which expires on May 31, 1998. (5) The Company leases the Pikeville, Tennessee facility pursuant to a Lease Purchase Contract entered into as part of agreements for the issuance of two series of industrial development bonds. Title to the facility will be transferred to the Company for Ten Dollars ($10.00) on completion of payment on the bond issues on July 1, 1999. Rent is payable semi- annually with respect to the Series A bonds and is equal to the principal and interest due on the bonds. Semi-annual principal payments on the Series A bonds currently are $75,000. Interest on the outstanding principal balance of the Series B bonds is payable quarterly, with an annual payment of principal in the amount of $200,000. (6) The Company leases the Juarez, Mexico facility pursuant to a month-to- month lease. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS On February 22, 1993, the United States filed a lawsuit in the United States District Court for the Northern District of Indiana against the Company and certain other parties. On July 20, 1993, the Indiana Department of Environmental Management ("IDEM") joined the lawsuit. The lawsuit seeks recovery of the costs of enforcement, prejudgment interest and an amount in excess of $6.8 million, which represents costs incurred to date by the United States Environmental Protection Agency ("EPA") and IDEM in connection with the contamination of soil and groundwater on the Company's property in Elkhart, Indiana, and a well field of the City of Elkhart in close proximity to the Company's facility. The lawsuit also seeks a declaration that the Company and the other defendants are liable for any future costs incurred by the EPA and IDEM in connection with the site. For further information, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 8 to the Company's Consolidated Financial Statements included elsewhere herein. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS None Executive Officers of the Company The names and ages of all executive officers of the Company, all positions and offices held by each of them and the period during which each such person has served in these offices and positions is set forth below: Name Age Position and Offices James J. Lohman 52 Chairman of the Board and Chief Executive Officer James O. Futterknecht, Jr.47 President and Chief Operating Officer Joseph A. Robinson 55 Secretary, Treasurer and Chief Financial Officer James E. Crawford 47 Vice President-Product Development and Value Engineering Louis R. Csokasy 46 Vice President-Engineering and Quality Terrance L. Lindberg 51 Vice President-Specialty Products and General Manager-Nyloncraft Mr. Lohman has been the Chairman of the Board of Directors since 1985 and Chief Executive Officer since 1983. He joined the Company in 1964 and was Group Vice President from 1978 to 1981 and was President from 1981 to 1992. He has been a director of the Company since 1978. Mr. Futterknecht joined the Company in 1970, was Vice President - Corporate Sales from 1976 until 1984, was Vice President - Automotive Products from 1986 until 1987, was Vice President - Automotive Sales and engineering from 1987 to 1990, and was Executive Vice President from 1990 to 1992. He was elected as President and Chief Operating Officer and was appointed as a director in 1992. Mr. Robinson joined the Company as Secretary, Treasurer and Chief Financial Officer in December 1991 and was appointed as a director in 1992. Prior to that time, he was employed by the Standard Products Co., a manufacturer of automotive parts as Vice President from 1990 to 1991 and as Vice President - Finance from 1976 to 1990. Mr. Crawford joined the Company in 1978, was Product Engineering Manager from 1979 until 1984, was Vice President - Engineering/Research from 1984 until 1987, was Vice President - Modular Operations from 1987 to 1988, and was Vice President-Group Operations/Modular Products from 1988 to 1992. Mr. Crawford has been Vice President-Product Development and Value Engineering since 1992. Mr. Csokasy joined the Company in 1972. He was General Manager - Recreational Vehicles from 1985 to 1987, Manager of Corporate Engineering from 1987 to 1990, and was Vice President - Engineering from 1990 to 1992. He has been Vice President - Engineering and Quality since 1992. Mr. Lindberg joined the Company in 1983, was Manager of Mass Transit and Heavy Truck Products from 1984 to 1987, was Manager of Group Operations from 1987 until 1990, was Vice President - Group Operation from 1990 to 1992. Mr. Lindberg has been Vice President - Specialty Products and General Manager - Nyloncraft since 1992. PART II. ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The Common Shares are traded on the American Stock Exchange under the symbol EXC. The following table sets forth for the fiscal periods indicated the high and low sale prices of the Common Shares, as reported by the American Stock Exchange, and dividends declared per share. As of February 15, 1994, there were 502 holders of record of the Common Shares. The Company has paid cash dividends every quarter since becoming a public company in April 1984. The Company intends to continue to pay quarterly cash dividends on its Common Shares, but the payment of dividends and the amount and timing of such dividends will depend upon the Company's earnings, capital requirements, financial condition and other factors deemed relevant by the Company's Board of Directors. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA SELECTED CONSOLIDATED FINANCIAL INFORMATION (Amounts in thousands, except per share amounts) The following table presents selected consolidated financial data of the Company as of and for the five fiscal years ended December 31, 1993. The selected consolidated financial data have been derived from audited consolidated financial statements of the Company. Such selected consolidated financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements of the Company and the notes thereto included elsewhere herein. The comparability of the results for the periods presented is significantly affected by certain events, as described in "Management's Discussion and Analysis of Financial Condition and Results of Operations--General." EXCEL INDUSTRIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS Excel Industries, Inc. (Company) is engaged in the manufacture and sale of a broad line of window assemblies, manual and electric window regulators, upper door frames, and injection molded thermoplastic parts. The Company's products are used in the manufacture of automobiles, heavy and light trucks, buses and recreational vehicles. 2. SIGNIFICANT ACCOUNTING POLICIES Principles of consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions, profits and balances are eliminated. Net income per share Primary net income per share is computed using the weighted average number of shares outstanding during the period. Shares used to compute primary net income per share were 10,122,000 for 1993, 7,553,000 for 1992, and 6,488,000 for 1991. Fully diluted earnings per share assumes, when dilative, the conversion of the 10% convertible subordinated notes which were issued on January 2, 1990. Stock dividends and splits are given retroactive effect in computing the weighted average number of shares outstanding during the period. Short-term investments and marketable securities Short-term investments amounting to $5,771,000 at December 31, 1993 consist of investments generally in money market funds. Marketable securities consist of U.S. Government securities, tax- free municipal securities and municipal fund par value preferred shares with maturities generally longer than 90 days. Such investments are carried at cost which approximates market. Other income includes interest income of $1,916,000 in 1993, $1,010,000 in 1992, and $674,000 in 1991. Inventories Inventories are valued at the lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for domestic inventories and the first-in, first-out (FIFO) method for Canadian inventories. Properties Plant and equipment are carried at cost and include expenditures for new facilities and those which substantially increase the useful lives of existing plant and equipment. Depreciation The Company provides for depreciation of plant and equipment using methods and rates designed to amortize the cost of such equipment over its useful life. Depreciation is computed principally on accelerated methods for new plant and equipment and the straight-line method for used equipment. The estimated useful lives range from 10 to 40 years for buildings and improvements and 2 to 20 years for machinery and equipment. Goodwill The excess of purchase price over the fair value of net assets of acquired businesses (goodwill) is amortized on a straight-line basis over 20 to 40 years. Income taxes Deferred income taxes are provided using the liability method in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". 3. RESEARCH, ENGINEERING AND DEVELOPMENT Research, engineering and development expenditures charged to operations approximated $7,913,000 in 1993, $5,518,000 in 1992, and $5,200,000 in 1991. 4. RESTRUCTURING CHARGE In the fourth quarter of 1992, the Company provided a reserve of $4,500,000 for restructuring costs. The charge was equivalent to $2,900,000 or 34 cents per share after taxes. This charge represented estimated costs to downsize its Aurora, Ontario, Canada plant and relocate production of certain light truck and van windows to other manufacturing plants of the Company. A total of $1,010,000 was incurred in 1993 to transfer a portion of the planned production. 5. INVENTORIES Inventories consist of the following: December 31, 1993 1992 (000 Omitted) Raw materials $17,948 $15,302 Work in process and finished goods 12,378 11,699 LIFO reserve (459) (255) $29,867 $26,746 6. PENSION AND OTHER EMPLOYEE BENEFIT PLANS Pension and profit sharing plans The Company and its subsidiaries provide retirement benefits to substantially all employees through various pension, savings and profit sharing plans. Defined benefit plans provide pension benefits that are based on the employee's final average salary for salaried employees and stated amounts for each year of credited service for hourly employees. Contributions and costs for the Company's various other benefit plans are generally determined based on the employee's annual salary. Total expense relating to the Company's various retirement plans aggregated $2,199,000 in 1993, $2,102,000 in 1992, $1,712,000 in 1991. Components of net pension expense for all defined benefit pension plans are as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) Service cost $1,319 $1,312 $1,243 Interest cost 1,344 1,245 1,137 Actual return on assets (617) (1,242) (1,139) Net amortization and deferral (582) 190 222 Net defined benefit pension expense $1,464 $1,505 $1,463 The funded status of defined benefit pension plans is as follows: December 31, 1993 1992 (000 Omitted) Plan assets at fair value $15,844 $ 14,868 Projected benefit obligations 20,421 17,869 (4,577) (3,001) Unrecognized costs 1,862 472 Net accrued pension costs $(2,715) $(2,529) Actuarial present value of: Vested benefit obligations $15,644 $13,853 Accumulated benefit obligations $16,655 $14,815 Major assumptions: Discount rate 7.5% 8% Rate of increase in compensation 5% 5% to 8% Expected rate of return on plan assets 8 8% It is generally the Company's policy to fund the ERISA minimum contribution requirement. Plan assets are invested primarily in corporate equity securities and bonds and insurance annuity contracts. Supplemental and other postretirement benefits In addition to providing pension benefits, the Company provides certain health care benefits to substantially all active employees and postretirement health care benefits to management employees. The Company is primarily self-insured for such benefits and prior to 1992 followed the practice of expensing such benefits on a pay-as-you-go basis. In 1992, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company elected to immediately recognize the Accumulated Postretirement Benefit Obligation (APBO) as January 1, 1992 in the amount of $6,447,000 (approximately $4,000,000 after-tax or 61 cents per share). Summary information on the Company's plan is as follows: December 31, 1993 1992 (000 Omitted) Retirees $1,504 $1,060 Retirement-eligible actives 968 1,245 Other active participants 6,077 5,402 Unrecognized gain 407 -- Accrued liability $8,956 $7,707 Accrued postretirement benefit cost The Company plans to continue the policy of funding these benefits on a pay-as-you-go basis. The components of net periodic postretirement benefit cost are as follows: Year Ended December 31, 1993 1992 (000 Omitted) Service costs, benefits attributed to employee service during the year $ 821 $ 750 Interest cost on accumulated postretirement benefit obligation 578 510 Net periodic postretirement benefit cost $1,399 $1,260 The discount rate used in determining the APBO was 7.75% in 1993 and 8% in 1992. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 10.25% declining by 1% per year to a rate of 6.25%. An increase of 1% in health care cost trend rate would increase the accrued postretirement benefit cost at December 31, 1993 by $2,066,000 and the 1993 annual expense by $384,000. 7. LONG-TERM DEBT Following is a summary of long-term debt of the Company: December 31, 1993 1992 (000 Omitted) 10% Convertible subordinated notes $30,000 $30,000 Industrial Revenue Bonds 5,383 4,533 Capital lease obligations 1,264 1,620 36,647 36,153 Current portion (1,553) (1,561) $35,094 $34,592 During 1992, the Company prepaid the balance owing on its guaranteed senior notes and was subject to a prepayment premium of approximately $1.3 million. Such amount is included in the accompanying income statement in interest expense. The convertible notes are due on December 1, 2000 and require aggregate prepayments of $8,000,000 in 1996, $7,000,000 in 1997, $6,000,000 in 1998, $5,000,000 in 1999 and $4,000,000 in 2000. The holders of the notes have the option to convert their notes at any time into common shares of the Company at a current conversion price of $13.214 per share. The Notes are subject to prepayment at the option of the Company if the market value of the Company's common shares equals or exceeds 150% of the conversion price for a specified period. The note agreements provide for maintaining a current ratio of 1.5 to 1, restrict the amount of additional borrowings and limit the amount of dividends that can be paid. Currently the Company has available for payment of dividends $19,615,000 of retained earnings. The Industrial Revenue Bonds bear interest at rates of interest tied to short-term Treasury rates. Certain plant and equipment purchased with the proceeds of the bonds collateralize these obligations. The Company had available unused lines of credit of approximately $6,300,000 at December 31, 1993. Long-term debt maturities are $1,553,000 in 1994, $1,358,000 in 1995, $9,557,000 in 1996, $8,072,000 in 1997, $6,580,000 in 1998, and $9,527,000 thereafter. 8. CONTINGENCIES A chemical cleaning compound, trichlorethylene (TCE), has been found in the soil and groundwater on the Company's property in Elkhart, Indiana, and in 1981, TCE was found in a well field of the City of Elkhart in close proximity to the Company's facility. The Company has been named as one of nine potentially responsible parties (PRPs) in the contamination of this site. The United States Environmental Protection Agency (EPA) and the Indiana Department of Environmental Management (IDEM) have conducted a preliminary investigation and evaluation of the site and have undertaken temporary remedial action in the nature of air-stripping towers. In early 1992, the EPA issued a Unilateral Order under Section 106 of the Comprehensive Environmental Response, Compensation and Liability Act which required the Company and other PRPs to undertake remedial work. The Company and the other PRPs have reached an agreement regarding the funding of groundwater monitoring and the operation of the air-strippers as required by the Unilateral Order. The Company was required to install and operate a soil vapor extraction system to remove TCE from the Company's property. As of February 1, 1994, the Company has installed and is operating the equipment pursuant to the Unilateral Order. In addition, the EPA and IDEM have asserted a claim for reimburesement of their investigatory costs and the costs of installing and operating the air-strippers on the munipal well field (the EPA Costs). On February 22, 1993, the United States filed a lawsuit in the United States District Court for the Northern District of Indiana against eight of the PRPs, including the Company. On July 20, 1993, IDEM joined in the lawsuit. The lawsuit seeks recovery of the costs of enforcement, prejudgment interest and an amount in excess of $6.8 million, which represents costs incurred to date by the EPA and IDEM, and a declaration that the eight defendant PRPs are liable for any future costs incurred by the EPA and IDEM in connection with the site. The Company does not believe the annual cost to the Company of monitoring groundwater and operating the soil vapor extraction system and the air-strippers will be material. Each of the PRPs, including the Company, is jointly and severally liable for the entire amount of the EPA Costs. Certain PRPs, including the Company, are currently attempting to negotiate an agreed upon allocation of such liability. The Company believes that adequate provisions have been recorded for its costs and its anticipated share of EPA Costs and that its cash on hand, unused lines of credit or cash from operations are sufficient to fund any required expenditures. The EPA has also named the Company as a PRP for costs at three other disposal sites. It has also asked the Company for information about contamination at other sites. The Company believes it either has no liability as a responsible party or that adequate provisions have been recorded for any costs to be incurred. There are claims and pending legal proceedings against the Company and its subsidiaries with respect to taxes, workers' compensation, warranties and other matters arising out of the ordinary conduct of the business. The ultimate result of these claims and proceedings at December 31, 1993 is not determinable, but, in the opinion of management, adequate provision for anticipated costs has been made or insurance coverage exists to cover such costs. 9. LEASES The Company leases certain of its manufacturing facilities, sales offices, transportation and other equipment. Total rental expense for all leases was approximately $3,416,000 in 1993, $2,998,000 in 1992, and $2,123,000 in 1991. Future minimum lease payments under noncancellable operating leases are $1,341,000 in 1994, $1,055,000 in 1995, $826,000 in 1996, $753,000 in 1997 and $143,000 in 1998. 10. INCOME TAXES Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This statement mandates the liability approach for computing deferred income taxes similar to SFAS No. 96 previously followed by the Company. The cumulative effect of the change was to increase first quarter 1992 earnings by $800,000 (12 cents per share). The change had no impact on the 1992 income tax provision. Prior year financial statements have not been restated. Pre-tax income (loss) reported by U.S. and foreign subsidiaries was as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) United States $17,933 $8,688 $1,835 Foreign 2,292 (2,677) (1,562) $20,225 $6,011 $ 273 The provision (benefit) for income taxes is summarized below: Year Ended December 31, 1993 1992 1991 (000 Omitted) Current: US federal $ 6,049 $5,007 $1,615 Foreign 465 38 -- State 645 1,226 714 7,159 6,271 2,329 Deferred: US federal (317) (1,922) (1,388) Foreign 941 (1,256) (685) State 2 (659) (134) 626 (3,837) (2,207) $ 7,785 $2,434 $ 122 Deferred income taxes are provided for the temporary differences between the financial reporting basis and tax basis of the Company's assets and liabilities. At December 31, 1993, current deferred income tax assets of $2,886,000 are classified as prepaid expenses, long-term U.S. deferred income tax assets of $6,094,000 are classified as other assets, and $627,000 of long-term foreign deferred income tax liabilities are classified as other long-term liabilities. Deferred income taxes are comprised of the following at December 31: 1993 1992 (000 Omitted) Gross deferred tax liabilities Property, plant and equipment $ 2,257 $2,571 Inventories 436 308 Other 680 564 3,373 3,443 Gross deferred tax assets Postretirement benefit obligations 6,296 5,046 Restructuring reserve 1,103 1,655 Other accrued liabilities 3,708 4,210 Loss carryforwards 619 1,453 11,726 12,364 Net deferred tax assets $ 8,353 $ 8,921 The provision for income taxes computed by applying the Federal statutory rate to income before income taxes is reconciled to the recorded provision as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) Tax at United States statutory rate $7,079 $2,044 $ 93 State income taxes, net of federal benefit 421 374 383 Canadian rate differential on income/(losses) 344 (134) (154) Other (59) 150 (200) $7,785 $2,434 $ 122 Provision has been made for U.S. and Canadian taxes on undistributed earnings of the Company's Canadian subsidiary. The Company possesses approximately $10,570,000 of U.S. state income tax loss carryforwards. U.S. state loss carryforwards expire to the extent of $1,002,000 in the year 2005, $4,758,000 in 2006, and $4,810,000 in 2007. 11. SEGMENT INFORMATION AND MAJOR CUSTOMERS The Company operates in predominately one industry segment: the design, engineering and manufacture of certain components sold to manufacturers in the ground transportation industry. The Company, through its subsidiaries, operates primarily in two countries: the United States and Canada. The Company's Canadian subsidiary had net sales of $36,074,000 in 1993, $29,421,000 in 1992, and $21,735,000 in 1991. Total assets of the Canadian subsidiary were approximately $9,416,000 and $12,538,000 at December 31, 1993 and 1992, respectively. Intercompany sales were insignificant. Sales to three major customers, Ford Motor Company, Chrysler Corporation and General Motors Corporation, were approximately 72%, 11% and 4%, respectively, of the Company's net sales in 1993 as compared to 73%, 9% and 4% in 1992 and 69%, 8% and 8% in 1991. Accounts receivable from General Motors Corporation and Chrysler Corporation approximated 68% of trade accounts receivable at December 31, 1993 and 48% at December 31, 1992. Amounts due from Ford Motor Company are classified as "accounts receivable, related party" in the Company's balance sheet at December 31, 1993 and December 31, 1992. Sales to customers outside of the United States and Canada were not significant. 12. COMMON SHARES The Company has an incentive stock option plan covering key employees which was approved by shareholders in 1984. The plan provides that options may be granted at not less than fair market value and if not exercised, expire 10 years from the date of grant. At December 31, 1993, there were reserved 48,590 shares for the granting of options and options outstanding for 19,250 shares at an average exercise price of $6.59. During 1993, options for 7,875 shares were exercised at an average exercise price of $6.44. There were no options granted nor did any options expire during 1993. The Company has an employee stock purchase plan and has reserved 353,717 common shares for this purpose. The plan allows eligible employees to authorize payroll withholdings which are used to purchase common shares from the Company at ninety-percent (90%) of the closing price of the common shares on the date of purchase. Through December 31, 1993, 96,296 shares had been issued under the plan. The Company has reserved 2,270,319 common shares for possible future issuance in connection with its $30,000,000 convertible notes issued on January 2, 1990. 13. RELATED PARTY TRANSACTIONS Ford Motor Company owned 24% of the Company's common shares at December 31, 1993, 30% at December 31, 1992 and 40% at December 31, 1991. On January 11, 1994, Ford Motor Company donated 1,047,201 of the Company's common shares to the Ford Motor Company Fund. On January 13, 1994, Ford Motor Company and the Ford Motor Company Fund announced their intention to dispose of their combined 24% ownership in the Company through a secondary public offering. Ford officials stated that the disposition of common shares would not impact the customer-supplier relationship between Ford and the Company. Significant related party transactions are as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) Product sales $373,000 $311,000 $244,000 Product purchases 124,000 77,000 58,000 14. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following table sets forth in summary form the quarterly results of operations for the years ended December 31, 1993 and 1992. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth under the caption "ELECTION OF DIRECTORS" in the Company's proxy statement for the 1994 annual meeting of shareholders (the "Proxy Statement") is incorporated herein by reference. The Proxy Statement has previously been filed with the Securities and Exchange Commission. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the captions "Compensation of Directors," "Compensation Committee Interlocks and Insider Participation," "Compensation of Executive Officers," "Summary Compensation Table," "Pension Plan," and "Deferred Compensation Plans" in the Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the captions "Outstanding Shares," "Principal Shareholders," and "Security Ownership of Management" in the Proxy Statement is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Compensation Committee Interlocks and Insider Participation" in the Proxy Statement is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements The following consolidated financial statements of the Company and its subsidiaries are included in Item 8

708823_1993.txt

708823

1993

Item 1. Business - ----------------- GENERAL Centocor, Inc. ("Centocor" or the "Company") is a biopharmaceutical company specializing in the development and commercialization of monoclonal antibody- based products to meet critical human health care needs. Additionally, the Company performs research activities in the field of small peptide molecule- based pharmaceutical products. See "Business - Research and Development." The Company focuses on four major disease areas - infectious, cardiovascular and autoimmune diseases and cancer. The Company's therapeutic products under development include CentoRx, a product intended to treat or prevent the formation of blood clots in the cardiovascular system; Panorex, a product intended to treat colorectal cancer; CenTNF, a product targeted for the treatment of rheumatoid arthritis and inflammatory bowel diseases such as Crohn's disease; and HA-1A, a product intended for the treatment of patients with severe sepsis who are dying from endotoxemia. CentoRx is being developed by Centocor for Centocor Partners III, L.P. ("CPIII"). See "Business - Research and Development." For a further discussion of CentoRx, Panorex, CenTNF and HA- 1A, see "Products - Pharmaceutical Products." Other therapeutic products are also under development. The Company's imaging products include Myoscint, a cardiac imaging agent, and other contrast agents under development for use in in-vivo diagnostic imaging procedures. The Company has also developed a number of in-vitro diagnostic products which have generated substantially all of its product sales to date. Centocor has not received marketing approval from the U.S. Food and Drug Administration ("FDA") for any of its pharmaceutical products. One of the Company's in-vitro diagnostic products, CA 125, has received FDA approval. Since 1992, the Company has been implementing a business plan employing a collaborative strategy utilizing, among other things, alliances with established pharmaceutical companies. See Part II Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Part II Item 8 "Financial Statements and Supplementary Data." In the diagnostic area, Centocor has maintained distribution agreements with companies having established positions and distribution networks in applicable market segments. In conjunction with its business plan, Centocor eliminated its European and United States sales force and established collaborative arrangements in the pharmaceutical area in 1992 and 1993. Centocor expects to continue to pursue collaborative arrangements with pharmaceutical companies. At March 1, 1994, Centocor had approximately 500 full-time employees. To complement its own expertise in various fields, Centocor utilizes scientific consultants and advisors, many of whom have formal consulting agreements with Centocor. Centocor was incorporated in Pennsylvania in 1979 and maintains its principal executive offices at 200 Great Valley Parkway, Malvern, Pennsylvania 19355. Its telephone number is (610) 651-6000. The Company also maintains facilities in Leiden, The Netherlands, and Surrey, the United Kingdom, and an office in Tokyo, Japan. TECHNOLOGY AND KNOW-HOW Antibodies are proteins produced by cells from the immune system in response to the presence of specific antigens. An antigen is any substance which activates this immune response. Antibodies recognize the shape of particular compositions on the surface of antigens and bind specifically with only those antigens having such surface compositions. Prior to the development of monoclonal antibody technology in the 1970s, it was not practicable to separate and grow a single type of antibody. Monoclonal antibody technology involves the creation of a hybrid cell, or hybridoma, by combining a cell which produces a specific antibody with a cell which reproduces indefinitely. The resulting hybridoma produces a specific antibody continually. Antibodies produced by such hybridomas are chemically and structurally homogeneous and hence are monoclonal. Centocor believes that there is a significant potential for using monoclonal antibodies to develop human health care products. While the specificity of monoclonal antibodies makes them attractive candidates for pharmaceutical product development, antibody-based products generally must be administered by injection, usually in a hospital setting, and are therefore used principally to treat acute diseases. Centocor believes that small peptide molecule drugs may potentially be formulated for convenient administration, including oral delivery, thereby affording an opportunity to treat not only acute diseases, but the larger patient population with chronic disease indications as well. The Company is conducting research activities in the field of small peptide molecule-based pharmaceutical products. See "Business - Research and Development." PRODUCTS Pharmaceutical Products The Company is developing therapeutic products for use in the treatment of specific types of infectious, cardiovascular and autoimmune diseases and cancer. Cardiovascular Therapy. The Company's therapeutic products under ---------------------- development include CentoRx, a product intended to treat or prevent the formation of blood clots in the cardiovascular system. In the first quarter of 1993, the Company completed a randomized, double-blinded, placebo-controlled Phase III trial in high-risk coronary angioplasty patients that enrolled 2,099 patients at 56 medical centers. The Company filed product license applications for CentoRx in the United States and Canada in 1993 and has filed product license applications in several countries in Europe in 1994. There can be no assurance that CentoRx will be approved for commercial sale in the United States, Europe or elsewhere. See "Business -Research and Development." During the second quarter of 1993, Eli Lilly and Company ("Lilly") exercised its option to become the exclusive worldwide distributor of CentoRx and the Company and Lilly amended their Sales and Distribution Agreement to reflect such event. See "Business - Marketing and Sales." Pursuant to that amendment, Lilly has assisted the Company and will continue to assist the Company in the regulatory filings and continued development of CentoRx for various clinical indications. Cancer Therapy. Panorex, a product intended to treat colorectal -------------- cancer, has been tested in a Phase III trial at six German medical centers which enrolled 189 colorectal cancer patients who were subsequently monitored for the accumulation of five-year survival data. The Company expects to complete the filing of an application in 1994 requesting marketing approval for Panorex in Germany. There can be no assurance that Panorex will be approved for commercial sale in Germany or elsewhere. During 1993, the Company and Wellcome plc ("Wellcome") entered into an alliance agreement for the development and marketing of certain of the Company's monoclonal antibody-based cancer therapeutic products, including Panorex. See "Business - Marketing and Sales." Autoimmune Disease Therapy. The Company is currently developing -------------------------- CenTNF, a product targeted for the treatment of rheumatoid arthritis and inflammatory bowel diseases such as Crohn's disease. The Company is conducting Phase II clinical trials of CenTNF in rheumatoid arthritis and Crohn's disease and expects to commence a Phase III study in Europe in 1994. The Company has entered into an agreement with Tanabe Seiyaku Co., Ltd. under which Tanabe will undertake the human clinical testing and distribution of CenTNF in Japan. Infectious Disease Therapy. HA-1A is a product intended for the -------------------------- treatment of patients with severe sepsis who are dying from endotoxemia. The Company has filed product license applications in the United States, Europe, and other countries seeking approval to market HA-1A. Regulatory approvals to market HA-1A were received in several European countries. In April 1992, the FDA advised the Company that there was insufficient evidence of efficacy for approval of HA-1A at that time. In June 1992, the Company initiated a second randomized, double-blinded, placebo-controlled, Phase III U.S. clinical trial of HA-1A in the treatment of patients with Gram-negative bacteremia and septic shock. The Company terminated this trial in 1993 after concluding that there was no reduction in the mortality rate among HA-1A-treated patients who did have Gram-negative bacteremia in comparison with placebo-treated patients in the same group. The Company and its principal distributor of HA-1A, Lilly, also voluntarily suspended sales and conducted a recall of the drug in Europe and elsewhere where the drug is authorized for sale. The regulatory approvals to market HA-1A currently remain in effect pending the results of further clinical trials. The Company is currently conducting a randomized, double-blinded, placebo-controlled Phase III European clinical trial of the efficacy of HA-1A in the treatment of patients with fulminant meningococcemia. There can be no assurance that any further trials of HA-1A will be initiated or will be successful. The Company is supplying HA-1A on a limited compassionate-use basis in certain countries in Europe. There can be no assurance that any commercial sales of HA-1A will resume in Europe. Diagnostic Imaging Products The Company has developed techniques for modifying monoclonal antibodies so that they may be coupled with radioactive isotopes and used as contrast agents in diagnostic imaging procedures. After injection, antibodies labelled with a radioactive isotope travel to the disease site, allowing the site to be visualized or "imaged" with nuclear medicine equipment in a procedure similar to an X-ray. The Company's focus in this area is primarily on developing imaging agents for cardiovascular disease. The Company has received marketing approvals for Myoscint, a cardiac imaging agent, in several European countries and a United States product license application for Myoscint is expected to be resubmitted to the FDA in 1994. Revenues from the sale of Myoscint in Europe have not been significant. There can be no assurance that Myoscint will be approved by the FDA or that sales, if any, in the United States will be significant. In-Vitro Diagnostic Products In-vitro diagnostic products are used to test patient blood samples outside the body to detect or monitor disease. In this area, the Company has focused principally on developing cancer diagnostic assays, certain of which it now manufactures and sells, as follows: Ovarian Cancer Test, CA 125. CA 125, which aids in the detection of --------------------------- residual epithelial ovarian cancer following first-line therapy, is sold for clinical use in the United States, certain European countries and Japan. Pancreatic Cancer Test, CA 19-9. CA 19-9, which aids in the detection ------------------------------- of pancreatic cancer, is sold for clinical use in certain European countries and Japan. Breast Cancer Test, CA 15-3. CA 15-3, which aids in the monitoring of --------------------------- breast cancer, is sold for clinical use in certain European countries and Japan. Gastric Cancer Test, CA 72-4. CA 72-4, which aids in the monitoring ---------------------------- of gastrointestinal cancer, is sold for clinical use in certain European countries and Japan. Multidrug Resistance Test, P-glycoCHEK. P-glycoCHEK, which detects a -------------------------------------- cellular protein associated with resistance to chemotherapeutic drugs, is available for investigational use in certain European countries and Japan. Non-Small Cell Lung Cancer Test, CYFRA 21-1. CYFRA 21-1, which aids ------------------------------------------- in the monitoring of non-small cell lung cancer, is available for clinical use in certain European countries and investigational use in Japan. Additionally, the Company manufactures and sells various in-vitro diagnostic products for infectious disease primarily in Europe. The Company submitted an application to the FDA in 1994 seeking approval to market a blood test for the detection of syphilis. The following product names are trademarks of the Company: HA-1A, Centoxin, CentoRx, CenTNF, Panorex, Myoscint, Capiscint, P-glycoCHEK, CA 125, CA 19-9, CA 72-4, CA 15-3, and CYFRA 21-1. MARKETING AND SALES In the in-vitro diagnostic and imaging areas, Centocor has distribution agreements with companies having established positions and distribution networks in applicable market segments. During 1992, the Company adopted a similar collaborative strategy in its pharmaceutical business. In conjunction with such marketing strategy, the Company eliminated its European sales force in 1992 and eliminated its United States sales force in 1993. In July 1992, the Company and Lilly entered into a Sales and Distribution Agreement. During the second quarter of 1993, Lilly exercised its option under the Agreement to become the exclusive worldwide distributor of CentoRx and the Company and Lilly amended their Sales and Distribution Agreement to reflect such event. Under that Agreement, the Company is principally responsible for developing and manufacturing HA-1A and CentoRx and for securing regulatory approvals. If sales of HA-1A are resumed or approvals for the sale of CentoRx are obtained, Lilly will be principally responsible for the marketing, selling and distribution of HA-1A and CentoRx. The Company will sell the product to Lilly for Lilly's further sale to the end market. See Part II Item 8 "Financial Statements and Supplementary Data." In November 1993, the Company and Wellcome entered into an alliance agreement for the development and marketing of certain of the Company's monoclonal antibody-based cancer therapeutic products, including Panorex. Wellcome will contribute to the continuing clinical development of Panorex and six other potential drugs and then market and sell any approved drugs in most parts of the world. See Part II Item 8 "Financial Statements and Supplementary Data." During 1993, approximately 42 percent of the Company's total product sales were to three distributors: Toray-Fuji Bionics, Inc. in Japan, Compagnie Oris Industrie in France and Boehringer Mannheim GmbH in Germany. Additionally, prior to June 30, 1991, sales of in-vitro diagnostic products included investigational-use-only sales in the United States of certain products which have not been approved by the FDA, including CA 19-9, CA 15-3, CA 72-4, P- glycoCHEK and Gamma Interferon. Effective June 30, 1991, the Company ceased sales in the United States of all diagnostic products which had not been approved by the FDA. Certain financial information by geographic area as well as major customer information is set forth in Part II Item 8 "Financial Statements and Supplementary Data." The Company has no significant product backlog. MANUFACTURING The Company currently maintains a biopharmaceutical manufacturing facility in Leiden, The Netherlands, for the production of monoclonal antibody- based products using a proprietary cell-culture system. See Item 2

ITEM 2. PROPERTIES - ------------------- The Company owns four buildings in Malvern, Pennsylvania, and leases space in other buildings at this location. These buildings contain Centocor's corporate offices, research and development laboratories, marketing offices, and certain manufacturing facilities. Space is available in these buildings for future expansion. The acquisition costs of certain of these buildings were financed in part by mortgage loans which are still outstanding. The Company owns a biopharmaceutical manufacturing facility in Leiden, The Netherlands, and also leases research and development laboratories and office space at such location. A portion of the construction cost of the Leiden facility was financed by a mortgage loan which is still outstanding. See Part II Item 8 "Financial Statements and Supplementary Data." The Company also leases an in-vitro diagnostic manufacturing facility in Surrey, the United Kingdom. As a result of the downsizing of the Company's staff and present level of operations, portions of the Company's facilities and equipment in Malvern and Leiden are idle. The Company continually evaluates the future needs for its facilities and equipment. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS - -------------------------- SHAREHOLDER LITIGATION On December 23, 1993, a purported class action captioned Peter Cordaro v. Hubert J.P. Schoemaker, Stelios Papadopoulos, Marc Feldmann, David Golden, Centocor, Inc., and Tocor II, Inc. was filed in the Court of Common Pleas of the Commonwealth of Pennsylvania, in and for Chester County. The complaint alleges that the defendants breached their fiduciary duties to Tocor II Unitholders by, among other things, making the Exchange Offer, recommending acceptance of the Exchange Offer, and failing to maximize shareholder value. The complaint sought, among other relief, an injunction against consummation of the Exchange Offer, the establishment of a "truly independent" special committee and financial advisor to consider the Exchange Offer, and an award of damages (including rescissionary damages), costs and plaintiff's counsel fees. No injunction was, in fact, sought, and the Exchange Offer was made and consummated. The Company believes that the allegations set forth in the complaint are without merit and intends to vigorously defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. In January 1993, purported security holders of the Company and/or Tocor II filed complaints in the United States District Court for the Eastern District of Pennsylvania against the Company, Tocor II, and certain present and former directors and/or officers of the Company and/or Tocor II, and Lilly. The cases were consolidated pursuant to an order, and a Consolidated Class Action Complaint captioned In Re Centocor Securities Litigation II, No. 93-CV-0236 (the "Complaint") was filed in May 1993, based on alleged violations of securities laws and alleged breaches of the named individual defendants of fiduciary duties to Centocor. All claims against all defendants, except the Company and two of its officers/directors, were voluntarily dismissed when the Complaint was filed. The Complaint alleges that defendants knowingly or recklessly omitted certain material facts and made false and misleading statements of material facts about the Company in violation of Sections 10(b) and 20 of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and also alleges violations of the common law of negligent misrepresentation. The action has been conditionally certified as a class action on behalf of persons who purchased common stock of the Company from April 21, 1992 through January 15, 1993 and who were allegedly damaged thereby. The Complaint seeks compensatory damages in unspecified amounts, counsel fees, interest, costs of suit, and such other relief that the court deems appropriate. Defendants answered the Complaint and denied the allegations therein. The Company believes that the allegations set forth in the Complaint are without merit and intends to vigorously defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. On June 3, 1993, the United States District Court for the Eastern District of Pennsylvania entered an order approving as final a settlement of the class action securities litigation and derivative actions captioned In Re Centocor, Inc. Securities Litigation, No. 92-CV-1071, which had been preliminarily approved in December 1992. The court had previously entered an order certifying (i) the litigation to proceed as a class action and (ii) a class of plaintiffs consisting of all persons who purchased the Company's securities during the period February 19, 1991 through April 20, 1992, and who sustained damages as a result of such purchases. All claims against the Company and the other defendants were dismissed on June 3, 1993, except as to those who opted out of the class. In settlement of the securities claims, the Company made a cash payment of $18,000,000; in settlement of the derivative action brought on behalf of the Company, the Company received a cash payment of $8,000,000; and in settlement of the derivative action brought on behalf of Tocor II, the Company and Tocor II amended certain agreements between them to provide that the Company would, over time, forego $3,000,000 of contract payments. In connection with the settlement, the Company recorded a charge to earnings of $11,245,000 in the fourth quarter of 1992, representing the net cost of the proposed settlement to the Company, including legal fees. The Company does not expect the effect, if any, of the outcome of any litigation resulting from those who opted out of the class to be material to the Company's financial condition. OTHER LITIGATION In October 1992, the Company was served with a complaint filed by the Velos Group, a Maryland partnership ("Velos"), in the United States District Court for the District of Maryland. The complaint alleges, principally, that the Company breached certain provisions of a license agreement between Velos and the Company pursuant to which the Company has exclusive rights to U.S. Patent No. 5,057,598, which includes claims relating to monoclonal antibodies used in treating manifestations of Gram-negative bacterial infections. The complaint seeks declaratory relief, monetary relief in excess of $100,000,000, and requests that the Company place in escrow one-half of the amounts received by the Company pursuant to its agreements with Lilly. The complaint does not seek to terminate or rescind any of the Company's rights under the license agreement. The Company answered the complaint and asserted affirmative defenses and counterclaims on January 7, 1993, but the counterclaims and certain affirmative defenses were dismissed with leave to replead on June 22, 1993. On July 28, 1993, the Court permitted plaintiff to file an amended complaint that updated some of the claims in the original complaint but otherwise reasserted the basic factual allegations and, with one minor exception, relied upon the same legal theories. On August 27, 1993, the Company filed its Answer, Affirmative Defenses and Counterclaim for Damages and Equitable Relief (the "Amended Answer"). In the Amended Answer, the Company again denied all of the allegations made by Velos and stated certain affirmative defenses and counterclaims against Velos with respect to the license agreement, based on theories of (i) failure of consideration, (ii) fraud in the inducement, and (iii) unilateral mistake as to facts, which mistake was induced by the fraudulent misrepresentation of Velos. On September 22, 1993, plaintiff moved to dismiss the Company's counterclaims and to strike certain of Centocor's affirmative defenses. The Company has responded to that motion. The Company believes that the allegations of Velos are without merit and intends to vigorously defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. In May 1993, the Company was served with a complaint filed earlier in the United States District Court for the Southern District of California at San Diego. The plaintiff, who allegedly had purchased shares of Corvas International Inc. ("Corvas"), a California corporation, in its initial public offering on January 30, 1992, brought suit against Corvas and certain of its directors, the Company, and one of the Company's directors and a former director (the "Centocor defendants"), on behalf of similarly situated investors. The complaint alleges the defendants violated the federal securities laws by disclosing to Corvas' investors that Centocor and Corvas had entered into a "strategic alliance" to develop one of Corvas' products, but failing to disclose that the Company allegedly would not be able to perform on that agreement because of events relating to Centoxin (HA-1A). The Complaint sought to proceed as a class action on behalf of all those who purchased Corvas common stock during the period from January 30, 1992 through January 15, 1993. A motion to dismiss the complaint in its entirety as to the Centocor defendants was filed in early June 1993. Corvas and its directors had filed a motion to dismiss earlier. In September the Court dismissed a number of plaintiff's claims including claims relating to the period after April 14, 1992 and, in effect, the claim brought against the Company under Section 10(b) of the Securities Exchange Act of 1934. The Company believes the allegations which remain are without merit and intends vigorously to defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED - --------------------------------------------------------- STOCKHOLDER MATTERS ------------------- Centocor's Common Stock is traded on the National Market System of NASDAQ under the symbol CNTO. Set forth below for the indicated periods are the high and low sale prices for Centocor's Common Stock: The number of shareholders of record on March 1, 1994 was 5,657. No dividends have been paid on the Common Stock to date, and the Company does not expect to pay cash dividends in the foreseeable future. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA -------------------------------- (in thousands except per share data) CONSOLIDATED STATEMENTS OF OPERATIONS DATA CONSOLIDATED BALANCE SHEET DATA No dividends have been declared or paid during any of the periods presented. *Other contract revenues include $5,000 and $50,000 from Lilly in 1993 and 1992, respectively and $10,000 from Wellcome in 1993. **Costs and expenses include the following: (a) charges for acquired research and development of $70,147 and $115,475 in 1991 and 1990, respectively, (b) charges of $ 3,500, $ 64,877 and $3,518 in 1993, 1992 and 1990, respectively, related to HA-1A inventory and (c) restructuring charges of $9,387, $15,266 and $3,548 in 1993, 1992 and 1990, respectively. ***Other income (expenses) include a charge of $11,245 in 1992 related to the settlement of certain litigation and gains of $12,976 in 1990 from the sale of certain investments. ****Cash and investments at December 31, 1993 included equity investments of $11,230. Additionally, the Company maintained $26,375 of investments at certain banks as collateral for certain debt outstanding at December 31, 1993. The data above does not reflect the increase in cash and investments of $51,494, and an increase in shareholders' equity of $38,198, which would have resulted if the Tocor II Exchange Offer were consummated as of December 31, 1993. Further in connection with the consummation of the Tocor II Exchange Offer the Company will record a charge to earnings of $36,454 in the first quarter of 1994 representing principally the cost of acquired research and development. See Note 18 to the Company's Consolidated Financial Statements. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL - ---------------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS ----------------------------------- FINANCIAL CONDITION LIQUIDITY AND CAPITAL RESOURCES The Company's future financial condition is highly dependent upon the reduction of the Company's rate of net cash outflows and, ultimately, upon the achievement of significant and sustained levels of pharmaceutical product sales. The Company will need to secure significant additional capital in the future from collaborative arrangements with pharmaceutical companies or from the capital markets until significant and sustained levels of pharmaceutical sales are achieved. There can be no assurance that significant additional capital will be available to the Company. There also can be no assurance that the Company will materially reduce its current rate of net cash outflows or generate significant and sustained levels of pharmaceutical product sales. The FDA has not approved any of the Company's pharmaceutical products for marketing. There can be no assurance that FDA or other regulatory approvals of any of the Company's products will be obtained. Failure to obtain timely FDA or other regulatory approvals of pharmaceutical products will have a material adverse effect on the Company. The status of the Company's major pharmaceutical products is discussed below. The Company has been implementing a business plan employing a collaborative strategy utilizing, among other things, alliances with established pharmaceutical companies. The Company's ability to further reduce its current rate of net cash outflows is also dependent upon the extent to which it can expand collaborations with established pharmaceutical companies and achieve milestones under such collaborative agreements. No assurance can be given that such collaborations can be expanded or that such milestones can be achieved. At December 31, 1993, the Company had cash, cash equivalents and investments of $140,028,000, including equity investments of $11,230,000. During the year ended December 31, 1993, the Company had negative cash flows from operations of $42,297,000. The Company's total cash flows in 1993 included $30,000,000 received from Wellcome of which $20,000,000 was received for the purchase of 2,000,000 shares of the Company's Common Stock. Additionally, cash flows in 1993 included the proceeds of $11,900,000 from the sale of the Company's St. Louis facility and the repayment of $5,800,000 of mortgage debt related to that facility. If the exchange offer which is discussed in Note 18 to the Company's Consolidated Financial Statements had been consummated as of December 31, 1993, the Company's cash and investment balance at December 31, 1993 would have been $191,522,000. At December 31, 1992, the Company had cash, cash equivalents, and investments of $163,083,000, including equity investments of $12,924,000. During the year ended December 31, 1992, the Company had negative cash flows from operations of $109,818,000 and acquired $23,309,000 of fixed assets. Cash flows from operations for the year ended December 31, 1992 included $50,000,000 received from Lilly primarily for reimbursement of expenses associated with HA- 1A. Additionally, during 1992, the Company expended $12,375,000 to purchase the limited partnership interests in CPII, $8,700,000 to acquire all the outstanding shares of capital stock of Mercia Diagnostics Limited ("Mercia"), a European diagnostics manufacturing and sales company, and $10,000,000 in connection with the settlement of certain class action securities litigation. These cash outflows were partially offset by cash inflows which included the receipt of $50,000,000 from Lilly for the purchase of 2,000,000 shares of the Company's Common Stock and $15,931,000 from borrowings under loan agreements. During the year ended December 31, 1991, the Company had negative cash flows from operations of $137,039,000 and acquired $31,129,000 of fixed assets. Also during 1991, the Company received significant cash inflows from financing activities, principally the net proceeds of $224,537,000 from the issuance of the Company's 7-1/4 percent Notes and 6-3/4 percent Debentures. During the years ended December 31, 1992 and 1991, the Company received $17,726,000 and $80,272,000, respectively, from the exercise of warrants and options to purchase shares of the Company's Common Stock. The extent and timing of future warrant and option exercises, if any, are primarily dependent upon the market price of the Company's Common Stock and general financial market conditions, as well as the exercise prices and expiration dates of the warrants and options. Agreements covering $20,402,000 of the Company's outstanding debt balances contain certain financial and non-financial covenants, including the maintenance of minimum equity and cash balances and compliance with certain financial ratios. The Company has obtained waivers of certain of such covenants on the condition that it maintain certain investments at the lending bank, which at December 31, 1993 totalled $20,000,000. There can be no assurance that the Company will be able to continue to collateralize such loans and, accordingly, the Company has classified $20,402,000 of debt as short-term. Additionally, $6,186,000 of the Company's short- term debt is secured by investments at the lending bank of $6,375,000. If cash flows continue to be negative, the Company's ability to service its debt may be impaired. See Note 2 to the Company's Consolidated Financial Statements for a discussion of litigation and other factors which may affect the Company's future liquidity and capital resources. STATUS OF CENTORX The Company's therapeutic products under development include CentoRx, a product intended to treat or prevent the formation of blood clots in the cardiovascular system. In the first quarter of 1993, the Company completed a randomized, double-blinded, placebo-controlled Phase III trial in high-risk coronary angioplasty patients that enrolled 2,099 patients at 56 medical centers. The Company filed product license applications for CentoRx in the United States and Canada in 1993 and has filed product license applications in several countries in Europe in 1994. There can be no assurance that CentoRx will be approved for commercial sale in the United States, Europe or elsewhere. See Part I Item 1 "Business - Research and Development." During the second quarter of 1993, Lilly exercised its option to become the exclusive worldwide distributor of CentoRx and the Company and Lilly amended their Sales and Distribution Agreement to reflect such event. See Part I Item 1 "Business - Marketing and Sales." Pursuant to that amendment, Lilly has assisted the Company and will continue to assist the Company in the regulatory filings and continued development of CentoRx for various clinical indications. STATUS OF PANOREX Panorex, a product intended to treat colorectal cancer, has been tested in a Phase III trial at six German medical centers which enrolled 189 colorectal cancer patients who were subsequently monitored for the accumulation of five- year survival data. The Company expects to complete the filing of an application in 1994 requesting marketing approval for Panorex in Germany. There can be no assurance that Panorex will be approved for commercial sale in Germany or elsewhere. During 1993, the Company and Wellcome entered into an alliance agreement for the development and marketing of certain of the Company's monoclonal antibody-based cancer therapeutic products, including Panorex. See Part I Item 1 "Business - Marketing and Sales." STATUS OF HA-1A HA-1A is a product intended for the treatment of patients with severe sepsis who are dying from endotoxemia. The Company has filed product license applications in the United States, Europe, and other countries seeking approval to market HA-1A. Regulatory approvals to market HA-1A were received in several European countries. In April 1992, the FDA advised the Company that there was insufficient evidence of efficacy for approval of HA-1A at that time. In June 1992, the Company initiated a second randomized, double-blinded, placebo- controlled, Phase III U.S. clinical trial of HA-1A in the treatment of patients with Gram-negative bacteremia and septic shock. The Company terminated this trial in 1993 after concluding that there was no reduction in the mortality rate among HA-1A-treated patients who did have Gram-negative bacteremia in comparison with placebo-treated patients in the same group. The Company and its principal distributor of HA-1A, Lilly, also voluntarily suspended sales and conducted a recall of the drug in Europe and elsewhere where the drug is authorized for sale. The regulatory approvals to market HA-1A currently remain in effect pending the results of further clinical trials. The Company is currently conducting a randomized, double-blinded, placebo-controlled Phase III European clinical trial of the efficacy of HA-1A in the treatment of patients with fulminant meningococcemia. There can be no assurance that any further trials of HA-1A will be initiated or will be successful. The Company is supplying HA-1A on a limited compassionate-use basis in certain countries in Europe. There can be no assurance that any commercial sales of HA-1A will resume in Europe. ASSETS The decrease in the aggregate amount of cash and investments at December 31, 1993 as compared to December 31, 1992 is discussed under Liquidity and Capital Resources. The decrease in the Company's inventory balance at December 31, 1993 as compared to December 31, 1992 is primarily due to the recording of reserves for HA-1A inventories. Gross fixed assets at December 31, 1993 decreased as compared to December 31, 1992 principally due to the sale of the Company's St. Louis manufacturing facility in July 1993. The Company expects investments in fixed assets of approximately $6,000,000 in 1994. As a result of the downsizing of the Company's staff and present level of operations, the Company currently maintains idle facilities and equipment. The Company continually evaluates the future needs for its facilities and equipment. There can be no assurance that reserves to further reduce the carrying value of certain fixed assets will not be required in the future. LIABILITIES AND SHAREHOLDERS' EQUITY Shareholders' equity at December 31, 1993 decreased as compared to December 31, 1992 principally as a result of the Company's loss for the year ended December 31, 1993, partially offset by an increase in additional paid-in capital due to the issuance of Common Stock to Wellcome and the receipt of the proceeds from the exercise of options and warrants. The extent and timing of future warrant and option exercises, if any, are primarily dependent upon the market price of the Company's Common Stock and general financial market conditions, as well as the exercise prices and expiration dates of the warrants and options. At December 31, 1993, the Company's liabilities exceeded its assets, resulting in a negative shareholders' equity balance. Shareholders' equity will decrease further in future periods unless and until the Company is successful in securing additional capital from collaborative arrangements with pharmaceutical companies or the capital markets or significant and sustained levels of pharmaceutical product sales are achieved. There can be no assurance that significant and sustained levels of pharmaceutical products sales will be achieved or that any additional capital will be available to the Company. If the exchange offer, as described in Note 18 to the Company's Consolidated Financial Statements had been consummated as of December 31, 1993, the Company's shareholders' equity position at December 31, 1993 would have been approximately $19,004,000. RESULTS OF OPERATIONS SPECIAL CHARGES The results of operations for the year ended December 31, 1993 include restructuring charges of $4,273,000 related to reserves for certain fixed assets no longer used or subsequently disposed and $5,114,000 principally related to severance. A charge of $3,500,000 related to HA-1A inventory was recorded in the fourth quarter of 1993. The results of operations for the year ended December 31, 1992 included a charge of $64,877,000 representing reserves for HA- 1A inventories and a charge of $11,245,000 related to the settlement of certain class action securities litigation. Additionally, during the year ended December 31, 1992, the Company recorded a restructuring charge of $15,266,000 related to the downsizing of its operations. The results of operations for the year ended December 31, 1991 included a charge to earnings of $70,147,000 for acquired research and development as a result of the Company's purchase of all of the callable common stock of Tocor. Excluding the items described above, the Company incurred losses for each of the years in the three year period ended December 31, 1993. There can be no assurance that additional charges will not be required in the future. In the first quarter of 1994, the Company will record a charge to earnings of $36,454,000 for acquired research and development as a result of an exchange offer which is described in Note 18 to the Company's Consolidated Financial Statements. REVENUES Product sales have not produced sufficient revenues to cover the Company's operating expenses. The decrease in sales for 1993 as compared to 1992 is principally due to HA-1A sales recorded during 1992 which did not recur in 1993 (see Status of HA-1A). There were no HA-1A sales for 1993 whereas 1992 sales of HA-1A totalled $12,545,000. Contract revenues for the year ended December 31, 1993 include $10,109,000, net of warrant amortization costs, recognized pursuant to the Company's agreements with Tocor II as compared to $16,071,000 for the year ended December 31, 1992. Revenues from Tocor II for the year ended December 31, 1992 included a $2,500,000 non-refundable fee from Tocor II in connection with the license of certain technology by the Company to Tocor II. The decrease in such revenues for the year ended December 31, 1993 is principally due to a reduction in the Company's antibody research program costs allocated to the Tocor II research program. Contract revenues for the years ended 1993 and 1992 also included $5,000,000 and $50,000,000, respectively, of revenues recognized pursuant to the Company's agreements with Lilly and $10,000,000 of revenues recognized in 1993 pursuant to the Company's agreements with Wellcome. For the year ended December 31, 1991, contract revenues consisted principally of revenues from research and development agreements with CPII, CPIII, and Tocor. The Company acquired all of the callable common stock of Tocor in 1991 and the limited partnership interests in CPII in 1992. Funding for the CPIII research and development agreement was exhausted in 1991. As a result of an exchange offer which is more fully described in Note 18 to the Company's Consolidated Financial Statements, the revenues under the Tocor II research programs will terminate in 1994. The level of contract revenues in future periods will primarily depend upon the extent to which the Company enters into other collaborative contractual arrangements, if any, and the achievement of milestones under current arrangements. COSTS AND EXPENSES Cost of sales decreased in 1993 as compared to 1992 due to decreased sales, principally sales of HA-1A as discussed above. Cost of sales increased in 1992 as compared to 1991 due to increased sales, principally sales of HA-1A. The Company manufactures its pharmaceutical products at its manufacturing facility in Leiden, The Netherlands. Consequently, the strength of the Dutch Guilder in relation to the U.S. dollar may have an impact on the costs of production and, therefore, the profit margin from sales. Additionally, the Company's antibody- based products are produced through the growth of living cells in culture, which cells secrete the desired antibody. The production cost per unit and, consequently, the profit margin from sales, are highly dependent upon the antibody yields. As further described in Note 2 to the Company's Consolidated Financial Statements, the Company is required to make certain royalty payments based on sales of products, which payments are reflected in cost of sales. Royalty costs represent a significant percentage of sales. Research and development expenses decreased in 1993 as compared to 1992 due principally to a decrease in costs associated with clinical trials of products under development. Research and development expenses increased in 1992 as compared to 1991 principally due to an increase in the allocation of certain resources to research and development efforts due to a decrease in the level of inventory production, and increased costs associated with clinical trials of products under development. The Company expects an increased level of clinical trial expenses in 1994 as compared to 1993. Marketing, general and administrative expenses for the year ended December 31, 1993 decreased as compared to the year ended December 31, 1992, due principally to reductions in sales and administrative staffs, marketing costs and legal costs. Marketing, general and administrative expense for the year ended December 31, 1992 decreased as compared to 1991 due principally to reduced legal costs combined with decreased costs from selective reductions in staff and other cost reduction efforts. The Company expects to maintain current levels of marketing, general and administrative expenses in 1994. OTHER INCOME AND EXPENSES Interest income decreased in 1993 as compared to 1992 due principally to a reduction in the Company's cash and investment balances and reduced interest rates on investment. Interest income in future periods will depend primarily on the level of the Company's investments and the interest rates obtained on such investments. During 1993 and 1992, the Company recorded unrealized losses of $2,477,000 and $2,296,000, respectively, due to the other than temporary reduction in the market value of marketable equity investments below the Company's cost for such investments. During the year ended December 31, 1992, the Company recorded a gain of $1,170,000 from the sale of certain securities. PER SHARE CALCULATIONS At December 31, 1993, approximately 18,962,000 shares of the Company's Common Stock were issuable upon exercise of outstanding options and warrants and upon vesting of restricted stock awards. Options, warrants, and stock awards are considered Common Stock equivalents for purposes of per share data. The Company uses the modified treasury stock method of calculating per share data since the number of shares of the Company's Common Stock issuable upon the exercise of Common Stock equivalents is in excess of 20 percent of the Company's outstanding Common Stock. Under the modified treasury stock method, the effect of Common Stock issuable upon the exercise of Common Stock equivalents is reflected in the per share data calculation only if the aggregate effect would be dilutive. The 3,843,000 shares issuable upon conversion of the 7-1/4 percent Notes and the 2,049,000 shares issuable upon conversion of the 6-3/4 percent Debentures are not considered Common Stock equivalents and are not included in the calculation of primary per share data but are included in the calculation of fully diluted per share data if their effect is dilutive. No Common Stock equivalents or shares issuable upon conversion of the 7-1/4 percent Notes and 6-3/4 percent Debentures were included in the per share calculations for any periods presented since to do so would have been antidilutive as the Company has recorded net losses in all periods presented. In future periods, depending upon the market value of the Company's Common Stock and its results of operations for such periods, the Company may be required to include its then outstanding Common Stock equivalents as well as shares issuable upon the conversion of the 7-1/4 percent Notes and the 6-3/4 percent Debentures in its calculations of per share data for such periods if the effect would be dilutive. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ----------------------------------------------------- CONSOLIDATED BALANCE SHEETS (In thousands) See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEETS (CONT'D.) (In thousands) See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands except per share data) See accompanying Notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In thousands) Notes to Consolidated Financial Statements Note 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation --------------------- The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries and joint ventures. Investments ----------- The Company classifies investments with original maturities of three months or less as cash equivalents. Investments with maturities of one year or less are classified as short-term. Short-term marketable securities are carried at cost, which approximates market value. Long-term debt securities which the Company has the ability and intent to hold until maturity are carried at cost. Long-term marketable equity securities are carried at the lower of cost or market value. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" which must be adopted by the Company beginning January 1, 1994. The Company does not expect the effect of adoption of this statement to be material to its financial statements. Inventory --------- Inventory is stated at the lower of cost or market using the first-in, first-out method for diagnostic product inventories and the average cost method for pharmaceutical product inventories. Inventories have various expiration dates. Reserves are provided for inventories which are likely to expire prior to sale or are likely to be otherwise not available for sale. Fixed Assets and Depreciation ----------------------------- Fixed assets are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the assets, which range from 3 to 31 years. Leasehold improvements are amortized over the applicable lease period or their estimated useful lives, whichever is shorter. Maintenance and repairs are charged to expense, and major renewals and improvements are capitalized. Intangible Assets ----------------- Intangible assets are stated at cost, net of accumulated amortization. Amortization is provided using the straight-line method over the estimated useful lives of the assets, generally 10 to 20 years. Intangible assets at December 31, 1993 and 1992 were $9,364,000 and Notes to Consolidated Financial Statements $11,560,000, respectively, net of accumulated amortization of $3,666,000 and $5,583,000 at December 31, 1993 and 1992, respectively. Revenue Recognition ------------------- For contracts under which the Company is reimbursed for expenses, revenue is recognized as the related expenses are incurred. Non-refundable fees or milestone payments in connection with research and development or commercialization agreements are recognized when they are earned in accordance with the applicable performance requirements and contractual terms. Payments received which are related to future performance are deferred and recognized as revenue over the specified future performance periods. Sales revenues are recognized at the time the goods are shipped or when title to the goods passes to the buyer. Income Taxes ------------ Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes." The adoption of SFAS 109 had no impact on the Company's financial statements. See Note 13. Per Share Data -------------- Per share data are based upon the modified treasury stock method and are calculated using the weighted average number of outstanding shares of Common Stock. Common Stock issuable upon the exercise of stock options or warrants and upon the vesting of restricted stock awards are included in the per share calculations only to the extent their inclusion would have an aggregate dilutive effect. Common Stock issuable upon conversion of convertible debt securities are included only in the fully diluted per share calculations to the extent their inclusion would have a dilutive effect. Foreign Currency Translation ---------------------------- Assets and liabilities of subsidiaries denominated in foreign currencies are translated at rates in effect at the appropriate year-end. The revenues and expenses of such subsidiaries are translated at average rates for the period of operation. The differences resulting from such translation as compared to the equity of such subsidiaries translated at historical rates are included in cumulative foreign currency translation adjustments, a separate component of shareholders' equity. Notes to Consolidated Financial Statements Note 2 COMMITMENTS AND CONTINGENCIES Liquidity and Capital Resources The Company's future financial condition is highly dependent upon the reduction of the Company's rate of net cash outflows and, ultimately, upon the achievement of significant and sustained levels of pharmaceutical product sales. The Company will need to secure significant additional capital in the future from collaborative arrangements with pharmaceutical companies or from the capital markets until significant and sustained levels of pharmaceutical sales are achieved. There can be no assurance that significant additional capital will be available to the Company. There also can be no assurance that the Company will materially reduce its current rate of net cash outflows or generate significant and sustained levels of pharmaceutical product sales. The FDA has not approved any of the Company's pharmaceutical products for marketing. There can be no assurance that FDA or other regulatory approvals of any of the Company's products will be obtained. Failure to obtain timely FDA or other regulatory approvals of pharmaceutical products will have a material adverse effect on the Company. The status of the Company's major pharmaceutical products is discussed below. The Company has been implementing a business plan employing a collaborative strategy utilizing, among other things, alliances with established pharmaceutical companies. The Company's ability to further reduce its current rate of net cash outflows is also dependent upon the extent to which it can expand collaborations with established pharmaceutical companies and achieve milestones under such collaborative agreements. No assurance can be given that such collaborations can be expanded or that such milestones can be achieved. At December 31, 1993, the Company had cash, cash equivalents and investments of $140,028,000, including equity investments of $11,230,000. During the year ended December 31, 1993, the Company had negative cash flows from operations of $42,297,000. The Company's total cash flows in 1993 included $30,000,000 received from Wellcome of which $20,000,000 was received for the purchase of 2,000,000 shares of the Company's Common Stock. Additionally, cash flows in 1993 included the proceeds of $11,900,000 from the sale of the Company's St. Louis facility and the repayment of $5,800,000 of mortgage debt related to that facility. If the Exchange Offer which is discussed in Note 18 had been consummated as of December 31, 1993, the Company's cash and investment balance at December 31, 1993 would have been $191,522,000. At December 31, 1992, the Company had cash, cash equivalents, and investments of $163,083,000, including equity investments of $12,924,000. During the year ended December 31, 1992, the Company had negative cash flows from operations of $109,818,000 and acquired $23,309,000 of fixed assets. Cash flows from operations for the year ended December 31, 1992 included $50,000,000 received from Lilly primarily for reimbursement of expenses associated with HA-1A. Additionally, during 1992, the Company expended $12,375,000 to purchase the limited partnership interests in Notes to Consolidated Financial Statements CPII, $8,700,000 to acquire all the outstanding shares of capital stock of Mercia, a European diagnostics manufacturing and sales company, and $10,000,000 in connection with the settlement of certain class action securities litigation. These cash outflows were partially offset by cash inflows which included the receipt of $50,000,000 from Lilly for the purchase of 2,000,000 shares of the Company's Common Stock and $15,931,000 from borrowings under loan agreements. During the year ended December 31, 1991, the Company had negative cash flows from operations of $137,039,000 and acquired $31,129,000 of fixed assets. Also during 1991, the Company received significant cash inflows from financing activities, principally the net proceeds of $224,537,000 from the issuance of the Company's 7-1/4 percent Notes and 6-3/4 percent Debentures. During the years ended December 31, 1992 and 1991, the Company received $17,726,000 and $80,272,000, respectively, from the exercise of warrants and options to purchase shares of the Company's Common Stock. The extent and timing of future warrant and option exercises, if any, are primarily dependent upon the market price of the Company's Common Stock and general financial market conditions, as well as the exercise prices and expiration dates of the warrants and options. Agreements covering $20,402,000 of the Company's outstanding debt balances contain certain financial and non-financial covenants, including the maintenance of minimum equity and cash balances and compliance with certain financial ratios. The Company has obtained waivers of certain of such covenants on the condition that it maintain certain investments at the lending bank, which at December 31, 1993 totalled $20,000,000. There can be no assurance that the Company will be able to continue to collateralize such loans and, accordingly, the Company has classified $20,402,000 of debt as short-term. Additionally, $6,186,000 of the Company's short-term debt is secured by investments at the lending bank of $6,375,000. If cash flows continue to be negative, the Company's ability to service its debt may be impaired. Status of CentoRx The Company's therapeutic products under development include CentoRx, a product intended to treat or prevent the formation of blood clots in the cardiovascular system. In the first quarter of 1993, the Company completed a randomized, double-blinded, placebo-controlled Phase III trial in high-risk coronary angioplasty patients that enrolled 2,099 patients at 56 medical centers. The Company filed product license applications for CentoRx in the United States and Canada in 1993 and has filed product license applications in several countries in Europe in 1994. There can be no assurance that CentoRx will be approved for commercial sale in the United States, Europe or elsewhere. See Part I Item 1 "Business - Research and Development." During the second quarter of 1993, Lilly exercised its option to become the exclusive worldwide distributor of CentoRx and the Company and Lilly amended their Sales and Distribution Agreement to reflect such event. See Part I Item 1 "Business - Marketing and Sales." Pursuant to that amendment, Lilly has assisted the Company and will continue to assist the Company in the regulatory filings and continued development of CentoRx for various clinical indications. Notes to Consolidated Financial Statements Status of Panorex - ----------------- Panorex, a product intended to treat colorectal cancer, has been tested in a Phase III trial at six German medical centers which enrolled 189 colorectal cancer patients who were subsequently monitored for the accumulation of five- year survival data. The Company expects to complete the filing of an application in 1994 requesting marketing approval for Panorex in Germany. There can be no assurance that Panorex will be approved for commercial sale in Germany or elsewhere. During 1993, the Company and Wellcome entered into an alliance agreement for the development and marketing of certain of the Company's monoclonal antibody-based cancer therapeutic products, including Panorex. See Part I Item 1 "Business - Marketing and Sales." Status of HA-1A HA-1A is a product intended for the treatment of patients with severe sepsis who are dying from endotoxemia. The Company has filed product license applications in the United States, Europe, and other countries seeking approval to market HA-1A. Regulatory approvals to market HA-1A were received in several European countries. In April 1992, the FDA advised the Company that there was insufficient evidence of efficacy for approval of HA-1A at that time. In June 1992, the Company initiated a second randomized, double-blinded, placebo- controlled, Phase III U.S. clinical trial of HA-1A in the treatment of patients with Gram-negative bacteremia and septic shock. The Company terminated this trial in 1993 after concluding that there was no reduction in the mortality rate among HA-1A-treated patients who did have Gram-negative bacteremia in comparison with placebo-treated patients in the same group. The Company and its principal distributor of HA-1A, Lilly, also voluntarily suspended sales and conducted a recall of the drug in Europe and elsewhere where the drug is authorized for sale. The regulatory approvals to market HA-1A currently remain in effect pending the results of further clinical trials. The Company is currently conducting a randomized, double-blinded, placebo-controlled Phase III European clinical trial of the efficacy of HA-1A in the treatment of patients with fulminant meningococcemia. There can be no assurance that any further trials of HA-1A will be initiated or will be successful. The Company is supplying HA-1A on a limited compassionate-use basis in certain countries in Europe. There can be no assurance that any commercial sales of HA- 1A will resume in Europe. Shareholder Litigation On December 23, 1993, a purported class action captioned Peter Cordaro v. Hubert J.P. Schoemaker, Stelios Papadopoulos, Marc Feldmann, David Golden, Centocor, Inc., and Tocor II, Inc. was filed in the Court of Common Pleas of the Commonwealth of Pennsylvania, in and for Chester County. The complaint alleges that the defendants breached their fiduciary duties to Tocor II Unitholders by, among other things, making the Exchange Offer, recommending acceptance of the Exchange Offer, and failing to maximize shareholder value. The complaint sought, among other relief, an injunction against consummation of the Exchange Offer, the Notes to Consolidated Financial Statements establishment of a "truly independent" special committee and financial advisor to consider the Exchange Offer, and an award of damages (including rescissionary damages), costs and plaintiff's counsel fees. No injunction was, in fact, sought, and the Exchange Offer was made and consummated. The Company believes that the allegations set forth in the complaint are without merit and intends to vigorously defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. In January 1993, purported security holders of the Company and/or Tocor II filed complaints in the United States District Court for the Eastern District of Pennsylvania against the Company, Tocor II, and certain present and former directors and/or officers of the Company and/or Tocor II, and Lilly. The cases were consolidated pursuant to an order, and a Consolidated Class Action Complaint captioned In Re Centocor Securities Litigation II, No. 93-CV-0236 (the "Complaint") was filed in May 1993, based on alleged violations of securities laws and alleged breaches of the named individual defendants of fiduciary duties to Centocor. All claims against all defendants, except the Company and two of its officers/directors, were voluntarily dismissed when the Complaint was filed. The Complaint alleges that defendants knowingly or recklessly omitted certain material facts and made false and misleading statements of material facts about the Company in violation of Sections 10(b) and 20 of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and also alleges violations of the common law of negligent misrepresentation. The action has been conditionally certified as a class action on behalf of persons who purchased common stock of the Company from April 21, 1992 through January 15, 1993 and who were allegedly damaged thereby. The Complaint seeks compensatory damages in unspecified amounts, counsel fees, interest, costs of suit, and such other relief that the court deems appropriate. Defendants answered the Complaint and denied the allegations therein. The Company believes that the allegations set forth in the Complaint are without merit and intends to vigorously defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. On June 3, 1993, the United States District Court for the Eastern District of Pennsylvania entered an order approving as final a settlement of the class action securities litigation and derivative actions captioned In Re Centocor, Inc. Securities Litigation, No. 92-CV-1071, which had been preliminarily approved in December 1992. The court had previously entered an order certifying (i) the litigation to proceed as a class action and (ii) a class of plaintiffs consisting of all persons who purchased the Company's securities during the period February 19, 1991 through April 20, 1992, and who sustained damages as a result of such purchases. All claims against the Company and the other defendants were dismissed on June 3, 1993, except as to those who opted out of the class. In settlement of the securities claims, the Company made a cash payment of $18,000,000; in settlement of the derivative action brought on behalf of the Company, the Company received a cash payment of $8,000,000; and in settlement of the derivative action brought on behalf of Tocor II, the Company and Tocor II amended certain agreements between them to provide that the Company would, over time, forego $3,000,000 of contract payments. In connection with the settlement, the Company recorded a charge to earnings of $11,245,000 in the fourth quarter of 1992, representing the net cost of the proposed settlement to the Company, including legal fees. The Company does not expect the effect, if Notes to Consolidated Financial Statements any, of the outcome of any litigation resulting from those who opted out of the class to be material to the Company's financial condition. Other Litigation In October 1992, the Company was served with a complaint filed by Velos in the United States District Court for the District of Maryland. The complaint alleges, principally, that the Company breached certain provisions of a license agreement between Velos and the Company pursuant to which the Company has exclusive rights to U.S. Patent No. 5,057,598, which includes claims relating to monoclonal antibodies used in treating manifestations of Gram-negative bacterial infections. The complaint seeks declaratory relief, monetary relief in excess of $100,000,000, and requests that the Company place in escrow one-half of the amounts received by the Company pursuant to its agreements with Lilly. The complaint does not seek to terminate or rescind any of the Company's rights under the license agreement. The Company answered the complaint and asserted affirmative defenses and counterclaims on January 7, 1993, but the counterclaims and certain affirmative defenses were dismissed with leave to replead on June 22, 1993. On July 28, 1993, the Court permitted plaintiff to file an amended complaint that updated some of the claims in the original complaint but otherwise reasserted the basic factual allegations and, with one minor exception, relied upon the same legal theories. On August 27, 1993, the Company filed its Answer, Affirmative Defenses and Counterclaim for Damages and Equitable Relief (the "Amended Answer"). In the Amended Answer, the Company again denied all of the allegations made by Velos and stated certain affirmative defenses and counterclaims against Velos with respect to the license agreement, based on theories of (i) failure of consideration, (ii) fraud in the inducement, and (iii) unilateral mistake as to facts, which mistake was induced by the fraudulent misrepresentation of Velos. On September 22, 1993, plaintiff moved to dismiss the Company's counterclaims and to strike certain of Centocor's affirmative defenses. The Company has responded to that motion. The Company believes that the allegations of Velos are without merit and intends to vigorously defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. In May 1993, the Company was served with a complaint filed earlier in the United States District Court for the Southern District of California at San Diego. The plaintiff, who allegedly had purchased shares of Corvas in its initial public offering on January 30, 1992, brought suit against Corvas and certain of its directors, the Company, and one of the Company's directors and a former director (the "Centocor defendants"), on behalf of similarly situated investors. The complaint alleges the defendants violated the federal securities laws by disclosing to Corvas' investors that Centocor and Corvas had entered into a "strategic alliance" to develop one of Corvas' products, but failing to disclose that the Company allegedly would not be able to perform on that agreement because of events relating to Centoxin (HA-1A). The Complaint sought to proceed as a class action on behalf of all those who purchased Corvas common stock during the period from January 30, 1992 through January 15, 1993. A motion to dismiss the complaint in its entirety as to the Centocor defendants was filed in early June 1993. Corvas and its directors had filed a motion Notes to Consolidated Financial Statements to dismiss earlier. In September the Court dismissed a number of plaintiff's claims including claims relating to the period after April 14, 1992 and, in effect, the claim brought against the Company under Section 10(b) of the Securities Exchange Act of 1934. The Company believes the allegations which remain are without merit and intends vigorously to defend the suit. The Company does not expect the effect, if any, of the outcome of this litigation to be material to the Company's financial condition. Partnerships - ------------ The Company has licensed certain technology related to CentoRx and Capiscint to CPIII and performs research and development with respect to such technology on CPIII's behalf. CPIII holds the rights to the licensed technology and results of the research and development efforts related thereto. The Company has the option to acquire such rights through its option to purchase the limited partnership interests in CPIII. The Company's option to purchase the limited partnership interests in CPIII is exercisable upon the earlier of (a) each limited partner having received distributions related to sales of the CPIII products equal to $15,000 per full limited partnership interest and the expiration of at least 24 months after the first commercial sale of a CPIII product or (b) the expiration of at least 48 months after the first commercial sale of a CPIII product; but, in any event, not prior to the expiration of the then applicable long-term capital gains holding period after the expenditure by the Company of all funds paid to it pursuant to the Development Agreement with CPIII. There have not as yet been any commercial sales of CPIII products. If the Company elects to exercise its option to purchase the limited partnership interests in CPIII, the Company must make an advance payment of approximately $13,598,000 in cash or, at the Company's election, approximately $15,229,000 in the Company's Common Stock, and future payments generally of six percent of sales of products developed by CPIII. If the Company exercises its CPIII purchase option, the Company expects that it would record a significant charge to earnings representing the purchase of in-process research and development. See Note 3 for a discussion of the option that Lilly has exercised to become the exclusive distributor for CentoRx, a cardiovascular product being developed by the Company for CPIII. The Company has entered into indemnity agreements with CPIII and the former limited partners of CCIP and CPII pursuant to which the Company would be obligated, under certain circumstances, to compensate these parties for the fair market value of their respective interests under any license agreements with the Company relating to their respective products which are lost through the exercise by the United States Government of any of its rights relating to the licensed technology. The amount of any such loss would be determined annually by independent appraisal. Royalties The Company is required to make certain future payments to the former limited partners of CCIP and CPII based on sales of products developed by each of the respective partnerships, including payments to the former limited partners of CPII based on any sales of HA-1A. Upon any exercise by the Company of its option to acquire the limited partnership interests in CPIII, Notes to Consolidated Financial Statements the Company would be required to make future payments to the former limited partners of CPIII, including payments based on any sales of CentoRx. The Company has entered into agreements to support research at certain research institutions. These agreements, which grant the Company licenses and/or options to license certain technology resulting from the research, generally require the Company to pay royalties to such institutions on the sales of any products that utilize the licensed technology. Further, the Company has licenses under certain patents and pays the patent holders or their licensees royalties on sales of products covered by such patents. All royalties are reflected in cost of sales as incurred. Royalty costs represent a significant percentage of sales. Product Liability The testing and marketing of medical products entails an inherent risk of product liability. The Company maintains limited product liability insurance coverage. Such insurance is becoming increasingly difficult and expensive to obtain. The Company's business may be adversely affected by a successful product liability claim in excess of its insurance coverage. Under various contractual agreements, the Company has agreed to indemnify third parties against certain losses, including losses arising from product liability and patent infringement claims pertaining to the Company's products. Note 3 COLLABORATIVE ARRANGEMENTS Relationship with Eli Lilly and Company In July 1992, the Company and Lilly entered into various agreements pursuant to which Lilly made certain cash payments to the Company as further described below. During the second quarter of 1993, Lilly exercised its option to become the exclusive worldwide distributor of CentoRx and the Company and Lilly amended their Sales and Distribution Agreement. As part of the amendment Lilly has assisted the Company and will continue to assist the Company in the regulatory filings and continued development of CentoRx for various clinical indications. Under the Sales and Distribution Agreement, the Company is principally responsible for developing and manufacturing HA-1A and CentoRx and for securing regulatory approvals. Lilly is principally responsible for the marketing, selling and distribution of HA-1A and CentoRx after regulatory approvals. If approved, the Company will sell HA-1A and CentoRx to Lilly for Lilly's further sale to the end market. Under certain circumstances, such as acts of God, material breach of the agreement or bankruptcy by the Company, or in the event the Company cannot manufacture CentoRx, Lilly has the option to assume the manufacture of CentoRx and assure the continued supply of the product, even to the extent of acquiring the Company's related manufacturing assets at their independently appraised values. Lilly and the Notes to Consolidated Financial Statements Company are cooperating in order to maximize the commercial potential of CentoRx. See Note 2 for a discussion of the Company's option to acquire the rights to CentoRx through its option to acquire the limited partnership interests in CPIII. As further described in Note 2, the Company and Lilly suspended sales and conducted a recall of HA-1A in Europe. Under an Investment Agreement, Lilly acquired two million newly issued shares of the Company's Common Stock for $50 million in 1992. The Company received an additional $50 million from Lilly primarily for reimbursement of expenses related to HA-1A. In 1993, Lilly paid the Company $5 million for the achievement of certain milestones related to CentoRx and may make certain future payments based on the achievement of additional milestones. The Company may be required to make a payment to Lilly of $60 million through December 31, 1994, or decreasing amounts through December 31, 1999, in the event of any change in control of the Company or in the event of any governmental action or determination which results in the Sales and Distribution Agreement not being in full force and effect in all material respects in major jurisdictions, excluding the United States, and the subsequent termination of the Sales and Distribution Agreement by Lilly based solely on such events. Relationship with Wellcome plc In 1993, Centocor and Wellcome entered into an alliance agreement for the development and marketing of certain of Centocor's monoclonal antibody-based cancer therapeutic products, including Panorex. Wellcome will contribute to the continuing clinical development of Panorex and up to six other potential drugs and then market and sell any approved drugs in most parts of the world. Under an Investment Agreement, Wellcome paid Centocor $20 million in exchange for two million newly issued shares of the Company's Common Stock. In addition, Wellcome paid Centocor a $10 million non-refundable license fee at the closing of the transaction, and may make certain future payments up to $70 million based on the achievement of milestones and the acquisition of certain manufacturing technologies. Note 4 CASH EQUIVALENTS AND INVESTMENTS Cash equivalents and investments consist principally of U. S. Treasury securities and bank certificates of deposit. Short-term investments at December 31, 1993 also include equity investments with carrying values of $2,800,000. Long-term investments also include certain equity investments with carrying values of $8,430,000 and $12,924,000 at December 31, 1993 and December 31, 1992, respectively. The aggregate market value of all short-term investments at December 31, 1993 and December 31, 1992 was $76,739,000 and $121,669,000, respectively. The aggregate market value of all long-term investments at December 31, 1993 and December 31, 1992 was $17,156,000 and $14,523,000, respectively. Notes to Consolidated Financial Statements The Company has agreed to maintain investments of $26,375,000 at December 31, 1993 at certain banks as collateral for loans from those banks. See Notes 2 and 7. Note 5 INVENTORY Inventory consists of the following (in thousands): Inventory at December 31, 1993 and December 31, 1992 includes $5,920,000 and $10,387,000, respectively of certain pharmaceutical products for which the Company has not yet obtained marketing approval, including certain raw materials to be used in the production of such inventories. See Note 2. Inventories have various expiration dates. The Company continually evaluates the extent of inventory reserves considered necessary based upon the future regulatory and commercial status of such products. There can be no assurance that reserves for inventories will not be required in the future. Note 6 ACCRUED EXPENSES Accrued expenses consist of the following (in thousands): Note 7 DEBT Note Payable Note payable at December 31, 1993 and 1992 consists of $6,186,000 and $6,593,000, respectively of borrowings under short-term notes at an interest rate of 6.4 percent per annum at December 31, 1993, payable in Dutch guilders no later than March 28, 1994. These borrowings are secured by investments at the lending bank of $6,375,000. Notes to Consolidated Financial Statements Long-term debt Long-term debt consists of the following (in thousands): 7-1/4 Percent Notes On January 28, 1991, the Company issued $106,645,000 principal amount of 7-1/4 percent Convertible Subordinated Notes (the "7-1/4 percent Notes") due February 1, 2001. The 7-1/4 percent Notes are convertible by the holders into approximately 3,843,000 shares of the Company's Common Stock at a conversion price of $27.75 per share at any time prior to redemption or maturity. The 7- 1/4 percent Notes are subordinated in right of payment to senior indebtedness at December 31, 1993 of $33,114,000 and all future senior indebtedness of the Company, and rank pari passu with the 6-3/4 percent Debentures described below. The 7-1/4 percent Notes are redeemable by the Company for cash in whole or in part until February 1, 2001 at amounts ranging up to 105 percent of the principal amount of the 7-1/4 percent Notes. The Company may be required to redeem the 7-1/4 percent Notes at their principal amount at the option of the holders of the 7-1/4 percent Notes in certain limited circumstances, including a change in control of the Company. 6-3/4 Percent Debentures On October 16, 1991, the Company issued $125,000,000 principal amount of 6-3/4 percent Convertible Subordinated Debentures (the "6-3/4 percent Debentures") due October 16, 2001. The 6-3/4 percent Debentures are convertible by the holders into approximately 2,049,000 shares of the Company's Common Stock at a conversion price of $61.00 per share at any time prior to redemption or maturity. The 6-3/4 percent Debentures are subordinated in right of payment to senior indebtedness at December 31, 1993 of $33,114,000 and all future senior indebtedness of the Company, and rank pari passu with the 7-1/4 percent Notes. The 6-3/4 percent Debentures are redeemable by the Company for cash in whole or in part until October 16, 2001 at amounts ranging up to 104 percent of the principal amount of the 6-3/4 percent Debentures, provided that prior to October 16, 1994, the 6-3/4 percent Debentures may not be redeemed unless for 30 successive trading days ending within 15 days of the date of the redemption notice the closing price of the Company's Common Stock as reported on the NASDAQ National Market System is at least 130 percent of the then effective conversion price of the 6-3/4 percent Debentures. The Company may be required to redeem the 6-3/4 percent Debentures at their principal amount at the option of the holders of the 6-3/4 percent Debentures in certain limited circumstances, including a change in control in the Company. Notes to Consolidated Financial Statements Mortgage Debt Mortgage loans have been used to finance a portion of the acquisition and expansion of certain of the Company's facilities in the United States and The Netherlands. These loans are generally secured by the related land and buildings. In the United States, the Company has such a loan outstanding with a balance of approximately $6,526,000 at December 31, 1993 which bears interest at an annual rate of 10 percent through its maturity date of May 1, 1995. A Netherlands loan, with an outstanding balance of approximately $5,515,000 at December 31, 1993, is payable in Dutch guilders, bears interest at an annual rate of 8-1/4 percent through its final maturity date of September 30, 2011, and is secured by certain equipment, inventories, and accounts receivable. At December 31, 1993, this loan is classified as short-term (see "Loan Covenants"). In July 1993, the Company completed the sale of its St. Louis facility for $11,900,000 and in connection therewith, repaid $5,800,000 of debt related to this facility. Long-term Note The Company borrowed $10,793,000 under a 9-1/2 percent long-term note which is payable in Dutch guilders. This loan is secured by the same assets as the Netherlands loan discussed above. At December 31, 1993, this loan is classified as short-term (see "Loan Covenants"). Loan Covenants Agreements covering $20,402,000 of the Company's outstanding debt balances contain certain financial and non-financial covenants, including the maintenance of minimum equity and cash balances and compliance with certain financial ratios. The Company has obtained waivers of certain of such covenants on the condition that it maintains certain investments at the lending bank, which at December 31, 1993 totalled $20,000,000. There can be no assurance that the Company will be able to continue to collateralize such loans and, accordingly, the Company has classified $20,402,000 of debt as short-term. Additionally, $6,186,000 of the Company's short-term debt is secured by investments at the lending bank of $6,375,000. If cash flows continue to be negative, the Company's ability to service its debt may be impaired. Other Scheduled repayments on the mortgage debt and long-term note pursuant to the terms of the related loan agreements are $2,304,000 for 1994, $8,707,000 for 1995, $2,247,000 for 1996, $2,251,000 for 1997, $2,256,000 for 1998 and $9,163,000 due thereafter. The fair market value of the Company's long-term debt at December 31, 1993, principally determined by quoted market prices, was $192,637,000 as compared to its carrying value of $238,100,000. The carrying amount of the Company's debt classified as short-term at December 31, 1993 approximates its fair market value. Notes to Consolidated Financial Statements Note 8 SHAREHOLDERS' EQUITY Capital Stock In December 1993, the Company issued 2,000,000 shares of its Common Stock pursuant to the terms of an agreement with Wellcome as described in Note 3. Additionally, in August 1992, the Company issued 2,000,000 shares of its Common Stock pursuant to the terms of an Investment Agreement with Lilly as described in Note 3. At December 31, 1993, approximately 27,901,000 shares of Common Stock were reserved for issuance upon exercise of warrants and stock options, pursuant to employee retirement savings and stock award plans and agreements, and upon conversion of convertible debt securities. Additionally, at December 31, 1993, approximately 358,000 shares of preferred stock were reserved for issuance under a shareholder rights plan which is further described below. Further, in March 1994, the Company issued approximately 6,793,000 shares of its Common Stock in connection with an Exchange Offer. See Note 18. Warrants In January 1992, the Company and Tocor II completed the sale to the public of 2,250,000 units, each unit consisting of one share of callable common stock of Tocor II, one Series T warrant, and one callable warrant. The net proceeds of the offering were used by Tocor II principally to engage the Company to conduct research and development under contract (see Notes 10 and 18). In connection with the issuance of the Series T warrants, the Company recorded a deferred asset in an amount equal to the value of those warrants. Such asset was amortized over the term of the research and development contract. Notes to Consolidated Financial Statements At December 31, 1993, warrants to purchase approximately 12,833,000 shares of the Company's Common Stock were outstanding. The specific exercise prices per share and exercise periods of such warrants are set forth below (in thousands except per share amounts): * The exercise price increases by $2.50 per share for the last two years of the exercise period. ** See Note 18. *** These warrants are callable. The exercise price may vary depending on the closing price of the Company's Common Stock over a certain period, but shall in no event be less then $49.75 per share. See Note 18. Stock Option and Restricted Stock Award Plans The Company maintains stock option plans pursuant to which options to purchase a total of approximately 8,650,000 shares of its Common Stock have been authorized for grant to the Company's employees and to its non-employee directors. Under the terms of these plans, the option exercise price may not be less than the fair market value of the underlying stock at the time the option is granted. The options granted under these plans generally expire upon the earlier of the termination of the optionee's employment or service or ten years from the date of the grant. Additionally, non-qualified stock options have been granted to certain directors and employees of, and certain consultants to, the Company pursuant to non-qualified stock option agreements with terms similar to those set forth in the plans. The following table summarizes the activity with respect to the Company's stock options (in thousands except per share amounts): During 1993 and 1992, a substantial number of outstanding options were canceled in exchange for the grant of fewer options with an exercise price equal to the fair market value at date of grant of $7.125 per share in 1993 and $12.625 in 1992. At December 31, 1993, options Notes to Consolidated Financial Statements to purchase a total of approximately 2,726,000 shares of Common Stock were exercisable, and approximately 3,044,000 options become exercisable as follows (in thousands): The Company maintains a Restricted Common Stock Award Plan, pursuant to which a total of approximately 2,000,000 shares of the Company's Common Stock have been authorized for award to eligible employees. The number of shares awarded in each year and the terms under which such shares vest are determined by the Board of Directors at the time of the award. Generally, a portion of the shares awarded vests annually over a period of five years from the date of the award. As of December 31, 1993, awards of approximately 359,000 shares of the Company's Common Stock were outstanding and are scheduled to vest in the following periods (in thousands): The terms of options unexercisable as of December 31, 1993 for an aggregate of approximately 1,515,000 shares and restricted stock awards unvested as of December 31, 1993 for an aggregate of approximately 229,000 shares provide for the acceleration of the exercisability of such options and the vesting of such restricted stock awards upon the occurrence of certain events constituting a change in control of the Company. Further, in such event, the holders of approximately 2,808,000 options may then choose to receive cash through the exercise of a limited stock appreciation right in lieu of exercising their options. Qualified Savings and Retirement Plan The Company maintains a Qualified Savings and Retirement Plan for the benefit of its employees. Employees' benefits are based solely on the employees' discretionary contributions and the Company's discretionary matching contributions, which the Company generally makes in its Common Stock. Employee contributions to the Plan may be invested in various instruments, including the Company's Common Stock, at the discretion of the employee. Shareholder Rights Plan The Company maintains a Shareholder Rights Plan ("Rights Plan"). Under the Rights Plan, each common shareholder receives one-half of one Right (a "Right") for each share of Common Stock held. Each Right entitles the holder to purchase from the Company one one- Notes to Consolidated Financial Statements hundredth of a share of Series A Preferred Stock at an exercise price of $170. The Rights will become exercisable and will detach from the Common Stock in the event any individual or group acquires 20 percent or more of the Common Stock, or announces a tender or exchange offer which, if consummated, would result in the ownership by that person or group of at least 30 percent of the Common Stock. If, following an acquisition of 20 percent or more of the Common Stock, the Company is acquired by any person in a merger or other business combination transaction or sells more than 50 percent of its assets or earning power to any person, each Right will entitle the holder to purchase, for the exercise price, common stock of the acquiring company with a value of twice the exercise price. In addition, if any person acquires 30 percent or more of the Common Stock, each Right will entitle the holder, other than an acquiring person, to purchase Common Stock of the Company with a value of twice the exercise price. The Rights also provide for protection against self-dealing transactions by a 20 percent shareholder. The Company may redeem the Rights at $.02 per Right at any time until the tenth day after the acquisition by a person or group beneficially owning 20 percent or more of its Common Stock. The Rights will expire on September 26, 1998 unless earlier redeemed. Note 9 GEOGRAPHIC AND CUSTOMER INFORMATION In January 1992, the Company acquired, for approximately $8,700,000 in cash, all of the outstanding shares of Mercia. The transaction was recorded as a purchase and resulted in $6,711,000 of goodwill which is being amortized over a 20-year period. The totals for Europe in the above table include the operations of Mercia from January 1992. Customer Information Sales to three distributors of the Company's diagnostic products accounted for 42 percent, 40 percent, and 48 percent of total product sales in 1993, 1992, and 1991, respectively. Notes to Consolidated Financial Statements Approximately 88 percent, 90 percent, and 83 percent of total product sales in 1993, 1992, and 1991, respectively, are attributable to shipments to customers outside of the United States. Note 10 CONTRACT REVENUES Lilly Related ------------- For the years ended December 31, 1993 and 1992, the Company recognized $5,000,000 and $50,000,000, respectively, of revenues pursuant to the Company's agreements with Lilly as further described in Note 3. Wellcome Related ---------------- During the year ended December 31, 1993, the Company recognized $10,000,000 of revenues pursuant to the Company's agreements with Wellcome as further described in Note 3. Related Party Research & Development ------------------------------------ During 1992 and 1993, the Company conducted research and development under contract with Tocor II. Under the contract, the Company received reimbursement of its costs plus a management fee. Such revenues were recorded net of amortization of deferred costs resulting from the issuance of warrants to Tocor II Unitholders (see Note 8). Additionally, the Company recorded revenue of $2,500,000 in 1992 representing a non-refundable fee from Tocor II in connection with the license of certain technology by the Company to Tocor II. The Company amended the contract and a services agreement between the Company and Tocor II, in accordance with the settlement of the litigation described in Note 2, and reduced the management fee the Company is to receive in connection with the Tocor II research program from 10 percent to 5 percent. See Note 18 for a discussion of an exchange offer which resulted in the termination of the research and development contract and services agreement. In 1991, the Company performed research and development services under contracts with Tocor and CPII. In 1991, the Company acquired the callable common stock of Tocor and in 1992, the limited partnership interests in CPII. Notes to Consolodated Financial Statements Revenues and expenses, including general and administrative expenses, related to the research programs of Tocor II, Tocor, and CPII were as follows (in thousands): Not included in the above table are expenses of $19,389,000, $27,675,000, and $47,392,000, for the years ended December 31, 1993, 1992, and 1991, respectively, representing aggregate CPII, CPIII, and Tocor research costs funded by the Company in order to continue the progress of the research programs and to preserve the value of its purchase options (see Notes 2 and 11). Other The Company has entered into various commercialization agreements under which it has recognized revenues from non-refundable fees or milestone payments in support of its research and development efforts. Revenues recorded under these agreements amounted to $2,750,000, $1,767,000, and $3,606,000, for the years ended December 31, 1993, 1992, and 1991, respectively. Note 11 CHARGE FOR ACQUIRED RESEARCH AND DEVELOPMENT In June 1991, the Company issued approximately 2,057,000 shares of its Common Stock as payment of the Tocor option exercise price of $69,000,000. Additionally, the Company purchased the remaining 105,000 outstanding shares of Tocor callable common stock for $2,520,000 from directors of Tocor who acquired such Tocor shares through exercise of stock options granted to them under the Tocor 1989 Directors' Non-Qualified Stock Option Plan, which was approved by Tocor stockholders in 1990. The cost of the above transaction has been allocated principally to the Tocor technology acquired, and the Company recorded a charge to earnings in the second quarter of 1991 of $70,147,000 representing the purchase of in- process research and development. Notes to Consolodated Financial Statements Note 12 OTHER INCOME (EXPENSES) During 1992, the Company recorded a charge to earnings of $11,245,000 in connection with the settlement of certain class action securities litigation (see Note 2). During 1993 and 1992, the Company recorded a charge to earnings of $2,477,000 and $2,296,000, respectively, representing an unrealized loss due to the other than temporary decline in the market value of marketable equity investments below the Company's cost for such investments. Other income (expenses) in 1992 include gains of $1,170,000 from sales of the Company's investments. Other income (expenses) also includes the CPIII share of the earnings of the joint venture between the Company and CPIII. Note 13 INCOME TAXES Differences between the Company's (benefit) for income taxes for 1993, 1992, and 1991 and that computed by applying the statutory Federal income tax rate consist of the following (in thousands): The Company recorded a charge for acquired research and development of $70,147,000 in 1991, which was not fully deductible for tax purposes in the year incurred. The ultimate amount and timing of the deductions related to this charge is uncertain; however, the Company believes that a portion of the charge may be deductible for tax purposes over the estimated useful life of the related technology acquired. At December 31, 1993, the tax effect of the Company's federal net tax loss carryforwards was $117,681,000 with expiration dates ranging from 2005 to 2008. Additionally, at December 31, 1993, the Company had research and development tax credits of $3,576,000 with expiration dates ranging from 1999 to 2007, and minimum tax credits of $381,000, which do not expire. Further, the tax effect of inventory reserves that are not currently deductible at December 31, 1993 were $20,682,000. Realization of net deferred tax assets related to these items is dependent on future earnings, which are uncertain. Accordingly, a valuation reserve was recorded by the Company and, therefore, the Company had no net deferred tax assets at December 31, 1993. Notes to Consolodated Financial Statements Note 14 LEASES The Company is lessee under various non-cancelable operating leases, covering certain of the Company's facilities and equipment. The facility leases generally provide for the Company to pay all taxes and operating costs associated with the facility. The aggregate minimum rental commitments of leases are as follows (in thousands): Rent expense was $5,428,000, $9,665,000, and $6,412,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Note 15 SUPPLEMENTAL INFORMATION ON CASH FLOWS Interest paid, net of amounts capitalized of $800,000 in 1991, was $19,421,000, $19,703,000, and $6,405,000, in 1993, 1992 and 1991, respectively. Income tax payments of $46,000, $70,000 and $270,000 were made in 1993, 1992 and 1991, respectively. Cash used for the purchases of investments as well as the cash received upon the maturities and sales of investments were as follows (in thousands): During 1992, the Company issued warrants to purchase 4,500,000 shares of Common Stock, resulting in a noncash increase to additional paid-in capital of $14,625,000. As further described in Note 11, the Company's exercise of its option to purchase the callable common Notes to Consolodated Financial Statements stock of Tocor resulted in a noncash increase to additional paid-in capital of $68,979,000 in 1991. During 1992, the Company acquired $2,134,000 of fixed assets by assuming the related debt obligation. Note 16 QUARTERLY FINANCIAL DATA (UNAUDITED) (1) During the first and second quarters of 1993, the Company recorded restructuring charges of $4,273,000 and $5,114,000, respectively, representing reserves for fixed assets no longer used or subsequently disposed in the first quarter and severance related costs in the second quarter (See Note 17). (2) During the first and fourth quarters of 1992 and the fourth quarter of 1993, the Company recorded reserves of $9,000,000 and $55,877,000, and $3,500,000, respectively, relating to HA-1A inventories (see Note 2). (3) During the third and fourth quarters of 1992, the Company recorded restructuring charges of $7,861,000 and $7,405,000, respectively, representing principally severance costs. (4) During the fourth quarter of 1992 the Company recorded a charge to earnings of $11,245,000 in connection with the settlement of certain litigation (see Note 2). Notes to Consolodated Financial Statements Note 17 RESTRUCTURING CHARGES During 1993 and 1992, the Company recorded restructuring charges of $9,387,000 and $15,266,000, consisting principally of severance-related costs incurred in connection with the further downsizing of its workforce and reserves for certain fixed assets which are no longer used or have been subsequently disposed. As a result of the downsizing of the Company's staff and present level of operations, the Company currently maintains idle facilities and equipment. The Company continually evaluates the future needs for its facilities and equipment. There can be no assurance that reserves to further reduce the carrying value of certain fixed assets or other restructuring charges will not be required in the future. Note 18 SUBSEQUENT EVENT In February 1994, the Company initiated an Exchange Offer, pursuant to which the Company offered to exchange 3.2 shares of its Common Stock for each of the 2,250,000 outstanding Tocor II Units tendered. Each Unit consists of one share of callable common stock of Tocor II, one callable warrant to purchase one share of Centocor Common Stock and one Series T warrant to purchase one share of Centocor Common Stock (the "Warrants"). No fractional shares of Centocor Common Stock will be issued. The expiration date of the Exchange Offer was March 11, 1994. With respect to the Tocor II Units not tendered, the Company would issue 2.88 shares of its Common Stock in exchange for the remaining Tocor II callable common stock in a merger transaction which is expected to be completed by March 31, 1994 (the "Second-Step Transaction"). Non-tendering Tocor II Unitholders would retain their Warrants. On March 11, 1994, the Company accepted 94 percent of the Tocor II Units tendered pursuant to the Exchange Offer, and the Company exchanged 3.2 shares of its Common Stock for each Tocor II Unit tendered. As a result of the Exchange Offer and the Second-Step Transaction, the Company will issue approximately 7,159,000 shares of its Common Stock. The transaction will be accounted for as a purchase and the Company will allocate the excess of the consideration paid over the net assets of Tocor II to the value of the acquired research and development. The Company will record a charge to earnings in the first quarter of 1994 of approximately $36,454,000 representing principally the cost of acquired research and development. The unaudited pro forma condensed balance sheet, assuming the Exchange Offer was consummated as of December 31, 1993, and statement of operations data excluding the Notes to Consolodated Financial Statements charge for acquired research and development assuming the Exchange Offer was consummated as of January 1, 1993, would have been as follows: REPORT OF MANAGEMENT The consolidated financial statements presented in this report have been prepared by the Company's management in conformity with generally accepted accounting principles from the Company's financial records. The Company's management is responsible for all information and representations made in those financial statements and for their integrity and objectivity. In those cases where judgment and best estimates are necessary, appropriate consideration is given to materiality in the preparation of the financial statements. The Company's management has also prepared the other information in this report and is responsible for its accuracy and consistency with the financial statements. The Company's management has designed systems of internal accounting controls to provide reasonable, but not absolute, assurance that assets are safeguarded from unauthorized use or disposition, and that transactions are recorded according to management's policies and procedures. The concept of reasonable assurance is based on the recognition that there are inherent limitations in all systems of internal accounting control and that the costs of such systems should not exceed the benefits to be derived. These systems are continually reviewed and modified, where appropriate, to maintain such assurance. Additionally, in connection with their annual audit, independent auditors perform examinations in accordance with generally accepted auditing standards, which include a review of the system of internal accounting controls to the extent necessary in order to determine the nature, timing, and extent of audit tests to be applied on the financial statements. The Company's management believes that the Company's system of internal accounting controls is adequate to accomplish the objectives discussed herein. The selection of the Company's independent auditors, KPMG Peat Marwick, has been approved by the Company's Board of Directors. An Audit Committee of the Board of Directors, composed of three non-management directors, meets with, and reviews the activities of, corporate financial management and the independent auditors to ascertain that each is properly discharging its responsibilities. The independent auditors also meet separately with the Audit Committee without management present, to discuss the results of their work, the adequacy of internal accounting controls, and the quality of financial reporting. INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders, Centocor, Inc.: We have audited the accompanying consolidated balance sheets of Centocor, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Centocor, Inc. and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick Philadelphia, Pennsylvania March 11, 1994 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON - --------------------------------------------------------- ACCOUNTING AND FINANCIAL DISCLOSURE ----------------------------------- Not Applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------ DIRECTORS OF THE REGISTRANT The following table sets forth, as of March 1, 1994, information as to the directors of the Company, including their recent employment, positions with the Company, other directorships and age. Directors are elected to serve one-year terms. Section 16 of the Securities Exchange Act of 1934 (the "Exchange Act") requires that the officers and directors of a corporation, such as the Company, that has a class of equity securities registered under Section 12 of the Exchange Act, file reports of their ownership of such securities, as well as monthly statements of changes in such ownership, with the Securities and Exchange Commission (the "Commission") and the National Association of Securities Dealers, Inc. Based upon written representations received by the Company from its officers and directors, and the Company's review of the monthly statements of changes filed with the Commission by its officers and directors during 1993, the Company believes that following Ms. Tempel's election as a director of the Company, the Company did not timely file a Form 3 on her behalf. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company, who are elected to serve at the discretion of the Board of Directors, are as follows: Mr. Holveck has been associated with Centocor since June 1983, as President and Chief Executive Officer since November 1992, as President and Chief Operating Officer from April 1992 to October 1992, as Executive Vice President and President - Diagnostics Division from December 1988 to April 1992, and as Executive Vice President - In Vitro Diagnostic Products from April 1987 to December 1988. Mr. Hayter has been associated with Centocor since February 1993 as Executive Vice President - Diagnostics Division. Previously, Mr. Hayter was Executive Vice President and General Manager for the Americas and Far East for the Diagnostics Division of Cambridge Biotech, Inc., a biotechnology company, from January 1991 to January 1993, and President of ADI Diagnostics, Inc., an in-vitro diagnostics company, from June 1987 to January 1991. Mr. Venkatadri has been associated with Centocor since March 1992, as Executive Vice President - Pharmaceutical Division since August 1992, and as Vice President - Pharmaceutical Manufacturing from March 1992 to August 1992. Previously, Mr. Venkatadri was Senior Director of Pharmaceutical Operations for Warner-Lambert Puerto Rico, Inc., a division of Warner-Lambert Company, from October 1990 to February 1992, and President and Director of P. T. Warner-Lambert Indonesia, an affiliate of Warner-Lambert Company, from March 1988 to October 1990. Mr. Cost has been associated with Centocor since January 1994, as Senior Vice President - Investor Relations and Strategic Operations. Previously, Mr. Cost was Director of Investor Relations for Eastman Kodak Company from October 1991 to December 1993, and Director of Strategic Planning for Worldwide Manufacturing for Eastman Kodak Company from June 1989 to October 1991. Mr. Page has been associated with Centocor since September 1987, as Senior Vice President - Worldwide Regulatory Affairs since August 1992, as Vice President - Worldwide Regulatory Affairs from June 1990 to August 1992, and as Vice President - International Regulatory Affairs from September 1987 to June 1990. Dr. Woody has been associated with Centocor since August 1991, as Chief Scientific Officer since August 1992, and as Senior Vice President and Director - - Research and Development since August 1991. Previously, Dr. Woody served as Commanding Officer of the U.S. Navy Medical Research and Development Command from 1988 to 1991 and Director and Commanding Officer of the U.S. Navy Medical Research Unit No. 3, Cairo, Egypt from 1985 to 1988. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION - -------------------------------- EXECUTIVE COMPENSATION AND OTHER INFORMATION Summary of Cash and Certain Other Compensation The following table sets forth, for the fiscal years ended December 31, 1993, 1992 and 1991, the cash compensation paid by the Company, as well as certain other compensation paid with respect to those years, to each of the five most highly compensated key policy-making executive officers of the Company in all capacities in which they served. Cash bonuses are stated in the year for which they are awarded, whether paid or accrued. SUMMARY COMPENSATION TABLE (1) The 35,000 shares awarded to Mr. Holveck under the Company's 1983 Restricted Common Stock Award Plan (the "1983 Award Plan") during the three fiscal years ended December 31, 1993 vest 20% each year for five consecutive years after the award. At December 31, 1993, Mr. Holveck held unvested awards under the 1983 Award Plan for an aggregate of 36,200 shares with a market value of $429,875. The 15,000 shares awarded to Mr. Hayter under the 1983 Award Plan during the fiscal year ended December 31, 1993 vest 20% each year for five consecutive years after the award. At December 31, 1993, Mr. Hayter held unvested awards under the 1983 Award Plan for an aggregate of 15,000 shares with a market value of $178,125. The 10,000 shares awarded to Mr. Venkatadri under the 1983 Award Plan during the two fiscal years ended December 31, 1993 vest 20% each year for five consecutive years after the award. At December 31, 1993, Mr. Venkatadri held unvested awards under the 1983 Award Plan for an aggregate of 9,000 shares with a market value of $106,875. The 12,500 shares awarded to Mr. Page under the 1983 Award Plan during the three fiscal years ended December 31, 1993 vest 20% each year for five consecutive years after the award. At December 31, 1993, Mr. Page held unvested awards under the 1983 Award Plan for an aggregate of 13,100 shares with a market value of $155,565. The 32,000 shares awarded to Dr. Woody under the 1983 Award Plan during the three fiscal years ended December 31, 1993 vest 20% each year for five consecutive years after the award. At December 31, 1993, Dr. Woody held unvested awards under the 1983 Award Plan for an aggregate of 25,600 shares with a market value of $304,000. The vesting of all of the foregoing unvested shares may be accelerated under certain events constituting a change in control of the Company. The Company has not paid any dividends on its Common Stock and does not expect to pay any dividends in the foreseeable future. (2) All of the options granted to Mr. Holveck, Mr. Hayter and Dr. Woody in the three fiscal years ended December 31, 1993, the 60,000 options granted to Mr. Venkatadri in 1993, and the 40,000 options granted to Mr. Page in 1993, were granted in tandem with limited stock appreciation rights. (3) All of such amounts constitute contributions made by the Company to the Company's Qualified Savings and Retirement Plan for the accounts of the named executive officers. (4) Mr. Hayter joined the Company on February 16, 1993. (5) Mr. Venkatadri joined the Company on March 2, 1992. (6) Dr. Woody joined the Company on August 1, 1991. (7) Although Mr. Venkatadri was granted an aggregate of 110,000 options during 1992, 30,000 of such options were granted in exchange for 40,000 options at a higher exercise price which were surrendered pursuant to an Option Exchange Program (the "1992 Exchange Program"). The 40,000 options surrendered pursuant to the 1992 Exchange Program were granted to Mr. Venkatadri in 1992. While such 1992 Exchange Program was not offered to executive officers of the Company, Mr. Venkatadri was permitted to participate since he was not an executive officer at the time such 1992 Exchange Program was offered. Although Mr. Page was granted an aggregate of 33,200 options during 1992, 5,200 of such options were granted in exchange for 8,000 options at a higher exercise price which were surrendered pursuant to the 1992 Exchange Program. The 8,000 options surrendered pursuant to the 1992 Exchange Program were granted to Mr. Page in 1992. While such 1992 Exchange Program was not offered to executive officers of the Company, Mr. Page was permitted to participate since he was not an executive officer at the time such 1992 Exchange Program was offered. (8) Of such amount, $68,202 and $11,289 constituted relocation expenses and an automobile allowance, respectively. Stock Options and Stock Appreciation Rights The following table sets forth information concerning the grant of stock options and tandem limited stock appreciation rights under the Company's 1987 Non-Qualified Stock Option Plan to the executive officers named in the Summary Compensation Table during the fiscal year ended December 31, 1993: Option/LSAR Grants in Last Fiscal Year (1) The exercisability of all of the options will accelerate upon the occurrence of certain events constituting a change in control of the Company. (2) 670,406 of the options granted to employees in 1993 were granted in exchange for 791,377 options at higher exercise prices which were surrendered pursuant to a 1993 Option Exchange Program. (3) The price payable upon exercise of options may be paid in cash, property, services rendered, or, under certain circumstances, in shares of the Company's Common Stock having a fair market value equal on the date of exercise to the exercise price, or any combination thereof. (4) Each of the options generally expires upon the earlier of six months after the employee's termination of employment or the expiration date noted above. (5) All of the options were granted in tandem with limited stock appreciation rights ("LSARs"). LSARs may be exercised only upon the occurrence of certain events constituting a change in control of the Company, only during the 30-day period following shareholder approval of any such event (but may not in any event be exercised for six months after the date of grant of the LSAR), and will be exercisable only if and to the extent that the options to which they relate are exercisable. For each share for which an LSAR is exercised, the optionee will receive an amount in cash equal to the difference between (1) the exercise price per share of the option to which the LSAR relates and (2) the fair market value per share of the Common Stock issuable upon exercise of the option on the date the LSAR is exercised. (6) Such options first become exercisable as to one-half of the option shares on July 28, 1995, one-quarter of the option shares on July 28, 1996, and one- quarter of the option shares on July 28, 1997. (7) Such options first become exercisable as to one-half of the option shares on May 13, 1995, one-quarter of the option shares on May 13, 1996, and one- quarter of the option shares on May 13, 1997. (8) Such options first become exercisable as to one-half of the option shares on March 3, 1995, one-quarter of the option shares on March 3, 1996, and one- quarter of the option shares on March 3, 1997. (9) Such options first become exercisable as to one-half of the option shares on February 16, 1995, one-quarter of the option shares on February 16, 1996, and one-quarter of the option shares on February 16, 1997. Aggregated Option/LSAR Exercises in Last Fiscal Year and Fiscal Year-End Option/LSAR Values None of the executive officers named in the Summary Compensation Table exercised any options during the fiscal year ended December 31, 1993. The following table sets forth information with respect to the unexercised options and LSARs held by each of those executive officers as of the end of such fiscal year: Aggregated FY-End Option/LSAR Values (1) All of such options were granted in tandem with LSARs. (2) 60,000 of such options were granted in tandem with LSARs. (3) 40,000 of such options were granted in tandem with LSARs. BOARD OF DIRECTORS - ------------------ COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Board of Directors maintains a standing Compensation Committee, currently consisting of Dr. Evnin, Dr. Hamilton, and Dr. Knoppers. The Compensation Committee is responsible for reviewing matters pertaining to the compensation of the executive officers of the Company. No member of the Compensation Committee is, or was at any time, a member of the Company's management. During the fiscal year ended December 31, 1993, no executive officer of the Company served on the Compensation Committee (or other board committee performing equivalent functions) of any other entity, one of whose executive officers is a member of the Company's Board of Directors or Compensation Committee. COMPENSATION OF DIRECTORS Each director who was not an employee of the Company was compensated in the amount of $2,000 for each of five Board of Directors' meetings attended at the Company's Malvern, Pennsylvania offices, $3,000 for one Board of Directors' meeting attended at the Company's facility in Leiden, The Netherlands, and $1,000 for three telephonic Board of Directors' meetings attended during 1993. Each director who was not an employee of the Company was also granted options to purchase 15,000 shares of the Company's Common Stock during 1993. In addition, upon joining the Board of Directors in 1993, Ms. Tempel was granted additional options to purchase 1,250 shares of the Company's Common Stock. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND - ------------------------------------------------------------- MANAGEMENT ---------- The following table sets forth, as of March 1, 1994, information as to the number of shares of the Company's Common Stock owned by each director, each executive officer named in the Summary Compensation Table in this Annual Report, and all directors and executive officers as a group. (1) Includes shares with respect to which such persons have the right to acquire beneficial ownership within 60 days of March 1, 1994. As indicated on a copy of Schedule 13G furnished to the Company under the Securities Exchange Act of 1934 (the "1934 Act") by Ardsley Advisory Partners ("Ardsley"), an investment advisor, 646 Steamboat Road, Greenwich, CT 06830, as of March 1, 1994 Ardsley shared dispositive and voting power with respect to 3,589,200 shares of the Company's Common Stock, or 8.2% of such shares outstanding at the time. Ardley shares the power to vote or direct the vote of such shares and the power to dispose or direct the disposition of such shares with various of its clients for whom the share were purchased. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------------------------------------------------------- TRANSACTIONS INVOLVING MANAGEMENT At various times in 1993, various executive officers were awarded or vested in shares awarded pursuant to the 1983 Award Plan and were granted options pursuant to the 1987 Option Plan. The Company has arrangements with all executive officers other than Mr. Holveck pursuant to which each will receive severance payments of twelve months compensation in certain cases in the event of termination of his or her employment by the Company. The Company has an arrangement with Mr. Holveck pursuant to which he will receive a lump-sum payment of twelve months compensation in certain cases in the event of termination of his employment by the Company. The terms of options unexercisable as of March 1, 1994, for an aggregate of 1,617,835 shares and restricted common stock awards unvested as of March 1, 1994 for an aggregate of 235,985 shares granted to all executive officers and certain other employees of the Company provide for the acceleration of the exercisability of such options and the vesting of such common stock awards upon the occurrence of certain events constituting a change in control of the Company. In 1993, the Company made a research grant of approximately $37,500 to Dr. Steinman's laboratory at Stanford University to support research of Dr. Steinman and others. Dr. Steinman also provides consulting services to the Company under a consulting agreement. The Company pays Dr. Steinman $60,000 per year for services rendered under such agreement. In 1993, the Company loaned Mr. Hayter $115,000 to cover certain expenses he incurred in relocating to join the Company. Mr. Hayter fully repaid such loan in 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS - -------------------------------------------------------------- ON FORM 8-K ----------- (a) Documents filed as part of the Report: (1) (i) Financial Statements of Centocor Partners III, L.P.: Balance Sheets, December 31, 1993 and 1992. Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991. Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991. Statements of Partners' Capital for the Years Ended December 31, 1993, 1992 and 1991. Notes to Financial Statements. Independent Auditors' Report. (2) Financial Statement Schedules: Schedule I - Marketable Securities - Other Investments. Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties. Schedule V - Property, Plant and Equipment. Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-Term Borrowings Schedule X - Supplementary Income Statement Information. Schedules, other than those listed above, have been omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or the notes thereto. (3) Exhibits: 3.1 Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to Form S-1 Registration Statement, File No. 2- 80098). 3.2 Statement of Reduction of Authorized Shares filed September 19, 1983 (incorporated by reference to Exhibit 3.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 3.3 Statement of Reduction of Authorized Shares filed January 19, 1984 (incorporated by reference to Exhibit 3.3 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 3.4 Articles of Amendment filed April 18, 1984 (incorporated by reference to Exhibit 3.4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 3.5 Statement of Reduction of Authorized Shares filed February 25, 1985 (incorporated by reference to Exhibit 3.5 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 3.6 Statement of Reduction of Authorized Shares filed May 6, 1985 (incorporated by reference to Exhibit 3.6 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 3.7 Statement of Reduction of Authorized Shares filed October 23, 1985 (incorporated by reference to Exhibit 3.7 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 3.8 Articles of Amendment filed April 16, 1987 (incorporated by reference to Exhibit 3.8 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 3.9 Articles of Amendment filed April 21, 1988 (incorporated by reference to Exhibit 3.9 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 3.10 Articles of Amendment filed April 26, 1988 (incorporated by reference to Exhibit 3.10 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 3.11 Statement Re Series A Preferred Stock filed October 11, 1988 (incorporated by reference to Exhibit 3.11 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 3.12 Articles of Amendment filed April 13, 1990 (incorporated by reference to Exhibit 3.12 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). 3.13 Articles of Amendment filed April 26, 1991 (incorporated by reference to Exhibit 3.13 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 3.14 Statement of Correction filed October 16, 1991 to Articles of Amendment filed April 26, 1991 (incorporated by reference to Exhibit 3.14 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 3.15 By-Laws of Registrant, as amended October 30, 1992 (incorporated by reference to Exhibit 3.15 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 4.1 Specimen Certificate for Common Stock (incorporated by reference to Exhibit 4 to Amendment No. 1 to Form S-1 Registration Statement, File No. 2-80098). 4.2 Form of Warrant Issued to Purchasers of Limited Partnership Interests in CPIII (incorporated by reference to Exhibit 4.5 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 4.3 Rights Agreement between Centocor, Inc. and the First National Bank of Boston as Rights Agent dated September 26, 1988 (incorporated by reference to Exhibit 4 to Registrant's Current Report on Form 8-K dated September 26, 1988). 4.4 Form of Warrant Issued to Purchasers of Units, each Unit consisting of one share of Tocor Callable Common Stock and one warrant to purchase one share of Centocor Common Stock (incorporated by reference to Exhibit 4.6 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 4.5 Form of Indenture between Centocor, Inc. and CoreStates Bank, N.A. as Trustee Dated as of January 18, 1991 (incorporated by reference to Exhibit 4.3 to Amendment No. 1 to Form S-3 Registration Statement, Reg. No. 33-38110). 4.6 Form of Note Issued to Purchasers of 7 1/4% Convertible Subordinated Notes Due February 1, 2001 (incorporated by reference to Exhibit 4.4 to Amendment No. 1 to Form S-3 Registration Statement, Reg. No. 33-38110). 4.7 Form of Indenture between Centocor, Inc. and Chase Manhattan Trustees Limited as Trustee Dated as of October 16, 1991 (incorporated by reference to Exhibit 4.3 to Form S-3 Registration Statement, Reg. No. 33-44231). 4.8 Form of Debenture Issued to Purchasers of 6-3/4% Convertible Subordinated Debentures Due October 16, 2001 (included in Exhibit 4.9) (incorporated by reference to Exhibit 4.3 to Form S-3 Registration Statement, Reg. No. 33-44231). 4.9 Form of Series T Warrant Issued to Purchasers of Units, each Unit consisting of one share of Tocor II Callable Common Stock, one Series T warrant to purchase one share of Centocor Common Stock, and one Callable warrant to purchase one share of Centocor Common Stock (incorporated by reference to Exhibit 4.2 to Amendment No. 4 to Form S-1/S-3 Registration Statement of Tocor II and Centocor, Reg. No. 33-44072). 4.10 Form of Callable Warrant Issued to Purchasers of Units, each Unit consisting of one share of Tocor II Callable Common Stock, one Series T warrant to purchase one share of Centocor Common Stock, and one Callable warrant to purchase one share of Centocor Common Stock (incorporated by reference to Exhibit 4.3 to Amendment No. 4 to Form S-1/S-3 Registration Statement of Tocor II and Centocor, Reg. No. 33-44072). 10.1* Form of Non-Qualified Stock Option Agreement (incorporated by reference to Exhibit 10.01 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 10.2* Incentive Stock Option Plan, as amended (incorporated by reference to Exhibit 10.03 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 10.3* 1983 Incentive Stock Option Plan, as amended (incorporated by reference to Exhibit 10.04 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 10.4* 1983 Restricted Common Stock Award Plan, as amended and restated. 10.5* 1987 Non-Qualified Stock Option Plan, as amended and restated (incorporated by reference to Exhibit 10.05 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). 10.6* 1989 Non-Employee Directors' Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.06 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 10.7 Lease Agreement for property located at Great Valley Parkway, Malvern, PA 19355 (incorporated by reference to Exhibit 10.07 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 10.8 Partnership Purchase Option Agreement among Centocor, Inc., CCIP, Centocor Development Corporation I, each Class A limited partner and the Class B limited partner, dated September 12, 1985 (incorporated by reference to Exhibit 10.53 to Registrant's Post Effective Amendment No. 1 to Form S-1 Registration Statement, File No. 2-95057). 10.9 Indemnity Agreement between Centocor, Inc. and CCIP, dated September 12, 1985 (incorporated by reference to Exhibit 10.71 to Registrant's Post Effective Amendment No. 1 to Form S-1 Registration Statement, File No. 2-95057). 10.10 Qualified Savings and Retirement Plan, as amended and restated (incorporated by reference to Exhibit 10.14 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 10.11 Partnership Purchase Option Agreement among Centocor, Inc., CPII, Centocor Development Corporation II, each Class A limited partner and the Class B limited partner, dated December 17, 1986 (incorporated by reference to Exhibit 10.23 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986) 10.12 Indemnity Agreement between Centocor, Inc. and CPII, dated December 17, 1986 (incorporated by reference to Exhibit 10.26 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). 10.13 Consent Decree of Permanent Injunction in U.S. v. Centocor, Inc. et al., Civil Action No. 85-5613, in the United States District Court for the Eastern District of Pennsylvania (incorporated by reference to Exhibit 10.60 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985). 10.14 CPIII Agreement of Limited Partnership, dated December 23, 1987 as amended and restated on January 15, 1988 and March 23, 1988 (incorporated by reference to Exhibit 10.26 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.15 Cross License Agreement between CPIII and Centocor, Inc., dated December 23, 1987 (incorporated by reference to Exhibit 10.38 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 10.16 Amendment dated March 23, 1988 to Cross License Agreement between CPIII and Centocor, Inc. dated December 23, 1987 (incorporated by reference to Exhibit 10.28 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.17 Development Agreement between CPIII and Centocor, Inc., dated December 23, 1987 (incorporated by reference to Exhibit 10.39 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 10.18 Amendment dated March 23, 1988 to Development Agreement between CPIII and Centocor, Inc. dated December 23, 1987 (incorporated by reference to Exhibit 10.30 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.19 Joint Venture Agreement between CPIII and Centocor, Inc., dated December 23, 1987 (incorporated by reference to Exhibit 10.40 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 10.20 Amendment dated March 23, 1988 to Joint Venture Agreement between CPIII and Centocor, Inc. dated December 23, 1987 (incorporated by reference to Exhibit 10.32 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.21 Indemnity Agreement between CPIII and Centocor, Inc., dated December 23, 1987 (incorporated by reference to Exhibit 10.41 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 10.22 Inducement Agreement among Centocor, Inc., CPIII, Centocor Development Corporation III, PaineWebber Development Corporation, PaineWebber, Inc. and PaineWebber R&D Partners II, L.P., dated December 23, 1987 (incorporated by reference to Exhibit 10.42 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 10.23 Amendment dated March 23, 1988 to Inducement Agreement among Centocor, Inc., CPIII, Centocor Development Corporation III, PaineWebber Development Corporation, PaineWebber, Inc. and PaineWebber R&D Partners II, L.P. dated December 23, 1987 (incorporated by reference to Exhibit 10.35 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.24 Partnership Purchase Option Agreement among Centocor, Inc., CPIII, Centocor Development Corporation III, and the Class C limited partner, dated December 23, 1987 (incorporated by reference to Exhibit 10.43 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987). 10.25 Amendment dated March 23, 1988 to Partnership Purchase Option Agreement among Centocor, Inc., CPIII, Centocor Development Corporation III and the Class C limited partner dated December 23, 1987 (incorporated by reference to Exhibit 10.37 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.26 Technology License Agreement between Centocor, Inc. and Tocor II, Inc. dated January 21, 1992 (incorporated by reference to Exhibit 10.1 to Amendment No. 2 to Form S-1/S-3 Registration Statement of Tocor II and Centocor, Reg. No. 33-44072). 10.27 Research and Development Agreement between Centocor, Inc. and Tocor II, Inc., dated January 21, 1992 (incorporated by reference to Exhibit 10.2 to Amendment No. 2 to Form S-1/S-3 Registration Statement of Tocor II and Centocor, Reg. No. 33- 44072). 10.28 Purchase Option Agreement by and among Centocor, Inc., PaineWebber Incorporated, The First Boston Corporation, Hambrecht & Quist Incorporated and J. P. Morgan Securities Inc. dated January 21, 1992 (incorporated by reference to Exhibit 10.3 to Amendment No. 5 to Form S-1/S-3 Registration Statement of Tocor II and Centocor, Reg. No. 33-44072). 10.29 Services Agreement between Centocor B.V. and Tocor II, Inc. dated January 21, 1992 (incorporated by reference to Exhibit 10.4 to Amendment No. 2 to Form S-1/S-3 Registration Statement of Tocor II and Centocor, Reg. No. 33-44072). 10.30 Administrative Agreement between Centocor, Inc. and Tocor II, Inc. dated January 21, 1992 (incorporated by reference to Exhibit 10.5 to Form S-1/S-3 Registration Statement of Tocor II and Centocor, Reg. No. 33-44072). 10.31 Series E, F and G Preferred Stock Purchase Agreement dated as of November 20, 1991 between Centocor Delaware, Inc. and Corvas International, Inc. (incorporated by reference to Exhibit 10.28 to Form S-1 Registration Statement of Corvas International, Inc. Reg. No. 33-44555). 10.32 Sales and Distribution Agreement between Centocor, Inc. and Eli Lilly and Company dated July 15, 1992. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10.32 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.33 Reimbursement Agreement between Centocor, Inc. and Eli Lilly and Company dated July 15, 1992. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10.33 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.34 Investment Agreement between Centocor, Inc. and Eli Lilly and Company dated July 15, 1992. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10.34 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.35 Amendment to Sales and Distribution Agreement among Centocor, Inc., Centocor B.V. and Eli Lilly and Company dated June 27, 1993. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) 10.36 Option Agreement between Centocor B.V. and Eli Lilly Nederland B.V. dated August 20, 1993. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) 10.37 Deed of Mortgage from Centocor B.V. to Eli Lilly Nederland B.V. dated August 26, 1993. 10.38 Deed of Pledge from Centocor B.V. to Eli Lilly Nederland B.V. dated August 26, 1993. 10.39 Stock Purchase Agreement made as of December 16, 1993 by and between the Registrant and The Wellcome Foundation Limited (incorporated by reference to Exhibit 10(a) to the Registrant's Current Report on Form 8-K dated December 16, 1993). 10.40 Supply, Distribution and Sales Agreement dated December 16, 1993 by and among the Registrant, Centocor B.V., The Wellcome Foundation Limited and Burroughs Wellcome Co. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10(b) to the Registrant's Current Report on Form 8-K dated December 16, 1993). 10.41 Clinical and Regulatory Development Agreement dated December 16, 1993 among the Registrant, Centocor B.V., The Wellcome Foundation Limited and Burroughs Wellcome Co. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10(c) to the Registrant's Current Report on Form 8-K dated December 16, 1993). 10.42 Manufacturing Technology Option Agreement dated as of December 16, 1993 among the Registrant, Centocor B.V., The Wellcome Foundation Limited and Burroughs Wellcome Co. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10(d) to the Registrant's Current Report on Form 8-K dated December 16, 1993). 10.43 Centocor Technology License Agreement dated as of December 16, 1993 among the Registrant, Centocor B.V., The Wellcome Foundation Limited and Burroughs Wellcome Co. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10(e) to the Registrant's Current Report on Form 8-K dated December 16, 1993). 10.44 Relicense Agreement dated as of December 16, 1993 among the Registrant, Centocor B.V., The Wellcome Foundation Limited and Burroughs Wellcome Co. (incorporated by reference to Exhibit 10(f) to the Registrant's Current Report on Form 8-K dated December 16, 1993). 10.45 Appendix A - Glossary of Terms to each of the Agreements dated as of December 16, 1993 by and between the Registrant, Centocor B.V., The Wellcome Foundation Limited and Burroughs Wellcome Co. (The Registrant has requested confidential treatment from the Securities and Exchange Commission for portions of this Agreement.) (incorporated by reference to Exhibit 10(g) to the Registrant's Current Report on Form 8-K dated December 16, 1993). 12 Statement re Computation of Ratios. 21 Subsidiaries of the Registrant. 23 Consent of Independent Auditors. *These exhibits constitute compensatory plans. (b) The Registrant has filed the following reports on Form 8-K since the beginning of the quarter ended December 31, 1993: Date of Report Item Covered -------------- ------------ December 16, 1993 5,7 December 23, 1993 5,7 March 11, 1994 2,7 For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8, Nos. 2-86486, 33-16285, 33-00167, 33-35731, 33-23480, 33-16284, and 33-35730. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. Centocor Partners III, L.P. Balance Sheets See accompanying Notes to Financial Statements. Centocor Partners III, L.P. Statements of Operations See accompanying Notes to Financial Statements. Centocor Partners III, L.P. Statements of Partners' Capital See accompanying Notes to Financial Statements. Centocor Partners III, L.P. Statements of Cash Flows See accompanying Notes to Financial Statements. Centocor Partners III, L.P. Notes to Financial Statements - ----------------------------- 1. Organization and Business Operations ------------------------------------ Centocor Partners III, L.P. (the "Partnership"), was formed in December 1987, and is managed by its general partner, Centocor Development Corporation III, a wholly owned subsidiary of Centocor, Inc. ("Centocor"), a Pennsylvania corporation, which is subject to the reporting requirements of the Securities and Exchange Act of 1934. The Partnership was organized to develop and derive income from the sale of one therapeutic product (CentoRx) and one imaging product (Capiscint) which are expected to be used in the treatment and diagnosis, respectively, of two different types of cardiovascular disease. In 1987 and 1988, the Partnership and Centocor sold (a) 542.25 units, consisting of 111 Class C limited partnership interests and 431.25 Class A limited partnership interests each together with warrants to purchase shares of Centocor common stock, and (b) one Class B limited partnership interest together with warrants to purchase shares of Centocor common stock. The purchase prices were $90,000 for the Class C interests, $100,000 for the Class A interests and $150,000 for the Class B interest. The net proceeds from the sale of limited partnership interests were used primarily to pay expenses incurred under the Partnership's agreement with Centocor (the "Development Agreement") to perform research and development for the Partnership (see Note 6). The Partnership also entered into a Cross License Agreement pursuant to which Centocor granted to the Partnership an exclusive license to use all patent rights, know-how, technical information and biological materials owned or controlled by Centocor within the Partnership's field of activity. Under the Cross License Agreement, the Partnership agreed to grant to Centocor an exclusive royalty-free license to all patent rights, know-how, technical information and biological materials arising from research and development conducted under the Development Agreement for all purposes outside of the Partnership's field of activity. The profits and losses of the Partnership are generally allocated 1 percent to the general partner and 99 percent to the limited partners. Research and development costs in excess of the limited partners' capital contributions are allocated to the general partner. The general partner is permitted but not required to make additional capital contributions for the working capital of the partnership (see Note 6). 2. Summary of Significant Accounting Policies ------------------------------------------ Investment in Joint Venture --------------------------- The Partnership accounts for its investment in the joint venture (see Note 5) under the equity method of accounting. Income Taxes ------------ Income or loss credited to the partners' capital accounts is reportable for income tax purposes by the partners; therefore, no provision for income taxes has been made in the accompanying financial statements. The Partnership's tax returns are subject to examination by federal and state taxing authorities. Because many types of transactions are susceptible to varying interpretations under federal and state income tax laws and regulations, certain amounts may be subject to change at a later date upon final determination by the respective taxing authorities. 3. Bank Debt --------- In 1987, the Partnership borrowed $9,500,000 to fund certain syndication and organization costs and to make a working capital contribution to the joint venture. The outstanding balance of the loan was repaid on September 30, 1991. Interest paid in 1991 was $547,665. 4. Partnership Purchase Option --------------------------- Centocor has entered into a Partnership Purchase Option Agreement with each of the limited partners. Under its terms, Centocor has the option to purchase each limited partnership interest upon the earlier of (a) the limited partners having received distributions from the joint venture (see Note 5) equal to 15 percent of their capital contributions to the Partnership and the expiration of at least 24 months after the first commercial sale of products by the joint venture or (b) the expiration of at least 48 months after the first commercial sale of products by the joint venture; but, in any event, not prior to the expiration of the then applicable long-term capital gains holding period after the expenditure by Centocor of all funds paid to it pursuant to the Development Agreement. There have not been any sales of the Partnership's products. The ability of Centocor to exercise this option is highly dependent upon the future financial condition of Centocor. If Centocor exercises the Partnership Purchase Option, each limited partner will enter into a Partnership Purchase Agreement with Centocor which sets forth the terms by which Centocor will purchase the limited partnership interests. Under the terms of the Partnership Purchase Agreement, the aggregate purchase price for the limited partnership interests would be payable as follows: (a) an advance payment of $13,598,000 in cash (or, at Centocor's option, $15,229,000 in Centocor common stock), and (b) quarterly payments equal to certain percentages of revenue to Centocor from sales of the Partnership's products, or products of Centocor or its affiliates which are competitive, or sold in combination, with the Partnership's products. Beginning with the 12th calendar quarter after the calendar quarter in which the advance payment is made, Centocor's payment to the limited partners will be reduced by 25 percent of the amount which the limited partners would otherwise have received until Centocor has recouped the amount of the advance payment. 5. Joint Venture ------------- The Partnership and Centocor have formed a joint venture for the purpose of commercializing any products developed within the Partnership's field of activity. The joint venture agreement provides that Centocor shall manufacture the products on behalf of the joint venture for its actual costs of manufacturing. Under the joint venture agreement, Centocor also provides marketing services for the joint venture for a commission of 17 percent of joint venture sales and receives 10 percent of joint venture sales as reimbursement for its management and administrative services. The profits and losses of the joint venture are to be allocated 75 percent to Centocor and 25 percent to the Partnership. The joint venture will terminate upon the occurrence of certain events, principally related to the exercise or expiration of the purchase option granted to Centocor (see Note 4). On July 15, 1992, Centocor and Eli Lilly and Company ("Lilly") entered into a Sales and Distribution Agreement, pursuant to which, Lilly has the option to be the exclusive distributor for CentoRx world-wide. Pursuant to the Agreement, the Joint Venture recognized $500,000 of revenue in 1992 related to the CentoRx option. During the second quarter of 1993, Lilly exercised its option to become the exclusive worldwide distributor for CentoRx and Centocor and Lilly amended their Sales and Distribution Agreement. As part of the amendment, Lilly assisted Centocor and will continue to assist Centocor in the regulatory filings and continue development of CentoRx for various clinical indications. Status of CentoRx ------------------ CentoRx is a product intended to treat or prevent the formation of blood clots in the cardiovascular system. In the first quarter of 1993, Centocor completed a randomized, double-blinded, placebo-controlled Phase III trial in high-risk coronary angioplasty patients that enrolled 2,099 patients at 56 medical centers. Centocor filed product license applications for CentoRx in the United States and Canada in 1993 and has filed product license applications in several countries in Europe in 1994. There can be no assurance that CentoRx will be approved for commercial sale in the United States, Europe or elsewhere. 6. Research Funding ---------------- The initial funding by the limited partners for the Partnership's research program pursuant to the Development Agreement with Centocor was exhausted in 1990. In order to continue the research program, the Partnership extended the terms of the Development Agreement with Centocor. Approximately $64,166,000 of the Partnership's research costs through December 31, 1993 were funded by the general partner. At December 31, 1993 and December 31, 1992, approximately $4,134,000 and $6,596,000, respectively, was due to Centocor for expenditures under the Development Agreement. The general partner may continue to provide funding but is under no obligation to do so. The ability of the general partner to continue to fund, and the ability of Centocor to perform under, the Development Agreement is highly dependent upon the future financial condition of Centocor. INDEPENDENT AUDITORS' REPORT The Partners of Centocor Partners III, L.P.: We have audited the accompanying balance sheets of Centocor Partners III, L.P. as of December 31, 1993 and 1992, and the related statements of operations, partners' capital and cash flows for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Centocor Partners III, L.P. at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Continuation of the product research programs by the Partnership is dependent upon the general partner continuing to provide funding and/or the ability of the Partnership to obtain funding from another source. See Note 6 to the financial statements. KPMG Peat Marwick Philadelphia, Pennsylvania March 11, 1994 SCHEDULE I CENTOCOR, INC. AND SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 (IN THOUSANDS) (1) With respect to securities with no quoted market prices on December 31, 1993 market value is based on the determination of fair value made in good faith by management. (2) At December 31,1993, the Company recorded an unrealized loss of $2,380,000 due to the decline in market value of these securities. SCHEDULE II CENTOCOR, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) (1) In June 1991, the Company exercised its option to acquire all the callable common stock of Tocor, Inc., which thereafter became a consolidated subsidiary. (2) Stephen D. Hayter is an executive vice president of the Company. The amounts loaned by the Company were done so in connection with his relocation and employment by the Company. SCHEDULE V CENTOCOR, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) (1) Amounts relate to the transfer of cost of completed assets to active assets. (2) Land and building acquisitions include $4,268,000 related to the purchase of the Company's St. Louis manufacturing facility. Construction in progress and equipment, furniture, fixtures and improvements include additions to the Company's manufacturing and office facilities in Malvern, St. Louis and Leiden locations. (3) Land and building acquisitions include $11,151,000 related to manufacturing and administrative facilities at the Company's Leiden and St. Louis locations, including $2,134,000 acquired by assuming the related debt obligation. Equipment, furniture, fixtures and improvements include $904,000 of assets added by the acquisition of Mercia Diagnostics, Ltd. in January, 1992. (4) Retirements include the sale of the Company's St. Louis facility in 1993 for approximately $12,000,000 in addition to write-down of fixed asset balances to previously established reserves, the sale of certain equipment, and the retirement of fully depreciated assets which in the aggregate total $13,500,000. SCHEDULE VI CENTOCOR, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) SCHEDULE VIII CENTOCOR, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) (1) The Company recorded reserves for HA-1A inventories of $3,500,000 and $64,877,000 in 1993 and 1992, due to the uncertainties regarding future HA-1A sales resulting from the current regulatory and commercial status of HA-1A. SCHEDULE IX CENTOCOR, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) (1) Notes Payable to Bank represent borrowings under lines of credit arrangements which are subject to annual review. (2) The average amount outstanding is a weighted average calculation based upon the amount of daily debt outstanding. (3) The weighted average interest rate was computed by dividing actual interest expense by the average short-term debt outstanding. SCHEDULE X CENTOCOR, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) (1) Included within cost of sales. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CENTOCOR, INC. March 31, 1994 By:/s/David P. Holveck ---------------------- David P. Holveck (President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/Hubert J.P. Schoemaker Director, Chairman of March 31, 1994 - ------------------------- the Board Hubert J. P. Schoemaker /s/ Dominic J. Caruso Vice President, March 31, 1994 - ------------------------- Corporate Controller Dominic J. Caruso and Chief Accounting Officer (Principal Accounting and Financial Officer) /s/Anthony B. Evnin Director March 31, 1994 - ------------------------- Anthony B. Evnin /s/William F. Hamilton Director March 31, 1994 - ------------------------- William F. Hamilton /s/Antonie T. Knoppers Director March 31, 1994 - --------------------------- Antonie T. Knoppers /s/Lawrence Steinman Director March 31, 1994 - --------------------------- Lawrence Steinman /s/Jean C. Tempel Director March 31, 1994 - --------------------------- Jean C. Tempel

277577_1993.txt

277577

1993

ITEM 1. BUSINESS (Continued) Business Plan and Investment Policy (Continued) acquired through foreclosure, the Trust intends to enhance the value of such properties through renovations and, if possible, to finance such properties with first mortgages. The Trust also intends to pursue its rights vigorously with respect to mortgage notes that are in default. Management of the Trust Although the Trust's Board of Trustees is directly responsible for managing the affairs of the Trust and for setting the policies which guide it, the day-to-day operations of the Trust are performed by a contractual advisor under the supervision of the Trust's Board of Trustees. From March 1989 until March 31, 1994, Basic Capital Management, Inc. ("BCM" or the "Advisor") performed such services. The duties of the advisor include, among other things, locating, investigating, evaluating and recommending real estate and mortgage note investment and sales opportunities, as well as financing and refinancing sources, for the Trust. The advisor also serves as a consultant in connection with the business plan and investment policy decisions made by the Trust's Board of Trustees. William S. Friedman, the President and a Trustee of the Trust, served as the President of BCM until May 1, 1993. BCM is beneficially owned by a trust for the benefit of the children of Gene E. Phillips. Mr. Phillips served as a Trustee of the Trust until December 31, 1992. Messrs. Phillips and Friedman served as directors of BCM until December 22, 1989, and Mr. Phillips served as Chief Executive Officer of BCM until September 1, 1992. BCM is more fully described in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT - The Advisor". BCM has provided advisory services to the Trust since March 28, 1989. Renewal of the Trust's advisory agreement with BCM was approved by the Trust's shareholders at the Trust's last annual meeting of shareholders held on April 26, 1993, as required by Section 4.2 of the Trust's Declaration of Trust. BCM has resigned as advisor to the Trust effective March 31, 1994. BCM also serves as advisor to Continental Mortgage and Equity Trust ("CMET"), Income Opportunity Realty Trust ("IORT") and Transcontinental Realty Investors, Inc. ("TCI"). All of the Trustees of the Trust, except for John A. Doyle, William S. Friedman and Carl B. Weisbrod, are also directors or trustees of CMET, IORT and TCI. Mr. Phillips is also a general partner and until March 4, 1994, Mr. Friedman was a general partner of the general partner of National Realty, L.P. ("NRLP"). BCM performs certain administrative functions for NRLP and National Operating, L.P. ("NOLP"), the operating partnership of NRLP, on a cost-reimbursement basis. BCM also serves as advisor to American Realty Trust, Inc. ("ART"). Messrs. Phillips and Friedman served as executive officers and directors of ART until November 16, 1992 and December 31, 1992, respectively. On February 10, 1994, the Trust's Board of Trustees selected Tarragon Realty Advisors, Inc. ("Tarragon") to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will provide advisory ITEM 1. BUSINESS (Continued) Management of the Trust (Continued) services to the Trust under an advisory agreement as discussed in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR TO THE REGISTRANT - The Advisor." Mr. Friedman serves as director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as Director, President and Chief Operating Officer of Tarragon and Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. Tarragon also serves as advisor to Vinland Property Trust ("VPT"). All of the trustees of VPT serve as Trustees of the Trust. Commencing April 1, 1994, Tarragon will provide property management services to the Trust. Tarragon intends to subcontract with other entities for the provision of much of the property-level management services to the Trust. From February 1, 1990 through March 31, 1994, affiliates of BCM provided property management services to the Trust. Through March 31, 1994, affiliates of BCM also received real estate brokerage commissions in accordance with the terms of a non-exclusive brokerage agreement as discussed in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR TO THE REGISTRANT - The Advisor." Competition The Trust has no employees. Employees of the Advisor render services to the Trust. The real estate business is highly competitive and the Trust competes with numerous entities engaged in real estate activities (including certain entities described in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Related Party Transactions"), some of which may have greater financial resources than those of the Trust. The Trust's management believes that success against such competition is dependent upon the geographic location of the property, the performance of the property managers in areas such as marketing, collection and the ability to control operating expenses, the amount of new construction in the area and the maintenance and appearance of the property. Additional competitive factors with respect to commercial and industrial properties are the ease of access to the property, the adequacy of related facilities, such as parking, and sensitivity to market conditions in setting rent levels. With respect to apartments, competition is also based upon the design and mix of the units and the ability to provide a community atmosphere for the tenants. The Trust's management believes that general economic conditions and trends and new properties in the vicinity of each of the Trust's properties are also competitive factors. To the extent that the Trust seeks to sell any of its real estate portfolio, the sales price for such properties may be affected by competition from governmental and financial institutions seeking to liquidate foreclosed properties. ITEM 1. BUSINESS (Continued) Competition (Continued) As described above and in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Related Party Transactions", most of the Trustees of the Trust also serve as officers, directors or trustees of CMET, IORT, TCI, VPT and Tarragon. The Trust's Trustees owe fiduciary duties to such other entities as well as to the Trust under applicable law. In determining to which entity a particular investment opportunity will be allocated, the trustees or directors and Tarragon consider the respective investment objectives of each such entity and the appropriateness of a particular investment in light of each such entity's existing real estate and mortgage notes receivable portfolios. To the extent that any particular investment opportunity is appropriate to more than one of such entities, such investment opportunity will be allocated to the entity which has had uninvested funds for the longest period of time or, if appropriate, the investment may be shared among all or some of such entities. In addition, also as described in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Certain Business Relationships", the Trust also competes with other entities which may have investment objectives similar to the Trust's and that may compete with the Trust in purchasing, selling, leasing and financing real estate and real estate related investments. In resolving any potential conflicts of interest which may arise, Tarragon has informed the Trust that it intends to exercise its best judgment as to what is fair and reasonable under the circumstances in accordance with applicable law. Certain Factors Associated with Real Estate and Related Investments The Trust is subject to all the risks incident to ownership and financing of real estate and interests therein, many of which relate to the general illiquidity of real estate investments. These risks include, but are not limited to, changes in general or local economic conditions, changes in interest rates and the availability of permanent mortgage financing which may render the acquisition, sale or refinancing of a property difficult or unattractive and which may make debt service burdensome, changes in real estate and zoning laws, increases in real estate taxes, federal or local economic or rent controls, floods, earthquakes and other acts of God and other factors beyond the control of the Trust or the Advisor. The illiquidity of real estate investments generally may impair the ability of the Trust to respond promptly to changing circumstances. The Trust's management believes that such risks are partially mitigated by the diversification by geographic region and property type of the Trust's real estate and mortgage notes receivable portfolios. However, to the extent new equity investments and mortgage lending are concentrated in any particular region, the advantages of geographic diversification may be mitigated. ITEM 2.

ITEM 2. PROPERTIES The Trust's principal offices are located at One Turtle Creek, 3878 Oak Lawn Avenue, Suite 300, Dallas, Texas 75219. In the opinion of the ITEM 2. PROPERTIES (Continued) Trust's management, the Trust's offices are adequate for its present operations. Details of the Trust's real estate and mortgage notes receivable portfolios at December 31, 1993, are set forth in Schedules XI and XII, respectively, to the Consolidated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA". The discussions set forth below under the headings "Real Estate" and "Mortgage Loans" provide certain summary information concerning the Trust's real estate and mortgage notes receivable portfolios. The Trust's real estate portfolio consists of properties held for investment (which includes direct equity investments and partnerships) and properties held for sale, primarily obtained through foreclosure of mortgage notes receivable. The discussion set forth below under the heading "Real Estate" provides certain summary information concerning the Trust's real estate and further summary information with respect to the portion of the Trust's real estate which consists of properties held for investment, the portion which consists of investments in partnerships and the portion which consists of properties held for sale. At December 31, 1993, only the Century Centre II Office Building, with a carrying value of $24.5 million, accounted for 10% or more of the Trust's total assets. At December 31, 1993, 85% of the Trust's assets consisted of investments in real estate, 6% consisted of investments in partnerships and 6% consisted of mortgage notes and interest receivable. The remaining 3% of the Trust's assets at December 31, 1993, were cash, cash equivalents and other assets. It should be noted, however, that the percentage of the Trust's assets invested in any one category is subject to change and no assurance can be given that the composition of the Trust's assets in the future will approximate the percentages listed above. At December 31, 1993, the Trust held mortgage notes receivable secured by real estate located in several geographic regions of the continental United States, with a concentration in the Southeast, as shown more specifically in the table under "Mortgage Loans" below. The Trust's real estate is also geographically diverse. At December 31, 1993, the Trust held investments in apartments and commercial real estate in each of the geographic regions of the continental United States, although its apartments are concentrated in the Southeast, as shown more specifically in the table under "Real Estate" below. To continue to qualify for federal taxation as a REIT under the Internal Revenue Code of 1986, as amended, the Trust will, among other things, be required to hold at least 75% of the value of its total assets in real estate assets, government securities, cash and cash equivalents at the close of each quarter of each taxable year. ITEM 2. PROPERTIES (Continued) Geographic Regions The Trust has divided the continental United States into the following six geographic regions. Northeast region comprised of the states of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont, and the District of Columbia. Southeast region comprised of the states of Alabama, Florida, Georgia, Mississippi, North Carolina, South Carolina, Tennessee and Virginia. Southwest region comprised of the states of Arizona, Arkansas, Louisiana, New Mexico, Oklahoma and Texas. Midwest region comprised of the states of Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, West Virginia and Wisconsin. Mountain region comprised of the states of Colorado, Idaho, Montana, Nevada, Utah and Wyoming. Pacific region comprised of the states of California, Oregon and Washington. Real Estate At December 31, 1993, 85% of the Trust's assets were invested in real estate located throughout the continental United States. The Trust's real estate portfolio consists of properties held for investment, investments in partnerships, properties held for sale, primarily obtained through foreclosure of mortgage notes receivable, and an investment in the equity securities of CMET, a REIT advised by BCM. Types of Real Estate Investments. The Trust's real estate consists of apartments and commercial properties, primarily office buildings and shopping centers, or similar properties having established income-producing capabilities. In selecting real estate, the location, age and type of property, gross rentals, lease terms, financial and business standing of tenants, operating expenses, fixed charges, land values and ITEM 2. PROPERTIES (Continued) physical condition are considered. The Trust may acquire properties subject to, or assume, existing debt and may mortgage, pledge or otherwise obtain financing for a portion of its real estate. The Trust's Board of Trustees may alter the types of and criteria for selecting new equity investments and for obtaining financing without a vote of shareholders to the extent such policies are not governed by the Declaration of Trust. Although the Trust has typically invested in developed real estate, the Trust may invest in new construction or development either directly or in partnership with affiliated or unaffiliated partners. To the extent that the Trust invests in construction and development projects, the Trust would be subject to business risks, such as cost overruns and delays, associated with such high risk activities. At December 31, 1993, the Trust was making significant capital improvements to five of its properties, the Dunhill/Devonshire, Huntington Green and Lakepointe Apartments and the Emerson Center and Rancho Sorrento Office Buildings. In the opinion of the Trust's management, the real estate owned by the Trust is adequately covered by insurance. The following table sets forth the percentages, by property type and geographic region, of the Trust's real estate (other than the unimproved land and a single-family residence described below) at December 31, 1993. The foregoing table is based solely on the number of apartment units and amount of commercial square footage owned by the Trust and does not reflect the value of the Trust's investment in each region. The Trust also owns one parcel of unimproved land of 46.27 acres located in the Southeast region and one single-family residence located in the Southwest region. See Schedule XI to the Consolidated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA" for a more detailed description of the Trust's real estate portfolio. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 2. PROPERTIES (Continued) Real Estate (Continued) A summary of activity in the Trust's owned real estate portfolio during 1993 is as follows: (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 2. PROPERTIES (Continued) Real Estate (Continued) Properties Held for Investment. Set forth below are the Trust's properties held for investment and monthly rental rate for apartments and the average annual rental rate for commercial properties and occupancy thereof at December 31, 1993 and 1992: ITEM 2. PROPERTIES (Continued) Real Estate (Continued) Occupancy presented above and throughout this ITEM 2. is without reference to whether leases in effect are at, below or above market rates. In June 1993, the Trust obtained first mortgage financing secured by the Bayfront Apartments in the amount of $2.1 million. The Trust received net cash of $1.8 million. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. The Trust paid a 1% mortgage brokerage and equity refinancing fee of $21,000 to BCM based upon the new first mortgage financing of $2.1 million. In October 1991, after determining that further investment in the Century Centre II Office Building could not be justified without a substantial modification of the mortgage debt, the property was placed in bankruptcy. A plan of reorganization was filed with the bankruptcy court in March 1993 and the bankruptcy court confirmed the Plan in November 1993. The confirmed Plan of Reorganization reduces the interest rate on the $21 million first mortgage to 1-1/2% above LIBOR, which currently results in an interest rate of 5 1/2% per annum. The reduced interest rate was retroactively applied as of October 15, 1991. The Plan also extends the note's maturity two years to November 1995, with three consecutive one-year extension options. Under the Plan, the Trust deposited $1.0 million in cash with the lender to pay accrued and unpaid interest, 1993 property taxes and all closing costs associated with the transaction. In 1994, the Trust will be required to maintain a $200,000 balance in the escrow account with the lender. The Trust has also pledged one of its properties held for sale, Stewart Square Shopping Center, as additional collateral on the first mortgage. Also pursuant to the Plan of Reorganization, the Trust acquired the $7.5 million second mortgage plus all accrued and unpaid interest of $1.7 million, for $300,000 in cash. The Trust recognized an extraordinary gain of $8.9 million in connection with the debt modification and discounted debt purchase. ITEM 2. PROPERTIES (Continued) Real Estate (Continued) In 1990, the Trust ceased making payments on the first mortgage secured by a portion of the Dunhill/Devonshire Apartments. At the time, the Trust was the holder and 50% owner of this first mortgage. The other 50% of the mortgage was owned by a financial institution in receivership, which refused to fund its share of advances necessary to preserve the value of the property. Accordingly, the Trust, as mortgage holder, foreclosed on this property and was, for its own accord, the high bidder at the foreclosure sale. To date, the Trust has not received an executed release of lien. In lieu of recording a gain of $1.3 million on this transaction, the Trust has written down the carrying value of such property by that amount. The $1.6 million first mortgage secured by the Palm Court Apartments, located in Miami, Florida, matured in July 1993. Prior to the maturity, the Trust obtained the lender's written agreement to extend the note. Thereafter, the lender refused to execute the extension documents and has subsequently rejected the Trust's tender of mortgage payments in accordance with the extension agreement. The matter is presently in litigation. If adversely determined, the Trust is prepared to payoff the mortgage debt. In January 1994, the Trust obtained first mortgage financing secured by the Bay West Apartments in the amount of $5.1 million. The Trust received net cash of $1.0 million after the payoff of $3.9 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. The Trust paid a mortgage brokerage and equity refinancing fee of $51,000 to BCM based upon the new first mortgage financing of $5.1 million. In March 1994, the Trust obtained first mortgage financing secured by the Carlyle Towers Apartments in the amount of $4.5 million. The Trust received net cash of $2.3 million after the payoff of $2.2 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. Also in March 1994, the Trust obtained first mortgage financing secured by the Woodcreek Apartments, located in Denver, Colorado, in the amount of $3.0 million. The Trust received net cash of $1.2 million after the payoff of $1.7 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. Partnership Properties. Set forth below are the Trust's investments in partnership properties and the average annual rental rate and occupancy thereof at December 31, 1993 and 1992: ITEM 2. PROPERTIES (Continued) Real Estate (Continued) The Trust, in partnership with CMET, owns Sacramento Nine ("SAC 9"), which currently owns two office buildings in the vicinity of Sacramento, California. The Trust has a 70% interest in the partnership. The SAC 9 partnership agreement requires the consent of both the Trust and CMET for any material changes in the operations of the partnership's properties, including sales, refinancings and changes in the property manager. Therefore, the Trust is a noncontrolling partner and accounts for its investment in the partnership under the equity method. The Trustees of the Trust, except for Messrs. Friedman, Doyle and Weisbrod, also serve as trustees of CMET. BCM, the Trust's advisor until March 31, 1994, also serves as advisor to CMET. See ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". In April 1993, SAC 9 sold one of its office buildings for $1.2 million. SAC 9 received $123,000 in cash, of which the Trust's equity share was $86,000, after the payoff of an existing first mortgage with a principal balance of $685,000. SAC 9 also provided $356,000 of purchase money financing. The note receivable bears interest at 9% per annum, requires monthly payments of principal and interest and matures in June 1998. SAC 9 recognized a gain of $59,000 on the sale, of which the Trust's equity share was $41,000. In June 1993, SAC 9 sold two other of its office buildings. One was sold for $1.3 million in cash, of which the Trust's equity share was $910,000. SAC 9 recognized a gain of $437,000 on the sale, of which the Trust's equity share was $306,000. SAC 9 paid a 3% sales commission of $39,000 to Carmel Realty, Inc., an affiliate of BCM, ("Carmel Realty") based upon the $1.3 million sales price of the property. The other office building was sold for $2.0 million. SAC 9 received $1.1 million in cash, of which the Trust's equity share was $750,000. SAC 9 also provided $887,000 of purchase money financing. SAC 9 recognized a gain of $720,000 on the sale, of which the Trust's equity share was $504,000. One note receivable with a principal balance of $410,000 bears interest at a variable interest rate, currently 6% per annum, requires monthly interest only payments and matures in June 1994. A second note receivable, with a principal balance of $477,000 bears interest at 10% per annum, and all principal and accrued interest are due at maturity in May 1994. SAC 9 paid a 3% sales commission of $59,000 to Carmel Realty based upon the $2.0 million sales price of the property. The Trust and CMET are also the partners in Income Special Associates ("ISA"), a joint venture partnership in which the Trust has a 40% partnership interest. ISA owns a 100% interest in Adams Properties Associates ("APA"). APA owns 33 industrial warehouses. The Trust accounts for its investment in the APA partnership under the equity method. See ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". In November 1992, the Trust acquired all of the general and limited partnership interests in Consolidated Capital Properties II ("CCP II"), ITEM 2. PROPERTIES (Continued) Real Estate (Continued) whose assets included a 23% limited partnership interest in English Village Partners, L.P. ("English Village"). On July 1, 1993, CCP II made an additional capital contribution to English Village of $464,000 to increase its limited partnership ownership interest to 49% and to acquire a 1% general partnership interest in the partnership. The Trust continues to account for its investment in English Village under the equity method. Properties Held for Sale. Set forth below are the Trust's properties held for sale (primarily obtained through foreclosure), except for a single-family residence, and the monthly rental rate for apartments and the average annual rental rate for commercial properties and occupancy thereof at December 31, 1993 and 1992: ________________________ * Property obtained through foreclosure in 1993. N/A - Not applicable as property is shut down. In January 1993, the Trust shut down the Lake Highlands Apartments as a result of a change in zoning of the property. No assurance can be given that the Trust will be able to operate the property as an apartment complex in the future. Based on the land value under the current zoning, the Trust does not anticipate incurring a loss in excess of previously established reserves. In March 1993, the Trust recorded the insubstance foreclosure of the Lakepointe Apartments, a 540 unit apartment complex in Memphis, Tennessee. The Lakepointe Apartments had an estimated fair value (minus estimated costs of sale) of at least $8.3 million at the date of foreclosure. In connection with this insubstance foreclosure, the Trust recorded the $6.7 million mortgage payable secured by the property. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. Also in March 1993, the Trust recorded the insubstance foreclosure of the Huntington Green Apartments, an 81 unit apartment complex in West Town, Pennsylvania. The Huntington Green Apartments had an estimated ITEM 2. PROPERTIES (Continued) Real Estate (Continued) fair value (minus estimated costs of sale) of at least $1.8 million at the date of foreclosure. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. In 1993, the State of Wisconsin commenced eminent domain proceedings to acquire the Pepperkorn Building, located in Manitowoc, Wisconsin, for highway development. The State of Wisconsin's initial offer was $175,000, which is being appealed by the Trust. There is no assurance that the Trust's appeal will be successful or of the amount, if any, of additional compensation that it may receive. However, based on the information presently available, the Trust does not anticipate incurring any losses in excess of previously established reserves. Mortgage Loans In addition to real estate, a portion of the Trust's assets consist of mortgage notes, principally secured by income-producing properties including first, wraparound and junior mortgages. The Trust's investment policy is described in ITEM 1. "BUSINESS - Business Plan and Investment Policy." Types of Properties Subject to Mortgages. The types of properties securing the Trust's mortgage portfolio at December 31, 1993, consisted of office buildings, apartments, shopping centers, single-family residences, a retirement home and developed land. To the extent the Declaration of Trust does not control such matters, the Trust's Board of Trustees may alter the types of mortgages in which the Trust invests without a vote of the Trust's shareholders. In addition to restricting the types of collateral and priority of mortgages, the Declaration of Trust imposes certain restrictions on transactions with related parties which limits the entities to which the Trust may make a mortgage, as discussed in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". At December 31, 1993, the Trust's mortgage portfolio included 12 mortgage loans with an aggregate outstanding balance of $18.1 million, secured by income-producing properties located throughout the United States, 4 mortgage loans with an outstanding balance of $437,000 secured by single-family residences located in the Southwest and Pacific regions of the United States and one mortgage loan with a carrying value of $856,000 secured by 55 acres of land located near Sacramento, California. At December 31, 1993, 6% of the Trust's assets were invested in mortgages (5.1% in first mortgage loans, .2% in a wraparound mortgage and .7% in junior mortgage loans). The following table sets forth the percentages (based on the outstanding mortgage note balance), by both property type and geographic region, of the properties that serve as collateral for the Trust's outstanding mortgages at December 31, 1993. The table does not include the $437,000 in single-family mortgages or the $856,000 mortgage secured by land discussed in the preceding paragraph. See Schedule XII to the Consoli- ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) dated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA" for further details of the Trust's mortgage notes receivable portfolio. A summary of activity in the Trust's mortgage notes receivable portfolio during 1993 is as follows: First Mortgage Loans. The Trust may make first mortgage loans, with either short, medium or long-term maturities. These loans generally provide for level periodic payments of principal and interest sufficient to substantially repay the loan prior to maturity, but may involve interest-only payments or moderate amortization of principal and a "balloon" principal payment at maturity. With respect to first mortgage loans, it is the Trust's general policy to require that the borrower provide a mortgagee's title policy or an acceptable legal opinion of title as to the validity and the priority of the mortgage lien over all other obligations, except liens arising from unpaid property taxes and other exceptions normally allowed by first mortgage lenders in the relevant area. The Trust may grant to other lenders participations in first mortgage loans originated by the Trust. The Trust did not originate or acquire any first mortgage loans during 1993. The following discussion briefly describes the events that affected previously funded or otherwise acquired first mortgage loans during 1993: During 1993, the Trust received payment in full, totaling $2.4 million, on three first mortgages. At December 31, 1993, two of the Trust's first mortgages were classified as nonperforming. One note, with an outstanding principal balance of $943,000, is secured by an apartment complex located in Paris, Texas. The Trust has obtained a judgment against the maker and guarantors for the amount of this mortgage. The Trust does not anticipate incurring a loss in excess of previously established reserves on this note. ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) Another nonperforming first mortgage note with a carrying value of $856,000 and legal balance of $1.2 million at December 31, 1993 is secured by 55 acres of developed land located near Sacramento, California. The borrower on this note has recently confirmed a plan of reorganization, and has begun making principal payments on the note as parcels are sold. In addition, the note was modified to require monthly interest only payments at 9%, increasing to 24% until maturity in February 1999. The Trust does not anticipate incurring a loss on this note as the estimated value of the property is in excess of the total debt on the property. As discussed in "Real Estate" above, in March 1993, the Trust recorded the insubstance foreclosure of the Huntington Green Apartments, an apartment complex which secured a $2.4 million first mortgage. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. See "Real Estate" above. Wraparound Mortgage Loans. The Trust may invest in wraparound mortgage loans on real estate subject to prior mortgage indebtedness. A wraparound mortgage loan is a mortgage loan having an original principal amount equal to the outstanding balance under the prior existing mortgage plus the amount actually advanced under the wraparound mortgage loan. Wraparound mortgage loans may provide for full, partial or no amortization of principal. The Trust's policy is to make wraparound mortgage loans in amounts and on properties as to which it would otherwise make first mortgage loans. The Trust did not originate or acquire any wraparound mortgage loans in 1993. The following discussion briefly describes the events that affected previously funded or otherwise acquired wraparound mortgage loans during 1993. As part of the Trust's 1992 acquisition of the general and limited partnership interests in CCP II, the Trust received a wraparound mortgage note secured by the Plaza Jardin, an office building located in El Toro, California. In May 1993, the Trust foreclosed on the property securing the note receivable. Immediately following the foreclosure, the Trust sold the property for $200,000 in cash, subject to the $3.3 million underlying mortgage debt. The Trust recognized a $94,000 gain on the sale of the property. Junior Mortgage Loans. The Trust may invest in junior mortgage loans. Such loans are secured by mortgages that are subordinate to one or more prior liens either on the fee or a leasehold interest in real estate. Recourse on such loans ordinarily includes the real estate on which the loan is made, other collateral and personal guarantees by the borrower. The Trust's Declaration of Trust restricts investment in junior mortgage loans, excluding wraparound mortgage loans, to not more than 10% of the Trust's assets. At December 31, 1993, .7% of the Trust's assets were invested in junior mortgage loans. ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) The Trust did not originate or acquire any junior mortgage loans in 1993. As discussed in "Real Estate" above, in March 1993, the Trust recorded the insubstance foreclosure of the Lakepointe Apartments, an apartment complex which secured a $3.8 million junior mortgage loan. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. At December 31, 1993, four of the Trust's junior mortgages were classified as nonperforming. A nonperforming junior mortgage note with a principal balance of $256,000 at December 31, 1993 is secured by a retirement center in Tuscon, Arizona. The borrower on this note, Eldercare Housing Foundation ("Eldercare"), is currently in bankruptcy. The Trust does not anticipate incurring losses on this note in excess of previously established reserves. Ted P. Stokely, a Trustee of the Trust, was employed as a real estate consultant for Eldercare from April 1992 to December 1993. The three remaining nonperforming junior mortgage notes have an aggregate principal balance of $1.3 million and were acquired in a package of similar loans in 1991. All three loans are secured by shopping centers net leased to a major national tenant. The Trust is currently negotiating a settlement of these loans with the owners. The Trust expects that such settlement will not result in any loss in excess of previously established reserves. Equity Investment in REIT In December 1990, the Trust's Board of Trustees, based on the recommendation of its Related Party Transaction Committee, authorized the purchase of up to $1.0 million of the shares of beneficial interest of CMET through negotiated or open market transactions. The Trustees of the Trust, except for Messrs. Friedman, Doyle and Weisbrod, are also trustees of CMET. BCM, the Trust's advisor, also serves as advisor to CMET. BCM resigned as advisor to the Trust effective March 31, 1994. At December 31, 1993, the Trust owned 54,500 shares of beneficial interest of CMET which it had purchased through open market transactions in 1990 and 1991, at a total cost to the Trust of $250,000. At December 31, 1993, the market value of such shares was $702,000. Pursuant to an amendment to the Trust's Declaration of Trust approved by the Trust's shareholders, the Trust may hold the shares of CMET until July 30, 1996. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Securities and Exchange Commission Inquiry On December 1, 1988, the Trust was informed in writing that the staff of the Securities and Exchange Commission (the "Commission") had made a preliminary determination to recommend administrative proceedings ITEM 3. LEGAL PROCEEDINGS (Continued) Securities and Exchange Commission Inquiry (Continued) against the Trust, CMET and Consolidated Capital Equities Corporation, among others, for various alleged reporting violations in public filings made during certain periods in 1985, and possibly other matters. The allegations relate to a time prior to the time when the Trust's current management and Advisor or any of its personnel became associated with the Trust. No administrative proceeding was ever commenced and due to the lapse of time the Trust's management believes there will be no further activity involving this matter. Olive Litigation In February 1990, the Trust, together with CMET, IORT and TCI, three real estate entities with the same officers, directors or trustees and advisor as the Trust at the time, entered into a settlement of a class and derivative action entitled Olive et al. v. National Income Realty Trust et al., relating to the operation and management of each of such entities. On April 23, 1990, the court granted final approval of the terms of the settlement. By agreeing to settle these actions, the defendants, including the Trust, did not and do not admit any liability whatsoever. An evidentiary hearing was held in February and April 1993 concerning allegations by the plaintiffs that the terms of the settlement had been breached by the Trust, CMET, IORT and TCI. No determination on the matters has been made by the court pending the outcome of ongoing settlement discussions. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. (THIS SPACE INTENTIONALLY LEFT BLANK.) PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S SHARES OF BENEFICIAL INTEREST AND RELATED SHAREHOLDER MATTERS The Trust's shares of beneficial interest are traded in the over-the-counter market on the National Association of Securities Dealers Automated Quotation ("NASDAQ") system using the symbol "NIRTs". Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions. The following table sets forth the high and low bid quotations as reported by the NASDAQ system: As of March 11, 1994, the closing price of the Trust's shares of beneficial interest on the NASDAQ system was $12.50 per share. As of March 11, 1994, the Trust's shares of beneficial interest were held by 7,443 holders of record. Based on the performance of the Trust's properties, the Trust's Board of Trustees, at their July 1993 meeting, voted to resume regular quarterly distributions. The distributions paid in 1993 were as follows: In addition, on July 1, 1993, the Trust's Board of Trustees approved the payment of a 10% stock dividend, which was paid on September 1, 1993 to shareholders of record on August 16, 1993. No distributions were declared or paid in 1992. On December 5, 1989, the Trust's Board of Trustees approved a program for the Trust to repurchase its shares of beneficial interest. The Trust's Board of Trustees has authorized the Trust to repurchase a total of 1,026,667 of its shares of beneficial interest pursuant to such program. As of March 11, 1994, the Trust had repurchased 849,631 shares pursuant to such program at a cost to the Trust of $6.7 million. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA (1) Funds from operations is defined as net income (loss) before gains or losses from the sale of properties and debt restructurings plus depreciation and amortization. FUNDS FROM OPERATIONS DOES NOT REPRESENT CASH AVAILABLE TO FUND THE TRUST'S OPERATIONS. ITEM 6. SELECTED FINANCIAL DATA (Continued) Share and per share data have been restated to give effect to the 10% share distribution declared in July 1993 and the one-for-three reverse share split effected March 26, 1990. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction National Income Realty Trust (the "Trust") invests in real estate through acquisitions, leases and partnerships and in mortgages on real estate. The Trust was organized on October 31, 1978 and commenced operations on March 27, 1979. Liquidity and Capital Resources Cash and cash equivalents aggregated $1.1 million at December 31, 1993 compared with $1.8 million at December 31, 1992. The Trust's principal sources of cash have been and will continue to be property operations, proceeds from property sales, the collection of mortgage notes receivable and borrowings. The Trust expects that funds from operations, collection of mortgage notes receivable and from anticipated external sources, such as property sales and refinancings, will be sufficient to meet the Trust's various cash needs, including debt service obligations, property maintenance and improvements and continuation of regular distributions, as more fully discussed in the paragraphs below. The Trust's cash flow from property operations (rentals collected less payments for property operating expenses) has increased from $10.1 million for 1992 to $14.4 million for 1993. This increase in cash flow from property operations is primarily attributable to four apartment complexes purchased in November 1992 and two apartment complexes obtained through foreclosure in March 1993. Cash flows from property operations decreased from $10.7 million in 1991 to $10.1 million in 1992, primarily attributable to an increase in payments for property taxes in 1992. The Trust's interest collected decreased from $3.2 million in 1991 to $2.1 million in 1992 and $1.5 million in 1993. The decrease from 1991 to 1992 is primarily attributable to interest of $849,000 collected in 1991 on a revolving loan to National Operating, L.P. ("NOLP"), which was paid in full in September 1991. In addition, $166,000 of the decrease relates to other loans which were paid in full in 1991 and 1992. Of the decrease from 1992 to 1993, $245,000 is due to a note which was paid in full in March 1993 and $221,000 is due to interest payments received in 1992 on a cash flow mortgage, but not received in 1993. Interest collections are expected to continue to decline due to the $2.4 million in loans paid off in 1993. Interest paid on the Trust's indebtedness increased from $7.7 million in 1992 to $9.3 million in 1993. Of this increase, $1.3 million is due to interest paid on mortgages secured by properties acquired by the Trust ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) during 1992 and 1993 and an additional $723,000 of the increase is attributable to interest paid on the mortgage secured by the Century Centre II Office Building, on which the Trust made a $1.0 million payment of accrued interest in accordance with the confirmed Plan of Reorganization as discussed in NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." These increases were partially offset by a decrease in interest of $314,000 due to the mortgage secured by Pinecrest Apartments, whose variable interest rate decreased from 1992 to 1993. An additional decrease of $213,000 is attributable to two mortgages on which the Trust stopped making payments in 1993 also as discussed in NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." The Trust was not involved in significant investing activities during 1993. The Trust did however, make $3.1 million of improvements to its properties in 1993. The Trust anticipates making capital improvements to its properties of approximately $4 million in 1994. The Trust received $410,000 in net cash from the sale of three foreclosed properties during 1993. In addition, the Trust also received payment in full on three notes receivable resulting in cash of $2.4 million. Principal payments of $113,000 on other notes were also received. In the second quarter of 1993, Sacramento Nine ("SAC 9"), a joint venture partnership in which the Trust owns a 70% interest, sold 3 of its office buildings for $2.5 million in cash, of which the Trust's equity share was $1.7 million. In October 1992, the Trust borrowed $1.6 million from a bank secured by a $1.6 million unsecured note receivable of the Trust. The note payable was paid in full on its maturity date in March 1993 from the collection of the note receivable. In June 1993, the Trust obtained first mortgage financing secured by the Bayfront Apartments in the amount of $2.1 million, of which the Trust received net cash of $1.8 million from the financing proceeds. In January 1994, the Trust obtained first mortgage financing secured by the Bay West Apartments in the amount of $5.1 million. The Trust received net cash of $1.0 million after the payoff of $3.9 million in existing debt. In March 1994, the Trust also obtained first mortgage financing on both the Carlyle Towers Apartments and the Woodcreek Apartments totaling $7.5 million. The Trust received net cash of $3.5 million after the payoff of $4.0 million in existing debt. The Trust intends to increase its emphasis on obtaining financing or refinancing of its properties. However, there is no assurance that the Trust will continue to be successful in its efforts in this regard. Principal payments on the Trust's notes payable of $11.9 million are due in 1994. Of this amount, $1.6 million relates to a nonrecourse debt which had matured December 31, 1993. The Trust is currently negotiating a modification and extension of this debt secured by an apartment complex in Miami, Florida. However, in the event that the Trust is ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) unsuccessful in extending this note, the Trust is prepared to payoff the mortgage debt. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." During 1993, the Trust repurchased 280,038 of its shares of beneficial interest at a cost of $2.4 million pursuant to the repurchase program originally announced by the Trust on December 5, 1989. The Trust's Board of Trustees has authorized the repurchase of a total of 1,026,667 shares under such repurchase program of which 177,036 shares remain to be purchased as of March 11, 1994. Based on the performance of the Trust's properties, the Trust's Board of Trustees voted in July 1993 to resume the payment of regular quarterly distributions to shareholders. The Trust paid distributions totaling $617,000 ($0.20 per share) to its shareholders in 1993, and also paid a 10% stock dividend to its shareholders in 1993. On a quarterly basis, the Trust's management reviews the carrying value of the Trust's mortgages, properties held for investment and properties held for sale. Generally accepted accounting principles require that the carrying value of an investment held for sale cannot exceed the lower of its cost or its estimated net realizable value. In those instances in which estimates of net realizable value of the Trust's properties are less than the carrying value thereof at the time of evaluation, a provision for loss is recorded by a charge against operations. The estimate of net realizable value of the mortgage loans is based on management's review and evaluation of the collateral properties securing the mortgage loans. The review generally includes selective property inspections, a review of the property's current rents compared to market rents, a review of the property's expenses, a review of the maintenance requirements, discussions with the manager of the property and a review of the surrounding area. Results of Operations 1993 compared to 1992. For the year ended December 31, 1993, the Trust had net income of $5.8 million, as compared to a net loss of $8.3 million for the year ended December 31, 1992. The primary factors contributing to the improvement in the Trust's operating results are discussed in the following paragraphs. Net rental income (rental income less property operating expenses) increased from $9.4 million in 1992 to $14.6 million in 1993. Of this increase, $1.3 million is due to four apartment complexes acquired in November 1992 and an additional $654,000 is due to two apartment complexes obtained through foreclosure in 1993. An additional $618,000 is due to a decrease in the amortization of free rent at the Century Centre Office Building and $295,000 is due to a decrease in replacements at Park Dale Gardens, the renovation of which was completed in 1992. The remaining increase is due to increased occupancy and rental rates at ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) the Trust's apartment complexes, primarily in the Southeast and Southwest regions, and overall expense control at certain of the Trust's apartment and commercial properties. Interest income decreased from $2.5 million in 1992 to $1.6 million in 1993. Of this decrease, $553,000 is due to loans which were placed on nonaccrual status or loans on which the collateral securing the loan was foreclosed in 1993. In addition, a decrease of $245,000 is due to a note which was paid in full in March 1993 and a decrease of $221,000 is due to interest payments received in 1993 compared to 1992 on a mortgage where interest is recognized on the cash flow basis. Interest income is anticipated to decline further in 1994 due to notes which were paid off in 1993. The Trust's equity in income of partnerships was income of $204,000 in 1992 compared to a loss of $34,000 in 1993. This decrease in operating results is primarily due to the sale of three properties by the SAC 9 partnership in the second quarter of 1993. Interest expense decreased from $10.4 million in 1992 to $9.7 million in 1993. A decrease of $1.2 million is attributable to a reduction in the interest rate on the first mortgage secured by the Century Centre II Office Building and the purchase of the second mortgage at a significant discount. An additional decrease of $163,000 is due to a reduction in the variable interest rate on the note payable secured by Pinecrest Apartments and $414,000 is due to interest expense on the underlying note payable associated with one of the Trust's wraparound mortgage notes receivable, which was concurrently foreclosed and sold in 1993. These decreases were partially offset by an increase of $857,000 due to interest expense recorded on mortgages secured by four apartment complexes which were acquired in November 1992 and an additional $416,000 attributable to interest expense recorded on the underlying mortgage secured by a property acquired through foreclosure in March 1993. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." Depreciation expense increased from $4.0 million in 1992 to $4.6 million in 1993, primarily due to the acquisition of four apartment complexes in November 1992 and two additional apartment complexes through foreclosure in March 1993. Advisory fees increased from $1.4 million in 1992 to $1.5 million in 1993, as a result of increase in the average monthly gross assets of the Trust, calculated in accordance with the terms of the advisory agreement. Commencing April 1, 1994, Tarragon Realty Advisors, Inc. ("Tarragon") will become the Trust's advisor. The terms of the Trust's advisory agreement with Tarragon are substantially the same as those with Basic Capital Management, Inc., the Trust's current advisor, except for the annual base advisory fee and the elimination of the net income fee. If the ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) Tarragon advisory agreement had been in effect in 1993 the Trust's annual base advisory fee would have been reduced by approximately $1.0 million. See NOTE 8. "ADVISORY AGREEMENT." General and administrative expenses decreased from $2.2 million in 1992 to $1.8 million in 1993. Of this decrease, $250,000 is due to a reduction in legal fees, an additional $123,000 is related to the Trust's March 1992 annual meeting of shareholders and the February 1992 Rights redemption and $198,000 is due to a decrease in professional fees related to the reduced level of property acquisitions in 1993 compared to 1991 and 1992. For the year 1993, the Trust expensed $1.0 million for the issuance of a $1.0 million convertible subordinated debenture to John A. Doyle, Trustee and Executive Vice President of the Trust, in exchange for his 10% participation in the profits of the Consolidated Capital Properties II ("CCP II") assets, which were acquired in November 1992, over a year before Mr. Doyle's affiliation with the Trust. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." For the year 1993, the Trust recorded a provision for losses of $1.4 million to provide for estimated losses on one of the Trust's properties held for sale and one of the Trust's first lien mortgage notes. A provision for losses of $2.4 million was recorded in 1992 to reserve against certain junior mortgage notes receivable. For the year ended December 31, 1993, the Trust recognized gains on sales of real estate of $851,000 related to the sale of three properties by SAC 9 and $94,000 on the sale of the Plaza Jardin Office Building. No gains on sales of real estate were recognized in 1992. Also for the year 1993, the Trust recorded an extraordinary gain on the forgiveness of debt of $8.9 million related to the discounted purchase of the second lien mortgage secured by Century Centre II Office Building, which was purchased by the Trust for $300,000 as part of a bankruptcy Plan of Reorganization. The Trust recorded no extraordinary gain in 1992. 1992 compared to 1991. For the year ended December 31, 1992, the Trust had a net loss of $8.3 million as compared with a net loss of $3.1 million for the year ended December 31, 1991. The primary factors contributing to the increase in the Trust's net loss are discussed in the following paragraphs. Net rental income (rental income less property operations expenses) increased from $8.5 million in 1991 to $9.4 million in 1992. Of this increase $1.7 million is the result of net rental income recorded on properties purchased in 1992 and the fourth quarter of 1991 and an ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) additional $776,000 is attributable to increased net rental income at Pinecrest Apartments, where a major renovation was substantially completed during 1992. In addition, net rental income also increased $800,000 due to increased rental and occupancy rates at certain of the Trust's apartment complexes, primarily in the Southeast and Southwest. These increases were partially offset by a decrease in net rental income of $1.4 million at the Century Centre II Office Building, attributable to the temporary increases in vacancy coincident with the bankruptcy filing in October 1991. In addition, net rental income decreased $279,000 due to the transfer of the Afton Aero Business Park to the senior lienholder in August 1991, decreased $378,000 due to properties sold during 1992 and the fourth quarter of 1991 and decreased $340,000 due to a decrease in occupancy and rental rates at Rancho Sorrento Business Park related to weakness in the San Diego office market. Interest income on mortgage receivables decreased from $2.8 million in 1991 to $2.4 million in 1992. Of this decrease, $415,000 is attributable to interest recognized in 1991 on a $7.0 million revolving loan to NOLP, which was paid in full in September 1991. An additional $393,000 is due to interest income not being recognized on notes receivable classified as nonperforming and $190,000 of the decrease is related to notes which were paid off in 1991 and 1992. These decreases were partially offset by an increase of $332,000 attributable to interest income on mortgage loans funded or acquired during 1991 and $128,000 attributable to a note classified as nonperforming in 1991 which was brought current in 1992. Equity in results of operations of partnerships produced income of $204,000 in 1992 as compared to a loss of $171,000 in 1991. The 1991 loss was attributable to Adams Properties Associates ("APA"), a partnership in which the Trust has a 40% interest, recording a $1.2 million charge against earnings for the permanent write-down of three of the partnership's warehouses to their estimated net realizable value. The Trust's equity share of such charge was $480,000. In addition, SAC 9, a partnership in which the Trust has 70% interest, recorded a $1.1 million charge against earnings in 1991 relating to a property which was transferred to the senior lienholder. The Trust's equity share of such charge was $770,000. Neither partnership incurred similar charges in 1992. Interest expense increased from $9.4 million in 1991 to $10.4 million in 1992. Of this increase, $2.0 million is attributable to interest expense on notes payable secured by properties which were acquired in 1991 and 1992. This increase is partially offset by a decrease of $531,000 in the interest accrual rate, attributable to a decrease in the interest rate, on the Century Centre II first mortgage, a decrease of $222,000 related to the Afton Aero Business Park, which was returned to the senior lienholder in August 1991, and a decrease of $135,000 due to the restructuring of the mortgage secured by Emerson Center, which emerged from bankruptcy in March 1992. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) General and administrative expenses decreased from $2.4 million in 1991 to $2.2 million in 1992. This decrease is due to a decrease of $200,000 in legal fees paid in 1992 in connection with the Olive litigation discussed in NOTE 15. "COMMITMENTS AND CONTINGENCIES - Olive Litigation." In addition, $104,000 was recorded in 1991 for the settlement of the adversary proceedings with Southmark Corporation. For the year ended December 31, 1992, the Trust recorded a provision for losses of $2.4 million to reserve against certain junior mortgages. No such provision for losses was recorded in 1991. For the year ended December 31, 1991, the Trust reported gains on sales of real estate of $257,000 related to APA and SAC 9 partnerships and $205,000 on the sale of Coronado Village Apartments. No gains on sales of real estate were recognized in 1992. The Trust also recognized an extraordinary gain on the extinguishment of debt of $2.2 million for 1991 related to the return of one of the SAC 9 office buildings to the senior lienholder. None was recorded in 1992. Environmental Matters Under various federal, state and local environmental laws, ordinances and regulations, the Trust may be potentially liable for removal or remediation costs, as well as certain other potential costs relating to hazardous or toxic substances (including governmental fines and injuries to persons and property) where property-level managers have arranged for the removal, disposal or treatment of hazardous or toxic substances. In addition, certain environmental laws impose liability for release of asbestos- containing materials into the air, and third parties may seek recovery from the Trust for personal injury associated with such materials. The Trust's management is not aware of any environmental liability relating to the above matters that would have a material adverse effect on the Trust's business, assets or results of operations. Inflation The effects of inflation on the Trust's operations are not quantifiable. Revenues from property operations fluctuate proportionately with increases and decreases in housing costs. Fluctuations in the rate of inflation also affect the sales values of properties and, correspondingly, the ultimate gains to be realized by the Trust from property sales. Inflation also has an effect on the Trust's earnings from short-term investments. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Tax Matters For the years ended December 31, 1993, 1992 and 1991, the Trust elected, and in the opinion of the Trust's management, qualified to be taxed as a Real Estate Investment Trust ("REIT") as defined under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"). The Code requires a REIT to distribute at least 95% of its REIT taxable income plus 95% of its net income from foreclosure property, as defined in Section 857 of the Code, on an annual basis to shareholders. Recent Accounting Pronouncements The Financial Accounting Standards Board ("FASB") has recently issued Statement of Financial Accounting Standards ("SFAS") No. 114 - "Accounting by Creditors for Impairment of a Loan", which amends SFAS No. 5 - "Accounting for Contingencies" and SFAS No. 15 - "Accounting by Debtors and Creditors for Troubled Debt Restructurings." The statement requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. SFAS No. 114 is effective for fiscal years beginning after December 15, 1994. The Trust's management has not fully evaluated the effects of implementing this statement, but expects that they will not be material as the statement is applicable to debt restructurings and loan impairments after the earlier of the effective date of the statement or the Trust's adoption of the statement. At its January 26, 1994 meeting, the FASB directed its staff to prepare an exposure draft, that if approved, would eliminate the provisions of SFAS No. 114 that describe how a creditor should recognize income on an impaired loan and add disclosure requirements on income recognized on impaired loans. The effective date of SFAS No. 114 is not anticipated to change. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS All other schedules are omitted because they are not required, are not applicable or the information required is included in the Consolidated Financial Statements or the notes thereto. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Trustees of National Income Realty Trust We have audited the accompanying consolidated balance sheets of National Income Realty Trust and Subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. We have also audited the schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedules. We believe our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Income Realty Trust and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the schedules referred to above present fairly, in all material respects, the information set forth therein. BDO SEIDMAN Dallas, Texas March 25, 1994 NATIONAL INCOME REALTY TRUST CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The accompanying Consolidated Financial Statements of National Income Realty Trust and consolidated entities (the "Trust") have been prepared in conformity with generally accepted accounting principles, the most significant of which are described in NOTE 1. "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES". These, along with the remainder of the Notes to Consolidated Financial Statements, are an integral part of the Consolidated Financial Statements. The data presented in the Notes to Consolidated Financial Statements are as of December 31 of each year and for the year then ended, unless otherwise indicated. Dollar amounts in tables are in thousands, except per share amounts. Certain balances for 1991 and 1992 have been reclassified to conform to the 1993 presentation. NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Trust business. National Income Realty Trust ("NIRT"), is a California business trust organized on October 31, 1978. The Trust was formed to invest in real estate. Since 1991, the Trust has sought only to make equity investments and accordingly, its mortgage note receivable portfolio represents an increasingly smaller portion of the Trust's assets. Basis of consolidation. The Consolidated Financial Statements include the accounts of NIRT and partnerships and subsidiaries which it controls. All intercompany transactions and balances have been eliminated. Interest recognition on notes receivable. It is the Trust's policy to cease recognizing interest income on notes receivable that have been delinquent for 60 days or more. In addition, accrued but unpaid interest income is only recognized to the extent that the net realizable value of the underlying collateral exceeds the carrying value of the receivable. Allowance for estimated losses. Valuation allowances are provided for estimated losses on notes receivable and properties held for sale to the extent that the investment in the notes or properties exceeds the Trust's estimate of net realizable value of the property or collateral securing each such note, or fair value of the collateral if foreclosure is probable. In estimating net realizable value, consideration is given to the current estimated collateral or property value adjusted for costs to complete or improve, hold and dispose. The cost of funds, one of the criteria used in the calculation of estimated net realizable value (approximately 5.4% and 5.5% as of December 31, 1993 and 1992, respectively), is based on the average cost of all capital. The provision for losses is based on estimates, and actual losses may vary from current estimates. Such estimates are reviewed periodically and any additional provision determined to be necessary is charged against earnings in the period in which it becomes reasonably estimable. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Foreclosed real estate held for sale. Foreclosed real estate is initially recorded at new cost, defined as the lower of original cost or fair value minus estimated costs of sale. After foreclosure, the excess of new cost, if any, over fair value minus estimated costs of sale is recognized in a valuation allowance. Subsequent changes in fair value either increase or decrease such valuation allowance. See "Allowance for estimated losses" above. Properties held for sale are depreciated in accordance with the Trust's established depreciation policies. See "Real estate and depreciation" below. Annually, all foreclosed properties held for sale are reviewed by the Trust's management and a determination is made if the held for sale classification remains appropriate. The following are among the factors considered in determining that a change in classification to held for investment is appropriate: (i) the property has been held for at least one year; (ii) Trust management has no intent to dispose of the property within the next twelve months; (iii) the property is a "qualifying asset" as defined in the Internal Revenue Code of 1986, as amended; (iv) property improvements have been funded; and (v) the Trust's financial resources are such that the property can be held long-term. The subsequent classification of property previously held for sale to held for investment does not result in a restatement of previously reported revenues, expenses or net income (loss). Real estate and depreciation. Real estate is carried at the lower of cost or estimated net realizable value, except for foreclosed properties held for sale, which are recorded initially at the lower of original cost or fair value minus estimated costs of sale. Depreciation is provided for by the straight-line method over the estimated useful lives of the assets, which range from 5 to 40 years. Present value premiums/discounts. The Trust provides for present value premiums and discounts on notes receivable or payable that have interest rates that differ substantially from prevailing market rates and amortizes such premiums and discounts by the interest method over the lives of the related notes. The factors considered in determining a market rate for receivables include the borrower's credit standing, nature of the collateral and payment terms of the note. Revenue recognition on the sale of real estate. Sales of real estate are recognized when and to the extent permitted by Statement of Financial Accounting Standards No. 66, "Accounting for Sales of Real Estate" ("SFAS No. 66"). Until the requirements of SFAS No. 66 for full profit recognition have been met, transactions are accounted for using either the deposit, the installment, the cost recovery or the financing method, whichever is appropriate. Investment in noncontrolled partnerships. The Trust uses the equity method to account for investments in partnerships which the Trust does NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) not control. Under the equity method, the Trust's initial investment, recorded at cost, is increased by the Trust's proportionate share of the partnership's operating income and additional advances and decreased by the Trust's proportionate share of the partnership's operating losses and distributions received. Marketable equity securities. Marketable equity securities are considered to be available-for-sale and are carried at fair value, defined as year end closing market value. Net unrealized holding gains and losses are reported as a separate component of shareholders' equity. Such securities were carried at adjusted cost in the Trust's December 31, 1992 Consolidated Balance Sheet. Fair value of financial instruments. The Trust used the following assumptions in estimating the fair value of its notes receivable, marketable equity securities and notes payable. For performing notes receivable, the fair value was estimated by discounting future cash flows using current interest rates for similar loans. For nonperforming notes receivable, the estimated fair value of the Trust's interest in the collateral property was used. For marketable equity securities, fair value was based on the year end closing market price of each security. The estimated fair values presented do not purport to present amounts to be ultimately realized by the Trust. The amounts ultimately realized may vary significantly from the estimated fair values presented. For notes payable, the fair value was estimated using current rates for mortgages with similar terms and maturities. Cash equivalents. For purposes of the Consolidated Statements of Cash Flows, the Trust considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Earnings per share. Income (loss) per share of beneficial interest is computed based upon the weighted average number of shares of beneficial interest outstanding during each year. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 2. NOTES AND INTEREST RECEIVABLE Notes and interest receivable consisted of the following: The Trust does not recognize interest income on nonperforming notes receivable. Notes receivable are considered to be nonperforming when they become 60 days or more delinquent. For the years 1993, 1992 and 1991, unrecognized interest income on nonperforming notes totaled $833,000, $867,000 and $561,000, respectively. Notes receivable at December 31, 1993 mature from 1994 through 2021, with interest rates ranging from 6% to 24% and an effective weighted average interest rate of 6.4%. Notes receivable are generally nonrecourse and are generally collateralized by real estate. Scheduled principal maturities of $2.5 million are due in 1994, including $1.8 million in mortgage notes receivable classified as nonperforming at December 31, 1993. The Trust received payment in full on three mortgage loans during 1993 totaling $2.4 million. In addition, the Trust foreclosed on three mortgage loans with principal balances totaling $6.2 million, with the Trust obtaining three properties with a fair value of $10.1 million and assumed a $6.7 million mortgage payable secured by one of the properties. These transactions resulted in no loss to the Trust in 1993 as all losses had been previously provided. See NOTE 4. "REAL ESTATE AND DEPRECIATION." In May 1993, the Trust foreclosed on the Plaza Jardin mortgage receivable. Immediately following the foreclosure, the Trust sold the property for $200,000 in cash subject to the $3.3 million underlying mortgage. The Trust recognized a $94,000 gain on the sale of the property. At December 31, 1993, five mortgage notes receivable with a principal balance totaling $3.1 million were classified as nonperforming. The Trust does not anticipate incurring losses in excess of the reserves established at December 31, 1993. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 2. NOTES AND INTEREST RECEIVABLE (Continued) During 1992, the Trust funded or purchased two mortgage loans with principal balances totaling $3.8 million, and an additional mortgage loan with a principal balance of $550,000 was created through the sale of real estate. The Trust also received payment in full on four mortgage loans during 1992 totaling $975,000 and received payment on an additional mortgage note receivable, receiving cash of $775,000 and accepting a new second lien mortgage in the amount of $306,000. In addition, in 1992 the Trust foreclosed on one mortgage loan with a principal balance of $91,000 and wrote off as uncollectible another mortgage loan with a principal balance of $200,000. These transactions resulted in no loss to the Trust in 1992 as all losses had been previously provided. NOTE 3. ALLOWANCE FOR ESTIMATED LOSSES Activity in the allowance for estimated losses was as follows: NOTE 4. REAL ESTATE AND DEPRECIATION In January 1993, the Trust shut down the Lake Highlands Apartments as a result of a change in zoning of the property. No assurance can be given that the Trust will be able to operate the property as an apartment complex in the future. The Trust does not anticipate incurring a loss in excess of previously established reserves. In March 1993, the Trust recorded the insubstance foreclosure of the Lakepointe Apartments, a 540 unit apartment complex in Memphis, Tennessee. The Lakepointe Apartments had an estimated fair value (minus estimated costs of sale) of $8.3 million at the date of foreclosure. In connection with this insubstance foreclosure, the Trust recorded the $6.7 million mortgage payable secured by the property. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. Also in March 1993, the Trust recorded the insubstance foreclosure of the Huntington Green Apartments, an 81 unit apartment complex in West Town, Pennsylvania. The Huntington Green Apartments had an estimated fair value (minus estimated costs of sale) of $1.8 million at the date of foreclosure. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 4. REAL ESTATE AND DEPRECIATION (Continued) In 1992, the Trust sold two of its properties held for sale, receiving net cash of $368,000 and financing an additional $550,000 through a purchase money mortgage. Also in 1992, the Trust acquired all of the general and limited partnership interest in Consolidated Capital Properties II ("CCP II") for $2.6 million. CCP II's assets included cash of $1.6 million, four apartment complexes, a partnership interest, a note receivable participation and a note receivable. In connection with the acquisition, the Trust granted John A. Doyle, Trustee and Executive Vice President of the Trust since February 1994, a 10% participation in the profits of the acquired CCP II assets in excess of the return of the Trust's investment and a 10% annual cumulative return to the Trust. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. In December 1993, the Trust's Board of Trustees approved the issuance of a $1.0 million convertible subordinated debenture to Mr. Doyle in settlement of the Trust's participation obligation. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." NOTE 5. INVESTMENT IN EQUITY METHOD PARTNERSHIPS The Trust's investment in equity method partnerships consisted of the following: The Trust, in partnership with Continental Mortgage and Equity Trust ("CMET"), owns SAC 9, which currently owns two office buildings in the vicinity of Sacramento, California. The Trust has a 70% interest in the partnership's earnings, losses and distributions. The SAC 9 partnership agreement requires unanimous consent of both the Trust and CMET for any material changes in the operations of the partnership's properties, including sales, refinancings and changes in property management. The Trust, as a noncontrolling partner, accounts for its investment in the partnership under the equity method. Certain Trustees of the Trust are also trustees of CMET. In April 1993, SAC 9 sold one of its office buildings for $1.2 million. SAC 9 received $123,000 in cash, of which the Trust's equity share was $86,000, after the payoff of an existing first mortgage with a principal balance of $685,000. SAC 9 provided $356,000 of purchase money financing. The note receivable bears interest at a rate of 9% per NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 5. INVESTMENT IN EQUITY METHOD PARTNERSHIPS (Continued) annum, requires monthly payments of principal and interest and matures in June 1998. SAC 9 recognized a gain of $59,000 on the sale, of which the Trust's equity share was $41,000. In June 1993, SAC 9 sold two other of its office buildings. One was sold for $1.3 million in cash, of which the Trust's equity share was $910,000. SAC 9 recognized a gain of $437,000 on the sale, of which the Trust's equity share was $306,000. The other office building was sold for $2.0 million. SAC 9 received $1.1 million in cash, of which the Trust's equity share was $750,000, and provided $887,000 of purchase money financing. One note receivable with a principal balance of $410,000 bears interest at a variable interest rate, currently 6%, requires monthly interest only payments and matures in June 1994. A second note receivable with a principal balance of $477,000 bears interest at 10% per annum, and all principal and accrued interest are due at maturity in May 1994. SAC 9 recognized a gain of $720,000 on the sale, of which the Trust's equity share was $504,000. The Trust and CMET are also partners in Income Special Associates ("ISA"), a joint venture partnership in which the Trust has a 40% interest in earnings, losses and distributions. ISA in turn owns a 100% interest in APA, which owns 33 industrial warehouses. In November 1992, the Trust acquired all of the general and limited partnership interests in CCP II, whose assets included a 23% limited partnership interest in English Village Partners, L.P. ("English Village"). English Village owns a 300 unit apartment complex located in Memphis, Tennessee. On July 1, 1993, CCP II made an additional capital contribution to English Village of $464,000 to increase its limited partnership ownership interest to 49% and to acquire a 1% general partnership interest in the partnership. The Trust continues to account for its investment in English Village under the equity method. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 5. INVESTMENT IN EQUITY METHOD PARTNERSHIPS (Continued) Set forth below are summarized financial data for all partnerships the Trust accounts for using the equity method (unaudited): NOTE 6. NOTES, DEBENTURES AND INTEREST PAYABLE Notes, debentures and interest payable consisted of the following: Scheduled principal payments on notes payable are due as follows: NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 6. NOTES, DEBENTURES AND INTEREST PAYABLE (Continued) In June 1993, the Trust obtained first mortgage financing secured by the Bayfront Apartments in the amount of $2.1 million. The Trust received $1.8 million in net cash from the financing proceeds and the remainder of the proceeds were used to fund escrows for replacements and repairs and to pay various closing costs associated with the financing. In October 1991, after determining that further investment in the Century Centre II Office Building could not be justified without a substantial modification of the mortgage debt, the property was placed in bankruptcy. A plan of reorganization was filed with the bankruptcy court in March 1993 and the bankruptcy court confirmed the Plan in November 1993. The confirmed Plan of Reorganization reduces the interest rate on the $21 million first mortgage to 1-1/2% above LIBOR, which currently results in an interest rate of 5 1/2% per annum. The reduced interest rate was retroactively applied as of October 15, 1991. The Plan also extends the note's maturity by two years to November 1995, with three consecutive one-year extension options. Under the Plan, the Trust deposited $1.0 million in cash with the lender to pay accrued and unpaid interest, 1993 property taxes and all closing costs associated with the transaction. In 1994, the Trust will be required to maintain a $200,000 balance in the escrow account with the lender. The Trust has also pledged one of its properties held for sale, Stewart Square Shopping Center, as additional collateral on the first mortgage. Also pursuant to the Plan of Reorganization, the Trust acquired the $7.5 million second mortgage plus all accrued but unpaid interest of $1.7 million, for $300,000 in cash. The Trust recognized an extraordinary gain of $8.9 million in connection with the debt modification and discounted debt purchase. In 1993, the State of Wisconsin commenced eminent domain proceedings to acquire the Pepperkorn Building, located in Manitowoc, Wisconsin, for highway development and made an initial offer of $175,000. Such purchase price is being appealed by the Trust. There is no assurance that the Trust will be successful or of the amount, if any, of additional compensation that it may receive. Based on the information presently available, the Trust does not anticipate any losses in excess of previously established reserves. The $1.6 million first mortgage secured by the Palm Court Apartments, located in Miami, Florida, matured in July 1993. Prior to the maturity, the Trust obtained the lender's written agreement to extend the note. Thereafter, the lender refused to execute the extension documents and has subsequently rejected the Trust's tender of mortgage payments in accordance with the extension agreement. The matter is presently in litigation. If adversely determined, the Trust is prepared to payoff the mortgage debt. Notes payable at December 31, 1993 bear interest at rates ranging from 4.2% to 19.7% and mature from 1994 through 2022. These notes payable NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 6. NOTES, DEBENTURES AND INTEREST PAYABLE (Continued) are nonrecourse and are collateralized by deeds of trust on real estate with a carrying value of $157.0 million. In December 1993, the Trust's Board of Trustees approved the issuance of a $1.0 million convertible subordinated debenture to Mr. Doyle, Trustee and Executive Vice President of the Trust since February 1994, in exchange for his 10% participation in the profits of the CCP II assets, which the Trust had acquired in November 1992. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. The debenture bears interest at a rate of 6% per annum, matures in five years and is convertible into 76,923 of the Trust's shares of beneficial interest. Mr. Doyle also serves as Director, President and Chief Operating Officer and is a 50% shareholder of Tarragon Realty Advisors, Inc. ("Tarragon"), the Trust's advisor commencing April 1, 1994. See NOTE 4. "REAL ESTATE AND DEPRECIATION." NOTE 7. DISTRIBUTIONS The Trust's Board of Trustees voted at their July 1993 meeting to resume the payment of regular quarterly distributions. The first quarterly distribution of $.10 per share of beneficial interest and a 10% stock distribution was paid on September 1, 1993 to shareholders of record on August 16, 1993. On December 21, 1993, the Trust paid a distribution of $.10 per share of beneficial interest to shareholders of record on December 6, 1993. On May 15, 1991, the Trust's Board of Trustees declared a distribution of $2.11 per share of beneficial interest. The distribution, totaling $7.4 million, was paid on May 23, 1991 to shareholders of record on May 20, 1991. Such distribution had been accrued at December 31, 1990, in accordance with the terms of the Olive settlement as described in NOTE 15. "COMMITMENTS AND CONTINGENCIES - Olive Litigation". No distributions were declared or paid in 1992. The Trust reported to the Internal Revenue Service that 100% of the distribution paid in 1993 was taxable to Trust shareholders as ordinary income and 100% of the 1991 distribution represented a return of capital. NOTE 8. ADVISORY AGREEMENT Basic Capital Management, Inc. ("BCM" or the "Advisor") has served as advisor to the Trust since March 28, 1989. At the Trust's annual meeting of shareholders held on April 26, 1993, the renewal of the Trust's Advisory Agreement with BCM was approved. BCM resigned as advisor to the Trust effective March 31, 1994. William S. Friedman, the President and a Trustee of the Trust, served as President of BCM until May 1, 1993 and, prior to December 22, 1989, also served as director of NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8. ADVISORY AGREEMENT (Continued) BCM. BCM is beneficially owned by a trust for the benefit of the children of Gene E. Phillips. Mr. Phillips served as a Trustee of the Trust until December 31, 1992. Mr. Phillips served as a director of BCM until December 22, 1989, and served as Chief Executive Officer of BCM until September 1, 1992. On February 10, 1994, the Trust's Board of Trustees selected Tarragon to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will provide advisory services to the Trust under an advisory agreement. Mr. Friedman serves as a director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as a director, President and Chief Operating Officer of Tarragon and as a Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. The provisions of the Trust's advisory agreement with Tarragon are substantially the same as those of the BCM advisory agreement except for the annual base advisory fee and the elimination of the net income fee. The Tarragon advisory agreement calls for an annual base advisory fee of $100,000 plus an incentive advisory fee in the amount of 16% of the Trust's adjusted funds from operations before deduction of the advisory fee. Adjusted funds from operations is defined as net income (loss) before gains or losses from the sale of properties and debt restructurings plus depreciation and amortization plus any loss due to the writedown or sale of any real property or mortgage loan acquired prior to January 1, 1989. The BCM advisory agreement provided for BCM to be responsible for the day-to-day operations of the Trust and to receive an advisory fee comprised of a gross asset fee of .0625% per month (.75% per annum) of the average of the gross asset value of the Trust (total assets less allowance for amortization, depreciation or depletion and valuation reserves) and an annual net income fee equal to 7.5% per annum of the Trust's net income. Under both the Tarragon and the BCM advisory agreements, the advisor is required to formulate and submit annually for approval by the Trust's Board of Trustees a budget and business plan for the Trust containing a twelve-month forecast of operations and cash flow, a general plan for asset sales or acquisitions, lending, foreclosure and borrowing activity, and other investments, and the advisor is required to report quarterly to the Trust's Board of Trustees on the Trust's performance against the business plan. In addition, all transactions or investments by the Trust shall require prior approval by the Trust's Board of Trustees unless they are explicitly provided for in the approved business plan or are made pursuant to authority expressly delegated to the advisor or to the Trust's President by the Trust's Board of Trustees. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8. ADVISORY AGREEMENT (Continued) Each of the advisory agreements also require prior approval of the Trust's Board of Trustees for the retention of all consultants and third party professionals, other than legal counsel. The advisory agreements provide that the advisor shall be deemed to be in a fiduciary relationship to the Trust's shareholders; contain a broad standard governing the advisor's liability for losses by the Trust; and contain guidelines for the advisor's allocation of investment opportunities as among itself, the Trust and other entities it advises. Each of the advisory agreements also provide for the advisor to receive an annual incentive sales fee equal to 10% of the amount, if any, by which the aggregate sales consideration for all real estate sold by the Trust during such fiscal year exceeds the sum of: (i) the cost of each such property as originally recorded in the Trust's books for tax purposes (without deduction for depreciation, amortization or reserve for losses), (ii) capital improvements made to such assets during the period owned by the Trust, and (iii) all closing costs, (including real estate commissions) incurred in the sale of such property; provided, however, no incentive fee shall be paid unless (i) such real estate sold in such fiscal year, in the aggregate, has produced an 8% simple annual return on the Trust's net investment including capital improvements, calculated over the Trust's holding period before depreciation and inclusive of operating income and sales consideration and (ii) the aggregate net operating income from all real estate owned by the Trust for each of the prior and current fiscal years shall be at least 5% higher in the current fiscal year than in the prior fiscal year. Additionally, pursuant to each of the advisory agreements, the advisor or an affiliate of the advisor is to receive an acquisition commission for supervising the acquisition, purchase or long term lease of real estate for the Trust equal to the lesser of (i) up to 1% of the cost of acquisition, inclusive of commissions, if any, paid to nonaffiliated brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property acquisition services as an ongoing public activity in the same geographical location and for comparable property; provided that the purchase price of each property (including acquisition commissions and all real estate brokerage fees) may not exceed such property's appraised value at acquisition. Each of the advisory agreements require the advisor or any affiliate of the advisor to pay to the Trust one-half of any compensation received from third parties with respect to the origination, placement or brokerage of any loan made by the Trust; provided, however, that the compensation retained by the advisor or any affiliate of the advisor shall not exceed the lesser of (i) 2% of the amount of the loan committed by the Trust or (ii) a loan brokerage and commitment fee which is reasonable and fair under the circumstances. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8. ADVISORY AGREEMENT (Continued) Each of the advisory agreements also provide that the advisor or an affiliate of the advisor is to receive a mortgage or loan acquisition fee with respect to the acquisition or purchase from an unaffiliated party of any existing mortgage or loan by the Trust equal to the lesser of (i) 1% of the amount of the loan purchased or (ii) a loan brokerage or commitment fee which is reasonable and fair under the circumstances. Such fee will not be paid in connection with the origination or funding by the Trust of any mortgage loan. Under each of the advisory agreements, the advisor or an affiliate of the advisor is also to receive a mortgage brokerage and equity refinancing fee for obtaining loans to the Trust or refinancing on Trust properties equal to the lesser of (i) 1% of the amount of the loan or the amount refinanced or (ii) a brokerage or refinancing fee which is reasonable and fair under the circumstances; provided, however, that no such fee shall be paid on loans from the advisor or an affiliate of the advisor without the approval of the Trust's Board of Trustees. No fee shall be paid on loan extensions. Under each of the advisory agreements, the advisor is to receive reimbursement of certain expenses incurred by it in the performance of advisory services to the Trust. Under each of the advisory agreements (as required by the Trust's Declaration of Trust) all or a portion of the annual advisory fee must be refunded by the advisor to the Trust if the Operating Expenses of the Trust (as defined in the Trust's Declaration of Trust) exceed certain limits specified in the Declaration of Trust based on the book value, net asset value and net income of the Trust during such fiscal year. The operating expenses of the Trust did not exceed such limitation in 1991, 1992 or 1993. Additionally, if the Trust were to request that the advisor render services to the Trust other than those required by the advisory agreements, the advisor or an affiliate of the advisor will be separately compensated for such additional services on terms to be agreed upon from time to time. As discussed in NOTE 9. "PROPERTY MANAGEMENT", the Trust has hired Carmel Realty Services, Ltd. ("Carmel, Ltd."), an affiliate of BCM, to provide property management services for the Trust's properties and, as discussed in NOTE 10. "REAL ESTATE BROKERAGE", the Trust has engaged, on a non-exclusive basis, Carmel Realty, Inc. ("Carmel Realty"), also an affiliate of BCM, to perform brokerage services for the Trust. NOTE 9. PROPERTY MANAGEMENT Since February 1, 1990, affiliates of BCM have provided property management services to the Trust. Currently, Carmel, Ltd. provides property management services for a fee of 5% or less of the monthly NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 9. PROPERTY MANAGEMENT (Continued) gross rents collected on the properties under management. In many cases, Carmel, Ltd. subcontracts with other entities for the property-level management services to the Trust at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) Syntek West, Inc. ("SWI"), of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of eleven of the Trust's commercial properties and the commercial properties owned by two of the real estate partnerships in which the Trust is a partner, to Carmel Realty, which is owned by SWI. Carmel, Ltd. has resigned as property manager for the Trust's properties effective March 31, 1994. Commencing April 1, 1994, Tarragon will provide property management services to the Trust for a fee of 4.5% of the monthly gross rents collected on apartment properties and not in excess of 5% of the monthly gross rents collected on commercial properties. Tarragon intends to subcontract with other entities for the provision of property-level management services to the Trust. NOTE 10. REAL ESTATE BROKERAGE Prior to December 1, 1992, affiliates of BCM provided brokerage services to the Trust and received brokerage commissions in accordance with the advisory agreement. The Trust's Board of Trustees approved, effective December 1, 1992, the non-exclusive engagement by the Trust of Carmel Realty to perform brokerage services for the Trust. Such agreement terminates March 31, 1994. Carmel Realty is entitled to receive a real estate acquisition commission for locating and negotiating the lease or purchase by the Trust of any property equal to the lesser of (i) up to 3% of the purchase price, inclusive of commissions, if any, paid by the Trust to other brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property acquisition services in the same geographical location and for comparable property. Any commission which is paid to Carmel Realty by the seller shall be credited against the commission to be paid by the Trust. Carmel Realty is also entitled to receive a real estate sales commission for the sale of each Trust property equal to the lesser of (i) 3% (inclusive of fees, if any, paid by the Trust to other brokers) of the sales price of each property or (ii) the compensation customarily charged in arm's-length transactions paid by others rendering similar services in the same geographic location for comparable property. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 11. ADVISORY FEES, PROPERTY MANAGEMENT FEES, ETC. Fees and cost reimbursements to BCM, the Trust's advisor until March 31, 1994, and its affiliates: - -------------------------------- * Net of property management fees paid to subcontractors. NOTE 12. INCOME TAXES For the years 1993, 1992 and 1991, the Trust has elected and qualified to be treated as a Real Estate Investment Trust ("REIT"), as defined in Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"), and as such, will not be taxed for federal income tax purposes on that portion of its taxable income which is distributed to shareholders, provided that at least 95% of its REIT taxable income, plus 95% of its taxable income from foreclosure property as defined in Section 857 of the Code, is distributed. See NOTE 7. "DISTRIBUTIONS." The Trust had a net loss for federal income tax purposes in 1991, 1992 and 1993; therefore, the Trust recorded no provision for income taxes. The Trust's tax basis in its net assets differs from the amount at which its net assets are reported for financial statement purposes, principally due to the accounting for gains and losses on property sales, the difference in the allowance for estimated losses, depreciation on owned properties and investments in joint venture partnerships. At December 31, 1993, the Trust's tax basis in its net assets exceeded its basis for financial statement purposes by $53.2 million. As a result, aggregate future income for income tax purposes will be less than such amount for financial statement purposes, and the Trust will be able to maintain its REIT status without distributing 95% of its financial statement income. Additionally, at December 31, 1993, the Trust had a tax net operating loss carryforward of $41 million expiring through 2007. As a result of the Trust's election to be treated as a REIT for income tax purposes and of its intention to distribute its taxable income, no deferred tax asset, liability or valuation allowance was recorded. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 13. RENTALS UNDER OPERATING LEASES The Trust's rental operations include the leasing of office buildings and shopping centers. The leases thereon expire at various dates through 2005. The following is a schedule of minimum future rentals on non-cancelable operating leases as of December 31, 1993: NOTE 14. EXTRAORDINARY GAIN In 1993, the Trust acquired the $7.5 million second mortgage secured by its Century Center II Office Building for $300,000. In addition, the first lien holder retroactively reduced the interest rate on the debt owed by the Trust. The Trust recognized an extraordinary gain of $8.9 million in connection with the debt modification and discounted debt purchase. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." During 1991, SAC 9, a joint venture partnership, returned properties to senior lienholders in lieu of foreclosure proceedings. SAC 9 recognized an extraordinary gain of $3.1 million in 1991, of which the Trust's equity share was $2.2 million, from the forgiveness of nonrecourse mortgage debt and a provision for loss of $1.1 million, of which the Trust's equity share was $770,000. The provision for loss is included in equity in income of partnerships in 1991. This provision for losses and the extraordinary gain represent the amounts by which the nonrecourse mortgage debt exceeded the fair market value of the properties on the dates the properties were returned to the lienholders. NOTE 15. COMMITMENTS AND CONTINGENCIES Securities and Exchange Commission Inquiry. On December 1, 1988, the Trust was informed in writing that the staff of the Securities and Exchange Commission (the "Commission") had made a preliminary determination to recommend administrative proceedings against the Trust, CMET and Consolidated Capital Equities Corporation, a former advisor to the Trust, among others, for various alleged reporting violations in public filings made during certain periods in 1985, and possibly other matters. The allegations relate to a time prior to the time when the Trust's current management and BCM or any of its personnel became associated with the Trust. No administrative proceeding has been commenced and due to the lapse of time, the Trust's management believes that there will be no further activity regarding this matter. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 15. COMMITMENTS AND CONTINGENCIES (Continued) Olive Litigation. In February 1990, the Trust, together with CMET, Income Opportunity Realty Trust ("IORT") and Transcontinental Realty Investors, Inc. ("TCI"), three real estate entities with, at the time, the same officers, directors or trustees and advisor as the Trust, entered into a settlement of a class and derivative action entitled Olive et al. v. National Income Realty Trust et al., relating to the operation and management of each of the entities. On April 23, 1990, the court granted final approval of the terms of the settlement. By agreeing to settle these actions, the defendants, including the Trust, did not and do not admit any liability whatsoever. Among other things, the settlement required the creation of committees of the Board of Trustees to review transactions with related parties and certain litigation involving members of the Trust's management. In January 1991, the plaintiffs in this action filed a motion with the court for the appointment of a receiver for the Trust, CMET, IORT and TCI, based on an alleged failure by the trustees or directors of these entities to abide by the terms of the court-approved settlement. In March 1991, the court appointed a Special Master to review the facts and determine whether there had been any breach of the settlement agreement by the Trust, CMET, IORT or TCI. In his report to the court filed July 26, 1991, the Special Master found that the breaches which were found did not constitute deliberate violations of the settlement agreement and that the other allegations did not constitute breaches. In September and November 1991, hearings were held relating to the Special Master's report. An order was issued by the court on November 27, 1991. Under the order: (i) the plaintiffs' request for the appointment of a receiver was denied; (ii) the findings of the Special Master were confirmed and adopted by the court; (iii) independent counsel to the Related Party Transaction Committee and Litigation Committee of each of the Trust, CMET, IORT and TCI was required to submit, until December 1992, a written bimonthly report to the Special Master concerning the activities of such committees, and the Special Master was required to report periodically to the court on the activities of these committees; (iv) the Litigation Committees of each of the Trust, CMET, IORT and TCI were directed to evaluate the nature and quality of the allegations made in any litigations or investigations involving Messrs. Phillips and Friedman in order to assess whether Messrs. Phillips and Friedman should continue to act as trustees or directors of each entity and to assess whether BCM should continue to serve as advisor to each entity; and (v) the court retained jurisdiction to enforce the terms of its order and to issue subsequent orders if circumstances so dictate. A status conference was held in December 1992 to determine whether the bimonthly reports to the Special Master by the committees' independent NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 15. COMMITMENTS AND CONTINGENCIES (Continued) counsel and the Special Master's periodic reports to the court should be continued, or whether other appropriate relief should be ordered. The court held an evidentiary hearing on these matters in February and April 1993 concerning allegations by the plaintiffs that the terms of the settlement had been breached by the Trust, CMET, IORT and TCI. No determination on the matters has been made by the court pending the outcome of ongoing settlement discussions. Other litigation. The Trust is also involved in various lawsuits arising in the ordinary course of business. The Trust's management is of the opinion that the outcome of these lawsuits would have no material impact on the Trust's financial condition. NOTE 16. SUBSEQUENT EVENTS In January 1994, the Trust obtained first mortgage financing secured by the Bay West Apartments in the amount of $5.1 million. The Trust received net cash of $1.0 million after the payoff of $3.9 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. In March 1994, the Trust obtained first mortgage financing secured by the Carlyle Towers Apartments in the amount of $4.5 million. The Trust received net cash of $2.3 million after the payoff of $2.2 million in existing debt. Also in March 1994, the Trust obtained first mortgage financing secured by the Woodcreek Apartments, located in Denver, Colorado, in the amount of $3.0 million. The Trust received net cash of $1.2 million after the payoff of $1.7 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 17. QUARTERLY RESULTS OF OPERATIONS The following is a tabulation of the quarterly results of operations for the years ended December 31, 1993 and 1992 (unaudited): Fourth quarter results include a charge against earnings of $1.4 million to provide for estimated losses on one of the Trust's properties held for sale and one of the Trust's first lien notes receivable. In addition, $1.0 million was charged to operations in the fourth quarter in connection with the issuance of a $1.0 million convertible subordinated debenture in exchange for the buyout of the CCP II profit participation. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." Third quarter results include a charge against earnings of $2.4 million to provide for estimated losses on certain of the Trust's junior lien notes receivable. SCHEDULE X NATIONAL INCOME REALTY TRUST SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION SCHEDULE XI NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 SCHEDULE XI (Continued) NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 SCHEDULE XI (Continued) NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 - --------------- (1) The aggregate cost for federal income tax purposes is $195,478. (2) Also pledged as additional collateral on the $21 million first mortgage secured by Century Centre II. SCHEDULE XI (Continued) NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION SCHEDULE XII NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE December 31, 1993 SCHEDULE XII (Continued) NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE December 31, 1993 SCHEDULE XII (Continued) NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE December 31, 1993 _______________________ (1) The aggregate cost for federal income tax purposes is $19,547. (2) Note brought current subsequent to yearend. SCHEDULE XII (Continued) NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ______________________________________ PART III ITEM 10.

ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT Trustees The affairs of National Income Realty Trust (the "Trust" or the "Registrant") are managed by a ten-member Board of Trustees. The Trustees are elected at the annual meeting of shareholders or appointed by the incumbent Board of Trustees and serve until the next annual meeting of shareholders or until a successor has been elected or approved. The Trustees of the Trust are listed below, together with their ages, terms of service, all positions and offices with the Trust or its advisor, Basic Capital Management, Inc. ("BCM" or the "Advisor"), or Tarragon Realty Advisors, Inc. ("Tarragon"), the Trust's advisor commencing April 1, 1994, their principal occupations, business experience and directorships with other companies during the last five years or more. The designation "Affiliated", when used below with respect to a Trustee, means that the Trustee is an officer, director or employee of BCM or Tarragon or an officer or employee of the Trust. The designation "Independent", when used below with respect to a Trustee, means that the Trustee is neither an officer or employee of the Trust nor a director, officer or employee of BCM or Tarragon, although the Trust may have certain business or professional relationships with such Trustee as discussed in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Certain Business Relationships." WILLIE K. DAVIS: Age 62, Trustee (Independent) (since October 1988). President (1971 to 1985) and Chairman and 50% shareholder (since 1985) of Mid-South Financial Corporation, holding company for Mid-South Mortgage Company and Gibbs Mortgage Company; President (since 1978) and Chairman and sole shareholder (since December 1985) of FMS, Inc. ("FMS"), a property management and real estate development firm; President (1983 to February 1990) of BVT Management Services, Inc., a real estate advisory and tax service firm; Director (since 1987) of SouthTrust Bank of Middle Tennessee; Trustee and Treasurer (since 1986) of Baptist Hospital, Inc., Tennessee General Welfare nonprofit corporation; and Director or Trustee (since October 1988) of Continental Mortgage and Equity Trust ("CMET"), Income Opportunity Realty Trust ("IORT"), Transcontinental Realty Investors, Inc. ("TCI") and Vinland Property Trust ("VPT"). ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) JOHN A. DOYLE: Age 35, Trustee (Affiliated) and Executive Vice President (since February 1994). Trustee and Executive Vice President (since February 1994) of VPT; Director, President, Chief Operating Officer and 50% shareholder (since February 1994) of Tarragon; President and Chairman of the Board (since December 1993) of Investors General Acquisition Corp., which owns 100% of the shares of Investors General, Inc.; Director, President and Chief Executive Officer (since June 1992) of Garden Capital Incorporated; Director (since October 1993) of Home States Holdings; Director and Chief Operating Officer (October 1990 to December 1991) of ConCap Equities, Inc.; President, Chief Executive Officer, Chief Operating Officer and sole Director (April 1989 to October 1990) of Consolidated Capital Equities Corporation ("CCEC"); Director of Restructuring, Reorganization and Insolvency Services (February 1987 to April 1989) of Arthur Young & Co., independent certified public accountants; and Certified Public Accountant (since 1985). GEOFFREY C. ETNIRE: Age 45, Trustee (Independent) (since January 1993). Attorney engaged in the private practice of real estate law in Pleasanton, California (since 1981); Licensed Real Estate Broker in California (since 1985); Director (1985 to 1989) of Mission Valley Bancorp; Director (1984 to 1989) and Chairman (1986 to 1989) of Bank of Pleasanton; and Managing Partner (1981 to 1988) with Smith, Etnire, Polson & Scott law firm; and Trustee or Director (since January 1993) of CMET, IORT and TCI. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) WILLIAM S. FRIEDMAN: Age 50, Trustee (Affiliated) (since March 1988). Chief Executive Officer (since December 1993), President (since December 1988) and formerly Acting Chief Financial Officer (May 1990 to February 1991), Treasurer (August to September 1989) and Acting Principal Financial and Accounting Officer (December 1988 to August 1989). Trustee (since March 1988), Chief Executive Officer (since December 1993), President (since December 1988), Acting Chief Financial Officer (May 1990 to February 1991), Treasurer (August to September 1989) and Acting Principal Financial and Accounting Officer (December 1988 to August 1989) of VPT; Trustee or Director (March 1988 to February 1994), Chief Executive Officer (December 1993 to February 1994), President (December 1988 to February 1994), Acting Chief Financial Officer (May 1990 to February 1991), Treasurer (August to September 1989) and Acting Principal Accounting Officer (December 1988 to August 1989) of CMET, IORT and TCI; Director and Chief Executive Officer (since December 1990) of Tarragon, the Advisor to the Trust effective April 1, 1994; President (February 1989 to March 1993) and Director (February to December 1989) of BCM, the advisor to the Trust (March 1989 to March 1994); General Partner (1987 to March 1994) of Syntek Asset Management, L.P. ("SAMLP"), which is the General Partner of National Realty, L.P. ("NRLP") and National Operating, L.P. ("NOLP"); Director and President (March 1989 to February 1994)) and Secretary (March 1989 to December 1990) of Syntek Asset Management, Inc. ("SAMI"), the Managing General Partner of SAMLP and a corporation owned by BCM; President (1982 to October 1990) of Syntek Investment Properties, Inc. ("SIPI"), which has invested in, developed and syndicated real estate through its subsidiaries and other related entities since 1973; Director and President (1982 to October 1990) of Syntek West, Inc. ("SWI"); Vice President (1984 to October 1990) of Syntek Finance Corporation; Director (1981 to December 1992), President (July 1991 to December 1992), Vice President and Treasurer (January 1987 to July 1991) and Acting Chief Financial Officer (May 1990 to February 1991) of American Realty Trust, Inc. ("ART"); Practicing Attorney (since 1971) with the Law Offices of William S. Friedman; Director and Treasurer (November 1989 to February 1991) of Carmel Realty Services, Inc. ("CRSI"); Limited Partner (January 1991 to December 1992) of Carmel Realty Services, Ltd. ("Carmel, Ltd."); Trustee (1987 to November 1989) of Wespac Investors Trust; Director (1985 to April 1989) of Pratt Hotel Corporation; and Trustee (March 1988 to February 1989) of The Consolidated Companies. Until January 1989, Mr. Friedman served in the following positions: Director (from 1980), Vice Chairman of the Board of Directors (from 1982) and Secretary (from 1984) of Southmark Corporation; Director of Pacific Standard Life Insurance Company (from 1984), Servico, Inc. (from 1985), NACO Finance Corporation (from 1986), Integon Corporation (from 1986), Southmark San Juan, Inc. (from 1987), Thousand Trails, Inc. (from 1987), MGF Oil Corporation (from 1988), and two former advisors to the Trust - Consolidated Capital Equities Corporation and Consolidated Advisors, Inc. (from March 1988). ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) DAN L. JOHNSTON: Age 56, Trustee (Independent) (April 1990 to June 1990 and since February 1991). Attorney in solo practice in New York, New York (since 1991); Chief Counsel, Subcommittee on Criminal Justice, U.S. House of Representatives (June 1990 to January 1991); Executive Director (1986 to 1990) of Prosecuting Attorneys' Research Council, a nationwide organization of metropolitan prosecutors which acts to further research to improve the prosecutorial function; Consultant (February 1985 to June 1990) to the Edna McConnell Clark Foundation, which supports efforts of District Attorneys to reduce jail and prison overcrowding; Member (October 1987 to June 1990) of the Civilian Complaint Review Board of the New York City Police Department; Project Director (March 1985 to February 1986) and Consultant (January 1984 to March 1985) of the Vera Institute of Justice; County Attorney (March 1977 to March 1985) of Polk County, Des Moines, Iowa; Assistant Iowa Attorney General in charge of consumer fraud division (1965); Director or Trustee (April 1990 to June 1990 and since February 1991) of CMET, IORT and TCI; and Trustee (since December 1992) of VPT. A. BOB JORDAN: Age 61, Trustee (Independent) (since October 1992). Attorney in solo practice in Oklahoma City, Oklahoma; and Director or Trustee (since October 1992) of CMET, IORT and TCI. RAYMOND V.J. SCHRAG: Age 48, Trustee (Independent) (since October 1988). Attorney in solo practice in New York, New York (since 1975); Trustee (1986 to December 1989) of Hidden Strength Mutual Funds; and Director or Trustee (since October 1988) of CMET, IORT, TCI and VPT. BENNETT B. SIMS: Age 61, Trustee (Independent) (since April 1990). Author (since February 1964); Screen and Television Writer (since January 1960); Independent Marketing Consultant (since January 1980) for various companies; Professor of Dramatic Writing (since September 1987) at Tisch School of the Arts, New York University; Director or Trustee (since April 1990) of CMET, IORT and TCI; and Trustee (since December 1992) of VPT. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) TED P. STOKELY: Age 60, Trustee (Independent) (since April 1990). General Manager (since January 1993) of Minority and Elderly Housing Assistance Foundation, Inc., a nonprofit corporation; Part- time unpaid Consultant (since January 1993) of Eldercare Housing Foundation ("Eldercare"); Real Estate Consultant (April 1992 to December 1993) for Eldercare, a nonprofit corporation engaged in the acquisition of low income and elderly housing; President (since April 1992) of PSA Group (real estate management and consulting); Executive Vice President (1987 to 1991) of Key Companies Inc., a publicly traded company that develops, acquires and sells water and minerals; Managing General Partner (1985 to 1987) of RCB Houston Venture I, a Texas Partnership; Executive Vice President (1982 to 1985) of Success Properties, a Texas real estate investment company; and Director or Trustee (since April 1990) of CMET, IORT and TCI. CARL B. WEISBROD: Age 49, Trustee (Independent) (since February 1994). Consultant (since 1994), President and Chief Executive Officer (April 1990 to 1994) of New York City Economic Development Corporation; President (May 1987 to April 1990) of 42nd Street Development Project, Inc. of New York State Urban Development Corporation; Executive Director (March 1986 to May 1987) of Department of City Planning of the City of New York; and Executive Director (July 1984 to March 1986) of City Volunteer Corps of the City of New York. Separation of Messrs. Phillips and Friedman from Southmark. Until January 1989, Gene E. Phillips, who served as a Trustee of the Trust until December 31, 1992, and William S. Friedman, the President and a Trustee of the Trust, were executive officers and directors of Southmark Corporation ("Southmark"). Mr. Phillips served as Chairman of the Board and Director (since 1980) and President and Chief Executive Officer (since 1981) and Mr. Friedman served as Vice Chairman of the Board (since 1982), Director (since 1980) and Secretary (since 1984) of Southmark. As a result of a deadlock on Southmark's Board of Directors, Messrs. Phillips and Friedman reached a series of related agreements with Southmark on January 17, 1989 (collectively, the "Separation Agreement"), whereby Messrs. Phillips and Friedman resigned their positions with Southmark and certain of Southmark's subsidiaries and affiliates. The Separation Agreement was later modified by certain agreements in another set of agreements dated as of June 30, 1989 (collectively, the "June Agreements"). Southmark filed a voluntary petition in bankruptcy under Chapter 11 of the United States Bankruptcy Code on July 14, 1989. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) Litigation Against Southmark or its Affiliates Alleging Fraud or Mismanagement. In addition to the litigation related to the Southmark bankruptcy, there were several lawsuits filed against Southmark, its former officers and directors (including Messrs. Phillips and Friedman) and others, alleging, among other things, that such persons and entities engaged in conduct designed to defraud and mislead the investing public by intentionally misrepresenting the financial condition of Southmark. In so far as such allegations related to them, Messrs. Phillips and Friedman deny them. Those lawsuits in which Mr. Friedman was also a defendant are summarized below. THE TRUST IS NOT A DEFENDANT IN ANY OF THESE LAWSUITS. In Burt v. Grant Thornton, Gene E. Phillips and William S. Friedman, the plaintiff, a purchaser of Southmark preferred stock, alleged that the defendants disseminated false and misleading corporate reports, financial analysis and news releases in order to induce the public to continue investing in Southmark. Grant Thornton served as independent certified public accountants to Southmark and, for 1988 and 1989, to the Trust. The plaintiff sought actual damages in the amount of less than $10,000, treble damages and punitive damages in an unspecified amount plus attorneys' fees and costs. This case was settled in October 1993 for a nominal payment. Consolidated actions entitled Salsitz v. Phillips et al., purportedly brought as class actions on behalf of purchasers of Southmark securities during specified periods, were pending before the United States District Court for the Northern District of Texas. These actions alleged violations of the federal securities laws and state laws, based upon claims of fraud, deceit and negligent misrepresentations made in connection with the sale of Southmark securities. The plaintiffs sought unspecified damages, attorneys' fees and costs. The defendants included Messrs. Phillips and Friedman, among others. Messrs. Phillips and Friedman entered into a settlement agreement with the plaintiffs, which was approved by the court in October 1993. Messrs. Phillips and Friedman also served as directors of Pacific Standard Life Insurance Company ("PSL"), a wholly-owned subsidiary of Southmark, from October 1984 to January 1989. In a proceeding brought by the California Insurance Commissioner, a California Superior Court appointed a conservator for PSL on December 11, 1989, and directed that PSL cease doing business. On October 12, 1990, the California Insurance Commissioner filed suit against Messrs. Phillips and Friedman and other former directors of PSL seeking damages of $12 million and additional punitive damages. Such lawsuit alleged, among other things, that the defendants knowingly and willfully conspired among themselves to breach their duties as directors of PSL and to loot and waste corporate assets of PSL to benefit Southmark and its other subsidiaries and certain of the defendants (including Messrs. Phillips and Friedman), resulting in a required write-down of $25 million, PSL's insolvency and conservatorship. Such suit further alleged that the defendants caused ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) PSL to make loans to, or enter into transactions with, Southmark, Southmark affiliates and others in violation of applicable state laws, and to make loans and investments that could not be included as assets on PSL's balance sheet to entities controlled by Charles H. Keating, Jr. It is also alleged that PSL's board of directors failed to convene meetings and delegated to Mr. Phillips authority to make decisions regarding loans, investments and other transfers and exchanges of PSL assets. In August 1993, five former directors of PSL, including Messrs. Phillips and Friedman, settled this lawsuit without admitting any liability. Southmark Partnership Litigation. One of Southmark's principal businesses was real estate syndication and from 1981 to 1987 Southmark raised over $500 million in investments from limited partners of several hundred limited partnerships. Several lawsuits have been filed by investors against Messrs. Phillips and Friedman alleging breach of fiduciary duties. The following actions relate to and involve such activities. In Adkisson, et al. v. Friedman et al., the plaintiffs, limited partners in a tax shelter partnership sponsored by Southmark, alleged violations of state consumer protection laws, negligence and fraud. This case was settled in July 1993 for a nominal payment. In Sable et al. v. Southmark/Envicon Capital Corp. et al., the plaintiffs, limited partners in nine Southmark-sponsored limited partnerships, made several claims alleging breach of fiduciary duty and waste or mismanagement of partnership assets, among other things. In April 1993, the court dismissed all of the claims and awarded Messrs. Phillips and Friedman sanctions against plaintiffs' counsel. In Southmark/CRCA Healthcare Fund VIII, L.P. v. Southmark Investment Group 87, Inc., et al., the plaintiff, a former Southmark related public limited partnership, alleged that in 1988 the defendants caused the plaintiff to purchase five nursing homes in violation of the partnership agreement. The plaintiff sought to recover actual damages in an unspecified amount, plus punitive damages and attorneys' fees and costs. The defendants included, among others, Messrs. Phillips and Friedman and TCI, which provided refinancing for the properties. The case was settled in October 1993. In an action filed in January 1993 in a Michigan state court captioned Van Buren Associates Limited Partnership, et.al. v. Friedman, et. al., the plaintiff, an affiliate of the plaintiff in two other cases against Messrs. Phillips and Friedman which have been dismissed without payment, alleges a claim in connection with an alleged 1988 transfer of certain property by the partnership. The plaintiff seeks damages in an unspecified amount, plus costs and attorney's fees. The plaintiff also seeks to quiet title to the property at issue. The defendants include, among others, Messrs. Phillips and Friedman. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Board Committees The Trust's Board of Trustees held nine meetings during 1993. For such year, no incumbent Trustee attended fewer than 75% of the aggregate of (i) the total number of meetings held by the Board of Trustees during the period for which he had been a Trustee and (ii) the total number of meetings held by all committees of the Board of Trustees on which he served during the periods that he served. The Trust's Board of Trustees has an Audit Committee, the function of which is to review the Trust's operating and accounting procedures. The current members of the Audit Committee, all of whom are Independent Trustees, are Messrs. Schrag (Chairman), Davis and Etnire. The Audit Committee met three times during 1993. The Trust's Board of Trustees does not have Nominating or Compensation Committees. The Trust's Board of Trustees has a Related Party Transaction Committee which reviews and makes recommendations to the Board of Trustees with respect to transactions involving the Trust and any other party or parties related to or affiliated with the Trust, any of its Trustees or any of their affiliates, and a Litigation Committee which reviews litigation involving Messrs. Phillips and Friedman. Messrs. Johnston (Chairman), Davis, Etnire, Schrag, Sims and Stokely, all of whom are Independent Trustees, are the members of the Related Party Transaction Committee, while Messrs. Johnston (Chairman), Etnire, Jordan, Schrag, Sims and Stokely comprise the Litigation Committee. During 1993, the Related Party Transaction Committee met six times and the Litigation Committee met six times. The Litigation Committee has formally requested each of Messrs. Phillips and Friedman to furnish the Advisor's in-house counsel with copies of the complaints filed in all pending litigation in which either is named as a defendant. The Advisor's counsel, in turn, has furnished the Litigation Committee with summaries of the allegations contained in each such complaint as well as summaries of developments in existing and new matters. The Litigation Committee is represented by independent counsel, which counsel periodically reviews certain litigation matters and reports to the Committee thereon. The Litigation Committee evaluates the nature and quality of the allegations made in any litigations or investigations involving Messrs. Phillips and Friedman in order to assess whether Mr. Friedman should continue to act as a Trustee and to assess whether BCM should continue to act as the advisor to the Trust. The Litigation Committee, while not needing to duplicate the adjudicatory process, is also required to conduct any investigation that is appropriate and necessary to discharge the above obligations. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Executive Officers The following persons currently serve as executive officers of the Trust: William S. Friedman, President and Chief Executive Officer; John A. Doyle, Executive Vice President; and Ivan Roth, Treasurer and Chief Financial Officer. Their positions with the Trust are not subject to a vote of shareholders. The age, terms of service, all positions and offices with the Trust, BCM or Tarragon, other principal occupations, business experience and directorships with other companies during the last five years or more of Messrs. Friedman and Doyle are set forth above. Corresponding information regarding Mr. Roth is set forth below. IVAN ROTH: Age 58, Treasurer and Chief Financial Officer (since February 1994). Treasurer and Chief Financial Officer (since February 1994) of VPT; Treasurer (since February 1994) of Tarragon and Tarragon Capital Corporation; Treasurer and Chief Financial Officer (1978 to 1992) of Servico, Inc.; Financial Controller (1970 to 1978) of New York Motel Enterprises, Inc.; General Manager (1968 to 1970) of Affiliated Financial Corporation; and Certified Public Accountant (since 1968). On September 19, 1990, Servico, Inc. filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code and was reorganized effective August 5, 1992. Officers Although not executive officers of the Trust, the following persons currently serve as officers of the Trust: Cary L. Newburger, Vice President - General Counsel; John C. Stricklin, Vice President - Real Estate and Mary E. Montagnino, Secretary. Their positions with the Trust are not subject to a vote of shareholders. Their ages, terms of service, all positions and offices with the Trust, BCM or Tarragon, other principal occupations, business experience and directorships with other companies during the last five years or more are set forth below. CARY L. NEWBURGER: Age 34, Vice President - General Counsel (since February 1994) and Vice President - Real Estate (1992 to February 1994). Vice President - General Counsel (since February 1994) of VPT; Vice President (since February 1994) of Tarragon; Vice President and Real Estate Counsel (1990 to 1994) of BCM; Vice President (1993 to February 1994) of ART; Vice President and Real Estate Counsel (1992 to February 1994) of CMET, IORT and TCI; Attorney (1987 to 1989) of Southmark; and Associate (1985 to 1987) with the law firm of Baker & McKenzie. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Officers (Continued) JOHN C. STRICKLIN: Age 47, Vice President - Real Estate (since January 1994). Vice President - Real Estate (since February 1994) of VPT; Senior Vice President (since February 1994) of Tarragon; Vice President (June 1992 to January 1994) of Carmel Realty, Inc.; Real Estate Broker (June 1989 to May 1992) with Carmel, Ltd.; Executive Vice President (June 1980 to May 1989) of Windsor Financial Corporation; and Vice President (June 1975 to June 1980) of Syntek Corporation. MARY E. MONTAGNINO: Age 35, Secretary (since February 1994). Secretary (since February 1994) of VPT; Secretary and Paralegal (since February 1994) of Tarragon; Paralegal (1989 to February 1994) of BCM; and Paralegal (1984 to 1989) of Southmark. In addition to the foregoing officers, the Trust has other officers who are not listed herein. Compliance with Section 16(a) of the Securities Exchange Act of 1934 Under the securities laws of the United States, the Trust's Trustees, executive officers, and any persons holding more than ten percent of the Trust's shares of beneficial interest are required to report their ownership of the Trust's shares and any changes in that ownership to the Securities and Exchange Commission (the "Commission"). Specific due dates for these reports have been established and the Trust is required to report any failure to file by these dates during 1993. During 1993, all of these filing requirements were satisfied by its Trustees and executive officers and ten percent holders. In making these statements, the Trust has relied on the written representations of its incumbent Trustees and executive officers and its ten percent holders and copies of the reports that they have filed with the Commission. The Advisor Although the Trust's Board of Trustees is directly responsible for managing the affairs of the Trust and for setting the policies which guide it, the day-to-day operations of the Trust are performed by a contractual advisory firm under the supervision of the Trust's Board of Trustees. The duties of the advisor include, among other things, locating, investigating, evaluating and recommending real estate and mortgage note investment and sales opportunities, as well as financing and refinancing sources for the Trust. The advisor also serves as a consultant in connection with the business plan and investment policy decisions made by the Trust's Board of Trustees. CCEC was the sponsor of and original advisor of the Trust. CCEC was replaced as advisor on August 1, 1988, by Consolidated Advisors, Inc. ("CAI"), the parent of CCEC. On December 2, 1988, CCEC filed a petition ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) seeking reorganization under Chapter 11 of the United States Bankruptcy Code in the United States District Court for the Northern District of Texas. Mr. Friedman was a director of CCEC and CAI from March 1988 through January 1989. Mr. Doyle was President, Chief Executive Officer, Chief Operating Officer and sole director of CCEC from April 1989 through October 1990. Southmark was a controlling shareholder of The Consolidated Companies, the parent of CAI, from March 1988 through February 1989. In February 1989, the Trust's Board of Trustees voted to retain BCM as the Trust's advisor. BCM has served as the Trust's advisor since March 1989. Prior to December 22, 1989, Messrs. Phillips and Friedman also served as directors of BCM. Mr. Phillips served as chief executive officer of BCM until September 1, 1992 and Mr. Friedman served as President of BCM until May 1, 1993. BCM is beneficially owned by a trust for the benefit of the children of Mr. Phillips, who served as a Trustee of the Trust until December 7, 1992. At the Trust's annual meeting of shareholders held on April 26, 1993, the Trust's shareholders approved the renewal of the Trust's advisory agreement with BCM. BCM has resigned as advisor to the Trust effective March 31, 1994. On February 10, 1994, the Trust's Board of Trustees selected Tarragon to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will provide advisory services to the Trust under an advisory agreement. Mr. Friedman serves as a director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as a director, President and Chief Operating Officer of Tarragon and Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. The provisions of the Trust's advisory agreement with Tarragon are substantially the same as to those of the BCM advisory agreement except for the annual base advisory fee and the elimination of the net income fee. The Tarragon advisory agreement calls for an annual base advisory fee of $100,000 plus an incentive advisory fee equal to 16% of the Trust's adjusted funds from operations before deduction of the advisory fee. Adjusted funds from operations is defined as net income (loss) before gains or losses from the sales of properties and debt restructurings plus depreciation and amortization plus any loss due to the writedown or sale of any real property or mortgage loan acquired prior to January 1, 1989. The BCM advisory agreement provided for BCM to be responsible for the day-to-day operations of the Trust and to receive an advisory fee comprised of a gross asset fee of .0625% per month (.75% per annum) of the average of the gross asset value of the Trust (total assets less allowance for amortization, depreciation or depletion and valuation reserves) and an annual net income fee equal to 7.5% per annum of the Trust's net income. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) Under both the Tarragon and the BCM advisory agreements, the advisor is required to formulate and submit annually for approval by the Trust's Board of Trustees a budget and business plan for the Trust containing a twelve-month forecast of operations and cash flow, a general plan for asset sales or acquisitions, lending, foreclosure and borrowing activity, and other investments, and the advisor is required to report quarterly to the Trust's Board of Trustees on the Trust's performance against the business plan. In addition, all transactions or investments by the Trust shall require prior approval by the Trust's Board of Trustees unless they are explicitly provided for in the approved business plan or are made pursuant to authority expressly delegated to the advisor by the Trust's Board of Trustees. Both the Tarragon and the BCM advisory agreements also require prior approval of the Trust's Board of Trustees for retention of all consultants and third party professionals, other than legal counsel. The advisory agreements provide that the advisor shall be deemed to be in a fiduciary relationship to the Trust's shareholders; contain a broad standard governing the advisor's liability for losses by the Trust; and contain guidelines for the advisor's allocation of investment opportunities as among itself, the Trust and other entities it advises. The advisory agreements also provide for the advisor to receive an annual incentive sales fee equal to 10% of the amount, if any, by which the aggregate sales consideration for all real estate sold by the Trust during such fiscal year exceeds the sum of: (i) the cost of each such property as originally recorded in the Trust's books for tax purposes (without deduction for depreciation, amortization or reserve for losses), (ii) capital improvements made to such assets during the period owned by the Trust and (iii) all closing costs, (including real estate commissions) incurred in the sale of such property; provided, however, no incentive fee shall be paid unless (i) such real estate sold in such fiscal year, in the aggregate, has produced an 8% simple annual return of the Trust's net investment including capital improvements, calculated over the Trust's holding period before depreciation and inclusive of operating income and sales consideration and (ii) the aggregate net operating income from all real estate owned by the Trust for each of the prior and current fiscal years shall be at least 5% higher in the current fiscal year than in the prior fiscal year. Additionally, pursuant to each of the advisory agreements, the advisor or an affiliate of the advisor is to receive an acquisition commission for supervising the acquisition, purchase or long term lease of real estate for the Trust equal to the lesser of (i) up to 1% of the cost of acquisition, inclusive of commissions, if any, paid to nonaffiliated brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property acquisition services as an ongoing public activity in the same geographical location and for ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) comparable property; provided that the purchase price of each property (including acquisition commissions and all real estate brokerage fees) may not exceed such property's appraised value at acquisition. Each of the advisory agreements require the advisor or any affiliate of the advisor to pay to the Trust one-half of any compensation received from third parties with respect to the origination, placement or brokerage of any loan made by the Trust, provided, however, that the compensation retained by the advisor or any affiliate of the advisor shall not exceed the lesser of (i) 2% of the amount of the loan committed by the Trust or (ii) a loan brokerage and commitment fee which is reasonable and fair under the circumstances. Each of the advisory agreements also provide that the advisor or an affiliate of the advisor is to receive a mortgage or loan acquisition fee with respect to the acquisition or purchase from an unaffiliated party of any existing mortgage or loan by the Trust equal to the lesser of (i) 1% of the amount of the loan purchased or (ii) a loan brokerage or commitment fee which is reasonable and fair under the circumstances. Such fee will not be paid in connection with the origination or funding by the Trust of any mortgage loan. Under each of the advisory agreements, the advisor or an affiliate of the advisor is also to receive a mortgage brokerage and equity refinancing fee for obtaining loans to the Trust or refinancing on Trust properties equal to the lesser of (i) 1% of the amount of the loan or the amount refinanced or (ii) a brokerage or refinancing fee which is reasonable and fair under the circumstances; provided, however, that no such fee shall be paid on loans from the advisor or an affiliate of the advisor without the approval of the Trust's Board of Trustees. No fee shall be paid on loan extensions. Under each of the advisory agreements, the advisor is to receive reimbursement of certain expenses incurred by it in the performance of advisory services to the Trust. Under each of the advisory agreements (as required by the Trust's Declaration of Trust) all or a portion of the annual advisory fee must be refunded by the advisor to the Trust if the Operating Expenses of the Trust (as defined in the Trust's Declaration of Trust) exceed certain limits specified in the Declaration of Trust based on the book value, net asset value and net income of the Trust during such fiscal year. The operating expenses of the Trust did not exceed such limitation in 1991, 1992 or 1993. Additionally, if the Trust were to request that the advisor render services to the Trust other than those required by the advisory agreement, the advisor or an affiliate of the advisor would be separately compensated for such additional services on terms to be agreed upon from time to time. As discussed below under "Property ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) Management," the Trust has hired Carmel, Ltd., an affiliate of BCM, to provide property management services for the Trust's properties. Commencing, April 1, 1994, Tarragon will provide property management services for the Trust's properties. Also as discussed below under "Real Estate Brokerage," the Trust has engaged, on a non-exclusive basis, Carmel Realty, Inc. ("Carmel Realty"), also an affiliate of BCM, to perform brokerage services for the Trust until March 31, 1994. Approval of the renewal of the Tarragon advisory agreement is required by the Trust's shareholders. The advisory agreement may only be assigned with the prior consent of the Trust. The directors and principal officers of BCM are set forth below. MICKEY NED PHILLIPS: Director RYAN T. PHILLIPS: Director OSCAR W. CASHWELL: President and Director of Property and Asset Management KARL L. BLAHA: Executive Vice President and Director of Commercial Management HAMILTON P. SCHRAUFF: Executive Vice President and Chief Financial Officer CLIFFORD C. TOWNS, JR: Executive Vice President, Finance THOMAS A. HOLLAND: Senior Vice President and Chief Accounting Officer DREW D. POTERA: Vice President, Treasurer and Securities Manager ROBERT A. WALDMAN: Vice President, Corporate Counsel and Secretary Mickey Ned Phillips is Gene E. Phillips' brother and Ryan T. Phillips is Gene E. Phillips' son. The directors and principal officers of Tarragon are set forth below: WILLIAM S. FRIEDMAN: Director and Chief Executive Officer JOHN A. DOYLE: Director, President and Chief Operating Officer ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) CHRIS CLINTON: Senior Vice President TODD MINOR: Senior Vice President JOHN C. STRICKLIN: Senior Vice President CARY L. NEWBURGER: Vice President - General Counsel IVAN ROTH: Treasurer MARY E. MONTAGNINO: Secretary Property Management Since February 1, 1990, affiliates of BCM have provided property management services to the Trust. Currently Carmel, Ltd. provides property management services for a fee of 5% or less of the monthly gross rents collected on the properties under management. In many cases, Carmel, Ltd. subcontracts with other entities for the provision of the property-level management services to the Trust at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) SWI, of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of eleven of the Trust's commercial properties and the commercial properties owned by two of the real estate partnerships in which the Trust is a partner to Carmel Realty, which is owned by SWI. Carmel, Ltd. has resigned as property manager for the Trust's properties effective March 31, 1994. Commencing April 1, 1994, Tarragon will provide property management services to the Trust for a fee of 4.5% of the monthly gross rents collected on apartment properties and not in excess of 5% of the monthly gross rents collected on commercial properties. Tarragon intends to subcontract with other entities for the provision of most of the property-level management services to the Trust. Real Estate Brokerage Prior to December 1, 1992, affiliates of BCM provided brokerage services to the Trust and received brokerage commissions in accordance with the advisory agreement. Effective December 1, 1992, the Trust's Board of Trustees approved the non-exclusive engagement by the Trust of Carmel Realty to provide brokerage services for the Trust. Such agreement terminates March 31, 1994. Carmel Realty is entitled to receive a real estate acquisition commission for locating and negotiating the lease or purchase by the Trust of any property equal to the lesser of (i) up to 3% of the purchase price, inclusive of commissions, if any, paid by the Trust to other brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Real Estate Brokerage (Continued) acquisition services in the same geographical location and for comparable property. Any commission which is paid to Carmel Realty by the seller shall be credited against the commission to be paid by the Trust. Carmel Realty is also entitled to receive a real estate sales commission for the sale of each Trust property equal to the lesser of (i) 3% (inclusive of fees, if any, paid by the Trust to other brokers) of the sales price of each property or (ii) the compensation customarily charged in arm's-length transactions paid by others rendering similar services in the same geographic location for comparable property. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The Trust has no employees, payroll or benefit plans and pays no compensation to the executive officers of the Trust. The Trustees and executive officers of the Trust who are also officers or employees of the Trust's Advisor are compensated by the Advisor. Such affiliated Trustees and executive officers of the Trust perform a variety of services for the Advisor and the amount of their compensation is determined solely by the Advisor. BCM does not allocate the cash compensation of its officers among the various entities for which it serves as advisor. See ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT - The Advisor" for a more detailed discussion of the compensation payable to BCM or Tarragon by the Trust. The only direct remuneration paid by the Trust is to the Trustees who are not officers or directors of BCM or Tarragon or their affiliated companies. The Independent Trustees (i) review the business plan of the Trust to determine that it is in the best interest of the Trust's shareholders, (ii) review the Trust's contract with the advisor, (iii) supervise the performance of the Trust's advisor and review the reasonableness of the compensation which the Trust pays to its advisor in terms of the nature and quality of services performed, (iv) review the reasonableness of the total fees and expenses of the Trust and (v) select, when necessary, a qualified independent real estate appraiser to appraise properties acquired by the Trust. The Independent Trustees receive compensation in the amount of $6,000 per year, plus reimbursement for expenses. In addition, each Independent Trustee receives (i) $3,000 per year for each committee of the Board of Trustees on which he serves, (ii) $2,500 per year for each committee chairmanship and (iii) $1,000 per day for any special services rendered by him to the Trust outside of his ordinary duties as Trustee, plus reimbursement for expenses. During 1993, $128,516 was paid to the Independent Trustees in total Trustees' fees for all services, including the annual fee for service during the period June 1, 1993 through May 31, 1994, and 1993 special service fees: Willie K. Davis, $14,875; Geoffrey C. Etnire, $19,625; Randall K. Gonzalez, $12,750; Dan L. Johnston, $25,250; A. Bob Jordan, $10,042; Raymond V.J. Schrag, $17,500; Bennett B. Sims, $13,500; and Ted P. Stokely, $14,974. ITEM 11. EXECUTIVE COMPENSATION (Continued) Messrs. Davis and Schrag serve on the Fairness Committee of NRLP (for which they each received $4,000 in 1993) whose function is to review certain transactions between NRLP and its general partner and affiliates of such general partner. TMC, a company of which Mr. Gonzalez, a Trustee of the Trust until February 18, 1994, is the Managing Partner and President, provides property-level management services, as a sub-contractor to Carmel, Ltd., for certain properties owned by the Trust. In 1993, TMC earned fees of $58,000 for performing such services. TMC also provides property-level management services, as a subcontractor to Carmel, Ltd., for properties owned by ART, CMET, NOLP and TCI and through April 1993, for a property owned by a partnership which includes IORT and TCI. Christon, a company for which Mr. Gonzalez serves as Vice President, provides property leasing services, as a subcontractor to Carmel, Ltd., to such partnership. Mr. Gonzalez is the son of Al Gonzalez, an ART director not affiliated with BCM. Since January 1, 1993, FMS, a company of which Mr. Davis is Chairman, President and sole shareholder, has been providing property- level management services, as a subcontractor to Carmel, Ltd., for two properties owned by the Trust. In 1993, FMS earned fees of $54,000 for performing such services. During 1993, Mr. Jordan performed legal services for BCM and its affiliates, as well as for ART, TCI and the Trust. The Trust paid Mr. Jordan $4,000 in legal fees and cost reimbursements in 1993. The Trust believes that such fees received by FMS, TMC and Mr. Jordan were at least as favorable to the Trust as those that would be paid to unaffiliated third parties for the performance of similar services. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 11. EXECUTIVE COMPENSATION (Continued) Performance Graph The following performance graph compares the cumulative total shareholder return on the Trust's shares of beneficial interest with the Standard & Poor's 500 Stock Index ("S&P 500 Index") and the National Association of Real Estate Investment Trusts, Inc. Hybrid REIT Total Return Index ("REIT Index"). The comparison assumes that $100 was invested on December 30, 1988 in the Trust's shares of beneficial interest and in each of the indices and further assumes the reinvestment of all dividends. Past performance is not necessarily an indicator of future performance. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security Ownership of Certain Beneficial Owners. The following table sets forth the ownership of the Trust's shares of beneficial interest, both beneficially and of record, both individually and in the aggregate for those persons or entities known by the Trust to be beneficial owners of more than 5% of its shares of beneficial interest as of the close of business on March 11, 1994. - --------------- (1) Percentages are based upon 3,088,663 shares of beneficial interest outstanding at March 11, 1994. (2) Includes 12,612 shares owned by Lucy N. Friedman's husband, William S. Friedman. (3) Includes 609,595 shares owned by Lucy N. Friedman. In addition, includes 44,512 shares and 44,259 shares owned by Lucy N. Friedman's minor sons, Gideon and Samuel Friedman. Lucy Friedman has control of such shares. (4) Does not include 49,894 shares owned by Lucy N. Friedman's adult son, Ezra Friedman, and 48,190 shares owned by Lucy N. Friedman's adult daughter, Tanya Friedman. Mrs. Friedman disclaims beneficial ownership of such shares. (5) Includes 23,942 shares owned by a trust for the benefit of the children and grandchildren of Samuel Friedman, deceased, William S. Friedman's father, for which Robert A. Friedman and Gerald C. Friedman, siblings of William S. Friedman and Ruth Friedman, his mother, are the trustees. Lucy N. Friedman disclaims beneficial ownership of such shares. (6) Includes 33,000 shares owned by Tarragon Capital Corporation, of which Lucy N. Friedman and William S. Friedman are executive officers and directors and 34,466 shares owned by Tarragon Partners, Ltd., of which Lucy N. Friedman and William S. Friedman are limited partners. Mrs. Friedman disclaims beneficial ownership of such shares. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Continued) Security Ownership of Management. The following table sets forth the ownership of the Trust's shares of beneficially interest, both beneficially and of record, both individually and in the aggregate for the Trustees and executive officers of the Trust as of the close of business on March 11, 1994. - --------------- * Less than 1%. (1) Percentages are based upon 3,088,663 shares of beneficial interest outstanding at March 11, 1994. (2) Includes 28,968 shares held by a trust for the benefit of the children of Gene E. Phillips for which William S. Friedman is the trustee. Mr. Friedman disclaims beneficial ownership of such shares. Mr. Friedman also owns 12,612 shares of beneficial interest personally. (3) Includes 609,595 shares owned by William S. Friedman's wife, Lucy Friedman. Mr. Friedman disclaims beneficial ownership of such shares. In addition, includes 44,512 shares and 44,259 shares owned by William S. Friedman's minor sons, Gideon and Samuel Friedman. Lucy Friedman has control of such shares. Mr. Friedman disclaims beneficial ownership of such shares. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Continued) (4) Does not include 49,894 shares owned by William S. Friedman's adult son, Ezra Friedman, and 44,259 shares owned by William S. Friedman's adult daughter, Tanya Friedman. Mr. Friedman disclaims beneficial ownership of such shares. (5) Includes 23,942 shares owned by a trust for the benefit of the children and grandchildren of Samuel Friedman, deceased, William S. Friedman's father, for which Robert A. Friedman and Gerald C. Friedman, siblings of William S. Friedman and Ruth Friedman, his mother, are the trustees. Mr. Friedman disclaims beneficial ownership of such shares. (6) Includes 33,000 shares owned by Tarragon Capital Corporation, of which Lucy N. Friedman, William S. Friedman and John A. Doyle are executive officers and directors. (7) Includes 34,466 shares owned by Tarragon Partners, Ltd., of which Lucy N. Friedman and William S. Friedman are limited partners. Mr. Friedman disclaims beneficial ownership of such shares. (8) Includes 69,903 shares owned by CMET of which Messrs. Davis, Etnire, Johnston, Jordan, Schrag, Sims and Stokely may be deemed to be beneficial owners by virtue of their positions as CMET trustees. (9) Includes 76,923 shares in which Mr. Doyle has beneficial interest as a result of a $1.0 million subordinated debenture which is convertible to 76,923 of the Trust's shares. John A. Doyle also owns 2,860 shares personally. (10) Raymond V.J. Schrag owns 2,750 shares personally. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Certain Business Relationships In February 1989, the Trust's Board of Trustees voted to retain BCM as the Trust's advisor as discussed in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT - The Advisor." BCM is a corporation of which Messrs. Cashwell, Blaha, Schrauff and Holland serve as executive officers. Messrs. Phillips and Friedman served as directors of BCM until December 22, 1989. Mr. Phillips served as Chief Executive Officer of BCM until September 1, 1992 and Mr. Friedman served as President of BCM until May 1, 1993. BCM is beneficially owned by a trust for the benefit of the children of Mr. Phillips. On February 10, 1994, the Trust's Board of Trustees selected Tarragon to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will be providing advisory services to the Trust under an advisory agreement. Mr. Friedman serves as director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as President and Chief Operating Officer of Tarragon and Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. Also on February 10, 1994, VPT's Board of Trustees selected Tarragon to replace BCM as VPT's advisor commencing March 1, 1994. Messrs. Davis, Doyle, Friedman, Johnson, Schrag, Sims and Weisbrod, Trustees of the Trust, serve as trustees of VPT. Tarragon occupies office space at VPT's One Turtle Creek Office/Retail Complex, which serves as the Trust's executive offices. Since February 1, 1990, affiliates of BCM have provided property management services to the Trust. Currently, Carmel, Ltd. provides property management services for a fee of 5% or less of the monthly gross rents collected on the properties under management. In many cases, Carmel, Ltd. subcontracts with other entities for the property-level management services to the Trust at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) SWI, of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of eleven of the Trust's commercial properties and the commercial properties owned by two of the real estate partnerships in which the Trust is a partner to Carmel Realty, which is owned by SWI. Carmel, Ltd. resigned as property manager for the Trust's properties effective March 31, 1994. Commencing April 1, 1994, Tarragon will provide property management services to the Trust. Prior to December 1, 1992, affiliates of BCM provided brokerage services to the Trust and received brokerage commissions in accordance with the advisory agreement. Effective December 1, 1992, the Trust engaged Carmel Realty, on a non-exclusive basis, to provide brokerage services for the Trust. Carmel Realty is owned by SWI. Such agreement terminates March 31, 1994. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Certain Business Relationships (Continued) The Trustees, with the exception of Messrs. Etnire, Jordan and Stokely, and the officers of the Trust serve as trustees and officers of VPT. The Trustees, with the exception of Messrs. Friedman, Doyle and Weisbrod, also serve as trustees or directors of CMET, IORT and TCI. The Trust's Trustees owe fiduciary duties to such entities as well as to the Trust under applicable law. VPT has the same relationship with Tarragon as the Trust. CMET, IORT and TCI have the same relationships with BCM as the Trust. Mr. Phillips is the general partner and until March 4, 1994, Mr. Friedman was a general partner of the general partner of NRLP and NOLP. BCM performs certain administrative functions for NRLP and NOLP on a cost-reimbursement basis. BCM also serves as advisor to ART. Messrs. Phillips and Friedman served as executive officers and directors of ART until November 16, 1992 and December 31, 1992, respectively. As discussed in ITEM 11. "EXECUTIVE COMPENSATION," Messrs. Davis and Schrag serve on the Fairness Committee of NRLP, whose function is to review certain transactions between NRLP and its general partner and affiliates of such general partner. TMC, a company of which Mr. Gonzalez, a trustee of the Trust until February 18, 1994, is the Managing Partner and President, provides property-level management services as a subcontractor to Carmel, Ltd. for certain properties owned by ART, CMET, NOLP, TCI and the Trust and through April 30, 1993, for a property owned by a partnership which includes IORT and TCI. Christon, a company of which Mr. Gonzalez serves as Vice President, provides property leasing services, as a subcontractor to Carmel, Ltd., for such partnership property. Mr. Gonzalez is the son Al Gonzalez, a director of ART not affiliated with BCM. From April 1992 to December 31, 1993, Mr. Stokely was employed as a Real Estate Consultant for Eldercare, a nonprofit corporation engaged in the acquisition of low income and elderly housing. Eldercare has a revolving loan commitment from SWI which is owned by Mr. Phillips and affiliated with BCM. In addition, in November 1991, the Trust funded a $230,000 loan to Eldercare. Eldercare filed for bankruptcy protection in October 1993. At December 31, 1993, the Trust's loan to Eldercare was in default. During 1993, Mr. Jordan performed legal services for BCM and its affiliates, as well as for TCI, ART and the Trust. Related Party Transactions Historically, the Trust has engaged in and may continue to engage in business transactions, including real estate partnerships, with related parties. All related party transactions entered into by the Trust must be approved by a majority of the Trust's Board of Trustees, including a majority of the Independent Trustees. In addition, the Related Party Transaction Committee of the Trust's Board of Trustees must review all such transactions prior to their submission to the Trust's Board of Trustees for consideration. The Trust's management believes that all of ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Related Party Transactions (Continued) the related party transactions represented the best investments available at the time and were at least as advantageous to the Trust as could have been obtained from unrelated third parties. As more fully described in ITEM 2. "PROPERTIES - Real Estate", the Trust is a partner with CMET in the Sacramento Nine and Adams Properties Associates partnerships. On December 10, 1990, the Trust's Board of Trustees, based on the recommendation of its Related Party Transaction Committee, authorized the purchase of up to $1.0 million of the shares of beneficial interest of CMET through negotiated or open market transactions. At December 31, 1993, the Trust owned 54,500 shares of beneficial interest of CMET which it purchased in 1990 and 1991 through open market transactions, at a total cost to the Trust of $250,000. At December 31, 1993, the aggregate market value of the CMET shares was $702,000. See ITEM 2. "PROPERTIES - Equity Investment in REIT." In December 1993, the Trust's Board of Trustees approved the issuance of a $1.0 million convertible subordinated debenture to Mr. Doyle, Trustee and Executive Vice President of the Trust since February 1994, in exchange for his 10% participation in the profits of the Consolidated Capital Properties II ("CCP II") assets, which the Trust had acquired in November 1992. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. The debenture bears interest at a rate of 6% per annum, matures in five years and is convertible into 76,923 of the Trust's shares of beneficial interest. Mr. Doyle also serves as Director, President and Chief Operating Officer and is a 50% shareholder of Tarragon Realty Advisors, Inc. ("Tarragon"), the Trust's advisor commencing April 1, 1994. See NOTE 4. "REAL ESTATE AND DEPRECIATION." In 1993, the Trust paid BCM and its affiliates $1.5 million in advisory fees, $21,000 in real estate and mortgage brokerage commissions and $360,000 in property management fees and leasing commissions. In addition, as provided in the Advisory Agreement, BCM received cost reimbursements from the Trust of $627,000 in 1993. Restrictions on Related Party Transactions The Trust's Declaration of Trust provides that: "(t)he Trustees shall not . . . purchase, sell or lease any Real Properties or Mortgages to or from . . . the Advisor or any of (its) Affiliates," and that "(t)he Trustees shall not . . . make any loan to . . . the Advisor or any of (its) Affiliates." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Restrictions on Related Party Transactions (Continued) Moreover, the Declaration of Trust further provides that: (t)he Trust shall not purchase or lease, directly or indirectly, any Real Property or purchase any Mortgage from the Advisor or any affiliated Person, or any partnership in which any of the foregoing may also be a general partner, and the Trust will not sell or lease, directly or indirectly, any of its Real Property or sell any Mortgage to any of the foregoing Persons." The Declaration of Trust further provides that "the Trust shall not directly or indirectly, engage in any transaction with any Trustee, officer or employee of the Trust or any director, officer or employee of the Advisor . . . or of any company or other organization of which any of the foregoing is an Affiliate, except for . . . (among other things) transactions with . . . the Advisor or Affiliates thereof involving loans, real estate brokerage services, real property management services, the servicing of Mortgages, the leasing of real or personal property, or other services, provided such transactions are on terms not less favorable to the Trust than the terms on which nonaffiliated parties are then making similar loans or performing similar services for comparable entities in the same area and are not entered into on an exclusive basis. The Declaration of Trust defines "Affiliate" as follows: (A)s to any Person, any other Person who owns beneficially, directly, or indirectly, 1% or more of the outstanding capital stock, shares, or equity interests of such Person or of any other Person which controls, is controlled by, or is under common control with, such Person or is an officer, retired officer, director, employee, partner, or trustee (excluding independent trustees not otherwise affiliated with the entity) of such Person or of any other Person which controls, is controlled by, or is under common control with, such Person. The Declaration of Trust further provides that: The Trustees shall not...invest in any equity Security, including the shares of other REITs for a period in excess of 18 months, except for shares of a qualified REIT subsidiary, as defined in Section 856(i) of the Internal Revenue Code, and regular or residual interests in REMICs...(or) acquire Securities in any company holding investments or engaging in activities prohibited by this Section... As discussed in "Related Party Transactions," above, since September 1990, the Trust has invested in shares of CMET. As of March 11, 1994, the Trust owned 54,500 shares of CMET. CMET has the same advisor as the Trust and certain of its Trustees are also trustees of CMET. As noted above, under the terms of its Declaration of Trust, the Trust is prohibited from investing in equity securities for a period in excess of 18 months. The Trust's shareholders approved an amendment to the Trust's Declaration of Trust allowing the Trust to hold these shares of CMET until July 30, 1996. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Restrictions on Related Party Transactions (Continued) All related party transactions that the Trust may enter into must be reviewed by the Related Party Transaction Committee of the Trust's Board of Trustees to determine whether such transactions are (i) fair to the Trust and (ii) are permitted by the Trust's governing documents. Each of the members of the Related Party Transaction Committee is a Trustee who is not an officer, director or employee of the Trust's advisor, BCM or Tarragon, and is not an officer or employee of the Trust. ____________________________________ PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Report: 1. Consolidated Financial Statements Report of Independent Certified Public Accountants Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Operations - Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity - Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules Schedule X - Supplementary Income Statement Information Schedule XI - Real Estate and Accumulated Depreciation Schedule XII - Mortgage Loans on Real Estate All other schedules are omitted because they are not applicable or because the required information is shown in the Consolidated Financial Statements or the notes thereto. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (Continued) 3. Exhibits The following documents are filed as Exhibits to this report: Exhibit Number Description - ------- ----------- 3.1 Second Amended and Restated Declaration of Trust (incorporated by reference to the Registrant's Current Report on Form 8- K dated August 14, 1987). 3.2 Amendment No. 1 to the Second Amended and Restated Declaration of Trust, (incorporated by reference to the Registrant's Current Report on Form 8-K dated July 5, 1989) reporting change in name of Trust. 3.3 Amendment No. 2 to the Second Amended and Restated Declaration of Trust, (incorporated by reference to the Registrant's Current Report on Form 8-K dated March 22, 1990,) reporting deletion of liquidation provisions. 3.4 Amendment No. 3 to the Second Amended and Restated Declaration of Trust, (incorporated by reference to the Registrant's Current Report on Form 8-K dated June 3, 1992) reporting the extension of the holding period of the Trust's marketable equity securities. 3.5 Restated Trustees' Regulations dated as of April 21, 1989, (incorporated by reference to the Registrant's Current Report on Form 8-K dated March 24, 1989). 10.1 Advisory Agreement dated as of December 1, 1992, between National Income Realty Trust and Basic Capital Management, Inc. (incorporate by reference to Exhibit No. 10.2 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.2 Brokerage Agreement dated as of December 1, 1992, between National Income Realty Trust and Carmel Realty, Inc. (incorporated by reference to Exhibit No. 10.3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.3 Advisory Agreement dated as of February 15, 1994, between National Income Realty Trust and Tarragon Realty Advisors, Inc. (incorporated by reference to Exhibit No. 10 to the Registrant's Current Report on Form 8-K dated February 10, 1994). ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (Continued) (b) Reports on Form 8-K. A Current Report on Form 8-K, dated November 10, 1993, was filed with respect to Item 5, which reports the confirmation of the Plan of Reorganization of the Century Centre II Office Building. A Current Report on Form 8-K, dated February 10, 1994, was filed with respect to Item 5, which reports the selection of Tarragon Realty Advisors, Inc. as the new advisor to the Registrant. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NATIONAL INCOME REALTY TRUST Dated: March 30, 1994 By: /s/ William S. Friedman William S. Friedman President, Chief Executive Officer and Trustee Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. By: /s/ Willie K. Davis By: /s/ A. Bob Jordan Willie K. Davis A. Bob Jordan Trustee Trustee By: /s/ John A. Doyle By: /s/ Raymond V. J. Schrag John A. Doyle Raymond V. J. Schrag Trustee and Executive Vice President Trustee By: By: /s/ Bennett B. Sims Geoffrey C. Etnire Bennett B. Sims Trustee Trustee By: /s/ William S. Friedman By: /s/ Ted P. Stokely William S. Friedman Ted P. Stokely President, Chief Executive Officer Trustee and Trustee By: /s/ Dan L. Johnston By: /s/ Carl Weisbrod Dan L. Johnston Carl Weisbrod Trustee Trustee By: /s/ Ivan Roth Ivan Roth Treasurer and Chief Financial Officer Dated: March 30, 1994

49071_1993.txt

49071

1993

ITEM 1. BUSINESS GENERAL Humana Inc. is a Delaware corporation organized in 1961. Its principal executive offices are located at 500 West Main Street, Louisville, Kentucky 40202, and its telephone number at that address is (502) 580-1000. As used herein, the term "the Company" includes Humana Inc. and its subsidiaries. On March 1, 1993, the Company separated its acute-care hospital and managed care health plan businesses into two independent publicly-held companies (the "Spinoff"). The Spinoff was effected through the distribution to Humana stockholders of record as of the close of business on March 1, 1993, of all of the outstanding shares of common stock of a new hospital company, Galen Health Care, Inc. ("Galen"). Galen was subsequently merged, through an unrelated transaction, with a subsidiary of Columbia Healthcare Corporation (now Columbia/HCA Healthcare Corporation) ("Columbia") and, therefore, became a wholly-owned subsidiary of Columbia. The Company continues to operate the managed care health plan business. In conjunction with the Spinoff, the Company changed its fiscal year end from August 31 to December 31. Since 1983, the Company has offered managed health care products which integrate financing and management with the delivery of health care services through a network of providers who share financial risk or who have incentives to deliver cost-effective medical services. These products are marketed primarily through health maintenance organizations ("HMOs") and preferred provider organizations ("PPOs") that encourage, and in most HMO products require, use of contracting providers. HMOs and PPOs also control health care costs by various other means, including the use of utilization controls such as pre-admission approval for hospital inpatient services and pre-authorization of outpatient surgical procedures. The HMO and PPO products of the Company are primarily marketed to employer and other groups ("Commercial") and Medicare-eligible individuals. The products marketed to Medicare-eligible individuals are either HMO products that provide health care services which include all Medicare benefits, and in certain circumstances, additional health care services that are not included in Medicare benefits ("Medicare risk") or indemnity insurance policies that supplement Medicare benefits ("Medicare supplement"). Since 1983, the growth in the Company's HMO business has been primarily attributable to acquisitions, while the growth in its PPO business has been exclusively from internally produced sales. COMMERCIAL PRODUCTS HMOs An HMO provides prepaid health care services to its members through primary care and specialty physicians employed by the HMO at facilities owned by the HMO, or through a network of independent primary care and specialty physicians and other health care providers who contract with the HMO or the primary care physician to furnish such services. Primary care physicians include internists, family practitioners and pediatricians. Generally, access to specialty physicians and other health care providers must be approved by the member's primary care physician. These other health care providers include, among others, hospitals, nursing homes, home health agencies, pharmacies, mental health and substance abuse centers, diagnostic centers, optometrists, outpatient surgery centers, dentists, urgent care centers, and durable medical equipment suppliers. Because access to these other health care providers must be approved by the primary care physician, the HMO product is the most restrictive form of managed care. At December 31, 1993, the Company owned and operated ten HMOs, which contract with approximately 27,400 physicians (including approximately 5,900 primary care physicians) and 480 hospitals. In addition, the Company has approximately 1,300 contracts with other providers to provide services to HMO members. The Company also employed approximately 450 physicians in its HMOs. An HMO member pays a monthly fee which generally covers, with minimal co-payments, health care services received or approved by the member's primary care physician. For the year ended December 31, 1993, Commercial HMO premium revenues totaled approximately $1.4 billion or 43 percent of the Company's premium revenues of $3.1 billion. Approximately $168 million of the Company's premium revenues for the year ended December 31, 1993, were derived from contracts with the United States Office of Personnel Management ("OPM") under which the Company provides health care benefits to approximately 122,700 federal civilian employees and their dependents. Pursuant to these contracts, payments made by OPM may be retrospectively adjusted downward by OPM if an audit discloses that a comparable product was offered by the Company to a similarly sized subscriber group using a rating formula which resulted in a lower premium rate than that offered to OPM. PPOs PPO products include many elements of managed health care. In a PPO, the enrollee is encouraged, through financial incentives, to use preferred health care providers which have contracted with the PPO to provide services at favorable rates. PPOs are also similar to traditional health insurance because they provide an enrollee with the freedom to choose a physician or other health care provider. At December 31, 1993, approximately 24,300 physicians and 480 hospitals contracted with the Company to provide services to PPO enrollees. In addition, the Company has approximately 1,300 contracts with other providers to provide services to PPO enrollees. For the year ended December 31, 1993, premium revenues from Commercial PPOs totaled $357 million or 11 percent of the Company's premium revenues of $3.1 billion. MEDICARE PRODUCTS Medicare is a federal program that provides persons age 65 and over and some disabled persons certain hospital and medical insurance benefits, which include hospitalization benefits for up to 90 days per incident of illness plus a lifetime reserve aggregating 60 days. Each Medicare eligible individual is entitled to receive inpatient hospital care (Part A) without the payment of any premium, but is required to pay a premium to the federal government, which is annually adjusted, to be eligible for physician and other services (Part B). Even though participating in both Part A and Part B of Medicare, beneficiaries are still required to pay certain deductible and co-insurance amounts. They may, if they choose, supplement their Medicare coverage by purchasing policies which pay these deductibles and co-insurance amounts. Many of these policies also cover other services (such as prescription drugs) which are not included in Medicare coverage. These policies are known as Medicare supplement policies. Certain managed care companies which operate HMOs contract with the federal government's Health Care Financing Administration ("HCFA") to provide medical benefits to Medicare-eligible individuals residing in the geographic areas in which their HMOs operate in exchange for a fixed monthly payment from HCFA per enrollee. Individuals who elect to participate in these Medicare risk programs are relieved of the obligation to pay some or all of the deductible or co-insurance amounts but are required to use exclusively the services provided by the HMO. Other than the Part B premium paid by the enrollee to the Medicare program, the enrollee does not pay the HMO a premium for these services except where the benefits provided by the HMO exceed the benefits provided by the Medicare program. Medicare Risk As discussed above, a Medicare risk product involves a contract between an HMO and HCFA pursuant to which HCFA makes a fixed monthly payment to the HMO on behalf of each Medicare-eligible individual who chooses to enroll for coverage by the HMO. Enrollment may be terminated by the member upon 30 days' notice. The fixed monthly payment is determined and adjusted annually by HCFA, and takes into account, among other things, the cost of providing medical care in the geographic area where the member resides. The Company markets a variety of Medicare risk HMO products. All of these products provide an enrolled individual with all of the benefits covered by the Medicare program but relieve the enrolled individual of the obligation to pay deductibles and co-insurance that would otherwise apply. Some of these products also provide additional benefits not covered by Medicare, such as vision and dental care services and prescription drugs. Where competitive conditions permit, the Company also charges a premium to members (in addition to the payment from HCFA) for some of the Medicare risk products. At December 31, 1993, approximately 73,300 members in nine markets were paying premiums which totaled $51 million for the year ended December 31, 1993. The Company provides Medicare risk services under seven contracts with HCFA ("HCFA Contracts") in 10 markets. At December 31, 1993, HCFA Contracts covered approximately 270,800 Medicare risk members for which the Company received HCFA revenues of approximately $1.2 billion or 40 percent of the Company's premium revenues for the year ended December 31, 1993, of $3.1 billion. At December 31, 1993, one such HCFA Contract covered approximately 210,000 members in Florida. For the year ended December 31, 1993, this Florida HCFA Contract accounted for $1 billion or 80 percent of the Company's HCFA revenues of approximately $1.2 billion or 32 percent of the Company's total premium revenues. Each HCFA Contract is renewed each December 31 unless HCFA or the Company terminates it upon at least 90 days' notice prior thereto. Management believes termination of the HCFA Contract covering the members in Florida would have a material adverse effect on the Company's revenues, profitability and business prospects. Moreover, changes in the Medicare risk program, such as reduction in payments by HCFA or mandated increases in benefits without corresponding increases in payments, could also have a material adverse effect on the Company's revenues, profitability and business prospects. Effective January 1, 1994, payments under the Company's HCFA Contracts increased by an average of approximately 3 percent. Although annual increases have varied significantly, increases have averaged approximately 7 percent over the last five years, including the increase of January 1994. Medicare Supplement The Company's Medicare supplement product is an insurance policy which pays for hospital deductibles, co-payments and co-insurance for which the Medicare program participant is responsible. Under the terms of existing Medicare supplement policies, the Company may not reduce or cancel the benefits contracted for by policyholders. These policies are annually renewable by the insured at the Company's prevailing rates, which may increase subject to approval by appropriate state insurance regulators. At December 31, 1993, the Company provided Medicare supplement benefits to approximately 153,600 members. Premium revenues derived from this product for the year ended December 31, 1993, totaled $132 million. PROVIDER ARRANGEMENTS The Company's HMOs contract with individual or groups of primary care physicians, generally for an actuarially determined, fixed, per-member-per-month fee called a "capitation" payment. These contracts typically obligate primary care physicians to provide or arrange for the provision of all covered health care services to HMO members, including health care services provided by specialty physicians and other health care providers. The capitation payment does not vary with the nature or extent of health care services arranged for or provided to the member and is generally designed to shift all or part of the HMO's financial risk to the primary care physician. However, the degree to which the Company shifts its risk varies by provider. The Company remains financially responsible for the provision of or payment for such health care services if a primary care physician fails to perform his or her obligations under the contract. The Company also employs 450 physicians in markets where it operates staff model HMOs. The Company is directly responsible for all health care services provided by these employed physicians. In order to control costs, improve quality and create comprehensive networks, the Company also contracts with medical specialists and other providers to which a primary care physician may refer a member. Typically, payments by the Company to these specialists and other providers reduce the ultimate payment that otherwise would be made to a primary care physician. The Company's HMOs and PPOs contract for hospital services generally under a per diem payment arrangement for inpatient hospital services and a discounted fee-for-service payment arrangement for outpatient services. The Company's PPOs contract on a per diem or discounted basis with other health care providers. Many of the physicians who contract with the Company's HMOs also contract with its PPOs to provide services to enrollees at discounted fees. In addition, in a number of markets the Company's PPOs contract with physicians who have not contracted with its HMOs. Physician participation in the Company's HMOs and PPOs is conditioned upon meeting its HMOs' and PPOs' requirements concerning the physician's professional qualifications. Effective with the consummation of the Spinoff, the Company entered into a three-year operating agreement with Galen whereby the Company will use the services of Galen's hospitals guaranteeing certain minimum utilization levels. The rate increases charged for such services are defined under the terms of the agreement. Commercial rate increases are limited to the lesser of the increase in the hospital Consumer Price Index or the Company's premium rate increases, less 1 percent. The Medicare risk rate increases are equal to the percentage adjustment in HCFA's market specific hospital payment rate to the Company. During the year ended December 31, 1993, 16 percent of the Company's total medical costs were incurred in Galen's hospitals. MARKETING Individuals become members of the Company's Commercial HMOs and PPOs through their employer or other groups which typically offer employees or members a selection of health care products, pay for all or part of the premiums and make payroll deductions for any premiums payable by the employees. The Company attempts to become an employer's or group's exclusive source of health care benefits by offering HMO and PPO products that provide cost-effective quality care consistent with the health care needs and expectations of the employees or members. The Company uses various methods to market its Commercial and Medicare products, including television, radio, telemarketing and mailings. At December 31, 1993, the Company used approximately 2,000 independent licensed brokers and agents and 160 licensed employees to sell its Commercial products. Many employer groups are represented by insurance brokers and consultants who assist these groups in the design and purchase of health care products. The Company generally pays brokers a commission based on premiums, with commissions varying by market and premium volume. At December 31, 1993, approximately 260 independent licensed brokers and 430 employed sales representatives, who are each paid a salary and/or per member commission, marketed the Company's Medicare products. The following table lists the Company's Commercial, Medicare risk and Medicare supplement membership at December 31, 1993, by market and product: - --------------- (1) Includes Dade, Broward and Palm Beach counties. The Company acquired an HMO in Washington, D.C., with approximately 125,000 members for $55 million on February 28, 1994. The Company's 25 largest group contracts at December 31, 1993, accounted for approximately 33 percent of total Commercial membership. No one group contract accounted for as much as 5 percent of the Company's Commercial product premium revenues; however, certain employer groups accounted for a significant percentage of Commercial insurance premiums in some markets. The loss of one or more of these contracts in a particular market could have a material adverse effect on the Company's operations in that market. CONTROL OF HEALTH CARE COSTS The focal point for cost control in the Company's HMOs is the primary care physician, whether employed or under contract, who provides services and controls utilization of services by directing or approving hospitalization and referrals to specialists and other health care providers. Cost control in the Company's PPOs is achieved through obtaining discounts from participating health care providers. With respect to both HMO and PPO products, cost control is further achieved through use of a utilization review system managed by the Company designed to reduce unnecessary hospital admissions and lengths of stay and unnecessary or inappropriate medical procedures. New technologies (which typically require substantial expenditures), inflation, increasing hospital costs and numerous other external factors may adversely affect the ability of the Company to control health care costs in the future. RISK MANAGEMENT Through the use of internally developed underwriting criteria, the Company determines the risk it is willing to assume and the amount of premium to charge for its Commercial products. Employer and other groups must meet the Company's underwriting standards in order to qualify to contract with the Company for coverage. Underwriting techniques are not employed in connection with Medicare risk HMO products because of HCFA regulations that require the Company to accept all eligible Medicare applicants regardless of their health or prior medical history. COMPETITION The health care benefit industry is highly competitive and contracts for the sale of Commercial products are generally bid or renewed annually. The Company's competitors vary by local market and include Blue Cross/Blue Shield (including HMOs and PPOs owned by Blue Cross/Blue Shield plans), national insurance companies and other HMOs and PPOs. Many of the Company's competitors have larger enrollments in local markets or greater financial resources. The Company's ability to sell its products and to retain customers is influenced by such factors as benefits, pricing, contract terms, number and quality of participating physicians and other health care providers, utilization review, claims processing and administrative efficiency. GOVERNMENT REGULATION Of the Company's 13 licensed HMO subsidiaries, six are qualified under the Federal Health Maintenance Organization Act of 1973, as amended. Four of these six subsidiaries are parties to HCFA Contracts to provide Medicare risk HMO products in 10 markets. An HMO which is federally qualified may require employers with more than 25 employees that offer health insurance benefits to include federally qualified HMO products as an option available to their employees. To obtain federal qualification, an HMO must meet certain requirements, including conformance with financial criteria, a standard method of rate setting, a comprehensive benefit package, and prohibition of medical underwriting of individuals. In certain markets, and for certain products, the Company operates HMOs that are not federally qualified because this provides greater flexibility with respect to product design and pricing than is possible for federally qualified HMOs. HCFA audits Medicare risk HMOs at least biannually and may perform other reviews more frequently to determine compliance with federal regulations and contractual obligations. These audits include review of the HMOs' administration and management (including management information and data collection systems), fiscal stability, utilization management and incentive arrangements, health services delivery, quality assurance, marketing, enrollment activity, claims processing and complaint systems. HCFA regulations require quarterly and annual submission of financial statements and restrict the number of Medicare risk enrollees to no more than the HMO's Commercial enrollment in a specified service area. HCFA regulations also require independent review of medical records and quality of care, review and approval by HCFA of all advertising, marketing and communication materials, and independent review of all denied claims and service complaints which are not resolved in favor of a member. Laws in each of the states in which the Company operates its HMOs and PPOs regulate its operations, including the scope of benefits, rate formula, delivery systems, utilization review procedures, quality assurance, enrollment requirements, claim payments, marketing and advertising. The PPO products offered by the Company are sold under insurance licenses issued by the applicable state insurance regulators. The Company's HMOs and PPOs are required to be in compliance with certain minimum capital requirements. These requirements must be satisfied by investing in approved investments that generally cannot be used for other purposes. Under state laws, the Company's HMOs and PPOs are audited by state departments of insurance for financial and contractual compliance, and its HMOs are audited for compliance with health services standards by respective state departments of health. Management believes that the Company is in substantial compliance with all governmental laws and regulations affecting its business. NATIONAL HEALTH CARE REFORM Congress is in the process of evaluating a number of legislative proposals that would effect major changes in the United States health care system. Among the proposals under consideration are government imposed cost controls, measures to increase the availability of group health insurance coverage to employees, and the creation of statewide health alliances that would cover individuals and families not enrolled in large employer health plans. Legislative reform is not anticipated before the latter part of 1994 and implementation of any reform package could take several additional years. In general, managed care is being considered as a means by which health care costs may be reduced. Although management believes the Company is well positioned to take advantage of the opportunities which will be afforded by national health care reform, it is not possible to predict the final form these proposals will take or the affect these proposals may have on the Company's operations. STATE HEALTH CARE REFORM During 1993, the State of Florida adopted health care reform legislation which, among other things, established a mechanism through which small employers and self-employed individuals may acquire health care coverage through state chartered non-profit entities known as Community Health Purchasing Alliances (CHPAs). It is intended the CHPAs will also be used to acquire insurance for state employees and Medicaid beneficiaries in the future. The legislation divides the state into 11 geographic areas and establishes a separate CHPA in each area. Humana intends to offer products in each of these geographic areas. In order to sell health care coverage to CHPA membership, an entity must register as an Accountable Health Partnership (AHP). An AHP may be either an insurer or an HMO and must specify in which geographic areas it wishes to offer its product. There are other requirements relating to organization, grievance procedures, terminations and product offerings for AHPs. Applicable Company HMOs and PPOs are in the process of registering as AHPs. Certain other states in which the Company operates are also actively pursuing health care reform; however, at this time it is not possible to predict the ultimate impact on the Company's operations. OTHER RELATED PRODUCTS The Company offers administrative services to employers who self-insure their employee health benefits. At December 31, 1993, the Company provided claims processing, utilization review and other administrative services to 40 self-insured employer groups, for approximately 63,700 employees and employee dependents. For the year ended December 31, 1993, revenues from these services totaled approximately $5 million. The Company operates a prescription drug management service which administers drug benefit programs for various HMOs and PPOs, including those of the Company. For the year ended December 31, 1993, prescription drug management service revenues from third-party customers totaled approximately $3 million. On June 30, 1993, the Company acquired the operations of a dental services company which provides dental products to employer groups, HMOs and PPOs, including those of the Company. Since the acquisition, dental service revenues from third-party customers totaled approximately $2 million. On March 3, 1994, the Company acquired a minority interest in a mental health HMO, which will provide services to the Company's members in certain markets as well as to third-party customers. OTHER BUSINESSES Hospital The Company operates a 170-bed hospital in Lexington, Kentucky, which was contributed to the Company by Galen in connection with the Spinoff. The hospital provides care primarily to members of the Company's managed care plans in Lexington. The Company is currently reviewing alternatives for the ultimate sale or third-party management of the hospital. Captive Insurance Company The Company insures substantially all professional liability risks through a wholly-owned subsidiary (the "Captive Subsidiary") which was incorporated in January 1993 in the State of Vermont. Previous to the Captive Subsidiary beginning operations in February 1993, professional liability risks were insured by a subsidiary of Galen. In connection with the Spinoff, the Captive Subsidiary and the Galen subsidiary entered into a loss portfolio reinsurance agreement whereby the Captive Subsidiary will indemnify the Galen subsidiary, subject to aggregate limits, against all liabilities incurred by the Galen subsidiary related to the professional liability risks of the Company prior to September 1, 1993. Centralized Management Services Centralized management services are provided to each health plan from the Company's headquarters. These services include management information systems, financing, personnel, development, accounting, legal advice, public relations, marketing, insurance, purchasing, risk management, actuarial, underwriting and claims processing. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries had approximately 8,800 full-time employees. ITEM 2.

ITEM 2. PROPERTIES The Company owns its principal executive office, which is located in the Humana Building, 500 West Main Street, Louisville, Kentucky 40202. The Company provides medical services in medical centers owned or leased ranging in size from approximately 1,200 to 80,000 square feet. The Company's administrative market offices are generally leased, with square footage ranging from 1,000 to 75,000. The following chart lists the location of properties used in the operation of the Company at December 31, 1993: In addition, the Company owns buildings in Louisville, Kentucky, and San Antonio, Texas, and leases a facility in Jacksonville, Florida, which are used for customer service and claims processing. The Louisville facility also performs enrollment processing and other corporate functions. The Company also owns a hospital and medical office building in Lexington, Kentucky. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS 1. A class action law suit styled Mary Forsyth, et al v. Humana Inc., et al, Case #CV-5-89-249-PMP(L.R.L.), was filed on March 29, 1989, in the United States District Court for the District of Nevada (the "Forsyth" case). The claims asserted by plaintiffs included an ERISA count seeking $49,440,000 of damages plus approximately $15,396,000 of interest, a RICO count seeking $103,562,165 of damages (before trebling) plus approximately $31,800,000 of interest, and an antitrust count for an unspecified amount of damages which appears to be similar to those sought in the RICO count. Despite allegations made by the plaintiffs, the Company considered the substance of these claims to be a dispute concerning the calculation of health insurance benefits and believed the claimed damages were greatly in excess of any possible recovery even if plaintiffs were successful on every claim asserted. On July 21, 1993, summary judgment was entered in favor of the Company on all counts, although the court granted the co-payer class until August 24, 1993, to file a third amended complaint in which its members could seek to recover the difference between their co-insurance payments and what those payments would have been if co-insurance obligations of the co-payer class had originally been based on the discounted payments made by Humana Health Insurance Company of Nevada to Sunrise Hospital and Medical Center, Las Vegas, Nevada, (now owned by Columbia). On August 24, 1993, a third amended complaint styled Marietta Cade, et al vs. Humana Health Insurance of Nevada, Inc., et al was filed seeking damages as described above. On January 28, 1994, summary judgment was entered in favor of plaintiffs on this third amended complaint. A subsequent hearing will ascertain the amount of damages suffered by the co-payer class. The Company believes the final resolution of this litigation will not have a material adverse effect on its operations or financial position. 2. On April 22, 1993, an alleged stockholder of the Company filed a purported shareholder derivative action in the Court of Chancery of the State of Delaware, County of New Castle, styled Lewis v. Austen, et al, Civil Action No. 12937. The action was purportedly brought on behalf of the Company and Galen against all of the directors of both companies at the time of the Spinoff alleging, among other things, that the defendants had improperly amended the Company's existing stock option plans in connection with the Spinoff. The plaintiff claims that the amendment to the stock option plans constituted a waste of corporate assets to the extent that employees of each company received options in the stock of the other company. (The challenged amendment to the plan was approved by the Company's stockholders at the 1993 Annual Meeting of Stockholders.) The plaintiff requests, among other things, an injunction prohibiting the exercise of Galen (now Columbia) stock options by the Company's personnel and the exercise of Company stock options by Galen (now Columbia) personnel and an award of damages. On June 14, 1993, the defendants filed a motion to dismiss the plaintiff's complaint. That motion is still pending. The Company believes that the complaint is without merit. Damages for claims for personal injuries and medical benefit denials are usual in the Company's business. Personal injury claims are covered by insurance from the Captive Subsidiary and excess carriers, except to the extent that claimants seek punitive damages, which may not be covered by insurance if awarded. Punitive damages generally are not paid where claims are settled and generally are awarded only where there has been a willful act or omission to act. The Company does not believe that any pending actions will have a material adverse effect on its consolidated financial condition. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE COMPANY Set forth below are names and ages of all of the current executive officers of the Company as of March 1, 1994, their positions, date of election to such position and the date first elected an officer of the Company: - --------------- (1) Elected an officer of a predecessor corporation in 1961. (2) Mr. Murray was appointed Controller of the Company at the time of the Spinoff, previous to which he served in the capacity of Vice President and Controller -- Health Plans since August 1990 and Controller -- Health Care Division since October 1989. From October 1985 to October 1989, he was a Certified Public Accountant with Coopers & Lybrand. Executive officers are elected annually by the Company's Board of Directors and serve until their successors are elected or until resignation or removal. There are no family relationships among any of the directors or executive officers of the Company, except that Mr. Jones is the father of David A. Jones, Jr., a director of the Company. Except for Mr. Murray, all of the above-named executive officers have been employees of the Company for more than five years. PART II Information for Items 5 through 8 of this Report which appears in the 1993 Annual Report to Stockholders as indicated on the following table is incorporated by reference in this report: ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item other than the information set forth in Part I under the Section entitled "EXECUTIVE OFFICERS OF THE COMPANY", is herein incorporated by reference from the Registrant's Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 1994, appearing under the caption "ELECTION OF DIRECTORS OF THE COMPANY FOR 1994" on pages 3 through 6 of the Proxy Statement. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is herein incorporated by reference from the Registrant's Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 1994, appearing under the caption "EXECUTIVE COMPENSATION OF THE COMPANY" on pages 9 through 15 of the Proxy Statement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is herein incorporated by reference from the Registrant's Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 1994, appearing under the caption "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS OF COMPANY COMMON STOCK" on pages 6 through 8 of the Proxy Statement. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (3) Exhibits: - --------------- * Exhibits 10(a) through and including 10(u) are compensatory plans or management contracts. (b) Reports on Form 8-K: No reports on Form 8-K were filed by the Company during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. HUMANA INC. By: /s/ W. ROGER DRURY ------------------------------------ W. Roger Drury Chief Financial Officer Date: March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders Humana Inc. We have audited the consolidated financial statements and the financial statement schedules of Humana Inc. as listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion. In our opinion the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Humana Inc. as of December 31, 1993, and 1992, and the consolidated results of operations and cash flows for the years ended December 31, 1993, December 31, 1992, August 31, 1992, and August 31, 1991, and for the four-month period ended December 31, 1992, in conformity with generally accepted accounting principles. In addition, in our opinion the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 2 to the consolidated financial statements, Humana Inc. adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", effective September 1, 1991, and the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", effective December 31, 1993. COOPERS & LYBRAND Louisville, Kentucky January 31, 1994 HUMANA INC. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN THOUSANDS) - --------------- (a) Noninterest bearing ; collateralized by deed of trust on personal residence; payable either in periodic installments or upon termination of employment, sale of residence or default on any collateral instrument having priority over Humana Inc.'s deed of trust. (b) Bears interest at the rate of three percent; collateralized by second mortgage on personal residence; payable upon sale of residence, termination of employment or default on any other financing arrangement which is secured by a mortgage on the residence. HUMANA INC. SCHEDULE III -- PARENT COMPANY FINANCIAL INFORMATION(A) CONDENSED BALANCE SHEET DECEMBER 31, 1993 AND 1992 (DOLLARS IN MILLIONS) - --------------- (a) Parent company financial information has been derived from the consolidated financial statements of the Company and excludes the accounts of all operating subsidiaries. This information should be read in conjunction with the consolidated financial statements of the Company. (b) In the normal course of business the parent company indemnifies certain of its subsidiaries for their health plan obligations. HUMANA INC. SCHEDULE III -- PARENT COMPANY FINANCIAL INFORMATION(A) CONDENSED STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) - --------------- (a) Parent company financial information has been derived from the consolidated financial statements of the Company and excludes the accounts of all operating subsidiaries. This information should be read in conjunction with the consolidated financial statements of the Company. HUMANA INC. SCHEDULE III -- PARENT COMPANY FINANCIAL INFORMATION(A) CONDENSED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) - --------------- (a) Parent company financial information has been derived from the consolidated financial statements of the Company and excludes the accounts of all operating subsidiaries. This information should be read in conjunction with the consolidated financial statements of the Company. HUMANA INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) Exhibit Index - --------------- * Exhibits 10(a) through and including 10(u) are compensatory plans or management contracts.

77943_1993.txt

77943

1993

ITEM 1. BUSINESS (a) General Development of Business. The general development -------------------------------- of the registrant's business for the fiscal year ended October 31, 1993, is set out in the registrant's 1993 Annual Report to Stockholders on pages 10 through 13 and is incorporated by reference herein. No material changes in the registrant's mode of doing business occurred during the five years ended October 31, 1993. (b) Financial information about Industry Segments. Industry ---------------------------------------------- segment data is set out in the registrant's 1993 Annual Report to Stockholders on pages 14-17 under the caption "1993 Operating Results", page 18 under the caption "Industry Segment Data", page 19 under the caption "Worldwide Operations" and page 28 under the caption "Segment Information", and is incorporated by reference herein. (c) Narrative Description of Business. ---------------------------------- 1) Specialty Chemical Segment. Specialty chemicals are --------------------------- produced primarily from petrochemicals and petroleum derived raw materials, and include demulsifiers, corrosion inhibitors, drilling fluids, polymers and waxes, water treating chemicals, and fuel and other additives. Sales for the three major product groupings within the specialty chemical segment (oil field chemicals, industrial chemicals, and industrial polymers and waxes) for each of the three years in the period ended October 31, 1993, are provided in the 1993 Annual Report to Stockholders on page 18 under the caption "Industry Segment Data" which is incorporated by reference herein. Registrant markets its products and services primarily to producers and transporters of crude oil and natural gas, related service companies and petroleum refineries throughout the world through the registrant's own field staff and a limited number of agents and distributors. The registrant also serves other major markets, such as adhesives, agribusiness, coatings, packaging, petrochemicals, plastics fabrication, power utilities, and printing inks. During the fiscal year ended October 31, 1993, there have been no significant changes in the kinds of products or services rendered, or in the markets or methods of distribution by registrant. It is the continuing nature of the business for a number of new or improved products to be introduced annually; typically, no individual new product or service by itself is expected to be significant immediately in sales or earnings. Registrant's joint business alliance with Energy BioSystems Corporation continues to make steady progress in its efforts to commercialize a breakthrough biocatalytic desulfurization (BDS) process for hydrocarbons. Registrant's participation has expanded to worldwide coverage at 22% of gross profits from biodesulfurization unit sales and fees. In return, registrant will provide development resources, separation technology, engineering know-how and ongoing customer service for all BDS units, worldwide. Registrant is dependent on the availability of petrochemicals and petroleum-derived raw materials and supplies, which have been available in the past in adequate quantities. In the past year, registrant's operations were not affected materially by any raw material shortages. Registrant presently does not foresee any shortage of materials in the near future. Registrant has numerous patents, patent applications, and licenses under patents, of various durations which, in the aggregate, are material to the operation of the registrant. The registrant, however, does not believe that expiration of any particular patent or group thereof would have a material adverse effect upon its business as a whole. The specialty chemical business is not considered to be seasonal. The registrant traditionally has carried sufficient inventory at various stages of production in order to respond quickly to the needs of its customers. Accounts receivable generally are due within thirty days of invoicing, and letters of credit are employed when deemed appropriate. The registrant believes that its practices are consistent with industry standards. Registrant's customers are located throughout the world and no one customer constitutes more than 10% of the registrant's business. Foreign operations account for a significant portion of the registrant's specialty chemical business. Non-U.S. revenues were approximately 32% of total specialty chemical revenues during each of the last three years. Orders from customers for specialty chemical products generally are filled from stock or manufactured within a few days or weeks after receipt of the order and, as a result, backlog of orders is not significant in relation to total annual dollar volume of sales. The registrant's specialty chemical product lines, oil field chemicals, industrial chemicals, and industrial polymers and waxes are in competition with a number of manufacturers. Competitive companies vary in size from large international companies to small companies which may compete with the registrant in the sale of one product or a line of products. All aspects of this business are considered to be very competitive. Registrant is recognized as a leader in providing services and products to the oil field chemical market. In the registrant's opinion, registrant's overall competitive position in the market has not changed materially in the past fiscal year, although registrant is unable to predict the extent to which its business may be affected by future competition or by consolidations within the industry. Information on acquisitions made by the registrant in fiscal 1993 is set out in the registrant's 1993 annual report on page 25 under the caption "Acquisitions" and is incorporated by reference herein. 2. Equipment Segment - The equipment segment designs, ----------------- installs and services processing equipment for petroleum, petrochemical and electrical power generating industries. Products and services are marketed both domestically and in foreign countries through the registrant's own field staff and a limited number of agents and distributors. During the past year the registrant has not had, and in the foreseeable future does not anticipate, any shortage of raw materials. Certain products of the equipment segment are covered under patents, patent applications, and licenses under patents. Registrant does not believe that expiration of any particular patent or group thereof would have a material adverse effect upon its business as a whole. The equipment segment business is not seasonal, but is subject to the business cycles of the industries which it serves. This segment primarily produces processing equipment upon order from customers. Accounts receivable generally are due within thirty days of invoicing, and letters of credit are employed when deemed appropriate. The registrant believes that its practices are consistent with industry standards. Registrant's customers are located throughout the world and no one customer constitutes a significant portion of the registrant's business on a continuing basis. However, one or several equipment contracts may represent a significant portion of the equipment segment revenues in a particular year. Foreign operations account for a significant portion of the registrant's equipment business. Non-U.S. revenues ranged from 40% to 67% of total equipment revenues during the last three years. The amount of backlog orders for the equipment segment at October 31, 1993, approximates $11.5 million. Substantially all of these orders are expected to be completed in fiscal 1994. Backlog orders as of October 31, 1992 were $8.7 million. The equipment segment is in competition with similar equipment and services offered by other competitors. Although, in registrant's opinion, registrant's competitive position in its equipment business has not changed materially in the past year, the registrant is unable to predict the extent to which its business may be affected by future competition. 3. Registrant's Business in General - The registrant expended -------------------------------- $13,587,000, $12,224,000, and $11,431,000, in fiscal years 1993, 1992 and 1991, respectively, on research activities relating to development of new products and services, and on improvement of existing products and services. Approximately 95% was applicable to the registrant's specialty chemical products segment. The registrant also continued its strong commitment to technology by continuing to increase its emphasis on field applications support which, when combined with the research and development amounts, resulted in total technology expenditures of $24,444,000, $21,764,000, and $20,474,000 in fiscal years 1993, 1992 and 1991, respectively. The registrant directly sponsors substantially all of its research activities. The registrant is subject to various federal, state and local laws and regulations concerning environmental matters. The registrant maintains a separate Safety, Health and Environmental Affairs Department charged with the responsibility of monitoring compliance with these various laws and regulations. For fiscal year 1993, these efforts did not result in any material capital expenditure or material charges to income, and it is not likely that these efforts will result in any material capital expenditure or material charges to income during fiscal year 1994. Approximately 2,012 persons are employed worldwide by registrant and its subsidiaries. (d) Financial Information About Foreign and Domestic ------------------------------------------------ Operations and Export Sales. Information under this caption is - ---------------------------- included in the registrant's 1993 Annual Report to Stockholders for each of the three years ended October 31, 1993, 1992, and 1991, respectively, on page 19 under the caption "Worldwide Operations" and is incorporated by reference herein. Substantially all of the registrant's non-U.S. sales are made to major international companies, national oil companies and utilities, and contractors and distributors of long standing. Letters of credit are required when and where appropriate. The risk attendant to the foreign business conducted by registrant and its subsidiaries is believed to be slightly greater than the risk involved in doing business within the United States. The registrant protects itself from potential losses due to foreign currency fluctuations through pricing adjustments, maintenance of offsetting asset and liability balances, and utilization of foreign currency futures contracts when deemed appropriate. ITEM 2.

ITEM 2. PROPERTIES All properties are owned by the registrant, except for the following: Sales office facilities located at 16010 Barker's Point Lane, Houston, Texas, are leased under an agreement which expires April 14, 1997. Petrolite Saudi Arabia Ltd. blending facilities are located on leased properties with the lease expiring 2002. Petrolite Pacific Pte. Ltd. blending facilities are located on leased properties with the lease expiring 2009. P.T. Petrolite Indonesia Patrama manufacturing facilities are located on leased property with the lease expiring in October, 2015. In addition to the foregoing properties, the registrant and its subsidiaries occupy a number of small general and sales offices under short- term leases and its subsidiaries occupy a number of distribution warehouses located on small sites owned in fee. Although facilities are of varying ages, the registrant considers them generally to be well maintained, equipped with modern and efficient equipment, and in good operating condition. Current productive capacity is adequate to meet demands for the immediate future. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Neither the registrant nor any of its subsidiaries is a party to, nor is any of their property subject to, any material pending legal proceedings, other than routine litigation incidental to the business. The registrant is subject to various laws and governmental regulations concerning employee safety and environmental matters. The registrant maintains a separate Safety, Health and Environmental Affairs Department charged with the responsibility of monitoring compliance with these various laws and regulations. The registrant currently participates, as a potentially responsible party and otherwise, with various governmental agencies concerning certain environmental cleanup sites. After consultation with environmental and engineering advisors, and legal counsel, the registrant does not believe that the registrant's participation at these sites, individually and collectively, is likely to result in the payment of any material sanctions, capital expenditures or charges to income. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of fiscal 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information regarding registrant's common stock appears on page 17 of the registrant's 1993 Annual Report to Stockholders under the caption "Stockholders' Equity/Capital Stock" and is incorporated by reference herein. As of January 7, 1994 the registrant has 2,093 stockholders of record. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA A summary of selected financial data for the five years ended 10/31/93 appears on pages 30 and 31 of the registrant's 1993 Annual Report to Stockholders under the caption "11-Year Summary", and is incorporated by reference herein. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information under this caption is in the registrant's 1993 Annual Report to Stockholders on pages 14 through 19, under the caption "Financial Review", and on pages 25 and 26 under the captions "Acquisitions, Short-Term Borrowings and Lines of Credit, and Long-Term Debt" and is incorporated by reference herein. The registrant continued its program to cease manufacturing operations at its Webster Groves, Missouri facility to coincide with an expansion of its La Porte, Texas facility. As and when such operations cease, the registrant expects that appropriate reserves will be established. This program will increase manufacturing capacity, efficiency and flexibility, and ultimately will allow for any necessary additions to sales, administrative and research facilities at Webster Groves. On January 27, 1993, the registrant announced that it adopted Statement of Financial Accounting Standard No. 106 related to medical and other postretirement benefits. The adoption of this rule resulted in a one-time, non-cash charge of $6.5 million, or $0.58 per share, to net income in fiscal 1993's first quarter ending January 31. During the first quarter of fiscal 1994, the registrant will adopt Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." Statement 109 will change the company's method of accounting for income taxes from the deferred method (APB 11) to an asset and liability approach. The estimated cumulative effect of implementing the new standard, using current tax rates, will be a one-time, non-cash credit of $2.0 million, or $0.18 per share, to net income in fiscal 1994's first quarter ending January 31. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated Financial Statements of the registrant and its subsidiaries, and the Notes to Consolidated Financial Statements, together with the report thereon of Price Waterhouse dated November 30, 1993, appearing on pages 20 through 29, the Quarterly Results on pages 15 and 16, Industry Segment Information on page 18, and Worldwide Operations Information on page 19 in the registrant's 1993 Annual Report to Stockholders, are incorporated by reference in this Form 10-K Annual Report. Marketable securities are stated at their approximate market value at October 31, 1993. The registrant's provision for bad debts was $395,000, $338,000, and $281,000, for fiscal years 1993, 1992, and 1991, respectively. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During the registrants three most recent fiscal years, there were no changes in or disagreements with the registrants independent accountants on accounting or financial disclosure. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT a) Identification of directors - Information regarding identification --------------------------- of directors, on pages 3 through 7 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, hereby is incorporated by reference. Also see information on page 32 of the registrant's Annual Report to Stockholders under the caption "Corporate Organization" which is incorporated by reference herein. c) Identification of certain significant employees - S. Monro joined ------------------------------------------------ the registrant in January 1978. After having served in various sales and managerial positions within International operations, in March of 1989 he was appointed Managing Director of Petrolite Ltd. In June 1991, he was also appointed to the position of General Manager of the newly created EuroChem Division. He holds various diplomas and degrees including a Licentiate in Chemistry, a chartered engineer and an M.B.A. degree in Management from the City University in London. David Winslett joined Petrolite in December of 1982 with 15 years of Refinery and Speciality Chemical experience. From 1982 to 1989 Winslett was Operations Manager for the European Industrial Chemicals business based in Kirkby, England. Since 1989, he has served in various capacities in Petrolite's St. Louis office as Vice President in the Industrial Chemicals Division until June 16, 1993 when he was promoted to General Manager of the Industrial Chemicals Division. Winslett is a graduate of the University of Wales with a B.Sc. (Honors) in Chemistry. d) Business experience - Information regarding business experience of ------------------- directors, on pages 5 and 6 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, hereby is incorporated by reference. Officers are elected to serve until removed or until a successor has been elected or appointed. Except as noted below, each of the officers in Item 10 (b) has served in his present office for at least five years. The following is a brief description of past positions of those officers who were elected to their present position within the last five years. Mr. W.E. Nasser has been an employee of the registrant since 1962. He served as Vice President and General Manager of Petrolite's Specialty Polymers from March 1980 until May 1988, when he was elected President and Chief Operating Officer. In February 1992, he also was elected Chairman of the Board and Chief Executive Officer. Dr. R.J. Churchill returned to the registrant July 1, 1989 as Vice President-Corporate Development. In June 1990, he became Vice President of Technology and in January 1993, he also was named to the position of Vice President, Marketing. In December, 1993, he was appointed Vice President-Special Projects. He served the registrant in various research and management positions before leaving in 1981 to head his own management consulting firm. He holds a Ph.D. in sanitary engineering. Dr. T.R. Graves has been an employee of the registrant since 1972, and served as technical director of the registrant's Specialty Polymers Group from 1980 until June 1988,when he was elected Vice President and General Manager of such Group (now the Polymers Division). He holds a Ph.D in chemical engineering. Mr. J.F. McCartney has served as Assistant General Counsel since joining the registrant in 1973, managing legal aspects of the registrants international operations, primarily working to establish subsidiaries, affiliates and joint venture companies worldwide. He was named Vice President in August 1989. During July 1992, he also assumed responsibility for the administration of the Law Department and now is Vice President, General Counsel. Mr. E.E. Schooling joined the Registrant in February 1968, and has served in various plant manager positions. Most recently he was manufacturing manager before his July 1, 1991 promotion to the position of Vice President - Manufacturing/Distribution. Mr. W.F. Haberberger joined the Registrant in October 1977, as an internal auditor. Since 1980, he has served in various financial managerial positions of the registrant's international operations until his election to Controller on March 4, 1991. He holds a B.S. degree in Business from the University of Missouri - St. Louis and is a certified public accountant. Mr. S.F. Schaab joined the registrant in November 1992, and was elected Treasurer effective January 1, 1993. He has 19 years of experience in financial and treasury management, most recently with Peabody Holding Company, Inc. A certified public accountant, he holds a B.S.B.A. degree in accounting from the University of Missouri-Columbia. Mr. C.R. Miller joined the registrant in May 1990, as an attorney, and was elected Secretary on August 12, 1992. His title now is Corporate Secretary, Associate General Counsel. He has twelve years experience in the public and private practice of law, most recently as an attorney in the executive branch of Missouri state government. Derek Redmore joined Petrolite as a research chemist in 1965 and was promoted to group Leader in 1966. From 1972 to 1993, he held various managerial positions with increasing responsibility in Research and Development, most recently Director of Technology Support. In December 1993, he was elected Vice President, Technology. Redmore earned his B.Sc. and Ph.D. degrees in Organic Chemistry at the University of Nottingham. e) Compliance with Section 16(a) of the Exchange Act. Information -------------------------------------------------- regarding compliance with Section 16(a) of the Exchange Act, on page 14 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, hereby is incorporated by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information appearing under Compensation of Executive Officers, Retirement Benefits, and Compensation of Directors' on pages 10 through 14 of the registrant's Notice of Annual Meeting and Proxy statement dated January 20, 1994 is incorporated by reference herein. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership is set out on pages 3 and 4 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, under the heading "Security Ownership of Certain Beneficial Owners and Management", is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information appearing under Certain Transactions on page 7 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994 is incorporated by reference herein. PART IV b) No form 8-K's were filed with SEC during the fourth quarter of fiscal 1993. Individual financial statements of the registrant's subsidiaries have been omitted since the registrant is primarily an operating registrant and the operating subsidiaries included in the consolidated financial statements, in the aggregate, do not have minority equity interest and/or indebtedness to any person other than the registrant or its consolidated subsidiaries in amounts which together exceed 5 percent of total consolidated assets at October 31, 1993. Separate financial statements of subsidiaries not consolidated, and 50% or less owned entities (accounted for by the equity method) have been omitted because, if considered in the aggregate, they would not constitute a significant subsidiary. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PETROLITE CORPORATION --------------------- (Registrant) By s/ Herbert F. Eggerding, Jr. ------------------------------ Herbert F. Eggerding, Jr. Executive Vice President and Chief Financial Officer Dated: January 26, 1994 ---------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By s/ William E. Nasser By s/ Herbert F. Eggerding, Jr. -------------------------------------- ------------------------------- William E. Nasser Herbert F. Eggerding, Jr. Principal Executive Officer Principal Financial Officer and Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ Andrew B. Craig * By s/ William F. Haberberger --------------------------------------- ------------------------------- Andrew B. Craig, Director William F. Haberberger Principal Accounting Officer Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ Paul F. Cornelsen* By s/ Louis Fernandez* -------------------------------------- ------------------------------- Paul F. Cornelsen, Director Louis Fernandez, Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ Michael V. Janes* By s/ James E. McCormick* -------------------------------------- ------------------------------ Michael V. Janes, Director James E. McCormick, Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ William E. Maritz* By s/ Thomas P. Reidy* --------------------------------------- ----------------------------- William E. Maritz, Director Thomas P. Reidy, Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- *By: s/ Charles R. Miller ------------------------------------- Charles R. Miller Attorney-In-Fact REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- ON FINANCIAL STATEMENTS SCHEDULES --------------------------------- To the Directors of Petrolite Corporation Our audits of the consolidated financial statements referred to in our report dated November 30, 1993 appearing on page 29 of the Petrolite Corporation 1993 Annual Report to Stockholders (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. s/ Price Waterhouse PRICE WATERHOUSE St. Louis, Missouri November 30, 1993 CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We hereby consent to the incorporation by reference in the Prospectuses constituting part of the registration statements on Form S-8 (Nos. 2-80631, 33- 20553, 33-21962, 33-24261, 33-63108, 33-47814, 33-47815, and 33-63108) of Petrolite Corporation of our report dated November 30, 1993 appearing on page 29 of the Petrolite Corporation 1993 Annual Report to Stockholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page 19 of this Form 10-K. s/ Price Waterhouse PRICE WATERHOUSE St. Louis, Missouri January 26, 1994 ***************** Major capital expenditures in fiscal 1993, 1992, and 1991 included property, plant and equipment from the Welchem acquisition, a new information system principally to serve the Tretolite and Industrial Chemicals Divisions, continuing expansion and upgrading of the Bayport Chemical manufacturing plant, investments in bulk containers and related distribution facilities, and a new EuroChem Division office building in Kirkby, England. Depreciation is generally provided on a straight-line basis at rates based on estimated useful lives of properties.

67686_1993.txt

67686

1993

ITEM 1. BUSINESS. Monsanto Company and its subsidiaries are engaged in the worldwide manufacture and sale of a widely diversified line of agricultural products; chemical products, including plastics and manufactured fibers; pharmaceuticals; and food products, including low-calorie sweeteners. Monsanto Company was incorporated in 1933 under Delaware law and is the successor to a Missouri corporation, Monsanto Chemical Works, organized in 1901. Unless otherwise indicated by the context, "Monsanto" means Monsanto Company and consolidated subsidiaries, and the "Company" means Monsanto Company only. RECENT DEVELOPMENTS In May, 1993, Monsanto purchased the assets, including working capital, of the Ortho Consumer Products Division of Chevron Chemical Company. See "Principal Acquisitions and Divestitures" on page 44 of the 1993 Annual Report. INDUSTRY SEGMENTS; PRINCIPAL PRODUCTS For 1993, Monsanto reported its business under four industry segments: The Agricultural Group, The Chemical Group, Searle, and NutraSweet. The first two segments constitute, respectively, the business of The Agricultural Group and The Chemical Group, both of which are operating units of Monsanto. Searle reflects the consolidated business of G. D. Searle & Co., and NutraSweet reflects the consolidated business of The NutraSweet Company, both of which are wholly owned subsidiaries of the Company. The tabular information appearing under "Operating Unit Segment Data" and "Geographic Data" on pages 27 and 34 of the 1993 Annual Report is incorporated herein by reference. SALE OF PRODUCTS Monsanto's products are sold directly to customers in various industries, to wholesalers and other distributors and jobbers, to retailers and to the ultimate consumer, principally by its own sales force, or, in some cases, through third parties. With respect to pharmaceuticals, such sales force concentrates on detailing to physicians and managed health care providers. As indicated on page 35 of the 1993 Annual Report, Monsanto's net income is historically higher during the first half of the year, primarily because of the concentration of generally more profitable sales of The Agricultural Group during that part of the year. Monsanto's marketing and distribution practices do not result in unusual working capital requirements on a consolidated basis, although the seasonality of sales of The Agricultural Group segment sometimes results in short-term borrowings to finance the customer accounts receivable and inventories. Inventories of finished goods, goods in process and raw materials are maintained to meet customer requirements and Monsanto's scheduled production. In general, Monsanto does not manufacture its products against a backlog of firm orders; production is geared primarily to the level of incoming orders and to projections of future demand. Monsanto generally is not dependent upon one or a group of customers. The NutraSweet segment, however, makes a majority of its sales to a few companies for use in carbonated soft drinks. Monsanto has no material contracts with the government of the United States or any state, local or foreign government. However, pursuant to contracts executed under U.S. federal and state laws, Monsanto's Searle segment pays rebates to state governments for pharmaceuticals sold under state Medicaid programs and under state-funded programs for the indigent. The Searle segment also grants discounts to certain managed health care providers. Introduction of new products by The Agricultural Group, Searle and NutraSweet segments is typically subject to prior review and approval by the U.S. Food & Drug Administration, the U.S. Environmental Protection Agency and/or the U.S. Department of Agriculture (or comparable agencies of ex-U.S. governments) before they can be sold. Such reviews are often time-consuming and costly. These agencies also have continuing jurisdiction over many existing products of these segments. RAW MATERIALS AND ENERGY RESOURCES Monsanto is both a producer and significant purchaser of a wide spectrum of its basic and intermediate raw material requirements. Major requirements for key raw materials and fuels are typically purchased pursuant to long-term contracts. Monsanto is not dependent on any one supplier for a material amount of its raw materials or fuel requirements, but certain important raw materials are obtained from a few major suppliers. In general, where Monsanto has limited sources of raw materials, it has developed contingency plans to minimize the effect of any interruption or reduction in supply. Information with respect to specific raw materials is set forth in the table above under "Industry Segments; Principal Products." While temporary shortages of raw materials and fuels may occasionally occur, these items are sufficiently available to cover current and projected requirements. However, their continuing availability and price are subject to unscheduled plant interruptions occurring during periods of high demand, or due to domestic and world market and political conditions, as well as to the direct or indirect effect of U.S. and other countries' government regulations. The impact of any future raw material and energy shortages on Monsanto's business as a whole or in specific world areas cannot be accurately predicted. Operations and products may, at times, be adversely affected by legislation, shortages or international or domestic events. PATENTS, TRADEMARKS, LICENSES, FRANCHISES AND CONCESSIONS Monsanto owns a large number of patents which relate to a wide variety of products and processes, has pending a substantial number of patent applications, and is licensed under a small number of patents of others. Also, Monsanto owns a considerable number of established trademarks in many countries under which it markets its products. Monsanto's patents and trademarks in the aggregate are of material importance in the operation of its business, particularly in The Agricultural Group and Searle segments and with respect to NutraSweet(R) brand sweetener. Certain proprietary products such as Roundup(R) herbicide are covered by patents. Although patents protecting Roundup(R) herbicide have now expired in most countries, compound per se patent protection for the active ingredient in Roundup herbicide continues in the United States into the year 2000. All patents covering the use of aspartame as a sweetener have expired. NutraSweet(R) brand sweetener is currently manufactured under several patents owned by The NutraSweet Company and patented processes licensed from a third party for the duration of the applicable patents. Calan(R) SR, an antihypertensive pharmaceutical, is licensed through the year 2004 to Searle by a third party, which has retained co-marketing rights. The product no longer has patent protection nor non-patent market exclusivity conferred by the Waxman-Hatch amendments to the U.S. Food, Drug and Cosmetics Act. The trademarks "Equal(R)," "Canderel(R)" and "NutraSweet" and the NutraSweet symbol are protected by registration in the United States and in other countries where the products are marketed. Roundup herbicide, Calan SR antihypertensive and NutraSweet brand sweetener are each substantial contributors to earnings. Monsanto holds (directly or by assignment) numerous phosphate leases, which were issued on behalf of or granted by the United States, political subdivisions of various states, or private parties. None of these leases taken individually is deemed by Monsanto to be material, although Monsanto's phosphate leases in the aggregate are significant to The Chemical Group segment of its business. Monsanto's phosphate leases have varying terms, with leases obtained from the United States being of indefinite duration subject to the modification of lease terms at twenty-year intervals. COMPETITION Monsanto encounters substantial competition in each of its industry segments. This competition, from other manufacturers of the same products and from manufacturers of different products designed for the same uses, is expected to continue in both U.S. and ex-U.S. markets. Depending on the product involved, various types of competition are encountered, including price, delivery, service, performance, product innovation, product recognition and quality. The number of Monsanto's principal competitors varies from product to product. It is not practical to discuss Monsanto's numerous competitors because of the large variety of Monsanto's products, the markets served and the worldwide business interests of Monsanto. Overall, however, Monsanto regards its principal product groups to be competitive with many other products of other producers and believes that it is an important producer of many of such product groups. RESEARCH AND DEVELOPMENT Research and development constitute an important part of Monsanto's activities. See "Operating Unit Segment Data" on page 27 of the 1993 Annual Report, incorporated herein by reference. ENVIRONMENTAL MATTERS Monsanto is subject to various laws and government regulations concerning environmental matters, employee safety and employee health in the United States and other countries. It is anticipated that increasingly stringent requirements will be imposed upon Monsanto, its competitors and industry in general. U.S. federal environmental legislation having particular impact on Monsanto includes the Toxic Substances Control Act; the Federal Insecticide, Fungicide and Rodenticide Act; the Resource Conservation and Recovery Act; the Clean Air Act; the Clean Water Act; the Safe Drinking Water Act; and the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA," commonly known as "Superfund"), as amended by the Superfund Amendments and Reauthorization Act ("SARA"). Monsanto is also subject to the Occupational Safety and Health Act and regulations of the Occupational Safety and Health Administration ("OSHA") concerning employee safety and health matters. The Environmental Protection Agency ("EPA"), OSHA and other federal agencies have the authority to promulgate regulations which have an impact on Monsanto's operations. In addition to these federal activities, various states have been delegated certain authority under the aforementioned federal statutes. Many state and local governments have adopted environmental and employee safety and health laws and regulations, some of which are similar to federal requirements. State and federal authorities may seek fines and penalties for violation of these laws and regulations. Monsanto is dedicated to a long-term environmental protection program that reduces emissions of hazardous materials into the environment, as well as to the remediation of identified existing environmental concerns. In 1988, management committed to a 90 percent reduction in toxic air emissions from worldwide operations by the end of 1992, including emissions reportable in the U.S. under Title III of SARA. The reduction achieved was 92 percent, based on 1992 year-end operating rates. The cost to accomplish this target did not materially affect operating results. In fact, some of the target capital projects lowered operating costs and improved operating efficiency. Expenditures in 1993 were approximately $53 million for environmental capital projects and approximately $234 million for management of environmental programs, including the operation and maintenance of facilities for environmental control. Monsanto estimates that during 1994 and 1995 approximately $40 million-$70 million per year will be spent on additional capital projects for environmental protection. Monsanto periodically receives notices from the EPA that it is a potentially responsible party ("PRP") under Superfund. The EPA has designated Monsanto as a PRP at 89 Superfund sites. Monsanto has resolved disputes, entered partial consent decrees, and executed administrative orders between Monsanto and the EPA in 41 of these cases, settling a portion or all of Monsanto's liability for these Superfund cases. Six other matters involve sites where allegations are predicated on tentative findings of reuse of drums by others that once contained products sold by Monsanto. These six matters have been inactive as to Monsanto for at least nine years. At one other site, Monsanto has determined that it has no liability whatsoever. Monsanto's policy is to accrue costs for remediation of waste disposal sites in the accounting period in which the responsibility is established and the cost is estimable. Monsanto's estimates of its liabilities for Superfund sites are based on evaluations of currently available facts with respect to each individual site and take into consideration factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. These liabilities have not been reduced for any claims for recoveries from insurance or from third parties. However, Monsanto is engaged in litigation with some of its insurance carriers regarding both the applicability and the amount of its coverage responsive to claims for damages at these sites. Monsanto has an accrued liability of $102 million as of December 31, 1993, for Superfund sites. As assessments and remediation activities progress at individual sites, these liabilities are reviewed periodically and adjusted to reflect additional technical, engineering and legal information that becomes available. Major sites in this category include the noncompany-owned Brio, Fike/Artel, Motco and Woburn sites which account for $83 million of the accrued amount. Monsanto's estimate of its Superfund liability is affected by several uncertainties such as, but not limited to, the method and extent of remediation, the percentage of material attributable to Monsanto at the sites relative to that attributable to other parties, and the financial capabilities of the other PRPs at most sites. Due to these uncertainties, primarily related to the method and extent of remediation, potential future expenses could be as much as $30 million for these sites. These potential future expenses may be incurred over the balance of the decade. There are various other lawsuits, claims and proceedings that state agencies and others have asserted against the Company seeking remediation of alleged environmental impairments. Monsanto is in the process of determining its involvement, if any, at 44 of these sites. Monsanto has an accrued liability of $131 million as of December 31, 1993, for these matters and for environmental reserves at certain former Monsanto plant sites. The Company's estimate of its liability related to these sites is affected by several uncertainties such as, but not limited to, the extent of Monsanto's involvement, and the method and extent of remediation. Due to these uncertainties, potential future expenses could be as much as $70 million for these sites. Four sites in this category account for $63 million of the accrued amount and for approximately $60 million of the potential future expenses. Monsanto spent $39 million in 1993 for remediation of Superfund and other waste disposal sites. Most of these expenditures related to The Chemical Group, and similar or greater amounts can be expected in future years. For operational facilities, Monsanto recognizes post-closure environmental costs and site remediation costs over the estimated remaining useful life of the related facilities, not to exceed 20 years. Monsanto spent $14 million in 1993 for remediation of these facilities and has an accrued liability of $33 million as of December 31, 1993, for these sites. Uncertainties related to these costs are evolving government regulations, the method and extent of remediation, and future changes in technology. Monsanto's estimated closure costs for these plant sites are approximately $150 million. While the ultimate costs and results of remediation of waste disposal sites cannot be predicted with certainty, management believes that Monsanto's liquidity and profitability in any one year will not be materially affected. EMPLOYEE RELATIONS As of December 31, 1993, Monsanto had approximately 30,000 employees worldwide. Satisfactory relations have prevailed between Monsanto and its employees. INTERNATIONAL OPERATIONS Monsanto and affiliated companies are engaged in manufacturing, sales and/or research and development in the United States, Europe, Canada, Latin America, Australia, Asia and Africa. A large number of products are manufactured abroad. Monsanto's ex-U.S. operations are subject to a number of potential risks and limitations, such as: fluctuations in currency values; exchange control regulations; wage and price controls; approvals of therapeutic claims and pricing for pharmaceutical and other products; governmental regulation of food ingredients, agricultural and pharmaceutical products and biotechnology; employment regulations; import, export and trade restrictions, including embargoes; raw material supply constraints; governmental instability, civil disorders, civil wars and other hostilities; and other potentially detrimental domestic and foreign governmental practices or policies affecting U.S. companies doing business abroad. See "Geographic Data" on page 34 of the 1993 Annual Report, incorporated herein by reference. LEGAL PROCEEDINGS Because of the size and nature of its business, Monsanto is a party to numerous legal proceedings. Most of these proceedings have arisen in the ordinary course of business and involve claims for money damages. While the results of litigation cannot be predicted with certainty, Monsanto does not believe these matters or their ultimate disposition will have a material adverse effect on Monsanto's financial position. On April 12, 1985, the Company was named as a defendant in the first of a number of lawsuits in which plaintiffs claim injuries resulting from alleged exposure to substances present at or emanating from the Brio Superfund site near Houston, Texas. The Company is one of a number of companies that had sold materials to the chemical reprocessor at that site. Currently pending against the Company are the following matters: (a) The Company is one of a number of defendants in 14 cases brought in Harris County District Court on behalf of 751 plaintiffs who own homes or live in the Southbend or Sageglen subdivisions, attended school in the Southbend subdivision, or used nearby recreational baseball fields. Plaintiffs claim to have suffered various personal injuries and fear future disease; the need for medical monitoring; and, in the case of the homeowners, property damage. In addition to their claims of personal injury, four plaintiffs in one of these cases allege business losses. Plaintiffs seek compensatory and punitive damages in an unspecified amount. (b) The Company is also a defendant in two additional cases brought in Harris County District Court. The first case is brought by two recreational baseball leagues which claim to have suffered property damage and consequential damages. Plaintiffs seek compensatory and punitive damages in an unspecified amount. The second case is brought on behalf of the Clear Creek Independent School District for property damage and consequential damages. Plaintiff seeks compensatory and punitive damages in an unspecified amount. (c) The Company is one of a number of defendants in two additional actions brought in Harris County District Court by 407 plaintiffs, who are former employees of the owners/operators of the Brio site, persons who worked near the Brio site, Sageglen subdivision residents, and members of the employees' and residents' families. Plaintiffs claim physical and emotional injury and seek compensatory and punitive damages in an unspecified amount. The Company believes that it has meritorious defenses to all of these lawsuits including lack of proximate cause, lack of negligent or other improper conduct on the part of the Company, and negligence of plaintiffs (or their parents) and/or of builders and developers of the Southbend subdivision. The Company is vigorously defending these actions. In 1974, Searle introduced in the United States an intrauterine contraceptive product, commonly referred to as an intrauterine device ("IUD"), under the name Cu-7(R). Following extensive testing by Searle and review by the FDA, the Cu-7 was approved for sale as a prescription drug. Searle has been named a defendant in a number of product liability lawsuits alleging that the Cu-7 caused personal injury resulting from pelvic inflammatory disease, perforation, pregnancy or ectopic pregnancy. As of March 1, 1994, there were approximately 124 cases pending in various U.S. state and federal courts and approximately 361 cases filed outside the United States (the vast majority in Australia). The lawsuits seek damages in varying amounts, including compensatory and punitive damages, with most suits seeking at least $50,000 in damages. Searle believes it has meritorious defenses and is vigorously defending each of these lawsuits. On January 31, 1986, Searle voluntarily discontinued the sale of the Cu-7 in the United States, citing the cost of defending such litigation. The Company registered, on June 27, 1991, for the Compliance Audit Program ("CAP") administered by the EPA under the authority of Section 8(e) of the Toxic Substances Control Act ("TSCA"). It has been reported that over 120 companies in the United States registered for the CAP. The CAP requires registrants to audit health and environmental effect information in order to determine whether information in the registrant's possession is reportable to the EPA under TSCA Section 8(e). A registrant's liability, under the CAP, for late reporting of information under TSCA 8(e), will be assessed on the basis of a set amount per study submitted with the total liability not to exceed $1,000,000. The Company voluntarily entered into a similar Consent Agreement with the EPA before the CAP, and under that Agreement performed a more limited audit than is required by the CAP and paid a settlement of $648,000. This settlement amount has been credited to the Company under the CAP. It has now been determined that the Company's remaining liability under the CAP will be $352,000. RISK MANAGEMENT Monsanto continually evaluates risk retention and insurance levels for product liability, property damage and other potential areas of risk. Monsanto devotes significant effort to maintaining and improving safety and internal control programs, which reduce its exposure to certain risks. Based on the cost and availability of insurance and the likelihood of a loss, management determines the amount of insurance coverage to be purchased from unaffiliated companies and the appropriate amount of risk to retain. Since 1986, Monsanto's liability insurance has been on the "claims made" policy form. Management believes that the current levels of risk retention are consistent with those of other companies in the various industries in which Monsanto operates. There can be no assurance that Monsanto will not incur losses beyond the limits of, or outside the coverage of, its insurance. However, Monsanto's liquidity, financial position and profitability are not expected to be affected materially by the levels of risk retention that the Company accepts. ITEM 2.

ITEM 2. PROPERTIES. The General Offices of the Company are located on a 285-acre tract of land in St. Louis County, Missouri. The Company also owns a 210-acre tract in St. Louis County on which additional research facilities are located. Monsanto also has research laboratories and technical centers throughout the world. Information with respect to Monsanto's manufacturing locations worldwide and the industry segments which use such plants as of January 1, 1994, is set forth under "Business-Industry Segments; Principal Products" in Item 1 of this Report, which is incorporated herein by reference. Monsanto's principal plants are suitable and adequate for their use. Utilization of these facilities may vary with seasonal, economic and other business conditions, but none of the principal plants is substantially idle. The facilities generally have sufficient capacity for existing needs and expected near-term growth. Most of these plants are owned in fee. However, the land at the Antwerp, Belgium plant is leased. In addition, a portion of a plant at Augusta, Georgia is currently leased with an option to purchase, pursuant to an industrial revenue bond financing. The Company has granted leases, with options to purchase, on approximately 366 acres of the 3,000 acres at the Alvin, Texas plant site. In limited instances, Monsanto has granted leases on portions of other plant sites not required for current operations. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. For information concerning certain legal proceedings involving Monsanto, see "Business-Environmental Matters" and "Business-Legal Proceedings" contained in Item 1 of this Report. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to the security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT. Information regarding executive officers is contained in Item 10 of Part III of this Report (General Instruction G) and is incorporated herein by reference. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The narrative or tabular information regarding the market for the Company's common equity and related stockholder matters appearing under "Review of Cash Flow" on pages 39 through 41 and "Quarterly Data" on page 35 of the 1993 Annual Report is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The tabular information under "Financial Summary-Operating Results, Earnings per Share and Year-End Financial Position" and the amounts of Dividends per Share, all appearing on page 52 of the 1993 Annual Report, are incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The tabular and narrative information appearing under "Review of Consolidated Results of Operations" on pages 23 through 26, "Operating Unit Segment Data" on pages 27 through 33, "Review of Changes in Financial Position" on page 37, and "Review of Cash Flow" on pages 39 through 41 of the 1993 Annual Report is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of Monsanto appearing on pages 22, 36, 38, 42 and 43 through 51; the Independent Auditors' Opinion appearing on page 21; and the tabular and narrative information appearing under "Quarterly Data" on page 35 of the 1993 Annual Report are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The above-listed individuals are elected to the offices set opposite their names to hold office until their successors are duly elected and have qualified, or until their earlier death, resignation or removal. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Information appearing under "Directors' Fees and Other Arrangements" on page 8 and under "Executive Compensation" on pages 12 through 16 of the 1994 Proxy Statement is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information appearing under "Stock Ownership of Management and Certain Beneficial Owners" on pages 5 and 6 of the 1994 Proxy Statement is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Report: 1. The financial statements set forth at pages 22, 36, 38, 42 and 43 through 51 of the 1993 Annual Report (See Exhibit 13 under Paragraph (a)3 of this Item 14) 2. Financial Statement Schedules The following supplemental schedules for the years ended December 31, 1993, 1992 and 1991: V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment VII - Guarantees of Securities of Other Issuers (December 31, 1993, only) VIII - Valuation and Qualifying Accounts IX - Short-Term Borrowings X - Supplementary Income Statement Information All other supplemental schedules are omitted because of the absence of the conditions under which they are required. 3. Exhibits - See the Exhibit Index at page 24 of this Report. For a listing of all management contracts and compensatory plans or arrangements required to be filed as exhibits to this Form 10-K, see the Exhibits listed under Exhibit No. 10(iii) on pages 24-27 of the Exhibit Index which were previously filed. The following Exhibits listed in the Exhibit Index are filed with this Report: 13 The Company's 1993 Annual Report to shareowners 21 Subsidiaries of the registrant (See page 29) 23(ii) 1. Consent of Independent Auditors (See page 30) 2. Consent of Company Counsel (See page 30) 24 1. Powers of attorney submitted by Joan T. Bok, Robert M. Heyssel, Gwendolyn S. King, Philip Leder, Howard M. Love, Richard J. Mahoney, Frank A. Metz, Jr., Buck Mickel, Jacobus F.M. Peters, Nicholas L. Reding, John S. Reed, William D. Ruckelshaus, Bruce R. Sents, Robert B. Shapiro, John B. Slaughter, Francis A. Stroble and Stansfield Turner 2. Certified copy of Board resolution authorizing Form 10-K filing utilizing powers of attorney 99 1. Computation of the Ratio of Earnings to Fixed Charges for Monsanto Company and Subsidiaries (See page 31) (b) Reports on Form 8-K during the quarter ended December 31, 1993: No reports on Form 8-K were filed by the Company during the quarter ended December 31, 1993. OPINION OF INDEPENDENT AUDITORS Uonsanto Company: We have audited the statement of consolidated financial position of Monsanto Company and Subsidiaries as of December 31, 1993 and 1992 and the related statements of consolidated income, shareowners' equity and cash flow for each of the three years in the period ended December 31, 1993 and have issued our opinion thereon dated February 25, 1994; such financial statements and opinion are included in your 1993 Annual Report to shareowners and are incorporated herein by reference. Our audits also comprehended the schedules of Monsanto Company and Subsidiaries, listed in Item 14(a)2. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. DELOITTE & TOUCHE DELOITTE & TOUCHE Saint Louis, Missouri February 25, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. MONSANTO COMPANY ................................................ (Registrant) By BRUCE R. SENTS ............................................. Bruce R. Sents Vice President and Controller (Principal Accounting Officer) Date: March 15, 1994 APPENDIX Throughout the printed Form 10-K, trademarks are initially designated on each page by the superscript letter "R" in a circle or by the superscript letters "TM."

30573_1993.txt

30573

1993

ITEM 1. BUSINESS. General - -------------------------------------------------------------------------------- Duquesne Light Company (Duquesne) is a wholly owned subsidiary of DQE, an energy services holding company formed in 1989. Duquesne is engaged in the production, transmission, distribution and sale of electric energy. Duquesne was formed under the laws of Pennsylvania by the consolidation and merger in 1912 of three constituent companies. Service Territory Duquesne provides electric service to customers in Allegheny County, including the City of Pittsburgh, and Beaver County. This represents a service territory of approximately 800 square miles. The population of the area served by Duquesne, based on 1990 census data, is approximately 1,510,000, of whom 370,000 reside in the City of Pittsburgh. In addition to serving approximately 579,000 customers within this service area, Duquesne also sells electricity to other utilities beyond its service territory. Regulation Duquesne's utility operations are subject to regulation by the Pennsylvania Public Utility Commission (PUC). Duquesne is also subject to regulation by the Federal Energy Regulatory Commission (FERC) under the Federal Power Act in respect of rates for interstate sales, transmission of electric power, accounting and other matters. This regulation is designed to provide for the recovery of operating costs and investment and the opportunity to earn a fair return on funds invested in the utility business. The regulatory process imposes a time lag during which increases in operating expenses, capital costs or construction costs may not be recovered. Duquesne is also subject to regulation by the Nuclear Regulatory Commission (NRC) under the Atomic Energy Act of 1954, as amended, with respect to the operation of its jointly owned nuclear power plants, Beaver Valley Unit 1, Beaver Valley Unit 2 and Perry Unit 1. Seasonality Sales of electricity to ultimate customers by Duquesne tend to increase during the warmer summer and cooler winter seasons because of greater customer use of electricity for cooling and heating. [GRAPH FOR QTRLY KWH SALES APPEARS HERE] Results of Operations - -------------------------------------------------------------------------------- [GRAPH FOR 1993 ENERGY SALES BY CLASS OF CUSTOMERS APPEARS HERE] Power Sales In 1993, sales to Duquesne's 20 largest customers accounted for 14.5 percent of customer revenues. Sales to USX Corporation, Duquesne's largest customer, accounted for 3.7 percent of total 1993 customer revenues. Kilowatt- hour (KWH) sales to ultimate customers in 1993 increased 2.4 percent in comparison with KWH sales to ultimate customers in 1992. Above normal temperatures in the summers of 1993 and 1991 were responsible for increased KWH sales to residential and commercial customers in those years. Mild summer and winter temperatures had the opposite effect on residential and commercial sales in 1992. Power sales to other utilities in 1993, 1992 and 1991 were 2,820,920 KWH, 4,059,989 KWH and 2,978,662 KWH, respectively. Sales to other utilities in 1993 declined from the record level in 1992 because higher system demand and more planned and forced generating station outages in 1993 reduced Duquesne's generating capacity available for off-system sales. The increase from 1991 to 1992 in these short-term sales to other utilities resulted from greater availability of transmission and generating capacity, increased demand by other utilities for energy and Duquesne's marketing efforts. The profits from these sales were passed through the Energy Cost Rate Adjustment Clause (ECR) to benefit Duquesne's customers. See discussion on page 7. Customer operating revenues result from Duquesne's sales of electricity to ultimate customers and are based on rates authorized by the PUC. These rates are designed to recover Duquesne's operating expenses and investment in utility assets and to provide a return on the investment. Current and deferred customer revenues resulted from a $232 million rate increase granted in early 1988. The PUC required Duquesne to phase in this increase during a six-year period. The phase-in plan provided that, with no impact on total reported customer revenues, rates would increase by approximately $85 million in April of each year from 1988 through 1991, remain constant in 1992 and 1993, and decrease by approximately $85 million in April 1994. The phase-in plan also provided for recovery of deferred revenues and carrying costs on such deferred revenues. The rate increase has been recognized in operating revenues since March 1988. A regulatory asset has been established for that portion of revenues yet to be collected from customers, and carrying charges on this deferred asset have been recognized as a component of other income in the Statement of Consolidated Income. Duquesne expects the remaining deferred asset balance at December 31, 1993 of $28.6 million to be recovered by April 1994, the end of the phase-in period. Short-term sales to other utilities are made at market rates and are recorded in other operating revenues in the Statement of Consolidated Income. Revenues from sales to other utilities were $50.7 million, $72.4 million and $58.9 million in 1993, 1992 and 1991, respectively. Factors influencing record 1992 revenues correspond to those affecting KWH power sales to other utilities (above). Yearly fluctuations in fuel and purchased power expense result from changes in the cost of fuel, the mix between coal and nuclear generation, the total KWHs generated and the effects of deferred energy costs. In 1993, the impact of the ECR on deferred energy costs decreased fuel expense, in comparison to that for 1992. Also contributing to the 16.7 percent decline in fuel expense was a 6 percent decrease in generation that was primarily due to more scheduled and forced generating plant outages in 1993. Fuel expense for 1992 was greater than that for 1991 because of increased generation of electricity attributable to record sales to other utilities. The greater fuel expense in 1992, however, was partially offset by lower coal and nuclear fuel costs per KWH. In 1994, nuclear fuel costs per KWH generated are expected to continue to decline, and coal costs per KWH generated are expected to remain near the 1993 level. Other operating expenses were 6.5 percent higher in 1993 than in 1992. In 1993, Duquesne finalized plans to sublease the majority of its office space at corporate headquarters; relocation of its principal business offices is anticipated in 1994. A charge of approximately $13 million was recorded as an operating expense to reflect the shortfall in anticipated sublease revenues from the rental payments related to space leased through January 2003, the date the leasing arrangements expire. Included in 1991 operating expenses was an increase of $11.9 million in the allowance for uncollectible accounts receivable caused by the deterioration of Duquesne's past due customer accounts and increased collection costs. Maintenance expense incurred for scheduled refueling outages at Duquesne's nuclear units is deferred and amortized over the period between scheduled outages. During 1993, amortization of deferred nuclear refueling outage expense increased approximately $3.5 million over the 1992 level. Contributing further to the increase in maintenance expense in 1993 was Duquesne's change, as of January 1, 1993, in its method of accounting for maintenance costs during major fossil station outages. Prior to 1993, maintenance costs incurred for scheduled major outages at fossil stations were charged to expense as the costs were incurred. Under the new accounting policy, Duquesne accrues, over the period between outages, anticipated expenses for scheduled major fossil station outages. (Maintenance costs incurred for non-major scheduled outages and for forced outages continue to be charged to expense as the costs are incurred.) This new method was adopted to match more accurately the maintenance costs with the revenue produced during the periods between scheduled major fossil outages. Depreciation and amortization expense increased in 1993 by comparison with that for 1992 and 1991. The increase was primarily a result of an increase in depreciable property. Taxes other than income taxes decreased in 1993 primarily as a result of a favorable resolution of property tax assessments retroactive to 1987. Also in 1993, Duquesne recorded, on the basis of this revised assessment, the expected refunds of these overpayments in prior years. By comparison with those for 1991, taxes other than income taxes decreased in 1992 as the result of favorable resolution of capital stock tax, gross receipts tax and sales tax matters. Income taxes increased in 1993 as a result of an increase in taxable income and a 1 percent increase in the corporate federal income tax rate. [GRAPH OF NET CASH FLOW FROM OPERATIONS APPEARS HERE] * Graph excludes working capital and other-net changes. Other Income and Deductions Other income decreased in 1993, in comparison with that for 1992, as a result of a decrease of approximately $13 million in carrying charges on deferred revenues. During 1993, the deferred revenue balance upon which carrying charges are earned declined in comparison with that for 1992 and since April 1993, Duquesne has not recorded additional carrying charges on deferred revenues. (See the discussion of the phase-in plan under the section on Power Sales on page 2.) Income taxes related to other income decreased $15 million in 1993, in comparison with those for 1992, because of a favorable settlement (related to Duquesne's 1988 tax return and the consolidated 1989 tax return) with the United States Internal Revenue Service. The remaining decrease in 1993 was caused by lower non-operating income. Other income for 1992 increased, in comparison with that for 1991, primarily as the result of an increase of $3.5 million in interest income and a decrease of $3.7 million in fees related to Duquesne's sale of receivables. Other income for 1991 included a $5.3 million regulatory accounting reclassification that decreased other income, reduced depreciation expense and had no impact on net income. Financial Condition - -------------------------------------------------------------------------------- Financing Duquesne plans to meet its current obligations and debt maturities through 1998 with funds generated from operations and through new financings. At December 31, 1993, Duquesne was in compliance with all of its debt covenants. Duquesne continues to reduce capital costs by refinancing, repurchasing and retiring securities. Since the end of 1987, annual interest expense on long-term debt has been reduced by $55.3 million through the repurchase and refinancing of high cost debt. Preferred and preference dividend costs have been reduced $10.6 million through the repurchase or redemption of preferred and preference stock. During 1993, Duquesne issued $695 million of first collateral trust bonds with maturities ranging from the year 1996 through the year 2025 and with an average interest rate of 6.58 percent. The proceeds of these sales, together with other funds, were used to redeem $713.7 million of first mortgage bonds with an average interest rate of 8.16 percent. Specifically, on June 15, 1993, a shelf registration for the periodic sale of up to $300 million of First Collateral Trust Bonds became effective. Duquesne issued bonds totaling $200 million under this shelf registration and, in conjunction with the issuance of $495 million of First Collateral Trust Bonds under 1992 shelf registrations, redeemed the remaining balances of the following first mortgage bonds outstanding: $99.0 million of 9.00% First Mortgage Bonds, Series due February 1, 2017; $98.0 million of 9.50% First Mortgage Bonds, Series due December 1, 2016; $96.4 million of 8.375% First Mortgage Bonds, Series due April 1, 2007; $49.0 million of 9.50% First Mortgage Bonds, Series due March 1, 2005; $43.6 million of 8.625% First Mortgage Bonds, Series due April 1, 2004; $35.0 million of 7.75% First Mortgage Bonds, Series due July 1, 2003; $32.7 million of 7.25% First Mortgage Bonds, Series due January 1, 2003; $28.5 million of 7.50% First Mortgage Bonds, Series due June 1, 2002; $26.5 million of 7.50% First Mortgage Bonds, Series due December 1, 2001; $34.7 million of 7.875% First Mortgage Bonds, Series due March 1, 2001; $29.7 million of 8.75% First Mortgage Bonds, Series due March 1, 2000; $28.6 million of 7.75% First Mortgage Bonds, Series due July 1, 1999; $30.0 million of 7.00% First Mortgage Bonds, Series due January 1, 1999; $34.6 million of 6.375% First Mortgage Bonds, Series due February 1, 1998; $24.6 million of 5.25% First Mortgage Bonds, Series due February 1, 1997; and $22.8 million of 5.125% First Mortgage Bonds, Series due February 1, 1996. In June 1993, Duquesne participated in the issuance of $25 million of Beaver County Industrial Development Authority Pollution Control Revenue Bonds. In August 1993, Duquesne participated in the issuance of $20.5 million of Ohio Air Quality Development Authority Pollution Control Revenue Refunding Bonds to refund a like amount of pollution control obligations. On January 14, 1994, Duquesne redeemed all of its outstanding shares of $2.10 preference stock and $7.50 preference stock for approximately $38 million. Short-Term Borrowings Duquesne has extendible revolving credit agreements with a group of banks totaling $225 million. The current expiration date of this credit arrangement is September 30, 1994. Interest rates can, in accordance with the option selected at the time of each borrowing, be based on prime, federal funds, Eurodollar or CD rates. Commitment fees are based on the unborrowed amount of the commitments. There were no short-term borrowings during 1992. During 1993 and 1991, the maximum short-term bank and commercial paper borrowings outstanding were $27 million and $66 million; the average daily short-term borrowings outstanding were $1.6 million and $11.0 million; and the weighted average daily interest rates applied to such borrowings were 3.42 percent and 6.36 percent, respectively. At December 31, 1993, short-term borrowings were $11.0 million. There were no short-term borrowing balances outstanding at December 31, 1992 or 1991. Interest Charges Duquesne achieved reductions in interest charges in 1993 and 1992 through refinancing first mortgage bonds and through obtaining lower average short-term rates on certain tax exempt pollution control notes. Duquesne also retired $24.2 million of preferred and preference stock during 1992. Interest expense and dividends on preferred and preference stock declined to $121 million in 1993 from $135 million in 1992 and $145 million in 1991. Interest expense and dividends on preferred and preference stock are expected to decline in 1994 by approximately $9 million from the 1993 level. [GRAPH OF INTEREST EXPENSE OF PREF. & PREF. DIVS. APPEARS HERE] Sale of Accounts Receivable In 1989, Duquesne and an unaffiliated corporation entered into an agreement that entitled Duquesne to sell and the corporation to purchase, on an ongoing basis, up to $100 million of accounts receivable. At December 31, 1993, Duquesne had sold $9 million of receivables. The accounts receivable sales agreement, which expires in June 1994, is one of many sources of funds available to Duquesne. Duquesne is currently evaluating whether to seek an extension or a replacement of the agreement. Nuclear Fuel Leasing Duquesne finances its acquisitions of nuclear fuel through a leasing arrangement under which it may finance up to $75 million of nuclear fuel. As of December 31, 1993, the amount of nuclear fuel financed by Duquesne under this arrangement totaled approximately $65 million. Duquesne plans to continue leasing nuclear fuel to fulfill its requirements at least through 1995, the remaining term of the related leasing arrangement. ESOP As discussed in Notes C and I to Duquesne's consolidated financial statements, effective January 1, 1992, Duquesne established an Employee Stock Ownership Plan (ESOP) through which it will match up to $.50 (depending on whether certain incentive targets are met) of every $1.00 an employee contributes to the 401(k) Retirement Savings Plan for Management Employees up to a maximum of six percent of their eligible salary. Duquesne's matching contributions are invested in Duquesne Preference Stock which can be exchanged for DQE Common Stock. Duquesne may purchase shares of DQE Common Stock from DQE or on the open market to satisfy the exchange feature of the Preference Stock. Transmission Access - -------------------------------------------------------------------------------- During the fourth quarter of 1993, Duquesne recognized a charge to other income of approximately $15.2 million for its investment in the abandoned General Public Utilities (GPU) transmission line project. On December 8, 1993, the New Jersey Board of Regulatory Commissioners (BRC) denied a request by GPU's subsidiary Jersey Central Power and Light Company for approval of long-term power purchase* and operating agreements that were originally signed in 1990 by GPU and Duquesne and further amended in 1993. The BRC rejected an administrative law judge's recommended decision that the project be approved and, within hours of the BRC decision, GPU terminated its participation in the project. In view of GPU's decision, Duquesne also terminated its participation in the project and the Pennsylvania PUC transmission line siting proceeding. In March of 1994, Duquesne submitted, pursuant to the Federal Power Act, a "Good Faith" request for transmission service with the Allegheny Power System (APS) and Pennsylvania-New Jersey-Maryland Interconnection Association (PJM). The request is based on 20-year firm service with flexible delivery points for 300 megawatts of transfer capability over the transmission network that extends from Western Pennsylvania to the East Coast. In this request Duquesne has identified a $50 million investment that would enhance and stabilize this transmission system. APS and PJM have sixty days from the receipt of this request to formally respond. * For discussion of Duquesne's investment in the cold-reserved units, see Property Held for Future Use in Note J of Duquesne's consolidated financial statements. Construction - -------------------------------------------------------------------------------- During 1993, Duquesne spent approximately $100 million for construction to improve and expand its production, transmission and distribution systems. Duquesne estimates that it will spend approximately $110 million for construction in 1994. Construction expenditures are estimated to be $70 million in 1995 and $80 million in 1996. These amounts exclude AFC, nuclear fuel and expenditures for possible early replacement of steam generators at the Beaver Valley Power Station. (See Note K to Duquesne's consolidated financial statements.) Duquesne currently has no plans for construction of new base load generating plants. Duquesne anticipates that funds for planned capital expenditures in the next several years will be provided primarily from cash becoming available from operations and, to a lesser degree, from additional financings. Interim financing has been and will continue to be provided through bank borrowings and sales of commercial paper. Substantially all funds needed for 1994 capital expenditures are expected to be generated internally. See "Nuclear Fuel" on page 10 for a discussion of Duquesne's commitments with respect to the cost of nuclear fuel as of December 31, 1993, and for each of the years 1994 through 1998. Rate Matters - -------------------------------------------------------------------------------- Electric rates charged by Duquesne to its customers are regulated by the PUC. Electric rates charged to the Borough of Pitcairn and to other electric utilities are regulated by the FERC. These rates are designed to recover Duquesne's operating expenses, investment in utility assets, and a return on those investments. Sales to other utilities are made at market rates. See Note J to Duquesne's consolidated financial statements for additional discussion of rate-related matters. 1987 Rate Case In March 1988, the PUC adopted a rate order that increased Duquesne's annual revenues by $232 million phased-in from April 1988 through April 1994. Deficiencies which resulted from the phase-in plan in current revenues from customers have been included in the consolidated income statement as deferred revenues. Deferred revenues have been recorded on the balance sheet as a deferred asset for future recovery. As customers were billed for deficiencies related to prior periods, this deferred asset was reduced. As designed, the phase-in plan provided for carrying charges (at the after-tax AFC rate) on revenues deferred for future recovery. Duquesne has not recorded additional carrying charges on the deferred revenue balance since April 1993. Duquesne had recovered previously deferred revenues and carrying charges of $285.9 million as of December 31, 1993. Phase-in plan deferrals of $28.6 million remained unrecovered as of that date. Duquesne expects to recover this remaining unrecovered balance. At this time, Duquesne has no pending base rate case and no immediate plans to file a base rate case. Energy Cost Rate Adjustment Clause (ECR) Duquesne defers fuel and other energy costs for recovery in subsequent years through the ECR. The deferrals reflect the difference between the amount that Duquesne is currently collecting from customers and its actual fuel costs. The PUC reviews Duquesne's fuel costs annually, for the fiscal year April through March, against the previously projected fuel costs and adjusts the ECR for over- or under-recoveries and for two PUC-established coal cost caps. The ECR is based on projected unit costs, is recalculated each year, and is subject to PUC review. The adjustment includes a credit to Duquesne's customers for profits from short-term power sales to other utilities, as well as an adjustment for any over- or under-collections from customers that may have occurred in prior years. The 1993 ECR reduced customer costs from 1992 levels and has continued to reduce revenues through the first quarter of 1994 by a greater amount than in the prior year. From April 1994 through March 1995, the ECR is expected to reduce revenues by a lesser amount than in the prior year. This ECR treatment is intended to have no impact on net income. Deferred Rate Synchronization Costs In 1987, the PUC approved Duquesne's petition to defer initial operating and other costs of Perry Unit 1 and Beaver Valley Unit 2. Duquesne deferred the costs incurred from November 17, 1987, when the units went into commercial operation, until March 25, 1988 when a rate order was issued. In its order, the PUC postponed ruling on whether these costs would be recoverable from ratepayers. At December 31, 1993, these costs totaled $51.1 million, net of deferred fuel savings related to the two units. Duquesne is not earning a return on the deferred costs. Duquesne believes that these costs are recoverable. In 1990, another Pennsylvania utility was permitted recovery, with no return on the unamortized balance, of similar costs over a 10-year period. Demand-Side Management In March of 1994, Duquesne filed with the PUC an updated Demand-Side Management Plan (DSM) designed to encourage customer energy conservation and load management. Duquesne's proposed DSM programs include compact fluorescent lighting, load management, cool storage systems, emergency generation networks and long-term interruptible rates. The Pennsylvania Industrial Energy Coalition filed an appeal in Commonwealth Court of Pennsylvania on December 31, 1993, requesting reversal of the PUC order of December 13, 1993 which originated electric utility DMS programs in Pennsylvania and allows utilities to recover prudently incurred DSM program costs through rates. Implementation of Duquesne's DSM plan awaits PUC approval and disposition of this appeal. Joint Interests in Generating Units - -------------------------------------------------------------------------------- Duquesne has various contracts with The Potomac Edison Company, Monongahela Power Company, Ohio Edison Company, Pennsylvania Power Company, The Cleveland Electric Illuminating Company (CEI) and The Toledo Edison Company including provisions for coordinated maintenance responsibilities, limited and qualified mutual back-up in the event of outages and certain capacity and energy transactions. Duquesne has an interest in the following nuclear plants jointly with the following companies: *Denotes Operator (1) In 1987, Duquesne sold its 13.74 percent interest in Beaver Valley Unit 2; the sale was exclusive of transmission and common facilities. The total sales price of $537.9 million was the appraised value of Duquesne's interest in the property. Duquesne subsequently leased back its interest in the unit for a term of 29.5 years. The lease provides for semiannual payments and is accounted for as an operating lease. Duquesne is responsible under the terms of the lease for all costs of its interest in the unit. See Note E to Duquesne's consolidated financial statements. Duquesne owns the following fossil plants jointly with the following companies: *Denotes Operator Under the agreements governing the operation of these jointly owned generating units, the day-to-day operating authority is assigned to a specific company. CEI has such authority for Perry Unit 1 and Eastlake Unit 5, Ohio Edison Company has authority for Sammis Unit 7, Pennsylvania Power Company has authority for Bruce Mansfield Units 1, 2 and 3 and Monongahela Power Company operates Ft. Martin Unit 1. Duquesne monitors activities in connection with all of these units. Duquesne has day-to-day operating authority for Beaver Valley Units 1 and 2. All the companies with a joint interest in these units are kept fully informed of developments at these generating units. Employees - -------------------------------------------------------------------------------- At December 31, 1993, Duquesne had 4,042 employees, including 1,285 employees at the Duquesne-operated Beaver Valley Power Station. The International Brotherhood of Electrical Workers represents 2,481 of Duquesne's employees. The current contract runs through September 1994. Electric Operations - -------------------------------------------------------------------------------- Approximately 78% of the electric energy generated by Duquesne's system during 1993 was produced by its coal-fired generating capacity and approximately 22% by its nuclear generating capacity. Duquesne normally experiences its peak loads in the summer. The customer system peak for 1993 of 2,499 megawatts occurred on August 31, 1993. Duquesne's fossil plants operated at 83% availability in 1993 and 80% in 1992. Duquesne's nuclear plants operated at 63% availability in 1993 compared to 90% in 1992. The timing of scheduled maintenance and refueling outages, as well as the duration of forced outages, affect availability of power plants. In 1986, the PUC approved Duquesne's request to remove the Phillips and most of the Brunot Island (BI) power stations from service and place them in cold reserve. At that time, Duquesne's net investment in the cold-reserved stations was $106 million. In connection with a proposed long-term power sale, Duquesne invested in the cold-reserved plants an additional $24 million in preservation, condition assessment and plant improvements. Duquesne's net investment in the plants at December 31, 1993 is approximately $130 million. For further discussion of Duquesne's investment in the cold-reserved units, see Property Held for Future Use in "Outlook" and Note J of Duquesne's consolidated financial statements. The North American Electric Reliability Council, of which Duquesne is a member, uses capacity margin to report generating capability as compared to demand. Capacity margin is expressed as capacity less demand divided by capacity. Although Duquesne also uses criteria other than capacity margin for determining the need for installation of additional generating capability, Duquesne's capacity margin in 1993 was 10.7% based on installed non-cold- reserved generating capacity and internal peak load, including 93 megawatts of interruptible load. Duquesne has ties with regional utilities which provide the capability to import in excess of 4,000 megawatts of capacity to supplement Duquesne's generation, as required. Peak generation on June 28, 1993 was 2,621 megawatts, which included 483 megawatts of off-system sales. Additional information relating to Duquesne's electric operations is set forth on page 42 of DQE's Annual Report to Shareholders for the year ended December 31, 1993. The information is incorporated here by reference. Fossil Fuel - -------------------------------------------------------------------------------- Duquesne believes that sufficient coal for its coal-fired generating units will be available from various sources to satisfy its requirements for the foreseeable future. During 1993, approximately 2.4 million tons of coal were consumed at Duquesne's two wholly owned coal-fired stations - Cheswick and Elrama. Duquesne owns Warwick Mine, an underground mine located on the Monongahela River approximately 83 river miles from Pittsburgh. Warwick Mine has been excluded from rate base since 1981. Duquesne temporarily idled the mine in June 1988 due to excess coal inventories. In 1990, Duquesne restarted the mine by an agreement under which an unaffiliated company operates the mine until March 2000 and sells the coal produced. Production began in late 1990. The mine reached a full production rate in early 1991. Warwick Mine coal reserves include both high and low sulfur coal; the sulfur content averages in the mid-range at 1.7 percent - 1.9 percent. More than 90 percent of the coal mined at Warwick Mine currently is used by Duquesne, although Duquesne is not precluded from selling this coal on the open market. Duquesne receives a royalty on sales of coal to the open market. The Warwick Mine currently supplies less than one-fifth of the coal used in the production of electricity at the plants owned or jointly owned by Duquesne. Duquesne estimates that, at December 31, 1993, its economically recoverable coal reserves at Warwick Mine were 11.5 million tons. Costs at Warwick Mine and Duquesne's investment in the mine are expected to be recovered through the cost of coal in the ECR. Recovery is subject to the system-wide coal cost standard. Duquesne also has an opportunity to earn a return on its investment in the mine through the cost of coal during the period of the system- wide coal cost standard, including extensions. At December 31, 1993, Duquesne's net investment in the mine was $24.5 million. The estimated current liability, including final site reclamation, mine water treatment and certain labor liabilities for mine closing is $33.0 million and Duquesne has collected approximately $8.9 million toward these costs. For further discussion of Duquesne's investment in Warwick Mine costs, see Note J of Duquesne's consolidated financial statements. During 1993, 65% of Duquesne's coal supplies were provided by contracts, with the remainder satisfied through purchases on the spot market. Duquesne had four long-term contracts in effect at December 31, 1993, which, in combination with spot market purchases, are expected to furnish an adequate future coal supply. Duquesne does not anticipate any difficulty in replacing or renewing these contracts as they expire in future years ranging from 1995 through 2002. At December 31, 1993, Duquesne's wholly owned and jointly owned generating units had on hand an average coal supply of 45 days. The PUC has established two market price coal cost standards. One applies only to coal delivered at the Mansfield plant. The other, the system-wide coal cost standard, applies to coal delivered to the remainder of Duquesne's system. Both standards are updated monthly to reflect prevailing market prices of similar coalduring the month. The PUC has directed Duquesne to defer recovery of the delivered cost of coal over generally prevailing market prices for similar coal. Through the ECR, however, the PUC does allow deferred amounts to be recovered from customers when the delivered costs of coal fall below prevailing market prices. The unrecovered cost of Mansfield coal was $7.4 million and the unrecovered cost of the remainder of the system-wide coal was $8.8 million at December 31, 1993. Duquesne estimates that all deferred coal costs will be recovered. Duquesne's average cost per ton of coal consumed during the past three years at generating units which it operates or in which it has an ownership interest was as follows: 1993-$40.08; 1992-$40.44; and 1991-$42.49. See Note J to Duquesne's consolidated financial statements for a discussion of the coal cost standards. The cost of coal, which falls within the market price limitations discussed in Note J of Duquesne's consolidated financial statements, is recovered from Duquesne's customers through the ECR discussed previously in "Rate Matters" on page 7. Nuclear Fuel - -------------------------------------------------------------------------------- The cycle of production and utilization of nuclear fuel consists of (1) mining and milling of uranium ore and processing the ore into uranium concentrates, (2) conversion of uranium concentrates to uranium hexafluoride, (3) enrichment of the uranium hexafluoride, (4) fabrication of fuel assemblies, (5) utilization of the nuclear fuel in the generating station reactor and (6) storing and reprocessing or disposal of spent fuel. Adequate supplies of uranium and conversion services are under contract for Duquesne's requirements for its jointly owned nuclear units through 1997. Enrichment services are supplied under a 1984 United States Enrichment Corporation Utility Services Contract entered into for a period of 30 years by the companies for their joint interests in Perry Unit 1 and Beaver Valley Units 1 and 2. Under the terms of this contract Duquesne is committed to 100% of its enrichment needs through 1998. Fuel fabrication contracts are in place to supply reload requirements for the next three cycles for Beaver Valley Unit 1, the next three cycles for Beaver Valley Unit 2 and the next twenty-one cycles of Perry Unit 1. Duquesne will be required to make arrangements for uranium supply and related services as existing commitments expire. For joint interests in generating units (See page 8.), each company is responsible for financing its proportionate share of the costs of nuclear fuel for each nuclear unit in which it has an ownership interest. Duquesne has entered into a lease arrangement for the acquisition of nuclear fuel pursuant to which Duquesne is permitted to finance up to $75 million. As of December 31, 1993, the cost of Duquesne's nuclear fuel financed was $65 million. Duquesne's nuclear fuel costs, which are amortized to reflect fuel consumed, are charged to fuel expense and are recovered through rates. Duquesne estimates that, over the next three years, the amortization of nuclear fuel consumed will exceed the expenditures for new fuel by approximately $18 million. The actual nuclear fuel costs to be financed and amortized during the period 1994 through 1996 will be influenced by such factors as changes in interest rates, lengths of the respective fuel cycles and changes in nuclear material cost and services, the prices and availability of which are not known at this time. Such costs may also be influenced by other events not presently foreseen. Duquesne's nuclear fuel costs related to Beaver Valley Unit 1, Beaver Valley Unit 2 and Perry Unit 1 under the lease arrangement are charged to fuel expense based on the quantity of energy generated. Nuclear fuel costs for these units averaged .918 cents per KWH in 1993, inclusive of charges associated with spent fuel. Duquesne is recovering from its customers the costs associated with the ultimate disposal of spent fuel. All three units presently operate on an 18-month refueling cycle with the scheduled refueling dates established as follows: Beaver Valley Unit 1, October 1994; Beaver Valley Unit 2, March 1995 and Perry Unit 1, February 1994. Nuclear Decommissioning - -------------------------------------------------------------------------------- The PUC ruled that recovery of the decommissioning costs for Beaver Valley Unit 1 could begin December 24, 1977 and that recovery for Beaver Valley Unit 2 and Perry Unit 1 could begin March 25, 1988. Duquesne expects to decommission each nuclear plant at the end of its life, a date that currently coincides with the expiration of each plant's operating license. (See Note L to Duquesne's consolidated financial statements.) The total estimated decommissioning costs, including removal and decontamination costs, being recovered in rates are $70 million for Beaver Valley Unit 1, $20 million for Beaver Valley Unit 2, and $38 million for Perry Unit 1. These amounts were based upon the most recent studies available at the time of Duquesne's last rate case. Since the time of Duquesne's last rate case, site specific studies have been performed to update the estimated decommissioning costs, in current dollars, for each of its nuclear generating units. In 1992, Duquesne's share of the estimated decommissioning costs for Beaver Valley Unit 2 was revised to $35 million. Duquesne's share of decommissioning costs, which is based on preliminary site specific studies to be finalized early in 1994, is estimated to increase to $134 million for Beaver Valley Unit 1 and to $71 million for Perry. (See Note L to Duquesne's consolidated financial statements for additional NRC licensing information.) During 1994, it is Duquesne's intention to increase the annual contribution to its decommissioning trusts by $2 million to bring the total annual funding to approximately $4 million per year. Duquesne plans to continue making periodic reevaluations of estimated decommissioning costs, to provide additional funding from time to time, and to seek regulatory approval for recognition of these increased funding levels. Duquesne records decommissioning costs under the category of depreciation expense and accrues a liability, equal to that amount, for nuclear decommissioning expense. Such nuclear decommissioning funds are deposited in external, segregated trust accounts. Trust fund earnings increase the fund balance and the recorded liability. The aggregate trust fund balances at the end of 1993 totaled $18.1 million. On the Company's consolidated balance sheet, the decommissioning trusts have been reflected in other property and investments, and the related liability has been recorded as other deferred credits. Environmental Matters - -------------------------------------------------------------------------------- The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and the Superfund Amendments and Reauthorization Act of 1986 established a variety of informational and environmental action programs. The Environmental Protection Agency (EPA) has informed Duquesne of its involvement or potential involvement in three hazardous waste sites. If Duquesne is ultimately determined to be a responsible party with respect to these sites, it could be liable for all or a portion of the cleanup costs. However, in each case, other solvent, potentially responsible parties that may bear all or part of any liability are also involved. In addition, Duquesne believes that available defenses, along with other factors (including overall limited involvement and low estimated remediation costs for one site) will limit any potential liability that Duquesne may have for cleanup costs. Duquesne believes that it is adequately reserved for all known liabilities and costs and, accordingly, that these matters will not have a materially adverse effect on its financial position or results of operations. In 1990, Congress approved amendments to the Clean Air Act. Among other innovations, this legislation established the Emission Allowance Trading System. An "emission allowance" permits fuel emission of one ton of sulphur dioxide (SO\\2\\) for one year. These allowances are issued by the EPA to fossil-fired stations with generating capability of more than 25 megawatts that were in existence as of the passage of the 1990 amendments. Allowances are part of a market-based approach to SO\\2\\ reduction. Emission allowances can also be obtained through purchases on the open market or directly from other sources. Excess allowances may be banked for future use or sold on the open market to other parties for their use in offsetting emissions. The legislation requires significant reductions of SO\\2\\ and oxides of nitrogen (NO\\X\\) by 1995 and additional reductions by the year 2000. Duquesne continues to work with the operators of its jointly owned stations to implement cost-effective compliance strategies to meet these requirements. Duquesne's plans for meeting the 1995 SO\\2\\ compliance requirements include increasing the use of scrubbed capacity, switching to fuel with a lower sulfur content and purchasing emission allowances. NO\\X\\ reductions under Title IV are required by 1995 at only the Cheswick station; work to achieve the reductions was completed in 1993. The ozone attainment provisions of Title I of the Clean Air Act Amendments will require NO\\X\\ reductions by 1995 at Duquesne's Elrama plant and at the jointly owned Mansfield plant. Duquesne plans to achieve such reductions with low NO\\X\\ burner technology. Duquesne has currently 1,187 megawatts of scrubbed capacity, including 300 megawatts at the currently cold-reserved Phillips plant, as well as 570 megawatts of capacity that meets the 1995 standards of the Clean Air Act amendments through the use of low sulfur coal. The estimated capital costs to achieve 1995 compliance standards are approximately $30 million, of which approximately $15 million has already been spent. Through the year 2000, Duquesne is planning a combination of compliance methods that include fuel switching; increased use of, and improvements in, scrubbed capacity; flue gas conditioning; low NO\\X\\ burner technology; and the purchase of emission allowances. Duquesne currently estimates that additional capital costs to comply with environmental requirements from 1995 through the year 2000 will be approximately $20 million. This estimate is subject to the finalization of federal and state regulations. Duquesne is closely monitoring other potential air quality programs and air emission control requirements that could be imposed in the future. These areas include additional NO\\X\\ control requirements that could be imposed on fossil fuel plants by the Ozone Transport Commission, more stringent ambient air quality and emission standards for SO\\2\\ and particulates, or carbon dioxide (CO\\2\\) control measures. As these potential programs are in various stages of discussion and consideration, it is impossible to make reasonable estimates of the potential costs and impacts of these programs at this time. In July 1992, the Pennsylvania Department of Environmental Resources (DER) issued Residual Waste Management Regulations governing the generation and management of non-hazardous waste. Duquesne is currently conducting tests and developing compliance strategies. Capital compliance costs are estimated, on the basis of information currently available, at $10 million through 1995. The expected additional capital cost of compliance from 1995 through 2000 is approximately $25 million; this estimate is subject to the results of ground water assessments and DER final approval of compliance plans. Duquesne operates the scrubbed Elrama plant and converts the scrubber slurry to a fixated pozolonic material. This material is placed at an off-site disposal area having approximately six years of remaining capacity. Additionally, Duquesne owns 17 percent of the scrubbed Mansfield plant, which is operated by Pennsylvania Power. This plant pumps a similar slurry to an off-site impoundment where the slurry is treated by using a Calcilox fixation process. The site has at least 14 years of remaining capacity. Both plants have limited temporary on-site storage for flue gas desulfurization material and no permanent on-site disposal capacity. While there is no imminent shortage of disposal capacity, Duquesne continues to monitor this situation and to plan for future disposal. The siting of future disposal facilities will be facilitated by the 1993 EPA determination that coal combustion waste products are not hazardous waste and are therefore exempt from the Hazardous Waste Regulations. The second phase of EPA's determination will consider the co-management of coal combustion wastes with other low volume fossil fuel combustion waste streams. Under the Nuclear Waste Policy Act of 1982, which establishes a policy for handling and disposing of spent nuclear fuel and requires the establishment of a final repository to accept spent fuel, contracts for jointly owned nuclear plants have been entered into with the Department of Energy (DOE) for permanent disposal of spent nuclear fuel and high-level radioactive waste. The DOE has indicated that the repository will not be available for acceptance of spent fuel before 2010. Existing on-site spent fuel storage capacities at Beaver Valley 1, Beaver Valley 2 and Perry Unit 1 are expected to be sufficient until 1996, 2010, and 2009, respectively. Duquesne is currently increasing the storage capacity at Beaver Valley 1 by equipping the spent fuel pool with high density fuel storage racks. Duquesne anticipates that such action will increase the spent fuel storage capacity at Beaver Valley 1 to provide for sufficient storage through 2014. In October 1992, the President signed into law the National Energy Policy Act of 1992 (energy act). The energy act addresses a wide range of energy issues, including several matters affecting bulk power competition in the electric utility industry. See discussion in "Outlook" below. The energy act requires utilities (including Duquesne) that have purchased uranium enrichment services from the DOE to collectively contribute as much as $150 million annually (adjusted for inflation) up to a total of $2.25 billion for decommissioning and decontamination of DOE enrichment facilities. Assessments are based on the amount of uranium a utility had processed for enrichment prior to enactment of the energy act and are to be paid by such utilities over a 15-year period. The energy act states that the assessments shall be deemed a necessary and reasonable current cost of fuel and shall be fully recoverable in rates in all jurisdictions in the same manner as the utility's other fuel costs. Duquesne believes these assessments will be fully recoverable through rates. Duquesne's total estimated liability for contributions is $12.5 million. The Low-Level Waste Policy Act of 1980 (LLWPA) mandated that the responsibility for the disposal of low-level radioactive waste rests with the individual states. Most states, including Pennsylvania and Ohio, have formed regional compacts to comply with the LLWPA by providing permanent disposal sites for radioactive waste generated within each compact. However, plans for these disposal sites have not progressed as anticipated in the LLWPA and it is not certain when the regional sites will be available for disposal of waste. Radioactive waste from Duquesne's jointly owned nuclear plants is currently shipped to a disposal facility in South Carolina. This facility has announced that it will not accept any additional waste from outside the Southeast Compact after June 30, 1994. The co-owners have constructed on-site waste storage facilities at the Beaver Valley Power Station and the Perry Power Plant for interim storage of the plants' low-level radioactive waste. The Beaver Valley on-site facility is expected to be sufficient to meet site storage requirements until regional disposal facilities become available. The Perry on-site facility is expected to be sufficient to meet site storage requirements for a period of five years. The Company believes that it is adequately reserved for all known environmental liabilities and costs. Accordingly, the Company believes that the ultimate outcome of these environmental matters will not have a material adverse effect on its financial position or the results of its operations. Outlook - -------------------------------------------------------------------------------- Competition Regulatory developments in the industry are placing increasing competitive pressures on electric public utilities. Duquesne, like the industry in general, is continuing to assess the impact of these competitive forces on its future operations. The National Energy Policy Act of 1992 (energy act) was designed, among other things, to foster competition. Among other provisions, the energy act amends the Public Utility Holding Company Act of 1935 (1935 act) and the Federal Power Act. Amendments to the 1935 act create a new class of independent power producers known as Exempt Wholesale Generators (EWGs), which are exempt from the corporate structure regulations of the 1935 act. EWGs, which may include independent power producers as well as affiliates of electric utilities, do not require Securities and Exchange Commission approval or regulation. At the current time, Duquesne has not made, and has no plans to make, any investment in EWGs. Amendments to the Federal Power Act create the potential for utilities and other power producers to gain increased access to transmission systems of other utilities to facilitate sales to other utilities. The amendments would permit the FERC to order utilities to transmit power over their lines for use by other suppliers and to enlarge or construct additional transmission capacity to provide these services. The FERC may not, however, issue any order that would unreasonably impair the continuing reliability of affected electric systems. Finally, the legislation allows brokers and marketers, without owning or operating any generation or transmission facilities, to enter into the business of buying and selling electric capacity and energy. The energy efficiency title of the energy act requires states to consider adopting integrated resource planning, which allows utility investments in conservation and other demand-side management techniques to be at least as profitable as supply investments. The energy act also establishes new efficiency standards in industrial and commercial equipment and lighting and requires states to establish commercial and residential building codes with energy efficiency standards. Additionally, the energy act requires utilities to consider energy efficiency programs in their integrated resource planning. The effects on Duquesne of these standards and requirements cannot be determined at this time. The energy act encourages increased use of alternative transportation fuels by federal, state, city and power provider fleets. The energy act also provides funding for development of electric vehicles and associated infrastructures. The effects on Duquesne cannot be determined at this time. The nuclear-related provisions of the energy act generally encourage further development of the nuclear power industry through a variety of measures, including the consolidation of construction and operating license steps into one proceeding. The impact of these provisions on Duquesne is not expected to be material. These new regulations also permit industrial and large commercial customers to own and operate facilities to generate their own electric energy requirements and, if such facilities are qualifying facilities, to require the displaced electric utility to purchase the output of such facilities. Customers may also have the option of substituting fuels, such as the use of natural gas, oil or wood for heating and/or cooling purposes rather than electric energy or of relocating their facilities to a lower cost environment. In addition, increased competition may also result from the 1990 Amendments to the Clean Air Act. Such amendments exempt from SO2 and NOX control requirements existing units with less than 25 megawatts of generating capacity and new or existing co-generation units supplying less than one-third of their electric output and less than 25 megawatts for commercial sale. Property Held for Future Use In 1986, the PUC approved Duquesne's request to remove the Phillips and most of the Brunot Island power stations from service and place them in cold reserve. Duquesne's capitalized costs and net investment in the plants at December 31, 1993 totaled $130 million. (See Note L to Duquesne's consolidated financial statements.) Duquesne expects to recover its net investment in these plants through future sales. Phillips and BI represent licensed, certified, clean sources of electricity that will be necessary to meet expanding opportunities in the power markets. Duquesne believes that anticipated growth in peak load demand for electricity within its service territory will require additional peaking generation. Duquesne looks to BI to meet this need. The Phillips Power Plant is an important component in meeting market opportunities to supply long-term bulk power. Recent legislation may permit wider transmission access to these long- term bulk power markets. In summary, Duquesne believes its investment in these cold-reserved plants will be necessary in order to meet future business needs. If business opportunities do not develop as expected, Duquesne will consider the sale of these assets. In the event that market demand, transmission access or rate recovery do not support the utilization or sale of the plants, Duquesne may have to write off part or all of their costs. Retirement Plan Measurement Assumptions Duquesne reduced the discount rate used to determine the projected benefit obligation on Duquesne's retirement plans at December 31, 1993 to 7 percent. The assumed change in future compensation levels was also decreased by 0.5 percent to reflect current market and economic conditions. The effect of these changes on Duquesne's retirement plan obligations is reflected in the amounts shown in Note I to Duquesne's consolidated financial statements. The resulting increase in related expenses for subsequent years is not expected to be material. Other Duquesne's utility operations are subject to regulation by the PUC and the FERC. This regulation is designed to provide for the recovery of operating costs and investment and the opportunity to earn a fair return on funds invested in the utility business. The regulatory process imposes a time lag during which increases in operating expenses, capital costs or construction costs may not be recovered. --------------------------- Information relating to the business of Duquesne and additional information relating to Duquesne is set forth on pages 9 to 44 of DQE's Annual Report to Shareholders for the year ended December 31, 1993. The information is incorporated here by reference. Executive Officers of the Registrant - -------------------------------------------------------------------------------- Set forth below are the names, ages as of March 1, 1994, positions and brief accounts of the business experience during the past five years of the executive officers of Duquesne. (a) Mr. Marshall was Assistant to the President from October 1990 to January 1992 and Vice President - Corporate Development from August 1987 to January 1992. (b) Mr. Schwass was Vice President and Treasurer from September 1987 to April 1988. (c) Mr. DeLeo was Vice President - Corporate Planning and Management Information Services from April 1989 to December 1990. He also served as General Manager, Planning, Budgeting and Business Development from November 1987 to March 1989. (d) Ms. Green was General Manager, Human Resources Unit from May 1988 to August 1988. She served Xerox Corporation as Vice President - Personnel of the Information Products Division from May 1985 to April 1988. (e) Mr. Sieber was Vice President - Nuclear Operations from August 1986 to March 1988. (f) Mr. Mitchell was Assistant Treasurer from October 1988 to June 1989. He served US West Information Systems, Inc. as Executive Director from August 1985 to September 1988. (g) Mr. Panza served as Assistant Controller of Squibb Corporation from May 1989 to July 1990. He served RKO General, a GenCorp company, from May 1985 to May 1989 in various positions including Vice President - Controller and Assistant Controller. ITEM 2.

ITEM 2. PROPERTIES. Duquesne's properties consist of electric generating stations, transmission and distribution facilities and supplemental properties and appurtenances, comprising as a whole an integrated electric utility system, located substantially in Allegheny and Beaver counties in southwestern Pennsylvania. Duquesne owns all or a portion of the following generating units except Beaver Valley 2, which is leased. (1) Amounts represent Duquesne's share of the unit which is owned by Duquesne in common with one or more other electric utilities (or, in the case of Beaver Valley Unit 2, leased by Duquesne). Duquesne owns 24 transmission substations (including interests in common in the step-up transformers at Fort Martin No. 1; Sammis No. 7; Eastlake No. 5; Bruce Mansfield No. 1; Beaver Valley Unit 1; Beaver Valley Unit 2; Perry Unit 1; Bruce Mansfield No. 2; and Bruce Mansfield No. 3) and 563 distribution substations. Duquesne has 714 circuit-miles of transmission lines, comprised of 345,000, 138,000 and 69,000 volt lines. Street lighting and distribution circuits of 23,000 volts and less include approximately 50,000 miles of lines and cable. Duquesne owns the Warwick Mine, including 4,849 acres owned in fee of unmined coal lands and mining rights, located on the Monongahela River in Greene County, Pennsylvania, approximately 83 river miles from Pittsburgh. See Item 1. "Fossil Fuel" on page 10. Substantially all of Duquesne's properties are subject to a first mortgage lien of the Trust Indenture dated as of August 1, 1947 securing Duquesne's first mortgage bonds. In May 1992, Duquesne began issuing secured debt under a new First Collateral Trust Indenture. This new indenture will ultimately replace Duquesne's First Mortgage Bond Indenture. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Westinghouse Lawsuit - -------------------------------------------------------------------------------- Beaver Valley Units 1 and 2 are jointly owned/leased generating units (See Item 1. Business.). In 1991, the co-owners of Beaver Valley Units 1 and 2 filed suit against Westinghouse Electric Corporation (Westinghouse) in the United States District Court for the Western District of Pennsylvania. The suit alleges that six steam generators supplied by Westinghouse for the two units contain serious defects -- in particular defects causing tube corrosion and cracking. Duquesne is seeking monetary and corrective relief. Steam generator maintenance costs have increased as a result of these defects and are likely to continue increasing. The condition of the steam generators is being monitored closely. If the corrosion and cracking continue, replacement of the steam generators could be required prior to the ends of their 40-year design lives. Duquesne is continuing to conduct a corrective maintenance program and to explore longer term options, including replacement of the steam generators. While Duquesne has no current plans to replace the steam generators and has not yet completed a detailed, site-specific study, replacement cost per unit is estimated to be between $100 million and $150 million. (Other utilities with similar units have replaced steam generators at costs in this range.) Duquesne cannot predict the outcome of this matter; however, Duquesne does not believe that resolution will have a materially adverse effect on Duquesne's financial position or results of operations. Duquesne's percentage interests (ownership and leasehold) in Beaver Valley Unit 1 and in Beaver Valley Unit 2 are 47.5 percent and 13.74 percent, respectively. The remainder of Beaver Valley Unit 1 is owned by Ohio Edison Company and by Pennsylvania Power Company. The remaining interest in Beaver Valley Unit 2 is held by Ohio Edison Company, The Cleveland Electric Illuminating Company and The Toledo Edison Company. Duquesne operates both units on behalf of the joint owners. General Electric Settlement - -------------------------------------------------------------------------------- In January 1994, Duquesne Light Company, The Cleveland Electric Illuminating Company, Ohio Edison Company, Pennsylvania Power Company and The Toledo Edison Company reached a settlement in connection with a 1991 lawsuit filed in the United States District Court in Cleveland against General Electric Company (GE) regarding the Perry Plant. These co-owners jointly constructed Perry Unit 1, a nuclear power plant on the southern shore of Lake Erie in Ohio for which GE supplied the nuclear steam supply systems and other goods and services. The out-of-court settlement disposed of a complaint filed by the co- owners of Perry Unit 1 which included claims of breach of contract, warranty, and duties of good faith and fair dealing, as well as constructive fraud, negligence, misrepresentation and various RICO violations in connection with delays and cost increases relating to the construction of Perry Unit 1. The settlement provides for cash payments to the Perry owners and discounts on their future purchases from GE. This settlement will not materially affect Duquesne's results of operations in future years. Rate-Related and Environmental Litigation - -------------------------------------------------------------------------------- Proceedings involving Duquesne's rates are reported in Item 1. "Rate Matters". Proceedings involving environmental matters are reported in Item 1. "Environmental Matters". ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS. Effective July 7, 1989, Duquesne Light Company became a wholly owned subsidiary of DQE, the holding company formed as part of a shareholder-approved restructuring. As a result of the restructuring, DQE common stock replaced all outstanding shares of Duquesne Light Company common stock, except for ten shares which DQE holds. As such, this item is not applicable to Duquesne Light Company because all its common equity is held solely by DQE. During 1993, Duquesne declared quarterly dividends on its common stock totaling $144 million for the year. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. Selected financial data for Duquesne Light Company for each year of the six-year period ended December 31, 1993 are set forth on page 67. The financial data is incorporated here by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's discussion and analysis of financial condition and results of operations are set forth in Item 1. BUSINESS and on pages 10 through 17 of the DQE Annual Report to Shareholders for the year ended December 31, 1993. The discussion and analysis are incorporated here by reference. ITEM 8.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Consolidated Balance Sheet of Duquesne Light Company and its Subsidiary as of December 31, 1993 and 1992, and the related Statements of Consolidated Income, Retained Earnings and Cash Flows for each of the three years in the period ended December 31, 1993 together with the Independent Auditors' Report dated January 25, 1994 are set forth here on pages 43 to 66. The financial statements and report are incorporated here by reference. Quarterly financial information is included on page 66 in Note M to Duquesne's consolidated financial statements and is incorporated here by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information relating to the Directors of Duquesne Light Company is set forth under the captions "Proposal No. 1 - Election of Directors", "Nominees for Director" and "Standing Directors" in the DQE definitive Proxy Statement, filed with the Securities and Exchange Commission in connection with its annual meeting of shareholders to be held on April 20, 1994. The Proxy Statement is incorporated here by reference. All Directors of DQE are also Directors of Duquesne Light Company. Information relating to the executive officers of the Registrant is set forth in Part I of this Report under the caption "Executive Officers of the Registrant". ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information relating to executive compensation is set forth in Exhibit 28.1, filed as part of this Report. The information is incorporated here by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. DQE is the beneficial owner and holder of all shares of outstanding Common Stock, $1 par value, of Duquesne Light, consisting of 10 shares as of February 23, 1994. Information relating to the ownership of equity securities of DQE and Duquesne Light by directors and executive officers of Duquesne Light is set forth in Exhibit 28.1, filed as part of this Report. The information is incorporated here by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) The following financial statements are included on pages 43 to 66. Independent Auditors' Report. Statement of Consolidated Income for the Three Years Ended December 31, 1993. Consolidated Balance Sheet, December 31, 1993 and 1992. Statement of Consolidated Cash Flows for the Three Years Ended December 31, 1993. Statement of Consolidated Retained Earnings for the Three Years Ended December 31, 1993. Notes to Consolidated Financial Statements. (a)(2) The following financial statement schedules and the related Independent Auditors' Report (See page 43.) are filed here as a part of this Report: Schedules for the Three Years Ended December 31, 1993: V - Property, Plant and Equipment. VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment. VIII - Valuation and Qualifying Accounts. X - Supplementary Income Statement Information. The remaining schedules are omitted because of the absence of the conditions under which they are required or because the information called for is shown in the financial statements or notes to the financial statements. (a)(3) Exhibits relating to Duquesne Light Company filed as a part of this Report are set forth in the Duquesne Light Company Exhibit List on pages 22 to 33, incorporated here by reference. Documents other than those designated as being filed here are incorporated here by reference. Documents incorporated by reference to a DQE Annual Report on Form 10-K, a Quarterly Report on Form 10-Q or a Current Report on Form 8-K are at Securities and Exchange Commission File No. 1-956. (b) On December 8, 1993 a Form 8-K was filed with respect to Duquesne Light Company regarding a long-term power sales contract with General Public Utilities. (c) Executive Compensation Plans and Arrangements DUQUESNE LIGHT COMPANY EXHIBITS - ---- x An additional document, substantially identical in all material respects to this Exhibit, has been entered into relating to one additional limited partnership Owner Participant. Although the additional document may differ in some respects (such as name of the Owner Participant, dollar amounts and percentages), there are no material details in which the document differs from this Exhibit. y Additional documents, substantially identical in all material respects to this Exhibit, have been entered into relating to four additional corporate Owner Participants. Although the additional documents may differ in some respects (such as names of the Owner Participants, dollar amounts and percentages), there are no material details in which the documents differ from this Exhibit. z Additional documents, substantially identical in all material respects to this Exhibit, have been entered into relating to six additional Owner Participants. Although the additional documents may differ in some respects (such as name of the Owner Participant, dollar amounts and percentages), there are no material details in which the documents differ from this Exhibit. * This document is required to be filed as an exhibit to this form under Item 14(c). Copies of the exhibits listed above will be furnished, upon request, to holders or beneficial owners of any class of the Company's stock as of February 23, 1994, subject to payment in advance of the cost of reproducing the exhibits requested. SCHEDULE V SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1993 (Thousands of Dollars) - ---- Notes: (A) Reclassifications and adjustments including $150 million as a result of the January 1, 1993 adoption of SFAS No. 109. (B) Duquesne provides for depreciation of electric plant, including plant-related intangibles, on a straight-line basis. Amortization of other intangibles is on a straight-line basis over a five-year period. At December 31, 1993 depreciation was computed on the basis of the following annual rates expressed as a percentage of original cost: production plant - 2.48% to 5.01%, transmission plant - 1.35% to 3.70%, distribution plant - 1.10% to 4.81% and general plant - 1.82% to 4.82%. Amortization of capital leases is based on nuclear fuel burned and rental payments made. Nonutility property is depreciated under the Modified Accelerated Cost Recovery System (MACRS) for various classes of property as defined in section 168 of the Internal Revenue Code. (C) Represents net change in construction work in progress. SCHEDULE V SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1992 (Thousands of Dollars) - ---- Notes: (A) Reclassifications and adjustments. (B) Duquesne provides for depreciation of electric plant, including plant-related intangibles, on a straight-line basis. Amortization of other intangibles is on a straight-line basis over a five-year period. At December 31, 1992 depreciation was computed on the basis of the following annual rates expressed as a percentage of original cost: production plant - 2.48% to 5.01%, transmission plant - 1.35% to 3.70%, distribution plant - 1.10% to 4.81% and general plant - 1.82% to 4.82%. Amortization of capital leases is based on nuclear fuel burned and rental payments made. (C) Represents net change in construction work in progress. SCHEDULE V SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1991 (Thousands of Dollars) - ---- Notes: (A) Reclassifications and adjustments. (B) Duquesne provides for depreciation on a straight-line basis. At December 31, 1991 depreciation was computed on the basis of the following annual rates expressed as a percentage of original cost: production plant - 2.48% to 5.01%, transmission plant - 1.35% to 3.70%, distribution plant - 1.10% to 4.81% and general plant - 1.82% to 4.82%. Amortization of capital leases is based on nuclear fuel burned and rental payments made. (C) Represents net change in construction work in progress. SCHEDULE VI SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1993 (Thousands of Dollars) - ---- Notes: (A) Amounts shown in column C do not agree with depreciation and amortization shown in the Statement of Consolidated Income due to inclusion on this schedule of fuel amortization. The amounts are included in fuel expense on the Statement of Consolidated Income. SCHEDULE VI SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1992 (Thousands of Dollars) - ---- Notes: (A) Amounts shown in column C do not agree with depreciation and amortization shown in the Statement of Consolidated Income due to inclusion on this schedule of fuel amortization. The amounts are included in fuel expense on the Statement of Consolidated Income. SCHEDULE VI SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1991 (Thousands of Dollars) Notes: (A) Amounts shown in column C do not agree to depreciation and amortization shown in the Statement of Consolidated Income due to inclusion on this schedule of nuclear fuel amortization. Such amounts are included in fuel expense on the Statement of Consolidated Income. SCHEDULE VIII SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) - --- Notes: (A) Recovery of accounts previously written off. (B) Accounts receivable written off. SCHEDULE X SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) - --- Under the system of accounting followed by Duquesne, a portion of maintenance expenses and of taxes other than payroll and income taxes represents amounts charged to coal inventories. The inventory accounts are relieved and operation expense charged as the coal is used. (A) Duquesne changed, as of January 1, 1993, its method of accounting for maintenance costs during scheduled major fossil station outages. Prior to that time, maintenance costs incurred for scheduled major outages at fossil stations were charged to expense as these costs were incurred. Under the new accounting policy, Duquesne accrues, over the periods between outages, anticipated expenses for scheduled major fossil station outages. (Maintenance costs incurred for non-major scheduled outages and for forced outages will continue to be charged to expense as such costs are incurred.) This new method was adopted to match more accurately the maintenance costs and the revenue produced during the periods between scheduled major fossil station outages. The cumulative effect of $5.4 million (net of income taxes of $3.9 million) of the change on prior years is reflected on the Statement of Consolidated Income as "Accounting for maintenance costs - net". (B) The 1993 decrease reflects a favorable resolution of property tax assessments. In 1993, Duquesne recorded on the basis of this revised assessment, the expected refunds of these overpayments related to prior years. SIGNATURES Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DUQUESNE LIGHT COMPANY (Registrant) Date: March 22, 1994 By: /s/ Wesley W. von Schack ------------------------------------- (Signature) Wesley W. von Schack Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ Wesley W. von Schack Chairman of the Board, President, March 22, 1994 ------------------------- Chief Executive Officer and Wesley W. von Schack Director /s/ Gary L. Schwass Vice President - Finance and March 22, 1994 ------------------------- Chief Financial Officer Gary L. Schwass /s/ Raymond H. Panza Controller and Principal March 22, 1994 ------------------------- Accounting Officer Raymond H. Panza /s/ John M. Arthur Director March 22, 1994 ------------------------- John M. Arthur /s/ Daniel Berg Director March 22, 1994 ------------------------- Daniel Berg /s/ Doreen E. Boyce Director March 22, 1994 ------------------------- Doreen E. Boyce /s/ Robert P. Bozzone Director March 22, 1994 ------------------------- Robert P. Bozzone /s/ Sigo Falk Director March 22, 1994 ------------------------- Sigo Falk Director March 22, 1994 ------------------------- W. H. Knoell /s/ G. Christian Lantzsch Director March 22, 1994 ------------------------- G. Christian Lantzsch /s/ Robert Mehrabian Director March 22, 1994 ------------------------- Robert Mehrabian /s/ Thomas J. Murrin Director March 22, 1994 ------------------------- Thomas J. Murrin /s/ Robert B. Pease Director March 22, 1994 ------------------------- Robert B. Pease /s/ Eric W. Springer Director March 22, 1994 ------------------------- Eric W. Springer INDEPENDENT AUDITORS' REPORT To the Directors and Stockholder of Duquesne Light Company: We have audited the accompanying consolidated balance sheets of Duquesne Light Company and its subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Duquesne Light Company and its subsidiary as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109, and the Company changed its method of accounting for maintenance costs during scheduled major fossil station outages. /s/ Deloitte & Touche Pittsburgh, Pennsylvania January 25, 1994 Glossary of Terms Following are explanations of certain financial and operating terms used in our report and unique in our core business. Allowance for Funds Used During Construction (AFC) - -------------------------------------------------- AFC is an amount recorded on the books of a utility during the period of construction of plant. The amount represents the estimated cost of both debt and equity used to finance the construction. Construction Work In Progress (CWIP) - ------------------------------------ This amount represents utility plant in the process of construction but not yet placed in service. The amount is shown on the consolidated balance sheet as a component of property, plant and equipment. Deferred Energy Costs - --------------------- In conjunction with the Energy Cost Rate Adjustment Clause, Duquesne Light Company records deferred energy costs to offset differences between actual energy costs and the level of energy costs currently recovered from customers. Energy Cost Rate Adjustment Clause (ECR) - ---------------------------------------- Duquesne Light Company recovers through the ECR, to the extent that such amounts are not included in base rates, the cost of nuclear fuel, fossil fuel and purchased power costs and passes to its customers the profits from short- term power sales to other utilities. Federal Energy Regulatory Commission (FERC) - ------------------------------------------- FERC is an independent five-member commission within the U.S. Department of Energy. Among its many responsibilities, FERC sets rates and charges for the wholesale transportation and sale of natural gas and electricity, and the licensing of hydroelectric power projects. Kilowatt (KW) - ------------- A kilowatt is a unit of power or capacity. A kilowatt hour (KWH) is a unit of energy or kilowatts times the length of time the kilowatts are used. For example, a 100-watt bulb has a demand of .1 KW and, if burned continuously, will consume 1 KWH in ten hours. One thousand KWs is a megawatt (MEGAWATT). One thousand KWHs is a megawatt hour (MWH). Nuclear Decommissioning Costs - ----------------------------- Decommissioning costs are expenses to be incurred in connection with the entombment, decontamination, dismantlement, removal and disposal of the structures, systems and components of a nuclear power plant that has permanently ceased the production of electric energy. Peak Load - --------- Peak load is the amount of electricity required during periods of highest demand. Peak periods fluctuate by season and generally occur in the morning hours in winter and in late afternoon during the summer. Pennsylvania Public Utility Commission (PUC) - -------------------------------------------- The Pennsylvania governmental body that regulates all utilities (electric, gas, telephone, water, etc.) is made up of five members (one a chairman) appointed by the governor. Regulatory Asset - ---------------- Costs that Duquesne Light Company would otherwise have charged to expense are capitalized or deferred because these costs are currently being recovered or because it is probable that the PUC will allow recovery of these costs through rates. See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. SUPPLEMENTAL CASH FLOW INFORMATION See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SUMMARY OF ACCOUNTING POLICIES Consolidation and Reclassifications - -------------------------------------------------------------------------------- The consolidated financial statements include the accounts of Duquesne Light Company (Duquesne) and its wholly owned subsidiary. All material intercompany balances and transactions have been eliminated in the preparation of the consolidated financial statements. Basis of Accounting - -------------------------------------------------------------------------------- The consolidated financial statements reflect the rate-making practices of Duquesne and contain regulatory assets and liabilities as deferred charges and credits in accordance with Statement of Financial Accounting Standards Number 71, Accounting for the Effects of Certain Types of Regulation (SFAS No. 71). Duquesne's accounting practices conform to the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and the requirements of the Pennsylvania Public Utility Commission (PUC). The Company is also subject to the accounting and reporting requirements of the Securities and Exchange Commission (SEC). Property, Plant and Equipment - -------------------------------------------------------------------------------- The asset values of properties are stated at original construction cost, which includes related payroll taxes, pensions, and other fringe benefits, as well as administrative and general costs. Also included in original construction cost is an allowance for funds used during construction (AFC), which represents the estimated cost of debt and equity funds used to finance construction. The amount of AFC that is capitalized will vary according to changes in the cost of capital and in the level of construction work in progress (CWIP). On a current basis, Duquesne does not realize cash from the allowance for funds used during construction. Duquesne does realize cash, during the service life of the plant, through increased revenues reflecting a higher rate base (upon which a return is earned) and increased depreciation. The AFC rates applied to CWIP were 9.6 percent in 1993, 10.3 percent in 1992, and 9.6 percent in 1991. Additions to, and replacements of, property units are charged to plant accounts. Maintenance, repairs and replacement of minor items of property are recorded as expenses when they are incurred. The costs of properties that are retired (plus removal costs and less any salvage value) are charged to the accumulated provision for depreciation. Substantially all of Duquesne's properties are subject to a first mortgage lien, and substantially all of Duquesne's electric properties are subject to junior liens. Depreciation - -------------------------------------------------------------------------------- Depreciation of property, plant and equipment, including plant-related intangibles, is recorded on a straight-line basis over the estimated useful lives of properties. Amortization of other intangibles is recorded on a straight-line basis over a five-year period. Depreciation and amortization of other properties are calculated on various bases. Nuclear Decommissioning - -------------------------------------------------------------------------------- The PUC ruled that recovery of the decommissioning costs for Beaver Valley Unit 1 could begin in 1977 and that recovery for Beaver Valley Unit 2 and Perry Unit 1 could begin in 1988. Duquesne expects to decommission each nuclear plant at the end of its life, a date that currently coincides with the expiration of each plant's operating license. (See Note L.) The total estimated decommissioning costs, including removal and decontamination costs, being recovered in rates are $70 million for Beaver Valley Unit 1, $20 million for Beaver Valley Unit 2, and $38 million for Perry Unit 1. These amounts were based upon the most recent studies available at the time of Duquesne's last rate case. Since the time of Duquesne's last rate case, site specific studies have been performed to update the estimated decommissioning costs, in current dollars, for each of its nuclear generating units. In 1992, Duquesne's share of the estimated decommissioning costs for Beaver Valley Unit 2 was revised to $35 million. Duquesne's share of decommissioning costs, which is based on preliminary site specific studies to be finalized early in 1994, is estimated to increase to $134 million for Beaver Valley Unit 1 and to $71 million for Perry. During 1994, it is Duquesne's intention to increase the annual contribution to its decommissioning trusts by $2 million to bring the total annual funding to approximately $4 million per year. Duquesne plans to continue making periodic reevaluations of estimated decommissioning costs, to provide additional funding from time to time, and to seek regulatory approval for recognition of these increased funding levels. Duquesne records decommissioning costs under the category of depreciation expense and accrues a liability, equal to that amount, for nuclear decommissioning expense. Such nuclear decommissioning funds are deposited in external, segregated trust accounts. Trust fund earnings increase the fund balance and the recorded liability. The aggregate trust fund balances at the end of 1993 totaled $18.1 million. On Duquesne's consolidated balance sheet, the decommissioning trusts have been reflected in other property and investments, and the related liability has been recorded as other deferred credits. Maintenance - -------------------------------------------------------------------------------- Maintenance expense incurred for scheduled refueling outages at Duquesne's nuclear units is deferred and amortized over the period between scheduled outages. Duquesne changed, as of January 1, 1993, its method of accounting for maintenance costs during scheduled major fossil station outages. Prior to that time, maintenance costs incurred for scheduled major outages at fossil stations were charged to expense as these costs were incurred. Under the new accounting policy, Duquesne accrues, over the periods between outages, anticipated expenses for scheduled major fossil station outages. (Maintenance costs incurred for non- major scheduled outages and for forced outages will continue to be charged to expense as such costs are incurred.) This new method was adopted to match more accurately the maintenance costs and the revenue produced during the periods between scheduled major fossil station outages. The cumulative effect (approximately $5.4 million, net of income taxes of approximately $3.9 million) of the change on prior years was included in income in 1993. The effect of the change in 1993 was to reduce income, before the cumulative effect of changes in accounting principle, by approximately $2.4 million or $.05 per share and to reduce net income, after the cumulative effect of changes in accounting principle, by approximately $7.8 million or $.15 per share. Revenues - -------------------------------------------------------------------------------- Meters are read monthly and customers are billed on the same basis. Revenues are recorded in the accounting periods for which they are billed. Deferred revenues are associated with Duquesne's 1987 rate case. (See Note J.) Income Taxes - -------------------------------------------------------------------------------- On January 1, 1993, Duquesne adopted Statement of Financial Accounting Standards Number 109 (SFAS No. 109). Implementation of SFAS No. 109 involved a change in accounting principle. The cumulative $8 million effect on prior years was reported in 1993 as an increase in net income. SFAS No. 109 requires that the liability method be used in computing deferred taxes on all differences between book and tax bases of assets. These book tax differences occur when events and transactions recognized for financial reporting purposes are not recognized in the same period for tax purposes. As a utility, Duquesne recognizes uncollected deferred income taxes for these deferred tax liabilities that are expected to be recovered from customers through rates. The adoption of SFAS No. 109 on January 1, 1993 resulted in a $700 million increase in deferred tax liabilities and the recognition of $550 million in net regulatory assets. Prior to the adoption of SFAS No. 109, Duquesne recorded certain costs in electric plant in service net of taxes. Because SFAS No. 109 eliminates this "net of tax" accounting, the adoption of SFAS No. 109 also resulted in an increase in plant assets of $150 million. When applied to reduce Duquesne's income tax liability, investment tax credits related to utility property generally were deferred. Such credits are subsequently reflected, over the lives of the related assets, as reductions to tax expense. Energy Cost Rate Adjustment Clause (ECR) - -------------------------------------------------------------------------------- Through the ECR, Duquesne recovers (to the extent that such amounts are not included in base rates) nuclear fuel, fossil fuel and purchased power expenses and, also through the ECR, passes to its customers the profits from short-term power sales to other utilities. Nuclear fuel expense is recorded on the basis of the quantity of electric energy generated and includes such costs as the fee, imposed by the United States Department of Energy (DOE), for future disposal and ultimate storage and disposition of spent nuclear fuel. Fossil fuel expense includes the costs of coal and fuel oil used in the generation of electricity. Duquesne defers fuel and other energy expenses for recovery through the ECR in subsequent years. The deferrals reflect the difference between the amount that Duquesne is currently collecting from customers and its actual fuel costs. The Pennsylvania Public Utility Commission (PUC) annually reviews Duquesne's fuel costs for the fiscal year April through March, compares them to previously projected fuel costs and adjusts the ECR for over- or under-recoveries and for two PUC-established coal cost standards. (See Note J.) Over- or under-recoveries from customers are recorded in the Consolidated Balance Sheet of Duquesne as payable to, or receivable from, customers. At December 31, 1993 and 1992, $10.1 million and $18.9 million were payable to customers and shown as deferred energy costs. Cash Flows - -------------------------------------------------------------------------------- For the purpose of the statement of cash flows, Duquesne considers all highly liquid investments maturing in three or fewer months to be cash equivalents. Reclassifications - -------------------------------------------------------------------------------- The 1992 and 1991 financial statements have been reclassified to conform with accounting presentations adopted during 1993. B. EXTRAORDINARY PROPERTY LOSS In 1984, Duquesne, Ohio Edison Company, The Cleveland Electric Illuminating Company, Pennsylvania Power Company and The Toledo Edison Company agreed to minimize construction work and cash expenditures on Perry Unit 2 until several alternatives, including resumption of construction or cancellation of the unit, were evaluated. Duquesne abandoned its interest in the unit in 1986 and subsequently disposed of its interest in 1992. In 1987, the PUC approved recovery, over a 10-year period, of Duquesne's original $155 million investment in Perry Unit 2. Duquesne is not earning a return on the as yet unrecovered portion (approximately $39.4 million at December 31, 1993) of its investment in the unit. C. CAPITALIZATION Common Stock and Capital Surplus - -------------------------------------------------------------------------------- In July 1989, Duquesne became a wholly owned subsidiary of DQE, the holding company formed as part of a shareholder-approved restructuring. As a result of the restructuring, DQE common stock replaced all outstanding shares of Duquesne common stock, except for ten shares which DQE holds. DQE or its predecessor, Duquesne, has continuously paid dividends on common stock since 1953. Dividends may be paid on DQE common stock to the extent permitted by law and as declared by its board of directors. However, in Duquesne's Restated Articles of incorporation, provisions relating to preferred and preference stock may restrict the payment of Duquesne's common dividends. No dividends or distributions may be made on Duquesne's common stock if Duquesne has not paid dividends or sinking fund obligations on its preferred or preference stock. Further, the aggregate amount of Duquesne's common stock dividend payments or distributions may not exceed certain percentages of net income if the ratio of common stockholders' equity to total capitalization is less than specified percentages. As all of Duquesne's common stock is owned by DQE, to the extent that Duquesne cannot pay common dividends, DQE may not be able to pay dividends to its common stockholders. No part of the retained earnings of Duquesne was restricted at December 31, 1993. Preferred and Preference Stock - -------------------------------------------------------------------------------- Holders of Duquesne's preferred stock are entitled to cumulative quarterly dividends. If four quarterly dividends on any series of preferred stock are in arrears, holders of the preferred stock are entitled to elect a majority of Duquesne's board of directors until all dividends have been paid. At December 31, 1993, Duquesne had made all preferred stock dividend payments. Holders of Duquesne's preference stock are entitled to receive cumulative quarterly dividends if dividends on all series of preferred stock are paid. If six quarterly dividends on any series of preference stock are in arrears, holders of the preference stock are entitled to elect two of Duquesne's directors until all dividends have been paid. At December 31, 1993, Duquesne had made all dividend payments. Outstanding preferred and preference stock is generally callable, on notice of not less than 30 days, at stated prices (See table on page 55.) plus accrued dividends. On January 14, 1994, Duquesne called for redemption of all of its outstanding shares of $2.10 and $7.50 preference stock. None of the remaining preferred or preference stock issues has mandatory purchase requirements. In December 1991, Duquesne established an Employee Stock Ownership Plan (ESOP) to provide matching contributions for a 401(k) Retirement Savings Plan for Management Employees. (See Note I.) Duquesne issued and sold 845,070 shares of redeemable preference stock, plan series A to the trustee of the ESOP. As consideration for the stock, Duquesne received a note valued at $30 million from the trustee. The preference stock has an annual dividend rate of $2.80 per share, and each share of the preference stock is exchangeable for one share of DQE common stock. At December 31, 1993, $27.1 million of preference stock issued in connection with the establishment of the ESOP had been offset, for financial statement purposes, by the recognition of a deferred ESOP benefit. Dividends on the preference stock and cash contributions from Duquesne will be used to repay the ESOP note. During 1993, Duquesne made cash contributions of approximately $2.1 million, the difference between the ESOP debt service and the amount of dividends on ESOP shares (approximately $2.3 million). As shares of preference stock are allocated to the accounts of participants in the ESOP, Duquesne recognizes compensation expense, and the amount of the deferred compensation benefit is amortized. In 1993, Duquesne recognized $1.7 million of compensation expense related to the 401(k) plan. Preferred and Preference Stock of Duquesne Light Company at December 31 - -------------------------------------------------------------------------------- (a) Preferred stock: 4,000,000 authorized shares; $50 par value; cumulative (b) $50 per share involuntary liquidation value (c) Non-redeemable (d) $100 per share involuntary liquidation value (e) Redeemable (f) Preference stock: 8,000,000 authorized shares; $1 par value; cumulative (g) $25 per share involuntary liquidation value (h) Redeemed January 14, 1994 (i) $35.50 per share involuntary liquidation value Long-Term Debt - -------------------------------------------------------------------------------- At December 31, 1993, Duquesne had $1.433 billion of outstanding debt securities; these consisted of $960 million of first collateral trust bonds, $49 million of first mortgage bonds, $418 million of pollution control notes and $6 million of debentures. During 1992, Duquesne began issuing secured debt under a new first collateral trust indenture. This indenture will ultimately replace Duquesne's 1947 first mortgage bond indenture. First collateral trust bonds totaling $695 million and $265 million, and having weighted average interest rates of 6.58 percent and 8.04 percent, were issued in 1993 and 1992. Since 1985, Duquesne has reacquired $1.561 billion of first mortgage bonds. The difference between the purchase prices and the net carrying amounts of these bonds has been included in the consolidated balance sheet as unamortized loss on reacquired debt. At December 31, 1993, the balance of unamortized loss on reacquired debt was $95.3 million. (a) These interest rates are the average coupon rate for multiple issuances with the same maturity dates. (b) Sinking fund requirement relates to the first mortgage bonds held by the trustee as collateral for the publicly-held collateral trust bonds. The outstanding collateral trust bonds do not have a sinking fund requirement. (c) Certain of the pollution control notes have adjustable interest rate periods currently ranging from 1 to 360 days. On 30 days' to 90 days' notice prior to any interest reset date, Duquesne can change the subsequent interest rate period on the notes to a different interest rate period ranging from 1 day to the final maturity of the bonds. (d) Issued in the form of first mortgage bonds or first collateral trust bonds (e) Fixed rate through first five years, thereafter becoming variable rates as in footnote c (f) As of January 1994, the sinking fund requirement for 1995 had been met and the requirement for 1996 had been partially satisfied. At December 31, 1993 and 1992, Duquesne was in compliance with all of its debt covenants. At December 31, 1993, sinking fund requirements and maturities of long-term debt outstanding for the next five years were: $11.8 million and $.1 million in 1994; $11.4 million and $49.6 million in 1995; $11.2 million and $50.1 million in 1996; $10.8 million and $50.0 million in 1997; and $10.1 million and $75.0 million in 1998. Sinking fund requirements relate primarily to the first mortgage bonds and may be satisfied by cash or the certification of property additions equal to 166-2/3 percent of the bonds required to be redeemed. During 1993, annual sinking fund requirements of $.5 million were satisfied by cash and $4.8 million by certification of property additions. Total interest costs incurred were $118.1 million in 1993, $133.9 million in 1992 and $147.2 million in 1991. Of these amounts, which included AFC, $2.0 million in 1993, $4.7 million in 1992 and $9.3 million in 1991 were capitalized. Debt discount or premium and related issuance expenses are amortized over the lives of the applicable issues. In 1992, Duquesne was involved in the issuance of $419.0 million of collateralized lease bonds, which were originally issued by an unaffiliated corporation for the purpose of partially financing the lease of Beaver Valley Unit 2. Duquesne is also associated with a letter of credit securing the lessors' $188 million equity interest in the unit and certain tax benefits. If certain specified events occur, the letter of credit could be drawn down by the owners, the leases could terminate and the bonds would become direct obligations of Duquesne. The pollution control notes arise from the sale of bonds by public authorities for the purposes of financing construction of pollution control facilities at Duquesne's plants or refunding previously issued bonds. Duquesne is obligated to pay the principal and interest on the bonds. For certain of the pollution control notes, there is an annual commitment fee for an irrevocable letter of credit. Under certain circumstances, the letter of credit is available for the payment of interest on, or redemption of, a portion of the notes. In June 1993, $25 million of pollution control notes were issued; the proceeds were used to reimburse Duquesne for pollution control expenditures related to the Beaver Valley plant. In August 1993, pollution control notes totaling $20.5 million were refinanced at lower interest rates. At December 31, 1993, the fair value of Duquesne's long-term debt and redeemable preference stock approximated the carrying value. The fair value of Duquesne's long-term debt and redeemable preference stock was estimated on the basis of (a) quoted market prices for the same or similar issues or (b) current rates offered to Duquesne for debt of the same remaining maturities. At December 31, 1993, the fair market value of Duquesne's investment in DQE common stock was $34.0 million. D. RECEIVABLES An arrangement between Duquesne and an unaffiliated corporation entitles Duquesne to sell, and the corporation to purchase, up to $100 million of Duquesne's accounts receivable. At December 31, 1993 and 1992, Duquesne had sold $7.1 million and $66.3 million of electric customer accounts receivable and $1.9 million and $9.7 million of receivables under contracts from co-owners of jointly owned generating facilities, respectively, to the unaffiliated corporation. The sales agreement includes a limited recourse obligation under which Duquesne could be required to repurchase certain of the receivables. The maximum amount of Duquesne's contingent liability was $2.8 million at December 31, 1993. E. LEASES Duquesne leases nuclear fuel, a portion of a nuclear generating plant, office buildings, computer equipment and other property and equipment. (a) Includes $3,492 in 1993 and $3,782 in 1992 of capital leases with associated obligations retired In 1987, Duquesne sold its 13.74 percent interest in Beaver Valley Unit 2; the sale was exclusive of transmission and common facilities. The total sales price of $537.9 million was the appraised value of Duquesne's interest in the property. Duquesne subsequently leased back its interest in the unit for a term of 29.5 years. The lease provides for semiannual payments and is accounted for as an operating lease. Duquesne is responsible under the terms of the lease for all costs of its interest in the unit. In December 1992, Duquesne participated in the refinancing of collateralized lease bonds originally issued in 1987 for the purpose of partially financing the lease of Beaver Valley Unit 2. In accordance with the Beaver Valley Unit 2 lease agreement, Duquesne paid the premiums of approximately $36.4 million as a supplemental rent payment to the lessors. This amount was deferred and is being amortized over the remaining lease term.Leased nuclear fuel is amortized as the fuel is burned. The amortization of all other leased property is based on rental payments made. Payments for capital and operating leases are charged to operating expenses on the statement of consolidated income. Future minimum lease payments for capital leases are related principally to the estimated use of nuclear fuel financed through leasing arrangements and building leases. Minimum payments for operating leases are related principally to Beaver Valley Unit 2 and the corporate headquarters. Future payments due to Duquesne, as of December 31, 1993, under subleases of its corporate headquarters space are approximately $1.7 million in 1994, $3.4 million in 1995 and $24.9 million thereafter. E. INCOME TAXES Since DQE's formation in 1989, Duquesne has filed consolidated federal income tax returns with its parent and other companies in the affiliated group. Duquesne's federal income tax returns have been audited by the Internal Revenue Service and closed for the tax years through 1989. Returns filed for the tax years 1990 to date remain subject to IRS review. Duquesne does not believe that final settlement of the federal tax returns for these years will have a materially adverse effect on its financial position or results of operations. The effects of the 1993 adoption of SFAS No. 109 are discussed in Note A. Implementation of the standard involved a change in accounting principle. The cumulative effect of $8 million on prior years was reported in 1993 as an increase in net income. The SFAS No. 109 impact to 1993 income before cumulative effect of changes in accounting principle is immaterial. At December 31, 1993, the accumulated deferred income taxes of Duquesne totaled $1.146 billion. As discussed in Note A, this includes the deferred tax liability for the book and tax bases differences associated with (i) electric plant in service of $855 million; (ii) uncollected deferred income taxes of $199 million; and (iii) unamortized loss on reacquired debt of $40.9 million. Duquesne also nets against this liability balance the deferred tax assets associated with (i) investment tax credits unamortized of $45.3 million and (ii) the gain on the sale and leaseback of Beaver Valley Unit 2 of $67.1 million. Duquesne expects to realize these deferred tax assets. Total income taxes differ from the amount computed by applying the statutory federal income tax rate to income before income taxes, preferred and preference dividends of subsidiary and before the cumulative effect of changes in accounting principle. G. SHORT-TERM BORROWING AND RELATED CREDIT AGREEMENTS Duquesne has extendible revolving credit agreements with banks totaling $225 million. Expiration dates vary during 1994. Interest rates can, in accordance with the option selected at the time of each borrowing, be based on prime, federal funds, Eurodollar or CD rates. Commitment fees are based on the unborrowed amount of the commitments. There were no short-term borrowings during 1992. During 1993 and 1991, the maximum short-term bank and commercial paper borrowings outstanding were $27 million and $66 million; the average daily short-term borrowings outstanding were $1.6 million and $11.0 million; and the weighted average daily interest rates applied to such borrowings were 3.42 percent and 6.36 percent, respectively. At December 31, 1993, short-term borrowings were $11.0 million. There were no short-term borrowings at December 31, 1992 or 1991. H. CHANGES IN WORKING CAPITAL OTHER THAN CASH I. EMPLOYEE BENEFITS Retirement Plans - -------------------------------------------------------------------------------- Duquesne maintains retirement plans to provide pensions for all full-time employees. Upon retirement, an employee receives a monthly pension based on his or her length of service and compensation. The cost of funding the pension plan is determined by the unit credit actuarial cost method. Duquesne's policy is to record this cost as an expense and to fund the pension plans by an amount that is at least equal to the minimum funding requirements of the Employee Retirement Income Security Act (ERISA) but not to exceed the maximum tax deductible amount for the year. Pension costs charged to expense or construction were $9.8 million for 1993, $11.4 million for 1992 and $11.2 million for 1991. Pension assets consist primarily of common stocks, United States obligations and corporate debt securities. Retirement Savings Plan and Other Benefit Options - -------------------------------------------------------------------------------- Duquesne sponsors separate 401(k) retirement plans for its union-represented employees and its management employees. The 401(k) Retirement Savings Plan for Management Employees provides that Duquesne will match employee contributions to a 401(k) account up to a maximum of 6 percent of his or her eligible salary. Duquesne's match consists of a $.25 base match and an additional $.25 incentive match, if targets approved by it's board of directors are met. The 1993 incentive target was met. Duquesne is funding its matching contributions with contributions to an ESOP established in December 1991. (See Note C.) Duquesne's shareholders have approved a long-term incentive plan through which Duquesne may grant management employees options to purchase, during the years 1987 through 2003, up to a total of five million shares of DQE common stock at prices equal to the fair market value of such stock on the dates the options were granted. At December 31, 1993, approximately 2.9 million of these shares were available for future grants. As of December 31, 1993, 1992 and 1991, respectively, active grants totaled 1,174,000; 823,000; and 1,263,000 shares. Exercise prices of these options ranged from $12.3125 to $34.1875 at December 31, 1993 and from $12.3125 to $28.75 at December 31, 1992 and 1991. Expiration dates of these grants ranged from 1997 to 2003 at December 31, 1993; from 1997 to 2002 at December 31, 1992; and from 1997 to 2001 at December 31, 1991. As of December 31, 1993, 1992 and 1991, respectively, stock appreciation rights (SARs) had been granted in connection with 778,000; 612,000; and 822,000 of the options outstanding. During 1993, 103,000 SARs were exercised; 8,500 options were exercised at prices ranging from $12.3125 to $28.375; and 52,000 options lapsed. During 1992, 108,000 SARs were exercised; 50,000 options were exercised at prices ranging from $12.3125 to $26.375; and 59,000 options lapsed. During 1991, 229,000 SARs were exercised; 11,000 options were exercised at $12.3125; and 48,000 options lapsed. Of the active grants at December 31, 1993, 1992 and 1991, respectively, 549,000; 211,000; and 526,000 were not exercisable. Other Postretirement Benefits - -------------------------------------------------------------------------------- In addition to pension benefits, Duquesne provides certain health care benefits and life insurance for some retired employees. Substantially all of Duquesne's full-time employees may, upon attaining the age of 55 and meeting certain service requirements, become eligible for the same benefits available to retired employees. Participating retirees make contributions, which are adjusted annually, to the health care plan. The life insurance plan is non-contributory. Company-provided health care benefits terminate when covered individuals become eligible for Medicare benefits or reach age 65, whichever comes first. Duquesne funds actual expenditures for obligations under the plans on a "pay-as-you-go basis." Duquesne has the right to modify or terminate the plans. As of January 1, 1993, Duquesne adopted Statement of Financial Accounting Standards Number 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires the actuarially determined costs of the aforementioned postretirement benefits to be accrued over the period from the date of hire until the date the employee becomes fully eligible for benefits. Duquesne has adopted the new standard prospectively and has elected to amortize the transition liability over 20 years. In prior years, Duquesne recognized the cost of providing postretirement benefits by expensing the contributions as they were made. Costs recognized under this method in 1992 approximated $1.2 million. The new accrual method increased the cost recognized for providing postretirement benefits to approximately $6.0 million. The accumulated postretirement benefit obligation comprises the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. Funded Status of Postretirement Plan and Amounts Recognized on the Consolidated Balance Sheet of Duquesne at December 31, 1993 - -------------------------------------------------------------------------------- For measurement purposes, a 10.5 percent increase in the cost of covered health care benefits was assumed as of January 1, 1993. This rate is assumed to decrease to 5.5 percent by 1999 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. A 1 percent increase in the health care cost trend rate would increase the accumulated postretirement benefit obligation by $4.0 million at January 1, 1994 and the net annual cost by $0.6 million for the year. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7 percent. J. RATE MATTERS 1987 Rate Case - -------------------------------------------------------------------------------- In March 1988, the PUC adopted a rate order that increased Duquesne's annual revenues by $232 million to be phased in from April 1, 1988 through April 1, 1994. Deficiencies which resulted from the phase-in plan in current revenues from customers have been included in the consolidated income statement as deferred revenues. Deferred revenues have been recorded on the balance sheet as a deferred asset for future recovery. As customers were billed for deficiencies related to prior periods, this deferred asset was reduced. As designed, the phase-in plan provided for carrying charges (at the after-tax AFC rate) on revenues deferred for future recovery. Since April 1993, Duquesne has not recorded additional carrying charges on the deferred revenue balance. As of December 31, 1993, Duquesne had recovered previously deferred revenues and carrying charges of $285.9 million. Phase-in plan deferrals of $28.6 million remained unrecovered as of that date. Duquesne expects to recover this remaining unrecovered balance by the end of the phase-in period. At this time, Duquesne has no pending base rate case and has no immediate plans to file a base rate case. Deferred Rate Synchronization Costs - -------------------------------------------------------------------------------- In 1987, the PUC approved Duquesne's petition to defer initial operating and other costs of Perry Unit 1 and Beaver Valley Unit 2. Duquesne deferred the costs incurred from November 17, 1987, when the units went into commercial operation, until March 25, 1988 when a rate order was issued. In its order, the PUC deferred ruling on whether these costs would be recoverable from ratepayers. At December 31, 1993, these costs totaled $51.1 million, net of deferred fuel savings related to the two units. Duquesne is not earning a return on the deferred costs. Duquesne believes that these deferred costs are recoverable. In 1990, another Pennsylvania utility was permitted recovery, with no return on the unamortized balance, of similar costs over a 10-year period. Deferred Energy Costs - -------------------------------------------------------------------------------- Duquesne defers fuel and other energy costs for recovery in subsequent years through the ECR. The deferrals reflect the difference between the amount that Duquesne is currently collecting from customers and its actual fuel costs. The PUC reviews Duquesne's fuel costs annually, for the fiscal year April through March, against the previously projected fuel costs and adjusts the ECR for over- or under-recoveries and for two PUC-established coal cost caps. The PUC has established market price coal cost standards for all Pennsylvania utilities that have interests in mines that supply coal to their generating stations. Duquesne is subject to two such standards. One applies only to coal delivered at the Mansfield plant. The other, the system-wide coal cost standard, applies to coal delivered to the remainder of Duquesne's system. Both standards are updated monthly to reflect prevailing market prices for similar coal. The PUC has directed Duquesne to defer recovery of the delivered cost of coal to the extent that such cost exceeds generally prevailing market prices, as determined by the PUC, for similar coal. The PUC allows deferred amounts to be recovered from customers when the delivered costs of coal fall below such PUC-determined prevailing market prices. In 1990, the PUC approved a joint petition for settlement that clarified certain aspects of the system-wide coal cost standard and gave Duquesne options to extend the standard through March 2000. In December 1991, Duquesne exercised the first of two options that extended the standard through March 1996. The unrecovered cost of coal used at Mansfield amounted to $7.4 million and the unrecovered cost of coal used throughout the system amounted to $8.8 million at December 31, 1993. Duquesne believes that all deferred coal costs will be recovered. Warwick Mine Costs - -------------------------------------------------------------------------------- The 1990 joint petition for settlement (See preceding section on deferred energy costs.) also recognized costs at Duquesne's Warwick Mine, which had been on standby since 1988, and allowed for recovery of such costs, including the costs of ultimately closing the mine. In 1990, Duquesne entered into an agreement under which an unaffiliated company will operate the mine until March 2000 and sell the coal produced. Production began in late 1990. The mine reached a full production rate in early 1991. The Warwick Mine coal reserves include both high and low sulfur coal; the sulfur content averages in the mid-range at 1.7 percent - -- 1.9 percent sulfur content. More than 90 percent of the coal mined at Warwick currently is used by Duquesne. Duquesne receives a royalty on sales of coal in the open market. The Warwick Mine currently supplies less than one-fifth of the coal used in the production of electricity at the plants owned or co-owned by Duquesne. Costs at the Warwick Mine and Duquesne's investment in the mine are expected to be recovered through the ECR. Recovery is subject to the system-wide coal cost standard. Duquesne also has an opportunity to earn, through the ECR, a return on its investment in the mine during the period, including extensions, of the system-wide coal cost standard. At December 31, 1993, Duquesne's net investment in the mine was $24.5 million. The estimated current liability for mine closing (including final site reclamation, mine water treatment and certain labor liabilities) is $33.0 million and Duquesne has collected approximately $8.9 million toward these costs. Property Held for Future Use - -------------------------------------------------------------------------------- In 1986, the PUC approved Duquesne's request to remove the Phillips and most of the Brunot Island (BI) power stations from service and place them in cold reserve. Duquesne's capitalized costs and net investment in the plants at December 31, 1993 totaled $130 million. (See Note L.) On December 8, 1993, the New Jersey Board of Regulatory Commissioners (BRC) denied a request by General Public Utilities' (GPU) subsidiary Jersey Central Power and Light Company for approval of the long-term power purchase and operating agreements, originally signed in 1990, between GPU and Duquesne and further amended earlier in 1993. The BRC rejected an administrative law judge's recommended decision that the project be approved and, within hours of the BRC decision, GPU terminated its participation in the project. In view of GPU's decision not to proceed, Duquesne terminated its participation in the project and in the PUC transmission line siting proceeding. During the fourth quarter of 1993, Duquesne recognized a charge of approximately $15.2 million for its investment in this abandoned GPU transmission line project. Duquesne expects to recover its net investment in these plants through future sales. Phillips and BI represent licensed, certified, clean sources of electricity that will be necessary to meet expanding opportunities in the power markets. Duquesne believes that anticipated growth in peak load demand for electricity within its service territory will require additional peaking generation. Duquesne looks to BI to meet this need. The Phillips Power Plant is an important component in meeting market opportunities to supply long term bulk power. Recent legislation may permit wider transmission access to these long- term bulk power markets. In summary, Duquesne believes its investment in these cold-reserved plants will be necessary in order to meet future business needs. If business opportunities do not develop as expected, Duquesne will consider the sale of these assets. In the event that market demand, transmission access or rate recovery do not support the utilization or sale of the plants, Duquesne may have to write off part or all of their costs. K. COMMITMENTS AND CONTINGENCIES Construction - -------------------------------------------------------------------------------- Duquesne estimates that it will spend approximately $110 million on construction during 1994. Construction expenditures are estimated to be $70 million in 1995 and $80 million in 1996. These amounts exclude AFC, nuclear fuel and expenditures for possible early replacement of steam generators at the Beaver Valley Station. Westinghouse Lawsuit - -------------------------------------------------------------------------------- In 1991, the co-owners of Beaver Valley Units 1 and 2 filed suit against Westinghouse Electric Corporation (Westinghouse) in the United States District Court for the Western District of Pennsylvania. The suit alleges that six steam generators supplied by Westinghouse for the two units contain serious defects -- in particular defects causing tube corrosion and cracking. Duquesne is seeking monetary and corrective relief. Steam generator maintenance costs have increased as a result of these defects and are likely to continue increasing. The condition of the steam generators is being monitored closely. If the corrosion and cracking continue, replacement of the steam generators could be required prior to the ends of their 40-year design lives. Duquesne is continuing to conduct a corrective maintenance program and to explore longer term options, including replacement of the steam generators. While Duquesne has no current plans to replace the steam generators and has not yet completed a detailed, site-specific study, replacement cost per unit is estimated to be between $100 million and $150 million. (Other utilities with similar units have replaced steam generators at costs in this range.) Duquesne cannot predict the outcome of this matter; however, Duquesne does not believe that resolution will have a materially adverse effect on it's financial position or results of operations. Duquesne's percentage interests (ownership and leasehold) in Beaver Valley Unit 1 and in Beaver Valley Unit 2 are 47.5 percent and 13.74 percent, respectively. The remainder of Beaver Valley Unit 1 is owned by Ohio Edison Company and Pennsylvania Power Company. The remaining interest in Beaver Valley Unit 2 is owned by Ohio Edison Company, Cleveland Electric Illuminating Company and Toledo Edison Company. Duquesne operates both units on behalf of these co-owners. Nuclear Insurance - -------------------------------------------------------------------------------- Co-owners of the Beaver Valley Power Station maintain the maximum available nuclear insurance for the $5.9 billion total investment in Beaver Valley Units 1 and 2. The insurance program provides $2.7 billion for property damage, decommissioning, and decontamination liabilities. Similar property insurance is held by the joint owners of the Perry Plant for their $5.4 billion total investment in Perry Unit 1. Duquesne would be responsible for its share of any damages in excess of insurance coverage. In addition, if the property damage reserves of Nuclear Electric Insurance Limited (NEIL), an industry mutual, are inadequate to cover claims arising from an incident at any United States nuclear site covered by that insurer, Duquesne could be assessed retrospective premiums of as much as $6.5 million for up to seven years. The Price-Anderson Amendments to the Atomic Energy Act limit public liability from a single incident at a nuclear plant to $9.4 billion. Duquesne has purchased $200 million of insurance, the maximum amount available, which provides the first level of financial protection. Additional protection of $8.8 billion would be provided by an assessment of up to $75.5 million per incident on each nuclear unit in the United States. Duquesne's maximum total assessment, $56.6 million, which is based upon its ownership interests in nuclear generating stations, would be limited to a maximum of $7.5 million per incident per year. A further surcharge of 5 percent could be levied if the total amount of public claims exceeded the funds provided under the assessment program. Additionally, a premium tax of 3 percent would be charged on the assessment and surcharge. Finally, the United States Congress could impose other revenue-raising measures on the nuclear industry if funds prove insufficient to pay claims. Duquesne carries extra expense insurance; coverage includes the incremental cost of any replacement power purchased (in addition to costs that would have been incurred had the units been operating) and other incidental expense after the occurrence of certain types of accidents at it's nuclear units. The amounts of the coverage are 100 percent of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67 percent of such estimate per week for the following 104 weeks. The amount and duration of actual extra expense could substantially exceed insurance coverage. Guarantees - -------------------------------------------------------------------------------- Duquesne and the other co-owners have guaranteed certain debt and lease obligations related to a coal supply contract for the Bruce Mansfield plant. At December 31, 1993, Duquesne's share of these guarantees was $35.2 million. The prices paid for the coal by the companies under this contract are expected to be sufficient to meet debt and lease obligations to be satisfied in the year 2000. (See Note J.) The minimum future payments to be made by Duquesne solely in relation to these obligations are $6.9 million in 1994, $6.6 million in 1995, $6.3 million in 1996, $5.9 million in 1997, $5.6 million in 1998, $5.3 million in 1999 and $4.1 million in 2000. Duquesne's total payments for coal purchased under the contract were $26.5 million in 1993, $25.2 million in 1992 and $32.6 million in 1991. Residual Waste Management Regulations - -------------------------------------------------------------------------------- In July 1992, the Pennsylvania Department of Environmental Resources (DER) issued residual waste management regulations governing the generation and management of non-hazardous waste. Duquesne is currently conducting tests and developing compliance strategies for these regulations. Capital compliance costs are estimated, on the basis of currently available information, at $10 million through 1995. Through the year 2000, the expected additional capital cost of compliance, which is subject to the results of ground water assessments and DER final approval of compliance plans, is approximately $25 million. Other - -------------------------------------------------------------------------------- Duquesne is involved in various other legal proceedings and environmental matters. Duquesne believes that such proceedings and matters, in total, will not have a materially adverse effect on its financial position or results of operations. L. GENERATING UNITS In addition to its wholly owned generating units, Duquesne, together with other electric utilities, has an ownership or leasehold interest in certain jointly owned units. Duquesne is required to pay its share of the construction and operating costs of the units. Duquesne's share of the operating expenses of the units is included in the Statement of Consolidated Income. (a) The unit is equipped with flue gas desulfurization equipment. (b) The NRC has granted a license to operate through January 2016. (c) On October 2, 1987 Duquesne sold its 13.74 percent interest in Beaver Valley Unit 2; the sale was exclusive of transmission and common facilities. Amounts shown represent facilities not sold and subsequent leasehold improvements. (d) The NRC has granted a license to operate through May 2027. (e) The NRC has granted a license to operate through March 2026. M. QUARTELY FINANCIAL INFORMATION (UNAUDITED) Summary of Selected Quarterly Financial Data (thousands of dollars, except per share amounts) - -------------------------------------------------------------------------------- [The quarterly data reflect seasonal weather variations in Duquesne's service territory.] - -------------------------------------------------------------------------------- (a) Fourth quarter 1993 results included the effects of a $15.2 million charge for the write-off of Duquesne's investment in abandoned transmission line project (See Note J.) and a $14.6 million reduction of taxes other than income as a result of a favorable resolution of tax assessments. (b) Restated to conform with presentations adopted during 1993. SELECTED FINANCIAL DATA GRAPHICS APPENDIX LIST _______________________________________________________________________________ PAGE WHERE GRAPHIC DESCRIPTION OF GRAPHIC OR CROSS-REFERENCE APPEARS _______________________________________________________________________________ 1 Title of Graphics: Quarterly Kilowatt-Hour Sales This bar graph shows the four quarterly kilowatt-hour sales for three years. Quarter ________ 1 2 3 4 1991 2911 2853 3256 2842 1992 2936 2732 3036 2865 1993 2994 2762 3279 2816 2 Title of Graphics: 1993 Energy Sales by Class of Customers Subtitle in parenthesis: (Excluding Sales to Other Utilities) Two pie charts showing the percentage of residential, commercial and industrial customers. All Electric DLCO Utilities ____ ____________ Commercial 47.0% 33.1% Residential 27.3% 32.9% Industrial 25.7% 34.0% A footnote under the DLCO pie chart: Total Sales to Ultimate Customers-11,851,000 mwh A footnote under the All Electric Utilities pie chart: Source: Edison Electric Institute 3 Title of Graphics: Net Cash Flow From Operations* This bar graph shows a five year comparison from 1989 through 1993. 1989 220 1990 276 1991 355 1992 395 1993 384 There is a footnote designated by an asterisk at the bottom of the graph. *Graph excludes working capital and other-net changes. 5 Title of Graphics: Interest Expense and Preferred and Preference Dividends This bar graph shows a five year comparison from 1989 through 1993 1989 168 1990 160 1991 145 1992 135 1993 121 DUQUESNE LIGHT COMPANY EXHIBITS INDEX - ----- x An additional document, substantially identical in all material respects to this Exhibit, has been entered into relating to one additional limited partnership Owner Participant. Although the additional document may differ in some respects (such as name of the owner participant, dollar amounts and percentages), there are no material details in which the document differs from this Exhibit. y Additional documents, substantially identical in all material respects to this Exhibit, have been entered into relating to four additional corporate Owner Participants. Although the additional documents may differ in some respects (such as names of the Owner Participants, dollar amounts and percentages), there are no material details in which the documents differ from this Exhibit. z Additional documents, substantially identical in all material respects to this Exhibit, have been entered into relating to six additional Owner Participants. Although the additional documents may differ in some respects (such as name of the Owner Participant, dollar amounts and percentages), there are no material details in which the documents differ from this Exhibit. * This document is required to be filed as an exhibit to this form under Item 14(c). Copies of the exhibits listed above will be furnished, upon request, to holders or beneficial owners of any class of the Company's stock as of February 23, 1994, subject to payment in advance of the cost of reproducing the exhibits requested. EXHIBIT 4.2 CONFORMED COPY ================================================================================ EIGHTY-FIFTH SUPPLEMENTAL TRUST INDENTURE between DUQUESNE LIGHT COMPANY (a Pennsylvania corporation) and MELLON BANK, N.A., Trustee --------- Dated as of June 1, 1993 --------- Supplemental to Trust Indenture dated as of August 1, 1947 --------- Providing for $300,000,000 First Mortgage Bonds, Collateral Series E ================================================================================ -ii- EIGHTY-FIFTH SUPPLEMENTAL TRUST INDENTURE Dated as of the first day of June, 1993, although executed and delivered on the date of the latest acknowledgment at the end hereof, made by and between DUQUESNE LIGHT COMPANY, a corporation organized and existing under and by virtue of the laws of the Commonwealth of Pennsylvania, having its principal office in the City of Pittsburgh in said Commonwealth of Pennsylvania (hereinafter called the "Company"), party of the first part, and MELLON BANK, N.A., successor by merger to Mellon National Bank and Trust Company, a national banking association, having its principal corporate trust office in the City of Pittsburgh in the Commonwealth of Pennsylvania, as Trustee (hereinafter sometimes called the "Trustee"), party of the second part. Whereas, the Company has heretofore executed and delivered to Mellon Bank, N.A., as Trustee, a certain Trust Indenture (hereinafter called the "Original Indenture") dated as of August 1, 1947 securing its First Mortgage Bonds and at various times since the execution of the Original Indenture has executed and delivered to Mellon Bank, N.A., as Trustee, eighty-four supplemental trust indentures and an amendment to one thereof, all for the purposes recited therein and as permitted by the Original Indenture; and Whereas, for convenience of reference the Original Indenture and all indentures supplemental thereto heretofore or hereafter executed, including this Eighty-Fifth Supplemental Trust Indenture, are sometimes hereinafter collectively called the "Indenture"; and Whereas, the Company has caused the Original Indenture and the aforesaid eighty-four supplemental trust indentures to be recorded and filed, and has caused financing statements and continuation statements under the Uniform Commercial Code to be filed, all in such manner and in such places as are required by law to make effective and maintain the lien intended to be created by the Indenture; and Whereas, there have been issued under the Original Indenture and certain of the indentures supplemental thereto heretofore executed forty-three series of First Mortgage Bonds, of which $1,249,933,000 aggregate principal amount was outstanding as of the date hereof; and Whereas, the Company desires to provide for the issuance from time to time under the Indenture of a new series of bonds secured thereby in an aggregate principal amount not to exceed $300,000,000 to be designated as "First Mortgage Bonds, Collateral Series E", said new series to be hereinafter sometimes called the "Forty-Fourth Series," the bonds of said series to be issued as registered bonds without coupons in the denominations of $1,000 and any integral multiple of $1,000 that the Company may execute and deliver, and the bonds of said series to be substantially in the form and of the tenor following, to wit: [FORM OF BOND OF THE FORTY-FOURTH SERIES] This Bond is not transferable except to a successor trustee under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented, between Duquesne Light Company and Mellon Bank, N.A., trustee. DUQUESNE LIGHT COMPANY (Incorporated under the laws of the Commonwealth of Pennsylvania) FIRST MORTGAGE BOND, COLLATERAL SERIES E No. $ ORIGINAL ISSUE DATE: STATED MATURITY DATE: DUQUESNE LIGHT COMPANY, a corporation organized and existing under and by virtue of the laws of the Commonwealth of Pennsylvania (hereinafter called the "Company"), for value received, hereby promises to pay to ____________ or registered assigns the sum of _________________ Dollars in lawful money of the United States of America on the Stated Maturity Date specified above. This bond shall not bear interest except that, if the Company should default in the payment of the principal hereof, this bond shall bear interest at the rate of five percent per annum until the Company's obligation with respect to the payment of such principal shall be discharged as provided in the Indenture hereinafter mentioned. Principal of and interest, if any, on this bond shall be payable upon presentation hereof at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency as may be designated for such purpose by the Company from time to time. Any payment by the Company under its Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented (the "1992 Mortgage"), to Mellon Bank, N.A., as trustee, of the principal of or interest, if any, on securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to such trustee of this bond (other than by the application of the proceeds of a payment in respect of this bond) shall, to the extent thereof, be deemed to satisfy and discharge the obligation of the Company, if any, to make a payment of principal of or interest on this bond, as the case may be, which is then due. This bond is one of a duly authorized issue of bonds of the Company, known as its First Mortgage Bonds, unlimited in aggregate principal amount, of the series and designation indicated above, which issue of bonds consists, or may consist, of several series of varying denominations, dates and tenors, all issued and to be issued under and equally secured (except insofar as a sinking fund, or similar fund, established in accordance with the provisions of the Indenture may afford additional security for the bonds of any specific series) by a Trust Indenture dated as of August 1, 1947 executed by the Company to Mellon Bank, N.A., formerly Mellon National Bank and Trust Company (herein called the "Trustee"), as Trustee, as heretofore supplemented and amended (said Trust Indenture as supplemented and amended being herein called the "Indenture"), to which Indenture reference is hereby made for a description of the property mortgaged and pledged, the nature and extent of the security, the rights of the holders of the bonds as to such security, and the terms and conditions upon which the bonds may be issued under the Indenture and are secured. The principal hereof may be declared or may become due on the conditions, in the manner and at the time set forth in the Indenture, upon the happening of a completed default as provided in the Indenture. The Indenture provides that such declaration may in certain events be waived by the holders of a majority in principal amount of the bonds outstanding. With the consent of the Company and to the extent permitted by and as provided in the Indenture, the rights and obligations of the Company and/or of the holders of the bonds and/or the terms and provisions of the Indenture and/or of any instruments supplemental thereto may be modified or altered by the affirmative vote of the holders of at least seventy percent in principal amount of the bonds then outstanding under the Indenture and any instruments supplemental thereto (excluding bonds disqualified from voting by reason of the interest of the Company or of certain related persons therein as provided in the Indenture), and by the affirmative vote of at least seventy percent in principal amount of the bonds of any series entitled to vote then outstanding under the Indenture and any instruments supplemental thereto (excluding bonds disqualified from voting as aforesaid) and affected by such modification or alteration, in case one or more but less than all of the series of bonds then outstanding are so affected; provided that no such modification or alteration shall permit the extension of the maturity of the principal of this bond or the reduction in the rate of interest hereon or any other modification in the terms of payment of such principal or interest or the taking of certain other action as more fully set forth in the Indenture, without the consent of the holder hereof. The Company, the Trustee and any paying agent may deem and treat the person in whose name this bond is registered as the absolute owner hereof for the purpose of receiving payment of or on account of the principal hereof and interest hereon and for all other purposes and shall not be affected by any notice to the contrary. In the manner and with the effect provided in the Indenture, this bond may, in whole at any time, or in part from time to time prior to maturity, be redeemed by the Company with funds derived from any source by payment at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, at a redemption price equal to 100% of the principal amount of this bond to be redeemed. This bond is entitled to the benefits of, and is subject to call for redemption for, the Sinking Fund, upon the notice, in the manner, and with the effect provided in the Indenture by payment of the principal amount hereof. This bond shall initially be issued in the name of Mellon Bank, N.A., trustee under the 1992 Mortgage, and is not transferable except to any successor trustee under the 1992 Mortgage. Any such transfer shall be made as prescribed in the Indenture by the registered holder hereof in person, or by his duly authorized attorney, at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, upon surrender and cancellation of this bond, and thereupon a new bond or bonds of the same series and of authorized denominations for a like aggregate principal amount, and having the same Original Issue Date and Stated Maturity Date, will be issued to the transferee in exchange herefor as provided in the Indenture. Bonds of this series are interchangeable as to denominations in the manner and upon the conditions prescribed in the Indenture. No charge shall be made to any holder of any bond of this series for any transfer or exchange of bonds except for any tax or taxes or other governmental charge required to be paid in connection therewith. No recourse shall be had for the payment of principal of or interest, if any, on this bond, or any part thereof, or of any claim based hereon or in respect hereof or of the Indenture, against any incorporator or any past, present or future stockholder, officer or director of the Company or of any predecessor or successor corporation, either directly or through the Company, or through any such predecessor or successor corporation, or through any receiver or a trustee in bankruptcy, whether by virtue of any constitution, statute or rule of law or by the enforcement of any assessment or penalty or otherwise, all such liability being, by the acceptance hereof and as part of the consideration for the issue hereof, expressly waived and released, as more fully provided in the Indenture. This bond shall not be valid or become obligatory for any purpose unless and until Mellon Bank, N.A., as Trustee under the Indenture, or its successor thereunder, shall have signed the certificate of authentication endorsed hereon. In Witness Whereof, DUQUESNE LIGHT COMPANY has caused this bond to be signed in its name with the facsimile signature of its Chairman of the Board, President and Chief Executive Officer, and its corporate seal, or a facsimile thereof, to be hereto affixed and attested with the facsimile signature of its Secretary. Dated _______________ DUQUESNE LIGHT COMPANY [Seal] By ___________________ Attest: ___________________ Secretary [END OF FORM OF BOND] Whereas, Sections 8.09 and 20.03 of the Original Indenture provide in substance that the Company and the Trustee may enter into indentures supplemental thereto for the purpose, among others, of making subject to the lien of the Original Indenture property acquired subsequent to the execution and delivery thereof and for any other purpose not inconsistent with the terms of the Indenture; and Whereas, Sections 2.01, 4.01 and 20.03 of the Original Indenture provide in substance that the Company and the Trustee may enter into indentures supplemental thereto for the purposes, among others, of creating and setting forth the particulars of any new series of bonds and of providing the terms and conditions of the issue of the bonds of any series not expressly provided for in the Original Indenture; and Whereas, the execution and delivery of this Eighty-Fifth Supplemental Trust Indenture have been duly authorized by a resolution adopted by the Board of Directors of the Company; and Whereas, all things necessary to make said $300,000,000 aggregate principal amount of said bonds of the Forty-Fourth Series, when duly executed by the Company and authenticated and delivered by the Trustee (or a duly appointed authenticating agent) and issued, the valid, binding and legal obligations of the Company entitled to the benefits and security of the Indenture and to make this Eighty-Fifth Supplemental Trust Indenture a valid, binding and legal instrument in accordance with its terms have been done and performed, and the issue of said Bonds, as herein provided, has been in all respects duly authorized; NOW, THEREFORE, THIS INDENTURE WITNESSETH: Duquesne Light Company, intending to be legally bound hereby, in consideration of the premises and of One Dollar to it duly paid by the Trustee at or before the issuance and delivery of these presents, the receipt whereof is hereby acknowledged, and of the purchase and acceptance from time to time of said bonds of the Forty-Fourth Series by the holders thereof, and in order to declare the conditions and terms upon and subject to which the bonds of said series are to be issued and secured, and in order to create the bonds of said series and further to secure the payment of the principal of, and premium, if any, and interest on all bonds of the Company at any time outstanding under the Indenture according to their tenor and effect and the performance of and compliance with the covenants and conditions in the Indenture contained, has executed and delivered this Eighty-Fifth Supplemental Trust Indenture and hereby grants, bargains, sells, warrants, releases, conveys, assigns, transfers, mortgages, pledges, sets over and confirms unto Mellon Bank, N.A., as Trustee under the Indenture, and to its respective successors in said trust, forever, all property, real, personal and mixed, now owned or hereafter acquired or to be acquired by the Company and wheresoever situated (except as excepted from the lien of the Indenture by the provisions thereof), subject to the rights reserved by the Company in and by various provisions of the Indenture, including (without in anywise limiting or impairing by the enumeration of the same the scope and intent of the foregoing or of any general description contained in the Indenture) all lands, rights of way, roads, all powerhouses, buildings and other structures, and all offices, buildings and the contents thereof; all machinery, engines, boilers, dynamos, electrical machinery, regulators, meters, transformers, generators, motors, electrical and mechanical appliances, conduits, cables, water or other pipes, pole and transmission lines, poles, wires, cross-arms, insulators, substations and superstructures, generating, distributing and transmitting equipment, tools, implements, apparatus and supplies and coal in place and interests in coal; whether appertaining to any existing or future system of the Company or otherwise and including all other property now used or provided for use or hereafter acquired for use, in the construction, repair, maintenance and operation of such systems, both those now owned and those which may hereafter be acquired by the Company; all municipal or other grants, rights, permits, consents, franchises, privileges, easements, licenses, ordinances, rights of way, liberties and immunities of the Company, howsoever conferred or acquired and whether now owned or hereafter acquired; and all leases, leaseholds, power contracts, street lighting contracts and other rights with respect to the construction, maintenance, repair and operation of any systems now owned or hereafter acquired by the Company, and any additions thereto or extensions thereof; Together with all and singular the tenements, hereditaments and appurtenances belonging or in anywise appertaining to the aforesaid property or any part thereof, with the reversion and reversions, remainder and remainders, tolls, rents and revenues, issues, income, product and profits thereof and all the estate, right, title, interest and claim whatsoever, at law as well as in equity, which the Company now has or may hereafter acquire in and to the aforesaid property and every part and parcel thereof except as excepted or excluded from the lien of the Indenture; There Being Hereby Excepted from the lien of the Indenture, whether now owned or hereafter acquired by the Company, anything herein contained to the contrary notwithstanding, all those certain items of property of the classes specifically excepted from the lien of the Original Indenture by the terms thereof; To Have and To Hold all properties, real, personal and mixed, mortgaged, pledged or conveyed by the Company as aforesaid, or intended so to be, unto the Trustee and its successors and assigns, FOREVER; subject, however, to permissible encumbrances, as defined in the Original Indenture, and to all the other terms, conditions, covenants, uses, trusts and defeasances incorporated in the Indenture. The parties hereto shall have, possess and enjoy the same rights, powers, duties and privileges as affecting the property hereby conveyed as they have under the Original Indenture insofar as the same may be applicable hereto, with the same force and effect as though the terms, conditions, and defeasances of the Original Indenture had been embodied herein. It Is Hereby Covenanted, Declared and Agreed by the Company and the Trustee, and its successors in the trust under the Indenture, for the benefit of those who hold or shall hold the bonds, or any of them, issued or to be issued thereunder, as follows: ARTICLE I Form and Execution of First Mortgage Bonds, Collateral Series E Section 1.01. There is hereby created, for issuance under the Indenture and to be secured thereby, a series of bonds, designated "First Mortgage Bonds, Collateral Series E," each of which shall bear the descriptive title "First Mortgage Bond, Collateral Series E," and the form thereof shall be substantially of the tenor and purport hereinbefore recited. The bonds of the Forty-Fourth Series shall be issued from time to time in an aggregate principal amount not to exceed $300,000,000 and shall be issued as registered bonds without coupons in denominations of $1,000 and integral multiples thereof. The bonds of the Forty- Fourth Series shall not bear interest except as provided in Article XIII of the Original Indenture. Each bond of the Forty-Fourth Series shall (a) be issued in such principal amount, (b) mature on such date not less than nine months nor more than forty years from its Original Issue Date (as hereinafter defined), and (c) have such other terms and conditions, all as shall be specified by the Company in an officers' certificate delivered to the Trustee relating to such bond and referring to this Eighty-Fifth Supplemental Trust Indenture (such officers' certificate being hereinafter sometimes called the "Issuance Certificate") and substantially in the form of bond of the Forty-Fourth Series hereinbefore recited. The principal of and interest, if any, on each bond of the Forty-Fourth Series shall be payable at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, in lawful money of the United States of America. Each bond of the Forty-Fourth Series shall be dated as of its Original Issue Date. The term "Original Issue Date" as used in this Section 1.01 shall mean, with respect to any bonds of said series of identical stated maturity and other terms and conditions, the date of the first authentication and delivery hereunder of such bonds. Section 1.02. Each bond of the Forty-Fourth Series shall be redeemable at the option of the Company in whole at any time, or in part from time to time, prior to maturity, at a redemption price equal to 100.00% of the principal amount thereof to be redeemed, by payment at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time. Any such redemption shall be made upon not less than 30 days' previous notice to be given in the manner provided in Section 10.02 of the Original Indenture. Section 1.03. The bonds of the Forty-Fourth Series shall be redeemable on October 1 of each year commencing one year after the date of issuance of the first bonds of said series for the Sinking Fund for bonds of said series provided for in Article XII of the Original Indenture, upon not less than 30 days' previous notice of redemption to be given in the manner provided in Section 10.02 of the Original Indenture, at the principal amount thereof. Section 1.04. The bonds of the Forty-Fourth Series shall be issued and delivered to Mellon Bank, N.A., as trustee under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented (the "1992 Mortgage"), of the Company to such trustee (the "1992 Mortgage Trustee"), as the basis for the authentication and delivery under the 1992 Mortgage of a series of securities. As provided in the 1992 Mortgage, the bonds of the Forty-Fourth Series will be registered in the name of the 1992 Mortgage Trustee or its nominee and will be owned and held by the 1992 Mortgage Trustee, subject to the provisions of the 1992 Mortgage, for the benefit of the holders of all securities from time to time outstanding under the 1992 Mortgage, and the Company shall have no interest therein. Any payment by the Company under the 1992 Mortgage of the principal of or interest, if any, on the securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to the 1992 Mortgage Trustee of bonds of the Forty-Fourth Series (other than by the application of the proceeds of a payment in respect of such bonds) shall, to the extent thereof, be deemed to satisfy and discharge the obligation of the Company, if any, to make a payment of principal of or interest on such bonds, as the case may be, which is then due. The Trustee may conclusively presume that the obligation of the Company to pay the principal of the bonds of the Forty-Fourth Series as the same shall become due and payable shall have been fully satisfied and discharged unless and until it shall have received a written notice from the 1992 Mortgage Trustee, signed by an authorized officer thereof, stating that the principal of specified bonds of the Forty-Fourth Series has become due and payable and has not been fully paid, and specifying the amount of funds required to make such payment. Section 1.05. The bonds of the Forty-Fourth Series shall not be transferable, except to any successor trustee under said 1992 Mortgage. Any such transfer shall be made by the registered holder thereof, in person or by a duly authorized attorney, at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time, upon surrender and cancellation of such bonds, and thereupon a new bond or bonds of said series and of authorized denominations for a like aggregate principal amount and having the same Original Issue Date, Stated Maturity Date and other terms and conditions will be issued to the transferee in exchange therefor. New bonds issued upon any such transfer shall be so dated and shall carry such rights to any interest accrued and unpaid that neither gain nor loss in interest shall result from such transfer. Section 1.06. The registered holder of any bond or bonds of the Forty- Fourth Series at his option may surrender the same at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time, for cancellation in exchange for another or other bonds of the said series of authorized denominations, but of the same aggregate principal amount and having the same Original Issue Date, Stated Maturity Date and other terms and conditions and being so dated and carrying such rights to any interest accrued and unpaid that neither gain nor loss in interest shall result from such exchange. Thereupon, the Company shall execute and deliver to the Trustee, and the Trustee shall authenticate and deliver such other bond or bonds to such registered holder either at its office or at said office or agency of the Company. Section 1.07. No charge shall be made to any registered holder of any bond of the Forty-Fourth Series for any exchange or transfer of bonds of said series except that in case of any exchange or transfer the Company may make a charge therefor sufficient to reimburse it for any tax or taxes or other governmental charge required to be paid in connection therewith. Section 1.08. For the purpose only of complying with the Original Indenture (particularly Sections 10.02 and 12.02(b) thereof) in connection with the redemption of bonds of the Forty-Fourth Series, for each $1,000 principal amount of bonds authenticated and delivered hereunder there shall be assigned a number in such manner and at such time as the Trustee may deem appropriate. Portions of the principal amount less than the entire principal amount of a bond of the Forty-Fourth Series of a denomination larger than $1,000 may be redeemed only in integral multiples of $1,000. ARTICLE II Miscellaneous Section 2.01. The holders of the bonds of the Forty-Fourth Series shall be deemed to have consented and agreed that the Company may, but shall not be obligated to, fix a record date for the purpose of determining the holders of the bonds of the Forty-Fourth Series entitled to consent to any amendment or supplement to the Indenture or the waiver of any provision thereof or any act to be performed thereunder. If a record date is fixed, those persons who were holders at such record date (or their duly designated proxies), and only those persons, shall be entitled to consent to such amendment, supplement or waiver or to revoke any consent previously given, whether or not such persons continue to be holders after such record date. No such consent shall be valid or effective for more than 90 days after such record date. Section 2.02. The recitals of fact herein and in the bonds (except the Trustee's Certificate) shall be taken as statements of the Company and shall not be construed as made or warranted by the Trustee. The Trustee makes no representations as to the value of any of the property subjected to the lien of the Indenture, or any part thereof, or as to the title of the Company thereto, or as to the security afforded thereby and hereby, or as to the validity of this Eighty-Fifth Supplemental Trust Indenture or of the bonds of the Forty-Fourth Series (except the Trustee's Certificate), and the Trustee shall incur no responsibility in respect of such matters. Section 2.03. This Eighty-Fifth Supplemental Trust Indenture shall be construed in connection with and as part of the Indenture. Section 2.04. (a) If any provision of this Eighty-Fifth Supplemental Trust Indenture limits, qualifies, or conflicts with another provision of the Indenture required to be included in indentures qualified under the Trust Indenture Act of 1939 (as in force at the date of this Eighty-Fifth Supplemental Trust Indenture) by any of the provisions of Sections 310 to 317, inclusive, of said Act, such required provision shall control. (b) In case any one or more of the provisions contained in this Eighty- Fifth Supplemental Trust Indenture or in the bonds issued hereunder should be invalid, illegal or unenforceable in any respect, the validity, legality and enforceability of the remaining provisions contained herein and therein shall not in any way be affected, impaired, prejudiced or disturbed thereby. Section 2.05. Whenever in this Eighty-Fifth Supplemental Trust Indenture either of the parties hereto is named or referred to, this shall be deemed to include the successors or assigns of such party, and all the covenants and agreements in this Eighty-Fifth Supplemental Trust Indenture contained by or on behalf of the Company or by or on behalf of the Trustee shall bind and inure to the benefit of the respective successors and assigns of such parties, whether so expressed or not. Section 2.06. This Eighty-Fifth Supplemental Trust Indenture may be simultaneously executed in several counterparts, and all said counterparts executed and delivered, each as an original, shall constitute but one and the same instrument. The Table of Contents and the descriptive headings of the several Articles of this Eighty-Fifth Supplemental Trust Indenture were formulated, used and inserted herein for convenience only and shall not be deemed to affect the meaning or construction of any of the provisions hereof. Section 2.07. Duquesne Light Company does hereby constitute and appoint Diane S. Eismont to be its attorney for it and in its name and as and for its corporate deed to acknowledge this Eighty-Fifth Supplemental Trust Indenture before any person having authority by law to take such acknowledgment. Mellon Bank, N.A. does hereby constitute and appoint D.M. Babich to be its attorney-in-fact for it and in its name and as and for its corporate deed to acknowledge this Eighty-Fifth Supplemental Trust Indenture before any person having authority by law to take such acknowledgment. In Witness Whereof, the party of the first part has caused its corporate name to be subscribed and this Eighty-Fifth Supplemental Trust Indenture to be signed by its Chairman of the Board, President and Chief Executive Officer or a Vice President, and its corporate seal to be hereunto affixed and attested by its Secretary or an Assistant Secretary, for and on its behalf, and the party of the second part, to evidence its acceptance of the trust hereby created, has caused its corporate name to be subscribed, and this Eighty-Fifth Supplemental Trust Indenture to be signed by its President, a Vice President or an Assistant Vice President and its corporate seal to be hereunto affixed and attested by its authorized officer, for and in its behalf, all done as of the first day of June, 1993. DUQUESNE LIGHT COMPANY [Seal] By: /s/ Gary L. Schwass -------------------------------------- Vice President-Finance and Chief Financial Officer Attest: /s/ Diane S. Eismont - ----------------------------- Secretary MELLON BANK, N.A. [Seal] By: /s/ J.H. McAnulty -------------------------------------- Vice President Attest: /s/ D.M. Babich - ----------------------------- Authorized Officer COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 7th day of June, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared Diane S. Eismont, the attorney-in-fact named in the foregoing Eighty-Fifth Supplemental Trust Indenture, and by virtue and in pursuance of the authority therein conferred upon her acknowledged the said Eighty-Fifth Supplemental Trust Indenture to be the act and deed of the said Duquesne Light Company and that she desired the same to be recorded as such. Witness my hand and notarial seal the day and year aforesaid. /s/ Joanne E. Kirin --------------------------------- Notary Public COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 7th day of June, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared D.M. Babich, the attorney-in-fact named in the foregoing Eighty-Fifth Supplemental Trust Indenture, and by virtue and in pursuance of the authority therein conferred upon him acknowledged the said Eighty-Fifth Supplemental Trust Indenture to be the act and deed of the said Mellon Bank, N.A., and that he desired the same to be recorded as such. Witness my hand and notarial seal the day and year aforesaid. /s/ Judith Ann Hyde --------------------------------- Notary Public CERTIFICATE OF PRECISE RESIDENCE I hereby certify that the precise residence of Mellon Bank, N.A. is One Mellon Bank Center, Second Ward, Pittsburgh, Allegheny County, Pennsylvania. /s/ D.M. Babich ------------------------------------------ Authorized Signatory of Mellon Bank, N.A. June 7, 1993 RECORDING INFORMATION Allegheny County, Pennsylvania Office of Recorder of Deeds Recorded June 9, 1993 Mortgage Book Volume 13181, page 219 Beaver County, Pennsylvania Office of Recorder of Deeds Recorded June 9, 1993 Mortgage Book Volume 1264, page 643 Greene County, Pennsylvania Office of Recorder of Deeds Recorded June 8, 1993 Mortgage Book Volume 115, page 214 Washington County, Pennsylvania Office of Recorder of Deeds Recorded June 8, 1993 Mortgage Book Volume 2007, page 467 Westmoreland County, Pennsylvania Office of Recorder of Deeds Recorded June 8, 1993 Mortgage Book Volume 3138, page 616 Belmont County, Ohio Office of Recorder Received June 8, 1993 Recorded June 9, 1993 Mortgage Book Volume 602, page 832 Columbiana County, Ohio Officer of Recorder Recorded June 9, 1993 Mortgage Book Volume 378, page 217 Jefferson County, Ohio Officer of Recorder Received June 8, 1993 Recorded June 9, 1993 Mortgage Book Volume 102, page 257 Lake County, Ohio Officer of Recorder Recorded June 9, 1993 Mortgage Book Volume 864, page 677 Monroe County, Ohio Officer of Recorder Received June 8, 1993 Recorded June 9, 1993 Mortgage Book Volume 132, page 876 Hancock County, West Virginia Office of Clerk of County Commission Recorded June 9, 1993 Deed of Trust Book 304, page 337 Monongalia County, West Virginia Office of Clerk of County Commission Recorded June 8, 1993 Deed of Trust Book 710, page 341 EXHIBIT 4.2 CONFORMED COPY ================================================================================ EIGHTY-SIXTH SUPPLEMENTAL TRUST INDENTURE between DUQUESNE LIGHT COMPANY (a Pennsylvania corporation) and MELLON BANK, N.A., Trustee ----------- Dated as of June 1, 1993 ----------- Supplemental to Trust Indenture dated as of August 1, 1947 ----------- Providing for $25,000,000 First Mortgage Bonds, Pollution Control Collateral Series F ================================================================================ -i- EIGHTY-SIXTH SUPPLEMENTAL TRUST INDENTURE Dated as of the first day of June, 1993, although executed and delivered on the date of the latest acknowledgment at the end hereof, made by and between DUQUESNE LIGHT COMPANY, a corporation organized and existing under and by virtue of the laws of the Commonwealth of Pennsylvania, having its principal office in the City of Pittsburgh in said Commonwealth of Pennsylvania (hereinafter called the "Company"), party of the first part, and MELLON BANK, N.A., successor by merger to Mellon National Bank and Trust Company, a national banking association, having its principal corporate trust office in the City of Pittsburgh in the Commonwealth of Pennsylvania, as Trustee (hereinafter sometimes called the "Trustee"), party of the second part. Whereas, the Company has heretofore executed and delivered to Mellon Bank, N.A., as Trustee, a certain Trust Indenture (hereinafter called the "Original Indenture") dated as of August 1, 1947 securing its First Mortgage Bonds; and Whereas, the Original Indenture has been recorded in the Recorders' Offices of the various counties of Pennsylvania as follows: In Allegheny County in Mortgage Book Vol. 2897, page 4; In Beaver County in Mortgage Book Vol. 430, page 1; In Greene County in Mortgage Book Vol. 125, page 1; In Washington County in Mortgage Book Vol. 332, page 1; and In Westmoreland County in Mortgage Book Vol. 692, page 2; has been filed in the Prothonotary's Office in each of said Counties; and has also been recorded in the Office of the Clerk of County Commission of Monongalia County, West Virginia, in Deed of Trust Book Vol. 321, page 327, the Office of the Clerk of County Commission of Hancock County, West Virginia, in Deed of Trust Book Vol. 176, page 1, the Recorder's Office of Belmont County, Ohio, in Mortgage Book Vol. 437, page 109, the Recorder's Office of Columbiana County, Ohio, in Mortgage Book Vol. 1542, page 25, the Recorder's Office of Jefferson County, Ohio, in Mortgage Book Vol. 405, page 1, the Recorder's Office of Lake County, Ohio, in Mortgage Book Vol. 821, page 1, and the Recorder's Office of Monroe County, Ohio, in Mortgage Book Vol. 89, page 1; and Whereas, since the execution of the Original Indenture, the Company has executed and delivered to Mellon Bank, N.A., as Trustee, eighty-five supplemental trust indentures and an amendment to one thereof, all for the purposes recited therein and as permitted by the Original Indenture; and Whereas, for convenience of reference the Original Indenture and all indentures supplemental thereto heretofore or hereafter executed, including this Eighty-Sixth Supplemental Trust Indenture, are sometimes hereinafter collectively called the "Indenture"; and Whereas, the Company has caused the Original Indenture and the aforesaid eighty-five supplemental trust indentures to be recorded and filed, and has caused financing statements and continuation statements under the Uniform Commercial Code to be filed, all in such manner and in such places as are required by law to make effective and maintain the lien intended to be created by the Indenture; and Whereas, there have been issued under the Original Indenture and certain of the indentures supplemental thereto heretofore executed forty-four series of First Mortgage Bonds, of which $1,249,933,000 aggregate principal amount was outstanding as of the date hereof; and Whereas, the Company desires to provide for the issuance under the Indenture of a new series of bonds secured thereby in an aggregate principal amount not to exceed $25,000,000 to be designated as "First Mortgage Bonds, Pollution Control Collateral Series F", said new series to be hereinafter sometimes called the "Forty-Fifth Series," the bonds of said series to be issued as registered bonds without coupons in the denominations of $1,000 and any integral multiple of $1,000 that the Company may execute and deliver, and the bonds of said series to be substantially in the form and of the tenor following, to wit: [FORM OF BOND OF THE FORTY-FIFTH SERIES] This Bond is not transferable except to a successor trustee under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented, between Duquesne Light Company and Mellon Bank, N.A., trustee. DUQUESNE LIGHT COMPANY (Incorporated under the laws of the Commonwealth of Pennsylvania) FIRST MORTGAGE BOND, POLLUTION CONTROL COLLATERAL SERIES F No. $ ORIGINAL ISSUE DATE: STATED MATURITY DATE: DUQUESNE LIGHT COMPANY, a corporation organized and existing under and by virtue of the laws of the Commonwealth of Pennsylvania (hereinafter called the "Company"), for value received, hereby promises to pay to ____________ or registered assigns the sum of _________________ Dollars in lawful money of the United States of America on the Stated Maturity Date specified above. This bond shall not bear interest except that, if the Company should default in the payment of the principal hereof, this bond shall bear interest at the rate of five percent per annum until the Company's obligation with respect to the payment of such principal shall be discharged as provided in the Indenture hereinafter mentioned. Principal of and interest, if any, on this bond shall be payable upon presentation hereof at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency as may be designated for such purpose by the Company from time to time. Any payment by the Company under its Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented (the "1992 Mortgage"), to Mellon Bank, N.A., as trustee, of the principal of or interest, if any, on securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to such trustee of this bond (other than by the application of the proceeds of a payment in respect of this bond) shall, to the extent thereof, be deemed to satisfy and discharge the obligation of the Company, if any, to make a payment of principal of or interest on this bond, as the case may be, which is then due. This bond is one of a duly authorized issue of bonds of the Company, known as its First Mortgage Bonds, unlimited in aggregate principal amount, of the series and designation indicated above, which issue of bonds consists, or may consist, of several series of varying denominations, dates and tenors, all issued and to be issued under and equally secured (except insofar as a sinking fund, or similar fund, established in accordance with the provisions of the Indenture may afford additional security for the bonds of any specific series) by a Trust Indenture dated as of August 1, 1947 executed by the Company to Mellon Bank, N.A., formerly Mellon National Bank and Trust Company (herein called the "Trustee"), as Trustee, as heretofore supplemented and amended (said Trust Indenture as supplemented and amended being herein called the "Indenture"), to which Indenture reference is hereby made for a description of the property mortgaged and pledged, the nature and extent of the security, the rights of the holders of the bonds as to such security, and the terms and conditions upon which the bonds may be issued under the Indenture and are secured. The principal hereof may be declared or may become due on the conditions, in the manner and at the time set forth in the Indenture, upon the happening of a completed default as provided in the Indenture. The Indenture provides that such declaration may in certain events be waived by the holders of a majority in principal amount of the bonds outstanding. With the consent of the Company and to the extent permitted by and as provided in the Indenture, the rights and obligations of the Company and/or of the holders of the bonds and/or the terms and provisions of the Indenture and/or of any instruments supplemental thereto may be modified or altered by the affirmative vote of the holders of at least seventy percent in principal amount of the bonds then outstanding under the Indenture and any instruments supplemental thereto (excluding bonds disqualified from voting by reason of the interest of the Company or of certain related persons therein as provided in the Indenture), and by the affirmative vote of at least seventy percent in principal amount of the bonds of any series entitled to vote then outstanding under the Indenture and any instruments supplemental thereto (excluding bonds disqualified from voting as aforesaid) and affected by such modification or alteration, in case one or more but less than all of the series of bonds then outstanding are so affected; provided that no such modification or alteration shall permit the extension of the maturity of the principal of this bond or the reduction in the rate of interest hereon or any other modification in the terms of payment of such principal or interest or the taking of certain other action as more fully set forth in the Indenture, without the consent of the holder hereof. The Company, the Trustee and any paying agent may deem and treat the person in whose name this bond is registered as the absolute owner hereof for the purpose of receiving payment of or on account of the principal hereof and interest hereon and for all other purposes and shall not be affected by any notice to the contrary. In the manner and with the effect provided in the Indenture, this bond may, in whole at any time, or in part from time to time prior to maturity, be redeemed by the Company with funds derived from any source by payment at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, at a redemption price equal to 100% of the principal amount of this bond to be redeemed. This bond is entitled to the benefits of, and is subject to call for redemption for, the Sinking Fund, upon the notice, in the manner, and with the effect provided in the Indenture by payment of the principal amount hereof. All bonds of this series shall be redeemed, at a redemption price equal to 100% of the principal amount thereof, if, and at such time as, the securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to the trustee thereunder of the bonds of this series shall have become subject to mandatory redemption. The holder of this bond, by its acceptance hereof, consents and agrees that no notice of such redemption shall be required to be given. This bond shall initially be issued in the name of Mellon Bank, N.A., trustee under the 1992 Mortgage, and is not transferable except to any successor trustee under the 1992 Mortgage. Any such transfer shall be made as prescribed in the Indenture by the registered holder hereof in person, or by such holder's duly authorized attorney, at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, upon surrender and cancellation of this bond, and thereupon a new bond or bonds of the same series and of authorized denominations for a like aggregate principal amount, and having the same Original Issue Date and Stated Maturity Date, will be issued to the transferee in exchange herefor as provided in the Indenture. Bonds of this series are interchangeable as to denominations in the manner and upon the conditions prescribed in the Indenture. No charge shall be made to any holder of any bond of this series for any transfer or exchange of bonds except for any tax or taxes or other governmental charge required to be paid in connection therewith. No recourse shall be had for the payment of principal of or interest, if any, on this bond, or any part thereof, or of any claim based hereon or in respect hereof or of the Indenture, against any incorporator or any past, present or future stockholder, officer or director of the Company or of any predecessor or successor corporation, either directly or through the Company, or through any such predecessor or successor corporation, or through any receiver or a trustee in bankruptcy, whether by virtue of any constitution, statute or rule of law or by the enforcement of any assessment or penalty or otherwise, all such liability being, by the acceptance hereof and as part of the consideration for the issue hereof, expressly waived and released, as more fully provided in the Indenture. This bond shall not be valid or become obligatory for any purpose unless and until Mellon Bank, N.A., as Trustee under the Indenture, or its successor thereunder, shall have signed the certificate of authentication endorsed hereon. In Witness Whereof, DUQUESNE LIGHT COMPANY has caused this bond to be signed in its name with the facsimile signature of its Chairman of the Board, President and Chief Executive Officer, and its corporate seal, or a facsimile thereof, to be hereto affixed and attested with the facsimile signature of its Secretary. Dated ----------------------- DUQUESNE LIGHT COMPANY [Seal] By --------------------------- Attest: - ---------------------------- Secretary [END OF FORM OF BOND] Whereas, Sections 2.01, 4.01 and 20.03 of the Original Indenture provide in substance that the Company and the Trustee may enter into indentures supplemental thereto for the purposes, among others, of creating and setting forth the particulars of any new series of bonds and of providing the terms and conditions of the issue of the bonds of any series not expressly provided for in the Original Indenture; and Whereas, the execution and delivery of this Eighty-Sixth Supplemental Trust Indenture have been duly authorized by a resolution adopted by the Board of Directors of the Company; and Whereas, all things necessary to make said $25,000,000 aggregate principal amount of said bonds of the Forty-Fifth Series, when duly executed by the Company and authenticated and delivered by the Trustee (or a duly appointed authenticating agent) and issued, the valid, binding and legal obligations of the Company entitled to the benefits and security of the Indenture and to make this Eighty-Sixth Supplemental Trust Indenture a valid, binding and legal instrument in accordance with its terms have been done and performed, and the issue of said Bonds, as herein provided, has been in all respects duly authorized; NOW, THEREFORE, THIS INDENTURE WITNESSETH: Duquesne Light Company, intending to be legally bound hereby, in consideration of the premises and of One Dollar to it duly paid by the Trustee at or before the issuance and delivery of these presents, the receipt whereof is hereby acknowledged, and of the purchase and acceptance from time to time of said bonds of the Forty-Fifth Series by the holders thereof, and in order to declare the conditions and terms upon and subject to which the bonds of said series are to be issued and secured, and in order to create the bonds of said series and further to secure the payment of the principal of, and premium, if any, and interest on all bonds of the Company at any time outstanding under the Indenture according to their tenor and effect and the performance of and compliance with the covenants and conditions in the Indenture contained, has executed and delivered this Eighty-Sixth Supplemental Trust Indenture and hereby grants, bargains, sells, warrants, releases, conveys, assigns, transfers, mortgages, pledges, sets over and confirms unto Mellon Bank, N.A., as Trustee under the Indenture, and to its respective successors in said trust, forever, all property, real, personal and mixed, now owned or hereafter acquired or to be acquired by the Company and wheresoever situated (except as excepted from the lien of the Indenture by the provisions thereof), subject to the rights reserved by the Company in and by various provisions of the Indenture, including (without in anywise limiting or impairing by the enumeration of the same the scope and intent of the foregoing or of any general description contained in the Indenture) all lands, rights of way, roads, all powerhouses, buildings and other structures, and all offices, buildings and the contents thereof; all machinery, engines, boilers, dynamos, electrical machinery, regulators, meters, transformers, generators, motors, electrical and mechanical appliances, conduits, cables, water or other pipes, pole and transmission lines, poles, wires, cross-arms, insulators, substations and superstructures, generating, distributing and transmitting equipment, tools, implements, apparatus and supplies and coal in place and interests in coal; whether appertaining to any existing or future system of the Company or otherwise and including all other property now used or provided for use or hereafter acquired for use, in the construction, repair, maintenance and operation of such systems, both those now owned and those which may hereafter be acquired by the Company; all municipal or other grants, rights, permits, consents, franchises, privileges, easements, licenses, ordinances, rights of way, liberties and immunities of the Company, howsoever conferred or acquired and whether now owned or hereafter acquired; and all leases, leaseholds, power contracts, street lighting contracts and other rights with respect to the construction, maintenance, repair and operation of any systems now owned or hereafter acquired by the Company, and any additions thereto or extensions thereof; Together with all and singular the tenements, hereditaments and appurtenances belonging or in anywise appertaining to the aforesaid property or any part thereof, with the reversion and reversions, remainder and remainders, tolls, rents and revenues, issues, income, product and profits thereof and all the estate, right, title, interest and claim whatsoever, at law as well as in equity, which the Company now has or may hereafter acquire in and to the aforesaid property and every part and parcel thereof except as excepted or excluded from the lien of the Indenture; There Being Hereby Excepted from the lien of the Indenture, whether now owned or hereafter acquired by the Company, anything herein contained to the contrary notwithstanding, all those certain items of property of the classes specifically excepted from the lien of the Original Indenture by the terms thereof; To Have and To Hold all properties, real, personal and mixed, mortgaged, pledged or conveyed by the Company as aforesaid, or intended so to be, unto the Trustee and its successors and assigns, FOREVER; subject, however, to permissible encumbrances, as defined in the Original Indenture, and to all the other terms, conditions, covenants, uses, trusts and defeasances incorporated in the Indenture. The parties hereto shall have, possess and enjoy the same rights, powers, duties and privileges as affecting the property hereby conveyed as they have under the Original Indenture insofar as the same may be applicable hereto, with the same force and effect as though the terms, conditions, and defeasances of the Original Indenture had been embodied herein. It Is Hereby Covenanted, Declared and Agreed by the Company and the Trustee, and its successors in the trust under the Indenture, for the benefit of those who hold or shall hold the bonds, or any of them, issued or to be issued thereunder, as follows: ARTICLE I Form and Execution of First Mortgage Bonds, Pollution Control Collateral Series F Section 1.01. There is hereby created, for issuance under the Indenture and to be secured thereby, a series of bonds, designated "First Mortgage Bonds, Pollution Control Collateral Series F." Each bond of such series shall bear the descriptive title "First Mortgage Bond, Pollution Control Collateral Series F," and the form thereof shall be substantially of the tenor and purport hereinbefore recited. The bonds of the Forty-Fifth Series shall be issued from time to time in an aggregate principal amount of $25,000,000, excluding any bonds of the Forty-Fifth Series which may be authenticated in exchange for or in lieu of or in substitution for or on transfer of other bonds of such series pursuant to the provisions of the Indenture, and shall be issued as registered bonds without coupons in denominations of $1,000 and integral multiples thereof. The bonds of the Forty-Fifth Series shall mature on September 1, 2030 and shall not bear interest except as provided in Article XIII of the Original Indenture. The principal of and interest, if any, on each bond of the Forty-Fifth Series shall be payable at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, in lawful money of the United States of America. Each bond of the Forty-Fifth Series shall be dated as of its Original Issue Date. The term "Original Issue Date" as used in this Section 1.01 shall mean the date of the first authentication and delivery hereunder of such bonds. Section 1.02. Each bond of the Forty-Fifth Series shall be redeemable at the option of the Company in whole at any time, or in part from time to time, prior to maturity, at a redemption price equal to 100.00% of the principal amount thereof to be redeemed, by payment at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time. Any such redemption shall be made upon not less than 30 days' previous notice to be given in the manner provided in Section 10.02 of the Original Indenture. Section 1.03. The bonds of the Forty-Fifth Series shall be redeemable on October 1 of each year commencing one year after the date of issuance of the first bonds of said series for the Sinking Fund for bonds of said series provided for in Article XII of the Original Indenture, upon not less than 30 days' previous notice of redemption to be given in the manner provided in Section 10.02 of the Original Indenture, at the principal amount thereof. Section 1.04. All bonds of the Forty-Fifth Series shall be redeemed, at a redemption price equal to 100% of the principal amount thereof, if, and at such time as, the securities which shall have been authenticated and delivered under the 1992 Mortgage (as hereinafter defined) on the basis of the issuance and delivery to the 1992 Mortgage Trustee (as hereinafter defined) of the bonds of the Forty-Fifth Series shall have become subject to mandatory redemption. No notice of such redemption shall be required to be given. Section 1.05. The bonds of the Forty-Fifth Series shall be issued and delivered to Mellon Bank, N.A., as trustee under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented (the "1992 Mortgage"), of the Company to such trustee (the "1992 Mortgage Trustee"), as the basis for the authentication and delivery under the 1992 Mortgage of a series of securities. As provided in the 1992 Mortgage, the bonds of the Forty-Fifth Series will be registered in the name of the 1992 Mortgage Trustee or its nominee and will be owned and held by the 1992 Mortgage Trustee, subject to the provisions of the 1992 Mortgage, for the benefit of the holders of all securities from time to time outstanding under the 1992 Mortgage, and the Company shall have no interest therein. Any payment by the Company under the 1992 Mortgage of the principal of or interest, if any, on the securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to the 1992 Mortgage Trustee of bonds of the Forty-Fifth Series (other than by the application of the proceeds of a payment in respect of such bonds) shall, to the extent thereof, be deemed to satisfy and discharge the obligation of the Company, if any, to make a payment of principal of or interest on such bonds, as the case may be, which is then due. The Trustee may conclusively presume that the obligation of the Company to pay the principal of the bonds of the Forty-Fifth Series as the same shall become due and payable shall have been fully satisfied and discharged unless and until it shall have received a written notice from the 1992 Mortgage Trustee, signed by an authorized officer thereof, stating that the principal of specified bonds of the Forty-Fifth Series has become due and payable and has not been fully paid, and specifying the amount of funds required to make such payment. Section 1.06. The bonds of the Forty-Fifth Series shall not be transferable, except to any successor trustee under said 1992 Mortgage. Any such transfer shall be made by the registered holder thereof, in person or by a duly authorized attorney, at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time, upon surrender and cancellation of such bonds, and thereupon a new bond or bonds of said series and of authorized denominations for a like aggregate principal amount and having the same Original Issue Date, Stated Maturity Date and other terms and conditions will be issued to the transferee in exchange therefor. New bonds issued upon any such transfer shall be so dated and shall carry such rights to any interest accrued and unpaid that neither gain nor loss in interest shall result from such transfer. Section 1.07. The registered holder of any bond or bonds of the Forty- Fifth Series at his option may surrender the same at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time, for cancellation in exchange for another or other bonds of the said series of authorized denominations, but of the same aggregate principal amount and having the same Original Issue Date, Stated Maturity Date and other terms and conditions and being so dated and carrying such rights to any interest accrued and unpaid that neither gain nor loss in interest shall result from such exchange. Thereupon, the Company shall execute and deliver to the Trustee, and the Trustee shall authenticate and deliver such other bond or bonds to such registered holder either at its office or at said office or agency of the Company. Section 1.08. No charge shall be made to any registered holder of any bond of the Forty-Fifth Series for any exchange or transfer of bonds of said series except that in case of any exchange or transfer the Company may make a charge therefor sufficient to reimburse it for any tax or taxes or other governmental charge required to be paid in connection therewith. Section 1.09. For the purpose only of complying with the Original Indenture (particularly Sections 10.02 and 12.02(b) thereof) in connection with the redemption of bonds of the Forty-Fifth Series, for each $1,000 principal amount of bonds authenticated and delivered hereunder there shall be assigned a number in such manner and at such time as the Trustee may deem appropriate. Portions of the principal amount less than the entire principal amount of a bond of the Forty-Fifth Series of a denomination larger than $1,000 may be redeemed only in integral multiples of $1,000. ARTICLE II Miscellaneous Section 2.01. The holders of the bonds of the Forty-Fifth Series shall be deemed to have consented and agreed that the Company may, but shall not be obligated to, fix a record date for the purpose of determining the holders of the bonds of the Forty-Fifth Series entitled to consent to any amendment or supplement to the Indenture or the waiver of any provision thereof or any act to be performed thereunder. If a record date is fixed, those persons who were holders at such record date (or their duly designated proxies), and only those persons, shall be entitled to consent to such amendment, supplement or waiver or to revoke any consent previously given, whether or not such persons continue to be holders after such record date. No such consent shall be valid or effective for more than 90 days after such record date. Section 2.02. The recitals of fact herein and in the bonds (except the Trustee's Certificate) shall be taken as statements of the Company and shall not be construed as made or warranted by the Trustee. The Trustee makes no representations as to the value of any of the property subjected to the lien of the Indenture, or any part thereof, or as to the title of the Company thereto, or as to the security afforded thereby and hereby, or as to the validity of this Eighty-Sixth Supplemental Trust Indenture or of the bonds of the Forty-Fifth Series (except the Trustee's Certificate), and the Trustee shall incur no responsibility in respect of such matters. Section 2.03. This Eighty-Sixth Supplemental Trust Indenture shall be construed in connection with and as part of the Indenture. Section 2.04. (a) If any provision of this Eighty-Sixth Supplemental Trust Indenture limits, qualifies, or conflicts with another provision of the Indenture required to be included in indentures qualified under the Trust Indenture Act of 1939 (as in force at the date of this Eighty-Sixth Supplemental Trust Indenture) by any of the provisions of Sections 310 to 317, inclusive, of said Act, such required provision shall control. (b) In case any one or more of the provisions contained in this Eighty- Sixth Supplemental Trust Indenture or in the bonds issued hereunder should be invalid, illegal or unenforceable in any respect, the validity, legality and enforceability of the remaining provisions contained herein and therein shall not in any way be affected, impaired, prejudiced or disturbed thereby. Section 2.05. Whenever in this Eighty-Sixth Supplemental Trust Indenture either of the parties hereto is named or referred to, this shall be deemed to include the successors or assigns of such party, and all the covenants and agreements in this Eighty-Sixth Supplemental Trust Indenture contained by or on behalf of the Company or by or on behalf of the Trustee shall bind and inure to the benefit of the respective successors and assigns of such parties, whether so expressed or not. Section 2.06. This Eighty-Sixth Supplemental Trust Indenture may be simultaneously executed in several counterparts, and all said counterparts executed and delivered, each as an original, shall constitute but one and the same instrument. The Table of Contents and the descriptive headings of the several Articles of this Eighty-Sixth Supplemental Trust Indenture were formulated, used and inserted herein for convenience only and shall not be deemed to affect the meaning or construction of any of the provisions hereof. Section 2.07. Duquesne Light Company does hereby constitute and appoint Diane S. Eismont to be its attorney for it and in its name and as and for its corporate deed to acknowledge this Eighty-Sixth Supplemental Trust Indenture before any person having authority by law to take such acknowledgment. Mellon Bank, N.A. does hereby constitute and appoint D.M. Babich to be its attorney-in-fact for it and in its name and as and for its corporate deed to acknowledge this Eighty-Sixth Supplemental Trust Indenture before any person having authority by law to take such acknowledgment. In Witness Whereof, the party of the first part has caused its corporate name to be subscribed and this Eighty-Sixth Supplemental Trust Indenture to be signed by its Chairman of the Board, President and Chief Executive Officer or a Vice President, and its corporate seal to be hereunto affixed and attested by its Secretary or an Assistant Secretary, for and on its behalf, and the party of the second part, to evidence its acceptance of the trust hereby created, has caused its corporate name to be subscribed, and this Eighty-Sixth Supplemental Trust Indenture to be signed by its President, a Vice President or an Assistant Vice President and its corporate seal to be hereunto affixed and attested by its authorized officer, for and in its behalf, all done as of the first day of June, 1993. DUQUESNE LIGHT COMPANY [Seal] By: /s/ Gary L. Schwass --------------------------- Vice President-Finance and Chief Financial Officer Attest: /s/ Diane S. Eismont - ------------------------------- Secretary MELLON BANK, N.A. [Seal] By: /s/ J.H. McAnulty ------------------------------ Vice President Attest: /s/ D.M. Babich - ------------------------------- Authorized Officer COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 23rd day of June, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared Diane S. Eismont, the attorney-in-fact named in the foregoing Eighty-Sixth Supplemental Trust Indenture, and by virtue and in pursuance of the authority therein conferred upon her acknowledged the said Eighty-Sixth Supplemental Trust Indenture to be the act and deed of the said Duquesne Light Company and that she desired the same to be recorded as such. Witness my hand and notarial seal the day and year aforesaid. /s/ Joanne E. Kirin ------------------------ Notary Public COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 23rd day of June, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared D.M. Babich, the attorney-in-fact named in the foregoing Eighty-Sixth Supplemental Trust Indenture, and by virtue and in pursuance of the authority therein conferred upon him acknowledged the said Eighty-Sixth Supplemental Trust Indenture to be the act and deed of the said Mellon Bank, N.A., and that he desired the same to be recorded as such. Witness my hand and notarial seal the day and year aforesaid. /s/ Nancy A. Fletcher ------------------------ Notary Public CERTIFICATE OF PRECISE RESIDENCE I hereby certify that the precise residence of Mellon Bank, N.A. is One Mellon Bank Center, Second Ward, Pittsburgh, Allegheny County, Pennsylvania. /s/ D.M. Babich ---------------------------------------- Authorized Signatory of Mellon Bank, N.A. June 23, 1993 RECORDING INFORMATION Allegheny County, Pennsylvania Office of Recorder of Deeds Recorded June 23, 1993 Mortgage Book Volume 13225, page 203 Beaver County, Pennsylvania Office of Recorder of Deeds Recorded June 25, 1993 Mortgage Book Volume 1267, page 566 Greene County, Pennsylvania Office of Recorder of Deeds Recorded June 24, 1993 Mortgage Book Volume 115, page 1104 Washington County, Pennsylvania Office of Recorder of Deeds Recorded June 24, 1993 Mortgage Book Volume 2014, page 103 Westmoreland County, Pennsylvania Office of Recorder of Deeds Recorded June 24, 1993 Mortgage Book Volume 3151, page 608 Belmont County, Ohio Office of Recorder Received June 24, 1993 Recorded June 25, 1993 Mortgage Book Volume 603, page 776 Columbiana County, Ohio Officer of Recorder Recorded June 25, 1993 Mortgage Book Volume 380, page 833 Jefferson County, Ohio Officer of Recorder Received June 24, 1993 Recorded June 25, 1993 Mortgage Book Volume 104, page 1 Lake County, Ohio Officer of Recorder Recorded June 25, 1993 Mortgage Book Volume 871, page 970 Monroe County, Ohio Officer of Recorder Received June 24, 1993 Recorded June 24, 1993 Mortgage Book Volume 133, page 123 Hancock County, West Virginia Office of Clerk of County Commission Recorded June 25, 1993 Deed of Trust Book 305, page 654 Monongalia County, West Virginia Office of Clerk of County Commission Recorded June 24, 1993 Deed of Trust Book 712, page 666 EXHIBIT 4.2 CONFORMED COPY ================================================================================ EIGHTY-SEVENTH SUPPLEMENTAL TRUST INDENTURE between DUQUESNE LIGHT COMPANY (a Pennsylvania corporation) and MELLON BANK, N.A., Trustee ----------- Dated as of August 1, 1993 ----------- Supplemental to Trust Indenture dated as of August 1, 1947 ----------- Providing for $20,500,000 First Mortgage Bonds, Pollution Control Collateral Series G ================================================================================ -i- -ii- EIGHTY-SEVENTH SUPPLEMENTAL TRUST INDENTURE DATED as of the first day of August, 1993, although executed and delivered on the date of the latest acknowledgment at the end hereof, made by and between DUQUESNE LIGHT COMPANY, a corporation organized and existing under and by virtue of the laws of the Commonwealth of Pennsylvania, having its principal office in the City of Pittsburgh in said Commonwealth of Pennsylvania (hereinafter called the "Company"), party of the first part, and MELLON BANK, N.A., successor by merger to Mellon National Bank and Trust Company, a national banking association, having its principal corporate trust office in the City of Pittsburgh in the Commonwealth of Pennsylvania, as Trustee (hereinafter sometimes called the "Trustee"), party of the second part. WHEREAS, the Company has heretofore executed and delivered to Mellon Bank, N.A., as Trustee, a certain Trust Indenture (hereinafter called the "Original Indenture") dated as of August 1, 1947 securing its First Mortgage Bonds; and WHEREAS, the Original Indenture has been recorded in the Recorders' Offices of the various counties of Pennsylvania as follows: In Allegheny County in Mortgage Book Vol. 2897, page 4; In Beaver County in Mortgage Book Vol. 430, page 1; In Greene County in Mortgage Book Vol. 125, page 1; In Washington County in Mortgage Book Vol. 332, page 1; and In Westmoreland County in Mortgage Book Vol. 692, page 2; has been filed in the Prothonotary's Office in each of said Counties; and has also been recorded in the Office of the Clerk of County Commission of Monongalia County, West Virginia, in Deed of Trust Book Vol. 321, page 327, the Office of the Clerk of County Commission of Hancock County, West Virginia, in Deed of Trust Book Vol. 176, page 1, the Recorder's Office of Belmont County, Ohio, in Mortgage Book Vol. 437, page 109, the Recorder's Office of Columbiana County, Ohio, in Mortgage Book Vol. 1542, page 25, the Recorder's Office of Jefferson County, Ohio, in Mortgage Book Vol. 405, page 1, the Recorder's Office of Lake County, Ohio, in Mortgage Book Vol. 821, page 1, and the Recorder's Office of Monroe County, Ohio, in Mortgage Book Vol. 89, page 1; and WHEREAS, since the execution of the Original Indenture, the Company has executed and delivered to Mellon Bank, N.A., as Trustee, eighty-six supplemental trust indentures and an amendment to one thereof, all for the purposes recited therein and as permitted by the Original Indenture; and WHEREAS, for convenience of reference the Original Indenture and all indentures supplemental thereto heretofore or hereafter executed, including this Eighty-Seventh Supplemental Trust Indenture, are sometimes hereinafter collectively called the "Indenture"; and WHEREAS, the Company has caused the Original Indenture and the aforesaid eighty-six supplemental trust indentures to be recorded and filed, and has caused financing statements and continuation statements under the Uniform Commercial Code to be filed, all in such manner and in such places as are required by law to make effective and maintain the lien intended to be created by the Indenture; and WHEREAS, there have been issued under the Original Indenture and certain of the indentures supplemental thereto heretofore executed forty-five series of First Mortgage Bonds, of which $1,291,236,000 aggregate principal amount was outstanding as of the date hereof; and WHEREAS, the Company desires to provide for the issuance under the Indenture of a new series of bonds secured thereby in an aggregate principal amount not to exceed $20,500,000 to be designated as "First Mortgage Bonds, Pollution Control Collateral Series G", said new series to be hereinafter sometimes called the "Forty-Sixth Series," the bonds of said series to be issued as registered bonds without coupons in the denominations of $1,000 and any integral multiple of $1,000 that the Company may execute and deliver, and the bonds of said series to be substantially in the form and of the tenor following, to wit: [FORM OF BOND OF THE FORTY-SIXTH SERIES] This Bond is not transferable except to a successor trustee under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented, between Duquesne Light Company and Mellon Bank, N.A., trustee. DUQUESNE LIGHT COMPANY (Incorporated under the laws of the Commonwealth of Pennsylvania) FIRST MORTGAGE BOND, POLLUTION CONTROL COLLATERAL SERIES G No. $ ORIGINAL ISSUE DATE: STATED MATURITY DATE: DUQUESNE LIGHT COMPANY, a corporation organized and existing under and by virtue of the laws of the Commonwealth of Pennsylvania (hereinafter called the "Company"), for value received, hereby promises to pay to _______________ or registered assigns the sum of ______________________ Dollars in lawful money of the United States of America on the Stated Maturity Date specified above. This bond shall not bear interest except that, if the Company should default in the payment of the principal hereof, this bond shall bear interest at the rate of five percent per annum until the Company's obligation with respect to the payment of such principal shall be discharged as provided in the Indenture hereinafter mentioned. Principal of and interest, if any, on this bond shall be payable upon presentation hereof at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency as may be designated for such purpose by the Company from time to time. Any payment by the Company under its Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented (the "1992 Mortgage"), to Mellon Bank, N. A., as trustee, of the principal of or interest, if any, on securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to such trustee of this bond (other than by the application of the proceeds of a payment in respect of this bond) shall, to the extent thereof, be deemed to satisfy and discharge the obligation of the Company, if any, to make a payment of principal of or interest on this bond, as the case may be, which is then due. This bond is one of a duly authorized issue of bonds of the Company, known as its First Mortgage Bonds, unlimited in aggregate principal amount, of the series and designation indicated above, which issue of bonds consists, or may consist, of several series of varying denominations, dates and tenors, all issued and to be issued under and equally secured (except insofar as a sinking fund, or similar fund, established in accordance with the provisions of the Indenture may afford additional security for the bonds of any specific series) by a Trust Indenture dated as of August 1, 1947 executed by the Company to Mellon Bank, N.A., formerly Mellon National Bank and Trust Company (herein called the "Trustee"), as Trustee, as heretofore supplemented and amended (said Trust Indenture as supplemented and amended being herein called the "Indenture"), to which Indenture reference is hereby made for a description of the property mortgaged and pledged, the nature and extent of the security, the rights of the holders of the bonds as to such security, and the terms and conditions upon which the bonds may be issued under the Indenture and are secured. The principal hereof may be declared or may become due on the conditions, in the manner and at the time set forth in the Indenture, upon the happening of a completed default as provided in the Indenture. The Indenture provides that such declaration may in certain events be waived by the holders of a majority in principal amount of the bonds outstanding. With the consent of the Company and to the extent permitted by and as provided in the Indenture, the rights and obligations of the Company and/or of the holders of the bonds and/or the terms and provisions of the Indenture and/or of any instruments supplemental thereto may be modified or altered by the affirmative vote of the holders of at least seventy percent in principal amount of the bonds then outstanding under the Indenture and any instruments supplemental thereto (excluding bonds disqualified from voting by reason of the interest of the Company or of certain related persons therein as provided in the Indenture), and by the affirmative vote of at least seventy percent in principal amount of the bonds of any series entitled to vote then outstanding under the Indenture and any instruments supplemental thereto (excluding bonds disqualified from voting as aforesaid) and affected by such modification or alteration, in case one or more but less than all of the series of bonds then outstanding are so affected; provided that no such modification or alteration shall permit the extension of the maturity of the principal of this bond or the reduction in the rate of interest hereon or any other modification in the terms of payment of such principal or interest or the taking of certain other action as more fully set forth in the Indenture, without the consent of the holder hereof. The Company, the Trustee and any paying agent may deem and treat the person in whose name this bond is registered as the absolute owner hereof for the purpose of receiving payment of or on account of the principal hereof and interest hereon and for all other purposes and shall not be affected by any notice to the contrary. In the manner and with the effect provided in the Indenture, this bond may, in whole at any time, or in part from time to time prior to maturity, be redeemed by the Company with funds derived from any source by payment at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, at a redemption price equal to 100% of the principal amount of this bond to be redeemed. This bond is entitled to the benefits of, and is subject to call for redemption for, the Sinking Fund, upon the notice, in the manner, and with the effect provided in the Indenture by payment of the principal amount hereof. All bonds of this series shall be redeemed, at a redemption price equal to 100% of the principal amount thereof, if, and at such time as, the securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to the trustee thereunder of the bonds of this series shall have become subject to mandatory redemption. The holder of this bond, by its acceptance hereof, consents and agrees that no notice of such redemption shall be required to be given. This bond shall initially be issued in the name of Mellon Bank, N.A., trustee under the 1992 Mortgage, and is not transferable except to any successor trustee under the 1992 Mortgage. Any such transfer shall be made as prescribed in the Indenture by the registered holder hereof in person, or by such holder's duly authorized attorney, at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, upon surrender and cancellation of this bond, and thereupon a new bond or bonds of the same series and of authorized denominations for a like aggregate principal amount, and having the same Original Issue Date and Stated Maturity Date, will be issued to the transferee in exchange herefor as provided in the Indenture. Bonds of this series are interchangeable as to denominations in the manner and upon the conditions prescribed in the Indenture. No charge shall be made to any holder of any bond of this series for any transfer or exchange of bonds except for any tax or taxes or other governmental charge required to be paid in connection therewith. No recourse shall be had for the payment of principal of or interest, if any, on this bond, or any part thereof, or of any claim based hereon or in respect hereof or of the Indenture, against any incorporator or any past, present or future stockholder, officer or director of the Company or of any predecessor or successor corporation, either directly or through the Company, or through any such predecessor or successor corporation, or through any receiver or a trustee in bankruptcy, whether by virtue of any constitution, statute or rule of law or by the enforcement of any assessment or penalty or otherwise, all such liability being, by the acceptance hereof and as part of the consideration for the issue hereof, expressly waived and released, as more fully provided in the Indenture. This bond shall not be valid or become obligatory for any purpose unless and until Mellon Bank, N.A., as Trustee under the Indenture, or its successor thereunder, shall have signed the certificate of authentication endorsed hereon. IN WITNESS WHEREOF, DUQUESNE LIGHT COMPANY has caused this bond to be signed in its name with the facsimile signature of its Chairman of the Board, President and Chief Executive Officer, and its corporate seal, or a facsimile thereof, to be hereto affixed and attested with the facsimile signature of its Secretary. Dated -------------------- DUQUESNE LIGHT COMPANY [Seal] By ------------------------------- Attest: - --------------------------------- Secretary [END OF FORM OF BOND] WHEREAS, Sections 2.01, 4.01 and 20.03 of the Original Indenture provide in substance that the Company and the Trustee may enter into indentures supplemental thereto for the purposes, among others, of creating and setting forth the particulars of any new series of bonds and of providing the terms and conditions of the issue of the bonds of any series not expressly provided for in the Original Indenture; and WHEREAS, the execution and delivery of this Eighty-Seventh Supplemental Trust Indenture have been duly authorized by a resolution adopted by the Board of Directors of the Company; and WHEREAS, all things necessary to make said $20,500,000 aggregate principal amount of said bonds of the Forty-Sixth Series, when duly executed by the Company and authenticated and delivered by the Trustee (or a duly appointed authenticating agent) and issued, the valid, binding and legal obligations of the Company entitled to the benefits and security of the Indenture and to make this Eighty-Seventh Supplemental Trust Indenture a valid, binding and legal instrument in accordance with its terms have been done and performed, and the issue of said Bonds, as herein provided, has been in all respects duly authorized; NOW, THEREFORE, THIS INDENTURE WITNESSETH: Duquesne Light Company, intending to be legally bound hereby, in consideration of the premises and of One Dollar to it duly paid by the Trustee at or before the issuance and delivery of these presents, the receipt whereof is hereby acknowledged, and of the purchase and acceptance from time to time of said bonds of the Forty-Sixth Series by the holders thereof, and in order to declare the conditions and terms upon and subject to which the bonds of said series are to be issued and secured, and in order to create the bonds of said series and further to secure the payment of the principal of, and premium, if any, and interest on all bonds of the Company at any time outstanding under the Indenture according to their tenor and effect and the performance of and compliance with the covenants and conditions in the Indenture contained, has executed and delivered this Eighty-Seventh Supplemental Trust Indenture and hereby grants, bargains, sells, warrants, releases, conveys, assigns, transfers, mortgages, pledges, sets over and confirms unto Mellon Bank, N.A., as Trustee under the Indenture, and to its respective successors in said trust, forever, all property, real, personal and mixed, now owned or hereafter acquired or to be acquired by the Company and wheresoever situated (except as excepted from the lien of the Indenture by the provisions thereof), subject to the rights reserved by the Company in and by various provisions of the Indenture, including (without in anywise limiting or impairing by the enumeration of the same the scope and intent of the foregoing or of any general description contained in the Indenture) all lands, rights of way, roads, all powerhouses, buildings and other structures, and all offices, buildings and the contents thereof; all machinery, engines, boilers, dynamos, electrical machinery, regulators, meters, transformers, generators, motors, electrical and mechanical appliances, conduits, cables, water or other pipes, pole and transmission lines, poles, wires, cross-arms, insulators, substations and superstructures, generating, distributing and transmitting equipment, tools, implements, apparatus and supplies and coal in place and interests in coal; whether appertaining to any existing or future system of the Company or otherwise and including all other property now used or provided for use or hereafter acquired for use, in the construction, repair, maintenance and operation of such systems, both those now owned and those which may hereafter be acquired by the Company; all municipal or other grants, rights, permits, consents, franchises, privileges, easements, licenses, ordinances, rights of way, liberties and immunities of the Company, howsoever conferred or acquired and whether now owned or hereafter acquired; and all leases, leaseholds, power contracts, street lighting contracts and other rights with respect to the construction, maintenance, repair and operation of any systems now owned or hereafter acquired by the Company, and any additions thereto or extensions thereof; certain parts or parcels of such property being more specifically described as follows: All the following described property situate in the County of Allegheny and Commonwealth of Pennsylvania, the deed herein recited being recorded in the Recorder's Office of said County, and reference being made thereto for a more particular description of said property, viz: All that certain lot or piece of ground situate partly in the Township of North Fayette and partly in the Township of Findlay. Conveyed to Duquesne Light Company by: Miriam G. Lewis, widow, Deed dated July 24, 1992, Deed Book Volume 8794, page 633; Donald B. Lewis et ux, Deed dated July 22, 1992, Deed Book Volume 8794, page 638; Loren L. Lewis, et ux, Deed dated July 20, 1992, Deed Book Volume 8794, page 643; and Mellon Bank, N.A., Executor of the Estate of Gordon E. Williams, deceased, Deed dated August 10, 1992, Deed Book Volume 8794, page 649. (Transmission Line). TOGETHER WITH all and singular the tenements, hereditaments and appurtenances belonging or in anywise appertaining to the aforesaid property or any part thereof, with the reversion and reversions, remainder and remainders, tolls, rents and revenues, issues, income, product and profits thereof and all the estate, right, title, interest and claim whatsoever, at law as well as in equity, which the Company now has or may hereafter acquire in and to the aforesaid property and every part and parcel thereof except as excepted or excluded from the lien of the Indenture; THERE BEING HEREBY EXCEPTED from the lien of the Indenture, whether now owned or hereafter acquired by the Company, anything herein contained to the contrary notwithstanding, all those certain items of property of the classes specifically excepted from the lien of the Original Indenture by the terms thereof; TO HAVE AND TO HOLD all properties, real, personal and mixed, mortgaged, pledged or conveyed by the Company as aforesaid, or intended so to be, unto the Trustee and its successors and assigns, FOREVER; subject, however, to permissible encumbrances, as defined in the Original Indenture, and to all the other terms, conditions, covenants, uses, trusts and defeasances incorporated in the Indenture. The parties hereto shall have, possess and enjoy the same rights, powers, duties and privileges as affecting the property hereby conveyed as they have under the Original Indenture insofar as the same may be applicable hereto, with the same force and effect as though the terms, conditions, and defeasances of the Original Indenture had been embodied herein. IT IS HEREBY COVENANTED, DECLARED AND AGREED by the Company and the Trustee, and its successors in the trust under the Indenture, for the benefit of those who hold or shall hold the bonds, or any of them, issued or to be issued thereunder, as follows: ARTICLE I FORM AND EXECUTION OF FIRST MORTGAGE BONDS, POLLUTION CONTROL COLLATERAL SERIES G SECTION 1.01. There is hereby created, for issuance under the Indenture and to be secured thereby, a series of bonds, designated "First Mortgage Bonds, Pollution Control Collateral Series G." Each bond of such series shall bear the descriptive title "First Mortgage Bond, Pollution Control Collateral Series G," and the form thereof shall be substantially of the tenor and purport hereinbefore recited. The bonds of the Forty-Sixth Series shall be issued from time to time in an aggregate principal amount of $20,500,000, excluding any bonds of the Forty-Sixth Series which may be authenticated in exchange for or in lieu of or in substitution for or on transfer of other bonds of such series pursuant to the provisions of the Indenture, and shall be issued as registered bonds without coupons in denominations of $1,000 and integral multiples thereof. The bonds of the Forty-Sixth Series shall mature on October 1, 2027 and shall not bear interest except as provided in Article XIII of the Original Indenture. The principal of and interest, if any, on each bond of the Forty-Sixth Series shall be payable at the office or agency of the Company in Pittsburgh, Pennsylvania or at such other office or agency of the Company as shall be designated from time to time, in lawful money of the United States of America. Each bond of the Forty-Sixth Series shall be dated as of its Original Issue Date. The term "Original Issue Date" as used in this Section 1.01 shall mean the date of the first authentication and delivery hereunder of such bonds. SECTION 1.02. Each bond of the Forty-Sixth Series shall be redeemable at the option of the Company in whole at any time, or in part from time to time, prior to maturity, at a redemption price equal to 100.00% of the principal amount thereof to be redeemed, by payment at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time. Any such redemption shall be made upon not less than 30 days' previous notice to be given in the manner provided in Section 10.02 of the Original Indenture. SECTION 1.03. The bonds of the Forty-Sixth Series shall be redeemable on October 1 of each year commencing one year after the date of issuance of the first bonds of said series for the Sinking Fund for bonds of said series provided for in Article XII of the Original Indenture, upon not less than 30 days' previous notice of redemption to be given in the manner provided in Section 10.02 of the Original Indenture, at the principal amount thereof. SECTION 1.04. All bonds of the Forty-Sixth Series shall be redeemed, at a redemption price equal to 100% of the principal amount thereof, if, and at such time as, the securities which shall have been authenticated and delivered under the 1992 Mortgage (as hereinafter defined) on the basis of the issuance and delivery to the 1992 Mortgage Trustee (as hereinafter defined) of the bonds of the Forty-Sixth Series shall have become subject to mandatory redemption. No notice of such redemption shall be required to be given. SECTION 1.05. The bonds of the Forty-Sixth Series shall be issued and delivered to Mellon Bank, N.A., as trustee under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992, as supplemented (the "1992 Mortgage"), of the Company to such trustee (the "1992 Mortgage Trustee"), as the basis for the authentication and delivery under the 1992 Mortgage of a series of securities. As provided in the 1992 Mortgage, the bonds of the Forty-Sixth Series will be registered in the name of the 1992 Mortgage Trustee or its nominee and will be owned and held by the 1992 Mortgage Trustee, subject to the provisions of the 1992 Mortgage, for the benefit of the holders of all securities from time to time outstanding under the 1992 Mortgage, and the Company shall have no interest therein. Any payment by the Company under the 1992 Mortgage of the principal of or interest, if any, on the securities which shall have been authenticated and delivered under the 1992 Mortgage on the basis of the issuance and delivery to the 1992 Mortgage Trustee of bonds of the Forty-Sixth Series (other than by the application of the proceeds of a payment in respect of such bonds) shall, to the extent thereof, be deemed to satisfy and discharge the obligation of the Company, if any, to make a payment of principal of or interest on such bonds, as the case may be, which is then due. The Trustee may conclusively presume that the obligation of the Company to pay the principal of the bonds of the Forty-Sixth Series as the same shall become due and payable shall have been fully satisfied and discharged unless and until it shall have received a written notice from the 1992 Mortgage Trustee, signed by an authorized officer thereof, stating that the principal of specified bonds of the Forty-Sixth Series has become due and payable and has not been fully paid, and specifying the amount of funds required to make such payment. SECTION 1.06. The bonds of the Forty-Sixth Series shall not be transferable, except to any successor trustee under said 1992 Mortgage. Any such transfer shall be made by the registered holder thereof, in person or by a duly authorized attorney, at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time, upon surrender and cancellation of such bonds, and thereupon a new bond or bonds of said series and of authorized denominations for a like aggregate principal amount and having the same Original Issue Date, Stated Maturity Date and other terms and conditions will be issued to the transferee in exchange therefor. New bonds issued upon any such transfer shall be so dated and shall carry such rights to any interest accrued and unpaid that neither gain nor loss in interest shall result from such transfer. SECTION 1.07. The registered holder of any bond or bonds of the Forty- Sixth Series at his option may surrender the same at the office or agency of the Company in Pittsburgh, Pennsylvania, or at such other office or agency of the Company as shall be designated from time to time, for cancellation in exchange for another or other bonds of the said series of authorized denominations, but of the same aggregate principal amount and having the same Original Issue Date, Stated Maturity Date and other terms and conditions and being so dated and carrying such rights to any interest accrued and unpaid that neither gain nor loss in interest shall result from such exchange. Thereupon, the Company shall execute and deliver to the Trustee, and the Trustee shall authenticate and deliver such other bond or bonds to such registered holder either at its office or at said office or agency of the Company. SECTION 1.08. No charge shall be made to any registered holder of any bond of the Forty-Sixth Series for any exchange or transfer of bonds of said series except that in case of any exchange or transfer the Company may make a charge therefor sufficient to reimburse it for any tax or taxes or other governmental charge required to be paid in connection therewith. SECTION 1.09. For the purpose only of complying with the Original Indenture (particularly Sections 10.02 and 12.02(b) thereof) in connection with the redemption of bonds of the Forty-Sixth Series, for each $1,000 principal amount of bonds authenticated and delivered hereunder there shall be assigned a number in such manner and at such time as the Trustee may deem appropriate. Portions of the principal amount less than the entire principal amount of a bond of the Forty-Sixth Series of a denomination larger than $1,000 may be redeemed only in integral multiples of $1,000. ARTICLE II MISCELLANEOUS SECTION 2.01. The holders of the bonds of the Forty-Sixth Series shall be deemed to have consented and agreed that the Company may, but shall not be obligated to, fix a record date for the purpose of determining the holders of the bonds of the Forty-Sixth Series entitled to consent to any amendment or supplement to the Indenture or the waiver of any provision thereof or any act to be performed thereunder. If a record date is fixed, those persons who were holders at such record date (or their duly designated proxies), and only those persons, shall be entitled to consent to such amendment, supplement or waiver or to revoke any consent previously given, whether or not such persons continue to be holders after such record date. No such consent shall be valid or effective for more than 90 days after such record date. SECTION 2.02. The recitals of fact herein and in the bonds (except the Trustee's Certificate) shall be taken as statements of the Company and shall not be construed as made or warranted by the Trustee. The Trustee makes no representations as to the value of any of the property subjected to the lien of the Indenture, or any part thereof, or as to the title of the Company thereto, or as to the security afforded thereby and hereby, or as to the validity of this Eighty-Seventh Supplemental Trust Indenture or of the bonds of the Forty-Sixth Series (except the Trustee's Certificate), and the Trustee shall incur no responsibility in respect of such matters. SECTION 2.03. This Eighty-Seventh Supplemental Trust Indenture shall be construed in connection with and as part of the Indenture. SECTION 2.04. (a) If any provision of this Eighty-Seventh Supplemental Trust Indenture limits, qualifies, or conflicts with another provision of the Indenture required to be included in indentures qualified under the Trust Indenture Act of 1939 (as in force at the date of this Eighty-Seventh Supplemental Trust Indenture) by any of the provisions of Sections 310 to 317, inclusive, of said Act, such required provision shall control. (b) In case any one or more of the provisions contained in this Eighty- Seventh Supplemental Trust Indenture or in the bonds issued hereunder should be invalid, illegal or unenforceable in any respect, the validity, legality and enforceability of the remaining provisions contained herein and therein shall not in any way be affected, impaired, prejudiced or disturbed thereby. SECTION 2.05. Whenever in this Eighty-Seventh Supplemental Trust Indenture either of the parties hereto is named or referred to, this shall be deemed to include the successors or assigns of such party, and all the covenants and agreements in this Eighty-Seventh Supplemental Trust Indenture contained by or on behalf of the Company or by or on behalf of the Trustee shall bind and inure to the benefit of the respective successors and assigns of such parties, whether so expressed or not. SECTION 2.06. This Eighty-Seventh Supplemental Trust Indenture may be simultaneously executed in several counterparts, and all said counterparts executed and delivered, each as an original, shall constitute but one and the same instrument. The Table of Contents and the descriptive headings of the several Articles of this Eighty-Seventh Supplemental Trust Indenture were formulated, used and inserted herein for convenience only and shall not be deemed to affect the meaning or construction of any of the provisions hereof. SECTION 2.07. Duquesne Light Company does hereby constitute and appoint Joan S. Senchyshyn to be its attorney-in-fact for it and in its name and as and for its corporate deed to acknowledge this Eighty-Seventh Supplemental Trust Indenture before any person having authority by law to take such acknowledgment. Mellon Bank, N.A. does hereby constitute and appoint D.M. Babich to be its attorney-in-fact for it and in its name and as and for its corporate deed to acknowledge this Eighty-Seventh Supplemental Trust Indenture before any person having authority by law to take such acknowledgment. In Witness Whereof, the party of the first part has caused its corporate name to be subscribed and this Eighty-Seventh Supplemental Trust Indenture to be signed by its Chairman of the Board, President and Chief Executive Officer or a Vice President, and its corporate seal to be hereunto affixed and attested by its Secretary or an Assistant Secretary, for and on its behalf, and the party of the second part, to evidence its acceptance of the trust hereby created, has caused its corporate name to be subscribed, and this Eighty-Seventh Supplemental Trust Indenture to be signed by its President, a Vice President or an Assistant Vice President and its corporate seal to be hereunto affixed and attested by its authorized officer, for and in its behalf, all done as of the first day of August, 1993. DUQUESNE LIGHT COMPANY [Seal] By:/s/ Gary L. Schwass -------------------------------- Vice President-Finance and Chief Financial Officer Attest: /s/ Joan S. Senchyshyn - -------------------------------- Assistant Secretary MELLON BANK, N.A. [Seal] By:/s/ J.H. McAnulty ---------------------------------- Vice President Attest: /s/ D.M. Babich - -------------------------------- Authorized Officer COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 23rd day of August, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared Joan S. Senchyshyn, the attorney-in-fact named in the foregoing Eighty-Seventh Supplemental Trust Indenture, and by virtue and in pursuance of the authority therein conferred upon her acknowledged the said Eighty-Seventh Supplemental Trust Indenture to be the act and deed of the said Duquesne Light Company and that she desired the same to be recorded as such. WITNESS my hand and notarial seal the day and year aforesaid. /s/ Joanne E. Kirin ------------------------- Notary Public COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 24th day of August, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared D.M. Babich, the attorney-in-fact named in the foregoing Eighty-Seventh Supplemental Trust Indenture, and by virtue and in pursuance of the authority therein conferred upon him acknowledged the said Eighty-Seventh Supplemental Trust Indenture to be the act and deed of the said Mellon Bank, N.A., and that he desired the same to be recorded as such. WITNESS my hand and notarial seal the day and year aforesaid. /s/ Lorraine L. Henderson ---------------------------- Notary Public CERTIFICATE OF PRECISE RESIDENCE I hereby certify that the precise residence of Mellon Bank, N.A. is One Mellon Bank Center, Second Ward, Pittsburgh, Allegheny County, Pennsylvania. /s/ D.M. Babich ------------------------------------ Authorized Signatory of Mellon Bank, N. A. August 24, 1993 RECORDING INFORMATION Allegheny County, Pennsylvania Office of Recorder of Deeds Recorded: August 24, 1993 Mortgage Book Volume 13406, page 12 Beaver County, Pennsylvania Office of Recorder of Deeds Recorded: August 24, 1993 Mortgage Book Volume 1277, page 454 Greene County, Pennsylvania Office of Recorder of Deeds Recorded: August 25, 1993 Mortgage Book Volume 118, page 844 Washington County, Pennsylvania Office of Recorder of Deeds Recorded: August 26, 1993 Mortgage Book Volume 2037, page 203 Westmoreland County, Pennsylvania Office of Recorder of Deeds Recorded: August 25, 1993 Mortgage Book Volume 3197, page 532 Belmont County, Ohio Office of Recorder Received: August 25, 1993 Recorded: August 26, 1993 Mortgage Book Volume 606, page 682 Columbiana County, Ohio Office of Recorder Recorded: August 26, 1993 Mortgage Book Volume 390, page 695 Jefferson County, Ohio Office of Recorder Received: August 25, 1993 Recorded: August 26, 1993 Mortgage Book Volume 110, page 10 Lake County, Ohio Office of Recorder Recorded: August 26, 1993 Mortgage Book Volume 898, page 111 Monroe County, Ohio Office of Recorder Received: August 25, 1993 Recorded: August 25, 1993 Mortgage Book Volume 133, page 698 Hancock County, West Virginia Office of Clerk of County Commission Recorded: August 26, 1993 Deed of Trust Book 307, page 126 Monongalia County, West Virginia Office of Clerk of County Commission Recorded: August 25, 1993 Deed of Trust Book 719, page 348 EXHIBIT 4.2 CONFORMED COPY ================================================================================ EIGHTY-EIGHTH SUPPLEMENTAL TRUST INDENTURE between DUQUESNE LIGHT COMPANY (a Pennsylvania corporation) and MELLON BANK, N.A., Trustee ------------------- Dated September 23, 1993 ------------------- Subjecting additional property to the lien of the Trust Indenture dated as of August 1, 1947 ================================================================================ EIGHTY-EIGHTH SUPPLEMENTAL TRUST INDENTURE Made this 23rd day of September, 1993, by and between DUQUESNE LIGHT COMPANY, a corporation organized and existing under and by virtue of the laws of the Commonwealth of Pennsylvania, having its principal office in the City of Pittsburgh in said Commonwealth of Pennsylvania (hereinafter sometimes called the "Company"), party of the first part, A N D MELLON BANK, N.A., successor by merger to Mellon National Bank and Trust Company, a national banking association, having its principal corporate trust office in the City of Pittsburgh in the Commonwealth of Pennsylvania, as Trustee (hereinafter sometimes called the "Trustee"), party of the second part. WHEREAS, the Company has heretofore executed and delivered to Mellon Bank, N.A., as Trustee, a certain Trust Indenture (hereinafter called the "Original Indenture") dated as of August 1, 1947 securing its First Mortgage Bonds; and WHEREAS, the Original Indenture has been recorded in the Recorders' Offices of the various counties of Pennsylvania as follows: In Allegheny County in Mortgage Book Vol. 2897, page 4; In Beaver County in Mortgage Book Vol. 430, page 1; In Greene County in Mortgage Book Vol. 125, page 1; In Washington County in Mortgage Book Vol. 332, page 1; and In Westmoreland County in Mortgage Book Vol. 692, page 2; has been filed in the Prothonotary's Office in each of said Counties; and has also been recorded in the Office of the Clerk of County Commission of Monongalia County, West Virginia, in Deed of Trust Book Vol. 321, page 327, the Office of the Clerk of County Commission of Hancock County, West Virginia, in Deed of Trust Book Vol. 176, page 1, the Recorder's Office of Belmont County, Ohio, in Mortgage Book Vol. 437, page 109, the Recorder's Office of Columbiana County, Ohio, in Mortgage Book Vol. 1542, page 25, the Recorder's Office of Jefferson County, Ohio, in Mortgage Book Vol. 405, page 1, the Recorder's Office of Lake County, Ohio, in Mortgage Book Vol. 821, page 1, and the Recorder's Office of Monroe County, Ohio, in Mortgage Book Vol. 89, page 1; and WHEREAS, in and by Sections 8.09 and 20.03 of the said Trust Indenture, provision is made for the giving by the said Company of supplemental indentures supplemental to the said recited Trust Indenture for certain purposes, including, inter alia, to make subject to the lien of the Trust Indenture property acquired subsequent to the date thereof; and - 1 - WHEREAS, the Company has acquired certain additional properties which it desires to subject to the lien of said Trust Indenture by an Eighty-Eighth Supplemental Trust Indenture; NOW, THEREFORE, THIS EIGHTY-EIGHTH SUPPLEMENTAL TRUST INDENTURE WITNESSETH that Duquesne Light Company, in consideration of the premises and of the purchase and acceptance of bonds issued under the provisions of the Trust Indenture given by the Company to Mellon National Bank and Trust Company (now Mellon Bank, N.A.), Trustee, dated as of August 1, 1947, by the holders thereof, and of One Dollar ($1.00) to it paid by the Trustee at or before the sealing and delivery of this Eighty-Eighth Supplemental Trust Indenture, and in order to secure the payment both of the principal of and interest on all bonds of the Company at any time outstanding under said Trust Indenture according to their tenor and effect, and the performance of and compliance with the covenants and conditions in said Trust Indenture contained, grants, bargains, sells, warrants, releases, conveys, assigns, transfers, mortgages, pledges, sets over and confirms unto Mellon Bank, N.A., as Trustee under the said Trust Indenture, and to its respective successors in said trust forever, all property, real, personal and mixed, now owned or hereafter acquired or to be acquired by the Company and wheresoever situated (except as excepted from the lien of the Trust Indenture and this Eighty-Eighth Supplemental Trust Indenture by the provisions thereof and hereof), subject to the rights reserved by the Company in and by various provisions of said Trust Indenture and this Eighty-Eighth Supplemental Trust Indenture, including (without in any wise limiting or impairing by the enumeration of the same the scope and intent of the foregoing or of any general description contained in this Eighty-Eighth Supplemental Trust Indenture) all lands, rights of way, roads, all powerhouses, buildings and other structures, and all offices, buildings and contents thereof; all machinery, engines, boilers, dynamos, electrical machinery, regulators, meters, transformers, generators, motors, electrical and mechanical appliances, conduits, cables, water or other pipes, pole and transmission lines, poles, wires, crossarms, insulators, substations and superstructures, generating, distributing and transmitting equipment, tools, implements, apparatus and supplies, and coal in place and interests in coal; whether appertaining to any existing or future system of the Company or otherwise and including all other property now used or provided for use or hereafter acquired for use, in the construction, repair, maintenance and operation of such systems, both those now owned and those which may hereafter be acquired by the Company; all municipal or other grants, rights, permits, consents, franchises, privileges, easements, licenses, ordinances, rights of way, liberties and immunities of the Company, howsoever conferred or acquired and whether now owned or hereafter acquired; and all leases, leaseholds, power contracts, street lighting contracts and other rights with respect to the construction, maintenance, repair and operation of any systems now owned or hereafter acquired by the Company, and any additions thereto or extensions thereof. - 2 - TOGETHER with all and singular the tenements, hereditaments and appurtenances belonging or in any wise appertaining to the aforesaid property or any part thereof, with the reversion and reversions, remainder and remainders, tolls, rents and revenues, issues, income, product and profits thereof, and all the estate, right, title, interest and claim whatsoever, at law as well as in equity, which the Company now has or may hereafter acquire in and to the aforesaid property and franchises and every part and parcel thereof except as hereinafter excepted or excluded from the lien hereof, and of the above recited Trust Indenture. There are hereby excepted from the lien of this Eighty-Eighth Supplemental Trust Indenture, whether now owned or hereafter acquired by the Company, anything herein contained to the contrary notwithstanding, all those certain items of property of the classes specifically excepted from the lien of the above recited Trust Indenture by the terms thereof. TO HAVE AND TO HOLD ALL said properties, real, personal and mixed, mortgaged, pledged or conveyed by the Company as aforesaid, or intended so to be, unto the Trustee and its successors and assigns, FOREVER; subject, however, to permissible encumbrances, as defined in the above recited Trust Indenture, and to all of the other terms, conditions, covenants, uses, trusts and defeasances incorporated in the said recited Trust Indenture dated as of August 1, 1947. The parties hereto shall have, possess and enjoy the same rights, powers, duties and privileges as affecting the property hereby conveyed as they have under said recited Trust Indenture insofar as the same may be applicable hereto, with the same force and effect as though the terms, conditions, covenants and defeasances of said recited Trust Indenture had been embodied herein. This Eighty-Eighth Supplemental Trust Indenture is duly executed and delivered in accordance with resolutions of the Board of Directors of the Company adopted at a meeting held on August 31, 1993. - 3 - IN WITNESS WHEREOF, the party of the first part has caused its corporate name to be subscribed and this Eighty-Eighth Supplemental Trust Indenture to be signed by its Chairman of the Board, President and Chief Executive Officer or a Vice President, and its corporate seal to be hereunto affixed and attested by its Secretary or an Assistant Secretary, for and in its behalf, and the party of the second part, to evidence its acceptance of the additional trust hereby created, has caused its corporate name to be subscribed and this Eighty-Eighth Supplemental Trust Indenture to be signed by its Vice President or an Assistant Vice President, and its corporate seal to be hereunto affixed and attested by its Authorized Officer, for and in its behalf, all done as of the day and year first above written. DUQUESNE LIGHT COMPANY [Seal] By: /s/ Gary L. Schwass ------------------------------- Vice President-Finance and Chief Financial Officer Attest: /s/ Diane S. Eismont - ------------------------------ Secretary MELLON BANK, N.A. [Seal] By: /s/ M. J. Richards ------------------------------- Assistant Vice President Attest: /s/ D. M. Babich - ------------------------------ Authorized Officer - 4 - COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 23rd day of September, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared Gary L. Schwass, who acknowledged himself to be Vice President-Finance and Chief Financial Officer of Duquesne Light Company, a corporation, and that he as such Vice President-Finance and Chief Financial Officer, being authorized to do so, executed the foregoing instrument for the purposes therein contained by signing the name of the corporation by himself as Vice President-Finance and Chief Financial Officer. IN WITNESS WHEREOF I hereunto set my hand and official seal. /s/ Joanne E. Kirin ------------------------------ Notary Public COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On this 23rd day of September, 1993 before me, the subscriber, a notary public in and for said Commonwealth and County, personally appeared M.J. Richards, who acknowledged herself to be Assistant Vice President of Mellon Bank, N.A., a national banking association, and that she as such Assistant Vice President, being authorized to do so, executed the foregoing instrument for the purposes therein contained by signing the name of the corporation by herself as Assistant Vice President. IN WITNESS WHEREOF I hereunto set my hand and official seal. /s/ Lorraine L. Henderson ------------------------------ Notary Public - 5 - CERTIFICATE OF PRECISE RESIDENCE I hereby certify that the precise residence of Mellon Bank, N.A. is One Mellon Bank Center, Second Ward, Pittsburgh, Allegheny County, Pennsylvania. /s/ D. M. Babich ----------------------------------------- Authorized Signatory of Mellon Bank, N.A. September 23, 1993 - 6 - RECORDING INFORMATION Allegheny County, Pennsylvania Office of Recorder of Deeds Recorded September 27, 1993 Mortgage Book Volume 13497, page 457 Beaver County, Pennsylvania Office of Recorder of Deeds Recorded September 27, 1993 Mortgage Book Volume 1282, page 879 Greene County, Pennsylvania Office of Recorder of Deeds Recorded September 24, 1993 Mortgage Book Volume 120, page 54 Washington County, Pennsylvania Office of Recorder of Deeds Recorded September 24, 1993 Mortgage Book Volume 2552, page 67 Westmoreland County, Pennsylvania Office of Recorder of Deeds Recorded September 24, 1993 Mortgage Book Volume 3220, page 30 Belmont County, Ohio Office of Recorder Received September 24, 1993 Recorded September 27, 1993 Mortgage Book Volume 608, page 23 Columbiana County, Ohio Officer of Recorder Recorded September 27, 1993 Mortgage Book Volume 395, page 295 Jefferson County, Ohio Office of Recorder Received September 24, 1993 Recorded September 27, 1993 Mortgage Book Volume 112, page 710 Lake County, Ohio Office of Recorder Recorded September 27, 1993 Mortgage Book Volume 910, page 1178 - 7 - Monroe County, Ohio Office of Recorder Received September 24, 1993 Recorded September 24, 1993 Mortgage Book Volume 133, page 927 Hancock County, West Virginia Office of Clerk of County Commission Recorded September 27, 1993 Deed of Trust Book 308, page 276 Monongalia County, West Virginia Office of Clerk of County Commission Recorded September 24, 1993 Deed of Trust Book 722, page 241 - 8 - EXHIBIT 4.6 CONFORMED COPY ============================================================================== DUQUESNE LIGHT COMPANY TO MELLON BANK, N.A. Trustee _____________________ Supplemental Indenture No. 5 Dated as of June 1, 1993 Supplemental to the Indenture of Mortgage and Deed of Trust dated as of April 1, 1992 Establishing a series of Securities designated First Collateral Trust Bonds, Series E, limited in aggregate principal amount to $300,000,000 and amending Section 901 of the Original Indenture pursuant to Section 1401(j) thereof ============================================================================== SUPPLEMENTAL INDENTURE No. 5, dated as of June 1, 1993, between DUQUESNE LIGHT COMPANY, a corporation duly organized and existing under the laws of the Commonwealth of Pennsylvania (hereinafter sometimes called the "Company"), and MELLON BANK, N.A., a national banking association organized and existing under the laws of the United States of America, trustee (hereinafter sometimes called the "Trustee"), under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992 (hereinafter called the "Original Indenture"), this Supplemental Indenture No. 5 being supplemental thereto. The Original Indenture and any and all indentures and instruments supplemental thereto are hereinafter sometimes collectively called the "Mortgage." Recitals of the Company The Original Indenture was authorized, executed and delivered by the Company to provide for the issuance from time to time of its Securities (such term and all other capitalized terms used herein without definition having the meanings assigned to them in the Original Indenture), to be issued in one or more series as contemplated therein, and to provide security for the payment of the principal of and premium, if any, and interest, if any, on the Securities. The Company has heretofore executed and delivered to Mellon Bank, N.A., as Trustee, Supplemental Indentures for the purposes recited therein and for the purpose of creating series of Securities as set forth in Schedule A hereto. The Company desires to establish a series of Securities to be designated "First Collateral Trust Bonds, Series E" to be limited in aggregate principal amount (except as contemplated in Section 301(b) of the Original Indenture) to $300,000,000, such series of Securities to be hereinafter sometimes called "Series No. 4", and to amend Section 901 of the Original Indenture pursuant to Section 1401(j) thereof. The Company has duly authorized the execution and delivery of this Supplemental Indenture No. 5 to establish the Securities of Series No. 4 and to amend Section 901 of the Original Indenture and has duly authorized the issuance of such Securities; and all acts necessary to make this Supplemental Indenture No. 5 a valid agreement of the Company, and to make the Securities of Series No. 4 valid obligations of the Company, have been performed. NOW, THEREFORE, THIS SUPPLEMENTAL INDENTURE NO. 5 WITNESSETH, that, in consideration of the premises and of the purchase of the Securities by the Holders thereof, and in order to secure the payment of the principal of and premium, if any, and interest, if any, on all Securities from time to time Outstanding and the performance of the covenants contained therein and in the Mortgage and to declare the terms and conditions on which such Securities are secured, the Company hereby grants, bargains, sells, releases, conveys, assigns, transfers, mortgages, pledges, sets over and confirms to the Trustee, and grants to the Trustee a security interest in, the following: Granting Clause First All right, title and interest of the Company in and to property (other than Excepted Property), real, personal and mixed and wherever situated, in any case used or to be used in or in connection with the generation, purchase, transmission, distribution or sale by the Company of electric energy (whether or not such use is the sole use of such property), including without limitation (a) all lands, easements, servitudes, licenses, permits, rights of way and other rights and interests in or relating to real property or the occupancy or use of the same; (b) all plants, generators, turbines, engines, boilers, fuel handling and transportation facilities, air and water pollution control and sewage and solid waste disposal facilities and other machinery and facilities for the generation of electric energy; (c) all switchyards, lines, towers, substations, transformers and other machinery and facilities for the transmission of electric energy; (d) all lines, poles, conduits, conductors, meters, regulators and other machinery and facilities for the distribution of electric energy; (e) all buildings, offices, warehouses and other structures; and (f) all pipes, cables, insulators, ducts, tools, computers and other data processing and/or storage equipment and other equipment, apparatus and facilities and all other property, of whatever kind and nature, ancillary to or otherwise used or to be used in conjunction with any or all of the foregoing or otherwise, directly or indirectly, in furtherance of the generation, purchase, transmission, distribution or sale by the Company of electric energy; Granting Clause Second Subject to the applicable exceptions permitted by Section 810, Section 1303 and Section 1305 of the Original Indenture, all property (other than Excepted Property) of the kind and nature described in Granting Clause First which may be hereafter acquired by the Company, it being the intention of the Company that all such property acquired by the Company after the date of the execution and delivery of this Supplemental Indenture No. 5 shall be as fully embraced within and subjected to the Lien hereof as if such property were owned by the Company as of the date of the execution and delivery of this Supplemental Indenture No. 5; Granting Clause Fourth All other property of whatever kind and nature subjected or intended to be subjected to the Lien of the Mortgage by any of the terms and provisions thereof; Excepted Property Expressly excepting and excluding, however, from the Lien and operation of the Mortgage all Excepted Property of the Company, whether now owned or hereafter acquired; TO HAVE AND TO HOLD all such property, real, personal and mixed, unto the Trustee forever; SUBJECT, HOWEVER, to Permitted Liens and to Liens which have been granted by the Company to other Persons prior to the date of the execution and delivery of the Original Indenture (including, but not limited to, the Lien of the DLC 1947 Mortgage), and subject also, as to any property acquired by the Company after the date of execution and delivery of the Original Indenture, to vendors' Liens, purchase money mortgages and other Liens thereon at the time of the acquisition thereof (including, but not limited to, the Lien of any Class "A" Mortgage), it being understood that with respect to any of such property which was at the date of execution and delivery of the Original Indenture or thereafter became or hereafter becomes subject to the Lien of any Class "A" Mortgage, the Lien of the Mortgage shall at all times be junior and subordinate to the Lien of such Class "A" Mortgage; IN TRUST, NEVERTHELESS, for the equal and proportionate benefit and security of the Holders from time to time of all Outstanding Securities without any priority of any such Security over any other such Security; PROVIDED, HOWEVER, that if, after the right, title and interest of the Trustee in and to the Mortgaged Property shall have ceased, terminated and become void in accordance with Article Nine of the Original Indenture, the principal of and premium, if any, and interest, if any, on the Securities shall have been paid to the Holders thereof, or shall have been paid to the Company pursuant to Section 603 of the Original Indenture, then and in that case the Mortgage and the estate and rights thereby granted shall cease, terminate and be void, and the Trustee shall cancel and discharge the Mortgage and execute and deliver to the Company such instruments as the Company shall require to evidence the discharge thereof; otherwise the Mortgage shall be and remain in full force and effect; and THE PARTIES HEREBY FURTHER COVENANT AND AGREE as follows: ARTICLE ONE Fourth Series of Securities There is hereby created a series of Securities designated "First Collateral Trust Bonds, Series E" and limited in aggregate principal amount (except as contemplated in Section 301(b) of the Original Indenture) to $300,000,000. The form and terms of the Securities of Series No. 4 shall be established in an Officer's Certificate. ARTICLE TWO Amendment of Original Indenture Section 901 of the Original Indenture is hereby amended by: (1) deleting the word "and" from the end of clause (x) in the first paragraph thereof; (2) deleting the period at the end of clause (y) in the first paragraph thereof and adding at the end of clause (y) "; and"; (3) adding a new clause (z) at the end of the first paragraph thereof reading as follows: (z) an Officer's Certificate stating the Company's intention that, upon delivery of such Officer's Certificate, its indebtedness in respect of such Securities or portions thereof will have been satisfied. ; and (4) deleting the second paragraph thereof and substituting therefor a new second paragraph reading as follows: Upon receipt by the Trustee of money or Eligible Obligations, or both, in accordance with this Section, together with the documents required by clauses (x), (y) and (z) above, the Trustee shall, upon Company Request, acknowledge in writing that such Securities or portions thereof are deemed to have been paid for all purposes of this Indenture and that the entire indebtedness of the Company in respect thereof is deemed to have been satisfied and discharged. In the event that all of the conditions set forth in the preceding paragraph shall have been satisfied in respect of any Securities or portions thereof except that, for any reason, the Officer's Certificate specified in clause (z) shall not have been delivered to the Trustee, such Securities or portions thereof shall not be deemed to have been paid as contemplated in such paragraph, but the Holders of such Securities or portions thereof shall nevertheless be no longer entitled to the benefit of the covenants of the Company under Article Six (except the covenants contained in Sections 601(a), 602 and 603) or any other covenants made in respect of such Securities or portions thereof as contemplated by Section 301. ARTICLE THREE Miscellaneous Provisions This Supplemental Indenture No. 5 is a supplement to the Mortgage. As supplemented by this Supplemental Indenture No. 5, the Mortgage is in all respects ratified, approved and confirmed, and the Mortgage and this Supplemental Indenture No. 5 shall together constitute one and the same instrument. IN WITNESS WHEREOF, the parties hereto have caused this Supplemental Indenture No. 5 to be duly executed, and their respective corporate seals to be hereunto affixed and attested, all as of the day and year first above written. DUQUESNE LIGHT COMPANY [Seal] By: /s/ Gary L. Schwass ------------------------------------ Vice President-Finance and Chief Financial Officer Attest: /s/ Diane S. Eismont - -------------------------------- Secretary MELLON BANK, N.A., Trustee By: /s/ J.H. McAnulty ------------------------------------ [Seal] Vice President Attest: /s/ D.M. Babich --------------------------------- Authorized Officer COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On the 7th day of June, 1993, before me personally came Gary L. Schwass, to me known, who, being by me duly sworn, did depose and say that he is the Vice President-Finance and Chief Financial Officer of Duquesne Light Company, the corporation described in and which executed the foregoing instrument; that he knows the seal of said corporation; that the seal affixed to said instrument is such corporate seal; that it was so affixed by authority of the Board of Directors of said corporation, and that he signed his name thereto by like authority. /s/ Joanne E. Kirin --------------------------------- Notary Public COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On the 7th day of June, 1993, before me personally came J. H. McAnulty, to me known, who, being by me duly sworn, did depose and say that he is a Vice President of Mellon Bank, N.A., the national banking association described in and which executed the foregoing instrument; that he knows the seal of said national banking association; that the seal affixed to said instrument is the seal of said national banking association; that it was so affixed by authority of the Board of Directors of said national banking association, and that he signed his name thereto by like authority. /s/ Nancy A. Fletcher --------------------------------- Notary Public CERTIFICATE OF PRECISE RESIDENCE I hereby certify that the precise residence of Mellon Bank, N.A., is One Mellon Bank Center, Second Ward, Pittsburgh, Allegheny County, Pennsylvania. /s/ D.M. Babich ---------------------------------------- Authorized Signatory of Mellon Bank, N.A. June 7, 1993 Schedule A - ----------------------------- /1/ As of June 1, 1993. RECORDING INFORMATION Allegheny County, Pennsylvania Office of Recorder of Deeds Recorded June 9, 1993 Mortgage Book Volume 13181, page 194 Beaver County, Pennsylvania Office of Recorder of Deeds Recorded June 9, 1993 Mortgage Book Volume 1264, page 657 Greene County, Pennsylvania Office of Recorder of Deeds Recorded June 8, 1993 Mortgage Book Volume 115, page 206 Washington County, Pennsylvania Office of Recorder of Deeds Recorded June 8, 1993 Mortgage Book Volume 2007, page 481 Westmoreland County, Pennsylvania Office of Recorder of Deeds Recorded June 8, 1993 Mortgage Book Volume 3138, page 608 Belmont County, Ohio Office of Recorder Received June 8, 1993 Recorded June 9, 1993 Mortgage Book Volume 602, page 846 Columbiana County, Ohio Office of Recorder Recorded June 9, 1993 Mortgage Book Volume 378, page 231 Jefferson County, Ohio Office of Recorder Received June 8, 1993 Recorded June 9, 1993 Mortgage Book Volume 102, page 271 Lake County, Ohio Office of Recorder Recorded June 9, 1993 Mortgage Book Volume 864, page 691 Monroe County, Ohio Office of Recorder Received June 8, 1993 Recorded June 8, 1993 Mortgage Book Volume 132, page 868 Hancock County, West Virginia Office of Clerk of County Commission Recorded June 9, 1993 Deed of Trust Book 304, page 351 Monongalia County, West Virginia Office of Clerk of County Commission Recorded June 8, 1993 Deed of Trust Book 710, page 333 EXHIBIT 4.6 CONFORMED COPY ================================================================================ DUQUESNE LIGHT COMPANY TO MELLON BANK, N.A. Trustee --------------------- Supplemental Indenture No. 6 Dated as of June 1, 1993 Supplemental to the Indenture of Mortgage and Deed of Trust dated as of April 1, 1992 Establishing a series of Securities designated First Collateral Trust Bonds, Pollution Control Series F, limited in aggregate principal amount to $25,000,000 ================================================================================ SUPPLEMENTAL INDENTURE No. 6, dated as of June 1, 1993, between DUQUESNE LIGHT COMPANY, a corporation duly organized and existing under the laws of the Commonwealth of Pennsylvania (hereinafter sometimes called the "Company"), and MELLON BANK, N.A., a national banking association organized and existing under the laws of the United States of America, trustee (hereinafter sometimes called the "Trustee"), under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992 (hereinafter called the "Original Indenture"), this Supplemental Indenture No. 6 being supplemental thereto. The Original Indenture and any and all indentures and instruments supplemental thereto are hereinafter sometimes collectively called the "Mortgage." Recitals of the Company The Original Indenture was authorized, executed and delivered by the Company to provide for the issuance from time to time of its Securities (such term and all other capitalized terms used herein without definition having the meanings assigned to them in the Original Indenture), to be issued in one or more series as contemplated therein, and to provide security for the payment of the principal of and premium, if any, and interest, if any, on the Securities. The Original Indenture has been recorded in the Recorders' Offices of the various counties of Pennsylvania as follows: In Allegheny County in Mortgage Book Vol. 12068, page 8; In Beaver County in Mortgage Book Vol. 1208, page 520; In Greene County in Mortgage Book Vol. 100, page 174; In Washington County in Mortgage Book Vol. 1873, page 1; In Westmoreland County in Mortgage Book Vol. 2862, page 221; and has also been recorded in the Office of the Clerk of County Commission of Monongalia County, West Virginia, in Deed of Trust Book Vol. 672, page 129, the Office of the Clerk of County Commission of Hancock County, West Virginia, in Deed of Trust Book Vol. 293, page 46, the Recorder's Office of Belmont County, Ohio, in Mortgage Book Vol. 586, page 273, the Recorder's Office of Columbiana County, Ohio, in Mortgage Book Vol. 318, page 289, the Recorder's Office of Jefferson County, Ohio, in Mortgage Book Vol. 65, page 675, the Recorder's Office of Lake County, Ohio, in Mortgage Book Vol. 711, page 217, and the Recorder's Office of Monroe County, Ohio, in Mortgage Book Vol. 129, page 301. The Company has heretofore executed and delivered to Mellon Bank, N.A., as Trustee, Supplemental Indentures for the purposes recited therein and for the purpose of creating series of Securities as set forth in Schedule A hereto. The Company desires to establish a series of Securities to be designated "First Collateral Trust Bonds, Pollution Control Series F" to be limited in aggregate principal amount (except as contemplated in Section 301(b) of the Original Indenture) to $25,000,000, such series of Securities to be hereinafter sometimes called "Series No. 5." The Company has duly authorized the execution and delivery of this Supplemental Indenture No. 6 to establish the Securities of Series No. 5 and has duly authorized the issuance of such Securities; and all acts necessary to make this Supplemental Indenture No. 6 a valid agreement of the Company, and to make the Securities of Series No. 5 valid obligations of the Company, have been performed. NOW, THEREFORE, THIS SUPPLEMENTAL INDENTURE NO. 6 WITNESSETH, that, in consideration of the premises and of the purchase of the Securities by the Holders thereof, and in order to secure the payment of the principal of and premium, if any, and interest, if any, on all Securities from time to time Outstanding and the performance of the covenants contained therein and in the Mortgage and to declare the terms and conditions on which such Securities are secured, the Company hereby grants, bargains, sells, releases, conveys, assigns, transfers, mortgages, pledges, sets over and confirms to the Trustee, and grants to the Trustee a security interest in, the following: Granting Clause First All right, title and interest of the Company in and to property (other than Excepted Property), real, personal and mixed and wherever situated, in any case used or to be used in or in connection with the generation, purchase, transmission, distribution or sale by the Company of electric energy (whether or not such use is the sole use of such property), including without limitation (a) all lands, easements, servitudes, licenses, permits, rights of way and other rights and interests in or relating to real property or the occupancy or use of the same; (b) all plants, generators, turbines, engines, boilers, fuel handling and transportation facilities, air and water pollution control and sewage and solid waste disposal facilities and other machinery and facilities for the generation of electric energy; (c) all switchyards, lines, towers, substations, transformers and other machinery and facilities for the transmission of electric energy; (d) all lines, poles, conduits, conductors, meters, regulators and other machinery and facilities for the distribution of electric energy; (e) all buildings, offices, warehouses and other structures; and (f) all pipes, cables, insulators, ducts, tools, computers and other data processing and/or storage equipment and other equipment, apparatus and facilities and all other property, of whatever kind and nature, ancillary to or otherwise used or to be used in conjunction with any or all of the foregoing or otherwise, directly or indirectly, in furtherance of the generation, purchase, transmission, distribution or sale by the Company of electric energy; Granting Clause Second Subject to the applicable exceptions permitted by Section 810, Section 1303 and Section 1305 of the Original Indenture, all property (other than Excepted Property) of the kind and nature described in Granting Clause First which may be hereafter acquired by the Company, it being the intention of the Company that all such property acquired by the Company after the date of the execution and delivery of this Supplemental Indenture No. 6 shall be as fully embraced within and subjected to the Lien hereof as if such property were owned by the Company as of the date of the execution and delivery of this Supplemental Indenture No. 6; Granting Clause Fourth All other property of whatever kind and nature subjected or intended to be subjected to the Lien of the Mortgage by any of the terms and provisions thereof; Excepted Property Expressly excepting and excluding, however, from the Lien and operation of the Mortgage all Excepted Property of the Company, whether now owned or hereafter acquired; TO HAVE AND TO HOLD all such property, real, personal and mixed, unto the Trustee forever; SUBJECT, HOWEVER, to Permitted Liens and to Liens which have been granted by the Company to other Persons prior to the date of the execution and delivery of the Original Indenture (including, but not limited to, the Lien of the DLC 1947 Mortgage), and subject also, as to any property acquired by the Company after the date of execution and delivery of the Original Indenture, to vendors' Liens, purchase money mortgages and other Liens thereon at the time of the acquisition thereof (including, but not limited to, the Lien of any Class "A" Mortgage), it being understood that with respect to any of such property which was at the date of execution and delivery of the Original Indenture or thereafter became or hereafter becomes subject to the Lien of any Class "A" Mortgage, the Lien of the Mortgage shall at all times be junior and subordinate to the Lien of such Class "A" Mortgage; IN TRUST, NEVERTHELESS, for the equal and proportionate benefit and security of the Holders from time to time of all Outstanding Securities without any priority of any such Security over any other such Security; PROVIDED, HOWEVER, that if, after the right, title and interest of the Trustee in and to the Mortgaged Property shall have ceased, terminated and become void in accordance with Article Nine of the Original Indenture, the principal of and premium, if any, and interest, if any, on the Securities shall have been paid to the Holders thereof, or shall have been paid to the Company pursuant to Section 603 of the Original Indenture, then and in that case the Mortgage and the estate and rights thereby granted shall cease, terminate and be void, and the Trustee shall cancel and discharge the Mortgage and execute and deliver to the Company such instruments as the Company shall require to evidence the discharge thereof; otherwise the Mortgage shall be and remain in full force and effect; and THE PARTIES HEREBY FURTHER COVENANT AND AGREE as follows: ARTICLE ONE Fifth Series of Securities There is hereby created a series of Securities designated "First Collateral Trust Bonds, Pollution Control Series F" and limited in aggregate principal amount (except as contemplated in Section 301(b) of the Original Indenture) to $25,000,000. The form and terms of the Securities of Series No. 5 shall be established in an Officer's Certificate. ARTICLE TWO Miscellaneous Provisions This Supplemental Indenture No. 6 is a supplement to the Mortgage. As supplemented by this Supplemental Indenture No. 6, the Mortgage is in all respects ratified, approved and confirmed, and the Mortgage and this Supplemental Indenture No. 6 shall together constitute one and the same instrument. IN WITNESS WHEREOF, the parties hereto have caused this Supplemental Indenture No. 6 to be duly executed, and their respective corporate seals to be hereunto affixed and attested, all as of the day and year first above written. DUQUESNE LIGHT COMPANY [Seal] By: /s/ Gary L. Schwass ----------------------------------- Vice President-Finance and Chief Financial Officer Attest: /s/ Diane S. Eismont - -------------------------------- Secretary MELLON BANK, N.A., Trustee By: /s/ J.H. McAnulty ----------------------------------- [Seal] Vice President Attest: /s/ D.M. Babich - -------------------------------- Authorized Officer COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On the 23rd day of June, 1993, before me personally came Gary L. Schwass, to me known, who, being by me duly sworn, did depose and say that he is the Vice President-Finance and Chief Financial Officer of Duquesne Light Company, the corporation described in and which executed the foregoing instrument; that he knows the seal of said corporation; that the seal affixed to said instrument is such corporate seal; that it was so affixed by authority of the Board of Directors of said corporation, and that he signed his name thereto by like authority. /s/ Joanne E. Kirin --------------------------------- Notary Public COMMONWEALTH OF PENNSYLVANIA ) ) ss.: COUNTY OF ALLEGHENY ) On the 23rd day of June, 1993, before me personally came J. H. McAnulty, to me known, who, being by me duly sworn, did depose and say that he is a Vice President of Mellon Bank, N.A., the national banking association described in and which executed the foregoing instrument; that he knows the seal of said national banking association; that the seal affixed to said instrument is the seal of said national banking association; that it was so affixed by authority of the Board of Directors of said national banking association, and that he signed his name thereto by like authority. /s/ Kristine M. Baker --------------------------------- Notary Public CERTIFICATE OF PRECISE RESIDENCE I hereby certify that the precise residence of Mellon Bank, N.A., is One Mellon Bank Center, Second Ward, Pittsburgh, Allegheny County, Pennsylvania. /s/ D.M. Babich ------------------------------------------ Authorized Signatory of Mellon Bank, N.A. June 23, 1993 Schedule A - ----------------------------------- /1/ As of June 1, 1993. RECORDING INFORMATION Allegheny County, Pennsylvania Office of Recorder of Deeds Recorded June 23, 1993 Mortgage Book Volume 13225, page 174 Beaver County, Pennsylvania Office of Recorder of Deeds Recorded June 25, 1993 Mortgage Book Volume 1267, page 558 Greene County, Pennsylvania Office of Recorder of Deeds Recorded June 24, 1993 Mortgage Book Volume 115, page 1119 Washington County, Pennsylvania Office of Recorder of Deeds Recorded June 24, 1993 Mortgage Book Volume 2014, page 95 Westmoreland County, Pennsylvania Office of Recorder of Deeds Recorded June 24, 1993 Mortgage Book Volume 3151, page 600 Belmont County, Ohio Office of Recorder Received June 24, 1993 Recorded June 25, 1993 Mortgage Book Volume 603, page 791 Columbiana County, Ohio Office of Recorder Recorded June 25, 1993 Mortgage Book Volume 380, page 848 Jefferson County, Ohio Office of Recorder Received June 24, 1993 Recorded June 25, 1993 Mortgage Book Volume 103, page 987 Lake County, Ohio Office of Recorder Recorded June 25, 1993 Mortgage Book Volume 871, page 985 Monroe County, Ohio Office of Recorder Received June 24,1993 Recorded June 24, 1993 Mortgage Book Volume 133, page 115 Hancock County, West Virginia Office of Clerk of County Commission Recorded June 25, 1993 Deed of Trust Book 305, page 69 Monongalia County, West Virginia Office of Clerk of County Commission Recorded June 24, 1993 Deed of Trust Book 712, page 658 EXHIBIT 4.6 CONFORMED COPY ================================================================================ DUQUESNE LIGHT COMPANY TO MELLON BANK, N.A. Trustee ------------------- Supplemental Indenture No. 7 Dated as of August 1, 1993 Supplemental to the Indenture of Mortgage and Deed of Trust dated as of April 1, 1992 Establishing a series of Securities designated First Collateral Trust Bonds, Pollution Control Series G, limited in aggregate principal amount to $20,500,000 ================================================================================ SUPPLEMENTAL INDENTURE No. 7, dated as of August 1, 1993, between DUQUESNE LIGHT COMPANY, a corporation duly organized and existing under the laws of the Commonwealth of Pennsylvania (hereinafter sometimes called the "Company"), and MELLON BANK, N.A., a national banking association organized and existing under the laws of the United States of America, trustee (hereinafter sometimes called the "Trustee"), under the Indenture of Mortgage and Deed of Trust, dated as of April 1, 1992 (hereinafter called the "Original Indenture"), this Supplemental Indenture No. 7 being supplemental thereto. The Original Indenture and any and all indentures and instruments supplemental thereto are hereinafter sometimes collectively called the "Mortgage." Recitals of the Company The Original Indenture was authorized, executed and delivered by the Company to provide for the issuance from time to time of its Securities (such term and all other capitalized terms used herein without definition having the meanings assigned to them in the Original Indenture), to be issued in one or more series as contemplated therein, and to provide security for the payment of the principal of and premium, if any, and interest, if any, on the Securities. The Original Indenture has been recorded in the Recorders' Offices of the various counties of Pennsylvania as follows: In Allegheny County in Mortgage Book Vol. 12068, page 8; In Beaver County in Mortgage Book Vol. 1208, page 520; In Greene County in Mortgage Book Vol. 100, page 174; In Washington County in Mortgage Book Vol. 1873, page 1; In Westmoreland County in Mortgage Book Vol. 2862; page 221; and has also been recorded in the Office of the Clerk of County Commission of Monongalia County, West Virginia, in Deed of Trust Book Vol. 672, page 129, the Office of the Clerk of County Commission of Hancock County, West Virginia, in Deed of Trust Book Vol. 293, page 46, the Recorder's Office of Belmont County, Ohio, in Mortgage Book Vol. 586, page 273, the Recorder's Office of Columbiana County, Ohio, in Mortgage Book. Vol. 318, page 289, the Recorder's Office of Jefferson County, Ohio, in Mortgage Book Vol. 65, page 675, the Recorder's Office of Lake County, Ohio, in Mortgage Book Vol. 711, page 217, and the Recorder's Office of Monroe County, Ohio, in Mortgage Book Vol. 129, page 301. The Company has heretofore executed and delivered to Mellon Bank, N.A., as Trustee, Supplemental Indentures for the purposes recited therein and for the purpose of creating series of Securities as set forth in Schedule A hereto. The Company desires to establish a series of Securities to be designated "First Collateral Trust Bonds, Pollution Control Series G" to be limited in aggregate principal amount (except as contemplated in Section 301(b) of the Original Indenture) to $20,500,000, such series of Securities to be hereinafter sometimes called "Series No. 6." The Company has duly authorized the execution and delivery of this Supplemental Indenture No. 7 to establish the Securities of Series No. 6 and has duly authorized the issuance of such Securities; and all acts necessary to make this Supplemental Indenture No. 7 a valid agreement of the Company, and to make the Securities of Series No. 6 valid obligations of the Company, have been performed. NOW, THEREFORE, THIS SUPPLEMENTAL INDENTURE NO. 7 WITNESSETH, that, in consideration of the premises and of the purchase of the Securities by the Holders thereof, and in order to secure the payment of the principal of and premium, if any, and interest, if any, on all Securities from time to time Outstanding and the performance of the covenants contained therein and in the Mortgage and to declare the terms and conditions on which such Securities are secured, the Company hereby grants, bargains, sells, releases, conveys, assigns, transfers, mortgages, pledges, sets over and confirms to the Trustee, and grants to the Trustee a security interest in, the following: Granting Clause First All right, title and interest of the Company in and to property (other than Excepted Property), real, personal and mixed and wherever situated, in any case used or to be used in or in connection with the generation, purchase, transmission, distribution or sale by the Company of electric energy (whether or not such use is the sole use of such property), including without limitation (a) all land and interests in land described in Schedule B hereto; (b) all lands, easements, servitudes, licenses, permits, rights of way and other rights and interests in or relating to real property or the occupancy or use of the same; (c) all plants, generators, turbines, engines, boilers, fuel handling and transportation facilities, air and water pollution control and sewage and solid waste disposal facilities and other machinery and facilities for the generation of electric energy; (d) all switchyards, lines, towers, substations, transformers and other machinery and facilities for the transmission of electric energy; (e) all lines, poles, conduits, conductors, meters, regulators and other machinery and facilities for the distribution of electric energy; (f) all buildings, offices, warehouses and other structures; and (g) all pipes, cables, insulators, ducts, tools, computers and other data processing and/or storage equipment and other equipment, apparatus and facilities and all other property, of whatever kind and nature, ancillary to or otherwise used or to be used in conjunction with any or all of the foregoing or otherwise, directly or indirectly, in furtherance of the generation, purchase, transmission, distribution or sale by the Company of electric energy; Granting Clause Second Subject to the applicable exceptions permitted by Section 810, Section 1303 and Section 1305 of the Original Indenture, all property (other than Excepted Property) of the kind and nature described in Granting Clause First which may be hereafter acquired by the Company, it being the intention of the Company that all such property acquired by the Company after the date of the execution and delivery of this Supplemental Indenture No. 7 shall be as fully embraced within and subjected to the Lien hereof as if such property were owned by the Company as of the date of the execution and delivery of this Supplemental Indenture No. 7; Granting Clause Fourth All other property of whatever kind and nature subjected or intended to be subjected to the Lien of the Mortgage by any of the terms and provisions thereof; Excepted Property Expressly excepting and excluding, however, from the Lien and operation of the Mortgage all Excepted Property of the Company, whether now owned or hereafter acquired; TO HAVE AND TO HOLD all such property, real, personal and mixed, unto the Trustee forever; SUBJECT, HOWEVER, to Permitted Liens and to Liens which have been granted by the Company to other Persons prior to the date of the execution and delivery of the Original Indenture (including, but not limited to, the Lien of the DLC 1947 Mortgage), and subject also, as to any property acquired by the Company after the date of execution and delivery of the Original Indenture, to vendors' Liens, purchase money mortgages and other Liens thereon at the time of the acquisition thereof (including, but not limited to, the Lien of any Class "A" Mortgage), it being understood that with respect to any of such property which was at the date of execution and delivery of the Original Indenture or thereafter became or hereafter becomes subject to the Lien of any Class "A" Mortgage, the Lien of the Mortgage shall at all times be junior and subordinate to the Lien of such Class "A" Mortgage; IN TRUST, NEVERTHELESS, for the equal and proportionate benefit and security of the Holders from time to time of all Outstanding Securities without any priority of any such Security over any other such Security; PROVIDED, HOWEVER, that if, after the right, title and interest of the Trustee in and to the Mortgaged Property shall have ceased, terminated and become void in accordance with Article Nine of the Original Indenture, the principal of and premium, if any, and interest, if any, on the Securities shall have been paid to the Holders thereof, or shall have been paid to the Company pursuant to Section 603 of the Original Indenture, then and in that case the Mortgage and the estate and rights thereby granted shall cease, terminate and be void, and the Trustee shall cancel and discharge the Mortgage and execute and deliver to the Company such instruments as the Company shall require to evidence the discharge thereof; otherwise the Mortgage shall be and remain in full force and effect; and THE PARTIES HEREBY FURTHER COVENANT AND AGREE as follows: ARTICLE ONE Sixth Series of Securities There is hereby created a series of Securities designated "First Collateral Trust Bonds, Pollution Control Series G" and limited in aggregate principal amount (except as contemplated in Section 301(b) of the Original Indenture) to $20,500,000. The form and terms of the Securities of Series No. 6 shall be established in an Officer's Certificate. ARTICLE TWO Miscellaneous Provisions This Supplemental Indenture No. 7 is a supplement to the Mortgage. As supplemented by this Supplemental Indenture No. 7, the Mortgage is in all respects ratified, approved and confirmed, and the Mortgage and this Supplemental Indenture No. 7 shall together constitute one and the same instrument. IN WITNESS WHEREOF, the parties hereto have caused this Supplemental Indenture No. 7 to be duly executed, and their respective corporate seals to be hereunto affixed and attested, all as of the day and year first above written. DUQUESNE LIGHT COMPANY [Seal] By:/s/ Gary L. Schwass -------------------------------------- Vice President-Finance and Chief Financial Officer Attest: /s/ Joan S. Senchyshyn - -------------------------------- Assistant Secretary MELLON BANK, N.A., Trustee By:/s/ J.H. McAnulty -------------------------------------- [Seal] Vice President Attest: /s/ D.M. Babich - -------------------------------- Authorized Officer COMMONWEALTH OF PENNSYLVANIA ) ) SS.: COUNTY OF ALLEGHENY ) On the 23rd day of August, 1993, before me personally came Gary L. Schwass, to me known, who, being by me duly sworn, did depose and say that he is the Vice President-Finance and Chief Financial Officer of Duquesne Light Company, the corporation described in and which executed the foregoing instrument; that he knows the seal of said corporation; that the seal affixed to said instrument is such corporate seal; that it was so affixed by authority of the Board of Directors of said corporation, and that he signed his name thereto by like authority. /s/ Joanne E. Kirin ---------------------------------------- Notary Public COMMONWEALTH OF PENNSYLVANIA ) ) SS.: COUNTY OF ALLEGHENY ) On the 24th day of August, 1993, before me personally came J. H. McAnulty, to me known, who, being by me duly sworn, did depose and say that he is a Vice President of Mellon Bank, N.A., the national banking association described in and which executed the foregoing instrument; that he knows the seal of said national banking association; that the seal affixed to said instrument is the seal of said national banking association; that it was so affixed by authority of the Board of Directors of said national banking association, and that he signed his name thereto by like authority. /s/ Lorraine L. Henderson ---------------------------------------- Notary Public CERTIFICATE OF PRECISE RESIDENCE I hereby certify that the precise residence of Mellon Bank, N.A., is One Mellon Bank Center, Second Ward, Pittsburgh, Allegheny County, Pennsylvania. /s/ D.M. Babich -------------------------------- Authorized Signatory of Mellon Bank, N.A. August 24, 1993 Schedule A - ----------------------------- /1/ As of August 1, 1993. SCHEDULE B All the following described property situate in the County of Allegheny and Commonwealth of Pennsylvania, the deed herein recited being recorded in the Recorder's Office of said County, and reference being made thereto for a more particular description of said property, viz: All that certain lot or piece of ground situate partly in the Township of North Fayette and partly in the Township of Findlay. Conveyed to Duquesne Light Company by: Miriam G. Lewis, widow, Deed dated July 24, 1992, Deed Book Volume 8794, page 633; Donald B. Lewis et ux, Deed dated July 22, 1992, Deed Book Volume 8794, page 638; Loren L. Lewis, et ux, Deed dated July 20, 1992, Deed Book Volume 8794, page 643; and Mellon Bank, N.A., Executor of the Estate of Gordon E. Williams, deceased, Deed dated August 10, 1992, Deed Book Volume 8794, page 649. (Transmission Line). RECORDING INFORMATION Allegheny County, Pennsylvania Office of Recorder of Deeds Recorded: August 24, 1993 Mortgage Book Volume 13405, page 609 Beaver County, Pennsylvania Office of Recorder of Deeds Recorded: August 24, 1993 Mortgage Book Volume 1277, page 445 Greene County, Pennsylvania Office of Recorder of Deeds Recorded: August 25, 1993 Mortgage Book Volume 118, page 835 Washington County, Pennsylvania Office of Recorder of Deeds Recorded: August 25, 1993 Mortgage Book Volume 2037, page 194 Westmoreland County, Pennsylvania Office of Recorder of Deeds Recorded: August 25, 1993 Mortgage Book Volume 3197, page 511 Belmont County, Ohio Office of Recorder Received: August 25, 1993 Recorded: August 26, 1993 Mortgage Book Volume 606, page 697 Columbiana County, Ohio Office of Recorder Recorded: August 26, 1993 Mortgage Book Volume 390, page 710 Jefferson County, Ohio Office of Recorder Received: August 25, 1993 Recorded: August 26, 1993 Mortgage Book Volume 110, page 1 Lake County, Ohio Office of Recorder Recorded: August 26, 1993 Mortgage Book Volume 898, page 126 Monroe County, Ohio Office of Recorder Received: August 25, 1993 Recorded: August 25, 1993 Mortgage Book Volume 133, page 689 Hancock County, West Virginia Office of Clerk of County Commission Recorded: August 26, 1993 Deed of Trust Book 307, page 141 Monongalia County, West Virginia Office of Clerk of County Commission Recorded: August 25, 1993 Deed of Trust Book 719, page 363 EXHIBIT 10.10 CAPCO BASIC OPERATING AGREEMENT As Amended January 1, 1993 * * * The Cleveland Electric Illuminating Company Duquesne Light Company Ohio Edison Company Pennsylvania Power Company The Toledo Edison Company (Cont'd) CAPCO BASIC OPERATING AGREEMENT (As Amended January 1, 1993) This Agreement, effective as of the 1st day of January, 1993, by and among The Cleveland Electric Illuminating Company, an Ohio corporation ("CEI"); Duquesne Light Company, a Pennsylvania corporation ("DL"); Ohio Edison Company, an Ohio corporation; Pennsylvania Power Company, a Pennsylvania corporation and a wholly-owned subsidiary of Ohio Edison Company which company and its said subsidiary, except as otherwise provided herein, are considered as a single Party for the purposes of this Agreement and referred to as ("OE"); and The Toledo Edison Company, an Ohio corporation ("TE"); each of which is sometimes referred to as a Party, or Owner, and collectively as the Parties, Owners or CAPCO, W I T N E S S E T H : 0.01 The Parties own electric utility systems located in Western Pennsylvania, Northern and Central Ohio, and are engaged in the generation, transmission and distribution of electric power. 0.02 The systems of the Parties are interconnected directly or indirectly and are operated in synchronism. ARTICLE I --------- Purpose of Agreement -------------------- 1.01 It is the purpose of this Agreement to provide for the coordinated operation of the systems of the Parties, so as to (1) provide for the utilization by each of the Parties of facilities heretofore provided for by the Parties; (2) provide a degree of mutual support; (3) provide for capacity and energy transactions by and among the Parties; (4) permit coordination of the operation of the systems of the Parties; and (5) achieve an equitable sharing of the responsibilities, risks and expenses and of the resulting benefits of coordinated operation of the systems of the Parties. ARTICLE 2 --------- Definitions ----------- The definitions in this Article shall apply to this Agreement and to the Schedules hereto, unless otherwise expressly provided in such Schedules. 2.01 Actual Capacity of a Party shall mean the sum of the Net --------------- Demonstrated Capability of its ownership shares in CAPCO Units, plus its Individual Capacity (in all cases to the extent then in commercial operation) adjusted in all cases for seasonal factors existing at the time pursuant to the document entitled, - 2 - "CAPCO Group Common Method of Rating Generating Equipment," dated October 17, 1969, as amended from time to time, plus such Party's individual purchases less such Party's individual sales (but shall exclude power scheduled to be received by a Party to provide for deliveries to cooperative or municipal systems or other Parties or non-CAPCO parties' systems). 2.02 CAPCO Unit shall mean any one of the following listed Units: W. H. ---------- Sammis Generating Station Unit No. 7, Bruce Mansfield Unit No. 1, Bruce Mansfield Unit No. 2, Bruce Mansfield Unit No. 3, Davis-Besse Nuclear Power Station Unit No. 1, Beaver Valley Power Station Unit No. 1, Beaver Valley Power Station Unit No. 2, Eastlake Generating Station Unit No. 5, Perry Nuclear Power Plant Unit No. 1 and Perry Nuclear Power Plant Unit No. 2. 2.03 Coordinated Maintenance Schedule means the schedule established -------------------------------- under the direction of the Operating Committee pursuant to Section 5.01. 2.04 Individual Capacity of a Party as of any date is the sum of the ------------------- following: (a) The Net Demonstrated Capabilities of the generating units or portions thereof owned or leased by such Party in commercial operation and not placed in cold reserve, but exclusive of ownership of CAPCO Units. - 3 - (b) The equivalent Net Demonstrated Capability of such Party's portion of the Ohio Valley Electric Corporation ("OVEC") capacity. 2.05 Interruptible Load of a Party is the total of megawatthours ------------------ delivered during any clock hour to its retail customers or to municipal or cooperative systems which the Party, in its sole discretion, is privileged to curtail or completely interrupt in accordance with a rate schedule or contractual arrangement with such customer or customers. 2.06 Load of a Party during any clock hour is the total during any such ---- clock hour (eliminating on an agreed basis any distortion arising out of deliveries between systems where material) of megawatthours (a) delivered by the Party to its retail customers and its municipal systems, but excluding that portion of municipal system Load which is purchased from other Parties or systems, (b) used by the Party on its own system, exclusive of use for station auxiliary power, and (c) lost and unaccounted for on the system of the Party; but shall exclude Interruptible Load. 2.07 Minimum Operating Reserve of a Party, unless otherwise determined ------------------------- by the Operating Committee, shall mean a spinning reserve of not less than 3% of the projected daily Peak Load of such Party. - 4 - 2.08 Net Demonstrated Capability of a generating unit as of any time --------------------------- means that most recently determined pursuant to the methods and principles set forth in the document entitled, "CAPCO Group Common Method of Rating Generating Equipment," dated October 17, 1969, as amended from time to time. 2.09 Operating Capacity of a Party during a particular day shall mean ------------------ that portion of a Party's Actual Capacity to the extent actually in operation or expected to be in operation. 2.10 Operating Reserve of a Party means that component of Operating ----------------- Capacity which is unloaded, plus Quick Start Capacity and Interruptible Load to the extent they can be so included in accordance with rules and procedures established by the Operating Committee. 2.11 Peak Load of a Party for any period of time is the maximum Load of --------- the Party for any clock hour of the period. 2.12 Power shall include electric capacity and energy expressed in ----- megawatts and megawatthours. 2.13 Quick Start Capacity means generating capacity which can be started, -------------------- synchronized to the system and loaded within a time period as specified by the Operating Committee. - 5 - ARTICLE 3 --------- Operating Committee ------------------- 3.01 The Operating Committee shall be that established pursuant to the CAPCO Administration Agreement dated as of September 14, 1967, as the same may be amended from time to time. 3.02 Each Party shall make available to the Operating Committee all data and information reasonably required to enable it to perform its duties. 3.03 The Operating Committee shall be responsible for establishing, maintaining and revising as necessary the Coordinated Maintenance Schedule. 3.04 The Operating Committee shall be responsible for the establishment and administration of rules and procedures to coordinate the operation of the systems of the Parties to effectuate the purpose of this Agreement. Without limiting the generality of the foregoing, the Operating Committee shall establish rules and procedures for: (a) The determination of billing costs and other factors used for scheduling and billing of transactions hereunder; - 6 - (b) The determination of the increase or decrease of electrical losses incurred as the result of transactions hereunder; (c) The establishment and periodic revision of the Coordinated Maintenance Schedule which shall be reviewed at least annually; (d) The determination of the Minimum Operating Reserve for each Party; (e) The scheduling of CAPCO Back-Up Power as provided in Article 5; and (f) Accumulating and recording load, capacity and other operating data needed to evaluate performance under the various CAPCO agreements. 3.05 The Operating Committee shall conduct studies of the coordinated operation of the systems of the Parties for the purposes of this Agreement, and make recommendations with respect thereto, including recommendations with respect to the development and coordination of an adequate communication system. The Operating Committee is authorized to create task forces for particular studies and to appoint the members thereof who need not be members of the Operating Committee. Subject to - 7 - such limitations as may be imposed by the Executive Committee, the Operating Committee is authorized on behalf of the parties to hire consultants and computer time and to incur other expenses in the making of any of its studies. ARTICLE 4 --------- Operating Conditions -------------------- 4.01 Each party shall operate its system continuously in parallel with each other Party with which it is interconnected. Unless otherwise mutually agreed which agreement shall not be unreasonably withheld, all existing interconnections between the systems of the Parties operating at nominal voltages of 138,000 volts and above shall normally be operated closed. Each Party shall maintain and operate its system so as to minimize the likelihood and effect of disturbances on its system which might impair the service on the system of any other Party. Each Party shall be the sole judge whether service on its system is being impaired by conditions on the system of another Party and may itself take, or request such other Party to take, appropriate corrective action to restore normal operating conditions as soon as reasonably practicable. Power which is supplied by one Party to another Party through interconnections normally operated open or through a - 8 - temporary interconnection point shall be compensated for by the other Party delivering to the first Party through other interconnections equivalent Power adjusted for losses. It is the intent of the Parties that, whenever feasible, such compensation shall be made simultaneously with the delivery of Power through such interconnections. 4.02 Each Party shall use its best efforts to operate its system so as to aid in maintaining the frequency on the systems of the Parties at a nominal 60 Hz within the limits for normal operating deviations as established from time to time by the Operating Committee. 4.03 Each Party shall, to the extent practicable, operate its system so as to avoid the creation of objectionable operating conditions on the system of another Party due to the transfer of megavars. Subject to the foregoing, the Operating Committee shall (a) establish operating procedures for the coordination of megavar supply associated with flows of Power pursuant to this Agreement, and (b) determine the circumstances under which a Party shall compensate another for supplying megavars in connection with flows of Power pursuant to this Agreement and recommend the amount of such compensation. 4.04 Each Party shall exercise reasonable care to minimize, to the extent practicable, unscheduled deliveries or - 9 - receipts of electric energy. The Parties recognize, however, that despite their best efforts such unscheduled deliveries or receipts of electric energy may occur. Electric energy delivered or received in such event shall be settled for by return of equivalent energy. It shall be returned at times when the load conditions of the returning Party are equivalent to the load conditions of such Party at the time the energy for which it is returned was received, unless otherwise agreed. 4.05 The Parties recognize that in the day-to-day operation of their systems the transmission facilities of any Party may, as a natural result of the physical and electrical characteristics of the interconnected network of transmission lines of which the transmission lines of the Parties are a part, carry Power from one portion of the system of one of the Parties to another portion of that Party's system, or carry Power intended to be transmitted to or from the system of one of the Parties from or to the system of another Party or other systems. The Parties will use their best efforts to resolve promptly any operating problems thereby created, including but not limited to curtailing or interrupting Interruptible Load and Economy Power transactions with other Parties and/or other systems. 4.06 Each Party shall, to the fullest extent practicable: - 10 - (a) Maintain generating units in accordance with the Coordinated Maintenance Schedule. (b) Coordinate with the other Parties the scheduled outages of transmission facilities operating at nominal voltages of 138,000 volts or above. (c) Return generation and transmission facilities to service in good operating condition with reasonable promptness. (d) Advise the other Parties as to its maintenance practices and policies and any changes therein, and cooperate in attempts to accelerate or defer maintenance of generation and transmission facilities in emergency situations. 4.07 Each Party shall be the sole judge as to whether, due to physical conditions beyond its reasonable control, a generating unit operated by such Party is unavailable for operation or unavailable for continued operation or must be derated or temporarily removed from service; provided, however, that unavailability for operation or continued operation, or derating, for reasons of limitations of fuel supply for a CAPCO unit, shall be determined in accordance with rules and procedures established by the Operating Committee. - 11 - 4.08 Each Party shall be entitled to the full utilization, with respect to capacity and energy, when a CAPCO Unit is available and based on and in proportion to the actual day-by-day operating capacity, of (a) its ownership share of capacity in that Unit, plus (b) its entitlement to receive capacity from another Party's ownership share in such Unit, and minus (c) its obligation to provide capacity from such Unit. Scheduling of such capacity and energy entitlements shall be adjusted appropriately for transmission line losses. ARTICLE 5 --------- Coordinated Maintenance and CAPCO Back-Up Power ----------------------------------------------- 5.01 The Parties shall coordinate the outages for maintenance of all CAPCO Units and such other units of the Parties as are identified by the Operating Committee and for such purpose the Coordinated Maintenance Schedule shall be developed and maintained in accordance with rules and procedures established pursuant to Section 3.04. 5.02 In order to provide back-up for CAPCO Unit outages, each Party shall have an entitlement to receive or an obligation to provide operating capacity and associated energy in the form of CAPCO Back-Up Power. CAPCO Back-Up Power shall be calculated as specified in the next paragraph in this Section and shall be compensated for as specified in Schedule A of this - 12 - Agreement; provided, however, such CAPCO Back-Up Power shall not be available for any nuclear CAPCO Unit during those periods in which such CAPCO Unit is out of service for the reasons set forth in Schedule I. In the event of the forced or scheduled outage of any CAPCO Unit in commercial operation (except those Units in cold reserve), each Party agrees to provide or shall have the right to receive, as the case may be, CAPCO Back- Up Power in an amount equal to the difference between such Party's ownership share in the CAPCO Unit out of service, expressed in megawatts, and a value determined by multiplying the Net Demonstrated Capability of the CAPCO Unit out of service by the ratio of such Party's ownership share of the Net Demonstrated Capability of all of the CAPCO Units in commercial operation to the total Net Demonstrated Capability of all of the CAPCO Units in commercial operation. Each Party shall use its best efforts to operate its system so as to provide the amounts of Minimum Operating Reserve determined consistent with the rules and procedures established pursuant to Section 3.04. 5.03 Pursuant to rules and procedures established by the Operating Committee, CAPCO Back-Up Power for the next succeeding day shall be arranged on a net basis, initially at - 13 - 1200 hours on the preceding day or such other time mutually agreed upon by the Operating Committee, and shall be scheduled as requested by the receiving Party. The receiving Party shall have the right to receive all or any part of such Party's net entitlement to CAPCO Back-Up Power. 5.04 Each Party is obligated to provide CAPCO Back-Up Power after supplying its Load and meeting its Minimum Operating Reserve, except when the delivery of such Power would, in the judgment of the supplying Party, have to be interrupted or reduced to preserve the integrity of or to prevent or limit any instability on the supplying Party's system. If a Party having an obligation to supply does not have sufficient capacity available on its own system to meet the obligation, it is obligated to purchase capacity and associated energy if available to provide CAPCO Back-Up Power. For each day that a Party is unable to fulfill all or any part of its obligation to provide CAPCO Back-Up Power because it is supplying Power other than CAPCO Back-Up Power to another Party or to a non-CAPCO party, except pursuant to obligations imposed by governmental authorities, agreements referred to in Article 19, and any additional agreements excepted by the Parties, such Party shall pay an amount equal to twice the maximum daily demand charge for the CAPCO Back-Up Power not provided by such Party to the other Parties to be - 14 - shared in proportion to the entitlements which were not fulfilled. In the event any Party is unable to provide CAPCO Back-Up Power in any substantial amount over an extended period and reserves substantial CAPCO Back-Up Power from others, the parties shall develop corrective measures such as, but not limited to, increasing the demand charge rate. 5.05 CAPCO Back-Up Power will be made available in proportion to Party entitlements from supplying Parties in proportion to their obligations, and will be made available from the least-cost available Power. In the event that a receiving Party or Parties reserve less than its or their entitlement of CAPCO Back-Up Power, the remaining CAPCO Back-Up Power will be made available from the supplying Parties in proportion to their obligations to the other receiving Parties in proportion to their entitlements from such least-cost available Power. CAPCO Back-Up Power obligations not reserved by the receiving Parties shall be deemed released to the supplying Parties. ARTICLE 6 --------- Communications -------------- 6.01 The Parties will establish communication facilities as may be required to provide voice communication, telemetering, automatic generation control, monitoring, tie-line control, and other functions as may be determined from time to - 15 - time by the Operating Committee, or as required by other agreements among the Parties. Such communication facilities will consist of existing communication links owned or leased by the Parties as well as communication links to be built or leased by the Parties. It is understood that extensive use of microwave links will be made pursuant to the CAPCO Microwave Sharing Agreement, as amended January 1, 1993 and as it may be amended from time to time, although carrier current and wire communication facilities will be used as deemed appropriate by the Operating Committee. Communication links other than microwave will be provided, operated and paid for as determined by the Operating Committee following as closely as possible the principles established in said sharing Agreement. ARTICLE 7 --------- Services -------- 7.01 The specific services and transactions among the Parties pursuant to this Agreement shall be in conformance with the terms and conditions of this Agreement and as set forth in Schedules arranged from time to time among the Parties. The following Schedules are agreed to and hereby made a part of this Agreement: Schedule A - CAPCO Back-Up Power Schedule B - Short Term Power - 16 - Schedule C - Non-Displacement Power Schedule D - Economy Power Schedule E - Unit Power Schedule F - Out-of-Pocket Cost Schedule G - Emergency Power Schedule H - Transmission of Non-CAPCO Power Schedule I - Replacement Power The Parties may, from time to time, agree on modifications to or additional Schedules, and upon execution thereof the Parties any such modification or addition shall become a part of this Agreement. 7.02 Energy transactions (other than those arising under Schedule E) shall be scheduled as if there were zero transmission losses. A Party receiving such energy from another Party (whether such Party is acting as a supplying or transmitting Party arising under Schedule D of this Agreement) shall be charged with any increase in transmission losses and/or shall receive credit for any decrease in transmission losses associated with the transmission of the energy through the systems of Parties other than that of the supplying Party. Transmission losses will be accounted for by separate calculation in a manner prescribed by the Operating Committee. Loss imbalances shall be repaid through loss-payback schedules arranged among the Parties. - 17 - 7.03 If any transaction results in material interference with the facilities or operation of the system of any other Party, the Parties to the transaction promptly shall take appropriate actions which may include, among other things, modification of the transaction to eliminate such interference and provide compensation to the Party affected for increased operating costs or damage to facilities. ARTICLE 8 --------- Executive Committee ------------------- 8.01 The Executive Committee shall be that established pursuant to the CAPCO Administration Agreement, dated as of September 14, 1967, as the same may be amended from time to time. 8.02 The Executive Committee shall have the duties and powers conferred on it by this Agreement, including the making of any decision or determination necessary under any provision of this Agreement and not expressly specified to be decided or determined by any other person or persons. - 18 - ARTICLE 9 --------- Ohio Edison System ------------------ 9.01 Ohio Edison Company and Pennsylvania Power Company shall be considered to be separate Parties under this Agreement whenever and to the extent that separate corporate action is required of such Companies in order to accomplish the purpose of this Agreement, but their liability and responsibility for the performance of any obligation of OE hereunder to the other Parties shall be joint and several. The allocation between Ohio Edison Company and Pennsylvania Power Company of their collective obligations hereunder as OE shall be the sole responsibility of said Companies, but they undertake that they will, during the period that they shall be obligated under this Agreement, have in force one or more arrangements for the allocation of the whole of such collective obligations and will, upon the request of any of the other Parties hereto, furnish the requesting Party or Parties satisfactory evidence of the existence of their then effective arrangements relating to such allocation. ARTICLE 10 ---------- Interconnection Metering ------------------------ 10.01 Electricity flowing across an interconnection shall be measured by suitable metering equipment at metering - 19 - points agreed upon by the Parties to the interconnection. The equipment at such metering points shall be provided, owned and maintained as agreed by the affected Parties. 10.02 Measurements of electric energy for the purpose of effecting settlements shall be made by standard types of electric meters installed and maintained by the owners at the metering points. The timing devices of all meters having such devices shall be maintained in time snychronism as closely as practicable. The meters shall be sealed and the seals shall be broken only upon occasions when the meters are to be tested or adjusted. 10.03 The aforesaid standard metering equipment shall be tested by the owners at suitable intervals and its accuracy of registration maintained in accordance with good practice. On request of any affected Party, a special test may be made at the expense of the Party requesting such special test. Representatives of all affected parties shall be afforded opportunity to be present at all routine or special tests and upon occasions when any readings, for purposes of settlements, are taken from meters not bearing an automatic record. For the purpose of checking the records of the metering equipment installed by a Party as provided above, the other affected party shall have the right to install check metering equipment at its own expense at the metering points referred to in Section 10.01. - 20 - 10.04 If any test of metering equipment shall disclose an inaccuracy greater than 2%, the accounts among the affected Parties for service theretofore delivered shall, unless otherwise agreed by the affected Parties, be adjusted to correct for the inaccuracy disclosed over the shorter of the following two periods: (1) from 30 days prior to the receipt of written request of the test until the meter is corrected; or (2) for the period that such inaccuracy may be determined to have existed. Should the metering equipment at any time fail to register under load conditions, or registers during times of zero flow, the electric energy delivered shall be determined from the best available data. ARTICLE 11 ---------- Records ------- 11.01 Each party shall keep such records as may be reasonably required by the Executive Committee or the Operating Committee, and shall furnish to such committees such records, reports and other information as they may reasonably require. ARTICLE 12 ---------- Statements, Billings, Settlements and Payments ---------------------------------------------- 12.01 As promptly as practicable within 10 days after the end of each calendar month, the Parties shall prepare and - 21 - furnish to every other Party a statement showing the debits and credits to each Party for Power transactions hereunder during such month and, to the extent appropriate, offset or reduce said transactions to a net basis. From the Party balances so determined, each billing Party shall prepare and send to each other Party, as appropriate, a billing statement for all transactions which occurred during the month and involve payment of money. The billing Party shall take all reasonable measures to ensure that billing statements are mailed or otherwise transmitted on the billing statement date. Billing statements may be rendered on an estimated basis subject to corrective adjustments in subsequent statements. Other than as required by law or regulatory action or by billing adjustments must be made for power purchases from non-CAPCO companies, corrective adjustments for power purchases as defined in Schedules A, B, C, D, G, H and I must be made within one (1) year of the rendering of the initial billing statement and corrective adjustments for all other CAPCO billings must be made within four (4) years of the rendering of the initial billing statement. 12.02 Billing statements rendered pursuant to Section 12.01 shall be due and payable in good funds the fifteenth calendar day after the billing statement date of any such statement except that, if the 15th calendar day is not a business day, the amount billed will be payable the next business day. Good funds shall consist of checks received at - 22 - least one business day prior to the due date and wire transfers received by noon on the due date. Interest on unpaid billing statement amounts will be compounded monthly and prorated for any partial month based on a 365-day year, and will accrue at a rate equal to Chase Manhattan Bank's prime rate on the first day of the then current calendar quarter plus two percentage points for a period of up to one year and for any period thereafter at the higher of this rate or a rate equal to the billing Party's cost of capital which shall consist of the weighted average of the billing Party's long-term debt cost and preferred stock cost rates determined for issues outstanding on December 31 of the prior year and a common equity cost rate to be effective January 1 of each year equal to the average return on common equity for at least 50 major electric utilities with positive returns on common equity as reported in the prior year's December issue of the C.A. Turner Utility Reports or as reported in the prior year's latest issue of another report mutually agreed to by the Parties. The weighting for this calculation shall be the billing Party's capital structure at December 31 of the prior year, consisting solely of long-term debt, preferred stock and common equity, as reported in such party's FERC Form 1 or in another mutually agreed upon source. Billing adjustments which represent amounts to be refunded by the billing Party shall accrue interest as noted above, but billing adjustments payable to the billing Party for additional amounts shall not accrue interest. Notwithstanding the foregoing, any billing - 23 - statement shall not be due and payable to the extent that (1) any non-CAPCO party system fails to compensate a Party for amounts owed hereunder in which event such Party shall exercise its best efforts to collect such compensation from such non-CAPCO party system and will not compromise or settle any claim for such compensation without prior consent of all other affected parties, or (2) any non-CAPCO party system's payment date is later that the fifteen days stated above in which case such billing statement shall be due and payable on the same date as that of the non-CAPCO party system's payment date. To the extent that any non-CAPCO party system compensates a party in an amount less than the amount the non-CAPCO party system owes the Parties under the Party's billing statement for amounts owed hereunder, each party shall be entitled to be first compensated for Out-of-Pocket Costs associated with the transaction hereunder and so much of the balance as will result in a sharing of the remainder among the Parties in proportion to the amounts owed to such Parties for their respective unpaid charges. ARTICLE 13 ---------- Government Approvals -------------------- 13.01 The obligations of each of the Parties hereunder are subject to the obtaining of any requisite orders, approvals, permits, certificates or licenses from any government authorities having jurisdiction. - 24 - 13.02 This Agreement is made subject to the jurisdiction of any government authority or authorities having jurisdiction in the premises. Nothing contained in this Agreement or any Schedule of this Agreement shall be construed as affecting in any way the right of any Party to unilaterally make application to the Federal Energy Regulatory Commission for a change in rates under the Federal Power Act and pursuant to the Commission's Rules and Regulations promulgated thereunder. ARTICLE 14 ---------- Notices ------- 14.01 Notices or requests, when required under this Agreement to be in writing, shall be delivered in person or mailed to the addressee at such Party's general office. Other notices or requests required under this Agreement may be given orally and, if required by the other Party, shall thereafter be confirmed in writing within three working days. Copies of notices or requests, confirmations of oral notices or requests, and information as to oral notices or requests shall be provided to the Office in accordance with procedures established by the Operating Committee. - 25 - ARTICLE 15 ---------- Non-Waiver ---------- 15.01 Any waiver at any time by any Party of its rights with respect to any matter arising in connection with this Agreement shall not be deemed a waiver with respect to any subsequent similar matter. Any delay, short of the statutory period of limitation, in asserting or enforcing any right under this Agreement, shall not be deemed a waiver of such right, except as provided in Sections 12.01 and 12.02 and in Section 16.01. ARTICLE 16 ---------- Arbitration ----------- 16.01 Any controversy or claim arising out of this Agreement, including the refusal by any Party to perform the whole or any part hereof, shall, upon demand of any Party aggrieved, be settled by an Arbitration Board, which shall consist of three nonrepresentative members and such additional representative members as hereinafter provided in this Section. No person shall be eligible for appointment as a nonrepresentative member of the Arbitration Board who is an officer, employee, shareholder of, or otherwise interested in, any Party or any affiliate thereof or in the matter sought to be arbitrated. - 26 - Unless otherwise agreed, no demand for arbitration shall be made more than one year after the Parties have reached an impasse as to the controversy or claim involved. The Party or Parties demanding arbitration shall serve written notice upon the other Party or Parties to the controversy, setting forth in detail the matter or matters with respect to which arbitration is demanded, and shall serve copies of such notice upon any other Parties hereto. Within a period of 10 days from the date of receipt of the aforesaid written notice, each Party to the controversy shall appoint a representative to serve as a member of the Arbitration Board; and, within a period of 30 days from such date of receipt of such written notice, such representative members shall unanimously agree upon the persons who shall serve as the three nonrepresentative members of the Arbitration Board. If the representative members are not so appointed within the specified 30-day period, or if the representative members shall fail to unanimously agree under the appointment of any or all of the three nonrepresentative members of the Arbitration Board within the specified 30-day period, any Party to the controversy may, upon written notice to the other Parties to the controversy, request the American Arbitration Association to submit to the Parties to the controversy a list from its panels of arbitrators of the names of at least seven persons from which the nonrepresentative member or members who have not been so appointed shall be selected in accordance with the Commercial Arbitration Rules of such Association. - 27 - If any Party to the controversy shall fail to appoint its representative member within the specified 10-day period, such Party shall be deemed to have waived its right to appoint such representative member and the Arbitration Board shall consist of the three nonrepresentative members and such representative members, if any, as shall have been appointed in accordance with the provisions of this Section 16.01. The arbitration proceedings shall be conducted at a place, to be designated by the Arbitration Board, within the service area of one of the Parties to the controversy. The Arbitration Board shall afford adequate opportunity to each Party to the controversy to present information with respect to the controversy or claim submitted to arbitration and may request further information from any such Party. Except as provided in the preceding sentence, the Parties to the controversy may, by mutual agreement, specify the rules which are to govern any proceeding before the Arbitration Board and limit the matters to be considered by the Arbitration Board, in which event the Arbitration Board shall be governed by the terms and conditions of such agreement. To the extent of the absence of any such agreement specifying the rules which are to govern any proceeding, the then current applicable rules of the American Arbitration Association for the conduct of commercial arbitration shall govern the proceedings. - 28 - The arbitration shall be limited to the matter or matters specified in the initial notice demanding arbitration and the award of the Board shall not affect or change any provision of this Agreement or any other transaction between the Parties. Procedural matters pertaining to the conduct of the arbitration and the award of the Arbitration Board shall be determined by a majority of the nonrepresentative members thereof; provided, however, that the representative members shall have full right and authority to participate in all meetings and deliberations of the Arbitration Board leading to the award. The findings and award of the Arbitration Board, so made upon a determination of a majority of the nonrepresentative members thereof, shall be final and conclusive with respect to the controversy or claim submitted for arbitration and shall be binding upon the Parties to the controversy except as otherwise provided by law. Such award of the Arbitration Board shall specify the manner and extent of the division of the costs of the arbitration proceedings among the Parties to the controversy. Judgment upon the award may be entered in any court, State or Federal, having jurisdiction. - 29 - ARTICLE 17 ---------- Assignment ---------- 17.01 No Party may, without the prior written consent of the others, assign this Agreement, except as the same may be assigned (a) voluntarily or otherwise under its first mortgage, or (b) to a successor to all or substantially all of the assets of the Party by way of merger, consolidation, sale or otherwise, where the successor assumes and becomes liable for all the obligations of the Party hereunder. ARTICLE 18 ---------- Governing Law ------------- 18.01 This Agreement is made under and shall be governed by the laws of the State of Ohio insofar as applicable. ARTICLE 19 ---------- Other Agreements ---------------- 19.01 During the term of this Agreement, its terms, conditions and Schedules shall be applicable to transactions among the Parties. This Agreement is not to be interpreted as conflicting or interfering with the performance of any agreement including modifications or amendments thereto between any Party and any system not a Party to this Agreement, effective prior to August 31, 1980. - 30 - The Parties hereto shall be free to enter into any new agreements with other Parties or with other systems which do not impair operations under this Agreement or the ability of a Party to perform its obligations under this Agreement. The following agreements identified by FERC rate schedule numbers shown for each listed company are hereby terminated: ARTICLE 20 ---------- Term of Agreement ----------------- 20.01 Except as provided in Section 20.03, this Agreement shall continue in effect until such time as all CAPCO Units are retired. 20.02 Any Party may withdraw from this Agreement by giving one year's advance notice in writing to the members of - 31 - the Executive Committee of the other Parties, provided that in the event of such withdrawal, the provisions of this Agreement relating to coordinated maintenance of CAPCO Units, CAPCO Back-Up Power, and CAPCO Replacement Power shall continue in effect until such time as all CAPCO Units are retired. 20.03 Notwithstanding the retirement of all CAPCO Units under Section 20.01 and the withdrawal of any Party under Section 20.02, this Agreement shall continue in effect for those Parties who do not withdraw from this Agreement. ARTICLE 21 ---------- Separate Identities ------------------- 21.01 The duties, obligations and liabilities of the Parties are intended to be several and not joint or collective, and nothing herein contained shall ever be construed to create an association, joint venture, trust or partnership or to impose a trust or partnership duty, obligation or liability on or with regard to any Party. Each Party shall be individually responsible for its own obligations as herein provided. No Party shall be under the control of or shall be deemed to control another Party by virtue of this Agreement. No Party shall have a right or power to bind another without its or their express written consent, except as expressly provided in this Agreement. - 32 - ARTICLE 22 ---------- Force Majeure ------------- 22.01 No Party shall be considered to be in default in the performance of any of the obligations hereunder if failure of performance shall be due to uncontrollable forces. The term "uncontrollable forces" shall mean any cause beyond the control of the Party affected, including but not limited to the failure of facilities, flood, earthquake, storm, fire, lightning, epidemic, war, riot, civil disturbance, labor dispute, sabotage, restraint by Court order or public authority or inability to obtain necessary licenses or permits. Nothing herein shall be construed so as to require a Party to settle any strike or labor dispute in which it may be involved. Any Party which is unable to fulfill any obligations by reason of uncontrollable forces shall exercise due diligence to remove such inability with all reasonable dispatch. ARTICLE 23 ---------- Liability --------- 23.01 All claims arising out of any bodily injury, death or damages to property or business of third persons (other than customers, as such, of any of the Parties) arising because of operations under this Agreement caused or sustained on the system of a Party (the Defending Party) shall be defended or in - 33 - its discretion settled by such Party. In the event any action on any such claim is brought against any other Party, such other Party shall promptly notify the Defending Party in writing, and the Defending Party shall be entitled to and shall take over and direct the defense and disposition of the case. Any amounts paid by way of settlement or in satisfaction of any judgment and all expenses associated with such defense or settlement shall be the responsibility of the Defending Party. The provisions of this Section do not apply to claims of the employees of any Party under any workers' compensation law, for which the employing Party shall be responsible. 23.02 Each Party hereby waives any and all claims it may have against any other Party arising from negligence or other fault of another Party in connection with operations under this Agreement, except as otherwise provided in Section 7.03. - 34 - IN WITNESS WHEREOF, the Parties hereto have caused this Agreement to be executed by their duly authorized officers this 23rd day of December, 1993. THE CLEVELAND ELECTRIC ILLUMINATING COMPANY By: /s/ Terrence G. Linnert ----------------------------- Title: Vice President -------------------------- DUQUESNE LIGHT COMPANY By: /s/ G. R. Brandenberger ----------------------------- Title: Vice President -------------------------- OHIO EDISON COMPANY By: /s/ Arthur R. Garfield ----------------------------- Title: Vice President -------------------------- PENNSYLVANIA POWER COMPANY By: /s/ J. R. Edgerly ----------------------------- Title: Vice President -------------------------- THE TOLEDO EDISON COMPANY By: /s/ Terrence G. Linnert ----------------------------- Title: Vice President -------------------------- - 35 - EXHIBIT 10.11 AMENDMENT NO. 1 TO ------------------ CAPCO TRANSMISSION FACILITIES AGREEMENT --------------------------------------- THIS AGREEMENT, effective as of the 1st day of January 1, 1993, by and among The Cleveland Electric Illuminating Company, an Ohio corporation ("CEI"); Duquesne Light Company, a Pennsylvania corporation ("DL"); Ohio Edison Company, an Ohio corporation; Pennsylvania Power Company, a Pennsylvania corporation ("PP") and a wholly-owned subsidiary of Ohio Edison Company which Company and its said subsidiary, except as otherwise provided herein, are considered as a single Party for the purposes of this Agreement and referred to as ("OE"); and The Toledo Edison Company, an Ohio corporation ("TE"), each of which is sometimes referred to as a Party, and collectively as the Parties. W I T N E S S E T H: WHEREAS, the Parties entered into the CAPCO Transmission Facilities Agreement as of September 14, 1967 (herein referred to as the "Agreement"); and WHEREAS, the Parties entered into an Agreement on January 7, 1993, and approved an Addendum to the CAPCO Accounting and Procedure Manual to supersede applicable sections of the manual on a prospective basis as of January 1, 1993 (said Agreement being herein referred to as the "Addendum to CAPCO Accounting and Procedure Manual" or "Addendum"); and WHEREAS, the provisions of the Addendum to the CAPCO Accounting and Procedure Manual are intended to supersede any provisions of the Agreement which conflict with or are inconsistent with the Addendum, so that such conflicts and inconsistencies shall be removed by appropriate written amendments to the Agreement or by other appropriate action; and WHEREAS, the Parties desire to further amend the Agreement as hereinafter set forth; NOW, THEREFORE, in consideration of the premises and of the mutual covenants herein set forth, the Parties agree as follows: 1. Section 7.02 of the Agreement is amended to read as follows: The Party owning a CAPCO Line or portion thereof shall bill each other Party monthly for such other Party's Investment Responsibility with respect thereto. The invoice date shall be established as soon as possible after the close of each calendar month, and the owning Party shall prepare and make all reasonable efforts to transmit invoices on or before the invoice - 2 - date to each other Party for such other Party's Investment Responsibility. The amount billed will be payable in good funds the 15th calendar day after the invoice date except that, if the 15th calendar day is not a business day, the amount billed will be payable the next business day. Good funds shall consist of checks received at least one business day prior to the due date and wire transfers received by noon on the due date. Interest on unpaid invoice amounts will be compounded monthly and prorated for any partial month based on a 365-day year, and will accrue at a rate equal to Chase Manhattan Bank's prime rate on the first day of the then current calendar quarter plus two percentage points for a period of up to one year and for any period thereafter at the higher of this rate or a rate equal to the billing Party's cost of capital which shall consist of the weighted average of the billing Party's long-term debt cost and preferred stock cost rates determined for issues outstanding on December 31 of the prior year and a common equity cost rate to be effective January 1 of each year equal to the average return on common equity for at least 50 major electric utilities with positive returns on common equity as reported in the prior year's December issue of the C.A. Turner Utility Reports or as reported in the prior year's latest issue of another report mutually agreed to by the Parties. The weighting for - 3 - this calculation shall be the billing Party's capital structure at December 31 of the prior year, consisting solely of long-term debt, preferred stock and common equity, as reported in its FERC Form 1 or in another mutually agreed upon source. Invoices may not be changed or adjusted after four years from the invoice date, and invoice amounts to be refunded by the billing Party shall accrue interest as noted above, but invoice amounts payable to the billing Party for additional amounts shall not accrue interest. To the extent practicable all charges payable or receivable under this Agreement shall be offset and reduced to a net basis in order to provide a minimum practicable number of payments among the Parties. Such statements may be tendered on an estimated basis subject to corrective adjustments in subsequent statements. 2. Section 17.01 of the Agreement is amended to read as follows: Any waiver at any time by any Party of its rights with respect to any matter arising in connection with this Agreement shall not be deemed a waiver with respect to any subsequent similar matter. Any delay, short of the statutory period of limitation, in - 4 - asserting or enforcing any right under this Agreement, shall not be deemed a waiver of such right, except as provided in Section 7.02 and Section 14.01. 3. Exhibit B - Computation of Investment Responsibility of the Agreement is amended to read as attached: 4. Except as herein above amended, all of the terms and conditions of the Agreement shall remain in full force and effect. - 5 - IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized officers this 23rd day of December, 1993. THE CLEVELAND ELECTRIC ILLUMINATING COMPANY By /s/ Terrence G. Linnert ------------------------------------ Title Vice President --------------------------------- DUQUESNE LIGHT COMPANY By /s/ G. R. Brandenberger ------------------------------------ Title Vice President --------------------------------- OHIO EDISON COMPANY By /s/ Arthur R. Garfield ------------------------------------ Title Vice President --------------------------------- PENNSYLVANIA POWER COMPANY By /s/ J. R. Edgerly ------------------------------------ Title _________________________________ THE TOLEDO EDISON COMPANY By /s/ Terrence G. Linnert ----------------------------------- Title Vice President -------------------------------- - 6 - EXHIBIT 10.12 CAPCO MICROWAVE SHARING AGREEMENT --------------------------------- (As Amended January 1, 1993) THIS AGREEMENT, effective as of January 1, 1993, by and among The Cleveland Electric Illuminating Company, an Ohio corporation ("CEI"), Duquesne Light Company, a Pennsylvania corporation ("DL"), Ohio Edison Company, an Ohio corporation ("OE"), Pennsylvania Power Company, a Pennsylvania corporation ("PP)", and The Toledo Edison Company, an Ohio corporation ("TE"), each of which is herein referred to as a Party and collectively as the Parties, or as the CAPCO Group. WITNESSETH: WHEREAS, the Parties hereto have constructed and agreed to construct generating units owned by them as tenants in common ("CAPCO Generating Units"), and are engaged in the generation, transmission and distribution of electricity to the public in western Pennsylvania and in northern and Central Ohio, through electric systems which are interconnected directly or indirectly and are operated in synchronism; and WHEREAS, the Parties hereto have entered and proposed to enter into various agreements for planning, construction and interconnected operation of their facilities in order to achieve the benefits to be effected through coordination in the operation and development of their respective generation and transmission systems; and WHEREAS, each of the Parties hereto is eligible to be licensed by the Federal Communications Commission ("FCC") to operate microwave stations in the Power Radio Service, under Code of Federal Regulations, Title 47, Chapter 1, Part 94; and WHEREAS, each of the Parties hereto is licensed by the FCC to operate one or more microwave stations generally identified on the map annexed hereto as "Exhibit A" forming an interconnected microwave system, the use of which is to be shared by the Parties hereto, on a non-profit basis, in order to better coordinate the operation of their interconnected electric systems; and WHEREAS, the Parties desire to define the methods and procedures for the equitable sharing of certain costs of said interconnected microwave system hereinafter called the "CAPCO Microwave System" ("CMS"); and WHEREAS, the parties hereto desire to also define their rights and obligations relating to the construction, maintenance and use of the CMS. NOW THEREFORE, in consideration of the mutual agreements herein set forth, the Parties hereto agree as follows: A. Definitions - The terms used herein shall have the following meanings: ----------- 1. "CAPCO Accounting and Finance Committee" is one of the Standing Committees provided for in the CAPCO Administration Agreement, dated November 1, 1971, and is responsible for establishing methods, procedures and practices to be used in determining and assigning Costs, Investment Responsibility Base and Adjusted Investment Basis, Fixed Charges, and monthly - 2 - operation and expense factors related to facilities installed by the CAPCO Group including the CMS. 2. "CAPCO Microwave Facilities" designated as such by the CAPCO Operating Committee pursuant to this Agreement are generally defined in the CAPCO Accounting Procedure 05-24 dated May 13, 1977, and as subsequently revised, and CAPCO Accounting Procedure 05-25 dated May 18, 1976, and as subsequently revised (but shall not include terminal facilities such as load control, computer and other similar facilities). 3. The "CAPCO Microwave System" ("CMS") is that interconnected microwave system to be provided pursuant to this Agreement. 4. "CAPCO Operating Committee" is one of the Standing Committees provided for in the CAPCO Administration Agreement, dated November 1, 1971, and is responsible for establishing and maintaining rules and procedures for the coordinated operations of the CAPCO Group including operation of the CMS. 5. "Channel (Standard)" is a full duplex, 0 to 4 kHz bandwidth path suitable for the transmission of audio-controlled electric waves from one Station to another. A channel wider than 4 kHz will be divided by 4 kHz to determine the equivalent number of channels. Any fractional channel, or fractional use of a channel, shall be considered a full Channel for accounting purposes. 6. "Cost" of a Station means the total of all costs incurred by the construction Party associated with the acquisition of sites and construction of the Station and cost of - 3 - material and supplies required to be maintained for the operation and maintenance of such Station, including direct, additive or loading, and allocable costs, and interest during construction, as enumerated in CAPCO Accounting Procedure 19-01 dated August 2, 1976, and as subsequently revised. 7. "Fixed Charges" associated with a Station means an amount determined in accordance with attached Exhibit C. Fixed charge rates are determined annually for the year of investment and shall follow attached Exhibit C. 8. "Investment Responsibility" means the obligation to bear Fixed Charges, insurance charges, taxes and Operating Expense associated with a Station determined in accordance with attached Exhibit C. 9. "Load" of a Party during any clock hour is the total during any such clock hour (eliminating on an agreed basis any distortion arising out of deliveries between systems where material) of kilowatthours (a) delivered by the Party to its retail customers or to municipal systems, (b) used by the Party on its own system, exclusive of use for station auxiliary power, and (c) lost and unaccounted for on the system of the Party; but shall exclude Interruptible Load. 10. "Multiplex Equipment" is defined as the electronic equipment required to derive one or more Channels from a broadband radio frequency baseband. 11. "Operating Expense" of a Station means an amount determined in accordance with attached Exhibit C. 12. "Peak Load" is the maximum Load of a Party for any - 4 - clock hour of the period. 13. "Station" means all microwave facilities at a given geographic location which is a part of the CAPCO Microwave System. A Station may contain one or several paths to other stations. All transmitters and receivers at the same Station (within 1 second longitude and 1 second latitude) are considered to be one Station. B. Parties' Rights and Obligations in the CAPCO Microwave System ------------------------------------------------------------- 1. With regard to communications among the Parties which are provided by microwave, each Party shall, either by installation of new facilities or by the designation as such of existing facilities, subject to determinations as provided in the subparagraphs of this paragraph, provide, operate, maintain and control at Stations within its service area the necessary CAPCO microwave facilities (which facilities may be further identified by reference to call signs and other authorizations issued to the Party by the FCC), to supply Channels as follows: a. Those Channels determined by the CAPCO Operating Committee to be required to provide such functions as data transmission (which may include such functions as analog and digital telemetry and equipment status), voice communication, and facsimile transmission between the System Dispatching Offices of such Parties. b. Those Channels determined by the operating owner of each CAPCO Generating Unit to be required to provide such functions as telemetry, load control and voice - 5 - communication between the plant site and the System Dispatching Office and other supporting locations of the operating owner of such CAPCO Generating Unit. c. Those Channels, requested by a non-operating Party of a CAPCO Generating Unit having an entitlement out of such Unit and desiring to monitor the Unit and/or integrate its control of its entitlement directly with its other sources of generation, to permit such Party to communicate with the operating Owner's System Dispatching Office. d. Those Channels, with respect to each transmission line of the CAPCO Group ("CAPCO Line") determined by the owner or owners of such Line to be necessary for the operation, control and protection of the Line. e. Other Channels mutually agreed to by all Parties. 2. The Stations included as part of the CMS are shown diagrammatically on Exhibit A and are listed on Exhibit B. New stations may be added or existing stations may be deleted upon agreement by the Operating Committee. Review and update of Exhibits A and B shall be made every two (2) years by CAPCO Communications Working Group. Revised Exhibits A and B, upon issuance by the Operating Committee, will be included as part of this agreement. 3. Consistent with all applicable regulations of the FCC and with such rules as may be promulgated by the CAPCO Operating Committee (which shall be consistent with any such regulations), each Party shall construct, operate and maintain - 6 - those facilities which are a part of the CAPCO Microwave System for which it is licensed by the FCC in such a manner as to maintain the integrity and reliability of the entire CMS. 4. The CAPCO Microwave Facilities supplied pursuant to this Agreement shall be provided, operated and maintained in accordance with sound engineering practices and principles, and in a manner designed to achieve maximum practical coordination of the CMS. The Parties shall coordinate the design and construction of their respective portions of the CMS, and they shall coordinate CAPCO traffic within supergroups 3, 4 and 5 (unless otherwise mutually agreed to), and also within supergroups 6 and 7 for the Star-Massillon (OE) portion. 5. Each Party shall have full and exclusive responsibility for the control, operation and maintenance of those microwave stations with respect to which it is licensed by the FCC and nothing herein contained shall be interpreted as limiting or otherwise interfering with any Party's duties and responsibilities under the Rules and Regulations of the FCC. 6. Any Party may use for individual purposes or CAPCO purposes any unused capacity in CAPCO Microwave Facilities, up to the ultimate capacity of such facilities. In the event of simultaneous demands for individual use and CAPCO use of unused capacity, the demand for CAPCO use shall have priority. In the event of simultaneous demands for individual uses of unused capacity, the owner of the facility shall determine the priority to be observed. - 7 - 7. Any microwave facilities required for the purposes of Paragraph B-1 which are located at Stations outside the service areas of the Parties shall be provided, operation, maintained and controlled by the Party to whose microwave system such facilities are most closely related and the cost of such microwave facilities will be treated the same as those in Paragraph B-1. 8. Nothing in this Agreement shall be construed to require installation of any particular microwave facilities. C. Procedures for Determining Investment Responsibility and Procedures for ----------------------------------------------------------------------- Billing ------- 1. The procedure for determining the microwave Station investment responsibility portion which is to be allocated among the Parties are set forth in attached Exhibit C. 2. Each Party's allocation percentage of Investment Responsibility for CAPCO Microwave Facilities provided in accordance with paragraphs B-1-a, B-1-b, B-1-c, B-1-d and B-1-e shall be determined in the manner set forth in accordance with attached Exhibit C. 3. Investment Responsibility for a Station shall not commence earlier than October 1, 1977. 4. The Party owning a Station shall bill each other Party annually for such other Party's Investment Responsibility with respect thereto. Bills shall be forwarded as promptly as practicable on June 15 of each year and shall be due and payable in good funds the fifteenth calendar day after the date of any such statement except that, if the 15th calendar day is not a - 8 - business day, the amount billed will be payable the next business day. Good funds shall consist of checks received at least one business day prior to the due date and wire transfers received by noon on the due date. Interest on unpaid invoice amounts will be compounded monthly and prorated for any partial month based on a 365-day year, and will accrue at a rate equal to Chase Manhattan Bank's prime rate on the first day of the then current calendar quarter plus two percentage points for a period of up to one year and for any period thereafter at the higher of this rate or a rate equal to the billing Party's cost of capital which shall consist of the weighted average of the billing Party's long-term debt cost and preferred stock cost rates determined for issues outstanding on December 31 of the prior year and a common equity cost rate to be effective January 1 of each year equal to the average return on common equity for at least 50 major electric utilities with positive returns on common equity as reported in the prior year's December issue of the C.A. Turner Utility Reports or as reported in the prior year's latest issue of another report mutually agreed to by the Parties. The weighting for this calculation shall be the billing Party's capital structure at December 31 of the prior year, consisting solely of long-term debt, preferred stock and common equity, as reported in such Party's FERC Form 1 or in another mutually agreed upon source. Invoices may not be changed or adjusted after four years from the invoice date, and invoice amounts to be refunded by the billing Party shall accrue interest as noted above, but invoice amounts payable to the - 9 - billing Party for additional amounts shall not accrue interest. To the extent practicable all charges payable or receivable under this Agreement shall be offset and reduced to a net basis in order to provide a minimum practicable number of payments among the Parties. Such statements may be rendered on an estimated basis subject to corrective adjustments in subsequent statements as noted above. 5. Each Party shall keep such records as may be reasonably required by the CAPCO Operating Committee, and shall furnish to the CAPCO Operating Committee such records, reports and other information as the CAPCO Operating Committee may reasonably request. D. General ------- 1. Any waiver at any time by any Party of its rights with respect to any matter arising in connection with this Agreement shall not be deemed a waiver with respect to any subsequent similar matter. Any delay, other than one which occurs under Paragraph C.4 above short of the statutory period of limitation, in asserting or enforcing any right under this Agreement, shall not be deemed a waiver of such right. 2. No Party may, without the prior written consent of the others, assign this Agreement, except as the same may be assigned (a) voluntarily or otherwise under its first mortgage, or (b) to a successor to all or substantially all of the assets of the Party by way of merger, consolidation, sale or otherwise, where the successor assumes and becomes liable for all the obligations of the Party hereunder. - 10 - 3. This Agreement is made under and shall be governed by the laws of the State of Ohio insofar as applicable. 4. The duties, obligations and liabilities of the Parties are intended to be several and not joint or collective, and nothing herein contained shall ever be construed to create an association, joint venture, trust or partnership or to impose a trust or partnership duty, obligation or liability on or with regard to any Party. Each Party shall be individually responsible for its own obligations as herein provided. No Party shall be under the control of or shall be deemed to control another Party by virtue of this Agreement. No Party shall have a right of power to bind another without its or their express written consent except as expressly provided in this Agreement. 5. No Party shall be considered to be in default in the performance of any of the obligations hereunder if failure of performance shall be due to uncontrollable forces. The term "uncontrollable forces" shall mean any cause beyond the control of the Party affected, including but not limited to the failure of facilities, flood, earthquake, storm, fire, lightning, epidemic, war, riot, civil disturbance, labor dispute, sabotage, restraint by Court order or public authority, or inability to obtain necessary licenses or permits. Nothing herein shall be construed so as to require a party to settle any strike or labor dispute in which it may be involved. Any Party which is unable to fulfill any obligations by reason of uncontrollable forces - 11 - shall exercise due diligence to remove such inability with all reasonable dispatch. 6. All claims arising out of any bodily injury, death or damages to property or business of third persons arising because of operations under this Agreement caused or sustained on the system of a Party (the Defending Party) shall be defended or in its discretion settled by such Party. In the event any such claim is brought against any other Party, such other Party shall promptly notify the Defending Party in writing, and the Defending Party shall be entitled to and shall take over and direct the defense and disposition of the case. Any amounts paid by way of settlement or in satisfaction of any judgment and all expenses associated with such defense or settlement shall be the responsibility of the Defending Party. The provisions of this paragraph do not apply to claims of the employees of any Party under any workmen's compensation law, for which the employing Party shall be responsible. Each Party hereby waives any and all claims it may have against any other Party arising from negligence and other fault of another Party in connection with operations under this Agreement. 7. The Parties hereto shall be free to enter into any new microwave sharing agreements with others, which agreements do not impair obligations under this Agreement or the ability of a Party to perform its obligations under this Agreement. 8. The obligations of each of the Parties hereunder are subject to the obtaining of any requisite orders, approvals, - 12 - permits, certificates or licenses from any governmental authorities having jurisdiction. E. Modification and Duration ------------------------- 1. This Agreement shall continue in effect from the date hereof until terminated by the mutual agreement of all who are then Parties hereto. 2. Notice of withdrawal from the arrangement provided for in the CAPCO Basic Operating Agreement, as amended September 1, 1980, and as subsequently amended, shall be deemed to be notice of withdrawal from this Agreement. Such withdrawal from this Agreement shall be effective on the cessation of all rights and obligations of the withdrawing party provided that the withdrawing Party shall be relieved of any duty under this Agreement to incur any obligation or to participate in planning or other activities of the CAPCO Group with respect to any CAPCO Microwave Facilities determined upon subsequent to such notice of withdrawal. - 13 - IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized officers this 23rd day of December, 1993. CLEVELAND ELECTRIC ILLUMINATING COMPANY By /s/ Terrence G. Linnert ------------------------------------ Title Vice President --------------------------------- DUQUESNE LIGHT COMPANY By /s/ G. R. Brandenberger ------------------------------------ Title Vice President --------------------------------- OHIO EDISON COMPANY By /s/ Arthur R. Garfield ------------------------------------ Title Vice President --------------------------------- PENNSYLVANIA POWER COMPANY By /s/ J. R. Edgerly ------------------------------------ Title Vice President --------------------------------- TOLEDO EDISON COMPANY By /s/ Terrence G. Linnert ----------------------------------- Title Vice President -------------------------------- - 14 - EXHIBIT 10.13 AGREEMENT FOR THE TERMINATION OR CONSTRUCTION OF CERTAIN AGREEMENTS BY AND AMONG THE CLEVELAND ELECTRIC ILLUMINATING COMPANY, DUQUESNE LIGHT COMPANY, OHIO EDISON COMPANY, PENNSYLVANIA POWER COMPANY AND THE TOLEDO EDISON COMPANY -------------------------------------------------------- THIS AGREEMENT, effective as of the 1st day of September 1980, by and among The Cleveland Electric Illuminating Company, an Ohio corporation; Duquesne Light Company, a Pennsylvania corporation; Ohio Edison Company, an Ohio corporation, and its wholly-owned subsidiary, Pennsylvania Power Company, a Pennsylvania corporation, which two companies are considered as a single party for purposes of this Agreement; and The Toledo Edison Company, an Ohio corporation, all of which are referred to collectively as the Parties or the CAPCO Group. WITNESSETH: WHEREAS, each of the Parties is desirous of terminating or construing, effective as of September 1, 1980, certain agreements by and among the Parties. NOW THEREFORE, in consideration of the premises and of the mutual covenants herein set forth, the Parties agree as follows: 1. The CAPCO Memorandum of Understanding dated September 14, 1967, the Agreement of Chief Executives dated July 6, 1973, and the Memorandum of Agreement with an effective date of March 1, 1977, and captioned "Purchase and Sale Agreements Under Schedules E and H of the CAPCO Basic Operating Agreement for the period March 1, 1977 through December 31, 1977 and for 1978, and Tentative Purchase and Sale Agreements for 1979 and Beyond" are terminated and have no further force or effect. 2. The CAPCO Transmission Facilities Agreement with an effective date of September 14, 1967 (hereinafter referred to as the "Transmission Facilities Agreement") is to be construed so as to allow all of the services and transactions contemplated by the CAPCO Basic Operating Agreement as amended September 1, 1980 and as subsequently amended (hereinafter referred to as the "Basic Operating Agreement"), to be performed, accomplished or effected, as the case may be, under said Transmission Facilities Agreement. 3. This Agreement and the Basic Operating Agreement supersede any and all other agreements by and among the Parties involving the CAPCO Group which are not terminated in Paragraph 1, above, to the extent such other agreements conflict or are inconsistent therewith. All such conflicts or inconsistencies shall be removed by appropriate written amendments to these other agreements or by other appropriate action. 4. The Parties hereby reaffirm and agree to implement the pool restructuring principles heretofore described in the minutes of the meetings of the CAPCO Executive Committee on and - 2 - after November 1, 1979, and shall use their best efforts to prepare and execute as soon as reasonably possible any and all written amendments to agreements by and among the Parties involving the CAPCO Group and to take other appropriate action required by this Agreement, the Basic Operating Agreement, and the aforesaid minutes of the Executive Committee. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized officers this 23rd day of December, 1993. THE CLEVELAND ELECTRIC ILLUMINATING COMPANY By /s/ Terrence G. Linnert ------------------------------------ Title Vice President --------------------------------- DUQUESNE LIGHT COMPANY By /s/ G. R. Brandenberger ------------------------------------ Title Vice President --------------------------------- OHIO EDISON By /s/ Arthur R. Garfield ------------------------------------ Title Vice President --------------------------------- PENNSYLVANIA POWER COMPANY By /s/ J. R. Edgerly ------------------------------------ Title Vice President --------------------------------- THE TOLEDO EDISON COMPANY By /s/ Terrence G. Linnert ----------------------------------- Title Vice President -------------------------------- - 3 - EXHIBIT 10.14 FORT MARTIN CONSTRUCTION AND OPERATING AGREEMENT, dated April 30, 1965, among DUQUESNE LIGHT COMPANY, a Pennsylvania corporation ("Duquesne"), MONONGAHELA POWER COMPANY, a West Virginia corporation ("Monongahela"), and THE POTOMAC EDISON COMPANY, a Maryland corporation ("Potomac"). 1. Station. Duquesne, Monongahela and Potomac (the "Companies") hereby provide for the construction and operation of the first unit of approximately 500,000 kw name plate capacity (the "First Unit") of a steam electric generating station in Monongahela County, West Virginia, to be owned by the Companies as tenants in common with undivided ownership interests of Duquesne one-half, Monongahela one- quarter and Potomac one-quarter (their respective "Ownership Shares"), all as contemplated in the deed dated April 30, 1965 (the "Deed") from Monongahela to Duquesne and Potomac. The provisions of this Agreement are intended, as contemplated in the Deed, to establish as among the Companies more detailed provisions and procedures for carrying out provisions of the Deed. 2. Construction. Construction of the First Unit shall be carries out by the Companies under the general supervision and direction of a Construction Committee, which shall be the Allegheny Power System Fort Martin Construction Committee. Duquesne will have a representative on such Committee. The Companies intend to use their best efforts toward the end that the construction of the First Unit will be completed, and full-scale operation commenced, on or before May 1, 1967. The Companies shall, with reasonable expedition, enter into contracts (which may be purchase order contracts) providing for (a) the purchase of materials, equipment and services for, and construction of, the First Unit and (b) insurance to insure all work under construction against risks usually insured against for such work. Each such contract shall provide, among other things, that the performance of the contract shall be for the account of, and the charges therefor shall be billed to, and paid by the Companies in proportion to their respective Ownership Shares and that the invoices for such billing (Contractor's Invoice or Invoices) shall be submitted in the names of the Companies. Each of the Companies shall execute and deliver on its own behalf the contracts providing for the purchase of the following: Steam generator, turbine-generator, main transformers, equipment erection, piping installation, electrical installation, structural steel, substructure, superstructure, piping and equipment insulation, condenser, fly ash collectors, large pumps, and consulting engineering work. For their convenience the Companies may authorize an individual or individuals to execute and deliver on behalf of the Companies all other contracts to be entered into pursuant to this Section. Books of account and records containing details of the items of cost applicable to the construction of the First Unit - 2 - shall be kept under the supervision of the Construction Committee and shall be open to examination at any time by any Company or its representatives. The Construction Committee shall cause the Companies to be furnished with counterparts of such books of account and records as they may request. The basic books of account and records shall be turned over to and maintained by the Operating Company referred to in Section 3. 3. Operation and Maintenance. The First Unit shall be operated and maintained in accordance with good utility operating practice. The Companies shall establish an Operating Committee for the purpose of establishing policies for the operation and maintenance of the First Unit. The Companies shall be represented on the Operating Committee in proportion to their Ownership Shares. The Operating Committee shall meet at the call of any member. The First Unit will be operated and maintained by one of the Companies (the "Operating Company") in accordance with policies to be established by the Operating Committee. Until otherwise agreed by all the Companies, Monongahela shall be the Operating Company. The Operating Company shall not be liable in respect of operation or maintenance except for its gross negligence or willful misconduct. The Operating Company shall keep books of account and records containing details of the items of cost applicable to the operation and maintenance of the First Unit. Such books of account and records shall be open to - 3 - examination at any time by any Company or its representatives. The Operating Company shall furnish the Companies with counterparts of such books of account and records as they may request. 4. Renewals, Replacements, Additions and Retirements. Renewals and replacements necessary for the operation of the First Unit shall be made as required by good utility operating practice. Other renewals and replacements and any additions to the First Unit may be made only by agreement of all the Companies. Retirements, sales and other dispositions of First Unit property shall be effected only in a manner consistent with the Companies' respective mortgage indentures, if any. Renewals, replacements, additions, and retirements (and related dispositions and sales) shall be effected by the Operating Company subject to the policies established by the Operating Committee. 5. Title to Property. Title to all property (including Common Facilities as defined in the Deed) acquired or constructed in connection with the First Unit (including without limitation property acquired for use or consumption in connection with its construction, operation and maintenance) shall be in the Companies as tenants in common in proportion to their Ownership Shares, subject in the case of Common Facilities to any sales pursuant to subpara- graph 5 of the Deed. Construction, acquisitions and purchases shall be made in such manner that title shall vest in accordance with the foregoing. - 4 - 6. Power and Energy. Subject to Section 9, each Company shall at all times have full ownership of and available to it at the First Unit the portion of the generating capability of the First Unit and the energy associated therewith, corresponding to its Ownership Share. Each Company shall keep the Operating Company informed as to the amount of power it requires to be generated for it. Subject to its capability and to necessary or unavoidable outages, the First Unit shall be operated so as to produce an output equal to the sum of the power requirements of the Companies therefrom. 7. Expenditures. All expenditures in respect of the First Unit shall be accounted for in accordance with the Uniform System of Accounts prescribed by the Federal Power Commission for Public Utilities and Licensees (Class A and B Electric Utilities) as in effect on the date of this Agreement. All expenditures (including without limitation all expenditures for administration, labor, payroll taxes, employee benefits, maintenance, materials, research and development, supplies and services), except those in respect of Common Facilities as defined in the Deed, for the construction, operation and maintenance (excluding fuel) of the First Unit and for renewals, replacements, additions and retirements in respect thereof shall be shared by the Companies in proportion to their Ownership Shares. All such expenditures in respect of Common - 5 - Facilities shall be shared by the Companies in proportion to each Company's Ownership Share (after reduction by a fraction equal to any fraction of such Company's ownership interest in Common Facilities sold pursuant to the provisions of the Deed). All expenditures in respect of the First Unit properly chargeable to Account 501 (Fuel) of such Uniform System of Accounts for any period shall be shared by the Companies pro rata according to the total kilowatthours of energy respectively taken by them from the First Unit during such period. Interest charges on borrowed funds, income taxes, and property, business and occupation and like taxes, of each Company shall be borne entirely by such Company; and such items, as well as depreciation, amortization, and interest charged to construction, shall not be deemed expenditures for purposes of this Section. 8. Joint Account. The Companies shall maintain one or more joint accounts (collectively, the "Joint Account") in a bank or banks agreed upon by them, the title of each such account to include Duquesne (50%), Monongahela (25%) and Potomac (25%). All expenditures referred to in the second paragraph of Section 7 shall be paid out of the Joint Account. From time to time the Construction Committee or the Operating Company may request the Companies to advance to the Joint Account such amount as is then needed for cash working capital. Within ten days thereafter the Companies, pro rata - 6 - according to their respective Ownership Shares, shall deposit in the Joint Account the amount specified in such request. As promptly as practicable after the end of each month, the Construction Committee or the Operating Company shall send to each of the Companies a statement in reasonable detail of all expenditures for such month and the amount of each Company's share thereof. Within ten days after its receipt of such statement, each Company shall deposit its share in the Joint Account. The Construction Committee or Operating Company shall cause to be drawn against the Joint Account, and to be delivered, checks or drafts in the names of the Companies in payment of expenditures. Funds shall be disbursed from the Joint Account in accordance with sound accounting and disbursement procedures. All persons authorized to handle or disburse funds from the Joint Account shall be bonded in favor of Duquesne, Monongahela and Potomac, as their respective interests may appear, for not less than $500,000. 9. Default. During any period that a Company is in default in whole or in part in making the most recent deposit in the Joint Account then required under this Agreement, (a) such Company shall be entitled to no energy from the First Unit during such period (but shall be obligated to pay any damages to the non- defaulting Companies resulting from the default) and (b) the non-defaulting Companies shall be entitled to all of the energy from the First Unit in proportion to their Ownership Shares. No - 7 - such default shall affect any Company's ownership interest, or any Company's obligations under Sections 7 and 8. 10. Arbitration. The Companies hereby declare their intention and agree that any controversy arising out of or relating to this Agreement or the Deed, or the breach of either thereof, shall be settled by arbitration in accordance with the Rules of the American Arbitration Association and that judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. 11. Term of Agreement. This Agreement shall continue in full force and effect for a period of forty-two years from the date hereof and for such longer period as the Companies shall by mutual agreement continue to operate the First Unit. Termination of this Agreement shall not terminate the provisions of Section 10. 12. Amendment. This Agreement may be amended from time to time or canceled at any time, by an instrument or instruments in writing signed by all of the Companies (or their successors or assigns). 13. Successors and Assigns. This Agreement shall inure to the benefit of and bind the successors and assigns of the parties hereto, but it may be - 8 - assigned in whole or in part only in connection with transfer to the assign of a corresponding ownership interest in the First Unit. IN WITNESS WHEREOF each of the parties has caused this Agreement to be duly executed. DUQUESNE LIGHT COMPANY By /s/ Philip A. Fleger -------------------------- Chairman of the Board and President MONONGAHELA POWER COMPANY By /s/ John A. Freeman -------------------------- Vice President THE POTOMAC EDISON COMPANY By /s/ Charles D. Lyon -------------------------- President - 9 - EXHIBIT 10.15 TRANSMISSION AGREEMENT, dated March 15, 1967, among DUQUESNE LIGHT COMPANY, a Pennsylvania corporation ("Duquesne"), MONONGAHELA POWER COMPANY, an Ohio corporation ("Monongahela") and WEST PENN POWER COMPANY, a Pennsylvania corporation ("West Penn"), W I T N E S S E T H : 1. Preamble. The systems of Monongahela and West Penn are part of the integrated electric utility system of Allegheny Power System, Inc. and its subsidiaries, and they and Duquesne's system are interconnected directly or indirectly and will be further interconnected through the facilities provided for in this Agreement. Duquesne, Monongahela, and The Potomac Edison Company are providing for the construction and operation of the first unit of approximately 540,000 kw capacity (the "First Unit") of a steam electric generating station in Monongalia County, West Virginia, to be owned by them as tenants in common. The station is known as the Fort Martin Generating Station. Duquesne has no transmission lines from the location of the Fort Martin Generating Station and wishes to arrange for the transmission into its system of its share of the energy produced by the First Unit, and Monongahela and West Penn are willing to provide the necessary transmission. 2. Transmission Service. Monongahela and West Penn agree to transmit or cause to be transmitted Duquesne's share of the power and energy from the First Unit to the Elrama- Mitchell interconnection and/or to the systems of other electric utilities now directly interconnected with Duquesne or to such other point or points as may from time to time be agreed upon by the parties; such power and energy to be delivered at 138,000 volts or at such other voltages as may be acceptable to the parties. 3. Facilities. A. Monongahela and West Penn shall each provide, operate, and maintain, or cause to be provided, operated and maintained, the facilities referred to in the Schedules hereto shown opposite its name below. Monongahela Schedules I and II West Penn Schedules III and IV West Penn will, at its own expense, reconductor its 138 kv transmission line between Yukon and Shepler Hill, Pennsylvania. Installation of the facilities referred to in the above Schedules, other than the 500 kv line circuit breakers referred to in Schedule IV, shall be completed by the date of first commercial operation of the First Unit or as soon thereafter as possible. Installation of said circuit breakers shall be made when required, as determined by West Penn. - 2 - B. Monongahela and West Penn shall each provide, operate, and maintain, or cause to be provided, operated, and maintained, such other facilities, (including replacements and relocations of, and additions to, the facilities provided or caused to be provided by it under Subsection A of this Section) as may be required on its system to meet its obligations under Section 2, such other facilities being hereinafter collectively called the "Other Facilities". C. For the purposes of this Agreement there shall be maintained a set of records, hereinafter called the "Special Accounts", corresponding to the following accounts of the Uniform System of Accounts prescribed by the Federal Power Commission for Public Utilities and Licensees (Class A and B Electric Utilities) as in effect on the date of this Agreement (the "Uniform System"): Account 350 - Land and Land Rights Account 351 - Clearing of Land and Land Rights Account 352 - Structures and Improvements Account 353 - Substation Equipment Account 354 - Towers and Fixtures Account 356 - Overhead Conductors and Devices Account 359 - Roads and Trails Account 397 - Telemetering, Control and Communication Equipment The original cost of each facility provided or caused to be provided hereunder shall, as of the date of its - 3 - installation, be separately identified, classified in accordance with the aforesaid accounts of the Uniform System, and recorded in the Special Accounts corresponding thereto. Upon the retirement of any facility whose original cost is recorded in a Special Account corresponding to Account 350 or 351 of the Uniform System, such cost shall be deducted from such Account. Upon retirement of any facility whose original cost is recorded in any other Special Account, there shall be deducted from the Special Account in which its original cost is recorded only the original cost of materials, if any, that constitutes a part thereof and that are still used or useful. The excess, if any, of any cash received by reason of damage to, or relocation or salvage of, any such other facility over the cost of removal thereof shall be credited in equal amounts to the payments to be made thereafter and prior to May 1, 2009 with respect to such facility under Section 4. D. Any party on whose property the facilities of another party are to be located will permit the construction, reconstruction, maintenance, operation or removal thereof by such other party and will provide freedom of access for such other party for such purposes. 4. Payments. For the first calendar month following the date of the first commercial operation of the First Unit and each succeeding calendar month during the term of this Agreement, Duquesne shall, subject to Section 10, make the following payments: - 4 - a. To Monongahela with respect to the facilities referred to in Schedule I an amount equal to 0.50 of the sum of (1) the product of (a) each amount carried for such facilities in a Special Account at the end of the preceding month and (b) the Factor set forth in Schedule V hereto opposite the Special Account in which such amount is carried; and (2) the Operating and Maintenance Expense incurred by Monongahela in respect of such facilities during such calendar month; B. To Monongahela with respect to the facilities referred to in Schedule II an amount equal to 0.1588 of the sum of (1) the product of (a) each amount carried for such facilities in a Special Account at the end of the preceding month and (b) the Factor set forth in Schedule V hereto opposite the Special Account in which such amount is carried; and (2) the Operating and Maintenance Expense incurred by Monongahela in respect of such facilities during such calendar month; - 5 - C. To West Penn with respect to the facilities referred to in Schedule III an amount equal to the sum of (1) the product of (a) each amount carried for such facilities in a Special Account at the end of the preceding month and (b) the Factor set forth in Schedule V hereto opposite the Special Account in which such amount is carried; and (2) the Operating and Maintenance Expense incurred by West Penn in respect of such facilities during such calendar month; D. To West Penn with respect to the facilities referred to in Schedule IV an amount equal to 0.1588 of the sum of (1) the product of (a) each amount carried for such facilities in a Special Account at the end of the preceding month and (b) the Factor set forth in Schedule V hereto opposite the Special Account in which such amount is carried; and (2) the Operating and Maintenance Expense incurred by West Penn in respect of such facilities during such calendar month; E. To Monongahela and West Penn with respect to Other Facilities such amount as shall be agreed upon by - 6 - the parties as comparable to the other payments provided for in this Section or, if they are unable to agree, as shall be determined by arbitration under Section 9 to be so comparable; provided, however, that if at the end of 12 months after the date of its first commercial operation the capability of the First Unit shall be determined to be other than 540 mw (net unit capability - winter rating) the decimal in Subsections B and D of this Section shall be changed, as of the end of such 12 months, to the 4 place decimal obtained by dividing 1700 (being the mw capability of the facilities provided for in Schedules II and IV) into one-half of the mw capability of the First Unit. Operating and Maintenance Expense incurred in respect of any facilities means all expenses with respect thereto arising from the operation and maintenance (as distinguished from construction) of such facilities recordable in Operation and Maintenance Expense Accounts or Income Accounts of the Uniform System. Interest charges on borrowed funds, return on equity investment, income taxes, deferment or amortization of investment tax credit, Pennsylvania capital stock tax, depreciation or amortization of investment in plant, cost of removal, and terminal salvage (all of which are reflected in the Factors set forth in Schedule V) and expenditures recordable in Electric Plant Accounts of the Uniform System, shall not be deemed Operating and Maintenance Expense. Cash received by reason of damage to facilities that are not retired as a result - 7 - thereof shall be credited to appropriate Maintenance Expense Accounts. Schedule V hereto will be revised whenever necessary to reflect in the Factors therein changes in taxes or tax rates or the imposition of new taxes after the date hereof. As soon as practicable after the end of each month, Monongahela and West Penn shall each submit to Duquesne a statement in reasonable detail showing the amount payable by Duquesne to it hereunder for such month, and Duquesne shall pay each such amount within 10 days after receipt of the statement with respect to it. Monongahela and West Penn shall keep books of account and records in reasonable detail in respect to the items of cost applicable to the capital investment, operation, and maintenance of the facilities recorded in the Special Accounts. Such books of account and records shall be open to examination at any reasonable time by Duquesne. Monongahela and West Penn shall furnish Duquesne with single counterparts of such books of account and records as Duquesne shall request. 5. Metering. Arrangements with respect to location, type and ownership of metering facilities required for purposes of this Agreement shall be made from time to time as agreed upon by the parties. Metering facilities provided hereunder shall be tested by the owners thereof at suitable intervals and their accuracy - 8 - maintained in accordance with good utility operating practice. Representatives of all parties shall be afforded an opportunity to be present at all tests. 6. Indemnity. Each party will indemnify and save harmless each other party from all claims, liability, and expense arising out of any bodily injury, death, or damage to property (other than those caused by such other party or its employees, agents, or servants) occurring in or about facilities owned by it and used for the purposes of this Agreement, including liability to employees, agents, or servants of the indemnifying party, except that each party shall be responsible for all claims of its own employees, agents, and servants under any workmen's compensation or similar law. 7. General. No party shall be considered to be in default in respect of any obligation hereunder if prevented from fulfilling such obligation by reason of any cause beyond its reasonable control, including, without limitation, strikes and labor disputes. No party shall be liable for the failure of any other party to perform any of its obligations hereunder. No provision of this Agreement shall be changed unilaterally by any party. - 9 - 8. Regulatory Approvals. This Agreement is made subject to the jurisdiction of any governmental authority or authorities having jurisdiction in the premises. 9. Arbitration. The parties hereby declare their intention and agree that any controversy arising out of or relating to this Agreement, or the breach thereof, shall be settled by arbitration in accordance with the Rules of the American Arbitration Association and that judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. 10. Term. Unless earlier terminated as hereinafter provided, this Agreement shall continue in effect until May 1, 2009, and for such longer period as Duquesne shall own an undivided interest in the First Unit. Duquesne may, by prior written notice to Monongahela and West Penn, terminate its obligations under Section 4C on the last day of any calendar month after it completes the disposition of its entire interest in the First Unit upon payment to West Penn of the then depreciated original cost to West Penn of the facilities referred to in Schedule III that are no longer used or useful to West Penn. Upon such payment West - 10 - Penn shall transfer to Duquesne title to such of said facilities as Duquesne shall request. Duquesne may, by prior written notice to Monongahela and West Penn, terminate its obligations under Sections 4A, 4B and 4D on the last day of any calendar month during which it completes the sale of its entire interest in the First Unit to a subsidiary or subsidiaries of Allegheny Power System, Inc. Upon termination of Duquesne's obligations under Section 4C, 4A, 4B and 4D, this Agreement shall terminate in its entirety. 11. Successors and Assigns. This Agreement shall inure to the benefit of and bind the successors and assigns of the parties. IN WITNESS WHEREOF, each of the parties has caused this Agreement to be duly executed. DUQUESNE LIGHT COMPANY By /s/ Philip A. Fleger ----------------------- Chairman of the Board and President MONONGAHELA POWER COMPANY signature illegible By /s/ no name specified ----------------------- Vice President WEST PENN POWER COMPANY signature illegible By /s/ no name specified ----------------------- Vice President - 11 - Schedule I A 500 kv generator circuit breaker and associated facilities located at the Fort Martin switching station installed for the control of the First Unit. Approximately 3,000 feet of 500 kv transmission line between the First Unit and the Fort Martin switching station. Cable and duct system between the First Unit and the Fort Martin switching station. Schedule II Two 500 kv line circuit breakers and associated facilities located at the Fort Martin switching station installed for the control of the Fort Martin- Kammer and Fort Martin-Yukon transmission lines. Schedule III Telemetering and control equipment required by Duquesne and installed at West Penn's Charleroi Systems Operations Building and Mitchell Power Station. Communication circuits required by Duquesne between West Penn's Charleroi Systems Operations Building and Mitchell Power Station. One 350 Mva, 500-138 kv transformer located at West Penn's Yukon Substation. One 500 kv circuit breaker and associated equipment located at West Penn's Yukon Substation. One 138 kv circuit breaker and associated equipment located at West Penn's Yukon Substation. Schedule IV Fort Martin-Yukon 500 kv transmission line. West Penn's portion of the Yukon-Keystone 500 kv transmission line. West Penn's portion of the Fort Martin-Kammer transmission line. When required, two 500 kv line circuit breakers located at West Penn's Yukon Substation. Schedule V ---------- * The symbol "M" means the number of months for which payments have previously been made with respect to the facility as to which the Factor is being used. EXHIBIT 10.16 AMENDMENT OF JANUARY 1, 1988 TO TRANSMISSION AGREEMENT EFFECTIVE JULY 17, 1967 ---------------------------- This Amendment, effective as of the 1st day of January 1988, is made by and between West Penn Power Company, Monongahela Power Company, and Duquesne Light Company, collectively "the Parties" hereinafter, WITNESSETH: WHEREAS, the Parties entered into a Transmission Agreement, dated March 15, 1967, effective July 17, 1967; and WHEREAS, Schedule V of that Agreement requires revision as a result of the Tax Reform Act of 1986 and other tax changes; NOW, THEREFORE, the Parties agree that Schedule V of the aforesaid Transmission Agreement is revised effective January 1, 1988, as shown on the page attached hereto marked "Schedule V - Revised Effective January 1, 1988." This Amendment shall inure to the benefit of and be binding upon the successors and assigns of the Parties. Except as herein modified and amended, the aforesaid Transmission Agreement shall remain in full force and effect. IN WITNESS WHEREOF, the Parties have caused this Amendment to be executed by their duly authorized officers. WEST PENN POWER COMPANY signature illegible BY /s/ no name specified ------------------------- President ------------------------- (Title) MONONGAHELA POWER COMPANY BY /s/ Robert R. Winter ------------------------- Vice President ------------------------- (Title) DUQUESNE LIGHT COMPANY BY /s/ G. R. Brandenberger ------------------------- V.P. Power Supply Gp. ------------------------- (Title) - 2 - EXHIBIT 12.1 Duquesne Light Company and Subsidiary Calculation of Ratio of Earnings to Fixed Charges (Thousands of Dollars) Duquesne's share of the fixed charges of an unaffiliated coal supplier, which amounted to approximately $4.0 million for the year ended December 31, 1993, has been excluded from the ratio. DUQUESNE LIGHT COMPANY EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement Nos. 33-52782 and 33-63602 of Duquesne Light Company on Form S-3 of our report dated January 25, 1994, appearing in the Annual Report on Form 10-K of Duquesne Light Company for the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE Pittsburgh, Pennsylvania March 22, 1994 EXHIBIT 28.1 EXECUTIVE COMPENSATION OF CERTAIN DUQUESNE LIGHT COMPANY EXECUTIVE OFFICERS FOR 1993 AND SECURITY OWNERSHIP OF DUQUESNE LIGHT COMPANY DIRECTORS AND EXECUTIVE OFFICERS AS OF FEBRUARY 23, 1994 REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OF DIRECTORS ON EXECUTIVE COMPENSATION This Compensation Committee Report summarizes the 1993 components of executive officer compensation and, with respect to certain components of compensation, 1992 performance. All components of executive officer compensation for 1993 were approved by the Board of Directors based on the recommendations of the Compensation Committee, which is composed entirely of non-employee directors. COMPENSATION PHILOSOPHY The primary objective of the Compensation Committee is to ensure that Duquesne Light Company's (Duquesne) executive compensation programs and strategies are designed and administered to attract, retain and motivate the executive talent required to achieve Duquesne's overall mission of creating and enhancing value for its shareholders, customers and employees, as well as for the community in which it operates. The Compensation Committee's actions are governed by a long-standing philosophy of developing and administering executive compensation programs that encourage a high level of operational excellence and financial performance to maximize shareholder value and customer satisfaction. The Committee also strives to simultaneously foster community participation and support, quality leadership initiatives and innovative methodologies to effectively manage Duquesne's human resources and capital assets. Throughout the development and administration of Duquesne's strategic compensation plans, the Committee has adhered to a results-based approach by linking a significant percentage of total compensation to meeting performance objectives. The three variable components of executive compensation (adjustments to base salary, cash incentives and stock options) are based on performance. The Committee has purposely placed an emphasis on the "at risk" elements of compensation for Duquesne's executives. Duquesne's awards under these incentive programs are tied to corporate and individual performance. The accomplishment of goals and objectives is at the center of the Committee's decision to make awards under these incentive programs. The Committee exercises a degree of discretion in administering these incentive plans which the Committee believes encourages the executives to continually focus on building long-term shareholder value. An independent outside consultant with significant industry expertise has determined that a greater percentage of Duquesne's executive officers' total compensation is variable and placed at risk, when benchmarked against a comparative industry panel of electric utility companies of similar operating revenue size. COMPENSATION PLAN COMPONENTS The three components of Duquesne's executive compensation program are base salary, annual cash and stock-option incentives and long-term incentive-based stock options. All stock options are granted under the Long-Term Incentive Plan and are performance based. Annually, toward mid-year, the Committee reviews and determines base salary levels, annual incentive compensation, and long-term incentive performance-based stock option vesting, with vesting decisions intended to encourage long-term results that increase shareholder value. Executive officers may or may not earn, on the basis of performance, cash in the form of adjustments to base salary and annual cash incentives of from 0% - 40% of base salary. Executive officers also have the opportunity to earn annual incentive stock options under the Long-Term Incentive Plan as described under the caption "Annual Incentives." Finally, they have the opportunity to also earn Long-Term Incentive Plan performance- based stock options under a three-year grant made in 1991, with a 0% - 30% vesting opportunity in the first year, a 0% - 60% vesting opportunity in the second year and a 0% - 100% vesting opportunity in the third year. Following shareholder approval of amendments to the Long-Term Incentive Plan to provide for stock-for-stock (reload) options, the Committee took action in April 1993 to grant reload options to the executive officers. The reload options granted by the Committee attached to all outstanding options granted to the executive officers after 1987. The Committee believes that the grant of reload options is consistent with Duquesne's overall compensation policy of more closely aligning the interests of its executive officers with those of the shareholders since reload options encourage officers to convert their options to shares earlier. As a result of the operation of reload options, an officer, who exercises underlying options to which the reload options are attached, has the opportunity to convert the reload options to shares without forfeiting the underlying options' potential for future appreciation. BASE SALARY. The base salaries of executive officers are competitively benchmarked against a comparative industry panel of electric utility companies of similar operating revenue size in major metropolitan areas possessing, in most cases, both fossil and nuclear power management and operating responsibilities. The Committee's goal is to target base salaries at the average of the comparative industry panel. In addition to the industry panel comparison, the Committee considered 1992 results in the areas of customer service levels, cost-effective management and operational performance including, for example, generating plant performance and system reliability, in determining whether a base salary increase would be granted to the executive officers in 1993. The named executive officers, other than Mr. von Schack, received increases in base salary in 1993. ANNUAL INCENTIVES. The executive officers have the opportunity to earn annual cash and stock option incentive awards by meeting short-term operating and financial goals. Individual objectives are established for each executive officer in consultation with the CEO and approved by the Compensation Committee. The Committee reviews the specific results for each executive officer and the corporate performance with the Board of Directors toward mid-year of the following year. The Board of Directors, upon the recommendation of the Compensation Committee, approves the amount of annual incentive awards granted to each executive officer based on the achievement of corporate and individual objectives. Annual incentive awards are granted only if a pre-determined corporate financial performance threshold is met. The threshold recommended by the Compensation Committee and approved by the Board of Directors for 1992 was that DQE's earnings per share must equal or exceed a specified percentage of the 1991 common stock dividend. This goal was met in 1992. Each executive officer must also meet his or her individual objectives. Specific objectives established in 1992 and considered by the Committee toward mid-year 1993 in determining the annual incentive compensation awards earned by the executive officers for 1992 supported one or more of five corporate objectives, including maximizing long-term shareholder value, providing quality service and superior customer satisfaction, cost-effective management of assets, maintaining excellent operational performance and providing leadership in the community. Assessment of operational performance was based upon such measures as generating plant availability and system reliability, for example. The weighting for each specific objective varies but, in the aggregate, does not exceed 40% of base salary for Mr. von Schack and 30% of base salary for all other executive officers. Annual cash incentive awards for executives range from 0-40% of base salary depending upon the degree to which performance objectives are met. See the Summary Compensation Table for the annual cash compensation awards earned by Mr. von Schack and the other executive officers for 1992. The number of incentive stock options awarded annually under the Long-Term Incentive Plan to executive officers is determined by multiplying their cash incentives by a performance multiplier of 2 to 10 and then dividing the product by the price per share of DQE Common Stock. The size of the multiplier is based on the amount of increase in earnings per share. The Committee awarded annual incentive options in the amount of 42,685 to Mr. von Schack, 13,276 to Mr. Marshall, 14,276 to Mr. Schwass, 10,355 to Mr. Sieber and 11,396 to Ms. Green. Additional options were not earned because not all of the established performance objectives were achieved (see footnote (4) to the Summary Compensation Table). An executive must wait one year before being able to exercise the first 33% of the stock-option award. An additional 33% is exercisable after two years and the final increment after three years. LONG-TERM INCENTIVES. Long-Term Incentive Plan performance-based stock options were granted to executive officers under the provisions of a 1991 three- year plan, currently ending in mid-1994, recommended by the Compensation Committee and approved by the Board of Directors. Three-year strategies were developed by each executive officer and annual milestones designed to enhance the general well-being of Duquesne were established for each executive officer by the CEO and approved by the Compensation Committee. Through a performance-based vesting schedule, each executive officer has the opportunity to earn a percentage of the three-year grant annually. Mr. von Schack has the opportunity to earn up to 40,000 options and the other named officers as a group could earn up to 39,000. The Compensation Committee reviews the performance results and determines the amount of the award with the approval of the Board of Directors. No more than 30% of the options can vest in the first year and no more than 60% can vest in the first two years. The long-term strategies are designed to support the long-term corporate objectives of maximizing shareholder value, providing quality service and superior customer satisfaction, cost-effective assets management, maintaining excellent operational performance and providing leadership in the community. With respect to the 1993 vesting for the Long-Term Incentive Plan based on achievement of their long-term strategies, Messrs. von Schack, Marshall, Schwass, Sieber and Ms. Green received 30% vesting. The grant relative to these vested stock options was disclosed in the applicable stock option grant table included in the DQE Proxy Statement for the 1993 Annual Meeting. Final vesting results will be determined in mid-1994. CEO PERFORMANCE AND COMPENSATION RATIONALE As with all executive officers, the Committee reviews the CEO's prior year's performance when evaluating whether or not a prospective performance increase is recommended with respect to his base salary and whether awards are made under the annual cash and stock-option incentive programs and for the long-term incentive performance-based stock option vesting. The CEO's performance is evaluated on the basis of the overall performance of Duquesne, the performance of the other members of his management team and, as discussed in more detail below, his leadership in developing and implementing operating and strategic plans to further Duquesne's long-term corporate objectives. Within the parameters of the specific compensation programs previously discussed, the Committee has the flexibility to exercise a degree of discretion in evaluating the CEO's total performance. The Committee believes that emphasis should be placed on the variable compensation portion (i.e., incentive cash and stock options) of the CEO's total compensation (see previous discussion on pages 1 through 3). Both the Committee and the Board believe that this strengthens the relationship between corporate performance and ultimate total compensation for the CEO, thus maximizing shareholder value. The Committee, in focusing on the at-risk compensation aspect of Mr. von Schack's total compensation, made no adjustment to his base salary in 1992 or 1993. His current base salary level is below the average of the comparative industry panel referred to on page 2. Under the leadership of Mr. von Schack, the management team continued to achieve good results during 1993 with respect to Duquesne's long-term corporate objectives. In 1993 DQE and Duquesne continued to demonstrate a solid track record of financial and operational performance. Earnings per share increased five cents, despite a one-time charge of sixteen cents as a result of the termination of the GPU transmission line project. DQE's common stock has had a total return which consistently exceeded both the Standard & Poor's 500 and S&P Electric Companies returns over the same period. A full report on DQE's financial performance can be found in the 1993 Annual Report to Stockholders. These results are consistent with DQE's shareholder objective to "achieve measurable and meaningful increases in the value of our shareholders' investment." In fulfillment of Duquesne's customer service objective to "deliver quality service and provide superior customer satisfaction..." customers having interaction with Duquesne Light during 1993 rated their service experience significantly higher than the national average for electric utilities, according to an independent monthly survey. In fact, Duquesne Light customers experience the highest level of service availability of all electric utilities in the state according to a study conducted by a national consulting firm. That study demonstrated that Duquesne Light's service availability consistently rates in the top 25% of the utilities nationwide. These studies confirm the results of Duquesne's internal benchmarked performance measures which showed that in 1993 the levels of service reliability exceeded the corporate goals. Also, despite record snowfalls in March 1993 and January 1994, Duquesne Light customers experienced extremely high levels of reliable service. For the second year in a row, Duquesne received Pennsylvania's "Governor's Energy Award" for its enhanced low-income customer program focusing on reducing base-load usage and related electric costs. This program subsequently became Pennsylvania's entry in the U.S. Department of Energy's national awards contest for 1994. These results, as well as our continuing environmental accomplishments which are discussed below, also meet our operations objective "to be recognized for excellence in operating performance and environmental protection." As a result of policies consistently directed by Mr. von Schack over the years, Duquesne continues to be widely recognized as an environmental leader. Examples of environmental accomplishments in 1993 include developing an environmental strategic plan and an environmental charter, installing innovative low NOx burners, creating and participating in various environmental stewardship programs, including those related to education, recycling and land management, and developing a comprehensive environmental training program for all Duquesne employees. Other recent examples include having the first generating plant in the nation to reduce emissions by using natural gas to co-fire a coal-fueled boiler, establishing a wildlife habitat, being the first investor-owned utility to purchase emission allowance credits under the Clean Air Act amendments and being acknowledged for its "foresight and leadership" by the Environmental Protection Agency for participation in a program to reduce sulfur dioxide emissions. Duquesne received special commendations from American Forests, the nation's oldest non-profit forestry organization, and from Allegheny County and the Pennsylvania legislature for various environmental stewardship programs. Duquesne remains fully committed to being an environmentally clean utility and an innovative and forward thinking environmental leader into the future. Throughout 1993, Duquesne maintained compliance with all environmental regulations. Mr. von Schack also has taken a strong leadership role in community affairs, including active participation on boards and committees of various organizations which focus resources on the most pressing community problems and which serve to improve the quality of life for people who live and work in Duquesne's service territory. These activities and those in the environmental area relate directly to DQE's community objective to "be a community leader in improving the quality of life in our service territory." The objective recognizes that "our future success is clearly linked to the economic health and vitality of the region we serve." We, the members of the Compensation Committee of the Board of Directors, are confident that our existing compensation philosophy has been effective in attracting and retaining the management talent necessary to ensure a desirable and consistent performance for shareholders and customers alike. G. Christian Lantzsch, Chairman Doreen E. Boyce Robert P. Bozzone Sigo Falk COMPENSATION The following Summary Compensation Table sets forth certain information as to cash and noncash compensation earned and either paid to or accrued for the benefit of the Chairman of the Board, President and Chief Executive Officer and the four highest paid executive officers of Duquesne Light for services during the periods indicated. Messrs. von Schack, Schwass and Marshall are executive officers of DQE and Duquesne Light. The titles listed are those held for Duquesne Light, but the amounts shown are for services in all capacities to DQE and certain affiliates, including Duquesne Light. Mr. Sieber and Ms. Green are executive officers of Duquesne Light only, and the amounts shown are for services in those capacities. SUMMARY COMPENSATION TABLE (1) The amount of compensation set forth in columns (c) and (g) was paid or awarded in the year indicated based on the prior year's performance. Compensation determinations are made toward mid-year of the year shown. (2) No incentive compensation is shown for 1993 as the annual review of corporate and individual performance for 1993, which will determine such compensation, has not occurred. The amount of any such compensation is determined toward mid-year of each year based upon the prior year's performance and either paid or deferred (via an eligible participant's prior election) in the following year. The amounts shown for 1991 and 1992 are the awards earned in those years but established and paid or deferred in the subsequent years. (3) In accordance with the transitional provisions applicable to the revised rules on compensation disclosure adopted by the SEC, amounts of Other Annual Compensation and All Other Compensation are excluded for 1991. Amounts of Other Annual Compensation are connected to the funding of past service obligations for non-qualified pension benefits earned prior to 1993. Duquesne Light decided it was desirable, due to tax law changes and to ERISA requirements, to complete the funding of past service obligations in 1993. Amounts of All Other Compensation shown are Duquesne Light match contributions during 1992 and 1993 under the Duquesne Light Company 401(k) Retirement Savings Plan for Management Employees. (4) Includes total number of stock options awarded during the fiscal year, with or without tandem SARs, as applicable, and stock for stock (reload) options on option exercises, whether vested or not. See table titled Option/SAR Grants in Last Fiscal Year. The stock options are subject to vesting (exercisability) based on Duquesne Light and individual performance and achievement of specified goals and objectives. Of the original amount of 1991 stock options granted, Messrs. von Schack, Marshall, Sieber and Ms. Green have lost 10,965; 1,554; 6,549 and 2,141 stock options, respectively. Of the original amount of 1992 stock options granted, Messrs. von Schack, Schwass, Marshall, Sieber and Ms. Green have lost 12,435; 3,569; 4,698; 6,528 and 4,432 stock options, respectively. SUPPLEMENTAL TABLES The following tables provide information with respect to options to purchase DQE Common Stock and tandem stock appreciation rights in 1993 under the Plan. Option grants in 1993 to executives were structured to align their compensation with the creation of value for common stockholders. For example, should DQE stock rise 50% in value over the ten year option term (from $34.5625 per share to $51.84 per share), shareholder value would increase an estimated $932,929,435, while the value of the grants to the individuals listed below would increase an estimated .22% ($2,059,570) of the total gain realized by all shareholders. OPTION/SAR GRANTS IN LAST FISCAL YEAR Individual Grants * The actual value, if any, an executive may realize will depend on the difference between the actual stock price and the exercise price on the date the option is exercised. There is no assurance that the value ultimately realized by an executive, if any, will be at or near the value estimated. (1) The stock options with tandem stock appreciation rights granted during 1993 are not presently exercisable. The Compensation Committee will determine the number of stock option/stock appreciation rights that will vest in 1994 based on 1993 performance. Once the number is determined, the executive must wait one year before being able to exercise 1/3 of the award. An additional 1/3 is exercisable after two years and the final increment is exercisable after three years. Vesting will be accelerated on the occurrence of a change in control as provided in the Plan. These grants included tandem stock appreciation rights. These grants did not include dividend equivalent accounts. (2) These represent stock for stock (reload) options received upon exercise of stock options by the applicable officer electing to use previously-owned DQE stock to exercise the options under the terms of the Plan. These reload options included dividend equivalent accounts. (3) Such exercise price, which was the fair market value on the date of grant, may be payable in cash or previously owned shares of DQE Common Stock. The price of the options or stock for stock (reload) options is the fair market value of DQE Common Stock on the date such options were granted. (4) The grant date present value shown in column (f) gives the theoretical value of the options listed in column (b) on the grant dates using the Black-Scholes option pricing model, modified to account for the payment of dividends. The theoretical value of the options expiring on 4/22/2003 ($34.5625 strike) and 7/31/98 ($34.6250, $33.6875, and $34.1875 strikes) were calculated assuming an option life of 10, 5.2, 4.6, and 4.6 years respectively; a periodic risk-free rate of return equal to the yield of the U.S. Treasury note having a similar maturity date as the option expiration date, as reported on the grant date (5.85%, 5.07%, 4.97%, and 4.95% respectively); a quarterly dividend of $0.40 with an expected growth rate of 4.5% per year; and an expected stock price volatility over the same length of time as the option life, as reported on the grant date (19.10%, 12.98%, 13.04% and 13.04% per month, respectively). No adjustments to the grant date present values have been made with respect to exercise restrictions, cancellation, or early exercise. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES (1) Stock option exercised for stock by tendering shares of previously-owned DQE Common Stock. (2) Stock appreciation rights exercised for cash. (3) Stock appreciation rights exercised for stock. (4) Represents the difference between the exercise price of the options or SARs and the fair market value of DQE Common Stock on the date of exercise. (5) Represents the difference between the exercise price of the options and the fair market value of DQE Common Stock at 12/31/93. (6) The values set forth do not include options/SARs previously granted (including those granted in 1993) but not yet earned. The number to be earned will be based on individual performance and could range from zero to the numbers (values) listed below for the five named executives, respectively: 90,922 ($327,500); 28,058 ($98,250); 31,558 ($106,906); 24,817($81,875); and 21,931 ($65,500). These values may be earned by the executive over future periods from one to three years as established with each option grant. RETIREMENT PLAN The following table illustrates the estimated annual benefits payable upon retirement at age 65 to management employees in the specified earnings classifications and years of service shown: Compensation utilized for pension formula purposes includes salary and bonus reported in columns (c) and (d) of the Summary Compensation Table. An employee who has at least five years of service has a vested interest in the retirement plan. Benefits are received by an employee upon retirement, which may be as early as age 55. Benefits are reduced by reason of retirement prior to age 60 or by reason of the operation of certain options under which benefits are payable to survivors upon the death of the employee. Retirement benefits are not subject to any offset or other reduction based on the amount of any other benefits, including Social Security. A Pension Service Supplement Program covering selected senior executives was established to provide one additional service year for each full year of active service, subject to certain vesting requirements, and to recognize compensation in excess of any applicable ceiling on compensation earned by the executive. The executive officers named in the Summary Compensation Table had the following years of credited service and five-year average compensation with Duquesne Light (including additional service credits and compensation recognized under the Pension Service Supplement Program) as of January 1, 1994: Mr. von Schack -- 26 years, current five-year average compensation $524,986; Mr. Schwass -- 16 years, current five-year average compensation $195,049; Mr. Marshall -- 17 years, current five-year average compensation $187,259; Mr. Sieber -- 32 years, current five-year average compensation $173,950; Ms. Green -- 12 years, current five- year average compensation $167,305. EMPLOYMENT AGREEMENT In 1992, Mr. von Schack entered into a four-year employment agreement with DQE and Duquesne Light, subject to automatic one-year renewals unless prior written notice of termination is given by Mr. von Schack or DQE. The agreement provides, among other things, for Mr. von Schack to serve as a director and Chairman of the Board, President and Chief Executive Officer of DQE and Duquesne Light, at an annual base salary of at least $440,000 subject to periodic review, and for his participation in executive compensation and other employee benefit plans of DQE and Duquesne Light. If Mr. von Schack is discharged other than for cause or resigns for good reason, then, in addition to any amounts earned but not paid as of the date of termination, he would receive in a cash lump sum the balance of his base salary for the remaining term of the agreement, a bonus amount in respect of the remaining term of the agreement calculated at a rate equivalent to his prior year's bonus and the actuarial equivalent of the additional pension he would have accrued had his service for pension purposes continued until the expiration of the agreement. In addition, Mr. von Schack would be entitled to immediate vesting (or the redemption in cash) of all of his stock-based awards from DQE or Duquesne Light. The agreement also provides for continued payment of base salary and bonus amounts for the remaining term of the agreement if Mr. von Schack's employment is terminated due to death or disability. In the event that any payments, whether under the employment agreement or otherwise, would subject Mr. von Schack to federal excise tax or interest or penalties with respect to such excise tax, he will be entitled to be made whole for the payment of any such taxes, interest or penalties. BENEFICIAL OWNERSHIP OF STOCK The following list shows all equity securities of DQE (Common Stock only) and its principal subsidiary, Duquesne Light (Preferred and Preference Stock only), beneficially owned by all directors and executive officers of Duquesne Light as a group (21 persons) as of February 23, 1994, including shares owned by officers and directors jointly with other persons: The directors and executive officers as a group did not own beneficially in excess of 1% of any class of equity securities of DQE or Duquesne Light as of February 23, 1994. The amounts shown do not include 240,963 shares of DQE Common Stock which all executive officers of Duquesne Light as a group have the right to acquire within 60 days of February 23, 1994 through the exercise of stock options granted under the Long-Term Incentive Plan. The following list shows all equity securities of DQE and Duquesne Light beneficially owned, directly or indirectly, by each director and by each executive officer named in the Summary Compensation Table as of February 23, 1994: (1) The term "Joint" means owned jointly with the person's spouse. The initials "VP" and "IP" mean sole voting power and sole investment power, respectively, and the initials "SVP" and "SIP" mean shared voting power and shared investment power, respectively. (2) The amount shown as owned by Mr. Arthur does not include 17,400 shares of Common Stock which he has the right to acquire within 60 days of February 23, 1994 through the exercise of stock options granted under the Plan. Mr. Arthur also owns 50 shares of Preferred Stock of Duquesne Light. (3) These shares are held by a trust in which Mr. Falk is an income beneficiary but not a trustee. (4) These shares are held by a trust in which Mr. Knoell is a trustee and the income beneficiary. (5) These shares are held by a Keogh trust in which Dr. Mehrabian is the sole trustee; he and his spouse are the beneficiaries. (6) The amounts shown as owned by Messrs. von Schack, Schwass, Marshall, Sieber and Ms. Green do not include shares of Common Stock which they have the right to acquire within 60 days of February 23, 1994 through the exercise of stock options granted under the Plan in the following amounts: 87,376; 24,675; 27,980; 44,489; and 35,537, respectively. These officers also own 259; 259; 259; 243; and 259 shares, respectively, of Preference Stock of Duquesne Light. EXHIBIT 28.2 Energy for Change [LOGO OF DQE APPEARS HERE] 1 9 9 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 [PHOTO APPEARS HERE] DQE FINANCIAL AND OPERATING HIGHLIGHTS MW - a megawatt is a measure of electric use at a point in time. KWH - a kilowatt hour is a kilowatt of electric usage over a period of hours. (A) - Excludes working capital and other - net changes. DQE EARNINGS PER SHARE [GRAPH APPEARS HERE] DQE ANNUALIZED DIVIDENDS PER SHARE [GRAPH APPEARS HERE] 1993 RESULTS . Earnings per share were $2.72, an increase of 1.9% over 1992 and our seventh consecutive yearly increase. . Sales to Duquesne's customers were up 2.4% in 1993. The company had a system peak demand of ?2499 megawatts, our second highest ever. . Residential sales grew 5.3% and commercial sales grew 2.5%, while industrial sales remained at 1992 levels. DQE is an energy services holding company nationally and regionally recognized for excellence, quality, integrity and value. Duquesne Light Company, whose origin dates to 1880, is the principal subsidiary of DQE. Duquesne Light is engaged in the production, transmission, distribution and sale of electric energy. Its service territory is approximately 800 square miles in southwestern Pennsylvania, with a population of 1.5 million. In addition to serving almost 580,000 customers in Allegheny and Beaver counties, the company sells electricity to other utilities. DQE's other subsidiaries include Duquesne Enterprises and Montauk. Duquesne Enterprises owns Allegheny Development Corporation and Property Ventures, Ltd., and has substantial equity interests in Chester Environmental, Inc. and International Power Machines. These companies are involved in initiatives related to the core business, including energy services, environmental services, power quality equipment, and real estate investment. Montauk makes both short and long term investments for the enterprise,and provides a source of capital for these other subsidiaries. COMMON STOCK TRENDS To Our Shareholders Wesley W. von Schack at the scenic Montour hiking and biking trail, one of the company's many environmental partnerships (see page 8). [PHOTO APPEARS HERE] Throughout 1993, our DQE team kept its focus on three basic objectives: delivering a fair return to our shareholders; providing top quality service to our customers; and preparing for emerging changes in the electric utility industry. Our results continue to be good on all three fronts. Net income for 1993 increased $2.5 million over that for 1992, and earnings per share rose from $2.67 in 1992 to $2.72. Since year end 1988, DQE's earnings per share have increased 46 percent. In November, the annual dividend was increased by 5 percent, to $1.68. DQE possesses an abundance of energy resources that hold long term promise and opportunity as the market for power grows. A recent industry forecast projects annual growth of 2 percent in electric demand through 2010. To meet such demand, more than 210 gigawatts of additional generation will be required. Less than 20 percent of this additional capacity currently is under construction. DQE has a total of 3,374 megawatts of environmentally clean generating capacity, of which only 2,834 megawatts currently are in service. This generation provides what we believe is an important long term competitive advantage and a benefit to our customers. For example, during the deep freeze of January 1994 when rolling blackouts disrupted the lives and businesses of millions of people in eastern and central Pennsylvania, New Jersey, Maryland, Delaware, Virginia and the District of Columbia, Duquesne Light fortunately did not have to institute voltage reductions or rolling blackouts. It was, therefore, ironic that our planned sale, to be initiated in January 1994, of 500 megawatts to General Public Utilities (GPU) did not take place. In December 1993, GPU abruptly cancelled its three-year-old agreement to purchase bulk power from Duquesne Light and to construct a jointly owned high voltage transmission line. Termination of the project resulted in a charge to DQE earnings of $15 million (16 cents per share). As reported to you in last year's annual report, we expect much change in our industry because of the National Energy Policy Act of 1992. This legislation gives federal regulators broad power to mandate the transfer of wholesale bulk power over the nation's high voltage transmission systems. The net result will be increased competition in the electric utility industry. Electric companies now have one foot in competition and one foot in regulation. Dealing with this dichotomy requires flexible and capable management. Our management team has demonstrated the ability to focus on building a market and customer driven company while at the same time remaining responsive to the requirements and obligations of state regulation. During the last eight years, you have been kept apprised of the excellent progress we've been able to make in positioning our company for the changes ahead. One strategy continuously evident in all aspects of our business is to be prepared for the market based realities that "OUR FUNDAMENTAL STRATEGY IS TO BE RECOGNIZED FOR EXCELLENCE IN OUR OPERATIONS AND TO PROVIDE A HIGH LEVEL OF CUSTOMER SATISFACTION." the industry is experiencing. We are focused on constantly improving performance to lower the cost of production, and our least cost planning and innovative pricing policies reflect our commitment to deliver a competitive product to our customers. In fact, through our continued efforts, we are positioned to reduce average retail rates by approximately 8 percent, as of April 1994. Also, the marginal cost for us to produce a kilowatt-hour of electricity is competitive. This low cost of production enabled us to sell more than 19 percent of our output to other electric utilities in the bulk power market in 1993. Our fundamental strategy is to be recognized for excellence in our operations and to provide a high level of customer satisfaction. Independent surveys and our own internal measurements indicate that customers are highly satisfied with the way we treat them and the quality of service. Our system reliability is among the top 25 percent in the nation. Duquesne Light customers experience fewer minutes of power interruptions each year than the customers of any other utility in Pennsylvania. Our customers are getting good value. This commitment to customers was put to the test in 1993 when the "Blizzard of the Century" blanketed the eastern United States. A state-of-the- art automated distribution system pinpointed weather related damage to electrical equipment and allowed our operators to switch service circuits by computer so that customers affected by the blizzard were restored to service in quick order. Environmental leadership remains a strong component of our overall strategy, and we are proud of maintaining the highest standards in this area of public interest. All of our wholly owned fossil fuel units currently emit sulfur dioxide (SO2) at a lower rate than federal standards for the year 2000. In 1993, we completed installation of low nitrogen oxide (NOX) burners at our Cheswick station. We will need to invest only $35 million more to meet Phase I and Phase II SO2 and NOX Clean Air Act of 1990 requirements. Environmental leadership represents good value for shareholders. Utility companies that have not invested in the environmental quality of their operations over the years will see production costs increase as they catch up with our nation's new environmental standards. For reasons that are both natural and man-made, the electric utility business will continue to be challenging. Our people are up to meeting these challenges. We are grateful for their leadership and contributions, and to you, our shareholders, for your continued confidence in DQE. On behalf of the Board of Directors, /s/ Wesley W. von Schack Wesley W. von Schack Chairman of the Board and Chief Executive Officer February 15, 1994 Energy for Change With passage of the National Energy Policy Act(NEPA)in 1992, we have no doubt that change--and increasing competition--will be constants in our industry. We know that to compete successfully in the new energy marketplace, we must concentrate on providing high levels of customer satisfaction, improving our performance, and reducing costs. Our longstanding corporate objectives, highlighted on the following pages, focus our people's energies on five key areas: shareholders, customers, employees, operations, and community. As we work to meet these all-important objectives, we continue to demonstrate that we have "energy for change." Objective: Manage company resources to maximize return on Investment. CUSTOMER SATISFACTION Our goal is to deliver customer value through a combination of top quality service and helping our customers increase their efficiency and reduce their overall operating costs. Independent statistics show that Duquesne Light customers annually experience fewer minutes of power interruptions than the customers of any other utility in Pennsylvania. Thanks to advanced technology and good old-fashioned commitment to quality service, we were able to limit the effect on customers of extreme weather conditions in 1993 and early 1994, including two major winter blizzards; extended periods of hot, humid summer weather; and record-low winter temperatures. When storms damage electric lines or equipment, our automated distribution system senses the trouble, identifies the problem area, and allows us to use remote control to reroute electricity almost instantly to all customers on the circuit except those in the immediate vicinity. And for those customers, some very determined troubleshooters are on the scene quickly to restore service--usually within an hour. We strive to provide all of our customers with a high degree of service. Reliability tops the list. We also want to ensure that any interaction, from meter reading to billing to repair of storm-damaged electric circuits, is fast, reliable and accurate. Monthly opinion surveys give our people high ratings for the way they handle customer concerns. That approval rating is significantly better than the national average, according to a national firm specializing in customer satisfaction measurements. [PHOTO APPEARS HERE] Duquesne Light's electric service is the most reliable in Pennsylvania. That is especially important when you consider the integral role of electricity in improving personal lifestyles and business efficiency. Objective: Deliver quality service and provide superior customer satisfaction in a way that differentiates us within the energy services marketplace. We're increasing the satisfaction of mid- and large-sized commercial and industrial customers by introducing them to electrotechnologies that can improve the efficiency of their businesses while reducing their impact on the environment. For example, in 1993 we worked closely with hospitals and individual dental and medical practices to introduce electrotechnologies that safely sterilize infectious medical waste. The U.S. Environmental Protection Agency estimates that American hospitals each year generate more than 375,000 tons of soiled bandages and other materials that can cause disease. Through use of these electrotechnologies, such material can be disinfected on-site. It then can be buried in standard landfills, eliminating higher-priced special handling. The KNOWING OUR CUSTOMERS Duquesne Light's service territory is relatively compact--approximately 800 square miles. Yet the company's almost 580,000 customers hold a wide range of attitudes and preferences concerning their use of electricity and their relationship with the provider of that important service. By monitoring and analyzing that information, we are finding new and better ways to serve our customers. We've studied various customer surveys and reviewed a wide range of typical interactions with customers, as well as usage patterns and payment histories. Analysis of this research has enabled us to break down the company's service territory into six specific demographic regions--each with its own particular characteristics. This enables us to target programs and services to customers who can best benefit from them. We recently initiated a whole-house surge protection program for customers who want added protection from lightning and voltage surges for their computers, VCRs, stereos and other sensitive electric equipment. Our analysis helps pinpoint areas where this customer service will be most valuable. We use information from the analysis in a number of ways, from scheduling tree trimming most effectively to placement of cooperative heat pump advertising with local heating contractors. Another key target audience is the more than 50,000 customers who move into new residences each year. Within three days of their arrival, one of our representatives delivers a welcome package that includes information about our services and coupons to local attractions and other money-saving offers. We also survey these new customers to learn how we can better serve them. For example, we know that many will be making decisions about adding or upgrading cooling and heating equipment. Response to the welcome program has been very favorable. This good first impression provides a solid customer satisfaction foundation to build on. All of our customer satisfaction activities recognize that as competition increases, the importance of each interaction with each of our customers increases. Objective: Be a reliable, low-cost producer of electric energy and be recognized for excellence in our operat- ing performance. process not only reduces disposal costs, but also eliminates any potential future liability for untreated infectious waste. Application of another innovative electrotechnology will help a local university reduce its air-conditioning costs as well as help level the overall customer peak demand on our system during periods of high temperatures and humidity. Thermal storage technology will be showcased at Carnegie Mellon University's new research facility, currently under construction at a Pittsburgh-area advanced technology business park located on the site of a former steel mill. Ice-making to supply air-conditioning will occur during off-peak hours. The ice then will be stored for use as needed. This will enable us to achieve more efficient use of our generating capacity. It's another example of the "win-win" solutions we are developing with our customers. PERFORMANCE IMPROVEMENT Previous annual reports have detailed our strong focus on cost control and performance improvement. Thanks to the initiative and commitment of our people, we continue to find ways to take costs out of our core business without sacrificing customer satisfaction, quality performance, safety, or our environmental commitment. By taking a fresh look at all facets of the way we do business, we are discovering additional measures to improve efficiency, including re-engineering work processes, taking advantage of new technologies, and eliminating less important activities. Clearly defined performance and budget goals are at the heart of efforts to improve operations performance. We've also benefitted from changes relating to crew size, scheduling and increased work force flexibility. New analytical technology is helping reduce utility pole replacement costs. "Just-in-time" tree-trimming around power lines is improving productivity and system reliability. A new, state-of-the-art customer information and billing system increases our ability to store a wide range of information that helps us provide a quick, comprehensive response when customers call. Benchmarking is a valuable source of information to improve operations performance, implement process improvements, and reduce costs. We benchmark against the best companies in the industry and leaders outside the industry. In addition to measuring performance, benchmarking provides opportunities to adapt to our operations best practices observed at other companies. We want to be recognized as a low-cost producer of electric energy and known for excellence in operating performance. Clean, abundant, reasonably priced electricity will be a key competitive advantage as the market responds to NEPA. DQE already is a major supplier of reliable energy to markets outside southwestern Pennsylvania. Sales to other utilities totaled 2.8 billion kilowatt-hours in 1993. RECYCLABLE REPORT The annual report you are reading now is an example of both our environmental and our cost-reduction commitments. Printed on recycled paper, it also is completely recyclable and was produced at a cost approximately 30 percent less than last year's report, and approximately 40 percent less than the 1991 report. Our people recognize that their actions on and off the job affect the world around them. We're proud of our environmental performance--from maintaining clean power plants, to educating youth, to improving the habitat for wildlife. Objective: Recognize the value of the individual, encourage increased responsibility and accountability, and provide equal opportunity for personal growth and development. more than 19 percent of our total sales. That underscores the importance of the wholesale market and our ability to provide it with competitively priced power. ENVIRONMENTAL STEWARDSHIP Through the years, we have earned a reputation as an environmental leader within our industry. Opinion surveys show that environmental quality is a paramount concern to utility customers. Our commitment also provides a competitive advantage as other utilities begin to make investments necessary to comply with new environmental regulations. We pioneered use of wet scrubber systems to help control power plant emissions. Our Pennsylvania coal-fired generating units are among the cleanest in the United States. We pioneered industrial use of fly ash in highway construction. Our Beaver Valley Power Station is an industry leader in minimizing the volume of low-level radioactive waste. In 1993, we formalized our long-standing commitment by developing an environmental strategic plan, adopting a corporate environmental charter, and establishing an environmental stewardship program. In a move we believe is unique to our industry, we have initiated an environmental training program for all Duquesne Light employees--not just those involved in power production and distribution. We want all of our people to be environmentally conscious, competent and responsible, both on and off the job. Our approach to environmental protection goes beyond simply complying with environmental laws and regulations. We take pride in carrying our commitment into the communities we serve. Education is a cornerstone of our stewardship activities. A wide variety of programs is helping area youths increase their environmental awareness. For example, a cooperative program with the Western Pennsylvania Conservancy, a regional conservation group, helps elementary through high school students increase their understanding of the environment and their roles in it. Another very successful program enables grade school students to learn about and plant trees descended from those with historic importance. We received a special commendation from American Forests, the nation's oldest non-profit forestry organization, for the results of this program. In a cooperative program with Allegheny County, our people helped collect approximately 170 tons of old appliances and a wide range of scrap metal--from hot water tanks and auto parts to metal sinks and paint cans. The material will be recycled for use as feedstock for new steel and metal products. We received commendations from the county and the Pennsylvania Legislature for our participation. On the job, our people recycled more than 70 tons of paper in 1993, along with scrap metal from various company operations, oil from transformers, and Objective: Be a community leader in improving the quality of life in our service territory by being recognized as a premier economic development organization and by enhancing the overall value of the human and natural resources of the region. wooden pallets. We also increased the use of environmentally compatible paints, non-hazardous solvents and parts cleaners, and are working with vendors to accept return of boxes, pallets and other packaging/shipping materials. Our Brunot Island Wildlife Habitat enhancement project continues to demonstrate the ability of our power facilities to coexist with nature. Our participation in a "rails-to-trails" project along a transmission line right-of-way provides another example of this facet of our environmental commitment. We recently energized a new 7.3 mile power line near the new Pittsburgh International Airport. The line runs along an old railroad right-of-way that was developed as a segment of a hiking and biking trail. We worked closely with the Montour Trail Council to ensure our line blended in with the picturesque setting. The right-of-way was constructed using selective tree trimming and state-of-the-art erosion and sedimentation control. The 110 poles that carry the line along the right-of-way are made of a steel that will oxidize to an earthy brown over time. Through this cooperative effort, local residents can enjoy a new recreational facility and better electric service at the same time. We expect the community partnership aspect of our environmental charter to gain additional momentum with the inaugural Three Rivers Environmental Awards in 1994. The goal of the awards, cosponsored by Duquesne Light and the Pennsylvania Environmental Council, is to honor organizations and individuals that have demonstrated a commitment to environmental excellence, leadership and accomplishment in business, education, community, government, communication, or design and development. We hope to encourage the community to emulate the achievements of the successful nominees, thereby promoting innovative environmental efforts and further enhancing the quality of life. Another community outreach initiative planned for 1994 will help small and mid-sized businesses learn more about environmental regulations related to their businesses. With the Southwestern Pennsylvania Industrial Resource Center, we are cosponsoring the first of a series of seminars this spring that will link these important customers with regulatory and legal experts who can help them develop cost-effective strategies to meet their environmental obligations. - -------------------------------------------------------------------------------- CHESTER ENVIRONMENTAL ACQUISITION - -------------------------------------------------------------------------------- In 1993, our Duquesne Enterprises subsidiary acquired a controlling interest in Chester Environmental, Inc., an engineering and consulting company that specializes in environmental matters. We made this investment because Chester's experience and expertise relate closely to our core business. We believe the strong demand for environmental services will continue to grow in response to new regulations. Investment in Chester provides an opportunity to extend our environmental leadership. Chester provides water quality, residual solid waste and air quality consulting and analytical laboratory services to industrial and government clients around the world. Two major contracts were signed in 1993 with steel companies in Taiwan and India. GLOSSARY OF TERMS Following are explanations of certain financial and operating terms used in our report and unique in our core business. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFC) - -------------------------------------------------------------------------------- AFC is an amount recorded on the books of a utility during the period of construction of plant. The amount represents the estimated cost of both debt and equity used to finance the construction. CENTRAL AREA POWER COORDINATION GROUP (CAPCO) - -------------------------------------------------------------------------------- These companies (Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company, The Cleveland Electric Illuminating Company and The Toledo Edison Company) joined together as CAPCO in 1967 to jointly develop power generation and transmission facilities. CONSTRUCTION WORK IN PROGRESS (CWIP) - -------------------------------------------------------------------------------- This amount represents utility plant in the process of construction but not yet placed in service. The amount is shown on the consolidated balance sheet as a component of property, plant and equipment. DEFERRED ENERGY COSTS - -------------------------------------------------------------------------------- In conjunction with the Energy Cost Rate Adjustment Clause, Duquesne Light Company records deferred energy costs to offset differences between actual energy costs and the level of energy costs currently recovered from customers. ENERGY COST RATE ADJUSTMENT CLAUSE (ECR) - -------------------------------------------------------------------------------- Duquesne Light Company recovers through the ECR, to the extent that such amounts are not included in base rates, the cost of nuclear fuel, fossil fuel and purchased power costs and passes to its customers the profits from short-term power sales to other utilities. FEDERAL ENERGY REGULATORY COMMISSION (FERC) - -------------------------------------------------------------------------------- FERC is an independent five-member commission within the U.S. Department of Energy. Among its many responsibilities, FERC sets rates and charges for the wholesale transportation and sale of natural gas and electricity, and the licensing of hydroelectric power projects. KILOWATT (KW) - -------------------------------------------------------------------------------- A kilowatt is a unit of power or capacity. A kilowatt hour (KWH) is a unit of energy or kilowatts times the length of time the kilowatts are used. For example, a 100-watt bulb has a demand of .1 KW and, if burned continuously, will consume 1 KWH in ten hours. One thousand KWs is a megawatt (MW). One thousand KWHs is a megawatt hour (MWH). NUCLEAR DECOMMISSIONING COSTS - -------------------------------------------------------------------------------- Decommissioning costs are expenses to be incurred in connection with the entombment, decontamination, dismantlement, removal and disposal of the structures, systems and components of a nuclear power plant that has permanently ceased the production of electric energy. PEAK LOAD - -------------------------------------------------------------------------------- Peak load is the amount of electricity required during periods of highest demand. Peak periods fluctuate by season and generally occur in the morning hours in winter and in late afternoon during the summer. PENNSYLVANIA PUBLIC UTILITY COMMISSION (PUC) - -------------------------------------------------------------------------------- The Pennsylvania governmental body that regulates all utilities (electric, gas, telephone, water, etc.) is made up of five members (one a chairman) appointed by the governor. REGULATORY ASSET - -------------------------------------------------------------------------------- Costs that Duquesne Light Company would otherwise have charged to expense are capitalized or deferred because these costs are currently being recovered or because it is probable that the PUC will allow recovery of these costs through rates. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CORPORATE STRUCTURE DQE (the Company) is an energy services holding company. Its principal subsidiary, Duquesne Light Company (Duquesne), is an electric utility engaged in the production, transmission, distribution and sale of electric energy. During 1993, Duquesne's operations accounted for most of DQE's total assets, revenues and income. While electric utility activities will continue to comprise most of DQE's business, the Company has taken important steps to develop its other subsidiaries: Duquesne Enterprises (DE) and Montauk. DE is involved in initiatives related to the core business; these include providing all the energy services for the Pittsburgh International Airport, providing environmental consulting and engineering services, and investing in real estate. Montauk makes both short- and long-term investments for the Company, and provides a source of capital for these other subsidiaries. RESULTS OF OPERATIONS OPERATING REVENUES - -------------------------------------------------------------------------------- Customer operating revenues result from Duquesne's sales of electricity to ultimate customers and are based on rates authorized by the Pennsylvania Public Utility Commission (PUC). These rates are designed to recover Duquesne's operating expenses and investment in utility assets and to provide a return on the investment. Current and deferred customer revenues resulted from a $232 million rate increase granted in early 1988. The PUC required Duquesne to phase in this increase during a six-year period. The phase-in plan provided that, with no impact on total reported customer revenues, rates would increase by approximately $85 million in April of each year from 1988 through 1991, remain constant in 1992 and 1993, and decrease by approximately $85 million in April 1994. The phase-in plan also provided for recovery of deferred revenues and carrying costs on such deferred revenues. The rate increase has been recognized in operating revenues since March 1988. A regulatory asset has been established for that portion of revenues yet to be collected from customers, and carrying charges on this deferred asset have been recognized as a component of other income in the Statement of Consolidated Income of DQE. Duquesne expects the remaining balance of this deferred asset to be recovered by April 1994, the end of the phase-in period. Short-term sales to other utilities are made at market rates and are included, along with Duquesne's non-KWH revenues and revenues of DQE's other subsidiaries, in other operating revenues in the Statement of Consolidated Income of DQE. Revenues from sales of electricity to ultimate customers were favorably impacted in 1993 and 1991 by warmer than normal summer temperatures. Mild summer weather in 1992 had the opposite effect on residential and commercial customer sales. ECR revenues are Duquesne's recovery of fuel and other energy costs not otherwise recovered from customers through base rates. The ECR is based on projected unit costs, is recalculated each year, and is subject to PUC review. This revenue adjustment includes a credit to DUQUESNE CUSTOMER SALES 1993 VS. 1992 (Millions of KWH) [BAR GRAPH APPEARS HERE] Duquesne's customers for profits from short-term power sales to other utilities, as well as an adjustment for any over- or under-collections from customers that may have occurred in prior years. The 1993 ECR reduced customer costs from 1992 levels and will continue to reduce revenues through the first quarter of 1994 by a greater amount than in the prior year. From April 1994 through March 1995, the ECR is expected to reduce revenues by a lesser amount than in the prior year. This ECR treatment is intended to have no impact on net income. State tax adjustment surcharge revenues result from the August 1991 tax increases enacted by the Pennsylvania legislature. Most of these increases were retroactive to January 1, 1991. The PUC allowed Duquesne to recover these increases in tax expense by applying, as of August 24, 1991, an adjustment to customers' bills. Because of the timing of the increase and the rates applied, Duquesne recovered more state tax adjustment surcharge revenues in 1992 than in 1993 or 1991. This tax recovery is expected, as of April 1994, to become part of base rates. This tax recovery treatment is intended to have no impact on net income. Revenues from other utilities declined in 1993, from the record level of 1992, because higher system demand and more planned and forced generating station outages in 1993 decreased Duquesne's capacity available for off-system sales. The increase, from 1991 to 1992, in these short-term sales to other utilities resulted from greater availability of transmission and generating capacity, increased demand by other utilities for energy and Duquesne's marketing efforts. Other revenues include revenues of DE and Montauk, as well as Duquesne's rental income and billings to other companies in the CAPCO group. Revenues of DE increased approximately $23 million in 1993; the increase was partially due to the acquisition of a controlling interest in Chester Environmental, Inc. (See Note A to the consolidated financial statements.) and higher sales to the Pittsburgh International Airport. Primarily as a result of increased leasing activities and other tax advantaged investments, Montauk revenues increased approximately $8 million. OPERATING EXPENSES - -------------------------------------------------------------------------------- Yearly fluctuations in fuel and purchased power expense result from changes in the cost of fuel, the mix between coal and nuclear generation, the total KWHs generated and the effects of deferred energy costs. In 1993, the impact of the ECR on deferred energy costs decreased fuel expense, in comparison to that for 1992. Also contributing to the decline in fuel expense was a 6 percent decrease in generation that was primarily due to more planned and forced generating plant outages in 1993. Fuel expense for 1992 was greater than that for 1991 because of increased generation of electricity for sale to other utilities; however, the greater fuel expense was partially offset in 1992 by lower coal and nuclear fuel costs per KWH. In 1994, nuclear fuel costs are expected to continue to decline, and coal costs are expected to remain near the 1993 level. Other operating expenses were higher in 1993 than 1992. In 1993, Duquesne finalized plans to sublease the majority of its office space at corporate headquarters; relocation of its principal business offices is anticipated in 1994. A charge of approximately $13 million was recorded as an operating expense to reflect the shortfall in anticipated sublease revenues from the rental payments related to space leased through January 2003, the date the leasing arrangements expire. Additionally, operating expenses at DE increased approximately $17 million in 1993 as a reflection of the acquisition of a controlling interest in Chester Environmental, Inc. (See Note A to the consolidated financial statements.) Included in 1991 operating expenses was an increase, caused by the deterioration of Duquesne's past due customer accounts and increased collection costs, of $11.9 million in the allowance for uncollectible accounts receivable. Maintenance expense incurred for scheduled refueling outages at Duquesne's nuclear units is deferred and amortized over the period between scheduled outages. During 1993, amortization of deferred nuclear refueling outage expense increased approximately $3.5 million over the 1992 level. Also increasing maintenance expense in 1993 was Duquesne's change, as of January 1, 1993, in its method of accounting for maintenance costs during major fossil station outages. Prior to 1993, maintenance costs incurred for scheduled major outages at fossil stations were DUQUESNE CUSTOMER REVENUES (Millions of Dollars) [BAR GRAPH APPEARS HERE] DUQUESNE OTHER OPERATING AND MAINTENANCE EXPENSE [BAR GRAPH APPEARS HERE] charged to expense as the costs were incurred. Under the new accounting policy, Duquesne accrues, over the period between outages, anticipated expenses for scheduled major fossil station outages. (Maintenance costs incurred for non- major scheduled outages and for forced outages continue to be charged to expense as the costs are incurred.) This new method was adopted to match more accurately the maintenance costs with the revenue produced during the periods between scheduled major fossil outages. Depreciation and amortization expense increased in 1993 by comparison with that for 1992 and 1991. The increase was primarily a result of an increase in depreciable property. Taxes other than income taxes decreased in 1993, primarily as a result of a favorable resolution of property tax assessments. In 1993, Duquesne recorded, on the basis of this revised assessment, the expected refunds of these overpayments in prior years. By comparison with those for 1991, taxes other than income taxes decreased in 1992 as the result of favorable resolution of capital stock tax, gross receipts tax and sales tax matters. Income taxes increased in 1993 as a result of an increase in taxable income and a 1 percent increase in the corporate federal income tax rate. OTHER INCOME AND DEDUCTIONS - -------------------------------------------------------------------------------- During the fourth quarter of 1993, Duquesne recognized a charge to other income of approximately $15.2 million for its investment in the abandoned General Public Utilities (GPU) transmission line project. On December 8, 1993, the New Jersey Board of Regulatory Commissioners (BRC) denied a request by GPU's subsidiary Jersey Central Power and Light Company for approval of long-term power purchase and operating agreements that were originally signed in 1990 by GPU and Duquesne and further amended in 1993. The BRC rejected an administrative law judge's recommended decision that the project be approved and, within hours of the BRC decision, GPU terminated its participation in the project. In view of GPU's decision, Duquesne also terminated its participation in the project and the PUC transmission line siting proceeding. Other income also decreased in 1993, in comparison with that for 1992, as a result of a decrease of approximately $13 million in carrying charges on deferred revenues. During 1993, the deferred revenue balance upon which carrying charges are earned declined in comparison with that for 1992 and since April 1993, Duquesne has not recorded additional carrying charges on deferred revenues. (See the discussion of the phase-in plan under the section on operating revenues.) Income taxes related to other income decreased $15 million in 1993, in comparison with those for 1992, because of a favorable settlement (related to Duquesne's 1988 tax return and the consolidated 1989 tax return) with the United States Internal Revenue Service. The remaining decrease in 1993 was caused by lower non-operating income. Other income for 1992 increased, in comparison with that for 1991, primarily as the result of an increase of $3.5 million in interest income and a decrease of $3.7 million in fees related to Duquesne's sale of receivables. Other income for 1991 included a $5.3 million regulatory accounting reclassification that decreased other income, reduced depreciation expense and had no impact on net income. INTEREST AND OTHER CHARGES - -------------------------------------------------------------------------------- Duquesne achieved reductions in interest and other charges in 1993 and 1992 through refinancing first mortgage bonds and through obtaining lower average short-term rates on certain tax exempt pollution control notes. Duquesne also retired $24.2 million of preferred and preference stock during 1992. Interest expense and dividends on preferred and preference stock declined to $121 million in 1993 from $135 million in 1992 and $145 million in 1991. Interest expense and preferred stock dividends are expected to decline in 1994 by approximately $9 million from the 1993 level. DQE INTEREST EXPENSE AND OTHER CHARGES (Millions of Dollars) [BAR GRAPH APPEARS HERE] CAPITAL RESOURCES AND LIQUIDITY CONSTRUCTION - -------------------------------------------------------------------------------- During 1993, Duquesne spent approximately $100 million for construction. Duquesne expended these amounts to improve and expand its production, transmission and distribution systems. Duquesne estimates that it will spend approximately $110 million for construction in 1994. Construction expenditures are estimated to be $70 million in 1995 and $80 million in 1996. These amounts exclude AFC, nuclear fuel and expenditures for possible early replacement of steam generators at the Beaver Valley Power Station. (See Note K to the consolidated financial statements.) Duquesne currently has no plans for construction of new base load generating plants and expects that funds generated from operations will continue to be sufficient to finance a large part of its capital needs. INVESTING - -------------------------------------------------------------------------------- Through DE and Montauk, DQE's investments are focused in four principal areas: energy, environmental services, leasing and tax-advantaged investments. After achieving a modest profit of $.02 per DQE share in 1992, these subsidiaries contributed $.13 per share to the Company's 1993 earnings. During 1993, the level of investing activities increased in comparison with that for 1992. On August 17, 1993, DE acquired a controlling interest in Chester Environmental, Inc. for approximately $12 million. Chester provides total environmental consulting and engineering services to a wide range of clients. During 1993, DE also made real estate investments totaling approximately $22 million. Previous DE investments included Allegheny Development Corporation (which provides all energy services for the Pittsburgh International Airport) and International Power Machines (which manufactures products and systems designed to provide non- interruptible electric power). During 1993, Montauk invested approximately $44 million in leases and other tax-advantaged investments. The lease rentals in these transactions are guaranteed by the lessee's parents or affiliates. FINANCING - -------------------------------------------------------------------------------- The Company plans to meet its current obligations and debt maturities through 1998 with funds generated from operations and through new financings. At December 31, 1993, the Company was in compliance with all of its debt covenants. Duquesne continues to reduce capital costs by refinancing and retiring securities. During 1993, Duquesne issued $695 million of first collateral trust bonds with maturities ranging from the year 1996 through the year 2025 and with an average interest rate of 6.58 percent. The proceeds of these sales were used to redeem $713.7 million of first mortgage bonds with an average interest rate of 8.16 percent. In June 1993, Duquesne participated in the issuance of $25 million of Beaver County Industrial Development Authority Pollution Control Revenue Bonds. In August 1993, Duquesne participated in the issuance of $20.5 million of Ohio Air Quality Development Authority Pollution Control Revenue Refunding Bonds to refund a like amount of pollution control obligations. In August 1993, Montauk entered into a revolving credit agreement with a group of banks. Under this agreement, Montauk can borrow, on a revolving basis, up to $50 million for working capital and other general corporate purposes. If the agreement is not extended at the end of its 364-day commitment period, Montauk can convert any outstanding borrowings into a two-year, amortizing term loan. At December 31, 1993, Montauk had borrowed $25 million under this agreement. On January 14, 1994, Duquesne redeemed all of its outstanding shares of $2.10 preference stock and $7.50 preference stock for approximately $38 million. In 1992, Duquesne refinanced $312.9 million and retired $82.1 million of long- term debt. Duquesne established, as of January 1, 1992, an Employee Stock Ownership Plan (ESOP) to fund a match of a portion of employee contributions for a 401(k) plan. Duquesne may purchase shares of DQE common stock from DQE or on the open market to satisfy the exchange feature of its Preference Stock, Plan Series A. The Company expects the ESOP to have minimal dilutive impact on earnings per share. DQE NET CASH FLOW FROM OPERATIONS (Millions of Dollars) [BAR GRAPH APPEARS HERE] DQE RATIO OF EARNINGS TO FIXED CHARGES [BAR GRAPH APPEARS HERE] SALE OF ACCOUNTS RECEIVABLE - -------------------------------------------------------------------------------- In 1989, Duquesne and an unaffiliated corporation entered into an agreement that entitled Duquesne to sell and the corporation to purchase, on an ongoing basis, up to $100 million of accounts receivable. At December 31, 1993, Duquesne had sold $9 million of receivables. The accounts receivable sales agreement, which expires in June 1994, is one of many sources of funds available to Duquesne. Duquesne is currently evaluating whether to seek an extension of the agreement. NUCLEAR FUEL LEASING - -------------------------------------------------------------------------------- Duquesne finances its acquisitions of nuclear fuel through a leasing arrangement under which it may finance up to $75 million of nuclear fuel. As of December 31, 1993, the amount of nuclear fuel financed by Duquesne under this arrangement totaled approximately $65 million. Duquesne plans to continue leasing nuclear fuel to fulfill its requirements at least through 1995, the remaining term of the current leasing arrangement. DIVIDENDS - -------------------------------------------------------------------------------- The Company or its predecessor, Duquesne, has continuously paid dividends on common stock since 1953. The quarterly dividends paid have increased by an average annual rate of 5.9 percent over the past five years, even though the Company has maintained a more conservative payout ratio than the industry in general. The Company expects that funds generated from operations will continue to be sufficient to meet sinking fund and long-term debt maturities and to pay dividends. The Company's need for funds and the availability of those generated from operations will be affected by the level of economic activity in Duquesne's service area and by legislation, rate-related proceedings, competition and environmental and other matters experienced by the Company and the electric utility industry generally. Dividends may be paid on DQE common stock to the extent permitted by law and as declared by the board of directors. However, in Duquesne's Restated Articles of incorporation, provisions relating to preferred and preference stock may restrict the payment of Duquesne's common dividends. No dividends or distributions may be made on Duquesne's common stock if Duquesne has not paid dividends or sinking fund obligations on its preferred or preference stock. Further, the aggregate amount of Duquesne's common stock dividend payments or distributions may not exceed certain percentages of net income if the ratio of common stockholders' equity to total capitalization is less than specified percentages. As all of Duquesne's common stock is owned by DQE, to the extent that Duquesne cannot pay common dividends, DQE may not be able to pay dividends to its common shareholders. No part of the retained earnings of DQE or any of its subsidiaries was restricted at December 31, 1993. OUTLOOK COMPETITION - -------------------------------------------------------------------------------- Duquesne, like the electric utility industry in general, faces increasing competition. The Company is continuing to assess the impact of these competitive forces on its future operations. The National Energy Policy Act of 1992 (energy act) was designed, among other things, to foster competition. Among other provisions, the energy act amends the Public Utility Holding Company Act of 1935 (1935 act) and the Federal Power Act. Amendments to the 1935 act create a new class of independent power producers known as Exempt Wholesale Generators (EWGs), which are exempt from the corporate structure regulations of the 1935 act. EWGs, which may include independent power producers as well as affiliates of electric utilities, do not require Securities and Exchange Commission approval or regulation. At the current time, the Company has not made any investment, and has no plans to make any investment, in EWGs. Amendments to the Federal Power Act create the potential for utilities and other power producers to gain increased access to transmission systems of other utilities to facilitate sales to other utilities. The amendments would permit the Federal Energy Regulatory Commission (FERC) to order utilities to transmit power over their lines for use by other suppliers and to enlarge or construct additional transmission capacity to provide these services. The FERC may not, however, issue any order that would unreasonably impair the continuing reliability of affected electric systems. Finally, brokers and marketers, without owning or operating any generation or transmission facilities, have also entered into the business of buying and selling electric capacity and energy. DQE NET INCOME (Millions of Dollars) [BAR GRAPH APPEARS HERE] Industrial and large commercial customers may have the ability to own and operate facilities to generate their own electric energy requirements and, if such facilities are qualifying facilities, to require the displaced electric utility to purchase the output of such facilities. Customers may also have the option of substituting fuels, such as the use of natural gas, oil or wood for heating and/or cooling purposes rather than electric energy or of relocating their facilities to a lower cost environment. In addition, increased competition may also result from the 1990 Amendments to the Clean Air Act. Such amendments exempt from sulfur dioxide (SO2) and oxides of nitrogen (NOX) control requirements existing units with less than 25 MWs of generating capability, and new or existing co-generation units supplying less than one-third of their electric output and less than 25 MWs for commercial sale. GENERATING UNITS HELD FOR FUTURE USE - -------------------------------------------------------------------------------- In 1986, the PUC approved Duquesne's request to remove the Phillips and most of the Brunot Island (BI) power stations from service and place them in cold reserve. Duquesne's capitalized costs and net investment in the plants at December 31, 1993 totaled $130 million. (See Note L to the consolidated financial statements.) Duquesne expects to recover its net investment in these plants through future sales. Phillips and BI represent licensed, certified, clean sources of electricity that will be necessary to meet expanding opportunities in the power markets. Duquesne believes that anticipated growth in peak load demand for electricity within its service territory will require additional peaking generation. Duquesne looks to BI to meet this need. The Phillips Power Plant is an important component in meeting market opportunities to supply long term bulk power. Recent legislation may permit wider transmission access to these long term bulk power markets. In summary, Duquesne believes its investment in these cold-reserved plants will be necessary in order to meet future business needs. If business opportunities do not develop as expected, Duquesne will consider the sale of these assets. In the event that market demand, transmission access or rate recovery do not support the utilization or sale of the plants, Duquesne may have to write off part or all of their costs. ENVIRONMENTAL MATTERS - -------------------------------------------------------------------------------- The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and the Superfund Amendments and Reauthorization Act of 1986 established a variety of informational and environmental action programs. The Environmental Protection Agency (EPA) has informed Duquesne of its involvement or potential involvement in three hazardous waste sites. If Duquesne is ultimately determined to be a responsible party with respect to these sites, it could be liable for all or a portion of the cleanup costs. However, in each case, other solvent, potentially responsible parties that may bear all or part of any liability are also involved. In addition, Duquesne believes that available defenses, along with other factors (including overall limited involvement and low estimated remediation costs for one site) will limit any potential liability that Duquesne may have for cleanup costs. Duquesne believes that it is adequately reserved for all known liabilities and costs and, accordingly, that these matters will not have a materially adverse effect on its financial position or results of operations. In 1990, Congress approved amendments to the Clean Air Act. Among other innovations, this legislation established the Emission Allowance Trading System. Emission allowances are permits to emit one ton of SO2 for one year. These allowances are issued by the EPA to fossil-fired stations with generating capability of more than 25 megawatts that were in existence as of the passage of the 1990 amendments. Allowances are part of a market-based approach to SO2 reduction. Emission allowances can also be obtained through purchases on the open market or directly from other sources. Excess allowances may be banked for future use or sold on the open market to other parties for their use in offsetting emissions. The legislation requires significant reductions of SO2 and NOX by 1995 and additional reductions by the year 2000. Duquesne continues to work with the operators of its jointly owned stations to implement cost-effective compliance strategies to meet these requirements. Duquesne's plans for meeting the 1995 SO2 compliance requirements include increasing the use of scrubbed capacity, switching to fuel with a lower sulfur content and purchasing emission allowances. NOX reductions under Title IV are required by 1995 at only the Cheswick station; work to achieve the reductions was completed in 1993. The ozone attainment provisions of Title I of the Clean Air Act Amendments will require NOX reductions by 1995 at Duquesne's Elrama plant and at the jointly owned Mansfield plant. Duquesne plans to achieve such reductions with low NOX burner technology. The estimated capital costs to achieve 1995 compliance standards are approximately $30 million, of which approximately $15 million has already been spent. Through the year 2000, Duquesne is planning a combination of compliance methods that include fuel switching; increased use of, and improvements in, scrubbed capacity; flue gas conditioning; low NOX burner technology; and the purchase of emission allowances. The Company currently estimates that additional capital costs to comply with environmental requirements from 1995 through the year 2000 will be approximately $20 million. This estimate is subject to the finalization of federal and state regulations. Duquesne is closely monitoring other potential air quality programs and air emission control requirements that could be imposed in the future. These areas include additional NOX control requirements that could be imposed on fossil fuel plants by the Ozone Transport Commission, more stringent ambient air quality and emission standards for SO2 and particulates, or CO2 control measures. As these potential programs are in various stages of discussion and consideration, it is impossible to make reasonable estimates of the potential costs and impacts of these programs at this time. In July 1992, the Pennsylvania Department of Environmental Resources (DER) issued Residual Waste Management Regulations governing the generation and management of non-hazardous waste. Duquesne is currently conducting tests and developing compliance strategies. Capital compliance costs are estimated, on the basis of information currently available, at $10 million through 1995. The expected additional capital cost of compliance from 1995 through 2000 is approximately $25 million; this estimate is subject to the results of ground water assessments and DER final approval of compliance plans. Duquesne operates the scrubbed Elrama plant and converts the scrubber slurry to a fixated pozolonic material. This material is placed at an off-site disposal area having approximately six years of remaining capacity. Additionally, Duquesne owns 17 percent of the scrubbed Mansfield plant, which is operated by Pennsylvania Power. This plant pumps a similar slurry to an off-site impoundment where the slurry is treated by using a Calcilox fixation process. The site has at least 14 years of remaining capacity. Both plants have limited temporary on- site storage for flue gas desulfurization material and no permanent on-site disposal capacity. While there is no imminent shortage of disposal capacity, Duquesne continues to monitor this situation and to plan for future disposal. The siting of future disposal facilities will be facilitated by the 1993 EPA determination that coal combustion waste products are not hazardous waste and are therefore exempt from the Hazardous Waste Regulations. Under the Nuclear Waste Policy Act of 1982, which establishes a policy for handling and disposing of spent nuclear fuel and requires the establishment of a final repository to accept spent fuel, the CAPCO companies have entered into contracts with the Department of Energy (DOE)for permanent disposal of spent nuclear fuel and high-level radioactive waste. The DOE has indicated that the repository will not be available for acceptance of spent fuel before 2010. Existing on-site spent fuel storage capacities at Beaver Valley 1, Beaver Valley 2 and Perry are expected to be sufficient until 1996, 2010, and 2009, respectively. Duquesne is currently increasing the storage capacity at Beaver Valley 1 by equipping the spent fuel pool with high density fuel storage racks. Duquesne anticipates that such action will increase the spent fuel storage capacity at Beaver Valley 1 to provide for sufficient storage through 2014. OTHER SUBSIDIARY OPERATIONS - -------------------------------------------------------------------------------- The continued growth of DE and Montauk is expected to play an increasing role in DQE's overall corporate strategy and future earnings. RETIREMENT PLAN MEASUREMENT ASSUMPTIONS - -------------------------------------------------------------------------------- The Company reduced the discount rate used to determine the projected benefit obligation on the Company's retirement plans at December 31, 1993, to 7 percent. The assumed change in future compensation levels was also decreased by 0.5 percent to reflect current market and economic conditions. The effects of these changes on the Company's retirement plan obligations are reflected in the amounts shown in Note I to the consolidated financial statements. The resulting increase in related expenses for subsequent years is not expected to be material. GENERAL ELECTRIC SETTLEMENT - -------------------------------------------------------------------------------- In January 1994, the CAPCO companies reached a settlement in connection with a 1991 lawsuit against General Electric Company (GE) regarding the Perry Plant. The settlement provides for cash payments to the CAPCO companies and discounts on future purchases from GE. This settlement will not materially affect the Company's results of operations in future years. OTHER - -------------------------------------------------------------------------------- Duquesne's utility operations are subject to regulation by the PUC and the FERC. This regulation is designed to provide for the recovery of operating costs and investment and the opportunity to earn a fair return on funds invested in the utility business. The regulatory process imposes a time lag during which increases in operating expenses, capital costs or construction costs may not be recovered. - -------------------------------------------------------------------------------- COMPANY REPORT ON FINANCIAL STATEMENTS The Company is responsible for the financial information and representations contained in the financial statements and other sections of this annual report. The Company believes that the consolidated financial statements have been prepared in conformity with generally accepted accounting principles that are appropriate in the circumstances to reflect, in all material respects, the substance of events and transactions that should be included in the statements and that the other information in the annual report is consistent with those statements. In preparing the financial statements, the Company makes informed judgments and estimates based on currently available information about the effects of certain events and transactions. The Company maintains a system of internal accounting control designed to provide reasonable assurance that the Company's assets are safeguarded and that transactions are executed and recorded in accordance with established procedures. There are limits inherent in any system of internal control and such limits are based on recognition that the cost of such a system should not exceed the benefits derived. The system of internal accounting control is supported by written policies and guidelines and is supplemented by a staff of internal auditors. The Company believes that the internal accounting control system provides reasonable assurance that its assets are safeguarded and the financial information is reliable. /s/ Wesley W. von Schack /s/ Gary L. Schwass Wesley W. von Schack Gary L. Schwass Chairman of the Board, President Vice President and and Chief Executive Officer Treasurer REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS TO THE DIRECTORS AND STOCKHOLDERS OF DQE: We have audited the accompanying consolidated balance sheets of DQE and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of DQE and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note A to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109, and the Company changed its method of accounting for maintenance costs during scheduled major fossil station outages. /s/ Deloitte & Touche Deloitte & Touche Pittsburgh, Pennsylvania January 25, 1994 - -------------------------------------------------------------------------------- REPORT OF THE AUDIT COMMITTEE OF THE BOARD OF DIRECTORS OF DQE The Audit Committee, composed entirely of non-employee directors, meets regularly with the independent public accountants and the internal auditors to discuss results of their audit work, their evaluation of the adequacy of the internal accounting controls and the quality of financial reporting. In fulfilling its responsibilities in 1993, the Audit Committee recommended to the Board of Directors, the selection, subject to shareholder approval, of the Company's independent public accountants. The Audit Committee reviewed the overall scope and details of the independent public accountants' and internal auditors' respective audit plans and reviewed and approved the independent public accountants' general audit fees and non-audit services. Audit Committee meetings are designed to facilitate open communications with internal auditors and independent public accountants. To ensure auditor independence, both the independent public accountants and the internal auditors have full and free access to the Audit Committee. The Audit Committee of the Board of Directors of DQE See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SUMMARY OF ACCOUNTING POLICIES CONSOLIDATION - -------------------------------------------------------------------------------- The consolidated financial statements include the accounts of DQE (the Company) and its subsidiaries. All material intercompany balances and transactions have been eliminated in the preparation of the Consolidated Financial Statements of DQE. On August 17, 1993, DE acquired a controlling interest in Chester Environmental, Inc. (Chester) for approximately $12 million. The acquisition was accounted for under the purchase method of accounting and Chester's results of operations have been included in the Company's consolidated financial statements since that date. BASIS OF ACCOUNTING - -------------------------------------------------------------------------------- The consolidated financial statements reflect the rate-making practices of Duquesne Light Company (Duquesne) and, as a result, contain regulatory assets and liabilities as deferred charges and credits in accordance with Statement of Financial Accounting Standards Number 71, Accounting for the Effects of Certain Types of Regulation (SFAS No. 71). Duquesne's accounting practices conform to the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC)and the requirements of the Pennsylvania Public Utility Commission (PUC). The Company is also subject to the accounting and reporting requirements of the Securities and Exchange Commission (SEC). PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- The asset values of properties are stated at original construction cost, which includes related payroll taxes, pensions, and other fringe benefits, as well as administrative and general costs. Also included in original construction cost is an allowance for funds used during construction (AFC), which represents the estimated cost of debt and equity funds used to finance construction. The amount of AFC that is capitalized will vary according to changes in the cost of capital and in the level of construction work in progress (CWIP). On a current basis, Duquesne does not realize cash from the allowance for funds used during construction. Duquesne does realize cash, during the service life of the plant, through increased revenues reflecting a higher rate base (upon which a return is earned) and increased depreciation. The AFC rates applied to CWIP were 9.6 percent in 1993, 10.3 percent in 1992, and 9.6 percent in 1991. Additions to, and replacements of, property units are charged to plant accounts. Maintenance, repairs and replacement of minor items of property are recorded as expenses when they are incurred. The costs of properties that are retired (plus removal costs and less any salvage value) are charged to the accumulated provision for depreciation. Substantially all of Duquesne's properties are subject to a first mortgage lien, and substantially all of Duquesne's electric properties are subject to junior liens. DEPRECIATION - -------------------------------------------------------------------------------- Depreciation of property, plant and equipment, including plant-related intangibles, is recorded on a straight-line basis over the estimated useful lives of properties. Amortization of other intangibles is recorded on a straight-line basis over a five-year period. Depreciation and amortization of other properties are calculated on various bases. NUCLEAR DECOMMISSIONING - -------------------------------------------------------------------------------- The PUC ruled that recovery of the decommissioning costs for Beaver Valley Unit 1 could begin in 1977 and that recovery for Beaver Valley Unit 2 and Perry Unit 1 could begin in 1988. Duquesne expects to decommission each nuclear plant at the end of its life, a date that currently coincides with the expiration of each plant's operating license. (See Note L.) The total estimated decommissioning costs, including removal and decontamination costs, being recovered in rates are $70 million for Beaver Valley Unit 1, $20 million for Beaver Valley Unit 2, and $38 million for Perry Unit 1. These amounts were based upon the most recent studies available at the time of Duquesne's last rate case. Since the time of Duquesne's last rate case, site specific studies have been performed to update the estimated decommissioning costs, in current dollars, for each of its nuclear generating units. In 1992, Duquesne's share of the estimated decommissioning costs for Beaver Valley Unit 2 was revised to $35 million. Duquesne's share of decommissioning costs, which is based on preliminary site specific studies to be finalized early in 1994, is estimated to increase to $134 million for Beaver Valley Unit 1 and to $71 million for Perry. During 1994, it is Duquesne's intention to increase the annual contribution to its decommissioning trusts by $2 million to bring the total annual funding to approximately $4 million per year. Duquesne plans to continue making periodic reevaluations of estimated decommissioning costs, to provide additional funding from time to time, and to seek regulatory approval for recognition of these increased funding levels. Duquesne records decommissioning costs under the category of depreciation expense and accrues a liability, equal to that amount, for nuclear decommissioning expense. Such nuclear decommissioning funds are deposited in external, segregated trust accounts. Trust fund earnings increase the fund balance and the recorded liability. The aggregate trust fund balances at the end of 1993 totaled $18.1 million. On the Company's consolidated balance sheet, the decommissioning trusts have been reflected in other property and investments, and the related liability has been recorded as other deferred credits. MAINTENANCE - -------------------------------------------------------------------------------- Maintenance expense incurred for scheduled refueling outages at Duquesne's nuclear units is deferred and amortized over the period between scheduled outages. Duquesne changed, as of January 1, 1993, its method of accounting for maintenance costs during scheduled major fossil station outages. Prior to that time, maintenance costs incurred for scheduled major outages at fossil stations were charged to expense as these costs were incurred. Under the new accounting policy, Duquesne accrues, over the periods between outages, anticipated expenses for scheduled major fossil station outages. (Maintenance costs incurred for non- major scheduled outages and for forced outages will continue to be charged to expense as such costs are incurred.) This new method was adopted to match more accurately the maintenance costs and the revenue produced during the periods between scheduled major fossil station outages. The cumulative effect (approximately $5.4 million, net of income taxes of approximately $3.9 million) of the change on prior years was included in income in 1993. The effect of the change in 1993 was to reduce income, before the cumulative effect of changes in accounting principles, by approximately $2.4 million or $.05 per share and to reduce net income, after the cumulative effect of changes in accounting principles, by approximately $7.8 million or $.15 per share. REVENUES - -------------------------------------------------------------------------------- Meters are read monthly and customers are billed on the same basis. Revenues are recorded in the accounting periods for which they are billed. Deferred revenues are associated with the Company's 1987 rate case. (See Note J.) INCOME TAXES - -------------------------------------------------------------------------------- On January 1, 1993, the Company adopted Statement of Financial Accounting Standards Number 109 (SFAS No. 109). Implementation of SFAS No. 109 involved a change in accounting principles. The cumulative $8 million effect on prior years was reported in 1993 as an increase in net income. SFAS No. 109 requires that the liability method be used in computing deferred taxes on all differences between book and tax bases of assets. These book tax differences occur when events and transactions recognized for financial reporting purposes are not recognized in the same period for tax purposes. As a utility, Duquesne recognizes uncollected deferred income taxes for these deferred tax liabilities that are expected to be recovered from customers through rates. The adoption of SFAS No. 109 on January 1, 1993, resulted in a $700 million increase in deferred tax liabilities and the recognition of $550 million in net regulatory assets. Prior to the adoption of SFAS No. 109, Duquesne recorded certain costs in electric plant in service net of taxes. Because SFAS No. 109 eliminates this "net of tax" accounting, the adoption of SFAS No. 109 also resulted in an increase in plant assets of $150 million. When applied to reduce the Company's income tax liability, investment tax credits related to utility property generally were deferred. Such credits are subsequently reflected, over the lives of the related assets, as reductions to tax expense. ENERGY COST RATE ADJUSTMENT CLAUSE (ECR) - -------------------------------------------------------------------------------- Through the ECR, Duquesne recovers (to the extent that such amounts are not included in base rates) nuclear fuel, fossil fuel and purchased power expenses and, also through the ECR, passes to its customers the profits from short-term power sales to other utilities. Nuclear fuel expense is recorded on the basis of the quantity of electric energy generated and includes such costs as the fee, imposed by the United States Department of Energy (DOE), for future disposal and ultimate storage and disposition of spent nuclear fuel. Fossil fuel expense includes the costs of coal and fuel oil used in the generation of electricity. Duquesne defers fuel and other energy expenses for recovery through the ECR in subsequent years. The deferrals reflect the difference between the amount that Duquesne is currently collecting from customers and its actual fuel costs. The Pennsylvania Public Utility Commission (PUC) annually reviews Duquesne's fuel costs for the fiscal year April through March, compares them to previously projected fuel costs and adjusts the ECR for over- or under-recoveries and for two PUC-established coal cost standards. (See Note J.) Over- or under-recoveries from customers are recorded in the Consolidated Balance Sheet of DQE as payable to, or receivable from, customers. At December 31, 1993 and 1992, $10.1 million and $18.9 million were payable to customers and shown as deferred energy costs. CASH FLOWS - -------------------------------------------------------------------------------- For the purpose of the statement of cash flows, the Company considers all highly liquid investments maturing in three or fewer months to be cash equivalents. RECLASSIFICATIONS - -------------------------------------------------------------------------------- The 1992 and 1991 financial statements have been reclassified to conform with accounting presentations adopted during 1993. B. EXTRAORDINARY PROPERTY LOSS In 1984, companies comprising the CAPCO group agreed to minimize construction work and cash expenditures on Perry Unit 2 until several alternatives, including resumption of construction or cancellation of the unit, were evaluated. Duquesne abandoned its interest in the unit in 1986 and subsequently disposed of its interest in 1992. In 1987, the PUC approved recovery, over a 10-year period, of Duquesne's original $155 million investment in Perry Unit 2. Duquesne is not earning a return on the as yet unrecovered portion (approximately $39.4 million at December 31, 1993) of its investment in the unit. C. CAPITALIZATION COMMON STOCK - -------------------------------------------------------------------------------- The Company or its predecessor, Duquesne, has continuously paid dividends on common stock since 1953. The quarterly dividend declared in the fourth quarter of 1993 was increased to $.42 per share. This annualized dividend of $1.68 per share was increased from $1.60 per share in 1992. The annualized dividend per share was $1.52 in 1991 and $1.44 in 1990. Dividends may be paid on DQE common stock to the extent permitted by law and as declared by the board of directors. However, in Duquesne's Restated Articles of incorporation, provisions relating to preferred and preference stock may restrict the payment of Duquesne's common dividends. No dividends or distributions may be made on Duquesne's common stock if Duquesne has not paid dividends or sinking fund obligations on its preferred or preference stock. Further, the aggregate amount of Duquesne's common stock dividend payments or distributions may not exceed certain percentages of net income if the ratio of common stockholders' equity to total capitalization is less than specified percentages. As all of Duquesne's common stock is owned by DQE, to the extent that Duquesne cannot pay common dividends, DQE may not be able to pay dividends to its common stockholders. No part of the retained earnings of DQE or any of its subsidiaries was restricted at December 31, 1993. PREFERRED AND PREFERENCE STOCK - -------------------------------------------------------------------------------- Holders of Duquesne's preferred stock are entitled to cumulative quarterly dividends. If four quarterly dividends on any series of preferred stock are in arrears, holders of the preferred stock are entitled to elect a majority of Duquesne's board of directors until all dividends have been paid. At December 31, 1993, Duquesne had made all preferred stock dividend payments. Holders of Duquesne's preference stock are entitled to receive cumulative quarterly dividends if dividends on all series of preferred stock are paid. If six quarterly dividends on any series of preference stock are in arrears, holders of the preference stock are entitled to elect two of Duquesne's directors until all dividends have been paid. At December 31, 1993, Duquesne had made all dividend payments. Outstanding preferred and preference stock is generally callable, on notice of not less than 30 days, at stated prices (See table on page 27.) plus accrued dividends. On January 14, 1994, Duquesne called for redemption of all of its outstanding shares of $2.10 and $7.50 preference stock. None of the remaining preferred or preference stock issues has mandatory purchase requirements. In December 1991, the Company established an Employee Stock Ownership Plan (ESOP) to provide matching contributions for a 401(k) Retirement Savings Plan for Management Employees. (See Note I.) Duquesne issued and sold 845,070 shares of redeemable preference stock, plan series A to the trustee of the ESOP. As consideration for the stock, Duquesne received a note valued at $30 million from the trustee. The preference stock has an annual dividend rate of $2.80 per share, and each share of the preference stock is exchangeable for one share of DQE common stock. At December 31, 1993, $27.1 million of preference stock issued in connection with the establishment of the ESOP had been offset, for financial statement purposes, by the recognition of a deferred ESOP benefit. Dividends on the preference stock and cash contributions from Duquesne will be used to repay the ESOP note. During 1993, Duquesne made cash contributions of approximately $2.1 million, the difference between the ESOP debt service and the amount of dividends on ESOP shares (approximately $2.3 million). As shares of preference stock are allocated to the accounts of participants in the ESOP, the Company recognizes compensation expense, and the amount of the deferred compensation benefit is amortized. In 1993, the Company recognized $1.7 million of compensation expense related to the 401(k) plan. (a) Preferred stock: 4,000,000 authorized shares; $50 par value; cumulative. (b) $50 per share involuntary liquidation value (c) Non-redeemable (d) $100 per share involuntary liquidation value (e) Redeemable (f) Preference stock: 8,000,000 authorized shares; $1 par value; cumulative (g) $25 per share involuntary liquidation value (h) Redeemed January 14, 1994 (i) $35.50 per share involuntary liquidation value LONG-TERM DEBT - -------------------------------------------------------------------------------- At December 31, 1993, Duquesne had $1.433 billion of outstanding debt securities; these consisted of $960 million of first collateral trust bonds, $49 million of first mortgage bonds, $418 million of pollution control notes and $6 million of debentures. During 1992, Duquesne began issuing secured debt under a new first collateral trust indenture. This indenture will ultimately replace Duquesne's 1947 first mortgage bond indenture. First collateral trust bonds totaling $695 million and $265 million, and having average interest rates of 6.58 percent and 8.04 percent, were issued in 1993 and 1992. Since 1985, the Company has reacquired $1.561 billion of first mortgage bonds. The difference between the purchase prices and the net carrying amounts of these bonds has been included in the consolidated balance sheet as unamortized loss on reacquired debt. At December 31, 1993, the balance of unamortized loss on reacquired debt was $95.3 million. (a) These interest rates are the average coupon rate for multiple issuances with the same maturity dates. (b) Sinking fund requirement relates to the first mortgage bonds held by the trustee as collateral for the publicly-held collateral trust bonds. The outstanding collateral trust bonds do not have a sinking fund requirement. (c) Certain of the pollution control notes have adjustable interest rate periods currently ranging from 1 to 360 days. On 30 days' to 90 days' notice prior to any interest reset date, the Company can change the subsequent interest rate period on the notes to a different interest rate period ranging from 1 day to the final maturity of the bonds. (d) Issued in the form of first mortgage bonds or first collateral trust bonds. (e) Fixed rate through first five years, thereafter becoming variable rates as in footnote c. (f) As of January 1994, the sinking fund requirement for 1995 had been met and the requirement for 1996 had been partially satisfied. At December 31, 1993 and 1992, the Company was in compliance with all of its debt covenants. At December 31, 1993, sinking fund requirements and maturities of long-term debt outstanding for the next five years were: $11.8 million and $.1 million in 1994; $11.4 million and $49.6 million in 1995; $11.2 million and $50.1 million in 1996; $10.8 million and $50.0 million in 1997; and $10.1 million and $75.0 million in 1998. Sinking fund requirements relate primarily to the first mortgage bonds and may be satisfied by cash or the certification of property additions equal to 166 2/3 percent of the bonds required to be redeemed. During 1993, annual sinking fund requirements of $.5 million were satisfied by cash and $4.8 million by certification of property additions. Total interest costs incurred were $118.1 million in 1993, $133.9 million in 1992 and $147.2 million in 1991. Of these amounts, which included AFC, $2.0 million in 1993, $4.7 million in 1992 and $9.3 million in 1991 were capitalized. Debt discount or premium and related issuance expenses are amortized over the lives of the applicable issues. In 1992, Duquesne was involved in the issuance of $419.0 million of collateralized lease bonds, which were originally issued by an unaffiliated corporation for the purpose of partially financing the lease of Beaver Valley Unit 2. Duquesne is also associated with a letter of credit securing the lessors' $188 million equity interest in the unit and certain tax benefits. If certain specified events occur, the letter of credit could be drawn down by the owners, the leases could terminate and the bonds would become direct obligations of Duquesne. The pollution control notes arise from the sale of bonds by public authorities for the purposes of financing construction of pollution control facilities at Duquesne's plants or refunding previously issued bonds. Duquesne is obligated to pay the principal and interest on the bonds. For certain of the pollution control notes, there is an annual commitment fee for an irrevocable letter of credit. Under certain circumstances, the letter of credit is available for the payment of interest on, or redemption of, a portion of the notes. In June 1993, $25 million of pollution control notes were issued; the proceeds were used to reimburse Duquesne for pollution control expenditures related to the Beaver Valley plant. In August 1993, pollution control notes totaling $20.5 million were refinanced at lower interest rates. At December 31, 1993, the fair value of the Company's long-term debt and redeemable preference stock approximated the carrying value. The fair value of the Company's long-term debt and redeemable preference stock was estimated on the basis of (a) quoted market prices for the same or similar issues or (b) current rates offered to the Company for debt of the same remaining maturities. D. RECEIVABLES An arrangement between Duquesne and an unaffiliated corporation entitles Duquesne to sell, and the corporation to purchase, up to $100 million of Duquesne's accounts receivable. At December 31, 1993 and 1992, Duquesne had sold $7.1 million and $66.3 million of electric customer accounts receivable and $1.9 million and $9.7 million of CAPCO receivables, respectively, to the unaffiliated corporation. The sales agreement includes a limited recourse obligation under which Duquesne could be required to repurchase certain of the receivables. The maximum amount of Duquesne's contingent liability was $2.8 million at December 31, 1993. Other receivables in the Consolidated Balance Sheet of DQE include receivables of DQE's other subsidiaries. These receivables amounted to $31.8 million and $1.0 million at December 31, 1993 and 1992, respectively. E. LEASES Duquesne leases nuclear fuel, a portion of a nuclear generating plant, office buildings, computer equipment and other property and equipment. (a) Includes $3,492 in 1993 and $3,782 in 1992 of capital leases with associated obligations retired. In 1987, Duquesne sold its 13.74 percent interest in Beaver Valley Unit 2; the sale was exclusive of transmission and common facilities. The total sales price of $537.9 million was the appraised value of Duquesne's interest in the property. Duquesne subsequently leased back its interest in the unit for a term of 29.5 years. The lease provides for semiannual payments and is accounted for as an operating lease. Duquesne is responsible under the terms of the lease for all costs of its interest in the unit. In December 1992, Duquesne participated in the refinancing of collateralized lease bonds originally issued in 1987 for the purpose of partially financing the lease of Beaver Valley Unit 2. In accordance with the Beaver Valley Unit 2 lease agreement, Duquesne paid the premiums of approximately $36.4 million as a supplemental rent payment to the lessors. This amount was deferred and is being amortized over the remaining lease term. At December 31, 1993, the balance was approximately $34.9 million. Leased nuclear fuel is amortized as the fuel is burned. The amortization of all other leased property is based on rental payments made. Payments for capital and operating leases are charged to operating expenses on the statement of consolidated income. Future minimum lease payments for capital leases are related principally to the estimated use of nuclear fuel financed through leasing arrangements and building leases. Minimum payments for operating leases are related principally to Beaver Valley Unit 2 and the corporate headquarters. Future payments due to the Company, as of December 31, 1993, under subleases of its corporate headquarters space are approximately $1.7 million in 1994, $3.4 million in 1995 and $24.9 million thereafter. The Company, through its Montauk subsidiary, is the lessor in five leveraged lease arrangements involving manufacturing equipment, mining equipment, rail equipment and natural gas processing equipment. These leases expire in various years beginning 2001 through 2012. The residual value of the equipment, which belongs to the Company after the leases expire, is estimated to approximate 14 percent of the original cost. The Company's aggregate equity investment represents 22 percent of the aggregate original cost of the property and is secured by guarantees of each lessee's parent or affiliate. The remaining 78 percent was financed by non-recourse debt provided by lenders who have been granted, as their sole remedy in the event of default by the lessees, an assignment of rentals due under the leases and a security interest in the leased property. This debt amounted to $143.5 million at December 31, 1993. In 1993, the Company's pre-tax and after-tax income from leveraged leasing in 1993 was $5.1 million and $3.2 million, respectively. F. INCOME TAXES The annual federal corporate income tax returns have been audited by the United States Internal Revenue Service (IRS) for the tax years through 1989. Returns filed for the tax years 1990 to date remain subject to IRS review. The Company does not believe that final settlement of the federal tax returns for these years will have a materially adverse effect on its financial position or results of operations. The effects of the 1993 adoption of SFAS No. 109 are discussed in Note A. Implementation of the standard involved a change in accounting principles. The cumulative effect of $8 million on prior years was reported in 1993 as an increase in net income. The SFAS No. 109 impact to 1993 income before cumulative effect of changes in accounting principles is immaterial. At December 31, 1993, the accumulated deferred income taxes of the Company totaled $1.169 billion. As discussed in Note A, this includes the deferred tax liability for the book and tax bases differences associated with (i) electric plant in service of $855 million; (ii) uncollected deferred income taxes of $199 million; and (iii) unamortized loss on reacquired debt of $40.9 million. The Company also nets against this liability balance the deferred tax assets associated with (i) investment tax credits unamortized of $45.3 million and (ii) the gain on the sale and leaseback of Beaver Valley Unit 2 of $67.1 million. The Company expects to realize these deferred tax assets. Total income taxes differ from the amount computed by applying the statutory federal income tax rate to income before income taxes, preferred and preference dividends of subsidiary and before the cumulative effect of changes in accounting principles. G. SHORT-TERM BORROWING AND REVOLVING CREDIT ARRANGEMENTS The Company, through its subsidiaries, has, with banks, extendable revolving credit agreements totaling $278.5 million. Expiration dates vary during 1994. Interest rates can, in accordance with the option selected at the time of each borrowing, be based on prime, federal funds, Eurodollar or CD rates. Commitment fees are based on the unborrowed amount of the commitments. There were no short-term borrowings during 1992. During 1993 and 1991, the maximum short-term bank and commercial paper borrowings outstanding were $36 million and $66 million; the average daily short-term borrowings outstanding were $9.9 million and $11.0 million; and the weighted average daily interest rates applied to such borrowings were 3.91 percent and 6.36 percent, respectively. At December 31, 1993, short-term borrowings were $36 million. There were no short-term borrowings at December 31, 1992 or 1991. H. CHANGES IN WORKING CAPITAL OTHER THAN CASH I. EMPLOYEE BENEFITS RETIREMENT PLANS - -------------------------------------------------------------------------------- The Company maintains retirement plans to provide pensions for all full-time employees. Upon retirement, an employee receives a monthly pension based on his or her length of service and compensation. The cost of funding the pension plan is determined by the unit credit actuarial cost method. The Company's policy is to record this cost as an expense and to fund the pension plans by an amount that is at least equal to the minimum funding requirements of the Employee Retirement Income Security Act (ERISA) but not to exceed the maximum tax deductible amount for the year. Pension costs charged to expense or construction were $9.8 million for 1993, $11.4 million for 1992 and $11.2 million for 1991. Pension assets consist primarily of common stocks, United States obligations and corporate debt securities. RETIREMENT SAVINGS PLAN AND OTHER BENEFIT OPTIONS - -------------------------------------------------------------------------------- The Company sponsors separate 401(k) retirement plans for its union-represented employees and its management employees. The 401(k) Retirement Savings Plan for Management Employees provides that the Company will match employee contributions to a 401(k) account up to a maximum of 6 percent of his or her eligible salary. The Company match consists of a $.25 base match and an additional $.25 incentive match, if targets approved by the Company's board of directors are met. The 1993 incentive target was met. The Company is funding its matching contributions with contributions to an ESOP established in December 1991. (See Note C.) DQE shareholders have approved a long-term incentive plan through which the Company may grant management employees options to purchase, during the years 1987 through 2003, up to a total of five million shares of DQE common stock at prices equal to the fair market value of such stock on the dates the options were granted. At December 31, 1993, approximately 2.9 million of these shares were available for future grants. As of December 31, 1993, 1992 and 1991, respectively, active grants totaled 1,204,000; 848,000; and 1,278,000 shares. Exercise prices of these options ranged from $12.3125 to $34.1875 at December 31, 1993 and from $12.3125 to $28.75 at December 31, 1992 and 1991. Expiration dates of these grants ranged from 1997 to 2003 at December 31, 1993; from 1997 to 2002 at December 31, 1992; and from 1997 to 2001 at December 31, 1991. As of December 31, 1993, 1992 and 1991, respectively, stock appreciation rights (SARs) had been granted in connection with 800,000; 623,000; and 822,000 of the options outstanding. During 1993, 103,000 SARs were exercised; 16,000 options were exercised at prices ranging from $12.3125 to $28.375; and 52,000 options lapsed. During 1992, 108,000 SARs were exercised; 50,000 options were exercised at prices ranging from $12.3125 to $26.375; and 59,000 options lapsed. During 1991, 229,000 SARs were exercised; 11,000 options were exercised at $12.3125; and 48,000 options lapsed. Of the active grants at December 31, 1993, 1992 and 1991, respectively, 578,000; 232,000; and 541,000 were not exercisable. OTHER POSTRETIREMENT BENEFITS - -------------------------------------------------------------------------------- In addition to pension benefits, the Company provides certain health care benefits and life insurance for some retired employees. Substantially all of the Company's full-time employees may, upon attaining the age of 55 and meeting certain service requirements, become eligible for the same benefits available to retired employees. Participating retirees make contributions, which are adjusted annually, to the health care plan. The life insurance plan is non-contributory. Company-provided health care benefits terminate when covered individuals become eligible for Medicare benefits or reach age 65, whichever comes first. The Company funds actual expenditures for obligations under the plans on a "pay-as- you-go basis." The Company has the right to modify or terminate the plans. As of January 1, 1993, the Company adopted Statement of Financial Accounting Standards Number 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, which requires the actuarially determined costs of the aforementioned postretirement benefits to be accrued over the period from the date of hire until the date the employee becomes fully eligible for benefits. The Company has adopted the new standard prospectively and has elected to amortize the transition liability over 20 years. In prior years, the Company recognized the cost of providing postretirement benefits by expensing the contributions as they were made. Costs recognized under this method in 1992 approximated $1.2 million. The new accrual method increased the cost recognized for providing postretirement benefits to approximately $6.0 million. The accumulated postretirement benefit obligation comprises the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. For measurement purposes, a 10.5 percent increase in the cost of covered health care benefits was assumed as of January 1, 1993. This rate is assumed to decrease to 5.5 percent by 1999 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. A 1 percent increase in the health care cost trend rate would increase the accumulated postretirement benefit obligation by $4.0 million at January 1, 1994, and the net annual cost by $.6 million for the year. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7 percent. J. RATE MATTERS 1987 RATE CASE - -------------------------------------------------------------------------------- In March 1988, the PUC adopted a rate order that increased Duquesne's annual revenues by $232 million. This increase is being phased in from April 1, 1988 through April 1, 1994. Deficiencies which resulted from the phase-in plan in current revenues from customers have been included in the consolidated income statement as deferred revenues. Deferred revenues have been recorded on the balance sheet as a deferred asset for future recovery. As customers are billed for deficiencies related to prior periods, this deferred asset is reduced. As designed, the phase-in plan provides for carrying charges (at the after-tax AFC rate) on revenues deferred for future recovery. Since April 1993, Duquesne has not recorded additional carrying charges on the deferred revenue balance. Duquesne had recovered previously deferred revenues and carrying charges of $285.9 million as of December 31, 1993. Phase-in plan deferrals of $28.6 million remained unrecovered as of that date. Duquesne expects to recover this remaining unrecovered balance by the end of the phase-in period. At this time, Duquesne has no pending base rate case and has no immediate plans to file a base rate case. DEFERRED RATE SYNCHRONIZATION COSTS - -------------------------------------------------------------------------------- In 1987, the PUC approved Duquesne's petition to defer initial operating and other costs of Perry Unit 1 and Beaver Valley Unit 2. Duquesne deferred the costs incurred from November 17, when the units went into commercial operation, until March 25, 1988 when a rate order was issued. In its order, the PUC deferred ruling on whether these costs would be recoverable from ratepayers. At December 31, 1993, these costs totaled $51.1 million, net of deferred fuel savings related to the two units. Duquesne is not earning a return on the deferred costs. Duquesne believes that these deferred costs are recoverable. In 1990, another Pennsylvania utility was permitted recovery, with no return on the unamortized balance, of similar costs over a 10-year period. DEFERRED ENERGY COSTS - -------------------------------------------------------------------------------- Duquesne defers fuel and other energy costs for recovery in subsequent years through the ECR. The deferrals reflect the difference between the amount that Duquesne is currently collecting from customers and its actual fuel costs. The PUC reviews Duquesne's fuel costs annually, for the fiscal year April through March, against the previously projected fuel costs and adjusts the ECR for over- or under-recoveries and for two PUC-established coal cost caps. The PUC has established market price coal cost standards for all Pennsylvania utilities that have interests in mines that supply coal to their generating stations. Duquesne is subject to two such standards. One applies only to coal delivered at the Mansfield plant. The other, the system-wide coal cost standard, applies to coal delivered to the remainder of Duquesne's system. Both standards are updated monthly to reflect prevailing market prices for similar coal. The PUC has directed Duquesne to defer recovery of the delivered cost of coal to the extent that such cost exceeds generally prevailing market prices, as determined by the PUC, for similar coal. The PUC allows deferred amounts to be recovered from customers when the delivered costs of coal fall below such PUC-determined prevailing market prices. In 1990, the PUC approved a joint petition for settlement that clarified certain aspects of the system-wide coal cost standard and gave Duquesne options to extend the standard through March 2000. In December 1991, Duquesne exercised the first of two options that extended the standard through March 1996. The unrecovered cost of coal used at Mansfield amounted to $7.4 million and the unrecovered cost of coal used throughout the system amounted to $8.8 million at December 31, 1993. Duquesne believes that all deferred coal costs will be recovered. WARWICK MINE COSTS - -------------------------------------------------------------------------------- The 1990 joint petition for settlement (See preceeding section on deferred energy costs.) also recognized costs at Duquesne's Warwick Mine, which had been on standby since 1988, and allowed for recovery of such costs, including the costs of ultimately closing the mine. In 1990, Duquesne entered into an agreement under which an unaffiliated company will operate the mine until March 2000 and sell the coal produced. Production began in late 1990. The mine reached a full production rate in early 1991. The Warwick Mine coal reserves include both high and low sulfur coal; the sulfur content averages in the mid-range at 1.7 percent - 1.9 percent sulfur content. More than 90 percent of the coal mined at Warwick currently is used by Duquesne. Duquesne receives a royalty on sales of coal in the open market. The Warwick Mine currently supplies less than one- fifth of the coal used in the production of electricity at the plants operated by Duquesne and those owned by CAPCO. Costs at the Warwick Mine and Duquesne's investment in the mine are expected to be recovered through the ECR. Recovery is subject to the system-wide coal cost standard. Duquesne also has an opportunity to earn, through the ECR, a return on its investment in the mine during the period, including extensions, of the system-wide coal cost standard. At December 31, 1993, Duquesne's net investment in the mine was $24.5 million. The estimated current liability for mine closing (including final site reclamation, mine water treatment and certain labor liabilities) is $33.0 million and Duquesne has collected approximately $8.9 million toward these costs. PROPERTY HELD FOR FUTURE USE - -------------------------------------------------------------------------------- In 1986, the PUC approved Duquesne's request to remove the Phillips and most of the Brunot Island (BI) power stations from service and place them in cold reserve. Duquesne's capitalized costs and net investment in the plants at December 31, 1993 totaled $130 million. (See Note L.) On December 8, 1993, the New Jersey Board of Regulatory Commissioners (BRC) denied a request by General Public Utilities' (GPU) subsidiary Jersey Central Power and Light Company for approval of the long-term power purchase and operating agreements, originally signed in 1990, between GPU and Duquesne and further amended earlier in 1993. The BRC rejected an administrative law judge's recommended decision that the project be approved and, within hours of the BRC decision, GPU terminated its participation in the project. In view of GPU's decision not to proceed, Duquesne terminated its participation in the project and in the PUC transmission line siting proceeding. During the fourth quarter of 1993, Duquesne recognized a charge of approximately $15.2 million for its investment in this abandoned GPU transmission line project. Duquesne expects to recover its net investment in these plants through future sales. Phillips and BI represent licensed, certified, clean sources of electricity that will be necessary to meet expanding opportunities in the power markets. Duquesne believes that anticipated growth in peak load demand for electricity within its service territory will require additional peaking generation. Duquesne looks to BI to meet this need. The Phillips Power Plant is an important component in meeting market opportunities to supply long term bulk power. Recent legislation may permit wider transmission access to these long term bulk power markets. In summary, Duquesne believes its investment in these cold-reserved plants will be necessary in order to meet future business needs. If business opportunities do not develop as expected, Duquesne will consider the sale of these assets. In the event that market demand, transmission access or rate recovery do not support the utilization or sale of the plants, Duquesne may have to write off part or all of their costs. K. COMMITMENTS AND CONTINGENCIES CONSTRUCTION - -------------------------------------------------------------------------------- Duquesne estimates that it will spend approximately $110 million on construction during 1994. Construction expenditures are estimated to be $70 million in 1995 and $80 million in 1996. These amounts exclude AFC, nuclear fuel and expenditures for possible early replacement of steam generators at the Beaver Valley Station. WESTINGHOUSE LAWSUIT - -------------------------------------------------------------------------------- The CAPCO companies are owners of various portions of Beaver Valley Units 1 and 2. In 1991, the CAPCO companies filed suit against Westinghouse Electric Corporation (Westinghouse) in the United States District Court for the Western District of Pennsylvania. The suit alleges that six steam generators supplied by Westinghouse for the two units contain serious defects - in particular defects causing tube corrosion and cracking. The Company is seeking monetary and corrective relief. Steam generator maintenance costs have increased as a result of these defects and are likely to continue increasing. The condition of the steam generators is being monitored closely. If the corrosion and cracking continue, replacement of the steam generators could be required prior to the ends of their 40-year design lives. The Company is continuing to conduct a corrective maintenance program and to explore longer term options, including replacement of the steam generators. While the Company has no current plans to replace the steam generators and has not yet completed a detailed, site-specific study, replacement cost per unit is estimated to be between $100 million and $150 million. (Other utilities with similar units have replaced steam generators at costs in this range.) The Company cannot predict the outcome of this matter; however, the Company does not believe that resolution will have a materially adverse effect on the Company's financial position or results of operations. The Company's percentage interests (ownership and leasehold) in Beaver Valley Unit 1 and in Beaver Valley Unit 2 are 47.5 percent and 13.74 percent, respectively. The remainder is held by the other CAPCO companies. Duquesne operates both units on behalf of the CAPCO companies. NUCLEAR INSURANCE - -------------------------------------------------------------------------------- The CAPCO companies maintain the maximum available nuclear insurance for the $5.9 billion total investment in Beaver Valley Units 1 and 2. The insurance program provides $2.7 billion for property damage, decommissioning, and decontamination liabilities. The CAPCO companies have similar property insurance for the $5.4 billion total investment in Perry Unit 1. Duquesne would be responsible for its share of any damages in excess of insurance coverage. In addition, if the property damage reserves of Nuclear Electric Insurance Limited (NEIL), an industry mutual, are inadequate to cover claims arising from an incident at any United States nuclear site covered by that insurer, Duquesne could be assessed retrospective premiums of as much as $6.5 million for up to seven years. The Price-Anderson Amendments to the Atomic Energy Act limit public liability from a single incident at a nuclear plant to $9.4 billion. Duquesne has purchased $200 million of insurance, the maximum amount available, which provides the first level of financial protection. Additional protection of $8.8 billion would be provided by an assessment of up to $75.5 million per incident on each nuclear unit in the United States. Duquesne's maximum total assessment, $56.6 million, which is based upon its ownership interests in nuclear generating stations, would be limited to a maximum of $7.5 million per incident per year. A further surcharge of 5 percent could be levied if the total amount of public claims exceeded the funds provided under the assessment program. Additionally, a premium tax of 3 percent would be charged on the assessment and surcharge. Finally, the United States Congress could impose other revenue-raising measures on the nuclear industry if funds prove insufficient to pay claims. Duquesne carries extra expense insurance; coverage includes the incremental cost of any replacement power purchased (in addition to costs that would have been incurred had the units been operating) and other incidental expense after the occurrence of certain types of accidents at the Company's nuclear units. The amounts of the coverage are 100 percent of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67 percent of such estimate per week for the following 104 weeks. The amount and duration of actual extra expense could substantially exceed insurance coverage. GUARANTEES - -------------------------------------------------------------------------------- Duquesne and the other CAPCO companies have guaranteed certain debt and lease obligations related to a coal supply contract for the Bruce Mansfield plant. At December 31, 1993, Duquesne's share of these guarantees was $35.2 million. The prices paid for the coal by the CAPCO companies under this contract are expected to be sufficient to meet debt and lease obligations to be satisfied in the year 2000. (See Note J.) The minimum future payments to be made by Duquesne solely in relation to these obligations are $6.9 million in 1994, $6.6 million in 1995, $6.3 million in 1996, $5.9 million in 1997, $5.6 million in 1998, $5.3 million in 1999 and $4.1 million in 2000. Duquesne's total payments for coal purchased under the contract were $26.5 million in 1993, $25.2 million in 1992 and $32.6 million in 1991. RESIDUAL WASTE MANAGEMENT REGULATIONS - -------------------------------------------------------------------------------- In July 1992, the Pennsylvania Department of Environmental Resources (DER) issued residual waste management regulations governing the generation and management of non-hazardous waste. Duquesne is currently conducting tests and developing compliance strategies for these regulations. Capital compliance costs are estimated, on the basis of currently available information, at $10 million through 1995. Through the year 2000, the expected additional capital cost of compliance, which is subject to the results of ground water assessments and DER final approval of compliance plans, is approximately $25 million. OTHER - -------------------------------------------------------------------------------- The Company is involved in various other legal proceedings and environmental matters. The Company believes that such proceedings and matters, in total, will not have a materially adverse effect on its financial position or results of operations. L. GENERATING UNITS In addition to its wholly owned generating units, Duquesne, together with other electric utilities, has an ownership or leasehold interest in certain jointly owned units. Duquesne is required to pay its share of the construction and operating costs of the units. Duquesne's share of the operating expenses of the units is included in the statement of consolidated income. (a) The unit is equipped with flue gas desulfurization equipment. (b) The NRC has granted a license to operate through January 2016. (c) On October 2, 1987 Duquesne sold its 13.74 percent interest in Beaver Valley Unit 2; the sale was exclusive of transmission and common facilities. Amounts shown represent facilities not sold and subsequent leasehold improvements. (d) The NRC has granted a license to operate through May 2027. (e) The NRC has granted a license to operate through March 2026. M. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (a) Fourth quarter 1993 results included the effects of a $15.2 million charge for the write-off of Duquesne's investment in abandoned transmission line project (See Note J.) and a $14.6 million reduction of taxes other than income as a result of a favorable resolution of tax assessments. (b) Restated to conform with presentations adopted during 1993. DQE BOARD OF DIRECTORS (All terms 3 years) DQE/Duquesne Light Committees: 1. Audit 2. Compensation 3. Finance 4. Nominating Duquesne Light Committees: 5. Employment and Community Relations 6. Nuclear Review JOHN M. ARTHUR 71. Term expires 1995 (5,6). Retired Chairman, Duquesne Light. Directorships include Mine Safety Appliances Company (worker and plant protection equipment and systems) and Chambers Development Company, Inc. (waste management operations). DANIEL BERG 64. Term expires 1994 (1,6). Institute Professor. Rensselaer Polytechnic Institute. Directorships include Hy-Tech Machine, Inc. (specialty parts), Joachim Machinery Co., Inc. (distributor of machine tools), and Chester Environmental, Inc. (environmental engineering). DOREEN P. BOYCE 59. Term expires 1995 (2,5). President of the Buhl Foundation (support of educational and community programs). Directorships include Microbac Laboratories, Inc. and Dollar Bank, Federal Savings Bank. Trustee of Franklin & Marshall College. ROBERT P. BOZZONI 60.Term expires 1994 (1,2). President and Chief Executive Officer of Allegheny Ludlum Corporation (specialty metals production). Directorships include Allegheny Ludlum Corporation; Chairman, Pittsburgh branch of the Federal Reserve Bank of Cleveland. SIGO FALK 59. Term expires 1996 (2,3,4). Management of personal investments. Chairman of Maurice Falk Medical Fund and trustee of Chatham College. WILLIAM H. KNOEHL 69. Term expires 1994 (3,4,6). Retired Chairman and Chief Executive Officer of Cyclops Industries, Inc. (basic and specialty steels and fabricated steel products; industrial and commercial construction). Directorships include Cabot Oil and Gas Corporation, Life trustee of Carnegie Mellon University. G. CHRISTIAN LANTZSCK 69. Term expires 1995 (2,3). Retired Vice Chairman and Treasurer, Mellon Bank Corporation (bank holding company); retired Vice Chairman and Chief Financial Officer, Mellon Bank, N.A. (commercial banking and trust services). Directorships include Koger Equity, Inc. (real estate investment trust). ROBERT MEHRABIAN 52. Term expires 1995 (1,5). President, Carnegie Mellon University; Dean, College of Engineering, University of California at Santa Barbara, 1983-90. Directorships include PPG Industries, Inc. (producer of glass, chemicals, coatings and resins), Mellon Bank Corporation and Mellon Bank, N.A. THOMAS J MURHIN 64.Term expires 1994 (3,6). Dean, A.J. Palumbo School of Business Administration, Duquesne University; former Deputy Secretary of U.S. Dept. of Commerce; former President, Westinghouse Electric Corporation Energy and Advanced Technology Group. Directorships include Motorola, Inc. (manufacturer of electrical equipment and components). Member of the private sector Council on Competitiveness and the NASA Advisory Council. ROBERT B. PFASI 68. Term expires 1996 (1,5). Senior Vice President, National Development Corporation (real estate); Executive Director, Allegheny Conference on Community Development, 1968-91. Directorships include Blue Cross of Western Pennsylvania, the Port Authority of Allegheny County, and the Regional Industrial Development Corporation of Southwestern Pennsylvania. ERIC W. SPRINGER 64. Term expires 1996 (1,4). Partner of Horty, Springer and Mattern, P.C. (attorneys-at-law). Directorships include Presbyterian University Hospital. President of the Allegheny County Bar Association. WESLEY W. VON SCHACK 49. Term expires 1996 (3,4,5,6). Chairman, President and Chief Executive Officer of DQE and Duquesne Light. Directorships include Mellon Bank Corporation, RMI Titanium Co. (producer of titanium metal products), the Pittsburgh branch of the Federal Reserve Bank of Cleveland, the Regional Industrial Development Corporation of Southwestern Pennsylvania, the Pennsylvania Business Roundtable, and the Pittsburgh Cultural Trust. DQE OFFICERS WESLEY W. VON SCHACK 49. DQE Chairman of the Board, President and Chief Executive Officer; Duquesne Light Chairman of the Board since 1987, President and Chief Executive Officer since 1986, and Chief Financial Officer from 1984 through 1986. Previously Senior Vice President--Finance and Administrative Services for Central Vermont Public Service Corporation. Also served in executive positions with American Electric Power Company and Appalachian Power Company. DAVID D. MARSHALL 41. DQE Vice President; Duquesne Light Executive Vice President since 1992, previously Assistant to the President (1990) and Vice President, Corporate Development (1987). Joined Duquesne Light in 1985 as General Manager, Planning, Budgeting and Rates; previously was Assistant Vice President of Finance for Central Vermont Public Service Corporation. FREDERICK S. POTTER 48. DQE Vice President since 1991; previously a senior banker with Bear, Stearns & Co., Inc.; a vice president for Planmetrics, Inc.; and an investment banker with Merrill Lynch & Co., Inc. GARY L. SCHWASS 48. DQE Vice President and Treasurer; Duquesne Light Chief Financial Officer since 1989; Vice President, Finance (1988); and Vice President and Treasurer (1987). Joined Duquesne Light in 1985 as Treasurer; previously served in a variety of senior management positions for Consumers Power Company, including Executive Director of Financial Planning and Projects. - -------------------------------------------------------------------------------- DUQUESNE LIGHT COMPANY - -------------------------------------------------------------------------------- DUQUESNE ENTERPRISES - -------------------------------------------------------------------------------- MONTAUK Shareholder Reference Guide Common Stock - -------------------------------------------------------------------------------- Trading Symbol: DQE Stock Exchanges Listed and Traded: New York, Philadelphia, Chicago Number of Common Shareholders of Record at Year End: 81,343 Annual Meeting - -------------------------------------------------------------------------------- Shareholders are cordially invited to attend our Annual Meeting of Shareholders at 11 a.m. (local time), April 20, 1994, at the Pittsburgh Theological Seminary, 616 N. Highland Ave., Pittsburgh, PA 15206. Dividends - -------------------------------------------------------------------------------- The Board of Directors historically has declared quarterly dividends payable on the first business day of January, April, July and October. The record dates for 1994 are expected to be March 7, June 10, September 9 and December 9. Direct Deposit of Dividends - -------------------------------------------------------------------------------- Your DQE quarterly dividend payments can be deposited automatically into a personal checking or savings account. Through this free service, your dividend income is available for use on the payment date. Standing in bank lines is eliminated, as well as the fear of misplacing or losing your check. Call us toll free for more information. Tax Status of Common Stock Dividends - -------------------------------------------------------------------------------- The company estimates that all of the common stock dividends paid in 1993 are taxable as dividend income. This estimate is subject to audit by the Internal Revenue Service. Form 10-K - -------------------------------------------------------------------------------- If you hold or are a beneficial owner of our stock as of February 23, 1994, the record date for the 1994 Annual Meeting, we will send you, free upon request, a copy of DQE's Annual Report on Form 10-K, as filed with the Securities and Exchange Commission for 1993. All requests must be made in writing to: Secretary DQE Box 68 Pittsburgh, PA 15230-0068 Shareholder Services/Assistance - -------------------------------------------------------------------------------- Shareholder inquiries relating to dividends, missing stock certificates, dividend reinvestment, direct deposit, direct debit, change of address notification, and other account information should include your account number and be directed to: Shareholder Relations Department DQE Box 68 Pittsburgh, PA 15230-0068 Shareholders also can call between 7:30 a.m. and 4:30 p.m., Eastern time, Monday through Friday. Please have your account number handy. Pittsburgh area: 393-6167 Toll free outside Pittsburgh area: 1-800-247-0400 FAX: 412-393-6087 Questions relating to re-registering stock, including shares held in the Dividend Reinvestment and Stock Purchase Plan, can be answered by our Shareholder Relations Department. To actually transfer stock certificates, contact our transfer agent: Bank of Boston Transfer Processing 150 Royall Street 45-01-05 Canton, MA 02021 617-575-2900 Duplicate Mailings - -------------------------------------------------------------------------------- If you hold multiple accounts, you may be receiving duplicate mailings of annual and quarterly reports. Help us eliminate this unnecessary expense by calling our toll free number. Elimination of these duplicate mailings will not affect separate delivery of dividend checks and proxy materials to each account. Financial Community Inquiries - -------------------------------------------------------------------------------- Analysts, investment managers, and brokers should direct their inquiries to 412-393-4133. Written inquiries should be sent to: Investor Relations Department DQE Box 68 Pittsburgh, PA 15230-0068 FAX: 412-393-6448 DQE and its affiliated companies are Equal Opportunity Employers. Reg. U.S. Pat. & Tm. Off. [LOGO OF DUQUESNE APPEARS HERE] [RECYCLABLE LOGO APPEARS HERE] The 1993 DQE Annual Report was printed entirely on recycled paper and is 100 percent recyclable. Exhibit 28.2 1993 GRAPHICS APPENDIX LIST DQE' Annual Report to Shareholders _______________________________________________________________________________ PAGE WHERE GRAPHIC DESCRIPTION OF GRAPHIC OR CROSS-REFERENCE APPEARS - -------------------------------------------------------------------------------- 1 DQE Earnings per share: Bar graph shows five years of increasing earnings per share. 1989-$2.03; 1990- $2.24; 1991-$2.50; 1992-$2.67; 1993-$2.72. 1 DQE Annualized Dividends per share: Bar graph shows five years of annualized dividends per share. 1989 $1.36 1990 $1.44 1991 $1.52 1992 $1.60 1993 $1.68 2 Photo appears of Wesley W. von Schack Chairman of the Board and Chief Executive Officer 10 Duquesne Customer Sales 1993 vs. 1992 bar graph in millions of KWH. 1993 1992 Difference Residential 3,231 3,069 +162 Commercial 5,490 5,358 +132 Industrial 3,046 3,059 -13 11 Duquesne Customer Revenues bar graph (Millions of Dollars) 1989 1990 1991 1992 1993 Residential $ 383 $ 380 412 393 401 Commercial 444 455 477 477 470 Industrial 200 203 195 196 187 ----- ----- ----- ----- ----- $1,027 $1,038 $1,084 1,066 1,058 11 Duquesne Other Operating and Maintenance Expense bar graph (Millions of Dollars) 1989-$356 1990-$366 1991-$373 1992-$358 1993-$365 (Excludes one time lease termination charge.) 12 DQE Interest Expense and Other Charges bar graph (Millions of Dollars) 1989-$167.8 1990-$159.7 1991-$144.6 1992-$135.3 1993-$121.2 13 DQE Net Cash Flow from Operations bar graph (Millions of Dollars) Net Cash Flow Capital Expenditures 1989 $208.3 $ 85.4 1990 $278.6 $103.7 1991 $345.3 $125.4 1992 $396.6 $112.4 1993 $383.1 $100.6 (Excludes working capital and other-net charges.) 13 DQE Ratio of Earnings to Fixed Charges bar graph showing: 1989 $1.78 1990 $1.89 1991 $2.09 1992 $2.22 1993 $2.33 14 DQE Net Income bar graph showing (Millions of Dollars) data which appears in the "Selected Financial Data" on page 41 of the DQE 1993 Annual Report to Shareholders.

52466_1993.txt

52466

1993

Item 1. BUSINESS Ionics, Incorporated ("Ionics," the "Company," or the "Registrant") is a leading water purification company engaged worldwide in the supply of water and of water treatment equipment through the use of proprietary separations technologies and systems. Ionics' products and services are used by the Company or its customers to desalt brackish water and seawater, to purify and supply bottled water, to treat water in the home, to manufacture and supply water treatment chemicals and ultrapure water, to recycle and reclaim process water and wastewater, and to measure levels of water-borne contaminants and pollutants. The Company's customers include industrial companies, consumers, municipalities and utilities. The Company's business activities are divided into three segments: membranes and related equipment, water and chemical supply, and consumer water products, which in 1993 accounted for approximately 53%, 29% and 18% of revenues, respectively. Since 1985, the Company has pursued a strategy of expanding beyond its traditional focus of selling desalination plants and equipment by owning and operating its own equipment to produce and sell water and chemicals. Approximately 45% of the Company's 1993 revenues were derived from foreign sales or operations. Over forty years ago, the Company pioneered the development of the ion-exchange membrane and the electrodialysis process. Since that time, the Company has expanded its separations technology base to include the electrodialysis reversal (EDR), reverse osmosis (RO), ultrafiltration (UF) and microfiltration (MF) membrane processes, as well as related processes such as electrodeionization (EDI), ion exchange and carbon adsorption. With its acquisition of the business of Resources Conservation Company (RCC) at the end of 1993, the Company's separations technology base now includes thermal processes such as evaporation and crystallization. The Company believes that it is the world's leading manufacturer of ion- exchange membranes and of membrane-based systems for the desalination of water. The Company was incorporated in Massachusetts in 1948. The Company's principal executive offices are located at 65 Grove Street, Watertown, Massachusetts 02172. Financial Information About Business Segments The information contained in Note 14 of Notes to Consolidated Financial Statements contained in the Company's Annual Report to Stockholders for the year ended December 31, 1993 is incorporated herein by reference. Membranes and Related Equipment The Company's membranes and related equipment business segment, which /3 I-1 accounted for approximately 53% of revenues in 1993, currently encompasses the following products: electrodialysis reversal systems; reverse osmosis systems; microfiltration systems; non-membrane water and wastewater treatment equipment; other separations technology products; instruments for monitoring and on-line detection of pollution levels; fabricated products; and brine concentrators, evaporators and crystallizers utilizing thermal separations processes. EDR Systems The Company's AquamiteR desalination systems utilize Ionics' EDR process to treat brackish water and produce potable water for commercial, municipal, and a variety of industrial purposes. The Company has built and installed approximately 2,000 systems and plants utilizing its ED and EDR technology. Today, the Company sells, under the Aquamite name, a number of standardized versions of EDR equipment, which are designed for ease of installation and low maintenance and have production capacities ranging from 500 gallons to 1.5 million gallons per day. Multiple unit configurations are used for systems of larger capacities. Customers for water purification systems increasingly have requested the Company to supply complete turnkey plants. For such customers, Ionics provides basic Aquamite equipment, peripheral water treatment equipment, complete engineering services, process and equipment design, project engineering, commissioning, operator training and field service. RO Systems The Company manufactures seawater desalination plants as well as systems for the production of ultrapure water which utilize RO membrane technology. The Company owns and operates seawater desalination plants in Grand Canary, Spain, Santa Barbara, California, and at the Diablo Canyon Power Plant in California. See "Water and Chemical Supply." MF Systems Utilizing the Company's proprietary Aqua-PoreR microfiltration membranes, the Company's EnviromatR Integrated Membrane Filtration System removes toxic contaminants such as lead, nickel and other materials from industrial wastewaters and enables manufacturers to meet stringent regulations for effluent compliance. Non-Membrane Water and Wastewater Treatment Equipment Through its wholly owned Italian subsidiary, Ionics Italba, S.p.A., Ionics designs, engineers and constructs customized systems for wastewater and municipal water treatment. These include ion-exchange systems which provide purified water for power stations, chemical and petrochemical plants, metalworking and automobile factories, textile manufacture and a variety of other industrial applications. Other systems neutralize and /4 I-2 filter industrial wastewater, separate suspended solids and, in some cases, recover chemicals. Ionics Italba also provides custom municipal and packaged sewage treatment systems. Ionics Italba generally subcontracts the construction activities associated with its projects. Through its Resources Conservation Company (RCC) business unit, Ionics designs, engineers and constructs brine concentrators, evaporators and crystallizers which are used to clean, recover and recycle wastewater, particularly in zero liquid discharge industrial uses. RCC also developed, and holds an exclusive license for, a patented solvent extraction technology known as B.E.S.T. (Basic Extractive Sludge Technology), which separates contaminated sludges, sediments and soils into oil, water and solids, and has potential use for the cleanup of toxic organic materials at Superfund Sites. Other Separations Technology Products Using its separations technology, Ionics manufactures, markets or supplies products which are used in the recovery and recycling of selected components from process streams, the manufacture of commodity and specialty compounds and the purification of valuable fluids. The Company's ElectromatR system is used in the demineralization of cheese whey to produce a major component utilized extensively in infant formula products. A similar Ionics system is used to deacidify fruit juices for a manufacturer of canned fruit products. The Company's food product revenues have been derived from three sources: the design and construction of the system, the manufacture and sale of replacement membranes used in the system, and in certain applications a royalty (based on Ionics' U.S. patents) on the throughput of product. At the end of 1993, the Company obtained an additional source of food produce revenues by entering into an agreement with a major U.S. dairy cooperative to oversee whey processing activities at plants owned by the cooperative, for which the Company will receive a processing fee based on the production of demineralized whey. Other Ionics process systems include the ChemomatR system to generate organic acids and to recover, recycle, remove and separate metals and other components from industrial wastewaters, and the CloromatR system for the production of sodium hypochlorite and related chlor-alkali chemicals. Instruments for Monitoring and On-Line Detection of Pollution Levels The Company designs, manufactures and sells equipment to measure the quality of treated or untreated water. Its products, which are used by industrial and governmental customers to measure organic and toxic contaminants in water and chemical process streams, include process and laboratory instruments to measure total carbon, total organic carbon, chemical oxygen demand and total oxygen demand. The Company recently expanded the monitoring capabilities of its instruments with the introduction of analyzers to measure concentrations at the parts per billion level of dissolved metals such as copper, lead, iron, mercury, and arsenic and specific chemical analyzers for ammonia, phosphates, nitrates, /5 I-3 and chlorine. The process systems provide real-time measurement of the level of contaminants in active waste streams. Another product, the DigichemR, sold principally to the printed circuit board, pulp and paper, and chemical and petrochemical industries, functions as a "robot chemist" capable of performing automatically "wet chemistry" analyses traditionally done manually. Fabricated Products At its Bridgeville, Pennsylvania facility, the Company fabricates specially designed products for defense-related and industrial applications. The Company's experience and expertise in design, welding, machining and assembly to meet exceptionally fine tolerances have been utilized to fabricate products ranging from intricate small parts to very large 35-ton assemblies. Water and Chemical Supply The water and chemical supply business segment accounted in 1993 for approximately 29% of the Company's revenues. The Company's strategy is to sell, where appropriate, water and chemicals produced by its membrane-based equipment, rather than selling the equipment itself. The water and chemical supply business segment can be divided into three categories: sale of desalted water for municipal and industrial use; sale of ultrapure water for electronics and other industries; and sale of bleach and related chemicals. Sale of Desalted Water for Municipal and Industrial Use Ionics' position in water supply as a seller of purified or treated water has evolved from its traditional role as a supplier of water treatment equipment. In certain situations, opportunities are available for the Company to provide a complete service package involving financing, construction, operation and maintenance of water treatment facilities. Ionics, through its wholly owned subsidiary, Ionics Iberica, S.A., owns and operates a 5.5 million gallon per day capacity brackish water EDR facility and a 2.0 million gallon per day RO seawater facility on Grand Canary Island, Spain. Under long-term contracts, the Company is selling the desalted water from both facilities to the local water utility for distribution. The Company's wholly owned subsidiary, Ionics (Bermuda) Ltd., operates a 600,000 gallon per day EDR brackish water desalting plant on the island of Bermuda. This plant supplies fresh water under a long-term contract with Watlington Waterworks Ltd., a Bermuda corporation partially owned by Ionics. /6 I-4 The Company financed and constructed, and owns and operates, an RO desalination facility in Santa Barbara, California. The facility began operation in March 1992, has the capacity to produce 7,500 acre-feet per year (approximately 6.7 million gallons per day) of desalinated water, and is expandable to 10,000 acre-feet per year. Under the terms of the Company's contract with the City, the City can either purchase water from the Company or, under conditions in which the City deems it unnecessary to purchase water, pay the Company a "stand-by fee" during the contract's five-year term and, if the City elects to continue, a five-year extension term. The City has placed the facility on "stand-by" status because of the alleviation of the area's drought. At the end of the initial five-year term, the City will have the right to renew the contract for another five- year term, purchase the facility from the Company, or direct the Company to remove the facility (most of which is housed in trailers) from its site. In the event the City purchases the facility, the City must reimburse the Company for all costs not previously recovered from operations, plus a factor to cover general and administrative expenses and profit. Sale of Ultrapure Water for Electronics and Other Industries In industries from biotechnology and chemical processing to pharmaceuticals and semiconductors, ultrapure water (water in which the impurities have been reduced to concentrations of less than several parts per billion) is critical to product quality and yield. In the electric power industry, ultrapure boiler feedwater minimizes corrosion, inefficiency and downtime in steam boilers and turbines. Depending on the composition and quantity of the impurities to be removed or treated, any one of several membrane separations methods can be utilized to provide ultrapure water to the customer. Ionics has pioneered in the application of three membrane technologies (EDR, RO and UF) combined together in a mobile system called the "triple membrane" trailer, which the Company believes to be the most advanced technology used in the commercial processing of ultrapure water. Ionics provides ultrapure water services through the sale of ultrapure water in 6,000 gallon tank trucks and the production and sale of ultrapure water from trailer-mounted units at the customer sites. In 1992, Ionics announced the commercial implementation of its new electrodeionization (EDI) technology in the production of ultrapure water. EDI is a continuous, electrically driven, membrane-based water purification process which produces ultrapure water without the use of the strong chemical regenerants, such as sulfuric acid and caustic soda, which are commonly required. In 1993, trailers utilizing EDI technology were in service at sites in Florida, Arkansas and Mississippi. In March 1992, the Company began a ten-year, $20 million contract to provide process water and ultrapure boiler feedwater to Pacific Gas and Electric's Diablo Canyon Power Plant on the central coast of California. In 1993, ten-year ultrapure water contracts were obtained from Florida Power and Light for its Turkey Point fossil fuel power plant near Florida City, and for the Seabrook Nuclear Station in Seabrook, New Hampshire. /7 I-5 The Company serves the ultrapure water market from its headquarters facilities in Watertown, Massachusetts, through the Ionics Pure Solutions Division in Phoenix, Arizona, and through the following subsidiaries: Ionics Ultrapure Water Corporation, Campbell, California; Ionics (U.K.) Limited, London, England; Ionics Italba, S.p.A., Milan, Italy; and Eau et Industrie, Paris, France. Sale of Bleach and Related Chemicals In the chemical supply area, the Company uses its CloromatR technology to produce sodium hypochlorite (household bleach) and related chlor-alkali chemicals in a membrane-based process that principally relies on water and salt as raw materials. The Company's wholly owned Australian subsidiary, Elite Chemicals Pty. Ltd., utilizes Cloromat systems to produce sodium hypochlorite on-site in Brisbane, for sale to the bulk market. In 1993, the Company's wholly owned English subsidiary, Ionics (U.K.) Limited, commenced bulk bleach sales at a new Cloromat facility in Bridgwater, England. A large portion of the facility's output is being sold to Courtaulds Films (Holdings) Limited for use in cellophane manufacture, and the balance is being sold to the regional market. In the United States, the Company's Elite Chemicals New England division operates a Cloromat facility in Springfield, Massachusetts which produces and distributes bleach-based products for the consumer market, primarily one-gallon bleach products under private label or under the Company's own "Elite" brand. In September 1993, the Company contracted to purchase a larger manufacturing facility, located in Ludlow, Massachusetts. The Company intends to pursue a strategy of utilizing Cloromat equipment and technology at Company-owned facilities to produce high quality bleach and other chlor-alkali products at selected regional sites in the United States and overseas. Consumer Water Products Ionics' consumer water products business segment accounted for approximately 18% of the Company's revenues in 1993. The Company's consumer water products include bottled water, over and under-the-sink point-of-use devices, and point-of-entry systems for treating the entire home water supply. Aqua CoolR Pure Bottled Water Ionics entered the bottled water business in 1984. The Company's strategy is to utilize its proprietary desalination and purification technology to create a brand of drinking water, named Aqua Cool Pure Bottled Water, which can be reproduced with uniform consistency and high quality at numerous locations around the world. Distribution operations have been established to serve the areas in and around London and Manchester, England; Boston, Washington and Baltimore in the United States; and, through joint ventures, in Bahrain, Kuwait and Saudi Arabia. The Company's business focuses on the sale of Aqua Cool in five-gallon bottles to a variety of customers including banks, office buildings, commercial /8 I-6 establishments, hospitals and private homes. The Company also manufactures coolers in a wide variety of colors which offer options for hot, cold and room temperature water. In 1989, the Company entered into agreements with Aqua Cool Enterprises, Inc. (ACE), a newly formed, independently owned corporation, which established ACE as a marketer and distributor of Aqua Cool in 10 eastern states and the District of Columbia, and provided for Ionics' supply to ACE of products, management services and operational support. In May 1993, the Company loaned $8.25 million to ACE which was used by ACE to redeem debt and preferred stock of ACE held by Westinghouse Credit Corporation. In June 1993, the Company's loan was converted into preferred stock, and as a result of these transactions, the Company now consolidates the operating results of ACE. ACE operates eight distribution centers in Massachusetts, Connecticut, New York, New Jersey, Pennsylvania and Virginia, which augment the Company's distribution network. At the end of 1993, there were a total of 17 Aqua Cool distribution centers in the United States and overseas, supplied with Aqua Cool by five regional water purification and bottling facilities which are owned and operated by the Company. Construction was being completed of a new, larger bottling facility located outside Washington, D.C., and plans were being prepared to construct a third U.S. bottling facility in northern New Jersey. In January 1994, the Company announced plans to begin distribution of Aqua Cool in the Cincinnati, Ohio area. Aqua Cool's focus has been in particular to obtain large commercial or governmental supply contracts for five-gallon delivery, such as the estimated $2 million, two-year contract awarded in 1993 by the City of New York Department of General Services. Point-of-Use Devices The Company participates in the "point-of-use" market for over and under-the-sink water purifiers through the manufacture and sale of HYgeneR, a proprietary, EPA-registered, silver-impregnated activated carbon filtering media, and through the sale of reverse osmosis and activated carbon-based filtering devices. The Company incorporates HYgene, which is designed to prevent bacterial build-up while providing the capability of removing undesirable tastes and odors from the water supply, into its own bacteriostatic water conditioners and also sells HYgene to manufacturers of household point-of-use water filters. In 1993, a substantial decline in HYgene sales to other manufacturers continued as a result of lack of business from the largest of the Company's HYgene customers. Point-of-Entry Systems Ionics' point-of-entry water products include ion-exchange water conditioners to "soften" hard water, and chemicals and media for filtration and treatment. The Company sells its products, under the General Ionics brand, through both independent distributorships and wholly owned sales and service dealerships. For water conditioners sold by the latter, the Company provides customer financing. /9 I-7 Raw Materials and Sources of Supply All raw materials essential to the business of the Company can normally be obtained from more than one source. In those few instances where raw materials are being supplied by only one source, the current supplier has given the Company a lead time for cancellation, which the Company believes is sufficient to enable it to obtain other suppliers. In addition, the Company maintains inventories of single source items which it believes are adequate under the circumstances. The Company produces the membranes required for its equipment and systems that use the ED, EDR, MF, and EDI processes. Membranes used for the RO and UF processes are purchased from outside suppliers, and are normally available from multiple sources. Patents and Trademarks The Company believes that its products, know-how, servicing network and marketing skills are more significant to its business than trademark or patent protection of its technology. Nevertheless, the Company has a policy of applying for patents both in the United States and abroad on inventions made in the course of its research and development work for which a commercial use is considered likely. The Company owns numerous United States and foreign patents and trademarks and has issued licenses thereunder, and currently has additional pending patent applications. Of the 107 active U.S. patents held by the Company, a substantial portion involves membranes, membrane technology and related separations processes such as electrodialysis and electrodialysis reversal, reverse osmosis, ultrafiltration and electrodeionization. The Company believes that none of its individual patents or groups of related patents, nor any of its trademarks, is of sufficient importance for its termination or abandonment, or cancellation of licenses extending rights thereunder, to have a material adverse effect on the Company. Seasonality The activities of the Company's businesses are not of a seasonal nature, except that bottled water sales and bleach products for swimming pool use tend to increase during the summer months. Also, the Company's Elite Chemicals New England Facility produces windshield wash solution, for which sales levels increase in the winter months. Customers The nature of the Company's business is such that it frequently has in progress large contracts with one or more customers for specific projects; however, there is no one customer whose purchases account for 10% or more of the Company's consolidated revenues and whose loss would have a material adverse effect on the Company and its subsidiaries taken as a whole. /10 I-8 Backlog The Company's backlog of firm orders was $129,271,000 at December 31, 1993 and $125,506,000 at December 31, 1992. In the case of multi-year contracts entered into through June 30, 1991, the Company initially included in reported backlog only the revenues expected from the first four years of the contract. For multi-year contracts entered into after that date, the Company has initially included in reported backlog the revenues associated with the first five years of the contract. Also, the Company now includes in backlog up to one year of revenues relating to multi-year contracts which are not otherwise included in backlog. Ionics expects to fill approximately 75% of its December 31, 1993 backlog during 1994. The Company does not believe that there are any seasonal aspects to these backlog figures. Government Contracts The Company does not believe that any of its sales under U.S. Government contracts or subcontracts during 1993 are subject to renegotiation. The Company has not had adjustments to its negotiated contract prices, nor are any proceedings pending for such adjustments. Research and Development Since the development of the ion exchange membrane and the EDR process, Ionics has continued its commitment to research and development directed toward products for use in water purification, processing and measurement, and separations technology. The Company's research and development expenses were approximately $3,678,000 in 1993, $3,084,000 in 1992, and $2,886,000 in 1991. Competition The Company experiences competition from a variety of sources with respect to virtually all of its products, systems and services, although the Company knows of no single entity that competes with it across the full range of its products and services. Competition in the markets served by the Company is based on a number of factors, which may include price, technology, applications experience, know-how, availability of financing, reputation, product warranties, reliability, service and distribution. With respect to the Company's membrane and related equipment business segment, there are a number of companies, including several sizable chemical companies, that manufacture membranes, but not equipment. There are numerous smaller companies, primarily fabricators, that build water treatment and desalination equipment, but which generally do not have their own proprietary membrane technology. A limited number of companies manufacture both membranes and equipment. The Company has numerous competitors in its conventional water treatment, instruments and fabricated products business lines. /11 I-9 In 1992, the International Desalination Association released a report providing data regarding the manufacturers of desalination equipment. According to the report, which covered land-based water desalination plants delivered or under construction as of December 1991, with a capacity to produce 100 cubic meters (approximately 25,000 gallons) or more of fresh water daily, Ionics ranked first in terms of the cumulative number of such plants sold, having sold 1,127 plants of such capacity, more than the next three manufacturers combined. When compared only to manufacturers of membrane-type desalination equipment, Ionics ranked first in both number of units sold and the total capacity of units sold. With respect to the water and chemical supply business segment, the Company competes with regional suppliers of ultrapure water services, and with other manufacturers of membrane-related equipment. In the chemical supply activity, the Company competes with manufacturers and distributors of bleach and water treatment chemicals. With respect to the Company's consumer water products business segment, there are numerous bottled water companies which compete with the Company, including several which are much larger than the Company. Most of the Company's competitors in point-of-entry and point-of-use products for the home are small assemblers, serving local or regional markets. However, there are also several large companies competing nationally in these markets. In the case of its silver-impregnated activated carbon product lines, the Company knows of two competitors with which it competes on a national basis. The Company is unable to state with certainty its relative market position in all aspects of its business. Many of its competitors have financial and other resources greater than those of the Company. Environmental Matters Continued compliance by the Company or by its subsidiaries with federal, state and local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment is expected to have no material effect upon capital expenditures, earnings or the competitive position of the Company or any of its subsidiaries. The Company is one of more than 200 potentially responsible parties (PRPs) in connection with the Silresim Superfund Site in Lowell, Massachusetts. Under the Comprehensive Environmental Response Compensation and Liability Act (CERCLA or Superfund), the U.S. Environmental Protection Agency (EPA) has the authority to undertake remedial action at a Superfund site and hold responsible parties liable, on a joint and several basis and without regard to fault or negligence for costs incurred. Under the terms of a 1992 Settlement Agreement among the PRPs, EPA and the Commonwealth of Massachusetts, Ionics paid $381,000 as a settlement amount to the site settlement trust fund, representing the Company's approximately 1% volumetric contribution of wastes to the site. This fund will be used by /12 I-10 the EPA to clean up the Silresim Site. The amount paid by Ionics had been fully reserved at December 31, 1991, and the payment had no material adverse impact on the Company. Because the pollution problems at the site have been extensively studied and because the funds collected from the settling PRPs by the site settlement trust fund substantially exceeds the EPA's own estimate of remediation costs, the Company believes that it is highly unlikely that it will incur any further monetary obligations with respect to this site, other than site access costs that will be incurred by the EPA in connection with its remediation activities. The Company's share of these site access costs is expected to be $30,000 to $40,000 over the next several years. The Company was notified in June 1992 that it is a PRP at another Superfund site, Solvent Recovery Service of New England, in Southington, Connecticut (the "SRS Site"). The EPA has not yet completed its remedial investigation or issued a record of decision specifying estimated clean-up costs, and therefore it is too early to determine what the Company's liability might be with respect to the SRS Site. However, based upon the very large number of PRPs identified with respect to the SRS Site (over 1,000), the Company's small volumetric ranking in comparison to the total volume of wastes brought to the SRS Site (just under 0.5%), and the identities of the larger generators, which include many substantial companies, the Company believes that its liability in this matter will not have a material effect on the Company or its financial results. The Company's intention is to participate in the settlement agreement finally structured for the Site, so long as such agreement is fair to the parties. The Company has never had a product liability claim grounded in environmental liability, and believes that the nature of its products and business makes such a claim unlikely. Employees The Company and its consolidated subsidiaries employ approximately 1,300 full-time persons, none of whom are represented by unions except for the employees of the Company's Australian subsidiary and certain employees of the Company's Spanish subsidiary. The Company considers its relations with its employees to be good. Foreign Operations The Company's sales to customers in foreign countries primarily involve desalination systems, water and wastewater treatment systems and related products and services. The Company seeks to minimize financial risks relating to its international operations. Wherever possible, the Company obtains letters of credit or similar payment assurances denominated in dollars. If dollar payments cannot be secured, the Company, where appropriate, enters into foreign currency hedging transactions. The Company also uses foreign sources for equipment parts and may borrow funds in local (foreign) currency to offset the asset risk of foreign currency devaluation. Net foreign currency transaction gains included in income before taxes totalled $157,000 in 1993, $587,000 in 1992, and $180,000 in 1991. /13 I-11 Ionics engages in certain foreign operations both directly and through the following wholly owned subsidiaries: Ionics (Bermuda) Ltd.; Ionics Iberica, S.A.; Ionics (U.K.) Limited; Ionics Italba, S.p.A.; Ionics Nederland N.V.; Global Water Services, S.A.; Elite Chemicals Pty. Ltd.; Eau et Industrie; Resources Conservation Co. International; and Ionics Foreign Sales Corporation Limited. The Company engages in various foreign operations through investments in affiliated companies and joint venture relationships. The activities include the production, sale and distribution of bottled water through a 40% owned affiliate in Bahrain, a 40% owned affiliate in Saudi Arabia and a 49% owned affiliate in Kuwait. In addition, the Company has a 23% ownership interest in Watlington Waterworks Ltd. in Bermuda. Watlington collects, treats and distributes water throughout Bermuda for both potable and non-potable uses. The Company also has a 50% ownership interest in Yuasa-Ionics Co., Ltd., Tokyo, Japan, which among its other activities serves as a distributor of certain of the Company's products in Japan. Further geographical and financial information concerning the Company's foreign operations appears in Notes 1, 5, 8, 12, and 14 to the Company's Consolidated Financial Statements included as part of the Company's 1993 Annual Report to the Stockholders, which Notes are incorporated herein by reference. Financial Information About Foreign and Domestic Operations and Export Sales The information contained in Note 14 of Notes to Consolidated Financial Statements contained in the Company's Annual Report to Stockholders for the year ended December 31, 1993 is incorporated herein by reference. Item 2.

Item 2. PROPERTIES The Company owns or leases and occupies various manufacturing and office facilities in the United States and abroad. The principal facilities owned by the Company include two buildings in Watertown, Massachusetts housing the executive offices, laboratories and manufacturing and assembly operations; and facilities in Bridgeville, Pennsylvania; Phoenix, Arizona; Lorton, Virginia; Elkridge, Maryland; and Milan, Italy, for various operations relating to the design and manufacture of water purification and treatment equipment or water-related services. The two buildings in Watertown, Massachusetts which are owned by the Company and together contain approximately 250,000 square feet, are the subject of a mortgage securing the Company's guaranty with respect to industrial revenue bond financing of such facilities. The industrial revenue bond indebtedness will be discharged in 1994. /14 I-12 The other major facility owned by the Company is its Bridgeville, Pennsylvania facility, consisting of two buildings containing approximately 77,000 square feet and housing manufacturing operations for home water conditioners and stainless steel fabrication. The Company considers the business facilities that it utilizes to be adequate for the uses to which they are being put. Item 3.

Item 3. LEGAL PROCEEDINGS The Company is from time to time involved in litigation in the normal course of its business. At the present, the Company believes that there is no pending or threatened litigation the result of which would have a material adverse effect on the Company's earnings or financial position. See "BUSINESS - Environmental Matters." Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. /15 I-13 PART II Item 5.

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Reference is made to the Company's Annual Report to Stockholders for the year ended December 31, 1993. The information set forth on page 32 entitled "Common Stock Price Range" and the inside back cover of such Annual Report is hereby incorporated by reference. Item 6.

Item 6. SELECTED FINANCIAL DATA Reference is made to the Company's Annual Report to Stockholders for the year ended December 31, 1993. The information set forth on page 32 of such Annual Report entitled "Selected Quarterly Financial Data (unaudited)" is hereby incorporated by reference. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to the Company's Annual Report to Stockholders for the year ended December 31, 1993. The information set forth on pages 17 through 19 of such Annual Report entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" is hereby incorporated by reference. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Company's Annual Report to Stockholders for the year ended December 31, 1993. The consolidated balance sheets of the Registrant as of December 31, 1993 and 1992, the related consolidated statements of operations, cash flows and stockholders' equity for the years ended December 31, 1993, 1992 and 1991, and the related notes with the opinion thereon of Coopers & Lybrand, independent accountants, on pages 20 through 31, and Selected Quarterly Financial Data (unaudited) on page 32, are hereby incorporated by reference. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE This item is not applicable to the Company. /16 II-1 PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 with respect to Directors is hereby incorporated by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 5, 1994 to be filed with the Securities and Exchange Commission on or about March 30, 1994. The information regarding executive and other officers is as follows: Age as of Positions Name March 1, 1994 Presently Held Executive Officers: Arthur L. Goldstein* 58 President, Chief Executive Officer and Director since 1971; Chairman of the Board since 1990 Kachig Kachadurian 44 Senior Vice President since 1991 and Vice President since 1983, Director since 1986 William E. Katz 69 Executive Vice President since 1983 and Director since 1961 Robert J. Halliday 39 Vice President, Finance and Accounting since December 1990; Chief Financial Officer since August 1992. Stephen Korn 48 Vice President, General Counsel and Clerk since September 1989 Theodore G. Papastavros 60 Vice President since 1975 and Treasurer since February 1990 Other Officers: Alan M. Crosby 41 Vice President, Corporate Quality Programs and Watertown Operations since 1991 Edward P. Geishecker 58 Vice President, United States and Canada Sales and Marketing, Water Systems Division since 1991 William B. Iaconelli 60 Vice President, Separations Technology since 1983 Patrick K. Lam 54 Vice President, Project Management and International Subsidiaries since 1991 Joseph M. Loftis 52 Vice President, Fabricated Products since 1986 and General Manager, Bridgeville Leon Mir 55 Vice President, Research and Development since September 1992 Ark W. Pang 44 Vice President, International Sales and Marketing, Water Systems Division since 1991 Walter J. Polens 72 Vice President, Household Water Conditioning since 1968 ___________________ * Member of Executive Committee There are no family relationships between any of the officers or directors. Officers of the Registrant are elected each year at the annual meeting of Directors. /17 III-1 All of the above executive officers have been employed by the Registrant in various capacities for more than five years, except for Messrs. Halliday and Korn. Prior to joining the Company in December 1990, Mr. Halliday served from April 1987 to December 1990 as Corporate Controller of Alliant Computer Systems Corporation, a manufacturer of mini-supercomputers, and between September 1984 and April 1987 as Assistant Controller and Controller of Symbolics, Inc., a developer and manufacturer of symbolic processing computers. Prior to joining the Company in 1989, Mr. Korn served as Vice President/General Counsel and Secretary of Symbolics, Inc. from July 1986 to August 1989. Prior to joining Symbolics, Mr. Korn had been a member of the Boston law firm of Widett, Slater and Goldman, P.C. for more than five years. Item 11.

Item 11. EXECUTIVE COMPENSATION The information required by Item 11 is hereby incorporated by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 5, 1994 to be filed with the Securities and Exchange Commission on or about March 30, 1994. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is hereby incorporated by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 5, 1994 to be filed with the Securities and Exchange Commission on or about March 30, 1994. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is hereby incorporated by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 5, 1994 to be filed with the Securities and Exchange Commission on or about March 30, 1994. /18 III-2 PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements See Index to Financial Statements and Financial Statement Schedules on page IV-7. The Financial Statement Schedules are filed as part of this Annual Report on Form 10-K. 2. Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules on page IV-7. 3. Exhibits Exhibit Page No. Description No. 3.0 Articles of Organization and By-Laws 3.1 Restated Articles of Organization (filed * as Exhibit 3(a) to Form 10-K for year ended December 31, 1986). 3.1(a) Amendment to the Restated Articles of * Organization (filed as Exhibit 3(b) to Form 10-K for year ended December 31, 1987). 3.1(b) Amendment to Restated Articles of * Organization (filed as Exhibit 3.1(b) to Registration Statement No. 33-38290 on Form S-2 effective January 24, 1991). 3.2 By-Laws, as amended (filed as Exhibit 19 to * Form 10-Q for the quarter ended September 30, 1989). 4.0 Instruments defining the rights of security holders, including indentures 4.1 Industrial Revenue Bond issued by the Town ** of Watertown, Massachusetts in the amount of $3,000,000 guaranteed by Registrant, and related documents. 4.2 Agreement for a loan payable by a consolidated ** subsidiary to a bank in Australia in the principal amount of 725,000 Australian dollars guaranteed by Registrant, and related documents. /19 IV-1 4.3 Rights Agreement, dated as of December 22, 1987, * as amended and restated as of August 15, 1989, between Registrant and The First National Bank of Boston (filed as Exhibit 1 to Registrant's Current Report on Form 8-K dated August 30, 1989). 4.4 Indenture, dated as of December 22, 1987, between * Registrant and The First National Bank of Boston, relating to Rights Agreement (filed as Exhibit 2 to Registrant's Current Report on Form 8-K dated December 22, 1987). 4.5 Form of Common Stock Certificate (filed as Exhibit * 4.10 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). 10. Material Contracts 10.1 1979 Stock Option Plan, as amended through February 17, 1994. 10.2 1986 Stock Option Plan for Non-Employee Directors, * as amended though February 18, 1992 (filed as Exhibit 10.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 10.3 Amended and Restated Credit Agreement between * Registrant and The First National Bank of Boston dated as of December 31, 1992 (filed on Exhibit 10.3 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.4 Operating Agreement dated as of September 27, * 1989 between Registrant and Aqua Cool Enter- prises, Inc. (filed as Exhibit 10.4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 10.5 Term Lease Master Agreement dated as of * September 27, 1989 between Registrant and Aqua Cool Enterprises, Inc. (filed as Exhibit 10.5 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 10.6 Option Agreement dated as of September 27, 1989 * among Registrant, Aqua Cool Enterprises, Inc. and the other parties named therein (filed as Exhibit 10.6 to Registrant's registration statement on Form S-2, No. 33-38290, effective January 24, 1991). 10.7 Agreement for Privatization of Water Supplies * dated as of September 18, 1990 between the Company and the City of Santa Barbara, California (filed as Exhibit 10.7 to Registrant's registration statement on Form S-2, No. 33-38290, effective January 24, 1991). /20 IV-2 10.8 Amendment No. 1, dated as of January 3, 1992, to * Agreement for Privatization of Water Supplies dated as of September 18, 1990 between the Company and the City of Santa Barbara, California (filed as Exhibit 10.8 to Registrant's annual report on Form 10-K for the year ended December 31, 1991). 10.9 Amendment No. 2, dated as of January 19, 1993, * to Agreement for Privatization of Water Supplies dated as of September 18, 1990 between the Company and the City of Santa Barbara, California (filed as Exhibit 10.9 to the Registrant's annual report on Form 10-K for the year ended December 31, 1992). 10.10 Asset Purchase Agreement Among the Company, * Resources Conservation Company, Resources Conservation Co. International and Halliburton NUS Corporation dated December 30, 1993 (filed as Exhibit 2 to Registrant's current report on Form 8-K dated February 7, 1994 and filed electronically on the same date). 11. Statement re Computation of Earnings Per Share. 13. Annual Report to Stockholders of the Registrant for the year ended December 31, 1993 (only pages 17 through 32 and the inside back cover constitute an exhibit to this report). 22. Subsidiaries of the Registrant. 24. Consents 24.1 Consent of Coopers & Lybrand to incorporation by reference of that firm's report dated February 22, 1994, which is included on page 31 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1993. 25. Power of Attorney. ________________________________ * incorporated herein by reference ** copies of which will be filed by Registrant with the Securities and Exchange Commission upon its request /21 IV-3 (b) Reports on Form 8-K No reports on Form 8-K were filed by the Registrant during the last quarter of fiscal 1993. Undertaking For purposes of complying with the amendments to the rules governing Form S-8 effective July 13, 1990 under the Securities Act of 1933, the undersigned hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's registration statements on Form S-8 Nos. 33-14194, 33-5814, 33-2092, 2-72936, 2-82780, 2-64255, 33-41598, and 33-54400. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. /22 IV-4 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. IONICS, INCORPORATED (Registrant) By/s/ Arthur L. Goldstein Arthur L. Goldstein, Chairman of the Board, President and Chief Executive Officer Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 28, 1994 By/s/ Arthur L. Goldstein Arthur L. Goldstein, Chairman of the Board, President and Chief Executive Officer (principal executive officer) and Director Date: March 28, 1994 By/s/ Robert J. Halliday Robert J. Halliday, Vice President, Finance and Accounting and Chief Financial Officer (principal financial and accounting officer) /23 IV-5 Date: March 28, 1994 By/s/ William L. Brown William L. Brown, Director Date: March 28, 1994 By Arnaud de Vitry d'Avaucourt Arnaud de Vitry d'Avaucourt, Director Date: March 28, 1994 By/s/ Lawrence E. Fouraker Lawrence E. Fouraker, Director Date: March 28, 1994 By/s/ Samuel A. Goldblith Samuel A. Goldblith, Director Date: March 28, 1994 By/s/ Kachig Kachadurian Kachig Kachadurian, Director Date: March 28, 1994 By/s/ William E. Katz William E. Katz, Director Date: By/s/ Robert B. Luick, Director Date: By/s/ John J. Shields, Director DATE: March 28, 1994 By/s/ Mark S. Wrighton Mark S. Wrighton, Director Date: March 28, 1994 By/s/ Allen S. Wyett Allen S. Wyett, Director By/s/ Stephen Korn Attorney-in-fact /24 IV-6 IONICS, INCORPORATED INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES PAGES Report of Independent Accountants 31* Financial Statements: Consolidated Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 20* Consolidated Balance Sheets as of December 31, 1993 and 1992 21* Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 22* Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 23* Notes to Consolidated Financial Statements 24-31* Supporting Financial Statement Schedules for the years Ended December 31, 1993, 1992 and 1991: Schedule I - Marketable Securities and Other Short-Term Investments IV-8 Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees other than Related Parties IV-9 Schedule V - Property, Plant and Equipment IV-10 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment IV-11 Schedule VIII - Valuation and Qualifying Accounts IV-12 Schedule IX - Short-Term Borrowings IV-13 Report of Independent Accountants on Financial Statement Schedules IV-14 __________________ All other schedules are omitted because the amounts are immaterial, the schedules are not applicable or the required information is shown in the financial statements or the notes thereto. * Page references are to the Annual Report to Stockholders of the Company for the year ended December 31, 1993, which pages are incorporated herein by reference. /25 IV-7 IONICS, INCORPORATED SCHEDULE I - MARKETABLE SECURITIES AND OTHER SHORT-TERM INVESTMENTS /26 IV-8 IONICS, INCORPORATED SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES /27 IV-9 IONICS, INCORPORATED SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT /28 IV-10 IONICS, INCORPORATED SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT /29 IV-11 IONICS, INCORPORATED SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS /30 IV-12 IONICS, INCORPORATED SCHEDULE IX - SHORT-TERM BORROWINGS /31 IV-13 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Ionics, Incorporated: Our report on the consolidated financial statements of Ionics, Incorporated as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 has been incorporated by reference in this Form 10-K from page 31 of the 1993 Annual Report to Stockholders of Ionics, Incorporated. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the Index on page IV-7 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Boston, Massachusetts February 22, 1994 /32 IV-14 EXHIBIT INDEX /33 10.2 1986 Stock Option Plan for Non-Employee Directors, * as amended though February 18, 1992 (filed as Exhibit 10.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 10.3 Amended and Restated Credit Agreement between * Registrant and The First National Bank of Boston dated as of December 31, 1993. 10.4 Operating Agreement dated as of September 27, * 1989 between Registrant and Aqua Cool Enter- prises, Inc. (filed as Exhibit 10.4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 10.5 Term Lease Master Agreement dated as of * September 27, 1989 between Registrant and Aqua Cool Enterprises, Inc. (filed as Exhibit 10.5 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). 10.6 Option Agreement dated as of September 27, 1989 * among Registrant, Aqua Cool Enterprises, Inc. and the other parties named therein (filed as Exhibit 10.6 to Registrant's registration statement on Form S-2, No. 33-38290, effective January 24, 1991). 10.7 Agreement for Privatization of Water Supplies * dated as of September 18, 1990 between the Company and the City of Santa Barbara, California (filed as Exhibit 10.7 to Registrant's registration statement on Form S-2, No. 33-38290, effective January 24, 1991). 10.8 Amendment No. 1, dated as of January 3, 1992, to * Agreement for Privatization of Water Supplies dated as of September 18, 1990 between the Company and the City of Santa Barbara, California (filed as Exhibit 10.8 to Registrant's annual report on Form 10-K for the year ended December 31, 1991). 10.9 Amendment No. 2, dated as of January 19, 1993, * to Agreement for Privatization of Water Supplies dated as of September 18, 1990 between the Company and the City of Santa Barbara, California (filed as Exhibit 10.9 to the Registrant's annual report on Form 10-K for the year ended December 31, 1992). 10.10 Asset Purchase Agreement among the Company, * Resources Conservation Company, Resources Conservation Co. International and Halliburton NUS Corporation dated December 30, 1993 (filed as Exhibit 2 to Registrant's current report on Form 8-K dated February 7, 1994 and filed electronically on the same date). /34 11. Statement re Computation of Earnings Per Share. 47 13. Annual Report to Stockholders of the Registrant for 48 the year ended December 31, 1993 (only pages 17 through 32 and the inside back cover constitute an exhibit to this report). 22. Subsidiaries of the Registrant. 81 24.1 Consent of Coopers & Lybrand to incorporation 82 by reference of that firm's report dated February 22, 1994, which is included on page 31 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1993. 25. Power of Attorney. 83 * incorporated herein by reference /35

799319_1993.txt

799319

1993

ITEM 1. BUSINESS. IDB Communications Group, Inc., a Delaware corporation (the "Company" or "IDB"), operates a domestic and international communications network providing international private line and public switched long distance telephone services, facsimile and data connections, television and radio transmission services and mobile satellite communications capabilities. The Company was established in 1983 by Jeffrey P. Sudikoff, IDB's Chairman and Chief Executive Officer, to provide transmission of sporting and music events to radio stations nationally. Aided by the AT&T divestitures in 1984 and the opening of overseas telecommunications markets, the Company has become a full service provider of international telecommunications services as well as specialized broadcasting services. The Company has expanded rapidly through the growth of its existing businesses as well as through the selective acquisition of complementary companies which have provided strategic facilities, international operating agreements and customers. The Company operates through four service units: IDB WorldCom, IDB Broadcast, IDB Mobile and IDB Systems. The Company's principal executive offices are located at 10525 West Washington Boulevard, Culver City, California 90232-1922 and its telephone number is (213) 870-9000. "IDB" or the "Company", unless the context otherwise requires, refers to IDB Communications Group, Inc. and its subsidiaries. IDB WorldCom IDB WorldCom offers international private line and public switched long distance telephone services to government and commercial organizations worldwide. IDB WorldCom has private line operating agreements in over 150 countries and has significantly expanded the number of countries with which it has public switched voice operating agreements from one at the end of 1991 to over 50 at December 31, 1993. The Company believes it is the fourth largest U.S.-based provider of international long distance communications services based on net revenues. IDB WorldCom provides permanent and temporary domestic and international private-line services to customers for a number of applications. These applications generally involve creating private, international point-to-point communications links for clients who need special services, such as heavy data and voice usage, lower cost and greater security. IDB WorldCom has private line operating agreements with over 150 countries and is the carrier for many of the world's most critical communications links, including the Washington-Moscow hotline, the nuclear risk reduction circuit and launch control circuits for the NASA Space Program. IDB WorldCom also provides international private-line services for a range of financial, airline, commercial and governmental communications networks. Four U.S. Government agencies, eight international common carriers and over 850 other customers use IDB's network for private-line services. These customers include such organizations as ABC, CBS, NBC, CNN, EDS, General Electric, the Associated Press, Agence France Presse and Intel Corporation. IDB WorldCom also offers public switched international telephone services worldwide and provides direct services to more than 50 countries. IDB sells telephone services both to corporate customers and to domestic long distance carriers that lack transmission facilities to locations served by IDB or need more transmission capacity. Accessing IDB's international switching center via permanent domestic connections or via dial-up access code, customers can make international telephone calls. IDB's network also receives inbound calls from foreign countries. The Company has received permanent authority from the U.S. Federal Communications Commission ("FCC") to provide international public switched telephone service to over 150 countries and has entered into direct operating agreements with over 50 of these countries. IDB is pursuing traffic agreements with other U.S. and overseas telephone carriers to provide similar services to additional countries as well as provide "Phone USA" services and international 800, debit card and calling card services. In 1993, the Company significantly expanded its international private line and public switched long distance international telecommunications presence and capabilities through the acquisitions of TRT Communications, Inc., a Delaware corporation ("TRT"), and TC WorldCom AG, a Switzerland corporation ("WorldCom Europe"). See "Recent Events" below. For the year ended December 31, 1993, revenues generated from IDB's private line and public switched telephone services totalled $166,917,000, which represented approximately 54% of IDB's total 1993 revenues. IDB Broadcast IDB Broadcast provides radio and television broadcast transmission services for major network, cable, syndication, pay-per-view, sports and special event programmers. Services are provided domestically and internationally on a full-time or occasional-use basis using C-band and Ku-band technology, and include uplink and downlink services, tape playback, scrambling and resale of satellite transponder time. IDB is also making increased use of terrestrial fiber transmission to meet its customers' needs. Based on revenues, the Company believes it is one of the largest suppliers of domestic television and radio transmission services. The Company's communications network provides for the transmission and distribution of a variety of television programming. Currently, television networks, cable systems, producers of syndicated television programming and home shopping networks use IDB's network for program distribution or coverage of late-breaking news and special events from locations throughout the United States and the world. Customers for IDB Broadcast's services include ABC, CBS, NBC, ESPN, CNN, Madison Square Garden, USA Network, Lifetime, The Walt Disney Company, the BBC, Television New Zealand, European Broadcasting Union and the Tokyo Broadcasting System. IDB is the principal supplier of transmission services for holders of television rights for Major League Baseball, National Basketball Association and National Hockey League teams. During 1993, IDB provided transmission services for approximately 7,000 televised sporting events. IDB is also a major supplier of transmission services for the thoroughbred horse racing, harness racing and dog racing industries, providing such services from over 50 race tracks to Las Vegas, Nevada and other offtrack betting locations. IDB distributes radio programming for a wide variety of domestic and international broadcasting applications. During 1993, IDB provided radio transmission services for approximately 6,000 sporting events, making IDB the leading supplier of radio satellite communications services to holders of broadcast rights for Major League Baseball, National Football League and National Hockey League teams. IDB also distributes radio programming to more than 3,500 domestic radio stations affiliated with radio networks such as the Unistar Radio Network. Radio networks, stations and program syndicators use IDB's transportable and fly-away earth stations for special events programming and live coverage of late-breaking news from around the world, including locations such as the Persian Gulf and the former Soviet Union. Customers for IDB's radio services include ABC, CBS, Westwood One, the BBC, European Broadcasting Union, KDD (Japan's telecommunications authority), Digital Cable Radio and The Walt Disney Company. To support existing customers and attract new customers, the Company operates a 24-hour Program Booking Center, which acts as a clearinghouse for customer utilization of the IDB network. The Program Booking Center is an ordering and service support organization which provides phone-in, on- demand scheduling of the full range of services of IDB Broadcast. IDB's customers are able to place initial orders, change orders, make special service requests and receive scheduling updates for on-going services. IDB believes that this centralized clearinghouse for access to its network assists the Company in providing flexible and responsive service to its customers. For the year ended December 31, 1993, revenues generated from IDB's television and radio transmission services totalled $73,723,000, which represented approximately 24% of IDB's total 1993 revenues. IDB Mobile IDB Mobile is a joint venture of IDB and Teleglobe International (U.S.), Inc. of Canada. IDB Mobile provides mobile satellite communications services to commercial and private maritime, aviation and land mobile users, as well as to AT&T and all other major U.S. telecommunications companies. IDB Mobile also offers worldwide "turn-key" land mobile satellite services by packaging portable satellite terminals with Inmarsat satellite transmission. IDB Mobile provides satellite communications services to connect mobile units to the IDB communications network which in turn allows the mobile units to establish a communications link to private communications networks and the public switched telephone networks. The quality of IDB Mobile's aeronautical service is superior to the quality of traditional ground mobile and airphone services which rely on ground-based systems. In 1993, IDB provided satellite communications services to over 7,500 customers in the shipping, fishing, oil and cruise ship industries. These services enable ships to have on-board phone, facsimile and computer connectivity to home offices and communications systems around the world. IDB Mobile is one of only two companies currently providing mobile satellite service within all four oceanic regions. The Company has also provided satellite communications services using portable, 80-pound satellite terminals which have been used by reporters from the front lines of the Bosnian conflict, as well as in Somalia and in support of expeditions in Africa, the former Soviet Union and Antarctica. For the year ended December 31, 1993, revenues generated from the provision of mobile satellite communication services totalled $40,931,000, which represented approximately 13% of IDB's total 1993 revenues. IDB Systems Through its IDB Systems unit, the Company designs, installs and integrates "turn key" transmission facilities and communications networks primarily for international customers. Services provided include fixed customer premise earth stations, network management systems, system integration consulting and project management. The Company regards these services as an important part of its business because they allow IDB to increase its customer base and expand network connectivity. The Company also provides diagnostic and maintenance services for the satellite communications facilities it constructs. The Company has recently completed major installations in the People's Republic of China, Azerbaijan, Eritrea, Iran, India, Somalia, Syria, Mexico and Italy. This service unit also designs and assembles fixed earth stations in the IDB satellite communications network. For the year ended December 31, 1993, revenues generated from the provision of systems integration services totalled $20,423,000, which represented approximately 7% of IDB's total 1993 revenues. The IDB Communications Network IDB uses its communications network to provide its customers with international private line and public switched long distance telephone services, television and radio transmission services, facsimile and data connections and mobile satellite communications capabilities. Such services are provided through the Company's network of domestic terrestrial and trans-oceanic fiber optic cables, fixed and transportable satellite earth stations and leased satellite transponder capacity. The Company has made considerable investment in computerized monitoring systems, redundant circuits and back- up power systems to help ensure reliable and high quality service to its customers. On December 31, 1993, the Company employed over 300 engineers and technicians. The Company's engineers and technicians are based at key locations in the IDB network to monitor network transmissions and perform earth station and equipment installations, preventive maintenance and repairs. IDB provides network services for a spectrum of applications by creating several kinds of communications circuits. These include point-to-point transmissions, such as phone calls, data and facsimile connections between offices, and transmission of sporting, news or special events from the event site to the studios of IDB's radio or television customers, who then broadcast the event. IDB also provides point-to-multipoint transmissions, or program distribution, in which, for example, IDB transmits a data signal to a network of small antennas or transmits the radio or television programming of a network or program syndicator to its affiliated stations. For point-to-multipoint transmission, satellites generally are superior to other technologies because they disperse a signal throughout a large geographic area for cost-effective transmission. Satellites also permit signal transmission from remote sites where no other communications facilities are available and are used particularly for television signals that cannot be transmitted through conventional phone lines. For point-to-point applications, the increasing availability of fiber optic cable, which has sound quality comparable to satellite circuits without the disadvantage of propagation delay (the approximately one-quarter second delay between the time a person speaks and is heard by the other party), has expanded significantly IDB's routing options and network connectivity. Facilities The Company has international teleports in Los Angeles and New York. These teleports, which include 22 international gateway earth stations and approximately 50 domestic earth stations, enable IDB to provide radio, television, private line and public switched telephone communications to and from locations throughout the world. The Company believes that these teleports represent the largest concentration of satellite transmission equipment in the United States. The Company also owns fixed earth stations located in 33 other metropolitan areas, including seven international gateway earth stations in San Francisco and Washington, D.C., which serve as central collection points for domestic traffic and connect the network with international satellites. The Company owns a number of transportable earth stations (which are mounted on trucks or trailers) and fly-away earth stations (which can be air-freighted to an event site and quickly assembled). These mobile earth stations, most of which were assembled by IDB, enable the Company to provide transmission services to and from virtually any location in the world. The Company owns fiber optic facilities on most major international cable systems in the Pacific and Atlantic Ocean regions, providing fiber optic cable connections between the United States and the Pacific Rim and the United States and Europe. The Company also owns fiber optic cable for services to the former Soviet Union and in 1994 will purchase fiber optic cable facilities to Latin America. Domestically, the Company leases fiber optic cabling to connect various U.S. cities, including New York City, Los Angeles, Washington, D.C., Boston, San Francisco, Philadelphia, and Chicago. These domestic fiber optic facilities, which are connected to the fiber networks of GTE and Williams Telecommunications Group, expand facilities and transmission options available to IDB's customers. The Company also has relationships with numerous suppliers of transmission services who provide television transmission services to IDB for sports and special events. Some of these firms are under contract with the Company and are sometimes used by IDB when such firms have transmission facilities which can more readily reach the location of a sporting event. IDB leases 35 full-time transponders on domestic and international satellites. To augment its leased time, the Company also purchases transponder time at discounted rates under bulk time commitments from satellite owners such as AT&T, GTE Spacenet, Hughes Communications Galaxy, GE Americom, Telesat Canada, Inmarsat, PanAmSat, Intelsat and Intersputnik. Under certain transponder agreements, the Company receives favorable rates if its purchases of transponder space exceed certain minimum requirements, subject to retroactive charges if the minimum levels are not satisfied. In May 1990, IDB entered into an agreement with Communications Satellite Corporation under which IDB committed to purchase a minimum of $35,000,000 in maritime and aeronautical transponder services over a five-year period that commenced in September 1991. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 7 of Notes to Consolidated Financial Statements of the Company. Sales and Marketing On December 31, 1993, IDB employed over 200 sales and marketing personnel. The Company's sales and marketing personnel concentrate their efforts within one of the Company's four service units. The Company has developed specific marketing programs and sales commission plans for each of its units. Commission plans reward sales personnel for renewal business from existing customers, additional services for existing customers and business from new customers. Each salesperson is assigned specific existing accounts and is responsible for targeting new customers in the assigned market. IDB employs several marketing channels. Due to the high percentage of recurring services provided to its customers, IDB focuses on maintaining and increasing the usage level of its current clients. In attracting major new accounts, the Company benefits from the active involvement of senior management. Other marketing efforts include focused telemarketing and attendance at major conventions for targeted user groups. In all of its marketing efforts, IDB tailors its activities to the specific market being addressed. Competition Historically, the Company has emphasized customized communications services and applications where the Company could offer solutions with significant improvements in transmission quality or ease of use. As the Company's network has expanded to serve a broader range of users, IDB has increasingly encountered competition from major domestic and international communications companies, including AT&T, MCI Communications Corporation ("MCI") and U.S. Sprint Communications, Ltd. ("U.S. Sprint"), many of which have significantly greater resources and more extensive domestic and international satellite and fiber optic communications networks than the Company. For television transmission services, IDB competes with Keystone Communications, Inc. and Reuters Television. Various local teleports and small communications companies also compete with certain of the Company's broadcasting applications. Many cable networks own their own transmission facilities. The Company believes that its extensive network of facilities and its ability to react quickly to customers' technical requirements and service needs are competitive advantages in this market. In providing radio transmission services and transmission of live and special events radio programming, IDB generally competes with satellite service companies. In the distribution of programming to radio stations, IDB competes primarily with ABC Radio Network and National Public Radio, which provide satellite distribution of radio programming for several program producers. For resale of transponder capacity, the Company primarily competes with satellite owners such as AT&T, GE Americom, GTE Spacenet and Hughes Communications, all of which have significantly greater resources than the Company. The Company also competes with other resellers of transponder capacity. For international transponder services, the Company competes with Comsat, which enjoys a government granted monopoly controlling access to the Inmarsat and Intelsat international satellite systems. The Company uses both of these and other satellite systems to meet its customers' requirements. In providing mobile satellite services, the Company's most significant competition is from Comsat, British Telecom, Inc. and KDD. With respect to the maritime services currently offered by the Company, price and convenience of service are the principal competitive factors. In providing private-line telephone, facsimile and data communications services, the Company's most significant competition is from AT&T, MCI and U.S. Sprint. For most of the Company's communications services, the factors critical to a customer's choice of a service provider are cost, ease of use, speed of installation, broadcast quality, reputation and, in some cases, geography and network size. The Company has built a reputation as one of the most responsive service providers, particularly when providing customized communications services. IDB's array of communications facilities and international relationships, together with its extensive engineering and operations capability, provide the Company with considerable flexibility in tailoring cost-effective communications services to meet its customers' requirements. This network allows IDB to implement complex permanent and temporary communications circuits to and from virtually any location in the world. The Company believes that this responsiveness has often been the determining factor in a customer's selection of IDB. The Company's size also allows it to provide services more promptly and conveniently, particularly when customer's needs require rapid installation of service or unique solutions. Many markets which are important to IDB are not large enough for a substantially larger competitor to focus the resources necessary to provide cost competitive and responsive service. In addition, IDB's understanding of international telecommunications technical and regulatory issues has often allowed IDB to provide prompt solutions to the diverse communications needs of multinational corporations, government entities and news organizations. Employees On December 31, 1993, the Company had approximately 780 full-time employees, of whom approximately 470 provided operational and technical services. The balance of the Company's employees are engaged in sales and marketing, administration and accounting. A majority of the Company's employees are not represented by any labor union. Certain TRT employees are covered by a collective bargaining agreement that expires on April 30, 1994. From time to time, the Company supplements its labor force with part-time employees who operate transportable and fly-away earth stations during periods of heavy demand for these services. The Company considers its employee relations to be good and has not experienced any work stoppages or labor difficulties. Government Regulation The Company's communications operations and services are subject to regulation by the FCC. Transmissions from earth stations to all satellites, transmissions from microwave and other transmitters, reception from international satellites, and transmission of international traffic by any means, including satellite and undersea cable, must be pursuant to a license or other authorization granted by the FCC. FCC licensing decisions or changes in U.S. government policies increasing or decreasing access to non-Intelsat satellites or other network components could adversely affect the Company. No FCC authorization or any consent other than from the owner of the material received is required for reception via domestic satellites from points within the United States. The Company can rely on a third party's license or authorization when it transmits domestic traffic through earth stations operated by that third party. The FCC prescribes technical standards for transmission equipment which change from time to time. The FCC also requires a coordination process for earth stations operating in the frequency band used by some of the satellites on which the Company provides services to demonstrate that the earth station will not interfere with land based microwave systems. This requirement in some cases restricts how close an earth station can be located to a customer and thus may require a telephone line or other terrestrial link to be installed between the customer and the earth station. Transmission equipment must also be installed and operated in a manner that avoids exposing humans to harmful levels of radio frequency radiation. The services of telecommunications common carriers must be offered at just and reasonable rates and on a nondiscriminatory basis, but the FCC does not currently regulate market entry or exit by competitive domestic carriers such as the Company. The Company is deemed a common carrier for many of its services, but even if it were deemed to be a common carrier for all of its services, the Company does not believe that there would be any material impact on its business operations or profitability. The transmission of international traffic for customers, whether by satellite or undersea cable, and the operation of satellite earth stations that communicate with international satellites are subject to more detailed regulation based upon special statutory provisions and foreign policy considerations. As a result, the Company is subject to entry and exit regulations, restrictions on the number and type of transmissions it may provide using certain international satellites and various filing and reporting requirements with respect to its international operations. The Company holds numerous FCC licenses and other authorizations required for the operation of its business. Earth station and microwave licenses of the type described below are normally granted for a period of ten years, except that authorizations for certain transportable earth stations are granted for a one year period. Generally, authorizations to provide service are of indefinite duration and are valid until revoked or surrendered, except that cable landing license authorizations are issued for a period of twenty-five years. Under current regulations, the conduct of the Company's business requires a continuing process of applying for new, modified and renewed licenses and authorizations from the FCC. Although the Company has never had a license application denied, there can be no assurance that the Company will receive all authorizations or licenses necessary for new communications services or that delays in the licensing process will not adversely affect the Company's business. The Company's rates and practices are subject to review in the event of a third party complaint to the FCC or on the FCC's own motion. The Company has been the subject of certain third party complaints, but none has had or is expected to have a materially adverse impact on the Company or its business. To the extent that the Company is a common carrier, FCC equal employment opportunity requirements apply. A federal statute prohibits the issuance of the kind of transmission licenses the Company's operations require to any corporation with any officer or director who is not a U.S. citizen or more than 20% of whose stock is owned of record or voted by noncitizens or a foreign government or its representatives. The statute would also bar the subsidiaries from holding licenses if any officer or more than one-fourth of the Company's directors were noncitizens or more than one- fourth of the Company's shares of stock were owned of record or voted by noncitizens or a foreign government or its representatives and the FCC found that the public interest would be served by the refusal or revocation of the licenses under those circumstances. In order to allow foreign ownership of the Company to exceed 25% without risk of refusal or revocation of licenses pursuant to the Communications Act, on December 17, 1992, the Company's subsidiaries that had been holding the transmission licenses used by the Company, after seeking and obtaining required approvals from the FCC, assigned all of their common carrier earth station and microwave licenses to Southwest Communications, Inc. ("SCI"). Messrs. Jeffrey P. Sudikoff, Edward R. Cheramy and Peter F. Hartz, the Chief Executive Officer, President and Senior Vice President, Sales and Marketing of the Company, own 49%, 40%, and 11%, respectively, of the capital stock of SCI. The Company entered into Operator Agreements with SCI on December 17, 1992. These Operator Agreements have initial terms of ten years and provide for SCI to be the operator and FCC licensee of the satellite earth stations and microwave stations owned by the Company. After the initial term, the Operator Agreements will continue on a year to year basis. The Company's foreign ownership does not currently exceed 25%, but it has exceeded that level in the past and may do so again in the future. The Operator Agreements with SCI allow the Company's Common Stock to be freely traded without the risk that purchases by foreigners will create a violation of the statutory restriction on alien ownership. The placement of earth stations or other antennas is typically subject to regulation under local zoning ordinances. The export of certain telecommunications equipment requires the authorization of the United States Department of Commerce, the United States Treasury Department or the United States Department of State. The Company is subject to foreign regulation in certain countries, particularly those countries where the Company operates its own facilities. To the extent required, the Company has obtained the requisite authority to operate in such countries. Recent Events On December 30, 1993, the Company consummated its acquisition of WorldCom Europe in exchange for $10 million in cash, plus other consideration. IDB previously held 40% of the capital stock of WorldCom Europe, which it received in connection with its acquisition of World Communications, Inc. ("WorldCom") in December 1992. WorldCom Europe, a provider of international private line and public switched long distance telephone services, is now part of IDB WorldCom. The acquisition of WorldCom Europe expanded the Company's domestic and international private line, public switched long distance and satellite transmission services. The results of this acquisition will be reflected in the Company's revenues and results of operations for fiscal 1994 and are expected to be positive. On February 4, 1994, the Company effected a 3.15-to-1 Common Stock split in the form of a 215% Common Stock dividend, payable on the Common Stock of the Company outstanding at the close of business on January 21, 1994. The stockholders received cash in lieu of fractional share interests. ITEM 2.

ITEM 2. PROPERTIES. The Company owns real property at the Los Angeles international teleport location consisting of an approximately 15,000 square foot building which houses radio and television master control centers, an approximately 2,750 square foot building which houses equipment related to the operation of earth stations, and space for earth stations and parking facilities. The Company leases additional space at the Los Angeles teleport location for earth stations and related facilities. The Company also leases space through May 2004 at the New York international teleport location for earth stations and a television and radio master control facility. The Company also leases space at the Niles Canyon, California teleport location for earth stations and related facilities. The Company leases office and technical operations space in New York, New York, Rockville, Maryland and Houston, Texas, and leases office and industrial space in Dallas, Texas, where its systems integration operations are located. Additionally, the Company leases fiber optic facilities and transponder capacity pursuant to long-term agreements. See "Business -- Facilities," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 7 of Notes to Consolidated Financial Statements of the Company. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. As of March 28, 1994, the Company was involved in certain legal proceedings, none of which is expected to have a material adverse impact on the financial condition or business of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS. Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is traded in the NASDAQ National Market System under the symbol "IDBX." The following table sets forth the range of high and low closing sales prices on the NASDAQ National Market System for the indicated periods: As of March 15, 1994, the number of record holders of the Company's Common Stock was 732. On November 10, 1992, the Company issued a 5% Common Stock dividend to the record holders of IDB Common Stock as of September 30, 1992. The stock prices listed above have been adjusted to reflect the Common Stock dividend paid on November 10, 1992 and the 3.15-to-one Common Stock split in the form of a 215% Common Stock dividend paid on February 4, 1994. The Company has never paid any cash dividends on its Common Stock. The Company intends to retain earnings for further business development and does not anticipate paying any cash dividends on its Common Stock in the foreseeable future. None of the Company's existing debt agreements restrict its ability to pay dividends on the Common Stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information below should be read in conjunction with the Company's Consolidated Financial Statements and related Notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations." (1)Extraordinary item reflects the write-off of the unamortized portion of costs which had been incurred in connection with extinguished bank borrowings (net of income tax benefit) of $820,000 in 1991 and $5,639,000 in 1993. (2)Earnings per share and the weighted average common shares outstanding have been adjusted to reflect the payment of a 5% Common Stock dividend declared and paid by the Company during each of 1991 and 1992 and the 3.15-to-one Common Stock split in the form of a 215% Common Stock dividend paid on February 4, 1994. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion should be read in conjunction with the Company's Consolidated Financial Statements and related Notes. General The following table shows the percentage relationship to total revenues of certain items included in Selected Financial Data for each of the periods indicated: Results of Operations The Company derived 1993 revenues principally from international private line and public switched long distance telephone services, radio and television transmission services, mobile communications and systems integration services provided on the Company's domestic and international communications network. See "Business." 1993 Compared to 1992 Operating results for 1993 resulted in the highest revenues and income before extraordinary item and preferred stock dividend in the Company's history. Total revenues and income before extraordinary item and preferred stock dividend for 1993 were $310,708,000 and $20,139,000, respectively, versus $155,344,000 and $8,528,000, respectively, for 1992. Revenues for 1993 increased $155,364,000 or 100% over 1992 revenue principally from an increase of $130,638,000 in international private line and international public switched long distance telephone services resulting from the acquisitions of WorldCom on December 31, 1992 and TRT on September 30, 1993 (the "Acquisitions", See Note 9 of Consolidated Financial Statements of the Company) and the growth in IDB Mobile's communications services of $19,205,000. These services comprised 67% of total revenues in 1993 compared to 35% in 1992. Broadcast revenues, which declined slightly in 1993 compared to 1992 due to the Company's decision not to renew certain less profitable customer contracts, comprised 24% of total revenue in 1993 compared to 49% in 1992. The Company also earned fees of $8,000,000 and $7,700,000 in 1993 and 1992, respectively, from operational assistance and other consulting services provided to WorldCom during 1992 and TRT during 1993. The fees earned in connection with the operational assistance and consulting services ended upon completion of the acquisition of TRT in September 1993. Costs of sales increased $102,383,000 in 1993 or 100% over 1992 due to higher levels of revenue provided by the Acquisitions. Cost of sales as a percentage of revenue improved slightly due to the Company's changing revenue mix. The fastest growing revenue element, international long distance services, has lower cost of sales than the private line and broadcast services historically provided by the Company. This is somewhat offset by higher cost of sales related to IDB Mobile and IDB Systems integration activities. Selling, general and administrative expenses increased to $37,381,000 in 1993 from $18,889,000 in 1992 principally due to the Acquisitions. Selling, general and administrative expenses as a percentage of revenue declined slightly due to economies of scale resulting from higher revenue levels and the Company's efforts to control administrative costs during the integration of the WorldCom and TRT acquisitions offset by higher selling and marketing costs related to the Company's efforts to further expand its international private line and long distance telephone services. Depreciation expense as a percentage of revenues decreased to 5.6% in 1993 from 6.2% in 1992 as a result of increased utilization of the Company's network facilities. Depreciation expense increased from $9,587,000 in 1992 to $17,269,000 principally due to the Acquisitions. Amortization expense increased to $4,669,000 in 1993 from $3,507,000 in 1992 principally due to the amortization of additional intangible assets acquired in connection with the Acquisitions. Amortizable assets consist primarily of intangibles including goodwill, bank loan fees and satellite transmission and customer contracts. Streamlining charge represents $5,920,000 of charges related to the Company's plans approved in the fourth quarter of 1993 to reduce the number of employees and dispose of certain assets. Interest expense net of interest income for 1993 of $6,350,000 remained consistent with 1992 due to higher average outstanding debt ($142,807,000 in 1993 versus $90,542,000 in 1992) offset by a lower effective interest rate (8.1% in 1993 versus 10.9% in 1992) and the Company's ability to invest excess cash in interest earning investments ($2,055,000 increase in interest income in 1993). Extraordinary item in 1993 represents a $7,949,000 charge, net of $5,639,000 income tax benefit, redemption premiums and the unamortized portion of debt issuance costs associated with the repayment and defeasance of substantially all of the Company's then existing debt. The Company's provision for income taxes as a percentage of income before taxes increased to 41.5% in 1993 from 40.5% in 1992 primarily as a result of the increase in the federal statutory income tax rate to 35%. 1992 Compared to 1991 Revenues in 1992 increased $50,907,000, or 48.7%, to $155,344,000. This increase was primarily attributable to a $15,964,000 increase in revenues from IDB Mobile, resulting from its first full year of operations and its success in capturing a growing share of the maritime communications market. IDB Systems' revenues increased $11,167,000 in 1992 primarily from increased sales activity in Europe, China and Africa. Additionally, in it's first year of providing international long distance telephone services, IDB generated approximately $8,000,000 in such revenues in 1992. IDB Broadcast's revenues, which accounted for approximately 49% of total revenues in 1992 and 66% in 1991, increased $6,500,000 in 1992 principally due to additional fulltime video transmission services. The Company also earned $5,000,000 in fees generated from services provided under an operational assistance agreement with WorldCom and $2,700,000 in fees earned from sales and engineering support and management provided to WorldCom during 1992. Cost of sales has historically included a relatively high percentage of fixed costs, consisting primarily of employee salaries, satellite transponder costs and satellite and telephone line charges provided through the facilities of outside vendors. Cost of sales as a percentage of revenues increased from 63.7% in 1991 to 66.0% in 1992. The increase reflects a change in the mix of the Company's business during 1992. The Company's systems integration activities, mobile communications services to the maritime market and certain fulltime video services carry higher cost of sales than the services historically provided by the Company. In addition, a joint venture agreement which had provided for reduced rates on satellite transponder capacity expired in March 1992. These factors are partially offset by relatively lower cost of sales on international long distance services. Selling, general and administrative expenses increased to $18,889,000 in 1992 from $14,688,000 in 1991, primarily from the consolidation of IDB Mobile and Houston International Teleport, Inc. and the investment the Company made in 1992 in enhancing its internal systems. However, selling, general and administrative expenses decreased as a percentage of revenues from 14.1% in 1991 to 12.2% in 1992 due to economies of scale from higher revenue levels and improved operating efficiencies. Depreciation expense as a percentage of revenues decreased to 6.2% in 1992 from 7.0% in 1991 as a result of increased utilization of the Company's network facilities. Depreciation expense increased from $7,305,000 in 1991 to $9,587,000 in 1992 principally due to the addition of network facilities (including undersea fiber optic cable and earth stations) to support the Company's revenue growth. Amortization expense increased by $662,000 from 1991 to 1992 primarily as a result of amortization of foreign carrier license costs incurred by IDB Mobile and public switched long distance telephone services. Amortizable assets consist primarily of intangibles, bank loan fees and satellite transmission and customer contracts. Amortization expense as a percentage of revenues decreased to 2.2% in 1992 from 2.7% in 1991 as a result of increased revenues and the fixed nature of these costs. Interest expense decreased by $2,026,000 from 1991 to 1992 primarily as a result of lower effective interest rates (10.9% in 1992 versus 11.5% in 1991) and a decrease in the average debt outstanding ($90,542,000 in 1992 versus $93,792,000 in 1991). In addition, capitalized interest increased in 1992 due to a greater level of construction in progress on the Company's transmission and related facilities. The Company's provision for income taxes as a percentage of income before taxes remained relatively constant at 40.5% in 1992 as compared to 39.0% in 1991. See Note 6 of Notes to Consolidated Financial Statements of the Company. Seasonality and Inflation Historically, the Company's business has been seasonal because its transmission services have been purchased in larger volumes during periods of favorable weather when more sporting and special events are held. Increases in full-time radio and television distribution services, private line telephone and data services, satellite-based mobile services and international public switched long distance telephone services have substantially lessened the impact of this seasonality. Since its inception, the Company's results of operations have not been materially affected by inflation. Liquidity and Capital Resources The Company has financed growth through borrowings, cash generated from profitable operations and sales of shares of its Common Stock and 5% Convertible Subordinated Notes due 2003 (the "Subordinated Notes"). Prior to August 20, 1993, the Company borrowed funds under a $25,000,000 revolving credit facility (the "Revolver"), issued $50,000,000 of senior secured notes (the "Senior Notes") and $26,000,000 principal amount of 13% Senior Subordinated Notes due 1998 (the "1998 Notes"). On December 21, 1992, the Company also assumed a $15,000,000 loan payable by WorldCom to TeleColumbus U.S.A., Inc (the "Assumed Loan"). Substantially all outstanding borrowings of the Company were repaid and defeased by September 1993, using a portion of the proceeds of the public offering of $195,500,000 in aggregate principal amount of Subordinated Notes in August 1993 and the public offering of an aggregate of 4,724,997 shares of Common Stock in May 1993. The Assumed Loan was repaid by the Company upon the consummation of the acquisition of WorldCom Europe in December 1993. The Subordinated Notes issued in August 1993 are convertible at any time prior to maturity, unless previously redeemed, into Common Stock of the Company at a conversion price of $18.15 per share, as adjusted to reflect the 3.15-to- one Common Stock split in the form of a 215% Common Stock dividend paid on February 1994 and subject to further adjustment in certain events. The Subordinated Notes bear interest at a rate of 5% per annum and interest is payable on February 15 and August 15 of each year. The Subordinated Notes are redeemable at any time after August 15, 1996, in whole or in part, at the option of the Company, at declining redemption prices plus accrued interest. The Subordinated Notes are unsecured and subordinated to all existing and future senior indebtedness of the Company and will be effectively subordinated to all indebtedness and other liabilities of subsidiaries of the Company. The Subordinated Notes contain no limitation on the incurrence of additional indebtedness by the Company and its subsidiaries. In November 1993, Bank of America National Trust and Savings Association agreed to make a $15,000,000 line of credit available to the Company (the "Line of Credit"). Advances made pursuant to the Line of Credit bear interest at a floating rate based, at the option of the Company, on a domestic index or an offshore index. All advances and letters of credit made under the Line of Credit mature on October 31, 1995 and the Line of Credit expires on such date. The Company may at any time terminate the Line of Credit by payment of all outstanding advances and other obligations under the Line of Credit and cash collateralization of all letters of credit existing at that time. As of December 31, 1993, there were no amounts outstanding under the Line of Credit. In addition, the Company has ongoing discussions with several financial institutions regarding credit facilities, committed and uncommitted. During 1993, the Company's capital expenditures, including improvements, replacements and additions of communications equipment and facilities, were approximately $48,300,000. The Company historically has invested significantly to build its communications network. See "Business -- The IDB Communications Network" and "Business -- Facilities." Net cash provided by operating activities in 1993 decreased to $2,040,000, compared to net cash provided by operating activities of $27,763,000 in 1992 principally due to increases in accounts receivables associated with the Acquisitions. Cash provided by financing activities in 1993 was $129,576,000, as compared to cash provided by financing activities of $16,694,000 in 1992 and principally relate to the sale of Subordinated Notes offset by the repayments or defeasance of substantially all of the Company's then existing debt. Net cash used in investing activities in 1993 was $78,323,000, as compared to $45,900,000 in 1992, principally due to property and equipment expenditures for additional facilities in the IDB network, the purchase of short-term investments, and costs incurred in connection with the Acquisitions. In May 1990, the Company entered into an agreement with Comsat, Inc. ("Comsat") under which it may obtain satellite transponder capacity for maritime and aeronautical services offered or to be offered by IDB Mobile, at long-term fixed rates over a five-year period that commenced in September 1991. As of December 31, 1993, IDB's minimum remaining total commitment under the agreement was to purchase 8 million minutes of transponder capacity (representing aggregate costs of approximately $20,400,000, calculated at the rate set forth in the agreement, which the Company would pay in 1996 to satisfy any remaining volume commitment under the agreement that the Company did not purchase by that time). Based on current and projected usage, the Company believes that it will meet the minimum purchase commitment under the agreement. If the Company were to materially breach the agreement (including provisions relating to interference with the operation of the satellites), the Company would not be entitled to the rates set forth in the agreement, but would be required, from the date of such material breach, to pay higher rates for satellite transponder capacity for maritime and aeronautical services. See "Business -- Facilities" and Note 7 of Notes to Consolidated Financial Statements of the Company. The Company's capital commitments, as of March 16, 1994, consisted primarily of outstanding purchase orders (some of which are cancelable at the Company's option) to acquire approximately $30,900,000 of equipment, including long term commitments on undersea fiber optic cables of $20,500,000, which will be financed by cash from operations and bank borrowings. It is anticipated that the Company's 1994 expenditures will exceed that amount. The Company expects that cash flow from operations, its current holdings of cash and marketable securities and its borrowing capabilities under its current credit facility will satisfy its projected working capital and capital expenditure requirements through fiscal 1994. The Company may seek additional debt or equity financing from time to time to supplement cash generated from operations and finance future growth opportunities. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's financial statements and supplementary financial information appear in this Annual Report on Form 10- K beginning on page, immediately after the Signature Page hereof, and such information is incorporated in this Item 8 by reference thereto. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Company's directors, executive officers and key employees are as follows: _______________________ (1) Member of Compensation Committee. (2) Member of Audit Committee. (3) Member of Stock Option Committee. Jeffrey P. Sudikoff, a founder of the Company, has been instrumental in the Company's development. Mr. Sudikoff has been the Chief Executive Officer and a director of the Company since its incorporation in September 1983 and has been Chairman of the Board of Directors since May 1986. He also served as the Company's President from September 1983 until March 1989. From 1978 until founding the Company, Mr. Sudikoff provided consulting services to the radio broadcast industry in the areas of programming production and distribution. Edward R. Cheramy was appointed President of the Company in March 1989 and has been a director since joining the Company in May 1986. Mr. Cheramy also served as Chief Financial Officer of the Company from September 1990 to November 1992 and from May 1986 to July 1989, and as Executive Vice President of the Company from May 1986 to March 1989. From 1978 until joining the Company, Mr. Cheramy was a partner in the accounting firm of Price Waterhouse. Peter F. Hartz joined the Company in November 1984 and has been Senior Vice President, Sales and Marketing since February 1991 and a director since April 1988. From June 1990 to January 1991, Mr. Hartz served as President of IDB Broadcast Division, and from September 1985 to February 1991, he served as Vice President, Sales and Marketing. From September 1980 to January 1982, Mr. Hartz was Director of Advertising and Promotion for Watermark, Inc., now ABC Watermark, a radio programming syndicator. From January 1982 to January 1983, Mr. Hartz served as Director of Marketing for Diamond P Sports, a television program supplier, and from January 1983 to November 1984, Mr. Hartz authored a nonfiction book about the financial community. Rudy Wann joined the Company in May 1991 and has been Vice President, Finance since April 1992 and Chief Financial Officer since November 1992. From August 1990 to April 1991, Mr. Wann was Vice President, Finance and Chief Financial Officer of Tiger Media, Inc., a developer of computer software. From July 1979 to July 1990, Mr. Wann was with the accounting firm of Price Waterhouse, most recently as a senior manager, except for eleven months from August 1984 to June 1985 when he held various accounting positions with Inter-Con Systems, a government contractor. James E. Kolsrud joined the Company in October 1989 in connection with the Company's acquisition of CICI, Inc. and has served as Vice President of Engineering and Administration since November 1992. From October 1989 to November 1992, Mr. Kolsrud served as President of the Company's International division. From March 1989 through October 1989, Mr. Kolsrud served as President of CICI, Inc. when it was a subsidiary of Contel ASC. From April 1985 through March 1989, Mr. Kolsrud served as Vice President of Engineering and Operations at CICI, Inc. and from 1975 until joining CICI, Inc., Mr. Kolsrud held several positions for Comsat, Inc. including Senior Director of Engineering for World Systems Division and United States Representative to the Intelsat Board of Governors Technical Advisory Committee. Neil J Wertlieb joined the Company in August 1992 as a Vice President. He was promoted to General Counsel in October 1993 and to Secretary in November 1993. From October 1984 to June 1992, Mr. Wertlieb was an associate at the law firm of O'Melveny & Myers. Stephen N. Carroll, a 15-year veteran of the telecommunications industry, joined the Company in September 1991 as President of IDB WorldCom (formerly IDB&T). Prior to joining IDB, Mr. Carroll was employed by Comsat, Inc.'s World Systems Division, where he was Vice President of Sales and Business Development since 1986 and Director of Carrier Sales since 1983. During his tenure at Comsat, Inc., Mr. Carroll represented the services of Intelsat to U.S. long distance carriers, authorized users, and U.S. and international broadcasters. John A. Tagliaferro joined the Company in January 1989 in connection with the Company's acquisition of the assets of Hughes Television Network. Mr. Tagliaferro has been President of IDB Broadcast Group since January 1991, and from January 1989 through January 1991, Mr. Tagliaferro served as President of the Company's HTN division. From December 1986 through January 1989, Mr. Tagliaferro served as President and Chief Operating Officer of Hughes Television Network. William L. Snelling, a founder of the Company, has been a director since the Company's incorporation in September 1983. In addition, Mr. Snelling served as Chairman of the Board and Chief Financial Officer from the Company's incorporation until May 1986 and as Secretary from the Company's incorporation until June 1991. Mr. Snelling is also currently the Secretary and a director of the Bank of Santa Maria, located in Santa Maria, California. From June 1991 through November 1992, Mr. Snelling was a private investor. From November 1992 to November 1993, Mr. Snelling was a consultant to Southwest Leasing Corporation. Since November 1993, Mr. Snelling has been the Chairman of California Commercial Spaceport, Inc., a company that launches low orbital communications satellites. Mr. Snelling also provides consulting services to the Company pursuant to a consulting agreement. See "Executive Compensation -- Compensation Committee Interlocks and Insider Participation." Franklin E. Fried has been a director of the Company since December 1988. From January 1989 to November 1991, Mr. Fried was the President of the San Diego-based Fried-Schegan, which specialized in entertainment and creative developments in the hospitality field. From 1977 to January 1989, Mr. Fried was President of Franklin E. Fried Associates, an entertainment and hospitality services firm. From 1984 to 1988, Mr. Fried was also President of the Delta Queen Steamboat Company, a firm specializing in the operation of paddleboats on the Mississippi River. From June 1991 through November 1992, Mr. Fried was the Chairman of Old New Orleans Seafood Company, a seafood distributor. Joseph M. Cohen has been a director of the Company since June 1989 and also served as a member of the Board of Directors from March 1988 through November 1988. From 1991 to January 1994, Mr. Cohen was the President of Spectacor West, overseeing all West Coast activities of the international sports and entertainment company Spectacor. Since January 1994, Mr. Cohen has been a consultant to Rainbow Programming Services for Sports Channel Networks, Inc. and has been involved in planning the construction of a new sports arena in Los Angeles. From January 1988 to March 1989, Mr. Cohen served as President and Chief Executive Officer of Z Channel, a pay television channel in Santa Monica, California. Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's directors and certain of its officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "Commission") and the NASDAQ National Market System. Such directors, officers and stockholders are required by the Commission's regulations to furnish the Company with copies of all Section 16(a) reports they file. Based solely on its review of the copies of such reports received by it, or written representations from certain reporting persons that no such reports were required for those persons, the Company believes that from January 1, 1993 to December 31, 1993, all filing requirements applicable to such directors, officers and stockholders were complied with, except for the following: Each of Messrs. Sudikoff and Cohen filed Form 4 reports related to sales of shares of Common Stock in July 1993 more than ten days following the end of the month in which such transactions occurred. Mr. Fried filed a Form 4 report related to the exercise of stock options and subsequent sale of the resulting shares in May 1993 more than 10 days following the end of the month in which such transactions occurred. David W. Anderson failed to file a Form 4 report relating to the exercise of stock options and subsequent sale of the resulting shares of Common Stock; however, such transactions were reported in a timely filed Form 5 report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Summary Compensation Table The following table sets forth information concerning the compensation paid by the Company during the last three fiscal years to the Company's Chief Executive Officer and the four other most highly compensated executive officers of the Company. _______________________ (1)Bonus payments are reported for the year in which they were earned. (2)Adjusted to reflect the 5% Common Stock dividends paid on each of October 11, 1991 and November 10, 1992 and the 3.15- to-one Common Stock split in the form of a 215% Common Stock dividend paid on February 4, 1994 (the "Common Stock Split"). (3)Represents the dollar value of Company matching contributions under the Company's 401(k) Savings and Retirement Plan. (4)The named individual received certain perquisites and other personal benefits from the Company; however, the dollar value of such other annual compensation did not exceed the lesser of $50,000 or 10% of the total annual salary and bonus for such individual in each of 1992 and 1993. (5)Does not include the grant to each of Messrs. Sudikoff and Cheramy of options to purchase 2,835,000 shares of Common Stock (as adjusted to reflect the Common Stock Split) and the grant to Mr. Wann of options to purchase 236,250 shares of Common Stock (as adjusted to reflect the Common Stock Split). Such options were granted subject to stockholder approval, which has not yet been received. (6)In accordance with the transitional provisions applicable to the revised rules on executive compensation disclosure adopted by the Securities and Exchange Commission, information with respect to Other Annual Compensation and All Other Compensation for 1991 has been omitted. (7)Rudy Wann joined the Company in May 1991. Options Granted in 1993 The following information is furnished for the year ended December 31, 1993 with respect to the Company's Chief Executive Officer and each of the four other most highly compensated executive officers of the Company for stock options which were granted in 1993. _______________________ (1) Adjusted to reflect the Common Stock Split. (2) Options granted in 1993 vest over a four-year period, with 25% of the shares covered thereby becoming exercisable on each anniversary date. (3) Under the terms of the Company's stock incentive plans, the Board of Directors or the Stock Option Committee thereof retains discretion, subject to plan limits, to modify the terms of outstanding options and to reprice the options. (4) The options were granted for a term of ten years, subject to earlier termination in certain events related to termination of employment. (5) Does not include the grant to each of Messrs. Sudikoff and Cheramy of options to purchase 2,835,000 shares of Common Stock (as adjusted to reflect the Common Stock Split) and the grant to Mr. Wann of options to purchase 236,250 shares of Common Stock (as adjusted to reflect the Common Stock Split). Such options were granted on November 29, 1993, will expire on November 30, 2003 and have an exercise price of $14.37 (as adjusted to reflect the Common Stock Split), the fair market value on the date that the options were granted (as adjusted to reflect the Common Stock Split). Such options were granted subject to stockholder approval, which has not yet been received. (6) The exercise price may be paid by delivery of a promissory note, already owned shares or other lawful consideration, subject to certain conditions and as otherwise approved by the Board of Directors or the Stock Option Committee. (7) The potential realizable values indicated are based solely on arbitrarily assumed rates of appreciation required by applicable regulations of the Securities and Exchange Commission. The actual value, if any, an executive may realize will depend upon the excess of the stock price on the date an option is exercised over the exercise price. As a result, such assumed values are not necessarily indicative of the values that can be realized upon exercise of such options, and use of such rates should not be viewed in any way as a forecast of the future performance of the Company's stock. Aggregated Option Exercises in 1993 and Year-End Value Table The following information is furnished for the year ended December 31, 1993 with respect to the Company's Chief Executive Officer and each of the four other most highly compensated executive officers of the Company for stock options exercised during 1993 and for unexercised options held at year end 1993. _______________________ (1) Adjusted to reflect the Common Stock Split. (2) This amount is the aggregate of the market value of the Common Stock at the time each stock option was exercised minus the exercise price for that option. (3) Does not include the grant to each of Messrs. Sudikoff and Cheramy of options to purchase 2,835,000 shares of Common Stock (as adjusted to reflect the Common Stock Split) and the grant to Mr. Wann of options to purchase 236,250 shares of Common Stock (as adjusted to reflect the Common Stock Split). Such options are subject to stockholder approval. (4) This amount is the aggregate of the number of options multiplied by the difference between the closing price of the Common Stock on the NASDAQ National Market System on December 31, 1993 ($17.46, as adjusted to reflect the Common Stock Split) and the exercise price for such options. Compensation of Directors No director received any compensation during the Company's last fiscal year for any service provided as a director. Beginning in 1994, the Company will compensate each non-employee director $2,000 for each month of membership on the Board of Directors and $1,000 for each meeting of the Board that the director attends. Nonemployee directors of the Company are entitled to receive annually a limited number of non-qualified stock options pursuant to the Company's 1992 Stock Option Plan for Nonemployee Directors (the "Nonemployee Director Plan"). The Nonemployee Director Plan provides for the annual automatic granting of options to purchase 6,615 shares, subject to adjustment, of IDB Common Stock to each nonemployee director immediately following the annual meeting of stockholders. The option exercise price is the fair market value (as defined) of the Common Stock on the date of grant. The options vest over a four year period, and expire ten years and one day from the date of grant, subject to earlier termination in accordance with the terms of the Nonemployee Director Plan. As of the date hereof, an aggregate of 33,075 options have been granted under the Nonemployee Director Plan. Employment Agreements The Company entered into employment agreements with Messrs. Sudikoff, Cheramy and Hartz on January 1, 1992, each for a five year term, which is automatically renewed each year thereafter, subject to earlier termination under certain circumstances. Mr. Sudikoff's employment agreement provides for a minimum base salary of $500,000 in 1992, $575,000 in 1993, $661,250 in 1994, $760,437 in 1995 and $874,503 in 1996. Mr. Cheramy's employment agreement provides for a minimum base salary of $400,000 in 1992, $460,000 in 1993, $529,000 in 1994, $608,350 in 1995 and $699,602 in 1996. Mr. Hartz' employment agreement provides for a minimum base salary of $180,000 in 1992, $190,800 in 1993, $202,248 in 1994, $214,383 in 1995 and $227,246 in 1996. Each of Messrs. Sudikoff, Cheramy and Hartz is entitled to receive an annual bonus in an amount determined by the Compensation Committee of the Board of Directors. Messrs. Sudikoff's, Cheramy's and Hartz' employment agreements also provide for the reimbursement of business and automobile expenses and certain other benefits, including an allowance of up to $50,000, $50,000 and $15,000, respectively, for each contract year for personal accounting, financial, tax and legal consulting and other similar expenses for Messrs. Sudikoff, Cheramy and Hartz. In the event of a change of control of the Company (as defined), amounts payable through the remaining term of the employment agreements become payable, with the Company obligated to pay any taxes that are specifically levied on payments made pursuant to change of control provisions. Compensation Committee Interlocks and Insider Participation The Compensation Committee of the Board of Directors consists of Edward R. Cheramy, William L. Snelling, Joseph M. Cohen and, prior to his resignation as a member of the Board of Directors in October 1993, John S. Reiland. Mr. Cheramy is, and during 1993 was, President of the Company. Until June 1991, Mr. Snelling was an officer of the Company. See "Directors and Executive Officers of the Registrant." Mr. Reiland is the Chairman of TeleColumbus USA, Inc., a Delaware corporation ("TC USA"). TC USA acquired 13,230,000 shares of Common Stock (as adjusted to reflect the Common Stock Split) and 34,000 shares of the Company's 4% Cumulative Convertible Preferred Stock, which was convertible into 6,158,709 shares of Common Stock (as adjusted to reflect the Common Stock Split), in connection with the Company's acquisition of World Communications, Inc. from TC USA in 1992. TC USA sold 18,928,255 shares of Common Stock (as adjusted to reflect the Common Stock split) in a secondary offering in November 1993. The Company entered into a consulting agreement with William L. Snelling as of January 1, 1992. Under the consulting agreement, Mr. Snelling will be paid an annual fee over a 15-year period, beginning at $125,000 in 1992, with cost of living increases each year. See "Certain Relationships and Related Transactions." ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth information regarding the ownership of the Company's shares of Common Stock as of March 15, 1994 by (a) stockholders known by the Company to own beneficially more than 5% of the Company's shares of Common Stock, (b) each director, (c) each executive officer named in the Summary Compensation Table and (d) all directors and executive officers as a group. Except as otherwise noted, the Company knows of no agreements among its stockholders that relate to voting or investment power of its shares of Common Stock. ____________________ * Less than 1%. (1)Except as indicated in other notes to this table, each such stockholder listed has sole voting and dispositive power with respect to the shares beneficially owned, subject to any limitations on such power arising under community property or similar laws. (2)Shares are held by the Edward R. and Shirley J. Cheramy Trust, of which Mr. Cheramy and his spouse, Shirley J. Cheramy, are co-trustees. Includes 366,261 shares covered by outstanding stock options granted to Mr. Cheramy that are exercisable within 60 days of March 15, 1994. (3)Includes 10,335 shares covered by outstanding stock options granted to Mr. Hartz that are exercisable within 60 days of March 15, 1994. (4)Includes 25,229 shares covered by outstanding stock options granted to Mr. Wann that are exercisable within 60 days of March 15, 1994. (5)Includes 34,631 shares covered by outstanding stock options granted to Mr. Kolsrud that are exercisable within 60 days of March 15, 1994. (6)Shares are held by the Snelling 1986 Trust, of which Mr. Snelling and his spouse, Cleora A. Snelling, are co-trustees. Includes 19,325 shares covered by outstanding stock options granted to Mr. Snelling that are exercisable within 60 days of March 15, 1994. (7)Includes 6,406 shares covered by outstanding stock options granted to Mr. Fried that are exercisable within 60 days of March 15, 1994. (8)Shares are held by Joseph M. Cohen, Inc., a corporation that is wholly owned by Mr. Cohen. (9)Includes 474,983 shares covered by outstanding stock options granted to all directors and executive officers that are exercisable within 60 days of March 15, 1994. (10)Fidelity Management & Research Company, a wholly-owned subsidiary of FMR Corp., is the beneficial owner of 4,916,205 shares of Common Stock, and Fidelity Management Trust Company, a wholly-owned subsidiary of FMR Corp., is the beneficial owner of 634,725 shares of Common Stock. (11)Shares are held by State Street Research & Management Company, a wholly-owned subsidiary of Metropolitan Life Insurance Company. Metropolitan Life Insurance Company and State Street Research & Management Company have disclaimed beneficial ownership of all of such shares. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. In order to allow foreign ownership of the Company to exceed 25% without risk of refusal or revocation of licenses pursuant to the Communications Act, on December 17, 1992 the Company's subsidiaries that had been holding the transmission licenses used by the Company assigned all of their common carrier earth station and microwave licenses to Southwest Communications, Inc. ("SCI") in exchange for SCI's entering into the Operator Agreements described below. See "Business - - Government Regulation." Messrs. Jeffrey P. Sudikoff, Edward R. Cheramy and Peter F. Hartz, the Chairman and Chief Executive officer, President and Senior Vice President, Sales and Marketing of the Company, respectively, own 49%, 40% and 11%, respectively, of the capital stock of SCI. See "Directors and Executive Officers of the Registrant." The Company entered into Operator Agreements with SCI on December 17, 1992. No monetary compensation has been received by the Company in connection with such assignments. These Operator Agreements have initial terms of ten years and provide for SCI to be the operator and FCC licensee of the satellite earth stations and microwave stations owned by the Company. In accordance with the Operator Agreements, the Company paid $34,200 to SCI during 1993 as an operator fee. Such fees are subject to adjustment annually. The Company has entered into employment agreements with each of Jeffrey P. Sudikoff, Edward R. Cheramy and Peter F. Hartz. See "Executive Compensation -- Employment Agreements." In addition, the Company entered into a consulting agreement with William L. Snelling, a director of the Company, as of January 1, 1992. Under the consulting agreement, Mr. Snelling will be paid an annual fee over a 15-year period, beginning at $125,000 in 1992, with cost of living increases each year. In 1993, the Company paid Mr. Snelling $135,000 pursuant to the Consulting Agreement. In December 1993, each of Messrs. Sudikoff and Cheramy borrowed $1,400,000 from the Company for his own personal use. Such loans bear interest at an annual rate equal to five percent. In December 1993 and March 1994, Messrs. Cheramy and Sudikoff, respectively, repaid all outstanding amounts under the loans made in 1993. During 1992, each of Messrs. Sudikoff and Cheramy borrowed an aggregate of $250,000 from the Company for his own personal use. Such loans are due in equal annual installments of $50,000, beginning in December 1993, and bear interest at a rate of five percent per annum. Each of Messrs. Sudikoff and Cheramy paid the annual installment due in December 1993. During 1991, 1992 and 1993, IDB Mobile Communications, Inc. ("IDB Mobile") made progress payments of $1,750,000, $1,798,000 and $832,000, respectively, to Aesses Equipment Corporation ("Aesses"), which is 42.5% owned by Mr. Sudikoff and 42.5% owned by Mr. Cheramy. These progress payments were made under an agreement to purchase from Aesses $4,380,000 of satellite transmission equipment for use on airplanes. Aesses paid $2,000,000 to a supplier to develop such equipment and has agreed to purchase minimum quantities of the equipment from such supplier. A disinterested majority of the Board of Directors of IDB and IDB Mobile elected not to incur such development costs and enter Aesses' business. The prices paid by IDB Mobile for such equipment were no less favorable to IDB Mobile than the prices payable for such equipment by unrelated parties. See Note 8 of Notes to Consolidated Financial Statements of the Company. In November 1993, Aesses agreed to pay IDB Mobile $3,441,000 in cash consideration to repurchase all of the equipment, except one unit, previously sold by Aesses to IDB Mobile. All amounts owed by Aesses to IDB Mobile pursuant to the agreement to repurchase the equipment have been paid and all remaining obligations for IDB Mobile to purchase equipment from Aesses pursuant to the agreement between Aesses and IDB Mobile have terminated. In February 1993, Aesses borrowed $300,000 from the Company, which amount bears interest at a rate equal to 5% per annum. In March 1994, Aesses repaid all amounts outstanding under the loan made by the Company in February 1993. In August 1993, the Company purchased a $1,500,000 loan evidenced by a note secured by a deed of trust with an assignment of rents (the "Loan") from William L. Snelling and Cleora A. Snelling, as trustees of the Snelling 1986 Trust (the "Trust"). In December 1992, the Trust made the Loan to the Olympic-Centinela Partnership, a California limited partnership (the "Partnership"), in connection with the Partnership's acquisition of certain facilities which the Company now leases as part of its Los Angeles international teleport. See "Properties." The loan made by the Trust to the Partnership bears interest at a rate equal to the prime rate plus 3% and is due in December 1995. The Company paid $1,500,000 for the Loan, $500,000 of which was paid at the time the Company acquired the Loan and the remainder of which will be paid in equal annual installments of $100,000 or upon the demand of the Trust. The unpaid balance of the purchase price bears interest at a rate equal to the prime rate plus 2%. In connection with three public offerings of securities of the Company, the acquisition of TRT and certain other Company business, the Company paid approximately $3,600,000 related to the use during 1993 of aircraft owned by Messrs. Sudikoff and Cheramy. See Note 8 of Notes to Consolidated Financial Statements of the Company. The amounts paid by the Company in connection with the use during 1993 of such aircraft were commercially competitive and such payments were approved by the Board of Directors of the Company. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) List of documents filed as part of this Annual Report on Form 10-K: 1. Financial Statements: Independent Auditors' Report. Consolidated Balance Sheets as of December 31, 1992 and 1993. Consolidated Income Statements for the years ended December 31, 1991, 1992 and 1993. Consolidated Statement of Shareholders' Equity for the years ended December 31, 1991, 1992 and 1993. Consolidated Statements of Cash Flows for the years ended December 31, 1991, 1992 and 1993. Notes to the Consolidated Financial Statements. 2. Financial Statement Schedules and Unaudited Quarterly Financial Data: Schedules supporting the audited financial statements for each of the three years in the period ended December 31, 1993. Schedule II - Related Party Receivables. Schedule V - Property, Plant and Equipment. Schedule VI - Schedule of Accumulated Depreciation. Schedule VIII - Valuation and Qualifying Accounts. Schedules other than those referred to above have been omitted because they are not required under the instructions contained in Regulation S-X or because the information is included elsewhere in the financial statements or the Notes thereto. 3. Exhibits: The exhibits listed on the accompanying Index to Exhibits are filed as part of this Annual Report. The management contracts and compensatory plans or arrangements required to be filed pursuant to Item 14(c) are included as Exhibits 10.1(a) through 10.1(e) and Exhibits 10.2(a) through 10.2(f). (b) The Registrant filed the following Current Reports on Form 8-K in the fourth quarter of 1993: SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. IDB COMMUNICATIONS GROUP, INC. Dated: March 28, 1994 By: /s/ EDWARD R. CHERAMY Edward R. Cheramy President Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities indicated on the 28th day of March, 1994. /s/ JEFFREY P. SUDIKOFF Chairman of the Board, Jeffrey P. Sudikoff Chief Executive Officer and Director (Principal Executive Officer) /s/ EDWARD R. CHERAMY President and Director Edward R. Cheramy /s/ RUDY WANN Vice President, Finance Rudy Wann and Chief Financial Officer (Principal Financial and Accounting Officer) /s/ PETER F. HARTZ Senior Vice President, Peter F. Hartz Sales and Marketing and Director /s/ WILLIAM L. SNELLING Director William L. Snelling /s/ FRANKLIN E. FRIED Director Franklin E. Fried /s/ JOSEPH M. COHEN Director Joseph M. Cohen INDEPENDENT AUDITORS' REPORT IDB COMMUNICATIONS GROUP, INC: We have audited the accompanying consolidated balance sheets of IDB Communications Group, Inc. and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We did not audit the balance sheet of World Communications, Inc. (a consolidated subsidiary) as of December 31, 1992, which statement reflects total assets constituting 24% of consolidated total assets as of December 31, 1992. This statement was audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for World Communications, Inc. as of December 31, 1992, is based solely on the report of such other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of the other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of IDB Communications Group, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also in our opinion, based on our audits and the report of the other auditors, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Los Angeles, California March 7, 1994 Report of Independent Certified Public Accountants World Communications, Inc. New York, New York We have audited the consolidated balance sheet of World Communications, Inc. (a wholly-owned subsidiary of IDB Communications Group, Inc.) as of December 31, 1992. This financial statement, not separately presented herein, is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements is free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the balance sheet. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated balance sheet referred to above present fairly, in all material respects, the consolidated financial position of World Communications, Inc. at December 31, 1992 in conformity with generally accepted accounting principles. BDO SEIDMAN New York, New York March 17, 1993 IDB COMMUNICATIONS GROUP, INC. CONSOLIDATED BALANCE SHEET ASSETS See accompanying notes to consolidated financial statements. IDB COMMUNICATIONS GROUP, INC. CONSOLIDATED INCOME STATEMENT See accompanying notes to consolidated financial statements. IDB COMMUNICATIONS GROUP, INC. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY See accompanying notes to consolidated financial statements. IDB COMMUNICATIONS GROUP, INC. CONSOLIDATED STATEMENT OF CASH FLOWS See accompanying notes to consolidated financial statements. IDB COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES IDB Communications Group, Inc., a Delaware corporation, and its subsidiaries (together referred to herein as the "Company"), operate a domestic and international communications network which provides their customers with international private-line and switched long distance telephone services, radio and television transmission services, facsimile and data connections and mobile satellite communications capabilities. Consolidation - The consolidated financial statements include the accounts of IDB Communications Group, Inc. and its subsidiaries. Effective December 31, 1992, the Company acquired WorldCom (see Note 9). As a result, the balance sheet of WorldCom has been consolidated as of December 31, 1992 and the operations of WorldCom were consolidated beginning January 1, 1993. Effective September 30, 1993, the Company acquired TRT (see Note 9). The operations of TRT were consolidated beginning October 1, 1993. All significant intercompany balances and transactions have been eliminated in consolidation. Revenue Recognition - The Company generally recognizes revenues when transmission and distribution services are provided. For switched long distance telephone services, revenues are recorded on the basis of minutes of traffic processed and contracted fees. The Company also performs systems integration services consisting of design and installation of transmission equipment and systems for its customers. Revenues and the related costs for these services are recorded under the percentage of completion method. Unbilled revenues under customer contracts represent revenues earned under the percentage of completion method but not yet billable under the terms of the contract. Cash Equivalents and Short-Term Investments - The Company considers all highly liquid investments purchased with a maturity of ninety days or less to be cash equivalents. Similar investments with original maturities beyond ninety days are considered short-term investments and carried at cost, which approximates market value. Short-term investments principally consist of tax exempt municipal bonds and corporate bonds. The Company believes that the carrying amount of this category is a reasonable estimate of its fair value. Inventory - Consists principally of equipment used in the Company's systems integration services group in the assembly of earth station equipment for customers. Inventories are stated at the lower of cost or market; cost is determined using the specific identification method. Property and Equipment - Property and equipment are stated at cost. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are 5 to 25 years for equipment and cable and 10 to 25 years for buildings and improvements. In 1991, the Company revised its estimates of the depreciable lives of certain assets resulting in additional income before income taxes of approximately $359,000 and net income before extraordinary items of approximately $213,000 ($.01 earnings per share for the year ended December 31, 1991). Construction in Progress - The Company constructs certain of its own transmission systems and related facilities. All internal costs directly related to the construction of such facilities, including interest and salaries of certain employees, are capitalized. Such costs were $5,320,000 ($2,347,000 in interest), $7,656,000 ($3,490,000 in interest) and $8,271,000 ($3,126,000 in interest) in 1991, 1992 and 1993, respectively. Deferred Financing Costs - The Company defers all direct costs incurred in obtaining long term financing and amortizes these costs over the term of the related debt. Intangible Assets - These assets consist principally of intangible assets acquired in acquisitions accounted for by the purchase method and are being amortized using the straight-line method over the lives of the related assets, which vary from 6 to 40 years. Minority Interest - In 1990, the Company and Teleglobe International (U.S.), Inc. ("Teleglobe"), a wholly-owned subsidiary of Teleglobe, Inc., a Canadian data communications products, systems integration and telecommunications company, formed IDB Mobile Communications, Inc. ("IDB Mobile"), a provider of mobile satellite voice and data communication services to the maritime and aeronautical markets. The Company and Teleglobe each have a 50% equity interest in IDB Mobile. Effective January 1, 1992, the assets and liabilities of IDB Mobile were consolidated with those of the Company and Teleglobe's interest is included in the Company's consolidated financial statements as minority interest. Income Taxes - Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. The cumulative effect of the change was insignificant. Deferred income taxes represent the amounts which will be paid or received in future periods based on the income tax rates that are expected to be in effect when the temporary differences are scheduled to reverse. Earnings Per Share - Earnings per share is based upon the weighted average number of common shares and common stock equivalents (common stock options, when dilutive) outstanding during each year. Fully diluted earnings per share assumes the conversion of the preferred stock into common stock and also reflects additional dilution related to common stock options when the use of the market price at the end of the period is higher than the average price for the period. The effect on earnings per share of the conversion of the convertible subordinated debt is antidilutive. Earnings per share for the years ended December 31, 1991, 1992 and 1993 have been adjusted to reflect 5% stock dividends declared and paid in each of 1991 and 1992 and the 3.15-to-one common stock split of February 4, 1994 (Note 5). Reclassifications - Certain reclassifications have been made to the prior years' financial statements to conform to the current year's classifications. 2. INTANGIBLE ASSETS Intangible assets at December 31, 1992 and 1993 consist of the following: Fully amortized intangible assets of $3,582,000 were eliminated from the above balances in 1993. 3. OTHER ACCRUED LIABILITIES Other accrued liabilities at December 31, 1992 and 1993 consist of the following: Acquisition allowances relate principally to duplicate facility and severance costs related to acquired operations (See Note 9). 4. LONG TERM DEBT On August 20, 1993, the Company issued $195,500,000 of convertible subordinated notes (the "Notes"), proceeds of which were approximately $189,550,000 net of direct fees and expenses. Interest on the Notes is payable semiannually on February 15 and August 15 of each year at an interest rate of 5% per annum. The Notes are convertible at the option of the holder at anytime prior to maturity into Common Stock of the Company at $18.15 per share. The Notes include certain antidilution rights and rights with regard to changes in control. At its option, the Company may redeem the Notes at any time after August 1996, but will incur a redemption premium. The Notes mature and are due in full on August 15, 2003. The Company used the proceeds of this issue, together with the proceeds of a May 1993 common stock issuance (see Note 5) to repay and defease substantially all of its then existing debt. Total debt repayments in 1993 were approximately $89,000,000 while $18,000,000 of debt was defeased. The repayment and defeasance of this debt resulted in an extraordinary charge of $7,949,000, net of income tax benefit of $5,639,000, which represents payment of debt redemption premiums and the write- off of unamortized debt issuance costs. In connection with the debt repayment, the Company canceled its revolving line of credit. In November, 1993, the Company established a new $15,000,000 line of credit ("Line of Credit"). The Line of Credit bears interest at a floating rate based, at the option of the Company, on a domestic index or offshore index. The Line of Credit expires October 31, 1995. As of December 31, 1993, there were no amounts outstanding under the Line of Credit. The fair values of financial instruments, other than the Notes, closely approximate their carrying value. At December 31, 1993, the estimated fair value of the Notes, based on reference to quoted market prices, exceeded the carrying value by $31,000,000. In connection with the acquisition of WorldCom (see Note 9), the Company assumed a $15 million loan payable by WorldCom to TeleColumbus USA, Inc. This debt was unsecured and subordinated to all of the Company's senior debt. No interest accrued for two years from the date of each advance and any interest accruing was payable quarterly in arrears, at LIBOR plus 2% per annum, beginning June 30, 1994. The principal was repayable in five equal annual installments beginning June 30, 1995. In order to reflect the effect of the non-interest bearing period, the Company discounted the note to $13,400,000 at December 31, 1992. In December 1993, the Company repaid the $15 million subordinated debt owed to TeleColumbus at its carrying value of $14,030,000. Senior and subordinated debt at December 31, 1992 consisted of the following: 5. SHAREHOLDERS' EQUITY The Company has established three stock option plans, the 1986 Incentive Stock Plan, the 1992 Incentive Stock Plan and the 1992 Nonemployee Director Plan (the "Plans"). The exercise price of all options and purchase price for restricted stock under the Plans is equal to or greater than 100% of the fair market of the Company's common stock on the date of the grant. The Company also may grant stock options outside of the Plans. The following summarizes all stock option activity for the three years ended December 31, 1993: Options to purchase 3,806,725 shares under the Plans were outstanding at December 31, 1993, of which options to purchase 116,642 were fully exercisable. At December 31, 1993, 307,651 options were available to be issued under the Plans. The total number of options outstanding outside the Plans as of December 31, 1993 were 736,262, of which options to purchase 383,424 shares were fully exercisable. In November, 1993, certain officers of the Company were granted options to purchase 5,906,250 shares of the Company's common stock at an exercise price of $14.37 per share, subject to shareholder approval which has not yet been received. The exercise price of the options is at the fair market value of the common stock on the date of grant. In connection with a secondary offering of stock, TeleColumbus U.S.A., Inc. ("TC USA") converted 31,458 shares of its preferred stock into 5,698,256 shares of common stock. In December 1993, TC USA converted the remaining 2,542 shares of preferred stock into 460,454 shares of common stock. In May 1993, the Company sold 4,724,997 shares of Common Stock, of which proceeds were approximately $51,000,000. In November 1991, the Company sold 7,607,250 shares of Common Stock, the net proceeds of which were $30,598,000. All share amounts and per share prices have been adjusted to reflect the 5% stock dividends paid in each of 1991 and 1992 and the 3.15-to-one common stock split effective on February 4, 1994. 6.INCOME TAXES As described in Note 1, the Company changed its method of accounting for income taxes in 1992 from the deferred method to the asset and liability method. The provision for income taxes is comprised of the following: Deferred income tax assets and (liabilities) resulting from temporary differences between accounting for financial reporting and tax purposes and the benefit of net operating loss carryforwards included in the Company's balance sheet are as follows: The acquisition adjustment relates principally to the difference between the financial statement and income tax basis of the assets and liabilities acquired in connection with the WorldCom, HIT and TRT acquisitions (see Note 9). The deferred tax asset has been recorded upon the Company's belief, based upon available evidence, that the income tax benefit will be realized. The Company's effective income tax rate differs from the Federal statutory income tax rate due to the following: The Company has a net operating loss carryforward for Federal income tax purposes of $47,366,000 which begin to expire in varying amounts between 2002 and 2008. 7.COMMITMENTS AND CONTINGENCIES AND OTHER The Company has entered into leases for office space, certain of its ground facilities, fiber lines and equipment. Rental expense under operating leases was $3,309,000, $4,227,000, and $15,048,000 for 1991, 1992 and 1993, respectively. Future minimum lease payments under long-term operating leases and commitments as of December 31, 1993 are as follows: 1994, $17,369,000; 1995, $15,968,000; 1996, $15,697,000; 1997, $14,869,000; 1998, $8,913,000; thereafter, $54,127,000. Certain of the Company's facility leases include renewal options, and all leases include provisions for rent escalation to reflect increased operating costs and/or require the Company to pay certain maintenance and utility costs. Under certain transponder agreements, the Company receives favorable rates if its purchases of transponder space exceed certain minimum requirements. The Company is charged, and accrues expenses, for transponder space at a price computed based upon the assumption that its purchases will exceed the minimum levels. If the Company's subsequent use of transponder space falls below the minimum levels, the Company will be subject to retroactive charges for the transponder space. To date, the Company has met all minimum usage requirements. In May 1990, the Company entered into an agreement under which it may obtain satellite transponder capacity for maritime and aeronautical services offered by IDB Mobile at long-term fixed rates over a five-year period which commenced on September 9, 1991. The minimum remaining total commitment, at December 31, 1993, of approximately $20,400,000 is subject to increase if the Company does not perform certain obligations under the agreement. At December 31, 1993, the Company had outstanding purchase orders and agreements (some of which are cancelable) to acquire approximately $30,900,000 of equipment, including $20,500,000 in long term commitments for undersea fiber optic cable. 8.RELATED PARTY TRANSACTIONS The Company paid approximately $1,000,000 and $3,600,000 related to the use of aircraft owned by two officers in 1992 and 1993, respectively. The use of the aircraft was approved by the Board of Directors in both years. During 1991, 1992 and 1993, IDB Mobile made progress payments of $1,750,000, $1,798,000 and $832,000, respectively, to an entity controlled by two officers of the Company. The progress payments were made under an agreement, which ended December 31, 1993, to purchase $4,380,000 of satellite transmission equipment for use on airplanes. In November 1993, the entity paid IDB Mobile $3,441,000 to repurchase the remaining equipment inventory. Included in prepaid expenses and other current assets at December 31, 1993, is a $1,400,000 receivable from an officer of the Company. The receivable bears interest at 5% per annum and was repaid in March, 1994. Also included in prepaid expenses and other current assets is a $300,000 receivable from an entity controlled by two officers of the Company. The amount is due within one year and bears interest at 5% per annum. In 1992, two officers of the Company borrowed $250,000 each. The loans are due in equal annual installments of $50,000 each, beginning in December 1993, and bear interest at 5% per annum. In August 1993, the Company purchased a $1,500,000 note receivable from a director of the Company. The note is secured by a deed of trust related to a facility the Company currently leases. The note receivable bears interest at a rate of prime plus 3% and is due in December 1995. The Company purchased the loan for $500,000 in cash and issued a note payable to the director for $1,000,000. The note payable is due in equal annual installments of $100,000 or upon demand, and bears interest at a rate of prime plus 2%. 9.ACQUISITIONS TRT Communications Inc. In 1993, the Company entered into an Exchange Agreement (the "Exchange Agreement") with Pacific Telecom, Inc. ("PTI"), and two of its subsidiaries, International Communications Holdings, Inc. ("ICHI") and PTI Harbor Bay, Inc. ("Harbor Bay"), to acquire all of the outstanding capital stock of TRT Communications, Inc., a subsidiary of ICHI ("TRT"), and Niles Canyon Earth Station, Inc. ("Niles Canyon"), a subsidiary of Harbor Bay. Pursuant to the first phase of the Exchange Agreement, effective January 22, 1993, the Company issued to ICHI and Harbor Bay a total of 4,095,000 shares of Common Stock (adjusted for the Stock Split, see Note 5) and acquired all of the outstanding common stock of Niles Canyon. On September 23, 1993, the Company completed the second phase of the Exchange Agreement, and issued and paid to ICHI and Harbor Bay a total of 10,080,000 shares of Common Stock and $1,000,000 in cash in exchange for all of the outstanding stock of TRT. During the first phase of the Exchange Agreement, ICHI made loans totalling $4.4 million to TRT which were repaid by the Company at the closing of the second phase. Also as part of the Exchange Agreement, the Company agreed to assist in operations of, and provide certain support services to, TRT and ICHI for aggregate monthly fees of approximately $1,000,000 per month through the completion of the second phase of the acquisition. The Company earned approximately $8,000,000 in such fees in 1993 and in addition charged TRT $1,088,000 in costs incurred on their behalf. The purchase price of $80,000,000 represents the $1,000,000 cash plus the estimated fair market value of the Common Stock of the Company. Additionally, $27,500,000 in other accrued liabilities and long-term liabilities have been recorded to reflect direct acquisition costs, estimated costs related to closing duplicate facilities, employee severance costs and other nonrecurring duplicative costs expected to be incurred in the integration of TRT into the operations of the Company. In addition, TRT had a retirement plan and provided health care and life insurance benefits to eligible retired employees under a defined post retirement benefit plan. Included in long term liabilities is $19 million which is an estimate of the excess of the accumulated post retirement benefit obligation over the fair value of the plan assets and other pension obligations. The Company is in the process of resolving the final status of the plan and of obtaining an actuarial determination of the ultimate liability. The acquisition, which was accounted for under the purchase method of accounting, resulted in a preliminary allocation of approximately $39,000,000 (net of tax benefits of $41,047,000) to intangible assets, which will be amortized over periods up to 40 years. WorldCom Communications, Inc. In 1992, the Company acquired all of the outstanding stock of World Communications, Inc. ("WorldCom") and Houston International Teleport ("HIT") from TeleColumbus USA, Inc. ("TC USA"), a subsidiary of TeleColumbus AG, a Swiss based telecommunications company, in a two-tiered, stock-for-stock transaction. Pursuant to the first phase of the acquisition, the Company issued to TC USA 3,181,500 shares of Common Stock (adjusted for the Stock Split, see Note 5) in exchange for 52.02% of the issued and outstanding shares of HIT common stock. In December 1992, the Company completed the second phase of the acquisition and acquired the remaining 47.98% of HIT common stock and all of the issued and outstanding common stock of WorldCom from TC USA in exchange for 9,889,425 shares of Common Stock (adjusted for the Stock Split, see Note 5) and 34,000 shares of the Company's convertible preferred stock ("Preferred Stock"), having an aggregate liquidation preference of $34,000,000 and an annual cash dividend yield of 4%. In November 1993, the Common Stock and 31,458 shares of Preferred Stock (subsequently converted to Common Stock) issued in connection with the acquisition of WorldCom and HIT were sold by TC USA in a secondary public offering. Also as part of the first phase of the acquisition of WorldCom, the Company agreed to assist in operations of, and provide certain support services to, TC USA and WorldCom for aggregate monthly fees of approximately $500,000 per month through the completion of the second phase of the acquisition. The Company earned approximately $5,000,000 in such fees in 1992. The Company also earned $2,700,000 in fees for sales and engineering management and support, sold $327,000 in services to WorldCom and purchased $1,401,000 in transmission services from WorldCom in 1992. The purchase price of $59,300,000 represents the fair market value of the Common Stock and Preferred Stock of the Company discounted to reflect restrictions on the sale of such stock and acquisition expenses. Additionally, $26,700,000 in accrued expenses and long-term liabilities have been included to reflect direct acquisition costs and estimated costs related to closing duplicate facilities, employee severance costs and other nonrecurring duplicative costs expected to be incurred in the integration of WorldCom and HIT into the operations of the Company. The acquisition, which was accounted for under the purchase method, resulted in an allocation of $38,600,000 (net of tax benefits of $34,897,000) to intangible assets, which are being amortized over periods up to 40 years. The following unaudited pro forma results of continuing operations assume TRT, HIT and WorldCom were acquired as of the beginning of the respective years presented after giving effect to certain adjustments including the elimination of intercompany revenues and expenses among the Company, TRT, Worldcom and HIT, and certain historical operating and selling, general and administrative expenses representing duplicate costs to be eliminated upon the integration of TRT, WorldCom and HIT. The pro forma financial information does not purport to be indicative of the results of operations that would have occurred had the transactions taken place at the beginning of the periods presented or of future results of operations. TC WorldCom AG On December 31, 1993, the Company acquired the remaining 60% interest in TC WorldCom AG ("WorldCom Europe"), a company that provides public switched and private line telephone services in Europe, for $10,517,000 in cash. The acquisition was accounted for under the purchase method. Pro forma information for this acquisition is not presented as its effect is not significant. 10. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information is as follows: In 1993, the Company issued 14,175,000 shares of Common Stock to acquire 100% of the issued and outstanding Common Stock of TRT. In 1993, 34,000 shares of preferred stock were converted into 6,158,710 shares of common stock (Note 5). In 1993, the Company purchased the remaining 60% interest in TC WorldCom AG for $10,517,000. In conjunction with the acquisition, liabilities were assumed as follows: In 1992, the Company issued 13,070,925 shares of Common Stock and 34,000 shares of Preferred Stock to acquire 100% of the issued and outstanding common stock of World Communications, Inc. and Houston International Teleport. In 1992, the Company entered into capital leases for equipment totalling $2,350,000. The Company, in turn, sold the equipment through sales type leases recording receivables of $3,497,000, unearned interest of $670,000 and a gain on sale of $477,000. 11.STREAMLINING CHARGE During 1993, plans were approved to reduce the Company's cost structure and to improve productivity. Such plan includes a reduction in the number of employees and the disposition of certain assets. The consolidated statement of income for 1993 includes a charge of $5,920,000 relating to this program. IDB COMMUNICATIONS GROUP, INC. SCHEDULE II - RELATED PARTY RECEIVABLES (1) The amounts receivable accrue interest at 5% per year. The amount due from Mr. Sudikoff was repaid in March, 1994. (2) The receivable accrues interest at 5% per year and is payable in full in 1994. (3) The Notes accrue interest at a rate of 5% per year. The principal balances are due in five equal annual installments of $50,000 beginning in December, 1993. IDB COMMUNICATIONS GROUP, INC. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (1)Includes transfer of net assets from construction in progress to equipment and buildings and improvements. (2)Amount represents transfers from other assets to property and equipment related to assets held for sale. (3)Amount represents consolidation of IDB Mobile on January 1, 1992 and the acquisition of WorldCom and HIT. (4)Amount represents the acquisition of TRT and WorldCom Europe. IDB COMMUNICATIONS GROUP, INC. SCHEDULE VI - SCHEDULE OF ACCUMULATED DEPRECIATION (1) Amount represents consolidation of IDB Mobile on January 1, 1992. (2) Amount represents reclass of assets between buildings and improvements and equipment. IDB COMMUNICATIONS GROUP, INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (1) Addition is due to the acquisition of WorldCom on December 31, 1992. (2) Addition is due to the acquisition of TRT on September 30, 1993. (3) Deductions represent the write-off of accounts receivable balances to the allowance, net of recoveries. IDB COMMUNICATIONS GROUP, INC. Unaudited Selected Quarterly Financial Data Since there are changes in the weighted average number of common shares outstanding each quarter, the sum of fully diluted earnings per share before extraordinary item by quarter may not equal the fully diluted earnings per share before extraordinary item for the year. (1) The three months ended December 31, 1993 include the results of operations of TRT Communications, Inc. which was acquired on September 23, 1993. This quarter also includes a streamlining charge related to reductions in the number of employees and the disposition of certain assets. (2) The three months ended September 30, 1993 includes an extraordinary charge of $7,949,000, net of income tax benefit of $5,639,000, which represents the payment of debt redemption premiums and the write-off of unamortized debt issuance costs associated with the early extinguishment of debt. (3) The three months ended March 31, 1993 include the results of World Communications, Inc. which was acquired on December 31, 1992. IDB COMMUNICATIONS GROUP, INC. 1993 Annual Report on Form 10-K File Number: 0-14972 INDEX TO EXHIBITS Item Number Description 3.1(a) Restated Certificate of Incorporation of the Company, as filed with the Secretary of State of the State of Delaware on July 23, 1987. (1) 3.1(b) Designation of Preferences of the Company, as filed with the Secretary of State of the State of Delaware on December 16, 1992. (1) 3.1(c) Certificate of Amendment of Restated Certificate of Incorporation of the Company, as filed with the Secretary of State of the State of Delaware on September 23, 1993. (2) 3.2 Bylaws of the Company, as amended to date. (1) 10.1(a) IDB Communications Group, Inc. 1986 Incentive Stock Plan dated July 11, 1986, as amended. (3)(4) 10.1(b) IDB Communications Group, Inc. 1992 Incentive Stock Plan dated September 1, 1992. (4)(5) 10.1(c) IDB Communications Group, Inc. 1992 Stock Option Plan for Nonemployee Directors dated September 1, 1992. (4)(5) 10.1(d) Form of Non-Plan Nonqualified Stock Option Agreement executed by the Company and each of the following individuals: Jeffrey P. Sudikoff, William L. Snelling, Edward R. Cheramy and Franklin Fried. (4)(6) 10.1(e) IDB Communications Group, Inc. 401(k) Savings and Retirement Plan. (4)(7) 10.2(a) Form of Indemnity Agreement executed by the Company and each of the following individuals: Jeffrey P. Sudikoff, William L. Snelling, Edward R. Cheramy, Rudy Wann, Peter F. Hartz, Franklin Fried, Joseph M. Cohen, James E. Kolsrud and Neil J Wertlieb. (4)(8) 10.2(b) Consulting Agreement dated as of January 1, 1992 between the Company and William L. Snelling. (4)(9) 10.2(c) Employment Agreement dated as of January 1, 1992 between the Company and Jeffrey P. Sudikoff. (1)(4) 10.2(d) Employment Agreement dated as of January 1, 1992 between the Company and Edward R. Cheramy. (1)(4) 10.2(e) Employment Agreement dated as of January 1, 1992 between the Company and Peter F. Hartz. (1)(4) 10.2(f) Severance Agreement dated as of August 3, 1992 between the Company and Neil J Wertlieb. (4) 10.3 Agreement dated as of May 25, 1990 between Comsat, Inc. and the Company. (10) 10.6 Joint Venture and Shareholder Agreement dated February 12, 1990 between IDB Mobile Holdings, Inc., formerly known as IDB Aeronautical Holdings, Inc., and TII Aeronautical Corporation. (6) 10.7(a) Operator Agreement dated December 17, 1992 among the Company, CICI, Inc. and Southwest Communications, Inc. (1) 10.7(b) Operator Agreement dated December 17, 1992 among the Company, IDB Communications Corporation and Southwest Communications, Inc. (1) 10.8 Lease dated as of December 14, 1992 between the Company and Olympic-Centinela Partnership, Ltd. (1) 10.9(a) Antenna Slip Lease Agreement dated April 14, 1986 between Teleport Communications and The IDB Communications Group, Ltd. (11) 10.9(b) Amendment to Antenna Slip Lease Agreement dated April 28, 1988 between the Company and Teleport Communications. (12) 11.1 Statement re: computation of per share earnings. 22.1 List of Subsidiaries of the Company. 24.1 Consent of Deloitte & Touche. _______________________________ (1) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-14972) for the fiscal year ended December 31, 1992, and incorporated herein by reference. (2) Filed as an exhibit to the Company's Registration Statement on Form S-3 (File No. 33-70024) dated October 6, 1993, and incorporated herein by reference. (3) Filed as an exhibit to the Company's Registration Statement on Form S-8 (File Number 33-38738), and incorporated herein by reference. (4) Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. (5) Filed as an exhibit to the Company's Proxy Statement dated July 17, 1992 (File Number 0-14972), and incorporated herein by reference. (6) Filed as an exhibit to the Company's Annual Report on Form 10-K (File Number 0-14972) for the fiscal year ended December 31, 1989, and incorporated herein by reference. (7) Filed as an exhibit to the Company's Registration Statement on Form S-8 (Registration Number 33-38739), and incorporated herein by reference. (8) Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration Number 33-16488), and incorporated herein by reference. (9) Filed as an exhibit to the Company's Annual Report on Form 10-K (File Number 0-14972) for the fiscal year ended December 31, 1991, and incorporated herein by reference. (10)Filed as an exhibit to the Company's Current Report on Form 8-K (File Number 0-14972) dated January 31, 1989, and incorporated herein by reference. (11)Filed as an exhibit to the Company's Post-Effective Amendment No. 2 to Registration Statement on Form S-1 (Registration Number 33-28366), and incorporated herein by reference. (12)Filed as an exhibit to the Company's Quarterly Report on Form 10-Q (File Number 0-14972) for the fiscal quarter ended March 31, 1988, and incorporated herein by reference.

60026_1993.txt

60026

1993

Item 1. Business The Registrant is Lockheed Corporation which, together with its consolidated subsidiaries (unless the context otherwise indicates), will be referred to hereinafter as the "company." Lockheed was incorporated in California in 1932. In 1986, under a plan of reorganization approved by its stockholders, the company's domicile was changed from California to Delaware. Its executive offices are located at 4500 Park Granada Boulevard, Calabasas, California 91399, and its telephone number is (818) 876-2000. Lockheed's primary businesses involve research, development, and production of aerospace products and systems. During 1993, approximately 77 percent of sales were to the United States government--64 percent in defense programs and 13 percent in nondefense. Sales to foreign governments accounted for 13 percent of revenues and sales to commercial customers 10 percent. Sales made to foreign governments through the United States government are included in sales to foreign governments. Industry Segments Lockheed's operating companies are aligned into four segments: Aeronautical Systems, Missiles and Space Systems, Electronic Systems, and Technology Services. The company is engaged in a number of classified programs, and the results of operations related to those programs are included in the company's consolidated financial statements and other financial data included herein. While no specific references to individual classified programs are--or could be--made, Management's Discussion and Analysis provides comments regarding trends and results of the classes of products that include these programs. The characteristics and business risks associated with classified business do not differ materially from those of the other programs and products in which the company participates. Financial information about industry segments, foreign and domestic operations, and export sales is included in the Selected Financial Data, Management's Discussion and Analysis, and in Note 13 to the Consolidated Financial Statements included in Part II. Aeronautical Systems The Aeronautical Systems segment comprises design and production of fighter/bomber aircraft, special mission and high performance aircraft, and systems for military operations, for airlift, for antisubmarine warfare, and for reconnaissance and surveillance; and aircraft modification and maintenance for military and civilian customers. In the first quarter of 1993, the company completed the acquisition of the former tactical military aircraft business of General Dynamics Corporation. This division, now called the Lockheed Fort Worth Company, is the prime contractor for the "Fighting Falcon" fighter aircraft. The company ended 1993 with a backlog of nearly 600 firm orders for aircraft from the United States Air Force and international customers. The company is also involved with upgrade and modification programs for the existing fleet ofs, and is the principal subcontractor to develop and manufacture the FS-X fighter aircraft for Japan, which will resemble the . As a result of the Lockheed Fort Worth Company acquisition, the company's share of the air superiority fighter program increased to two-thirds. A team, composed of the company as prime contractor with teammates Boeing and Pratt & Whitney, is currently engaged in the Engineering and Manufacturing Development phase of the program for the United States Air Force. During 1993, the program completed preliminary design review that finalized the interior and exterior lines of the production aircraft. The C-130 airlifter aircraft passed its 40th anniversary in 1993. As production of existing models continues, the company is developing an improved version, the C-130J. It will feature a two-person flight station, fully integrated digital avionics, more powerful engines, and a new, more efficient propeller system. The company is engaged in upgrade programs for its high performance aircraft. This includes re-engining the Air Force fleet of U-2 reconnais- sance aircraft and modifying theA aircraft with an advanced cockpit update for full-color displays and automated flight management system, including navigation, targeting, and mission planning systems. The company's aircraft modification and maintenance programs include major modification to C-130's for special military missions. In addition, the company performs modifications, service life extensions, modernizations, and maintenance services on both military and commercial aircraft. Missiles and Space Systems The Missiles and Space Systems segment comprises military and civil space systems, research laboratories, strategic fleet ballistic missiles, tactical defense missiles, and communications systems. The Trident II D-5 is the sixth generation of submarine-launched, strategic deterrent, fleet ballistic missiles developed and produced by the company for the U.S. Navy. The company is working on its eighth Trident production and support contract. Lockheed also provides fleet ballistic missiles and operations support to the United Kingdom. The company delivered the first Milstar communications satellite to the United States Air Force in 1993. It was launched in early 1994, and is the first of several Milstar satellites designed to provide assured, highly mobile, antijam, worldwide communication links to tactical troops as well as strategic users. As prime contractor for the Theater High Altitude Area Defense (THAAD) program, the company is working under a four-year, $745 million contract awarded in 1992 by the U.S. Army to develop a system capable of intercepting, at high altitudes and long ranges, theater ballistic missiles headed toward deployed military forces and population centers. The company is a part of NASA's Hubble Space Telescope team, having designed and built the spacecraft, provided systems integration, and participated in the 1993 telescope repair mission. Lockheed continues to support the Hubble, working each day with NASA at Goddard Space Center in Greenbelt, Maryland. The company remains as a principal subcontractor on the space station, and supported NASA on the modification of the space station as it went through a major redesign in 1993. The Lockheed components include the laboratory equipment, hardware and rotating joints for the station's exterior, and the solar arrays to power the station. In 1993, the company signed a contract to build spacecraft for Motorola's Iridium TM/SM global communication system. This system will consist of 66 low-Earth orbiting satellites sending signals that can link any telephone to Motorola's small hand-held unit. Lockheed will design and build the Iridium TM/SM bus, consisting of the structure, electrical power system and attitude control system. The company completed the preliminary design phase in 1993 and is scheduled to deliver the first Iridium TM/SM bus in 1995. Lockheed has created a partnership with two of the Russian Federation's major aerospace firms, Khrunichev Enterprises and NPO Energia, and incorporated Lockheed-Khrunichev-Energia International (LKEI), a consortium with worldwide rights to Russia's Proton rocket. In the latter part of 1993, LKEI and Space Systems Loral announced an agreement to provide up to five launches for Loral beginning in 1995. Lockheed's commercial space initiatives also include a new family of Lockheed Launch Vehicles (LLV). The first demonstration flight is scheduled for late 1994. LLV provides the capability to launch small satellites and science missions into low-Earth orbit. Electronic Systems The Electronic Systems segment participates in both defense and commercial markets. For defense markets, the company develops and manufactures radar frequency, infrared, and electro-optic countermeasures systems; mission planning systems; surveillance systems; automated test equipment; antisubmarine warfare systems; microwave systems; and avionics. The company was chosen to produce the new Air Force Mission Support System, a computer-based mission planner that automates many functions including flight and route planning, weapons delivery, and threat analysis. This segment also performs work on advanced cockpit display subsystems for the fighter and C-130J airlifter. This technology can be used to provide state-of-the-art cockpits for other new aircraft as well as upgrades for older systems. The Sanders unit is also supporting a number of Lockheed programs with state-of-the-art microwave monolithic integrated circuits technology. Revolutionary advances in this technology permit smaller, affordable electronic systems to operate more reliably and many times faster than the highest-speed silicon processors. The company also manufactures computer graphics equipment through its CalComp subsidiary, other electronic products, and distributes computer equipment and workstations through its Access Graphics subsidiary, for commercial markets worldwide. Technology Services The Technology Services segment comprises space shuttle processing, engineering sciences and support, military equipment maintenance and support services, airport facilities development and management, data processing and transaction services. The company marked its tenth year as NASA's space shuttle processing contractor in 1993. During the year, the program successfully launched seven shuttle missions. In 1993, NASA again selected Lockheed for the engineering services contract at the Johnson Space Center. Under the contract, the company will help develop NASA manned spaceflight programs and provide them with engineering and scientific support, and will operate and maintain NASA's engineering and science facilities and laboratories. The company provides information services directed to the state and municipal services markets, including processing of parking and moving violations and emergency medical services billing for cities. The company also provides child support locating and collecting services and payment processing for five states and the county of Los Angeles. The company is expanding its presence in government and commercial environmental markets, with contracts to decontaminate and decommission sites and remediate soil contaminated with heavy metals for commercial customers, as well as mixed-waste-technology demonstration projects for two Department of Energy (DOE) locations. The company continues to provide environmental monitoring and technical support services for the Environmental Protection Agency. General No portion of the business of the company is considered to be seasonal. Consolidated funded backlog at December 26, 1993, and December 27, 1992, was $13.2 billion and $8.9 billion, respectively. Of the year-end 1993 backlog, $4.9 billion is not anticipated to be filled by December 25, 1994. The company, along with others, is involved, or has been notified of potential involvement, in several United States Environmental Protection Agency "Superfund" sites. Federal, state, and local requirements relating to the discharge of materials into the environment, the disposal of hazard- ous wastes, and other factors affecting the environment have had and will continue to have an impact on the manufacturing operations of the company. Thus far, compliance with such provisions has been accomplished without material effect on the company's capital expenditures, earnings, and com- petitive position. For a further discussion, see Notes 1 and 11 to the Consolidated Financial Statements included in Part II. The company does not believe that expiration of any patent, trademark, license, franchise, concession, or termination of any agreement relating thereto would have a material effect on its business. Research and Development During 1993, 1992, and 1991, the company performed $3.1 billion, $3.1 billion, and $3.3 billion, respectively, of research and development work under customer contracts. In addition, it expended $449 million in 1993, $420 million in 1992, and $384 million in 1991 on company-sponsored research and development and bid and proposal efforts, a substantial portion of which was included in overhead allocable to U. S. government contracts. During fiscal year 1993, the company did not undertake the development of a new product or line of business requiring the investment of a material amount of its total assets. Raw Materials The company has not experienced difficulty in recent years in obtain- ing an adequate supply of any raw materials or other supplies needed in its manufacturing processes. The company believes that its experience in ob- taining such items will enable it to maintain its competitive position. Procurement and Subcontracting Many materials, items of equipment, and components used in the produc- tion of the company's products are purchased from other manufacturers. The company also purchases from outside sources such items as propulsion sys- tems, guidance systems, telemetry and gyroscopic devices, and electronic functional subsystems in support of its missiles and space programs. In addition, the company often subcontracts major sections of aircraft, such as wings, empennages, and landing gears, to other companies. The company utilizes competitive bidding in its procurement practices wherever feasible. A significant portion of the equipment and components, especially engines, propellers, selected avionics systems, and flight and engine instruments, used by the company in the manufacture of its products under United States government contracts is furnished without charge to the company by the government. The company does not include in its sales that value which is represented by such government-furnished equipment. The company is dependent upon the ability of certain of its suppliers and subcontractors to meet performance specifications, quality standards, and delivery schedules in order to fulfill its commitments to its custo- mers. While the company endeavors to assure the availability of multiple sources of supply, in certain cases involving complex equipment, it relies on a sole source. The failure of certain suppliers or subcontractors to meet the company's needs would adversely affect the company's operations. Although certain priorities under United States government contracts may be available, it has been and may continue to be necessary for the company to enter early orders for its materials with long lead time re- quirements to assure continued availability of materials needed for its programs under which such priorities are unavailable. United States Government Contracts and Regulations The company's United States government business is performed under cost-reimbursement-type contracts (cost-plus-fixed-fee, cost-plus- incentive-fee, and cost-plus-award-fee) and under fixed-price-type contracts (firm fixed-price and fixed-price incentive). During 1993, 39 percent of the company's total sales to the government were under fixed-price-type contracts, and 61 percent were under cost-reimbursement-type contracts. Cost-plus-fixed-fee contracts provide for reimbursement of costs, to the extent that such costs are allowable, and the payment of a fixed fee. This type of contract differs from the cost-plus-incentive fee contract in that the latter provides for increases or decreases in the contract fee, within specified limits, based upon actual results as compared to contrac- tual targets for such factors as cost, quality, schedule, and performance. In addition, these contract types differ from the cost-plus-award-fee con- tract in that the latter provides for an award fee to be paid upon a sub- jective evaluation by the customer of the company's performance, judged in such areas as quality, timeliness, ingenuity, and cost-effectiveness of work. Under firm fixed-price contracts, the company agrees to perform certain work for a fixed price and, accordingly, realizes all the benefit or detriment occasioned by decreased or increased costs of performing the contract. Fixed-price incentive contracts are fixed-price-type contracts providing for adjustment of profit and establishment of final contract prices by a formula based on the relationship which final total costs bear to total target costs, with the contractor absorbing costs which exceed a stipulated ceiling price. Other factors affecting incentive compensation under a fixed-price incentive contract, in addition to cost, may include reliability, schedule, and performance. Under United States government regulations, certain costs--including certain financing costs and marketing expenses--are not allowable. The government also regulates the methods under which costs are allocated to government contracts. For information concerning the company's accounting policies regarding sales and earnings, accounts receivable, and inventories under government contracts, see Notes 1, 5, and 6, respectively, to the Consolidated Financial Statements included in Part II. United States government contracts are, by their terms, subject to termination by the United States government either for its convenience or for default of the contractor. Cost-reimbursement-type contracts provide that, upon termination, the contractor is entitled to reimbursement of its allowable costs; and, if the termination is for convenience, a total fee proportionate to the percentage of the work completed under the contract. Fixed-price-type contracts provide for payment upon termination for items delivered to and accepted by the government; and, if the termination is for convenience, for payment of the contractor's costs incurred plus the costs of settling and paying claims by terminated subcontractors, other settle- ment expenses, and a reasonable profit on its costs incurred. However, if a contract termination is for default, (i) the contractor is paid such amount as may be agreed upon for completed and partially completed products and services accepted by the government, (ii) the government is not liable for the contractor's costs with respect to unaccepted items, and is entitled repayment of advance payments and progress payments, if any, related to the terminated portions of the contracts, and (iii) the contractor may be liable for excess costs incurred by the government in procuring undelivered items from another source. In addition to the right of the government to terminate, government contracts are conditioned upon the continuing availability of Congressional appropriations. Congress usually appropriates funds on a fiscal-year basis even though contract performance may take many years. Consequently, at the outset of a major program, the contract is usually partially funded, and additional monies are normally committed to the contract by the procuring agency only as appropriations are made by Congress for future fiscal years. Licenses are required from United States government agencies for export from the United States of many of the company's products. The Export Administration Act of 1979 forbids participation by Americans in international boycotts of countries with which the United States maintains friendly trading relations. Competition and Risk The company encounters extensive competition in all of its lines of business from numerous other companies. Substantial efforts must be undertaken continually on a long-term basis in order to maintain existing levels of business. In some cases, investment in fixed assets is involved. Emphasis is placed by all United States government agencies on the technical and managerial capabilities of the corporations seeking business. Consequently, the degree to which the company may participate in future government business will depend to a large extent on the effectiveness and innovativeness of its research and development programs, its ability to offer better program performance than its competitors at a lower cost to the government, and its readiness in facilities, equipment, and manpower to undertake the programs for which it may be competing. A significant portion of the company's sales is associated with long- term contracts and programs for the United States government in which there are significant inherent risks. These risks include the uncertainty of economic conditions, dependence on Congressional appropriations and admin- istrative allotment of funds, changes in governmental policies which may reflect military and political developments, time required for design and development, significant changes in contract scheduling, complexity of designs and the rapidity with which product lines become obsolete due to technological advances, constant necessity for design improvements, intense competition for available government business, difficulty of forecasting costs and schedules when bidding on developmental and highly sophisticated technical work, and other factors characteristic of the industry. Foreign sales involve additional risks due to possible changes in economic and political conditions. For a further discussion of the risks inherent in the current defense industry environment, see the Management's Discussion and Analysis in Item 7, Part II. At December 26, 1993, the company had approximately 83,500 employees, the majority of whom are located in the United States. The company has a continuing need for many skilled and professional personnel in order to meet contract schedules and obtain new and ongoing orders for its products. Item 2.

Item 2. Properties At December 26, 1993, the company operated approximately 40 manufac- turing plants and research and development facilities throughout the U. S. and the remainder consisted of sales offices, warehouses, and service centers. These facilities had an aggregate floor space of approximately 43 million square feet, a summary of which is listed in the table which follows. Of this floor space, approximately 36% was owned by the company, approximately 23% was leased, with the balance being made available under facilities contracts for use in the performance of contracts with the United States government. Floor Area (thousands of square feet) Company Government Industry Segments: Owned Leased Owned Total ----------------- ------- ------ ---------- ----- Aeronautical Systems Segment: Abilene, Texas ....................... 360 409 769 Fort Worth, Texas .................... 200 1,095 7,077 8,372 Burbank, California .................. 373 99 472 Palmdale, California ................. 1,918 165 754 2,837 Marietta, Georgia .................... 1,876 414 6,336 8,626 Charleston, South Carolina ........... 160 160 Ontario, California .................. 1,276 1,276 Greenville, South Carolina ........... 469 469 Tucson, Arizona ...................... 270 270 San Bernardino, California ........... 198 198 Various (8) .......................... 185 130 315 Missiles and Space Systems Segment: Sunnyvale and Palo Alto, California .. 6,508 2,439 770 9,717 Austin, Texas ........................ 605 156 761 Santa Cruz, California ............... 194 50 244 Huntsville, Alabama .................. 62 57 119 Houston, Texas ....................... 174 174 Various locations (12) ............... 304 304 Electronic Systems Segment: Nashua, New Hampshire ................ 2,501 163 2,664 Anaheim, California .................. 433 433 Scottsdale, Arizona .................. 68 49 117 Ottawa, Ontario, Canada .............. 108 108 Reno, Nevada ......................... 94 94 Various locations (64) ............... 12 319 331 Technology Services Segment: Arlington, Texas ..................... 36 36 Kennedy Space Center, Florida ........ 126 48 2,296 2,470 White Sands, New Mexico .............. 243 243 Teaneck, New Jersey .................. 41 41 Las Vegas, Nevada .................... 135 4 139 Houston, Texas ....................... 313 34 347 Various locations (60) ............... 4 622 132 758 Corporate Office Facilities: Calabasas, California ................ 350 350 Washington, D. C. .................... 52 52 Denver, Colorado ..................... 98 98 ------ ------ ------ ------ Total 15,775 9,893 17,696 43,364 ====== ====== ====== ====== In addition to the amounts included in the above table, the company owned or leased facilities with approximately 211,000 square feet in Seattle, Washington, related to discontinued operations and approximately 652,000 square feet of non-operating facilities in Plainfield, New Jersey, related to the merger of Lockheed Electronics Company into Lockheed Sanders, Inc. As discussed in Note 3 to the Consolidated Financial Statements, included in Part II, the company is consolidating its Aeronautical Systems manufacturing facilities and intends to dispose of surplus properties resulting from that consolidation. The company believes its facilities are generally well maintained, that it has sufficient productive capacity to meet its projected needs, and such productive capacity is adequately utilized but under continual review. A large part of the company's activity is related to engineering and research and development which is not susceptible to productive capacity analysis. In the area of manufacturing, most of the operations are of a job-order nature rather than an assembly line process, and productive equipment has multiple uses for multiple products. Item 3.

Item 3. Legal Proceedings The EPA issued a notice of violation to the company on October 25, 1990, alleging violation of the Clean Water Act by discharging chromium- containing wastewater without pretreatment. The company believes the matter is settled and will not result in liability or other financial impact in excess of $500,000. See also Note 11 to the Consolidated Financial Statements, which is included in Part II. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant As of February 1, 1994, the following individuals were executive officers of the company. Information relating to the ages and five-year position history of these individuals is listed below. No family rela- tionship between officers exists. There were no arrangements or under- standings between any officer and any other person pursuant to which he was selected as an officer. Of the top six members of senior management, five are 62 years of age or older. In view of this situation, management and the Board of Directors of the company are continuing to develop an orderly succession plan primarily focusing on the many internal candidates for senior positions who are regarded as qualified for those positions. D. M. Tellep, 62, Chairman of the Board and Chief Executive Officer since 1-1-89; Director since 1987. V. N. Marafino, 63, Vice Chairman of the Board and Chief Financial and Administrative Officer since 8-1-88; Director since 1980. V. D. Coffman, 49, Executive Vice President since 3-2-92. He was Vice President from 10-3-88 to 3-2-92; President -- Space Systems Division, Lockheed Missiles & Space Company, Inc., from 10-3-88 to 3-2-92. He was a Vice President of Lockheed Missiles & Space Company, Inc., from 8-3-85 to 3-2-92 and an employee of that company since 1967. K. W. Cannestra, 63, President -- Aeronautical Systems Group since 11-7-88. J. N. McMahon, 64, President -- Missiles and Space Systems Group and President-- Lockheed Missiles & Space Company, Inc., since 8-1-88. V. P. Peline, 63, President -- Electronic Systems Group since 3-2-87. R. B. Young Jr., 59, Vice President since 4-4-83; President -- Technology Services Group since 7-1-92; he was President -- Lockheed Engineering & Sciences Company from 12-10-79 until 7-1-92. D. O. Allen, 57, Vice President -- Information and Administrative Services since 5-12-87. M. S. Araki, 62, Executive Vice President, Missiles and Space Systems Group and Executive Vice President -- Lockheed Missiles & Space Company, Inc., since 10-3-88. J. A. Blackwell, 53, Vice President since 4-28-93; and President -- Lockheed Aeronautical Systems Company since 4-28-93. He has been an executive employee of Lockheed Aeronautical Systems Company since 9-27-86. H. T. Bowling, 59, President -- Lockheed Aircraft Service Company since 2-6-89. He was Executive Vice President and General Manager -- Lockheed Aeronautical Systems Company - Ontario from 9-3-87 until 2-6-89. V. M. Butler, 51, Vice President since 8-6-90; President -- Lockheed Air Terminal, Inc., since 6-1-84. R. P. Caren, 61, Vice President -- Science and Engineering since 1-1-88. R. K. Cook, 62, Vice President -- Washington Area since 5-1-73. R. B. Corlett, 54, Vice President -- Human Resources since 3-1-91. He was an employee of Lockheed Advanced Development Company from 5-21-90 until 3-1-91, and an employee of Lockheed Aeronautical Systems Company from 5-28-87 until 5-21-90. J. F. Egan, 58, Vice President -- Corporate Development since 4-5-93; Vice President, Planning and Technology -- Electronic Systems Group from 12-27-86 until 4-5-92. G. R. England, 56, Vice President since 3-1-93; and President -- Lockheed Fort Worth Company since 3-1-93. From 1975 until 3-1-93 he was an executive employee of General Dynamics Corporation. B. E. Ewing, 49, Vice President since 3-1-93; and Vice President Aircraft Programs Operations -- Lockheed Fort Worth Company since 3-1-93. From 1-19-81 until 3-1-93 he was an employee of General Dynamics Corporation. R. R. Finkbiner, 54, Vice President -- Contracts and Pricing since 8-3-92. He has been an employee of Lockheed Corporation since 3-19-90. From 1987 until 3-19-90 he was an employee of Ernst & Young. D. M. Hancock, 52, Vice President since 3-1-93; and Vice President and Program Director -- Lockheed Fort Worth Company since 3-1-93. From 1966 until 3-1-93 he was an employee of General Dynamics Corporation. K. N. Hollander, 52, Vice President -- International Business Development since 7-1-90. From 1988 until 7-1-90 he was an employee of Ford Aerospace, Inc. J. R. Kreick, 49, Vice President since 1-1-88; President -- Lockheed Sanders, Inc., since 1-1-90; President -- Sanders Associates, Inc., from 1-1-88 until 1-1-90. G. M. Laden, 57, Vice President since 5-1-87; and Vice President and Assistant General Manager -- Missile Systems Division, Lockheed Missiles & Space Company, Inc., since 10-2-89. He was Vice President and General Manager -- Austin Division, Lockheed Missiles & Space Company, Inc., from 5-1-87 until 10-2-89. J. F. Manuel, 54, Vice President -- Domestic Business Development since 4-5-93. He was Staff Vice President -- Domestic Business Development from 5-4-91 until 4-5-93; and has been an employee of the Corporation since 9-12-79. C. R. Marshall, 40, Vice President -- Secretary and Assistant General Counsel since 1-1-92. From 7-25-86 until 1-1-92 she was a Corporate Counsel for the Corporation. L. D. Montague, 60, Vice President; and President -- Missile Systems Division, Lockheed Missiles & Space Company, Inc., since 5-9-89. He has been an executive employee of Lockheed Missiles & Space Company, Inc., since 2-19-77. S. N. Mullin, 58, Vice President since 10-3-88; President -- Lockheed Advanced Development Company since 12-3-90. He was Vice President and General Manager, Team Program Office, Advanced Tactical Fighter -- Lockheed Aeronautical Systems Company from 10-2-89 until 12-3-90. From 8-15-88 until 10-2-89 he was Vice President and General Manager, Advanced Tactical Fighter -- Lockheed Aeronautical Systems Company. G. T. Oppliger, 57, Vice President since 6-3-91; and President -- Lockheed Space Operations Company, Inc., since 8-1-91. He has been an employee of Lockheed Space Operations Company, Inc., since 6-22-85. A. G. Otsea, 64, Assistant Treasurer since 7-7-75. R. P. Parten, 58, Vice President; and President -- Lockheed Engineering and Sciences Company since 7-1-92. He has been an executive of that company since 7-1-85. S. M. Pearce, 56, Vice President - Corporate Communications since 7-17-90. From 1979 until 7-17-90 she was an employee of Ford Aerospace, Inc. J. B. Reagan, 59, Vice President; and Vice President and Assistant General Manager -- Research and Development Division, Lockheed Missiles & Space Company, Inc., since 1-1-91. He has been an employee of Lockheed Missiles & Space Company, Inc., since 1959. P. C. Reynolds, 60, Assistant Treasurer since 10-5-92. He has been an employee of Lockheed Corporation since 1960. R. E. Rulon, 51, Vice President and Controller since 2-3-92. He was Vice President -- Internal Audit from 8-6-90 until 2-3-92, and has been an executive employee of Lockheed Corporation since 1981. C. R. Scanlan, 59, Vice President since 1-2-90; Executive Vice President, Missiles and Space Systems Group and Executive Vice President, Lockheed Missiles & Space Company, Inc., since 1-2-90. He has been an employee of Lockheed Missiles & Space Company, Inc., since 1961. W. E. Skowronski, 45, Vice President and Treasurer since 9-18-92. He was Staff Vice President -- Investor Relations from 1-2-90 until 9-18-92. He was Assistant Treasurer of Boston Edison Company from 8-8-83 until 1-2-90. W. R. Sorenson, 52, Vice President -- Operations since 1-1-92. He was Staff Vice President -- Manufacturing from 1-2-91 until 1-1-92. From 3-31-81 until 1-2-91 he was an employee of Lockheed Aeronautical Systems Company. D. F. Tang, 60, Vice President since 10-7-91; President -- Space Systems Division, Lockheed Missiles & Space Company, Inc., since 3-2-92. He was Vice President and Assistant General Manager -- Space Systems Division of Lockheed Missiles & Space Company, Inc. from 11-19-88 until 3-2-92. R. W. Taylor, 55, Vice President since 7-12-75; and Vice President -- Business Strategy -- Aeronautical Systems Group since 8-1-93. He was Vice President -- Corporate Development from 10-2-89 until 8-1-93; and President -- Information Systems Group from 4-4-83 until 10-2-89. R. E. Tokerud, 57, Vice President since 2-1-93; and President -- Lockheed Support Systems, Inc., since 9-2-89. He has been an employee of the Corporation since 4-12-65. A. G. Van Schaick, 48, Vice President since 6-1-84; and Vice President Business Operations -- Aeronautical Systems Group since 8-17-92. From 7-1-85 until 8-17-92 he was Vice President and Treasurer of the Corporation. W. T. Vinson, 50, Vice President and General Counsel since 1-1-92. From 1-2-90 until 1-1-92 he was Vice President, Secretary and Assistant General Counsel. From 7-1-75 until 1-2-90 he was an employee of Lockheed Missiles & Space Company, Inc. PART II Item Page - ---- ---- 5. Market for the Registrant's Common Equity and 13 Related Stockholder Matters. 6. Selected Financial Data. 14 - 15 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 16 - 27 8. Consolidated Financial Statements and Supplemen- 28 - 56 tary Data. 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. Common Stock Prices (New York Stock Exchange -- composite transactions) High Low Fiscal Close ------------------------------------------ 1993 FISCAL QUARTERS 4th 72 3/8 62 1/2 69 3/8 3rd 68 1/2 59 3/4 2nd 66 58 1st 63 54 1/4 1992 FISCAL QUARTERS 4th 58 3/8 43 5/8 56 7/8 3rd 49 1/8 42 7/8 2nd 47 1/8 42 1/8 1st 46 39 5/8 Dividends Paid on Common Stock March 1 $.53 June 7 .53 September 7 .53 December 6 .53 March 2 .50 June 3 .53 September 8 .53 December 7 .53 As of December 26, 1993, there were approximately 11,400 holders of record of Lockheed common stock. Independent Auditors: Ernst & Young, 515 South Flower Street Los Angeles, California 90071 Common Stock: Stock symbol: LK Listed: New York; Pacific; London; Zurich and Geneva; and Amsterdam stock exchanges Transfer Agent: First Interstate Bank, 26610 West Agoura Road Calabasas, California 91302 1-800-522-6645 Item 6.

Item 6. Selected Financial Data Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS Consolidated Sales and Program Profits Consolidated sales were $13.1 billion in 1993, a 29 percent increase over 1992 due to the 1993 acquisition of Lockheed Fort Worth Company (LFWC), the former tactical military aircraft business of General Dynamics Corporation. Total sales increased three percent in 1992 compared with the previous year. Revenues from U.S. government defense customers continued to decline as a percentage of total sales, to 64 percent in 1993 from 67 percent in 1992 and 70 percent in 1991, while sales to foreign governments increased to 13 percent of total sales in 1993, largely due to the LFWC acquisition, compared with eight percent in 1992 and six percent in 1991. Sales made to foreign governments through the U.S. government are included in sales to foreign governments. Sales to commercial customers increased as an absolute amount, but held steady as a percentage of total sales. The table below illustrates the changing customer mix. Sales by customer 1993 1992 1991 - ---------------------------------------------------------------- U.S. government Defense 64% 67% 70% Nondefense 13 15 15 - ---------------------------------------------------------------- 77 82 85 Foreign governments 13 8 6 Commercial 10 10 9 - ---------------------------------------------------------------- 100% 100% 100% - ---------------------------------------------------------------- Total program profits increased by 31 percent in 1993 following growth of about 12 percent in 1992. Program profit margins for 1993, 1992, and 1991 were 6.5 percent, 6.4 percent, and 5.9 percent, respectively. The 1993 results reflected, among other factors, the LFWC acquisition, the favorable settlement of a major dispute with a customer, a reduction in accrued future retiree medical costs due to reduced employment levels (reflected in varying degrees in the program profits of each business segment), as well as charges related to Aeronautical Systems Burbank property and the closure of the Norton maintenance operation. The 1992 improvement compared with 1991 reflected better performance in most business areas partly offset by higher investment in certain emerging lines of business. Operations by business segment are discussed beginning on page 18. Interest Expense Interest expense in 1993 increased by about 41 percent over 1992's amount due to substantially higher debt outstanding during most of the year. The higher debt was incurred to finance the purchase of LFWC. The average interest rate on outstanding borrowings was lower in 1993 than in the previous year. Interest expense was about the same in 1992 as in 1991, as both average outstanding borrowing levels and the company's effective borrowing rate showed little fluctuation from year to year. Other Income, Net Net other income was negligible in 1993, lower than in 1992 primarily due to lower interest income from the temporary investment of excess cash. Net other income was higher in 1992 compared with 1991 primarily due to higher interest income and the absence of costs associated with the 1991 stockholder proxy contest, partly offset by higher other costs. Provision for Income Taxes Income tax expense was higher in 1993 than in 1992 primarily due to the effect of higher pretax earnings, with a higher effective tax rate (nearly 38 percent in 1993 versus close to 37 percent in 1992) also having an impact. The increase in the effective tax rate was due to the settlement of certain tax issues outstanding from prior periods for a higher amount than had been accrued, and a higher nondeductible amount of intangible asset amortization related to the purchase of LFWC. Congress enacted an increase in the federal statutory tax rate from 34 percent to 35 percent in 1993, but the effect of this rate increase was offset by a related favorable one-time adjustment of the company's net deferred tax assets. Income tax expense was higher in 1992 compared with 1991, also due to higher pretax earnings and a higher effective tax rate. The effective rate (about 37 percent in 1992, compared with 35 percent in 1991) was higher primarily because certain tax credits used in 1991 were not available to the company in 1992. Earnings Before Cumulative Effect of Change in Accounting Principle Earnings increased 21 percent in 1993 compared with 1992 due to higher program profits, partly offset by higher interest expense, lower other income, and higher income tax expense. The per-share increase in earnings was slightly lower (19 percent) due to the higher average number of shares and equivalents outstanding in 1993. Earnings growth in 1992 came primarily from higher program profits. Higher other income also contributed, while higher income tax expense partly offset the effect of these improvements. Earnings per share before the effect of the change in accounting was higher in 1992 compared with 1991 as a result of these same factors, plus a lower average number of common and common equivalent shares outstanding during 1992, the result of the company's common stock repurchase program under way at that time. If inflation were taken into account, earnings would differ from the reported results due to the recognition of additional depreciation expense. Contracts in the aerospace industry generally reflect the impact of anticipated inflation in the selling price, and often contain price escalation clauses that protect against abnormal inflation. In the case of depreciation, however, regulations that determine U.S. government contract revenues do not allow inflation-adjusted depreciation to be taken into account. Therefore, earnings would have been lower than reported if inflation had been considered. Income taxes would not have been adjusted because tax laws do not permit deduction of such additional inflationary cost. Inflation rates in the United States have been relatively low in recent years. Net Earnings (Loss) The net loss in 1992, caused by the effect of a change in accounting principle, was related to the company's adoption of the accrual method of accounting for retiree medical costs specified by Statement of Financial Accounting Standards No. 106 (SFAS 106). The company's 1992 adoption of a new standard related to accounting for income taxes, SFAS 109, did not have a significant impact. Results of Operations by Business Segment Aeronautical Systems Aeronautical Systems sales more than doubled in 1993, reflecting the acquisition of LFWC during the first quarter. Revenues grew about 12 percent in 1992 compared with 1991. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Fighter aircraft programs $3,661 $ 363 $ 49 Airlift aircraft programs 915 1,169 1,150 Aircraft modification and maintenance programs 517 538 431 Other aircraft programs and support activities 917 887 1,005 - ---------------------------------------------------------------- Total $6,010 $2,957 $2,635 - ---------------------------------------------------------------- Program profits $ 465 $ 193 $ 153 - ---------------------------------------------------------------- The approximately ten-fold increase in fighter aircraft sales in 1993 was primarily due to the acquisition of LFWC, whose business included the fighter program and one third of the advanced tactical fighter engineering and manufacturing development (EMD) program. Also contributing to the increase compared with 1992 were higher program revenues from the original one-third portion of the program held by Lockheed. The substantial growth in fighter aircraft revenues in 1992 compared with 1991 reflected the first full year of activity of the EMD program. Prior to mid-1991, effort was limited to the design development and prototype phase of the program. Airlift aircraft sales were 22 percent lower in 1993 than in 1992, principally due to five fewer deliveries of C-130 aircraft (30 versus 35 in 1992). Airlift aircraft sales were about the same in 1992 as in 1991. Although fewer C-130 aircraft were delivered in 1992 (35 versus 43 in 1991), the effects of increased spares sales and changes in contract pricing made up the difference. Revenues from aircraft modification and maintenance activities were down four percent in 1993 due to lower military and commercial aircraft modification sales. Aircraft modification and maintenance sales were up about 25 percent in 1992 over the prior year, primarily due to higher military aircraft modification activities, with higher commercial revenues also contributing. Other aircraft programs and support activities sales were up three percent in 1993 over 1992, mostly due to the delivery of two P-3/CP-140 maritime patrol aircraft (compared with one aircraft in 1992). Higher S-3 patrol aircraft upgrade sales were more than offset by other programs and spares sales which, on balance, were lower in 1993. Sales from other aircraft programs and support activities dropped by about 12 percent in 1992 from 1991's level, mostly due to the end of significant commercial aircraft subcontract activity in 1991. The sales increase associated with the delivery of one P-3/CP-140 aircraft in 1992 (there were none in 1991) was offset by lower S-3 aircraft upgrade revenues and lower spares sales. Program profits in Aeronautical Systems in 1993 were more than twice the 1992 amount, reflecting the LFWC acquisition. Other factors essentially offset one another. The sales variances described above had corresponding effects on program profits. In addition, negative cost adjustments on certain programs recorded in 1992 were absent in 1993. Program profit margins generally improved in most program areas. However, C-130 airlifter margins were lower in 1993, reflecting a change in customer mix. Also, 1993 saw higher spending on the development of an improved version of the C-130 aircraft (the C-130J) than in 1992. Intangible asset amortization related to the purchase of LFWC, reflected in program profits, amounted to $84 million in 1993. In addition, the following 1993 developments were significant. The U.S. Navy and the company settled their dispute related to the termination of the company's fixed-price contract for the P-7A aircraft development program. The contract was terminated for default by the U.S. Navy in July 1990. The settlement provided that the termination for default be converted to a termination of the contract by mutual agreement of the parties. After adjustment for final resolution of subcontractor claims and closure costs, the settlement amount of $111 million resulted in a reversal of approximately $90 million of the pretax losses recognized on this program in the fourth quarter of 1989. This reversal was reflected in program profits for the third quarter of 1993. The company recorded a charge to program profits in the third quarter of 1993 of $35 million, representing an expected excess of costs over anticipated sales proceeds related to its Burbank, California, property. (See Note 3 to the consolidated financial statements.) Also during the third quarter of 1993, the company concluded that its wide- body commercial aircraft modification and maintenance operations at Norton Air Force Base would be discontinued, and recorded a charge to program profits of $30 million related to the discontinuance. Program profits in Aeronautical Systems grew about 26 percent in 1992 over the 1991 level, primarily due to the first full year of the EMD program, more favorable contract pricing resulting in higher margins on the C-130 program, and improvements and favorable adjustments on certain other aircraft programs. Partly offsetting these increases were higher costs associated with the development of the C-130J airlifter, negative cost adjustments to several programs and, to a lesser extent, higher costs related to commercial aircraft maintenance operations. Missiles and Space Systems Missiles and Space Systems sales declined by about eight percent in 1993 following a six percent reduction in 1992. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Fleet ballistic missiles $1,281 $1,503 $1,563 Other missile systems 579 429 442 Space and other programs 2,378 2,655 2,854 - ---------------------------------------------------------------- Total $4,238 $4,587 $4,859 - ---------------------------------------------------------------- Program profits $ 348 $ 401 $ 360 - ---------------------------------------------------------------- Fleet ballistic missiles sales declined 15 percent in 1993, primarily reflecting the completion of the development portion of the Trident II program. Fleet ballistic missiles revenues were down four percent in 1992 compared with 1991 as Trident II development activities wound down and production was relatively stable. Other missile systems sales were 35 percent higher in 1993 than in 1992, mostly due to the Theater High Altitude Area Defense (THAAD) defensive missile program, which was just getting under way in 1992. This increase was partly offset by lower revenues from most other missile programs, including the Advanced Solid Rocket Motor (ASRM) program which was cancelled in 1993. Other missile systems sales were three percent lower in 1992 compared with 1991, as slight increases in defensive missiles and the ASRM program were more than offset by decreases in other programs. Space and other programs sales were down 11 percent in 1993 compared with 1992 due to lower revenues from certain classified space programs and, to a lesser extent, lower NASA sales. Higher sales from the Milstar military communications satellite program partly offset the declines. Sales in space and other programs declined by about seven percent in 1992 compared with one year earlier, primarily due to reductions in certain classified space programs partly offset by slight increases in Milstar, tactical command and control, and NASA programs. Missiles and Space Systems program profits were down about 13 percent in 1993 compared with 1992. The reduction reflected the impact of the lower sales volume, the absence in 1993 of significant amounts of reliability incentive fees from the Trident II program recognized in 1992 as testing under the development portion of the program neared completion, and negative cost adjustments on several programs. Higher operating margins in most other programs, and the initial recognition of profits related to the IRIDIUM TM/SM commercial satellite program, partly offset the declines. Program profits in Missiles and Space Systems were up about 11 percent in 1992 over 1991, primarily due to the recognition of significantly higher Trident II reliability incentive fees in 1992, and to the resumption of the recording of profits on the Milstar program. The recognition of Milstar profits had been deferred in 1991 while the program was being restructured. In addition, operating margins were better in most business areas in 1992 than in 1991 and a prior year contract issue was favorably resolved, but these developments were mostly offset by initial development costs related to the IRIDIUM TM/SM program. Electronic Systems Sales in Electronic Systems were about eight percent higher in 1993, com- pared with a 15 percent increase registered in 1992. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Defense electronics programs $ 619 $ 622 $ 603 Commercial product manufacturing 388 413 408 Commercial distribution activities 389 254 111 - ---------------------------------------------------------------- Total $1,396 $1,289 $1,122 - ---------------------------------------------------------------- Program profits (loss) $ (1) $ 32 $ 21 - ---------------------------------------------------------------- Revenues from defense electronics programs in 1993 were approximately equal to 1992's level. Increases in countermeasures, information systems, and avionics product lines were offset by decreases in defense system and surveillance system programs. Defense electronics sales grew about three percent in 1992 compared with 1991, mostly due to increases in antisubmarine warfare, countermeasures, and other electronic support programs, partly offset by reductions in surveillance systems revenues. Sales from commercial product manufacturing dipped six percent in 1993, principally due to further weakness and competitive pricing pressures in the computer peripherals market. Commercial product manufacturing sales were about the same in 1992 compared with 1991. Commercial distribution sales grew 53 percent in 1993, reflecting expansion of the Access Graphics subsidiary's business. Revenues from commercial distribution activities more than doubled in 1992 compared with 1991, mostly due to Access Graphics being included for the full year of 1992 versus only a portion of 1991. A small program loss was incurred by Electronic Systems in 1993, compared with program profits in 1992, due primarily to losses at CalComp. This commercial manufacturing unit suffered significant operating losses due to market weakness and pricing pressures, and also recorded charges related to downsizing and restructuring. Program profits from defense programs increased in 1993 due to improved operating performance at Sanders, and profits from commercial distribution activities were higher in 1993 than in 1992 due to improved performance and higher sales. In addition, Electronic Systems program profits were negatively affected in 1993 when the company recognized expense for future environmental remediation costs that are expected to be allocated to the company's commercial business. (See Notes 1 and 11 to the consolidated financial statements for additional information on the company's accounting policies related to environmental matters and the status of environmental matters now before the company.) Electronic Systems program profits grew 52 percent in 1992 compared with 1991, with the defense and commercial business sectors contributing about equally to the increase. In defense, the greater profits resulted from improved performance as well as higher volume at Sanders. Commercial distribution activities, included for the full year, were the primary cause of the commercial profit improvement. Purchase cost amortization related to the acquisition of Sanders and CalComp, reflected in program profits each year, was $25 million in 1993 and in 1992, and $26 million in 1991. Technology Services Technology Services sales increased by 13 percent in 1993, after growing about six percent in 1992. In millions 1993 1992 1991 - ---------------------------------------------------------------- Sales Space shuttle processing services $ 609 $ 600 $ 638 Engineering and scientific services 335 349 342 State and municipal government services 180 88 58 Other services 303 230 155 - ---------------------------------------------------------------- Total $1,427 $1,267 $1,193 - ---------------------------------------------------------------- Program profits $ 32 $ 18 $ 42 - ---------------------------------------------------------------- Space shuttle processing revenues increased about two percent in 1993, following a decrease of about six percent in 1992. Fluctuations in levels of activity in support of space shuttle operations were responsible for the variances. Sales from engineering and scientific services were down about four percent in 1993 compared with 1992 mostly due to lower levels of NASA support work, partly offset by higher environmental services revenue. Sales in 1992 were relatively stable compared with 1991, up about two percent. Revenues from state and municipal government services doubled in 1993, mostly due to the expansion of children and family services and transportation systems and services provided to state and local government agencies. Sales in this business area were up by about one-half in 1992 compared with 1991, mostly from growth in the children and family services and other municipal services business lines. Other services revenues were 32 percent higher in 1993 compared with 1992, and nearly 50 percent higher in 1992 compared with 1991, in both cases due to significantly increased levels of contract field support services provided to the military. Program profits increased substantially in 1993, primarily due to higher revenues and improved performance on contract field support programs, improved performance in airport management and consulting operations, and a reduction in accrued future retiree medical costs due to reduced employment levels. Elsewhere in this segment, program profits were approximately the same in 1993 as in 1992, reflecting both similar performance and a similar level of new business investment in each year. Program profits dropped by about 57 percent in 1992 compared with 1991, mostly because of higher investment in new business initiatives, particularly in state, county, and municipal services and environmental lines of business. FINANCIAL CONDITION Liquidity and Cash Flows Liquidity is primarily provided by cash generated from operating activities. Net cash provided by operating activities during 1993 was $795 million, over 35 percent higher than in 1992, due to higher earnings plus noncash-expending depreciation and amortization, partly offset by higher operating capital requirements. Operating cash flow was negatively impacted in 1993 by the withholding of a portion (currently approximately $170 million) of certain progress billings at LFWC by agreement with a U.S. government customer. These billings are being withheld pending resolution of issues pertaining to LFWC's manufacturing cost allocation system. The system issues are currently being addressed and withheld amounts are expected to be substantially reduced during 1994. With the exception of the temporary delay in cash flows from operating activities and higher net inventories, management expects the issues to be ultimately resolved with little, if any, effect on the company's financial statements. The company borrowed approximately $1.5 billion for the purchase of LFWC during the first quarter of 1993. Initially in the form of short-term obligations, these borrowings were subsequently refinanced with intermediate and long-term debt. By the end of the year, operating and other cash flows were sufficient to allow the company to reduce debt by over $400 million from the high point reached at the end of the first quarter. Additions to property, plant, and equipment were $321 million in 1993, approximately the same as in 1992. The amount expended on additions compared favorably with the company's 1993 depreciation expense of $328 million. The company continually monitors its capital spending in relation to current and anticipated business needs. As circumstances dictate, facilities are added, consolidated, disposed of, or modernized. Note 3 to the consolidated financial statements provides additional information regarding the disposal of excess Aeronautical Systems property. Significant numbers of employee stock options were exercised in 1993. The cash inflow from these exercises amounted to about $71 million and resulted in the issuance of approximately 1.6 million shares of company stock. Cash dividends amounted to $2.12, $2.09, and $1.95 per share in 1993, 1992, and 1991, respectively. Capital Resources Total debt, including the guarantee of salaried ESOP obligations, increased to $2,596 million at December 26, 1993, up from $1,681 million outstanding one year earlier, due to the financing of the purchase of LFWC. As discussed above, debt was reduced subsequent to the acquisition date. Cash flows are expected to allow a steady reduction of the higher debt levels over the next few years. Most of Lockheed's debt at the end of 1993 and 1992 was in the form of publicly issued fixed-rate notes. Total debt represented approximately 52 percent and 45 percent of the company's total capitalization at the respective year-end dates, about 43 percent and 34 percent if the effect of the guarantee of certain obligations of the salaried ESOP (accounted for as a component of debt and an offset to stockholders' equity) is excluded. The calculation of the debt ratio ex-ESOP reflects the fact that the assets of the salaried ESOP trust, not reflected on the company's balance sheet, are available for the service and repayment of the ESOP obligations guaranteed by the company. At its peak at the end of the first quarter of 1993, total debt was about 59 percent of total capitalization, 51 percent ex-ESOP. The "net debt" ratio consists of total debt, net of cash, as a percentage of total capitalization. Using this approach, the measures were 50 percent, 57 percent, and 40 percent at December 1993, March 1993, and December, 1992. Ex-ESOP, the amounts were 42 percent, 48 percent, and 28 percent, respectively. At December 26, 1993, the company had available committed credit lines aggregating $1.3 billion from groups of domestic and foreign banks. Generally, these lines are maintained to back up the company's commercial paper borrowings. There were no commercial paper borrowings, nor any borrowings outstanding under the committed lines, at year-end. The company receives advances on certain contracts and uses them to finance the inventories required to complete the contracted work. The amount of such advances in excess of costs incurred on these contracts was $606 million at December 26, 1993, and was mostly related to contracts with foreign government and commercial customers. These funds may be used for working capital requirements and other general corporate purposes until needed to complete the contracts. Cash on hand and temporarily invested, internally generated funds, and available financing resources are sufficient to meet anticipated operating and debt service requirements and discretionary investment needs. Stockholders' equity at December 26, 1993 was up by about $400 million or 20 percent compared with a year earlier due to the retention of earnings in excess of cash dividends paid, the issuance of new shares upon the exercise of employee stock options, and accounting benefits related to the salaried ESOP (the reduction of guaranteed debt and certain tax benefits). OTHER MATTERS Company-Sponsored Research and Development Spending on company-sponsored research and development is included in results from operations and amounted to $449 million in 1993, a seven percent increase over 1992. The company regularly monitors its research and development effort to assure an appropriate level of spending in relation to expected future benefits. Company-sponsored research and development is necessary to support the company's technologies and maintain its competitive position in the aerospace and electronics industries. Backlog Funded backlog consists of unfilled firm orders for the company's products for which funding has been both authorized and appropriated by the customer (Congress, in the case of U.S. government customers). Negotiated (total) backlog includes firm orders for which funding has not been appropriated. The following table shows funded backlog by major category for the company's two largest segments, and totals for the other two segments, at the end of each of the last three years: In millions 1993 1992 1991 - ----------------------------------------------------------------- Aeronautical Systems Fighter aircraft programs $ 6,229 $ 286 $ 300 Airlift aircraft programs 1,283 891 1,204 Aircraft modification and maintenance programs 460 504 514 Other aircraft programs and support activities 1,361 1,599 1,740 - ----------------------------------------------------------------- 9,333 3,280 3,758 Missiles and Space Systems Fleet ballistic missiles 1,423 2,389 2,254 Other missile systems 90 317 194 Space and other programs 1,273 1,605 1,262 - ----------------------------------------------------------------- 2,786 4,311 3,710 Electronic Systems 732 870 873 Technology Services 305 395 410 - ----------------------------------------------------------------- $13,156 $8,856 $8,751 - ----------------------------------------------------------------- Funded backlog was nearly 50 percent higher in 1993 compared with 1992 due to increases in Aeronautical Systems, the most significant of which was the acquisition of LFWC and its existing backlog. Funded backlog was lower in the other segments. In 1992, funded backlog increased slightly, about one percent, compared with 1991. An increase in Missiles and Space Systems was mostly offset by decreases in the other segments. In Aeronautical Systems, funded backlog almost tripled in 1993. The addition of LFWC with its fighter program and one-third share of the fighter program was most responsible for the increase. However, C-130 airlifter backlog was also significantly higher, primarily reflecting more U.S. government aircraft on order. These increases were partly offset by lower backlogs related to military aircraft modification work and maritime patrol aircraft. Funded backlog in Aeronautical Systems declined by about 13 percent in 1992 compared with 1991, mostly due to the absence of foreign and commercial C-130 airlifter sign-ups, partly offset by a higher U.S. government C-130 backlog. Elsewhere in the segment, lower funded backlog related to maritime patrol aircraft upgrade programs also had an effect. Funded backlog in Missiles and Space Systems declined by about 35 percent in 1993 compared with 1992, mostly due to a difference in the timing of the funding for the Trident II fleet ballistic missile program. Annual funding for this program, generally provided in the company's fourth quarter, was not obtained until the first quarter of 1994. The workdown of the initial THAAD defensive missile development program backlog, reductions in certain space programs, and lower Milstar and NASA backlogs, also contributed to the decrease. These reductions were partly offset by increases related to the start of the IRIDIUM TM/SM commercial satellite program. Missiles and Space Systems backlog grew about 16 percent in 1992 compared with 1991 due to higher funding of certain military space systems and defensive missile programs, partly offset by lower funded backlog in certain other space programs. In Electronic Systems, funded backlog is primarily related to defense electronics programs. In 1993, backlog was down about 16 percent compared with a year ago, with increases in surveillance systems and avionics programs more than offset by decreases in other defense electronics areas. Commercial backlogs grew slightly. In 1992, funded backlog remained about the same as in 1991, as increases in surveillance and avionics systems backlogs offset the decreases in other defense programs and in the commercial product sector. In Technology Services, 1993 funded backlog was down about 23 percent from 1992, primarily due to lower backlog of contract field support services, and timing differences in NASA funding of space shuttle processing and engineering and scientific support activities. In 1992, funded backlog was about four percent lower than in 1991, with changes in the timing of NASA funding partly offset by increased funding on contract field support programs. Service contracts represent the majority of this business segment's revenues, and are generally funded with less lead time than other contracts. As a result, funded backlog figures tend to be less of an indicator of future activity for this segment than for the others. The figures above do not include negotiated but unfunded amounts. Total negotiated backlog, both funded and unfunded, amounted to $28.9 billion in 1993, $19.4 billion in 1992, and $17.1 billion in 1991. The increase in 1993 was caused by many of the same factors responsible for the funded backlog variances described above, with the addition of LFWC in the Aeronautical Systems segment and the reductions in certain space programs in the Missiles and Space Systems segment the most prominent. The increase in 1992 compared with 1991 came from the win of the THAAD development program in the Missiles and Space Systems segment and the follow-on space shuttle processing contract in Technology Services, in addition to the funded backlog variances already discussed. As in previous years, a substantial portion of unfunded backlog is related to programs for the U.S. government and is dependent on future governmental appropriations for funding. Defense Industry Environment In recent years, significant changes in the global political climate have redefined the needs of the Department of Defense (DoD). New requirements emphasize a smaller, more technologically superior military, and the industrial base to support it. In addition, initiatives to reduce the federal budget deficit have placed increased downward pressure on defense budget levels. Defense budgets have been declining in real terms (after accounting for inflation) since 1985. Industry analysts generally expect defense spending to continue to decline through the latter part of the decade and then hold constant in real terms at a reduced level, but the ultimate outcome is uncertain. Reduced budget levels, rapidly changing customer requirements, and increased competition are expected for the defense industry in the years to come. The U.S. defense budget has a major impact on Lockheed's business base. In 1993, 64 percent of the company's sales were to DoD customers. The company provides a wide variety of products and services, and Lockheed's major programs have generally been well supported thus far during the budget decline. The company is a leader in advanced technologies, research and development, and limited production-rate manufacturing, all of which have been emphasized during the ongoing debate over the focus of future defense spending. However, uncertainty remains over the size and shape of future defense budgets and their impact on specific programs. The company has responded to these conditions and is focusing attention and resources on its most promising businesses and opportunities in both the defense and nondefense markets. The 1993 acquisition of Lockheed Fort Worth Company further broadened Lockheed's portfolio of programs and increased the company's presence in the international market. Other measures, such as cost reduction efforts, are continuing. Employment levels have been reduced to reflect changing business requirements, and will continue to be monitored and adjusted where appropriate. Management believes that the company is well-positioned for the future, with the resources and capabilities to respond appropriately to further industry developments. Environmental Matters The company is involved in a number of proceedings and potential proceedings relating to environmental matters. These matters and their impact on the company are discussed in Note 11 to the consolidated financial statements. As described in Note 11, a substantial portion of currently anticipated environmental expenditures will be reflected in the company's sales and costs of sales pursuant to U.S. government agreement or regulation. However, a timing difference in cash flows is expected between incurrence of certain of the costs related to the Burbank cleanup and allocation of these costs as part of the company's general and administrative expense. At the end of 1993, expenditures that had been made but not yet allocated amounted to $52 million. This timing difference is expected to increase through the end of 1995 before declining in subsequent years. Item 8.

Item 8. Consolidated Financial Statements and Supplementary Data CONSOLIDATED STATEMENT OF EARNINGS In millions, except per-share data 1993 1992 1991 - ------------------------------------------------------------------------- Sales Aeronautical Systems $ 6,010 $ 2,957 $ 2,635 Missiles and Space Systems 4,238 4,587 4,859 Electronic Systems 1,396 1,289 1,122 Technology Services 1,427 1,267 1,193 ----------------------------------------------------------------------- Total sales 13,071 10,100 9,809 Costs and expenses 12,227 9,456 9,233 - ------------------------------------------------------------------------- Program profits Aeronautical Systems 465 193 153 Missiles and Space Systems 348 401 360 Electronic Systems (1) 32 21 Technology Services 32 18 42 ----------------------------------------------------------------------- Total program profits 844 644 576 Interest expense (168) (119) (118) Other income, net 24 16 - ------------------------------------------------------------------------- Earnings before income taxes and cumulative effect of change in accounting principle 676 549 474 Provision for income taxes 254 201 166 - ------------------------------------------------------------------------- Earnings before cumulative effect of change in accounting principle 422 348 308 Cumulative effect of change in accounting principle for retiree medical benefits, net of tax (631) - ------------------------------------------------------------------------- Net earnings (loss) $ 422 $ (283) $ 308 ========================================================================= Earnings per share Before cumulative effect of change in accounting principle $ 6.70 $ 5.65 $ 4.86 Cumulative effect of change in accounting principle (10.23) ----------------------------------------------------------------------- Net earnings (loss) per share $ 6.70 $ (4.58) $ 4.86 ========================================================================= Average number of common and common equivalent shares outstanding 62.9 61.7 63.4 - ------------------------------------------------------------------------- Number of common shares outstanding at year-end 62.7 61.1 62.8 - ------------------------------------------------------------------------- See accompanying notes. CONSOLIDATED STATEMENT OF CASH FLOWS In millions 1993 1992 1991 - -------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net earnings (loss) $ 422 $(283) $ 308 Adjustments to reconcile net earnings (loss) to net cash provided by operating activities Cumulative effect of change in accounting principle, net of tax 631 Depreciation and amortization 498 355 339 Changes in operating assets and liabilities Accounts receivable 232 (23) 545 Gross inventories 498 292 (12) Accounts payable 5 89 (118) Salaries and related items (41) (31) 9 Income taxes 18 (15) 12 Customer advances and progress payments (824) (238) (204) Other, net (13) (192) (171) ---------------------------------------------------------------------- Net cash provided by operating activities 795 585 708 - -------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Additions to property, plant, and equipment (321) (327) (312) Purchase of Lockheed Fort Worth Company (1,521) Purchases of marketable securities (200) Proceeds from sales of marketable securities 210 Capitalized restructuring and related costs (26) (22) (19) Decrease (increase) in finance and other long-term receivables 8 (11) (40) Other, net 41 (47) 21 - -------------------------------------------------------------------------- Net cash used for investing activities (1,819) (397) (350) - -------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Decrease in short-term borrowings (9) (2) (11) Borrowings of long-term debt 1,581 341 246 Repayments of long-term debt (634) (294) (555) Purchases of treasury shares (101) (25) Cash dividends (132) (128) (124) Proceeds from stock options exercised 71 24 5 - -------------------------------------------------------------------------- Net cash provided by (used for) financing activities 877 (160) (464) - -------------------------------------------------------------------------- Increase (decrease) in cash and cash equivalents (147) 28 (106) Cash and cash equivalents, beginning of year 294 266 372 - -------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 147 $ 294 $ 266 ========================================================================== Supplemental Disclosure Information Cash paid during the year for Interest $ 165 $ 101 $ 104 Income taxes 230 219 155 ========================================================================== See accompanying notes. CONSOLIDATED BALANCE SHEET Dollar figures in millions, except per-share data 1993 1992 - -------------------------------------------------------------------------- Assets Current assets Cash and cash equivalents $ 147 $ 294 Accounts receivable 1,644 1,590 Inventories 1,699 1,178 Other current assets 350 171 ---------------------------------------------------------------------- Total current assets 3,840 3,233 Property, plant, and equipment, at cost Land 93 91 Buildings, structures, and leasehold improvements 1,686 1,678 Machinery and equipment 2,812 2,679 ---------------------------------------------------------------------- 4,591 4,448 Less accumulated depreciation and amortization 2,641 2,566 ---------------------------------------------------------------------- Net property, plant, and equipment 1,950 1,882 Noncurrent assets Intangible assets related to tactical aircraft programs acquired (net of accumulated amortization of $84) 1,425 Excess of purchase price over fair value of assets acquired (net of accumulated amortization of $204 in 1993 and $171 in 1992) 782 815 Deferred tax assets, net 33 227 Other noncurrent assets 931 867 - -------------------------------------------------------------------------- $8,961 $7,024 ========================================================================== Liabilities and Stockholders' Equity Current liabilities Short-term borrowings $ 21 $ 30 Accounts payable 841 758 Salaries and related items 355 296 Income taxes, including deferred amounts of $44 in 1993 and $72 in 1992 44 112 Customers' advances in excess of related costs 606 442 Current portion of long-term debt 28 323 Current portion of accumulated retiree medical benefit obligation 155 106 Other current liabilities 483 375 ---------------------------------------------------------------------- Total current liabilities 2,533 2,442 Long-term debt 2,547 1,328 Accumulated retiree medical benefit obligation 942 803 Other long-term liabilities 496 409 Commitments and contingencies Stockholders' equity Preferred stock Common stock, $1 par value, 100,000,000 shares authorized; 72,471,642 shares issued (70,876,030 in 1992) 73 71 Additional capital 804 735 Retained earnings 2,427 2,121 Treasury shares, at cost (9,775,996 shares) (454) (454) Guarantee of ESOP obligations (407) (431) ---------------------------------------------------------------------- Total stockholders' equity 2,443 2,042 - -------------------------------------------------------------------------- $8,961 $7,024 ========================================================================== See accompanying notes. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Guarantee of ESOP In millions, except Common Additional Retained Treasury Obliga- per-share data Stock Capital Earnings Shares tions Total - ------------------------------------------------------------------------------ At December 30, 1990 $70 $707 $2,332 $(328) $(472) $2,309 Net earnings 308 308 Reduction of ESOP obligations guaranteed 20 20 Tax benefits from dividends paid to ESOP 10 10 Stock options exercised 5 5 Dividends declared on common stock ($1.95 per share) (124) (124) Treasury shares purchased (25) (25) - ------------------------------------------------------------------------------ At December 29, 1991 70 712 2,526 (353) (452) 2,503 Earnings before cumulative effect of change in accounting principle 348 348 Cumulative effect of change in accounting principle, net of tax (631) (631) Reduction of ESOP obligations guaranteed 21 21 Tax benefits from dividends paid to ESOP on unallocated shares 6 6 Stock options exercised 1 23 24 Dividends declared on common stock ($2.09 per share) (128) (128) Treasury shares purchased (101) (101) - ------------------------------------------------------------------------------ At December 27, 1992 71 735 2,121 (454) (431) 2,042 Net earnings 422 422 Reduction of ESOP obligations guaranteed 24 24 Tax benefits from dividends paid to ESOP on unallocated shares and stock options exercised 16 16 Stock options exercised 2 69 71 Dividends declared on common stock ($2.12 per share) (132) (132) ----------------------------------------------------------------------------- At December 26, 1993 $73 $804 $2,427 $(454) $(407) $2,443 ============================================================================== See accompanying notes. Lockheed Corporation Notes to Consolidated Financial Statements Note 1 -- Summary of Significant Accounting Policies - ---------------------------------------------------- Basis of consolidation--The consolidated financial statements for the years ended December 26, 1993, December 27, 1992, and December 29, 1991, include the accounts of wholly owned and majority-owned subsidiaries. The accounts of Lockheed Finance Corporation (LFC), a wholly owned finance company subsidiary, are included in the consolidated financial statements. LFC's assets, revenues, and earnings are immaterial and therefore not separately disclosed. Because LFC's business differs significantly from the rest of Lockheed's operations, LFC's results of operations are presented as a component of other income, net. Certain reclassifications have been made to the 1992 and 1991 data to conform to the 1993 presentation. Cash and cash equivalents -- The company considers securities purchased within three months of their date of maturity to be cash equivalents. Due to the short maturity of these instruments, carrying value on the company's consolidated balance sheet approximates fair value. Under Lockheed's cash management system, certain divisions' and subsidiaries' cash accounts reflect credit balances to the extent checks written have not been presented for payment. The amounts of these credit balances included in accounts payable were $154 million at December 26, 1993, and $178 million at December 27, 1992. Inventories -- Inventories are stated at the lower of cost or estimated net realizable value. In the case of materials and spare parts, cost represents average cost. Work-in-process inventory includes direct production costs, allocable operating overhead, and, except for commercial contracts and programs, general and administrative expenses. Inventories are primarily attributable to long-term contracts or programs on which the related operating cycles are longer than one year. In accordance with industry practice, these inventories are included in current assets. Property, plant, and equipment -- Depreciation is provided on most plant and equipment using declining balance methods of depreciation during the first half of the estimated useful lives of the assets; thereafter, straight-line depreciation is used. Estimated useful lives generally range from eight years to 33 years for buildings and structures and two years to 20 years for machinery and equipment. Leasehold improvements are amortized over the useful lives of the related assets or the terms of the leases, whichever is shorter. Intangible assets related to tactical aircraft programs acquired -- Intangible assets related to the acquisition of Lockheed Fort Worth Company (the former tactical military aircraft business of General Dynamics Corporation) are amortized on a straight-line basis over an estimated period of benefit of fifteen years. Excess of purchase price over fair value of net assets acquired -- The excess of purchase price over fair value of net assets of acquired businesses is amortized on a straight-line basis over the estimated periods of benefit. Such periods do not exceed 40 years. Sales and earnings -- Sales under cost-reimbursement-type contracts are recorded as costs are incurred. Applicable estimated profits are included in sales in the proportion that incurred costs bear to total estimated costs. Sales and anticipated profits under certain fixed-price contracts that require substantial performance over a long period of time before deliveries begin are accounted for under the percentage-of-completion (cost-to-cost) method. Under all other contracts, sales are recorded at delivery or on completion of specified tasks, as applicable, and estimated contract profits are taken into earnings in proportion to recorded sales. Some contracts include provisions for adjusting prices to reflect specification changes and other matters. For accounting purposes, estimates of such adjustments are used in recording sales and costs and expenses. Incentives or penalties applicable to performance on contracts are considered in estimating sales and profit rates and are recorded when there is sufficient information to assess anticipated contract performance. When the adjustments are ultimately determined, any changes from the estimates are reflected in earnings. Any anticipated losses on contracts or programs are charged to earnings when identified. Research and development costs -- Company-sponsored research and development costs (shown in Selected Financial Data on page 15) primarily include research and development and bid and proposal effort related to government products and services. Except for certain arrangements described below, these costs are generally included as part of the general and administrative costs that are allocated among all contracts and programs under U.S. government contractual arrangements. Company-sponsored product development costs not otherwise allocable are charged to expense when incurred. Under certain arrangements in which a customer shares in product development costs, the company's portion of such costs is expensed as incurred. Customer-sponsored research and development costs incurred pursuant to contracts are accounted for as program costs. Environmental matters -- The company records a liability for environmental matters when it is probable that a liability has been incurred and the amount can be reasonably estimated. A substantial portion of the costs are expected to be reflected in sales and costs of sales pursuant to U.S. government agreement or regulation. At the time a liability is recorded for future environmental costs, an asset is recorded for the probable future recovery of those costs in pricing U.S. government business. With the exception of applicable amounts representing current assets and liabilities, these amounts are included in other noncurrent assets and other long-term liabilities. The portion of those costs expected to be allocated to commercial business is reflected in cost of sales at the time the liability is established. Prior to 1993, environmental liabilities were recorded by the company net of the estimated expenditures that would be allocated and allowable in establishing prices of U.S. government business. The 1992 amounts have been reclassified on the consolidated balance sheet to conform to the 1993 presentation. Earnings per share -- Earnings per share are computed from the weighted average number of common shares, including common share equivalents, outstanding during each year. In general, this computation assumes that dilutive stock options were exercised and the resulting proceeds were used to purchase outstanding common stock. When there is no material difference between the computations of primary and fully diluted earnings per share, only the primary number is presented. Note 2 - Acquisition - -------------------- Effective February 28, 1993, the company acquired Lockheed Fort Worth Company (LFWC), formerly the tactical military aircraft business (Fort Worth Division) of General Dynamics Corporation, for approximately $1.5 billion in cash, plus the assumption of certain liabilities related to the business. The acquisition was accounted for as a purchase, and financed by intermediate and long-term borrowings. LFWC is active in research, design, and systems integration for manufacturing and upgrading manned tactical aircraft and related products, including electronic warfare, training, and mission support systems. The operating results of LFWC since February 28, 1993, are reported in the company's Aeronautical Systems segment. The excess of the purchase price over the fair value of the net assets acquired represented intangible assets related to the aircraft programs acquired and amounted to approximately $1.5 billion. These intangible assets are being amortized over 15 years. The following pro forma financial information combines Lockheed's and LFWC's results of operations assuming that the acquisition took place at the beginning of 1992. These pro forma results are not necessarily indicative of future operations of the combined company. In millions, except per-share data 1993 1992 - ------------------------------------------------------------- Sales $13,520 $12,941 Earnings before cumulative effect of change in accounting principle 426 388 Net earnings (loss) 426 (243) Earnings per share Before change in accounting principle 6.77 6.29 Net earnings (loss) 6.77 (3.94) - ------------------------------------------------------------- Note 3 - Restructuring Activities - --------------------------------- The company is holding and preparing for sale the excess property, primarily in Burbank, California, resulting from the restructuring of its Aeronautical Systems business in 1989. As a result of declining real estate values, the company recorded a charge of $35 million in the third quarter of 1993 representing the excess of capitalized and future costs applicable to the restructuring properties over the anticipated proceeds at time of sale. Until the properties are prepared for sale and sold, the ultimate cost and sales value of the properties will continue to be subject to change. Note 4 - Other Income, Net - -------------------------- Other income, net consisted of the following components: In millions 1993 1992 1991 - --------------------------------------------------------- Interest income $ 14 $ 38 $ 31 Earnings before income taxes of Lockheed Finance Corporation 6 6 6 Other (20) (20) (21) - --------------------------------------------------------- $ $ 24 $ 16 ========================================================= Note 5 - Accounts Receivable - ---------------------------- Accounts receivable consisted of the following components: In millions 1993 1992 - ------------------------------------------------------------ U.S. government, primarily on long-term contracts $ 521 $ 538 Commercial and foreign government Long-term contracts 48 111 Other 336 235 Unbilled costs and accrued profits, primarily related to U.S. government and foreign government contracts 739 706 - ------------------------------------------------------------ $1,644 $1,590 ============================================================ Unbilled costs and accrued profits consisted primarily of revenues on long-term contracts that had been recognized for accounting purposes but not yet billed to customers. Of this total at December 26, 1993, it is expected that approximately $670 million will be billed within 90 days. The remaining amount of unbilled costs and accrued profits represent amounts related to Lockheed's estimate of contract price adjustments that are expected to be billed and collected on completion of negotiations. Note 6 - Inventories - -------------------- Inventories consisted of the following components: In millions 1993 1992 - ----------------------------------------------------------------- Work in process, primarily on long-term contracts or programs $3,166 $1,524 Materials and spare parts 310 259 Advances to subcontractors 394 205 Finished goods 105 115 - ----------------------------------------------------------------- 3,975 2,103 Less customer advances and progress payments 2,276 925 - ----------------------------------------------------------------- $1,699 $1,178 ================================================================= A substantial portion of inventories was applicable to U.S. government contracts. Under contractual arrangements whereby Lockheed receives progress payments from the U.S. government, title to inventories identified with the related contracts is vested in the government. Inventories do not include any significant amounts of unamortized tooling, learning curve and other deferred costs, claims, or other similar items whose recovery is uncertain. An analysis of general and administrative costs included in work in process follows: In millions 1993 1992 1991 - -------------------------------------------------------------------- Beginning of period $ 215 $ 186 $ 207 Incurred during the year 1,113 913 812 Charged to costs and expenses during the year (956) (884) (833) - -------------------------------------------------------------------- $ 372 $ 215 $ 186 ==================================================================== Included in costs and expenses in 1993, 1992, and 1991, were general and administrative costs of approximately $110 million, $102 million, and $66 million, respectively, incurred by business units whose sales were principally not under government contracts. Note 7 - Income Taxes - --------------------- The provision for income taxes consisted of the following components: In millions 1993 1992 1991 - ------------------------------------------------------------ Current U.S. federal $ 83 $ 210 $ 199 Foreign 5 7 11 Deferred U.S. federal 166 (16) (44) - ------------------------------------------------------------ $ 254 $ 201 $ 166 ============================================================ All of the pretax earnings shown in the company's consolidated statement of earnings were included in the computation of the provision for U.S. federal income tax. For the approximate amounts of foreign pretax income, see Note 13. Net provisions for state taxes on income are included in general and administrative expenses which, as explained in Note 6, are primarily allocable to government contracts. Such state taxes were $30 million in 1993, $43 million in 1992, and $35 million in 1991. The following is a reconciliation of the difference between the actual provision for income taxes and the provision computed by applying the federal statutory tax rate on earnings before income taxes and cumulative effect of change in accounting principle: In millions 1993 1992 1991 - ------------------------------------------------------------ Computed income taxes using statutory tax rate (35% in 1993, 34% in 1992 and 1991) $ 237 $ 187 $ 161 Increases (reductions) from Amortization of purchase costs 16 13 12 Revisions to prior years' estimated income tax liabilities Tax credits (15) Other revisions 16 5 12 Other, net (15) (4) (4) - ------------------------------------------------------------ $ 254 $ 201 $ 166 ============================================================ The company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," in 1992. Deferred income tax assets and liabilities on the consolidated balance sheet reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. SFAS 109 requires a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The company has no recorded deferred tax assets which require a valuation allowance. Deferred tax assets and liabilities consisted of the following components: December 26, December 27, In millions 1993 1992 - ------------------------------------------------------------- Deferred tax assets related to: Accumulated retiree medical benefit obligation $384 $304 Accrued compensation and benefits 140 114 Other 27 25 - ------------------------------------------------------------- 551 443 - ------------------------------------------------------------- Deferred tax liabilities related to: Acquired intangible assets 257 Contract costing methods 170 158 Depreciation methods 85 83 Debt settlement costs 37 35 Restructuring costs 13 12 - ------------------------------------------------------------- 562 288 - ------------------------------------------------------------- Net deferred tax assets (liabilities) $(11) $155 ============================================================= The computation of the deferred tax provision for 1991, the last year in which the deferred method was used, included tax effects related to the following: In millions 1991 - ----------------------------------------------------------- Contract costing methods $ (9) Foreign tax credits (3) Undistributed earnings of foreign subsidiaries 11 Costing adjustment (10) Transition adjustments for changes in tax accounting methods (25) Other, net (8) - ----------------------------------------------------------- $ (44) =========================================================== Note 8 - Employee Benefit Plans - ------------------------------- DEFINED CONTRIBUTION PLANS The company maintains contributory 401(k) savings plans for salaried employees (the Salaried Plan) and hourly employees (the Hourly Plans) which cover substantially all employees. The Salaried Plan In 1989, a leveraged Employee Stock Ownership Plan (ESOP) was created and incorporated into the Salaried Plan. The ESOP purchased approximately 10.7 million shares of Lockheed stock with the proceeds from a $500 million note issue which is guaranteed by Lockheed (see Note 10). These shares are held in a suspense account in a salaried ESOP trust until allocated to participants as described below. Under provisions of the Salaried Plan, employees' eligible contributions are matched by the company at a 60 percent rate. The company's matching obligation is accounted for as compensation and was $104 million in 1993, $91 million in 1992, and $85 million in 1991. Since January 1992, one half of the company match has consisted of cash contributions to employee-selected investment options (including Lockheed stock) and one half of the company match has consisted of Lockheed stock. In 1991, the company match consisted entirely of Lockheed stock. The Lockheed stock portion of the matching obligation is fulfilled, in part, with stock allocated from the suspense account (approximately 710,000 shares per year) through the year 2004. The balance of the stock portion of the matching obligation is fulfilled through purchases of Lockheed stock from retiring participants or on the open market. Approximately 77,000, 184,000, and 1.2 million shares of Lockheed stock were purchased on the open market by the salaried ESOP trust in 1993, 1992, and 1991, respectively. The salaried ESOP trust also sold on the open market approximately 110,000 and 285,000 shares purchased from retirees in 1993 and 1992, respectively. Company payments to the salaried ESOP trust for the stock portion of the matching obligation consist of dividends on the unallocated shares, and an amount sufficient to fully service the ESOP debt and meet the company's matching obligation to employees that is not otherwise covered through the allocation of suspense account shares. In 1993, compensation expense accrued and dividends on unallocated shares exceeded the amount required to fully service the ESOP debt and fulfill the company's matching obligation by approximately $2 million. The amount was recognized as an addition to the company's other income, net. In 1992 and 1991, the company paid an amount in excess of compensation expense accrued and dividends on unallocated shares. These additional payments were recognized as additions to Lockheed's interest expense. The amount varied in each year due to changes in the market value of company stock allocated from the suspense account. The impact of the ESOP on the company also includes special tax benefits on dividends paid on allocated and unallocated ESOP shares. These various items are reflected in components of the company's consolidated statement of earnings or as direct increases to the company's retained earnings. The aggregate of these items resulted in a net favorable effect to the company of about $12 million, $6 million, and $5 million in 1993, 1992, and 1991, respectively. The salaried ESOP trust requirements and the company's payments are shown in the following table: In millions 1993 1992 1991 - ------------------------------------------------------------------- ESOP trust requirements: Debt service (including interest of $35 million in 1993, $38 million in 1992, and $39 million in 1991) $ 59 $ 59 $ 59 Purchase of additional shares (required to meet company matching obligation) 8 12 55 - ------------------------------------------------------------------- $ 67 $ 71 $ 114 =================================================================== Met by: Dividends on unallocated shares $ 17 $ 18 $ 22 Company matching funds (Lockheed stock portion) 52 45 85 Amounts recognized as additions to Lockheed's interest expense (other income) (2) 8 7 - ------------------------------------------------------------------- $ 67 $ 71 $ 114 =================================================================== The Hourly Plans In 1990, ESOPs were created and incorporated into the Hourly Plans. The company matches 60 percent of a participating employee's eligible contribution to the Hourly Plans through payments to an ESOP trust. The company's match consists of Lockheed stock purchased by the ESOPs on the open market and from retiring participants. The company's required match, which is reported as compensation, was $15 million in 1993, $16 million in 1992, and $17 million in 1991. Approximately 123,000, 311,000, and 370,000 shares were purchased on the open market to provide the company match in 1993, 1992, and 1991, respectively. ESOP Ownership of the Company's Stock The salaried and hourly ESOP trusts held approximately 16 million shares of the company's stock at December 26, 1993, December 27, 1992, and December 29, 1991, representing about 26 percent, 26 percent, and 25 percent of the total shares outstanding, respectively. DEFINED BENEFIT PLANS Most employees are covered by Lockheed-sponsored contributory or noncontributory defined benefit pension plans. Normal retirement age is 65, but provision is made for earlier retirement. Benefits for salaried plans are generally based on salary and years of service, while those for hourly plans are based on negotiated benefits and years of service. Substantially all benefits are paid from funds previously provided to trustees. Lockheed's funding policy is to make contributions that are consistent with U.S. government cost allowability and Internal Revenue Service deductibility requirements, subject to the full-funding limits of the Employee Retirement Income Security Act of 1974 (ERISA). When any Lockheed funded plan exceeds the full-funding limits of ERISA, no contribution is made to that plan. In addition, Lockheed has certain supplemental retirement and other benefit plans which are not material. Under these plans, benefits are paid directly by Lockheed and charged against liabilities previously accrued. Net pension cost for 1993, 1992 and 1991, as determined by Statement of Financial Accounting Standards No. 87 (SFAS 87), was $110 million, $76 million, and $90 million, respectively, as shown in the following table: In millions 1993 1992 1991 - ------------------------------------------------------------------- Service cost - benefits earned during the period $ 221 $ 176 $ 165 Interest cost on projected benefit obligation 534 439 419 Actual return on plan assets (856) (358) (1,266) Net amortization and deferral 214 (178) 775 Employee contributions (3) (3) (3) - ------------------------------------------------------------------- $ 110 $ 76 $ 90 =================================================================== An analysis of the status of the plans follows: December 26, December 27, In millions 1993 1992 - -------------------------------------------------------------- Plan assets, at fair value $8,322 $6,608 ============================================================== Actuarial present value of benefit obligations Vested benefits $6,696 $5,021 Nonvested benefits 77 81 - -------------------------------------------------------------- Accumulated benefit obligation 6,773 5,102 Effect of projected future salary increases 844 634 - -------------------------------------------------------------- Projected benefit obligation 7,617 5,736 - -------------------------------------------------------------- Plan assets in excess of projected benefit obligation $ 705 $ 872 ============================================================== Consisting of Unrecognized net asset existing at the date of initial application of SFAS 87 $ 422 $ 507 Unrecognized prior service cost (242) (148) Unrecognized net gain 308 528 Prepaid pension expense 217 (15) - -------------------------------------------------------------- $ 705 $ 872 ============================================================== At December 26, 1993 and December 27, 1992, approximately 48 percent and 49 percent, respectively, of the plan assets were equity securities and the rest were primarily fixed income securities. The actuarial determinations were based on various assumptions as illustrated in the following table. Net pension costs in 1993, 1992, and 1991 were based on assumptions in effect at the end of the respective preceding year-end. Benefit obligations as of each year-end were based on assumptions in effect as of those dates. 1993 1992 1991 - -------------------------------------------------------------------------- Discount rate on benefit obligations 7.0% 8.0% 8.25% Average of full-career compensation increases for those employees whose benefits are affected by compensation levels 6.0% 7.0% 7.0% Expected long-term rate of return on plan assets 8.0% 8.0% 8.0% - -------------------------------------------------------------------------- As required by SFAS 87, the projected benefit obligation includes the effect of projected future salary increases, but not the effect of projected future credited service. The excess of plan assets over the projected benefit obligation will be required to fund the plans' continuing benefit obligations that will result from, among other things, future credited service. The change in this excess in 1993 from 1992 resulted from an increase in the accumulated benefit obligation primarily due to the lower discount rate, as well as the assumption of benefit obligations for certain employees and retirees of the former Fort Worth Division of General Dynamics Corporation, offset in part by plan assets acquired related to the assumed benefit obligations, as well as earnings of the plan assets exceeding benefit payments and expenses. The net pension cost for 1993 includes costs associated with the assumed obligations related to the Fort Worth Division of General Dynamics. The company has no present intention of terminating any of its pension plans. However, if a qualified defined benefit pension plan is terminated, the company would be required to vest all participants and purchase annuities with plan assets to meet the accumulated benefit obligation for such participants. At December 26, 1993, the cost to purchase annuities to satisfy the accumulated benefit obligation of Lockheed's qualified defined benefit plans would be in excess of $8.8 billion, compared to the $6.8 billion of accumulated benefit obligation reflected on the second table on page 41. The main salaried retirement plan provides that, after satisfaction of the accumulated benefit obligation and payment of federal excise taxes and federal and state income taxes, remaining plan assets would, in the event of plan termination within five years following a change in control of the company, be transferred to a trust and applied to the payment of certain other employee benefits otherwise payable to employees and retirees (e.g. retiree medical benefits). To the extent that contributions to a defined benefit plan were reimbursed under U.S. government contracts, any remaining surplus amounts at the time of plan termination are subject to equitable sharing under an agreement with the government. RETIREE MEDICAL PLANS Lockheed currently provides medical benefits under a contributory group medical plan for certain early (pre-65) retirees and under a noncontributory group Medicare supplement plan for certain retirees aged 65 and over (post-65). Under the accrual accounting methods of Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," the present value of the actuarially determined expected future cost of providing medical benefits is attributed to each year of employee service. The service and interest cost recognized each year is added to the accumulated retiree medical benefit obligation. Net retiree medical benefit costs as determined under SFAS 106 were $102 million in 1993 and $91 million in 1992, and are shown in the following table: In millions 1993 1992 - ------------------------------------------------------- Service cost - benefits accrued during the year $ 24 $18 Interest cost on accumulated retiree medical benefit obligation 84 76 Actual return on plan assets (5) (2) Net amortization and deferral (1) (1) - ------------------------------------------------------- $102 $91 ======================================================= Lockheed has implemented funding approaches to help manage future retiree medical costs. A Voluntary Employees' Beneficiary Association (VEBA) trust was established and began receiving funding in 1991, and other trusts established under Internal Revenue Service (IRS) regulations began receiving funding in 1992. At December 26, 1993, these trusts held $113 million in assets, of which 52 percent were equity securities and the rest were primarily fixed income securities. In 1992, assets were held in short-term investment fund accounts. The funded amounts are allowable under government contracts in the pricing of the company's products and services and are deductible in the year of contribution under IRS regulations. Earnings on trust assets operate as a reduction to annual SFAS 106 costs. Upon adopting SFAS 106 effective the beginning of fiscal 1992, Lockheed elected to record the transition obligation (present value of future retiree medical benefits attributed to years prior to 1992) on the immediate recognition basis. This resulted in a charge to 1992 earnings for the cumulative effect of the accounting change of $631 million, or $10.23 per share, after recognition of the deferred tax benefit of $325 million associated with this transition obligation. Under SFAS 106, actual medical benefit payments to retirees reduce Lockheed's accumulated retiree medical benefit obligation, and any trust funding reduces the unfunded portion of this obligation on the company's consolidated balance sheet. An analysis of the status of the retiree medical benefit plans follows: December 26, December 27, In millions 1993 1992 - -------------------------------------------------------------- Plan assets at fair value $ 113 $ 63 ============================================================== Actuarial present value of benefit obligation: Retirees $ 726 $585 Employees eligible to retire 233 160 Employees not eligible to retire 309 195 - -------------------------------------------------------------- Accumulated retiree medical benefit obligation 1,268 940 Unrecognized net gain (loss) (58) 32 - -------------------------------------------------------------- Net unfunded retiree medical benefit obligation $1,097 $909 ============================================================== In 1993, in response to economic conditions affecting a number of U.S. government and commercial programs, the company undertook significant workforce reductions at several of its companies. This action resulted in a net curtailment gain of $28 million, representing a reversal of a portion of the previously accrued obligation for future retiree medical costs. In addition, the retiree medical benefit obligations at December 26, 1993, and the 1993 net retiree medical benefit costs reflect the assumption of benefit obligations for certain employees and retirees of the former Fort Worth Division of General Dynamics Corporation. Actuarial determinations were based on various assumptions as illustrated in the following table. Net retiree medical costs for 1993 and 1992 were based on assumptions in effect at the end of the respective preceding years. Benefit obligations as of the end of each year reflect assumptions in effect as of those dates. 1993 1992 - -------------------------------------------------------------- Discount rate 7.0% 8.25% Expected long-term rate of return on plan assets 8.0% 8.0% Range of medical trend rates: Initial: pre-65 retirees 11.0% 13.0% post-65 retirees 7.5% 10.0% Ultimate (20 years and after): pre-65 retirees 5.0% 6.0% post-65 retirees 2.0% 2.0% - -------------------------------------------------------------- An increase of one percentage point in the assumed medical trend rates would result in an accumulated retiree medical benefit obligation of $1.3 billion at December 26, 1993, and a 1993 net retiree medical benefit cost of approximately $119 million. The company believes that the cost containment features it has previously adopted and the funding approaches under way will allow it to effectively manage its retiree medical expenses, but it will continue to monitor the costs of retiree medical benefits and may further modify the plans if circumstances warrant. POSTEMPLOYMENT BENEFITS In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits." This statement establishes standards for accounting for benefits to former or inactive employees after employment, other than retirement benefits. Lockheed will adopt SFAS 112 in 1994, the required implementation date. Adoption of SFAS 112 is not expected to have a significant effect on the company's financial statements. Note 9 - Leases - --------------- Total rental expenses under operating leases, net of immaterial amounts of sublease rentals and contingent rentals, were $112 million, $114 million, and $123 million for 1993, 1992, and 1991, respectively. Future minimum lease commitments at December 26, 1993, for all operating leases that have a remaining term of more than one year were $507 million ($104 million in 1994, $80 million in 1995, $69 million in 1996, $51 million in 1997, $47 million in 1998, and $156 million in later years). Substantially all real estate leases contain renewal options ranging from one year to 10 years. Certain major plant facilities and equipment are furnished by the U.S. government under short-term or cancelable arrangements. Note 10 - Debt - -------------- At December 26, 1993, the company had two loan agreements (the 1993 Agreements) with a group of domestic and foreign banks. One agreement makes available $1 billion through August 30, 1996, while the other agreement makes available $300 million through August 29, 1994. The primary purpose of these agreements is to back up the company's commercial paper borrowings. There were no borrowings outstanding under either agreement, and no commercial paper borrowings outstanding, at December 26, 1993 (considerable commercial paper borrowing activity took place during the year, however, primarily to provide the initial financing of the LFWC acquisition and for temporary working capital needs). Borrowings under the 1993 Agreements would be unsecured and bear interest, at the company's option, at rates based on the Eurodollar rate or a bank base rate (as defined). The 1993 Agreements contain financial covenants relating to equity and debt, and provisions which relate to certain changes in control. Long-term debt consisted of the following components: In millions 1993 1992 - ------------------------------------------------------------ 7 7/8% notes due 1993 $ 300 8 1/2% notes due 1996, redeemed 1993 200 Variable-rate notes due 1995 $ 200 80 Fixed-rate notes due 1995 to 2004 140 77 4 7/8% notes due 1996 275 5.65% notes due 1997 100 5 7/8% notes due 1998 300 9 3/8% notes due 1999 300 300 6 3/4% notes due 2003 300 9% notes due 2022 200 200 7 7/8% notes due 2023 300 Obligations under long-term capital leases 17 10 Other obligations 36 53 - ------------------------------------------------------------ 2,168 1,220 Guarantee of ESOP obligations 407 431 - ------------------------------------------------------------ 2,575 1,651 Less portion due within one year 28 323 - ------------------------------------------------------------ $ 2,547 $ 1,328 ============================================================ All of the notes contain covenants relating to debt, and provisions which relate to certain changes in control. The variable-rate notes due in 1995 are unsecured and bear interest at rates based on the Eurodollar rate. The fixed-rate notes due in 1995 to 2004 are unsecured, were issued in various denominations with various maturity dates, and bear interest at fixed rates ranging from 4.55 percent to 8.34 percent. The 9 3/8% notes due in 1999 stipulate that, in the event of both a "designated event" and a related "rating decline" occurring within a specified period of time, holders of the notes may require Lockheed to redeem the notes and pay accrued interest. In general, a "designated event" occurs when any one of certain ownership, control, or capitalization changes takes place. A "rating decline" occurs when the ratings assigned to Lockheed debt are reduced below investment-grade levels. Lockheed's leveraged ESOP (see Note 8) borrowed $500 million through a private placement of notes in 1989. These notes bear interest at fixed rates ranging from 8.27 percent to 8.41 percent, and are being repaid in quarterly installments over terms ending in 2004. The ESOP note agreement stipulates that, in the event that the ratings assigned to Lockheed's long-term senior unsecured debt are below investment grade, holders of the notes may require Lockheed to purchase the notes and pay accrued interest. These notes are obligations of the ESOP but guaranteed by Lockheed and, in accordance with financial accounting standards, are reported as debt on Lockheed's balance sheet, with a corresponding offset to stockholders' equity. As the ESOP notes are repaid, the amount guaranteed decreases, as do the amounts reported as Lockheed debt and offsetting stockholders' equity. While the amount guaranteed affects Lockheed's consolidated balance sheet, the issuance of the guarantee and the subsequent reductions in its amount were not cash transactions and, accordingly, are not reflected on the consolidated statement of cash flows. Lockheed Finance Corporation (LFC) has a $155 million line of credit with a group of banks. The agreement limits borrowings to an amount reduced by the balance outstanding ($58 million at December 26, 1993) of LFC notes and leases receivable sold to the banks with certain recourse provisions. The company's long-term debt maturities, including those of LFC and the guaranteed ESOP obligations, for the five years following December 26, 1993, are: $28 million in 1994; $272 million in 1995; $306 million in 1996; $162 million in 1997; and $373 million in 1998. Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires the disclosure of the fair value of financial instruments, both assets and liabilities recognized and not recognized on the consolidated balance sheet, for which it is practicable to estimate fair value. Unless otherwise indicated elsewhere in the notes to the consolidated financial statements, the carrying value of the company's financial instruments approximates fair value. The estimated fair values of the company's long-term debt instruments at December 26, 1993, aggregated $2,776 million, compared with a carrying amount of $2,575 million on the consolidated balance sheet. The fair values were estimated based on quoted market prices for those instruments publicly traded. For privately placed debt, the fair values were estimated based on the quoted market prices for the same or similar issues, or on current rates offered to the company for debt of the same remaining maturities. Note 11 - Commitments and Contingencies - --------------------------------------- ENVIRONMENTAL MATTERS In March 1991, the company entered into a consent decree with the U.S. Environmental Protection Agency (EPA) relating to certain property in Burbank, California, which obligates the company to design and construct facilities to monitor, extract, and treat groundwater and operate and maintain such facilities for approximately eight years. The company currently estimates that expenditures required to comply with the terms of the consent decree over the remaining term of the project will approximate $120 million. The company has also been operating under a cleanup and abatement order from the California Regional Water Quality Control Board affecting its facilities in Burbank, California. This order requires site assessment and action to abate groundwater contamination by a combination of groundwater and soil cleanup and treatment. Based on experience being derived from initial remediation activities, the company currently estimates the anticipated costs of these actions in excess of the requirements under the EPA consent decree to approximate $175 million over the remaining term of the project; however, this estimate will be subject to changes as work progresses and as additional experience is gained. The company is also involved in several other proceedings and potential proceedings relating to environmental matters, including disposal of hazardous wastes and soil and water contamination. The company has not incurred any material costs relating to these environmental matters. The extent of the company's financial exposure cannot in all cases be reasonably estimated at this time. A liability of approximately $55 million for those cases in which an estimate of financial exposure can be determined has been recorded. Under an agreement with the U.S. government, the Burbank groundwater treatment and soil remediation expenditures are being allocated to all of the company's operations as general and administrative costs (see Note 1), and under existing government regulations these and other environmental expenditures related to U.S. government business are allowable in establishing the prices of the company's products and services. As a result, a substantial portion of the expenditures will be reflected in the company's sales and costs of sales pursuant to U.S. government agreement or regulation. The company has recorded a liability for probable future environmental costs as discussed above, and has recorded an asset for probable future recovery of these costs in pricing of the company's products and services for U.S. government business. The portion that is expected to be allocated to commercial business has been reflected in cost of sales. OTHER MATTERS Lockheed is a defendant in a number of shareholder lawsuits relating to the fourth quarter 1989 write-off of $300 million on the P-7A aircraft development program. The plaintiffs allege, among other things, that disclosure with respect to potential losses under the contract was not made on a timely basis. The company believes that if these actions, in the aggregate, were decided adversely to it, the result would not have a material impact on the company. Lockheed Missiles and Space Company, Inc., a subsidiary of Lockheed, is a defendant in a civil suit in the United States District Court for the Northern District of California brought under the so-called qui tam provisions of the False Claims Act, which permit an individual to bring suit in the name of the government and share in any recovery received. The suit, captioned United States ex rel. Margaret A. Newsham and Martin Overbeek Bloem v. Lockheed Missiles and Space Company, Inc., was filed by two ex-employees in 1988. The complaint sets forth numerous allegations of improper conduct by Lockheed and seeks unspecified damages. The Department of Justice conducted a thorough investigation of the matter after the complaint was filed and has declined to take over prosecution of the case. The company believes the litigation to be without merit and intends to aggressively defend its position. A number of other lawsuits and administrative proceedings are pending against the company and its subsidiaries. Management believes the lawsuits and administrative proceedings are either without merit or, if decided adversely, would be covered by insurance or by contract or would not be of material significance. The company has entered into standby letter of credit agreements and other arrangements with financial institutions primarily relating to the guarantee of future performance on certain contracts. At December 26, 1993, the company was contingently liable on outstanding letters of credit, guarantees, and other arrangements aggregating approximately $406 million. Lockheed Finance Corporation sold certain finance notes and leases receivable with certain recourse provisions during 1993 and in previous years. At December 26, 1993, the unpaid principal balance of these notes and leases was about $58 million. At December 26, 1993, LFC had entered into approximately $400 million in interest rate swap agreements to reduce the impact of changes in interest rates on its operations. The effect of these agreements is that the aggregate of the carrying value of LFC's financial instruments approximates their fair market value. LFC is exposed to credit loss, to the extent of future interest rate differentials, in the event of nonperformance by the intermediaries to the interest rate swap agreements. The company does not anticipate nonperformance by the intermediaries. Note 12 - Stockholders' Equity and Related Items - ------------------------------------------------ EMPLOYEE STOCK OPTIONS Lockheed's 1992 Employee Stock Purchase Program (1992 Program) authorizes grants of options to purchase up to 3,000,000 shares of the company's authorized but unissued common stock. Options granted under the 1992 Program and its predecessors, the 1986 Program and the 1982 Program, can be exercised at a price not less than the fair market value of the stock on the date that the option is granted. At December 26, 1993, 2,856,770 shares of the company's common stock were reserved for stock options granted. The 1992 Program is composed of two separate stock option plans. The first plan provides for the grant of incentive stock options. The second plan provides for the grant of nonstatutory stock options that may, at the discretion of the board of directors, be accompanied by stock appreciation rights. The following table summarizes the options exercisable and available for grant at December 26, 1993: Exercisable --------------------- Available Number Price range for grant - ---------------------------------------------------- 1992 Program 226,973 $42.75-58.81 1,821,500 1986 Program 1,447,538 31.94-55.31 1982 Program 287,009 46.00-47.50 ==================================================== The following table summarizes the activity under the company's plans during 1993: Option Shares price under range option - ------------------------------------------------ Outstanding at December 27, 1992 $31.94-55.31 3,870,883 Granted 58.31-58.81 633,450 Terminated 40.19-58.81 (26,200) Exercised 34.81-55.31 (1,621,363) - ------------------------------------------------ Outstanding at December 26, 1993 $31.94-58.81 2,856,770 ================================================ PREFERRED STOCK There are 2,500,000 shares of preferred stock, $1 par value, authorized for issuance. At December 26, 1993, there was no preferred stock outstanding and 1,000,000 shares of preferred stock were reserved for issuance in connection with the rights described below. In December 1986, Lockheed adopted a Shareholder Rights Plan and distributed a dividend of one right for each outstanding share of common stock. Upon becoming exercisable, each right entitles the holder to purchase one one-hundredth of a share of Series A Junior Participating Preferred stock (Series A Preferred), par value $1, at a price of $150, which is subject to adjustment. Shares of common stock issued by the company subsequent to the adoption of the plan have had rights attached. The rights are not exercisable into common stock or transferable apart from the common stock, and no separate rights certificates will be distributed until ten business days after the public announcement that a person or group either (i) has acquired, or has obtained the right to acquire, beneficial ownership of 20 percent or more of the outstanding common shares, or (ii) has commenced, or announced an intention to make, a tender offer or exchange offer if, upon consummation, such person or group would be the beneficial owner of 20 percent or more of the outstanding common shares. When such rights become exercisable, as described above, each right will entitle its holder, other than such person or group referred to above, upon payment of the exercise price, to receive Lockheed common shares with a deemed market value of twice such exercise price. Such rights will not be triggered in the event of a "qualifying offer" (basically defined as an all cash offer, fully financed, to acquire a majority of outstanding shares not owned by the offeror, which meets specified irrevocable criteria), or if the 20 percent acquisition is made pursuant to a tender or exchange offer for all outstanding common shares which a majority of the directors of the company deem to be in the best interests of the company and its stockholders. If there is a merger with an acquirer of 20 percent or more of Lockheed's common stock and Lockheed is not the surviving corporation, or more than 50 percent of Lockheed's assets, earning power, or cash flow is transferred or sold, each right will entitle its holder, other than the acquirer, to receive the acquiring company's common shares with a deemed market value of twice such exercise price. All of the rights may be redeemed by the board of directors of the company at a price of $.05 per right until the earlier of (i) ten business days after the public announcement that a person or group has acquired beneficial ownership of 20 percent or more of the outstanding common shares or (ii) December 1996. After a person or group acquires 20 percent or more of Lockheed's common shares, the board of directors may redeem the rights only with the concurrence of a majority of the continuing directors (as defined in the plan). The rights, which do not have voting rights and are not entitled to dividends, expire in December 1996. Note 13 - Information on Industry Segments, Foreign and - ------------------------------------------------------- Domestic Operations, and Major Customers - ---------------------------------------- Unaudited information on Lockheed's business segments is included in Part I of this Form 10-K and Management's Discussion and Analysis beginning on page 16. Selected additional information is summarized below: SELECTED FINANCIAL DATA BY BUSINESS SEGMENT In millions 1993 1992 1991 - --------------------------------------------------------------------- Depreciation and amortization Aeronautical Systems $ 216 $ 106 $ 95 Missiles and Space Systems 164 156 157 Electronic Systems 72 74 70 Technology Services 14 11 10 Corporate* 32 8 7 - --------------------------------------------------------------------- Total $ 498 $ 355 $ 339 ===================================================================== Expenditures for property, plant, and equipment Aeronautical Systems $ 148 $ 140 $ 108 Missiles and Space Systems 98 133 159 Electronic Systems 35 40 34 Technology Services 10 12 10 - --------------------------------------------------------------------- Total segments 291 325 311 Corporate 30 2 1 - --------------------------------------------------------------------- Total $ 321 $ 327 $ 312 ===================================================================== Identifiable assets Aeronautical Systems $4,336 $2,109 $2,248 Missiles and Space Systems 1,810 2,028 2,011 Electronic Systems 1,468 1,506 1,496 Technology Services 317 300 229 - --------------------------------------------------------------------- Total segments 7,931 5,943 5,984 Lockheed Finance Corporation 112 121 111 Corporate 918 960 522 - --------------------------------------------------------------------- Total $8,961 $7,024 $6,617 ===================================================================== *Depreciation and amortization is allocated to the operating segments. SELECTED FINANCIAL DATA BY GEOGRAPHIC AREA* In millions 1993 1992 1991 - ------------------------------------------------------------ Sales United States $12,390 $ 9,656 $ 9,481 Other 681 444 328 - ------------------------------------------------------------ Total $13,071 $10,100 $ 9,809 ============================================================ Program profits United States $ 827 $ 613 $ 545 Other 17 31 31 - ------------------------------------------------------------ Total $ 844 $ 644 $ 576 ============================================================ Identifiable assets United States $ 8,730 $ 6,777 $ 6,413 Other 231 247 204 - ------------------------------------------------------------ Total $ 8,961 $ 7,024 $ 6,617 ============================================================ * Defined by the location of Lockheed operations and not necessarily the locations of customers. Transfers between geographic areas were not material in any year. Identifiable assets in each segment or geographic area include the assets used in Lockheed's operations, and any applicable excess of the purchase price over the fair value of net assets acquired or intangible assets acquired, as appropriate. Consistent with Securities and Exchange Commission rules, identifiable assets are not reduced by identifiable liabilities. Corporate assets consisted primarily of cash and cash equivalents, property, plant, equipment, assets related to the probable future recovery of certain environmental remediation costs, current and deferred tax assets, and investments. SALES BY CUSTOMER CATEGORY In millions 1993 1992 1991 - --------------------------------------------------------------------- U.S. government* Aeronautical Systems $ 4,477 $2,245 $1,984 Missiles and Space Systems 3,846 4,386 4,777 Electronic Systems 547 507 476 Technology Services 1,179 1,103 1,058 - --------------------------------------------------------------------- Total $10,049 $8,241 $8,295 ===================================================================== Foreign governments Aeronautical Systems $ 1,408 $ 551 $ 424 Missiles and Space Systems 282 172 54 Electronic Systems 81 126 133 - --------------------------------------------------------------------- Total $ 1,771 $ 849 $ 611 ===================================================================== Commercial Aeronautical Systems $ 125 $ 161 $ 227 Missiles and Space Systems 110 29 28 Electronic Systems 768 656 513 Technology Services 248 164 135 - --------------------------------------------------------------------- Total $ 1,251 $1,010 $ 903 ===================================================================== * Sales made to foreign governments through the U.S. government are included in sales to foreign governments. Export sales were $1,743 million, $831 million, and $666 million in 1993, 1992, and 1991, respectively. Note 14 - Summary of Quarterly Information (Unaudited) - ------------------------------------------------------ 1993 Quarters In millions, except ----------------------------- per-share data First Second Third Fourth - -------------------------------------------------------------- Sales $2,508 $3,349 $3,475 $3,739 Program profits 158 200 226 260 Earnings before income taxes 126 149 187 214 Net earnings 76 94 117 135 Earnings per share 1.22 1.50 1.85 2.13 - -------------------------------------------------------------- 1992 Quarters ----------------------------- First Second Third Fourth - -------------------------------------------------------------- Sales $2,226 $2,480 $2,474 $2,920 Program profits 125 147 161 211 Earnings before income taxes 105 122 136 186 Earnings before change in accounting 66 77 86 119 Net earnings (loss) (565) 77 86 119 Earnings per share Before change in accounting 1.06 1.24 1.40 1.95 Net earnings (loss) (9.04) 1.24 1.40 1.95 - -------------------------------------------------------------- THE COMPANY'S RESPONSIBILITY FOR FINANCIAL REPORTING Management prepared, and is responsible for, the consolidated financial statements and all related financial information contained in this report. The consolidated financial statements, which include amounts based on estimates and judgments, were prepared in accordance with generally accepted accounting principles appropriate in the circumstances. Other financial information in this report is consistent with that in the consolidated financial statements. Management recognizes its responsibilities for conducting the company's affairs in an ethical and socially responsible manner. The company has written policy statements covering its business code of ethics which emphasize the importance of total allegiance to codes of personal and corporate conduct that leave no latitude for legal infractions or moral improprieties. The importance of ethical behavior is regularly communicated to all employees through ongoing education and review programs that are designed to create a strong compliance environment. Management maintains an accounting system and related internal controls which it believes provide reasonable assurance, at appropriate cost, that transactions are properly executed and recorded, that assets are safeguarded, and that accountability for assets is maintained. An environment that establishes an appropriate level of control consciousness is maintained and monitored and includes examinations by an internal audit staff. The audit committee of the board of directors is composed of five outside directors. This committee is convened at least four times a year and frequently meets separately with representatives of the independent auditors, company officers, and the internal auditors to review their activities. The consolidated financial statements have been audited by Ernst & Young, independent auditors, whose report follows. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS Board of Directors and Stockholders Lockheed Corporation We have audited the accompanying consolidated balance sheet of Lockheed Corporation at December 26, 1993 and December 27, 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the three years in the period ended December 26, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lockheed Corporation at December 26, 1993 and December 27, 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 26, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth herein. As discussed in Notes 8 and 7 to the financial statements, effective December 30, 1991 (the beginning of Lockheed's 1992 fiscal year), the company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." ERNST & YOUNG Los Angeles, California February 7, 1994 PART III The information required to be set forth herein, Item 10, "Directors and Executive Officers of the Registrant," Item 11, "Executive Compensation," Item 12, "Security Ownership of Certain Beneficial Owners and Management," and Item 13, "Certain Relationships and Related Transactions," except for a list of the Executive Officers which is provided in Part I of this report, is included in a definitive Proxy Statement pursuant to Regulation 14A, which is incorporated herein by reference, filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year ended December 26, 1993. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Index to Consolidated Financial Statements, Consolidated Financial Statement Schedules and Exhibits: Page No. -------- 1. Consolidated Financial Statements included in Part II Consolidated Statement of Earnings for Years Ended December 26, 1993, December 27, 1992, and December 29, 1991.................................... 28 Consolidated Statement of Cash Flows for Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 ................................................. 29 Consolidated Balance Sheet at December 26, 1993, Decem- ber 27, 1992, and December 29, 1991 .................. 30 Consolidated Statement of Stockholders' Equity for Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 .................................... 31 Notes to Consolidated Financial Statements ............ 32 The Company's Responsibility for Financial Reporting .. 55 Report of Ernst & Young, Independent Auditors ......... 56 2. Consolidated Financial Statement Schedules V -- Property, Plant, and Equipment .............. VI -- Accumulated Depreciation and Amortization of Property, Plant, and Equipment .............. VIII -- Valuation and Qualifying Accounts ........... IX -- Short-term Borrowings ....................... X -- Supplementary Income Statement Information .. 3. Index to Exhibits ...................................... E-1 All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Con- solidated Financial Statements and related notes. (b) Reports on Form 8-K: Form 8-K dated September 29, 1993, Item 5, Other Events. SCHEDULE V LOCKHEED CORPORATION PROPERTY, PLANT, AND EQUIPMENT Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) Balance Add- Retire- Balance Beginning itions ments Other End of Description of Year at Cost or Sales Changes(1)Year(2) 1993: Land...................... $ 91 $ 2 $ (5) $ 5 $ 93 Buildings and structures.. 1,358 96 (139) 32 1,347 Machinery and equipment... 2,571 245 (217) 138 2,737 Leasehold improvements.... 206 16 (5) 13 230 Construction in progress(3) 222 (38) (2) 2 184 -------- -------- -------- -------- ------- $ 4,448 $ 321 $ (368) $ 190 $ 4,591 ======== ======== ======== ======== ======= 1992: Land...................... $ 90 $ 1 $ 91 Buildings and structures.. 1,318 $ 43 $ (3) 1,358 Machinery and equipment... 2,402 226 (57) 2,571 Leasehold improvements.... 208 10 (12) 206 Construction in progress(3) 174 48 222 -------- -------- -------- -------- ------- $ 4,192 $ 327 $ (72) $ 1 $ 4,448 ======== ======== ======== ======== ======== 1991: Land...................... $ 90 $ 90 Buildings and structures.. 1,289 $ 56 $ (23) $ (4) 1,318 Machinery and equipment... 2,342 212 (158) 6 2,402 Leasehold improvements.... 173 41 (6) 208 Construction in progress(3) 170 3 1 174 -------- -------- -------- -------- -------- $ 4,064 $ 312 $ (187) $ 3 $ 4,192 ======== ======== ======== ======== ======== Methods of depreciation for plant and equipment and leasehold improvements are discussed in Note 1 to the Consolidated Financial Statements. (1) Other changes in 1993 primarily consist of Lockheed Fort Worth Company asset balances at acquisition. (2) Includes $22 million at December 26, 1993, $14 million at December 27,1992, and $16 million at December 29, 1991, of leases capitalized in accordance with Statement of Financial Accounting Standards No. 13. (3) Construction in progress at December 26, 1993, December 27, 1992, and December 29, 1991 includes approximately $170 million, $154 million, and $128 million, respectively, of purchases that will be reclassified to the other property, plant, and equipment catagories in the following year. The remainder of the amount relates to projects that were in process at year-end, including construction of facilities primarily for the Aeronautical Systems and Missiles and Space Systems business segments. The cost of completed fixed assets transferred from construction in progress to another fixed asset category is recorded as a negative addition to construction in progress and a positive addition to the appropriate category. SCHEDULE VI LOCKHEED CORPORATION ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) Balance Retire- Balance Beginning Pro- ments Other End of Description of Year vision or Sales Changes Year(1) 1993: Buildings and structures.. $ 634 $ 62 $ (79) $ 617 Machinery and equipment... 1,805 249 (165) $ 1 1,890 Leasehold improvements.... 127 17 (10) 134 -------- -------- -------- -------- -------- $ 2,566 $ 328 $ (254) $ 1 $ 2,641 ======== ======== ======== ======== ======== 1992: Buildings and structures.. $ 583 $ 53 $ (2) $ $ 634 Machinery and equipment... 1,649 227 (71) 1,805 Leasehold improvements.... 121 14 (8) 127 -------- -------- -------- -------- -------- $ 2,353 $ 294 $ (81) $ $ 2,566 ======== ======== ======== ======== ======== 1991: Buildings and structures.. $ 538 $ 56 $ (12) $ 1 $ 583 Machinery and equipment... 1,558 213 (109) (13) 1,649 Leasehold improvements.... 109 15 (3) 121 -------- -------- -------- -------- -------- $ 2,205 $ 284 $ (124) $ (12) $ 2,353 ======== ======== ======== ======== ======== (1) Includes $8 million at December 26, 1993, $7 million at December 27, 1992, and $9 million at December 29, 1991, of accumulated amortization of capital leases. SCHEDULE VIII LOCKHEED CORPORATION VALUATION AND QUALIFYING ACCOUNTS Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) Balance Additions Deduct- Balance Beginning Charged to ions and End of Description of Year Earnings Other Year Deducted from assets to which applicable: 1993: Allowance for doubtful receivables: Accounts receivable............. $ 12 $ 20 $ 7 $ 25 ======= ======= ======= ======= 1992: Allowance for doubtful receivables: Accounts receivable............. $ 9 $ 8 $ 5 $ 12 ======= ======= ======= ======= 1991: Allowance for doubtful receivables: Accounts receivable............. $ 9 $ 3 $ 3 $ 9 ======= ======= ======= ======= SCHEDULE IX LOCKHEED CORPORATION SHORT-TERM BORROWINGS(1) Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of dollars) Maximum Average Weighted Category of Amount Amount Average Aggregate Balance Weighted Outstanding Outstanding Interest Short-Term at End Average During the During the Rate During Year Borrowings of Period Interest Rate Year Year(2) the Year(3) - ---- ---------- --------- ------------- ---- ------- ---------- 1993 Commercial Paper -0- -0- $1,551 $ 288 3.4% 1992 Commercial Paper -0- -0- 140 30 4.5 1991 Not Applicable (1) See Note 10 to the Consolidated Financial Statements. (2) Averages are based on the amount outstanding each day multiplied by the number of days outstanding divided by 364 days. (3) Averages are based on the actual interest expense on commercial paper borrowings divided by the average commercial paper borrowings outstanding during the year. SCHEDULE X LOCKHEED CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 26, 1993, December 27, 1992, and December 29, 1991 (Millions of Dollars) 1993 1992 1991 ----- ----- ----- Maintenance and repairs..................... $ 176 $ 182 $ 168 Most of the above amounts are accumulated in overhead and general and administrative expense pools, and are subsequently allocated to the U.S. government and foreign government contracts or commercial programs. The remainder of the above amounts is charged directly to contracts, and is ultimately included in the cost of sales in the same manner as overhead expenses. See Notes 1 and 6 to the consolidated financial statements included in Part II for a description of the company's accounting for inventories. INDEX TO EXHIBITS Exhibit Number - ------- 3.1 Certificate of Incorporation (A) 3.2 Amendment to Certificate of Incorporation (B) 3.3 Bylaws of Lockheed Corporation (C) 3.4 Amendment to Bylaws of Lockheed Corporation 4.1 Certificate of Incorporation (A) 4.2 Amendment to Certificate of Incorporation (B) 4.3 Bylaws of Lockheed Corporation (C) 4.4 Amendment to Bylaws of Lockheed Corporation (D) 4.5 The registrant undertakes to file with the Commission upon its request any agreements otherwise excluded from Item 601(b)(4) as not exceeding ten percent of the total assets of the registrant and its subsidiaries on a consolidated basis. 10.1 Asset Purchase Agreement, dated as of December 8, 1992, between the Registrant and General Dynamics Corporation (E) 10.2 $2,500,000,000 Loan Agreement dated February 8, 1993 (E) 10.3 Terms Agreement, dated April 13, 1993, among the Registrant and Goldman, Sachs & Co., The First Boston Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated and J.P. Morgan Securities, Incorporated. (F) 10.4 Terms Agreement, Dated May 4, 1993, among the Registrant and Merrill Lynch, Pierce, Fenner & Smith Incorporated, the First Boston Corporation, Goldman, Sachs & Company and J.P. Morgan Securities Incorporated. (G) 10.5 $1,000,000,000 Loan Agreement dated August 30, 1993 (H) 10.6 $300,000,000 Loan Agreement dated August 30, 1993 (H) 11 Computation of Earnings per Share of Common Stock 12 Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant 23 Consent of Ernst & Young, Independent Auditors 99.1 Annual Report on Form 11-K for the Lockheed Salaried Employee Savings Plan Plus (to be filed at a later date under Form 10-K/A). 99.2 Annual Report on Form 11-K for the Lockheed Hourly Employee Savings Plan Plus (to be filed at a later date under Form 10-K/A). 99.3 Annual Report on Form 11-K for the Lockheed Space Operations Company Hourly Employee Investment Plan Plus (to be filed at a later date under Form 10-K/A). 99.4 Annual Report on Form 11-K for the Lockheed Corporation Hourly Employee Savings and Stock Investment Plan - Fort Worth and Abilene Divisions (to be filed at a later date under Form 10-K/A). ------------ (A) Incorporated by reference to registrant's registration on Form 8-B filed July 1, 1986, as Exhibit 3(a). (B) Incorporated by reference to registrant's report on Form 10-Q for the quarter ended June 28, 1987, as Exhibit 3. (C) Incorporated by reference to registrant's report on Form 10-Q for the quarter ended June 27, 1993, as Exhibit 3. (D) Incorporated herein as Exhibit 3.4. (E) Incorporated by reference to registrant's report on Form 10-K for the year ended December 27, 1992. (F) Incorporated by reference to registrant's report on Form 8-K dated April 13, 1993. (G) Incorporated by reference to registrant's report on Form 8-K dated May 4, 1993. (H) Incorporated by reference to registrant's report on Form 8-K dated August 30, 1993. E-1 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. LOCKHEED CORPORATION (Registrant) /s/ C. R. MARSHALL ----------------------------- C. R. Marshall (Vice President and Secretary) Date: March 7, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ D. M. TELLEP Chairman of the Board March 7, 1994 - ------------------------- and Chief Executive D. M. Tellep Officer (Principal Executive Officer) and Director /s/ V. N. MARAFINO Vice Chairman of the March 7, 1994 - ------------------------- Board, Chief Financial V. N. Marafino and Administrative Officer (Principal Financial Officer) and Director /s/ R. E. RULON Vice President and March 7, 1994 - ------------------------- Controller (Principal R. E. Rulon Accounting Officer) /s/ L. V. CHENEY Director March 7, 1994 - ------------------------- L. V. Cheney /s/ L. M. COOK Director March 7, 1994 - ------------------------- L. M. Cook /s/ H. I. FLOURNOY Director March 7, 1994 - ------------------------- H. I. Flournoy /s/ J. F. GIBBONS Director March 7, 1994 - ------------------------- J. F. Gibbons Signature Title Date --------- ----- ---- /s/ R. G. KIRBY Director March 7, 1994 - ------------------------- R. G. Kirby /s/ L. O. KITCHEN Director March 7, 1994 - ------------------------- L. O. Kitchen /s/ J. J. PINOLA Director March 7, 1994 - ------------------------- J. J. Pinola /s/ D. S. POTTER Director March 7, 1994 - ------------------------- D. S. Potter /s/ F. SAVAGE Director March 7, 1994 - ------------------------- F. Savage /s/ C. A. H. TROST Director March 7, 1994 - ------------------------- C. A. H. Trost /s/ J. R. UKROPINA Director March 7, 1994 - ------------------------- J. R. Ukropina /s/ D. C. YEARLEY Director March 7, 1994 - ------------------------- D. C. Yearley

72909_1993.txt

72909

1993

Item 1. Business Northern States Power Company ("the Company"), incorporated in 1901 under the laws of Wisconsin as the La Crosse Gas and Electric Company, is an operating public utility company with executive offices at 100 North Barstow Street, Eau Claire, Wisconsin 54702-0008 (Phone: (715) 839-2621). The Company is a wholly- owned subsidiary of Northern States Power Company, a Minnesota corporation ("the Minnesota Company"). The Company is engaged in the production, transmission, distribution, and sale of electric energy to approximately 196,000 retail customers in an area of approximately 18,900 square miles in northwestern Wisconsin, to approximately 9,100 electric retail customers in an area of approximately 300 square miles in the western portion of the Upper Peninsula of Michigan, and to 10 wholesale customers in the same general area. The Company is also engaged in the distribution and sale of natural gas in the same service territory to approximately 60,000 customers in Wisconsin and 4,700 customer. In Wisconsin, some of the larger communities the Company provides Eau Claire, Chippewa Falls, La Crosse, Hudson, Menomonie and Ashland. In the Upper Peninsula of Michigan, the largest community to which the Company provides natural gas is Ironwood. In 1993 the Company derived 83 percent of its total operating revenues from electric utility operations and 17 percent from gas utility operations. As of December 31, 1993, the Company had 893 full-time employees. REGULATIONS AND RATES Regulation The Public Service Commission of Wisconsin ("PSCW") and Michigan Public Service Commission ("MPSC") regulate the rates and service of the Company with respect to retail sales within the State of Wisconsin and the State of Michigan, respectively, the issuance of new securities by the Company and various other aspects of the Company's operations. The PSCW also exercises jurisdiction over the construction of certain electric and gas facilities. The Company is also subject to the jurisdiction of the Federal Energy Regulatory Commission ("FERC") with respect to its sales to wholesale electric customers and certain other aspects of its operations, including the licensing and operation of hydro projects and the Company's Interchange Agreement (see Electric Operations- Interchange Agreement). Approximately 96.9 percent of the Company's 1993 electric retail revenues from sales and 93.6 percent of its retail gas revenues from sales were subject to PSCW jurisdiction with the remaining retail revenues subject to MPSC jurisdiction. In 1993, the Company's wholesale revenues from sales were approximately 5.5 percent of the Company's electric revenues from sales. Prior to construction of all major projects, the Company is required to obtain various licenses, permits and a certificate of public convenience and necessity from the PSCW. As part of this process, advance plan hearings are held by the PSCW, whereby the Company's generation and transmission construction plans and those of several neighboring utilities are reviewed by the PSCW. For the purpose of rate regulation, all three of the regulatory jurisdic- tions allow a "forward looking" test year corresponding to the time that rates are to be put into effect. Rate Changes Wisconsin On January 14, 1993, the PSCW issued an order approving an $8.0 million (3.1 percent) increase on an annual basis in the Company's electric retail rates and a $1.1 million (1.8 percent) increase on an annual basis in its gas rates. A January 16, 1993 effective date was authorized for these rate changes. On June 3, 1993, the Company filed with the PSCW for a $1.37 million (1.9 percent) increase in gas retail rates to be effective January 1, 1994. On August 18, 1993, the Company increased its request to $1.7 million (2.4 percent) to recover a portion of the acquisition premium paid by the Minnesota Company for Viking Gas Transmission Company in recognition of reduced gas costs. Hearings were held in October 1993 regarding the rate increase request. No change in the retail electric rates was requested. On December 23, 1993, the PSCW issued an order approving a $1.41 million (2.0 percent) increase on an annual basis in the Company's gas rates. A January 1, 1994 effective date was authorized for these rate changes. Wholesale On February 26, 1993, the Company filed for an increase of $600,000 (3.7 percent) on an annual basis in its wholesale electric rates. The filing consisted of a settlement agreement between the Company and the municipal whole- sale customers. On April 22, 1993, the FERC issued an order approving the settlement agreement. The new wholesale electric rates became effective September 1, 1993. Michigan There were no changes in the Michigan electric or gas base rates during 1993. Fuel and Purchased Gas Adjustment Clauses Wisconsin The Wisconsin automatic retail electric fuel adjustment clause was eliminated for the Company in the electric retail rate order issued by the PSCW dated March 11, 1986. The electric fuel adjustment clause has been replaced by a procedure which compares actual monthly and anticipated annual fuel costs with those costs which were included in the latest retail electric rates approved by the PSCW. If the comparison results in a difference a range of eight percent for the first month, five percent for the second month, or two percent for the remainder of the year, the PSCW may hold hearings limited to revise rates. The PSCW will be holding a technical conference and possibly hearings during 1994 to determine the appropriate process to handle fuel costs under a new biennial rate filing procedure that the PSCW adopted in 1993. The Company's retail gas rate schedules include a purchased gas adjustment clause which provides for inclusion of the current unit cost of gas from its gas suppliers. The factors applied under the purchased gas adjustment clause are adjusted on an ongoing basis to reflect a reconciliation of gas costs incurred and recovered. Michigan The Company's Michigan retail gas and electric rate schedules include Gas Cost Recovery factors (GCRF) and Power Supply Cost Recovery Factors (PSCRF), respectively, which are based on a twelve-month projection. The MPSC conducts formal hearings because approval must be obtained before implementation of the factors. After each twelve-month period is completed, a reconciliation is submitted whereby over-collections are refunded and any under-collections are collected from the customers. Wholesale The Company calculates the fuel adjustment factor for the current month based on estimated fuel costs for that month. The fuel adjustment factor is adjusted for over or under collected resale fuel costs from prior month's actual operations which provide an ongoing true-up mechanism. Demand Side Management The Company continues to implement various Demand Side Management (DSM) programs designed to improve load factor and reduce the Company's power production cost and system peak demands, thus reducing or delaying the need for additional investment in new generation and transmission facilities. The Company currently offers a broad range of DSM programs to all customer sectors, including information programs, rebate and financing programs, and rate incentive programs. In management's opinion, these programs respond to customer needs and focus on increasing value of service which, over the long term, will reduce the Company's capital requirements and help its customer base become more stable, energy efficient and competitive. During 1993, the Company's programs accomplished over 19 Megawatts (MW) of system peak demand reduction in the commercial, industrial and agricultural customer sectors and over 3 MW in the residential sector. These impacts were obtained through appliance lighting, motor, and cooling efficiency improvements, peak curtailable and time of use rate applications, and direct load control of water heaters and air conditioners. Since 1986, the Company's DSM programs have achieved 126 MW of summer peak demand reduction, which is equivalent to 13% of its 1993 summer peak demand A cumulative goal of 200 MW of peak demand reduction by 1997 has been established. The Company continues to focus on improving the cost-effectiveness of its DSM programs through market research studies and program evaluations. ELECTRIC OPERATION NSP System The Company's electric production and transmission systems are interconnected with the production and transmission system of the Minnesota Company. The combined electric production and transmission systems of the Company and the Minnesota Company are hereinafter called the "NSP System." The facilities of the NSP system include coal and nuclear generating plants, hydro, waste wood, and waste wood/refuse derived fuel ("RDF") generating plants, an interconnection with Manitoba Hydro Electric Board for the purpose of exchanging power, and extra-high voltage transmission facilities for inter- connection to Kansas City, Milwaukee and St. Louis to provide the necessary back up for the large plants. Capability and Demand The Company's record peak demand occurred on August 26, 1993, and was recorded at 982 MW. The NSP System's net generating capability, plus commitments for capacity purchases, less commitments for capacity sales, must be at least equal to the NSP System obligation which is the sum of its maximum demand and its reserve requirements. Being a member of the Mid-Continent Area Power Pool ("MAPP"), NSP's reserve requirement is determined jointly with the other parties to the MAPP Agreement. Currently, the reserve requirement equals 15 percent of the NSP System's maximum demand. The reserve requirement reflects the benefit of MAPP members sharing their reserves to protect against equipment failures on their systems (See Electric Power Pooling Agreements). The Company primarily relies on the Minnesota Company, through the Inter- change Agreement (see Electric Operations - Interchange Agreement), for base load generation. Approximately 77 percent of the total kilowatt hour requirements of the Company were provided by the Minnesota Company generating facilities or purchases made by the Minnesota Company for system uses in the year 1993. The Company also has two electric steam generating facilities. One is the Bay Front Generating Plant which is located in Ashland, Wisconsin. The plant is fueled primarily by coal and wood residue. Recent modifications to the facility allow for more effective utilization of additional waste wood fuel supplies and have extended the useful life of the facility approximately 20 years from their completion in 1992. In 1992 the Company received authorization from the Wisconsin Department of Natural Resources ("burn tire derived fuel on a regular basis. The Company's second electric steam generating plant is the French Island plant located in La Crosse, Wisconsin, which has two fluidized bed boilers installed for the purpose of burning a mixture of waste wood and RDF. The Bay Front plant in Ashland and the French Island steam plant are primarily used on an intermediate load basis. The Company's thermal peaking capability consists of two oil-fired gas turbine peaking plants and a gas and oil turbine peaking plant. The Company also has 19 hydro plants that operate as peaking facilities or run-of-river facilities. Interchange Agreement The electric production and transmission costs of the NSP System are shared by the Company and the Minnesota Company. The cost-sharing arrangement between the companies is the Agreement to Coordinate Planning and Operation and Interchange Power and Energy between Northern States Power (Minnesota) and Northern States Power (Wisconsin) ("Interchange Agreement"). It is a FERC regulated agreement and has been accepted by the PSCW and the MPSC for determination of costs recoverable in rates by the Company for charges from the Minnesota Company in rate cases. Historically the Company's share of the NSP System annual production and transmission costs has been in the 14 to 17 percent range. Revenues received from billings to the Minnesota Company for its share of the Company's production and transmission costs are recorded as electric operating revenues on the Company's income statement. The portions of the Minnesota Company's production and transmission costs that were charged to the Company were recorded as purchased and interchange power expenses and other operation expenses, respectively, on the Company's income statement. (See Note 6 Financial Statements). Under the Interchange Agreement, the Company could be charged a portion of the cost of an assessment made against the Minnesota Company pursuant to the Price-Anderson liability provisions of the Atomic Energy Act of 1954. (See Note 3 to Financial Statements). Electric Power Pooling Agreements The Company is included with the Minnesota Company as one of 12 investor- owned utilities, 9 rural electric generation and transmission cooperatives, 3 public power districts, 18 municipal electric systems, 3 municipal power agencies, the Western Area Power Authority (Department of Energy) and 2 Canadian Crown corporations that are members of MAPP pursuant to an agreement, as amended , dated March 31, 1972. The agreement provides for the members to coordinate the installation and operation of generating plants and transmission line facilities. The MAPP agreement was accepted for filing by has been effective since December 1, 1972. Fuel Supply In 1993 the Company shared in the fuel supply costs incurred by the Minnesota Company in accordance with the Interchange Agreement. Coal and nuclear fuel will continue to dominate the NSP System fuel requirements for the generation of electricity. It is expected that approximately 98 percent of the NSP System annual fuel requirements in 1994 will be provided by these two sources and that 2 percent of NSP's annual fuel requirements for generation will be provided by other fuels (including natural gas, refuse derived fuel, waste materials, and wood) over the next several years. Fuel Use on Btu Basis (Est.) (Est.) 1993 1994 1995 Coal 62.3% 62.9% 61.2% Nuclear 36.2% 35.4% 37.1% Other * 1.5% 1.7% 1.7% * Includes oil, gas, refuse derived fuel and wood Environmental Matters The Wisconsin DNR has been authorized by the United States Environmental Protection Agency to administer the National Pollutant Discharge Elimination System Permits under the Federal Water Pollution Control Act Amendments of 1977. Such permits are required for the lawful discharge of any pollutant into navigable waters from any point source (e.g. power plants). Permits have been issued for all of the Company's affected plants and all plants are in compliance with permit requirements. The DNR has jurisdiction over emissions to the atmosphere from the Company's power plants. The operation of the Company's generating plants substantially conforms to federal and state limitations pertaining to discharges to the air. Occasional, infrequent exceedances of Wisconsin DNR air emission limitations occurred in 1993 at the Company's Bay Front and French Island facilities. These are being resolved through operating changes or permit modifications and no agency enforcement action is anticipated. presently operates hydro, coal, natural gas, oil-fired, wood and RDF equipment. Regulatory approval is required for the construction of generating plants and major transmission lines. Also additional regulations have been instituted governing the use, transport, disposal and inspection of hazardous material and electrical equipment containing polychlorinated biphenyls. The Company has procedures in place to comply with these regulations. The Company has been identified as a "Potentially Responsible Party" (PRP) for a solid and hazardous waste landfill. The Company contends that it did not dispose of hazardous wastes in the subject landfill during the time period in question. Because neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined, it is not feasible to determine the outcome of this matter time. GAS OPERATIONS In 1993, the Company continued its strategy of holding a diversified portfolio of natural gas supplies and transportation arrangements. The Company complied with the requirements of FERC's Order 636, which significantly changed the services available to, and provided by, local distribution companies and interstate pipelines. The Company is now relying almost entirely on third party suppliers for its natural gas supply needs, and is utilizing the pipelines only for transportation and storage services. The Company continues to hold annual and/or winter peaking transportation contracts from Northern Natural Gas Company (NNG), Great Lakes Transmission Limited Partnership, Viking Gas Transmission Company, and TransCanada Pipeline, LTD. The Company picked up three new gas supply contracts in 1993 from assignment of NNG's supply under Order 636, and purchased additional baseload and peaking supplies from two new third party suppliers. The Company is continuing its pursuit of growth and profitability through expansion of its distribution system and services both inside and outside of its existing service territories. CONSTRUCTION AND FINANCING Expenditures for the Company's construction program in 1993 totaled $60 million. The 1994 construction expenditures are estimated to be $60.7 million with approximately $38.3 million for electric facilities, $8.6 million for gas facilities and $13.8 million for general plant and equipment. Expenditures for the Company's construction programs for the next five- year period 1994-1998, are estimated to be as follows: Year Estimated Construction Expenditures 1994 $ 61 million 1995 $ 60 million 1996 $ 59 million 1997 $ 62 million 1998 $ 60 million TOTAL $302 million It is presently estimated that approximately 83 percent of the 1994-1998 construction expenditures will be provided by internally generated funds and the remainder from short-term and long-term external financing. At December 31, 1993, the Company's short-term borrowings outstanding were $23.5 million. The foregoing estimates of construction expenditures, internally generated funds and external financing requirements can be affected by numerous factors, including load growth, inflation, changes in the tax laws, rate relief, earnings and regulatory actions. Major electric and gas utility projects are subject to the jurisdiction of the PSCW and require it Hence, the above estimated construction program and financing program could change from time to time due to variations in these other factors. During the five years ended December 31, 1993, the Company had gross additions to utility plant in service of approximately $249 million. Included in the Company's gross additions is $38.5 million for electric production facilities, $155 million for other electric properties, $35 million for gas utility properties, and $20.5 million for other utility properties. Retirements during the same period were approximately $37.5 million. Based on studies made by the Company, the weighted average age of depreciable property was 13 years at December 31, 1993. Item 2.

Item 2. Properties Electric Utility The Company's major electric generating facilities consist of the following: Projected Year 1993-4 Winter Station and Units Fuel Installed Capability (MW) Combustion Turbine: Flambeau Station Gas/Oil 1969 17 (1 unit) Wheaton Oil 1973 440 (6 units) French Island Oil 1974 192 (2 units) Steam: Bay Front Coal/Wood/ 1974-1960 73 (3 units) Gas French Island Wood/RDF 1940-1948 29 (2 units) Hydro Plants: (19 plants) - Various dates 248 TOTAL 999 At December 31, 1993, the Company owned approximately 2,382 pole miles of overhead electric lines, 8,029 pole miles of overhead electric distribution lines, 38 conduit miles and 976 direct buried cable miles of underground electric lines. Gas Utility The gas properties of the Company include approximately 1,313 miles of natural gas distribution mains. The Company owns two liquefied natural gas facilities with a combined storage capacity of the equivalent of 400,000 Mcf to supplement the available pipeline supply of natural gas during periods of peak demands. In January of 1993, the Company installed propane air facilities with a capacity of 144,000 gallons to further supplement gas supply in the La Crosse, Wisconsin area during peak periods. Item 3.

Item 3. Legal Proceedings The Company is currently involved in various claims and lawsuits incidental to its business. In the opinion of management, if the Company were ultimately found to be liable in these claims and lawsuits, such liability would not have a material effect on the financial statements of the Company. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Omitted per conditions set forth in general instruction J (1) and (a) and (b) of Form 10-K for wholly-owned subsidiaries (reduced disclosure format). PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters This is not applicable as the Company is a wholly owned subsidiary. Item 6.

Item 6. Selected Financial Data This is omitted per conditions set forth in general instructions J (1) (a) and (b) of Form 10-K for wholly owned subsidiaries (reduced disclosure format). Item 7.

Item 7. Management Discussion and Analysis Management's Discussion and Analysis of Financial Condition and Results of Operations is omitted per conditions as set forth in general instructions J (1) (a) and (b) of Form 10-K for wholly owned subsidiaries. It is replaced with management's narrative analysis of the results of operations set forth in general instructions J (2) (a) of Form 10-K for wholly owned subsidiaries (reduced disclosure format). This analysis will primarily forth the Company's accounting changes and compare its revenue and expens year ended December 31, 1993 with the year ended December 31, 1992. The Company's net income for the year ended December 31, 1993 was $38.0 million, down from the $38.2 million earned in the same period of 1992. The 1993 operating income increased by $1.3 million from the 1992 level. Accounting Changes Postretirement Benefits See Note 5 for discussion of the 1993 change in accounting for postretirement medical and death benefits. There was no material effect on net income due to rate recovery of the expense increases. Income Taxes The Company adopted SFAS No. 109 - Accounting for Income Taxes, effective Jan. 1, 1993. See Note 1 for discussion of the adoption of SFAS No. 109. Adoption of SFAS No. 109 had no effect on earnings and no material effect on financial condition due to its similarity to SFAS No. 96 - Accounting for Income Taxes, which the Company adopted in 1988, and which SFAS No. 109 supersedes. 1994 Changes In 1994, the Company will adopt SFAS No. 112 - Accounting for Postemployment Benefits. SFAS No. 112 requires the accrual of certain employee costs (such as injury compensation and severance) to be paid in future periods. Its adoption in 1994 is not expected to have a material effect on the Company's results of operations or financial condition. Electric Sales and Revenues Electric revenues for 1993 increased $17.2 million, a 5.0 percent increase from the 1992 revenues. Revenues from retail sales, which accounted for 75 percent of the electric revenues in 1993, increased $14.6 million or 5.7 percent. Included in the 1993 retail increase is $6.2 million directly related to the rate changes discussed in Part I, Item 1: Business-Regulation and Rates. Also reflected in the 1993 retail revenue increase increase of $8.4 million due to increased sales. The cool summer weather of 1992 was a major cause of this increase in sales. Our wholesale customers accounted for 4.4 percent of the total electric revenues. Wholesale revenues increased $1.3 million or 8.5 percent in 1993. This increase is also largely a result of 1992's cool summer weather. Another major component of electric revenues is charges billed to the Minnesota Company through the Interchange Agreement (see Part I, Item 1; Business-Electric Operations). Interchange Agreement billings charged to the Minnesota Company increased $1.5 million primarily as a result of added transmission investment. Other electric revenues decreased $0.2 million in 1993. Gas Sales and Revenues Gas revenues in 1993 increased by $11.7 million or 19.1 percent as compared with 1992. This is the net impact of increased revenues due to the rate increase effective January 1993, increased revenues due to sales growth, increased revenues due to higher gas costs passed through the purchased gas adjustment clause, and increased revenues of $8.2 million due to 1992's warm winter weather. Operating Expenses and Other Factors Electric Production The cost of interchange power increased $6.3 million or 4.0 percent in 1993 compared to the same period one year ago. This expense represents charges billed from the Minnesota Company through the Interchange Agreement (see Part I, Item 1: Business-Electric Operations). The company's increased electric sales during 1993 over 1992, combined with increased costs associated with the NSP system's new contract with Manitoba Hydro resulted in the company's purchased power and fuel purchased under its interchange agreement with its parent to increase by approximately $7.6 million. Total interchange power is offset by decreases in operation and maintenance expenses in the charges. Fuel for electric generation, which represents the Company's fuel generation, increased $1.2 million or 56.6 percent in 1993 from 1992. This is primarily due to increased requirements due to the increased sales in 1993. Gas Purchased for Resale This cost increased $9.7 million or 23.2 percent. $3.5 million of this increase in 1993 is a result of increased volumes purchased. Increased transportation prices resulted in $4.2 million of the increase with the balance of the increase due to commodity and demand price increases. Administrative and General, Other Operation and Maintenance The $5.2 million increase in administrative and general expense is partially due to the Company having had no disbursement of the employee incentive pay program (which is dependent upon corporate earnings) in 1992, but incurring its disbursement in 1993. This accounted for $1.7 million of the $5.2 million increase. An increase of $2.1 million was due to the SFAS 106 accruals of postretirement benefits. The remaining increases were general increase and general expenses. Depreciation and Amortization The increase in depreciation between 1993 and 1992 primarily reflects higher levels of depreciable plant. Property and General Taxes The property and general taxes increase is primarily due to higher gross receipts tax (a tax assessed on prior year revenues) as a result of 1992 revenues increasing over 1991 revenues. Income Taxes $0.7 million of the increase in income taxes in 1993 over 1992 is the result of the Federal Rate increasing from 34% to 35% and the balance of the increase is primarily attributable to changes in pretax book income. See Note 8 to the Financial Statements for a detailed reconciliation of effective tax rates and statutory rates. Allowances for Funds During Construction (AFC) The differences in AFC for the reported periods are attributable to varying levels of construction work in progress and lower AFC rates associated with increased use of low-cost short- term borrowings. Other Income and Deductions The decrease in other income is primarily due to a greater number of sales of certain land and land rights in 1992 by NSP Lands, Inc., a wholly owned subsidiary of the Company. Interest Charges On March 16, 1993 the Company issued $110.0 million of first mortgage bonds due March 1, 2023 with an interest rate of 7-1/4%. The Company entered into an interest rate swap agreement with the underwriters of this bond issue relating to $20.0 million of the principal, which effectively converted the interest cost of this debt from fixed rate to variable rate, with the variable rate changing on March 1 and September each year until March 1, 1998. The net interest rate for the entire $110 millio approximately 6.9% in 1993. The proceeds from these bonds were used to redeem $47.5 million in principal amount of its First Mortgage Bonds, Series due July 1, 2016, 9-1/4% at a redemption price of 105.78%, to redeem $38.4 million in principal amount of its First Mortgage Bonds, Series due March 1, 2018, 9-3/4%, at the redemption price of 107.31% and to repay outstanding short-term borrowings, including short - -term borrowings incurred to redeem on January 20, 1993 $7.8 million in principal amount of its First Mortgage Bonds, Series due December 1, 1999, 9-1/4%, at the redemption price of 102.2%. On October 5, 1993 the Company issued $40.0 million of first mortgage bonds due October 1, 2003 with an interest rate of 5-3/4%. The proceeds from these bonds were used to redeem $24.3 million in principal amount of its First Mortgage Bonds, Series due October 1, 2003, 7-3/4% at a redemption price of 102.49%, to redeem $10.8 million in principal amount of its First Mortgage Bonds, Series due August 1, 1994, 4-1/2%, at the redemption price of 100.00% and to repay outstanding short-term borrowings. These transactions had no material impact on the 1993 interest charges compared to the charges of 1992 because in 1993, all costs associated with the redemption of these bonds were treated on a basis by which all savings of interest due to refinancing was offset by the amortization of the costs. Item 8

Item 8 Financial Statements and Supplementary Data See Item 14(a)-1 in Part IV for financial statements included herein. See Note 12 to the financial statements for summarized quarterly financial data. INDEPENDENT AUDITORS' REPORT Northern States Power Company (Wisconsin): We have audited the accompanying financial statements, of Northern States Power Company (Wisconsin), (the Company) listed in the accompanying table of contents of Item 14(a)1. Our audits also included the financial statement schedules listed in Item 14(a)2. These financial statements and the financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules , when considered in relation to the basic financial statements taken as a whole , present fairly, in all material respects, the information set forth therein. As discussed in Note 5 to the financial statements, the Company changed its method of accounting for postretirement health care costs in 1993. Minneapolis, Minnesota February 4, 1994 Item 8 Financial Statements and Supplementary Data Statements of Income and Retained Earnings Year-Ended December 31 (Thousands of dollars) 1993 1992 1991 Operating Revenues Electric $362 473 $345 289 $349 027 Gas 72 760 61 071 56 348 Total 435 233 406 360 405 375 Operating Expenses Purchased and interchange power 162 510 156 196 160 324 Fuel for electric generation 3 185 2 034 2 696 Gas purchased for resale 51 501 41 814 39 332 Administrative and general 26 842 21 610 21 761 Other operation 49 907 47 470 47 054 Maintenance 21 703 21 806 23 487 Depreciation and amortization 28 585 26 832 25 321 Property and general taxes 13 091 12 925 12 107 Income taxes 23 103 22 184 21 641 Total operating expenses 380 427 352 871 353 723 Operating Income 54 806 53 489 51 652 Other Income and Deductions Allowance for funds used during construction-equity 694 907 514 Other income and deductions 844 1 361 1 128 Total Other Income 1 538 2 268 1 642 Income Before Interest Charges 56 344 55 757 53 294 Interest Charges Interest on long-term debt 16 343 17 269 15 863 Other interest and amortization 2 406 857 1 396 Allowance for funds used during construction-debt (411) (569) (517) Total interest charges 18 338 17 557 16 742 Net Income 38 006 38 200 36 552 Retained Earnings, January 1 192 816 179 510 173 508 Dividends (25 708) (24 894) (30 550) Retained Earnings, December 31 $ 205 114 $192 816 $179 510 See Notes to Financial Statements. Item 8 Financial Statements and Supplementary Data Statements of Cash Flows Year Ended December 31 (Thousands of dollars) 1993 1992 1991 Cash Flows from Operating Activities: Net Income $38 006 $38 200 $36 552 Adj to recon. net income to cash from op activities: Depreciation and amortization 33 580 28 179 26 852 Deferred income taxes 7 228 3 089 4 319 Investment tax credit adjustments (948) (956) (971) AFC-equity (694) (907) (514) Gain on sale of land (681) Other (2 440) (643) Cash used for changes in certain working capital items 299 2 438 (1 571) Net Cash Provided by Operating Activities 77 471 67 603 63 343 Cash Flows from Financing Activities: Proceeds from issuance of long-term debt 146 587 48 563 Proceeds from issuance of notes payable-parent company 12 600 Repayment of notes payable-parent company (800) (31 800) Repayment of long-term debt (136 090) (1 415) (557) Dividends paid to parent (25 708)(24 894) (30 550) Net Cash provided by (used for) Financing Activities (16 011)(13 709) (14 344) Cash Flows from Investing Activities: Construction expenditures capitalized (59 954)(54 588) (50 832) Increase (decrease) in construction payables (2 143) (2 013) 1 115 AFC-equity 694 907 514 Other (489) Net Cash Used for Investing Activities (61 892)(55 694) (48 467) Net Increase (Decrease) in Cash and Cash Equivalents (432) (1 800) 532 Cash and Cash Equivalents at Beginning of Period 881 2 681 2 149 Cash and Cash Equivalents at End of Period $449 $881 $2 681 Working Capital Changes: Accounts receivable-net $(1 597) $921 $(4 414) Materials and supplies (453) (647) (241) Accounts payable and accrued liabilities 7 633 412 1 450 Payables to affiliated companies 127 2 444 (2 899) Income and other taxes accrued (2 762) 634 3 528 Other (2 649) (1 326) 1 005 Net $299 $2 438 $(1 571) Supplemental Disclosures of Cash Flow Information: Cash paid during the year for: Interest (net of amount capitalized) $17 440 $17 136 $15 424 Income taxes $18 825 $19 256 $14 905 See Notes to Financial Statements. Item 8 Financial Statements and Supplementary Data Balance Sheets December 31 (Thousands of dollars) 1993 1992 Assets Utility Plant Electric-including construction work in progress: 1993, $16,697; 1992, $14,571 $810 691 $781 573 Gas 81 567 75 250 Other 43 279 28 565 Total 935 537 885 388 Accumulated provision for depreciation (320 938) (300 393) Net utility plant 614 599 584 995 Other Property and Investments Nonutility property - at cost 3 157 3 119 Accumulated provision for depreciation (364) (363) Other investments - at cost which approximates market 4 094 3 661 Total other property and investments 6 887 6 417 Current Assets Cash and cash equivalents 449 881 Accounts receivable 38 424 36 738 Accumulated provision for uncollectible accounts (708) (646) Materials and supplies - at average cost Fuel 2 293 2 535 Other 8 692 7 996 Accrued utility revenues 17 230 15 990 Prepayments and other 9 855 9 920 Deferred tax asset 1 254 2 980 Total current assets 77 489 76 394 Deferred Debits Unamortized debt expense 3 078 3 031 Regulatory assets 30 036 21 062 Other 4 890 2 570 Total deferred debits 38 004 26 663 Total $736 979 $694 469 See Notes to Financial Statements. Item 8 Financial Statements and Supplementary Data Balance Sheets December 31 (Thousands of dollars) 1993 1992 Liabilities Capitalization Common stock-authorized 870,000 shares of $100 par value; issued shares: 1993 and 1992, 862,000 $86 200 $86 200 Premium on common stock 10 461 10 461 Retained earnings 205 114 192 816 Total common equity 301 775 289 477 Long-term debt 217 600 187 737 Total capitalization 519 375 477 214 Current Liabilities Notes payable - parent company 23 500 24 300 Long-term debt due within one year 0 9 608 Accounts payable 15 264 12 051 Salaries, wages, and vacation pay accrued 5 481 3 204 Payables to affiliated companies (principally parent) 11 636 11 509 Federal income taxes accrued 1 606 3 862 Other taxes accrued 2 492 2 998 Interest accrued 4 823 5 934 Other 1 917 2 252 Total current liabilities 66 719 75 718 Deferred Credits Accumulated deferred income taxes 88 426 78 434 Accumulated deferred investment tax credits 23 653 24 886 Regulatory liability 22 416 29 395 Other 16 390 11 822 Total deferred credits 150 885 141 537 Commitments and Contingent Liabilities Total $736 979 $694 469 See Notes to Financial Statements. NORTHERN STATES POWER COMPANY (WISCONSIN) NOTES TO FINANCIAL STATEMENTS 1. Summary of Accounting Policies System of Accounts The Company maintains the accounting records in accordance with either the uniform system of accounts prescribed by the Federal Energy Regulatory Commission (FERC) or those prescribed by the Public Service Commission of Wisconsin (PSCW) and the Michigan Public Service Commission (MPSC) , which systems are the same in all material respects. Reclassifications Certain reclassifications have been made to the 1992 financial statements in order to conform to the 1993 presentation of regulatory deferrals. These reclassifications have no effect on the net income or common equity as previously reported. Investment in Subsidiaries The Company carries its investment in its subsidiaries (Chippewa and Flambeau Improvement Company, 75.86% owned; NSP Lands , Incorporated, 100% owned; and Clearwater Investments, Incorporated, 100% owned) at cost plus equity in earnings since acquisition. The impact of consolidation of these subsidiaries is considered immaterial to the Company's financial position. Utility Plant and Retirements Utility Plant is stated at original cost. The cost of additions to utility plant includes contracted work, direct labor and materials, allocable overheads and allowance for funds used during construction (AFC). The cost of units of property retired, plus net removal cost, is charged to the accumulated provision for depreciation and amortization. Maintenance and replacement of items determined to than units of property are charged to operating expenses. Depreciation For financial reporting purposes, depreciation is computed on the straight-line method based on the annual rates certified by the PSCW and MPSC for the various classes of property. Depreciation provisions, as a percentage of the average balance of depreciable property in service, were 3.40% in 1993, 3.38% in 1992, and 3.36% in 1991. Revenues Customers' meters are read and bills rendered on a cycle basis. The Company accrues the amount of estimated unbilled revenues for services provided from the monthly meter reading date to month-end. The current asset, accrued utility revenues, is being adjusted monthly, with a corresponding adjustment to revenues, to reflect changes in unbilled revenues. Regulatory Deferrals As a regulated utility, the Company accounts for certain income and expense items under the provisions of SFAS No. 71 - Accounting for the Effects of Regulation. In doing so, certain costs which would otherwise be charged to expense are deferred as regulatory assets based on expected recovery from customers in future rates. Likewise, certain credits which would otherwise be reflected as income are deferred as regulatory liabilities based on expected flowback to customers in future rates. Management's expected recovery of deferred costs and expected credits are generally based on specific ratemaking decisions or precedent for each item. Regulatory assets and liabilities are being amortized consistent with ratemaking treatment as established by regulators. See Note 7 for discussion of these regulatory deferrals. Income Taxes The Company records income taxes in accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109) - Accounting For Income Taxes. SFAS 109 requires the use of the liability method of accounting for deferred income taxes. Before 1993, the Company followed Statement of Accounting Standards No. 96 (SFAS 96) - Accounting for Income Taxes, resulting in substantially the same accounting for the Company as SFAS No. 109. Income taxes are deferred for temporary differences between pretax financial and taxable income, and between the book and tax bases of assets and liabilities . Deferred taxes are recorded using the tax rates scheduled by tax law to be in effect when the temporary differences reverse. Due to the effects of regulation , income tax expense is provided for the reversal of some temporary differences previously accounted for by the flow-through method. Also, regulation results in the creation of certain assets and liabilities related to income taxes as discussed in Note 7. Investment tax credits are deferred and amortized over the estimated lives of the related property. Purchased Tax Benefits The Company purchased tax-benefit transfer leases under the Safe Harbor Lease provisions of the Economic Recovery Tax Act of 1981. For both financial reporting and regulatory purposes, the Company is amortizing the difference between the cost of the purchased tax benefits and the amounts to be realized through reduced current income tax liabilities over the remaining terms of the lease after the initial investments have been recovered. Cash Equivalents The Company considers certain debt instruments (primarily commercial paper) with a remaining maturity of three months or less at the time of purchase to be cash equivalents. Environmental Costs Costs related to environmental remediation are accrued when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. 2. Long-Term Debt First Mortgage Bonds - less reacquired bonds of $0 and $42 December 31 at December 31, 1993 and 1992, respectively: 1993 1992 (Thousands of dollars) Series due: Aug. 1, 1994, 4-1/2% $10 938 Dec. 1, 1999, 9-1/4% 7 800 Oct. 1, 2003, 7-3/4% 24 570 Jul. 1, 2016, 9-1/4% 47 500 Mar. 1, 2018, 9-3/4% 38 400 Apr. 1, 2021, 9-1/8% $49 000 49 500 Mar. 1, 2023, 7 1/4% 110 000 Oct. 1, 2003, 5 3/4% 40 000 Total $199 000 $178 708 Less Dec. 1, 1999, 9 1/4% bonds redeemed in January 1993 7 800 Less sinking fund requirements not reacquired 1 808 Net $199 000 $169 100 City of LaCrosse Resource Recovery Revenue Bonds - Series due Nov. 1, 2011, 7 3/4% 18 600 18 600 Unamortized premium on long-term debt 0 37 Total long-term debt $217 600 $187 737 The Supplemental and Restated Trust Indenture dated March 1, 1991, permits an amount of established Permanent Additions to be deemed equivalent to the payment of cash necessary to redeem 1% of the highest principal amount of each series of first mortgage bonds (other than pollution control financing) at any time outstanding. This Supplemental and Restated Trust Indenture became effective for the Company on October 1, 1993. On January 20, 1993, the Company redeemed its $7.8 million of 9 1/4% bonds at 102.2%; this amount has, therefore, been classified as current on the December 31, 1992 financial statements. Except for minor exclusions, all real and personal property is subject to the lien of the Company First Mortgage Bond Trust Indenture. The Indenture also provides for certain restrictions on the payment of cash dividends on common stock. At December 31, 1993, the payment of cash dividends on common stock was not restricted. 3. Commitments and Contingent Liabilities The Company presently estimates capital expenditures will be $61 million in 1994 and $302 million for 1994-98. The Company has capital lease obligations of $3.1 million. These leases will require principle payments of $715,000, $780,000, $854,000, $524,000, and $189,000, respectively, for the years 1994 to 1998. Rentals under operating leases were approximately $2,651,000, $2,547,000 and $1,962,000, for 1993, 1992, and 1991, respectively. Although the Company does not own a nuclear facility, any assessment made against Northern States Power Company (Minnesota), the parent company, under the Price-Anderson liability provisions of the Atomic Energy Act of 1954, would be a cost included under the Interchange Agreement (Note 6) and the Company would be charged its proportion of the assessment. Such provisions set a limit of $9.4 billion for public liability claims that could arise from a nuclear incident. The parent company has secured insurance of $200 million to satisfy such claims. The remaining $9.2 billion of exposure is funded by the Secondary Financial Protection Fund, a fund available from assessments by the Federal government in the event of nuclear incidents. The parent company assessment of $79.3 million for each of its three licensed reactors to be applied for public liability arising from a nuclear incident at any licensed nuclear facility in the United States with a maximum funding requirement of $10 million per reactor during any one year. The Company has been identified as a "Potentially Responsible Party" (PRP) for a solid and hazardous waste landfill. The Company contends that it did not dispose of hazardous wastes in the subject landfill during the time period in question. Because neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined, it is not feasible to determine the outcome of this matter at this time. 4. Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107 (SFAS 107) - Disclosures About Fair Value of Financial Instruments became effective in 1992. For cash and investments, the carrying amount approximates fair value. The fair value of the Company's long term debt is estimated based on the quoted market prices for the same or similar issues, or on the current rates offered to the Company for debt of the same remaining maturities. The estimated fair value of the Company's long-term debt (including debt due within one year classified as current) of $217.6 million at December 31, 1993 and $197.3 million at December 31, 1992, is $233.3 million and $212.2 million, respectively. 5. Pension Plans and Other Post Retirement Benefits Employees of the Company participate in the Northern States Power Company Pension Plan. This noncontributory defined benefit pension plan covers substantially all employees. Benefits are based on years of service, the employees highest average pay for 48 consecutive months and Social Security wage base. Pension costs are determined and funded under the aggregate-cost method, using market value of assets of the trust fund. The portion of annual pension costs was $1,236,000 for 1993, $2,400,000 for 1992, and $2,478,000 for 1991. Until 1993, for financial reporting and regulatory purposes, the Company's pension expense was determined and recorded under the aggregate cost method. Statement of Financial Accounting Standards No. 87 - Employers' Accounting for Pensions (SFAS 87) provides that any difference between the pension expense recorded for rate making purposes and the amounts determined under SFAS 87 should be recorded as an asset or liability on the balance sheet. Effective January 1, 1993, for financial reporting and regulatory purposes, the Company's pension expense was determined and recorded under the SFAS-87 method and the Company's accumulated SFAS-87 asset is being amortized over a 15- year period. Net periodic pension costs for the total (the Company and Minnesota Company) plan include the following components: 1993 1992 1991 (Thousands of dollars) Service Cost - benefits earned during the period $25 015 $24 080 $22 097 Interest cost on projected benefit obligation 71 075 69 853 65 557 Actual return on assets (152 019)(115 455)(246 678) Net amortization and deferral 66 299 39 019 181 543 Net periodic pension cost determined under SFAS 87 10 370 17 497 22 519 Expenses recognized (deferred) due to actions of regulators 5 117 2 741 (1 549) Pension expense recorded during the period 15 487 20 238 20 970 Portion of expense recognized for early retirement program 0 (165) (165) Net periodic pension cost recognized for ratemaking $15 487 $20 073 $20 805 The funding status for the total plan is as follows: Actuarial present value of benefit obligation: Vested $655 002 $614 446 Nonvested 139 346 129 183 Accumulated benefit obligation $794 348 $743 629 Projected benefit obligation $974 160 $914 019 Plan assets at fair value 1 244 650 1 156 782 Plan assets in excess of projected benefit obli. (270 490) (242 763) Unrecognized prior service cost (22 580) (14 790) Unrecognized net (gain) 315 049 269 086 Unrecognized net transitional (asset) 767 843 Net pension liability recorded $22 746 $12 376 The weighted average discount rate used in determining the actuarial present value of the projected obligation was 7% in 1993 and 8% in 1992. The rate of increase in future compensation levels used in determining the actuarial present value of the projected obligation was 5% in 1993 and 6% in 1992. The assumed long-term rate of return on assets used for cost determinations under SFAS 87 was 8% in 1993 and 1992 and 8.5% in 1991. Plan assets consist principally of common stock of public companies and U.S. Government Securities. Effective Jan. 1, 1993, the Company adopted the provisions of SFAS No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS No. 106 requires that the actuarially determined obligation for postretirement health care and death benefits is to be fully accrued by the date employees attain full eligibility for such benefits, which is generally when they reach retirement age. This is a significant change from the Company's prior policy of recognizing benefit costs on a cash basis after retirement. In conjunction with the adoption of SFAS No. 106, for financial reporting purposes, NSP elected to amortize on a straight-line basis over 20 years the unrecognized accumulated postretirement benefit obligation (APBO) of approximately $215.6 million (including the Company and Minnesota Company) for current and future retirees. This obligation considers anticipated 1994 plan design changes not in effect in 1993, including Medicare integration, increased retiree cost sharing and managed indemnity measures. In the past, NSP has funded benefit payments to retirees internally. While the Company generally prefers to continue using internal funding of benefits paid and accrued, there have been some external funding requirements imposed by the Company's regulators, as discussed below, including the use of tax advantaged trusts. Plan assets held in such trusts as of Dec. 31, 1993, consisted of investments in equity mutual funds and cash equivalents. The following table sets forth the total (the Company and Minnesota Company) health care plan's funded status in 1993. (Millions of dollars) Dec. 31, 1993 Jan. 1, 1993 APBO: Retirees $120.2 $105.8 Fully eligible plan participants 18.8 18.8 Other active plant participants 90.8 91.0 Total APBO 229.8 215.6 Plan Assets (6.1) 0 APBO in excess of plant assets 223.7 215.6 Unrecognized net actuarial gain (loss) (1.3) Unrecognized transition obligation (204.8) (215.6) Postretirement benefit obligation $17.6 $0 The assumed health care cost trend rate used in measuring the APBO at Dec. 31 , 1993, was 14.1 percent for those under age 65 and 8.0 percent for those over age 65. The trend rates used in the Jan. 1, 1993 calculations were 15.1 percent and 9.0 percent respectively. The assumed cost trend rates are expected to decrease each year until they reach 4.5 percent for both age groups in the year 2004, after which they are assumed to remain constant. A one percent increase in the assumed health care cost trend rate for each year would increase the APBO as of December 31, 1993, by approximately 17 percent, and service and interest cost components of the net periodic postretirement cost by approximately 20 percent. The assumed discount rate used in determining the APBO was 7 percent for Dec. 31, 1993, and 8 percent for Jan. 1, 1993, compounded annually. The assumed long-term rate of return on assets used for cost determinations under SFAS No. 106 was 8 percent for both measurement dates. While the assumption changes made for the Dec. 31 calculations had no effect on 1993 benefit costs, the effect of the changes in 1994 (for the Company and Minnesota Company) is expected to be a cost decrease of approximately $2 million. In each 1992 and 1991, the Company recognized $1.9 million as the cost attributable to postretirement health care and death benefits based on payments made. The net annual periodic postretirement benefit cost recorded for 1993 consists of the following components (millions of dollars): Service cost-benefits earned during the year $ 0.6 Interest cost (on service cost and APBO) 2.4 Amortization of transition obligation 1.5 Return on assets (.1) Net periodic postretirement health care cost under SFAS No. 106 4.4 Regulators have allowed full recovery of increased benefit costs under SFAS No. 106, effective in 1993. External funding was required in Wisconsin and Michigan to the extent it is tax advantaged. The FERC has required external funding for all benefits paid and accrued under SFAS NO. 106. Funding began for both retail and FERC in 1993. The Company will adopt SFAS No. 112-Accounting for Postemployment Benefits, which requires the accrual of certain employee costs to be paid in future periods, in 1994; its adoption will have no material effect on the Company's results of operations or financial condition. 6. Parent Company and Intercompany Agreements The Company is wholly-owned by Northern States Power Company (Minnesota). The electric production and transmission costs of the NSP system are shared by the Company and the Minnesota Company. A FERC approved agreement (Interchange Agreement) between the Company and the Minnesota Company provides for the sharing of all costs of electric generation and transmission facilities of the NSP System, including capital costs. Billings under the Interchange Agreement and an intercompany gas agreement which are included in the statement of income are as follows: Year Ended December 31 1993 1992 1991 (Thousands of dollars) Operating revenues: Electric $ 72 162 $ 70 671 $ 70 623 Gas 56 55 62 Operating expenses: Purchased and interchange power 162 510 156 196 160 324 Gas purchased for resale 267 214 183 Other operation 12 515 11 668 11 809 7. Regulatory Assets and Liabilities The following summarizes the individual components of unamortized regulatory assets and liabilities shown on the Balance Sheet at Dec. 31: (Thousands of dollars) 1993 1992 AFC recorded in plant on a net-of-tax basis 8 795 8 520 Losses on reacquired debt 10 857 5 037 Conservation and energy management programs 8 291 5 738 Pensions and other 2 093 1 767 Total Regulatory Assets 30 036 21 062 Excess deferred income taxes collected from customers 5 914 12 821 Investment tax credit deferrals 15 841 16 038 Fuel refunds and other 661 536 Total Regulatory Liabilities 22 416 29 395 The AFC regulatory asset and the tax-related regulatory liabilities result from the Company's adoption of SFAS No. 96 in 1988 and SFAS No. 109 in 1993. The excess deferred income tax liability represents the net amount expected to be reflected in future customer rates based on the collection in prior ratemaking of deferred income tax amounts in excess of the actual liabilities currently recorded by the Company. This excess is the effect of the use of "flow through" tax accounting in prior ratemaking and the impact of changes in statutory tax rates in 1981, 1986-87 and 1993. This regulatory liability will change each year as the related deferred income tax liabilities reverse. 8. Income Tax Expense The Company is included in the consolidated Federal income tax return filed by the Minnesota Company and files separate state returns for Wisconsin and Michigan. The Company records current and deferred income taxes at the statutory rates as if it filed a separate return for Federal income tax purposes . All tax payments are made directly to the taxing authorities. The total income tax expense differs from the amount computed by applying the Federal income tax statutory rate of 35% in 1993 (34% in 1992 and 1991) to net income before income tax expense. The reasons for the difference are as follows: 1993 1992 1991 (Thousands of dollars) Tax computed at statutory rate $21 387 $20 434 $19 640 Increases (decreases) in tax from: State income taxes, net of Federal income tax benefit 3 165 3 037 3 205 Allowance for funds used during construction (243) (284) (175) Investment tax credit adjustments - net (948) (956) (971) Use of the flow-through method for deprec'n in prior yr 474 673 649 Effect of tax rate changes for plant related items (487) (420) (332) Gain on sale of tax benefit transfer leases (88) Other - net (162) (583) 412 Total income tax expense $23 098 $21 901 $21 211 Effective income tax rate 37.8% 36.4% 36.7% Income tax expense is comprised of the following: Included in income taxes: Current Federal tax expense $12 919 $15 340 $13 479 Current state tax expense 3 180 3 598 3 286 Deferred Federal tax expense 6 173 3 075 4 270 Deferred state tax expense 1 778 1 127 1 577 Investment tax credit adjustments - net (948) (956) (971) Total 23 103 22 184 21 641 Included in income deductions: Current Federal tax expense 875 953 1 106 Current state tax expense (90) (123) (7) Deferred Federal tax expense (790) (1 113) (1 529) Total income tax expense $23 098 $21 901 $21 211 The components of the Company's net deferred tax liability at Dec. 31 were as follows: (Thousands of dollars) 1993 1992 Deferred tax liabilities: Differences between book and tax bases of property $91 195 $80 628 Tax benefit transfer leases 6 146 6 935 Regulatory assets 11 371 8 326 Other 398 13 Total deferred tax liabilities 109 110 95 902 Deferred tax assets: Deferred investment tax credits 9 487 9 753 Regulatory liabilities 8 726 11 310 Deferred compensation accrued vacation and other reserves not currently deductible 3 193 1 818 Other 532 567 Total deferred tax assets 21 938 23 448 Net deferred tax liability $87 172 $72 454 The Omnibus Budget Reconciliation Act of 1993 (Act) was signed into law on August 10, 1993, and increased the federal corporate income tax rate from 34 percent to 35 percent retroactive to January 1, 1993. Deferred tax liabilities were increased for the rate change by $2.7 million. However, due to the effects of regulation, earnings were reduced only by immaterial adjustments to deferred tax liabilities related to nonutility operations. 9. Segment Information Year Ended December 31 1993 1992 1991 (Thousands of dollars) Operating revenues: Electric $362 473 $345 289 $349 027 Gas 72 760 61 071 56 348 Total operating revenues $435 233 $406 360 $405 375 Operating income before income taxes: Electric $73 012 $70 202 $69 299 Gas 4 897 5 471 3 994 Total operating income before income taxes $77 909 $75 673 $73 293 Depreciation and amortization: Electric $25 179 $23 870 $22 717 Gas 3 406 2 962 2 604 Total depreciation and amortization $28 585 $26 832 $25 321 Construction expenditures: Electric $49 664 $44 332 $44 145 Gas 10 258 10 235 9 362 Total construction expenditures $59 922 $54 567 $51 507 Net utility plant: Electric $560 999 $537 576 $518 788 Gas 53 600 47 419 39 820 Total net utility plant 614 599 584 995 558 608 Other corporate assets 122 380 109 474 95 940 Total assets $736 979 $694 469 $654 548 10.Short-Term Borrowings The Company had bank lines of credit aggregating $1,000,000 at December 31, 1993. Compensating balance arrangements in support of such lines of credit were not required. These credit lines make short-term financing available by providing bank loans. During 1993 and 1992 there were no bank loans outstanding as the Company obtained short-term borrowings from the Minnesota Company at the Minnesota Company's average daily interest rate, including the cost of their compensating balance requirements. 11.Common Stock The Company's common shares have a par value of $100 per share. At December 31, 1993 and 1992, 870,000 shares were authorized and 862,000 shares were issued . 12. Summarized Quarterly Financial Data (Unaudited) Quarter Ended March 31, June 30, September December 1993 1993 30, 1993 31, 1993 (Thousands of dollars) Operating revenues $ 124 285 $ 97 107 $ 97 821 $ 116 020 Operating income 20 080 10 199 7 986 16 541 Net income 15 857 6 062 3 762 12 325 Quarter Ended March 31, June 30, September December 1992 1992 30, 1992 31, 1992 (Thousands of Dollars) Operating revenues $ 113 555 $ 91 496 $ 89 722 $ 111 587 Operating income 18 483 9 171 10 067 15 768 Net income 14 371 5 197 6 133 12 499 Item 9.

Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure During 1993 there were no disagreements with the Company's independent certified public accountants on accounting procedures or accounting and financial disclosures. PART III Part III of Form 10-K has been omitted from this report in accordance with conditions set forth in general instructions J (1) (a) and (b) of Form 10-K for wholly-owned subsidiaries. Item 10.

Item 10 Directors and Executive Officers of the Registrant28 Item 11

Item 11 Executive Compensation28 Item 12

Item 12 Security Ownership of Certain Beneficial Owners and Management28 Item 13

Item 13 Certain Relationships and Related Transactions28 PART IV Item 14

Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K29 SIGNATURES 41

806086_1993.txt

806086

1993

ITEM 1. BUSINESS STRUCTURE OF THE COMPANY Advanced Technology Laboratories, Inc. ("ATL" or the "Company") is engaged in the high-technology electronic medical systems business. ATL develops, manufactures, markets and services diagnostic medical ultrasound systems worldwide. Prior to June 26, 1992, ATL was named Westmark International Incorporated ("Westmark"). In February 1992, Westmark announced that its Board of Directors would recommend to its shareholders that Westmark be divided into two separate, publicly-traded companies, one engaged in the diagnostic ultrasound business ("ATL") and the other, SpaceLabs Medical, Inc. ("SpaceLabs"), engaged in the patient monitoring and clinical information systems business. The recommendation was approved by the shareholders of Westmark at the 1992 Annual General Meeting and the tax-free distribution of SpaceLabs stock to the shareholders was effected on June 26, 1992. Concurrently, Westmark changed its name to Advanced Technology Laboratories, Inc., the same name as that of its major operating subsidiary. COMPANY HISTORY ATL was founded in 1969 and acquired by Squibb Corporation ("Squibb") in 1980. In 1982 Squibb acquired Advanced Diagnostic Research Corporation ("ADR") and A.B. Kranzbuehler ("Kranzbuehler") and integrated these businesses with ATL's operations. ADR, based in Tempe, Arizona, was an established leader in the manufacture of real-time ultrasound systems for obstetrical and abdominal applications. Kranzbuehler, based in Solingen, Germany, manufactured ultrasound products and distributed products of ADR and its own manufacture throughout Europe. Westmark was incorporated in 1983 as a wholly owned subsidiary of Squibb and became the holding company for Squibb's high technology medical equipment businesses, ATL and SpaceLabs, in November 1986. On January 2, 1987, Squibb distributed to Squibb shareholders the shares of Westmark common stock (the "Common Stock") as a dividend. ATL subsequently acquired two ultrasound based businesses; Nova MicroSonics in 1988 (which currently operates as a division of ATL), and Precision Acoustic Devices ("PAD") in 1990. Nova MicroSonics, located in Mahwah, New Jersey, manufactures and markets real time and off-line acquisition and measurement products for use in ultrasound data and image management by hospitals, labs, clinics and physician offices. PAD, located until recently in Fremont, California, develops, manufactures and supplies high-performance ultrasound transducers to industrial and medical imaging markets. In March 1993, the Company decided to relocate PAD's Fremont operations to Bothell, Washington and to sell the OEM transducer business of PAD to Blatek, Inc., a transducer company in State College, Pennsylvania. The relocation of PAD to Bothell was completed in August 1993. On February 10, 1994 the Company announced that it had entered into a Merger Agreement with Interspec, Inc., a manufacturer of medical diagnostic ultrasound systems and transducers. See ITEM 7 MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION-- Subsequent Event on page 20. THE ULTRASOUND BUSINESS ATL develops, manufactures, markets and services diagnostic medical ultrasound systems that are widely used in a number of medical applications to assist the physician in monitoring and diagnosing a variety of conditions, such as tumors, inflammations, obstructions, cardiovascular diseases and fetal development. Ultrasound systems provide a safe, noninvasive and painless means of observing soft tissues and internal body organs and assessing blood flow through the heart and vessels. ATL is one of the leading suppliers of diagnostic ultrasound systems in the world. Its Ultramark(R) product line serves all major diagnostic ultrasound clinical markets--radiology, cardiology, obstetrics/gynecology ("OB/GYN") and vascular medicine. The Company believes that it has become a worldwide leader in ultrasound technology through its proprietary position in digital, broad bandwidth beamforming and broad bandwidth scanhead technologies. Diagnostic ultrasound systems, which are sold for use in hospitals, clinics and physicians' offices, represented an estimated $1.9 billion worldwide market in 1993. The total medical imaging industry is estimated to be over $8.4 billion worldwide in 1993. ULTRASOUND TECHNOLOGY Medical Applications Medical ultrasound systems obtain images of the interior of the body by focusing high-frequency sound waves at the organs, soft tissues and vasculature being examined. Echoes are created as the sound waves are reflected from internal structures of differing acoustic properties. These echoes are gathered and electronically processed by the transducer (scanhead) of the ultrasound system. Repeated scanning of the interior of the body at very high speeds produces moving, two-dimensional, black and white video images in real time. Ultrasound information can be captured on film or paper or stored on videotape or portable digital media such as floppy or optical discs. In addition to black and white imaging functions (also known as grayscale or two-dimensional imaging), ultrasound systems can analyze blood flow characteristics using the Doppler principle. Doppler technology allows the measurement and display of the velocity and direction of blood flow through vessels or between chambers of the heart. This information is typically displayed in a graphical format. Color Doppler, introduced in the mid-1980s, permits visualization of blood flow by superimposing a color depiction of blood flow on the grayscale image of the tissue or vessel structure. Blood flow toward the scanhead is presented as one color and flow away from the scanhead is presented as a different color, with velocity presented as gradations of these colors or intensities. Ultrasound offers several important advantages compared with other medical imaging modalities. Safety. Physicians can often diagnose disease without using invasive materials, ionizing radiation or exploratory surgery. Cost effectiveness. Ultrasound is generally less expensive to purchase, costs less per patient examination, and requires little or no patient preparation compared to other imaging modalities such as computed tomography ("CT"), magnetic resonance imaging and positron emission tomography ("P.E.T."). Real-time. Ultrasound examinations provide the physician with live, real-time images of anatomy and physiology, which yield more diagnostic information and can facilitate a faster diagnosis than static images of other imaging modalities. In contrast to high-energy modalities such as x-ray and gamma-ray systems, ultrasound has difficulty imaging through air or bone and generally does not image the skeletal structure. Due to acoustic properties such as scattering or attenuation, ultrasound may not provide the clarity of more expensive modalities in certain applications. However, by reason of its clinical efficacy and safety, ultrasound is often the first imaging examination ordered by a diagnosing physician and is typically the preferred imaging method for soft tissues examination. PRINCIPAL COMPONENTS Beamformer. The process leading to the formation of an ultrasound image begins in the beamformer. The beamformer acts as the acoustic "lens" and steers, focuses and processes the ultrasound signals provided by the scanhead. The beamformer's complex electronics can account for a significant portion of the cost of the entire system. Historically, ultrasound systems have been based on analog beamformers which process signals in a continuous, wave-like form. ATL has pioneered the development of digital beamformers, which digitize the signals returning from the body prior to processing. For a discussion of ATL's digital beamformer technology, see "ATL's Products." Scanhead. The scanhead, a hand-held device placed against the patient's skin, transmits the sound wave and receives echoes back from the body. A piezoelectric transducer, a component within the scanhead, converts the electrical signals from the beamformer into transmitted sound waves and the returning sound waves (echoes) back into electrical signals for processing by the beamformer. Scanheads are categorized according to the five major technologies employed: phased array, annular array, linear array, curved array and mechanical scanheads. Images are acquired and displayed in three different image formats: sector (pie-shaped), linear (rectangular) or trapezoidal. Scanheads are also categorized by their ability to process a range, or bandwidth, of frequencies. Scanheads which, in conjunction with the beamformer, are capable of transmitting and receiving a band of frequencies which is at least 65% of a band defined by the scanhead's fundamental frequency are considered by ATL to be broad bandwidth scanheads. Broad bandwidth scanheads capture more acoustic information for processing and display by the ultrasound system. Each of the five scanhead technologies offers certain clinical advantages in specific applications. Phased arrays, linear arrays and curved arrays are electronically controlled, which permit the simultaneous use of Doppler, color Doppler and grayscale imaging. Mechanical scanheads perform mechanical scanning and generally provide a wide range of imaging frequencies at a relative low cost. Mechanical scanheads are increasingly being replaced by high-performance annular arrays and electronic arrays. Annular array, a type of mechanical scanhead, offers the highest resolution of any scanning technology through its ability to image the thinnest cross-sectional slice of anatomy. Thin slice imaging ability may be enhanced for electronic arrays by providing two dimensions of array elements which perform what is known as elevation focusing. A number of specialty scanheads have been developed in recent years which employ one or more of these scanning technologies. These include intravaginal scanheads for imaging general pelvic anatomy, transrectal and prostate scanheads, bi-plane scanheads (a scanhead able to alternate between two different planes or cross-sectional views) and transesophageal echocardiography ("TEE") scanheads for cardiovascular scanning from the esophagus and stomach without interference from ribs, lungs or surrounding cartilage. Scanhead technology is becoming more complex and highly specialized. Consequently, the cost of scanheads represents an increasing proportion of the total cost of an ultrasound system. PRINCIPAL MARKETS The worldwide ultrasound market is typically categorized by clinical application, price range and geographic area. Clinical Applications. Ultrasound products are used in four primary medical applications: radiology, cardiology, OB/GYN (including perinatology), and vascular applications. RADIOLOGY. The radiology application, at approximately 42%, is the largest market for ultrasound equipment. The major radiology markets are in the United States and Europe. Most radiology examinations are conducted in hospitals or large imaging centers. In radiology, ultrasound is used to obtain diagnostic information on organs and soft tissue, particularly in the abdomen. It is also used to ascertain fetal development, to guide tissue biopsies and to visualize blood flow. Color Doppler is a standard feature on most high performance radiology ultrasound systems. A substantial portion of the radiology market also requires systems which include cardiac imaging capabilities. In the United States and Canada this market segment is often referred to as the shared service market. Most community or small hospitals without a dedicated cardiology department fall into this category. In Europe, the internal medicine segment requires systems which include cardiac imaging capability. CARDIOLOGY. The cardiology ultrasound, or echocardiography, application, at approximately 30%, is the second largest market for ultrasound systems. Most dedicated echocardiography system sales occur in the United States, Western Europe, and the more developed Asian and Latin American markets. While most cardiology system sales are to hospitals, the cardiology office practice represents a significant and growing share of the market for echocardiography equipment. Cardiologists use ultrasound as a noninvasive means of capturing real-time images of the heart and its valves. These images, together with various Doppler techniques, help the physician assess heart function as well as congenital and valvular disease. With new advances in scanheads plus acquisition and image display technology, echocardiography is a useful tool for the detection and assessment of coronary artery disease. Ultrasound has also been shown to be valuable in assessing the effectiveness of drug therapy and intervention for the heart attack patient. OB/GYN AND PERINATOLOGY. The third largest market for ultrasound systems is the OB/GYN and perinatology application, at approximately 17%. The majority of OB/GYN ultrasound system sales are to office-based practitioners in the United States, Western Europe, and the more developed Asian markets. Perinatology is a clinical specialty dedicated to high risk obstetrics. Most perinatology ultrasound sales are to hospitals and institutions in the United States. Ultrasound is the preferred imaging technology for the assessment of fetal development since it is noninvasive and involves no ionizing radiation. Ultrasound is also used for general gynecological and infertility examinations. The introduction of the intravaginal scanhead in the 1980s expanded the usefulness of ultrasound for first-trimester obstetrical studies and the diagnosis of ectopic pregnancies. The advent of ATL's broadband digital imaging technology with the ESP option (see "ATL's Products") has enabled physicians to visualize details of fetal development at earlier stages of pregnancy than had previously been possible. VASCULAR. The smallest of the primary clinical markets for ultrasound systems, at approximately 5%, is the vascular ultrasound application, primarily located in the United States and Western Europe. Most vascular ultrasound examinations are performed in hospitals. Vascular ultrasound studies utilize real-time imaging, Doppler and color Doppler information to identify plaque deposits and their characteristics, clots, and valve competence in blood vessels. Most vascular examinations are performed on the body's extremities, cerebrovascular and deep abdominal regions. Price Ranges. The world ultrasound market can be divided into five segments based on broad price ranges. Each market segment is characterized by the level of system performance and the number of scanheads and features. PREMIUM PERFORMANCE. The premium market segment, at 13% of the world market, is characterized by ultrasound systems that typically sell for over $150,000 per unit. These systems provide the physician with superior definition of subtle tissue characteristics and incorporate high resolution gray scale imaging, advanced color and spectral Doppler capability, image acquisition storage, display and review capability, advanced automation capabilities, and other features providing additional clinical utility. Typically, systems sold in the premium market are equipped with a wide variety of specialty scanheads. HIGH PERFORMANCE. The high performance market, at 35% of the world market, is characterized by systems with high resolution gray scale imaging and advanced color and spectral Doppler capabilities. Systems in this market segment sell between $120,000 to $150,000 per unit and generally include advanced measurement and analysis software, image review capabilities, and a variety of scanhead offerings. MID-RANGE COLOR. This mid-range market segment, at 25% of the world market, is characterized by ultrasound systems that sell between $80,000 and $120,000 per unit. These units are basic gray scale imaging, color and spectral Doppler systems used for standard routine examinations and utilize a minimum number of scanheads. Refurbished premium systems and high performance systems with fewer purchased optional features are also sold in this price range. MID-RANGE GRAY SCALE. This mid-range market segment, at 17% of the world market, is characterized by black and white imaging systems with spectral Doppler and some calculation and report features. Many of these systems are sold to small hospitals and clinics and are used in radiology and OB/GYN applications. Systems in this market segment sell at prices ranging from $40,000 to $80,000. LOW-END. The low-end market segment, at 10%, is characterized by basic black and white imaging systems that sell below $40,000 per unit. These systems provide limited diagnostic information and are used primarily for monitoring fetal development and in other radiology and OB/GYN applications. Most of these systems are sold to private office practitioners and small hospitals. Due to the growing acceptance and affordability of color Doppler systems, units with only greyscale capability represent the slowest growing portion of the market. Geographic Areas. The ultrasound market is divided into four major geographic markets. UNITED STATES. The United States, at 38% of the market, accounts for the largest portion of ultrasound sales. This market is characterized by its emphasis on high performance systems driven by competition for patient referrals. These factors encourage the rapid adoption of new technology. EUROPE. The European market, at 29% of the market, is the second largest market for ultrasound systems. European health care systems are more centralized than the United States market and are often subject to more rigid governmental regulation. JAPAN. This market accounts for approximately 16% of worldwide ultrasound sales. Its complex distribution system is highly competitive and Japanese manufacturers account for almost all sales. ASIA PACIFIC, LATIN AMERICA AND CANADA. The remaining geographic areas of the world account for approximately 17% of the market. The Australian and Canadian markets are similar in structure to those of the European countries. Parts of Asia and Latin America represent some of the fastest growing areas for high performance and mid-range ultrasound products. The remainder of this group are mostly developing countries with limited resources to devote to health care. Many ultrasound systems sold in these regions are mid-range systems, refurbished systems or new low-priced Japanese systems. Emerging Opportunities. Growth in the ultrasound industry has depended upon and been fueled by the emergence and adoption of new technologies which increase the diagnostic information available to the clinician, thereby expanding the use of ultrasound for both existing and new clinical applications. Most recently, the adoption of color Doppler technology made a major impact on industry growth during the latter half of the 1980s. ATL believes that numerous emerging ultrasound technologies offer future growth opportunities. For example, broad bandwidth ultrasound imaging, if proven effective for tumor characterization, may spur growth in oncology and radiology applications; three-dimensional ultrasound display may assist the assessment of heart conditions and fetal abnormalities; and miniature ultrasound scanheads coupled with laparoscopic technology may help guide minimally invasive therapy. There can be no assurance that the Company will pursue these opportunities or, if it does so, that its efforts will result in viable products. In 1993 new emerging opportunities began to become apparent. The economic and regulatory environment of healthcare in many of the more highly industrialized countries has created a situation where significant growth opportunities for ultrasound are located in emerging nations and are premised upon increasing demand for mid-range products. Companies positioned to take advantage of these evolving market dynamics will be characterized by a distribution system of considerable scope and an offering of a variety of value oriented products. ATL'S PRODUCTS The Company's focus is on developing new technologies, both to improve the performance of its products and to advance the clinical application of ultrasound. The performance of ultrasound products is determined primarily by the type of beamforming and scanhead technologies utilized. ATL has established an important proprietary position in digital beamforming and broad bandwidth scanhead technologies. ATL believes these technologies enable physicians to diagnose disease and other conditions with significantly greater certainty and offer the potential to extend the use of ultrasound into new clinical applications. The Company has pioneered the development of digital beamforming ultrasound technology since the introduction of its digital Ultramark 9 system in 1988. In November 1993, General Electric joined this exclusive category with the introduction of its own line of digital ultrasound products, the second company to do so. ATL's digital beamformer can process the full bandwidth of frequencies returning through the scanhead while exactly preserving the returning signal information. Other manufacturers utilize analog technology to process signals returning from the body. Analog beamformer technology limits the range or integrity of bandwidth which the beamformer can process at one time. This inherent limitation leads analog beamformer companies toward offerings of multiple frequency scanheads, by which a full signal band can be acquired through serial scans as the frequency band is changed or stepped. Analog beamformers are also subject to variations and tolerances of analog components which can distort and weaken the ultrasound signal. In ATL's digital beamformer the broadband signals returning from the body are converted into a numerical sequence of ones and zeros, or digitized, preserving the quantity and quality of the diagnostic information contained within the signal's broad bandwidth. The principal functions of ATL's digital beamformer are performed by application-specific integrated circuits ("ASICs") designed by ATL. These proprietary custom microchips, each containing approximately 160,000 transistors, replace the traditional wire windings and ferrite cores of analog beamformers with pure digital signal control which preserves signal information with no degradation. ATL is also a leader in scanhead technology that complements the capability of its digital beamforming technology to process broad bandwidth signals. Each tissue within the body reflects ultrasound in a unique way referred to as its "tissue signature." Tissue signature is composed of a broad bandwidth of ultrasound frequencies that differs with tissue condition (healthy versus diseased) and with tissue type (such as muscle, fat or gland). The Company has developed scanheads that utilize proprietary technology to permit finer, more precise tissue structure response and color flow images by allowing the scanhead to receive ultrasound signals over a broad bandwidth of frequencies. ATL's broad bandwidth scanheads, when used in conjunction with its digital beamformer, are able to acquire and process up to twice the bandwidth of conventional scanheads. As a result, physicians can see more of the tissue signature with greater clarity and are therefore better able to detect subtle changes or anomalies. Ultrasound Systems. ULTRAMARK 9 HIGH DEFINITION(TM) IMAGING SYSTEM. The Ultramark 9 system with High Definition Imaging ("HDI") is the Company's premium and high performance product. Introduced in April 1991, the system contains an ASIC-based digital beamformer which allows higher resolution images and captures a broader bandwidth of tissue signature. The Ultramark 9 HDI system also offers a series of new high performance scanheads, including a line of broad bandwidth scanheads which provide a broad range of clinical applications for the system and substantially enhance the system's competitive advantage. In 1993, the Company increased the value of the Ultramark 9 HDI system with the introduction of the following broad bandwidth scanheads: P5-3 Phased Array Scanhead. The P5-3 scanhead extends broad bandwidth capability to pediatric cardiology and small adult applications. C7-4 Curved Array Scanhead. The C7-4 scanhead is a broad bandwidth scanhead for abdominal and obstetrical applications. C4-2 Curved Array Scanhead. The C4-2 scanhead provides the penetration required for deep abdominal and obstetrical applications. L7-4 Linear Array Scanhead. The L7-4 scanhead provides broad bandwidth scanning in vascular applications. These new scanhead offerings complement the other four members of ATL's family of broadband scanheads, including the L10-5 Linear Array Scanhead, the A6-3 Annular Array Scanhead, the P3-2 Cardiovascular Phased Array Scanhead, and the C9-5 Intracavitary Scanhead. The Ultramark 9 HDI system competes in the radiology, perinatology and vascular segments of the ultrasound market. It is priced from $135,000 to $230,000 per unit, depending upon the configuration of the system and the number of scanheads. Since its introduction the Ultramark 9 HDI system has enabled the Company to gain share in the largest premium ultrasound market, radiology. In 1992, the installed base of Ultramark 9 HDI systems received a free software upgrade, providing additional analysis and performance improvements. In 1993 ATL again demonstrated the versatile upgrade capability of the Ultramark 9 system by extending a new diagnostic capability to its customers, Doppler Power Imaging, through a free software upgrade. The capability of HDI technology to capture and display a broad tissue signature has enabled physicians to visualize anatomical detail, subtle tissue characteristics and disease processes that they could not see or confidently identify before with ultrasound. In April 1993, the Company introduced the Ultramark 9 HDI system with the Extended Signal Processing ("ESP") option. This new, premium feature added additional broad bandwidth scanhead capabilities to the HDI system. ESP also provided a new level of performance with the ability to substantially reduce a major ultrasound imaging artifact, speckle, which has been an enduring challenge in ultrasound. In the fall of 1993, the Company introduced the HDIcv model of the HDI system. The HDIcv model is a performance system for the cardiology, shared services and internal medicine markets. During 1993 the Company sold used, refurbished HDI systems at prices ranging from $90,000 to $120,000. ULTRAMARK 9 DP ULTRASOUND SYSTEM. The Ultramark 9 system was introduced in 1988 as a full featured, color Doppler, multipurpose ultrasound system incorporating ATL's proprietary digital beamforming technology. In November 1990 the product was enhanced with a number of features known as the Digital Plus ("DP") package. With the success of the Ultramark 9 system with the HDI option, the company has discontinued the manufacture of new Ultramark 9 DP systems. ATL's entire installed base of Ultramark 9 DP systems can be upgraded with the HDI option, continuing ATL's commitment of upgradeability to its customers. Throughout 1993, refurbished Ultramark 9 DP systems were sold at prices below $100,000. ULTRAMARK 4 ULTRASOUND SYSTEM. This highly portable gray scale and Doppler system is the Company's principal product for private OB/GYN offices and is also used in medical institutions worldwide. This product has various configurations that cover a range of prices from $25,000 to $60,000. Recent major introductions include Cineloop(R) image review, curved-array scanhead technology and a multifrequency intravaginal scanhead. Scanheads. ATL believes that its internal resources devoted to development and manufacturing of scanheads make it one of the largest scanhead manufacturers in the world. The Company's manufacturing capabilities allow it to rapidly commercialize its new scanhead designs. The Company develops and manufactures scanheads of the five major technologies to be sold with ATL's ultrasound systems for a wide variety of clinical applications. Other Products. IMAGE MANAGEMENT PRODUCTS. The Company's Nova MicroSonics division develops, manufactures and markets a complete line of ultrasound image management products for use in the acquisition, storage, display and management of ultrasound information. For cardiac applications, the Nova MicroSonics technology facilitates the review and comparison of images produced at different times during a cardiac study, expanding the diagnostic applications of echocardiography to the detection of coronary artery disease. The ImageVue(R)/DCR Workstation is a state-of-the-art digital and ultrasound image management system. This workstation performs analysis and review of ultrasound exams conducted from a variety of ultrasound systems. The Image LAN Network provides network connection between ultrasound systems, workstations, printers and other medical imaging devices. USED EQUIPMENT. The Company refurbishes and sells used ATL systems received as trade-ins or after use by the Company's sales force as demonstration equipment. The following systems are among the used systems sold by ATL: the Ultramark 7 mid-range cardiology system developed under joint agreement with Fujitsu Limited; the Ultramark 4 system, the Ultramark 9 DP system; and the Ultramark 9 system with the HDI option. Customers who own these systems can upgrade them or trade them in for more advanced ATL systems. A significant portion of the Company's used discontinued equipment is sold in developing countries. ACCESSORIES AND SUPPLIES. The Company sells a variety of ultrasound accessories and supplies, most of which are not manufactured by the Company. These include disposable supplies, such as ultrasound gel and thermal paper, and accessories, such as biopsy guides, printers, cameras and videocassette recorders ("VCRs"). The Company markets these products through direct mail and its customer support organization. RESEARCH AND DEVELOPMENT The Company conducts extensive research and development activities. Its activities include the development of new scanheads, new system features and new ultrasound system designs, as well as the investigation of applications for emerging technologies and clinical procedures. The Company enters into research agreements with the medical community, including leading physicians and teaching institutions. Beginning in late 1989 the Company substantially increased its investment in research and development to accelerate the introduction of several new technologies and in particular to establish its important proprietary position in digital beamforming and broad bandwidth scanhead technologies. In 1991 the Company instituted a multi-center study at a number of institutions in Europe and North America to evaluate the ability of the Ultramark 9 HDI system to distinguish benign and malignant breast disease. These studies were concluded in 1993. Based upon the findings of these studies, in February 1994 the Company submitted a Premarket Approval ("PMA") application to the U.S. Food and Drug Administration ("FDA") for the use of HDI technology in the differentiation of solid breast masses. The Company believes this to be the first PMA application submitted to the FDA for diagnostic ultrasound. While the Company has requested expedited handling of the PMA application by the FDA, there is no assurance that this request will be granted. The time required for the application to be processed by the FDA is unknown, although such applications typically require twelve to twenty-seven months. There can be no assurances that product clearance under the PMA will ultimately be realized. The high technology ultrasound business is characterized by rapidly evolving technology, resulting in relatively short product life cycles and continuing competitive pressure to develop and market new products. Although the Company intends to continue extensive research and development activities, there can be no assurance that it will be able to develop and market new products on a cost- effective and timely basis, that such products will compete favorably with products developed by others, or that the Company's existing technology will not be superseded by new discoveries by competitors. MANUFACTURING The Company manufactures substantially all its products at its facility in Bothell, Washington. The image management systems of Nova MicroSonics are manufactured in Nova's New Jersey facilities. Over the past six years the Company has consolidated its principal manufacturing operations from three plant locations to the Bothell facility while doubling manufacturing output. In 1990, the Company upgraded its manufacturing line with a major investment in state-of-the-art surface mount technology ("SMT") for printed circuit board assembly. Relative to conventional "through hole" assembly, SMT improves the reliability of printed circuit boards used in the Company's Ultramark systems, greatly increases the electronic capacity of the board and allows for more automated production. The SMT processing line has been integrated with the Company's computer-aided design capability, enabling the production of prototype printed circuit boards for potential new products in a quarter of the time previously required. The Company purchases certain specialty scanheads from original equipment manufacturers. The Company also purchases the hard-copy output devices sold with its ultrasound systems, such as VCRs and cameras, and other materials and component parts. The specialty scanheads and many of the materials and components used by ATL in the manufacture of ultrasound equipment are available from more than one source of supply. Certain components, however, are single sourced, such as crystals and hybrid and integrated circuits which are critical to the quality and manufacture of ultrasound equipment. While any of these single-source items could be replaced over time, abrupt disruption in the supply of a single-source part could have a material adverse effect on ATL's manufacturing production of the products relying on such items. In addition, these items generally have long order lead times, restricting the Company's ability to respond quickly to changing market conditions. SALES AND MARKETING The Company's sales and marketing strategy has been to compete in the major clinical, price and geographic segments of the ultrasound market. In the United States, with the exception of the third-party business of Nova MicroSonics, the Company markets its products through its direct sales organization. The United States sales organization is organized into three geographic zones, each staffed with regional management, sales representatives and clinical application specialists knowledgeable in radiology, cardiology, OB/GYN and perinatology, and peripheral vascular applications. The role of the application specialists is to demonstrate the product and train customers in its clinical use. The Company markets its products internationally through its direct sales and service operations in Argentina, Australia, Austria, Belgium, Canada, France, Germany, Italy, the Netherlands and the United Kingdom. In addition, the Company markets its products in Sweden through a joint venture with AxTrade East, an Axel Johnson Trade Company, and in India through a joint venture with Indchem Electronics. Other principal markets are covered through a dealer network. European, Middle Eastern and African dealers are managed through ATL's European headquarters in Munich, Germany. Dealers serving the Pacific Rim countries, Latin America and South America are managed from Bothell, Washington. Foreign customers accounted for approximately 47% of revenues in 1993. See Note 18 on page 36. The Company's marketing efforts emphasize the development of strong relationships with key medical professionals, participation in national and regional meetings and conventions for physicians and hospitals, direct mail advertising, journal advertising and sponsorship of educational programs. CUSTOMER SUPPORT AND WARRANTY The Company warrants its new and used products for all parts and labor generally for one year from the date of original delivery. Under the terms of the warranty, the customer is assured of service and parts so that the equipment will operate in accordance with specifications. The Company offers a variety of post-warranty service agreements permitting customers to contract for the level of equipment maintenance they require. Alternatively, customers can contact ATL as needed and receive service at rates based on labor and cost of parts. The Company's warranty costs are included in cost of product sales in the Consolidated Financial Statements below. The Company maintains its own customer support organization in the United States and other countries where the Company has direct operations. Local dealers and distributors provide service and support in most other countries. The Company provides manuals and expedites delivery of repair parts to all geographic locations from its facility in Bothell, Washington, with the assistance of its direct operations in Europe. The Company's customer service organizations are considered an integral part of its sales effort because a customer's decision to purchase a particular product is based in part on the availability and reputation of the service for that product. In addition, the customer support group provides training for biomedical technicians so that customers can service their own systems. The group also provides customer education programs on clinical applications and the use of the Company products. COMPETITION The ultrasound market is competitive. The Company competes worldwide in each of the four major clinical applications of the ultrasound market, in each price range and in each major geographic market. Four companies, ATL, Toshiba Corporation's Medical Systems Group, Hewlett-Packard Company's Medical Products Group and Acuson Corporation, account for approximately 60% of the worldwide ultrasound market. The Company believes that these four companies have approximately equal market shares. Each of the Company's primary competitors initially participated in only one or two of the clinical ultrasound markets (such as radiology or cardiology), but all are increasingly seeking to sell their ultrasound products in additional markets. In addition to the Company's primary competitors, the global leaders of the medical imaging industry--the Medical Systems Group of General Electric Company, Siemens Medical Systems, Inc. and Philips Medical Systems, Inc.--have signaled their intention to become more competitive in the ultrasound market. General Electric stepped up its participation in ultrasound in November 1993 with the announcement of a new digital ultrasound system. Philips has announced its plans to collaborate in ultrasound with Hewlett-Packard. Siemens recently relocated its central world ultrasound facility to Issaquah, Washington, approximately twelve miles from ATL's headquarters. These companies and several of the Company's other competitors have far greater financial, marketing, servicing, technical and research and development resources than those of the Company. The Company believes that significant competitive factors in the diagnostic ultrasound market include the clinical performance of the systems, depth of product line, reputation for technology leadership, upgradeability to advanced features and reliability and price of products and service. See "Research and Development." The Company believes that it presently competes favorably with respect to each of these competitive factors. Ultrasound is only one of a number of diagnostic imaging technologies currently available, including conventional x-ray, CT, magnetic resonance imaging and P.E.T. A development in another diagnostic technology could adversely affect the ultrasound industry. Nevertheless, the Company believes that ultrasound's inherent advantages of safety, cost-effectiveness and real- time imaging will continue to make ultrasound a primary imaging modality. PATENTS, TRADEMARKS AND LICENSES The Company has obtained patents on certain of its products and has applied for patents which are presently pending. The Company has also sought trademark protection for the brand names of the products it currently markets. There can be no assurance that any additional patents will be issued or that trademark protection will be granted and maintained. Certain critical technology incorporated in the Company's products, including software algorithms, broad bandwidth scanhead technology and ASIC technology, is protected by copyright laws and confidentiality and licensing agreements. The Company's proprietary digital beamformer is protected by confidentiality agreements, copyright and trade secret law. Companies in high technology businesses routinely review the products of others for possible conflict with their own patent rights. The Company has from time to time received notices of claims from others alleging patent infringement. While the Company believes that it does not infringe any valid patent of any third party, there can be no assurance that the Company will not be subject to future claims of patent infringement or that any claim will not require that the Company pay substantial damages or delete certain features from its products or both. While such claims could temporarily interrupt the Company's ability to ship affected products, the Company believes that any such interruption can be overcome by technical changes to product features. See ITEM 3, LEGAL PROCEEDINGS, below. GOVERNMENTAL REGULATION Product Regulation. The Company's products are subject to extensive regulation by numerous governmental authorities, principally the FDA and corresponding state and foreign agencies, and to various domestic and foreign electrical safety and emission standards. The Company's manufacturing facilities and the manufacture of its products are subject to FDA regulations respecting registration of manufacturing facilities and compliance with the FDA's Good Manufacturing Practices regulations. The Company is also subject to periodic on-site inspection for compliance with such regulations. The FDA also has broad regulatory powers with respect to preclinical and clinical testing of new medical products and the manufacturing, marketing and advertising of medical products. The FDA requires that all medical devices introduced to the market be preceded either by a premarket notification clearance order under Section 510(k) of the Federal Food, Drug and Cosmetic Act, as amended (the "FDC Act"), or an approved premarket approval application. A 510(k) premarket notification clearance order indicates FDA agreement with an applicant's determination that the product for which clearance has been sought is substantially equivalent to medical devices that were on the market prior to 1976 or have subsequently received clearance. An approved premarket approval application indicates that the FDA has determined that the device has been proven, through the submission of clinical trial data and manufacturing quality assurance information, to be safe and effective for its labeled indications. The process of obtaining 510(k) clearance typically takes approximately six to nine months, while the premarket approval application process typically lasts more than a year. All of ATL's current products have required only 510(k) clearance. The Company believes that its products comply generally with applicable electrical safety standards, such as those of Underwriters Laboratories and non-U.S. safety standards authorities. Following a routine inspection by the FDA in 1992, the Company put into place expanded programs of documentation, process control, and continuous quality improvement to enhance regulatory compliance. During the latter half of 1993, the FDA completed a routine follow up of its 1992 inspection. The Company is awaiting the results of this follow up inspection and also the results of a routine FDA inspection of the Mahwah, New Jersey facility of Nova MicroSonics. The Company's ability to obtain timely FDA export and new product approvals is dependent upon the results of such inspections. The Company can also incur substantial expense in responding to process improvements and modification of products previously sold to customers which stem from comments and new requirements of the FDA. The Company's FDA compliance programs have been expanded into programs which will verify the Company's compliance with international standards for medical device design, manufacture, installation and servicing known as the ISO 9001 standards. During 1994, the Company's facilities and products will be audited by a European auditing service to obtain quality systems and product certifications for the Company. This will enable the Company to continue marketing its products in the European Community after these requirements become law in 1995. The FDA is in the process of adopting the ISO 9001 standards as regulatory standards for the United States, and it is anticipated these standards will be phased in for U.S. manufacturers of medical devices over a period of time. Federal, state and foreign regulations are constantly undergoing change. The U.S. government is currently considering healthcare system reform. The national focus on possible healthcare legislation has caused U.S. ultrasound customers to become more cautious in making expenditures and investing in capital equipment. In addition, the U.S. healthcare system has undergone various consolidations in recent years. The Company cannot predict what effect, if any, such change may have on its business, or when the deleterious effect of these conditions on its business will change. Reimbursement. The Company's products are used by healthcare providers for diagnostic testing services and other services for which the providers may seek reimbursement from third-party payors, principally, in the United States, Medicare, Medicaid and private health insurance plans. Such reimbursement is subject to the regulations and policies of governmental agencies and other third-party payors. For example, the Medicare program, which reimburses hospitals and physicians for services provided to a significant percentage of hospital patients, places certain limitations on the methods and levels of reimbursement of hospitals for procedure costs and for capital expenditures made to purchase equipment, such as that sold by the Company. The Medicare program also limits the level of reimbursement to physicians for diagnostic tests. The state-administered Medicaid programs and private payors also place limitations on the reimbursement of both facilities and physicians for services provided in connection with diagnostic and clinical procedures. Reduced governmental expenditures in many countries continue to put pressure on diagnostic procedure reimbursement. The Company cannot predict what changes may be forthcoming in these policies and procedures, nor the effect of such changes on its business. Third-party payors worldwide, including governmental agencies, are under increasing pressure to contain medical costs. Limits on reimbursement or other cost containment measures imposed by third-party payors may adversely affect the financial condition and ability of hospitals and other users to purchase products, such as those of the Company, by reducing funds available for capital expenditures or otherwise. The Company is unable to forecast what additional legislation or regulation, if any, relating to the health care industry or third-party reimbursement may be enacted in the future or what effect such legislation or regulation would have on the Company. Many of ATL's ultrasound systems are used in an outpatient setting, replace higher-cost imaging modalities or enable a hospital or clinic to receive higher payments for services commensurate with the higher level of diagnostic information provided. Environmental. The Company is subject to Federal, state and local provisions regulating the discharge of materials into the environment or otherwise for the protection of the environment. Although the Company's current operations have not been significantly affected by compliance with environmental laws or regulations, Federal, state and local governments are becoming increasingly sensitive to environmental issues, and the Company cannot predict what impact future environmental regulations may have on its operations. Employees. As of December 31, 1993, the Company had 1,977 employees. None of the Company's United States employees is covered by collective bargaining agreements, and the Company considers its employee relations to be satisfactory. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Refer to information set forth in "Geographic Segment Information" of the Notes to the Consolidated Financial Statements contained in Note 18, included in Item 8 of this Form 10-K. ITEM 2.

ITEM 2. PROPERTIES The Company owns premises at 22100 Bothell Everett Highway, Bothell, Washington 98041, consisting of 285,000 square feet. These premises include the Company's corporate headquarters and a major manufacturing facility, as well as the Company's research and development, sales, service, marketing and administrative functions. The Company also leases another 41,000 square feet in an adjoining business park. Westmark's former principal executive offices were in 10,424 square feet of leased premises at the Columbia Center, Suite 6800, 701 Fifth Avenue, Seattle, Washington 98104; such offices have been vacated and are fully subleased through the term of the lease. The Company's Nova MicroSonics division has two leased facilities, one in Indianapolis, Indiana, and one in Mahwah, New Jersey, with a total square footage of 26,600. The Company's PAD division has a leased manufacturing facility in Fremont, California, with a total square footage of 18,075. The lease on the Fremont, California facility terminates in August 1994. The Company also rents two regional sales offices for two employees at each location, and one regional customer service facility. The Company's direct business operations in foreign countries lease office and warehouse space in their respective countries. The Company also owns two buildings in Solingen, Germany, a 28,020 square foot building which was used as an ultrasound systems manufacturing facility and is currently a storage facility, and a 32,765 square foot building which is used as the temporary management and operations headquarters for ATL's German subsidiary. In 1990 the Company transferred its manufacturing operations in Solingen to its Bothell, Washington facility and is now offering for sale its Solingen property. The sale of the Solingen property, with an operating lease provision for a certain portion of the space, is expected to be completed in 1994. There are no significant unutilized facilities for ongoing operations which have not yet been disposed of, other than those discussed above, and the Company believes its existing facilities are sufficient to meet its near-term operating requirements. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is subject to various product liability claims and other proceedings which arise in the ordinary course of its businesses and believes that such proceedings, individually or in the aggregate, will not have a material adverse effect on the business or financial condition of the Company. Insured claims arising from ATL's businesses subsequent to 1986 are covered by the Company's insurance policies. The Company intends to maintain insurance coverage against business risks at levels that take into account the nature and magnitude of the respective businesses to be conducted by ATL. There can be no assurance that the Company's current insurance coverage will prove adequate or that the amount or type of coverage available to the Company will remain available on a cost-effective basis. In November 1992, a U.S. District Court in California granted a motion by SRI International, Inc. ("SRI") requesting partial summary judgment on a patent infringement claim relating to an electrical circuit alleged to be used in the Company's Ultramark 4 system. In February 1993, the Court entered an order enjoining further use of the circuit until the patent expires in April 1994. This injunction will not pose an obstacle to continued shipment of products by the Company through the expiry of the SRI patent. The Company has appealed the summary judgment decision to the U.S. Federal Circuit Court of Appeals and is awaiting the decision of this Court. Further proceedings to determine a damage award have been stayed pending the outcome of the appeal. SRI stated in a February 1993 press release that it is seeking over $5 million in damages. The Company continues to believe the SRI patent is invalid and not infringed by the Company. At this stage of the litigation, the Company cannot predict the outcome of the suit or estimate the amount of loss, if any, but believes its defenses are meritorious and is vigorously pursuing its rights in the Appellate Court. There can be no assurance the Company will not be subject to claims of patent infringement by other parties or that such claims will not require the Company to pay substantial damages or delete certain features from its products or both. The Company is involved in various other legal actions and claims arising in the ordinary course of business, none of which is expected to have a material effect on the Company's financial condition. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market and Market Price for Common Stock. The Company Common Stock, $0.01 par value, is traded over the counter under the symbol ATLI and is an authorized security for quotation in National Association of Securities Dealers, Inc. Automated Quotation National Market System ("Nasdaq National Market"). The market prices of a share of Westmark common stock during a six-month period, and of the Company's Common Stock during the eighteen-month period ended December 31, 1993 are set forth below. The prices reflect the high and low trading prices for each quarter as reported by Nasdaq National Market for Westmark or ATL. Stock prices quoted beginning with the quarter ended September 25, 1992 reflects stock price adjustment after the SpaceLabs stock dividend. Stockholders. The approximate number of stockholders of record of the Company's Common Stock as recorded on the books of ATL's Registrar and Transfer Agent as of February 25, 1994 was 9,900. Dividends. The Company has not paid cash dividends on its capital stock and does not currently have any plans to pay such dividends in the foreseeable future. The dividend policy of ATL is reviewed from time to time by the Company's Board of Directors. The Company's dividend policy is dependent upon its earnings, the overall financial condition of ATL, and other factors to be considered by the Board of Directors from time to time. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The loss from operations in 1993 includes a restructuring charge of $4,275. Income from operations in 1992 includes $4,959 of stock distribution expenses and restructuring charges related to the Distribution of SpaceLabs. Income from operations in 1991 includes a $6,338 award as a result of the Company's lawsuit against a competitor. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS ATL (the "Company") develops, manufactures, markets and services medical diagnostic ultrasound systems worldwide. These systems are used in radiology, cardiology, obstetrics and gynecology, and peripheral vascular diagnostic applications. The ultrasound business is competitive and market demand is influenced by a variety of factors. These include the introduction of new technologies which offer improved clinical capabilities and create demand for new products, the relative cost-effectiveness and clinical utility of competing technologies, government policies with respect to reimbursement and containment of medical costs, and changing demographics of the populations in the Company's markets. Ultrasound systems are typically sold based on image quality, Doppler sensitivity, product reliability, upgradeability, clinical versatility, and ease of use. Price competition, however, is an important factor when the growth rate in the market slows below historical norms, when a manufacturer seeks to defend or increase market share, when products are perceived to be equivalent in terms of clinical utility, or when a product line ages. The impact of price deterioration is sometimes offset by changes in product mix, lower service costs, and lower unit manufacturing costs due to declines in component prices, manufacturing efficiencies, design changes to reduce cost, and volume increases. REVENUES AND GROSS PROFIT Revenues in 1993 were $304.5 million, a decrease of 6% from revenues of $323.7 million in 1992. The decrease in revenues primarily reflects changes in the U.S. medical equipment market as well as changes in the Company's product mix. Revenues from U.S. operations decreased 13% from 1992. Uncertainties in the U.S. health care industry regarding potential health care reform legislation and hospital consolidation trends significantly affected the capital equipment purchases by doctors, clinics, and hospitals. The constrained U.S. market also intensified competitive price pressures in the medical equipment industry. International revenues increased 4% to $141.7 million in 1993 or 47% of total revenues. The increase in international revenues was led by increases in the Asia, Pacific, and Latin America regions in 1993. Revenues in Europe decreased slightly in 1993, reflecting the continued weakness of the European economies, as well as the strengthening of the U.S. dollar, which adversely affected the Company's revenues. The Company opened a new sales and customer service subsidiary in Italy in 1993 and announced the opening of an Argentine subsidiary in December 1993. The Company's product mix continues to shift toward the high performance, premium priced systems included in the Ultramark(R) 9 ("UM 9") product family. In 1993, the Company introduced the Extended Signal Processing ("ESP") option or upgrade for its Ultramark 9 High Definition(TM) Imaging ("HDI") systems. Sales of the UM 9 product family now account for three quarters of product sales, up from two thirds in 1992. The Company also sells pre-owned and clinical marketing demonstration equipment to its customers and these sales are becoming an increasing portion of the Company's UM 9 product family sales. Service revenues continued to grow in 1993, up 4% over 1992 mainly due to the growing installed base of the Company's products and the change in product mix. In 1992, revenues increased by 16% to $323.7 million. This increase reflects higher revenues from high performance, premium priced systems, particularly the UM 9 HDI system which was introduced in April 1991. International revenues grew 19% to $136.0 million in 1992 or 42% of the total revenues compared to 41% in 1991. Gross profit decreased to $136.7 million in 1993, compared with $149.1 million in 1992. As a percent of revenues, gross margin decreased to 44.9% from 46.1% in 1992. The decline in gross profit primarily represents the impact of competitive price pressures and lower volumes. These factors were partially offset by favorable changes in product mix toward premium priced systems, continued manufacturing efficiencies and reductions in the cost of service. In 1992, gross profit increased to $149.1 million reflecting higher revenues and higher percentage gross margin on both product and service revenues. Product margins increased due to a higher mix of the UM 9 family product sales as a proportion of total product sales and improved manufacturing efficiencies. Improved service margins resulted primarily from cost containment measures and the change in mix of the installed base of ATL products. RESTRUCTURING OF OPERATIONS In August 1993, the Company restructured its operations which resulted in a reduction in its worldwide workforce of approximately 11%. The restructuring was undertaken in response to the continued uncertainty in the U.S. health care industry and to streamline the Company's operations. As a result of this restructuring, the Company reported a charge of $4.3 million which provided for severance payments and other costs associated with the restructuring. On June 26, 1992, the Company distributed to its shareholders all of the common stock of SpaceLabs Medical, Inc., a wholly owned subsidiary, on a one- for-one basis (the "Distribution"). The Distribution had the effect of dividing the Company into two separate, publicly traded companies: Advanced Technology Laboratories, Inc. (previously named Westmark International Incorporated) and SpaceLabs Medical, Inc. In connection with the Distribution, the Company incurred two non-recurring charges totaling $5.0 million: stock distribution expenses totaling $1.2 million for legal, accounting, investment advisory, printing and other fees and a restructuring charge of $3.8 million primarily related to the closure of the former headquarters office, the severance of certain personnel as a result of the Distribution and the write- down to estimated market value of the Company's former ultrasound manufacturing facilities in Germany. OPERATING EXPENSES Selling, general, and administrative ("SG&A") expenses decreased 4% to $92.0 million in 1993 compared to 1992. The decrease reflects the impact of the August 1993 restructuring discussed previously, as well as other cost reduction programs. These savings were partially offset by selling and marketing activities related to the introduction of the Extended Signal Processing option for the UM 9 HDI system and expenses incurred to support the continued growth of international sales activity. In 1992, SG&A expenses increased 9% to $95.3 million, reflecting expenses incurred to support the growth in revenues and the expansion of international sales and marketing activities. Research and development expenses in 1993 increased 14% over 1992 to $43.8 million or 14.4% of revenues. In 1992, R&D expenses were $38.3 million or 11.8% of revenues. In 1993, ATL introduced new product features such as the Extended Signal Processing technology and four new broadband scanheads for the HDI system. Management expects to continue its investment in product development programs to enhance its position in proprietary and other technologies. In 1993, other expense (income), net, includes a $1.1 million gain on the sale of an investment in a third party. The equity investment was sold in the fourth quarter of 1993 generating $3.2 million in cash proceeds. Other expense (income), net, also includes foreign exchange gains or losses, Washington state business and occupation (B&O) tax, and amortization of costs in excess of net assets of businesses acquired. Foreign exchange gains and losses include principally gains and losses on intercompany accounts of ATL's foreign subsidiaries and on forward foreign currency exchange contracts. Net losses on foreign currency transactions were $1.2, $1.8, and $.7 million in 1993, 1992, and 1991, respectively. B&O tax, a gross receipts tax for products manufactured in the state of Washington, amounted to $1.1, $1.1, and $1.0 million in 1993, 1992, and 1991, respectively. In 1991, other expense (income), net, includes a $6.3 million arbitration award received by the Company as a result of its lawsuit against a competitor. INVESTMENT INCOME Net investment income decreased to $2.2 million in 1993. The decrease reflects lower cash balances available for investment in 1993, as well as lower interest rates on invested cash. Net investment income remained at $3.4 million in 1992, comparable to 1991. TAXES AND NET INCOME (LOSS) The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). Under FAS 109, the provision for income taxes and the effective tax rate are subject to volatility. Changes in statutory rates and taxable income will affect the amount of net deferred tax assets which can be recognized under FAS 109 and the related provision for income taxes. For the Company to realize its U.S. net deferred tax assets, its U.S. taxable income must be comparable to or higher than recent years. Reductions in taxable income levels will result in increased deferred income tax expense. Likewise, significant increases in taxable income will result in the recognition of deferred tax benefits, providing deferred tax assets have not previously been recognized. Taxable income has differed from pretax earnings for financial reporting purposes in the past due to permanent differences, the timing of recognizing certain income and deductions, and deductions for stock option compensation. Due to the restructuring charge and the slow U.S. ultrasound market in 1993, the Company has not sustained the U.S. taxable income level of recent years. This contributed significantly to the $2.2 million increase in the deferred tax asset valuation allowance which was reported as part of deferred tax expense for 1993. During 1993, the Internal Revenue Service completed an examination of the Company's tax returns for the years 1989 and 1990. The audit resulted in a net refund of $1.1 million and allowed the Company to reduce its liability for income taxes by $2 million in 1993. The Company believes it has made adequate provision for income taxes that may become payable with respect to open tax years. The provision for income taxes includes benefits from the utilization of foreign tax loss carryforwards. Foreign tax loss carryforwards of approximately $6.7 million remain at the end of 1993. No benefit has been recognized for the majority of these remaining benefits due to uncertainty surrounding their realization. CAPITAL RESOURCES AND LIQUIDITY The Company has financed operations primarily with internal resources, including its cash and short-term investment balances. Cash and short-term investments totaled $54.6 million at December 31, 1993. The Company also holds $5.0 million in a marketable debt security which matures beyond 1994. Short- term borrowings of $3.7 million at December 31, 1993 represent working capital lines of credit maintained at several of the Company's foreign subsidiaries to facilitate intercompany cash flow. The Company has no long-term debt. Shareholders' equity at December 31, 1993 was $186.4 million, or 67% of total assets. The Company generated positive cash flow of $5.7 million from operating activities. However, the Company's investment in inventories increased to $74.7 million at December 31, 1993, reflecting slower shipment levels and the introduction of new feature upgrades for products during 1993. In the fourth quarter of 1993, the Company implemented an inventory reduction program which resulted in a $9.0 million reduction in the inventory balance during the quarter. During 1993, the Company invested $14.2 million in additions to property, plant and equipment, net of asset retirements. Total depreciation and amortization expense for 1993 was $11.9 million. The Company repurchased 794,000 shares of its own common stock in the open market for $13.4 million under a share repurchase program which began in February 1993. The Company is authorized to purchase up to 1,000,000 shares under this program, subject to certain criteria. Shares purchased are used to service the Company's employee benefit plans. The Company also purchased 12,481 shares of its common stock under a separate, oddlot shareholder program. The oddlot program expired in December 1993. In 1992, the Company made a $36.2 million cash contribution to SpaceLabs Medical, Inc. in connection with the Distribution and received $28.2 million from the exercise of employee stock options. The Company has occasionally utilized its cash resources to make acquisitions of technology or small technology-related businesses. The Company may undertake further acquisitions of technology in the future. In addition to its cash balances, the Company has available unsecured credit facilities of $25 million, including a committed line of credit of $15 million. Management expects that barring any unforeseen circumstances or events, existing cash and short-term investments together with available credit lines and funds generated from operations should be sufficient to meet the Company's operating requirements for 1994. OTHER BUSINESS FACTORS Companies in high technology businesses can from time to time experience difficulty with the availability of technology employed in their products. While the Company strives to develop alternate sources for the components it requires and works closely with vendors of specialty items, the Company's vendors of highly specialized and unique parts such as custom semiconductor devices can occasionally experience difficulty in the manufacture of products. Vendors can also experience difficulty in meeting quality standards the Company requires of its vendors. Such difficulties can lead to long order lead times or delays in the Company's manufacture of products. Manufacturing efforts can also be impeded by third party assertions of patent infringement by the Company's products. See ITEM 3 - -LEGAL PROCEEDINGS on Page 13. The Company is subject to certain rules and regulations of the U.S. Food and Drug Administration ("FDA") regarding the design, documentation, manufacture, marketing, and reporting of the performance of its products. See ITEM 1 - - BUSINESS--Governmental Regulation on Page 11. IMPACT OF NEW ACCOUNTING STANDARD The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which the Company will be required to adopt prospectively on January 1, 1994. Implementation of this accounting standard will not have a material effect on the Company's financial statements. SUBSEQUENT EVENT On February 10, 1994, the Company announced it had entered into a Merger Agreement with Interspec, Inc. ("Interspec"), a manufacturer of medical diagnostic ultrasound systems and transducers, headquartered in Ambler, Pennsylvania. Pursuant to the Merger Agreement, which is subject to approval by shareholders of both companies, Interspec would become a wholly owned subsidiary of the Company through an exchange of 0.413 shares of the Company's common stock for each share of Interspec stock. The proposed merger plan will be submitted to shareholders of Interspec and the Company at their respective shareholder meetings in May 1994. The transaction is expected to be accounted for as a pooling-of-interests. The Company believes the merger will enable the Company and Interspec to combine resources and product lines to expand the Company's market position in the cardiology and mid-priced market segments of the ultrasound market. The Company is filing a proxy statement with the Securities and Exchange Commission relating to the merger proposal which will more fully describe the proposed merger. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following Consolidated Financial Statements are included herewith: See Item 14 for the Financial Statement Schedules filed with Form 10-K Report. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS ADVANCED TECHNOLOGY LABORATORIES, INC. We have audited the accompanying consolidated balance sheets of Advanced Technology Laboratories, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the index referred to in Part IV, Item 14(2) of the Form 10-K report. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Advanced Technology Laboratories, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick KPMG Peat Marwick Seattle, Washington February 10, 1994 ADVANCED TECHNOLOGY LABORATORIES, INC. CONSOLIDATED BALANCE SHEETS See accompanying notes to Consolidated Financial Statements. ADVANCED TECHNOLOGY LABORATORIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes to Consolidated Financial Statements ADVANCED TECHNOLOGY LABORATORIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to Consolidated Financial Statements ADVANCED TECHNOLOGY LABORATORIES, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY See accompanying notes to Consolidated Financial Statements ADVANCED TECHNOLOGY LABORATORIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The consolidated financial statements include the accounts of Advanced Technology Laboratories, Inc. and its wholly-owned subsidiaries (the "Company"). All significant intercompany accounts and transactions have been eliminated in consolidation. The Company's fiscal year ends on December 31. Prior to 1992, the Company's fiscal year was a 52 or 53 week period, ending on the last Friday in December. Fiscal years 1993 and 1991 included 52 weeks; fiscal year 1992 included 53 weeks. Operations The Company develops, manufactures, markets, and services medical diagnostic ultrasound systems worldwide. These systems are used primarily in radiology, cardiology, obstetrics and gynecology, and peripheral vascular applications. Inventories Inventories are valued at the lower of cost, determined by the first-in, first-out method, or market. The Company maintains a uniform policy for its worldwide operations to provide adequate reserves for inventory obsolescence. Property, Plant and Equipment The costs of significant additions and improvements to property, plant and equipment are capitalized. Maintenance and repairs are expensed as incurred. Buildings, machinery and equipment are depreciated primarily on the straight- line method over the following estimated useful lives: Leasehold improvements are amortized over the shorter of their useful lives or the term of the lease. Cost in Excess of Net Assets of Businesses Acquired The cost in excess of net assets of businesses acquired is amortized on the straight-line method over seven years. Foreign Currency Revenues, costs and expenses of the Company's international operations denominated in foreign currencies are translated to U.S. dollars at average rates of exchange prevailing during the year. Assets and liabilities are translated at the exchange rate on the balance sheet date. Translation adjustments resulting from this process are accumulated and reported in shareholders' equity. The Company enters into foreign currency exchange contracts as a hedge against exposure to foreign currency fluctuations associated primarily with intercompany receivables and payables. Foreign exchange contracts generally have maturities of less than one year. Gains and losses resulting from these instruments are recognized in the same period as the underlying hedged transactions. At December 31, 1993, foreign currency exchange contracts hedging anticipated transactions totaled approximately $19,500, primarily denominated in Canadian, Australian, and European currencies. The estimated fair value of these contracts approximates the aggregate contract value, based on quoted forward rates at December 31, 1993. Realized and unrealized gains and losses on foreign currency transactions and forward exchange contracts are included in other expense (income), net. Revenue Revenue is generally recognized upon shipment of products and delivery of services to customers. Deferred revenue consists of deposits received from customers and unrecognized service contract revenue. Service contracts are generally issued for a 12-month period and are carried as unbilled receivables from date of issue until invoiced to the customer in accordance with the terms of the contract. The revenue derived from these contracts is initially deferred and subsequently recognized on the straight-line method over the lives of the contracts. Sales-type Leases In 1993, the Company began a product leasing program for its customers. Under this program, the Company leases its medical ultrasound imaging equipment to customers under sales-type leases with terms ranging from two to five years. The Company currently sells its lease contract receivables to outside parties on a regular basis. At December 31, 1993, the majority of lease contract receivables had been sold, without recourse. The remaining lease contract receivables at December 31, 1993 are not significant. Product Warranty The Company provides at the time of product shipment for the estimated cost to repair or replace products sold under warranties. Such warranties generally cover a 12-month period. Income Taxes The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements and tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. Pension Plans Pension costs are funded in accordance with requirements set forth by the Employee Retirement Income Security Act of 1974. Diversification of Credit Risk Financial instruments which potentially subject the Company to credit risk consist primarily of cash investments and trade receivables. The Company's investment portfolio is diversified and primarily consists of investment grade securities that approximate fair market value. Concentrations of credit risk with respect to receivables are limited due to the Company's large customer base, generally short payment terms, and the dispersion of customers across geographic areas. The Company performs credit evaluations of its customers' financial condition and requires collateral, such as letters of credit, in certain circumstances. Per Share Data Per share data is based on the weighted average number of common shares and dilutive common share equivalents outstanding. Common share equivalents are calculated under the treasury stock method and consist of unexercised employee stock options. Reclassifications Certain amounts reported in previous years have been reclassified to conform to the 1993 presentation. 2. DISTRIBUTION OF SPACELABS MEDICAL, INC. On June 26, 1992, the Company (previously named Westmark International Incorporated) distributed to its shareholders all of the common stock of SpaceLabs Medical, Inc., a wholly owned subsidiary, on a one-for-one basis (the "Distribution"). The Distribution had the effect of dividing the Company into two separate, publicly traded companies: Advanced Technology Laboratories, Inc. (previously Westmark International Incorporated) and SpaceLabs Medical, Inc. ("SpaceLabs"). The spin-off of a company, such as SpaceLabs, would normally be reported as a discontinued operation. However, the historical consolidated financial statements of the Company were retroactively restated to deconsolidate the financial statements of SpaceLabs to reflect the Distribution. The Company believes this exception to the usual method of reporting a spin-off is appropriate given the highly unique circumstances surrounding the relationship between SpaceLabs and the Company. These circumstances were reviewed with the staff of the Securities and Exchange Commission. Management believes that deconsolidation, which presents the historical financial statements of the Company as if there never had been an affiliation between the Company and SpaceLabs, is the most meaningful financial presentation. Corporate and administrative expenses were allocated to the Company and SpaceLabs based on relative revenues. Management believes this allocation method was reasonable. Further, management believes that reported expenses, including income taxes, would not have been materially different had the Company operated as an unaffiliated entity. In connection with the Distribution, the Company made a net contribution of assets and liabilities to SpaceLabs, which reduced the Company's shareholders' equity by $28,855. The contribution consisted of $36,212 in cash and $550 in other assets, offset by the elimination of a $7,907 payable to SpaceLabs. At June 26, 1992, the payable due to SpaceLabs represented cumulative cash transfers prior to the Distribution between SpaceLabs and the Company arising from SpaceLabs' operating and financing activities. As part of the Distribution, the Company and SpaceLabs entered into an Intercompany Tax Agreement that provides for payment to or reimbursement from SpaceLabs for pre-Distribution tax matters. In 1993, the Company received a net amount of $1,055 from SpaceLabs under this agreement as a result of the conclusion of an Internal Revenue Service examination for the years 1989 and 1990. The amount was reported as an increase to shareholders' equity. Expenses related to the Distribution totaling $1,195 were incurred in 1992 for legal, accounting, investment advisory, printing and other fees and are reported as stock distribution expenses in the consolidated statements of operations. The Company also incurred restructuring charges of $3,764 including expenses related to the closure of the Seattle headquarters' office, severance of certain personnel as a result of the Distribution, and a $1,400 write down to estimated market value of the Company's former ultrasound manufacturing facility in Germany. 3. RESTRUCTURING CHARGE In August 1993, the Company incurred a restructuring charge of $4,275 related to the reduction of its worldwide workforce of approximately 11%. The restructuring was primarily undertaken in response to the uncertainty in the health care industry and to streamline operations. The charge provided for severance payments and other costs associated with the restructuring of the Company's operations. 4. CASH, SHORT-TERM INVESTMENTS AND MARKETABLE DEBT SECURITY Short-term investments and the marketable debt security are stated at cost which approximates fair market value. For purposes of the statement of cash flows, cash equivalents are defined as investments with maturities of three months or less at the date of purchase. The Company holds a marketable debt security issued by the U.S. Government which matures in 1996. The marketable debt security is classified as a non-current asset on the consolidated balance sheet. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", which the Company will be required to adopt prospectively on January 1, 1994. Implementation of this accounting standard will not have a material effect on the Company's financial statements. 5. RECEIVABLES 6. INVENTORIES 7. PROPERTY, PLANT AND EQUIPMENT, AT COST The Company has accepted an offer to sell property formerly used as a manufacturing facility in Germany. The transaction is expected to close in early 1994 with a small gain on the sale. The property secures a foreign line of credit. A portion of the proceeds from the sale of the property will be used to pay off the outstanding balance on this line of credit. 8. OTHER ASSETS Amortization of costs in excess of net assets of businesses acquired was $659 in 1993, $675 in 1992, and $669 in 1991, and is included in other expense (income), net. During 1993, the Company sold its equity investment in a third party for $3,235. A gain on the sale of the investment of $1,125 is included in other expense (income), net. 9. SHORT-TERM BORROWINGS Short-term borrowings represent foreign currency borrowings carrying interest rates ranging from 8% to 12% under lines of credit maintained by various foreign subsidiaries for working capital purposes. These credit lines are primarily unsecured, except as discussed in note 7. At December 31, 1993, the Company had available unsecured credit facilities totaling $25,000, including a committed line of credit of $15,000. No borrowings were outstanding under these facilities at December 31, 1993. The loan agreement for the committed line of credit includes various covenants relating to financial ratios and restrictions on cash dividends. The Company was in compliance with, or had obtained waivers for, these covenants at December 31, 1993. Interest expense as reported in the consolidated statements of operations approximates amounts paid each year. 10. ACCOUNTS PAYABLE AND ACCRUED EXPENSES 11. EMPLOYEE BENEFIT PLANS Substantially all employees of the Company's U.S. operations are covered under a noncontributory, defined benefit pension plan. The benefits are based on the employee's years of service and highest consecutive five-year average compensation. Net pension cost is comprised of the following: The funded status of the plans at December 31, 1993 and 1992 follows: The projected benefit obligations are based on employee census information as of the beginning of each year. The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.75% for 1993, and 8.5% for 1992 and 1991. The assumed annual rate of increase in future compensation levels was 9% for the first five years of service and 5.75% thereafter, for 1993; and 10% and 6.5% in both 1992 and 1991. The expected long-term rate of return on plan assets was 9% in each of 1993, 1992 and 1991. A 401(k) retirement savings plan is maintained for all U.S. employees. The Company's contributions to this plan were $895, $748, and $670 in 1993, 1992 and 1991, respectively. 12. SHAREHOLDERS' EQUITY In 1992, the Company adopted the 1992 Option, Stock Appreciation Right, Restricted Stock, Stock Grant and Performance Unit Plan and the 1992 Non- Officer Employee Stock Option Plan (the "1992 Plans"). Under the 1992 Plans, 1,750,000 common shares are reserved primarily for issuance of stock options at prices equal to the fair market value of the Company's common shares at the date of grant and for issuance of restricted shares at par value. Stock options and restricted stock granted under the 1992 Plans are generally exercisable at 25% each year over a four year vesting period. At December 31, 1993, approximately 359,000 shares were available for grants under the 1992 Plans. In 1993, the Company established the Non-Employee Director Stock Option Plan. Under this plan, 50,000 common shares were reserved for issuance of stock options at prices equal to the fair market value of the common shares at the date of grant. At December 31, 1993, 42,000 shares were available for grants under this plan. The Company also granted stock options and restricted stock under two plans which were in effect prior to the Distribution of SpaceLabs. At the date of the Distribution, the remaining shares available for issuance under these plans were cancelled and the exercise price for remaining stock options outstanding was adjusted in proportion to the relative values of the Company and SpaceLabs stock prices at the time of the Distribution. The following table summarizes option activity (shares in thousands). Option prices prior to June 26, 1992, the date of the Distribution, reflect the fair market value on the date of grant. Option prices on or subsequent to June 26, 1992 represent either the option prices adjusted to reflect the Distribution or the fair market value of the Company's common shares for options granted subsequent to June 26, 1992. In 1993 and 1992, 33,000 and 131,000 shares, respectively, of restricted stock were issued at par value under the 1992 plans. Deferred compensation representing the fair market value of the shares at the date of grant is amortized over the four year vesting period. In February 1993, the Company's Board of Directors authorized a plan to repurchase up to 1,000,000 shares of its own common stock in the open market subject to certain criteria. The Company repurchased 794,000 shares totaling $13,441 under this program in 1993. The shares purchased will be used to service the Company's employee benefit plans. In October 1993, the Board of Directors authorized an oddlot shareholder program for the purpose of repurchasing oddlot share positions or allowing oddlot shareholders to establish a position of 100 shares. Under this program the Company made net purchases of 12,481 shares, totaling $312. The oddlot repurchase program expired in December 1993. 13. INCOME TAXES The components of income (loss) before income taxes were: Income tax expense consists of the following: The difference between taxes computed by applying the U.S. Federal income tax rate of 34% to income (loss) before income taxes and the actual income tax expense follows: The Company had net refunds of income taxes of $4,322, $574, and $718 in 1993, 1992, and 1991, respectively. The tax effects of temporary differences and carryforwards which give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and December 31, 1992 are presented below. For the Company to realize its U.S. net deferred tax assets, its taxable income must be comparable to or higher than recent years. Although the Company believes such taxable income levels will be achieved, reductions in taxable income levels can result in an increased deferred income tax expense. Due primarily to the restructuring charge and a slow U.S. ultrasound market, the Company has been unable to sustain the U.S. taxable income level of recent years. This is reflected in the increase in the total valuation allowance of $2,181 during the year. Additional factors considered in determining the realizability of deferred tax assets included a tax planning strategy involving the sale/leaseback of real estate and potential carryback opportunities. At December 31, 1993, the Company had international net operating loss carryforwards for statutory purposes of approximately $6,700, which expire as follows: $850 in 1994, $850 in 1995, $950 in 1996, and $4,050 indefinitely. The Company also has U.S. research and experimentation credit carryforwards of approximately $4,300 with expiration dates through 2008. During 1993, the Internal Revenue Service completed an examination of the Company's tax returns for the years 1989 and 1990. The audit resulted in a net refund of $1,071 which allowed the Company to reduce its liability for income taxes by $2,013. The Company believes it has made adequate provision for income taxes that may become payable with respect to open tax years. Provision has not been made for U.S. or additional foreign taxes on the undistributed earnings of the Company's foreign subsidiaries which total approximately $1,300. These earnings, which are anticipated to be reinvested, could become subject to additional tax if they were remitted as dividends, lent to the Company, or if the Company should sell its stock in these subsidiaries. 14. OTHER EXPENSE (INCOME), NET Other expense (income), net, includes foreign exchange gains and losses consisting of realized gains and losses on cash transactions involving various foreign currencies, unrealized gains and losses resulting from exchange rate fluctuations primarily affecting intercompany accounts and gains and losses on forward exchange contracts. Net losses from foreign currency transactions were $1,234, $1,839, and $712 in 1993, 1992 and 1991, respectively. Other expense (income), net, also includes Washington State Business and Occupation taxes of $1,086, $1,144, and $981 in 1993, 1992 and 1991, respectively. This tax is a gross receipts tax imposed on products manufactured in the state of Washington and is levied in lieu of a state income tax. In 1993, other expense (income), net, includes a $1,125 gain on the sale of an investment and in 1991, includes a $6,338 award received as a result of the Company's lawsuit against a competitor. 15. INVESTMENT INCOME Investment income consists of the following: 16. LEASES The Company was obligated at December 31, 1993 under long-term operating leases for various types of property and equipment, with minimum aggregate rentals totaling $11,093 as follows: $3,752 in 1994, $2,122 in 1995, $1,659 in 1996, $1,338 in 1997, $1,315 in 1998 and $907 in later years. Many of the Company's leases contain renewal options and clauses for escalations and payment of real estate taxes, maintenance, insurance and certain other operating expenses of the properties. Certain leases are expected to be renewed or replaced at expiration. Total rental expense under operating leases was $4,563, $4,599, and $4,675 in 1993, 1992 and 1991, respectively. 17. LEGAL CONTINGENCIES In November 1992, a U.S. District Court in California granted a motion by SRI International, Inc. ("SRI") requesting partial summary judgment on a patent infringement claim relating to an electrical circuit alleged to be used in the Company's Ultramark 4 system. In February 1993, the Court entered an order enjoining further use of the circuit in dispute by the Company until the patent expires in April 1994. This injunction will not pose an obstacle to continued shipment of products by the Company through the expiry of the SRI patent in April 1994. The Company has appealed the summary judgment decision to the U.S. Federal Circuit Court of Appeals, and further proceedings to determine a damage award have been stayed pending the outcome of the Company's appeal. SRI has stated in a February 1993 press release that it is seeking over $5 million in damages. The Company continues to believe the SRI patent is invalid and not infringed by the Company. At this stage of the litigation, the Company cannot predict the outcome of the suit or estimate the amount of loss, if any, but believes its defenses are meritorious and is vigorously pursuing its rights in the Appellate Court. In addition to the foregoing proceedings, the Company is involved in various other legal actions and claims arising in the ordinary course of business. The Company believes the ultimate resolution of these matters will not have a material adverse effect on the Company's financial condition. 18. GEOGRAPHIC SEGMENT INFORMATION The Company operates in one industry segment: developing, manufacturing, marketing and servicing medical ultrasound imaging systems. Internationally, the Company's products are marketed through its subsidiaries and independent distributors, with principal subsidiaries located in Europe, Canada and Australia. U.S. revenues in the following table include export sales to customers in foreign countries of $44,996, $41,267, and $30,848 in 1993, 1992 and 1991, respectively. A summary of the Company's operations by geographic area follows: International revenues, including both international operations and export sales, were as follows: Geographic assets may be reconciled to consolidated assets as follows: 19. QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly per share data shown do not add to the total due to changes in the number of weighted average shares outstanding during the year. The loss from operations in the third quarter of 1993 includes a restructuring charge of $4.3 million. The loss from operations in the second quarter of 1992 includes $5.0 million of stock distribution expenses and restructuring charges related to the Distribution of SpaceLabs. 20. SUBSEQUENT EVENT In February 1994, the Company entered into a Merger Agreement with Interspec, Inc. ("Interspec"), a manufacturer of medical diagnostic ultrasound systems and transducers, headquartered in Ambler, Pennsylvania. Pursuant to the Merger Agreement, which is subject to approval by shareholders of both companies, Interspec would become a wholly owned subsidiary of the Company through an exchange of 0.413 shares of the Company's common stock for each share of Interspec stock. The proposed merger plan will be submitted to shareholders of Interspec and the Company at their respective shareholder meetings in May 1994. The transaction is expected to be accounted for as a pooling-of-interests. Interspec reported revenues of $61,377, net income of $1,950, and net income per share of $0.31 for its fiscal year ended November 30, 1993. The Company is filing a proxy statement with the Securities and Exchange Commission relating to the merger proposal which will more fully describe the proposed merger. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEMS 10-13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Part III (Items 10-13) is set forth in ATL's definitive proxy statement which will be filed pursuant to Regulation 14A within 120 days of December 31, 1993. Such information is incorporated herein by reference and made a part hereof. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 1. FINANCIAL STATEMENTS The following consolidated financial statements of the Company are included in Item 8 of this Form 10-K report: Independent Auditors' Report Consolidated Financial Statements: Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Operations for each of the years in the three-year period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 1993 Consolidated Statements of Shareholders' Equity for each of the years in the three-year period ended December 31, 1993 Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULES An index to the financial statement schedules required to be filed by Part II, Item 8 of this Form is set forth immediately before the attached financial statement schedules on pages 41 through 43 of this filing. 3. EXHIBITS The required exhibits are included at the back of this Form 10-K and are described in the Exhibit Index immediately preceding the first exhibit. 4. REPORTS ON FORM 8-K None. INDEX TO FINANCIAL STATEMENT SCHEDULES All other schedules are omitted because they are not applicable, the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. SCHEDULE VIII ADVANCED TECHNOLOGY LABORATORIES, INC. VALUATION AND QUALIFYING ACCOUNTS - -------- NOTE: (1) Accounts charged off, net of recoveries. (2) Adjustments to the valuation allowance for deferred tax assets, based on the ability to realize net deferred tax assets in the future, according to the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." SCHEDULE IX ADVANCED TECHNOLOGY LABORATORIES, INC. SHORT-TERM BORROWINGS - -------- NOTES: (1) The weighted average interest rate on short-term borrowings outstanding at fiscal year-end 1993, 1992 and 1991 was approximately 8.0%, 10.3% and 10.8%, respectively. (2) The weighted average interest rate related to the average amount of short- term borrowings outstanding during 1993, 1992 and 1991 was approximately 10.6%, 10.8% and 13.4%, respectively. These rates, as well as the average amounts outstanding during the period, are based upon month-end balances. SCHEDULE X ADVANCED TECHNOLOGY LABORATORIES, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION As to the items omitted, the answer is none or the required information is disclosed in the notes to the consolidated financial statements or the amounts are not sufficient to require disclosure. CONSENT OF KPMG PEAT MARWICK The Board of Directors Advanced Technology Laboratories, Inc.: We consent to incorporation by reference in the registration statements 33- 38218, 33-38217, 33-28830, 33-28092, 33-22434, 33-10618, 33-47967, and 33-66298 on Form S-8 of Advanced Technology Laboratories, Inc., of our report dated February 10, 1994, relating to the consolidated balance sheets of Advanced Technology Laboratories, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows and related financial statement schedules for each of the years in the three-year period ended December 31, 1993, which report appears in the December 31, 1993 annual report on Form 10-K of Advanced Technology Laboratories, Inc. /s/ KPMG Peat Marwick KPMG Peat Marwick Seattle, Washington February 25, 1994 KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints DENNIS C. FILL, HARVEY N. GILLIS, and W. BRINTON YORKS, Jr. and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution, and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his/her substitute or substitutes, may lawfully do or cause to be done by virtue hereof. PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Advanced Technology Laboratories, Inc. (Registrant) By /s/ Dennis C. Fill ----------------------------------- Dennis C. Fill Chairman of the Board PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.

801124_1993.txt

801124

1993

Item 1. Business - ---------------- Vanguard Real Estate Fund I, A Sales-Commission-Free Income Properties Fund (the "Fund"), was organized on September 10, 1986 as a Massachusetts business trust and intends to continue to qualify as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). The Fund has a finite life and intends to commence the liquidation of its remaining real estate investments over the next five years, market conditions permitting. In addition, the Fund is precluded from making any additional real estate investments. The Fund has no employees. Pursuant to a Services Agreement dated December 23, 1986 (the "Services Agreement") between the Fund and The Vanguard Group, Inc. (the "Sponsor"), the Sponsor has been retained to provide administrative services for the Fund, including the maintenance of financial records, oversight of the performance of outside service providers and the preparation and distribution of communications to shareholders, etc., and to supervise its day-to-day business affairs. Pursuant to an Advisory Agreement dated December 23, 1986 (the "Advisory Agreement") between the Fund and Aldrich, Eastman & Waltch, Inc. (the "Adviser"), the Adviser has been retained to advise the Fund in connection with the evaluation, selection, management and disposition of its real estate investments. For additional information concerning the Sponsor, the Adviser, the Services Agreement and the Advisory Agreement, see Item 8, Financial Statements and Supplementary Data - Notes to Financial Statements, and Item 13, Certain Relationships and Related Transactions. The Fund's business consists of holding investments primarily in income- producing real properties and mortgage loans that offer the potential to achieve the following investment objectives: (i) to preserve and protect shareholders' capital; (ii) to provide shareholders with current income in the form of quarterly cash distributions and to provide growth of income over the remaining life of the Fund; and (iii) to provide long-term growth through appreciation in the value of the Fund's real estate investments. In order to achieve these objectives, the Fund has invested, through direct ownership or shared-appreciation mortgages, in five existing income- producing properties or portfolios of properties, including one portfolio of three office buildings, two shopping centers, a portfolio of warehouses and industrial properties, and one apartment complex. The Adviser believes that the Fund's investments are diversified by both type of investment and geographic location. As of February 28, 1994, the Fund had invested approximately $75 million in real estate assets, of which $44 million (59%) consisted of real estate owned directly, $29 million (39%) consisted of mortgage loan investments - including $17 million (23%) considered to be in-substance foreclosed assets and $2 million (2%) consisted of marketable securities. The Fund has elected to be treated as a REIT under the Code. The Fund intends to invest and operate in a manner that will continue to maintain its qualification as a REIT. The Fund's real estate investments are subject to competition from existing commercial, industrial, and residential properties and will be subject to competition from properties that are developed in the future. The REIT provisions of the Code impose certain financial, investment and operational restrictions that are not applicable to competing entities that are not REITs. For additional information regarding the Fund's investments, operations, and other significant events, see Item 2, Properties, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data. The following table sets forth the names and positions with the Fund of the executive officers of the Fund: NAME AGE POSITIONS ------------------ --- --------------------------------- John C. Bogle 65 Trustee and Chairman of the Board John J. Brennan 39 President Ralph K. Packard 49 Vice President and Controller Richard F. Hyland 57 Treasurer Raymond J. Klapinsky 55 Secretary All executive officers of the Fund also serve as executive officers of Vanguard Real Estate Fund II, A Sales-Commission-Free Income Properties Fund ("VREFII"). All executive officers of the Fund, with the exceptions of Mr. Packard, who was elected as an officer of the Fund in May 1988, and Mr. Klapinsky, who was elected as an officer of the Fund in May 1989, have served since the Fund's inception. Under the Fund's Declaration of Trust, the officers of the Fund serve at the pleasure of the Trustees. There are no family relationships between any Trustee or executive officer. Mr. Bogle is Chairman and Chief Executive Officer of the Fund, The Vanguard Group, Inc. (the Sponsor of the Fund) and each of the investment companies in The Vanguard Group. Mr. Bogle has served in such capacities during each of the past eight years. Mr. Bogle also serves as a Director of The Mead Corporation and General Accident Insurance Companies. Mr. Brennan is President of The Vanguard Group, Inc. and has served in such capacity since May 1989. Mr. Brennan also serves as a Director (Trustee) of The Vanguard Group, Inc., and each of the investment companies in The Vanguard Group. Mr. Brennan served as Executive Vice President and Chief Financial Officer of The Vanguard Group, Inc. from July 1986 to May 1989. Mr. Brennan served as Senior Vice President and Chief Financial Officer of The Vanguard Group, Inc. from July 1985 to July 1986, and as Assistant to the Chairman of the Board of The Vanguard Group, Inc. from July 1982 to July 1985. Mr. Packard is Senior Vice President and Chief Financial Officer of The Vanguard Group, Inc. and has served in such capacity since June 1989. Mr. Packard served as Vice President and Controller of The Vanguard Group, Inc. from February 1986 to June 1989. Prior to joining The Vanguard Group, Inc., Mr. Packard served as Senior Vice President, Controller, and Deputy Director of Finance for the Society for Savings Bank, Hartford, Connecticut. Mr. Hyland is, and has served for each of the past eight years as, Treasurer of The Vanguard Group, Inc. and each of the investment companies in The Vanguard Group. Mr. Klapinsky is, and has served for each of the past eight years as, Senior Vice President and Secretary of The Vanguard Group, Inc. and each of the investment companies in The Vanguard Group. Item 2.

Item 2. Properties - ------------------ As of December 31, 1993, the Fund held the following real estate investments: Set forth below is a summary of the general competitive conditions for those properties whose book value is ten percent or more of the Fund's total assets as of December 31, 1993, or whose gross revenues are ten percent or more of the aggregate gross revenues of the Fund for the year ended December 31, 1993. Plaza del Amo - ------------- There are approximately 85,000 households (average household income of $70,000) and 210,000 people within a three-mile radius of the shopping center. Southern California's economy and, in particular, the South Bay market, have been seriously undermined by the recent recession prompted, in part, by difficulties in the defense and aerospace industries. As a result, the retail property market has suffered for several years from weak demand growth. Current market vacancy has remained relatively unchanged at approximately 10-12% and estimated effective rent at comparable properties is $15-$18 per square foot for shop space and $5.25-$8.10 for anchor space. Oakcreek Village - ---------------- There are approximately 14,500 households (average household income of $57,000) and 32,000 people within a three-mile radius of the center. Employment in the Raleigh-Durham metropolitan area grew 2.6% over the 12 month period ended December 1993. Estimated market rents for comparable properties are approximately $10-$12 per square foot. Tightening market conditions, however, have resulted in several significant proposed projects in Oakcreek Village's trade area. If built, these proposed competitive projects may reduce rent growth and increase the vacancy rate in the area. Seattle Industrial Park - ----------------------- Boeing Company is the region's driving economic force (and the Seattle Industrial Park's lead tenant). The combination of weak worldwide demand and the severe oversupply of commercial aircraft has resulted in a significant contraction at Boeing. Over the past three years the Seattle economy has had to cope with a transition from a high-growth economy to a little or no-growth environment. Currently, the market is weak with vacancy rates averaging approximately 7%. The estimated triple net market rent for comparable properties is $2.75 per square foot for Valley Industrials and $4-$5 per square foot for Sea-Tac. Sheffield Forest Apartments - --------------------------- Washington DC's superior growth over the past decade has slowed appreciably to a rate more in line with the national average. With little near-term stimulus from the region's traditional growth sectors, government and construction, total employment growth is expected to be moderate over the next several years. Estimated market rents for comparable properties stand at $0.70 to $1.10 per square foot and the estimated vacancy rate for comparable properties is 5-6%. Minnesota Portfolio - ------------------- The Twin Cities economy is characterized by a broad economic base. As a result, employment growth has remained relatively stable over the past decade, and the region has avoided significant job losses during the latest recession. Currently, employment is increasing at an annual rate of 2.1%. Vacancy rates and net market rents for comparable properties are as follows: Shoreview - rent of $7.50 to $9.00 per square foot and vacancy rate of 11%; Arden Hills - rent of $6.00 to $12.50 per square foot and vacancy rate of 5%; and Fairview - rent of $3.25 to $5.00 per square foot and vacancy rate of 13%. Set forth below is certain operating data for those properties held by the Fund whose book value is ten percent or more of the Fund's total assets as of December 31, 1993 or whose gross revenues are ten percent or more of the aggregate gross revenues of the Fund for the year ended December 31, 1993. Occupancy Rates: - ---------------- Plaza Del Oakcreek Seattle Ind. Minnesota Sheffield Amo Village Park Portfolio Forest Apt. --- ------- ---- --------- ----------- 1993 98% 96% 99% 99% 93% 1992 94% 95% 99% 99% 93% 1991 92% 94% 98% 99% 93% 1990 100% 97% 98% 75% 96% 1989 98% 91% 99% 97% 95% Avg. Effective Rental/Sq.Ft/Yr.: - ----------------- Plaza Del Oakcreek Seattle Ind. Minnesota Sheffield Amo Village Park Portfolio Forest Apt.* --- ------- ---- --------- ----------- 1993 $13.23 $9.07 $3.00 $8.06 $8,796 1992 $13.06 $9.11 $2.47 $7.95 $8,976 1991 $13.72 $9.47 $1.95 $8.71 $9,240 1990 $13.11 $8.82 $1.96 $7.40 $9,180 1989 $13.15 $9.61 $1.92 $7.74 $8,952 * Annual rent/unit. Real Estate Tax/Fiscal Year: - ---------------------------- Effective Rate Per $1000 of Assessed Value $11.63 $15.34 $14.30 $61.14 $32.92 Annual Taxes $85,723 $96,141 $239,927 $308,888 $220,639 Tenants Occupying 10% or more of rentable square footage: - --------------------------------------------------------- Lease Expirations during the next ten years: - -------------------------------------------- A mortgage loan payable, secured by the Plaza del Amo property, is outstanding at December 31, 1993. Information concerning its principal, interest rate, amortization and maturity provisions is included in Note H to the Fund's financial statements, incorporated by reference in Item 8, Financial Statements and Supplementary Data, and in Schedule XII to Item 14. Information concerning the interest rates, shared-appreciation features, and other terms of the Fund's mortgage investments is included in Note F to the Fund's Financial Statements, included in Item 8, Financial Statements and Supplementary Data, and in Schedule XII to Item 14. Excluding the Fund's Sheffield investment, the Fund believes that its direct ownership properties, and the properties underlying its mortgage investments, are well maintained, in good repair, suitable for their intended uses and are adequately covered by insurance. For additional information regarding the Fund's real estate investments see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, Item 8, Financial Statements and Supplementary Data, and Schedules XI and XII to Item 14. With respect to the Sheffield investment, cash flow from the property has been insufficient to cover debt service obligations owing to the Fund. As a result, the partnership which owns the property deferred certain maintenance on the property and subsequently defaulted on the mortgage loan in January 1994. The Fund is currently negotiating with the partnership, whose sole asset is the Sheffield property, to obtain title to the property via a transfer of all of its partnership interests to the Fund in full satisfaction of the mortgage loan outstanding. Upon gaining ownership of the property, which the Fund believes to be imminent, the Fund intends to remedy the deferred maintenance on the property. The cost of such renovations, expected to be $150,000 - $250,000, will be financed from the Fund's current operating cash flow. The Fund believes that the Sheffield property is suitable for its intended use and is adequately covered by insurance. Except for Sheffield as discussed above, the Fund has no other significant renovation, improvement or development plans for its other properties. Information concerning the Federal tax basis and depreciation method and lives of the Fund's properties and components thereof and on which deprecation is taken is included in Notes A and E to the Fund's Financial Statements, included in Item 8, Financial Statements and Supplementary Data, and in Schedule XI to Item 14. All real estate owned is depreciated over 40 years for both financial and tax reporting purposes on a straight-line basis except for leasehold improvements which are depreciated over the term of the respective lease for financial reporting purposes. Item 3.

Item 3. Legal Proceedings - ------------------------- None Item 4.

Item 4. Submission of Matters to a Vote of Security Holders - ----------------------------------------------------------- None PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Shareholder Matters - --------------------------------------------------------------------- The Fund's shares of beneficial interest ("Shares") are traded on the American Stock Exchange (AMEX) under the symbol "VRO". The Shares have been traded on the AMEX since August 20, 1991. From July 24, 1989 to August 19, 1991, the Fund's shares were traded on the over the counter market and were quoted by the National Association of Securities Dealers Automated Quotation System ("NASDAQ"). Prior to July 24, 1989, there was no trading market for the Shares. As of February 28, 1994, there were approximately 15,554 holders of record of the Fund's Shares. Set forth below is certain information regarding the Fund's Shares for each of the eight fiscal quarters in the period ended December 31, 1993: Year Ended December 31, ------------------------------------------- 1993 1992 Share Prices Share Prices ------------------ ------------------ High Low High Low -------- -------- -------- -------- For the Quarter Ended: March 31 $8-1/4 $6-5/8 $7-5/8 $6-5/8 June 30 8 7-1/4 7-3/4 6-5/8 September 30 8-1/4 7-3/8 8 6-5/8 December 31 8-3/4 7-3/8 7-1/4 6-1/4 The tables below indicate the amount of cash dividends per share declared during the years ended December 31, 1993 and 1992. Record Distribution Date Per Share ----------------- -------------- 03-31-93 $ .15 06-30-93 .15 09-30-93 .15 12-22-93 1.24 ---- Total Distributions - 1993 $1.69 Record Distribution Date Per Share ----------------- -------------- 04-01-92 $ .15 06-30-92 .15 09-30-92 .15 12-22-92 .24 ---- Total Distributions - 1992 $ .69 Status of Distributions 1993 1992 ----------------------- ---- ---- Ordinary Income $ - $ .57 Return of Capital 1.69 .12 ---- ---- Total $1.69 $ .69 Except during its offering period, the Fund has historically paid dividends on a quarterly basis, and there are currently no contractual restrictions on the Fund's present or future ability to pay such dividends. Item 6.

Item 6. Selected Financial Data - ------------------------------- The information required by this Item is included on page 18 of the Fund's 1993 Annual Report to Shareholders and is incorporated herein by reference thereto. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - ----------------------------------------------------------------------- The information required by this Item is included on pages 20 through 23 of the Fund's 1993 Annual Report to Shareholders and is incorporated herein by reference thereto. Item 8.

Item 8. Financial Statements and Supplementary Data - --------------------------------------------------- The Fund's financial statements at December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993 are included on pages 6-17 of the Fund's 1993 Annual Report to Shareholders and are incorporated herein by reference thereto. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure - ----------------------------------------------------------------------- None PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant - ----------------------------------------------------------- The information required by this Item with respect to Trustees is included in the Fund's definitive proxy statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. (Information with respect to executive officers of the Fund is included in Item 1.) Item 11.

Item 11. Executive Compensation - ------------------------------- The information required by this Item is included in the Fund's definitive Proxy Statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management - ----------------------------------------------------------------------- The information required by this Item is included in the Fund's definitive Proxy Statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. Item 13.

Item 13. Certain Relationships and Related Transactions - ------------------------------------------------------- The information required by this Item is included in the Fund's definitive Proxy Statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - ------------------------------------------------------------------------- (a) 1. Financial Statements: --------------------- The following financial statements as of, and for the years ended, December 31, 1993, 1992 and 1991 are incorporated in Item 8 herein by reference from the following pages of the Fund's 1993 Annual Report to Shareholders, which is filed as an Exhibit hereto. ANNUAL REPORT PAGE NO. Balance Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Statements of Operations. . . . . . . . . . . . . . . . . . . . . . . . . 7 Statements of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . . 8-9 Statements of Changes in Shareholders' Equity . . . . . . . . . . . . . .10 Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . 11-17 Report of Independent Accountants . . . . . . . . . . . . . . . . . . . .17 The following financial statements of Lincoln Park Place II, a Maryland Limited Partnership, as of and for the year ended October 31, 1993 are filed as part of this Report on Form 10-K. Such partnership owns and operates the property underlying the Fund's Sheffield investment. FORM 10-K PAGE NO. Independent Auditors' Report. . . . . . . . . . . . . . . . . . . . . . .25 Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Statement of Operations . . . . . . . . . . . . . . . . . . . . . . . . .27 Statement of Changes in Partners' Deficit . . . . . . . . . . . . . . . .28 Statement of Cash Flows 29 Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . 30-32 2. Financial Statement Schedules: ------------------------------ The financial statement schedules included in Part IV of this report should be read in conjunction with the Fund's financial statements incorporated by reference in Item 8 of this report. FORM 10-K SCHEDULE PAGE NO. I Marketable Securities - Other Investments . . . . . . . . . . .18 X Supplementary Income Statement Information. . . . . . . . . . .19 XI Real Estate and Accumulated Depreciation. . . . . . . . . . 20-21 XII Mortgage Loans on Real Estate . . . . . . . . . . . . . . . 22-23 Report of Independent Accountants . . . . . . . . . . . . . . .33 All other schedules have been omitted since the required information is presented in the financial statements, the related notes, or is not applicable. 3. Exhibits: --------- Exhibit No. Description ----------- ----------- 3.1 Amended and Restated Declaration of Trust, dated December 9, 1986, filed as exhibit 3 to the Fund's Registration Statement on Form S-11, SEC Registration #33-8649, and incorporated herein by reference. 3.2 Amendment #1 to Amended and Restated Declaration of Trust, dated January 10, 1987, filed as exhibit 3(b) to the Fund's Registration Statement on Form S-11, SEC Registration #33-15040, and incorporated herein by reference. 3.3 Amendment #2 to Amended and Restated Declaration of Trust, dated May 31, 1988, filed as exhibit 3 to the Fund's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988, and incorporated herein by reference. 3.4 By-laws, filed as exhibit 3 to the Fund's Registration Statement on Form S-11, SEC Registration #33-8649, and incorporated herein by reference. 10.1 Advisory Agreement between the Fund and Aldrich, Eastman & Waltch, Inc. dated December 23, 1986, filed as exhibit 10.1 to the Fund's Annual Report on Form 10- K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.2 Services Agreement between the Fund and The Vanguard Group, Inc. dated December 23, 1986, filed as exhibit 10.2 to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.3(a) Loan Agreement by and between Plaza Del Amo and Lawrence W. Doyle, J. Grant Monahon and Richard F. Burns, Trustees of AEW #82 Trust, established by Declaration of Trust dated August 14, 1987, dated September 16, 1987, filed as exhibit 10.3(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.3(b) Declaration of Trust, AEW #82 Trust and Schedule of Beneficial Interest dated August 14, 1987, filed as exhibit 10.3(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.3(c) All-Inclusive Promissory Note from Plaza Del Amo in favor of Lawrence W. Doyle, J. Grant Monahon and Richard F. Burns, Trustees of AEW #82, established by Declaration of Trust dated August 14, 1987, dated September 16, 1987, filed as exhibit 10.3(c) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 and incorporated herein by reference. 10.4(a) Purchase and Sale Agreement of Oakcreek Village Shopping Center, between Pacific Guaranty Retail Development Corporation and Michael O. Craig, Richard F. Burns and J. Grant Monahon as Trustees of AEW #96 Trust, under Declaration of Trust dated November 6, 1987, dated October 31, 1987, filed as exhibit 10.4(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.4(b) Declaration of Trust, AEW #96 Trust and Schedule of Beneficial Interest, dated November 6, 1987, filed as exhibit 10.4(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.4(c) First Amendment to Purchase and Sale Agreement of Oakcreek Village Shopping Center between Pacific Guaranty Retail Development Corporation and Michael O. Craig, Richard F. Burns and J. Grant Monahon as Trustees of AEW #96 Trust, under Declaration of Trust dated November 6, 1987, dated November 24, 1987, filed as exhibit 10.4(c) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.5(a) Purchase and Sale Agreement of Valley Industrial Park and Sea-Tac Industrial Park between Prudential Insurance Company of America and Joseph F. Azrack, Richard F. Burns and J. Grant Monahon as Trustees of AEW #105 Trust, under Declaration of Trust dated December 23, 1987, dated January 8, 1988, filed as exhibit 10.5(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.5(b) Declaration of Trust, AEW #105 Trust and Schedule of Beneficial Interest, dated December 23, 1987, filed as exhibit 10.5(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.6(a) Purchase and Sale Agreement of Vita-Fresh Vitamin Facility, dated January 10, 1988, between Vita- Fresh Vitamin Company, Inc. and Lawrence W. Doyle, Richard F. Burns and J. Grant Monahon as Trustees of AEW #113 Trust, under Declaration of Trust dated January 10, 1988, filed as exhibit 10.6(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.6(b) Declaration of Trust, AEW #113 Trust and Schedule of Beneficial Interest, dated January 19, 1988, filed as exhibit 10.6(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.7(a) Purchase and Sale Agreement of Everest I, Everest II, Fairview Industrial Building and Shoreview Professional Building between Everest Development ltd. and Michael O. Craig, Richard F. Burns and J. Grant Monahon as Trustees of AEW #106 Trust, under Declaration of Trust dated December 17, 1987, dated February 8, 1988, filed as exhibit 10.7(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.7(b) Declaration of Trust, AEW #106 Trust and Schedule of Beneficial Interest, dated December 17, 1987, filed as exhibit 10.7(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.8 All-Inclusive Promissory Note (Wraparound note) dated May 11, 1988, Escrow Agreement dated May 27, 1988 and Option Agreement dated May 11, 1988, all relating to the Fund's mortgage investment in the Carmel Executive Park, filed as exhibit 10 to the Fund's Quarterly Report on Form 10-Q Report for the quarter ended June 30, 1988, and incorporated herein by reference. 10.9(a) Purchase and Sale Agreement of Citadel II office building, between Crow Vista #1 and Aldrich, Eastman & Waltch, Inc., a Massachusetts Corporation acting as agent for the Fund, filed as exhibit 10(a) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, and incorporated herein by reference. 10.9(b) Citadel II Escrow Agreement, filed as exhibit 10(b) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, and incorporated herein by reference. 10.10(a) Loan Agreement for Sheffield Forest Apartments by and between Lincoln Park Place II Limited Partnership and J. Grant Monahon, Richard F. Burns and Marvin M. Franklin, Trustees of AEW #145 Trust, established by Declaration of Trust dated October 14, 1988, dated December 7, 1988, filed as exhibit 10.10(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and incorporated herein by reference. 10.10(b) Second Amended and Restated Promissory Note for Sheffield Forest Apartments from Lincoln Park Place II Limited Partnership in favor of J. Grant Monahon, Richard F. Burns and Marvin M. Franklin, Trustees of AEW #145 Trust, established by Declaration of Trust dated October 14, 1988, dated December 7, 1988, filed as exhibit 10.10(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988 and incorporated herein by reference. 10.10(c) Amended and Restated Deed of Trust for Sheffield Forest Apartments by and between Lincoln Park Place II Limited Partnership and J. Grant Monahon, Richard F. Burns and Marvin M. Franklin, Trustees of AEW #145 Trust, established by Declaration of Trust dated October 14, 1988, dated December 7, 1988, filed as exhibit 10.10(c) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and incorporated herein by reference. 10.10(d) Declaration of Trust, AEW #145 Trust and Schedule of Beneficial Interest dated October 14, 1988, filed as exhibit 10.10(d) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and incorporated herein by reference. 10.11(a) Promissory note of Citadel II by and between the Variable Annuity Life Insurance Company and J. Grant Monahon, Richard F. Burns, and Lee H. Sandwen, Trustees of AEW #131 Trust, established by Declaration of Trust dated June 7, 1988, dated October 9, 1990, filed as exhibit 10.1(a) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 10.11(b) Mortgage and Security Agreement of Citadel II by and between the Variable Annuity Life Insurance Company and J. Grant Monahon, Richard F. Burns, and Lee H. Sandwen, Trustees of AEW #131 Trust, established by Declaration of Trust dated June 7, 1988, dated October 9, 1990, filed as exhibit 10.1(b) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 10.11(c) Assignment of Lessor's Interest in Leases of Citadel II by and between the Variable Annuity Life Insurance Company and J. Grant Monahon, Richard F. Burns, and Lee H. Sandwen, Trustees of AEW #131 Trust, established by Declaration of Trust dated June 7, 1988, dated October 9, 1990, filed as exhibit 10.1(c) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 10.12 Standard Offer, Agreement and Escrow Instructions for Purchase of Real Estate by and between the Fujita Corporation USA, a California Corporation, and Richard F. Burns, J. Grant Monahon, Lawrence W. Doyle, Trustees of AEW #113 Trust, established by Declaration of Trust dated January 19, 1988, filed as exhibit 10.12 to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 and incorporated herein by reference. 10.13 Purchase and Sale Agreement of the Everest I ("Zycad") Building by and between Richard F Burns, J. Grant Monahon, and Bruce H. Freedman as Trustees of AEW #106, under Declaration of Trust dated December 17, 1987 and JLS and L.P., dated April 23, 1991, filed as exhibit 10.13 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991 and incorporated herein by reference. 10.14 Settlement Agreement and Mutual Release from mortgage by and among J. Grant Monahon, Richard F Burns and Lee. H. Sandwen, Trustees of AEW #155 Trust under Declaration of Trust dated January 11, 1989, Mark C. Dickinson, Dickinson Development Corp. and Citadel III Partners, Ltd., a Florida limited partnership, dated December 30, 1991, filed as exhibit 10.14 to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference. 10.15 First Amendment to Second Amended and Restated Promissory Note by and between Lincoln Park Place II Limited Partnership, a Maryland limited partnership and J. Grant Monahon, Richard F. Burns and Devin McCall, Trustees of AEW #145 Trust under Declaration of Trust dated October 14, 1988 dated April 30, 1992, filed as exhibit 10.15 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 10.16 Amendment No.1 to Loan Agreement by and between Lincoln Park Place II Limited Partnership, a Maryland limited partnership and J. Grant Monahon, Richard F. Burns and Kevin McCall, Trustees of AEW #145 Trust under Declaration of Trust dated October 14, 1988, dated April 30. 1992, filed as exhibit 10.16 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 10.17 Amendment No.1 to All-Inclusive Promissory Note by and between Piazzagalli Development Company, a Vermont General Partnership and J. Grant Monahon, Richard F. Burns and Lee H. Andwen, Trustees of AEW #127 Trust, under Declaration of Trust dated May 3, 1988, dated December 23, 1991 for purposes of reference, filed as exhibit 10.17 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 10.18 Amendment No.1 to Loan Agreement by and between Piazzagalli Development Company, a Vermont General Partnerhip and J. Grant Monahon, Richard F. Burns and Lee H. Sandwen, Trustees of AEW #127 Trust, under Declaration of Trust dated May 3, 1988, dated December 23, 199 for purposes of reference, filed as exhibit 10.18 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 13 1993 Annual Report to Shareholders. (With the exception of the information and data incorporated by reference in Items 6, 7, and 8 of this Annual Report on Form 10-K, no other information or data appearing in the 1993 Annual Report to Shareholders is to be deemed filed as part of this report.) (b) Reports on Form 8-K The Fund has filed no reports on Form 8-K during the fourth quarter ended December 31, 1993. SCHEDULE I VANGUARD REAL ESTATE FUND I, A SALES-COMMISSION-FREE INCOME PROPERTIES FUND MARKETABLE SECURITIES - OTHER INVESTMENTS December 31, 1993 Number of Shares or Units -- Cost and Name of Issuer and Principal Amount of Market Value Title of Issue Bonds and Notes (000) - ------------------ ------------------------- ------------ Vanguard Money Market Reserves: Prime Portfolio $2,482,738 $2,483 ------ TOTAL $2,483 ====== Temporary Cash Investments: Certificates of Deposit Commerz Bank $2,000,007 $2,000 3.35% 1/4/94 Canadian Imperial Bank 2,000,000 2,000 of Commerce 3.25% 1/5/94 Westdeutsch Landes Bank 2,000,000 2,000 3.18% 1/6/94 ------ TOTAL $6,000 ====== SCHEDULE X VANGUARD REAL ESTATE FUND I A SALES-COMMISSION-FREE INCOME PROPERTIES FUND SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, ------------------------------------------------- 1993 1992 1991 (000) (000) (000) ----- ----- ----- 1. Maintenance and repairs $ 275 $ 374 $ 448 2. Depreciation and amortization 1,503 1,610 1,519 3. Real estate taxes 823 887 897 Schedule XI VANGUARD REAL ESTATE FUND I, A SALES-COMMISSION-FREE INCOME PROPERTIES FUND REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 (000) Property Description -------------------- Seattle Oakcreek Industrial Minnesota Village, Parks, Two Portfolio, Shopping Industrial Three Office Center, Parks, Buildings, Durham, NC Seattle, WA Roseville, MN TOTALS ------------ ------------ ------------- ------- Encumbrances None None None Initial Cost to Fund Land $ 3,100 $ 8,250 $ 1,725 $13,075 Building and Improvements $ 7,492 $14,066 $10,043 $31,601 Total $10,592 $22,316 $11,768(d) $44,676 Cost capitalized subsequent to acquisition Improvements $ 606 $ 778 $ 341 $ 1,725 Gross amount at which carried at close of period (a) Land $ 3,100 $ 8,250 $ 1,440 $12,790 Building and Improvements $ 8,098 $14,844 $ 8,490 $31,432 Total (b) $11,198 $23,094 $ 9,930 $44,222 Accumulated Depreciation (c) $ 1,304 $ 2,232 $ 1,253 $ 4,789 Date of 1967 and 1978 and Construction 1986 1979 1986 Date Acquired 11/87 1/88 2/88 Depreciable Life 40 years 40 years 40 years PAGE SCHEDULE XI (Continued) (d) Zycad Building sold in 1991 with a land and building cost of $1,894,000. Schedule XII VANGUARD REAL ESTATE FUND I, A SALES-COMMISSION-FREE INCOME PROPERTIES FUND MORTGAGE LOANS ON REAL ESTATE (e) DECEMBER 31, 1993 Wraparound Mortgages Senior Mortgage -------------------- --------------- Plaza del Amo Sheffield Forest Shopping Center, Apartments, Torrance, CA (a) Silver Spring, MD (b) -------------------- --------------------- Effective Rate 10.3% 9.3% Pay Rate 9.7%-10.8% 8.5%-9% Maturity Date 1997 1998 Call Date 1994 1995 Periodic Interest only, Interest only, Payment principal due principal due Terms upon maturity upon maturity or call date. or call date. Prior Liens (a) None Face Amount of Totals Mortgages ------- (000) $10,646 $17,992 $28,638 Carrying Amount of Mortgages (000) (c)(d) $10,646 $17,192 $27,838 Principal Amount of Loans Subject to Delinquent Principal or Interest None None (a) The Fund advanced $7,750,000 to enter into a shared-appreciation, wraparound, mortgage loan secured by the Plaza del Amo Shopping Center ("Plaza"). In addition, Plaza secures two existing senior mortgage loans, which at the time of investment had an aggregate outstanding balance of $2,896,000. The funds advanced plus these two existing senior mortgages resulted in a total wraparound loan of $10,646,000. Upon repayment of the loan, the Fund is entitled to a share of Plaza's appreciation, if any, equal to 50% of Plaza's fair market value in excess of the original balance of the wraparound loan. Schedule XII (Continued) Deloitte & Touche - ---------- - ------------------------------------------------------------------------- LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP ------------------------------ Financial Statements for the Year Eanded October 31, 1993, and Independent Auditors' Report - ------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT General Partners of Lincoln Park Place II, A Maryland Limited Partnership We have audited the accompanying balance sheet of Lincoln Park Place II, A Maryland Limited Partnership (the Partnership) as of October 31, 1993, and the related statements of operations, changes in partners' deficit and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Partnership as of October 31, 1993, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 5 to the financial statements, conditions exist which raise substantial doubt about the ability of the Partnership to continue as a going concern. Management's plans in regard to these matters are also described in Note 5. The financial statements do not include any adjustment that might result from the outcome of this uncertainty. Deloitte & Touche Dallas, Texas 75201-6778 November 20, 1993 LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP BALANCE SHEET OCTOBER 31, 1993 ASSETS INVESTMENT IN REAL ESTATE, AT COST: Land $ 2,600,376 Buildings and improvements 10,796,809 Less accumulated depreciation (2,782,304) ------------- 10,614,881 DUE FROM AFFILIATE 1,788,684 DEFERRED FINANCING COSTS, NET OF ACCUMULATED AMORTIZATION OF $97,299 142,345 CASH 97,439 ESCROW DEPOSITS 26,436 OTHER ASSETS 167,035 ----------- TOTAL $ 12,836,820 ============= LIABILITIES AND PARTNERS' DEFICIT MORTGAGE PAYABLE $ 18,620,029 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES 303,079 TENANT SECURITY DEPOSITS 75,629 Total liabilities 18,998,737 PARTNERS' DEFICIT (6,161,917) ------------- TOTAL $ 12,836,820 ============= See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP - ----------------------------------------------------- STATEMENT OF OPERATIONS YEAR ENDED OCTOBER 31, 1993 - --------------------------------------------------------------------------- REVENUES: Rental $ 1,982,340 Other 33,795 --------- 2,016,135 EXPENSES: Interest 1,668,949 Depreciation and amortization 447,027 Operating 589,773 Real estate taxes 225,065 --------- 2,930,814 --------- NET LOSS $ (914,679) ========= See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP STATEMENT OF CHANGES IN PARTNERS' DEFICIT YEAR ENDED OCTOBER 31, 1993 Managing General Partner,Limited Partner, Lincoln PropertyAmerican Financial Company No. 1288 Realty, Inc. Total PARTNERS' DEFICIT, NOVEMBER 1, 1992 $(5,247,738) $500 $(5,247,238) Net loss (914,679) (914,679) ----------- ----- ----------- PARTNERS' DEFICIT, OCTOBER 31, 1993 $(6,162,417) $500 $(6,161,917) =========== ==== =========== See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP STATEMENT OF CASH FLOWS YEAR ENDED OCTOBER 31, 1993 CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(914,679) Depreciation and amortization 447,027 Changes in assets and liabilities: Decrease in deposits 1,898 Decrease in other assets 7,721 Increase in accounts payable 117,064 Increase in tenant security deposits 11,938 -------- Net cash used in operating activities (329,031) CASH FLOWS FROM INVESTING ACTIVITIES: Additions to buildings and improvements (24,129) CASH FLOWS FROM FINANCING ACTIVITIES: Decrease in due from affiliate 227,614 Increase in mortgage payable 141,450 Decrease in deferred financing costs 384 --------- Net cash provided by financing activities 369,448 --------- NET INCREASE IN CASH 16,288 CASH, BEGINNING OF YEAR 81,151 --------- CASH, END OF YEAR $ 97,439 ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $1,530,388 ========== See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP - ----------------------------------------------------- NOTES TO FINANCIAL STATEMENTS YEAR ENDED OCTOBER 31, 1993 - --------------------------------------------------------------------------- 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Organization - Lincoln Park Place II, A Maryland Limited Partnership (the Partnership) was formed December 1, 1985, for the purpose of owning, developing and operating a 256-unit garden apartment project in Montgomery County, Maryland. Lincoln Property Company No. 1288, A Maryland Limited Partnership is the managing general partner, and American Financial Realty, Inc. (AFR) is the limited partner. The project was started in November 1986 and completed in December 1987 and had an occupancy rate of 97% at October 31, 1993. Basis of Accounting - The accounts of the Partnership are maintained on the basis of accounting used for federal income tax reporting purposes. Memorandum entries have been made to present the accompanying financial statements in accordance with generally accepted accounting principles. Depreciation and Amortization - Buildings and improvements are stated at cost and are depreciated or amortized using the straight-line method over useful lives ranging from 5 to 30 years. Deferred Financing Costs - Financing costs incurred in connection with obtaining and closing the mortgage payable have been capitalized and are being amortized over the term of the note. Other Assets - Other assets consist primarily of prepaid real estate taxes and insurance and deferred expenses. Federal Income Taxes - The financial statements include only those assets, liabilities and results of operations which relate to the business of the Partnership. The financial statements do not include any assets, liabilities, revenues or expenses attributable to the partners' individual activities. No federal or state income taxes are payable by the Partnership, and none have been provided in the accompanying financial statements. The partners are to include their respective share of partnership profits or losses in their individual tax returns. Net income or loss determined under generally accepted accounting principles is allocated among the partners based upon provisions in the partnership agreement even though actual partnership allocations are made on an income tax basis. Consequently, the amounts so allocated will not agree to the allocations on the income tax returns. 2. TRANSACTIONS WITH AFFILIATES Certain of the Partnership's expenses and other disbursements are paid from a central operating account of a general partnership affiliated with the managing general partner in the normal course of business. The Partnership reimburses the affiliate on a regular basis for disbursements made on its behalf. All disbursements are identified by partnership, and the disbursements and reimbursements are accounted for by the Partnership as due to or from the affiliate. The Partnership has entered into an agreement with Lincoln Property Company N.C., Inc., an affiliate of the managing general partner, which provides for management of the property. For its services, Lincoln Property Company N.C., Inc. is entitled to receive a fee of 5% of monthly rents, as defined, amounting to $101,804 for the fiscal year. 3. MORTGAGE PAYABLE The permanent financing was obtained from Aldrich, Eastman & Waltch #145 Trust in the amount of $18,000,000, evidenced by the second amended and restated promissory note. The note accrues interest at the base rate of 9.0% and requires monthly payments in arrears at the current pay rate of 8.5%. The pay rate increases 0.5% on December 7, 1993, and remains at the rate of 9.0% thereafter. Accrued but unpaid interest is added to the outstanding principal balance monthly and bears interest at the base rate of 9.0%. Participation interest based on adjusted gross revenue, as defined, may become due and payable quarterly (no participation interest was paid during the fiscal year ended October 31, 1993). Upon the occurrence of certain events, appreciation interest, as defined, becomes due. The note matures December 7, 1998, at which time all principal and deferred interest become due. The note may be prepaid after December 7, 1995, and the lender has the right to call the note, making it fully due and payable any time following December 7, 1994, provided six months' notice of such intention is given. The land, building and improvements serve as collateral for the note which is nonrecourse to the partners of the Partnership. However, certain partners of the managing general partner have guaranteed the payment of this indebtedness under certain conditions in an amount not to exceed $2,000,000. The note payable has an outstanding balance of $18,000,000 and deferred interest of $620,029 at October 31, 1993. 4. PARTNERS' DEFICIT Capital Contributions - In accordance with the partnership agreement, no additional contributions are required from partners to provide funds for the Partnership. Allocation of Profits and Losses - The net profits, net gains and net losses from operations of the Partnership and capital transactions shall be allocated 100% to the managing general partner, and the limited partner shall have no interest in such net profits, gains or losses. 5. CASH DEFICITS During the year ended October 31, 1993, the Partnership incurred cash deficits from operations. Management anticipates that the Partnership will continue to incur cash deficits from operations. There can be no assurance that the Partnership will be able to obtain loans to fund such deficits. Management intends to continue operating the Partnership in its present form while investigating options to improve operations of the Partnership. However, there is no assurance management will be successful in its efforts. This uncertainty raises substantial doubt about the Partnership's ability to continue as a going concern. * * * * * * REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Trustees of Vanguard Real Estate Fund I, A Sales-Commission-Free Income Properties Fund Our audits of the financial statements referred to in our report dated January 27, 1994 appearing on page 17 of the 1993 Annual Report to Shareholders of Vanguard Real Estate Fund I, A Sales-Commission-Free Income Properties Fund, (which report and financial statements are incorporated by reference in this Annual Report on Form 10-K) also included audits of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. PRICE WATERHOUSE Philadelphia, Pennsylvania January 27, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. VANGUARD REAL ESTATE FUND I, A Sales-Commission-Free Income Properties Fund 3/30/94 /s/ John J. Brennan _________________ _________________________________ DATE John J. Brennan President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities on the dates indicated. 3/30/94 /s/ J. Mahlon Buck, Jr. _________________ _________________________________ DATE J. Mahlon Buck, Jr. Trustee 3/30/94 /s/ William S. Cashel, Jr. _________________ _________________________________ DATE William S. Cashel, Jr. Trustee 3/30/94 /s/ David C. Melnicoff _________________ _________________________________ DATE David C. Melnicoff Trustee 3/30/94 /s/ J. Lawrence Wilson _________________ _________________________________ DATE J. Lawrence Wilson Trustee 3/30/94 /s/ Ralph K. Packard _________________ _________________________________ DATE Ralph K. Packard Vice President & Controller EXHIBIT INDEX EXHIBIT NO. DESCRIPTION PAGE NO. 13 1993 Annual Report to Shareholders . . . . . . . . . . . .36

105839_1993.txt

105839

1993

ITEM 1. BUSINESS Allegheny Power System, Inc. (APS), incorporated in Maryland in 1925, is an electric utility holding company that derives substantially all of its income from the electric utility operations of its direct and indirect subsidiaries (Subsidiaries), Monongahela Power Company (Monongahela), The Potomac Edison Company (Potomac Edison), West Penn Power Company (West Penn), and Allegheny Generating Company (AGC). The properties of the Subsidiaries are located in Maryland, Ohio, Pennsylvania, Virginia, and West Virginia, are interconnected, and are operated as a single integrated electric utility system (System), which is interconnected with all neighboring utility systems. The three electric utility operating Subsidiaries are Monongahela, Potomac Edison, and West Penn (Operating Subsidiaries). Monongahela, incorporated in Ohio in 1924, operates in northern West Virginia and an adjacent portion of Ohio. It also owns generating capacity in Pennsylvania. Monongahela serves about 340,700 customers in a service area of about 11,900 square miles with a population of about 710,000. The seven largest communities served have populations ranging from 10,900 to 33,900. On December 31, 1993, Monongahela had 1,962 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, glass sand, natural gas, rock salt, and other natural resources. Its service area's principal industries produce coal, chemicals, iron and steel, fabricated products, wood products, and glass. There are two municipal electric distribution systems and two rural electric cooperative associations in its service area. Except for one of the cooperatives, they purchase all of their power from Monongahela. Potomac Edison, incorporated in Maryland in 1923 and in Virginia in 1974, operates in portions of Maryland, Virginia, and West Virginia. It also owns generating capacity in Pennsylvania. Potomac Edison serves about 354,300 customers in a service area of about 7,300 square miles with a population of about 782,000. The six largest communities served have populations ranging from 11,900 to 40,100. On December 31, 1993, Potomac Edison had 1,152 employees. Its service area is generally rural. Its service area's principal industries produce aluminum, cement, fabricated products, rubber products, sand, stone, and gravel. There are four municipal electric distribution systems in its service area, all of which purchase power from Potomac Edison, and six rural electric cooperatives, one of which purchases power from Potomac Edison. There are also several large federal government installations served by Potomac Edison. - 2 - West Penn, incorporated in Pennsylvania in 1916, operates in southwestern and north and south central Pennsylvania. It also owns generating capacity in West Virginia. West Penn serves about 646,700 customers in a service area of about 9,900 square miles with a population of about 1,399,000. The 10 largest communities served have populations ranging from 11,200 to 38,900. On December 31, 1993, West Penn had 2,043 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, limestone, and other natural resources. Its service area's principal industries produce steel, coal, fabricated products, and glass. There are two municipal electric distribution systems in its service area, which purchase their power requirements from West Penn, and five rural electric cooperative associations, located partly within the area, which purchase virtually all of their power through a pool supplied by West Penn and other nonaffiliated utilities. AGC, organized in 1981 under the laws of Virginia, is jointly owned by the Operating Subsidiaries as follows: Monongahela, 27%; Potomac Edison, 28%; and West Penn, 45%. AGC has no employees, and its only operating assets are a 40% undivided interest in the Bath County (Virginia) pumped- storage hydroelectric station, which was placed in commercial operation in December 1985, and its connecting transmission facilities. AGC's 840-megawatt (MW) share of capacity of the station is sold to its three parents. The remaining 60% interest in the Bath County Station is owned by Virginia Electric and Power Company (Virginia Power). APS has no employees. Its officers are employed by Allegheny Power Service Corporation (APSC), a wholly-owned subsidiary of APS. On December 31, 1993, the Subsidiaries and APSC had 6,025 employees. The Subsidiaries in the past have experienced and in the future may experience some of the more significant problems common to electric utilities in general. These include increases in operating and other expenses, difficulties in obtaining adequate and timely rate relief, restrictions on construction and operation of facilities due to regulatory requirements and environmental and health considerations, including the requirements of the Clean Air Act Amendments of 1990 (CAAA), which among other things, require a substantial annual reduction in utility emissions of sulfur dioxides and nitrogen oxides. Additional concerns include proposals to restructure and, to some extent, deregulate portions of the industry and increase competition, particularly as a result of the National Energy Policy Act of 1992 (EPACT). EPACT may increase competition by allowing the formation of Exempt Wholesale Generators (EWGs), with the approval of the FERC, and providing mandatory access to the interconnected electric grid for wholesale transactions. It further provides for expansion of the grid where constraints are determined to exist - at the expense of the requestor of such transmission service and provided necessary authority to construct such facilities can be obtained. EPACT permits utility generation facilities to qualify as EWGs and allows sales to nonaffiliated and to affiliated utilities provided state commissions approve such transactions. (See ITEM 1. SALES, ELECTRIC FACILITIES and REGULATION for a further discussion of the impact of EPACT.) - 3 - In an effort to meet the challenges of the new competitive environment in the industry, APS is considering forming a new nonutility subsidiary, subject to regulatory approval, to pursue new business opportunities which have a meaningful relationship to the core utility business. APS would also consider establishing or acquiring its own EWGs, if that is feasible, particularly in view of the possible constraints imposed by regulations under the Public Utility Holding Company Act of 1935 (PUHCA) on nonexempt public utility holding companies such as APS and its Subsidiaries. Further concerns of the industry include possible restrictions on carbon dioxide emissions, uncertainties in demand due to economic conditions, energy conservation, market competition, weather, and interruptions in fuel supply because of weather and strikes. (See ITEM 1. CONSTRUCTION AND FINANCING, RATE MATTERS, and ENVIRONMENTAL MATTERS for information concerning the effect on the Subsidiaries of the CAAA.) SALES In 1993, consolidated kilowatthour (kWh) sales to the Operating Subsidiaries' retail customers increased 3.3% from those of 1992, as a result of increases of 6.5%, 5.2% and 0.3% in residential, commercial and industrial sales, respectively. The increased Kwh sales in 1993 reflect both growth in number of customers and higher use. Consolidated revenues from residential, commercial, and industrial sales increased 11.4%, 9.8%, and 5.6%, respectively, primarily because of several rate increases effective in 1993 as described in ITEM 1. RATE MATTERS, increases in fuel and energy cost adjustment clause revenues, and increased kWh sales. Consolidated kWh sales to and revenues from nonaffiliated utilities decreased 30.2% and 25.5%, respectively, due to increased native load, decreased demand, and price competition. The System's all-time peak load of 7,153 MW occurred on January 18, 1994. The peak loads in 1993 and 1992 were 6,678 MW and 6,530 MW, respectively. The increased 1994 peak was due in part to record cold temperatures throughout the Operating Subsidiaries' service areas and would have been higher except for voluntary curtailments. The average System load (Yearly Net Power Supply divided by number of hours in the year) was 4,674 megawatthours (MWh) and 4,526 MWh in 1993 and 1992, respectively. More information concerning sales may be found in the statistical sections and ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Consolidated electric operating revenues for 1993 were derived as follows: Pennsylvania, 44.8%; West Virginia, 28.4%; Maryland, 20.2%; Virginia, 5.0%; Ohio, 1.6% (residential, 35.1%; commercial, 18.4%; industrial, 28.9%; nonaffiliated utilities, 14.9%; and other, 2.7%). The following percentages of such revenues were derived from these industries: iron and steel, 6.0%; chemicals, 3.3%; fabricated products, 3.3%; aluminum and other nonferrous metals, 3.2%; coal mines, 3.1%; cement, 1.8%; and all other industries, 8.2%. The coal mine percentage decreased in 1993 principally due to the coal strike. More information concerning the coal strike may be found in ITEM 1. FUEL SUPPLY. Revenues from each of 16 industrial customers exceeded $5 million, including one coal customer of both Monongahela and West Penn with total revenues exceeding $15 million, three steel customers with revenues exceeding $26 million each, and one aluminum customer with revenues exceeding $63 million. - 4 - During 1993, Monongahela's kWh sales to retail customers increased 0.3% as a result of increases of 6.4% and 4.7% in residential and commercial sales, respectively, and a decrease of 4.4% in industrial sales, primarily due to the coal strike and lower sales to one iron and steel customer because of increased use of its own generation. Revenues from such customers increased 9.2%, 7.8% and 0.7%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 7.8%. Monongahela's all- time peak load of 1,667 MW occurred on December 21, 1989. (For a discussion of the coal strike, See ITEM 1. FUEL SUPPLY.) Monongahela's electric operating revenues were derived as follows: West Virginia, 94.0% and Ohio, 6.0% (residential, 28.8%; commercial, 17.3%; industrial, 29.2%; nonaffiliated utilities, 13.4 %; and other, 11.3%). Revenues from each of five industrial customers exceeded $8 million, including one coal customer with revenues exceeding $13 million and one steel customer with revenues exceeding $26 million. The decreases in the revenues of these customers from 1992 levels were primarily due to the coal strike. During 1993, Potomac Edison's kWh sales to retail customers increased 6.3% as a result of increases of 8.4%, 7.1%, and 4.3% in residential, commercial, and industrial sales, respectively. Revenues from such customers increased 12.7%, 11.8%, and 11.8%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 23.1%. Potomac Edison's all-time peak load of 2,595 MW occurred on January 19, 1994. Potomac Edison's electric operating revenues were derived as follows: Maryland, 66.6%; West Virginia, 16.8%; and Virginia 16.6% (residential, 38.5%; commercial, 17.5%; industrial, 24.7%; nonaffiliated utilities, 15.2%; and other, 4.1%). Revenues from one industrial customer, the Eastalco aluminum reduction plant near Frederick, Maryland, amounted to $63.4 million (8.9% of total electric operating revenues). Minimum annual charges to Eastalco under an electric service agreement which continues through March 31, 2000, with automatic extensions thereafter unless terminated on notice by either party, were $19.3 million in 1993. Said agreement may be canceled before the year 2000 upon 90 days notice of a governmental decision resulting in a material modification of the agreement. During 1993, West Penn's kWh sales to retail customers increased 3.1% as a result of increases of 5.2%, 4.4% and 0.8% in residential, commercial, and industrial sales, respectively. Revenues from residential, commercial, and industrial customers increased 11.5%, 9.6%, and 5.4%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 24.3%. West Penn's all- time peak load of 3,068 MW occurred on January 18, 1994. - 5 - West Penn's electric operating revenues were derived as follows: Pennsylvania, 100% (residential, 33.1%; commercial, 18.0%; industrial, 28.5%; nonaffiliated utilities, 14.1%; and other, 6.3%). Revenues from each of three steel customers exceeded $10 million, including two with revenues exceeding $31 million each. On average, the Operating Subsidiaries are the lowest or among the lowest cost producers of electricity in their regions and therefore the Operating Subsidiaries' delivered power prices should compete favorably with those of potential alternate suppliers who use cost-based pricing. However, the Operating Subsidiaries are experiencing cost increases due to compliance with the CAAA and purchases from Public Utility Regulatory Policies Act of 1978 (PURPA) projects. (See page 7 for a discussion of PURPA projects, and ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings concerning PURPA capacity.) In 1993, the Operating Subsidiaries provided approximately 13.3 billion kWh of energy to nonaffiliated utility companies, of which 1.5 billion kWh were generated by the Subsidiaries and the rest were transmitted from electric systems located primarily to the west. These sales included a long-term transaction under which the Operating Subsidiaries purchased 450 MW of firm capacity and its associated energy from Ohio Edison Company for resale to Potomac Electric Power Company, both nonaffiliated utilities. The transaction began in mid-1987 and will continue through 2005, unless terminated earlier. Sales to nonaffiliated utility companies vary with the needs of those companies for imported power; the availability of System generating facilities, fuel, and regional transmission facilities; and the availability and price of competitive sources of power. System sales decreased in 1993 relative to 1992 primarily because of continued decreased demand, increased Operating Subsidiaries' native load, coal conservation because of the coal strike, and increased willingness of other suppliers to make sales at lower prices. Further decreases in kWh sales to nonaffiliated utilities are expected in 1994 and beyond. Substantially all of the revenues from kWh sales to nonaffiliated utilities are passed on to retail customers and as a result have little effect on net income. The Operating Subsidiaries reactivated a peak diversity exchange arrangement with Virginia Power effective June 1993 which continues indefinitely. The Operating Subsidiaries will annually supply Virginia Power with 200 MW during each June, July, and August, in return for which Virginia Power will supply the Operating Subsidiaries with 200 MW during each December, January, and February, at least through February 1997. Thereafter, specific amounts of annual diversity exchanges beyond those currently established are to be mutually determined no less than 34 months prior to each year for which an exchange is to take place. The total number of MWh to be delivered by each to the other over the term of the arrangement is expected to be equal. - 6 - The Operating Subsidiaries and Duquesne Light Company (Duquesne Light) in 1991 entered into an exchange arrangement under which the Operating Subsidiaries will supply Duquesne Light with up to 200 MW for a specified number of weeks, generally during each March, April, May, September, October, and November. In return, Duquesne Light will supply the Operating Subsidiaries with up to 100 MW, generally during each December, January, and February. The total number of MWh delivered by each utility to the other over the term of the arrangement is expected to be the same. West Penn supplies power to the Borough of Tarentum (Tarentum) using in part leased distribution facilities from Tarentum under a 30 year lease agreement terminating in 1996. In June 1993, Tarentum, which in that year had a load of 6.5 MW and revenues of $1.8 million, notified West Penn of its intention to exercise its option to end the lease agreement. The termination of the lease agreement and resulting transfer and sale of electric facilities will result in Tarentum becoming a municipal customer which will purchase electricity on a wholesale basis from West Penn or another supplier. The sale of electric facilities will require Pennsylvania Public Utility Commission approval. The System provides wholesale transmission services to applicants under its Federal Energy Regulatory Commission (FERC) approved Standard Transmission Service tariff. The tariff provides that such service is subordinate in priority to native load and reliability requirements of interconnected systems to avoid adverse effects on regional reliability in general and on the reliability of the Operating Subsidiaries' service to their retail and full- requirements wholesale customers in particular. (See ITEM 1. ELECTRIC FACILITIES for a discussion of stress on the System's transmission system.) Transmission services requiring special arrangements or long-term commitments have been and continue to be negotiated through mutually acceptable bilateral agreements. Substantially all of the revenues from transmission service sales are passed on to retail customers and as a result have little effect on net income. EPACT permits wholesale generators, utility-owned and otherwise, and wholesale consumers to request from System and other owners of bulk power transmission facilities a commitment to supply transmission services. Generators include nonaffiliated utilities and nonutility generators (NUG) of electricity (including classifications of generators known as Independent Power Producers (IPP) and EWGs). Consumers of wholesale power include qualifying nonaffiliated utilities or groups of utilities including the many small electric systems owned by municipalities and rural electric cooperative associations in the service areas of the Operating Subsidiaries. Many of these small systems currently purchase substantially all of their power from the Operating Subsidiaries. Under EPACT, these small systems may now seek an order from the FERC to force the Operating Subsidiaries to wheel power over the System to them from sources outside the System service area. All of the small electric wholesale customers in the Operating Subsidiaries' service areas which might avail themselves of this opportunity produced $42 million of total revenues in 1993. - 7 - Under PURPA, certain municipalities and private developers have installed, are installing or are proposing to install hydroelectric and other generating facilities at various locations in or near the Operating Subsidiaries' service areas with the intent of selling some or all of the electric capacity and energy to the Operating Subsidiaries at rates provided under PURPA and approved by appropriate state commissions. The System's total generation capacity includes 292 MW of on-line PURPA capacity. Payments for PURPA capacity and energy in 1993 totaled approximately $105 million at an average cost to the System of 5.04 cents per kWh. The System projects an additional 180 MW of PURPA capacity to come on-line in future years. In addition, lapsed purchase agreements totaling 203 MW and other PURPA complaints totaling 520 MW (none of which are included in the System's integrated resource plan as of August 20, 1993), are the subject of pending litigation. (See ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings in Pennsylvania, Maryland, and West Virginia affecting PURPA capacity.) In the future, ratings of the Operating Subsidiaries' first mortgage bonds and preferred stock may be affected by increased concern of rating agencies that purchased power contracts are a risk factor deserving consideration in assessing the credit- worthiness of electric utilities. ELECTRIC FACILITIES The following table shows the System's December 31, 1993, generating capacity, based on the maximum monthly normal seasonal operating capacity of each unit. The System-owned capacity totaled 7,991 MW, of which 7,089 MW (88.7%) are coal-fired, 840 MW (10.5%) are pumped-storage, and 62 MW (0.8%) are hydroelectric. The term "pumped-storage" refers to the Bath County station which stores energy for use principally during peak load hours by pumping water from a lower to an upper reservoir, using the most economic available electricity, generally during off-peak hours. During the generating cycle, power is produced by water falling from the upper to the lower reservoir through turbine generators. The average age of the System-owned coal-fired stations shown below, based on generating capacity at December 31, 1993, was about 23.6 years. In 1993, their average heat rate was 10,020 Btu's/kWh, and their availability factor was 87.0%. - 8 - - 9 - (a) Excludes 361 MW of West Penn oil-fired capacity, which was placed on cold reserve status as of June 1, 1983. Current plans call for the reactivation of these units within the next five years. (b) Where more than one year is listed as a commencement date for a particular source, the dates refer to the years in which operations commenced for the different units at that source. (c) The installation of flue-gas desulfurization equipment (See ITEM 1. ENVIRONMENTAL MATTERS) is expected to reduce the net generating capacity of each unit by about 3%. (d) Capacity entitlement through percentage ownership of AGC. (e) The FERC issued an annual license to West Penn for Lake Lynn for 1994. A relicensing application has been filed with the FERC for Lake Lynn and a license with a 30 to 50 year term is expected to be issued in late 1994. Potomac Edison's license for hydroelectric facilities, Dam #4 and Dam #5 will expire in 2003. Potomac Edison has received 30 year licenses, effective January 1994, for the Shenandoah, Warren, Luray and Newport projects. (f) Nonutility generating capacity available through contractual arrangements pursuant to PURPA. - 10 - SYSTEM MAP The Allegheny Power System Map (System Map), which has been omitted, provides a broad illustration of the names and approximate locations of the System's major generation and transmission facilities, both existing and under construction, in a five state region which includes portions of Pennsylvania, Ohio, West Virginia, Maryland and Virginia. Additionally, Extra High Voltage substations are displayed. By use of shading, the System Map also provides a general representation of the service areas of Monongahela (portions of West Virginia and Ohio), Potomac Edison (portions of Maryland, Virginia and West Virginia), and West Penn (portions of Pennsylvania). Power Stations shown on the System Map which appear within the Monongahela service area are Willow Island, Pleasants, Harrison, Rivesville, Albright, and Fort Martin. The single Power Station appearing within the Potomac Edison service area is R. Paul Smith. The Bath County Power Station appears on the map just south of the westernmost portion of Potomac Edison's service area formed by the borders of Virginia and West Virginia. Power Stations appearing within the West Penn service area are Armstrong, Mitchell, Hatfield's Ferry, Springdale and Lake Lynn. The System Map also depicts transmission facilities which are (i) owned solely by the Operating Subsidiaries; (ii) owned by the Operating Subsidiaries in conjunction with other utilities; or (iii) owned solely by other utilities. The transmission facilities portrayed range in capacity from 138kV to 765kV. Additionally, interconnections with other utilities are displayed. - 11 - The following table sets forth the existing miles of tower and pole transmission and distribution lines and the number of substations of the Subsidiaries as of December 31, 1993: (a) The System has a total of 5,203 miles of underground distribution lines. (b) The substations have an aggregate transformer capacity of 37,512,771 kilovoltamperes. (c) Total Bath County transmission lines, of which AGC owns an undivided 40% interest and Virginia Power owns the remainder. The System has 11 extra-high-voltage (345 kV and above) (EHV) and 29 lower-voltage interconnections with neighboring utility systems. The interregional EHV transmission system, including System facilities, continues to experience periods of heavy loading in a west-to-east direction. Increases in customer load, power transfers by the Subsidiaries and by nonaffiliated entities, and parallel flows caused by transactions to which the Operating Subsidiaries are not a party, all contribute to the heavy west-to-east power flows. In late 1992 and early 1993, a substantial amount of reactive power sources (shunt capacitors) were added to neighboring eastern utilities' EHV systems. These capacitors complement the capacitors added in 1991 and 1992 on the System and together they serve to increase transfer capability by improving voltage on the transmission system during heavy loading periods. While the additional capacitors installed by the Subsidiaries' eastern neighbors have enhanced transfer capability, the interregional transmission facilities are still expected periodically to operate up to their reliability limits; therefore, restrictions on transfers may still be necessary at times as was the case in recent years. Under certain provisions of EPACT, wholesale generators, utility-owned or otherwise, may seek from System and other owners of bulk power transmission facilities a commitment to supply power transmission services, so long as the FERC finds reliability and native load and existing contractual customers are not adversely affected (See discussion under ITEM 1. SALES and REGULATION). Such demand on the System for transmission service may add periodically to heavy power flows on the System's facilities. - 12 - The Operating Subsidiaries have, to date, provided managed contractual access to the System's transmission facilities via the provisions of their Standard Transmission Service tariff, or the terms and conditions of bilateral contracts with purchasers of transmission service. As a result of EPACT, the FERC is investigating the continued desirability of traditional methods of pricing and providing transmission service. The FERC may choose to maintain existing methods, implement new methodologies which the Operating Subsidiaries and their ratepayers may or may not find to be beneficial, or a combination thereof. The Operating Subsidiaries are participating fully in the FERC proceedings with the principal intent of safeguarding the reliability of the System's transmission facilities, and the rights and interests of its native load customers. The outcome of those deliberations cannot be predicted. RESEARCH AND DEVELOPMENT The Operating Subsidiaries spent $4.6 million, $2.7 million, and $2.8 million in 1993, 1992, and 1991, respectively, for research programs. Of these amounts, $3.2 million and $0.6 million were for Electric Power Research Institute (EPRI) dues in 1993 and 1992, respectively. The Operating Subsidiaries plan to spend approximately $7.5 million for research in 1994, with EPRI dues representing $5.9 million of that total. The Operating Subsidiaries joined EPRI, an industry- sponsored research and development institution, effective October 1, 1992, contingent upon the approval by state commissions of recovery of the dues in rates, which approval was subsequently received in all jurisdictions except Ohio and West Virginia, where the matter is pending. Ongoing participation in EPRI depends upon continued approval by state commissions of recovery of dues in rates. Dues are based on a three-year, new-member ramping formula. Independent research conducted by the Operating Subsidiaries in 1993, which will be completed or continued in 1994, concentrated on environmental protection, generating unit performance, future generating technologies, delivery systems, and customer-related research. Two U.S. Department of Energy Clean Coal Technology nitrogen oxide control projects, which the Operating Subsidiaries cofounded, have recently been completed. Based upon the results of one of the projects, retrofitting of low nitrogen oxide cell burners at the Hatfield's Ferry Power Station units has been undertaken at much lower costs than would otherwise have been required. - 13 - Research is also being directed to help address major issues facing the Operating Subsidiaries including electric and magnetic field (EMF) risk, waste disposal, greenhouse gas, client-server information system prospects, renewable resources, fuel cells, new combustion turbines and other cogeneration technologies. In addition, evaluation of technical proposals for business opportunities is also ongoing. EMF research includes monitoring work done by EPRI, Department of Energy (DOE), the Environmental Protection Agency (EPA) and other government researchers. It also includes monitoring literature, law and litigation, and standards as developed. This research enables the Operating Subsidiaries to evaluate any potential health risks to employees and customers which may exist. Research activities related to alleged global climate change include monitoring government activity, studying possible joint implementation activities in connection with the Clinton Climate Change Action Plan, and studying demand- side management, electro- technologies and possible joint implementation plans. The Operating Subsidiaries also made research grants to regional colleges and universities to encourage the development of technical resources related to current and future utility problems. CONSTRUCTION AND FINANCING Construction expenditures by the Subsidiaries in 1993 amounted to $574 million and for 1994 and 1995 are expected to aggregate $500 million and $400 million, respectively. In 1993, these expenditures included $240 million for compliance with the CAAA. The 1994 and 1995 estimated expenditures include $161 million and $53 million, respectively, to cover the costs of compliance with the CAAA. (See ITEM 1. ENVIRONMENTAL MATTERS.) Allowance for funds used during construction (AFUDC) (shown below) has been reduced for carrying charges on CAAA expenditures that are being collected through currently approved surcharges or in base rates. - 14 - * Includes allowance for funds used during construction for 1993, 1994 and 1995 of: Monongahela $5.8, $4.1 and $1.9; Potomac Edison $7.1, $5.7 and $2.7; and West Penn $8.6, $12.7 and $6.2. These construction expenditures include major capital projects at existing generating stations, including the construction of flue-gas desulfurization equipment (scrubbers) at the Harrison Power Station, upgrading distribution lines and substations, and the strengthening of the transmission and subtransmission systems. It is anticipated that the Harrison scrubber project will be completed on schedule and that the final costs will be approximately 24% below the original budget. Primary factors contributing to the reduced cost are: a) the absence of any major construction problems to date; b) financing and material and equipment costs lower than expected; and c) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. In order to avoid unnecessary and uneconomic additional outages, power station construction and long-range maintenance schedules and the expenditures associated therewith will have to be coordinated over the next several years with outages to meet the in-service dates of the new emission control facilities. - 15 - On a System basis, total expenditures for 1993, 1994, and 1995 include $270 million, $191 million, and $93 million, respectively, for construction of environmental control technology. The Operating Subsidiaries continue to study ways to reduce or meet future increases in customer demand, including aggressive demand- side management programs, new and efficient electric technologies, construction of various types and sizes of generating units and increasing the efficiency and availability of System generating facilities, reducing company electrical use and transmission and distribution losses, and where feasible and economical, acquisition of reliable long- term capacity from other electric systems and from nonutility developers. The Operating Subsidiaries are implementing demand-side management activities. Potomac Edison and West Penn are engaged in state commission supported or ordered evaluations of demand-side management programs (See ITEM 1. REGULATION for a further discussion of these programs). Several jurisdictions have adopted mechanisms which provide for recovery of the costs of such activities, some return on the related investment, the associated revenue reductions and a performance incentive, either on a current basis or through deferral to a base rate case. Current forecasts, which reflect demand-side management efforts and other considerations and assume normal weather conditions, project average annual winter and summer peak load growth rates of 1.47% and 1.28%, respectively, in the period 1994-2004. After giving effect to the reactivation of West Penn capacity in cold reserve (see page 9), peak diversity exchange arrangements described in ITEM 1. SALES above, demand- side management and conservation programs, and the capacity of an anticipated new PURPA plant, the System's integrated resource plan indicates that new System-owned generating capacity will not be required until the year 2000 or beyond. If future customer demand materially exceeds that forecast or anticipated supply-side resources do not become available or demand-side management efforts do not succeed, or under extremely adverse weather conditions, the Operating Subsidiaries may be unable at times to meet all of their customers' requirements for electric service. In connection with their construction and demand- side management programs, the Operating Subsidiaries must make estimates of the availability and cost of capital as well as the future demands of their customers that are necessarily subject to regional, national, and international developments, changing business conditions, and other factors. The construction of facilities and their cost are affected by laws and regulations, lead times in manufacturing, availability of labor, materials and supplies, inflation, interest rates, and licensing, rate, environmental, and other proceedings before regulatory authorities. As a result, future plans of the Operating Subsidiaries, as well as their projected ownership of future generating stations, are subject to continuing review and substantial change. - 16 - The Subsidiaries have financed their construction programs through internally generated funds, first mortgage bond, debenture, medium-term note and preferred stock issues, pollution control and solid waste disposal notes, instalment loans, long-term lease arrangements, equity investments by APS (or, in the case of AGC, by the Operating Subsidiaries), and, where necessary, interim short-term debt. Effective January 1994, the Operating Subsidiaries also have available a $300 million multi-year credit facility. The future ability of the Subsidiaries to finance their construction programs by these means depends on many factors, including rate levels sufficient to provide internally generated funds and adequate revenues to produce a satisfactory return on the common equity portion of the Subsidiaries' capital structures and to support their issuance of senior and other securities. APS obtains most of the funds for equity investments in the Operating Subsidiaries through the issuance and sale of its common stock publicly and through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In May 1993, Monongahela, Potomac Edison, and West Penn issued $10.68 million, $13.99 million, and $18.04 million, respectively, in solid waste disposal notes to Harrison County, West Virginia. Harrison County in turn issued $24.67 million of 6-1/4% and $18.04 million of 6.3% tax-exempt 30-year solid waste disposal revenue bonds. The Operating Subsidiaries are using the proceeds from the issuance to finance certain solid waste disposal facilities which comprise a portion of the scrubbers located at the Harrison Power Station. On November 3, 1993, the holders of more than two-thirds of the shares of APS common stock voted to split the common stock by amending the charter to reclassify each share of common stock, par value $2.50, issued or unissued, into two shares of common stock, par value $1.25 each. The stock split became effective on November 4, 1993. All references to APS common stock herein reflect the two-for-one stock split. On October 14, 1993, APS issued and sold 2,400,000 shares of its common stock in an underwritten offering with net proceeds to APS of $64.1 million, and in 1993 sold 1,364,846 shares of its common stock for $36.1 million through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In October 1993, Potomac Edison and West Penn issued and sold to APS 2,500,000 and 5,000,000 additional shares of each of their common stock, respectively, at a price of $20 per share. During 1993, the rate for West Penn's 400,000 shares of market auction preferred stock, par value $100 per share, reset approximately every 90 days at 2.62%, 2.55%, 2.595% and 2.7%. The rate set at auction on January 14, 1994, was 2.52%. In August 1993, Potomac Edison redeemed the remaining $404,600 of 4.70% Series B Preferred Stock outstanding. - 17 - In 1993, the Subsidiaries issued $651.9 million of securities having interest rates between 4.95% and 7.75%, to refund outstanding debt with rates of 7.0% to 9.75%, with an annual after-tax savings in interest cost of almost $9 million. In February 1993, Potomac Edison issued $45 million of 7-3/4%, 30-year first mortgage bonds to refund $25 million, 8-5/8% series due 2007 and $15 million, 8-5/8% series due 2003. In March 1993, West Penn issued $61.5 million of 10-year, 4.95% Pollution Control Revenue Notes to refund $30 million, 9-3/4% series due 2003 and $31.5 million, 9-1/2% series due 2003. In March 1993, AGC issued $50 million of 5- 3/4% medium-term notes due in 1998 to refund $50 million, 8% debentures due in 1997. In March 1993, Potomac Edison issued $75 million of 5-7/8% first mortgage bonds due 2000 to refund $72 million of four series due 1998-2002 with rates ranging from 7% to 8- 3/8%. In April 1993, Monongahela, Potomac Edison and West Penn issued $7.05 million, $8.6 million, and $7.75 million, respectively, in 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia. Monongalia County, in turn issued $23.4 million of 5.95%, 20-year Pollution Control Revenue Bonds to refund $23.4 million of three series due in 2013 with rates ranging from 9.375% to 9.5%. In April 1993, Monongahela issued $65 million of 5-5/8% first mortgage bonds due in 2000 to refund $60 million of three series due 1998-2002 with rates ranging from 7.5% to 8.125%. In June 1993, West Penn issued $102 million of 5-1/2% first mortgage bonds due in 1998 to refund $102 million of three series due 1997-1999 with rates ranging from 7% to 7-7/8%. Also in June 1993, West Penn issued $80 million of 6-3/8% first mortgage bonds due 2003 to refund $75 million of two series due 2001-2002 with rates of 7-5/8% and 8-1/8%. In September 1993, AGC issued $50 million of 5-5/8% debentures due 2003 and $100 million of 6-7/8% debentures due 2023 to refund $50 million, 8-3/4% debentures due 2017 and $100 million, 9-1/8% debentures due 2016. At December 31, 1993, APS had $67.5 million and Monongahela had $63.1 million outstanding in short-term debt, and AGC had $50.87 million outstanding in commercial paper and notes payable to affiliates, while Potomac Edison and West Penn had short-term investments of $4.6 million and $24.9 million, respectively. The Subsidiaries' ratios of earnings to fixed charges for the year ended December 31, 1993, were as follows: Monongahela, 3.49; Potomac Edison, 3.34; West Penn, 3.49; and AGC, 2.88. APS and the Subsidiaries' consolidated capitalization ratios as of December 31, 1993, were: common equity, 46.1%; preferred stock, 6.5%; and long- term debt, 47.4%. APS and the Subsidiaries' long-term objective is to maintain the common equity portion above 45%, reduce the long-term debt portion toward 45%, and maintain the preferred stock ratio for the balance of the capital structure. In January 1994, the Operating Subsidiaries jointly entered into an aggregate $300 million multi- year credit agreement with eighteen lenders. Each Operating Subsidiary's borrowings under the agreement are limited to its pro rata share of the stock of AGC, which stock was pledged to secure the credit agreement. The Operating Subsidiaries' percentage ownership of AGC and resulting borrowing limitations are: Monongahela 27%, $81,000,000; Potomac Edison 28%, $84,000,000; and West Penn 45%, $135,000,000. The agreement may be used as a supplement to or in lieu of public financings and short-term debt programs. - 18 - During 1994, Monongahela, Potomac Edison and West Penn plan to issue up to $50 million, $75 million, and $105 million, respectively, of new securities, consisting of both debt and preferred and common equity, for general corporate purposes, including their construction programs. In addition, the Operating Subsidiaries may engage in tax-exempt solid waste disposal financings to the extent funds are available to Harrison County from the West Virginia cap allocation. APS plans to fund Operating Subsidiaries' sales of common stock to it through the issuance of short-term debt and the sale of APS' common stock through its Dividend Reinvestment and Stock Purchase Plan and Employee Stock Ownership and Savings Plan. The Operating Subsidiaries, if economic and market conditions make it desirable, may refund during 1994 up to $550 million of first mortgage bonds, up to $100 million of preferred stock, and up to $78 million of pollution control revenue notes through tender offers or optional redemptions. FUEL SUPPLY System-operated stations burned approximately 15.7 million tons of coal in 1993. Of that amount, 67% was cleaned (6.7 million tons) or used in stations equipped with scrubbers (3.9 million tons). Use of desulfurization equipment and cleaning and blending of coal make burning local higher-sulfur coal practical, and in 1993 about 96% of the coal received at System stations came from mines in West Virginia, Pennsylvania, Maryland, and Ohio. The Operating Subsidiaries do not mine or clean any coal. All raw, clean or washed coal is purchased from various suppliers as necessary to meet station requirements. Long-term arrangements, subject to price change, are in effect and will provide for approximately 12 million tons of coal in 1994. The System depends on short-term arrangements and spot purchases for its remaining requirements. Through the year 1999, the total coal requirements of present System-operated stations are expected to be met with coal acquired under existing contracts or from known suppliers. The Operating Subsidiaries will meet the requirements of Phase I of the CAAA by installing scrubbers at Harrison Power Station. This will allow the continued use of local, high-sulfur coal there. A long-term contract for the supply of lime for use in the scrubber operation and for fixation of the scrubber byproduct has been negotiated and is expected to be signed in early 1994. It is expected that the use of lime will increase the costs of operating the station. For each of the years 1989 through 1992, the average cost per ton of coal burned was, respectively, $34.64, $35.97, $36.74 and $36.31. For the year 1993, the cost per ton decreased to $36.19, and in December 1993 the cost per ton was $36.45. - 19 - The labor agreement between the United Mine Workers of America (UMWA) and the Bituminous Coal Operators' Association (BCOA) expired on February 1, 1993. As a result, the UMWA initiated selective strikes against BCOA member companies on February 2, 1993. In late May and early June, numerous mines which serve the Operating Subsidiaries' power stations were closed down to various degrees. The UMWA and BCOA agreed to a new five year contract on December 14, 1993, and mining operations resumed at most mines during the week of December 20, 1993. The Operating Subsidiaries continued to meet customer needs during this approximately seven-month period through the use of existing low cost inventories, additional spot and substitute contract coal purchases, and some conservation measures, primarily at the Harrison Power Station. The Operating Subsidiaries own coal reserves estimated to contain about 125 million tons of high- sulfur coal recoverable by deep mining. There are no present plans to mine these reserves and, in view of economic conditions now prevailing in the coal market, the Operating Subsidiaries plan to hold the reserves as a long-term resource. RATE MATTERS Rate case decisions in Pennsylvania and Maryland were issued for West Penn and Potomac Edison in May and February, 1993. West Penn On May 14, 1993, the Pennsylvania Public Utility Commission (PUC) issued an order in West Penn's base rate case effective May 18, 1993, authorizing an increase in revenues of $61.6 million, of which $26.1 million was for recovery of carrying charges (return on investment and taxes) associated with West Penn's CAAA compliance plan through June 30, 1993. West Penn had originally filed for a base rate increase designed to produce $101.4 million. West Penn received all maintenance expenses that it had requested, and a return on equity (ROE) of 11.5%. West Penn filed a petition on January 12, 1994 with the PUC requesting authorization to accrue post in-service carrying charges on the Harrison scrubbers and to defer related depreciation and operating and maintenance expenses until they are recognized in rates. West Penn cannot predict the outcome of this proceeding. West Penn plans to file an application with the PUC on or about March 31, 1994, for a base rate increase to recover the remaining carrying charges on investment, depreciation and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the new rates will become effective on or about December 31, 1994. West Penn cannot predict the precise amount to be requested or the outcome of this proceeding. On February 20, 1992, the Commonwealth Court of Pennsylvania affirmed the PUC's December 13, 1990, decision relating to West Penn's challenge to the PUC's methodology for calculation of ROE. Three industrial customers also appealed to the Commonwealth Court that part of the PUC order which failed to allocate capacity costs of PURPA projects on a demand basis in West Penn's Energy Cost Rate. On June 25, 1992, the Commonwealth Court reversed the PUC's decision on this issue and remanded the case to the PUC for further proceedings. West Penn and other parties have negotiated a settlement on capacity costs of PURPA projects and other demand-related costs in West Penn's Energy Cost Rate, which settlement does not affect West Penn's revenues. The settlement agreement was approved by the PUC and was implemented in 1993. - 20 - Monongahela On January 18, 1994, Monongahela filed an application with the West Virginia Public Service Commission (West Virginia PSC) for a base rate increase designed to produce $61.3 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Monongahela cannot predict the outcome of this proceeding. Monongahela filed a petition on January 11, 1994, with the Public Utilities Commission of Ohio (PUCO) requesting authorization to accrue post-in-service carrying charges on the Harrison scrubbers until its investment in such scrubbers is recognized in rates. The petition also requested authorization for Monongahela to defer depreciation, and operating and maintenance expenses, including property taxes (but not including fuel costs) with respect to the scrubbers until the recovery of the deferrals can be addressed in Monongahela's next base rate case or otherwise, as the PUCO may deem appropriate. Monongahela is currently awaiting a decision on this petition. If the petition is approved, Monongahela will file its Ohio base rate case in early 1995. Potomac Edison The Maryland Public Service Commission (Maryland PSC) issued a final order in Potomac Edison's base rate case on February 24, 1993, authorizing an annual increase of $11.3 million, effective February 25, 1993, which included CAAA carrying charges through February 28, 1993. The original filing in July of 1992 was designed to produce approximately $23.0 million in additional annual revenues. Subsequent adjustments reduced this request to $17.6 million. Potomac Edison received most of the maintenance expenses that it had requested and a ROE of 11.9%. On April 30, 1993, Potomac Edison filed with the Virginia State Corporation Commission (SCC) for a rate increase designed to produce $10.0 million in additional annual revenues. The new rates went into effect on September 28, 1993, subject to refund. Hearings have been held and a final SCC decision is expected by April 1994. Potomac Edison cannot predict the outcome of this proceeding. - 21 - On January 14, 1994, Potomac Edison filed an application with the West Virginia PSC for a base rate increase designed to produce $12.2 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Potomac Edison cannot predict the outcome of this proceeding. On or about April 15, 1994, and June 30, 1994, Potomac Edison plans to file new rate cases in Maryland and Virginia, respectively. The amounts of the requested increases have not yet been determined, but they will include recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the Maryland decision will be rendered in late 1994, and the Virginia decision in mid-1995. However, in both jurisdictions, it is expected that increases will be effective in late 1994. Monongahela and Potomac Edison Pursuant to its order of December 12, 1991, approving Monongahela and Potomac Edison's plan for compliance with Phase I of the CAAA, the West Virginia PSC authorized recovery by Monongahela and Potomac Edison of $5.6 million and $1.4 million, respectively, of carrying charges on Phase I CAAA compliance costs through March 31, 1993, effective July 1, 1993. This brings the annual Phase I CAAA recovery for Monongahela and Potomac Edison to $8.7 million and $2.2 million, respectively. Pursuant to the order, Monongahela and Potomac Edison will submit requests for recovery of carrying charges through March 31, 1994, on Phase I CAAA compliance costs in the annual energy cost review proceedings with any increase to be effective July 1, 1994. The annual values of all CAAA revenues authorized in these proceedings will be removed from this collection process effective when full Phase I CAAA costs are included in base rates as a result of the 1994 rate case filings. AGC Through February 29, 1992, AGC's ROE was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties filed to reduce the ROE to 10%. Hearings were completed in June 1992, and a recommendation has been issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the other parties argue should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate filed a joint complaint with the FERC against AGC claiming that both the existing ROE of 11.53% and the ROE recommended by the ALJ of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53% with rates subject to refund beginning April 1, 1994. AGC cannot predict the outcome of these proceedings. - 22 - FERC West Penn, Potomac Edison, and Monongahela implemented settlement agreements in 1993 covering wholesale rates in effect for their municipal, co-op, and borderline agreement customers subject to the jurisdiction of the FERC. Each included carrying charges for work in progress on the scrubbers at the Harrison Power Station, additional expenses for postretirement benefits other than pensions (see below), and future automatic rate changes resulting from changes to taxes or tax rates (federal, state and local for Monongahela and West Penn, and federal for Potomac Edison). The amounts of the increases and the effective dates for West Penn, Potomac Edison, and Monongahela were $1.6 million on June 15, 1993; $1.5 million on September 15, 1993; and $0.6 million on December 1, 1993, respectively. It is anticipated that additional filings to include recovery of the remaining carrying charges on investment, depreciation, as well as all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense for each Operating Subsidiary will be made in 1994 with increases to be effective around the end of 1994. Postretirement Benefits Other Than Pensions (SFAS No. 106) The Operating Subsidiaries and APSC adopted SFAS No. 106 as of January 1, 1993. This requires all companies to accrue for the cost of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years that the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Operating Subsidiaries and APSC for retired employees and their dependents were recovered in rates on a pay-as-you-go basis. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for FERC wholesale customers effective on the rate case effective date described above under ITEM 1. RATE MATTERS, FERC. Regulatory actions have been taken by the PUCO and Virginia PSC, which indicate that substantial recovery is probable. The West Virginia PSC considers recovery of SFAS No. 106 costs on a case- by-case basis and therefore Monongahela and Potomac Edison cannot predict the outcome of such proceedings. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. Recovery of these costs in Ohio will be requested in the next base rate case which is expected to be filed in early 1995. The Operating Subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. The Operating Subsidiaries have recorded regulatory assets relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates. The Operating Subsidiaries do not anticipate that SFAS No. 106 will have a substantial effect on consolidated net income. - 23 - ENVIRONMENTAL MATTERS The operations of the Subsidiaries are subject to regulation as to air and water quality, hazardous and solid waste disposal, and other environmental matters by various federal, state, and local authorities. Meeting known environmental standards is estimated to cost the Subsidiaries about $361 million in capital expenditures over the next three years, including $254 million for compliance with Phase I of the CAAA, described below, and initial cost for anticipated compliance with Phase II. The full costs of compliance with Phase II cannot be estimated at this time, but may be substantial. Additional legislation or regulatory control requirements, if enacted, may well require modifying, supplementing, or replacing equipment at existing stations at substantial additional cost. Air Standards The Operating Subsidiaries meet applicable standards as to particulates and opacity at major stations with high-efficiency electrostatic precipitators, cleaned coal, flue-gas conditioning, and, at times, reduction of output. From time to time minor excursions of opacity normal to fossil fuel operations are experienced and are accommodated by the regulatory process. In February 1994, three notices of violation were received by the Operating Subsidiaries from the West Virginia Division of Environmental Protection (WVDEP) regarding opacity excursions for three power stations in West Virginia. The Operating Subsidiaries are working with the WVDEP to resolve the alleged violations. It is not anticipated that the alleged violations will result in substantial penalties. At the major stations (other than Mitchell Unit No. 3 and Pleasants, which have scrubbers), the Operating Subsidiaries meet current emission standards as to sulfur dioxide by using low-sulfur coal, by purchasing cleaned coal to lower the sulfur content, or by blending low-sulfur with higher sulfur coal. The CAAA, among other things, require an annual reduction in total utility emissions within the United States of 10 million tons of sulfur dioxide and two million tons of nitrogen oxides from 1980 emission levels, to be completed in two phases, Phase I and Phase II. Five coal-fired System plants are affected in Phase I and the remaining five coal-fired plants and any coal-fired plants or units reactivated in the future will be affected in Phase II. Installation of scrubbers at the Harrison Power Station is the strategy undertaken by the Operating Subsidiaries to meet the required sulfur dioxide emission reductions for Phase I (1995). Continuing studies will determine the compliance strategy for Phase II (2000). It is expected that burner modifications at all power stations will satisfy the nitrogen oxide emission reduction requirements for the acid rain (Title IV) provisions of the CAAA. Additional post-combustion controls may be mandated in Maryland and Pennsylvania for ozone nonattainment (Title I) reasons. Continuous emission monitoring equipment has been installed on all Phase I units and is being installed on Phase II units. Studies to evaluate cost effective options to comply with Phase II of the CAAA, including those which may be available from the use of Operating Subsidiaries' banked emission allowances and from the emission allowance trading market, are continuing. - 24 - In an effort to introduce market forces into pollution control, the CAAA created sulfur dioxide emission allowances. An allowance is defined as an authorization for an owner to emit one ton of sulfur dioxide into the atmosphere during or following a specified calendar year. Subject to regulatory limitations, allowances (including bonus and extension allowances) not used by an owner for its own compliance may be sold or "banked" for future use or sale. Through an industry allowance pooling agreement, the Operating Subsidiaries will receive a total of approximately 570,000 bonus and extension allowances during Phase I. These allowances are in addition to the Table A allowances of approximately 356,000 per year. As a result of EPA's 1993 auctioning of a number of Table A allowances retained from each utility's annual allotment, approximately 16,000 allowances were sold for the Operating Subsidiaries. Such auctions will be held every year for the foreseeable future and allowances sold thereby will result in a prorational allocation of revenues back to the Operating Subsidiaries. If some allowances offered at auction remain unsold, the balance will also be prorationally rebated to the utilities which contributed them. The proceeds from these auctions are expected to be relatively minimal and the Operating Subsidiaries plan to credit these proceeds against the capital cost of emission compliance activities, subject to regulatory approval. Other allowance trading activities may be undertaken by the Operating Subsidiaries once certain tax questions are answered and once studies to determine Phase II compliance strategy are completed. In 1989, the West Virginia Air Pollution Control Commission approved the construction of a cogeneration facility in the vicinity of Rivesville, West Virginia. Emissions impact modeling for that facility raised concerns about the compliance status of Monongahela's Rivesville Station with the National Ambient Air Quality Standards (NAAQS) for sulfur dioxide. Pursuant to a consent order, Monongahela agreed to collect on- site meteorological data and conduct additional dispersion modeling in order to demonstrate compliance. The modeling study and a compliance strategy recommending construction of a new "good engineering practices" (GEP) stack was submitted to the WVDEP in June 1993. Costs associated with the GEP stack are approximately $7 million. Monongahela is awaiting action by the WVDEP. - 25 - Under an EPA-approved consent order with Pennsylvania, West Penn completed construction of a GEP stack at the Armstrong Station in 1982 at a cost of over $13 million with the expectation that EPA's reclassification of Armstrong County to "attainment status" under NAAQS for sulfur dioxide would follow. As a result of the 1985 revision of its stack height rules, EPA refused to reclassify the area to attainment status. West Penn appealed the EPA's decision. In 1988, the U. S. Court of Appeals for the Third Circuit dismissed West Penn's appeal for lack of jurisdiction, stating that West Penn's request for reconsideration before EPA made EPA's denial a non-final agency action. West Penn's request for reconsideration before EPA remains pending. West Penn cannot predict the outcome of this proceeding. Water Standards Under the National Pollutant Discharge Elimination System (NPDES) permitting procedures, permits for all System-owned stations are in place. However, in proposed NPDES renewal permits for some stations which are currently being sought, some conditions are being appealed through the regulatory process since the Operating Subsidiaries believe the effluent limitations being applied are overly stringent. The Operating Subsidiaries continue to work with the appropriate state agencies to resolve these issues. In the meantime, the existing permits remain in effect during the appeal process. The EPA and states are now implementing stormwater runoff regulations for controlling discharges from industrial and municipal sources as well as construction sites. Stormwater discharges have been identified and included in NPDES renewals, but controls have not yet been required. Since the current round of permit renewals began in 1993, monitoring requirements have been imposed, with pollution reduction plans and additional control of some discharges anticipated. Pursuant to the National Groundwater Protection Strategy, which supplements existing West Virginia groundwater protection policy, West Virginia has adopted a Groundwater Protection Act. This law establishes a statewide antidegradation policy which could require the Operating Subsidiaries to undertake reconstruction of existing landfills and surface impoundments as well as groundwater remediation, and may affect herbicide use for right-of-way maintenance in West Virginia. Groundwater protection standards were approved and implemented in 1993 (based on EPA drinking water criteria) which established compliance limits which cannot be exceeded. The Operating Subsidiaries anticipate that some facilities will not be able to meet the new compliance limits. Variance requests and requests for stays of implementation have been made for all affected facilities. However, variance rules have not yet been promulgated and action on the requests has not been taken. Therefore, it is not possible to predict the difficulty and costs associated with obtaining variances. If variances are not granted, costs may be incurred by the Operating Subsidiaries for groundwater remediation. Such costs, if any, cannot be predicted at this time. - 26 - The Pennsylvania Department of Environmental Resources (PADER) developed a Groundwater Quality Protection Strategy which established a goal of nondegradation of groundwater quality. However, the strategy recognizes that there are technical and economic limitations to immediately achieving the goal and further recognizes that some groundwaters need greater protection than others. The PADER is beginning to implement the strategy by promulgating changes to the existing rules that heretofore did not consider the nondegradation goal. The full extent of the impact of the strategy on the Operating Subsidiaries cannot be anticipated at this time. In 1993, two notices of violation were received by the Operating Subsidiaries from the WVDEP regarding excursions above limits contained in NPDES permits for discharge of leachate from fly ash landfills in West Virginia. One violation notice was withdrawn by the state agency and the other was resolved without payment of substantial penalty. On January 27, 1994 and February 9, 1994, the Operating Subsidiaries received two separate notices of violation from PADER regarding excursions above limits contained in the NPDES permit for discharge of leachate from Hatfield's Ferry Power Station fly ash landfill. One violation notice was resolved without payment of substantial penalty. The Operating Subsidiaries are working with the PADER to resolve the other alleged violation. It is not anticipated that the alleged violation will result in substantial penalties. Hazardous and Solid Wastes Pursuant to the Resource Conservation and Recovery Act of 1976 and the Hazardous and Solid Waste Management Amendments of 1984 (RCRA), EPA regulates the disposal of hazardous and solid waste materials. Pennsylvania, West Virginia, Maryland, Ohio, and Virginia have also enacted hazardous and solid waste management legislation. With the installation of the scrubbers at the Harrison Power Station, approximately 2.8 million tons per year of scrubber sludge, consisting principally of limestone and ash, will be generated and disposed of in a disposal facility owned and operated by the Operating Subsidiaries. The expected capacity of the site is 30 years. Pleasants Power Station processes its scrubber sludge using a wet-fixation and slurry system, with the treated sludge disposed of in a properly permitted sludge pond. Mitchell and Harrison Power Stations process their scrubber sludge by a dry-fixation process with the stabilized sludge disposed of in a properly permitted landfill. Coal combustion byproducts from all other facilities are either sold for beneficial reuse or landfilled in properly permitted and currently adequate disposal facilities owned and operated by the Operating Subsidiaries. The Operating Subsidiaries are in the process of permitting additional capacity to meet future disposal needs. - 27 - Costs are being incurred as the Operating Subsidiaries progress with implementation of both West Virginia's and Pennsylvania's 1992 solid waste regulatory changes. A predominant portion of the costs are attributable to two major factors: 1) liner systems for new disposal sites and the expansion portion of existing disposal sites, and 2) the assessment of groundwater impacts via monitoring wells. Because past operating practices, while in compliance with then existing regulations, may not meet the current criteria, as measured by new standards, it is possible that groundwater remediation may be required at some of the Operating Subsidiaries' facilities. In addition, under West Virginia's Solid Waste Rules, it is possible that certain active disposal sites may have to be retrofitted with liner systems to address potential groundwater degradation. The draft permit renewal from WVDEP for the currently active disposal site at Albright Power Station requires, on a portion of the site, retrofitting with a new liner system with possible removal of already placed coal combustion byproducts. The Operating Subsidiaries are working to have this proposed permit condition removed; however if it is not, it is anticipated that this condition will be appealed. EPA regulations on the burning of hazardous waste in utility boilers are expected to be amended in 1994 making the practice cost prohibitive for the Operating Subsidiaries. Until such time as the regulations are amended, the Operating Subsidiaries will continue to minimize their hazardous waste and to burn small quantities of hazardous waste generated in accordance with EPA boiler and industrial furnace disposal rules. Once such regulations are amended, the low volume wastes will be disposed of in incinerators or landfills which are owned by third parties. None of the Operating Subsidiaries are required to obtain hazardous waste treatment, storage or disposal permits under RCRA. With a continued effort to reduce hazardous waste, disposal costs and potential environmental liability should be minimized. Potomac Edison has received a notice from the Maryland Department of the Environment (MDE) regarding a remediation ordered under Maryland law at a facility previously owned by Potomac Edison. The MDE has identified Potomac Edison as a potentially responsible party under Maryland law. Remediation is currently being implemented by the current owner of the facility in Frederick, Maryland. It is not anticipated that Potomac Edison's share of remediation costs, if any, will be substantial. Emerging Environmental Issues Title I of the CAAA establishes an ozone transport region consisting of 11 northeast states including Maryland and Pennsylvania. Sources within the region will be required to reduce nitrogen oxide emissions, a precursor of ozone, to a level conducive to attainment of the ambient ozone standard. The first step for Title I compliance will result in the installation of low nitrogen oxide burners and potentially overfire air at all Pennsylvania and Maryland stations by 1995. This is compatible with Title IV nitrogen oxide reduction requirements. Modeling studies being conducted by the states will determine if a second step of reductions will be necessary which could require installation of post- combustion control technologies. - 28 - Title III of the CAAA requires EPA to conduct studies of toxic air pollutants from utility plants to determine if emission controls are necessary. EPA's reports are expected to be submitted to Congress in late 1995. The impact of Titles I and III on the Operating Subsidiaries is unknown at this time. Both the CWA and the RCRA are expected to be reauthorized in 1994. It is anticipated that coal combustion byproducts will continue to be regulated as nonhazardous waste, minimizing the Operating Subsidiaries' disposal costs. An additional issue which could impact the Operating Subsidiaries and which is undergoing intense study, is the effect, if any, of electric and magnetic fields. The financial impact of this issue on the Operating Subsidiaries, if any, cannot be assessed at this time. In connection with President Clinton's Climate Change Action Plan concerning greenhouse gases, the Operating Subsidiaries expressed by letter to the DOE in August 1993, their willingness to work with the DOE on implementing voluntary, cost-effective courses of action that reduce or avoid emission of greenhouse gases. Such courses of action must take into account the unique circumstances of each participating company, such as growth requirements, fuel mix and other circumstances. Furthermore, they must be consistent with the Operating Subsidiaries' integrated resource planning process and must not have an adverse effect on competitive position in terms of costs and rates or be unacceptable to their regulators. Some 63 other utility systems submitted similar letters. REGULATION APS and the Subsidiaries are subject to the broad jurisdiction of the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935 (PUHCA). APS is also subject to the jurisdiction of the Maryland PSC as to certain of its activities. The Subsidiaries are regulated as to substantially all of their operations by regulatory commissions in the states in which they operate and also by the DOE and the FERC. In addition, they are subject to numerous other city, county, state, and federal laws, regulations, and rules. EPACT became law on October 24, 1992. This broad legislation, among other things, amends PUHCA to permit utilities subject to PUHCA to compete in the wholesale generation business with other wholesale generators which it exempts from PUHCA; to ease restrictions on financing for that purpose; and to permit investment in foreign utilities. EPACT also amends the Federal Power Act to permit the FERC to order, under specified circumstances, access to transmission systems (including those of the System) so long as it would not unreasonably impair reliability nor adversely affect its existing wholesale, retail and transmission customers. It also amends PURPA to encourage states to study and regulate various matters, including the capital structures of EWGs, integrated resource planning, and the amount of purchased power that electric utilities should have in their generation mix. EPACT also sets forth waste disposal standards, new nuclear licensing procedures, and contains provisions promoting alternate transportation fuels, research on environmental issues, and increased energy from renewables (See discussion of EPACT in ITEM 1. BUSINESS, SALES and ELECTRIC FACILITIES). - 29 - Pursuant to the requirements of Section 712 of EPACT, the Maryland, Ohio, Pennsylvania, Virginia, and West Virginia commissions issued orders regarding four broad economic and regulatory policy issues related to the purchase of wholesale power. All of the commissions decided to evaluate these issues on a case- by-case basis or within their existing regulatory framework, instead of establishing generic standards. On January 24, 1994, the Maryland PSC issued an order which instituted a proceeding for the purpose of determining whether to implement standards which, under EPACT, a state commission must consider in order to encourage integrated resource planning and investments in conservation and energy efficiency by electric utilities. The order provides for the filing of initial and reply comments and for a hearing on May 3, 1994. Potomac Edison intervened and will be submitting comments in this proceeding. Under EPACT, the FERC has initiated several proceedings, one of the most significant being the request for comments on transmission pricing, including pricing as it may apply to parallel power flows. The Operating Subsidiaries have developed and submitted a pricing philosophy intended to meet certain goals, including reliable operation of the transmission system and protection of native load customers, while promoting accurate price signals and offering third- party transmission service at the lowest reasonable rates. Other FERC initiatives included the issuance of guidelines governing open access transmission requests and rules governing the establishment of Regional Transmission Groups. The Operating Subsidiaries founded and continue to participate in, along with other utilities, an organization whose primary purpose is to develop a mutually acceptable method of resolving the inequities imposed on transmission network owners by parallel power flows. The SEC has also issued regulations and proposed regulations to implement EPACT, including the integration of EPACT with PUCHA and the effect of EPACT on nonexempt PUCHA companies such as APS and its Subsidiaries. In July 1993, the PUC directed the Bureau of Conservation, Economics and Energy Planning to develop competitive bidding regulations to replace, at least in part, the existing state PURPA regulations. In November 1993, West Penn filed a petition with the PUC requesting an Order that, pending the revision and replacement of the existing state PURPA regulations, any proceedings or orders regarding purchase by West Penn of capacity from a qualifying facility under PURPA shall be based on competitive bidding. The Office of Consumer Advocate, the Office of Small Business Advocate, the West Penn Power Industrial Intervenors, and West Penn's two largest industrial customers have intervened in support of West Penn's position. Several PURPA developers and a group purporting to represent PURPA interests have filed in opposition to certain parts of the petition. West Penn cannot predict the outcome of this proceeding. - 30 - On October 8, 1993, the West Virginia PSC issued proposed regulations concerning bidding procedures for capacity additions for electric utilities and invited comment by December 7, 1993. A number of interested parties, including Monongahela and Potomac Edison, filed comments. The West Virginia PSC has taken no further action since the filing of comments. On December 17, 1992, the PUCO issued proposed rules concerning competitive bidding for supply-side resources, transmission access for winning bidders and incentives for the recovery of the cost of purchased power. The PUCO invited comments by March 3, 1993 and reply comments by March 24, 1993. A number of interested parties, including Monongahela, submitted comments. The PUCO has taken no further action following the filing of comments. Maryland and Virginia have not mandated compulsory competitive bidding at this date. The Omnibus Budget Reconciliation Act of 1993 increased the marginal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. As a result, the Operating Subsidiaries' income tax expense for 1993 increased by about $3 million. On June 13, 1990, the Maryland PSC began an investigation to determine whether Potomac Edison's methodology for calculating avoided costs under PURPA is appropriate. On October 11, 1991, the Maryland PSC incorporated this review of avoided costs into a collaborative process already formed between its Staff, the Maryland Department of Natural Resources, Potomac Edison, Eastalco Aluminum, the Maryland Energy Administration, and the Office of People's Counsel. Although the group's primary mission was to avoid litigation by working cooperatively to develop demand- side management programs, the issue of avoided costs was addressed because avoided costs are needed for determining the cost-effectiveness of programs. These negotiations culminated in a Settlement Agreement which was signed by the six parties and filed with the Maryland PSC on October 14, 1993. The Hearing Examiner issued a proposed order accepting the Settlement Agreement on November 17, 1993. The proposed order became final on December 17, 1993, thereby concluding this proceeding. In October 1990, the PUC ordered Pennsylvania's major electric utilities, including West Penn, to file programs for demand-side management designed to reduce customer demand for electricity and to reduce the need for additional generating capacity. The PUC's order proposed that the affected utilities receive full recovery of the costs of approved programs, as well as financial incentives for implementing such programs, including recovery of lost revenues. West Penn filed its proposed programs with the PUC. On December 13, 1993, the PUC entered an order which provides for the recovery of program costs either through a surcharge or deferral to a base rate case; the recovery of revenues lost due to the implementation of demand-side management programs through a base rate case; and the award of incentives for good program performance or the assessment of penalties for poor performance. Two parties to this proceeding have petitioned the PUC for reconsideration and clarification and the Pennsylvania Industrial Energy Coalition has filed an appeal with the Commonwealth Court of Pennsylvania. West Penn cannot predict the final outcome of this proceeding. - 31 - During 1993, Potomac Edison continued its participation in the Collaborative Process for demand- side management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and Potomac Edison's largest industrial customer. Potomac Edison received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993 Potomac Edison had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. ITEM 2.

ITEM 2. PROPERTIES Substantially all of the properties of the Operating Subsidiaries are held subject to the lien securing each company's first mortgage bonds and, in many cases, subject to certain reservations, minor encumbrances, and title defects which do not materially interfere with their use. Some properties are also subject to a second lien securing certain solid waste disposal and pollution control notes. The indenture under which AGC's unsecured debentures and medium-term notes are issued, prohibits AGC, with certain limited exceptions, from incurring or permitting liens to exist on any of its properties or assets unless the debentures and medium-term notes are contemporaneously secured equally and ratably with all other indebtedness secured by such lien. Transmission and distribution lines, in substantial part, some substations and switching stations, and some ancillary facilities at power stations are on lands of others, in some cases by sufferance, but in most instances pursuant to leases, easements, permits or other arrangements, many of which have not been recorded and some of which are not evidenced by formal grants. In some cases no examination of titles has been made as to lands on which transmission and distribution lines and substations are located. Each of the Operating Subsidiaries possesses the power of eminent domain with respect to its public utility operations. (See also ITEM 1. BUSINESS and SYSTEM MAP.) - 32 - ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In 1979, National Steel Corporation (National Steel) filed suit against certain Subsidiaries in the Circuit Court of Hancock County, West Virginia, alleging damages of approximately $7.9 million as a result of an order issued by the West Virginia PSC requiring curtailment of the plaintiff's use of electric power during the United Mine Workers' strike of 1977-8. A jury verdict in favor of the defendants was rendered in June 1991. National Steel has filed a motion for a new trial, which is still pending before the Circuit Court of Hancock County. The Subsidiaries believe the motion is without merit; however, they cannot predict the outcome of this case. In 1987, West Penn entered into separate agreements with developers of four PURPA projects: Milesburg (43 MW), Burgettstown (80 MW), Shannopin (80 MW) and Point Marion (2 MW). The agreements provided for the purchase of each project's power over 30 years or more at rates generally approximating West Penn's avoided costs at the time the agreements were negotiated, as defined by PURPA. Yearly capacity payments under the four agreements would total in excess of $50 million. Each agreement was subject to prior PUC approval of the pass-through to West Penn's customers of the total cost incurred under each agreement, on a current basis. In 1987 and 1988, West Penn filed a separate petition with the PUC for each agreement requesting an appropriate PUC order, and various parties intervened. Since that time, all four agreements have been, in varying degrees, the subject of complex and continuing regulatory and judicial proceedings. During 1993, West Penn entered into a settlement agreement with Point Marion and that project has been terminated. On November 24, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Milesburg project which upheld the decision of the Commonwealth Court concerning the time frame for the calculation of avoided cost and upheld the decision that the PUC had the authority under PURPA to revise and reinstate a lapsed power purchase contract. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. On December 30, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Shannopin project which upheld the decision of the Commonwealth Court affirming the PUC's authority under PURPA to revise voluntarily negotiated power purchase contracts. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. As of December 31, 1993, petitions for allowance of an appeal of the decision of the Pennsylvania Commonwealth Court on the Burgettstown project were pending before the Pennsylvania Supreme Court. West Penn cannot predict the outcome of these proceedings. On October 28, 1993, South River Power Partners, L.P. ("South River") filed a complaint against West Penn with the PUC. The complaint seeks to require West Penn to purchase 240 MW from a proposed coal-fired PURPA project which South River proposes to build in Fayette County, Pennsylvania. South River's proposed initial price for this power would be over $0.09 per kWh. West Penn is opposing this complaint as the power is not needed and the price is in excess of avoided cost. The Pennsylvania Consumer Advocate, the Small Business Advocate, the PUC Trial Staff and various industrial customers have also intervened in opposition to the complaint. West Penn cannot predict the outcome of this proceeding. - 33 - Two previously reported complaints had been filed with the West Virginia PSC by developers of cogeneration projects in Marshall and Barbour Counties, West Virginia to require Monongahela and Potomac Edison to purchase capacity from the projects. These two cases were consolidated. The West Virginia PSC on March 5, 1993, found that: Monongahela had no need for additional capacity; Potomac Edison will need new combustion turbine generating capacity beginning in 1996; and Potomac Edison's avoided cost estimate, which is substantially below the costs sought by the developers of the projects, is reasonable. The developers have asked the West Virginia PSC to consider issues not resolved in the March 5, 1993 order. On June 25, 1993 the West Virginia PSC found that Potomac Edison had a PURPA obligation to purchase power from qualifying facilities properly interconnected to the System in Monongahela's service territory and ordered negotiations by Monongahela and Potomac Edison with the two PURPA developers. On August 9, 1993, the West Virginia PSC deconsolidated the two cases. Following the West Virginia Supreme Court's denial of a petition for review of this order, both developers requested the start of negotiations. Monongahela and Potomac Edison cannot predict the outcome of these proceedings. On November 16, 1992, Potomac Edison and the developer of a proposed cogeneration project located in Cumberland, Maryland, requested that the Maryland PSC approve an amendment to a previously approved agreement for the sale of 180 MW of capacity and associated energy from the project to Potomac Edison. The amendment provides for the relocation of the proposed project within the Cumberland area; a delay of one year in the project's earliest in-service date to October 1, 1996, without increase in the initial capacity rate (which otherwise escalates annually at one-half the rate of actual inflation); and other changes consistent with the site and in-service date modifications. The Maryland PSC commenced an investigation of the amendment in December 1992. After hearings, the parties reached a settlement which was approved by the Maryland PSC on March 17, 1993. The settlement agreement resulted in a further delay of the project's in-service date to October 1, 1999, modified the initial capacity rate with only a slight escalation, and provided that Potomac Edison would pay, and recover from customers by a surcharge, a portion of the project's costs resulting from the delay. On December 22, 1993, the Maryland PSC approved the surcharge and these costs are being recovered from customers effective January 1, 1994. As previously reported, effective March 1, 1989, West Virginia enacted a new method for calculating the Business and Occupation Tax (B & O Tax) on electricity generated in that state, which disproportionately increased the B & O Tax on shipments of electricity to other states. In 1989, West Penn, the Pennsylvania Consumer Advocate, and several West Penn industrial customers filed a joint complaint in the Circuit Court of Kanawha County, West Virginia seeking to have the B & O Tax declared illegal and unconstitutional on the grounds that it violates the Interstate Commerce Clause and the Equal Protection Clause of the federal Constitution and certain provisions of federal law that bar the states from imposing or assessing taxes on the generation or transmission of electricity that discriminate against out-of-state entities. In 1991, West Penn amended the complaint to include a 1990 increase in the rate of the B & O Tax. The trial was held in July 1993 and briefs have been filed. West Penn cannot predict the outcome of this litigation. - 34 - As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shot- gun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Operating Subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the Operating Subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at Subsidiary-operated stations were employed by third- party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Operating Subsidiaries believe potential liability of the Operating Subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the Operating Subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. On March 4, 1994, the Operating Subsidiaries received notice that the EPA had identified them as potentially responsible parties ("PRPs") under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), with respect to the Jack's Creek/Sitkin Smelting Superfund Site ("Site"). The Operating Subsidiaries are among some 880 PRPs that have been identified at the Site. EPA is planning to issue a Proposed Plan and Record of Decision in September 1994 delineating the remedy selected for the Site. At this time it is not possible to determine what liability, if any, the Operating Subsidiaries may have regarding the Site. - 35 - In 1970, the Operating Subsidiaries filed with the Federal Power Commission (FPC) an application for a license to build a 1,000-MW energy-storage facility near Davis, West Virginia. In 1977, FPC issued a license for the project, but various parties, including the State of West Virginia and the U.S. Department of Interior, filed appeals, which are now pending before the U.S. Court of Appeals for the District of Columbia. The U.S. Army Corps of Engineers (Corps) denied a dredge and fill permit for the project, which decision was appealed. The U.S. District Court for the District of Columbia decided that the Corps had no jurisdiction in the matter. The Corps filed an appeal with the U.S. Court of Appeals for the District of Columbia. In 1987, the appellate Court decided that the Corps did have jurisdiction and remanded the case to the U.S. District Court for further consideration of the Corps' denial of the permit. The U. S. Supreme Court refused to review that decision. In 1988, the U.S. District Court reversed the Corps' denial of the dredge and fill permit. The District Court's decision, which has now been appealed, found, among other things, that the Operating Subsidiaries were denied an opportunity to review and comment upon written materials and other communications used by the Corps in making its decision, and as a result the Court remanded the matter to the Corps for further proceedings. Negotiations are ongoing to settle this matter. The Operating Subsidiaries cannot predict the outcome of these proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The holders of 46,537,924 shares of common stock of APS voted at a special meeting held on November 3, 1993 to amend APS' charter to reclassify each share of common stock, par value $2.50 per share, issued or unissued, into two shares of common stock, par value $1.25 each. The holder of 259,451 shares voted against the proposal and the holders of 296,598 shares abstained. The charter amendment became effective at the close of business on November 4, 1993. The amount of APS' stated capital was not changed as a result of the amendment. The holder of the common stock of Monongahela on December 13, 1993, waived the holding of a meeting and consented in writing to the amendment of its Charter to reflect the redemption of 50,000 shares of $9.64 series cumulative preferred stock. No other company submitted matters to a vote of shareholders during the fourth quarter. - 36 - Executive Officers of the Registrants The names of the executive officers of each company, their ages, the positions they hold and their business experience during the past five years appears below: (a) All officers and directors are elected annually. - 37 - (a) All officers and directors are elected annually. - 48 - (a) All officers and directors are elected annually. - 39 - PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS APS. AYP is the trading symbol of the common stock of APS on the New York, Chicago, and Pacific Stock Exchanges. The stock is also traded on the Amsterdam (Netherlands) and other stock exchanges. As of December 31, 1993, there were 63,396 holders of record of APS' common stock. The tables below show the dividends paid and the high and low sale prices of the common stock for the periods indicated: The high and low prices in 1994 were 26-1/2 and 24-1/8 through February 3. The last reported sale on that date was at 25. Monongahela, Potomac Edison, and West Penn. The information required by this Item is not applicable as all the common stock of these Subsidiaries is held by APS. AGC. The information required by this Item is not applicable as all the common stock of AGC is held by Monongahela, Potomac Edison, and West Penn. - 40 - ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Page No. APS D-1 Monongahela D-3 Potomac D-5 West Penn D-7 AGC D-9 D-1 D-2 (a) Reflects a two-for-one common stock split effective November 4, 1993. (b) Capability available through contractual arrangements with nonutility generators. (c) Preliminary. D-3 D-3 (a) Capability available through contractual arrangements with nonutility generators. D-5 D-6 D-7 D-8 (a) Capability available through contractual arrangements with nonutility generators. D-9 - 41 - ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page No. APS M-1 Monongahela M-9 Potomac M-18 West Penn M-27 AGC M-36 M-1 APS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONSOLIDATED NET INCOME Earnings per share were $1.88 in 1993 and were $1.83 and $1.80 in 1992 and 1991. Consolidated net income was $215.8 million, $203.5 million, and $194.0 million. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. All per share amounts have been adjusted to reflect the November 4, 1993, two-for-one stock split (See Note F to the consolidated financial statements). SALES AND REVENUES KWh sales to and revenues from residential, commercial, and industrial customers are shown on page D-2. Such kWh sales increased 3.3% and 1.5% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $ 46.6 $ 9.1 Fuel and energy cost adjustment clauses (a) 57.0 37.9 Rate increases (b): Pennsylvania 25.2 5.8 Maryland 12.7 11.7 West Virginia 5.3 12.4 Virginia 2.5 1.8 Ohio 2.1 1.7 47.8 33.4 Other 6.2 .1 $157.6 $80.5 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) See ITEM 1. RATE MATTERS for further information on rate changes. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were approximately normal, cooling degree days increased 69% over 1992 and were 25% over normal, contributing to the 1993 kWh sales increases. The subsidiaries experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M -2 KWh sales to industrial customers increased .3% in 1993 and 2.9% in 1992. The relatively flat industrial sales growth in 1993 followed record industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From subsidiaries' generation 1.2 3.2 5.8 From purchased power 11.2 14.6 12.4 12.4 17.8 18.2 Revenues (in millions): From subsidiaries' generation $ 28.5 $ 91.7 $158.5 From sales of purchased power 318.2 373.8 366.5 $346.7 $465.5 $525.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by subsidiaries' generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the subsidiaries' ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989--a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $14 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M -3 OPERATING EXPENSES Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with other utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA) and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Purchased power: For resale to other utilities $280.9 $344.0 $332.7 From PURPA generation 105.2 94.0 68.9 Other 33.8 12.7 29.0 Total power purchased 419.9 450.7 430.6 Power exchanges, net (2.5) .7 (1.4) $417.4 $451.4 $429.2 The amount of power purchased from other utilities for use by subsidiaries and for resale to other utilities depends upon the availability of the subsidiaries' generating equipment, transmission capacity, and fuel, and their cost of generation and the cost of operations of other utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to other utilities is described under SALES AND REVENUES above. The cost of power purchased for use by the subsidiaries, including power from PURPA generation, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the subsidiaries' regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net income. The increases in purchases from PURPA generation reflect additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $5 million. The subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates and will be requesting recovery of substantially all of the remainder in 1994 rate cases. During 1992, the subsidiaries implemented significant changes to their benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 20% greater than 1993 amounts. M-4 Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other postemployment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The subsidiaries currently accrue for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The subsidiaries are also experiencing, and expect to continue to experience, increased expenditures due to the aging of their power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the Clean Air Act Amendments of 1990 (CAAA). Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note I to the consolidated financial statements) and the replacement of aging equipment at the subsidiaries' power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $4 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($5 million) and increased property taxes ($2 million). These increases were offset by decreased West Virginia Business and Occupation taxes (B&O taxes) due to decreased generation in that state. The 1992 increase resulted from increased property taxes ($4 million), increases in gross receipts taxes ($3 million), and increased capital stock taxes ($2 million), offset by decreased B&O taxes ($2 million). The net increase of $13 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($9 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($3 million). The net decrease in 1992 of $4 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the consolidated financial statements provides a further analysis of income tax expenses. M-5 The combined increase of $4 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. Fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the levels of short-term debt maintained by the companies. The decrease in dividends on preferred stock of subsidiaries reflects the 1992 redemption of three series totaling $25 million with dividend rates of 9.4% to 9.64% and the 1993 redemption of an additional $2 million of 4.7% to $7.16 series, offset by the 1992 sale of $40 million of market auction preferred stock with an average dividend rate of 2.6%. LIQUIDITY AND CAPITAL RESOURCES SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". System companies need cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stocks, and for their construction programs. To meet these needs, the companies have used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the companies' cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. CAPITAL REQUIREMENTS Construction expenditures for 1993 were $574 million and for 1994 and 1995 are estimated at $500 million and $400 million, respectively. These estimates include $161 million and $53 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA discussed under ITEM 1. ENVIRONMENTAL MATTERS. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for M-6 compliance with both Phase I and Phase II of the CAAA. The subsidiaries are estimating amounts of approximately $1.4 billion, which includes $482 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the subsidiaries have additional capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note G to the consolidated financial statements). INTERNAL CASH FLOWS Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $270 million in 1993. Regulatory commission orders received in Maryland, Pennsylvania, Virginia, and West Virginia provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and requested and new rate cases planned in 1994, internal generation of cash can be expected to increase. The increase in other investments reflects the 1993 cash surrender values for secured benefit plans and a related prepayment. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($54 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the subsidiaries' regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. FINANCINGS In October 1993, the Company issued 2,400,000 shares of its common stock for $64.1 million. Also during 1993, the Company issued 1,364,846 shares of common stock under its Dividend Reinvestment and Stock Purchase Plan (DRISP), and Employee Stock Ownership and Savings Plan (ESOP) for $36.1 million. During 1993 the subsidiaries issued $43 million of 6.25% to 6.3% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $634 million of debt securities having interest rates of 7% to 9.75% through the issuance of $652 million of securities having interest rates of 4.95% to 7.75%. The costs M-7 associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $44 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long-term securities. Short-term debt increased from $11.2 million in 1992 to $130.6 million in 1993. The subsidiaries canceled or postponed approximately $152 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its subsidiaries established an internal money pool whereby surplus funds of the Company and certain subsidiaries may be borrowed on a short-term basis by the Company's subsidiaries. This has contributed to the decrease in the 1993 temporary cash investment amounts. Allegheny Generating Company in 1992 replaced its $65.7 million of commercial paper with $50.9 million of money pool borrowings and $2.4 million of four-year, 6.05%-6.10% medium-term notes. Allegheny Generating Company has available an established program to replace money pool borrowings with medium-term notes or commercial paper. At December 31, 1993, unused lines of credit with banks were $149 million. In addition, a multi-year credit program was established in January 1994, which provides that the subsidiaries may borrow on a standby revolving credit basis up to $300 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the subsidiaries plan to issue about $230 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $728 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The subsidiaries may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company plans to fund the subsidiaries' sale of common stock through the issuance of short-term debt and DRISP/ESOP common stock sales. The subsidiaries anticipate that they will be able to meet their future cash needs through internal cash generation and external financings as they have in the past and possibly through alternative financing procedures. M-8 ENVIRONMENTAL MATTERS AND OTHER CONTINGENCIES In the normal course of business, the subsidiaries are subject to various contingencies and uncertainties relating to their operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note I to the consolidated financial statements. All of the state jurisdictions in which the subsidiaries operate have enacted hazardous and solid waste management legislation. While the subsidiaries do not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The subsidiaries are incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the subsidiaries. As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison, and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at subsidiary-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the subsidiaries believe potential liability of the subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. M-9 Monongahela MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $61.7 million, $58.3 million, and $54.1 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-3 and D-4 Such kWh sales increased .3% in 1993 and decreased 1.0% in 1992. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase (Decrease) from Prior Year 1993 1992 (Millions of Dollars) Increased (decreased) kWh sales $ 6.6 $(5.3) Fuel and energy cost adjustment clauses (a) 11.8 12.3 Rate increases (b): West Virginia 4.1 12.1 Ohio 2.1 1.6 6.2 13.7 Other .2 (1.3) $24.8 $19.4 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a surcharge in West Virginia for recovery of carrying charges on expenditures to comply with the Clean Air Act Amendments of 1990 (CAAA), designed to produce $3.1 million on an annual basis effective on July 1, 1992, which was increased to $8.7 million on an annual basis effective on July 1, 1993, and a rate increase in Ohio, designed to produce $3.3 million on an annual basis, which became effective on July 21, 1992. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were only 6% above normal, cooling degree days increased 54% over 1992, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-10 KWh sales to industrial customers decreased 4.4% in 1993 and .7% in 1992. The 1993 decrease was primarily due to continuing declines in sales to coal and primary metals customers. Coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. Lower sales to primary metals customers was due in part to one iron and steel customer's increased use of its own generation. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .3 1.0 1.8 From purchased power 2.8 3.6 3.1 3.1 4.6 4.9 Revenues (in millions): From Company generation $ 8.4 $ 26.7 $ 48.5 From sales of purchased power 77.6 92.9 91.5 $86.0 $119.6 $140.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWH) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The increase in other revenues in 1993 and 1992 resulted from continued increases in sales of capacity, energy, and spinning reserve to other affiliated companies because of additional capacity and energy available from new PURPA projects in both years. This increase was offset in part in 1993 by an agreement with the Federal Energy Regulatory Commission to record in 1993 about $3 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. About 90% of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on net income. M-11 Operating Expenses Fuel expenses decreased 3% in 1993 and 9% in 1992. Both decreases were primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $ 68.6 $ 85.5 $ 83.0 From PURPA generation 55.7 37.4 13.2 Other 8.1 3.1 7.2 Power exchanges, net (.6) .3 (.5) Affiliated transactions: AGC capacity charges 23.3 24.2 25.1 Energy and spinning reserve charges .5 2.8 5.3 $155.6 $153.3 $133.3 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The increases in purchases from PURPA generation reflects additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. Energy and spinning reserve charges decreased in 1993 and 1992 primarily because of additional generation available from new PURPA projects. M-12 The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, will increase future employee benefit costs for postretirement benefit expenses. The Company is currently recovering approximately 50% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 and early 1995 rate cases. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-13 Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes (B&O taxes) ($1 million) due to decreased generation in that state. The 1992 decrease resulted from decreased B&O taxes ($2 million) and prior period B&O tax adjustments ($2 million), offset somewhat by increases in gross receipts and property taxes ($2 million). The net increase of $6 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($4 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $3 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures primarily associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to decrease as the Company completes its Phase I compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used M-14 internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $141 million and for 1994 and 1995 are estimated at $103 million and $83 million, respectively. These estimates include $39 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $400 million, which includes $122 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, was about $69 million for 1993. A regulatory commission order has been received in West Virginia authorizing procedures to provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and new rate cases planned in 1994 and early 1995, internal generation of cash can be expected to increase. M-15 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($13 million). The five- year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $10.68 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $67 million of debt securities having interest rates of 7.5% to 9.5% through the issuance of $72 million of securities having interest rates of 5.625% to 5.95%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. Short-term debt, including notes payable to affiliates under the money pool, increased from $8.0 million in 1992 to $63.1 million in 1993. The Company canceled or postponed approximately $69 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $100 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $81 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $50 million of new equity securities and, if economic and market conditions make it desirable, may refinance up to $285 million of first M-16 mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. As of January 1994, the Company has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the M-17 Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of the Company. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by the Company for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-18 Potomac MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $73.5 million, $67.5 million, and $58.2 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-5 and D-6. Such kWh sales increased 6.3% and 2.0% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $24.4 $ 7.7 Fuel and energy cost adjustment clauses (a) 19.1 10.4 Rate increases (b): Maryland 12.7 11.7 Virginia 2.5 1.8 West Virginia 1.1 .3 16.3 13.8 Other 2.9 .2 $62.7 $32.1 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a rate increase in Maryland, designed to produce $11.3 million on an annual basis, which became effective on February 25, 1993, and a rate increase in Virginia, designed to produce $10.0 million on an annual basis, which became effective on September 28, 1993, subject to refund. The Maryland surcharge for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance investment of $1.7 million effective on June 4, 1992, which was increased to $3.9 million effective on December 3, 1992, was rolled into base rates effective with the February 1993 increase. Rate increases also include a CAAA surcharge in West Virginia designed to produce $.8 million on an annual basis effective July 1, 1992, which was increased to $2.2 million on an annual basis effective July 1, 1993. The increased kWh sales to residential and commercial customers in 1993 reflect both higher use and growth in number of customers. While 1993 heating degree days showed only a slight increase over 1992, and were only 7% M-19 above normal, cooling degree days increased 82% over 1992 and were 12% over normal, contributing to the 1993 kWh sales increases. The Company experienced a normal winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. KWh sales to industrial customers increased 4.3% in 1993 and 2.0% in 1992. The increase in both years occurred in almost all industrial groups, the most significant of which in 1993 was from sales to cement customers. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.0 1.8 From purchased power 3.5 4.4 3.8 3.9 5.4 5.6 Revenues (in millions): From Company generation $8.6 $27.5 $47.4 From sales of purchased power 99.5 113.6 114.3 $108.1 $141.1 $161.7 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $4 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M-20 Operating Expenses Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities, capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $87.9 $104.6 $103.7 Other 10.5 3.7 8.9 Power exchanges, net (.8) .2 (.4) Affiliated transactions: AGC capacity charges 28.0 29.6 31.3 Other affiliated capacity charges 28.4 21.9 23.4 Energy and spinning reserve charges 51.1 41.2 37.6 $205.1 $201.2 $204.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power purchased from nonaffiliates for use by the Company and affiliated energy and spinning reserve charges are mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The 1993 increase in other purchased power reflects efforts to conserve coal because of selective work stoppages by the United Mine Workers of America for most of the year. M-21 While the Company does not currently purchase generation from qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), several projects have been proposed, and an agreement has been reached with one facility to commence purchasing generation in 1999. This project and others may significantly increase the cost of power purchases passed on to customers. The increase in affiliated capacity and energy and spinning reserve charges in 1993 was due to growth of kWh sales to retail customers and an increase in affiliated energy available because of energy purchased by an affiliate from new PURPA projects in 1992 and 1993. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $1.5 million. The Company is currently recovering approximately 90% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 rate cases. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. M-22 The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes due to decreased generation in that state ($1 million). The 1992 increase was due to increased property ($1 million) and gross receipts ($1 million) taxes. The net increase of $2 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($3 million) and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million), offset by plant removal tax deductions for which deferred taxes were not provided ($1 million). The net increase in 1992 was primarily due to an increase in income before taxes. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stock, M-23 and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. During 1993, the Company continued its participation in the Collaborative Process for Demand-Side Management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and the Company's largest industrial customer. The Company received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993, the Company had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. Capital Requirements Construction expenditures for 1993 were $179 million and for 1994 and 1995 are estimated at $136 million and $106 million, respectively. These estimates include $40 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $350 million, which includes $153 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has M-24 additional annual capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $75 million in 1993. Regulatory commission orders received in all of the state jurisdictions and the FERC provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and new rate cases planned in 1994, internal generation of cash can be expected to increase. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($14 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $13.99 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $121 million of debt securities having interest rates of 7% to 9.5% through the issuance of $129 million of securities having interest rates of 5.875% to 7.75%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $9 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $36 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. M-25 At December 31, 1993, the Company had SEC authorization to issue up to $115 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $84 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $75 million of new debt securities and, if economic and market conditions make it desirable, may refinance up to $231 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-26 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in five generating plants, including four operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-27 West Penn MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Net Income Consolidated net income was $102.1 million, $98.2 million, and $101.2 million in 1993, 1992, and 1991, respectively. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases, offset in part by higher expenses. Higher retail revenues in 1992 from a surcharge to recover increases in various state taxes and greater kWh sales were more than offset by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-7 and D-8. Such kWh sales increased 3.1% and 2.7% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $15.5 $ 6.7 Fuel and energy cost adjustment clauses (a) 26.2 15.2 Rate increases (b) 25.2 5.8 Other 3.1 1.3 $70.0 $29.0 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) Reflects a base rate increase on an annual basis of about $61.6 million in Pennsylvania effective May 18, 1993, including $26.1 million for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance costs, and in 1992 also reflects a surcharge effective August 24, 1991, to recover Pennsylvania tax increases. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days remained about the same as 1992, and were only 6% below normal, cooling degree days increased 70% over 1992 and were 46% over normal, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-28 KWh sales to industrial customers increased .8% in 1993 and 6.3% in 1992. The relatively flat industrial sales growth in 1993 followed increases in industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.3 2.3 From purchased power 5.0 6.5 5.4 5.4 7.8 7.7 Revenues (in millions): From Company generation $11.5 $37.5 $62.5 From sales of purchased power 141.0 167.2 160.7 $152.5 $204.7 $223.2 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The decrease in other revenues in 1993 and 1992 resulted from continued decreases in sales of energy and spinning reserve to an affiliated company because of additional energy available to it from new PURPA projects commencing in both years. The 1993 decrease was also due in part to an agreement with the Federal Energy Regulatory Commission to record in 1993 about $6 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. Most of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. M-29 Operating Expenses Fuel expenses decreased 4% in each of the years of 1993 and 1992 primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $124.5 $153.9 $146.0 From PURPA generation 49.6 56.5 55.6 Other 15.2 5.9 12.9 Power exchanges, net (1.2) .3 (.5) Affiliated transactions: AGC capacity charges 42.3 43.5 44.1 Energy and spinning reserve charges 4.7 3.5 3.8 Other affiliated capacity charges .7 .6 .6 $235.8 $264.2 $262.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net M-30 income. The decrease in purchases from PURPA generation in 1993 was due to a planned generating outage at one PURPA project. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and in 1993 also from employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $3.1 million. The Company is currently recovering all of SFAS No. 106 expenses in rates. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 5% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-31 Depreciation expense increases resulted primarily from additions to electric plant and in 1993 also from a change in depreciation rates and net salvage amortization as a result of the May 1993 rate order. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the consolidated financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $2 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($3 million) offset in part by decreased West Virginia Business and Occupation taxes (B&O taxes) ($2 million) due to decreased generation in that state. The 1992 increase resulted from increased property and capital stock taxes ($4 million), increased B&O taxes ($1 million), and increases in gross receipts taxes ($1 million). The net increase of $7 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($6 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $4 million resulted primarily from a decrease in income before taxes. Note B to the consolidated financial statements provides a further analysis of income tax expenses. The combined increase of $.3 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the consolidated financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such M-32 as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $251 million and for 1994 and 1995 are estimated at $258 million and $208 million, respectively. These estimates include $82 million and $33 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable ruling of the Pennsylvania PUC allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $700 million, which includes $207 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the consolidated financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $119 million in 1993. A regulatory commission order has been received from the PUC which provides for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and a new rate case planned in 1994, internal generation of cash can be expected to increase. M-33 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($27 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $18.04 million of 6.30% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $246 million of debt securities having interest rates of 7% to 9.75% through the issuance of $251 million of securities having interest rates of 4.95% to 6.375%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $47 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $170 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $135 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $105 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $212 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction program, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the consolidated financial statements. Pennsylvania has enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-35 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System- operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in four generating plants, including three operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-36 AGC MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As described under Liquidity and Capital Resources, revenues are determined under a cost of service formula rate schedule. Therefore, if all other factors remain equal, revenues are expected to decrease each year due to a normal continuing reduction in the Company's net investment in the Bath County station and its connecting transmission facilities upon which the return on investment is determined. Revenues for 1993 and 1992 decreased due to a reduction in interest charges and net investment, and reduced operating expenses which are described below. Additionally, revenues for 1993 and 1992 were reduced by the recording of estimated liabilities for possible refunds pending final Federal Energy Regulatory Commission (FERC) decisions in rate case proceedings (see Liquidity and Capital Resources). The net investment (primarily net plant less deferred income taxes) decreases to the extent that provisions for depreciation and deferred income taxes exceed net plant additions. The decrease in operating expenses in 1993 resulted from a decrease in federal income taxes due to a decrease in income before taxes ($1.9 million) offset by an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($.5 million), partially offset by an increase in operation and maintenance expense. The decrease in operating expenses in 1992 resulted primarily from reduced federal income taxes because of a decrease in income before taxes, partially offset by increases in taxes other than income. The increase in taxes other than income in 1992 was due to increased property taxes. The decreases in interest on long-term debt in 1993 and 1992 were the combined result of decreases in the average amount of and interest rates on long-term debt outstanding. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company's only operating assets are an undivided 40% interest in the Bath County (Virginia) pumped-storage hydroelectric station and its connecting transmission facilities. The Company has no present plans for construction of any other major facilities. M-37 Pursuant to an agreement, the Parents buy all of the Company's capacity in the station priced under a "cost of service formula" wholesale rate schedule approved by the FERC. Under this arrangement, the Company recovers in revenues all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment. Through February 29, 1992, the Company's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. On March 1, 1990, the ROE decreased from 12% to 11.25%, and on March 1, 1991, it was increased to 11.53%. In December 1991, the Company filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. In 1993, the Company issued $50 million of 5.75% medium-term notes due 1998, $50 million of 5.625% debentures due 2003, and $100 million of 6.875% debentures due 2023 to refund $50 million 8% debentures due 1997, $50 million 8.75% debentures due 2017, and $100 million 9.125% debentures due 2016. The Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. - 42 - ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Financial Statement Schedules - All other schedules are omitted because they are not applicable or the required information is shown in the Financial Statements or Notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Power System, Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Power System, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and E to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 APS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The Company and its subsidiaries (companies) are subject to regulation by the Securities and Exchange Commission. The subsidiaries are subject to regulation by various state bodies having jurisdiction and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company and its subsidiaries are summarized below. CONSOLIDATION: The Company owns all of the outstanding common stock of its subsidiaries. The consolidated financial statements include the accounts of the Company and all subsidiary companies after elimination of intercompany transactions. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures followed by Monongahela Power Company in West Virginia, revenues include service rendered but unbilled at year end. Certain increases in rates being collected by subsidiaries are subject to final commission approvals, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used by the subsidiaries for computing AFUDC in 1993, 1992, and 1991 averaged 9.37%, 9.19%, and 8.84%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4% of average depreciable property in 1993 and 3.3% in each of the years 1992 and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INVESTMENTS: The investment in subsidiaries consolidated represents the excess of acquisition cost over book equity (goodwill) prior to 1966. Goodwill is not being amortized because, in management's opinion, there has been no reduction in its value. Other investments primarily represent the cash surrender values and prepayments of purchased life insurance contracts on certain qualifying management employees under an executive life insurance plan and a supplemental executive retirement plan (Secured Benefit Plan). Payment of future premiums will fully fund these benefits. INCOME TAXES: Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The subsidiaries have a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The subsidiaries also provide partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the subsidiaries adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the subsidiaries adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before preferred dividends and income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the subsidiaries recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $ 105 289 Unbilled revenue 38 363 Tax interest capitalized 22 236 Contributions in aid of construction 17 176 State tax loss carryback/carryforward 14 560 Other 21 658 219 282 Deferred tax liabilities: Book vs. tax plant basis differences, net 1 051 500 Other 42 122 1 093 622 Total net deferred tax liabilities 874 340 Less portion above included in current liabilities 645 Total long-term net deferred tax liabilities $ 873 695 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the subsidiaries have recorded regulatory assets for an amount equal to the $562 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $108 million increase in deferred tax assets to reflect the subsidiaries' obligation to pass such tax benefits on to their customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. NOTE C--DIVIDEND RESTRICTION: Supplemental indentures relating to most outstanding bonds of subsidiaries contain dividend restrictions under the most restrictive of which $461,539,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on their common stocks, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by a subsidiary as a capital contribution or as the proceeds of the issue and sale of shares of such subsidiary's common stock. The benefits earned to date and funded status at December 31 using a measurement date of September 30 were as follows: In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. NOTE E--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: The subsidiaries adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the subsidiaries for retired employees and their dependents were recorded in expense in the period in which they were paid and were $6,553,000 and $5,691,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost--benefits earned $ 2 000 Interest cost on accumulated postretirement benefit obligation 11 300 Actual return on plan assets (24) Amortization of unrecognized transition obligation 7 300 Other net amortization and deferral 24 SFAS No. 106 postretirement cost 20 600 Regulatory deferral (4 790) Net postretirement cost $15 810 The benefits earned to date and funded status at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $115 019 Fully eligible employees 24 135 Other employees 55 255 Total obligation 194 409 Plan assets at market value in short-term investment fund 4 646 Accumulated postretirement benefit obligation in excess of plan assets 189 763 Less: Unrecognized cumulative net loss from past experience different from that assumed 41 450 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 138 200 Postretirement benefit liability at September 30, 1993 10 113 Fourth quarter 1993 contributions and benefit payments 4 549 Postretirement benefit liability at December 31, 1993 $ 5 564 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $145,500,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $13.4 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $1.0 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for the FERC wholesale customers effective in mid-to-late 1993. Regulatory actions have been taken by the Virginia and Ohio regulatory commissions which provide support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The subsidiaries have recorded regulatory assets at December 31, 1993, of $4.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. NOTE F--STOCKHOLDERS' EQUITY: COMMON STOCK: In November 1993, the common shareholders approved a two-for-one split of the Company's common stock which was effective November 4, 1993. The stock split reduced the par value of the common stock from $2.50 per share to $1.25 per share and increased the number of authorized shares of common stock from 130,000,000 to 260,000,000. The number of common stock shares outstanding and per share information for all periods reflect the two-for-one split. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. The holders of West Penn Power Company's auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. MANDATORILY REDEEMABLE PREFERRED STOCK: The Potomac Edison Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. That subsidiary has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, The Potomac Edison Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. NOTE G--LONG-TERM DEBT: Maturities for long-term debt for the next five years are: 1994, $26,000,000; 1995, $28,000,000; 1996, $43,575,000; 1997, $48,262,000; and 1998, $185,400,000. Substantially all of the properties of the subsidiaries are held subject to the lien securing each subsidiary's first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Commercial paper borrowings issuable by Allegheny Generating Company are backed by a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. However, to the extent that funds are available from the companies, Allegheny Generating Company borrowings are made through an internal money pool as described in Note H. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $2,129,923,000 and $2,033,103,000, respectively, based on actual market prices or market prices of similar issues. NOTE H--SHORT-TERM DEBT: To provide interim financing and support for outstanding commercial paper, lines of credit have been established with several banks. The companies have fee arrangements on all of their lines of credit and no compensating balance requirements. At December 31, 1993, unused lines of credit with banks were $149,175,000. In addition to bank lines of credit, in 1992 the companies established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, a multi-year credit program was established which provides that the subsidiaries may borrow up to $300 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of notes payable to banks ($75,825,000) and commercial paper ($54,811,000) and at the end of 1992 consisted of a note payable to a bank ($11,205,000). The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. NOTE I--COMMITMENTS AND CONTINGENCIES: CONSTRUCTION PROGRAM: The subsidiaries have entered into commitments for their construction programs, for which expenditures are estimated to be $500 million for 1994 and $400 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: The companies are subject to laws, regulations, and uncertainties as to environmental matters discussed under ITEM 1. ENVIRONMENTAL MATTERS. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The subsidiaries are estimating expenditures of approximately $1.4 billion, which includes $482 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $161 million and $53 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the subsidiaries will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION: In the normal course of business, the companies become involved in various legal proceedings. The companies do not believe that the ultimate outcome of these proceedings will have a material effect on their financial position. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Monongahela Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Monongahela Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 1,500,000 shares, outstanding as follows (Note G): Monongahela NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures in West Virginia, revenues include service rendered but unbilled at year end. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 8.69%, 8.23%, and 6.17%, respectively. In accordance with FERC guidelines, the 1991 rate was based solely on borrowed funds because the Company's average outstanding short-term debt was greater than the average construction work in progress balance. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.8% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $18 043 Unbilled revenue 4 181 Tax interest capitalized 2 430 Contributions in aid of construction 2 058 Vacation pay 1 958 Advances for construction 1 601 Other 4 455 34 726 Deferred tax liabilities: Book vs. tax plant basis differences, net 205 829 Other 23 411 229 240 Total net deferred tax liabilities 194 514 Less portion above included in current liabilities 2 048 Total long-term net deferred tax liabilities $192 466 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $158 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,482,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 27% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.3 million, $8.3 million, and $8.9 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 30%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $2,390,000 and $2,029,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 478 Interest cost on accumulated postretirement benefit obligation 2 819 Actual return on plan assets (5) Amortization of unrecognized transition obligation 1 772 Other net amortization and deferral 5 SFAS No. 106 postretirement cost 5 069 Regulatory deferral (1 981) Net postretirement cost $3 088 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $32 469 Fully eligible employees 4 348 Other employees 14 664 Total obligation 51 481 Plan assets at market value in short-term investment fund 1 230 Accumulated postretirement benefit obligation in excess of plan assets 50 251 Less: Unrecognized cumulative net loss from past experience different from that assumed 14 161 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 34 059 Postretirement benefit liability at September 30, 1993 2 031 Fourth quarter 1993 contributions and benefit payments 997 Postretirement benefit liability at December 31, 1993 $ 1 034 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $35,800,000 (transition obligation), is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $3.5 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.2 million. Recovery of SFAS No. 106 costs has been authorized for FERC wholesale customers effective in December 1993. Recovery has been requested in a rate case filed in West Virginia for which a final commission decision is expected in 1994. Regulatory action has been taken by the Ohio regulatory commission which provides support that substantial recovery is probable. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million for West Virginia and Ohio where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: In September 1992, the Company issued and sold to its parent, 800,000 shares of its common stock at $50 per share. Other paid-in capital decreased $4,000 in 1992 as a result of a preferred stock redemption. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994 and 1995, none; 1996, $18,500,000; 1997, $15,500,000; and 1998, $20,100,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $65 million of 5-5/8% 7-year first mortgage bonds to refund a $10 million 8-1/8% issue due in 1999, a $30 million 7-7/8% issue due in 2002, and a $20 million 7-1/2% issue due in 1998. The Company also issued $7.05 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund a $7.05 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $485,713,000 and $461,663,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Debt: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $100 million including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $81 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of $63.1 million of notes payable to banks and at the end of 1992 consisted of money pool borrowings from affiliates of $8.03 million. The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $103 million for 1994 and $83 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $400 million, which includes $122 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $39 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 27% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of The Potomac Edison Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Potomac Edison Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Potomac NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. Revenues of $63.4 million from one industrial customer, Eastalco Aluminum Company, were 8.9% of total electric operating revenues in 1993. Certain increases in rates being collected by the Company in Virginia are subject to final commission approval, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.97%, 9.92%, and 9.93%, respectively. AFUDC is not recorded for construction applicable to the state of Virginia, where construction work in progress is included in rate base. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.6% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $17 922 Unbilled revenue 12 556 Contributions in aid of construction 10 530 Tax interest capitalized 9 056 State tax loss carryback/carryforward 5 770 Advances for construction 1 303 Other 3 279 60 416 Deferred tax liabilities: Book vs. tax plant basis differences, net 183 892 Other 10 122 194 014 Total net deferred tax liabilities 133 598 Less portion above included in current liabilities 571 Total long-term net deferred tax liabilities $133 027 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $74 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,730,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 28% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.6 million, $8.6 million, and $9.2 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 35%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long- term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,790,000 and $1,564,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 35%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 383 Interest cost on accumulated postretirement benefit obligation 3 042 Actual return on plan assets (7) Amortization of unrecognized transition obligation 1 986 Other net amortization and deferral 7 SFAS No. 106 postretirement cost 5 411 Regulatory deferral (846) Net postretirement cost $4 565 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 189 Fully eligible employees 7 741 Other employees 14 635 Total obligation 57 565 Plan assets at market value in short-term investment fund 1 375 Accumulated postretirement benefit obligation in excess of plan assets 56 190 Less: Unrecognized cumulative net loss from past experience different from that assumed 15 695 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 37 995 Postretirement benefit liability at September 30, 1993 2 500 Fourth quarter 1993 contributions and benefit payments 1 132 Postretirement benefit liability at December 31, 1993 $1 368 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $40,000,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.0 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.3 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993 and for the FERC wholesale customers effective in September 1993. Regulatory action has been taken by the Virginia regulatory commission which provides support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The Company has recorded regulatory assets at December 31, 1993, of $.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL The Company issued and sold common stock to its parent, at $20 per share, 2,500,000 shares in October 1993, 4,000,000 shares in September 1992, and 1,250,000 shares in September 1991. Other paid-in capital decreased $2,000 in 1992 as a result of preferred stock transactions. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. MANDATORILY REDEEMABLE PREFERRED STOCK: The Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. The Company has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, the Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, $16,000,000; 1995, none; 1996, $18,700,000; 1997, $800,000; and 1998, $1,800,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $45 million of 7-3/4% 30-year first mortgage bonds and $75 million of 5-7/8% 7-year first mortgage bonds to refund a $25 million 8-5/8% issue due in 2007, a $15 million 8-5/8% issue due in 2003, a $20 million 8-3/8% issue due in 2001, a $15 million 7-5/8% issue due in 1999, a $12 million 7-1/2% issue due in 2002, and a $25 million 7% issue due in 1998. The Company also issued $8.6 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund an $8.6 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $566,070,000 and $538,211,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $115 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $84 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $4.6 million and $38 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $136 million for 1994 and $106 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $350 million, which includes $153 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $40 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 28% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of West Penn Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of West Penn Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock of the Company (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 3,097,077 shares, outstanding as follows (Note G): West Penn NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries (the companies). REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.40%, 9.25%, and 9.46%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4%, 3.3%, and 3.2% of average depreciable property in 1993, 1992, and 1991, respectively. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The companies join with the parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $40 455 Unbilled revenue 21 626 Tax interest capitalized 10 750 State tax loss carryback/carryforward 8 790 Contributions in aid of construction 4 588 Other 7 416 93 625 Deferred tax liabilities: Book vs. tax plant basis differences, net 507 214 Other 8 437 515 651 Total net deferred tax liabilities 422 026 Add portion above included in current assets 1 974 Total long-term net deferred tax liabilities $424 000 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $326 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $41 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $285,914,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 45% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $12.2 million, $13.8 million, and $14.8 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Consolidated Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 25%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,907,000 and $1,721,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 25%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 939 Interest cost on accumulated postretirement benefit obligation 4 389 Actual return on plan assets (9) Amortization of unrecognized transition obligation 2 817 Other net amortization and deferral 9 SFAS No. 106 postretirement cost 8 145 Regulatory deferral (1 963) Net postretirement cost $6 182 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 748 Fully eligible employees 9 030 Other employees 18 378 Total obligation 63 156 Plan assets at market value in short-term investment fund 1 510 Accumulated postretirement benefit obligation in excess of plan assets 61 646 Less: Unrecognized cumulative net loss from past experience different from that assumed 3 362 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 53 746 Postretirement benefit liability at September 30, 1993 4 538 Fourth quarter 1993 contributions and benefit payments 1 960 Postretirement benefit liability at December 31, 1993 $2 578 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $56,600,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.3 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.4 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Pennsylvania effective in May 1993 and for the FERC wholesale customers effective in June 1993. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million relating to SFAS No. 106 costs in Pennsylvania incurred prior to the May rate order, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. The Company will seek to recover these costs in its next base rate case. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: The Company issued and sold common stock to its parent, at $20 per share, 5,000,000 shares in October 1993, and 1,750,000 shares in December 1991. Other paid-in capital decreased $145,000 in 1993 and $550,000 in 1992 as a result of the underwriting fees and commissions and miscellaneous expenses associated with the Company's sale of $40 million of preferred stock in 1992. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 per share. The holders of the Company's market auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, none; 1995, $27,000,000; 1996 and 1997, none; and 1998, $103,500,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $102 million of 5-1/2% 5-year first mortgage bonds to refund a $25 million 7% issue due in 1997, a $25 million 7-7/8% issue due in 1999, and a $52 million 7-1/8% issue due in 1998, and sold $80 million of 6-3/8% 10-year first mortgage bonds to refund a $35 million 7-5/8% issue due in 2002 and a $40 million 8-1/8% issue due in 2001. The Company also issued $7.75 million of 5.95% 20-year Pollution Control Revenue Notes to refund a $7.75 million 9-3/8% issue due in 2013, and issued $61.5 million of 10-year 4.95% Pollution Control Revenue Notes to refund a $30 million 9-3/4% series and a $31.5 million 9-1/2% series due in 2003. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $823,333,000 and $783,379,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $170 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $135 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $24.9 million and $20.9 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $258 million for 1994 and $208 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $700 million, which includes $207 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $82 million and $33 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 45% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Generating Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Generating Company (an Allegheny Power System, Inc. affiliate) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A and B to the financial statements, the Company changed its method of accounting for income taxes in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 AGC NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company was incorporated in Virginia in 1981. Its common stock is owned by Monongahela Power Company - 27%, The Potomac Edison Company - 28%, and West Penn Power Company - 45% (the Parents). The Parents are wholly-owned subsidiaries of Allegheny Power System, Inc. and are a part of the Allegheny Power integrated electric utility system. The Company is subject to regulation by the Securities and Exchange Commission (SEC) and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, and consist of a 40% undivided interest in the Bath County pumped-storage hydroelectric station and its connecting transmission facilities. The cost of depreciable property units retired plus removal costs less salvage are charged to accumulated depreciation. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 2.1% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged to operating expenses. INCOME TAXES: The Company joins with its parents and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are deferred. Prior to 1987, provisions for federal income tax were reduced by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. ACCOUNTING CHANGE: Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes. Note B - Income Taxes: Details of federal income tax provisions are: In 1993, the total provision for income taxes ($13,262,000) was less than the amount produced by applying the federal income tax statutory rate to financial accounting income before income taxes ($14,155,000), due primarily to amortization of deferred investment credit ($1,316,000). Federal income tax returns through 1989 have been examined and substantially settled. The Company adopted SFAS No. 109 as of January 1, 1993, and in doing so recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets Unamortized investment tax credit $ 28 869 Deferred tax liabilities Book vs. tax plant basis differences, net 154 565 Other 152 154 717 Total net deferred tax liabilities $125 848 It is expected the FERC will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $4 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $29 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Long-Term Debt: The Company had long-term debt outstanding as follows: The Company has a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. Amounts borrowed are guaranteed by the Parents in proportion to their equity interest. Interest rates are determined at the time of each borrowing. The revolving credit agreement serves as support for the Company's commercial paper. In addition to bank lines of credit, the Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At the end of 1993, the Company had outstanding $29,500,000 of money pool borrowings from affiliates. Maturities for long-term debt for the next five years are: 1994, 10,000,000; 1995, $1,000,000; 1996, $6,375,000; 1997, $61,462,000; and 1998, $60,000,000. The estimated fair value of debentures and medium- term notes at December 31, 1993 and 1992, was $233,445,000 and $249,850,000 respectively, based on actual market prices or market prices of similar issues. The carrying amount of commercial paper and notes payable to affiliates approximates their fair value because of the short maturity of those instruments. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Classified as long-term debt by Allegheny Generating Company (AGC). Charges for maintenance and depreciation other than amounts shown in the consolidated statement of income were not material. Charges for maintenance and depreciation other than amounts shown in the statement of income were not material. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Internal arrangement for borrowing funds on a short-term basis. - 43 - - 44 - ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE For APS and the Subsidiaries, none. - 45 - PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS APS, Monongahela, Potomac Edison, West Penn, and AGC. Reference is made to the Executive Officers of the Registrants in Part I of this report. The names, ages, and the business experience during the past five years of the directors of the System companies are set forth below: (1) See Executive Officers of the Registrants in Part I of this report for further details. (a) Eleanor Baum. Dean of the Albert Nerken School of Engineering of The Cooper Union for the Advancement of Science and Art. Director of United States Trust Company, Commissioner of the Engineering Manpower Commission, and a fellow of the Institute of Electrical and Electronic Engineers and the Society of Women Engineers. Ms. Baum filed one late report on Form 4 concerning one purchase transaction in 1993. (b) William L. Bennett. Co-Chairman, Director and Chief Executive Officer of Noel Group, Inc. Formerly, General partner, Discovery Funds, a venture capital affiliate of Rockefeller & Company, Inc. Chairman of the Board of TDX Corporation. Director of Forschner Group, Inc., Global Natural Resources Inc., Lincoln Snacks Company, Simmons Outdoor Corporation and VISX, Inc. (c) Phillip E. Lint. Retired. Formerly, partner, Price Waterhouse. (d) Edward H. Malone. Retired. Formerly, Vice President of General Electric Company and Chairman, General Electric Investment Corporation. Director of Fidelity Group of Mutual Funds, General Re Corporation, Mattel, Inc., and Corporate Property Investors, a real estate investment trust. (e) Frank A. Metz, Jr. Retired. Formerly, Senior Vice President, Finance and Planning, and Director, International Business Machines Corporation. Director of Monsanto Company and Norrell Corporation. (f) Clarence F. Michalis. Chairman of the Board of Directors of Josiah Macy, Jr. Foundation, a tax-exempt foundation for medical research and education. Director of Schroder Capital Funds Inc. (g) Steven H. Rice. Business consultant and attorney-at-law. Formerly, President and Chief Operating Officer and Director of The Seamen's Bank for Savings. Director and member of the Investment and Audit Committees of Royal Group, Inc. (The Royal Insurance Companies). Director and Vice Chairman of the Board of The Stamford (CT) Federal Savings Bank. (h) Gunnar E. Sarsten. President and Chief Operating Officer of Morrison Knudsen Corporation. Formerly, President and Chief Executive Officer of United Engineers & Constructors International, Inc., a subsidiary of the Raytheon Company, and Deputy Chairman of the Third District Federal Reserve Bank in Philadelphia. (i) Peter L. Shea. Managing director of Hydrocarbon Energy, Inc., a privately owned oil and gas development drilling and production company. - 46 - ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION During 1993, and for 1992 and 1991, the annual compensation paid by each of the System companies, APS, APSC, Monongahela, Potomac Edison, West Penn, and AGC directly or indirectly for services in all capacities to such companies to their Chief Executive Officer and each of the four most highly paid executive officers of each such company whose cash compensation exceeded $100,000 was as follows: (a) APS has no paid employees. All salaries and bonuses are paid by APSC. (b) Bonus amounts are determined and paid in April of the year in which the figure appears and are based upon performance in the prior year. (c) Amounts constituting less than 10% of the total annual salary and bonus are not disclosed. All officers did receive miscellaneous other items amounting to less than 10% of total annual salary and bonus. (d) Effective January 1, 1992, the basic group life insurance provided employees was reduced from two times salary during employment, which reduced to one times salary after 5 years in retirement, to a new plan which provides one times salary until retirement and $25,000 thereafter. Executive officers and other senior managers remain under the prior plan. In order to pay for this insurance for these executives, during 1992 insurance was purchased on the lives of each of them. Effective January 1, 1993, APS started to provide funds to pay for the future benefits due under the supplemental retirement plan (Secured Benefit Plan) as described in note (a) on p. 53. To do this, APS purchased, during 1993, life insurance on the lives of the covered executives. The premium costs of both the 1992 and 1993 policies plus a factor for the use of the money are returned to APS at the earlier of (a) death of the insured or (b) the later of age 65 or 10 years from the date of the policy's inception. The figures in this column include the present value of the executives' cash value at retirement attributable to the current year's premium payment for both the Executive Life Insurance and Secured Benefit Plans (based upon the premium, future valued to retirement, using the policy internal rate of return minus the corporation's premium payment), as well as the premium paid for the basic Group Life Insurance program plan and the contribution for the 401(k) plan. For 1993, the figure shown includes amounts representing (a) the aggregate of life insurance premiums and dollar value of the benefit to the executive officer of the remainder of the premium paid on the Group Life Insurance program and the Executive Life Insurance and Secured Benefit Plans and (b) 401(k) contributions as follows: Mr. Bergman $42,392 and $4,497; Mr. Garnett $19,509 and $4,497; Mr. Skrgic $14,181 and $4,497; Ms. Gormley $11,152 and $4,294; and Mr. Jones $8,382 and $4,497, respectively. (e) These amounts as previously reported did not include the following amounts representing the dollar value of the benefit to the executive officer of the remainder of the premium paid on the Executive Life Insurance Plan: Mr. Bergman $786; Mr. Garnett $210; Mr. Skrgic $218; Ms. Gormley $232; and Mr. Jones $519. (f) See Executive Officers of the Registrants for other positions held. (g) Although less than 10% of total annual salary and bonus, Mr. Skrgic received a $15,000 housing allowance in 1993, 1992 and 1991. (h) The incentive plan was not in effect for these officers in 1991. (i) Includes $15,000 housing allowance for both 1993 and 1992 and miscellaneous other items totaling $2,423 and $2,457 for 1993 and 1992, respectively. - 47 - - 48 - - 49 - - 50 - Summary Compensation Tables AGC Annual Compensation (a) Name All Other and Compen- Principal sation Position Year Salary($) Bonus($) ($) (a) AGC has no paid employees. - 51 - DEFINED BENEFIT OR ACTUARIAL PLAN DISCLOSURE Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) APS (b) Klaus Bergman, President* $235,270 and Chief Executive Officer (c) Stanley I. Garnett, II, 112,320 Vice President, Finance (c) Peter J. Skrgic, 126,000 Vice President (c) Kenneth M. Jones, 90,004 Vice President and Comptroller (c) Nancy H. Gormley, 78,404 Vice President (c) Monongahela Klaus Bergman, $ Chief Executive Officer (c)(d) Benjamin H. Hayes, 113,364 President Thomas A. Barlow, 70,788 Vice President Robert R. Winter, 67,896 Vice President Richard E. Myers, 67,200 Comptroller * Elected Chairman of the Board effective January 1, 1994. - 52 - Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) Potomac Edison Klaus Bergman, $ Chief Executive Officer (c)(d) Alan J. Noia, 133,200 President Robert B. Murdock, 80,677 Vice President James D. Latimer, 75,298 Vice President Thomas J. Kloc, 68,591 Comptroller West Penn Klaus Bergman, $ Chief Executive Officer (c)(d) Jay S. Pifer, 111,463 President Thomas K. Henderson, 73,127 Vice President Charles S. Ault, 71,100 Vice President Charles V. Burkley, 66,442 Comptroller Allegheny Generating Company No paid employees. - 53 - (a) Assumes present insured benefit plan and salary continue and retirement at age 65 with single life annuity. Under plan provisions, the annual rate of benefits payable at the normal retirement age of 65 are computed by adding (i) 1% of final average pay up to covered compensation times years of service up to 35 years, plus (ii) 1.5% of final average pay in excess of covered compensation times years of service up to 35 years, plus (iii) 1.3% of final average pay times years of service in excess of 35 years. Covered compensation is the average of the maximum taxable Social Security wage bases during the 35 years preceding the member's retirement, except that years before 1959 are not taken into account for purposes of this average. The final average pay benefit is based on the member's average total earnings during the highest-paid 60 consecutive calendar months or, if smaller, the member's highest rate of pay as of any July 1st. Effective July 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. The maximum amount will be reduced to $150,000 effective July 1, 1994 as a result of The Omnibus Budget Reconciliation Act of 1993. Benefits for employees retiring between 55 and 62 differ from the foregoing. Pursuant to a supplemental plan (Secured Benefit Plan), senior executives of Allegheny Power System companies who retire at age 60 or over with 40 or more years of service are entitled to a supplemental retirement benefit in an amount that, together with the benefits under the basic plan and from other employment, will equal 60% of the executive's highest average monthly earnings for any 36 consecutive months. The supplemental benefit is reduced for less than 40 years service and for retirement age from 60 to 55. It is included in the amounts shown where applicable. In order to provide funds to pay such benefits, effective January 1, 1993 the Company purchased insurance on the lives of the plan participants. The Secured Benefit Plan has been designed that if the assumptions made as to mortality experience, policy dividends, and other factors are realized, the Company will recover all premium payments, plus a factor for the use of the Company's money. All executive officers are participants in the Secured Benefit Plan. This does not include benefits from an Employee Stock Ownership and Savings Plan (ESOSP) established as a non-contributory stock ownership plan for all eligible employees effective January 1, 1976, and amended in 1984 to include a savings program. Under the ESOSP for 1993, all eligible employees may elect to have from 2% to 7% of their compensation contributed to the Plan as pre-tax contributions and an additional 1% to 6% as post-tax contributions. Employees direct the investment of these contributions into one or more of five available funds. Each System company matches 50% of the pre-tax contributions up to 6% of compensation with common stock of Allegheny Power System, Inc. Effective January 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. Effective January 1, 1994, the amount was reduced to $150,000 as a result of The Omnibus Budget Reconciliation Act of 1993. Employees' interests in the ESOSP vest immediately. Their pre-tax contributions may be withdrawn only upon meeting certain financial hardship requirements or upon termination of employment. (b) APS has no paid employees. These executives are employees of APSC. (c) See Executive Officers of the Registrants for other positions held. (d) The total estimated annual benefits on retirement payable to Mr. Bergman for services in all capacities to APS, APSC and the Subsidiaries is set forth in the table for APS. Compensation of Directors In 1993, APS directors who were not officers or employees of System companies received for all services to System companies (a) $16,000 in retainer fees, (b) $800 for each committee meeting attended, except Executive Committee meetings which are $200, and (c) $250 for each Board meeting of each company attended. Under an unfunded deferred compensation plan, a director may elect to defer receipt of all or part of his or her director's fees for succeeding calendar years to be payable with accumulated interest when the director ceases to be such, in equal annual installments, or, upon authorization by the Board of Directors, in a lump sum. - 55 - ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.

25445_1993.txt

25445

1993

Item 1. Business -------- The company is a diversified manufacturer of engineered industrial products, serving niche markets in aerospace, fluid handling, automatic merchandising and the construction industry. The company's wholesale distribution business serves the building products markets and industrial customers. Founded in 1855, Crane Co. employs over 8,700 people in North America, Europe and Australia. The company's strategy is to maintain a balanced business mix, to focus on niche businesses with high market share and to avoid capital-intensive and cyclical businesses. In the past five years, the company has completed seven acquisitions. In 1990 it acquired Lear Romec, a manufacturer of lubrication and fuel pumps for the aerospace industry. In 1992, certain assets of Jenkins Canada, Inc., a manufacturer of bronze and iron valves, were acquired as an addition to the company's North American valve unit. In 1993, the company made five acquisitions. Perflow Instruments, Ltd., a British manufacturer of pressure and flow measurement equipment, was added to Crane Ltd. Huttig Sash and Door Company expanded its nationwide millwork distribution by acquiring Rondel's Inc., a millwork distributor serving the eastern Washington/western Idaho region, and the Whittier-Ruhle Millwork Company, serving the Mid-Atlantic region. The company significantly expanded its position as a supplier of fiberglass reinforced plastic (FRP) panels to the recreational vehicle market with the acquisition of Filon. Filon was integrated with the company's Kemlite unit in the fourth quarter of 1993. The company acquired Burks Pumps, Inc., a manufacturer of engineered pumps, in December 1993. This acquisition will complement the company's Chempump and Deming pump businesses and significantly increases its involvement in niche markets in the pump industry. In 1990 the company sold Sea-Pac Sales Co., a distributor of floor covering products, and its McAvity division, a Canadian manufacturer of waterwork valves and hydrants for an aggregate sales price of approximately $19 million. In April 1993, the company sold its precision ordnance business, UniDynamics/Phoenix for approximately $6 million. During March 1992 the company sold $100,000,000 8 1/2% notes that will mature on March 15, 2004. See page 24 of the Annual Report to Shareholders for the contributions to the company's sales and operating profit of each of its business segments and the assets employed in each segment. ENGINEERED INDUSTRIAL PRODUCTS ------------------------------ This segment is composed of operations that design and manufacture engineered products and systems for the aerospace, fluid handling, automatic merchandising, transportation, commercial construction and defense markets. The company serves the global valve market through manufacturing facilities in North America, the United Kingdom and Australia. The company sells a wide variety of valves and fluid control products for the chemical, processing, power and general industrial and commercial construction industries. Products include gate, globe, check, angle, ball and butterfly valves of steel, carbon and stainless steel, alloy, iron, cast iron and bronze designed for use under various pressures and temperatures, along with pipe fittings, actuators, pumps and flow measurement equipment. The North American unit also provides a full range of valve aftermarket services including parts, repairs, and modifications through eight service centers and the company's subsidiary in the United Kingdom also maintains repair and service facilities for valves, pumps, compressors, heat exchangers and similar equipment. PART I ------ Item 1. Business (continued) -------- Crane Pumps & Systems manufactures pumps used in the chemical, power, hydro-carbon processing, municipal, general industrial and commercial industries. Products include sealless canned motor pumps designed to handle environmentally hazardous fluids, horizontal and vertical centrifugal pumps, standard vertical turbine pumps, submersible wastewater pumps, regenerative turbine, end suction centrifugal pumps, submersible deaerator pumps, split case pumps, and in-line pumps. The pumps are marketed under the Chempump, Deming, Barnes, Burks, Weinman and Prosser brand names. The company's Cochrane Environmental Systems division designs and markets water and wastewater treatment equipment for almost every major industry. Cochrane's products include deaerators, demineralizers, hot and cold process softeners, dealkalizers, filters, multiport relief valves, condensate drainage systems and clarifiers. These products have applications for boiler feed, industrial processes and wastewater treatment and recovery and are sold principally to public utilities and authorities and major industrial plants. The above products are sold directly to end users through Crane's sales organizations and through independent distributors and manufacturers' representatives. The company designs, manufactures and sells, under the name "Hydro-Aire", anti-skid and automatic brake control systems, fuel and hydraulic pumps, and other aerospace components for the commercial, military and general aircraft industries as original equipment. In addition, the company designs and manufactures systems similar to those above for the retrofit of aircraft with improved systems and manufactures replacement parts for systems installed as original equipment by the aircraft manufacturer. All of these products are largely proprietary to the company and, to some extent, are custom designed to the requirements and specifications of the aircraft manufacturer or program contractor. These systems and replacement parts are sold directly to airlines, governments, and aircraft maintenance and overhaul companies. Lear Romec designs, manufactures and sells pumps and fluid handling systems for military and commercial aerospace industries. Lear Romec has a leading share of the non-captive market for turbine engine lube and scavenge oil pumps. Also, it is the leading supplier of fuel boost and transfer pumps for commuter and business aircraft. The company, through Resistoflex/Defense, designs and manufactures high performance fittings used primarily in military aircraft under the name "Dynatube". The company, through Crane Defense Systems is engaged in the development and manufacture of specialized handling systems, elevators, ground support equipment, cranes and associated electronics. These products are sold directly to the government and defense contractors and represented less than 2% of 1993 sales. Ferguson designs and manufactures, in the United States and through Ferguson Machine S. A. in Europe, precision index and transfer systems for use on and with machines which perform automatic forming, assembly, metal cutting, testing and inspection operations. Products include index drives and tables, mechanical parts handlers, inline transfer machines, rotary tables, press feeds and custom cams. These products are sold through company and independent sales representatives and distributors. PART I ------ Item 1. Business (continued) -------- Kemlite manufactures fiberglass-reinforced plastic panels for use principally by the transportation industry in refrigeration and dry van truck trailers and recreational vehicles. Kemlite products are also sold to the commercial construction industry for food processing, fast food restaurant and supermarket applications, and to institutions where fire rated materials with low smoke generation and minimum toxicity are required. Kemlite sells its products directly to the truck trailer and recreational vehicle manufacturers and uses distributors to serve its commercial construction market. Cor Tec is the leading domestic manufacturer of fiberglass-reinforced laminated panels. The primary market for these panels is the truck and truck trailer segment of the transportation industry. Cor Tec markets its products directly to the truck and truck trailer manufacturers. Resistoflex/Industrial is engaged in the design, manufacture and sale of plastic-lined steel pipe, fittings, valves, bellows and hose used primarily by the pharmaceutical, chemical processing, pulp and paper, petroleum distribution, and waste management industries. Resistoflex sells its products through industrial distributors who provide stocking and fabrication services to industrial users in the United States. The Canadian operations of the company are conducted by Crane Canada, Inc., a wholly-owned subsidiary. Crane Canada manufactures plumbing fixtures and related building products. The unit commands a large share of the Canadian market for these products. Polyflon manufactures radio frequency and microwave components, substrates, capacitors, and antennas for commercial and aerospace uses, and resonating structures for the medical industry. National Vendors is the largest domestic manufacturer of full line vending machines for the automatic merchandising industry. Products include machines which dispense snacks, refrigerated and frozen foods, hot and cold beverages and postal commodities. These products are marketed in North America directly to vending machine operators. In Europe products are marketed through wholly- owned subsidiaries with operations located in the United Kingdom, Germany and France. National Rejectors, GmbH designs and manufactures electronic coin validators and handling systems for vending operations throughout Europe. These devices are sold directly to the vending, amusement, soft-drink, and ticket issuing industries. WHOLESALE DISTRIBUTION ---------------------- The company distributes millwork products through its wholly-owned subsidiary, Huttig Sash & Door Company ("Huttig"). These products include doors, windows, moldings and related building products. Huttig assembles certain of these products to customer specification prior to distribution. Its principal customers are building material dealers and building contractors that service the new construction and remodeling markets. Wholesale operations are conducted nationally through forty-seven branch warehouses throughout the United States, in both major and medium-sized cities. Huttig's sales are made on both a direct shipment and out-of-warehouse basis entirely through its own sales force. Huttig maintains a saw mill and a manufacturing plant in Missoula, Montana, where it produces certain of the above products and other finished lumber, the bulk of which is sold directly to third parties, some of whom compete with Huttig branches. In addition, Huttig manufactures wood windows in Rock Hill, South Carolina. Valve Systems and Controls is a value added industrial distributor providing power operated valves and flow control systems to the petroleum, chemical, power and general processing industries. It services its customers through facilities in Texas, Louisiana, Oklahoma and California. PART I ------ Item 1. Business (continued) -------- Canadian wholesale operations are conducted through the Crane Canada Supply Division of Crane Canada, Inc. This division, a distributor of plumbing supplies, valves and piping, maintains thirty-seven branches throughout Canada and is the largest single distributor for Crane manufactured products. This division also distributes products which are both complementary to and partly competitive with Crane Canada's own manufactured products. COMPETITIVE CONDITIONS ---------------------- The company's lines of business are conducted under actively competitive conditions in each of the geographic and product areas they serve. Because of the diversity of the classes of products manufactured and sold, they do not compete with the same companies in all geographic or product areas. Accordingly, it is not possible to estimate the precise number of competitors or to identify the principal methods of competition. Although reliable statistics are not available, management believes the company and its subsidiaries are important manufacturers or suppliers in a number of market niches and geographic areas it serves. The company's products have primary application in the industrial, construction, aerospace, automated merchandising, transportation, and fluid handling industries. As such, they are dependent upon numerous unpredictable factors, including changes in market demand, general economic conditions, residential and commercial building starts, capital spending, energy exploration and energy allocations during times of scarcity. Since these products are also sold in a wide variety of markets and applications, management does not believe it can reliably quantify or predict the possible effects upon its business resulting from such changes. Seasonality is a considerable factor in Huttig and the Canadian operations. Order backlog totalled approximately $226 million as of December 31, 1993, compared with $262 million as of December 31, 1992. Management believes backlog is not material to understanding its overall business because long- term contracts are not customary to significant portions of its business, except within the defense and aerospace related businesses. RECENT DEVELOPMENTS ------------------- On March 18, 1994 pursuant to a tender offer, Crane Acquisition Corp., a wholly owned subsidiary of Crane ("Crane Acquisition"), acquired 5,620,383 shares of the common stock of ELDEC Corporation ("ELDEC") at $13.00 per share. With this purchase, Crane Acquisition Corp. acquired 98.7 percent of the outstanding shares of ELDEC and thereafter consummated the merger of ELDEC into Crane Acquisition Corp., each remaining share of ELDEC common stock would be converted into the right to receive $13.00 in cash. Therefore, ELDEC is now a wholly owned subsidiary of Crane. Funds in the amount of up to $74,000,000 required for the acquisition of ELDEC have been made available through short-term credit lines. ELDEC, a Washington based corporation, designs, manufactures and markets custom electronic and electromechanical products and systems for applications that are technically and environmentally demanding. The company serves both the commercial and military aerospace markets, and its major customers are airframe and aircraft engine manufacturers and electronic systems manufacturers. The company has four product lines; sensing systems that monitor the status of aircraft landing gear, doors and flight surfaces; low voltage and high voltage power supplies for avionic and defense electronic systems; monitor and control devices for aircraft engines, including flowmeters and engine diagnostic systems; battery chargers, transformer- rectifiers and other devices that regulate DC power on an aircraft. For the year ended March 31, 1993, ELDEC had net sales of $108,415,000, net income of $2,430,000, and total assets of $112,235,000. PART I ------ Item 1. Business (continued) -------- The company's engineering and product development activities are directed primarily toward improvement of existing products and adaptation of existing products to particular customer requirements. While the company owns numerous patents and licenses, none are of such importance that termination would materially affect its business. Product development and engineering costs aggregated approximately $18,300,000 in 1993 ($19,200,000 and $18,600,000 in 1992 and 1991, respectively). In addition, approximately $139,000, $4,100,000, and $6,900,000 were received by the company in 1993, 1992, and 1991, respectively, for customer sponsored research and development relating to projects within the Engineered Industrial Products segment. Costs of compliance with federal, state and local laws and regulations involving the discharge of materials into the environment or otherwise relating to the protection of the environment are not expected to have a material effect upon the company or its competitive position. Item 2.

Item 2. Properties *Includes plants under lease agreements: Engineered Industrial operates seven valve service centers in the United States, of which three are owned. The company also operates internationally nine distribution and eight service centers. Wholesale Distribution has forty-seven Huttig branch warehouses in the United States, of which twenty-nine are owned. The Canadian wholesale operation maintains thirty-seven distribution branch warehouses in Canada, of which sixteen are owned. Valve Systems and Controls operates four leased distribution facilities in the United States. In the opinion of management, properties have been well maintained, are in sound operating condition, and contain all necessary equipment and facilities for their intended purposes. PART I ------ Item 3.

Item 3. Legal Proceedings ----------------- Neither the company, nor any subsidiary of the company has become a party to, nor has any of their property become the subject of any material legal proceeding other than ordinary routine litigation incidental to their businesses. The following proceeding is included herein because it has been reported in the media. On September 22, 1992 the company was served with a complaint filed in the U.S. District Court, Eastern District of Missouri naming the company and its former subsidiary CF&I Steel Corporation ("CF&I") as defendants and alleging violations of the False Claims Act in connection with the distribution of CF&I to the company's shareholders in 1985 (Civil Actions Nos. 91-0429-C-1 and 4:92CV00514JCH). The complaint alleges a continuing agreement and concert of action between the company and CF&I to distribute CF&I to the company's shareholders, thereafter to terminate CF&I's pension plan so as to cause the Pension Benefit Guaranty Corporation ("PBGC") to assume CF&I's liability for $140 million in unfunded pension liabilities and to prevent the PBGC from obtaining any reimbursement from the company, and to publish and file misleading information in furtherance of that objective. The complaint seeks treble damages and attorney's fees. The company believes it has defenses to the complaint on the grounds, among others, that the allegations are without merit, the plaintiff has no standing and the False Claims Act does not apply. On June 1, 1993 the federal court in the Eastern District of Missouri dismissed the complaint for lack of standing of the plaintiff. The plaintiff has filed an appeal. The company expects the dismissal to be affirmed by the appellate court. The following proceedings are not considered by the company to be material to its business or financial condition and are reported herein because of the requirements of the Securities and Exchange Commission with respect to the descriptions of administrative or judicial proceedings by governmental authorities arising under federal, state or local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment. In a letter dated October 15, 1992 the office of the Attorney General of the State of Ohio advised Cor Tec, a division of Dyrotech Industries, Inc. which is a subsidiary of the company, that Cor Tec's plant facility in Washington Court House, Ohio, had operated numerous air contaminant sources in its manufacturing process which emitted air pollutants for an extended period of time without the required state permits. The Ohio Attorney General's office also alleged that certain contaminant sources at the Cor Tec facility were installed without obtaining permits to install. The main air contaminant in question is styrene, a volatile organic compound that is alleged to be a carcinogen. Cor Tec recently constructed an air remediation system in its plant which included the installation of a hood, vent and incinerator to capture and incinerate the styrene emissions. At a meeting in Columbus, Ohio on March 4, 1993 the Attorney General's office proposed that Cor Tec and the company sign a Consent Decree which would include general injunctive relief and civil penalties in the amount of $4.6 million. Cor Tec has refused to execute such a Decree or pay a penalty. No formal complaint has been filed by the Ohio Attorney General against the company or Cor Tec with regard to the styrene emissions. Cor Tec believes it has adequate defenses to the allegations made by the Attorney General and it plans to vigorously resist paying any damages, fines, or penalties. On July 12, 1985 the company received written notice from the United States Environmental Protection Agency (the "EPA") that the EPA believes the company may be a potentially responsible party ("PRP") under the Federal Comprehensive Environmental Response Compensations and Liability Act of 1980 ("CERCLA") to pay for investigation and corrective measures which may be required to be taken at the Roebling Steel Company site in Florence Township, Burlington County, New Jersey (the "Site") of which its former subsidiary, CF&I Steel Corporation ("CF&I") was a past owner and operator prior to the enactment of CERCLA. The PART I ------ Item 3. Legal Proceedings (continued) ----------------- stated grounds for the EPA's position was the EPA's belief that the company had owned and/or operated the Site. The company had advised the EPA that such was not the case and does not believe that it is responsible for any testing or clean-up at the Site based on current facts. CF&I also has received notice from the State of New Jersey Department of Environmental Protection, Office of Regulatory Services ("NJDEP)", advising CF&I that an investigation by the NJDEP had identified what was considered an existing and potential environmental problem at the Site. As a past owner and operator at the Site, CF&I was notified of the NJDEP's belief that further investigatory action was needed to identify all potential environmental problems at the Site and thereafter formulate and implement a remedial plan to address any identified problems. The NJDEP has subsequently requested information from CF&I, and CF&I has cooperated in providing information, including results of tests which CF&I has conducted at the Site. The EPA identified sources of contamination, which must be examined for potential environmental damage, including: chemical waste drums, storage tanks, transformers, impressed gas cylinders, chemical laboratories, bag house dust, rubber tires, inactive railroad cars, wastewater treatment plants, lagoons, slag disposal areas, and a landfill. On November 7, 1990 CF&I filed a petition for reorganization and protection under Chapter 11 of the United States Bankruptcy Code. The EPA has disclosed that two surface clean-ups have been performed at a cost in excess of $2,000,000 and a further surface clean-up has been announced at an estimated cost of approximately $5,000,000. On July 1, 1991 the company received a letter from the EPA providing an update of the clean-up at the Site. The EPA's July 1, 1991 letter describes a proposed third phase of the investigation, including a Focused Feasibility Study which defined the nature of contaminants and evaluated remedial alternatives for two portions of the Site. The estimated cost for the preferred remedy selected by the EPA for these locations is $12,000,000. In the bankruptcy proceeding of CF&I the EPA was allowed an unsecured claim against CF&I for $27.1 million related to EPA's environmental investigations and remediation at the Roebling Site. Based on the analysis above, the company does not believe it is responsible for any portion of the clean-up. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- There have been no matters submitted to a vote of security holders during the fourth quarter of 1993. PART I ------ EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ The executive officers of the registrant are as follows: (1) Resigned March 16, 1994 (2) Effective January 27, 1994 (3) Effective March 21, 1994 PART II ------- The information required by Items 5 through 8 is hereby incorporated by reference to Pages 6 through 27 of the Annual Report to Shareholders. Item 9.

Item 9. Changes in and Disagreements on Accounting and Financial Disclosure ------------------------------------------------------------------- Not applicable PART III -------- Item 10.

Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- The information required by Item 10 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation l4A except that such information with respect to Executive Officers of the Registrant is included, pursuant to Instruction 3, paragraph (b) of Item 401 of Regulation S-K, under Part I. Item l1. Executive Compensation ---------------------- The information required by Item l1 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation l4A. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- The information required by Item 12 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation 14A. Item 13.

Item 13. Certain Relationships and Related Transactions ---------------------------------------------- The information required by Item 13 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation 14A. PART IV ------- Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ---------------------------------------------------------------- *The consolidated balance sheets of Crane Co. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, changes in common shareholders' equity and cash flows for the years ended December 31, 1993, 1992 and 1991 and the financial review, appearing on Pages 6 through 27 of Crane Co.'s Annual Report to Shareholders which will be furnished with the company's proxy statement as required by Regulation 14A, Rule 14a-3(c), are incorporated herein by reference and are supplemented by schedules beginning on Page 14 of this report. All other statements and schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission have been omitted because they are not required under related instructions or are inapplicable, or the information is shown in the financial statements and related notes. (b) Reports on Form 8-K: (1) 8-K filed January 12, 1994 regarding acquisition of Burks Pumps, Inc. (2) 8-KA filed January 26, 1994 including financial statements of Burks Pumps and Crane Co. pro forma. (c) Exhibits to Form 10-K: (3) Articles of Incorporation and By-laws: There is incorporated by reference herein: (a) The company's Articles of Incorporation contained in Exhibit D to the company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. (b) The company's by-laws contained in Exhibit A to the company's Annual Report on Form 10-K for the fiscal year ended December 31, (4) Instruments Defining the Rights of Security Holders, including Indentures: (a) There is incorporated by reference herein: (1) Preferred Share Purchase Rights Agreement contained in Exhibit 1 to the company's Report on Form 8-K filed with the Commission on July 12, 1988. (2) Amendment to Preferred Share Purchase Rights Agreement contained in Exhibit 1 to the company's Report on Form 8-K filed with the Commission on June 29, 1990. PART IV ------- Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ---------------------------------------------------------------- (continued) (b) There is incorporated by reference herein: 1) Indenture dated as of April 1,1991 between the Registrant and the Bank of New York contained in Exhibit 4 to Registration Statement No. 33-39658. 2) Third Supplemental Indenture dated as of April 30, 1969 between Registrant and B of A contained in Exhibit 4.2 to Registration Statement No. 2-32586 (5% Convertible Subordinated Debentures, Series B, due July 1, 1994). (10) Material Contracts: ------------------ (iii)Compensatory Plans Exhibit A: The Crane Co. Restricted Stock Award Plan as amended through May 10, 1993. Exhibit B: The Crane Co. Non-Employee Directors Restricted Stock Award Plan as amended through May 10, 1993. There is incorporated by reference herein: (a.) The Crane Co. Restricted Stock Award Plan contained in Exhibit 4.1.1 to Post-Effective Amendment No. 2 to the Registrant's Registration Statement No. 33-22904 on Form S-8 filed on July 6, 1988 and the related agreements filed as Exhibit 4.4.2-2 to Post-Effective Amendment No. 4, Exhibit 4.4.2-3 to Post-Effective Amendment No. 5 and Exhibit 4.4.2- 4 to Post-Effective Amendment No. 6, and Exhibit 4.4.2-5 to Post-Effective Amendment No. 7. (b.) The indemnification agreements entered into with Mr. R. S. Evans, each other director of the company and Mr. P. R. Hundt the form of which is contained in Exhibit C to the company's definitive proxy statement filed with the Commission in connection with the company's April 27, 1987 Annual Meeting. (c.) The Crane Co. Retirement Plan for Non-Employee Directors contained in Exhibit E to the company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. (d.) The forms of Agreement and Supplemental Agreement between the company and each of its five most highly compensated officers which provide for the continuation of certain employee benefits upon a change of control contained in Exhibit E to the company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. (e.) The Crane Co. Stock Option Plan as amended through May 6, 1991 contained in Exhibit 1(a)(2) to Post-Effective Amendment No. 2 to the company's Registration Statement No. 33-18251 on Form S-8 filed with the Commission on November 2, 1987. (11) Statement re computation of per share earnings: Exhibit C: Computation of net income per share. (13) Annual report to security holders: Exhibit D: Annual Report to shareholders for the year ended December 31, 1993. (22) Subsidiaries of the Registrant: Exhibit E: Subsidiaries of the Registrant. (24) Consent of Experts and Counsel Exhibit F: Independent auditors' consent. All other exhibits are omitted because they are not applicable or the required information is shown elsewhere in this Annual Report on Form 10- K. SIGNATURES - ---------- Pursuant to the requirements of Section l3 or l5(d) of the Securities Exchange Act of l934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CRANE CO. ---------------------- (Registrant) By D. S. Smith ------------------------- D. S. Smith Vice President-Finance Date 3/28/94 ----------------- Pursuant to the requirements of the Securities Exchange Act of l934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. OFFICERS -------- R. S. Evans - -------------------------- R. S. Evans Chairman, Chief Executive Officer, President and Director Date 3/28/94 ------------------ D. S. Smith M. L. Raithel - -------------------------- -------------------------- D. S. Smith M. L. Raithel Vice President-Finance Controller Date 3/28/94 Date 3/28/94 ---------------------- ---------------------- DIRECTORS --------- INDEPENDENT AUDITORS' REPORT - ---------------------------- To the Shareholders of Crane Co.: We have audited the consolidated financial statements of Crane Co. and subsidiaries as of December 31, 1993 and 1992, and for each of three years in the period ended December 31, 1993 and have issued our report thereon dated January 24, 1994 (except for the note "Subsequent Event" on page 21, as to which the date is February 11, 1994); such financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Crane Co., listed in Item 14. These financial statement schedules are the responsibility of the Company's mamnagement. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche January 24, 1994 CRANE CO. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Rates of depreciation vary from three to twenty-five years in consideration of the use and character of the assets. (1) Includes $1,703 of computer software to other assets. CRANE CO. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands) CRANE CO. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (In Thousands) CRANE CO. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (In Thousands) NOTES: (1) Average monthly borrowings are calculated using month-end balances outstanding during the year. (2) The approximated weighted average is calculated by dividing the related interest expense by monthly average borrowings. CRANE CO. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (in Thousands) NOTE: Amounts for amortization of intangible assets, taxes other than payroll and income taxes, royalties and advertising costs are not presented as such amounts are less than 1% of net sales.

13239_1993.txt

13239

1993

Item 1. Business - ------- -------- The Company was incorporated on April 24, 1899. Information on the nature and type of business and industry segments is contained on pages 24-26 of the Company's 1993 Annual Report to Shareholders. A three-year summary of sales and operating income by operating division is presented on page 21 of the Company's 1993 Annual Report to Shareholders. All of the aforementioned pages are incorporated herein by reference in this Form 10-K Annual Report.* Item 2.

Item 2. Properties - ------- ---------- Information on properties, contained on page 25 of the Company's 1993 Annual Report to Shareholders, is incorporated herein by reference in this Form 10-K Annual Report.* Item 3.

Item 3. Legal Proceedings - ------- ----------------- Environmental Proceedings - ------------------------- The Company is involved in various proceedings relating to the designation of certain waste sites for cleanup where the Company, along with a large number of other companies, has potential liability under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") or similar state environmental laws. While the Company's ultimate liability will depend on many factors including its volumetric share of waste, the financial viability of the other companies and the remediation methods and technology used, management has determined that, as of the date hereof, any costs incurred in connection with individual sites will not be significant and even in the aggregate, will not have a material adverse effect on the financial condition of the Company. Private actions have been filed against the Company and numerous other defendants beginning in 1986 in the State Court in Livingston Parish, Louisiana, alleging personal injuries and property damage in connection with a waste disposal site in Louisiana. Beginning in 1987, similar actions were filed in state court in Camden, New Jersey, in connection with a waste disposal site in New Jersey. The Company's involvement in actions which were pending in Federal District Court in Baton Rouge, Louisiana arising from a waste disposal site in Louisiana was settled (January 1994) with payment by the Company of approximately $27,000. In February, 1993, an EPA Administrative Law Judge held that the Borden Chemicals and Plastics Limited Partnership ("BCP") Illiopolis, Illinois facility violated CERCLA and the Emergency Planning and Community Right to Know Act ("EPCRA") by failing to report certain relief valve releases that the Company believes are exempt from CERCLA and EPCRA reporting. A petition for reconsideration has been filed. In addition, the Louisiana Department of Environmental Quality ("LDEQ") has determined that a production _______________ * Except as specifically indicated herein, no other data appearing in the Company's 1993 Annual Report to Shareholders is deemed to be filed as part of this Form 10-K Annual Report. - 3 - unit at BCP's Geismar facility should be subject to regulation under Louisiana's hazardous waste statutes and regulations. That decision has been appealed to the state courts. It is believed that allegations relating to federal hazardous waste issues are being contemplated by the U.S. EPA. BCP maintains that the production unit is not subject to regulation under federal or state hazardous waste laws. The Company would be responsible for any violations that predate the formation of BCP. The U.S. EPA has issued a notice of violation alleging the violation of air pollution regulations by a plant in Massachusetts (September 1988). Allegations filed in Federal District Court in Helena, Montana in 1991 of water pollution violations were resolved in October 1993 by the Company entering into a consent decree and paying a civil fine of $265,000. A notice of violation has been issued by the Maine Department of Environmental Protection (April 1991) alleging the violation of certain solid waste and wetlands regulations at a Scarborough, Maine facility. OTHER LEGAL PROCEEDINGS - ----------------------- The States of West Virginia, Virginia and Ohio have filed suits (12/93, 4/93 and 8/93) alleging antitrust violations in connection with the sale of milk to schools in West Virginia, Virginia and Ohio school districts. A private antitrust suit containing similar allegations was filed in Federal Court in Oklahoma (4/93) on behalf of four school districts and seeks class action certification. Federal Grand Jury investigations of similar allegations are pending in Michigan, Indiana and Kentucky (6/91), Oklahoma (8/92), Ohio (2/93) and the Plains States (9/93). Similar investigations by the state Attorneys General are pending in Illinois (11/91) and North Carolina (6/93). Two private antitrust suits alleging price fixing of wholesale/retail accounts were filed in Florida (7/93) and W. Virginia (9/93). From 1973 through 1980 the Company manufactured chemical components under the name "Insulspray," for on-site installation of urea-formaldehyde foam insulation in residences and commercial buildings. The Company has been a defendant in litigation in Montreal, Canada involving allegations of personal injury or property damage arising from the misapplication of, or defects in, the insulation. The litigation, which was tried from September 1983 through December 1989, was dismissed by the trial court in December 1991. An Appeal has been filed by plaintiffs. The Company and its Directors have been sued by persons purporting to represent a class of purchasers of shares of the Company in Federal District Court in New York (December 1993) for alleged violations of the Securities Exchange Act of 1934 in connection with certain statements made by or on behalf of the Company in 1992 and 1993. In addition, Company is involved in other litigation throughout the United States which is considered to be in the ordinary course of the Company's business. The Company believes, based upon the information it presently possesses, and taking into account its established accruals for estimated liability and its insurance coverage, including its risk retention program, that the foregoing proceedings and actions are unlikely to have a materially adverse effect on the Company's financial position or operating results. - 4 - Item 4.

Item 4. Submission of Matters to a Vote of Security Holders - ------- --------------------------------------------------- No matter was submitted during the fourth quarter of 1993 to a vote of security holders, through the solicitation of proxies or otherwise. Part II Item 5.

Item 5. Market for the Registrant's Common Equity and Related - ------- ----------------------------------------------------- Stockholder Matters ------------------- The Company's common stock is traded on the New York Stock Exchange and exchanges in Tokyo, Japan; and Basel, Geneva, Lausanne and Zurich, Switzerland. The following information included in the 1993 Annual Report to Shareholders is incorporated herein by reference in this Form 10-K Annual Report:* [#] The high and low sales prices of the Company's common stock for each quarterly period during the last two fiscal years, Note 15 page 40. [#] The amount of quarterly dividends paid during the last two fiscal years, Note 15, page 40. The high and low sales prices of the Company's common stock on January 31, 1994 were $15.750 and $15.375, respectively. The approximate number of holders of common stock, $0.625 par value, as of January 31, 1994 was 40,818. Item 6.

Item 6. Selected Financial Data - ------- ----------------------- The five-year selected financial data for the years 1989 through 1993, appearing on page 44 of the 1993 Annual Report to Shareholders, is incorporated herein by reference in this Form 10-K Annual Report.* Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition - ------- ----------------------------------------------------------- and Results of Operations ------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations, appearing on pages 18 through 24 of the 1993 Annual Report to Shareholders, is incorporated herein by reference in this Form 10-K Annual Report.* Item 8.

Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- The Consolidated Financial Statements and the report thereon of Price Waterhouse dated March 20, 1994 appearing on pages 27 through 41 of the 1993 Annual Report to Shareholders, are incorporated herein by reference in this Form 10-K Annual Report.* Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and - ------- --------------------------------------------------------------- Financial Disclosure -------------------- No Form 8-K was issued by the Company during the two most recent fiscal years ended December 31, 1993 reporting a change in or disagreement with accountants. ____________ * Except as specifically indicated herein, no other data appearing in the Company's 1993 Annual Report to Shareholders is deemed to be filed as part of this Form 10-K Annual Report. - 5 - Part III Item 10.

Item 10. Directors and Executive Officers of the Registrant - -------- -------------------------------------------------- (a) The information relating to directors required by this item will be contained under the caption "ELECTION OF DIRECTORS" in a definitive Proxy Statement involving the election of directors which the registrant will file with the Securities and Exchange Commission not later than 120 days after December 31, 1993 (the "1994 Proxy Statement"), and such information is incorporated herein by reference. (b) Set forth below are the names and ages of the Executive Officers of the Company and the positions and offices with the Company presently held by each of them. Their terms of office extend to the next Annual Meeting of the Board of Directors or until their successors are elected. There are no family relationships between any of the Executive Officers of the Company. - 6 - E. R. Shames was elected Chief Executive Officer effective December 9, 1993. He is also President, to which he was elected effective June 28, 1993. Prior to that he was Chairman, President and Chief Executive Officer of the Stride Rite Corporation since 1990. Prior to that he was Chairman, President and Chief Executive Officer of the Kendall Company. J. M. Saggese has been Executive Vice President of the Company and President of the Packaging and Industrial Products Division Domestic and International since July 1, 1990. Prior to that he served as a Senior Group Vice President of the Packaging and Industrial Products Division Domestic and International since January 1, 1989. G. P. Morris was elected Vice President and Chief Strategic Officer effective February 7, 1994. He is also Vice President of Finance - North American and International Foods Division, to which he was elected effective September 9, 1993. Prior to that he was Vice President and Group Executive of Maxwell House Coffee Company. R. D. Kautto was elected Vice President - Human Resources effective February 1, 1994. Prior to that he was Vice President - Employee Relations at Phillip Morris Companies, Inc. since 1992. Prior to that he was Vice President - Human Resources at General Foods U.S.A. P. J. Keuper was elected Vice President - Public Affairs effective September 1, 1991. Prior to that he served as the Company's outside public relations counsel as a Managing Director of Adams & Rinehart. P. J. Josenhans was elected Secretary of the Company effective April 26, 1991. He has served as Associate General Counsel since 1982. Item 11.

Item 11. Executive Compensation - -------- ---------------------- The information required by this item will be contained in the Company's 1994 Proxy Statement beginning with the information contained under the caption "COMPENSATION OF DIRECTORS" and continuing through the caption "EMPLOYMENT, TERMINATION AND CHANGE IN CONTROL ARRANGEMENTS," and such information is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management - -------- -------------------------------------------------------------- The information required by this item will be contained under the caption "OWNERSHIP BY MANAGEMENT OF EQUITY SECURITIES" in the Company's 1994 Proxy Statement, and such information is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions - -------- ---------------------------------------------- Not applicable - 7 - Part IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------- ---------------------------------------------------------------- a) 1. Financial Statements -------------------- The Consolidated Financial Statements and the report thereon of Price Waterhouse dated March 20, 1994, appearing on pages 27 to 41 of the 1993 Annual Report to Shareholders, are incorporated herein by reference in this Form 10-K Annual Report. Except as specifically indicated herein, no other data appearing in the Company's 1993 Annual Report to Shareholders is deemed to be filed as part of this Form 10-K Annual Report. 2. Financial Statement Schedules ----------------------------- The following additional financial data should be read in conjunction with the Consolidated Financial Statements in the 1993 Annual Report to Shareholders. All other schedules have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto. Financial statements of 50% or less owned persons and other unconsolidated persons accounted for by the equity method have been omitted because considered in the aggregate as a single subsidiary they do not constitute a significant subsidiary. 3. Exhibits -------- Executive Compensation Plans and Arrangements are listed herein at Exhibits (10)(iv) through (10)(xiv)(f). (3)(i) Restated Certificate of Incorporation and Amendments, incorporated herein by reference from Exhibit 3(i) to the 1992 Form 10-K Annual Report. (ii) By-Laws. (4)(i) Form of Indenture dated as of January 15, 1983, as supplemented by the First Supplemental Indenture dated as of March 31, 1986 relating to the $200,000,000 8-3/8% Sinking Fund Debentures due 2016, incorporated herein by reference from Exhibit 4(a) and (b) to Amendment No. 1 to Registration Statement of Form S-3, File No. 33-4381. - 8 - (ii) Form of Indenture dated as of December 15, 1986, as supplemented by the First Supplemental Debenture dated as of December 15, 1986 relating to the $315,000,000 Medium Term Notes, Series A, incorporated herein by reference from Exhibit 4(a) through (d) to Amendment No. 1 to Registration Statement on Form S-3, File No. 33-8775. (iii) Form of Indenture dated as of December 15, 1987, as supplemented by the First Supplemental Indenture dated as of December 15, 1987 and the Second Supplemental Indenture dated as of February 1, 1993, incorporated herein by reference from Exhibit 4(a) through (d) to Registration Statement on Form S-3, File No. 33-45770, relating to the following Debentures and Notes: (a) The $125,000,000 9-7/8% Notes due November 1, 1997. (b) The $150,000,000 9-1/4% Sinking Fund Debentures due 2019. (c) The $200,000,000 9-1/5% Debentures due 2021. (d) The $250,000,000 7-7/8% Debentures due 2023. (iv) Form of Indenture relating to Zero Coupon Notes due 2002, dated as of May 21, 1992, incorporated herein by reference from Exhibit 4(iv) to the 1992 Form 10-K Annual Report. (v) Form of Lynx Equity Unit Agreement relating to Zero Coupon Notes due 2002, dated as of May 21, 1992, incorporated herein by reference from Exhibit 4(v) to the 1992 Form 10-K Annual Report. (10)(i) Rights Agreement dated as of January 28, 1986, relating to preferred share purchase rights, incorporated herein by reference from Exhibit I to the Registrant's Form 8-K, dated January 28, 1986. (ii) Amendment to Rights Agreement dated as of November 29, 1988, incorporated herein by reference from Exhibit I to the Registrant's Form 8, dated December 6, 1988. (iii) Second Amendment to Rights Agreement dated as of May 22, 1991, incorporated herein by reference from Exhibit I to the Registrant's Form 8, dated June 7, 1991. (iv) 1994 Management Incentive Plan. (v) 1994 Stock Option Plan. - 9 - (vi) Executive Family Survivor Protection Plan as amended through December 9, 1993. (vii) Executives Excess Benefits Plan as amended through December 9, 1993. (viii) Executives Supplemental Pension Plan as amended through December 9, 1993. (ix) Advisory Directors Plan, incorporated herein by reference from Exhibit 10(viii) to the 1989 Form 10-K Annual Report. (x) Advisory Directors Plan Trust Agreement, incorporated herein by reference from Exhibit 10(ix) to the 1988 Form 10-K Annual Report. (xi) Supplemental Benefit Trust Agreement as amended through December 9, 1993. (xii) Form of Indemnification Letter Agreements entered into with all Directors of the Company, incorporated herein by reference from Exhibit 10(xii) to the 1988 Form 10-K Annual Report. (xiii) Form of Letter Agreement entered into with all holders of stock appreciation rights, incorporated herein by reference from Exhibit 10(xiii) to the 1989 Form 10-K Annual Report. (xiv) (a) Agreement with Mr. A. S. D'Amato, Chairman and Chief Executive Officer, incorporated herein by reference from Exhibit 10(i) to the June 30, 1993 Form 10-Q. (b) Amendment to Agreement with Mr. A. S. D'Amato, incorporated herein by reference from Exhibit 10(i) to the September 30, 1993 Form 10-Q. (c) Supplement to Agreement with Mr. A. S. D'Amato. (d) Agreement with Mr. E. R. Shames, President and Chief Operating Officer, incorporated herein by reference from Exhibit 10(ii) to the June 30, 1993 Form 10-Q. (e) Description of Amendment to Agreement with Mr. E. R. Shames. (f) Agreement with Mr. R. J. Ventres, Chairman of the Executive Committee, incorporated herein by reference from Exhibit 10(xvii)(b) to the 1991 Form 10-K Annual Report. - 10 - (g) Description of Amendment to Agreement with Mr. R. J. Ventres. (h) Form of salary continuance arrangement with Executive Officers, incorporated herein by reference from Exhibit 10(ix)(c) to the 1987 Form 10-K Annual Report. (i) Agreement with Mr. J. G. Hettinger. (j) Agreement with Mr. G. J. Waydo. (xv) Second Amended and Restated Deposit Agreement, dated February 16, 1993 among Borden Chemicals and Plastics Limited Partnership, Society National Bank, Borden, Inc. and BCP Management, Inc., incorporated herein by reference from Exhibit 10 (xviii) to the 1992 Form 10-K Annual Report. (12) Calculation of Ratio of Earnings to Fixed Charges. (13) Portion of 1993 Annual Report to Shareholders. (22) Subsidiaries of Registrant. (24) The Consent of Independent Accountants and Report of Independent Accountants on Financial Statement Schedules appear on page 12 of this Form 10-K Annual Report. Copies of the foregoing Exhibits are available to Shareholders of record upon written request to Investor Relations at the Executive Offices of the Company, and the payment of $.50 per page to help defray the cost of handling, copying, and postage. (b) Reports on Form 8-K ------------------- On December 13, 1993 Borden, Inc. filed a Form 8-K which announced the resignation by Anthony S. D'Amato of his position as Director, Chairman and Chief Executive Officer of Borden, Inc. and the appointment of Frank J. Tasco as Chairman of the Board and Ervin R. Shames as Chief Executive Officer. - 11 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BORDEN, INC. By /s/ George P. Morris ------------------------------------ George P. Morris, Vice President and Chief Strategic Officer (Principal Financial Officer) By /s/ Richard W. Pennell ------------------------------------ Richard W. Pennell, Assistant General Controller (Principal Accounting Officer) Date: March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated, on the date set forth above. Signature Title --------- ----- /s/ F. J. Tasco Director and Chairman of the Board - --------------------------------------- (F. J. Tasco) /s/ E. R. Shames Director, President and Chief - --------------------------------------- Executive Officer (E. R. Shames) /s/ Frederick E. Hennig Director - --------------------------------------- (Frederick E. Hennig) /s/ Wilbert J. LeMelle Director - --------------------------------------- (Wilbert J. LeMelle) /s/ Robert P. Luciano Director - --------------------------------------- (Robert P. Luciano) /s/ H. Barclay Morley Director - --------------------------------------- (H. Barclay Morley) /s/ John E. Sexton Director - --------------------------------------- (John E. Sexton) /s/ Patricia Carry Stewart Director - --------------------------------------- (Patricia Carry Stewart) - 12 - REPORT OF INDEPENDENT ACCOUNTANTS ON ------------------------------------ FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Board of Directors of Borden, Inc. Our audits of the consolidated financial statements referred to in our report dated March 20, 1994 appearing on page 41 of the 1993 Annual Report to Shareholders of Borden, Inc., (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14 (a) 2 of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Columbus, Ohio March 20, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (No. 33-45770) and Form S-8 (No. 33-24225 and No. 2-91503) of Borden, Inc. of our report dated March 20, 1994 appearing on page 41 of the Annual Report to Shareholders which is incorporated by reference in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page 12 of this Form 10-K. PRICE WATERHOUSE Columbus, Ohio March 28, 1994

311094_1993.txt

311094

1993

Item 1 Business. . . . . . . . . . . . . . . . . . . . . . . . . 2 Item 2

ITEM 2: DESCRIPTION OF PROPERTY BRANCH OFFICES AND FACILITIES The Banks are engaged in the banking business through 52 offices in eleven counties in Northern California, including twelve offices in Marin County, nine in Sonoma County, eight in Solano County, seven in Napa County, five in Contra Costa County, four in Lake County, two in Mendocino County, two in Nevada County, one in Sacramento County, one in San Francisco County and one in Placer County. All offices are constructed and equipped to meet prescribed security requirements. The Banks own fifteen banking office locations and four administrative buildings, including the Company's headquarters. Thirty-seven banking offices and two support facilities are leased. Substantially all of the leases contain multiple five-year renewal options and provisions for rental increase, principally for changes in the cost of living index, property taxes and maintenance. ITEM 3:

ITEM 3: LEGAL PROCEEDINGS The Company and its subsidiaries are defendants in various legal actions which, in the opinion of management based on discussions with counsel, will be resolved with no material effect on the Company's consolidated results of operations or financial position. ITEM 4:

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to the shareholders during the fourth quarter of 1993. PART II ITEM 5:

ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the American Stock Exchange (AMEX) under the symbol "WAB". The following table shows the high and low closing price for the common stock, for each quarter, as reported by AMEX. Period High Low - ----------------------------------------------------------------------- First quarter ........................... $30.25 $22.13 Second quarter ........................... 28.75 23.88 Third quarter ........................... 28.50 25.13 Fourth quarter ........................... 28.50 25.75 - ----------------------------------------------------------------------- First quarter ........................... $20.63 $18.88 Second quarter ........................... 22.25 18.50 Third quarter ........................... 22.25 18.25 Fourth quarter ........................... 23.75 19.50 As of December 31, 1993, there were 5,096 holders of record of the Company's common stock. This number does not include Napa Valley Bancorp. stockholders that as of December 31, 1993 had not yet tendered their shares for conversion to Company common stock. The Company has paid cash dividends on its common stock in every quarter since commencing operations on January 1, 1973, and it is currently the intention of the Board of Directors of the Company to continue payment of cash dividends on a quarterly basis. There is no assurance, however, that any dividends will be paid since they are dependent upon the earnings, financial condition and capital requirements of the Company and its subsidiaries. Furthermore, the Company's ability to pay future dividends is subject to contractual restrictions under the terms of three note agreements, as discussed in Note 6 to the Consolidated Financial Statements. Under the most restrictive of these contractual provisions, $17.1 million of retained earnings was available for the payment of dividends at December 31, 1993. Limitations of the Company's ability to pay dividends is discussed in Note 14 to the Consolidated Financial Statements on page 58 of this report. Additional information (required by Item 5) regarding the amount of cash dividends declared on common stock for the two most recent fiscal years is discussed in Note 16 to the Consolidated Financial Statements on page 62 of this report. *Restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. **Fully taxable equivalent *Restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. **Fully taxable equivalent ITEM 7: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion addresses information pertaining to the financial condition and results of operations of Westamerica Bancorporation (the Company) that may not be otherwise apparent from a review of the consolidated financial statements and related footnotes. It should be read in conjunction with those statements and notes found on pages 36 through 63, as well as with the other information presented throughout the report. All financial information has been restated on an historical basis to reflect the April 15, 1993 merger with Napa Valley Bancorp (the Merger) on a pooling-of-interests basis. The Company earned $9.5 million in 1993, representing a 38 percent decrease from 1992 record earnings of $15.2 million and a 21 percent reduction from 1991 earnings of $12.0 million. The 1993 results include a second quarter loss of $4.1 million, mostly due to $10.5 million after-tax merger-related charges that were taken in the form of asset write-downs, additions to the loan loss provision and other related charges. The asset write-downs and the additional loan loss provision reflect the Company's plan of asset resolution. Components of Net Income (Percent of average earning assets) 1993 1992 1991 - ------------------------------------------------------------------ Net interest income* 5.48% 5.50% 5.21% Provision for loan losses (.53) (.39) (.59) Non-interest income 1.34 1.33 1.36 Non-interest expense (5.43) (5.00) (4.82) Taxes* (.33) (.59) (.48) - ------------------------------------------------------------------- Net income .53% .85% .68% =================================================================== Net income as a percentage of average total assets .48% .77% .62% * Fully taxable equivalent (FTE) On a per share basis, 1993 net income was $1.17, compared to $1.92 and $1.52 in 1992 and 1991, respectively. During 1993, the Company continued to benefit from reductions in cost of funds, increases in service fees and other non-interest income, and expense controls. However, merger-related costs more than offset these benefits. Earnings in 1992 improved over 1991 principally due to higher net interest margin, lower provisions for loan losses and control of non-interest expense. The Company's return on average total assets was .48 percent in 1993, compared to .77 percent and .62 percent in 1992 and 1991, respectively. Return on average equity in 1993 was 6.51 percent, compared to 11.16 percent and 9.52 percent, respectively, in the two previous years. NET INTEREST INCOME Although interest rates continued to decline during most of 1993, the continuing downward repricing of interest-bearing liabilities and a more favorable composition of deposits, represented by increasing volumes of lower costing demand and savings account balances and declining volumes of higher costing time deposits, prevented declining earning-asset yields from significantly eroding the Company's net interest margin. Components of Net Interest Income (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Interest income $ 137.0 $ 154.8 $ 176.6 Interest expense (42.3) (58.9) (87.4) FTE adjustment 2.8 2.7 2.7 - ------------------------------------------------------------------- Net interest income (FTE) $ 97.5 $ 98.6 $ 91.9 - ------------------------------------------------------------------- Average interest earning assets $1,779.3 $1,793.8 $1,762.4 Net interest margin (FTE) 5.48% 5.50% 5.21% Net interest income (FTE) in 1993 decreased $1.1 million from 1992 to $97.5 million. Interest income decreased $17.8 million from 1992, due to a $14.5 million reduction in the average balance of interest earning assets and a 93 basis point decline in yields. This was partially offset by a $16.6 million decrease in interest expense, the combination of a $41.3 million decrease in the average balance of interest-bearing liabilities and a 101 basis point decline in rates paid, in part due to a more favorable composition of deposits. DISTRIBUTION OF AVERAGE ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY The following tables present, for the periods indicated, information regarding the consolidated average assets, liabilities and shareholders' equity, the amounts of interest income from average interest earning assets and the resulting yields, and the amount of interest expense paid on interest-bearing liabilities, expressed in thousand of dollars and rates. Average loan balances include non-performing loans. Interest income includes proceeds from loans on non-accrual status only to the extent cash payments have been received and applied as interest income. Yields on securities and certain loans have been adjusted upward to reflect the effect of income thereon exempt from federal income taxation at the current statutory tax rate. Amortized loan fees, which are included in interest and fee income on loans, were $1.5 million lower in 1993 than in 1992 and $2.6 million higher in 1992 than in 1991. Distribution of average assets, liabilities and shareholders' equity Yields/Rates and interest margin Full Year 1993 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $4,463 $170 3.80% Trading account securities 183 6 3.14 Investment securities 631,700 39,794 6.30 Loans: Commercial 615,981 53,990 8.76 Real estate construction 55,038 4,745 8.62 Real estate residential 168,379 13,322 7.91 Consumer 303,567 27,726 9.13 - --------------------------------------------------------------- Total interest earning assets 1,779,311 139,753 7.85 Other assets 200,561 - ------------------------------------------------------- Total assets $1,979,872 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $330,867 -- -- Savings and interest-bearing transaction 938,475 19,305 2.06% Time less $100,000 340,122 14,176 4.17 Time $100,000 or more 135,505 4,837 3.57 - --------------------------------------------------------------- Total interest-bearing deposits 1,414,102 38,318 2.71 Funds purchased 57,135 1,937 3.39 Notes and mortgages payable 17,959 2,016 11.22 - --------------------------------------------------------------- Total interest-bearing liabilities 1,489,196 42,271 2.84 Other liabilities 14,652 Shareholders' equity 145,157 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,979,872 ======================================================= Net interest spread (1) 5.01% Net interest income and interest margin (2) $97,482 5.48% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1992 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $42,964 $1,765 4.11% Trading account securities 103 4 3.67 Investment securities 534,793 40,332 7.54 Loans: Commercial 646,359 60,050 9.29 Real estate construction 76,173 7,058 9.27 Real estate residential 168,030 15,314 9.11 Consumer 325,393 33,003 10.14 - --------------------------------------------------------------- Total interest earning assets 1,793,815 157,526 8.78 Other assets 175,609 - ------------------------------------------------------- Total assets $1,969,424 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $284,366 -- -- Savings and interest-bearing transaction 903,211 26,518 2.94% Time less $100,000 406,161 20,948 5.16 Time $100,000 or more 184,799 8,365 4.53 - --------------------------------------------------------------- Total interest-bearing deposits 1,494,171 55,831 3.74 Funds purchased 15,729 698 4.44 Notes and mortgages payable 20,439 2,363 11.56 - --------------------------------------------------------------- Total interest-bearing liabilities 1,530,339 58,892 3.85 Other liabilities 18,263 Shareholders' equity 136,456 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,969,424 ======================================================= Net interest spread (1) 4.93% Net interest income and interest margin (2) $98,634 5.50% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1991 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $39,182 $2,227 5.68% Trading account securities 835 54 6.47 Investment securities 446,283 39,218 8.79 Loans: Commercial 672,999 71,512 10.63 Real estate construction 96,654 11,002 11.38 Real estate residential 150,943 15,436 10.23 Consumer 355,502 39,798 11.19 - --------------------------------------------------------------- Total interest earning assets 1,762,398 179,247 10.17 Other assets 169,089 - ------------------------------------------------------- Total assets $1,931,487 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $265,383 -- -- Savings and interest-bearing transaction 773,904 36,119 4.67% Time less $100,000 466,487 31,838 6.83 Time $100,000 or more 230,276 15,113 6.56 - --------------------------------------------------------------- Total interest-bearing deposits 1,470,667 83,070 5.65 Funds purchased 26,885 1,676 6.23 Notes and mortgages payable 22,464 2,611 11.62 - --------------------------------------------------------------- Total interest-bearing liabilities 1,520,016 87,357 5.75 Other liabilities 20,886 Shareholders' equity 125,202 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,931,487 ======================================================= Net interest spread (1) 4.42% Net interest income and interest margin (2) $91,890 5.21% =============================================================== (1) Net interest spread represents the average yield earned on interest- earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. RATE AND VOLUME VARIANCES. The following table sets forth a summary of the changes in interest income and interest expense from changes in average assets and liability balances (volume) and changes in average interest rates for the periods indicated. Changes not solely attributable to volume or rates have been allocated in proportion to the respective volume and rate components. PROVISION FOR LOAN LOSSES The provision for loan losses was $9.5 million in 1993, including a $3.1 million merger-related provision in the second quarter, reflecting a different workout strategy for loans and properties acquired in the Merger, compared to $7.0 million in 1992 and $10.4 million in 1991. The level of the provision reflects the Company's continuing efforts to improve loan quality by enforcing strict underwriting and administration procedures and aggressively pursuing collection efforts with troubled debtors. For further information regarding net credit losses and the reserve for loan losses, see the Non-Performing Assets section of this report. INVESTMENT PORTFOLIO The Company maintains a securities portfolio consisting of U.S.Treasury, U.S. Government Agencies and Corporations, State and political subdivisions, asset-backed and other securities. Investment securities are held in safekeeping by an independent custodian. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No.115"). The statement addresses the accounting and reporting for investments in equity securities that have a readily determinable fair value and for all investments in debt securities. The statement requires that all securities be classified, at acquisition, into one of three categories: held-to-maturity, available-for-sale, and trading. SFAS No. 115 is effective for fiscal years beginning after December 15, 1993; however, early implementation is permitted. The Company elected to implement SFAS No. 115 effective as of December 31, 1993. The classification of all securities is determined at the time of acquisition. In classifying securities as being held-to-maturity, available-for-sale or trading, the Banks consider their collateral needs, asset/liability management strategies, liquidity needs, interest rate sensitivity and other factors that will determine the intent and ability to hold the securities to maturity. The objective of the investment securities held-to-maturity is to strengthen the portfolio yield, and to provide collateral to pledge for federal, state and local government deposits and other borrowing facilities. The investments held-to-maturity had an average term to maturity of 47 months at December 31, 1993 and, as of the same date, those investments included $547.2 million in fixed rate and $9.9 million in adjustable rate securities. Investment securities available-for-sale are typically used to supplement the Banks' liquidity portfolio with the objective of increasing the portfolio yield. Unrealized net gains and losses on these securities are recorded as an adjustment to equity net of taxes, and are not reflected in the current earnings of the Company. If the security is sold, any gain or loss is recorded as a charge to earnings and the equity adjustment is reversed. At December 31, 1993, the Banks held $168.8 million classified as investments available-for-sale. At December 31, 1993, $2.5 million, net of taxes was recognized as the unrealized net gain related to these securities. The amount of trading securitiess at December 31, 1993, was not material. For more information on investment securities, see Notes 1 and 2 to the Consolidated Financial Statements on pages 43 to 47 of this report. The following table shows the book value of the Company's investment securities (in thousands of dollars) as of the dates indicated: December 31, 1993 1992 1991 - ----------------------------------------------------------- U.S. Treasury $249,613 $126,522 $24,411 U.S. government agencies and corporations 254,691 237,753 299,219 States and political subdivisions (domestic) 127,297 87,031 74,847 Asset backed securities 65,433 82,270 79,743 Other securities 28,842 36,660 37,404 - ----------------------------------------------------------- Total $725,876 $570,236 $515,624 =========================================================== The following table is a summary of the relative maturities (in thousands of dollars) and yields of the Company's investment securities as of December 31, 1993. Weighted average yields have been computed by dividing annual interest income, adjusted for amortization of premium and accretion of discount, by book value of the related securities. Yields on state and political subdivision securities have been calculated on a fully taxable equivalent basis using the federal tax rate of 34 percent. LOAN PORTFOLIO The following table shows the composition of loans of the Company (in thousands of dollars) by type of loan or type of borrower, on the dates indicated. Secured loans are classified by type of securities and unsecured by the purpose of the loan. Maturities and Sensitivity of Selected Loans to Changes in Interest Rates The following table shows the maturity distribution and interest rate sensitivity of Commercial and Real estate construction loans at December 31, 1993.* *Excludes loans to individuals and residential mortgages totaling $461,450. These types of loans are typically paid in monthly installments over a number of years. **Includes demand loans Commitments and Lines of Credit It is not the policy of the Company to issue formal commitments on lines of credit except to a limited number of well established and financially responsible local commercial enterprises. Such commitments can be either secured or unsecured and are typically in the form of revolving lines of credit for seasonal working capital needs. Occasionally, such commitments are in the form of Letters of Credit to facilitate the customer's particular business transaction. Commitment fees generally are not charged except where Letters of Credit are involved. Commitments and lines of credit typically mature within one year. See also Note 11 of the Consolidated Notes to the Financial Statements on page 55. RISK ELEMENTS The Company closely monitors the markets in which it conducts its lending Company's primary market areas, in Management's view such impact has not had a material, adverse effect on the Company's liquidity and capital resources. The Company continues its strategy to control its exposure to real estate development loans and increase diversification of credit risk. Asset reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. Assets receiving lesser grades fall under the classified assets category which includes all non-performing assets. These occur when known information about possible credit problems causes Management to have doubts about the ability of such borrowers to comply with loan repayment terms. These loans have varying degrees of uncertainty and may become non-performing assets. Classified assets receive an elevated level of Management attention to ensure collection. Total classified assets peaked following the second quarter Merger but declined significantly by December 31, 1993 due to extensive asset write-downs, loan collections, real estate liquidations and restructurings of the Napa Valley Bank loan portfolio reflecting the Company's workout strategy. Non-Performing Assets Non-performing assets include non-accrual loans, loans 90 days past due and still accruing, other real estate owned and loans classified as substantively foreclosed. Loans are placed on non-accrual status upon reaching 90 days or more delinquent, unless the loan is well secured and in the process of collection. Interest previously accrued on loans placed on non-accrual status is charged against interest income. Loans secured by real estate with temporarily impaired values and commercial loans to borrowers experiencing financial difficulties are placed on non-accrual status even though the borrowers continue to repay the loans as scheduled. Such loans are classied by Management as performing non-accrual and are included in total non-performing assets. Performing non-accrual loans are reinstated to accrual status when improvements in credit quality eliminate the doubt as to the full collectibility of both interest and principal. When the ability to fully collect non-accrual loan principal is in doubt, cash payments received are applied against the principal balance of the loan until such time as full collection of the remaining recorded balance is expected. Any subsequent interest received is recorded as interest income on a cash basis. Non-Performing Assets (In millions) 1993 1992 1991 1990 1989 - ---------------------------------------------------------------------------- Performing non-accrual loans $ 1.9 $ 1.1 $ 2.2 $16.0 $10.7 Non-performing non-accrual loans 7.2 14.9 37.7 9.3 -- - ---------------------------------------------------------------------------- Non-accrual loans 9.1 16.0 39.9 25.3 10.7 Loans 90 or more days past due and still accruing .3 .1 1.0 6.2 6.8 Loan collateral substantively foreclosed 5.4 16.6 7.1 6.0 6.0 Other real estate owned 12.5 17.9 4.9 2.7 4.2 - ---------------------------------------------------------------------------- Total non-performing assets $27.3 $50.6 $52.9 $40.2 $27.7 ============================================================================ Reserve for loan losses as a percentage of non-accrual loans and loans 90 or more days past due and still accruing 272% 153% 58% 60% 91% Performing non-accrual loans increased $800,000 to $1.9 million at December 31, 1993. This increase was principally due to one condominium construction loan. Non-performing non-accrual loans decreased $7.7 million to $7.2 million at December 31, 1993 due to loan collections, write-downs, foreclosure of loan collateral and reclassifications to loan collateral substantively foreclosed. Both loan collateral substantively foreclosed and other real estate owned declined $16.6 million due to asset write-downs and liquidations. The amount of gross interest income that would have been recorded for non-accrual loans for the year ending December 31, 1993, if all such loans had been current in accordance with their original terms while outstanding during the period, was $980,000. The amount of interest income that was recognized on non-accrual loans from cash payments made during the year ended December 31, 1993 totaled $345,000, representing an annualized yield of 3.06 percent. Cash payments received which were applied against the book balance of performing and non-performing non-accrual loans outstanding at December 31, 1993, totaled $534,000 compared to $104,000 in 1992. Restructured loans totaled $4,432,000 at December 31, 1993, $319,000 at December 31, 1992, $2,892,000 at December 31, 1991 $2,200,000, at December 31, 1990 and $5,927,000 at December 31, 1989. CREDIT LOSS EXPERIENCE The Company's reserve for loan losses is maintained at a level estimated by Management to be adequate to provide for losses that can be reasonably credit loss experience, the amount of past due, non-performing and classified loans, recommendations of regulatory authorities, prevailing economic conditions and other factors. Initially, the reserve is allocated to segments of the loan portfolio based in part on quantitative analyses of historical credit loss experience. Criticized and classied loan balances are analyzed using both a linear regression model and standard allocation percentages. The results of this analysis are applied to current criticized and classied loan balances to allocate the reserve to the respective segments of the loan portfolio. In addition, loans with similar characteristics not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on the historical rate of net losses and delinquency trends and are grouped by the number of days the payment on those loans are delinquent. While these factors are essentially judgmental and may not be reduced to a mathematical formula, Management considers that the $25.6 million reserve for loan losses, which constituted 2.30 percent of total loans at December 31, 1993, to be adequate as a reserve against inherent losses. Management continues to evaluate the loan portfolio and assess current economic conditions that will dictate future reserve levels. In May 1993, the Financial Accounting Standards Board (FASB) issued statement No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114) which addresses the accounting treatment of certain impaired loans and amends FASB Statements No. 5 and No. 15. SFAS 114 does not address the overall adequacy of the allowance for loan losses. SFAS 114 is effective January 1, 1995 but earlier implementation is encouraged. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Under SFAS 114, impairment is measured based on the present value of the expected future cash flows discounted at the loans effective interest rate. Alternatively, impairment may be measured by using the loans observable market price or the fair value of the collateral if repayment is expected to be provided solely by the underlying collateral. The Company intends to implement SFAS 114 in January 1995. The impact of implementation on the financial statements has not been determined, since measurement will be contingent upon the inventory of impaired loans outstanding as of January 1, 1995. ALLOCATION OF RESERVE FOR LOAN LOSSES The reserve for loan losses has been established to absorb possible future losses throughout the loan portfolio and off balance sheet credit risk. The Company's reserve for loan losses is maintained at a level estimated by management to be adequate to provide for losses that are reasonably foreseeable based upon specific conditions and other factors. The reserve is allocated to segments of the loan portfolio based in part upon quantitative analyses of historical net losses relative to loan balances outstanding. Criticized and classified loan balances, as identified by management using criteria similar to those used by the Banks' regulators, and historical net losses on those balances are analyzed using both a linear regression and standard allocation percentages model. The results of this statistical analysis are applied to current criticized and classified loan balances to allocate the reserve for loan losses to the respective segments of the loan portfolio. In addition, homogeneous loans, which are not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on historical rates of net loan losses experienced for loans grouped by the number of days payments are delinquent. Such rates of net loan losses are applied to the current aging of homogeneous loans to allocate the reserve for loan losses. Management may judgmentally adjust the allocation of the reserve for loan losses based on changes in underwriting standards, anticipated rates of net loan losses which may differ from historical experience, economic conditions, the experience of credit officers and any other factors considered pertinent. Management's continuing evaluation of the loan portfolio and assessment of current economic conditions will dictate future reserve levels. The following tables present the allocation of the loan loss reserve balance on the dates indicated: (in thousands) December 31 1993 1992 - ------------------------------------------------------------------------------- Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans - ------------------------------------------------------------------------------- Commercial $12,537 55.0% $13,551 53.4% Real estate construction 2,538 3.6 964 5.4 Real estate residential 85 15.5 545 14.8 Consumer 3,921 25.9 3,872 26.4 Unallocated portion of reserve 6,506 -- 5,810 -- - ------------------------------------------------------------------------------- Total $25,587 100.0% $24,742 100.0% =============================================================================== (in thousands) December 31 1991 1990 - ------------------------------------------------------------------------------ Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans -------- -------- -------- -------- Commercial $8,325 52.7% $2,698 52.5% Real estate construction 2,336 7.1 4,360 9.5 Real estate residential 50 12.9 29 10.4 Consumer 2,363 27.3 1,782 27.6 Unallocated portion of reserve 10,779 -- 10,132 -- - ------------------------------------------------------------------------------- Total $23,853 100.0% $19,001 100.0% =============================================================================== (in thousands) December 31 1989 - ------------------------------------------------------------ Loans as Allocation Percent of of reserve Total Type of loan balance Loans -------- -------- Commercial $5,216 52.4% Real estate construction 2,709 11.9 Real estate residential 0 10.3 Consumer 853 25.4 Unallocated portion of reserve 7,182 -- - ------------------------------------------------------------- Total $15,960 100.0% ============================================================= The reduced allocation to commercial loans from December 31, 1992 to December 31, 1993 is primarily due to a reduction in the balance of criticized loans. The increased allocation to construction loans over the same period is attributable to an increase in criticized loans due to the recessionary environment. The increase in the unallocated portion of the reserve is due to the establishment of an additional "recessionary reserve" to recognize the potential for increased chargeoffs. The changes in the allocation to loan portfolio segments from December 31, 1991 to December 31, 1992 reflect changes in criticized and classified loan balances. The decreased allocation to construction loans is attributable to a decrease in criticized loans due to full collection or principal reducing payments received from customers. The increased allocation to commercial and consumer loans is attributable to a reduced level of recoveries. ASSET AND LIABILITY MANAGEMENT The fundamental objective of the Company's management of assets and liabilities is to maximize its economic value while maintaining adequate liquidity and a conservative level of interest-rate risk. The principal sources of asset liquidity are investment securities available for sale. At December 31, 1993, investment securities available for sale totaled $168.8 million. The Company generates significant liquidity from its operating activities. The Company's profitability in 1993, 1992 and 1991 generated substantial increases in the cash flow provided from operations for such years to $28.4 million, $33.4 million and $26.7 million, respectively. Additional cash flow is provided by financing activities, primarily the acceptance of customer deposits and short-term borrowings from banks. After a considerable increase in deposits in 1991 of $66.2 million, growth was only $600,000 in 1992 and the Company experienced a decline of $58.7 million in 1993 mostly due to deposits sold in connection with the sale of Sonoma Valley Bank. In addition to a $57.0 million compensating increase in short-term borrowings in 1993, Westamerica Bank issued in December a ten-year, $20.0 million subordinated capital note that qualifies as Tier II Capital and will be used as a source of liquidity for working capital purposes. The Company uses cash flows from operating and financing activities to make investments in loans, money market assets and investment securities. Continuing with the strategy to reduce its exposure to real estate development loans, net loan repayments were $68.1 million, $32.8 million and $15.5 million in 1993, 1992 and 1991, respectively. The net repayment of loans resulted in added liquidity for the Company, which was used to increase its investment securities portfolios by $153.4 million, $75.8 million and $130.0 million in 1993, 1992 and 1991, respectively. Interest rate risk is influenced by market forces. However, that risk may be controlled by monitoring and managing the repricing characteristics of assets and liabilities. In evaluating exposure to interest rate risk, the Company considers the effects of various factors in implementing interest rate risk management activities, including the utilization of interest rate swaps. Interest rate swaps outstanding at December 31, 1993 had aggregate notional amounts of $110.0 million of which $50.0 million matures in 1994 and $60.0 million matures in 1995. These interest rate swaps were entered into to hedge the adverse impact interest rate fluctuations have on interest-bearing transaction and savings deposits in the current interest rate environment. The primary analytical tool used by Management to gauge interest-rate sensitivity is a simulation model used by many major banks and bank regulators. This industry standard model is used to simulate the effects on net interest income of changes in market interest rates that are up to 2 percent higher or 2 percent lower than current levels. The results of the model indicate that the mix of interest rate sensitive assets and liabilities at December 31, 1993 would not, in the view of Management, expose the Company to an unacceptable level of interest rate risk. CAPITAL RESOURCES The Company's capital position represents the level of capital available to support continued operations and expansion. The Company's primary captial resource is shareholders' equity, which increased $8.8 million or 6.1 percent from the previous year end and increased $23.0 million or 17.8 percent from December 31, 1991. As a result of the Company's profitability, the retention of earnings and slow asset growth, the ratio of equity to total assets increased to 7.6 percent at December 31, 1993, up from 7.3 percent at December 31, 1992 and 6.6 percent at December 31, 1991. Tier I risk-based capital to risk-adjusted assets increased to 11.11 percent at December 31, 1993, from 10.02 percent at year end 1992. The ratio of total risk-based capital to risk-adjusted assets increased to 14.40 percent at December 31, 1993, from 12.01 percent at December 31, 1992. Capital to Risk-Adjusted Assets Minimum Regulatory Capital Minimum Regulatory Capital At December 31, 1993 1992 Requirements - ----------------------------------------------------------- Tier I Capital 11.11% 10.02% 4.00% Total Capital 14.40 12.01 8.00 Leverage ratio 7.42 7.39 4.00 The risk-based capital ratios improved in 1993 due to two factors: equity capital grew at a faster rate than total assets, and the decline in loan volumes and increase in investment securities reduced the level of risk-adjusted assets. FINANCIAL RATIOS The following table shows key financial ratios for the periods indicated. For the Years Ended 1993 1992 1991 - ------------------------------------------------------------------------- Return on average total assets 0.48% 0.77% 0.62% Return on average shareholders' equity 6.51% 11.16% 9.52% Average shareholders' equity as a percent of: Average total assets 7.33% 6.93% 6.48% Average total loans 12.70% 11.22% 9.81% Average total deposits 8.32% 7.67% 7.21% DEPOSITS The following table sets forth, by time remaining to maturity the Company's domestic time deposits in amounts of $100,000 or more (in thousands of dollars). Time Remaining to Maturity December 31, 1993 1992 1991 - ------------------------------------------------------------ Three months or less $73,988 $92,581 $139,487 Three to six months 23,817 46,378 58,564 Six months to 12 months 10,503 12,895 10,695 Over 12 months 4,685 6,630 6,699 - ------------------------------------------------------------ Total $112,993 $158,484 $215,445 ============================================================ See additional disclosures in Note 6 to Consolidated Financial statements on page 52 of this report. SHORT-TERM BORROWINGS The following table sets forth the short-term borrowings of the Company. (In thousands) December 31 1993 1992 1991 - ----------------------------------------------------------------------- Federal funds purchased $25,000 $ -- $ -- Other borrowed funds: Retail repurchase agreements 28,038 4,099 3,204 Other 16,026 7,939 6,366 - ----------------------------------------------------------------------- Total other borrowed funds $44,064 $12,038 $9,570 - ----------------------------------------------------------------------- Total funds purchased $12,038 $12,038 $9,570 ======================================================================= Further details of the other borrowed funds are: (In thousands) December 31 1993 1992 1991 - ------------------------------------------------------------------------ Outstanding Average during the year $37,284 $11,509 $18,865 Maximum during the year 68,608 19,055 44,558 Interest rates Average during the period 3.13% 4.73% 6.51% Average at period end 3.04 3.23 6.80 NON-INTEREST INCOME Components of Non-Interest Income (In millions) 1993 1992 1991 - ----------------------------------------------------------------------- Service charges on deposit accounts $ 12.8 $ 12.4 $ 12.1 Merchant credit card 2.2 2.9 2.9 Mortgage banking income 1.5 1.8 1.5 Brokerage commissions .8 .6 .4 Net investment securities gains -- 1.1 1.7 Sale of Sonoma Valley Bank .7 -- -- Automobile receivable servicing 1.3 -- .5 Other 4.6 5.0 4.9 - ----------------------------------------------------------------------- Total $ 23.9 $ 23.8 $ 24.0 ======================================================================= Non-interest income increased to $23.9 million in 1993. Higher income from servicing automobile receivables, the sale of the Company's 50 percent interest in Sonoma Valley Bank, higher brokerage commissions, increased fees from deposit services, gains recognized on the sale of Napa Valley Bancorp cardholder portfolio and lower write-offs of mortgage service receivables, were partially offset by lower credit card merchant fees and lower mortgage servicing fees. 1992 non-interest income also reflects $1.1 million gains on the sale of investment securities held for sale. In 1992, non-interest income decreased $200,000 from the previous year, resulting principally from lower gains of investment securities held-for-sale and lower income from servicing automobile receivables partially offset by higher deposit account fees, mortgage banking income and brokerage commissions. NON-INTEREST EXPENSE Components of Non-Interest Expense (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Salaries $ 31.6 $ 33.7 $ 34.7 Other personnel benefits 7.4 7.2 7.1 Other real estate owned 13.2 6.2 2.9 Occupancy 8.6 8.5 8.4 Equipment 6.2 5.3 5.5 FDIC insurance assessment 4.1 4.0 3.5 Data processing 3.7 3.1 3.0 Professional fees 3.1 3.3 3.3 Operational losses 2.0 .7 .5 Stationery and supplies 1.9 1.7 1.8 Advertising and public relations 1.8 1.8 2.0 Loan expense 1.6 1.4 1.3 Merchant credit card 1.1 1.7 1.9 Insurance .9 1.0 .7 Other 9.4 10.0 8.3 - ------------------------------------------------------------------- Total $ 96.6 $ 89.6 $ 84.9 =================================================================== Average full-time equivalent staff 905 1,092 1,148 Non-interest expense increased $7.0 million or 8 percent in 1993 compared with an increase of $4.7 million or 6 percent in 1992. The increase in 1993 is the direct result of merger-related foreclosed real estate owned expenses, reflecting a $10.0 million write-down of assets acquired in the Merger to fair value net of estimated selling costs reflecting the implementation of the Company's workout strategy, and other costs associated with the Merger, including $1.2 million in relocation costs, chargeoffs of $921,000 for obsolete furniture and equipment, $745,000 in investment banker fees, and other merger-related costs totaling approximately $1.2 million. Partially offsetting these increases in 1993 non-interest expense, salaries decreased $2.1 million, or 6 percent, reflecting the benefits realized from consolidation of operations after the Merger. Merchant credit card, professional fees and insurance expenses also decreased from 1992. The ratio of average assets per full-time equivalent staff was $2.2 million in 1993 compared to $1.8 million in 1992; the Company strategy to improve efficiency can be clearly seen in the reduction of the average number of full-time equivalent staff from 1,092 in 1992 to 905 in 1993. PROVISION FOR INCOME TAX The provision for income tax decreased $4.9 million in 1993 as a direct result of lower pretax income and a $394,000 revaluation adjustment of deferred tax assets due to an increase in statutory tax rates. The provision was $3.0 million in 1993 compared to $7.9 million in 1992 and $5.8 million in 1991. The higher provision in 1992 is a direct result of higher pretax income. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Consolidated Balance Sheets as of December 31, 1993 and 1992 36 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 38 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 40 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 41 Notes to Consolidated Financial Statements 43 Management's Letter of Financial Responsibility 67 Independent Auditors' Report 68 CONSOLIDATED BALANCE SHEETS (In thousands) December 31, 1993 1992* - --------------------------------------------------------------------------- Assets Cash and cash equivalents (Note 14) $ 102,618 $ 139,497 Money market assets 250 1,366 Trading account securities 10 -- Investment securities available-for-sale (Note 2) 168,819 -- Investment securities held-to-maturity; market value of $563,563 in 1993 and $581,768 in 1992 (Note 2) 557,057 570,236 Loans, net of reserve for loan losses of: $25,587 at December 31, 1993 $24,742 at December 31, 1992 (Notes 3, 4 and 13) 1,089,152 1,166,205 Loan collateral substantively foreclosed and other real estate owned 17,905 34,506 Land held for sale 800 1,123 Investment in joint venture 766 1,026 Premises and equipment, net (Notes 5 and 6) 25,341 26,959 Interest receivable and other assets (Note 8) 41,701 40,431 - --------------------------------------------------------------------------- Total assets $2,004,419 $1,981,349 =========================================================================== Liabilities Deposits: Non-interest bearing $ 369,820 $ 323,719 Interest bearing: Transaction 289,322 369,871 Savings 654,766 564,763 Time (Notes 2 and 6) 417,320 531,565 - --------------------------------------------------------------------------- Total deposits 1,731,228 1,789,918 Funds purchased 69,064 12,038 Liability for interest, taxes, other expenses, minority interest and other (Note 8) 15,328 16,382 Notes and mortgages payable (Notes 6 and 14) 36,352 19,337 - --------------------------------------------------------------------------- Total liabilities 1,851,972 1,837,675 Commitments and contingent liabilities (Notes 4, 10 and 11) -- -- Shareholders' Equity (Notes 7 and 14) Common stock (no par value) Authorized- 20,000 shares Issued and outstanding- 8,080 shares in 1993 and 8,000 shares in 1992 52,499 51,053 Capital surplus 10,831 10,831 Unrealized gains on securities available for sale (Note 2) 2,527 -- Retained earnings 86,590 81,790 - --------------------------------------------------------------------------- Total shareholders' equity 152,447 143,674 - --------------------------------------------------------------------------- Total liabilities and shareholders' equity $2,004,419 $1,981,349 =========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------- Interest Income Loans $ 99,607 $115,357 $137,656 Money market assets and federal funds sold 298 1,745 2,191 Trading account securities 6 4 54 Investment securities: U.S. Treasury 10,284 4,484 6,159 Securities of U.S. government agencies and corporations 13,994 18,802 18,406 Obligations of states and political subdivisions 5,894 5,358 5,272 Asset backed 4,942 5,809 5,675 Other 1,891 3,194 1,139 - --------------------------------------------------------------------- Total interest income 136,916 154,753 176,552 - --------------------------------------------------------------------- Interest Expense Transaction deposits 4,219 7,680 13,371 Savings deposits 15,085 18,838 22,748 Time deposits (Note 6) 19,014 29,314 46,950 Funds purchased 1,937 698 1,677 Notes and mortgages payable (Note 6) 2,016 2,362 2,611 - --------------------------------------------------------------------- Total interest expense 42,271 58,892 87,357 - --------------------------------------------------------------------- Net Interest Income 94,645 95,861 89,195 Provision for loan losses (Note 3) 9,452 7,005 10,418 - --------------------------------------------------------------------- Net interest income after provision for loan losses 85,193 88,856 78,777 - --------------------------------------------------------------------- Non-Interest Income Service charges on deposit accounts 12,809 12,437 12,056 Merchant credit card 2,217 2,900 2,881 Mortgage banking 1,467 1,808 1,457 Brokerage commissions 839 555 392 Net investment securities gain 68 1,066 1,742 Other 6,546 5,061 5,448 - --------------------------------------------------------------------- Total non-interest income 23,946 23,827 23,976 - --------------------------------------------------------------------- Non-Interest Expense Salaries and related benefits (Note 12) 39,007 40,826 40,252 Other real estate owned 11,550 5,183 2,884 Occupancy (Notes 5 and 10) 8,625 8,524 8,401 Equipment (Notes 5 and 10) 6,195 5,302 5,522 FDIC insurance assessment 4,079 4,021 3,545 Data processing 3,658 3,137 2,964 Professional fees 3,071 3,332 3,346 Other 20,460 19,279 18,029 - ---------------------------------------------------------------------- Total non-interest expense 96,645 89,604 84,943 - ---------------------------------------------------------------------- Income Before Income Taxes 12,494 23,079 17,810 Provision for income taxes (Note 8) 3,039 7,857 5,833 - ---------------------------------------------------------------------- Net Income $ 9,455 $ 15,222 $ 11,977 ====================================================================== Average common shares outstanding 8,054 7,933 7,855 Per Share Data (Notes 7 and 17) Net income $ 1.17 $ 1.92 $ 1.52 Dividends declared .57 .51 .44 *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $ 15,222 $ 11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,622 4,198 4,189 Loan loss provision 9,452 7,005 10,418 Amortization of net deferred loan (cost)/fees (462) 615 433 (Increase) decrease in interest income receivable (2,542) 1,070 1,698 Decrease (increase) in other assets 2,888 (3,204) 2,062 Decrease in income taxes payable (1,529) (1,179) (2,752) Decrease in interest expense payable (1,169) (1,933) (1,145) (Decrease) increase in accrued expenses (1,809) 1,420 (405) Net gain on sale of investment securities (68) (1,066) (1,742) Loss (gain) on sale of developed land -- 2,930 (107) Loss (gains) on sales/write-down of premises and equipment 1,476 225 (86) Originations of loans for resale (92,374) (100,055) (102,300) Proceeds from sale of loans originated for resale 92,536 103,855 102,019 Loss on sale/write-down of property acquired in satisfaction of debt 9,618 3,507 2,559 Gain on sale of Sonoma Valley Bank (668) -- -- Net (purchases) maturities of trading securities (10) 779 (130) - --------------------------------------------------------------------------- Net cash provided by operating activities 28,416 33,389 26,688 - --------------------------------------------------------------------------- Investing Activities Net repayments of loans 68,109 32,782 15,470 Purchases of money market assets (325) (16,833) (34,551) Purchases of investment securities (427,886) (339,583) (269,505) Purchases of property, plant and equipment (3,481) (4,416) (5,161) Improvements on developed land -- (1,435) -- Proceeds from maturity/sale of money market assets 1,441 17,574 34,301 Proceeds from maturity of securities 274,451 263,793 139,549 Proceeds from sale of securities 184 21,128 49,580 Proceeds from sale of property and equipment -- 1,640 858 Net proceeds from sale of developed land 356 1,928 107 Proceeds from disposition of property acquired in satisfaction of debt 6,313 4,513 624 Proceeds from sale of Sonoma Valley Bank 2,733 -- -- Net repayments on loan collateral substantively foreclosed 669 1,187 629 - --------------------------------------------------------------------------- Net cash used in investing activities (77,436) (17,722) (68,099) - --------------------------------------------------------------------------- Financing Activities Net increase (decrease) in deposits (58,691) 617 66,203 Net (decrease) increase in federal funds purchased 57,026 2,468 (25,529) Proceeds from issuance of capital notes 20,000 -- -- Principal payments on notes and mortgages payable (2,985) (2,423) (1,672) Exercise of stock options 1,446 2,214 1,525 Retirement of stock -- (204) (843) Unrealized loss (gain) in marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - --------------------------------------------------------------------------- Net cash provided by (used in) financing activities 12,141 (306) 36,634 - --------------------------------------------------------------------------- Net (decrease) increase in cash and cash equivalents (36,879) 15,361 (4,777) Cash and cash equivalents at beginning of year 139,497 124,136 128,913 - --------------------------------------------------------------------------- Cash and cash equivalents at end of year $102,618 $139,497 $124,136 =========================================================================== Supplemental disclosures: Loans transferred to other real estate owned and substantively repossessed $16,111 $36,572 $9,132 Interest paid 42,982 57,491 87,163 Income tax payments 5,700 9,773 9,045 Unrealized gain on securities available for sale 2,527 -- -- *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. Westamerica Bancorporation NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: Business and Accounting Policies Westamerica Bancorporation, a registered bank holding Company, (the Company), provides a full range of banking services to individual and corporate customers in Northern California through its subsidiary banks (the Banks), Westamerica Bank and Subsidiary, Bank of Lake County and Napa Valley Bank and Subsidiary. The Banks are subject to competition from other financial institutions and to regulations of certain agencies and undergo periodic examinations by those regulatory authorities. Summary of Significant Accounting Policies The consolidated financial statements are prepared in conformity with generally accepted accounting principles and general practices within the banking industry. The following is a summary of significant accounting policies used in the preparation of the accompanying financial statements. In preparing the financial statements, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods indicated. Principles of Consolidation. The financial statements include the accounts of the Company, a registered bank holding company, and all the Company's subsidiaries which include the Banks and Community Banker Services Corporation and Subsidiary. Significant intercompany transactions have been eliminated in consolidation. All data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Cash Equivalents. Cash equivalents include Due From Banks balances and Federal Funds Sold which are both readily convertible to known amounts of cash and are so near their maturity that they present insignificant risk of changes in value because of interest rate volatility. Securities. Marketable investment securities at December 31, 1993 consist of U.S. Treasury, U. S. Government Agencies and Corporations, Municipal, asset-backed and other securities. The Company adopted the provisions of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 115) at December 31, 1993. Under SFAS No. 115, the Company classifies its debt and marketable equity securities into one of three categories: trading, available-for-sale or held-to-maturity. Trading securities are bought and held principally for the purpose of selling in the near term. Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held-to-maturity are classied as available-for-sale. Trading and available-for-sale securities are recorded at fair value. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Unrealized gains and losses on trading securities are included in earnings. Unrealized gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of shareholders' equity until realized. Unrealized gains and losses associated with transfers of securities from held-to-maturity to available-for-sale are recorded as a separate component of shareholders' equity. The unrealized gains or losses included in the separate component of shareholders' equity for securities transferred from available-for-sale to held-to-maturity are maintained and amortized into earnings over the remaining life of the security as an adjustment to yield in a manner consistent with the amortization or accretion of premium or discount on the associated security. A decline in the market value of held-to-maturity and available-for-sale securities below cost that is deemed other than temporary, results in a charge to earnings and the establishment of a new cost basis for the security. Premiums and discounts are amortized or accreted over the life of the related investment security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities classied as available-for-sale and held-to-maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Loans and Reserve for Loan Losses. The reserve for loan losses is a combination of specific and general reserves available to absorb estimated future losses in the loan portfolio and is maintained at a level considered adequate to provide for such losses. Credit reviews of the loan portfolio, designed to identify problem loans and to monitor these estimates, are conducted continually, taking into consideration market conditions, current and anticipated developments applicable to the borrowers and the economy, and the results of recent examinations by regulatory agencies. Management approves the conclusions resulting from credit reviews. Ultimate losses may vary from current estimates. Adjustments to previous estimates of loan losses are charged to income in the period which they become known. Unearned interest on discounted loans is amortized over the life of these loans, using the sum-of-the-months digits method for which the results are not materially different from those obtained by using the interest method. For all other loans, interest is accrued daily on the outstanding balances. Loans which are more than 90 days delinquent with respect to interest or principal, unless they are well secured and in the process of collection, and other loans on which full recovery of principal or interest is in doubt, are placed on non-accrual status. Non-refundable fees and certain costs associated with originating or acquiring loans are deferred and amortized as an adjustment to interest income over the estimated respective loan lives. Loans held for sale are identified upon origination and are reported at the lower of cost or fair value on an individual loan basis. Other Real Estate Owned and Loan Collateral Substantively Foreclosed. Other real estate owned includes property acquired through foreclosure or forgiveness of debt. These properties are transferred at fair value, which becomes the new cost basis of the property. Losses recognized at the time of acquiring property in full or partial satisfaction of loans are charged against the reserve for loan losses. Subsequent losses incurred due to the declines in property values as identified in independent property appraisals are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. The Company classifies loans as loan collateral substantively foreclosed (substantive repossessions) when the borrower has little or no equity in the collateral, when proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral, and the debtor has either formally or effectively abandoned control of the collateral to the Company or has retained control of the collateral but, because of the current financial condition of the debtor or the economic prospects for the debtor and/or collateral in the foreseeable future, it is doubtful that the debtor will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. Losses recognized at the time the loans are reclassified as substantive repossessions are charged against the reserve for loan losses. Subsequent losses incurred due to subsequent declines in property values, as identified in independent property appraisals, are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. Premises and Equipment. Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful life of each type of asset. Estimated useful lives of premises and equipment range from 20 to 50 years and from 3 to 20 years, respectively. Leasehold improvements are amortized over the terms of the lease or their estimated useful life, whichever is shorter. Fully depreciated and/or amortized assets are removed from the Company's balance sheet. Interest Rate Swap Agreements. The Company uses interest rate swap agreements as an asset/liability management tool to reduce interest rate risk. Interest rate swap agreements are exchanges of fixed and variable interest payments based on a notional principal amount. The primary risk associated with swaps is the exposure to movements in interest rates and the ability of the counter parties to meet the terms of the contracts. The Company controls the credit risk of the these agreements through credit approvals, limits and monitoring procedures. The Company is not a dealer but an end user of these instruments and does not use them speculatively. Accounted for as hedges, the differential to be paid or received on such agreements is recognized over the life of the agreements. Payments made or received in connection with early termination of interest rate swap agreements are recognized over the remaining term of the swap agreement. Earnings Per Share. Earnings per share amounts are computed on the basis of the weighted average of common shares outstanding during each of the years presented. Income Taxes. The Company and its subsidiaries file consolidated tax returns. For financial reporting purposes, the income tax effects of transactions are recognized in the year in which they enter into the determination of recorded income, regardless of when they are recognized for income tax purposes. Accordingly, the provisions for income taxes in the consolidated statements of income include charges or credits for deferred income taxes relating to temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Other. Securities and other property held by the Banks in a fiduciary or agency capacity are not included in the financial statements since such items are not assets of the Company or its subsidiaries. Certain amounts in prior years financial statements have been reclassified to conform with the current years presentation. These reclassifications had no effect on previously reported income. Note 2: Investment Securities An analysis of investment securities available-for-sale as of December 31, 1993, is as follows: *Includes $24.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.4 million; 1 to 5 years $15.2 million. The average yield of these securities is 5.56 percent. An analysis of investment securities held-to-maturity as of December 31, 1993, is as follows: *Includes $162.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.9 million; 1 to 5 years $9.3 million; 5 to 10 years $71.3 million; over 10 years $72.1 million. These securities have a market value of $162.4 million and an average yield of 5.45 percent. As of December 31, 1993, $173.5 million of investment securities held-to- maturity were pledged to secure public deposits. A summary of investment securities portfolio held-to-maturity as of December 31, 1992, is as follows: Gross Gross Book unrealized unrealized Fair Value gains losses Value - -------------------------------------------------------------------- U.S. Treasury securities $126,522 $2,208 ($156) $128,574 Securities of U.S. Govt. Agencies and Corporations 237,753 4,919 (517) 242,155 Obligations of States and Political Subdivisions 87,031 3,655 (197) 90,489 Asset Backed (Automobile Receivables) 82,270 1,040 (105) 83,205 Other Securities (Preferred Stocks & Corporate Bonds) 36,660 735 (50) 37,345 - -------------------------------------------------------------------- Total Securities Held-to-maturity $570,236 $12,557 ($1,025) $581,768 ==================================================================== Note 3: Loans and Reserve for Loan Losses Loans at December 31, consisted of the following: (In thousands) 1993 1992 - ------------------------------------------------------- Commercial $ 266,448 $ 439,494 Real estate-commercial 346,308 196,401 Real estate-construction 40,533 63,886 Real estate-residential 172,245 175,834 Installment and personal 304,993 334,215 Unearned income (15,788) (18,883) - ------------------------------------------------------- Gross loans 1,114,739 1,190,947 Loan loss reserve (25,587) (24,742) - ------------------------------------------------------- Net loans $1,089,152 $1,166,205 ======================================================= Included in real estate-residential at December 31, 1993 and 1992 are loans held for resale of $5.9 million and $3.6 million, respectively, the cost of which approximates market value. Changes in the loan loss reserve were: (In thousands) 1993 1992 1991 - ------------------------------------------------------------------ Balance at January 1, $24,742 $23,853 $19,002 Sale of Sonoma Valley Bank (684) -- -- Provision for loan losses 9,452 7,005 10,418 Credit losses (10,091) (8,794) (9,140) Credit loss recoveries 2,168 2,678 3,573 - ------------------------------------------------------------------ Balance at December 31, $25,587 $24,742 $23,853 ================================================================== Restructured loans were $4.4 million and $319,000 at December 31, 1993 and 1992, respectively. The following is a summary of interest foregone on restructured loans for the years ended December 31: (In thousands) 1993 1992 1991 - ------------------------------------------------------------- Interest income that would have been recognized had the loans performed in accordance with their original terms $472 $135 $173 Less: Interest income recognized on restructured loans (218) -- (8) - ------------------------------------------------------------- Interest foregone on restructured loans $254 $135 $165 ============================================================= Note 4: Concentrations of Credit Risk The Company's business activity is with customers in Northern California. The loan portfolio is well diversified with no industry comprising greater than ten percent of total loans outstanding as of December 31, 1993. The Company has a significant number of credit arrangements that are secured by real estate collateral. In addition to real estate loans outstanding as disclosed in Note 3, the Company had loan commitments and stand by letters of credit related to real estate loans of $18.7 million at December 31, 1993. The Company requires collateral on all real estate loans and generally attempts to maintain loan-to-value ratios no greater than 75 percent on commercial real estate loans and no greater than 80 percent on residential real estate loans. Note 5: Premises and Equipment A summary as of December 31, follows: Accumulated Depreciation and Net (In thousands) Cost Amortization Book Value - ------------------------------------------------------------------------- Land $ 3,735 $ -- $ 3,735 Buildings and improvements 20,072 (6,876) 13,196 Leasehold improvements 2,537 (1,513) 1,024 Furniture and equipment 14,347 (6,961) 7,386 - ------------------------------------------------------------------------- Total $40,691 $(15,350) $25,341 ========================================================================= Land $5,483 $ -- $ 5,483 Buildings and improvements 19,131 (7,225) 11,906 Leasehold improvements 4,878 (2,929) 1,949 Furniture and equipment 19,711 (12,090) 7,621 - ------------------------------------------------------------------------- Total $49,203 $(22,244) $26,959 ========================================================================= Depreciation and amortization included in non-interest expense amount to $3,621,800 in 1993, $4,198,000 in 1992 and $4,189,400 in 1991. Note 6: Borrowed Funds Notes payable include the unsecured obligations of the Company as of December 31, 1993 and 1992, as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------------ Unsecured note dated September, 1976, interest payable semiannually at 9 7/8% and principal payments of $267 due annually to September 1, 1996. $ 196 $ 463 Unsecured note dated May, 1984, interest payable quarterly at 12.95% and principal payments of $1,000 due annually beginning September 1, 1991 and ending on September 1, 1996. Note agreement provides for partial prepayment under certain conditions without penalty and for prepayment of all or a portion of the note under certain conditions with a premium which decreases over the contractual term. 2,100 3,100 Equity contract notes, originated in April 1986 and maturing on April 1, 1996. Interest payable semiannually at 11 5/8% and principal payments of $2,500 due annually, on April 1, starting in 1993. 7,500 10,000 Senior notes, originated in May 1988 and maturing on June 30, 1995. Interest payable semiannually at 10.87% and principal payment due at maturity. 5,000 5,000 Subordinated note, issued by Westamerica Bank, originated in December 1993 and maturing September 30, 2003. Interest at an annual rate of 6.99% payable semiannually on March 31 and September 30, with principal due at maturity. 20,000 -- - ------------------------------------------------------------------------ Total notes payable $34,796 $18,563 ======================================================================== Mortgages payable of $524,000 consist of a note of Westamerica Bank secured by a deed of trust on premises having a net book value of $790,000 and $824,000 at December 31, 1993 and 1992, respectively. The note, which has an effective interest rate of 10 percent, is scheduled to mature in April 1995. Included in notes and mortgages payable are senior liens on other real estate, land held for sale and investments in joint venture properties that totaled $1,032,000 and $250,000 at December 31, 1993 and 1992, respectively. The combined aggregate amount of maturities of notes payable is $3,696,000, $8,500,000, $2,600,000, $0 and $0 for the years 1994 through 1998, and $20,000,000 thereafter. At December 31, 1993, the Company had unused lines of credit amounting to $7,500,000. Compensating balance arrangements are not significant to the operations of the Company. At December 31, 1993, the Banks had $113.0 million in time deposit accounts in excess of $100,000; interest on these accounts in 1993 was $4,837,000. Note 7: Shareholders' Equity In April 1982, the Company adopted an Incentive Stock Option Plan and 413,866 shares were reserved for issuance. Under this plan, all options are currently exercisable and terminate 10 years from the date of the grant. Under the Stock Option Plan adopted by the Company in 1985, 750,000 shares have been reserved for issuance. Stock appreciation rights, incentive stock options, non-qualified stock options and restricted performance shares are available under this plan. Options are granted at fair market value and are generally exercisable in equal installments over a three-year period with the first installment exercisable one year after the date of the grant. Each incentive stock option has a maximum ten-year term while non-qualified stock options may have a longer term. The 1985 plan was amended in 1990 to provide for restricted performance share (RPS) grants. An RPS grant becomes fully vested after three years of being awarded, provided that the Company has attained its performance goals for such three-year period. At December 31, 1993, 299,046 options were available for grant under the 1985 Stock Option Plan. Information with respect to options outstanding and options exercised under the plans is summarized in the following table: Number Option Price of shares* $ per share $ Total Shares under option at December 31: 1993 313,564 8.88- 24.50 5,766,400 1992 278,544 6.06- 22.00 4,249,399 1991 400,247 6.06- 22.00 6,202,300 Options exercised during: 1993 51,260 8.88- 22.00 692,157 1992 168,423 6.06- 13.29 1,975,000 1991 120,362 6.06- 13.63 997,700 * Issuable upon exercise. At December 31, 1993, options to acquire 164,794 shares of common stock were exercisable. Shareholders have authorized issuance of two new classes of 1,000,000 shares each, to be denominated Class B Common Stock and Preferred Stock, respectively, in addition to the 20,000,000 shares of Common Stock presently authorized. At December 31, 1993, no shares of Class B or Preferred Stock had been issued. At December 31, 1993, the Company's Tier I Capital was $149,937,000 and Total Capital was $194,415,000 or 11.11 percent and 14.40 percent, respectively, of risk-adjusted assets. In December 1986, the Company declared a dividend distribution of one common share purchase right (the Right) for each outstanding share of common stock. The Rights are exercisable only in the event of an acquisition of, or announcement of a tender offer to acquire, 15 percent or more of the Company's stock or 50 percent or more of its assets without the prior consent of the Board of Directors. If the Rights become exercisable, the holder may purchase one share of the Company's common stock for $65. Following an acquisition of 15 percent of the Company's common stock or 50 percent or more of its assets without prior consent of the Company, each right will also entitle the holder to purchase $130 worth of common stock of the Company for $65. Under certain circumstances, the Rights may be redeemed by the Company at a price of $.05 per right prior to becoming exercisable and in certain circumstances thereafter. The Rights expire on December 31, 1999, or earlier, in connection with certain Board-approved transactions. Note 8: Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, (SFAS No. 109). Adoption of SFAS No. 109 required a change from the deferred method to the asset and liability method of accounting for income taxes. Under the deferred method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement reported amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.] Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The components of the net deferred tax asset as of December 31, are as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------- Deferred tax asset Reserve for loan losses $ 10,321 $ 9,013 State franchise taxes 676 941 Deferred compensation 534 723 Real estate owned 2,742 1,851 Net deferred loan fees -- 268 Other 1,037 587 - ------------------------------------------------------------------- 15,310 13,383 Valuation allowance -- -- - ------------------------------------------------------------------- Total deferred tax asset 15,310 13,383 - ------------------------------------------------------------------- Deferred tax liability Net deferred loan costs 502 -- Fixed assets depreciation 1,164 1,171 Securities available-for-sale 1,864 -- Other 148 373 - ------------------------------------------------------------------- Total deferred tax liability 3,678 1,544 - ------------------------------------------------------------------- Net deferred tax asset $11,632 $11,839 =================================================================== The Company believes a valuation allowance is not needed to reduce the deferred tax asset because there is no material portion of the deferred tax asset that will not be realized through sufficient taxable income. The provisions for federal and state income taxes consist of amounts currently payable and amounts deferred which, for the years ended December 31, are as follows: (In thousands) 1993 1992 1991 - ------------------------------------------------------------ Current income tax expense: Federal $2,501 $6,977 $5,314 State 2,195 3,130 2,638 - ------------------------------------------------------------ Total current 4,696 10,107 7,952 - ------------------------------------------------------------ Deferred income tax benefit: Federal (646) (1,758) (1,335) State (617) (492) (784) - ------------------------------------------------------------ Total deferred (1,263) (2,250) (2,119) - ------------------------------------------------------------ Adjustment of net deferred tax asset for enacted changes in tax rates: Federal (304) -- -- State (90) -- -- - ------------------------------------------------------------- Total adjustment (394) -- -- - ------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ============================================================= The provisions for income taxes differ from the provisions computed by applying the statutory federal income tax rate to income before taxes, as follows: (In thousands) 1993 1992 1991 - -------------------------------------------------------------------- Federal income taxes due at statutory rate $4,248 $7,846 $6,056 (Reductions) increases in income taxes resulting from: Interest not taxable for federal income tax purposes (1,895) (1,735) (1,836) State franchise taxes, net of federal income tax benefit 982 1,753 1,226 Deferred benefit and other (296) (7) 387 - --------------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ===================================================================== Note 9: Fair Value of Financial Instruments The fair value of financial instruments which have a relative short period of time between their origination and their expected realization were valued using historical cost. Such financial instruments and their estimated fair values at December 31, were: (In thousands) 1993 1992 - ------------------------------------------------------------------- Cash and cash equivalents $102,618 $139,497 Money market assets 250 1,366 Interest and taxes receivable 28,799 25,741 Non-interest bearing and interest-bearing transaction and savings deposits 1,313,908 1,258,353 Funds purchased 69,064 12,038 Interest payable 2,700 3,824 The fair value at December 31 of the following financial instruments was estimated using quoted market prices: (In thousands) 1993 1992 - ------------------------------------------------------------------- Investment securities available for sale $168,819 $ -- Investment securities held to maturity 563,563 581,768 Trading account securities 10 -- Loans were separated into two groups for valuation. Variable rate loans, which reprice frequently with changes in market rates, were valued using historical cost. Fixed rate loans were valued by discounting the future cash flows expected to be received from the loans using current interest rates charged on loans with similar characteristics. Additionally, the $25,587,000 and $24,742,000 reserves for loan losses as of December 31, 1993 and 1992, respectively, were applied against the estimated fair value to recognize future defaults of contractual cash flows. The estimated fair market value of loans at December 31, was: (In thousands) 1993 1992 - -------------------------------------------------------------------- Loans $1,096,164 $1,171,630 The fair value of time deposits and notes and mortgages payable was estimated by discounting future cash flows related to these financial instruments using current market rates for financial instruments with similar characteristics. The estimated fair values at December 31, were: (In thousands) 1993 1992 - --------------------------------------------------------------------- Time deposits $420,475 $534,920 Notes and mortgages payable 36,014 20,282 The estimated fair values of the Company's interest rate swaps, which are determined by dealer quotes and generally represent the amount that the Company would pay to terminate its swap contracts, were $(600,000) and $0, respectively, at December 31, 1993 and 1992. These fair values do not represent actual amounts that may be realized upon any sale or liquidation of the related assets or liabilities. In addition, these values do not give effect to discounts to fair value which may occur when financial instruments are sold in larger quantities. The fair values presented above represent the Company's best estimate of fair value using the methodologies discussed above. Note 10: Lease Commitments Fifteen banking offices and three administrative service centers are owned and thirty-seven banking offices and two support facilities are leased. Substantially all the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living, property taxes and maintenance. The Company also leases certain pieces of equipment. Minimum future rental payments on operating leases, net of sublease income, at December 31, 1993, are as follows: (In thousands) 1994 $ 3,253 1995 3,091 1996 2,632 1997 1,679 1998 1,183 Thereafter 3,659 - ------------------------------------------------- Total minimum lease payments $15,497 ================================================= Total rentals for premises and equipment net of sublease income included in non-interest expense were $3,862,000 in 1993, $3,910,000 in 1992 and $3,829,000 in 1991. Note 11: Commitments and Contingent Liabilities Loan commitments are agreements to lend to a customer provided there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future funding requirements. Loan commitments are subject to the Company's normal credit policies and collateral requirements. Unfunded loan commitments were $159.2 million at December 31, 1993. Standby letters of credit commit the Company to make payments on behalf of customers when certain specified future events occur. Standby letters of credit are primarily issued to support customers short-term financing requirements and must meet the Company's normal credit policies and collateral requirements. Standby letters of credit outstanding were $6.4 million at December 31, 1993. Interest rate swaps are agreements to exchange interest payments computed on notional amounts. The notional amounts do not represent exposure to credit risk; however, these agreements expose the Company to market risks associated with fluctuations of interest rates. As of December 31, 1993, the Company had entered into four interest rate swaps. The first two contracts have notional amounts totaling $25 million each and the second two contracts have notional amounts totaling $30 million each. On the first two contracts, which are scheduled to terminate in November and December of 1994, the Company pays an average fixed rate of interest of 5.06 percent and receives a variable rate of interest based on the London Interbank Offering Rate (LIBOR); on the second two contracts, scheduled to terminate in August of 1995, the Company pays a variable rate based on LIBOR and receives an average fixed rate of interest of 4.11 percent. The LIBOR rate has averaged 3.39 percent from the date the first two swaps were entered through December 31, 1993 and 3.33 percent from the date the second two swaps were entered through December 31, 1993. The effect of entering into these contracts resulted in a decrease to net interest income of $659,000 for the period ended December 31, 1993. The Company, because of the nature of its business, is subject to various threatened or filed legal cases. The Company, based on the advice of legal counsel, does not expect such cases will have material, adverse effect on its financial position or results of operations. Note 12: Retirement Benefit Plans The Company sponsors a defined benefit Retirement Plan covering substantially all of its salaried employees with one or more years of service. The Company's policy is to expense costs as they accrue as determined by the Projected Unit Cost method. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. The following table sets forth the Retirement Plans funded status as of December 31 and the pension cost for the years ended December 31: (In thousands) 1993 1992 - ----------------------------------------------------------------- Actuarial present value of benefit obligations: Vested benefit obligation $(11,245) $(10,625) - ----------------------------------------------------------------- Accumulated benefit obligation (11,430) (11,064) - ----------------------------------------------------------------- Projected benefit obligation (11,612) (11,275) Plan assets at fair market value 11,677 11,429 ================================================================= Funded status-projected benefit obligation (in excess of) or less than plan assets $65 $154 ================================================================= Comprised of: Prepaid pension cost $22 $182 Unrecognized net (loss) gain (75) (194) Unrecognized prior service cost 529 628 Unrecognized net obligation, net of amortization (411) (462) - ----------------------------------------------------------------- Total $65 $154 ================================================================= Net pension cost included in the following components: Service cost during the period $364 $384 Interest cost on projected benefit obligation 744 754 Actual return on plan assets (1,012) (686) Net amortization and deferral 64 (271) - ----------------------------------------------------------------- Net periodic pension cost $160 $181 ================================================================= The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 6.75 percent and 5 percent, respectively, at December 31, 1993 and 7 percent and 5 percent, respectively, at December 31, 1992. The expected long-term rate of return on plan assets in 1993 and 1992 was 7 percent and 8 percent, respectively. Effective January 1, 1992, the Company adopted a defined contribution Deferred Profit-Sharing Plan covering substantially all of its salaried employees with one or more years of service. Participant deferred profit-sharing account balances offset benefits accrued under the Retirement Plan which was amended effective January 1, 1992 to coordinate benefits with the Deferred Profit-Sharing Plan. The coordination of benefits results in the Retirement Plan benefit formula establishing the minimum value of participant retirement benefits which, if not provided by the Deferred Profit-Sharing Plan, are guaranteed by the Retirement Plan. The costs charged to non-interest expense related to benefits provided by the Retirement Plan and the Deferred Profit-Sharing Plan were $1,160,000 in 1993, $1,037,000 in 1992 and $759,000 in 1991. In addition to the Retirement Plan and the Deferred Profit-Sharing Plan, all salaried employees are eligible to participate in the voluntary Tax Deferred Savings/Retirement Plan (ESOP) upon completion of a 90-day introductory period. This plan allows employees to defer, on a pretax basis, a portion of their compensation as contributions to the plan. Participants are allowed to invest in five funds, including a Westamerica Bancorporation Common Stock Fund. The Company's matching contributions charged to operating expense were $482,000 in 1993, $462,000 in 1992 and $452,000 in 1991. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, Employers Accounting for Postretirement Benefits Other than Pensions (SFAS No. 106). Adoption of SFAS No. 106 required a change from the cash method to an actuarial based accrual method of accounting for postretirement benefits other than pensions. The Company offers continuation of group insurance coverage to employees electing early retirement, as defined by the Retirement Plan, for the period from the date of early retirement until age sixty-five. The Company contributes an amount toward early retirees insurance premiums which is fixed at the time of early retirement. The Company also reimburses Medicare Part B premiums for all retirees over age sixty-five, as defined by the Retirement Plan. The following table sets forth the net periodic postretirement benefit cost for the year ended December 31, 1993 and the funded status of the plan at December 31, 1993: (In thousands) Service cost $ 482 Interest cost 107 Actual return on plan assets -- Amortization of unrecognized transition obligation 61 Other, net (482) - ----------------------------------------------------------- Net periodic cost $ 168 =========================================================== Accumulated postretirement benefit obligation attributable to: Retirees $ 1,130 Fully eligible participants 265 Other 158 - ----------------------------------------------------------- Total 1,553 - ----------------------------------------------------------- Fair value of plan assets -- Accumulated postretirement benefit obligation in excess of plan assets $ 1,553 =========================================================== Comprised of: Unrecognized prior service cost -- Unrecognized net gain (loss) -- Unrecognized transition obligation 1,471 Recognized postretirement obligation 82 - ----------------------------------------------------------- Total $1,553 =========================================================== The discount rate used in measuring the accumulated postretirement benefit obligation was 6.75 percent at December 31, 1993. The assumed health care cost trend rate used to measure the expected cost of benefits covered by the plan was 9 percent for 1994 and declined steadily to an ultimate trend rate of 4 percent beginning in 1999. The effect of a one percentage point increase on the assumed health care cost trend for each future year would increase the aggregate of the service cost and interest cost components of the 1993 net periodic cost by $73,000 and increase the accumulated postretirement benefit obligation at December 31, 1993 by $204,000. Note 13: Related Party Transactions Certain directors and executive officers of the Company were lending customers of the Company during 1993 and 1992. All such loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral requirements. No related party loan represents more than normal risk of collection. Such loans were $5,238,000 and $10,591,000 at December 31, 1993 and 1992, respectively. Note 14: Restrictions Payment of dividends to the Company by Westamerica Bank, the largest subsidiary bank, is limited under regulations for Federal Reserve member banks. The amount that can be paid in any calendar year, without prior approval from regulatory agencies, cannot exceed the net profits (as defined) for that year plus the net profits of the preceding two calendar years less dividends declared. Under this regulation, Westamerica Bank, the largest subsidiary bank, was not restricted as to the payment of $13.6 million in dividends to the Company as of December 31, 1993. During 1992 and 1993, Napa Valley Bank, a banking subsidiary, was operating under a regulatory order which disallowed payment of dividends to the Company unless it reduced the level of problem assets, liquidated, or reserved adequately against, the real estate investments in its subsidiary company, and strengthened its loan loss reserve. Napa Valley Bank has complied with all conditions of the regulatory order which will be removed by the regulators based on their fourth quarter 1993 examination. Payment of dividends by the Company is also restricted under the terms of the note agreements as discussed in Note 6. Under the most restrictive of these agreements, $17.1 million was available for payment of dividends as of December 31, 1993. Under one of the note agreements, the Company has agreed to limit its funded debt to 40 percent of the total of funded debt plus shareholders' equity and maintain certain other financial ratios. The Company was in compliance with all such requirements as of December 31, 1993. The Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of its reservable deposits. The Banks daily average balance on deposit at the Federal Reserve Bank was $40.4 million in 1993 and $40.3 million in 1992. Note 15: Westamerica Bancorporation (Parent Company Only) Statements of Income (In thousands) Years ended December 31, 1993 1992* 1991* - ----------------------------------------------------------------------- Dividends from subsidiaries $16,671 $ 8,630 $ 6,620 Interest from subsidiaries 315 61 72 Other income 2,781 1,158 1,082 - ----------------------------------------------------------------------- Total income 19,767 9,849 7,774 - ----------------------------------------------------------------------- Interest on borrowings 1,958 2,434 2,617 Salaries and benefits 4,526 782 475 Other non-interest expense 5,464 3,451 2,261 - ----------------------------------------------------------------------- Total expenses 11,948 6,667 5,353 - ----------------------------------------------------------------------- Income before income tax benefit and equity in undistributed income of subsidiaries 7,819 3,182 2,421 Income tax benefit 3,478 1,890 1,813 Equity in undistributed (loss) income of subsidiaries (1,842) 10,150 7,743 - ----------------------------------------------------------------------- Net income $9,455 $15,222 $11,977 ======================================================================= *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Balance Sheets (In thousands) Years ended December 31, 1993 1992* - -------------------------------------------------------------------------- Assets Cash and cash equivalents $4,790 $ 1,729 Investment securities held-to-maturity 9,250 13,741 Loans 149 -- Investment in subsidiaries 154,257 145,762 Premises and equipment 29 2,506 Accounts receivable from subsidiaries 65 262 Other assets 2,056 2,704 - ------------------------------------------------------------------------- Total assets $170,596 $166,704 ========================================================================= Liabilities Long-term debt $ 14,796 $ 18,563 Notes payable to subsidiaries -- 2,493 Other liabilities 3,353 1,974 - ------------------------------------------------------------------------- Total liabilities 18,149 23,030 - ------------------------------------------------------------------------- Shareholders' equity 152,447 143,674 - ------------------------------------------------------------------------- Total liabilities and shareholders' equity $170,596 $166,704 ========================================================================= Statements of Cash Flows (In thousands) Years ended December 31, 1993 1992* 1991* - -------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $15,222 $11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 108 67 58 Equity in undistributed loss (income) of subsidiaries 1,842 (10,150) (7,743) Increase in equity in subsidiaries -- (1,797) -- (Increase) decrease in receivables from subsidiaries 197 1,020 (1,005) Provision for deferred income taxes 60 2,633 (551) Decrease (increase) in other assets 1,183 (1,394) (771) Increase in other liabilities 1,583 301 39 Gain on sale of Sonoma Valley Bank (668) -- -- Net gain on sale of land -- 43 -- - -------------------------------------------------------------------------- Net cash provided by operating activities 13,760 5,945 2,004 - -------------------------------------------------------------------------- Investing Activities Purchases of premises and equipment -- (2,189) (761) Net change in land held for sale (800) -- -- Net change in loan balances (149) -- -- Increase in investment in subsidiaries (9,874) (485) (510) Purchase of investment securities held-to-maturity (9,700) (13,991) (22,100) Proceeds from maturities of investment securities 14,191 10,500 23,100 Proceeds from sales of premises and equipment 2,369 2,149 -- Proceeds from sale of Sonoma Valley Bank 2,733 -- -- - -------------------------------------------------------------------------- Net cash used in investing activities (1,230) (4,016) (271) - -------------------------------------------------------------------------- Financing Activities Net (decrease) increase in short-term debt -- (656) 453 Principal reductions of long-term debt and notes payable to subsidiaries (6,260) (2,611) (2,767) Proceeds from issuance of note payable to subsidiaries -- 1,368 -- Proceeds from exercise of stock options 1,446 2,139 1,507 Unrealized loss (gains) on marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - -------------------------------------------------------------------------- Net cash used in financing activities (9,469) (2,738) (3,857) - -------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 3,061 (809) (2,124) Cash and cash equivalents at beginning of year 1,729 2,538 4,662 - -------------------------------------------------------------------------- Cash and cash equivalents at year end $4,790 $1,729 $2,538 ========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Note 16: Quarterly Financial Information (Unaudited) * As originally reported ** Represents prices quoted on the American Stock Exchange. Quoted prices are not necessarily representative of actual transactions. Note 17: Acquisition On April 15, 1993, the Company issued approximately 2,122,740 shares of its common stock in exchange for all of the outstanding common stock of Napa Valley Bancorp, a bank holding company, whose subsidiaries included Napa Valley Bank ("NVB"), a California-based, state-chartered banking association, and Subsidiary, 88 percent interest in Bank of Lake County ("BLC"), a national banking association, 50 percent interest in Sonoma Valley Bank, a state banking association, Suisun Valley Bank, also a state chartered bank, and Napa Valley Bancorp Services Corporation ("NVBSC"), estabilshed to provide data processing and other services to Napa Valley Bancorp's subsidiaries. This business transaction (the "Merger") was accounted for as a pooling-of-interests combination and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassifications have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. Subsequent to the combination, Westamerica Bancorporation sold the 50 percent interest in Sonoma Valley Bank at a gain of $668,000. This business combination has been accounted for as a pooling-of-interests combination; and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassification have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. The results of operations previously reported by the separate enterprises and the combined amounts presented in the accompanying consolidated financial statements are summarized as follows. Three months ended March 31, 1993 Years ended December 31, (In thousands) (unaudited) 1992 1991 - ----------------------------------------------------------------------- Net Interest Income: Westamerica Bancorporation $16,809 $67,192 $62,496 Napa Valley Bancorp 7,365 28,669 26,699 - ----------------------------------------------------------------------- Combined $24,174 $95,861 $89,195 - ----------------------------------------------------------------------- Net Income (loss): Westamerica Bancorporation $3,675 $13,979 $11,762 Napa Valley Bancorp (656) 1,243 215 - ----------------------------------------------------------------------- Combined $3,019 $15,222 $11,977 - ----------------------------------------------------------------------- Net Income (loss) Per Share: Westamerica Bancorporation* $.63 $2.40 $2.06 Napa Valley Bancorp* (.19) .36 .06 Combined $.38 $1.92 $1.52 - ----------------------------------------------------------------------- * As originally reported. Net income per share was reduced $.25 for the three months ended March 31, 1993, $.48 in 1992, and $.54 in 1991, attributable to dilution from shares issued in connection with the acquisition. In addition, net income of the Company for 1993 was reduced by an estimated $8.3 million due to the consolidation of Napa Valley Bancorp's branches and operations, certain merger-related expenses and the application of Westamerica Bancorporation's workout strategy to the non-performing assets of Napa Valley Bancorp. There were no significant transactions between Westamerica Bancorporation and Napa Valley Bancorp prior to the combination. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item 10 is incorporated herein by reference from the "Election of Directors" and "Executive Officers" section on Pages 2 through 9 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item 11 is incorporated herein by reference from the "Executive Compensation" and "Retirement Benefits and Other Arrangements" section on Pages 11 through 16 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is incorporated herein by reference from the "Security Ownership of Certain Beneficial Owners and Management" section on Pages 9 and 10 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item 13 is incorporated herein by reference from the "Indebtedness of Directors and Management" section on Page 6 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. All Financial Statements See Index to Financial Statements on page 36. (a) 2. Financial statement schedules required by Item 8 of Form 10-K and by Item 14(d). None (Information included in Financial Statements). (a) 3. Exhibits The following documents are included or incorporated by reference in this annual report on Form 10-K. Exhibit Number 3(a) Restated Articles of Incorporation (composite copy). 3(b)** By-laws. 10 Material contracts: (a)* Incentive Stock Option Plan (b)*** James M. Barnes --January 7, 1987 (Employment) (c)*** E. Joseph Bowler --January 7, 1987 (Employment) (d)*** Robert W. Entwisle --January 7, 1987 (Employment) (e)**** Amended and Restated Agreement and Plan of Reorganization by and between Westamerica Bancorporation and John Muir National Bank, proxy and prospectus dated November 27, 1991. (f)***** Agreement and Plan of Merger by and between Westamerica Bancorporation and Napa Valley Bancorp, proxy and prospectus dated November 12, 1992. 22 Subsidiaries of the registrant. *Exhibit 10(a) is incorporated by reference from Exhibit A to the Company's Proxy Statement dated March 22, 1983, which was filed with the Commission pursuant to Regulation 14A. **Exhibits 3(b), is incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ***Exhibits 3(a), 10(b), 10(c) and 10(d) are incorporated herein by reference from Exhibits 3(a), 10(n), 10(o), and 10(q) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ****Exhibit 3(e) is incorporated herein by reference from the Form S-4 dated November 27, 1991. *****Exhibit 3(f) is incorporated herein by reference from the Form S-4 dated November 12, 1992. The Corporation will furnish to shareholders a copy of any exhibit listed above, but not contained herein, upon written request to Mrs. M. Kitty Jones, Vice President and Secretary, Westamerica Bancorporation, P. O. Box 567, San Rafael, California 94915, and payment to the Corporation of $.25 per page. (b) Report on Form 8-K None MANAGEMENTS LETTER OF FINANCIAL RESPONSIBILITY To the Shareholders: The Management of Westamerica Bancorporation is responsible for the preparation, integrity, reliability and consistency of the information contained in this annual report. The financial statements, which necessarily include amounts based on judgments and estimates, were prepared in conformity with generally accepted accounting principles and prevailing practices in the banking industry. All other financial information appearing throughout this annual report is presented in a manner consistent with the financial statements. Management has established and maintains a system of internal controls that provides reasonable assurance that the underlying financial records are reliable for preparing the financial statements, and that assets are safeguarded from unauthorized use or loss. This system includes extensive written policies and operating procedures and a comprehensive internal audit function, and is supported by the careful selection and training of staff, an organizational structure providing for division of responsibility, and a Code of Ethics covering standards of personal and business conduct. Management believes that, as of December 31, 1993 the Corporation's internal control environment is adequate to provide reasonable assurance as to the integrity and reliability of the financial statements and related financial information contained in the annual report. The system of internal controls is under the general oversight of the Board of Directors acting through its Audit Committee, which is comprised entirely of outside directors. The Audit Committee monitors the effectiveness of and compliance with internal controls through a continuous program of internal audit and credit examinations. This is accomplished through periodic meetings with Management, internal auditors, loan quality examiners, regulatory examiners and independent auditors to assure that each is carrying out their responsibilities. The Corporation's financial statements have been audited by KPMG Peat Marwick, independent auditors elected by the shareholders. All financial records and related data, as well as the minutes of shareholders and directors meetings, have been made available to them. Management believes that all representations made to the independent auditors during their audit were valid and appropriate. David L. Payne Chairman, President and CEO James M. Barnes Executive Vice President and CFO Dennis R. Hansen Senior Vice President and Controller INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders of Westamerica Bancorporation We have audited the accompanying consolidated balance sheets of Westamerica Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the years in the three year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. As discussed in Note 1 to the consolidated financial statements, the consolidated balance sheet of the Company as of December 31, 1992 and the related statements of income, changes in shareholders' equity, and cash flows for each of the years in the two year period ended December 31, 1992, and the related footnote disclosures have been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. We did not audit the financial statements of Napa Valley Bancorp as of and for the periods ended December 31, 1992 and 1991, which statements reflect total assets constituting 30 percent in 1992 and net income constituting 8 percent and 2 percent in 1992 and 1991, respectively, of the related and restated consolidated totals. Those statements included in the 1992 and 1991 restated consolidated totals were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Napa Valley Bancorp, is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Westamerica Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1993 in conformity with generally accepted accounting principles. San Francisco, California January 25, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WESTAMERICA BANCORPORATION By Dennis R. Hansen By James M. Barnes - ---------------------- -------------------- Senior Vice President and Controller Executive Vice President and (Principal Accounting Officer) Chief Financial Officer SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Signature Title Date David L. Payne Chairman of the Board and 3/24/94 ------------------------------ Director and President and CEO E. Joseph Bowler Senior Vice President 3/24/94 ------------------------------ and Treasurer Etta Allen Director 3/24/94 ------------------------------ Louis E. Bartolini Director 3/24/94 ------------------------------ Charles I. Daniels, Jr. Director 3/24/94 ------------------------------ Don Emerson Director 3/24/94 ------------------------------ Arthur C. Latno Director 3/24/94 ------------------------------ Patrick D. Lynch Director 3/24/94 ------------------------------ Catherine Cope MacMillan Director 3/24/94 ------------------------------ James A. Maggetti Director 3/24/94 ------------------------------ Dwight H. Murray,Jr.,M.D. Director 3/24/94 ------------------------------ Ronald A. Nelson Director 3/24/94 ------------------------------ Carl Otto Director 3/24/94 ------------------------------ Edward B. Sylvester Director 3/24/94 ------------------------------ Exhibit 22 WESTAMERICA BANCORPORATION SUBSIDIARIES AS OF DECEMBER 31, 1993 State of Incorporation Westamerica Bank California Napa Valley Bank California Bank of Lake County California Community Banker Services Corporation California

ITEM 7: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion addresses information pertaining to the financial condition and results of operations of Westamerica Bancorporation (the Company) that may not be otherwise apparent from a review of the consolidated financial statements and related footnotes. It should be read in conjunction with those statements and notes found on pages 36 through 63, as well as with the other information presented throughout the report. All financial information has been restated on an historical basis to reflect the April 15, 1993 merger with Napa Valley Bancorp (the Merger) on a pooling-of-interests basis. The Company earned $9.5 million in 1993, representing a 38 percent decrease from 1992 record earnings of $15.2 million and a 21 percent reduction from 1991 earnings of $12.0 million. The 1993 results include a second quarter loss of $4.1 million, mostly due to $10.5 million after-tax merger-related charges that were taken in the form of asset write-downs, additions to the loan loss provision and other related charges. The asset write-downs and the additional loan loss provision reflect the Company's plan of asset resolution. Components of Net Income (Percent of average earning assets) 1993 1992 1991 - ------------------------------------------------------------------ Net interest income* 5.48% 5.50% 5.21% Provision for loan losses (.53) (.39) (.59) Non-interest income 1.34 1.33 1.36 Non-interest expense (5.43) (5.00) (4.82) Taxes* (.33) (.59) (.48) - ------------------------------------------------------------------- Net income .53% .85% .68% =================================================================== Net income as a percentage of average total assets .48% .77% .62% * Fully taxable equivalent (FTE) On a per share basis, 1993 net income was $1.17, compared to $1.92 and $1.52 in 1992 and 1991, respectively. During 1993, the Company continued to benefit from reductions in cost of funds, increases in service fees and other non-interest income, and expense controls. However, merger-related costs more than offset these benefits. Earnings in 1992 improved over 1991 principally due to higher net interest margin, lower provisions for loan losses and control of non-interest expense. The Company's return on average total assets was .48 percent in 1993, compared to .77 percent and .62 percent in 1992 and 1991, respectively. Return on average equity in 1993 was 6.51 percent, compared to 11.16 percent and 9.52 percent, respectively, in the two previous years. NET INTEREST INCOME Although interest rates continued to decline during most of 1993, the continuing downward repricing of interest-bearing liabilities and a more favorable composition of deposits, represented by increasing volumes of lower costing demand and savings account balances and declining volumes of higher costing time deposits, prevented declining earning-asset yields from significantly eroding the Company's net interest margin. Components of Net Interest Income (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Interest income $ 137.0 $ 154.8 $ 176.6 Interest expense (42.3) (58.9) (87.4) FTE adjustment 2.8 2.7 2.7 - ------------------------------------------------------------------- Net interest income (FTE) $ 97.5 $ 98.6 $ 91.9 - ------------------------------------------------------------------- Average interest earning assets $1,779.3 $1,793.8 $1,762.4 Net interest margin (FTE) 5.48% 5.50% 5.21% Net interest income (FTE) in 1993 decreased $1.1 million from 1992 to $97.5 million. Interest income decreased $17.8 million from 1992, due to a $14.5 million reduction in the average balance of interest earning assets and a 93 basis point decline in yields. This was partially offset by a $16.6 million decrease in interest expense, the combination of a $41.3 million decrease in the average balance of interest-bearing liabilities and a 101 basis point decline in rates paid, in part due to a more favorable composition of deposits. DISTRIBUTION OF AVERAGE ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY The following tables present, for the periods indicated, information regarding the consolidated average assets, liabilities and shareholders' equity, the amounts of interest income from average interest earning assets and the resulting yields, and the amount of interest expense paid on interest-bearing liabilities, expressed in thousand of dollars and rates. Average loan balances include non-performing loans. Interest income includes proceeds from loans on non-accrual status only to the extent cash payments have been received and applied as interest income. Yields on securities and certain loans have been adjusted upward to reflect the effect of income thereon exempt from federal income taxation at the current statutory tax rate. Amortized loan fees, which are included in interest and fee income on loans, were $1.5 million lower in 1993 than in 1992 and $2.6 million higher in 1992 than in 1991. Distribution of average assets, liabilities and shareholders' equity Yields/Rates and interest margin Full Year 1993 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $4,463 $170 3.80% Trading account securities 183 6 3.14 Investment securities 631,700 39,794 6.30 Loans: Commercial 615,981 53,990 8.76 Real estate construction 55,038 4,745 8.62 Real estate residential 168,379 13,322 7.91 Consumer 303,567 27,726 9.13 - --------------------------------------------------------------- Total interest earning assets 1,779,311 139,753 7.85 Other assets 200,561 - ------------------------------------------------------- Total assets $1,979,872 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $330,867 -- -- Savings and interest-bearing transaction 938,475 19,305 2.06% Time less $100,000 340,122 14,176 4.17 Time $100,000 or more 135,505 4,837 3.57 - --------------------------------------------------------------- Total interest-bearing deposits 1,414,102 38,318 2.71 Funds purchased 57,135 1,937 3.39 Notes and mortgages payable 17,959 2,016 11.22 - --------------------------------------------------------------- Total interest-bearing liabilities 1,489,196 42,271 2.84 Other liabilities 14,652 Shareholders' equity 145,157 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,979,872 ======================================================= Net interest spread (1) 5.01% Net interest income and interest margin (2) $97,482 5.48% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1992 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $42,964 $1,765 4.11% Trading account securities 103 4 3.67 Investment securities 534,793 40,332 7.54 Loans: Commercial 646,359 60,050 9.29 Real estate construction 76,173 7,058 9.27 Real estate residential 168,030 15,314 9.11 Consumer 325,393 33,003 10.14 - --------------------------------------------------------------- Total interest earning assets 1,793,815 157,526 8.78 Other assets 175,609 - ------------------------------------------------------- Total assets $1,969,424 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $284,366 -- -- Savings and interest-bearing transaction 903,211 26,518 2.94% Time less $100,000 406,161 20,948 5.16 Time $100,000 or more 184,799 8,365 4.53 - --------------------------------------------------------------- Total interest-bearing deposits 1,494,171 55,831 3.74 Funds purchased 15,729 698 4.44 Notes and mortgages payable 20,439 2,363 11.56 - --------------------------------------------------------------- Total interest-bearing liabilities 1,530,339 58,892 3.85 Other liabilities 18,263 Shareholders' equity 136,456 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,969,424 ======================================================= Net interest spread (1) 4.93% Net interest income and interest margin (2) $98,634 5.50% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1991 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $39,182 $2,227 5.68% Trading account securities 835 54 6.47 Investment securities 446,283 39,218 8.79 Loans: Commercial 672,999 71,512 10.63 Real estate construction 96,654 11,002 11.38 Real estate residential 150,943 15,436 10.23 Consumer 355,502 39,798 11.19 - --------------------------------------------------------------- Total interest earning assets 1,762,398 179,247 10.17 Other assets 169,089 - ------------------------------------------------------- Total assets $1,931,487 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $265,383 -- -- Savings and interest-bearing transaction 773,904 36,119 4.67% Time less $100,000 466,487 31,838 6.83 Time $100,000 or more 230,276 15,113 6.56 - --------------------------------------------------------------- Total interest-bearing deposits 1,470,667 83,070 5.65 Funds purchased 26,885 1,676 6.23 Notes and mortgages payable 22,464 2,611 11.62 - --------------------------------------------------------------- Total interest-bearing liabilities 1,520,016 87,357 5.75 Other liabilities 20,886 Shareholders' equity 125,202 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,931,487 ======================================================= Net interest spread (1) 4.42% Net interest income and interest margin (2) $91,890 5.21% =============================================================== (1) Net interest spread represents the average yield earned on interest- earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. RATE AND VOLUME VARIANCES. The following table sets forth a summary of the changes in interest income and interest expense from changes in average assets and liability balances (volume) and changes in average interest rates for the periods indicated. Changes not solely attributable to volume or rates have been allocated in proportion to the respective volume and rate components. PROVISION FOR LOAN LOSSES The provision for loan losses was $9.5 million in 1993, including a $3.1 million merger-related provision in the second quarter, reflecting a different workout strategy for loans and properties acquired in the Merger, compared to $7.0 million in 1992 and $10.4 million in 1991. The level of the provision reflects the Company's continuing efforts to improve loan quality by enforcing strict underwriting and administration procedures and aggressively pursuing collection efforts with troubled debtors. For further information regarding net credit losses and the reserve for loan losses, see the Non-Performing Assets section of this report. INVESTMENT PORTFOLIO The Company maintains a securities portfolio consisting of U.S.Treasury, U.S. Government Agencies and Corporations, State and political subdivisions, asset-backed and other securities. Investment securities are held in safekeeping by an independent custodian. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No.115"). The statement addresses the accounting and reporting for investments in equity securities that have a readily determinable fair value and for all investments in debt securities. The statement requires that all securities be classified, at acquisition, into one of three categories: held-to-maturity, available-for-sale, and trading. SFAS No. 115 is effective for fiscal years beginning after December 15, 1993; however, early implementation is permitted. The Company elected to implement SFAS No. 115 effective as of December 31, 1993. The classification of all securities is determined at the time of acquisition. In classifying securities as being held-to-maturity, available-for-sale or trading, the Banks consider their collateral needs, asset/liability management strategies, liquidity needs, interest rate sensitivity and other factors that will determine the intent and ability to hold the securities to maturity. The objective of the investment securities held-to-maturity is to strengthen the portfolio yield, and to provide collateral to pledge for federal, state and local government deposits and other borrowing facilities. The investments held-to-maturity had an average term to maturity of 47 months at December 31, 1993 and, as of the same date, those investments included $547.2 million in fixed rate and $9.9 million in adjustable rate securities. Investment securities available-for-sale are typically used to supplement the Banks' liquidity portfolio with the objective of increasing the portfolio yield. Unrealized net gains and losses on these securities are recorded as an adjustment to equity net of taxes, and are not reflected in the current earnings of the Company. If the security is sold, any gain or loss is recorded as a charge to earnings and the equity adjustment is reversed. At December 31, 1993, the Banks held $168.8 million classified as investments available-for-sale. At December 31, 1993, $2.5 million, net of taxes was recognized as the unrealized net gain related to these securities. The amount of trading securitiess at December 31, 1993, was not material. For more information on investment securities, see Notes 1 and 2 to the Consolidated Financial Statements on pages 43 to 47 of this report. The following table shows the book value of the Company's investment securities (in thousands of dollars) as of the dates indicated: December 31, 1993 1992 1991 - ----------------------------------------------------------- U.S. Treasury $249,613 $126,522 $24,411 U.S. government agencies and corporations 254,691 237,753 299,219 States and political subdivisions (domestic) 127,297 87,031 74,847 Asset backed securities 65,433 82,270 79,743 Other securities 28,842 36,660 37,404 - ----------------------------------------------------------- Total $725,876 $570,236 $515,624 =========================================================== The following table is a summary of the relative maturities (in thousands of dollars) and yields of the Company's investment securities as of December 31, 1993. Weighted average yields have been computed by dividing annual interest income, adjusted for amortization of premium and accretion of discount, by book value of the related securities. Yields on state and political subdivision securities have been calculated on a fully taxable equivalent basis using the federal tax rate of 34 percent. LOAN PORTFOLIO The following table shows the composition of loans of the Company (in thousands of dollars) by type of loan or type of borrower, on the dates indicated. Secured loans are classified by type of securities and unsecured by the purpose of the loan. Maturities and Sensitivity of Selected Loans to Changes in Interest Rates The following table shows the maturity distribution and interest rate sensitivity of Commercial and Real estate construction loans at December 31, 1993.* *Excludes loans to individuals and residential mortgages totaling $461,450. These types of loans are typically paid in monthly installments over a number of years. **Includes demand loans Commitments and Lines of Credit It is not the policy of the Company to issue formal commitments on lines of credit except to a limited number of well established and financially responsible local commercial enterprises. Such commitments can be either secured or unsecured and are typically in the form of revolving lines of credit for seasonal working capital needs. Occasionally, such commitments are in the form of Letters of Credit to facilitate the customer's particular business transaction. Commitment fees generally are not charged except where Letters of Credit are involved. Commitments and lines of credit typically mature within one year. See also Note 11 of the Consolidated Notes to the Financial Statements on page 55. RISK ELEMENTS The Company closely monitors the markets in which it conducts its lending Company's primary market areas, in Management's view such impact has not had a material, adverse effect on the Company's liquidity and capital resources. The Company continues its strategy to control its exposure to real estate development loans and increase diversification of credit risk. Asset reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. Assets receiving lesser grades fall under the classified assets category which includes all non-performing assets. These occur when known information about possible credit problems causes Management to have doubts about the ability of such borrowers to comply with loan repayment terms. These loans have varying degrees of uncertainty and may become non-performing assets. Classified assets receive an elevated level of Management attention to ensure collection. Total classified assets peaked following the second quarter Merger but declined significantly by December 31, 1993 due to extensive asset write-downs, loan collections, real estate liquidations and restructurings of the Napa Valley Bank loan portfolio reflecting the Company's workout strategy. Non-Performing Assets Non-performing assets include non-accrual loans, loans 90 days past due and still accruing, other real estate owned and loans classified as substantively foreclosed. Loans are placed on non-accrual status upon reaching 90 days or more delinquent, unless the loan is well secured and in the process of collection. Interest previously accrued on loans placed on non-accrual status is charged against interest income. Loans secured by real estate with temporarily impaired values and commercial loans to borrowers experiencing financial difficulties are placed on non-accrual status even though the borrowers continue to repay the loans as scheduled. Such loans are classied by Management as performing non-accrual and are included in total non-performing assets. Performing non-accrual loans are reinstated to accrual status when improvements in credit quality eliminate the doubt as to the full collectibility of both interest and principal. When the ability to fully collect non-accrual loan principal is in doubt, cash payments received are applied against the principal balance of the loan until such time as full collection of the remaining recorded balance is expected. Any subsequent interest received is recorded as interest income on a cash basis. Non-Performing Assets (In millions) 1993 1992 1991 1990 1989 - ---------------------------------------------------------------------------- Performing non-accrual loans $ 1.9 $ 1.1 $ 2.2 $16.0 $10.7 Non-performing non-accrual loans 7.2 14.9 37.7 9.3 -- - ---------------------------------------------------------------------------- Non-accrual loans 9.1 16.0 39.9 25.3 10.7 Loans 90 or more days past due and still accruing .3 .1 1.0 6.2 6.8 Loan collateral substantively foreclosed 5.4 16.6 7.1 6.0 6.0 Other real estate owned 12.5 17.9 4.9 2.7 4.2 - ---------------------------------------------------------------------------- Total non-performing assets $27.3 $50.6 $52.9 $40.2 $27.7 ============================================================================ Reserve for loan losses as a percentage of non-accrual loans and loans 90 or more days past due and still accruing 272% 153% 58% 60% 91% Performing non-accrual loans increased $800,000 to $1.9 million at December 31, 1993. This increase was principally due to one condominium construction loan. Non-performing non-accrual loans decreased $7.7 million to $7.2 million at December 31, 1993 due to loan collections, write-downs, foreclosure of loan collateral and reclassifications to loan collateral substantively foreclosed. Both loan collateral substantively foreclosed and other real estate owned declined $16.6 million due to asset write-downs and liquidations. The amount of gross interest income that would have been recorded for non-accrual loans for the year ending December 31, 1993, if all such loans had been current in accordance with their original terms while outstanding during the period, was $980,000. The amount of interest income that was recognized on non-accrual loans from cash payments made during the year ended December 31, 1993 totaled $345,000, representing an annualized yield of 3.06 percent. Cash payments received which were applied against the book balance of performing and non-performing non-accrual loans outstanding at December 31, 1993, totaled $534,000 compared to $104,000 in 1992. Restructured loans totaled $4,432,000 at December 31, 1993, $319,000 at December 31, 1992, $2,892,000 at December 31, 1991 $2,200,000, at December 31, 1990 and $5,927,000 at December 31, 1989. CREDIT LOSS EXPERIENCE The Company's reserve for loan losses is maintained at a level estimated by Management to be adequate to provide for losses that can be reasonably credit loss experience, the amount of past due, non-performing and classified loans, recommendations of regulatory authorities, prevailing economic conditions and other factors. Initially, the reserve is allocated to segments of the loan portfolio based in part on quantitative analyses of historical credit loss experience. Criticized and classied loan balances are analyzed using both a linear regression model and standard allocation percentages. The results of this analysis are applied to current criticized and classied loan balances to allocate the reserve to the respective segments of the loan portfolio. In addition, loans with similar characteristics not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on the historical rate of net losses and delinquency trends and are grouped by the number of days the payment on those loans are delinquent. While these factors are essentially judgmental and may not be reduced to a mathematical formula, Management considers that the $25.6 million reserve for loan losses, which constituted 2.30 percent of total loans at December 31, 1993, to be adequate as a reserve against inherent losses. Management continues to evaluate the loan portfolio and assess current economic conditions that will dictate future reserve levels. In May 1993, the Financial Accounting Standards Board (FASB) issued statement No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114) which addresses the accounting treatment of certain impaired loans and amends FASB Statements No. 5 and No. 15. SFAS 114 does not address the overall adequacy of the allowance for loan losses. SFAS 114 is effective January 1, 1995 but earlier implementation is encouraged. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Under SFAS 114, impairment is measured based on the present value of the expected future cash flows discounted at the loans effective interest rate. Alternatively, impairment may be measured by using the loans observable market price or the fair value of the collateral if repayment is expected to be provided solely by the underlying collateral. The Company intends to implement SFAS 114 in January 1995. The impact of implementation on the financial statements has not been determined, since measurement will be contingent upon the inventory of impaired loans outstanding as of January 1, 1995. ALLOCATION OF RESERVE FOR LOAN LOSSES The reserve for loan losses has been established to absorb possible future losses throughout the loan portfolio and off balance sheet credit risk. The Company's reserve for loan losses is maintained at a level estimated by management to be adequate to provide for losses that are reasonably foreseeable based upon specific conditions and other factors. The reserve is allocated to segments of the loan portfolio based in part upon quantitative analyses of historical net losses relative to loan balances outstanding. Criticized and classified loan balances, as identified by management using criteria similar to those used by the Banks' regulators, and historical net losses on those balances are analyzed using both a linear regression and standard allocation percentages model. The results of this statistical analysis are applied to current criticized and classified loan balances to allocate the reserve for loan losses to the respective segments of the loan portfolio. In addition, homogeneous loans, which are not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on historical rates of net loan losses experienced for loans grouped by the number of days payments are delinquent. Such rates of net loan losses are applied to the current aging of homogeneous loans to allocate the reserve for loan losses. Management may judgmentally adjust the allocation of the reserve for loan losses based on changes in underwriting standards, anticipated rates of net loan losses which may differ from historical experience, economic conditions, the experience of credit officers and any other factors considered pertinent. Management's continuing evaluation of the loan portfolio and assessment of current economic conditions will dictate future reserve levels. The following tables present the allocation of the loan loss reserve balance on the dates indicated: (in thousands) December 31 1993 1992 - ------------------------------------------------------------------------------- Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans - ------------------------------------------------------------------------------- Commercial $12,537 55.0% $13,551 53.4% Real estate construction 2,538 3.6 964 5.4 Real estate residential 85 15.5 545 14.8 Consumer 3,921 25.9 3,872 26.4 Unallocated portion of reserve 6,506 -- 5,810 -- - ------------------------------------------------------------------------------- Total $25,587 100.0% $24,742 100.0% =============================================================================== (in thousands) December 31 1991 1990 - ------------------------------------------------------------------------------ Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans -------- -------- -------- -------- Commercial $8,325 52.7% $2,698 52.5% Real estate construction 2,336 7.1 4,360 9.5 Real estate residential 50 12.9 29 10.4 Consumer 2,363 27.3 1,782 27.6 Unallocated portion of reserve 10,779 -- 10,132 -- - ------------------------------------------------------------------------------- Total $23,853 100.0% $19,001 100.0% =============================================================================== (in thousands) December 31 1989 - ------------------------------------------------------------ Loans as Allocation Percent of of reserve Total Type of loan balance Loans -------- -------- Commercial $5,216 52.4% Real estate construction 2,709 11.9 Real estate residential 0 10.3 Consumer 853 25.4 Unallocated portion of reserve 7,182 -- - ------------------------------------------------------------- Total $15,960 100.0% ============================================================= The reduced allocation to commercial loans from December 31, 1992 to December 31, 1993 is primarily due to a reduction in the balance of criticized loans. The increased allocation to construction loans over the same period is attributable to an increase in criticized loans due to the recessionary environment. The increase in the unallocated portion of the reserve is due to the establishment of an additional "recessionary reserve" to recognize the potential for increased chargeoffs. The changes in the allocation to loan portfolio segments from December 31, 1991 to December 31, 1992 reflect changes in criticized and classified loan balances. The decreased allocation to construction loans is attributable to a decrease in criticized loans due to full collection or principal reducing payments received from customers. The increased allocation to commercial and consumer loans is attributable to a reduced level of recoveries. ASSET AND LIABILITY MANAGEMENT The fundamental objective of the Company's management of assets and liabilities is to maximize its economic value while maintaining adequate liquidity and a conservative level of interest-rate risk. The principal sources of asset liquidity are investment securities available for sale. At December 31, 1993, investment securities available for sale totaled $168.8 million. The Company generates significant liquidity from its operating activities. The Company's profitability in 1993, 1992 and 1991 generated substantial increases in the cash flow provided from operations for such years to $28.4 million, $33.4 million and $26.7 million, respectively. Additional cash flow is provided by financing activities, primarily the acceptance of customer deposits and short-term borrowings from banks. After a considerable increase in deposits in 1991 of $66.2 million, growth was only $600,000 in 1992 and the Company experienced a decline of $58.7 million in 1993 mostly due to deposits sold in connection with the sale of Sonoma Valley Bank. In addition to a $57.0 million compensating increase in short-term borrowings in 1993, Westamerica Bank issued in December a ten-year, $20.0 million subordinated capital note that qualifies as Tier II Capital and will be used as a source of liquidity for working capital purposes. The Company uses cash flows from operating and financing activities to make investments in loans, money market assets and investment securities. Continuing with the strategy to reduce its exposure to real estate development loans, net loan repayments were $68.1 million, $32.8 million and $15.5 million in 1993, 1992 and 1991, respectively. The net repayment of loans resulted in added liquidity for the Company, which was used to increase its investment securities portfolios by $153.4 million, $75.8 million and $130.0 million in 1993, 1992 and 1991, respectively. Interest rate risk is influenced by market forces. However, that risk may be controlled by monitoring and managing the repricing characteristics of assets and liabilities. In evaluating exposure to interest rate risk, the Company considers the effects of various factors in implementing interest rate risk management activities, including the utilization of interest rate swaps. Interest rate swaps outstanding at December 31, 1993 had aggregate notional amounts of $110.0 million of which $50.0 million matures in 1994 and $60.0 million matures in 1995. These interest rate swaps were entered into to hedge the adverse impact interest rate fluctuations have on interest-bearing transaction and savings deposits in the current interest rate environment. The primary analytical tool used by Management to gauge interest-rate sensitivity is a simulation model used by many major banks and bank regulators. This industry standard model is used to simulate the effects on net interest income of changes in market interest rates that are up to 2 percent higher or 2 percent lower than current levels. The results of the model indicate that the mix of interest rate sensitive assets and liabilities at December 31, 1993 would not, in the view of Management, expose the Company to an unacceptable level of interest rate risk. CAPITAL RESOURCES The Company's capital position represents the level of capital available to support continued operations and expansion. The Company's primary captial resource is shareholders' equity, which increased $8.8 million or 6.1 percent from the previous year end and increased $23.0 million or 17.8 percent from December 31, 1991. As a result of the Company's profitability, the retention of earnings and slow asset growth, the ratio of equity to total assets increased to 7.6 percent at December 31, 1993, up from 7.3 percent at December 31, 1992 and 6.6 percent at December 31, 1991. Tier I risk-based capital to risk-adjusted assets increased to 11.11 percent at December 31, 1993, from 10.02 percent at year end 1992. The ratio of total risk-based capital to risk-adjusted assets increased to 14.40 percent at December 31, 1993, from 12.01 percent at December 31, 1992. Capital to Risk-Adjusted Assets Minimum Regulatory Capital Minimum Regulatory Capital At December 31, 1993 1992 Requirements - ----------------------------------------------------------- Tier I Capital 11.11% 10.02% 4.00% Total Capital 14.40 12.01 8.00 Leverage ratio 7.42 7.39 4.00 The risk-based capital ratios improved in 1993 due to two factors: equity capital grew at a faster rate than total assets, and the decline in loan volumes and increase in investment securities reduced the level of risk-adjusted assets. FINANCIAL RATIOS The following table shows key financial ratios for the periods indicated. For the Years Ended 1993 1992 1991 - ------------------------------------------------------------------------- Return on average total assets 0.48% 0.77% 0.62% Return on average shareholders' equity 6.51% 11.16% 9.52% Average shareholders' equity as a percent of: Average total assets 7.33% 6.93% 6.48% Average total loans 12.70% 11.22% 9.81% Average total deposits 8.32% 7.67% 7.21% DEPOSITS The following table sets forth, by time remaining to maturity the Company's domestic time deposits in amounts of $100,000 or more (in thousands of dollars). Time Remaining to Maturity December 31, 1993 1992 1991 - ------------------------------------------------------------ Three months or less $73,988 $92,581 $139,487 Three to six months 23,817 46,378 58,564 Six months to 12 months 10,503 12,895 10,695 Over 12 months 4,685 6,630 6,699 - ------------------------------------------------------------ Total $112,993 $158,484 $215,445 ============================================================ See additional disclosures in Note 6 to Consolidated Financial statements on page 52 of this report. SHORT-TERM BORROWINGS The following table sets forth the short-term borrowings of the Company. (In thousands) December 31 1993 1992 1991 - ----------------------------------------------------------------------- Federal funds purchased $25,000 $ -- $ -- Other borrowed funds: Retail repurchase agreements 28,038 4,099 3,204 Other 16,026 7,939 6,366 - ----------------------------------------------------------------------- Total other borrowed funds $44,064 $12,038 $9,570 - ----------------------------------------------------------------------- Total funds purchased $12,038 $12,038 $9,570 ======================================================================= Further details of the other borrowed funds are: (In thousands) December 31 1993 1992 1991 - ------------------------------------------------------------------------ Outstanding Average during the year $37,284 $11,509 $18,865 Maximum during the year 68,608 19,055 44,558 Interest rates Average during the period 3.13% 4.73% 6.51% Average at period end 3.04 3.23 6.80 NON-INTEREST INCOME Components of Non-Interest Income (In millions) 1993 1992 1991 - ----------------------------------------------------------------------- Service charges on deposit accounts $ 12.8 $ 12.4 $ 12.1 Merchant credit card 2.2 2.9 2.9 Mortgage banking income 1.5 1.8 1.5 Brokerage commissions .8 .6 .4 Net investment securities gains -- 1.1 1.7 Sale of Sonoma Valley Bank .7 -- -- Automobile receivable servicing 1.3 -- .5 Other 4.6 5.0 4.9 - ----------------------------------------------------------------------- Total $ 23.9 $ 23.8 $ 24.0 ======================================================================= Non-interest income increased to $23.9 million in 1993. Higher income from servicing automobile receivables, the sale of the Company's 50 percent interest in Sonoma Valley Bank, higher brokerage commissions, increased fees from deposit services, gains recognized on the sale of Napa Valley Bancorp cardholder portfolio and lower write-offs of mortgage service receivables, were partially offset by lower credit card merchant fees and lower mortgage servicing fees. 1992 non-interest income also reflects $1.1 million gains on the sale of investment securities held for sale. In 1992, non-interest income decreased $200,000 from the previous year, resulting principally from lower gains of investment securities held-for-sale and lower income from servicing automobile receivables partially offset by higher deposit account fees, mortgage banking income and brokerage commissions. NON-INTEREST EXPENSE Components of Non-Interest Expense (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Salaries $ 31.6 $ 33.7 $ 34.7 Other personnel benefits 7.4 7.2 7.1 Other real estate owned 13.2 6.2 2.9 Occupancy 8.6 8.5 8.4 Equipment 6.2 5.3 5.5 FDIC insurance assessment 4.1 4.0 3.5 Data processing 3.7 3.1 3.0 Professional fees 3.1 3.3 3.3 Operational losses 2.0 .7 .5 Stationery and supplies 1.9 1.7 1.8 Advertising and public relations 1.8 1.8 2.0 Loan expense 1.6 1.4 1.3 Merchant credit card 1.1 1.7 1.9 Insurance .9 1.0 .7 Other 9.4 10.0 8.3 - ------------------------------------------------------------------- Total $ 96.6 $ 89.6 $ 84.9 =================================================================== Average full-time equivalent staff 905 1,092 1,148 Non-interest expense increased $7.0 million or 8 percent in 1993 compared with an increase of $4.7 million or 6 percent in 1992. The increase in 1993 is the direct result of merger-related foreclosed real estate owned expenses, reflecting a $10.0 million write-down of assets acquired in the Merger to fair value net of estimated selling costs reflecting the implementation of the Company's workout strategy, and other costs associated with the Merger, including $1.2 million in relocation costs, chargeoffs of $921,000 for obsolete furniture and equipment, $745,000 in investment banker fees, and other merger-related costs totaling approximately $1.2 million. Partially offsetting these increases in 1993 non-interest expense, salaries decreased $2.1 million, or 6 percent, reflecting the benefits realized from consolidation of operations after the Merger. Merchant credit card, professional fees and insurance expenses also decreased from 1992. The ratio of average assets per full-time equivalent staff was $2.2 million in 1993 compared to $1.8 million in 1992; the Company strategy to improve efficiency can be clearly seen in the reduction of the average number of full-time equivalent staff from 1,092 in 1992 to 905 in 1993. PROVISION FOR INCOME TAX The provision for income tax decreased $4.9 million in 1993 as a direct result of lower pretax income and a $394,000 revaluation adjustment of deferred tax assets due to an increase in statutory tax rates. The provision was $3.0 million in 1993 compared to $7.9 million in 1992 and $5.8 million in 1991. The higher provision in 1992 is a direct result of higher pretax income. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Consolidated Balance Sheets as of December 31, 1993 and 1992 36 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 38 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 40 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 41 Notes to Consolidated Financial Statements 43 Management's Letter of Financial Responsibility 67 Independent Auditors' Report 68 CONSOLIDATED BALANCE SHEETS (In thousands) December 31, 1993 1992* - --------------------------------------------------------------------------- Assets Cash and cash equivalents (Note 14) $ 102,618 $ 139,497 Money market assets 250 1,366 Trading account securities 10 -- Investment securities available-for-sale (Note 2) 168,819 -- Investment securities held-to-maturity; market value of $563,563 in 1993 and $581,768 in 1992 (Note 2) 557,057 570,236 Loans, net of reserve for loan losses of: $25,587 at December 31, 1993 $24,742 at December 31, 1992 (Notes 3, 4 and 13) 1,089,152 1,166,205 Loan collateral substantively foreclosed and other real estate owned 17,905 34,506 Land held for sale 800 1,123 Investment in joint venture 766 1,026 Premises and equipment, net (Notes 5 and 6) 25,341 26,959 Interest receivable and other assets (Note 8) 41,701 40,431 - --------------------------------------------------------------------------- Total assets $2,004,419 $1,981,349 =========================================================================== Liabilities Deposits: Non-interest bearing $ 369,820 $ 323,719 Interest bearing: Transaction 289,322 369,871 Savings 654,766 564,763 Time (Notes 2 and 6) 417,320 531,565 - --------------------------------------------------------------------------- Total deposits 1,731,228 1,789,918 Funds purchased 69,064 12,038 Liability for interest, taxes, other expenses, minority interest and other (Note 8) 15,328 16,382 Notes and mortgages payable (Notes 6 and 14) 36,352 19,337 - --------------------------------------------------------------------------- Total liabilities 1,851,972 1,837,675 Commitments and contingent liabilities (Notes 4, 10 and 11) -- -- Shareholders' Equity (Notes 7 and 14) Common stock (no par value) Authorized- 20,000 shares Issued and outstanding- 8,080 shares in 1993 and 8,000 shares in 1992 52,499 51,053 Capital surplus 10,831 10,831 Unrealized gains on securities available for sale (Note 2) 2,527 -- Retained earnings 86,590 81,790 - --------------------------------------------------------------------------- Total shareholders' equity 152,447 143,674 - --------------------------------------------------------------------------- Total liabilities and shareholders' equity $2,004,419 $1,981,349 =========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------- Interest Income Loans $ 99,607 $115,357 $137,656 Money market assets and federal funds sold 298 1,745 2,191 Trading account securities 6 4 54 Investment securities: U.S. Treasury 10,284 4,484 6,159 Securities of U.S. government agencies and corporations 13,994 18,802 18,406 Obligations of states and political subdivisions 5,894 5,358 5,272 Asset backed 4,942 5,809 5,675 Other 1,891 3,194 1,139 - --------------------------------------------------------------------- Total interest income 136,916 154,753 176,552 - --------------------------------------------------------------------- Interest Expense Transaction deposits 4,219 7,680 13,371 Savings deposits 15,085 18,838 22,748 Time deposits (Note 6) 19,014 29,314 46,950 Funds purchased 1,937 698 1,677 Notes and mortgages payable (Note 6) 2,016 2,362 2,611 - --------------------------------------------------------------------- Total interest expense 42,271 58,892 87,357 - --------------------------------------------------------------------- Net Interest Income 94,645 95,861 89,195 Provision for loan losses (Note 3) 9,452 7,005 10,418 - --------------------------------------------------------------------- Net interest income after provision for loan losses 85,193 88,856 78,777 - --------------------------------------------------------------------- Non-Interest Income Service charges on deposit accounts 12,809 12,437 12,056 Merchant credit card 2,217 2,900 2,881 Mortgage banking 1,467 1,808 1,457 Brokerage commissions 839 555 392 Net investment securities gain 68 1,066 1,742 Other 6,546 5,061 5,448 - --------------------------------------------------------------------- Total non-interest income 23,946 23,827 23,976 - --------------------------------------------------------------------- Non-Interest Expense Salaries and related benefits (Note 12) 39,007 40,826 40,252 Other real estate owned 11,550 5,183 2,884 Occupancy (Notes 5 and 10) 8,625 8,524 8,401 Equipment (Notes 5 and 10) 6,195 5,302 5,522 FDIC insurance assessment 4,079 4,021 3,545 Data processing 3,658 3,137 2,964 Professional fees 3,071 3,332 3,346 Other 20,460 19,279 18,029 - ---------------------------------------------------------------------- Total non-interest expense 96,645 89,604 84,943 - ---------------------------------------------------------------------- Income Before Income Taxes 12,494 23,079 17,810 Provision for income taxes (Note 8) 3,039 7,857 5,833 - ---------------------------------------------------------------------- Net Income $ 9,455 $ 15,222 $ 11,977 ====================================================================== Average common shares outstanding 8,054 7,933 7,855 Per Share Data (Notes 7 and 17) Net income $ 1.17 $ 1.92 $ 1.52 Dividends declared .57 .51 .44 *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $ 15,222 $ 11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,622 4,198 4,189 Loan loss provision 9,452 7,005 10,418 Amortization of net deferred loan (cost)/fees (462) 615 433 (Increase) decrease in interest income receivable (2,542) 1,070 1,698 Decrease (increase) in other assets 2,888 (3,204) 2,062 Decrease in income taxes payable (1,529) (1,179) (2,752) Decrease in interest expense payable (1,169) (1,933) (1,145) (Decrease) increase in accrued expenses (1,809) 1,420 (405) Net gain on sale of investment securities (68) (1,066) (1,742) Loss (gain) on sale of developed land -- 2,930 (107) Loss (gains) on sales/write-down of premises and equipment 1,476 225 (86) Originations of loans for resale (92,374) (100,055) (102,300) Proceeds from sale of loans originated for resale 92,536 103,855 102,019 Loss on sale/write-down of property acquired in satisfaction of debt 9,618 3,507 2,559 Gain on sale of Sonoma Valley Bank (668) -- -- Net (purchases) maturities of trading securities (10) 779 (130) - --------------------------------------------------------------------------- Net cash provided by operating activities 28,416 33,389 26,688 - --------------------------------------------------------------------------- Investing Activities Net repayments of loans 68,109 32,782 15,470 Purchases of money market assets (325) (16,833) (34,551) Purchases of investment securities (427,886) (339,583) (269,505) Purchases of property, plant and equipment (3,481) (4,416) (5,161) Improvements on developed land -- (1,435) -- Proceeds from maturity/sale of money market assets 1,441 17,574 34,301 Proceeds from maturity of securities 274,451 263,793 139,549 Proceeds from sale of securities 184 21,128 49,580 Proceeds from sale of property and equipment -- 1,640 858 Net proceeds from sale of developed land 356 1,928 107 Proceeds from disposition of property acquired in satisfaction of debt 6,313 4,513 624 Proceeds from sale of Sonoma Valley Bank 2,733 -- -- Net repayments on loan collateral substantively foreclosed 669 1,187 629 - --------------------------------------------------------------------------- Net cash used in investing activities (77,436) (17,722) (68,099) - --------------------------------------------------------------------------- Financing Activities Net increase (decrease) in deposits (58,691) 617 66,203 Net (decrease) increase in federal funds purchased 57,026 2,468 (25,529) Proceeds from issuance of capital notes 20,000 -- -- Principal payments on notes and mortgages payable (2,985) (2,423) (1,672) Exercise of stock options 1,446 2,214 1,525 Retirement of stock -- (204) (843) Unrealized loss (gain) in marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - --------------------------------------------------------------------------- Net cash provided by (used in) financing activities 12,141 (306) 36,634 - --------------------------------------------------------------------------- Net (decrease) increase in cash and cash equivalents (36,879) 15,361 (4,777) Cash and cash equivalents at beginning of year 139,497 124,136 128,913 - --------------------------------------------------------------------------- Cash and cash equivalents at end of year $102,618 $139,497 $124,136 =========================================================================== Supplemental disclosures: Loans transferred to other real estate owned and substantively repossessed $16,111 $36,572 $9,132 Interest paid 42,982 57,491 87,163 Income tax payments 5,700 9,773 9,045 Unrealized gain on securities available for sale 2,527 -- -- *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. Westamerica Bancorporation NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: Business and Accounting Policies Westamerica Bancorporation, a registered bank holding Company, (the Company), provides a full range of banking services to individual and corporate customers in Northern California through its subsidiary banks (the Banks), Westamerica Bank and Subsidiary, Bank of Lake County and Napa Valley Bank and Subsidiary. The Banks are subject to competition from other financial institutions and to regulations of certain agencies and undergo periodic examinations by those regulatory authorities. Summary of Significant Accounting Policies The consolidated financial statements are prepared in conformity with generally accepted accounting principles and general practices within the banking industry. The following is a summary of significant accounting policies used in the preparation of the accompanying financial statements. In preparing the financial statements, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods indicated. Principles of Consolidation. The financial statements include the accounts of the Company, a registered bank holding company, and all the Company's subsidiaries which include the Banks and Community Banker Services Corporation and Subsidiary. Significant intercompany transactions have been eliminated in consolidation. All data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Cash Equivalents. Cash equivalents include Due From Banks balances and Federal Funds Sold which are both readily convertible to known amounts of cash and are so near their maturity that they present insignificant risk of changes in value because of interest rate volatility. Securities. Marketable investment securities at December 31, 1993 consist of U.S. Treasury, U. S. Government Agencies and Corporations, Municipal, asset-backed and other securities. The Company adopted the provisions of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 115) at December 31, 1993. Under SFAS No. 115, the Company classifies its debt and marketable equity securities into one of three categories: trading, available-for-sale or held-to-maturity. Trading securities are bought and held principally for the purpose of selling in the near term. Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held-to-maturity are classied as available-for-sale. Trading and available-for-sale securities are recorded at fair value. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Unrealized gains and losses on trading securities are included in earnings. Unrealized gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of shareholders' equity until realized. Unrealized gains and losses associated with transfers of securities from held-to-maturity to available-for-sale are recorded as a separate component of shareholders' equity. The unrealized gains or losses included in the separate component of shareholders' equity for securities transferred from available-for-sale to held-to-maturity are maintained and amortized into earnings over the remaining life of the security as an adjustment to yield in a manner consistent with the amortization or accretion of premium or discount on the associated security. A decline in the market value of held-to-maturity and available-for-sale securities below cost that is deemed other than temporary, results in a charge to earnings and the establishment of a new cost basis for the security. Premiums and discounts are amortized or accreted over the life of the related investment security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities classied as available-for-sale and held-to-maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Loans and Reserve for Loan Losses. The reserve for loan losses is a combination of specific and general reserves available to absorb estimated future losses in the loan portfolio and is maintained at a level considered adequate to provide for such losses. Credit reviews of the loan portfolio, designed to identify problem loans and to monitor these estimates, are conducted continually, taking into consideration market conditions, current and anticipated developments applicable to the borrowers and the economy, and the results of recent examinations by regulatory agencies. Management approves the conclusions resulting from credit reviews. Ultimate losses may vary from current estimates. Adjustments to previous estimates of loan losses are charged to income in the period which they become known. Unearned interest on discounted loans is amortized over the life of these loans, using the sum-of-the-months digits method for which the results are not materially different from those obtained by using the interest method. For all other loans, interest is accrued daily on the outstanding balances. Loans which are more than 90 days delinquent with respect to interest or principal, unless they are well secured and in the process of collection, and other loans on which full recovery of principal or interest is in doubt, are placed on non-accrual status. Non-refundable fees and certain costs associated with originating or acquiring loans are deferred and amortized as an adjustment to interest income over the estimated respective loan lives. Loans held for sale are identified upon origination and are reported at the lower of cost or fair value on an individual loan basis. Other Real Estate Owned and Loan Collateral Substantively Foreclosed. Other real estate owned includes property acquired through foreclosure or forgiveness of debt. These properties are transferred at fair value, which becomes the new cost basis of the property. Losses recognized at the time of acquiring property in full or partial satisfaction of loans are charged against the reserve for loan losses. Subsequent losses incurred due to the declines in property values as identified in independent property appraisals are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. The Company classifies loans as loan collateral substantively foreclosed (substantive repossessions) when the borrower has little or no equity in the collateral, when proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral, and the debtor has either formally or effectively abandoned control of the collateral to the Company or has retained control of the collateral but, because of the current financial condition of the debtor or the economic prospects for the debtor and/or collateral in the foreseeable future, it is doubtful that the debtor will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. Losses recognized at the time the loans are reclassified as substantive repossessions are charged against the reserve for loan losses. Subsequent losses incurred due to subsequent declines in property values, as identified in independent property appraisals, are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. Premises and Equipment. Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful life of each type of asset. Estimated useful lives of premises and equipment range from 20 to 50 years and from 3 to 20 years, respectively. Leasehold improvements are amortized over the terms of the lease or their estimated useful life, whichever is shorter. Fully depreciated and/or amortized assets are removed from the Company's balance sheet. Interest Rate Swap Agreements. The Company uses interest rate swap agreements as an asset/liability management tool to reduce interest rate risk. Interest rate swap agreements are exchanges of fixed and variable interest payments based on a notional principal amount. The primary risk associated with swaps is the exposure to movements in interest rates and the ability of the counter parties to meet the terms of the contracts. The Company controls the credit risk of the these agreements through credit approvals, limits and monitoring procedures. The Company is not a dealer but an end user of these instruments and does not use them speculatively. Accounted for as hedges, the differential to be paid or received on such agreements is recognized over the life of the agreements. Payments made or received in connection with early termination of interest rate swap agreements are recognized over the remaining term of the swap agreement. Earnings Per Share. Earnings per share amounts are computed on the basis of the weighted average of common shares outstanding during each of the years presented. Income Taxes. The Company and its subsidiaries file consolidated tax returns. For financial reporting purposes, the income tax effects of transactions are recognized in the year in which they enter into the determination of recorded income, regardless of when they are recognized for income tax purposes. Accordingly, the provisions for income taxes in the consolidated statements of income include charges or credits for deferred income taxes relating to temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Other. Securities and other property held by the Banks in a fiduciary or agency capacity are not included in the financial statements since such items are not assets of the Company or its subsidiaries. Certain amounts in prior years financial statements have been reclassified to conform with the current years presentation. These reclassifications had no effect on previously reported income. Note 2: Investment Securities An analysis of investment securities available-for-sale as of December 31, 1993, is as follows: *Includes $24.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.4 million; 1 to 5 years $15.2 million. The average yield of these securities is 5.56 percent. An analysis of investment securities held-to-maturity as of December 31, 1993, is as follows: *Includes $162.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.9 million; 1 to 5 years $9.3 million; 5 to 10 years $71.3 million; over 10 years $72.1 million. These securities have a market value of $162.4 million and an average yield of 5.45 percent. As of December 31, 1993, $173.5 million of investment securities held-to- maturity were pledged to secure public deposits. A summary of investment securities portfolio held-to-maturity as of December 31, 1992, is as follows: Gross Gross Book unrealized unrealized Fair Value gains losses Value - -------------------------------------------------------------------- U.S. Treasury securities $126,522 $2,208 ($156) $128,574 Securities of U.S. Govt. Agencies and Corporations 237,753 4,919 (517) 242,155 Obligations of States and Political Subdivisions 87,031 3,655 (197) 90,489 Asset Backed (Automobile Receivables) 82,270 1,040 (105) 83,205 Other Securities (Preferred Stocks & Corporate Bonds) 36,660 735 (50) 37,345 - -------------------------------------------------------------------- Total Securities Held-to-maturity $570,236 $12,557 ($1,025) $581,768 ==================================================================== Note 3: Loans and Reserve for Loan Losses Loans at December 31, consisted of the following: (In thousands) 1993 1992 - ------------------------------------------------------- Commercial $ 266,448 $ 439,494 Real estate-commercial 346,308 196,401 Real estate-construction 40,533 63,886 Real estate-residential 172,245 175,834 Installment and personal 304,993 334,215 Unearned income (15,788) (18,883) - ------------------------------------------------------- Gross loans 1,114,739 1,190,947 Loan loss reserve (25,587) (24,742) - ------------------------------------------------------- Net loans $1,089,152 $1,166,205 ======================================================= Included in real estate-residential at December 31, 1993 and 1992 are loans held for resale of $5.9 million and $3.6 million, respectively, the cost of which approximates market value. Changes in the loan loss reserve were: (In thousands) 1993 1992 1991 - ------------------------------------------------------------------ Balance at January 1, $24,742 $23,853 $19,002 Sale of Sonoma Valley Bank (684) -- -- Provision for loan losses 9,452 7,005 10,418 Credit losses (10,091) (8,794) (9,140) Credit loss recoveries 2,168 2,678 3,573 - ------------------------------------------------------------------ Balance at December 31, $25,587 $24,742 $23,853 ================================================================== Restructured loans were $4.4 million and $319,000 at December 31, 1993 and 1992, respectively. The following is a summary of interest foregone on restructured loans for the years ended December 31: (In thousands) 1993 1992 1991 - ------------------------------------------------------------- Interest income that would have been recognized had the loans performed in accordance with their original terms $472 $135 $173 Less: Interest income recognized on restructured loans (218) -- (8) - ------------------------------------------------------------- Interest foregone on restructured loans $254 $135 $165 ============================================================= Note 4: Concentrations of Credit Risk The Company's business activity is with customers in Northern California. The loan portfolio is well diversified with no industry comprising greater than ten percent of total loans outstanding as of December 31, 1993. The Company has a significant number of credit arrangements that are secured by real estate collateral. In addition to real estate loans outstanding as disclosed in Note 3, the Company had loan commitments and stand by letters of credit related to real estate loans of $18.7 million at December 31, 1993. The Company requires collateral on all real estate loans and generally attempts to maintain loan-to-value ratios no greater than 75 percent on commercial real estate loans and no greater than 80 percent on residential real estate loans. Note 5: Premises and Equipment A summary as of December 31, follows: Accumulated Depreciation and Net (In thousands) Cost Amortization Book Value - ------------------------------------------------------------------------- Land $ 3,735 $ -- $ 3,735 Buildings and improvements 20,072 (6,876) 13,196 Leasehold improvements 2,537 (1,513) 1,024 Furniture and equipment 14,347 (6,961) 7,386 - ------------------------------------------------------------------------- Total $40,691 $(15,350) $25,341 ========================================================================= Land $5,483 $ -- $ 5,483 Buildings and improvements 19,131 (7,225) 11,906 Leasehold improvements 4,878 (2,929) 1,949 Furniture and equipment 19,711 (12,090) 7,621 - ------------------------------------------------------------------------- Total $49,203 $(22,244) $26,959 ========================================================================= Depreciation and amortization included in non-interest expense amount to $3,621,800 in 1993, $4,198,000 in 1992 and $4,189,400 in 1991. Note 6: Borrowed Funds Notes payable include the unsecured obligations of the Company as of December 31, 1993 and 1992, as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------------ Unsecured note dated September, 1976, interest payable semiannually at 9 7/8% and principal payments of $267 due annually to September 1, 1996. $ 196 $ 463 Unsecured note dated May, 1984, interest payable quarterly at 12.95% and principal payments of $1,000 due annually beginning September 1, 1991 and ending on September 1, 1996. Note agreement provides for partial prepayment under certain conditions without penalty and for prepayment of all or a portion of the note under certain conditions with a premium which decreases over the contractual term. 2,100 3,100 Equity contract notes, originated in April 1986 and maturing on April 1, 1996. Interest payable semiannually at 11 5/8% and principal payments of $2,500 due annually, on April 1, starting in 1993. 7,500 10,000 Senior notes, originated in May 1988 and maturing on June 30, 1995. Interest payable semiannually at 10.87% and principal payment due at maturity. 5,000 5,000 Subordinated note, issued by Westamerica Bank, originated in December 1993 and maturing September 30, 2003. Interest at an annual rate of 6.99% payable semiannually on March 31 and September 30, with principal due at maturity. 20,000 -- - ------------------------------------------------------------------------ Total notes payable $34,796 $18,563 ======================================================================== Mortgages payable of $524,000 consist of a note of Westamerica Bank secured by a deed of trust on premises having a net book value of $790,000 and $824,000 at December 31, 1993 and 1992, respectively. The note, which has an effective interest rate of 10 percent, is scheduled to mature in April 1995. Included in notes and mortgages payable are senior liens on other real estate, land held for sale and investments in joint venture properties that totaled $1,032,000 and $250,000 at December 31, 1993 and 1992, respectively. The combined aggregate amount of maturities of notes payable is $3,696,000, $8,500,000, $2,600,000, $0 and $0 for the years 1994 through 1998, and $20,000,000 thereafter. At December 31, 1993, the Company had unused lines of credit amounting to $7,500,000. Compensating balance arrangements are not significant to the operations of the Company. At December 31, 1993, the Banks had $113.0 million in time deposit accounts in excess of $100,000; interest on these accounts in 1993 was $4,837,000. Note 7: Shareholders' Equity In April 1982, the Company adopted an Incentive Stock Option Plan and 413,866 shares were reserved for issuance. Under this plan, all options are currently exercisable and terminate 10 years from the date of the grant. Under the Stock Option Plan adopted by the Company in 1985, 750,000 shares have been reserved for issuance. Stock appreciation rights, incentive stock options, non-qualified stock options and restricted performance shares are available under this plan. Options are granted at fair market value and are generally exercisable in equal installments over a three-year period with the first installment exercisable one year after the date of the grant. Each incentive stock option has a maximum ten-year term while non-qualified stock options may have a longer term. The 1985 plan was amended in 1990 to provide for restricted performance share (RPS) grants. An RPS grant becomes fully vested after three years of being awarded, provided that the Company has attained its performance goals for such three-year period. At December 31, 1993, 299,046 options were available for grant under the 1985 Stock Option Plan. Information with respect to options outstanding and options exercised under the plans is summarized in the following table: Number Option Price of shares* $ per share $ Total Shares under option at December 31: 1993 313,564 8.88- 24.50 5,766,400 1992 278,544 6.06- 22.00 4,249,399 1991 400,247 6.06- 22.00 6,202,300 Options exercised during: 1993 51,260 8.88- 22.00 692,157 1992 168,423 6.06- 13.29 1,975,000 1991 120,362 6.06- 13.63 997,700 * Issuable upon exercise. At December 31, 1993, options to acquire 164,794 shares of common stock were exercisable. Shareholders have authorized issuance of two new classes of 1,000,000 shares each, to be denominated Class B Common Stock and Preferred Stock, respectively, in addition to the 20,000,000 shares of Common Stock presently authorized. At December 31, 1993, no shares of Class B or Preferred Stock had been issued. At December 31, 1993, the Company's Tier I Capital was $149,937,000 and Total Capital was $194,415,000 or 11.11 percent and 14.40 percent, respectively, of risk-adjusted assets. In December 1986, the Company declared a dividend distribution of one common share purchase right (the Right) for each outstanding share of common stock. The Rights are exercisable only in the event of an acquisition of, or announcement of a tender offer to acquire, 15 percent or more of the Company's stock or 50 percent or more of its assets without the prior consent of the Board of Directors. If the Rights become exercisable, the holder may purchase one share of the Company's common stock for $65. Following an acquisition of 15 percent of the Company's common stock or 50 percent or more of its assets without prior consent of the Company, each right will also entitle the holder to purchase $130 worth of common stock of the Company for $65. Under certain circumstances, the Rights may be redeemed by the Company at a price of $.05 per right prior to becoming exercisable and in certain circumstances thereafter. The Rights expire on December 31, 1999, or earlier, in connection with certain Board-approved transactions. Note 8: Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, (SFAS No. 109). Adoption of SFAS No. 109 required a change from the deferred method to the asset and liability method of accounting for income taxes. Under the deferred method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement reported amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.] Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The components of the net deferred tax asset as of December 31, are as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------- Deferred tax asset Reserve for loan losses $ 10,321 $ 9,013 State franchise taxes 676 941 Deferred compensation 534 723 Real estate owned 2,742 1,851 Net deferred loan fees -- 268 Other 1,037 587 - ------------------------------------------------------------------- 15,310 13,383 Valuation allowance -- -- - ------------------------------------------------------------------- Total deferred tax asset 15,310 13,383 - ------------------------------------------------------------------- Deferred tax liability Net deferred loan costs 502 -- Fixed assets depreciation 1,164 1,171 Securities available-for-sale 1,864 -- Other 148 373 - ------------------------------------------------------------------- Total deferred tax liability 3,678 1,544 - ------------------------------------------------------------------- Net deferred tax asset $11,632 $11,839 =================================================================== The Company believes a valuation allowance is not needed to reduce the deferred tax asset because there is no material portion of the deferred tax asset that will not be realized through sufficient taxable income. The provisions for federal and state income taxes consist of amounts currently payable and amounts deferred which, for the years ended December 31, are as follows: (In thousands) 1993 1992 1991 - ------------------------------------------------------------ Current income tax expense: Federal $2,501 $6,977 $5,314 State 2,195 3,130 2,638 - ------------------------------------------------------------ Total current 4,696 10,107 7,952 - ------------------------------------------------------------ Deferred income tax benefit: Federal (646) (1,758) (1,335) State (617) (492) (784) - ------------------------------------------------------------ Total deferred (1,263) (2,250) (2,119) - ------------------------------------------------------------ Adjustment of net deferred tax asset for enacted changes in tax rates: Federal (304) -- -- State (90) -- -- - ------------------------------------------------------------- Total adjustment (394) -- -- - ------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ============================================================= The provisions for income taxes differ from the provisions computed by applying the statutory federal income tax rate to income before taxes, as follows: (In thousands) 1993 1992 1991 - -------------------------------------------------------------------- Federal income taxes due at statutory rate $4,248 $7,846 $6,056 (Reductions) increases in income taxes resulting from: Interest not taxable for federal income tax purposes (1,895) (1,735) (1,836) State franchise taxes, net of federal income tax benefit 982 1,753 1,226 Deferred benefit and other (296) (7) 387 - --------------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ===================================================================== Note 9: Fair Value of Financial Instruments The fair value of financial instruments which have a relative short period of time between their origination and their expected realization were valued using historical cost. Such financial instruments and their estimated fair values at December 31, were: (In thousands) 1993 1992 - ------------------------------------------------------------------- Cash and cash equivalents $102,618 $139,497 Money market assets 250 1,366 Interest and taxes receivable 28,799 25,741 Non-interest bearing and interest-bearing transaction and savings deposits 1,313,908 1,258,353 Funds purchased 69,064 12,038 Interest payable 2,700 3,824 The fair value at December 31 of the following financial instruments was estimated using quoted market prices: (In thousands) 1993 1992 - ------------------------------------------------------------------- Investment securities available for sale $168,819 $ -- Investment securities held to maturity 563,563 581,768 Trading account securities 10 -- Loans were separated into two groups for valuation. Variable rate loans, which reprice frequently with changes in market rates, were valued using historical cost. Fixed rate loans were valued by discounting the future cash flows expected to be received from the loans using current interest rates charged on loans with similar characteristics. Additionally, the $25,587,000 and $24,742,000 reserves for loan losses as of December 31, 1993 and 1992, respectively, were applied against the estimated fair value to recognize future defaults of contractual cash flows. The estimated fair market value of loans at December 31, was: (In thousands) 1993 1992 - -------------------------------------------------------------------- Loans $1,096,164 $1,171,630 The fair value of time deposits and notes and mortgages payable was estimated by discounting future cash flows related to these financial instruments using current market rates for financial instruments with similar characteristics. The estimated fair values at December 31, were: (In thousands) 1993 1992 - --------------------------------------------------------------------- Time deposits $420,475 $534,920 Notes and mortgages payable 36,014 20,282 The estimated fair values of the Company's interest rate swaps, which are determined by dealer quotes and generally represent the amount that the Company would pay to terminate its swap contracts, were $(600,000) and $0, respectively, at December 31, 1993 and 1992. These fair values do not represent actual amounts that may be realized upon any sale or liquidation of the related assets or liabilities. In addition, these values do not give effect to discounts to fair value which may occur when financial instruments are sold in larger quantities. The fair values presented above represent the Company's best estimate of fair value using the methodologies discussed above. Note 10: Lease Commitments Fifteen banking offices and three administrative service centers are owned and thirty-seven banking offices and two support facilities are leased. Substantially all the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living, property taxes and maintenance. The Company also leases certain pieces of equipment. Minimum future rental payments on operating leases, net of sublease income, at December 31, 1993, are as follows: (In thousands) 1994 $ 3,253 1995 3,091 1996 2,632 1997 1,679 1998 1,183 Thereafter 3,659 - ------------------------------------------------- Total minimum lease payments $15,497 ================================================= Total rentals for premises and equipment net of sublease income included in non-interest expense were $3,862,000 in 1993, $3,910,000 in 1992 and $3,829,000 in 1991. Note 11: Commitments and Contingent Liabilities Loan commitments are agreements to lend to a customer provided there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future funding requirements. Loan commitments are subject to the Company's normal credit policies and collateral requirements. Unfunded loan commitments were $159.2 million at December 31, 1993. Standby letters of credit commit the Company to make payments on behalf of customers when certain specified future events occur. Standby letters of credit are primarily issued to support customers short-term financing requirements and must meet the Company's normal credit policies and collateral requirements. Standby letters of credit outstanding were $6.4 million at December 31, 1993. Interest rate swaps are agreements to exchange interest payments computed on notional amounts. The notional amounts do not represent exposure to credit risk; however, these agreements expose the Company to market risks associated with fluctuations of interest rates. As of December 31, 1993, the Company had entered into four interest rate swaps. The first two contracts have notional amounts totaling $25 million each and the second two contracts have notional amounts totaling $30 million each. On the first two contracts, which are scheduled to terminate in November and December of 1994, the Company pays an average fixed rate of interest of 5.06 percent and receives a variable rate of interest based on the London Interbank Offering Rate (LIBOR); on the second two contracts, scheduled to terminate in August of 1995, the Company pays a variable rate based on LIBOR and receives an average fixed rate of interest of 4.11 percent. The LIBOR rate has averaged 3.39 percent from the date the first two swaps were entered through December 31, 1993 and 3.33 percent from the date the second two swaps were entered through December 31, 1993. The effect of entering into these contracts resulted in a decrease to net interest income of $659,000 for the period ended December 31, 1993. The Company, because of the nature of its business, is subject to various threatened or filed legal cases. The Company, based on the advice of legal counsel, does not expect such cases will have material, adverse effect on its financial position or results of operations. Note 12: Retirement Benefit Plans The Company sponsors a defined benefit Retirement Plan covering substantially all of its salaried employees with one or more years of service. The Company's policy is to expense costs as they accrue as determined by the Projected Unit Cost method. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. The following table sets forth the Retirement Plans funded status as of December 31 and the pension cost for the years ended December 31: (In thousands) 1993 1992 - ----------------------------------------------------------------- Actuarial present value of benefit obligations: Vested benefit obligation $(11,245) $(10,625) - ----------------------------------------------------------------- Accumulated benefit obligation (11,430) (11,064) - ----------------------------------------------------------------- Projected benefit obligation (11,612) (11,275) Plan assets at fair market value 11,677 11,429 ================================================================= Funded status-projected benefit obligation (in excess of) or less than plan assets $65 $154 ================================================================= Comprised of: Prepaid pension cost $22 $182 Unrecognized net (loss) gain (75) (194) Unrecognized prior service cost 529 628 Unrecognized net obligation, net of amortization (411) (462) - ----------------------------------------------------------------- Total $65 $154 ================================================================= Net pension cost included in the following components: Service cost during the period $364 $384 Interest cost on projected benefit obligation 744 754 Actual return on plan assets (1,012) (686) Net amortization and deferral 64 (271) - ----------------------------------------------------------------- Net periodic pension cost $160 $181 ================================================================= The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 6.75 percent and 5 percent, respectively, at December 31, 1993 and 7 percent and 5 percent, respectively, at December 31, 1992. The expected long-term rate of return on plan assets in 1993 and 1992 was 7 percent and 8 percent, respectively. Effective January 1, 1992, the Company adopted a defined contribution Deferred Profit-Sharing Plan covering substantially all of its salaried employees with one or more years of service. Participant deferred profit-sharing account balances offset benefits accrued under the Retirement Plan which was amended effective January 1, 1992 to coordinate benefits with the Deferred Profit-Sharing Plan. The coordination of benefits results in the Retirement Plan benefit formula establishing the minimum value of participant retirement benefits which, if not provided by the Deferred Profit-Sharing Plan, are guaranteed by the Retirement Plan. The costs charged to non-interest expense related to benefits provided by the Retirement Plan and the Deferred Profit-Sharing Plan were $1,160,000 in 1993, $1,037,000 in 1992 and $759,000 in 1991. In addition to the Retirement Plan and the Deferred Profit-Sharing Plan, all salaried employees are eligible to participate in the voluntary Tax Deferred Savings/Retirement Plan (ESOP) upon completion of a 90-day introductory period. This plan allows employees to defer, on a pretax basis, a portion of their compensation as contributions to the plan. Participants are allowed to invest in five funds, including a Westamerica Bancorporation Common Stock Fund. The Company's matching contributions charged to operating expense were $482,000 in 1993, $462,000 in 1992 and $452,000 in 1991. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, Employers Accounting for Postretirement Benefits Other than Pensions (SFAS No. 106). Adoption of SFAS No. 106 required a change from the cash method to an actuarial based accrual method of accounting for postretirement benefits other than pensions. The Company offers continuation of group insurance coverage to employees electing early retirement, as defined by the Retirement Plan, for the period from the date of early retirement until age sixty-five. The Company contributes an amount toward early retirees insurance premiums which is fixed at the time of early retirement. The Company also reimburses Medicare Part B premiums for all retirees over age sixty-five, as defined by the Retirement Plan. The following table sets forth the net periodic postretirement benefit cost for the year ended December 31, 1993 and the funded status of the plan at December 31, 1993: (In thousands) Service cost $ 482 Interest cost 107 Actual return on plan assets -- Amortization of unrecognized transition obligation 61 Other, net (482) - ----------------------------------------------------------- Net periodic cost $ 168 =========================================================== Accumulated postretirement benefit obligation attributable to: Retirees $ 1,130 Fully eligible participants 265 Other 158 - ----------------------------------------------------------- Total 1,553 - ----------------------------------------------------------- Fair value of plan assets -- Accumulated postretirement benefit obligation in excess of plan assets $ 1,553 =========================================================== Comprised of: Unrecognized prior service cost -- Unrecognized net gain (loss) -- Unrecognized transition obligation 1,471 Recognized postretirement obligation 82 - ----------------------------------------------------------- Total $1,553 =========================================================== The discount rate used in measuring the accumulated postretirement benefit obligation was 6.75 percent at December 31, 1993. The assumed health care cost trend rate used to measure the expected cost of benefits covered by the plan was 9 percent for 1994 and declined steadily to an ultimate trend rate of 4 percent beginning in 1999. The effect of a one percentage point increase on the assumed health care cost trend for each future year would increase the aggregate of the service cost and interest cost components of the 1993 net periodic cost by $73,000 and increase the accumulated postretirement benefit obligation at December 31, 1993 by $204,000. Note 13: Related Party Transactions Certain directors and executive officers of the Company were lending customers of the Company during 1993 and 1992. All such loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral requirements. No related party loan represents more than normal risk of collection. Such loans were $5,238,000 and $10,591,000 at December 31, 1993 and 1992, respectively. Note 14: Restrictions Payment of dividends to the Company by Westamerica Bank, the largest subsidiary bank, is limited under regulations for Federal Reserve member banks. The amount that can be paid in any calendar year, without prior approval from regulatory agencies, cannot exceed the net profits (as defined) for that year plus the net profits of the preceding two calendar years less dividends declared. Under this regulation, Westamerica Bank, the largest subsidiary bank, was not restricted as to the payment of $13.6 million in dividends to the Company as of December 31, 1993. During 1992 and 1993, Napa Valley Bank, a banking subsidiary, was operating under a regulatory order which disallowed payment of dividends to the Company unless it reduced the level of problem assets, liquidated, or reserved adequately against, the real estate investments in its subsidiary company, and strengthened its loan loss reserve. Napa Valley Bank has complied with all conditions of the regulatory order which will be removed by the regulators based on their fourth quarter 1993 examination. Payment of dividends by the Company is also restricted under the terms of the note agreements as discussed in Note 6. Under the most restrictive of these agreements, $17.1 million was available for payment of dividends as of December 31, 1993. Under one of the note agreements, the Company has agreed to limit its funded debt to 40 percent of the total of funded debt plus shareholders' equity and maintain certain other financial ratios. The Company was in compliance with all such requirements as of December 31, 1993. The Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of its reservable deposits. The Banks daily average balance on deposit at the Federal Reserve Bank was $40.4 million in 1993 and $40.3 million in 1992. Note 15: Westamerica Bancorporation (Parent Company Only) Statements of Income (In thousands) Years ended December 31, 1993 1992* 1991* - ----------------------------------------------------------------------- Dividends from subsidiaries $16,671 $ 8,630 $ 6,620 Interest from subsidiaries 315 61 72 Other income 2,781 1,158 1,082 - ----------------------------------------------------------------------- Total income 19,767 9,849 7,774 - ----------------------------------------------------------------------- Interest on borrowings 1,958 2,434 2,617 Salaries and benefits 4,526 782 475 Other non-interest expense 5,464 3,451 2,261 - ----------------------------------------------------------------------- Total expenses 11,948 6,667 5,353 - ----------------------------------------------------------------------- Income before income tax benefit and equity in undistributed income of subsidiaries 7,819 3,182 2,421 Income tax benefit 3,478 1,890 1,813 Equity in undistributed (loss) income of subsidiaries (1,842) 10,150 7,743 - ----------------------------------------------------------------------- Net income $9,455 $15,222 $11,977 ======================================================================= *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Balance Sheets (In thousands) Years ended December 31, 1993 1992* - -------------------------------------------------------------------------- Assets Cash and cash equivalents $4,790 $ 1,729 Investment securities held-to-maturity 9,250 13,741 Loans 149 -- Investment in subsidiaries 154,257 145,762 Premises and equipment 29 2,506 Accounts receivable from subsidiaries 65 262 Other assets 2,056 2,704 - ------------------------------------------------------------------------- Total assets $170,596 $166,704 ========================================================================= Liabilities Long-term debt $ 14,796 $ 18,563 Notes payable to subsidiaries -- 2,493 Other liabilities 3,353 1,974 - ------------------------------------------------------------------------- Total liabilities 18,149 23,030 - ------------------------------------------------------------------------- Shareholders' equity 152,447 143,674 - ------------------------------------------------------------------------- Total liabilities and shareholders' equity $170,596 $166,704 ========================================================================= Statements of Cash Flows (In thousands) Years ended December 31, 1993 1992* 1991* - -------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $15,222 $11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 108 67 58 Equity in undistributed loss (income) of subsidiaries 1,842 (10,150) (7,743) Increase in equity in subsidiaries -- (1,797) -- (Increase) decrease in receivables from subsidiaries 197 1,020 (1,005) Provision for deferred income taxes 60 2,633 (551) Decrease (increase) in other assets 1,183 (1,394) (771) Increase in other liabilities 1,583 301 39 Gain on sale of Sonoma Valley Bank (668) -- -- Net gain on sale of land -- 43 -- - -------------------------------------------------------------------------- Net cash provided by operating activities 13,760 5,945 2,004 - -------------------------------------------------------------------------- Investing Activities Purchases of premises and equipment -- (2,189) (761) Net change in land held for sale (800) -- -- Net change in loan balances (149) -- -- Increase in investment in subsidiaries (9,874) (485) (510) Purchase of investment securities held-to-maturity (9,700) (13,991) (22,100) Proceeds from maturities of investment securities 14,191 10,500 23,100 Proceeds from sales of premises and equipment 2,369 2,149 -- Proceeds from sale of Sonoma Valley Bank 2,733 -- -- - -------------------------------------------------------------------------- Net cash used in investing activities (1,230) (4,016) (271) - -------------------------------------------------------------------------- Financing Activities Net (decrease) increase in short-term debt -- (656) 453 Principal reductions of long-term debt and notes payable to subsidiaries (6,260) (2,611) (2,767) Proceeds from issuance of note payable to subsidiaries -- 1,368 -- Proceeds from exercise of stock options 1,446 2,139 1,507 Unrealized loss (gains) on marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - -------------------------------------------------------------------------- Net cash used in financing activities (9,469) (2,738) (3,857) - -------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 3,061 (809) (2,124) Cash and cash equivalents at beginning of year 1,729 2,538 4,662 - -------------------------------------------------------------------------- Cash and cash equivalents at year end $4,790 $1,729 $2,538 ========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Note 16: Quarterly Financial Information (Unaudited) * As originally reported ** Represents prices quoted on the American Stock Exchange. Quoted prices are not necessarily representative of actual transactions. Note 17: Acquisition On April 15, 1993, the Company issued approximately 2,122,740 shares of its common stock in exchange for all of the outstanding common stock of Napa Valley Bancorp, a bank holding company, whose subsidiaries included Napa Valley Bank ("NVB"), a California-based, state-chartered banking association, and Subsidiary, 88 percent interest in Bank of Lake County ("BLC"), a national banking association, 50 percent interest in Sonoma Valley Bank, a state banking association, Suisun Valley Bank, also a state chartered bank, and Napa Valley Bancorp Services Corporation ("NVBSC"), estabilshed to provide data processing and other services to Napa Valley Bancorp's subsidiaries. This business transaction (the "Merger") was accounted for as a pooling-of-interests combination and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassifications have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. Subsequent to the combination, Westamerica Bancorporation sold the 50 percent interest in Sonoma Valley Bank at a gain of $668,000. This business combination has been accounted for as a pooling-of-interests combination; and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassification have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. The results of operations previously reported by the separate enterprises and the combined amounts presented in the accompanying consolidated financial statements are summarized as follows. Three months ended March 31, 1993 Years ended December 31, (In thousands) (unaudited) 1992 1991 - ----------------------------------------------------------------------- Net Interest Income: Westamerica Bancorporation $16,809 $67,192 $62,496 Napa Valley Bancorp 7,365 28,669 26,699 - ----------------------------------------------------------------------- Combined $24,174 $95,861 $89,195 - ----------------------------------------------------------------------- Net Income (loss): Westamerica Bancorporation $3,675 $13,979 $11,762 Napa Valley Bancorp (656) 1,243 215 - ----------------------------------------------------------------------- Combined $3,019 $15,222 $11,977 - ----------------------------------------------------------------------- Net Income (loss) Per Share: Westamerica Bancorporation* $.63 $2.40 $2.06 Napa Valley Bancorp* (.19) .36 .06 Combined $.38 $1.92 $1.52 - ----------------------------------------------------------------------- * As originally reported. Net income per share was reduced $.25 for the three months ended March 31, 1993, $.48 in 1992, and $.54 in 1991, attributable to dilution from shares issued in connection with the acquisition. In addition, net income of the Company for 1993 was reduced by an estimated $8.3 million due to the consolidation of Napa Valley Bancorp's branches and operations, certain merger-related expenses and the application of Westamerica Bancorporation's workout strategy to the non-performing assets of Napa Valley Bancorp. There were no significant transactions between Westamerica Bancorporation and Napa Valley Bancorp prior to the combination. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item 10 is incorporated herein by reference from the "Election of Directors" and "Executive Officers" section on Pages 2 through 9 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this Item 11 is incorporated herein by reference from the "Executive Compensation" and "Retirement Benefits and Other Arrangements" section on Pages 11 through 16 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is incorporated herein by reference from the "Security Ownership of Certain Beneficial Owners and Management" section on Pages 9 and 10 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item 13 is incorporated herein by reference from the "Indebtedness of Directors and Management" section on Page 6 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. All Financial Statements See Index to Financial Statements on page 36. (a) 2. Financial statement schedules required by Item 8 of Form 10-K and by Item 14(d). None (Information included in Financial Statements). (a) 3. Exhibits The following documents are included or incorporated by reference in this annual report on Form 10-K. Exhibit Number 3(a) Restated Articles of Incorporation (composite copy). 3(b)** By-laws. 10 Material contracts: (a)* Incentive Stock Option Plan (b)*** James M. Barnes --January 7, 1987 (Employment) (c)*** E. Joseph Bowler --January 7, 1987 (Employment) (d)*** Robert W. Entwisle --January 7, 1987 (Employment) (e)**** Amended and Restated Agreement and Plan of Reorganization by and between Westamerica Bancorporation and John Muir National Bank, proxy and prospectus dated November 27, 1991. (f)***** Agreement and Plan of Merger by and between Westamerica Bancorporation and Napa Valley Bancorp, proxy and prospectus dated November 12, 1992. 22 Subsidiaries of the registrant. *Exhibit 10(a) is incorporated by reference from Exhibit A to the Company's Proxy Statement dated March 22, 1983, which was filed with the Commission pursuant to Regulation 14A. **Exhibits 3(b), is incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ***Exhibits 3(a), 10(b), 10(c) and 10(d) are incorporated herein by reference from Exhibits 3(a), 10(n), 10(o), and 10(q) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ****Exhibit 3(e) is incorporated herein by reference from the Form S-4 dated November 27, 1991. *****Exhibit 3(f) is incorporated herein by reference from the Form S-4 dated November 12, 1992. The Corporation will furnish to shareholders a copy of any exhibit listed above, but not contained herein, upon written request to Mrs. M. Kitty Jones, Vice President and Secretary, Westamerica Bancorporation, P. O. Box 567, San Rafael, California 94915, and payment to the Corporation of $.25 per page. (b) Report on Form 8-K None MANAGEMENTS LETTER OF FINANCIAL RESPONSIBILITY To the Shareholders: The Management of Westamerica Bancorporation is responsible for the preparation, integrity, reliability and consistency of the information contained in this annual report. The financial statements, which necessarily include amounts based on judgments and estimates, were prepared in conformity with generally accepted accounting principles and prevailing practices in the banking industry. All other financial information appearing throughout this annual report is presented in a manner consistent with the financial statements. Management has established and maintains a system of internal controls that provides reasonable assurance that the underlying financial records are reliable for preparing the financial statements, and that assets are safeguarded from unauthorized use or loss. This system includes extensive written policies and operating procedures and a comprehensive internal audit function, and is supported by the careful selection and training of staff, an organizational structure providing for division of responsibility, and a Code of Ethics covering standards of personal and business conduct. Management believes that, as of December 31, 1993 the Corporation's internal control environment is adequate to provide reasonable assurance as to the integrity and reliability of the financial statements and related financial information contained in the annual report. The system of internal controls is under the general oversight of the Board of Directors acting through its Audit Committee, which is comprised entirely of outside directors. The Audit Committee monitors the effectiveness of and compliance with internal controls through a continuous program of internal audit and credit examinations. This is accomplished through periodic meetings with Management, internal auditors, loan quality examiners, regulatory examiners and independent auditors to assure that each is carrying out their responsibilities. The Corporation's financial statements have been audited by KPMG Peat Marwick, independent auditors elected by the shareholders. All financial records and related data, as well as the minutes of shareholders and directors meetings, have been made available to them. Management believes that all representations made to the independent auditors during their audit were valid and appropriate. David L. Payne Chairman, President and CEO James M. Barnes Executive Vice President and CFO Dennis R. Hansen Senior Vice President and Controller INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders of Westamerica Bancorporation We have audited the accompanying consolidated balance sheets of Westamerica Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the years in the three year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. As discussed in Note 1 to the consolidated financial statements, the consolidated balance sheet of the Company as of December 31, 1992 and the related statements of income, changes in shareholders' equity, and cash flows for each of the years in the two year period ended December 31, 1992, and the related footnote disclosures have been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. We did not audit the financial statements of Napa Valley Bancorp as of and for the periods ended December 31, 1992 and 1991, which statements reflect total assets constituting 30 percent in 1992 and net income constituting 8 percent and 2 percent in 1992 and 1991, respectively, of the related and restated consolidated totals. Those statements included in the 1992 and 1991 restated consolidated totals were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Napa Valley Bancorp, is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Westamerica Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1993 in conformity with generally accepted accounting principles. San Francisco, California January 25, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WESTAMERICA BANCORPORATION By Dennis R. Hansen By James M. Barnes - ---------------------- -------------------- Senior Vice President and Controller Executive Vice President and (Principal Accounting Officer) Chief Financial Officer SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Signature Title Date David L. Payne Chairman of the Board and 3/24/94 ------------------------------ Director and President and CEO E. Joseph Bowler Senior Vice President 3/24/94 ------------------------------ and Treasurer Etta Allen Director 3/24/94 ------------------------------ Louis E. Bartolini Director 3/24/94 ------------------------------ Charles I. Daniels, Jr. Director 3/24/94 ------------------------------ Don Emerson Director 3/24/94 ------------------------------ Arthur C. Latno Director 3/24/94 ------------------------------ Patrick D. Lynch Director 3/24/94 ------------------------------ Catherine Cope MacMillan Director 3/24/94 ------------------------------ James A. Maggetti Director 3/24/94 ------------------------------ Dwight H. Murray,Jr.,M.D. Director 3/24/94 ------------------------------ Ronald A. Nelson Director 3/24/94 ------------------------------ Carl Otto Director 3/24/94 ------------------------------ Edward B. Sylvester Director 3/24/94 ------------------------------ Exhibit 22 WESTAMERICA BANCORPORATION SUBSIDIARIES AS OF DECEMBER 31, 1993 State of Incorporation Westamerica Bank California Napa Valley Bank California Bank of Lake County California Community Banker Services Corporation California

47129_1993.txt

47129

1993

ITEM 1. BUSINESS. General The Hertz Corporation and its subsidiaries ("Hertz"), affiliates, independent licensees and associates are engaged principally in the business of renting automobiles and renting and leasing trucks, without drivers, in or through approximately 5,200 locations throughout the United States and in over 140 foreign countries. Collectively, they operate what the registrant believes is the largest rent a car business in the world and one of the largest one-way truck rental businesses in the United States. In addition, through its wholly-owned subsidiary, Hertz Equipment Rental Corporation, Hertz operates what it believes to be the largest rental, lease and sale of construction and materials handling equipment business in the United States. Other activities of Hertz include the sale of its used vehicles, the leasing of automobiles, primarily in Europe, Australia and New Zealand, operating car dealerships in Belgium and providing claim management and telecommunications services in the United States. The registrant, which was incorporated in Delaware in 1967, is a successor to corporations which were engaged in the automobile and truck leasing and rental business since 1924. UAL Corporation ("UAL") (formerly Allegis Corporation) purchased all of the registrant's outstanding capital stock from RCA Corporation ("RCA") on August 30, 1985. Park Ridge Corporation ("Park Ridge") purchased all of the registrant's outstanding capital stock from UAL on December 30, 1987. On July 19, 1993, Park Ridge (which had no material assets other than the registrant) was merged with and into the registrant, with the prior stockholders of Park Ridge becoming the stockholders of the registrant. See Notes 1 and 7 of the Notes to Consolidated Financial Statements included in this Report. For information with respect to the relative contributions to revenue of the various classes of services of Hertz' business, reference should be made to the Selected Financial Data included in this Report. For information with respect to business segments of Hertz, reference should be made to Note 10 of the Notes to Consolidated Financial Statements included in this Report. Rent A Car Hertz provides rent a car service throughout the United States, including virtually all major U.S. cities, and in major foreign countries. Rent a car service is also provided through independent licensees and associates (see Business - Licensees and Associates). A wide variety of makes and models of automobiles are used for daily rental purposes, nearly all of which are current year or the previous year's models. Car rentals are made on a daily, weekly or monthly basis, the rental charge being computed on a limited or unlimited mileage rate, or on a time rate plus a mileage charge. Rates vary at different locations depending on local market, competitive and cost factors, and most rentals are made utilizing rate plans under which the customer is responsible for gasoline used during the rental. Other services provided to customers include public liability and property damage protection. In the United States, Hertz owns operations in approximately 725 locations and its domestic licensee locations number approximately 450 and, currently, together they hold a combined fleet of approximately 172,000 vehicles. Outside the United States, and primarily in Europe, the Hertz system is serviced through approximately 1,600 company owned or authorized locations and 2,425 licensee locations with approximately 125,000 vehicles. In addition to vehicle rentals and licensee fees, revenues are generated from providing customers with ancillary products such as loss or collision damage waiver, theft protection, liability ITEM 1. BUSINESS (continued). insurance supplement, personal accident insurance and personal effects coverage. Rent a car operations are subject to seasonal factors with the greatest activity occurring in the second and third calendar quarters (see Note 13 of the Notes to Consolidated Financial Statements included in this Report). Hertz and certain licensees, under the Hertz "Rent it Here-Leave it There" program, offer customers in most parts of the world the convenience of leaving a rented car at a Hertz or licensee location in a city other than the one in which it was rented. Depending upon rental location and distance driven, a drop off charge or a special intercity rate may be imposed if the vehicle is not returned to the same location from which it is rented. A centralized reservations service is also offered within the continental United States by use of a toll free telephone number. In addition, through "The Hertz #1 Club", Hertz maintains a computerized data retrieval system on participating customers' preferences as to type of car and other information typically needed prior to the rental of a car, so that, when #1 Club members make a reservation using their membership number, the renting location is able to have a rental agreement prepared prior to the time of their arrival. A similar service is available to Hertz' customers in certain foreign countries under the name "Hertz No. 1 Club". In addition, a Hertz charge card is offered for use by Hertz customers in connection with car rental services. At most major airport locations within the United States, Canada, Europe and Australia, Hertz offers "Hertz #1 Club Gold," which is an expedited rental service designed for the frequent traveler. Enrollment is by application, which provides for the payment of an annual membership fee. The terms governing all rentals using this service are contained in the member's enrollment agreement. Hertz #1 Club Gold encompasses two services, canopied and counter service. When using #1 Club Gold canopy service, which is available at a number of major airport locations within the United States and the United Kingdom, the counter rental transaction is eliminated and members are taken by the Hertz courtesy bus to a separate canopied rental area, where an electronic sign board directs them to their assigned car, which is ready to go. Usually, there is nothing to sign. After presenting their driver's license and rental record at the gate, they are on their way. Hertz #1 Club Gold counter service is available at many airport locations where #1 Club Gold canopied service is unavailable, in which case, members with #1 Club Gold reservations proceed to a special counter for members, where they receive their rental record and are directed to their pre-assigned car so they can be on their way as quickly as possible. Hertz also participates in packaged tour plans in conjunction with airlines, tour operators and hotels under which a certain period of rent a car usage is included with air fare, and often hotel accommodations, at a combined quoted price. Automobile maintenance centers are operated at airports and in certain urban and suburban areas, providing maintenance facilities for the rental fleet. Many of these facilities, which include automatic car washes and vehicle diagnostic and repair equipment, are accepted by automobile manufacturers as eligible to perform warranty work. Collision damage and major repairs are generally performed by independent contractors. ITEM 1. BUSINESS (continued). Hertz believes that a majority of its customers are from cities other than those in which the automobiles are rented. Rent a car facilities are operated at virtually all major airports and at downtown locations in major cities in the United States. Hertz estimates that airport revenues accounted for approximately 90% of its rent a car revenues in the United States in 1993. Arrangements are also in effect at hotels, motels and railroad terminals to facilitate car rentals at such locations. The foreign rent a car operations of Hertz that generated the highest volumes of business during 1993 are those conducted in France, Germany, the United Kingdom, Italy, Canada, Spain, Australia and Switzerland. These operations are conducted by wholly-owned subsidiaries of Hertz. In general, Hertz' foreign rent a car operations are conducted along lines similar to those of rent a car operations of Hertz in the United States. Hertz believes there are no unusual risks associated with its foreign operations. Hertz' ability to withdraw earnings or investments from foreign countries is, in some cases, subject to exchange controls and the utilization of foreign tax credits. It may also be affected by fluctuations in exchange rates for foreign currencies and by revaluation of such currencies in relation to the U.S. dollar by the governments involved. Foreign operations have been financed to a substantial extent through loans from local lending sources in the currency of the countries in which such operations are conducted. Rent a car operations in currency of the foreign countries are, from time to time, subject to governmental regulations imposing varying degrees of restrictions. Hertz does not believe currency restrictions or other regulations have had any material impact on its operations as a whole. Equipment Rental and Sales Hertz also rents, leases and sells a wide range of construction and materials handling equipment to construction, industrial and governmental users through its subsidiaries, Hertz Equipment Rental Corporation ("HERC") in the United States, a subsidiary of Hertz Equipment Rental International, Ltd. in Spain, and a subsidiary in France owned 51% by Hertz International, Ltd. and 49% by Equipment Rental Services Netherlands B.V., which operates under a license from HERC. Rentals are made on a daily, weekly or monthly basis. Rates vary at different locations depending on local market and competitive factors. HERC believes it operates the largest rental, lease and sale of construction and materials handling equipment business in the United States and has become so through providing superior equipment, operations and services. In the United States, HERC operates 81 locations throughout the Northeast, Southeast, Southwest, Midwest and Gulf and West Coasts. The Spain subsidiary operates from one location and the France subsidiary operates from three locations. HERC operations are subject to seasonal factors with the greatest activity occurring in the second and third calendar quarters and its operations have been profitable. ITEM 1. BUSINESS (continued). Truck Leasing and Rental In 1988, the registrant sold its 50% interest in Hertz Penske Truck Leasing, Inc., which has been succeeded by Penske Truck Leasing Co., L.P., ("Penske"), and entered into a license agreement under which Penske has the right, as a Hertz System licensee, to conduct a one-way truck rental business (including trailers) for a 10 year period. The license agreement covers the entire United States, with certain exclusions for those cities and towns that were licensed to other Hertz System licensees, but under certain conditions, Penske may also operate in the localities of other Hertz System licensees. Penske currently maintains a one-way truck rental fleet of approximately 6,900 vehicles and is headquartered in Reading, Pennsylvania. Car Leasing and Car Dealerships Hertz has car leasing operations in Europe, Australia and New Zealand, and car dealership operations in Belgium. Leases are generally closed-end where the disposition of vehicles on lease termination is for Hertz' account. Hertz owns all of its car leasing operations in the United Kingdom, Australia and New Zealand, and 98% of Axus, S.A., a leasing company which operates in Belgium, Luxembourg, Holland, France, Italy and Spain, and also operates car dealerships in Belgium. Axus, S.A. uses the Hertz name pursuant to a license from Hertz. Claim Management Through its subsidiary Hertz Claim Management Corporation ("HCM"), Hertz provides a claim administration service to numerous customers, which includes investigating, evaluating, negotiating and disposing of a wide variety of claims, including third-party, first-party, bodily injury, property damage, general liability, product liability and workers compensation claims, but does not include underwriting of risks. In 1992, HCM became the claims administrator for workers compensation claims of the registrant, which are underwritten by an outside insurance carrier, and also became the administrator for the registrant's medical, dental and other employee health related benefit plans. HCM provides these services from 41 locations throughout the United States and its operations have been profitable. Telecommunication In 1991, Hertz began providing telecommunication services through its subsidiary Hertz Technologies, Inc. ("HTI"). HTI markets custom designed voice and data telecommunication packages of rates and services and makes available to customers throughout the United States the opportunity to take advantage of Hertz' negotiated rates with its underlying carriers providing, among other things, discounted long-distance services. HTI provides these services from Oklahoma City and its operations have been profitable. ITEM 1. BUSINESS (continued). Insurance For its domestic operations, the registrant is a qualified self-insurer against liability resulting from accidents under certificates of self-insurance for financial responsibility in all states wherein its motor vehicles are registered. The registrant also self-insures general public liability and property damage for all domestic operations. Effective July 1, 1987, all claims are retained and borne by the registrant up to a limit of $5,000,000 for each accident. Self-insurance retention borne by the registrant for each accident prior to July 1, 1987 was as follows: $10,000,000 from September 1, 1986 to June 30, 1987; $1,000,000 and 50% of claims for amounts exceeding $1,000,000 up to $6,000,000 from February 17, 1985 to August 31, 1986; and $1,000,000 prior to February 17, 1985. For its foreign operations, Hertz generally does not act as a self-insurer. Instead, Hertz purchases insurance to comply with local legal requirements from unaffiliated carriers. Effective January 1, 1993, motor vehicle liability insurance for claims arising on or after January 1, 1993, purchased locally from unaffiliated carriers by Hertz owned operations in Europe, has been reinsured by Hertz International RE Limited ("HIRE"), a newly formed reinsurer in Dublin, Ireland. HIRE effectively responds to the first $1,500,000 of motor vehicle liability for each accident, with excess liability insurance coverage maintained by Hertz with unaffiliated carriers. Provisions for public liability and property damage on self-insured domestic claims and reinsured foreign claims are made by charges to expense based upon evaluations of estimated ultimate liabilities on reported and unreported claims. At December 31, 1993, this liability was estimated at $264 million for combined domestic and foreign operations. Hertz also maintains insurance coverage with unaffiliated carriers for such amounts in excess of those retained and borne by Hertz, as it determines to be necessary. Ordinarily, collision damage costs and the costs of stolen or unaccounted for vehicles are carried on a self-insured basis, with such costs being charged to expense as incurred. HERC generally requires its customers to provide their own liability insurance on rented equipment with HERC held harmless under various agreements. Other types of insurance usually carried by business organizations, such as workers compensation, property (including boiler and machinery and business interruption), commercial crime and fidelity and performance bonds, are purchased from various insurance companies in amounts deemed adequate by Hertz for the respective hazards. ITEM 1. BUSINESS (continued). Vehicle Acquisition and Disposition Hertz believes it is the largest single private purchaser of new vehicles in the United States, buying and leasing approximately 269,000 vehicles in 1993. The acquisition and disposition of vehicles are, thus, important activities for Hertz and have a significant impact on profitability. Hertz obtains, subject to availability, a majority of its cars pursuant to various fleet programs established by original equipment manufacturers ("OEMs"). Such vehicles are deemed "nonrisk" because Hertz is able to return these vehicles to the OEMs at pre-established prices and time frames. In 1993, in Hertz' domestic and foreign operations, approximately 91% of the vehicles in the fleet were "nonrisk". Hertz disposes of "at risk" vehicles, whereby Hertz bears the economic risk of their eventual disposal, through wholesalers and miscellaneous other channels such as auctions. In recent years, the dynamics of the new and used car markets have had a negative impact on Hertz' sales efforts and Hertz has responded by purchasing fewer risk vehicles and by refining the vehicle mix of its fleet. Upon the sale of a vehicle, the difference between the net proceeds from sale and the remaining book value is recorded as an adjustment to depreciation in the period when sold (see Note 7 of the Notes to Consolidated Financial Statements included in this Report.) The average holding periods of vehicles and other revenue earning equipment are as follows: car rental vehicles 6 to 9 months, car leasing vehicles 36 months, and other equipment 18 to 48 months. At December 31, 1993, the average ages of owned vehicles and other revenue earning equipment are as follows: car rental vehicles 5 months, car leasing vehicles 18 months, and other equipment 28 months. At December 31, 1993, approximately 23% of owned vehicles and all other revenue earning equipment were "at risk." Domestically, approximately 74% of the vehicles purchased or leased in 1993 were manufactured by Ford Motor Company ("Ford"), 2% were manufactured by General Motors Corporation and the remainder were manufactured by Japanese and European manufacturers. In its foreign operations, Hertz utilizes vehicles manufactured abroad by subsidiaries of Ford and by other manufacturers. The percentage of vehicles procured from Ford is expected to continue at approximately this level in the future, pursuant to a long-term supply contract between the registrant and Ford. Hertz conducts purchase negotiations for all of the Hertz owned rental locations. Negotiations include determination of the initial purchase price of the vehicle and establishment of the payment terms with individual dealers. New vehicle guarantees of repurchase and/or depreciation, approval for using Hertz locations for warranty repairs, as well as the establishment of cooperative advertising and promotion programs are negotiated with the manufacturers. The purchases of vehicles are financed through funds provided from operations and by an active and ongoing global borrowing program. Domestic short-term requirements are funded primarily in the commercial paper market, while medium and long-term funds are obtained from the U.S. bond market or the Euro-markets. ITEM 1. BUSINESS (continued). Licensees and Associates The Hertz Corporation's wholly-owned subsidiaries, Hertz System, Inc. ("System") and Hertz International, Ltd. ("International"), respectively, issue licenses under franchise arrangements to independent licensees who are engaged in the vehicle renting and leasing business in the United States and many foreign countries. These licensees generally pay fees based on the number of vehicles they operate and/or on revenues. Licensees also share in the cost of the Hertz advertising program, reservations system, and certain other services. In return, licensees are provided with the use of the "Hertz" name, management and administrative assistance, training, the availability of Hertz charge cards, #1 Club, reservations service, the "Rent it Here-Leave it There" program and other services. System, which owns the Hertz service and trademarks and certain proprietary knowhow used by licensees, establishes the uniform standards and procedures under which all such licensees operate. The Hertz name has significant value. It is well known domestically and in all major international markets. System licenses ordinarily are limited as to transferability without Hertz' consent and are terminable by Hertz only for cause or after a fixed term. Licensees may generally terminate for any reason on 90 days notice to System. In some instances, the licenses may require purchase by System of license rights. The establishment and operations of all licensees are financed independently by the licensee with Hertz having no investment interest in the licensee (except for three foreign licensees) or in the licensee's fleet. Licenses outside the United States are granted by International, with the consent of System. Initial license fees or the price for the sale to a licensee of a corporate location may be payable over a term of several years. New licenses continue to be issued and in some cases licensee businesses are purchased by Hertz. In a small number of foreign countries, Hertz is associated with certain car rental firms in joint representation, marketing and reservations arrangements under which each party pays commissions to the other on completed rentals originated through reservations made by the other party. (These firms are referred to as "associates" in this Report.) Licensees and associates are of importance since they enable Hertz to offer expanded national and international service and a broader "Rent it Here-Leave it There" program. License fees and other payments made by licensees and associates do not contribute materially to Hertz' income. ITEM 1. BUSINESS (continued). Advertising Hertz conducts an active national and international advertising program, the cost of which, as noted above, is supported in part by contributions of the independent licensees. Hertz is also a party to a cooperative advertising agreement with Ford pursuant to which Ford participates in some of the cost of certain of Hertz' advertising programs in the United States and abroad which feature the Ford name or products. The advertising campaign also involves cooperative advertising arrangements with airlines, hotels and others in the travel industry. During the five year period ended December 31, 1993, total advertising and related expenditures of Hertz' advertising programs were approximately as follows: In addition, the licensees spend additional amounts for local advertising and sales promotions which feature the Hertz name. Employees On December 31, 1993, Hertz employed approximately 17,950 persons in its domestic and foreign operations. Labor contracts covering the terms of employment of approximately 4,800 employees in the United States are presently in effect with 96 local unions, affiliated primarily with the International Brotherhood of Teamsters and the International Association of Machinists (AFL-CIO). Labor contracts which cover approximately 2,300 of these employees will expire during 1994. Employee benefits in effect include group life insurance, hospitalization and surgical insurance, pension plans, and an income savings plan. Overseas employees are covered by a wide variety of union contracts and governmental regulations affecting, among other things, compensation, job retention rights and pensions. Hertz has had no material work stoppage as a result of labor problems during the last 10 years. Hertz believes its labor relations to be good. ITEM 1. BUSINESS (continued). Competition Hertz believes that, collectively with its affiliates, independent licensees and associates, its rent a car business is the largest in the world; that its licensed one-way truck rental business is one of the largest in the United States; and believes that its construction and materials handling equipment rental, lease and sales business is the largest in the United States. Hertz has substantial competitors with large resources in its rent a car and truck rental activities who compete with Hertz in all principal aspects of these activities, including price and service. Hertz is also faced with substantial competition from a growing number of smaller operators. At substantially all of its airport locations, it is faced with competition from one or more competitors on and off the airport. Competition in all of Hertz' areas of business is now, and is expected to continue to be, active and intense. Governmental Regulation Throughout the world, Hertz is subject to numerous types of governmental controls, including those relating to price regulation and advertising, currency controls, labor matters, charge card operations, environmental protection, used vehicle sales and franchising. The use of automobiles and other vehicles is subject to various governmental controls designed to limit environmental damage, including that caused by emissions and noise. Generally, these controls are met by the manufacturer, except in the case of occasional equipment failure requiring repair by Hertz. To comply with environmental regulations, measures are being taken at certain locations to reduce the loss of vapor during the fueling process and to maintain and replace underground fuel storage tanks. Hertz is also incurring and providing for expenses for the cleanup of fuel discharges and other alleged violations of environmental laws arising from the disposition of waste products. Hertz does not believe that it will be required to make any material capital expenditures for environmental control facilities or to make any other material expenditures to meet the requirements of governmental authorities in this area. Hertz' operations, as well as those of its competitors, could be affected by any limitation in the fuel supply or by any imposition of mandatory allocation or rationing regulations. In the event of a severe disruption of fuel supplies, the operations of all vehicle renting and leasing companies could be adversely affected. ITEM 2.

ITEM 2. PROPERTIES. Hertz' operations are carried on at approximately 1,800 locations at rental and sales offices and service facilities located at airports and in downtown and suburban areas. Most of such premises are leased, except for 93 which are owned in fee. Substantially all airport locations are leased from governmental authorities charged with the operation of such airports under arrangements generally providing for payment of rents and a percentage of revenues with a guaranteed annual minimum (see Note 9 of the Notes to Consolidated Financial Statements included in this Report). Hertz has facilities in the vicinity of Oklahoma City, operated under capital leases, at which reservations for its worldwide car rental operations are processed and major domestic accounting functions are performed. Hertz maintains its executive offices in a leased facility in Park Ridge, New Jersey in which Hertz has a 50% equity interest. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Various legal actions, governmental investigations and proceedings, and claims are pending or may be instituted or asserted in the future against the registrant and its subsidiaries. Litigation is subject to many uncertainties, and the outcome of the individual litigated matters is not predictable with assurance. It is reasonably possible that certain of the actions, investigations or proceedings could be decided unfavorably to the registrant or the subsidiary involved. Although the amount of liability at December 31, 1993 with respect to these matters cannot be ascertained, such liability could approximate up to $1.7 million (net of income tax benefits), and the registrant believes that any resulting liability should not materially affect the consolidated financial position, results of operations or cash flows of the registrant. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not required. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. There is no market for the registrant's common stock. All of the voting stock of the registrant is owned by Ford Motor Company, AB Volvo, Park Ridge Limited Partnership and Commerzbank Aktiengesellschaft. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. On July 19, 1993, Park Ridge was merged with and into the registrant. The merger has been recorded as a "pooling of interests". Under this method of accounting, when the entities before and after a merger are under common control with the same management, the operations are combined at historical cost. Consequently, the selected consolidated financial information of the registrant set forth in the following table prior to 1993 has been restated for all periods prior to the effective date of the merger, and is identical to and has been extracted from the audited consolidated financial statements of Park Ridge for such periods. The selected financial data for 1993 has been extracted from the audited consolidated financial information of the registrant for the year ended December 31, 1993. The information in the tables and the notes thereto should be read in conjunction with the "Management's Discussion and Analysis" and the registrant's consolidated financial statements and the notes thereto, which are included elsewhere in this Report. - ---------- (a) thru (g) see pages 13 and 14. ITEM 6. SELECTED FINANCIAL DATA (continued). (a) Depreciation of revenue earning equipment for the year 1993 includes net credits of $28.1 million as compared to net credits of $16.9 million in 1992, primarily attributable to higher proceeds received in 1993 on disposal of the equipment. The tax provision for the year 1993 includes a $1.1 million charge relating to the increase in net deferred tax liabilities as of January 1, 1993 due to changes in the tax laws enacted in August 1993, and a $2.0 million credit resulting from adjustments made to tax accruals in connection with tax audit evaluations and the effects of prior years' tax sharing arrangements between its former parent companies, UAL and RCA. Effective January 1, 1993, the registrant adopted the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("FAS No. 109"), which requires the recognition of deferred tax assets, net of applicable reserves, related to net operating loss carryforwards and certain temporary differences. The changes made in FAS No. 109, as they relate to the registrant, did not have a material effect on the registrant's consolidated financial position, results of operations or cash flows. (b) Depreciation of revenue earning equipment for the year 1992 includes net credits of $16.9 million as compared to net charges of $5.4 million in 1991, primarily attributable to higher proceeds received in 1992 on disposal of the equipment and the elimination of losses incurred in 1991 due to the increase in 1992 of "nonrisk" vehicles acquired which are returned to the vehicle manufacturers at pre-established prices. The tax provision includes credits of $9.8 million, $16.7 million, and $38.8 million for the years 1992, 1991 and 1990, respectively, resulting from adjustments made to tax accruals in connection with tax audit evaluations and the effects of prior years' tax sharing arrangements between the registrant and its former parent companies, UAL and RCA, and the reversal of tax accruals no longer required and benefits realized relating to certain foreign operations. The tax provision for the year 1991 also includes benefits of $5.5 million related to the close down and sale of certain unprofitable foreign operations. The decrease in income before income taxes for the year ended December 31, 1991, as compared to the prior year, was due to provisions made in 1991 of approximately $20 million primarily incurred to close down certain unprofitable foreign operations and depreciation adjustments made to residual values of certain vehicles, $15 million of lower interest income in 1991 primarily relating to refunds of prior years' income taxes, and the adverse effects of the decrease in travel due to the war in the Persian Gulf and a slowdown in the economy. The decrease was partly offset by net credits of $8.9 million relating to the sale and disposition of certain properties. (c) The tax provision for the year 1990 was favorable as compared to the tax provision for the prior year due to credit adjustments of $38.8 million recorded in 1990, resulting from adjustments made to tax accruals in connection with tax audit evaluations and the effects of prior years' tax sharing arrangements between the registrant and its former parent companies, UAL and RCA. ITEM 6. SELECTED FINANCIAL DATA (continued). (d) Effective January 1, 1992, the registrant adopted the provisions of Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions ("FAS No. 106"), which requires that postretirement health care and other non-pension benefits be accrued during the years the employee renders the necessary service. Prior to 1992, the registrant accrued for such benefits on a pay-as-you-go basis. As of January 1, 1992, the registrant recorded a cumulative decrease in net income of $4.3 million (net of $2.7 million tax benefit) as a result of implementing FAS No. 106. (e) Effective January 1, 1991, the registrant adopted the provisions of FASB Technical Bulletin No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts ("FAS No. 90-1"), which requires that proceeds received from warranty contracts should be deferred and recognized in income on a straight line basis over the contract period, and costs of services performed under the contract should be charged to expense as incurred. Prior to 1991, when vehicles were sold under an extended warranty contract, the proceeds received by the registrant under such contract, net of estimated costs to be incurred in fulfilling obligations under those contracts, were recorded in income when the sale occurred. As of January 1, 1991, the registrant recorded a cumulative decrease in net income of $3.5 million (net of $2.2 million tax benefit) as a result of implementing FAS No. 90-1. (f) Effective January 1, 1989, the registrant adopted the provisions of Statement of Financial Accounting Standards No. 96, Accounting for Income Taxes ("FAS No. 96"), which requires the use of the liability method in accounting for income taxes. Deferred tax assets and liabilities are recorded based on the differences between the financial statement and tax bases of assets and liabilities and the tax rates in effect when these differences are expected to reverse. In addition, deferred tax amounts are recorded with respect to assets and liabilities acquired in business combinations prior to adoption, when prior years' financial statements are not restated to reflect adoption of FAS No. 96. The cumulative decrease in net income as a result of implementing FAS No. 96 was $2 million. (g) Earnings have been calculated by adding interest expense and the portion of rentals estimated to represent the interest factor to income before income taxes. Fixed charges include interest charges (including capitalized interest) and the portion of rentals estimated to represent the interest factor. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. 1993 vs. 1992 Revenues in 1993 of $2,855 million increased by $39 million as compared to 1992. This improvement was primarily attributable to gains in the car rental operations resulting from a greater number of transactions and domestic rate increases, and higher revenues in telecommunication services and construction equipment rental and sales due to increased volume. These increases were principally offset by decreases in car leasing and car rental revenues resulting from changes in foreign exchange rates. Total expenses decreased $31 million to $2,753 million in 1993 as compared to $2,784 million in 1992. Direct operating expense increased principally due to higher costs in the car rental operations and in telecommunication services; these increases were partly offset by decreases resulting from changes in foreign exchange rates. Depreciation of revenue earning equipment increased primarily due to an increase in vehicles and equipment operated and the discontinuance by the domestic automobile manufacturers of fleet purchase cash incentives; partly offset by higher net proceeds received on disposal of revenue earning equipment in excess of book value, principally relating to the foreign and the construction equipment rental operations. In 1993, approximately 91% of the vehicles in the fleet were "nonrisk", which at the time of disposition will not result in any gain or loss. Selling, general and administrative expense decreased primarily due to lower administrative and advertising costs and changes in foreign exchange rates. The decrease in interest expense was primarily due to lower interest rates and higher interest income in 1993. The tax provision of $49 million in 1993 was $27 million higher than the tax provision in 1992, primarily due to higher income before income taxes in 1993 and changes in effective tax rates. The 1993 tax provision includes a $1.1 million charge relating to the increase in net deferred tax liabilities as of January 1, 1993 due to changes in the tax laws enacted in August 1993. The 1993 and 1992 tax provisions include credits of $2.0 million and $9.8 million, respectively, resulting from adjustments made to tax accruals in connection with tax audit evaluations and the effects of prior years' tax sharing arrangements between the registrant and its former parent companies, UAL and RCA. See Item 6 - Selected Financial Data and the notes thereto, and Notes 1 and 8 of the Notes to Consolidated Financial Statements included in this Report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (continued). 1992 vs. 1991 Revenues in 1992 of $2.8 billion increased by $.2 billion as compared to 1991. This improvement was primarily attributed to higher revenues in the car rental operations resulting from an increase in travel and changes in exchange rates; increased revenues in claim administration and telecommunication services due to increased volume in the businesses partly due to acquisitions; and, in Europe, higher revenues in car leasing and car dealership operations due to the higher volume of business, changes in the mix of vehicles being leased, and changes in exchange rates. These increases were partly offset by lower revenues in the foreign operations of construction equipment rental and sales. Total expenses increased $.2 billion to $2.8 billion in 1992 as compared to $2.6 billion in 1991. Direct operating expense increased principally due to higher volume in the car rental operations, increased costs in the claim administration and telecommunications service operations, higher costs in the domestic car rental operations for public liability and property damage claims, and net credits of $8.9 million included in 1991 relating to the sale and disposition of certain properties. Depreciation of revenue earning equipment increased primarily due to an increase in 1992 in the size of the car rental fleet and higher prices for the automobiles, substantially offset by higher net proceeds received on disposal of revenue earning equipment in excess of book value, and the additional depreciation recorded in 1991 to adjust residual values of certain vehicles partly related to the close down of certain unprofitable foreign operations. The adjustments included in depreciation of revenue earning equipment upon disposal of the equipment were $16.9 million credit in 1992 and $5.4 million charge in 1991; the improvement in 1992 was primarily attributable to the elimination of losses incurred in 1991 due to the increase in "nonrisk" vehicles in 1992, and higher proceeds received in 1992 on the sale of other equipment. In 1992, approximately 93% of the vehicles in the fleet were "nonrisk", which at the time of disposition will not result in any gain or loss. Selling, general and administrative expense increased primarily due to higher administrative expenses partly due to changes in exchange rates. The increase in interest expense was due to higher debt levels partly offset by lower interest rates in 1992. The tax provision of $22 million in 1992 was higher than the tax benefit of $1 million in 1991, primarily due to higher income before income taxes in 1992 and larger tax credits included in 1991. Tax credits of $9.8 million were included in 1992 and $22 million were included in 1991 resulting from adjustments made to tax accruals in connection with tax audit evaluations and the effects of prior years' tax sharing arrangements between the registrant and its former parent companies, UAL and RCA, and in 1991 the reversal of tax accruals no longer required and benefits realized relating to certain foreign operations. See Item 6 - Selected Financial Data and the notes thereto, and Notes 1 and 8 of the Notes to Consolidated Financial Statements included in this Report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (continued). Liquidity and Capital Resources Hertz' principal assets are highly liquid, consisting mainly of passenger automobiles and fairly standard classes of construction equipment. Disposal channels for these assets, including availability of vehicle manufacturers' guaranteed buyback programs, are large, well defined, and capable of absorbing Hertz' short fleet rotation requirements. Customer accounts receivable also turn rapidly and generate significant liquidity with approximately 30 days of sales outstanding. Cash requirements are highly seasonal, peaking when fleet acquisitions are the heaviest. In the annual business cycle, a typical low point for cash needs occurs during the fourth quarter. Hertz funds its domestic short-term borrowing requirements in the commercial paper market and through credit facilities with various banks. Hertz also has access to all global capital markets for its long-term debt requirements. Funding requirements of Hertz' foreign operations are generally provided through local currency short-term and revolving loans with local banks. During 1993 net cash flows used for operating activities of $558 million were primarily used for the net expenditures of revenue earning equipment. These expenditures were funded by net borrowings of $442 million, which included proceeds from the issuance of long-term debt of $846 million. The registrant has on file with the Securities and Exchange Commission, under Rule 415, a Registration Statement on Form S-3 which, as of December 31, 1993, allows the registrant to offer from time to time up to $300 million aggregate principal amount of its unsecured senior and senior subordinated debt securities on terms to be determined at the time the securities are offered for sale. In connection with this filing, the registrant issued in April 1993, $100 million, 6-1/2% Senior Notes, which mature April 1, 2000; issued in October 1993, $100 million, 6-3/8% Senior Notes, which mature October 15, 2005; and subsequently issued in February 1994, $150 million, 6% Senior Notes, which mature February 1, 2001. The funds were used for general corporate purposes and to reduce short-term borrowings. In July 1993, the registrant filed with the Securities and Exchange Commission, under Rules 415 and 430A, an additional Registration Statement on Form S-3, which allowed the registrant to offer from time to time up to $500 million aggregate principal amount of its unsecured debt securities, which may be senior, senior subordinated or junior subordinated in priority of payment, on terms to be determined at the time the securities are offered for sale. In connection with this filing, the registrant issued on July 19, 1993, $150 million, 6-5/8% Junior Subordinated Notes, which mature July 15, 2000; and $250 million, 7% Junior Subordinated Notes, which mature July 15, 2003. The proceeds from these borrowings were used to repay $334.3 million promissory notes of Park Ridge and to reduce short-term borrowings. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (continued). Liquidity and Capital Resources (continued) As of December 31, 1993, under a lease agreement with a third party lessor, the registrant may, at its option, lease from the third party lessor up to $500 million net cost of vehicles at any one time. At December 31, 1993, the net cost of the vehicles leased under this agreement was approximately $407 million (see Note 7 of the Notes to Consolidated Financial Statements included in this Report). At December 31, 1993, Hertz had approximately $1.6 billion of consolidated unused lines of credit subject to customary terms and conditions, which includes unused amounts under domestic bank facilities totalling $500 million to support commercial paper and other short-term borrowings. At December 31, 1993, approximately $52 million of the registrant's consolidated shareholders' equity was free of dividend limitations pursuant to its existing debt agreements. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", which requires a more detailed disclosure of debt and equity securities held for investment, the methods to be used in determining fair value, and when to record unrealized holding gains and losses in earnings or in a separate component of shareholders' equity for fiscal years beginning after December 15, 1993. Implementation of the standard is not expected to have a material effect on Hertz' consolidated financial position, results of operations or cash flows. Financial reporting in the United States has traditionally been expressed by virtually all companies in terms of historical or actual costs only. Financial data comparing historical dollars expended or received in different years do not reflect the impact of inflation for Hertz, except, as of December 30, 1987, in accordance with the purchase method of accounting, assets and liabilities of Hertz were recorded at their estimated fair value. As a result of this change, the value of Hertz' net assets included the effects of inflation as of December 30, 1987. Since a significant portion of the assets of Hertz, namely "revenue earning equipment" is held for a short period of time, the effects of inflation on Hertz' financial data after December 30, 1987 are not significant. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Consolidated Balance Sheet of the registrant at December 31, 1993 and 1992, and the related Consolidated Statement of Income and Reinvested Earnings and Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991, and other financial statement schedules are set forth under Item 14 hereof. Selected quarterly data for each quarter of the years 1993 and 1992 is set forth in Note 13 of the Notes to Consolidated Financial Statements included in this Report. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information regarding the directors and executive officers of the registrant, and their ages as of February 7, 1994, are as follows: All directors are elected annually to serve until the next annual meeting of shareholders and until their successors have been elected and qualified. The election of directors is governed by a Stockholders Agreement dated as of July 7, 1993 among Ford, Park Ridge Limited Partnership, Ford Motor Credit Company, AB Volvo, Commerzbank Aktiengesellschaft, the registrant and Park Ridge. Directors are not paid any compensation for their services as directors but are reimbursed for expenses incurred in connection with attending directors' meetings. Officers are elected at the organization meeting of the Board of Directors held each year for a term of one year and they are elected to serve until the next annual meeting. Mr. Olson has been Chairman of the Board of Directors since June 1980, and a director of the registrant since November 1974. In August 1987, he became President and a director of Park Ridge Corporation (the registrant's parent prior to July 19, 1993), Park Ridge, New Jersey. From June 9, 1987 to December 12, 1987 he was Chairman of the Board, President and Chief Executive Officer of UAL Corporation, Elk Grove, Illinois (the registrant's former parent). He is also a director of Becton, Dickinson and Co., Franklin Lakes, New Jersey; Cooper Industries, Inc., Houston, Texas; UAL Corporation, Chicago, Illinois; Commonwealth Edison Co., Chicago, Illinois; and Foundation Health Corporation, Rancho Cordova, California. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (continued). Mr. Koch was elected President and Chief Operating Officer of the registrant on September 1, 1993. From February 1988 through August 1993 he served as Executive Vice President and President of North America Rent A Car operations of the registrant. He served as President and Chief Operating Officer of the registrant from May 1987 to February 1988. In October 1983 he became Executive Vice President and General Manager of the registrant's Rent A Car Division after having served as Vice President and General Manager since March 1980. He previously served as a director of the registrant from May 1987 to July 1993 and from October 1983 to September 1985. Mr. Kaplan was elected Executive Vice President of the registrant in May 1987. Previously, he was Vice President, Materials and Support Services from July 1982 to September 1982 and continued as a Vice President until May 1987. In September 1982, he was elected a director and President of Hertz Equipment Rental Corporation, a subsidiary of the registrant. Mr. Kennedy was elected Executive Vice President, Sales and Marketing of the registrant in February 1988. From May 1987 through January 1988, he served as Executive Vice President and General Manager of the Rent A Car Division of the registrant, prior to which, from October 1983, he served as Senior Vice President, Marketing. Mr. Sider was elected Executive Vice President and Chief Financial Officer of the registrant in February 1988. During the period January 1988 until July 1993, he served Park Ridge as a director and Executive Vice President - Finance at various times. From June 25, 1987 to December 31, 1987, he served as Chief Financial Officer of UAL Corporation, Elk Grove, Illinois. From October 1983 to February 1988, he served as Senior Vice President, Finance of the registrant. In April 1981, he was elected Vice President, Finance, and in 1980 served as Vice President and Controller of the registrant. He has been a director of the registrant since October 1983. Mr. Bailey was elected Senior Vice President of the registrant in May 1990. Previously, he served in various functions with the registrant since 1956, except for the years 1966 and 1981. Mr. Blake was elected Senior Vice President, Properties and Facilities of the registrant in February 1988. In December 1984, he was elected Vice President, Properties and Facilities. Previously, he served in various functions with the registrant since 1970. Mr. Steele was elected Senior Vice President, Employee Relations of the registrant in July 1984. Previously, he served in various functions with the registrant since 1972. Mr. Tschirhart was elected Senior Vice President and General Counsel of the registrant in October 1986 and was elected Secretary in February 1988. Previously, he served as Senior Counsel for United Airlines, Inc., Elk Grove, Illinois, since 1982. Mr. Cau was elected Vice President of the registrant and President of Hertz International, Ltd., a subsidiary of the registrant, in April 1990. Previously, he served in various functions with Hertz International, Ltd. foreign operations since 1973. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (continued). Mr. Nothwang was elected Vice President and General Manager U.S. Rent A Car on September 1, 1993. Previously he served as Division Vice President, Region Operations since 1985. He has served in various operating positions since 1976. Mr. Santorelli was elected Vice President, Insurance of the registrant in March 1986 and in September 1986, he was elected President of Hertz Claim Management Corporation, a subsidiary of the registrant. Previously, he served in various positions with the registrant since 1977. Mr. Massad was elected Controller of the registrant in July 1986. Previously, he served in various positions with the registrant since 1965. Mr. Rillings was elected Treasurer of the registrant in November 1986. Previously, he served in various positions with the registrant since 1961. Ms. Staebler was elected Secretary of the registrant in July 1993. She served as Vice President and Secretary of Park Ridge from November 1992 until July 1993. Ms. Staebler is Assistant General Counsel - Corporate Transactions for Ford. From 1986 until May, 1993, she was Associate Counsel - Corporate Transactions for Ford. Mr. Dowden was elected a director of the registrant and became a member of the Compensation Committee in July 1993. Mr. Dowden served Park Ridge as a director from April 1991 until July 1993 and as Executive Vice President from January 1993 until July 1993. He is President, Chief Executive Officer and director of Volvo North America Corporation and Senior Vice President of its parent company, AB Volvo. From 1986 to 1991 he was Executive Vice President (Deputy Chief Executive Officer) and director of Volvo North America Corporation. Mr. Macdonald was elected an Assistant Treasurer and a director of the registrant and became a member of the Audit Committee in July 1993. During the period December 1987 until July 1993, he served Park Ridge as a director, Executive Vice President, Vice President, and Treasurer at various times. He became an Assistant Treasurer of Ford on September 10, 1981. He is also a director of Ford Holdings, Inc. Mr. Marrs was elected a director of the registrant in July 1993. He served as a director of Park Ridge from December 1990 until July 1993 and Executive Vice President from January 1993 until July 1993. From 1988 until 1990 he was Manager of Finance - North American Financial Services Group of Ford. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (continued). Mr. McCammon was elected a director of the registrant and became Chairman of the Audit Committee and a member of the Compensation Committee in July 1993. He served as a director and Executive Vice President of Park Ridge from August 1987 until July 1993. He was elected Vice President - Finance and Treasurer of Ford on October 13, 1987. Mr. McCammon is also a director of Ford Holdings, Inc. and Ford Motor Credit Company. Mr. Palm was elected a director of the registrant in July 1993. He was a director and Executive Vice President of Park Ridge from January 1993 until July 1993. He is President and Chief Executive Officer of Volvo Cars of North America, Inc. Prior to assuming his current responsibilities, Mr. Palm was Executive Vice President of Volvo Car Corporation, Gothenburg, Sweden. From 1985-1989 he was President of Volvo do Brasil Motores e Velculos S.A., in Curitiba, Brazil. Mr. Pestillo was elected a director of the registrant and Chairman of the Compensation Committee in July 1993. He served Park Ridge as Executive Vice President, director and Chairman of the Compensation Committee from August 1989 until July 1993. He is Executive Vice President, Corporate Relations of Ford. He was Vice President, Corporate Relations and Diversified Businesses of Ford from April 1990 to January 1993. From January 1986 to April 1990 he was Vice President, Employee and External Affairs for Ford. He is also a director of Rouge Steel Company. Mr. Reimnitz was elected a director of the registrant in July 1993. He served as a director of Park Ridge from June 1989 until July 1993. He has been a member of the Board of Managing Directors of Commerzbank Aktiengesellschaft since 1973. He is also a director of Commerzbank Capital Markets Corporation. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The following table sets forth the compensation earned and/or paid to the registrant's five most highly compensated executive officers for services rendered in all capacities to the registrant for the fiscal years ended December 31, 1993, 1992 and 1991. Compensation of the executive officers are reviewed and approved by the registrant's Compensation Committee and are determined in part by the operating performance and the contributions made to the consolidated results of the registrant. The members of the Compensation Committee are Peter J. Pestillo (Chairman), Albert R. Dowden and David N. McCammon, all of whom are directors of the registrant, are not employees of the registrant, and are not eligible to participate in the registrant's compensation plans. SUMMARY COMPENSATION TABLE (5) (1) Amounts included consist of salary payments for the respective year and amounts deferred pursuant to section 401(k) of the Internal Revenue Code. (2) Includes executive and long term incentive bonuses earned and paid for the respective year. The long term incentive first year (1991) award was determined in 1992 and was paid in 1992, and such amounts were included in the amounts reported for 1991 under "Bonus"; 1992 awards paid in 1993 were included in 1993 under "Long Term Compensation Payouts"; 1993 awards to be paid in 1994 have not yet been determined. (3) Includes the following for the years 1993, 1992 and 1991 (in thousands): $36, $51 and $52 housing allowance; $6, $7 and $11 automobile use; and $24, $28 and $28 tax equalization payments, respectively. (4) Represents the amounts contributed by the registrant to the Income Savings Plan for the respective year. (5) The registrant has not granted or issued any stock options or stock appreciation rights. ITEM 11. EXECUTIVE COMPENSATION (continued). Incentive Compensation Plans The registrant has an Executive Incentive Compensation Plan for key employees and officers of the registrant and its subsidiaries. The grant of awards and the size thereof depends upon the degree to which each operation's financial targets (pretax income and return on total capital, each as defined) approved by senior officers of the registrant and members of the registrant's Compensation Committee, are reached or exceeded. Performance is measured annually, and the awards are paid in full in the following year, or may be deferred pursuant to a prior election by a participant, to a period selected by the participant. In 1991, the registrant established a Long Term Incentive Plan for officers and other key employees of the registrant and its subsidiaries. The grant of awards and the size thereof will be determined by the achievement of certain qualitative and quantitative performance targets. A new four year performance cycle begins on each January 1. Performance is measured in four year periods and awards will be made in cash at the end of each performance period. The performance factors used include net income of the registrant relative to the net income average for the Dow 30 Industrials, market share and customer satisfaction. To phase in this plan, transitional grants were made as of January 1, 1991, covering one-year, two-year and three-year performance periods. Awards made in 1993 to the registrant's five most highly compensated executive officers are set forth in the table below. LONG TERM INCENTIVE PLANS - AWARDS IN 1993 (1) Awards for 1993 will be determined by 1993 performance versus performance for the three years ended December 31, 1992, and will be paid in 1994. The registrant also maintains Field Incentive Compensation Plans for certain employees of the registrant and its subsidiaries. Awards are made and paid annually based on the achievement of revenue and pretax income objectives. Each award is determined and approved by the registrant's Compensation Committee. ITEM 11. EXECUTIVE COMPENSATION (continued). Income Savings Plan The Income Savings Plan of The Hertz Corporation ("Hertz") was established effective August 30, 1985. Prior thereto, Hertz salaried employees participated in the RCA Income Savings Plan ("RCA Plan"). The assets and liabilities maintained under the RCA Plan attributable to participating Hertz salaried employees were transferred as of September 1, 1985 to Hertz' Income Savings Plan (the "Plan"). Under the Plan, Hertz continued substantially the same provisions as provided under the RCA Plan, except for the following: (1) the RCA Stock Fund as an investment option was discontinued and was reinvested in other investment funds as elected by the participants, and (2) the eligibility requirement for salaried employees hired on or after September 30, 1985 was changed to two years of service in lieu of the one year of service previously required. Effective January 1, 1989, the eligibility requirement was reduced to one year of service. The Plan is a defined contribution plan available to certain full-time and part-time salaried employees of Hertz, who have been credited with at least 1,000 hours of service during any twelve consecutive months commencing on the day he/she is credited with his/her first hour of service. Employees covered by a collective bargaining agreement are not eligible to participate in the Plan. As explained below, Hertz contributes a fixed percentage of eligible employees' base salary. Employees may also elect to have Hertz contribute on their behalf, subject to a percentage limitation, any whole percentage of their base salary to the Plan, in lieu of being paid such salary in cash under a qualified cash or deferred arrangement described in Section 401(k) of the Internal Revenue Code. Prior to July 1, 1987, employees could also make their own contributions of their base salary, subject to a percentage limitation. Effective July 1, 1987, the Plan was amended whereby Hertz contributes a percentage of eligible employees' salary only if the employee elects to contribute a portion of his/her base salary. Hertz' contribution was 66% of the first 6% of the employee's contribution for a maximum Hertz match of 4% of the employee's base salary. Employee after tax contributions were eliminated. Effective January 1, 1988, the Plan was further amended to change Hertz' contribution from 66% to 50% of the first 6% of the employee's contribution for a maximum Hertz match of 3% of the employee's base salary. Effective July 1, 1991, Hertz' contribution was suspended and was resumed on January 1, 1992. Employees hired prior to January 1, 1987 become fully vested when contributions are made. Employees hired on or after January 1, 1987 become fully vested in the amount contributed by Hertz after the employee completes five years of service. Each Plan member determines the fund distribution to which contributions will be applied. The funds include the General Common Stock Fund, a commingled index fund investing in common stock (shares in medium to large-size companies chosen for the purpose of approximating the rate of growth for the S&P 500 Composite Stock Index); the Fixed Income Fund invested in a managed commingled fund with high quality fixed rate securities, as well as with insurance companies that guarantee interest rates at agreed upon levels; a Balanced Fund consisting of a mix of stocks or bonds ranging from 30% to 70% (stocks are in medium to large-size companies chosen for the purpose of approximating the rate of growth for the S&P 500 Composite Stock Index, and bonds are in U.S. Treasury and Agency issues, as well as, high quality Corporate issues). Plan funds may be invested in interim investments prior to investments in the General Common Stock Fund, Fixed Income Fund and the Balanced Fund. Distributions are based on the unit value of the employee's account as of the valuation date next occurring after retirement, termination of service, or withdrawal from the Plan. Withdrawals are subject to conditions stated in the Plan. ITEM 11. EXECUTIVE COMPENSATION (continued). Pension Plan Effective August 30, 1985, The Hertz Corporation established the Retirement Plan for the Employees of The Hertz Corporation ("Hertz Plan"). Prior thereto, Hertz participated in the Retirement Plan for the Employees of RCA Corporation and Subsidiary Companies ("RCA Plan"). The assets and liabilities associated with benefits accrued by participating employees of Hertz as of August 30, 1985 were retained under the RCA Plan. Benefits accrued by Hertz' employees through August 30, 1985 will be paid under the RCA Plan. The Hertz Plan amended the RCA Plan in the form of a restated plan which continued the RCA Plan for Hertz employees without interruption. The Hertz Plan is qualified under the Internal Revenue Code and is a defined benefit plan for which contributions were made by the employees up to June 30, 1987 and by the employer. Effective July 1, 1987, the Hertz Plan was revised to an "Account Balance Pension Plan" under which Hertz pays the entire cost and employees are no longer required to contribute. Employees are eligible for participation in the Plan on the first day of the month coinciding with or following the date on which they complete one year of continuous service, as defined by the Employee Retirement Income Security Act of 1974 ("ERISA"). Employees covered by a collective bargaining agreement are not eligible unless their union contract makes the Hertz Plan applicable to them. Effective July 1, 1987, employees are credited annually with 3% of their pensionable earnings. This benefit is credited with guaranteed interest rates compounded annually based on rates issued by the Pension Benefit Guaranty Corporation in effect for the preceding December. In addition, all employees age 50 or over with 10 or more years of service as of July 1, 1987, will have an additional amount of their pensionable earnings credited to their account as follows: 1% for ages 50 through age 54, 2% for ages 55 through 59 and 3% for ages 60 and over. Officers of the registrant and its subsidiaries participate in the Hertz Plan. The amount of the normal retirement benefit under these plans is determined as a percentage of final average compensation (highest five of last ten years of covered compensation), based upon years of participation up to July 1, 1987. Effective July 1, 1987, the normal retirement benefit will be the value of their cash balance account accrued after July 1, 1987. The benefits are not offset by Social Security. Compensation covered by the Hertz Plan means all salary and wages, including overtime and premium pay, sales commissions and amounts paid under executive and field compensation plans. Set forth on the next page is a table indicating annual pension benefits payable under the plan formula prior to July 1, 1987, applicable to the Hertz Plan for participants in specified remuneration and years of service classifications, based on retirement at age 65 and selection of a straight life annuity (other annuity options are available, which would reduce the amounts shown on the following page). The amounts shown on the following page do not reflect limitations imposed by ERISA on retirement benefits which may be paid under plans qualified under the Internal Revenue Code. The registrant has instituted non-qualified pension plans for its officers to pay those benefits under the qualified plans which would otherwise be subject to the ERISA limitations. These plans have been filed with the Internal Revenue Service. ITEM 11. EXECUTIVE COMPENSATION (continued). PENSION PLAN TABLE Credited service with the registrant and its subsidiaries for persons named in the cash compensation table is as follows: Mr. Olson - 27 years; Mr. Koch - - 21 years; Mr. Sider - 27 years; and Mr. Kaplan - 15 years. Mr. Cau does not participate in the Hertz Plan or the RCA Plan. Employment Agreements Messrs. Olson, Koch, Sider, and Kennedy serve the registrant under employment agreements which currently expire on April 30, 1999, April 30, 1999, June 30, 1997, and June 30, 1997, respectively. Mr. Cau serves a subsidiary of the registrant under an employment agreement dated January 1, 1990, as amended, that is terminable by either party under certain circumstances stated therein. Mr. Daniel I. Kaplan serves a subsidiary of the registrant under an employment agreement which currently expires on December 14, 1994. The employment agreements do not provide for any compensatory plan or arrangement or termination of employment or change in control, except for the compensation of Antoine E. Cau (portions of his contract which were filed as an Exhibit to the registrant's report on Form 10-K for the year 1990, were granted confidential treatment under Rule 24b-2). Employment agreements of Messrs. Olson and Koch are automatically extended one (1) additional year unless not later than December 31st of the preceding year, the registrant or the executive shall have given notice not to extend the agreement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Park Ridge purchased all of the registrant's outstanding capital stock from UAL on December 30, 1987. On July 19, 1993, Park Ridge (which had no material assets other than the registrant) was merged with and into the registrant, with the prior stockholders of Park Ridge becoming the stockholders of the registrant. As of December 31, 1993, 76% of the Preferred Stock and 49% of the Common Stock of the registrant was owned by Ford (with a Ford subsidiary), 20% of the Common Stock was owned by Park Ridge Limited Partnership ("Partnership"), whose general partner is Frank A. Olson, Chief Executive Officer of the registrant, 24% of the Preferred Stock and 26% of the Common Stock was owned by AB Volvo ("Volvo") and 5% of the Common Stock was owned by Commerzbank Aktiengesellschaft ("Commerzbank"). Election of directors, public and private sales of equity securities and other matters related to the registrant are governed by a Stockholders Agreement dated as of July 7, 1993 among Ford, the Partnership, Ford Motor Credit Company, Volvo, Commerzbank, the registrant and Park Ridge. The following table sets forth certain information with regard to the beneficial ownership of the outstanding capital stock of the registrant, by each director of the registrant individually and by all directors and officers of the registrant as a group. Unless otherwise noted, the persons named in the table have sole voting and investment power with respect to all shares shown as beneficially owned by them: (1) Represents 100% of Class A Common Stock. All such shares are owned by the Partnership of which Mr. Olson is the sole general partner with sole voting power with respect to such shares. Messrs. Olson and Sider, who are directors of the registrant, are limited partners of the Partnership. In connection with the acquisition of the registrant on December 30, 1987 by Park Ridge, the Partnership contributed $20 million to Park Ridge, which included $1.5 million in cash and a $18.5 million, 10% Secured Promissory Note (the "Partnership Note"). As of December 31, 1993, the registrant had a receivable of $27.1 million due from the Partnership relating to the Partnership Note. The Partnership Note is secured by a pledge of the Common Stock of the registrant owned by the Partnership and is payable out of the proceeds of a dividend, distribution or other disposition of the Partnership's Common Stock in accordance with the Partnership Note. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (continued). In May 1990, Ford (with a Ford subsidiary) loaned $150 million in the form of subordinated debt (the "FMCC Note") to Park Ridge, which was assumed by the registrant upon the merger and is subordinated in right of payment to all "Superior Indebtedness" (as defined for purposes of the FMCC Note). The FMCC Note bears interest at a floating rate and matures on May 17, 2000. In addition, upon the first to occur of certain events, the registrant will be required to accrue additional interest ("Contingent Interest") on the FMCC Note as a payable due on maturity of the FMCC Note and ranking pari passu with the FMCC Note. In the event of a sale by the registrant of the stock or assets of either (a) Hertz Equipment Rental Corporation and its subsidiaries and certain affiliates ("HERC", as defined for purposes of the FMCC Note) or 20% or more of the net assets of HERC or (b) certain subsidiaries and certain licenses of Hertz International, Ltd. ("Hertz Europe", as defined for purposes of the FMCC Note) or 20% or more of the stockholder's equity of Hertz Europe, the registrant will be obligated to pay Contingent Interest equal to 50% of the amount by which the selling price thereof exceeds a base price thereof determined as of December 31, 1989 and adjusted thereafter to reflect changes in the net assets of HERC or changes in the stockholder's equity of Hertz Europe, respectively (computed on a pro rata basis if less than 100% is sold). In the case of the first such sale (whether relating to HERC or Hertz Europe), however, if the excess of the selling price over the adjusted base price of the entity being sold is less than the excess of the value of the entity not being sold (determined pursuant to an appraisal procedure) over its adjusted base price, then such sale shall not constitute an "event" for purposes of the preceding sentence. In the event of (x) the closing of an initial public offering of common stock issued by the registrant in accordance with the Stockholders Agreement among the registrant and its stockholders or (y) the FMCC Note becoming due and payable by reason of maturity, notice of prepayment or otherwise, the registrant will be obligated to pay Contingent Interest equal to 50% of the greater of (i) the amount by which the value of HERC (determined pursuant to an appraisal procedure) exceeds the adjusted base price thereof and (ii) the amount by which the value of Hertz Europe (determined pursuant to an appraisal procedure) exceeds the adjusted base price thereof, except that if HERC or Hertz Europe or a portion thereof was sold prior to the event referred to in (x) or (y) and such sale did not result in the determination of Contingent Interest, then Contingent Interest shall be determined with respect to the entity so sold. In 1994, Ford expects to acquire additional shares of Common Stock of the registrant, including Commerzbank's 5% of the registrant's Common Stock bringing Ford's ownership of the registrant's voting stock to 54%. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Hertz is party to a cooperative advertising agreement with Ford (see Item 1 - - Business - Advertising included in this Report). In addition, for each of the five years ended December 31, 1993, Hertz' domestic revenue earning vehicles included approximately 70% Ford products and 2% Volvo products. In its foreign operations, Hertz utilizes vehicles manufactured abroad by subsidiaries of Ford (which for the five years ended December 31, 1993, represented in the aggregate approximately 40% of Hertz' fleet) and by other manufacturers. Ford products are purchased from dealers who are independent from Ford. The percentages of Ford and Volvo products purchased by Hertz are expected to continue at approximately this level in the future, pursuant to long-term supply contracts between the registrant and Ford and the registrant and Volvo. Hertz purchases the vehicles from Ford dealers and Volvo at competitive prices. In 1992, the registrant entered into a lease agreement with a third party lessor providing for the lease of vehicles purchased by the third party lessor under a repurchase program offered by Ford. Under the lease, which is accounted for as an operating lease, the registrant makes payment equal to the monthly depreciation and all expenses (including interest) of the third party lessor and is responsible for the remaining net cost on any vehicles that become ineligible under the repurchase program. At December 31, 1993, the net cost of the vehicles leased under this agreement was approximately $407 million. See Note 7 of the Notes to Consolidated Financial Statements included in this Report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (continued). 3. Exhibits (continued): (4) Instruments defining the rights of security holders, including indentures. (iii) At December 31, 1993, Hertz had various obligations which could be considered as long-term debt, none of which exceeded 10% of the total assets of Hertz on a consolidated basis. Hertz agrees to furnish to the Commission upon request a copy of any such instrument defining the rights of the holders of such long-term debt. (10) Material Contracts. (i) (a) Agreement dated December 30, 1985 between The Hertz Corporation and Allegis Corporation incorporated herein by reference to Exhibit (10)(i)(a) to the registrant's report on Form 10-K for the year ended December 31, 1985 (File No. 1-7541). (b) Use Agreement dated December 30, 1985 between The Hertz Corporation and Allegis Corporation incorporated herein by reference to Exhibit (10)(i)(b) to the registrant's report on Form 10-K for the year ended December 31, 1985 (File No. 1-7541). (ii)(A) Stockholders Agreement dated as of July 7, 1993, among Ford Motor Company, Park Ridge Limited Partnership, Ford Motor Credit Company, AB Volvo, Commerzbank Aktiengesellschaft, The Hertz Corporation, Park Ridge Corporation, and the persons that become parties thereto pursuant to the terms thereof. (Portions of this Exhibit have been omitted pursuant to a request for confidential treatment of such omitted information under Rule 24b-2.) (ii)(B)(a) Agreement dated January 1, 1988 between The Hertz Corporation and Ford Motor Company (portions of this Exhibit have been omitted and granted confidential treatment under Rule 24b-2) incorporated herein by reference to Exhibit (10)(ii)(B)(a) to the registrant's report on Form 10-K for the year ended December 31, 1987 (File No. 1-7541). (b) Agreement dated January 1, 1988 between Hertz System, Inc. and Ford Motor Company (portions of this Exhibit have been omitted and granted confidential treatment under Rule 24b-2) incorporated by reference to Exhibit (10)(ii)(B)(b) to the registrant's report on Form 10-K for the year ended December 31, 1987 (File No. 1-7541). (c) Agreement dated September 25, 1992 between Hertz System, Inc. and Ford Motor Company. (Portions of this Exhibit have been omitted and granted confidential treatment under Rule 24b-2) incorporated by reference to Exhibit (10)(ii)(B)(c) to the registrant's report on Form 10-Q for the quarterly period ended September 30, 1992 (File No. 1-7541). ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (continued). 3. Exhibits (continued): (10) Material Contracts (continued): (iii)(A) (a) Employment contract with Frank A. Olson dated April 16, 1987, as amended December 30, 1987, incorporated by reference to Exhibit (10)(iii)(A)(a) to the registrant's report on Form 10-K for the year ended December 31, 1987 (File No. 1-7541). (b) Employment contract with Craig R. Koch dated April 16, 1987, as amended December 30, 1987, incorporated by reference to Exhibit (10)(iii)(A)(b) to the registrant's report on Form 10-K for the year ended December 31, 1987 (File No. 1-7541). (c) Employment contract with William Sider dated July 1, 1992, incorporated by reference to Exhibit (10)(iii)(A)(c) to the registrant's report on Form 10-K for the year ended December 31, 1992 (File No. 1-7541). (d) Employment contract with Brian J. Kennedy dated July 1, 1992, incorporated by reference to Exhibit (10)(iii)(A)(d) to the registrant's report on Form 10-K for the year ended December 31, 1992 (File No. 1-7541). (e) Employment contract with Daniel I. Kaplan dated December 14, 1989, incorporated by reference to Exhibit (10)(iii)(A)(f) to the registrant's report on Form 10-K for the year ended December 31, 1989 (File No. 1-7541). (f) Employment contract with Antoine E. Cau dated January 1, 1990, as amended April 4, 1990, December 13, 1990 and December 18, 1990 (portions of this Exhibit have been omitted and granted confidential treatment under Rule 24b-2) incorporated by reference to Exhibit (10)(iii)(A)(f) to the registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-7541). (g) Executive Incentive Compensation Plan, incorporated by reference to Exhibit (10)(iii)(A)(g) to the registrant's report on Form 10-K for the year ended December 31, 1989 (File No. 1-7541). (h) Long Term Incentive Plan, incorporated by reference to Exhibit (10)(iii)(A)(h) to the registrant's report on Form 10-K for the year ended December 31, 1991 (File No. 1-7541). ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (continued). 3. Exhibits (continued): (12) Computation of Consolidated Ratio of Earnings to Fixed Charges for each of the five years in the period ended December 31, 1993. (21) Subsidiaries of the registrant. Listing of subsidiaries of the registrant at December 31, 1993. (23) Consents of experts and counsel. Consent to the incorporation by reference of report of independent public accountants in previously filed registration statements under the Securities Act of 1933. (b) Reports on Form 8-K: The registrant filed a Form 8-K dated October 15, 1993 reporting under Items 5 and 7 thereof (a) certain audited consolidated financial statements of Park Ridge, which prior to July 19, 1993 was the parent corporation of the registrant and which on July 19, 1993 was merged with and into the registrant, (b) the report of Arthur Andersen & Co., independent public accountants, on such financial statements, and (c) the consent of Arthur Andersen & Co. to the inclusion of such report in Registration Statements on Form S-3 (File Nos. 33-39145 and 33-62902) filed by the registrant with the Securities and Exchange Commission covering the issuance of Debt Securities by the registrant. Schedules and exhibits not included above have been omitted because the information required has been included in the financial statements or notes thereto or are not applicable or not required. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE HERTZ CORPORATION (Registrant) By: /s/ William Sider ---------------------------------- William Sider Executive Vice President and Chief Financial Officer March 8, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the indicated capacities, on March 8, 1994: /s/ Frank A. Olson /s/ Craig R. Koch - --------------------------------- --------------------------------------- Frank A. Olson Craig R. Koch Chairman of the Board, Chief President and Chief Operating Officer Executive Officer and Director (Principal Executive Officer) /s/ William Sider /s/ Leo A. Massad, Jr. - --------------------------------- --------------------------------------- William Sider Leo A. Massad, Jr. Executive Vice President and Staff Vice President and Controller Chief Financial Officer (Principal Accounting Officer) and Director (Principal Financial Officer) /s/ Terrence F. Marrs /s/ David N. McCammon - --------------------------------- --------------------------------------- Terrence F. Marrs David N. McCammon Director Director /s/ Peter J. Pestillo - --------------------------------- Peter J. Pestillo Director REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Hertz Corporation: We have audited the accompanying consolidated balance sheet of The Hertz Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and reinvested earnings and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Hertz Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 1 to the consolidated financial statements, effective January 1, 1992 and January 1, 1991, the Company changed its methods of accounting for postretirement benefits other than pensions and for warranty contracts in order to comply with the Statement of Financial Accounting Standards No. 106 and the Financial Accounting Standards Board Technical Bulletin No. 90-1, respectively. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)2(i) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, New York February 7, 1994 THE HERTZ CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN THOUSANDS OF DOLLARS) ASSETS The accompanying notes are an integral part of this statement. THE HERTZ CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN THOUSANDS OF DOLLARS) LIABILITIES AND SHAREHOLDERS' EQUITY The accompanying notes are an integral part of this statement. THE HERTZ CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME AND REINVESTED EARNINGS (IN THOUSANDS OF DOLLARS) The accompanying notes are an integral part of this statement. THE HERTZ CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS OF DOLLARS) The accompanying notes are an integral part of this statement. THE HERTZ CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands of Dollars) In connection with acquisitions made during the years 1993 and 1991, liabilities assumed were $2.1 million and $.8 million, respectively. The accompanying notes are an integral part of this statement. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies Merger and Capitalization -- the registrant, which was incorporated in Delaware in 1967, is a successor to corporations which were engaged in the automobile and truck leasing and rental business since 1924. UAL Corporation ("UAL") (formerly Allegis Corporation) purchased all of the registrant's outstanding capital stock from RCA Corporation ("RCA") on August 30, 1985. Park Ridge Corporation ("Park Ridge") purchased all of the registrant's outstanding capital stock from UAL on December 30, 1987. On July 19, 1993, Park Ridge (which had no material assets other than the registrant) was merged with and into the registrant, with the prior stockholders of Park Ridge becoming the stockholders of the registrant. The merger has been recorded as a "pooling of interests". Under this method of accounting, when the entities before and after a merger are under common control with the same management, the operations are combined at historical cost. Consequently, the consolidated financial statements of the registrant included herein have been restated for all periods prior to the effective date of the merger, and are identical to the audited consolidated financial statements of Park Ridge for such periods. On the date of the merger, the registrant refinanced $334.3 million promissory notes of Park Ridge through the public issuance of $400 million aggregate principal amount of junior subordinated debt securities of the registrant; and a $150 million loan to Park Ridge from Ford Motor Credit Company ("FMCC") in the form of subordinated debt was assumed by the registrant (the "FMCC Note"). The FMCC Note, which has a scheduled maturity date of May 17, 2000, is subordinated in right of payment to all "Superior Indebtedness" (as defined for purposes of the FMCC Note) of the registrant including the junior subordinated debt securities referred to above. As of December 31, 1993, 76% of the Preferred Stock and 49% of the Common Stock of the registrant was owned by Ford Motor Company ("Ford"), with a Ford subsidiary, 20% of the Common Stock was owned by Park Ridge Limited Partnership ("Partnership"), whose general partner is Frank A. Olson, Chief Executive Officer of the registrant, 24% of the Preferred Stock and 26% of the Common Stock was owned by AB Volvo ("Volvo") and 5% of the Common Stock was owned by Commerzbank Aktiengesellschaft ("Commerzbank"). The capital stock of the registrant authorized and issued as of December 31, 1993 and 1992 and the additional capital paid-in are as follows: THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies (continued) The holders of the Series A Preferred Stock ("Series A Stock") and the Series B Preferred Stock ("Series B Stock") are entitled, when, as and if declared by the Board of Directors of the registrant, to cumulative annual dividends, but payable only out of funds legally available therefore, compounded annually (if in arrears). The annual dividend rate through December 31, 1998 is 10% for the Series A Stock and at various rates which average 4.5% for the Series B Stock. Commencing January 1, 1999 the annual dividend rate for the Series A Stock and Series B Stock are subject to adjustment and are reset on an annual basis. The Series A Stock and the Series B Stock are redeemable by their terms at the option of the registrant at any time, and do not have any voting rights, except that the holders of the Series A Stock shall have the right to elect two directors in the event of default, and the holders of the Series B Stock will be granted voting rights in the event of significant and continuing net operating losses. The holders of the Class A Common Stock and Class B Common Stock have one vote per share and no special preferences. The holders of the Class C Common Stock have one vote per share and have the right to designate three directors, until such time as fewer than 40 shares thereof (adjusted for stock splits and the like) shall be outstanding, provided, however, that the Class C Common Stock shall in any event have 40% of the general voting power and the right to elect not less than 40% of the members of such Board of Directors, until such time as fewer than 40 shares thereof (as so adjusted) shall be outstanding. The Class C Common Stock is convertible into Class B Common Stock on a share for share basis at any time at the holder's option. In connection with the acquisition of the registrant on December 30, 1987 by Park Ridge, the Partnership contributed $20 million to Park Ridge, which included $1.5 million in cash and a $18.5 million, 10% Secured Promissory Note (the "Partnership Note"). As of December 31, 1993, the registrant had a receivable of $27.1 million due from the Partnership relating to the Partnership Note. The Partnership Note is secured by a pledge of the Common Stock of the registrant owned by the Partnership and is payable out of the proceeds of a dividend, distribution or other disposition of the Partnership's Common Stock in accordance with the Partnership Note. As of December 31, 1993, the registrant's receivable due from the Partnership relating to the Partnership Note, included the $18.5 million Partnership Note and interest of $8.6 million which is included in Prepaid Expenses and Other Assets in the consolidated balance sheet. Principles of Consolidation -- the consolidated financial statements include the accounts of The Hertz Corporation and its domestic and foreign subsidiaries. All significant intercompany transactions are eliminated. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 1 - Summary of Significant Accounting Policies (continued) Consolidated Statement of Cash Flows -- for purposes of this statement, the registrant considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Depreciable Assets -- the provisions for depreciation and amortization are computed on a straight-line basis over the estimated useful lives of the respective assets, as follows: Hertz follows the practice of charging maintenance and repairs, including the cost of minor replacements, to maintenance expense accounts. Costs of major replacements of units of property are charged to property and equipment accounts and depreciated on the basis indicated above. Gains and losses on dispositions of property and equipment are included in income as realized. Upon disposal of revenue earning equipment, depreciation expense is adjusted for the difference between the net proceeds from sale and the remaining book value. Public Liability and Property Damage -- provisions for public liability and property damage on self-insured domestic claims and reinsured foreign claims are made by charges to expense based upon evaluations of estimated ultimate liabilities on reported and unreported claims. For its domestic operations, the registrant is a qualified self-insurer against liability resulting from accidents under certificates of self-insurance for financial responsibility in all states wherein its motor vehicles are registered. The registrant also self-insures general public liability and property damage for all domestic operations. Effective July 1, 1987, all claims are retained and borne by the registrant up to a limit of $5,000,000 for each accident. Self-insurance retention borne by the registrant for each accident prior to July 1, 1987 was as follows: $10,000,000 from September 1, 1986 to June 30, 1987; $1,000,000 and 50% of claims for amounts exceeding $1,000,000 up to $6,000,000 from February 17, 1985 to August 31, 1986; and $1,000,000 prior to February 17, 1985. For its foreign operations, Hertz generally does not act as a self-insurer. Instead, Hertz purchases insurance to comply with local legal requirements from unaffiliated carriers. Effective January 1, 1993, motor vehicle liability insurance for claims arising on or after January 1, 1993, purchased locally from unaffiliated carriers by Hertz owned operations in Europe, has been reinsured by Hertz International RE Limited ("HIRE"), a newly formed reinsurer in Dublin, Ireland. HIRE effectively responds to the first $1,500,000 of motor vehicle liability for each accident, with excess liability insurance coverage maintained by Hertz with unaffiliated carriers. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 1 - Summary of Significant Accounting Policies (continued) Accounting Changes and Federal and Foreign Taxes -- the registrant sponsors unfunded plans to provide selected postretirement health care and life insurance benefits for domestic employees who were hired prior to 1990. Employees who were hired on and after January 1, 1990 are not eligible to participate. Effective January 1, 1992, the registrant adopted the provisions of Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions ("FAS No. 106"), which requires that postretirement health care and other non-pension benefits be accrued during the years the employee renders the necessary service. Prior to 1992, the registrant accrued for such benefits on a pay-as-you-go basis. As of January 1, 1992, the registrant recorded a cumulative decrease in net income of $4.3 million (net of $2.7 million tax benefit) as a result of implementing FAS No. 106. The registrant adopted the provisions of FASB Technical Bulletin No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts ("FAS No. 90-1") effective January 1, 1991. FAS No. 90-1, which was issued in December 1990 by the Financial Accounting Standards Board, requires that proceeds received from warranty contracts should be deferred and recognized in income on a straight line basis over the contract period, and costs of services performed under the contract should be charged to expense as incurred. Prior to 1991, when vehicles were sold under an extended warranty contract, the proceeds received by the registrant under such contract, net of estimated costs to be incurred in fulfilling obligations under those contracts, were recorded in income when the sale occurred. As of January 1, 1991, the registrant recorded a cumulative decrease in net income of $3.5 million (net of $2.2 million tax benefit) as a result of implementing FAS No. 90-1. Effective January 1, 1993, the registrant adopted the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("FAS No. 109"), which requires the recognition of deferred tax assets, net of applicable reserves, related to net operating loss carryforwards and certain temporary differences. The changes made in FAS No. 109, as they relate to the registrant, did not have a material effect on the registrant's consolidated financial position, results of operations or cash flows. The registrant and its domestic subsidiaries filed consolidated Federal income tax returns after December 31, 1987, and from September 1, 1985 to December 31, 1987 were included in the consolidated Federal income tax return of UAL, and prior thereto in the consolidated Federal income tax return of RCA. Pursuant to arrangements with UAL and RCA, the registrant provides for current and deferred taxes as if it filed a separate consolidated tax return with its domestic subsidiaries, except that if any items are subject to limitations in the registrant's consolidated return calculations, such as foreign tax credits, investment tax credits, capital losses and net operating losses, such limitations are determined on the basis of the entire UAL or RCA consolidated group, as appropriate. To the extent that items which would be subject to limitation at the registrant's consolidated return level are not limited in the UAL and RCA consolidated return, the registrant and its domestic subsidiaries receive credit for such items. The registrant and its subsidiaries account for investment tax credits under the flow-through method. U.S. income taxes have not been provided on $212 million in undistributed earnings of subsidiaries that have been or are intended to be permanently reinvested outside the United States or are expected to be remitted free of taxes. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 1 - Summary of Significant Accounting Policies (continued) Pension and Income Saving Plans -- substantially all domestic employees, after completion of specified periods of service, are eligible to participate in the Retirement Plan for the Employees of The Hertz Corporation ("Hertz Retirement Plan") and in the Income Savings Plan of The Hertz Corporation ("Hertz Income Savings Plan") as of August 30, 1985, and prior thereto in the Retirement Plan and in the Income Savings Plan of RCA. Payments are made to pension plans of others pursuant to various collective bargaining agreements. Under the Hertz Retirement Plan, through June 30, 1987 employees contributed a part of the cost of current-service benefits while Hertz contributed the remainder and all other costs under the projected unit credit cost method. Effective July 1, 1987, the Hertz Retirement Plan was revised to an "Account Balance Pension Plan" under which Hertz pays the entire cost and employees are no longer required to contribute. The normal retirement benefits are based on years of credited service and the five highest amounts of annual compensation during the employee's last ten years of credited service up to July 1, 1987. Effective July 1, 1987, the normal retirement benefit will be the value of their cash balance account accrued after July 1, 1987. Hertz' funding policy is to contribute at least the minimum amount required by the Employee Retirement Income Security Act of 1974. Under the Hertz Income Savings Plan, as explained below, Hertz contributes a fixed percentage of eligible employees' base salary. Employees may also elect to have Hertz contribute on their behalf, subject to a percentage limitation, any whole percentage of their base salary to the Plan, in lieu of being paid such salary in cash under a qualified cash or deferred arrangement described in Section 401(k) of the Internal Revenue Code. Prior to July 1, 1987, employees could also make their own contributions of their base salary, subject to a percentage limitation. Effective July 1, 1987, the Hertz Income Savings Plan was amended whereby Hertz contributes a percentage of eligible employees' salary only if the employee elects to contribute a portion of his/her base salary. Hertz' contribution was 66% of the first 6% of the employee's contribution for a maximum Hertz match of 4% of the employee's base salary. Employee after tax contributions were eliminated. Effective January 1, 1988, the Plan was further amended to change Hertz' contribution from 66% to 50% of the first 6% of the employee's contribution for a maximum Hertz match of 3% of the employee's base salary. Effective July 1, 1991, Hertz' contribution was suspended and was resumed on January 1, 1992. Most of the registrant's foreign subsidiaries have defined benefit retirement plans or are required to participate in government plans. These plans are all funded, except in Germany, where an unfunded liability is recorded. In certain countries, when the subsidiaries make the required funding payments, they have no further obligations under such plans. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", which requires a more detailed disclosure of debt and equity securities held for investment, the methods to be used in determining fair value, and when to record unrealized holding gains and losses in earnings or in a separate component of shareholders' equity for fiscal years beginning after December 15, 1993. Implementation of the standard is not expected to have a material effect on Hertz' consolidated financial position, results of operations or cash flows. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 2 - Debt Debt of the registrant and its subsidiaries (in thousands of dollars) consists of the following: THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 2 - Debt (continued) The aggregate amounts of maturities of debt, in millions, are as follows: 1994, $905.0 (including $700.3 of demand and other short-term borrowings); 1995, $262.7; 1996, $224.4; 1997, $176.1; 1998, $319.8; after 1998, $1,052.5. During the year ended December 31, 1993, short-term borrowings, in millions, were as follows: maximum amounts outstanding $769.7 commercial paper, $940.1 banks and $48.0 other; monthly average amounts outstanding $287.5 commercial paper (weighted average interest rate 3.3%), $722.4 banks (weighted average interest rate 6.9%) and $25.2 other (weighted average interest rate 7.8%). During the year ended December 31, 1992, short-term borrowings, in millions, were as follows: maximum amounts outstanding $671.9 commercial paper, $855.9 banks and $68.2 other; monthly average amounts outstanding $242.8 commercial paper (weighted average interest rate 4.1%), $594.0 banks (weighted average interest rate 9.5%) and $41.1 other (weighted average interest rate 10.9%). During the year ended December 31, 1991, short-term borrowings, in millions, were as follows: maximum amounts outstanding $201.3 commercial paper, $588.5 banks and $73.6 other; monthly average amounts outstanding $67.4 commercial paper (weighted average interest rate 6.9%), $497.3 banks (weighted average interest rate 12.1%) and $38.6 other (weighted average interest rate 10.0%). The net amortized discount charged to interest expense for the years ended December 31, 1993, 1992 and 1991 relating to debt and other liabilities was $1.4 million, $2.1 million and $1.9 million, respectively. In addition, interest expense for the year 1993 was reduced by $8.2 million of interest income, relating to refunds of prior years' Federal income taxes. As of October 7, 1993, the registrant entered into a Credit Agreement ("Agreement") with Bank of America National Trust and Savings Association (as agent and a lender) and twenty-five other banks which is utilized to support commercial paper and other short-term borrowings and provide committed funding in the aggregate amount of $500 million to October 6, 1997. Under the Agreement, the facility can be utilized by the registrant and its domestic subsidiaries to borrow U.S. dollars or other currencies under various interest rate alternatives. A facility fee of .20% per annum is payable on the available credit regardless of utilization. Hertz had consolidated unused lines of credit subject to customary terms and conditions, which includes unused amounts under the bank facility indicated above, of approximately $1.6 billion at December 31, 1993. The terms of the registrant's loan agreements limit the payment of cash dividends. At December 31, 1993, approximately $52 million of consolidated shareholders' equity was free of such limitations. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 3 - Foreign Currency Foreign currency exchange gains and losses included in net income were net gains of $1.4 million, $2.2 million and $1.7 million for the years ended December 31, 1993, 1992 and 1991, respectively. The cumulative translation credit adjustment at December 31, 1990 was $15.1 million. The net translation charge adjustments were $16.3 million, $25.6 million and $1.9 million for the years ended December 31, 1993, 1992 and 1991, respectively. Note 4 - Additional Capital Paid-In There were no changes to additional capital paid-in during 1993, 1992 and 1991. Note 5 - Acquisitions In 1992 and 1991, the registrant acquired additional interests in Axus, S.A. (a leasing company which operates in Belgium, Luxembourg, Holland, France, Italy and Spain), increasing its ownership from 79% to 98%. In November and July 1991, the registrant acquired vocational rehabilitation service companies, which operate in California. The costs relating to these acquisitions approximated $8.6 million, which exceeded the net assets acquired by approximately $2.4 million. These acquisitions do not have a material effect on the registrant's consolidated financial position or results of operations. In connection with the acquisition of the registrant by Park Ridge in December 1987 and UAL in August 1985, the excess of the purchase price over the consolidated equity of the registrant at the time of these purchases was $658.3 million. These costs are being amortized by the registrant over 40 years. The unamortized amount of such costs at December 31, 1993 was $550.7 million. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 6 - Pension and Income Savings Plans and Postretirement Benefit Plans The following tables set forth the funded status and the net periodic pension cost of the Hertz Retirement Plan covering its domestic ("U.S.") employees and the retirement plans for foreign operations ("Non-U.S.") and amounts included in the consolidated balance sheet and statement of income (in millions of dollars): Significant assumptions used for the U.S. plan were as follows: weighted average discount rate of 7% at December 31, 1993 and 7-3/4% during 1993 (8.5% for 1992 and 1991), 6.4% rate of increase in future compensation levels; and expected long-term rate of return on assets of 9% in 1993 (8.5% in 1992 and 1991). Assumptions used for the Non-U.S. plans vary by country and are made in accordance with local conditions, but do not vary materially from those used in the U.S. plan. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 6 - Pension and Income Savings Plans and Postretirement Benefit Plans (continued) The provisions charged to income for the years ended December 31, 1993, 1992 and 1991 for all other pension plans were approximately (in millions) $5.6, $5.3 and $5.0, respectively. The provisions charged to income for the years ended December 31, 1993, 1992 and 1991 for the Hertz Income Savings Plan were approximately (in millions) $2.6, $2.5 and $1.3, respectively. Beginning in 1992, the estimated cost for postretirement health care and life insurance benefits has been accrued on an actuarially determined basis, in accordance with the requirements of FAS No. 106. The following sets forth the plans' status, reconciled with the amounts included in the consolidated balance sheet and statement of income (in millions): The significant assumptions used for the postretirement benefit plans were as follows: 7.0% weighted average discount rate (8.5% in 1992), 6.4% rate of increase in future compensation levels, 10.0% weighted average health care cost trend rate through 1998 (12% in 1992), and 8.6% weighted average trend rate in ten years (9.6% in 1992). Changing the assumed health care cost trend rates by one percentage point in each year would change the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $360,000, and the aggregate service and interest cost components of net periodic postretirement benefit cost for 1993 by approximately $50,000. The cost for the retiree postretirement benefit payments included in expense for the year ended December 31, 1991 was not material. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 7 - Revenue Earning Equipment Revenue earning equipment is used in the rental of vehicles and construction equipment and the leasing of vehicles under closed-end leases where the disposition of the vehicles upon termination of the lease is for the account of Hertz. Revenue is recorded when it becomes receivable and expenses are recorded as incurred. Hertz' domestic revenue earning vehicles include approximately 74% Ford products, which are acquired from dealers who are independent from Ford. The percentage of Ford products acquired by Hertz is expected to continue at approximately this level in the future, pursuant to a long-term supply contract between the registrant and Ford. Hertz purchases the vehicles from Ford dealers at competitive prices. Under operating leases, aggregate minimum future rentals for vehicles and equipment leased at December 31, 1993 are receivable approximately as follows (in millions): $156 in 1994, $91 in 1995, $37 in 1996, and $7 in 1997. Vehicles and other equipment under lease at December 31, 1993 which are owned by Hertz amounted to $357 million, net of accumulated depreciation of $144 million (see Note 9 for minimum obligations for vehicles leased under operating leases by Hertz). Depreciation of revenue earning equipment includes the following (in thousands of dollars): The improvements in the "adjustment of depreciation upon disposal of the equipment", from a charge of $5.4 million in 1991 to gains of $16.9 million in 1992, and $28.1 million in 1993, were primarily attributable to higher proceeds received in 1992 and 1993 on disposal of the equipment and the elimination of losses incurred in 1991 due to the increase in 1992 and 1993 of "nonrisk" vehicles acquired which are returned to the vehicle manufacturers at pre-established prices. As of December 31, 1993 and 1992, Ford owed Hertz $329 million and $28 million, respectively, in connection with various vehicle repurchase and warranty programs which were made and are being paid in the ordinary course of business. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 7 - Revenue Earning Equipment (continued) As of December 31, 1993, the registrant operated vehicles used in its domestic rent a car operations under a lease agreement between the registrant and a third party lessor. The leased vehicles are purchased by the third party lessor under a repurchase program with Ford. Under the lease, the registrant makes payments equal to the monthly depreciation and all expenses (including interest) of the third party lessor, and is responsible for the remaining net cost on any vehicles that become ineligible under the repurchase program. The leased vehicles are subject to a minimum holding period of four months up to maximum of thirteen months. The average holding period for vehicles leased by the registrant is eight months. There are no minimum lease payments required in future years. The registrant may, at its option, lease from the third party lessor up to $500 million net cost of vehicles at any one time. At December 31, 1993, the net cost of the vehicles leased under this agreement was approximately $407 million. Note 8 - Taxes on Income The provision (benefit) for taxes on income consists of the following (in thousands of dollars): The principal items in the deferred tax provision (benefit) are as follows (in thousands of dollars): THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 8 - Taxes on Income (continued) The principal items in the deferred tax liability at December 31, 1993 and 1992 are as follows (in thousands of dollars): The tax operating loss carryforwards at December 31, 1993 of $4.3 million relate to certain foreign operations which have no expiration dates. It is anticipated that such operations will become profitable in the future and the carryforwards will be fully utilized. As of December 31, 1993, the alternative minimum tax credit carryforwards of $32.5 million (which has no expiration date) and investment tax credit carryforwards of $11.5 million (which expires at the end of 1999) will be utilized when timing differences turnaround and from future taxable income. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 8 - Taxes on Income (continued) The principal items accounting for the difference in taxes on income computed at the U.S. statutory rate of 35% for 1993 and 34% for 1992 and 1991 and as recorded are as follows (in thousands of dollars): THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 9 - Lease and Concession Agreements Hertz has various concession agreements which provide for payment of rents and a percentage of revenue with a guaranteed minimum and real estate leases under which the following amounts were expensed (in thousands of dollars): As of December 31, 1993, minimum obligations under existing agreements referred to above are approximately as follows (in thousands of dollars): In addition to the above, Hertz has various leases on vehicles and office and computer equipment under which the following amounts were expensed (in thousands of dollars): As of December 31, 1993, minimum obligations under existing agreements referred to above that have a maturity of more than one year are as follows (in thousands): vehicles, which are substantially offset by sublease rental income under operating leases (see Note 7), 1994, $586; and office and computer equipment 1994, $20,259; 1995, $12,864; 1996, $2,125; 1997, $257; after 1997, $41. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 10 - Segment Information Hertz' business consists of two significant segments: Rental and leasing of automobiles and certain other activities ("car rental"); and rental, leasing, and sales of construction and materials handling equipment ("construction equipment rental and sales"). The contributions of these segments to revenues are indicated in the Consolidated Statement of Income. The contribution of these segments to other financial data (in millions of dollars) are as follows: THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 10 - Segment Information (continued) Hertz operates in the United States and in foreign countries. The operations within major geographic areas are summarized as follows (in millions of dollars): Note 11 - Litigation Various legal actions, governmental investigations and proceedings, and claims are pending or may be instituted or asserted in the future against the registrant and its subsidiaries. Litigation is subject to many uncertainties, and the outcome of individual litigated matters is not predictable with assurance. It is reasonably possible that certain of the actions, investigations or proceedings could be decided unfavorably to the registrant or the subsidiary involved. Although the amount of liability at December 31, 1993 with respect to these matters cannot be ascertained, such liability could approximate up to $1.7 million (net of income tax benefits), and the registrant believes that any resulting liability should not materially affect the consolidated financial position, results of operations or cash flows of the registrant. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 12 - Supplementary Income Statement Information (in thousands of dollars) Hertz is a party to a cooperative advertising agreement with Ford pursuant to which Ford participates in some of the cost of certain of Hertz' advertising programs in the United States and abroad which feature the Ford name or products. This program will continue in the future. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 13 - Quarterly Financial Information (Unaudited) A summary of the quarterly operating results during 1993 and 1992 (before the cumulative effect on prior years of the change in 1992 in the method of accounting for postretirement benefits other than pensions) was as follows: The tax provision in the third quarter of 1993 includes a $1.1 million charge relating to the increase in net deferred tax liabilities as of January 1, 1993 due to changes in the tax laws enacted in August 1993, and a $2.0 million credit resulting from adjustments made to tax accruals in connection with tax audit evaluations and the effects of prior years' tax sharing arrangements between the registrant and its former parent companies, UAL and RCA. The tax provision in the fourth quarter of 1992 includes credits of $9.8 million resulting from adjustments made to tax accruals in connection with tax audit evaluations and the effects of prior years' tax sharing arrangements between the registrant and its former parent companies, UAL and RCA, and the reversal of tax accruals no longer required and benefits realized relating to certain foreign operations. THE HERTZ CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 14 - Financial Instruments and Commitments Cash and equivalents -- fair value approximates cost indicated on the balance sheet at December 31, 1993, because of the short-term maturity of these instruments. Debt -- fair value is estimated based on quoted market rates as well as borrowing rates currently available to the registrant for loans with similar terms and average maturities. Carrying value was used as fair value for borrowings with an initial maturity of 90 days or less. The fair value of all debt at December 31, 1993 approximated $3.1 billion compared to carrying value of $2.9 billion. Interest rate swaps -- the registrant has outstanding interest rate swaps of various maturities with multiple financial institutions. At December 31, 1993, the aggregate notional principal amounts in various currencies were $842 million. Notional amounts do not represent cash flows and are not subject to credit risks. Credit and market risk exposures are limited to the net interest differentials. The fair value is calculated using information provided by outside quotation services and is the estimated amount that would be received or paid to terminate the swaps at December 31, 1993, taking into account current interest rates and the current credit worthiness of the swap counterparties. The fair value was estimated to be a net payable of $14 million at December 31, 1993, however, the registrant uses these interest rate swaps to fix interest rates on variable rate debt and does not anticipate any early terminations of these swaps. Therefore, this amount will not have to be paid in connection with such early termination. Note 15 - Subsequent Event In 1994, Ford expects to acquire additional shares of Common Stock of the registrant, including Commerzbank's 5% of the registrant's Common Stock bringing Ford's ownership of the registrant's voting stock to 54%. SCHEDULE II THE HERTZ CORPORATION AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (In Thousands of Dollars) In connection with the acquisition of the registrant on December 30, 1987 by Park Ridge, the Partnership contributed $20 million to Park Ridge, which included $1.5 million in cash and a $18.5 million, 10% Secured Promissory Note (the "Partnership Note"). As of December 31, 1993, the registrant had a receivable of $27.1 million due from the Partnership relating to the Partnership Note. The Partnership Note is secured by a pledge of the Common Stock of the registrant owned by the Partnership and is payable out of the proceeds of a dividend, distribution or other disposition of the Partnership's Common Stock in accordance with the Partnership Note. As of December 31, 1993, the registrant's receivable due from the Partnership relating to the Partnership Note, included the $18.5 million Partnership Note and interest of $8.6 million. SCHEDULE V Page 1 of 2 THE HERTZ CORPORATION AND SUBSIDIARIES REVENUE EARNING EQUIPMENT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (In Thousands of Dollars) (a) Retirements and transfers include charge adjustments relating to assets sold or retired of (in millions) $1.2 and $1.8 for the years ended December 31, 1993 and 1992, respectively, applicable to the reversal of credits resulting from valuing certain pre-acquisition assets on a net of tax basis. SCHEDULE V Page 2 of 2 THE HERTZ CORPORATION AND SUBSIDIARIES REVENUE EARNING EQUIPMENT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (In Thousands of Dollars) (a) Retirements and transfers include charge adjustments relating to assets sold or retired of $2.6 million for the year ended December 31, 1991, applicable to the reversal of credits resulting from valuing certain pre-acquisition assets on a net of tax basis. SCHEDULE VI Page 1 of 2 THE HERTZ CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF REVENUE EARNING EQUIPMENT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (In Thousands of Dollars) (a) Depreciation expense has been decreased by $28.1 million and $16.9 million for the years ended December 31, 1993 and 1992, respectively, for the difference between the remaining book values and the net proceeds from sale of revenue earning equipment, which includes credits resulting from valuing certain pre-acquisition assets on a net of tax basis. Rents paid for vehicles leased included in depreciation expense in the amount of (in millions) $90.3 and $79.6 for the years ended December 31, 1993 and 1992, respectively, have also been included above in retirements and transfers. (b) Depreciation expense relating to assets sold or retired has been reduced by (in millions) $1.2 and $1.8 for the years ended December 31, 1993 and 1992, respectively, applicable to credits resulting from valuing certain pre-acquisition assets on a net of tax basis and a contra charge has been included above in retirements and transfers. SCHEDULE VI Page 2 of 2 THE HERTZ CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF REVENUE EARNING EQUIPMENT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (In Thousands of Dollars) (a) Depreciation expense has been increased for the difference between the remaining book values and the net proceeds from sale of revenue earning equipment, which includes credits resulting from valuing certain pre-acquisition assets on a net of tax basis, by $5.4 million for the year ended December 31, 1991. Rents paid for vehicles leased included in depreciation expense in the amount of $59.9 million for the year ended December 31, 1991 have also been included above in retirements and transfers. (b) Depreciation expense relating to assets sold or retired has been reduced by $2.6 million for the year ended December 31, 1991, applicable to credits resulting from valuing certain pre-acquisition assets on a net of tax basis and a contra charge has been included above in retirements and transfers. SCHEDULE VIII THE HERTZ CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In Thousands of Dollars) (a) Amounts written off, net of recoveries. (b) Payments of claims and expenses. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------------- EXHIBITS filed with FORM 10-K for the fiscal year ended December 31, 1993 under THE SECURITIES EXCHANGE ACT OF 1934 ----------------------- THE HERTZ CORPORATION Commission file number 1-7541 INDEX TO EXHIBITS

205402_1993.txt

205402

1993

Item 1. Business ------- -------- Graybar Electric Company, Inc. (the "Company") is engaged internationally in the wholesale distribution of electrical and communications equipment and supplies primarily to contractors, industrial plants, independent telephone companies, power utilities, and commercial users. All products sold by the Company are purchased from others. The Company was incorporated under the laws of the State of New York on December 11, 1925 to take over the wholesale supply department of Western Electric Company, Incorporated. The location and telephone number of the principal executive offices of the Company are 34 North Meramec Avenue, St. Louis, Missouri (314) 727-3900, and the mailing address of the principal executive offices is P.O. Box 7231, St. Louis, Missouri 63177. Suppliers --------- The Company acts as a distributor of the products of more than 1,000 manufacturers. The relationship of the Company with a number of its principal suppliers goes back many years. It is customarily a nonexclusive national or regional distributorship terminable upon 30 to 90 days notice by either party. - 2 - During 1993, the Company purchased a significant portion of its products from its two largest suppliers. The termination by either of these companies, within a short period of time, of a significant number of their agreements with the Company might have an immediate material adverse effect on the business of the Company, but the Company believes that within a reasonable period of time it could find alternate sources of supply adequate to alleviate such adverse effect. Products Distributed -------------------- The Company distributes more than 100,000 different products and, therefore, is able to supply its customers with a wide variety of electrical and communications products. The products distributed by the Company are supply materials consisting primarily of products such as wire, conduit, wiring devices, tools, motor controls, transformers, lamps, lighting fixtures, hardware, power transmission equipment, telephone station apparatus, key systems and other telephone equipment, and are sold to customers such as contractors (both industrial and residential), industrial plants, independent telephone companies, private and public power utilities, and commercial users. - 3 - On December 31, 1993 and 1992, the Company had orders on hand which totalled approximately $174,928,000 and $175,792,000, respectively. The Company believes that the small decrease from 1992 to 1993 is a result of significantly higher sales during the month of December, 1993 than the Company has historically experienced. The Company expects that approximately 85% of the orders on hand at December 31, 1993 will be filled within the twelve-month period ending December 31, 1994. Historically, orders on hand for the Company's products have been firm, but customers from time to time request cancellation and the Company has historically allowed such cancellations. - 4 - Marketing --------- The Company sells its products through a network of distri- buting houses located in 17 geographical districts throughout the United States. In each district the Company maintains a main distributing house and a number of branch distributing houses, each of which carries an inventory of supply materials and operates as a wholesale distributor for the territory in which it is located. The main distributing house in each district carries a substantially larger inventory than the branch houses so that the branch houses can call upon the main distributing house for additional items of inventory. In addition, the Company maintains four (4) zone warehouses with special inventories so all locations can call upon them for additional items. The Company also has subsidiary operations with distribution facilities located in Mankato, Minnesota, Parsippany and Hackettstown, New Jersey, Puerto Rico, Mexico, Panama, Guam, Singapore, Canada and the United Arab Emirates. - 5 - The distribution facilities operated by the Company are shown in the following table: Where the specialized nature or size of a particular shipment warrants, the Company has products shipped directly from its suppliers to the place of use, while in other cases orders are filled from the Company's inventory. On a dollar volume basis, over one-half of the orders are filled from the Company's inventory and the remainder are shipped directly from the supplier to the place of use. The Company generally finances its inventory from internally generated funds and from long and short-term borrowings. - 6 - The Company distributes its products to more than 150,000 customers, which fall into five general classes. The following list shows the estimated percentage of the Company's total sales for each of the three years ended December 31, attributable to each of these classes: - 7 - At December 31, 1993, the Company employed approximately 1,880 persons in sales capacities. Approximately 880 of these sales personnel were supply sales representatives who work in the field making sales to customers at the work site. The remainder of the sales personnel were sales and marketing managers, and telemarketing, advertising, quotation, counter and clerical personnel. Competition ----------- The Company believes that it is the largest distributor of electrical products not affiliated with a manufacturing company, and one of the three largest distributors of such products in the United States. The field is highly competitive, and the Company estimates that the three largest distributors of electrical products account for only a small portion of the total market, with the balance of the market being accounted for by independent distributors and manufacturers operating on a local, state-wide or regional basis. The Company believes that its competitive position is primarily a result of its ability to supply its customers through conveniently located distribution facilities with a broad range of electrical and telecommunications supply materials within a short period of time. Price is also important, particularly where the Company is asked to submit bids to contractors in connection with large construction jobs. - 8 - Employees --------- At December 31, 1993, the Company employed approximately 5,100 persons on a full-time basis. Approximately 130 of these persons were covered by union contracts. The Company has not had a material work stoppage and considers its relations with its employees to be good. Item 2.

Item 2. Properties ------- ---------- As of December 31, 1993 the Company operated offices and distribution facilities in 222 locations. Of these, 131 were owned by the Company, and the balance were leased. The leases are for varying terms, the majority having a duration of less than five years. The Company's distribution facilities consist primarily of warehouse space. A small portion of the space in each facility is used for offices. Distribution facilities vary in size from approximately 3,000 square feet to 152,000 square feet, the average being 30,000 square feet. As of December 31, 1993, approximately $48.6 million in debt of the Company was secured by mortgages on thirty-four buildings. Twenty of these facilities are subject to a first mortgage securing a 12 1/4% note, of which approximately $14.5 million in principal amount remains outstanding. Seven of these facilities are subject to a first mortgage securing a 9 23/100% note, of which $30.0 million in principal amount remains outstanding. - 9 - Distribution houses in Norcross, Georgia; Salt Lake City, Utah; Pinellas County and Polk County, Florida; Tucson, Arizona; Beaumont, Texas and Glendale Heights, Illinois are subject to mortgages securing Industrial Revenue Bonds at variable interest rates with payments totaling $4.1 million due periodically to 2004. Item 3.

Item 3. Legal Proceedings ------- ----------------- The Company has been named, together with numerous other companies, as a co-defendant in actions by approximately 1,700 plaintiffs which have been filed in various federal and state courts in Arkansas, California, Louisiana, Maryland, Mississippi, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Washington, and West Virginia. The plaintiffs allege personal injuries due to exposure to asbestos products and seek substantial damages. The majority of the complaints do not identify any products containing asbestos allegedly sold by the Company. However, since all products sold by the Company have been and are purchased from suppliers, if a plaintiff were to successfully establish an asbestos-related injury claim with respect to a product sold by the Company, the Company believes it would normally have a claim against its supplier. Furthermore, the Company believes it has product liability insurance coverage available to cover these claims. Accordingly, based on information now known to the Company, in the opinion of management the ultimate disposition of the asbestos-related claims against the Company will not have a materially adverse effect on the Company's financial position. - 10 - Item 4.

Item 4. Submission of Matters to a Vote of Security ------- Holders ------------------------------------------- No matter was submitted to a vote of shareholders during the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K. PART II ------- Item 5.

Item 5. Market for the Registrant's Common Stock ------- and Related Shareholder Matters ---------------------------------------- The Company is wholly owned by its active and retired employees, and there is no public trading market for its Common Stock, par value $1 per share with a stated value of $20 per share. No shareholder may sell, transfer or otherwise dispose of shares of Common Stock without first offering the Company the option to purchase such shares at the price at which they were issued. The Company also has the option to purchase the Common Stock of any shareholder who dies or ceases to be an employee of the Company for any cause other than retirement on a Company pension. In the past all shares issued by the Company have been issued at $20 per share, and the Company has always exercised its repurchase option, and expects to continue to do so. The information as to number of holders of Common Stock and frequency and amount of dividends, required to be included pursuant to this Item 5, is included under the captions "Capital Stock Data" and "Dividend Data" on page 1 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, (the "1993 Annual Report") furnished to the Securities and Exchange Commission (the "Commission") pursuant to Rule 14c-3 under the - 11 - Securities Exchange Act of 1934, as amended (the "Exchange Act"), and such information is incorporated herein by reference. Currently there are no restrictions in the Company's Restated Certificate of Incorporation or its debt instruments that limit the Company's ability to pay dividends on its Common Stock or that the Company reasonably believes would be likely to limit materially the future payment of such dividends. Item 6.

Item 6. Selected Financial Data ------- ----------------------- The selected financial data for the Company as of December 31, 1993 and for the five years then ended, which is required to be included pursuant to this Item 6, is included under the caption "Selected Consolidated Financial Data" on page 11 of the 1993 Annual Report and is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of ------- Financial Condition and Results of Operations --------------------------------------------- Management's discussion and analysis required to be included pursuant to this Item 7 is included under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 12 and 13 of the 1993 Annual Report and is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data ------- ------------------------------------------- The financial statements required by this Item 8 are listed in Item 14(a)(1) of this Annual Report on Form 10-K under the caption "Index to Financial Statements." - 12 - Such financial statements specifically referenced from the 1993 Annual Report in such list are incorporated herein by reference. There is no supplementary financial information required by this item which is applicable to the Company. Item 9.

Item 9. Disagreements on Accounting and Financial ------ Disclosure ----------------------------------------- None. PART III -------- Item 10.

Item 10. Directors and Executive Officers of the ------- Registrant --------------------------------------- The information with respect to the directors and executive officers of the Company required to be included pursuant to this Item 10 will be included under the caption "Directors and Executive Officers -- Nominees for Election as Directors" in the Company's Information Statement relating to the 1994 Annual Meeting (the "Information Statement"), to be filed with the Commission pursuant to Rule 14c-5 under the Exchange Act, and is incorporated herein by reference. Item 11.

Item 11. Executive Compensation -------- ---------------------- The information with respect to executive compensation required to be included pursuant to this Item 11 will be included under the captions "Executive Compensation" and "Pension Plan" in the Information Statement and is incorporated herein by reference. - 13 - Item 12.

Item 12. Security Ownership of Certain ------- Beneficial Owners and Management -------------------------------- The information with respect to the security ownership of beneficial owners of more than 5% of the Common Stock, the directors of the Company and all directors and officers of the Company, which is required to be included pursuant to this Item 12, will be included in the introductory language and under the caption "Directors and Executive Officers -- Nominees for Election as Directors" in the Information Statement and is incorporated herein by reference. Item 13.

Item 13. Certain Relationships ------- and Related Transactions ------------------------ The information with respect to any reportable transactions, business relationships and indebtedness between the Company and the beneficial owners of more than 5% of the Common Stock, the directors or nominees for director of the Company, the executive officers of the Company or the members of the immediate families of such individuals, required to be included pursuant to this Item 13, will be included under the caption "Directors and Executive Officers" in the Information Statement and is incorporated herein by reference. - 14 - PART IV ------- Item 14.

Item 14. Exhibits, Financial Statement Schedules, -------- and Reports on Form 8-K ---------------------------------------- (a) Documents filed as part of this report: -------------------------------------- The following financial statements and Report of Independent Accountants are included on the indicated pages in the 1993 Annual Report and are incorporated by reference in this Annual Report on Form 10-K: 1. Index to Financial Statements ----------------------------- (i) Consolidated Statements of Income and Retained Earnings for each of the three years ended December 31, 1993 (page 14). (ii) Consolidated Balance Sheets, as of December 31, 1993 and December 31, 1992 (page 15). (iii) Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 (page 16). (iv) Notes to Consolidated Financial Statements (pages 17 to 20). (v) Report of Independent Accountants relating to above mentioned financial statements and notes for each of the three years ended December 31, 1993 (page 21). - 15 - 2. Index to Financial Schedules ---------------------------- The following schedules for each of the three years ended December 31, 1993, to the Financial Statements and Report of Independent Accountants thereon is included on the indicated pages in this Annual Report on Form 10-K: (i) Schedule V. Property, Plant and Equipment (page 21). (ii) Schedule VI. Accumulated Depreciation of Property, Plant and Equipment (page 22). (iii) Schedule VIII. Reserves (page 23). (iv) Report of Independent Accountants on Financial Statement Schedules (page 20). All schedules other than those indicated above are omitted because of the absence of the conditions under which they are required or because the required information is set forth in the financial statements and the accompanying notes thereto. 3. Exhibits -------- The following exhibits required to be filed as part of this Annual Report on Form 10-K have been included: (3) Articles of incorporation and by-laws (i) Restated Certificate of Incorporation dated March 9, 1984 filed as exhibit 3(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1984 (Commission File No. 0-255) and incorporated herein by reference. - 16 - (ii) By-laws as amended through August 1, 1991 filed as exhibit 6(a)(19) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991 (Commission File No. 0-255) and incorporated herein by reference. (4)and(9) Instruments defining the rights of security holders, including indentures and voting trust agreements. Voting Trust Agreement dated as of April 15, 1987, attached as Annex A to the Prospectus, dated January 20, 1987, constituting a part of the Registration Statement on Form S-13 (Registration No. 2-57861) and incorporated herein by reference. The Company hereby agrees to furnish to the Commission upon request a copy of each instrument omitted pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K. (10) Material contracts. (i) Management Incentive Plan, filed as Exhibit 4(a)(1) to the Annual Report on Form 10-K for the year ended December 31, 1972 (Commission File No. 0-255), as amended by the Amendment effective January 1, 1974, filed as Exhibit 13-c to the Registration Statement on Form S-1 (Registration No. 2-51832), the Amendment effective January 1, 1977, filed as Exhibit 13(d) to the Registration Statement on Form S-1 (Registration No. 2-59744), and the Amendment effective January 1, 1980, filed as Exhibit 5(f) to the Registration Statement on Form S-7 (Registration No. 2-68938) and incorporated herein by reference. (13) Annual Report to Shareholders for 1993 (except for those portions which are expressly incorporated by reference in this Annual Report on Form 10-K, this exhibit is furnished for the information of the Commission and is not deemed to be filed as part of this Annual Report on Form 10-K). (21) List of subsidiaries of the Company. (b) Reports on Form 8-K: ------------------- No reports on Form 8-K were filed during the last quarter of the Company's fiscal year ended December 31, 1993. - 17 - SIGNATURES ---------- Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, as of the 28th day of March, 1994. GRAYBAR ELECTRIC COMPANY, INC. By /s/ E. A. McGRATH ---------------------------- (E. A. McGrath, President) Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Company, in the capacities indicated, on March 28, 1994. /s/E. A. McGRATH Director and President --------------------- (E. A. McGrath) (Principal Executive Officer and Principal Financial Officer) /s/J. R. SEATON Director, Vice President -------------------- (J. R. Seaton) and Comptroller (Principal Accounting Officer) /s/J. R. HADE Director --------------------- (J. R. Hade) /s/C. L. HALL Director --------------------- (C. L. Hall) /s/R. H. HANEY Director --------------------- (R. H. Haney) /s/G. W. HARPER Director -------------------- (G. W. Harper) - 18 - /s/F. L. HIPP Director --------------------- (F. L. Hipp) /s/R. L. MYGRANT Director --------------------- (R. L. Mygrant) /s/I. ORLOFF Director --------------------- (I. Orloff) /s/R. A. REYNOLDS Director --------------------- (R. A. Reynolds) /s/A. A. THOMPSON Director --------------------- (A. A. Thompson) /s/G. S. TULLOCH, JR. Director --------------------- (G. S. Tulloch, Jr.) /s/J. F. VAN PELT Director --------------------- (J. F. Van Pelt) /s/J. W. WOLF Director --------------------- (J. W. Wolf) - 19 - Price Waterhouse REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Graybar Electric Company, Inc. Our audits of the consolidated financial statements referred to in our report dated February 18, 1994 appearing on page 21 of the 1993 Annual Report to Shareholders of Graybar Electric Company, Inc., (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/Price Waterhouse ............................... PRICE WATERHOUSE St. Louis, Missouri February 18, 1994 - 20 - - 21 - - 22 - - 23 - INDEX TO EXHIBITS - 25 -

36326_1993.txt

36326

1993

ITEM 1. BUSINESS. First Financial Management Corporation ("FFMC" or the "Company") provides a variety of information services to a diverse customer base. FFMC was incorporated as a Georgia corporation in 1971. Since becoming a public company in 1983, the Company has significantly expanded its customer base and range of services through internal growth and the completion of numerous acquisitions. STRATEGIC TRANSACTIONS FFMC periodically conducts a strategic reevaluation of its businesses, reviewing overall trends and developments in relation to its business investments and industry concentrations. These strategic reviews have resulted in numerous business acquisitions since 1987 that have broadened the Company's service offerings, and in dispositions in 1992 of business units no longer involved in FFMC's strategic direction. On May 31, 1989, FFMC acquired Georgia Federal Bank, FSB and its subsidiaries ("Georgia Federal"), including its consumer finance subsidiary, First Family Financial Services ("First Family"). This acquisition was completed specifically to ensure that the Company's merchant credit card processing business had access to the payment system through Georgia Federal's sponsorship in the VISA and MasterCard networks. During 1992, the Company implemented alternative measures to provide the Company's merchant credit card processing business continued access to the payment system, including a plan to form a credit card bank. These arrangements provided FFMC the flexibility to sell Georgia Federal, and FFMC entered into a definitive agreement to sell Georgia Federal on December 21, 1992. FFMC operated this business until the sale was consummated on June 12, 1993, although the agreement provided that all 1993 results accrued to the purchaser. FFMC also sold First Family on November 10, 1992. During the period of FFMC's ownership of Georgia Federal and First Family, these combined businesses comprised a separate segment ("Financial Services") for purposes of the Company's financial reporting. Georgia Federal was the largest thrift institution in the State of Georgia with assets of over $4 billion, and First Family was a regional consumer finance company with $600 million in assets and offices in eight southeastern states. These businesses have been presented as discontinued operations in FFMC's consolidated financial statements. On December 31, 1992, FFMC entered into a definitive agreement to sell Basis Information Technologies, Inc. ("Basis"), FFMC's original core business unit that provided data processing services to financial institutions. FFMC operated this business until the sale was consummated on February 10, 1993, although the agreement provided that all 1993 results accrued to the purchaser. During the fourth quarter of 1992, the Company discontinued software development for a major Basis product line in connection with the settlement of litigation with a vendor. As a part of its overall strategic reevaluation, FFMC's management determined that additional investments in its financial institutions processing business did not fit the Company's overall strategic direction and decided to pursue the sale of Basis. Basis was included in FFMC's Information Services segment for financial reporting purposes. CONTINUING OPERATIONS The continuing operations of the Company consist of its businesses previously presented as the Information Services segment together with the corporate entity. FFMC's service and related product offerings currently include merchant credit card authorization, processing and settlement; check guarantee and verification; debt collection and accounts receivable management; data imaging, micrographics and electronic data base management; health care claims processing and integrated management services; and the development and marketing of data communication and information processing systems, including in-store marketing programs and systems for supermarkets. FFMC operates in a single business segment, providing a vertically integrated set of data processing, storage and management services for the capture, manipulation, and distribution of information to a variety of commercial and governmental customers. Similarities exist among these businesses in the methods of providing services, in the customers served, and in the marketing activities utilized to obtain new customers. In addition, FFMC continues to pursue further integration of its services and products to gain competitive advantages. The Company's continuing operations encompass the areas of merchant services, health care services, and data imaging services. Merchant Services FFMC offers merchant services primarily through four of its operating units: National Bancard Corporation ("NaBANCO") - credit card authorization, processing and settlement services; TeleCheck Services, Inc. ("TeleCheck") - check verification and guarantee services; Nationwide Credit, Inc. ("Nationwide") - debt collection and accounts receivable management services; and MicroBilt Corporation ("MicroBilt") - the development and marketing of data communication and information processing systems. Services are provided to approximately 250,000 customers in all 50 states, the Caribbean and Canada through 56 locations with 4,000 employees. The percentages of FFMC's revenues from continuing operations contributed by merchant services were 70%, 60%, and 67%, respectively, during the years ended December 31, 1993, 1992 and 1991. Merchant services' business is not seasonal, except that its revenues, earnings and margins are favorably affected in the fourth quarter, primarily by increased merchant credit card and check volume during the holiday season. During 1993, FFMC continued its strategy of cross-selling the various product and service offerings within its merchant services area. MicroBilt's point-of-service processing systems were a factor in the decision of several national retail companies to sign merchant processing agreements with NaBANCO. NaBANCO is the largest full service provider of merchant credit card authorization, processing, and settlement services in the United States, providing these services for merchants with respect to transactions in which payment is made through bank cards (primarily VISA and MasterCard) and certain other credit cards. Fees for credit card authorization and settlement services are generally based on the dollar volume of transactions processed. Its processing centers are located in Sunrise, Florida and Melville, New York. These operations support electronic cash registers and dial up point-of-sale authorization and draft capture terminals. Approximately $54 billion in merchant credit card transactions were handled in 1993, compared with $43 billion in 1992 and $34 billion in 1991. Over 95% of the credit card authorizations by NaBANCO are performed electronically, compared with approximately 70% of all credit card transactions industry-wide. Automated response units are utilized at both the New York and Florida processing centers. This technology allows for the automated recognition of communication via voice or touch tone telephones, thus reducing the labor intensity of a large portion of NaBANCO's card authorization services. Also, voice authorization services are provided via the Florida center to merchants without electronic authorization capabilities and in the event that electronic authorization capabilities are interrupted. Essentially all of the electronic authorization volume can be handled through either of the two processing centers, enabling transactions to be load-shared between centers and ensuring availability of processing facilities. This capability provides virtually complete availability for electronic authorization services with electronic responses to customers usually within eight seconds. Starting in June 1993, NaBANCO began providing most of its services under an agreement as agent for and in conjunction with First Financial Bank ("FFB"), FFMC's credit card bank formed for the primary purpose of supporting the Company's merchant services activities. FFB replaced Georgia Federal as NaBANCO's primary sponsoring member bank in the VISA and MasterCard systems as required by their rules. NaBANCO also provides services as agent for and in conjunction with other sponsoring member banks and maintains ongoing relationships with these and other banks to assist in marketing and delivering NaBANCO's services to these banks' merchant customers. During 1993, NaBANCO continued its focus on new account growth among regional and local merchants through its commission-based sales staff that operates in a network of sales offices throughout the United States. NaBANCO also acquired merchant portfolios from the Bank of New York and Brown Foreman Enterprises in 1993. TeleCheck became a part of merchant services through the acquisition in July 1992 of TeleCheck Services, Inc. ("TSI") and its principal franchisee, Payment Services Company - U.S. ("PSC"), by FFMC. TSI was the owner and franchisor of the TeleCheck system, and provided these services along with eleven independent franchises (including PSC) operating in geographically- defined territories. PSC started in 1976 as the owner of the Houston TeleCheck franchise, and grew its volume and service offerings through internal growth and the acquisition of additional TeleCheck franchises and other related businesses. During 1993, FFMC continued the consolidation of these two organizations that was initiated during 1992. This consolidation centralized TeleCheck's operations in Houston and converted the former TSI Denver organization into an operating facility. The TeleCheck system provides check acceptance services through TeleCheck or independent franchises to retail merchants throughout the United States, Canada, Australia, and New Zealand using large consumer data bases and proprietary risk management systems operated under the "TeleCheck" trademark. The TeleCheck system was founded in 1964 to provide services to merchants who desired to pass the risk of bad checks to a third party, and is now one of the largest check acceptance services in the world. Over $24 billion in checks were authorized in 1993, compared with approximately $15 billion in checks authorized in 1992. TeleCheck provides check guarantee services, buying the approved check at face value from the merchant if it is subsequently dishonored, up to a pre-established warranty maximum. TeleCheck's check verification service helps merchants reduce bad check write-offs and control the costs of check acceptance by providing access to payment data bases and activity monitoring systems. These services allow merchants to maintain a liberal check acceptance program to increase sales and profits. Fees charged to customers for check verification and guarantee services are generally based on the dollar volume of transactions processed. During 1993, FFMC acquired five entities that operated TeleCheck franchises, four in the United States and one in the Commonwealth of Puerto Rico. These acquisitions gave the Company a 97% share of the domestic TeleCheck system volume by year-end. In addition, TeleCheck focused its 1993 marketing efforts toward the signing of new merchant customers through its internal sales organization. Nationwide provides debt collection and accounts receivable management services nationally to a wide variety of customers including retailers, health care providers, financial institutions and the federal government and its agencies through seven collection offices located throughout the United States. Fees charged to customers are generally based on the dollar amount of funds collected. Nationwide's debt collection and accounts receivable management services are performed with enhanced technological advancements, including on-line skiptracing capabilities and paperless collection systems, whereby its customers' transactions are managed through a collector's computer terminal linked to a central mainframe computer. During 1993, Nationwide continued to enhance the productivity of its collectors through system enhancements, and also focused on the successful renewal of several significant collection contracts with agencies of the federal government. MicroBilt serves as FFMC's research and development arm, particularly in the merchant services area, working to develop technological solutions to enhance the Company's product offerings. MicroBilt develops, markets, and supports data capture, communications and distribution systems to multi-location customers including financial institutions, retailers, health care providers, pharmaceutical providers and restaurants. These systems are low cost, easy to use data communication systems suited to a wide range of industries that require data transmissions to and from numerous remote locations. MicroBilt specializes in point of sale data communication applications through the sale of systems and network design. MicroBilt's systems integrate proprietary software with a range of hardware platforms which are distinguished by their application-specific design and common product framework. MicroBilt targets application-specific systems to selected industries. Its systems typically replace the use of mail, voice telephone and less efficient computer systems to send and receive information. Revenues are generated from both sales of systems and support services. During 1993, MicroBilt continued its delivery of point-of-sale equipment to merchant customers of NaBANCO, and began development of check-reading terminals targeted for TeleCheck's merchant customers. Also in 1993, MicroBilt strengthened its point-of-sale offerings by assimilating the acquisition of Techpoint, Inc., a provider of retail systems. FFMC completed its merger with International Banking Technologies, Inc. ("IBT") in August 1993, and began the consolidation of IBT under the MicroBilt organization during the fourth quarter. IBT was formed in 1985 and is a leader in developing in-store branch banking programs in supermarkets. IBT provides a comprehensive array of services for its financial institution customers, with the objective of developing a profitable retail financial services outlet while achieving a value-added arrangement to the food retailer. IBT derives its revenues from fees earned during the design and construction phases, and also from the on-going management of the in-store program between the financial institution and the supermarket. Health Care Services FFMC's health care services are provided through its subsidiaries FIRST HEALTH Services and FIRST HEALTH Strategies (collectively referred to as "FIRST HEALTH"). Services are provided to approximately 1,500 customers through 55 locations across the United States that employ 4,500 persons. Over 330 million health care claims totalling approximately $27 billion are processed annually on systems operated or developed and supported by FIRST HEALTH. The percentages of FFMC's revenues from continuing operations provided by health care services were 17%, 15%, and 6%, respectively, for the years ended December 31, 1993, 1992 and 1991. FIRST HEALTH Services is one of the largest providers of transaction processing and management services to governmental agencies and private and public third party payors. These services include processing for Medicaid and other state programs, pharmaceutical claims processing, drug utilization review services, and management services for mental health, substance abuse, and preventative care programs. Services for Medicaid programs are provided through its centers or management of its customers' facilities. Central to its claims processing business is its Medicaid Management Information System ("MMIS") which has been certified by the federal government as meeting the requirements of a full range Medicaid fiscal agent system. The MMIS system is a very large and flexible information management system, the use of which is not limited to the Medicaid market. FFMC completed the acquisition of ALTA Health Strategies, Inc., since renamed FIRST HEALTH Strategies, on April 1, 1992. One of the nation's largest processors of private sector health care claims, its services include claims administration, utilization management, provider networks, insurance brokerage and data analysis and reporting. Its services are designed to help control employer health care costs and to monitor the quality of health care provided. FIRST HEALTH Strategies markets its services principally to employers with self-funded group health benefit plans and to employers with insured plans which are seeking health care management alternatives. The acquisition of FIRST HEALTH Strategies significantly broadened FFMC's health care management services capabilities. During 1993, FIRST HEALTH Strategies substantially completed the development of its ACT3 electronic claims processing system. This system will be implemented for existing customers beginning in 1994, and the Company will also begin marketing the highly automated claims system to potential clients. FIRST HEALTH expanded its service offerings with the 1993 acquisition of VIPS, Inc., a leading supplier of Medicare claims processing systems to health care insurers. Insurance carriers utilize the VIPS system to process Part B Medicare health claims for senior citizens. HealthCare Cost Consultants, Inc., a provider of hospital information processing systems focused on revenue generation and cost containment, was also acquired in 1993. Health care reform measures have been introduced in 1993 by the executive and legislative branches of the federal government. These proposals, if enacted, could significantly impact the delivery and payment for health care services in the United States. It is uncertain what changes will actually be implemented and how such changes may impact FIRST HEALTH. However, the Company believes that its health care businesses, given their focus on the efficiency of information processing, are favorably positioned to benefit from an emphasis on reducing the level of administrative costs related to the delivery of health care products and services. Data Imaging Services FFMC's data imaging services are provided through First Image Management Company ("First Image") through 74 locations across the United States. First Image employs approximately 3,000 people in order to provide 12,000 customers with a variety of data management services. The majority of First Image's revenues are derived from contracts one to three years in length. Fees are based on the volume and complexity of the data imaging or management services provided as well as other factors such as required turnaround time, volume and duration of contract. The percentages of FFMC's revenues from continuing operations provided by data imaging services were 13% in 1993, 16% in 1992 and 19% in 1991. First Image's data imaging services include a full spectrum of data management services: the conversion of hard copy documents into machine readable form and production of computer output microfilm ("COM"); the design, installation and day-to-day management of immense data bases used by large corporations and federal and state governments; the customization, printing and mailing of reports and statements from large databases; and the publishing and distribution of training manuals, product catalogs and other documents. These services are offered by First Image under a "total solutions" approach with the objective of improving the utility of a user's data base through ease of access and efficient information output. In addition, First Image's services reduce the need for its clients to devote substantial capital investments to create, maintain, and access these large databases. First Image's COM services involve transferring data from computer tape to microforms, generally referred to as "microfiche." Duplicate microfiche can be produced quickly and inexpensively. Cost savings to the customer are obtained by the elimination of paper and reduced information distribution costs with compact storage and efficient information retrieval. In addition to the storage of data on microfiche, cartridge tape storage is also offered with sophisticated indexing methods to aid in data retrieval. This methodology improves efficiency for First Image's largest customers which previously stored much of their data on large space reels that now can be replaced with small cassette-type tapes. First Image's Data Input division creates and manages large-scale electronic data bases through the collection and conversion of paper source documents. Services are tailored to meet the specific information needs of a wide array of customers. Large volumes of source documents are transferred to machine readable media such as magnetic tape or diskette through key entry and high-speed Optical Character Recognition scanning techniques. The data bases are created from the converted data. These data bases are transmitted to the customer off-line, by dedicated transmission lines or satellite link, or on-line, by a direct link between the customer's mainframe computer and First Image's key entry terminals. Alternatively, the data bases may be stored for future access and retrieval upon the customer's request. First Image's report production services are a natural extension of its database management services. The Print and Mail division designs, prints and distributes large volumes of computer generated documents such as promotional mailings, invoices and account statements for its clients each month. The Corporate Publishing division maintains databases for training manuals, product catalogs, directories and other detailed and lengthy documents. Updates for these documents are transmitted electronically to First Image from its customers. First Image then updates the database, prints the required pages, and ships the hard copy output to predetermined client locations. First Image continued to consolidate its operations during 1993, positioning its branches geographically to enhance operational efficiencies while providing services to its clients. In addition, First Image made several small acquisitions during the year to increase the scope of its COM and report production operations. MARKETING FFMC markets its services through a variety of channels including direct solicitation and general advertising. The Company's employees are utilized in the direct solicitation of new customers and the cross-selling of additional services to existing customers. Marketing efforts are directed toward the solicitation of large multi-location retailers, established regional and local merchants, direct response (mail order) companies, restaurant chains and hotels, financial institutions, governments (both federal and state) and other commercial entities. In addition, the Company's acquisition strategy is designed to enhance existing products and to expand markets and services offered. The Company views this strategy as an efficient complement to direct marketing efforts. General advertising of FFMC's products and services is accomplished through industry and trade publications, direct mail, telemarketing and contact at trade conventions and FFMC-sponsored seminars as well as direct sales. Products and services complement each other and provide cross-selling opportunities within the Company's customer base. COMPETITION The most significant competitive factors in the sale of the Company's products and services are price, quality, technological advancement and reliability of service. Other important factors include the ability to handle large volumes of data in both data processing and data base management and a commitment to provide technologically competitive software and application packages. Competition is encountered from several different sources, which vary depending on the particular product or service involved and the size of the customer served. These sources include national service bureaus, in-house solutions sold by software and hardware vendors, and local competitor operations. In the merchant credit card services arena, the Company's principal competitors are two other national credit card processors, but it also encounters competition from banks and other companies which (in some instances acting together) offer authorization and processing services. In many cases, a customer using FFMC's competitors must buy services from several different companies to obtain a similar integrated system. FFMC's check verification and guarantee business is in competition principally with two other national companies. The data processing markets within the health care services and debt collection services industries continue to be fragmented, with no one company or group of companies considered dominant. While First Image is the largest provider in its imaging market, it competes in a market composed primarily of local area providers. REGULATION AND EXAMINATION The 1992 business dispositions removed certain product and service offerings that previously subjected FFMC to considerable regulation and examination. These included the consumer and commercial banking and lending services provided by Georgia Federal and First Family, and the data processing services provided by Basis to financial institutions. However, remaining services that the Company provides directly to governmental agencies and to banks and other regulated financial institutions may be reviewed by various federal and state regulatory agencies. First Financial Bank was formed effective May 7, 1993 under Georgia law as a special purpose bank that will conduct only those activities permitted for "credit card banks" under the Federal Bank Holding Company Act, as amended (the "BHC Act"). Under the BHC Act, FFMC may own a credit card bank without itself becoming subject to regulation as a bank holding company (or subject to related restrictions on the types of activities FFMC and its other subsidiaries may engage in) as long as the credit card bank: (a) engages only in credit card operations, (b) accepts no deposits other than time deposits of $100,000 or more, (c) maintains only one office that accepts deposits, and (d) does not engage in the business of making commercial loans. First Financial Bank operates within these limitations. First Financial Bank is subject to examination and regulation by the Georgia Department of Banking and Finance and applicable federal regulatory agencies, including the Federal Deposit Insurance Corporation ("FDIC"), which in 1993 approved First Financial Bank's application for FDIC deposit insurance. Certain activities of NaBANCO are subject to examination and regulation. In addition, certain minimum capital ratios must be maintained by First Financial Bank, and arrangements between First Financial Bank and its affiliates must be on terms at least as favorable as those available from independent third parties. In addition, First Financial Bank and NaBANCO continue to be subject to the VISA and MasterCard rules, including a requirement that First Financial Bank maintain adequate capital (currently $70 million) based on the merchant credit card processing volume settled through First Financial Bank. INDUSTRY TRENDS The technological capabilities required for the rapid and efficient creation, processing, handling, storage and retrieval of information are becoming increasingly complex, thus requiring large capital expenditures and resulting in an industry consolidation that is beneficial to FFMC. FFMC's customers are handling an expanding variety and rapidly growing volumes of transactions. This processing increasingly requires the use of sophisticated software, hardware and communication technologies. Third-party credit card processing and check verification services are being performed increasingly through electronic means, which provide faster and more reliable confirmations and quicker and more convenient transaction processing and settlement. Sophisticated technological and communication capabilities are also essential to permit the imaging, creation and effective management of large data bases. Likewise, within the health care and pharmaceutical claims industry, there is an increasing need for data to be available more rapidly in order to manage and pay for health care services. Significant capital commitments are becoming increasingly important in order to develop, maintain and update the systems (including software, hardware and communication equipment and methods) necessary to provide these technologically advanced services at a competitive price. Economies of scale are needed to justify these capital investments. In addition, as more on-line and other electronic delivery systems are used, it is becoming easier to serve a wider geographic area from centralized data processing centers. As a result of these developments, many institutions are contracting with outside specialists for these services, and many small information processing and handling organizations are consolidating with large providers of these services. FFMC believes that it can benefit from these trends by leveraging the collective capabilities developed through its varied, but related, services and products which lend themselves to cross-selling and to synergistic combinations. The Company also believes that its growing array of information services and products enhances its ability to provide a total solutions approach to many of its customers' needs. EMPLOYEES At December 31, 1993, FFMC and its subsidiaries had approximately 11,500 employees. FFMC employees are not represented by a union. FFMC believes that relations with its employees are excellent. Although the demand for technical data processing personnel is high, the Company seeks to minimize the turnover of these and other key personnel by providing competitive compensation and benefits within its various geographic markets. FFMC emphasizes thorough documentation of its software programs and procedures to minimize any adverse effect of employee turnover. PRODUCT DEVELOPMENT FFMC's capitalized expenditures for software development, purchase and modification totalled approximately $31 million in 1993, $27 million in 1992 and $16 million in 1991. The amounts prior to 1993 are exclusive of the development costs incurred by Basis during these years which were written off during 1992 in connection with the settlement of litigation with a vendor. In addition, costs of software maintenance, research and conceptualization have been expensed when incurred. ITEM 2.

ITEM 2. PROPERTIES. The Company's corporate headquarters at 3 Corporate Square, Atlanta, Georgia is under lease through June 1995, with renewal options available upon expiration. Approximately 95,000 square feet is leased, and FFMC has options to lease additional space in the building as it becomes available. The headquarters facilities are in good repair and in suitable condition for the purposes for which they are used. The Company leases over 200 operations facilities across the United States and two locations in Canada. Many of these facilities also contain sales and administrative offices. Included in these facilities are approximately 100 data processing and service centers and four warehouse storage areas. These facilities are under leases that have expiration dates ranging from 1994 to 2003, with most containing renewal options. The Company owns the FIRST HEALTH Strategies operations facility in Salt Lake City, Utah, and a First Image facility in London, Kentucky. All of FFMC's properties are in good repair and in suitable condition for the purposes for which they are used. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. There were no material legal proceedings involving FFMC or its property required to be disclosed herein. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of FFMC's shareholders during the fourth quarter of 1993. EXECUTIVE OFFICERS Set forth below is information about FFMC's executive officers: Messrs. Thomas, Kane and Pittard have been principally employed as executive officers of FFMC for more than five years. Mr. Jackson assumed his present position in January 1993. He was Vice Chairman and Chief Executive Officer of Georgia Federal Bank, FSB ("Georgia Federal"), since July 1986 and became Senior Executive Vice President of FFMC in June 1989. Mr. Greene joined FFMC in June 1992. Previously, he served since 1991 as President and Chief Executive Officer of National Data Corporation and, from 1987 to 1991, as President and Chief Operating Officer, Financial Systems Division for Unisys Corporation. Mr. Emmons assumed his present position with FFMC in June 1993. From May 1989 until such time, he served as Executive Vice President and Chief Financial Officer of Georgia Federal. Previously, Mr. Emmons was Senior Vice President, Chief Financial Officer and Treasurer of BarclaysAmerican where he was employed since 1979. Mr. Hutto joined FFMC in January 1992 as Executive Vice President, Secretary and General Counsel. Previously he had been a partner with the law firm of Sutherland, Asbill and Brennan, FFMC's principal outside counsel, since 1985. Mr. Macchia assumed his present position with FFMC in September 1991. From December 1989 until such time, he served as Senior Vice President and Chief Financial Officer, Commercial Services, then a division of FFMC. From 1985 until he joined FFMC, Mr. Macchia was Executive Vice President, Chief Financial Officer, Secretary and a Director of MicroBilt Corporation. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. FFMC's $.10 par value common stock is traded on the New York Stock Exchange under the symbol "FFM." The high and low prices for the Company's common stock for each quarter during the last two years were as follows: The closing sale price for the Company's common stock on March 11, 1994 was $57 1/2 per share, with approximately 1,755 holders of record as of that date. In 1989 the Company established a policy of making semi-annual dividend payments to shareholders and the Company's Board of Directors has since declared semi-annual cash dividends of $.05 per share ($.033 per share prior to the three-for-two stock split distributed in March 1992). The Company's ability to pay dividends is limited by a covenant in FFMC's debt facility. The dividend amount permitted under the covenant, however, significantly exceeds the Company's current cash dividend payment levels. The Company expects to pay future cash dividends semi-annually depending upon the Company's pattern of growth, profitability, financial condition, and other factors which the Board of Directors may deem appropriate. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. FIRST FINANCIAL MANAGEMENT CORPORATION The following data should be read in conjunction with the consolidated financial statements and related notes thereto included elsewhere in this Annual Report and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company's merger with International Banking Technologies, Inc. ("IBT") in August 1993 has been accounted for as a pooling of interests and, accordingly, the following information (including share information) has been restated to include both FFMC and IBT. During each of the periods presented below, FFMC has made various acquisitions, accounted for as purchases, which affect the comparability of information presented. For additional information concerning the Company's acquisitions, see Note B to the consolidated financial statements. In addition, in 1992 the Company disposed of one of its two business segments and recorded a loss in another business unit that was sold. These dispositions are outlined in Note C to the consolidated financial statements. * Includes loss in business unit sold of $79,567 ($1.10 after-tax loss per share). ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. CONTINUING AND DISCONTINUED OPERATIONS The continuing operations of First Financial Management Corporation (the "Company" or "FFMC") consist of its information services businesses together with the corporate entity. These businesses provide a vertically integrated set of data processing, storage and management products for the capture, manipulation and distribution of information. Similarities exist among these businesses in the methods of providing services, in the customers served, and in the marketing activities utilized to obtain new customers. In addition, the Company continues to pursue further integration of its product and service offerings to gain competitive advantages. Services include merchant credit card authorization, processing and settlement; check guarantee and verification; debt collection and accounts receivable management; data imaging, micrographics and electronic data base management; health care claims processing and integrated management services; and the development and marketing of data communication and information processing systems, including in-store marketing programs and systems for supermarkets. Discontinued operations consist of the Company's previous financial services businesses, comprised of Georgia Federal Bank, FSB ("Georgia Federal"), formerly the largest thrift institution in Georgia, together with First Family Financial Services ("First Family"), which previously was Georgia Federal's regional consumer finance subsidiary. FFMC consummated several significant business transactions in 1993 that resulted from the Company's strategic reevaluation of its businesses completed during 1992. During the fourth quarter of 1992, the Company entered into agreements to sell First Family and Georgia Federal. These sales were consummated on November 10, 1992 and June 12, 1993, respectively. FFMC also agreed to sell Basis Information Technologies, Inc. ("Basis") during 1992's fourth quarter. Basis was the unit within the Company's information service businesses that provided data processing services to financial institutions. The sale of Basis was consummated on February 10, 1993. The terms of both the Georgia Federal and Basis sale agreements provided that the results of operations of these businesses after December 31, 1992 accrued to the respective purchasers. Accordingly, the Company's financial results do not include results for these businesses for the year ended December 31, 1993. Prior to entering into the agreement for the sale of Basis, the Company discontinued software development and wrote off related costs for a major product line in connection with the settlement of litigation with a vendor, the combination of which resulted in income of $13.8 million included in other revenues. Concurrently, the Company decided to explore the sale of Basis. In reviewing the potential market value of Basis, FFMC's management determined that a write-down of the carrying value of Basis' net assets was appropriate. Accordingly, the Company recognized a pretax loss of $79.6 million, an after-tax loss of $1.10 per share in 1992. Revenues attributable to Basis were $113.8 million in 1992 and its contribution to income before income taxes, aside from the items mentioned above, was approximately $4.5 million. In August 1993, FFMC completed its merger with International Banking Technologies, Inc. ("IBT"). This business combination has been accounted for as a pooling of interests and, accordingly, the following discussions include IBT as a part of FFMC's continuing operations for all periods presented. RESULTS OF OPERATIONS The following discussions pertain to the Company's continuing operations. 1993 Compared with 1992 FFMC's revenues increased 17% to $1.7 billion in 1993 from $1.4 billion in the prior year. Excluding Basis' 1992 revenues, the revenue growth rate for the year was 27%. Income from continuing operations increased to $127.6 million in 1993 from $18.8 million in 1992. Excluding the Basis asset write-down from the prior year's results, income from continuing operations increased 53% in 1993 compared with the prior year. Income per share from continuing operations increased to $2.10 per share in 1993, compared with $.32 in 1992. Per share earnings increased 48% over 1992 excluding the Basis write-down. The effect on the year-to-year revenue comparison of excluding Basis' 1992 revenues is largely offset by the incremental 1993 revenue contributions from the 1992 acquisitions of ALTA Health Strategies, Inc., renamed as FIRST HEALTH Strategies ("Strategies"), in April 1992 and TeleCheck Services, Inc. and its principal franchisee, Payment Services Company - U.S. (collectively referred to as "TeleCheck"), in July 1992. As a result, the 17% increase in revenues in 1993 is all attributable to internal growth. The internal growth in 1993 was due primarily to significant volume growth within FFMC's existing businesses which more than offset continued pricing pressures in several of FFMC's product areas. The Company's merchant services areas experienced strong volume growth in its credit card services and check verification and guarantee businesses. Record new customer volume was added from marketing efforts, including national, regional and local merchants. In addition, FFMC continued to cross-sell the multiple product offerings within its merchant services area, which resulted in the signing of additional national merchants to processing contracts. FFMC also experienced volume growth in its health care services area, with increases in claims processing for both public and private sectors. Health care businesses received contract awards or began claims processing under previously awarded contracts during 1993. The Company's imaging business experienced volume growth in 1993, which competitive pricing pressure partially offset to produce a small increase in revenues for the year. FFMC demonstrated the leveragibility of its businesses by translating the revenue increases, despite the pricing pressures noted above, into higher percentage rate increases in pretax income, thereby producing higher pretax margins. The Company's pretax margin was 12.9% in 1993 compared with a 10.2% pretax margin in 1992 (excluding the Basis write-down). Margins were also favorably influenced by the Company's continued emphasis on expense controls and the successful integration of acquisitions completed in 1992. Depreciation and amortization expenses declined 8% in 1993 primarily due to the inclusion of Basis in 1992. General and administrative expenses increased only 2% for the year (and decreased as a percent of revenues) as the Company enjoyed the benefit of the restructuring of its corporate infrastructure which occurred as a result of the 1992 strategic evaluation of the Company. The impact of the revenue increases and the expansion of margins in 1993 was enhanced by lower net interest expense during 1993. FFMC experienced lower borrowing levels in 1993, as a substantial portion of its debt obligations were repaid during the second quarter from cash received from the sale of businesses. Proceeds from these sales, along with increased cash generated from operations, resulted in higher levels of cash investments during the second half of 1993 which favorably impacted the Company's net interest expense for the year. FFMC adopted Statement of Financial Accounting Standards No. 109 ("FAS 109"), "Accounting for Income Taxes," effective January 1, 1993. The Company elected the prospective method of adoption allowable under FAS 109 instead of restating prior period results. The cumulative effect on the Company's results of operations of adopting FAS 109 was not material, and no adjustment was recorded. In addition, the Omnibus Budget Reconciliation Act of 1993 (the "1993 Act") was signed into law during 1993 which contained several provisions which affected the Company's 1993 income tax expense. The Company's effective tax rate decreased 1.5% in 1993 to 40.8%. The comparable prior year rate of 42.3% excludes the impact of the Basis write-down. The decrease, which occurred despite the 1% increase in the federal corporate tax rate, is attributable to lower levels of nondeductible goodwill, lower effective state tax rates and other favorable impacts of the 1993 Act and the Company's tax strategies. 1992 Compared with 1991 FFMC's revenues increased 35% to $1.4 billion in 1992 from $1.1 billion in 1991, primarily from new business acquisitions and revenue growth within existing businesses. Both income from continuing operations and related per share amounts decreased in 1992 compared with 1991's results. However, excluding the Basis asset write-down of $79.6 million, the Company's 1992 income from continuing operations increased 33% to $83.5 million from the $62.7 million reported in 1991. Fully diluted income per share from continuing operations, excluding the Basis write-down, increased 15% to $1.42 from $1.23 in 1991. Revenue growth from business acquisitions in 1992 resulted primarily from the Company's acquisition of Strategies (April 1992) and TeleCheck (July 1992). Existing businesses expanded revenues in 1992 from volume increases as a result of new customers and expanded business with existing customers. The merchant credit card processing area benefited from an increase in retail activity during the 1992 holiday season in the fourth quarter. Health care services experienced increased claims processing volume and received several new long-term contracts with government agencies and became fully operational on several other processing contracts. Higher personnel costs within the newly acquired Strategies and TeleCheck businesses in 1992 caused operating expenses, as a percentage of service revenues, to increase in 1992 over the prior year. In addition, 1992's business acquisitions increased goodwill amortization from prior year levels. Interest expense (net of interest income) declined in 1992 due to lower interest rates and reduced borrowing levels due to the conversion of all of the Company's convertible subordinated debentures into common stock in October 1991, and repayment of borrowings under FFMC's revolving credit facility from the cash proceeds received from the First Family sale. FFMC's continuing operations, excluding the Basis asset write-down, generated 1992 earnings before taxes of $144.7 million, a pretax margin of 10.2%. This margin is consistent with the 9.9% pre-tax margin on earnings before income taxes of $104.6 million in 1991. The Company's 1992 effective tax rate of 71.1% was substantially above the federal statutory rate due to the nondeductibility of the majority of the Basis asset write-down. Excluding the effect of the write-down, FFMC's provision for income taxes from continuing operations increased to 42.3% in 1992 from 40.1% in 1991. This increase was due primarily to increased state income taxes, lower IBT Subchapter S income taxed at the shareholder level, and lower tax credits. ECONOMIC FLUCTUATIONS The Company's business is somewhat insulated from economic fluctuations due to recurring revenues from long-term service contracts, and the fact that the Company's services often result in cost savings for its customers. The slow growth, but steadily improving economic environment during 1993 benefited FFMC's results, as the Company experienced higher year-to-year processing volumes, particularly in its merchant services area. The results of FFMC's health care services area have not been significantly affected by recent reform oriented developments in that industry. The Company's business is not seasonal, except that its revenues, earnings and margins are favorably affected in the fourth quarter, primarily by increased merchant credit card and check volume during the holiday season. Although FFMC cannot precisely determine the impact of inflation on its operations, inflation affects the Company through increased costs of employee compensation and other operating expenses. In addition, competition for employees with data processing skills, programming expertise, and other technical knowledge contributes to increased costs in some parts of the country. To the extent permitted by the Company's service contracts, these increases in costs are passed along to customers in the form of periodic price increases. FFMC's revenues from merchant credit card processing and check verification and guarantee services are generally a percentage of the dollar volume of transactions processed. The Company's operating margins on these services are therefore relatively insulated from the effects of inflation on merchant prices for goods and services. As a result, the Company has not been significantly affected by inflation. CAPITAL RESOURCES AND LIQUIDITY The following discussions pertain to the Company's continuing operations, and the effects on cash flows of FFMC's business dispositions. Cash generated from operating activities increased 42% in 1993 to $207 million, as compared with the $146 million generated in 1992 and $121 million in 1991. This increase was due primarily to increased income from continuing operations. FFMC reinvests cash in its businesses, principally for property and equipment additions, software development and customer conversions. Amounts reinvested totalled $80 million in 1993 compared with $78 million in 1992 and $67 million in 1991. The Company anticipates that the level of these capital investments in its existing businesses for 1994 will be similar to 1993 amounts. Cash from operating activities exceeded non-acquisition investing activities by $128 million in 1993, $68 million in 1992, and $53 million in 1991. FFMC activated its credit card bank, First Financial Bank ("FFB"), during the second quarter of 1993 with a required initial capitalization of $70 million. The capitalization of FFB is based upon requirements of bank card associations given the size of FFMC's credit card processing operations. The primary purpose of FFB is to support the Company's merchant services activities, a function previously provided by Georgia Federal Bank. Except for the support FFB provides for FFMC's merchant services activities, FFB does not conduct any significant banking activities, accept deposits from unaffiliated parties, or engage in lending activities. FFB's capitalization and activities comply with applicable regulatory requirements and restrictions. The Company received $345 million in cash in 1993 through dividends from its discontinued operation and from the sale of businesses, after expenses, that were completed during 1993. The Company also had received $150 million in cash from Georgia Federal during 1992, comprised of a $100 million dividend and a $50 million payment toward the settlement of income tax liabilities from the sale of First Family which were paid by FFMC during 1993. The Company utilized these proceeds to repay $154 million of long-term debt obligations in 1993 and $146 million in 1992, including all outstanding borrowings under FFMC's revolving credit facility. The Company's long-term debt to equity ratio dropped to 1.2% at December 31, 1993 from 13.9% at December 31, 1992. Cash consideration paid for business acquisitions (net of cash acquired), including amounts paid related to acquisitions completed in prior years, utilized $92 million in 1993, $267 million in 1992 and $72 million in 1991. The Company funded the 1993 acquisitions from cash resulting from operations and from cash balances generated from the sale of businesses. FFMC utilized capital markets and borrowings under debt arrangements to supplement excess cash generated from operations to fund its acquisition program in 1992. FFMC has potential obligations under certain acquisition agreements to pay future consideration to the former shareholders of specified acquired businesses. Any such payments will be due only if the acquired entity's results of operations exceed specified targeted levels which are generally set substantially above the historical experience of the acquired entity. Thus, any such payments will not negatively impact the Company's financial position. The Company currently has available lines of credit of $460 million; no borrowings were outstanding under these arrangements at December 31, 1993. These arrangements consist primarily of a $450 million unsecured revolving credit facility. This facility has a term ending in June 1995, with two possible one year extensions, and allows FFMC flexibility to reduce borrowing levels with excess cash funds which are not immediately utilized for business investments. Remaining excess cash funds are invested in short-term interest-bearing securities. The Company continued its practice established in 1989 of paying semi-annual $.05 per share cash dividends to shareholders, maintaining a constant dividend rate per share despite a three-for-two stock split effective March 31, 1992. FFMC's cash and cash equivalents of $186 million at December 31, 1993, except for cash and cash equivalents in its credit card bank (currently $80 million), are available for acquisitions and general corporate purposes. If suitable opportunities arise for additional acquisitions the Company may use cash, draw on its credit facilities, or use common stock or other securities as payment of all or part of the consideration for such acquisitions, or FFMC may seek additional funds in the equity or debt markets. The Company believes that its current level of cash and future cash flows from operations are sufficient to meet the needs of its existing businesses. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements and supplementary data filed as a part of this Form 10-K are listed in the Index to Consolidated Financial Information. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. FFMC has not filed or been required to file a Form 8-K reporting a change of accountants or reporting a disagreement on any matter of accounting principles or practices or financial statement disclosures. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information concerning the nominees for Directors of FFMC is contained under "Election of Directors" at page 4 in FFMC's Proxy Statement for the April 27, 1994 Annual Meeting of Shareholders and is incorporated herein by reference in response to the information required by this item. Information concerning the Executive Officers of FFMC is contained in a separate section captioned "Executive Officers" in Part I of this Report and is incorporated herein by reference in response to the information required by this item. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information set forth under "Compensation Related Matters" at page 5 in FFMC's Proxy Statement for the April 27, 1994 Annual Meeting of Shareholders is incorporated herein by reference in response to the information required by this item. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information set forth under "Voting Securities" and "Election of Directors" (regarding ownership of FFMC stock) at pages 1 and 4, respectively, in FFMC's Proxy Statement for the April 27, 1994 Annual Meeting of Shareholders is incorporated herein by reference in response to the information required by this item. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information set forth under "Certain Transactions" at page 15 in FFMC's Proxy Statement for the April 27, 1994 Annual Meeting of Shareholders is incorporated herein by reference in response to the information required by this item. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. _____________________________ * Indicates management contract or compensatory plan or arrangement. (1) Filed on April 1, 1991 as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. (2) Filed on March 23, 1992 as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference. (B) REPORTS ON FORM 8-K The Company did not file any current report on Form 8-K during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 28, 1994. FIRST FINANCIAL MANAGEMENT CORPORATION By: /s/ Patrick H. Thomas ------------------------------------------ Patrick H. Thomas Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. FIRST FINANCIAL MANAGEMENT CORPORATION INDEX TO CONSOLIDATED FINANCIAL INFORMATION FINANCIAL STATEMENTS: All other schedules (as required under Article 5 of Regulation S-X) are omitted because they are either not applicable or the information is presented in the financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders First Financial Management Corporation Atlanta, Georgia We have audited the accompanying consolidated balance sheets of First Financial Management Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of First Financial Management Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note A to the financial statements, the Company changed its method of accounting for income taxes in 1993 to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Atlanta, Georgia January 28, 1994 FIRST FINANCIAL MANAGEMENT CORPORATION CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. FIRST FINANCIAL MANAGEMENT CORPORATION CONSOLIDATED STATEMENTS OF INCOME See notes to consolidated financial statements. FIRST FINANCIAL MANAGEMENT CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY See notes to consolidated financial statements. FIRST FINANCIAL MANAGEMENT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements. FIRST FINANCIAL MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION The consolidated financial statements include the accounts of First Financial Management Corporation and its wholly-owned subsidiaries (the "Company" or "FFMC"). All material intercompany profits, transactions, and balances have been eliminated. The Company's continuing operations operate in a single business segment ("Information Services") providing a vertically integrated set of data processing, storage and management products for the capture, manipulation and distribution of information. Services include merchant credit card authorization, processing and settlement; check guarantee and verification; debt collection and accounts receivable management; data imaging, micrographics and electronic data base management; health care claims processing and integrated management services; and the development and marketing of data communication and information processing systems, including in-store marketing programs and systems for supermarkets. In 1993, FFMC formed First Financial Bank ("FFB"), its credit card bank, whose only significant business purpose is to support the Company's merchant services activities. FFB does not conduct any other significant banking activities, accept deposits from unaffiliated parties, or engage in lending activities. DISCONTINUED OPERATIONS In 1993, FFMC completed the sale of its Financial Services businesses (see Note C - Dispositions). For purposes of the consolidated financial statements, net amounts for these businesses have been presented separately as discontinued operations. CASH EQUIVALENTS Cash equivalents, which consist of investment grade debt instruments with an original maturity of three months or less, are stated at cost which approximates market value. FFMC utilizes primarily repurchase agreements of government or mortgage-backed securities for its short-term cash investments. Cash and cash equivalents at December 31, 1993 include approximately $80 million in FFB, of which $70 million relates to FFB's current capital requirements. PROPERTY AND EQUIPMENT Property and equipment are stated at cost, less accumulated depreciation or amortization which is provided on a straight-line basis over the lesser of the useful life of the related assets or lease term. EXCESS OF COST OVER FAIR VALUE OF ASSETS ACQUIRED The excess of cost over fair value of assets acquired represents the excess of the cost of acquired businesses over the value assigned to tangible and identifiable intangible assets, and is amortized on a straight-line basis, primarily over 40 years. CUSTOMER CONTRACT COSTS Customer contract costs represent the costs assigned to purchased customer contracts, and are amortized on a straight-line basis over the estimated average lives of the contracts (10-15 years). OTHER ASSETS The principal components of other assets include software development costs and customer conversion costs, both of which are amortized on a straight-line basis over four years. INCOME TAXES FFMC adopted Statement of Financial Accounting Standards No. 109 ("FAS 109"), "Accounting for Income Taxes," effective January 1, 1993. Under FAS 109, deferred income taxes are determined based on the difference between financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the years in which such differences are expected to reverse. The Company elected the prospective method of adoption allowable under FAS 109 instead of restating prior period results. No cumulative effect on the Company's results of operations from adopting FAS 109 was recorded because it was insignificant. Prior to January 1, 1993 deferred income taxes were provided in accordance with Accounting Principles Board Opinion No. 11. REVENUE RECOGNITION Service revenues are recognized as services are performed and product sales (data processing equipment and related software enhancements) are recognized upon delivery. Interchange fees incurred in the settlement of merchant credit card transactions are included in operating expenses. INCOME PER SHARE Income per share amounts on a primary basis are computed by dividing income amounts by the weighted average number of common and common equivalent shares (when dilutive) outstanding during the period. Common stock equivalents consist of shares issuable under the Company's stock option plans and in connection with outstanding warrants. Income per share amounts on a fully diluted basis give effect to the conversion of outstanding convertible subordinated debentures through the date of their actual conversion in 1991 (after elimination of related after-tax interest expense). Weighted average shares for all periods reflect the shares issued in 1993 to effect FFMC's merger with International Banking Technologies, Inc., which was accounted for as a pooling of interests. Weighted average shares used in income per share computations were as follows (in thousands): B. BUSINESS COMBINATIONS AND ACQUISITIONS FFMC completed the following business combinations and asset acquisitions: All of the outstanding common stock was acquired for each of the businesses noted in the table above. Other consideration, not separately listed in the table, consists of promissory notes and accounts payable totalling $21.8 million and $10.7 million for acquisitions in 1993 and 1991, respectively. The merger with IBT was accounted for as a pooling of interests and, accordingly, the Company's financial statements include the accounts and operations of IBT for all periods presented. Prior to the combination, IBT was a Subchapter S Corporation and included no income taxes in its financial statements since its income was taxed at the shareholder level. Also, IBT owned shares of FFMC common stock for investment purposes prior to the merger with FFMC which have been reclassified as treasury stock in the accompanying balance sheets. Results of IBT included with FFMC's consolidated results are as follows: All other business combinations and asset acquisitions have been accounted for as purchases, and their results have been included in the results of the Company's continuing operations from the effective dates of acquisition. The following table summarizes the pro forma results of operations of the Company as if the Company's acquisitions of Strategies and TeleCheck had occurred on January 1, 1991. All other acquisitions have been excluded due to their immaterial effect. This pro forma information is not necessarily indicative of what the combined operations would have been if the Company had control of such combined businesses for the periods presented. The acquired entities provide the following types of information services and products: IBT, in-store marketing programs and systems for supermarkets; Strategies, health care management services; TeleCheck, check guarantee and verification services; Kalvar Corporation, micrographics and other data imaging services. The Company also acquired four companies that previously held TeleCheck franchises and purchased merchant credit card processing contracts from six different companies during these periods. Other acquisitions include twenty-one entities that expanded the Company's markets and service offerings in data imaging and micrographics, retail information processing systems, and information management systems and services to hospitals and Medicare programs. The terms of certain of the Company's acquisition agreements provide for additional consideration to be paid if the acquired entity's results of operations exceed certain targeted levels. Targeted levels are generally set substantially above the historical experience of the acquired entity at the time of acquisition. Such additional consideration is paid in cash and with shares of the Company's common stock, and is recorded if and when earned as "excess of cost over fair value of assets acquired." Acquisitions consummated in 1993 have a maximum of approximately $50 million in additional contingent consideration payable based upon the achievement of targeted revenue or profit levels for various periods through 1999. Additionally, cash was paid and shares of FFMC common stock were distributed totalling $10.7 million in 1993, $6.5 million in 1992 and $4.0 million in 1991 related to businesses acquired prior to 1993 which have maximum remaining contingent consideration totalling approximately $20 million, payable through 1995. C. DISPOSITIONS During the fourth quarter of 1992, FFMC sold or signed agreements to sell the following businesses: Georgia Federal and First Family formerly comprised FFMC's Financial Services business segment. Georgia Federal was the largest thrift institution in Georgia, and First Family was a regional consumer finance company. For purposes of the consolidated financial statements, net amounts for these businesses have been presented as discontinued operations. The assets and liabilities of these businesses are included in the December 31, 1992 balance sheet as net assets of discontinued operations. Interest expense was allocated to the Company's discontinued operations for each of the periods presented, including the 1993 period prior to the completion of the Georgia Federal sale. This allocation was based on the net assets of discontinued operations relative to the sum of the consolidated net assets plus long term debt of continuing operations, none of which was directly attributable to specific operations. The agreement for the sale of Georgia Federal provided that the results of operations of Georgia Federal after December 31, 1992 accrued to the buyer. Revenues attributable to FFMC's discontinued operations were $184.5 million in 1992 and $173.9 million in 1991, and income from discontinued operations was net of income taxes of $20.5 million in 1992 and $18.0 million in 1991. Basis provided data processing services to financial institutions, and prior to its sale was included in FFMC's continuing operations in the accompanying consolidated financial statements. The agreement for the sale of Basis provided that Basis' results of operations after December 31, 1992 would accrue to the buyer. Prior to entering into the stock purchase agreement for the sale of Basis, the Company discontinued software development and wrote off related costs for a major product line in connection with the settlement of litigation with a vendor, the combination of which resulted in income of $13.8 million included in other revenues in 1992. Concurrently, FFMC decided to explore the sale of Basis. In reviewing the market value of Basis, the Company's management determined that a write-down of the carrying value of Basis' net assets was appropriate and recognized a fourth quarter 1992 pretax loss of $79.6 million. D. PROPERTY AND EQUIPMENT Amounts charged to expense for the depreciation and amortization of property and equipment were $30.6 million, $31.9 million and $25.3 million, respectively, for the years ended December 31, 1993, 1992 and 1991. E. ACCOUNTS PAYABLE AND ACCRUED EXPENSES The accounts payable balance at December 31, 1993 includes $105.3 million in credit card settlements due to merchants from FFB. Related amounts due to FFB from credit card associations totalling $101.5 million are included in FFMC's accounts receivable balance at December 31, 1993. F. LONG-TERM DEBT FFMC has an unsecured revolving credit facility totalling $450 million. The facility has a term through June 1995 (with two possible one year extensions), with borrowings due at the end of the term. Borrowings at December 31, 1992 were classified as current due to the Company's intention to repay these borrowings in 1993. Interest rates for borrowings under the facility are established based on floating market rates in effect at the time of borrowing. The facility contains covenants which require the Company to meet certain financial tests and restrict certain activities in the future, none of which are expected to significantly affect the Company's operations. At December 31, 1993, the Company was in compliance with all of these covenants. The Company also has a separate $10 million unsecured line of credit available to cover short-term operating cash needs. Other obligations consist of equipment notes payable and capitalized lease obligations. These obligations have interest rates ranging from 2% to the prime commercial lending rate, and are due at various dates through 2003. Maturities of long-term debt at December 31, 1993 are due as follows: $6.2 million in 1994; $1.5 million in 1995; $4.9 million in 1996; $.9 million in 1997; $.6 million in 1998; and $.6 million in all periods thereafter. G. LEASES AND CONTINGENCIES The Company leases certain of its facilities and equipment under operating lease agreements. Lease terms generally range from one to seven years and substantially all agreements contain renewal options. Total rent expense for operating leases was $37.6 million, $41.9 million and $32.5 million for the years ended December 31, 1993, 1992 and 1991, respectively. Minimum rental commitments at December 31, 1993 under operating leases having an initial or remaining noncancelable term of one year or more are as follows: Additionally, one of the Company's merchant services businesses leases supermarket space which it concurrently leases to its bank customers. The lease terms, renewal options, and rent escalation provisions of the Company's lease to the bank generally mirror the corresponding provisions of the Company's lease from the supermarket. Lease rentals received exceed lease payments and the terms of the leases are generally for noncancelable initial terms of five years. Total lease payments to supermarkets were $5.7 million, $4.7 million, and $4.4 million for the years ended December 31, 1993, 1992 and 1991, respectively, and remaining obligations under supermarket leases as of December 31, 1993 are as follows: $6.8 million in 1994; $6.6 million in 1995; $5.7 million in 1996; $4.9 million in 1997; $3.5 million in 1998; and $2.9 million in all periods thereafter. A state has attempted to prematurely terminate its Medicaid claims processing contract with the Company. Management contends such action is improper, intends to pursue its rights under the contract and expects the ultimate outcome will not have a material negative impact on the Company's financial statements. H. INCOME TAXES The provision for income taxes for continuing operations includes: The Company's effective tax rates for continuing operations differ from statutory rates as follows: In years prior to 1993, deferred income taxes arose from the recognition of certain income and expenses for tax purposes in years different from those in which they are recognized in the financial statements. The tax effects of these timing differences, which are deducted from (added to) the amount currently payable in determining the provision for taxes on income, are as follows: Deferred tax assets and liabilities at December 31, 1993 consist of net noncurrent deferred tax liabilities of $63.3 million and net current deferred tax assets (included in prepaid expenses and other current assets) of $22.3 million. There is no valuation allowance. Principal components of deferred tax items, as aggregated under FAS 109, are as follows: During 1993, the Internal Revenue Service completed its examinations of the Company's 1986 and 1987 federal income tax returns, with no material negative impact to the Company. In addition, the Internal Revenue Service is currently conducting its examinations of FFMC's 1988 and 1989 federal income tax returns, for which no report has been issued. While the results of the 1988 and 1989 examinations are not currently determinable, the management of the Company believes the results will not have a material effect on the Company's financial position or results of operations. I. SHAREHOLDERS' EQUITY On August 18, 1993, FFMC issued 1,000,000 unregistered shares of its common stock related to the Company's merger with International Banking Technologies, Inc. On January 29, 1992, the Company's Board of Directors authorized a stock split of each two $.10 par value shares into three $.10 par value shares of the Company's common stock and increased the number of authorized shares from 100 million to 150 million. The split was distributed on March 31, 1992 to holders of record on March 2, 1992. All share and per share data have been restated to reflect this stock split. In June 1989, the Company sold 6.3 million shares of its common stock to an investment banking firm, resulting in net proceeds to the Company of $120.1 million. These shares were issued with warrants to subscribe for up to 2.1 million additional common shares at $26.67 per share. A total of 1.6 million shares remained under warrant at December 31, 1993, with such warrants exercisable during specified periods in 1994 and 1995. During 1988, the Company issued $172.5 million of 7% convertible subordinated debentures due 2013 convertible into shares of the Company's common stock. On October 9, 1991, the Company completed the retirement of these debentures (following a call for redemption) totally through conversion into common stock, resulting in the issuance of 7.3 million shares. Related conversion costs and unamortized issuance costs totalling $4.6 million were charged to paid-in capital. In July 1991, the Company completed an equity offering of 6.5 million shares of its common stock, resulting in net proceeds to the Company of $144.8 million. The Company's Articles of Incorporation authorizes 5,000,000 shares of preferred stock, none of which are issued. Also, the Company's ability to pay dividends on its common stock is limited by a covenant in its revolving credit facility. The dividend amount permitted under the covenant, however, significantly exceeds the Company's current cash dividend payment levels. J. STOCK OPTIONS AND AWARDS The Company has various plans that provide for the granting of stock options and restricted shares to certain officers, employees and non-employee members of the Company's Board of Directors. A total of 5.9 million shares of FFMC common stock has been authorized for issuance under these plans. The Company has reserved the appropriate number of shares of common stock to accommodate these plans and other outstanding options. Options to purchase shares of the Company's common stock are generally granted at not less than the common stock's fair market value at the date of grant, have ten-year terms, and become exercisable in five equal annual increments beginning six months after the grant date. In connection with the Company's acquisitions, outstanding options under certain stock option plans were assumed. These options were converted to options to purchase shares of FFMC common stock and are exercisable on specified conditions and at specified times not later than ten years from the date of grant. A summary of stock option transactions is as follows: Common stock awards have restrictions that generally expire after two to five years of continuous service from the grant date. The value of the awards is determined using closing prices of the Company's common stock on the grant date, and is amortized to expense on a straight-line basis over the restriction period. The unamortized portion of such awards is reported as a reduction in paid-in capital. A summary of stock award transactions is as follows: K. EMPLOYEE BENEFIT PLANS The Company maintains a defined contribution savings and profit sharing plan covering substantially all employees. The savings component of the plan provides a tax deferred amount for each participant consisting of an employee elective contribution and a matching amount provided by the Company. The profit sharing component consists of a Company contribution for each eligible participant. The profit sharing contribution and the extent of the Company's savings plan match are based on the Company's financial performance. The aggregate amounts charged to expense in connection with this plan were $2.4 million in 1993, $2.0 million in 1992 and $1.3 million in 1991. The Company has an employee stock purchase plan for which a total of 2,250,000 unissued shares have been reserved for purchase. Monies accumulated through payroll deductions elected by eligible employees are used to effect quarterly purchases of FFMC common stock at a 5% discount from the lower of the market price at the beginning or end of the quarter. The Company does not offer post-retirement health care or other insurance benefits for retired employees. FIRST FINANCIAL MANAGEMENT CORPORATION QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (In thousands, except per share data) FFMC completed its merger with International Banking Technologies, Inc. ("IBT") during the third quarter of 1993. This merger has been accounted for as a pooling of interests. Accordingly, the previously reported results for all quarterly periods prior to the merger have been restated to combine the results of FFMC and IBT. Per share amounts have been recalculated after adding the shares of FFMC common stock issued to effect the merger to weighted average share amounts. INDEPENDENT AUDITORS' REPORT To The Board of Directors and Shareholders of First Financial Management Corporation Atlanta, Georgia We have audited the consolidated financial statements of First Financial Management Corporation and subsidiaries (the "Company") as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 28, 1994; such report is included elsewhere in this Form 10-K. Our audits also included the financial statement schedules of the Company, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Atlanta, Georgia January 28, 1994 FIRST FINANCIAL MANAGEMENT CORPORATION SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (IN THOUSANDS) There were no reportable items for the year ended December 31, 1991. (1) David J. Cotcher is formerly the President of MicroBilt Corporation, a subsidiary of FFMC. These notes bear interest at a floating rate tied to the Federal short-term rate, as defined in the Internal Revenue Code of 1986, as amended (currently 3.9%), and are payable on demand. (2) Virgil R. Williams was elected as a Director of the Registrant in 1993, and was previously a principal shareholder of International Banking Technologies, Inc. ("IBT"). IBT had this note receivable from Mr. Williams prior to its merger with FFMC; such merger was completed in August 1993. This note bears interest at eight percent and is payable on demand. (3) ETI is a company 50% owned by Virgil R. Williams, a Director of the Registrant. IBT had loaned funds to ETI under a working capital line of credit prior to its merger with FFMC. Interest was payable at the prime commercial lending rate plus one percentage point. The entire balance of this loan, plus accrued interest, was repaid on February 28, 1994. FIRST FINANCIAL MANAGEMENT CORPORATION SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) (1) Additional amounts added during the year are from acquired businesses, representing balances at the date of acquisition. (2) Amounts represent write-offs. FIRST FINANCIAL MANAGEMENT CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) Taxes (other than payroll and income taxes), royalties, and advertising costs did not exceed one percent of total revenues in any year presented. INDEX TO EXHIBITS _____________________________ * Indicates management contract or compensatory plan or arrangement. (1) Filed on April 1, 1991 as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. (2) Filed on March 23, 1992 as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference.

859257_1993.txt

859257

1993

Item 1. Business The Sears Credit Account Trust 1990 A (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of January 12, 1990 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2.

Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in December, 1989 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3.

Item 3. Legal Proceedings None Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13.

Item 13. Certain Relationships and Related Transactions None PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Sears Credit Account Trust 1990 A (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1990 A 8.75% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated March 30, 1990, (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest.............................................$87.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$87.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods................................$471,908,076.33 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods....................................$117,419,677.70 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates...............................$356,582,636.70 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$75,689,509.69 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate................................$115,325,439.63 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$41,730,168.01 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest.............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer.........$8,074,999.96 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods................................$231,000,000.00 15) The aggregate amount of Investment Income during the related Due Periods...............$8,421,875.00 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year............................$231,000,000.00 17) The Deficit Accumulation Amount, as of the end of the reportable year...............................$0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods.....................................$43,749,999.96 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year........$18,229,166.65 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1989E November 13, 1989 Sears Credit Account Trust 1990A January 12, 1990 Sears Credit Account Trust 1990B February 22, 1990 Sears Credit Account Trust 1990C July 31, 1990 Sears Credit Account Trust 1990D October 15, 1990 Sears Credit Account Trust 1990E December 1, 1990 It is understood that this report is solely for your information and is not to be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations Report. We found such amounts to be in agreement. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Association as Trustee Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

79879_1993.txt

79879

1993

ITEM 1. BUSINESS PPG Industries Inc., incorporated in Pennsylvania in 1883, is comprised of three basic business segments: coatings and resins, glass and chemicals. Within these business segments, PPG has followed a careful program of directing its resources of people, capital and technology in selected areas where it enjoys positions of leadership. Primary areas in which resources have been focused are automotive, industrial and architectural coatings, flat glass, automotive original and replacement glass, aircraft transparencies, continuous strand fiber glass, and industrial and specialty chemicals. Each of the business segments in which PPG is engaged is highly competitive. However, the broad diversification of product lines and worldwide markets served tend to minimize the impact of changes in demand for a particular product line on total sales and earnings. Reference is made to "Business Segment Information" on pages 20 and 21 of the Annual Report to Shareholders, which is incorporated herein by reference, for financial information relating to business segments. COATINGS AND RESINS PPG is a major manufacturer of protective and decorative coatings. The coatings industry is highly competitive and consists of a few large firms with global presence, and many smaller firms serving local or regional markets. PPG competes in its primary markets with the world's largest coatings companies, most of which have operations in North America and Europe. Product development, innovation, quality and customer service have been stressed by PPG and have been significant factors in developing an important supplier position. The industrial portion of the coatings business involves the supply of protective and decorative finishes for autos, appliances, industrial equipment, and containers; factory finished aluminum extrusions and coils for architectural uses; and other industrial and consumer products. In addition to the supply of finishes to the automotive original equipment market, PPG supplies automotive refinishes to the aftermarket which are primarily sold through distributors. In the industrial portion of the coatings business, PPG sells directly to a variety of manufacturing companies. Product performance, quality and customer service are major competitive factors. The industrial coatings are formulated specifically for the customer's needs and application methods. PPG also manufactures adhesives and sealants for the auto industry and metal pretreatments for auto and industrial applications. The architectural finishes business consists primarily of coatings used by painting and maintenance contractors and by consumers for decoration and maintenance. PPG's products are sold through independent distributors, paint dealers, mass merchandisers and home centers. Price, quality and service are key competitive factors in the architectural finishes market. Coatings and resins' principal production facilities are concentrated in North America and Europe. North American production facilities consist of 14 plants in the United States, one in Canada and one in Mexico. The three largest facilities are the Cleveland, OH plant, which primarily produces automotive original coatings; the Oak Creek, WI plant, which produces automotive original and other industrial coatings; and the Delaware, OH plant, which primarily produces automotive refinishes and certain industrial coatings. Outside North America, PPG operates three plants each in Italy and Spain; two plants in France and one plant each in England and Germany. These plants produce a variety of industrial and architectural coatings. PPG owns a 60 percent interest in a sales operation in Hong Kong, 50 percent interests in operations in South Korea and in Japan, and a minority interest in an operation in Taiwan. Additionally, coatings and resins operates 11 service centers in the United States, two in Canada and one in Mexico to provide just-in-time delivery and service to selected automotive assembly plants. The average number of persons employed by the coatings and resins segment during 1993 was 9,400. GLASS PPG is one of the major producers of flat glass, fabricated glass and continuous strand fiber glass in the world. PPG's major markets are automotive original equipment, automotive replacement, residential and commercial construction, aircraft transparencies, the furniture, marine and electronics industries and other markets. Most glass products are sold directly to manufacturing and construction companies, although in some instances products are sold directly to independent distributors and through PPG distribution outlets. Fiber glass products are sold directly to manufacturing companies and independent distributors. PPG manufactures flat glass by the float process and fiber glass by the continuous filament process. The bases for competition are price, quality, technology, cost and customer service. The Company competes with five other major producers of flat glass, five other major producers of fabricated glass and two other major producers of fiber glass throughout the world. PPG's principal glass production facilities are concentrated in North America and Europe. Fourteen plants operate in the United States, of which six produce flat glass, five produce automotive glass, two produce fiber glass products and one produces aircraft transparencies. There are three plants in Canada, two of which produce automotive glass and one produces flat glass. Four plants operate in Italy; one manufactures automotive and flat glass, one produces automotive glass, one produces flat glass, and another produces aircraft transparencies. Three plants are located in France; one plant manufactures automotive and flat glass and two plants produce automotive glass. One plant in England and one plant in the Netherlands produce fiber glass. PPG owns equity interests in operations in the United States, Canada, France, the People's Republic of China, Taiwan and Venezuela and a majority interest in a glass distribution company in Japan. The average number of persons employed by the glass segment during 1993 was 15,800. CHEMICALS Major chlor-alkali products of PPG's chemicals business are chlorine, caustic soda, vinyl chloride monomer, chlorinated solvents, and chlorinated benzenes. Major specialty chemicals are silicas-based compounds for the tire, shoe and battery separator businesses; surfactants used for food emulsification, sugar processing, and personal care products; CR-39 monomer for optical plastics; photochromic lenses; calcium hypochlorite used for water treatment, primarily swimming pool applications; and phosgene derivatives for the pharmaceutical, herbicide and fuel additives businesses. PPG is a major producer of those chlor-alkali chemicals it manufactures. Most of the chemicals are sold directly to other manufacturing companies in the chemical processing, rubber and plastics, paper, minerals and metals, and water treatment industries. Price, availability and quality of product and customer services are competitive factors for chlor-alkali chemical products. In the specialty chemicals area, PPG's market share varies greatly and product performance and technical service are important competitive factors. PPG's chemical production facilities consist of ten plants in North America, two plants in Taiwan, and one each in France, the Netherlands and the People's Republic of China. The two largest facilities are the Lake Charles, LA and Natrium, WV plants which primarily produce chlor-alkali products and derivatives. PPG owns equity interests in one company each in Japan and in Thailand, and two in the United States. The average number of persons employed by the chemicals segment during 1993 was 4,300. BUSINESS TO BE DIVESTED IN 1994--BIOMEDICAL SYSTEMS DIVISION The Biomedical Systems Division is a manufacturer, supplier and servicer of integrated medical systems for human health care on a worldwide basis. Major markets involve cardiopulmonary applications, including cardiac catheterization, electrocardiographs and related equipment for diagnosis of cardiovascular diseases, patient monitoring systems and sensors for both vital signs and respiratory monitoring functions. A large number of competitors provide products on either a global or regional basis. PPG sells directly to hospital and clinical customers and through distributor organizations in selected markets, and distributes selected original equipment products for other manufacturers. Product performance, quality and technical service capability are major competitive factors. A decision was made in the fourth quarter of 1993 to divest the Company's Biomedical Systems Division. PPG expects the sale of the medical electronics portion of this business to be completed by the end of the first quarter of 1994. The remaining sensors business is expected to be sold by the end of 1994. Production facilities include two plants in the United States and two in Germany. The average number of persons employed by the Biomedical Systems Division during 1993 was 1,300. RAW MATERIALS The effective management of raw materials is important to PPG's continued success. The Company's most significant raw materials are sand, soda ash, energy and polyvinyl butyral in the glass segment, titanium dioxide and epoxy resins in the coatings and resins segment, and energy and ethylene in the chemicals segment. Most of the raw materials used in production are purchased from outside sources, and the Company has made, and will continue to make, supply arrangements to meet the planned operating requirements for the future. For the significant raw material requirements identified above, and other material, there is more than one source of supply. PATENTS Although PPG considers patent protection to be important from an overall standpoint, the Company's business segments are not materially dependent upon any single patent or group of related patents. PPG received $25 million, $27 million and $30 million from royalties and the sale of technical know-how during the years 1993, 1992 and 1991, respectively. RESEARCH AND DEVELOPMENT Research and development costs, including depreciation of research facilities, during 1993, 1992 and 1991 were $218 million, $221 million and $240 million, respectively. Research and development facilities are maintained for each business segment. Each of the facilities conducts research and development involving new and improved products and processes, and additional process and product development work is undertaken at many of the Company's manufacturing plants. PPG owns and operates 11 research and development facilities in the United States and Europe. BACKLOG In general, PPG does not manufacture its products against a backlog of orders; production and inventory levels are geared primarily to projections of future demand and the level of incoming orders. NON-U.S. OPERATIONS Although PPG has a significant investment in non-U.S. operations, based upon the extent and location of investments, management believes that the risk associated with its international operations is not significantly greater than domestic operations. EMPLOYEES The average number of persons employed by PPG during 1993 was 31,400. ENVIRONMENTAL MATTERS Like other companies, PPG is subject to the existing and evolving standards relating to the protection of the environment. Capital expenditures for environmental control projects were approximately $29 million, $48 million, and $18 million in 1993, 1992 and 1991, respectively. It is projected that expenditures for such projects in 1994 will approximate $40 million with similar amounts of annual expenditures expected in the near future. Although future capital expenditures are difficult to forecast accurately because of constantly changing regulatory standards, it can be anticipated that environmental control standards will become increasingly stringent and costly. PPG is negotiating with various government agencies concerning 75 National Priority List ("NPL") and various other cleanup sites. While PPG is not generally a major contributor of wastes to these sites, each potentially responsible party or contributor may face agency assertions of joint and several liability. Generally, however, a final allocation of costs is made based on relative contributions of wastes to the site. There is a wide range of cost estimates for cleanup of these sites, due largely to uncertainties as to the nature and extent of their condition and the methods which may have to be employed for their remediation. Additionally, remediation projects have been or may be undertaken at certain of the Company's current and former plant sites. The Company has established reserves for those sites where it is probable a liability exists and the amount can be reasonably estimated. Reserve balances were $90 million and $107 million at December 31, 1993 and 1992, respectively. Charges against income increasing environmental remediation reserves totaled approximately $23 million in 1993, $16 million in 1992 and $23 million in 1991. Cash outlays against these reserves were approximately $40 million, $58 million and $48 million in 1993, 1992 and 1991, respectively. The Company's experience to date regarding environmental matters leads PPG to believe that it will have continuing expenditures for compliance with provisions regulating the protection of the environment and for present and future remediation efforts at waste and plant sites. However, management believes such expenditures will not have a material adverse effect on the financial position, operating earnings or liquidity of the Company and its subsidiaries as a whole. In management's opinion, the Company operates in an environmentally sound manner and is well positioned, relative to environmental matters, within the industries in which it operates. ITEM 2.

ITEM 2. PROPERTIES See "Item 1. Business" for information on PPG's production and fabrication facilities. Generally, the Company's plants are suitable and adequate for the purposes for which they are intended, and overall have sufficient capacity to conduct business in the upcoming year. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Securities and Exchange Commission regulations require the disclosure of any environmental legal proceeding in which a governmental authority is a party and which may reasonably be expected to involve monetary sanctions in excess of $100,000. In this regard, on November 14, 1991, the Company received a penalty notice from the Louisiana Department of Environmental Quality (DEQ) proposing a penalty of $1,236,000 for alleged violations of hazardous waste regulations relating to the Company's investigation of groundwater contamination at the Company's Lake Charles, LA plant. The Company has filed an appeal of the proposed penalty and negotiations with the DEQ continue. Separately, the Company has voluntarily entered into an agreement with the EPA to participate in the EPA's Toxic Substances Control Act Section 8(e) Compliance Audit Program (the "Program"). Under the Program the Company conducted a self-audit. On October 28, 1992, the Company submitted the first of two final reports pursuant to the Program. Based on this submission, the Company would pay $522,000 in stipulated penalties. The EPA has not yet reviewed the report or issued any order as a result of the report. Under the Program, the EPA has agreed that the combined potential civil penalties for both final reports of the Company will not exceed a cap of $1,000,000. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None EXECUTIVE OFFICERS OF THE REGISTRANT (a) Mr. Dempsey was Senior Vice President of WMX Technologies, Inc., and Chairman of Chemical Waste Management, Inc., prior to his present position. (b) Dr. Heinze was President of the Chemical Division of BASF (U.S.) prior to his present position. (c) Mr. Horgan was Vice President, Administration prior to his present position. (d) Mr. Rompala was Group Vice President, Chemicals prior to his present position. The executive officers of the Company are elected annually in April by the Board of Directors. PART II Information with respect to the following Items can be found on the indicated pages of the Annual Report to Shareholders and is incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 regarding Directors is contained under the caption "Election of Directors" in the Registrant's definitive Proxy Statement for its 1994 Annual Meeting of Shareholders (the "Proxy Statement") which will be filed with the Securities and Exchange Commission, pursuant to Regulation 14A, not later than 120 days after the end of the fiscal year, which information under such caption is incorporated herein by reference. The information required by Item 10 regarding Executive Officers is set forth in Part I of this report under the caption "Executive Officers of the Registrant." The information required by Item 405 of Regulation S-K is set forth in the Proxy Statement under the caption "Reporting of Securities Transactions," which information under such caption is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is contained under the captions "Compensation of Executive Officers" and "Election of Directors--Compensation of Directors" in the Proxy Statement which information under such captions is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is contained under the caption "Voting Securities" in the Proxy Statement which information under such caption is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is contained under the caption "Election of Directors--Other Transactions" in the Proxy Statement which information under such caption is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements and Independent Auditors' Report (see Part II, Item 8

42293_1993.txt

42293

1993

ITEM 1. BUSINESS REGISTRANT Golden West Financial Corporation (Golden West or Company) is a savings and loan holding company, the principal business of which is the operation of a savings and loan business through its wholly owned subsidiary, World Savings and Loan Association, a Federal Savings and Loan Association (World or Association). Golden West also has two other subsidiaries, Atlas Advisers, Inc., and Atlas Securities, Inc. These companies were formed to provide services to Atlas Assets, Inc., a series open-end registered investment company sponsored by the Company. Atlas Advisers, Inc., is a registered investment adviser and the investment manager of Atlas Assets, Inc.'s twelve portfolios (the Atlas Funds). Atlas Securities, Inc., is a registered broker-dealer and the sole distributor of Atlas Fund shares. The Company was incorporated in 1959 and has its headquarters in Oakland, California. THE ASSOCIATION World was incorporated in 1912 as a capital stock savings and loan association and has its home office in Oakland, California. World became a federally chartered savings and loan association in September 1981. See Note T to the Financial Statements included in Item 14 for the contribution of the Association to the earnings of the Company. REGULATORY FRAMEWORK The Company is a savings and loan holding company within the meaning of the National Housing Act, as amended, (the Holding Company Act), and is subject to the regulation, examination, supervision, and reporting requirements of the Holding Company Act. The Association is a member of the Federal Home Loan Bank System and owns stock in the Federal Home Loan Bank (FHLB) of San Francisco, Topeka, and New York. The Association's savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC) Savings Association Insurance Fund (SAIF), up to the maximum amounts provided by law. The Company and the Association are subject to extensive examination, supervision, and regulation by the Office of Thrift Supervision (OTS) and the FDIC. Applicable regulations govern, among other things, the Associa- tion's lending and investment powers, the types of accounts it is permitted to offer, the types of business in which it may engage, and capital requirements. The Association is also subject to regulations of the Board of Governors of the Federal Reserve System (Federal Reserve Board) with respect to reserve requirements and certain other matters (see Regulation). ITEM 1. BUSINESS (Continued) OFFICE STRUCTURE As of December 31, 1993, the Company operated 112 savings branch offices in California, 59 in Colorado, 19 in Florida, 11 in Texas, ten in Kansas, nine in Arizona, and seven in New Jersey. The Company also operates 175 loan origination offices of which 154 are located in the same states as savings branch offices. The remaining 21 loan origination offices are located in Connecticut, Delaware, Idaho, Illinois, Maryland, Missouri, Nevada, New Mexico, Oregon, Pennsylvania, Utah, Virginia, Washington, and Wisconsin. Of the 154 offices mentioned earlier, 15 are fully-staffed offices that are located in the same premises as savings branch offices and 75 others are savings branch offices that have a single loan officer on site. The remaining loan origination offices are located in facilities that are separate from savings branch offices. ACQUISITIONS/DIVESTITURES On August 13, 1993, the Company acquired $320 million in deposits and seven branches in Arizona from PriMerit Bank. On September 17, 1993, the Company sold $133 million of savings in two Ohio branches to Trumbull Savings and Loan. On October 15, 1993, the Company sold its remaining five Ohio branches with $131 million in deposits to Fifth Third Bancorp. During 1992, the Company sold one branch in California containing $40 million in deposits to American Savings Bank and two branches in the state of Washington containing $37 million in deposits to Washington Mutual Savings Bank. On July 15, 1991, the Company took title to the common stock of Beach Federal Savings and Loan Association (Beach) of Boynton Beach, Florida, and its $1.5 billion in assets. The transaction has been accounted for as a purchase, and the subsidiary's results of operations have been included with those of the Company's since July 15, 1991. As a result of the Beach acquisition, the Company recognized, for tax purposes, certain Beach net operating losses that resulted in a $25 million benefit in 1992 and a $103 million benefit in 1991. For financial statement reporting, this benefit has been recorded as negative goodwill and is being amortized into income over ten years. In 1993, 1992, and 1991, $13 million, $12 million, and $5 million, respectively, of the negative goodwill was amortized. On March 31, 1991, World Savings and Loan Association of Ohio (World of Ohio), a wholly owned subsidiary of Golden West, was merged into World. In conjunction with Golden West's acquisition of World of Ohio in 1988, the benefits of net operating loss carryforwards resulted in recording $18 million of negative goodwill in 1991. This benefit was amortized into income over the period 1989 to 1993. In 1993, 1992, and 1991, $3 million, $4 million, and $11 million, respectively, of the negative goodwill was amortized. ITEM 1. BUSINESS (Continued) ACQUISITIONS (continued): During 1991, World acquired from the Resolution Trust Corporation a total of $355 million of deposits and 11 branches from four separate acquisitions. The foregoing acquisitions are not material to the financial position or net earnings of Golden West and pro forma information is not deemed necessary. OPERATIONS The principal business of the Company, through the Association, is attracting funds, primarily in the form of savings deposits acquired from the general public, and investing those funds principally in loans secured by deeds of trust or mortgages on residential and other real estate, and mortgage-backed securities (MBS)--securities backed by pools of residential loans that have many of the characteristics of mortgages including the monthly payment of principal and interest. Funds for the Association's operations are also provided through earnings, loan repayments, borrowings from the Federal Home Loan Banks, and debt collateralized by mortgages, MBS, or other securities. In addition, the Association has a number of other alternatives available to provide liquidity or finance operations. These include borrowings from public offerings of debt or equity, sales of loans and MBS, negotiable certificates of deposit, issuance of commercial paper, and borrowings from commercial banks. Furthermore, under certain conditions, World may borrow from the Federal Reserve Bank of San Francisco to meet short-term cash needs. The availability of these funds will vary depending on policies of the FHLB, the Federal Reserve Bank of San Francisco, and the Federal Reserve Board. The principal sources of funds for the holding company, Golden West, are dividends from World and the proceeds from the issuance of debt and equity securities. CUSTOMER DEPOSIT ACTIVITIES Customer deposit flows are affected by changes in general economic conditions, changes in prevailing interest rates, and competition among depository institutions and other investment alternatives. The Company currently offers a number of alternatives for depositors, including passbook, checking, and money market deposit accounts from which funds may be withdrawn at any time without penalty, and certificate accounts with varying maturities ranging up to seven years. The Company's certificate accounts are issued in non-negotiable form through its branch offices. All types of accounts presently offered by the Company have rates that are set by the Company consistent with prevailing interest rates. ITEM 1. BUSINESS (Continued) CUSTOMER DEPOSIT ACTIVITIES (continued) During 1993, customer deposits increased $880 million, including interest credited of $567 million and excluding $320 million from acquisitions and $264 million from divestitures compared to a decrease of $255 million, including interest credited of $676 million and excluding divestitures of $77 million during 1992. Customer deposits increased $640 million in 1991, including $903 million of interest credited and excluding $1.8 billion from acquisitions. The Company does not solicit brokered deposit accounts. Rates paid on new and repricing accounts dropped steadily in 1993 and 1992, reaching the lowest level in 20 years for most products. Although rates paid on new accounts were lower than they had been in previous years, consumer funds were attracted during 1993 as a result of special promotions in the Company's savings markets. The Company experienced a net outflow of deposits during 1992 because the Company elected to emphasize other, more cost-effective sources of funds, primarily Federal Home Loan Bank advances. The table below summarizes the Company's customer deposits by original term to maturity at December 31. ITEM 1. BUSINESS (Continued) CUSTOMER DEPOSIT ACTIVITIES (continued) The table below sets forth the Company's customer deposits by interest rate at December 31. The table below shows the maturities of customer deposits at December 31, 1993, by interest rate. (a) Includes passbook, checking, and money market deposit accounts, which have no stated maturity. ITEM 1. BUSINESS (Continued) CUSTOMER DEPOSIT ACTIVITIES (continued) As of December 31, 1993, the aggregate amount outstanding of time certificates of deposits in amounts of $100,000 or more was $1.5 billion of which $109 million were retail jumbo CDs. The following table presents the maturity of these time certificates of deposit at December 31, 1993. More information regarding customer deposits is included in Note J to the Financial Statements, in Item 14. BORROWINGS The Company generally may borrow from the FHLB of San Francisco upon the security of a) the capital stock of the FHLB owned by the Company, b) certain of its residential mortgage loans or c) certain other assets (principally obligations of, or guaranteed by, the United States Government or a federal agency). The Company uses FHLB borrowings, also known as "advances" to supplement cash flow and to provide funds for loan origination activities. Advances offer strategic advantages for asset- liability management, including long-term maturities and, in certain cases, prepayment at the Company's option. Each advance has a specified maturity and interest rate, which may be fixed or variable, as determined by the FHLB. At December 31, 1993, the Company had $6.3 billion in FHLB advances outstanding, compared to $5.5 billion at yearend 1992. From time to time, the Company enters into reverse repurchase agreements with selected major government securities dealers, as well as large banks. A reverse repurchase agreement involves the sale and delivery of U.S. Government securities or mortgage-backed securities by the Company to a broker or dealer coupled with an agreement to buy the securities back at a later date. Under generally accepted accounting principles, these transactions are properly accounted for as borrowings secured by securities. The Company pays the brokers and dealers a variable or fixed rate of interest for the use of the funds for the period involved, usually less than one year. At maturity, the borrowings are repaid (by repurchase ITEM 1. BUSINESS (Continued) BORROWINGS (continued) of the same securities) and the same securities are returned to the Company. These transactions are used to take advantage of arbitrage investment opportunities and to supplement cash flow. The Company also enters into dollar reverse repurchase agreements (dollar reverses) with selected major government securities dealers, as well as large banks. A dollar reverse involves the sale and delivery of mortgage-backed securities by the Company to a broker or dealer, coupled with an agreement to purchase securities of the same type and interest coupon at a fixed price for settlement at a later date. Under generally accepted accounting principles, these transactions are properly accounted for as borrowings secured by mortgage-backed securities. The Company pays the brokers and dealers a fixed rate of interest for the use of the funds for the period involved, which is generally short-term. At maturity, the secured borrowings are repaid (by purchase of similar securities) and similar securities are delivered to the Company. These transactions are used to take advantage of arbitrage investment opportunities and to supplement cash flow. The Company monitors the level of activity with any one party in connection with reverse repurchase agreements and dollar reverses in order to minimize its risk exposure in these transactions. Reverse repurchase agreements and dollar reverses with dealers and banks amounted to $377 mil- lion at December 31, 1993, compared to $486 million at yearend 1992. Golden West currently has on file a registration statement with the Securities and Exchange Commission for the sale of up to $100 million of subordinated debt securities. The Company issued subordinated debt securities of $100 million in January 1993 and $200 million in October 1993, bringing the total amount issued to $1.0 billion at December 31, 1993. As of December 31, 1993, Golden West's subordinated debt securities had ratings of A3 and A- from Moody's Investors Service (Moody's) and Standard & Poor's Corporation (S&P), respectively. World currently has on file a shelf registration with the OTS for the issuance of $2.0 billion of unsecured medium-term notes. At December 31, 1993, $1.2 billion was available for issuance. In total, at December 31, 1993, the Association had $677 million of medium-term notes outstanding under the current and prior registrations compared to $81 million at yearend 1992. As of December 31, 1993, the Association's medium-term notes had ratings of A1 and A+ from Moody's and S&P, respectively. World also has on file a registration statement with the OTS for the sale of up to $250 million of subordinated notes. Under a prior filing with the OTS, $50 million of subordinated notes remain unissued. As of December 31, 1993, the Association had issued a total of $200 million of ITEM 1. BUSINESS (Continued) BORROWINGS (continued) subordinated notes. As of December 31, 1993, World's subordinated notes had ratings of A2 and A from Moody's and S&P, respectively. The subordinated notes are included in the Association's risk-based regulatory capital as Supplementary Capital. The table below sets forth the composition of the Company's borrowings at December 31. More information concerning the borrowings of the Company is included in Notes K, L, M, and N to the Financial Statements, in Item 14. LENDING ACTIVITIES Income from real estate loans provides the principal source of revenue to the Company in the form of interest, loan origination fees, and other fees. Loans made by the Company are generally secured by first liens primarily on residential properties. Although the Company has from time to time made commercial real estate and construction loans, the Company is not currently active in these segments of the lending market. The Company has the power to originate loans in any part of the United States. The Company is currently originating loans primarily in California, as well as in Arizona, Colorado, Connecticut, Delaware, Florida, Idaho, Illinois, Kansas, Maryland, Missouri, Nevada, New Mexico, New Jersey, Oregon, Pennsylvania, Texas, Utah, Virginia, Washington, and Wisconsin. The Company also makes loans to customers on the security of their deposit accounts. Customer deposit loans constituted less than one percent of the Company's total loans outstanding as of December 31, 1993, and 1992. The tables on the following two pages set forth the Company's loan portfolio by state as of December 31, 1993, and 1992. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) (a) The Company has no commercial loans. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) (a) The Company has no commercial loans. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The table below sets forth the composition of the Company's loan portfolio (excluding mortgage-backed securities) by type of security at December 31. At December 31, 1993, 98% of the loans in the portfolio had remaining terms to maturity in excess of 10 years. The table below sets forth the amount of loans due after one year that have predetermined interest rates and the amount that have floating interest rates at December 31, 1993. The table on the following page sets forth information concerning new loans made by the Company during 1993, 1992, and 1991 by type and purpose of loan. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) Note: During 1993, 1992, and 1991, the Company also purchased $14 million, $5 million, and $302 million, respectively, of loans (not included above) of which $304 thousand, $1 million, and $178 million, respectively, were one-unit residential loans. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) Although the Company has lending operations in 21 states, the primary mortgage origination focus continues to be on residential properties in California. In 1993, 73% of total loan originations were on residential properties in California, compared to 83% and 88% in 1992 and 1991, respectively. Although California originations continue to be a large portion of total originations, the decrease in 1993 as compared to 1992 and 1991 was due to increased penetration by the Company in markets outside California and the slight decrease of originations in California. The percentage of the total loan portfolio (excluding mortgage-backed securities) that is comprised of residential loans in California was 81% at December 31, 1993, compared to 83% at yearend 1992. New loan originations in 1993, 1992, and 1991 amounted to $6.4 billion, $6.5 billion, and $4.9 billion, respectively. Refinanced loans constituted 59% of new loan originations in 1993 compared to 56% in 1992 and 46% in 1991. The new loan origination levels achieved in 1993 and 1992 were due, in large part, to strong demand in the marketplace for refinancing of existing loans due to the low interest rate environment. In addition, in 1992 and 1991, capital deficiencies and loan portfolio problems inhibited many of Golden West's competitors from making loans. The total portfolio growth for each of the years ended December 31, 1993, and 1992, was $1.9 billion or 9%. Federal regulations permit federally chartered savings and loan associations to make or purchase both fixed-rate loans and loans with periodic adjustments to the interest rate. These latter types of loans are subject to the following primary limitations: (i) the adjustments must be based on changes in a specified interest rate index, which may be selected by the association but which must be beyond the control of the association and readily verifiable by the borrower; and (ii) adjustments to the interest rate may be implemented through changes in the monthly payment amount and/or adjustment to the outstanding principal balance or terms, except that the original loan term may not be increased to more than 40 years. Pursuant to these powers, the Company began offering adjustable rate mortgages (ARMs) in the early 1980s and this type of mortgage continues to be the Company's primary real estate loan. The portion of the mortgage portfolio (excluding mortgage-backed securities) composed of rate-sensitive loans was 87% at yearends 1993, 1992, and 1991. Despite stiff competition from mortgage bankers who aggressively marketed fixed-rate mortgages at the lowest rates seen in the past 20 years, Golden West's ARM originations constituted approximately 75% of new mortgage loans made by the Company in 1993, compared with 80% in 1992 and 89% in 1991. Most of the Company's ARMs carry an interest rate that changes monthly based on movements in certain interest rate or cost of funds indices. During the life of the loan, the interest rate may not be raised above a ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) lifetime cap, set at the time of origination or assumption. Lifetime caps on the Company's ARMs are typically between 350 and 625 basis points (a basis point is one one-hundredth of one percent) higher than the loan's initial fully-indexed contract rate. On most of the Company's ARMs, monthly payments of principal and interest are adjusted annually with a maximum increase or decrease of 7-1/2% of the prior year's payment. At five year intervals, the payment may be adjusted without limit, to amortize the loan fully within the then remaining term. Within these five year periods, negative amortization (deferred interest) may occur to the extent that the loan balance remains below 125% of the original mortgage amount, unless the original loan to value ratio exceeded 85%, in which case the loan balance cannot exceed 110% of the original mortgage amount. On certain other ARMs, the payment and interest rate change every six months, with the maximum rate change capped at one percent. These ARMs do not allow negative amortization and, consequently, do not have the 7-1/2% payment increase limitation. The Company also offers a "modified" ARM, a loan that usually offers a low fixed rate from 1% to 3% below the initial fully indexed contract rate for an initial period, normally three to 36 months. (However, the borrower must generally qualify at the initial fully-indexed contract rate.) The weighted average maximum lifetime cap rate on the Company's ARM and modified ARM loan portfolio was 13.82%, or 7.39% above the actual weighted average rate at December 31, 1993, versus 14.18%, or 6.99% above the weighted average rate at yearend 1992. Approximately $4.5 billion of the Company's loans have terms that state that the interest rate may not fall below a lifetime floor, set at the time of origination or assumption. Due to the decline in interest rates, as of December 31, 1993, $1.5 billion of these loans had reached their rate floors. The weighted average floor rate on these loans was 7.4% at yearend 1993. Interest rates charged by the Company on real estate loans are affected principally by competition, and also by the supply of money available for lending, loan demand, and factors that are, in turn, affected by general economic conditions, regulatory and monetary policies of the federal government, the OTS and the Federal Reserve Board, and legislation and other governmental action dealing with budgetary and tax matters. The Company originates loans through offices that are staffed by salaried personnel who contact local real estate brokers regarding possible lending opportunities. All loan applications are completed, reviewed, and approved in the loan origination offices and forwarded to the Company's central offices in Oakland, California; Costa Mesa, California; or Denver, Colorado, for processing. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The Company also utilizes the services of selected mortgage brokers to obtain completed loan applications. In such cases, the Company, in addition to the review by the mortgage broker, performs its own quality review, including a physical inspection of the property, before processing the application and funding the loan. The Company's loan approval process is intended to assess both the borrower's ability to repay the loan and the adequacy of the pro-posed security. Documentation for all loans is maintained in the Company's loan servicing offices in San Leandro, California. The Company generally lends up to 80% of the appraised value of residential real property and, under certain circumstances, up to 90% of the appraised value of single-family residences. Commencing in 1992, it is the Company's policy that all loans originated in excess of 80% of the appraised value of the property are required to have mortgage insurance ex- cept on loans to facilitate the sale of REO. During 1993, 1992, and 1991, less than 3% of loans originated were in excess of 80% of the appraised value of the residence. The Company requires title insurance for all mortgage loans and requires that fire and casualty insurance be maintained on all improved properties that are security for its loans. The original contractual loan payment period for residential loans normally ranges from 15 to 40 years with most having original terms of 30 years. However, the majority of such loans remain outstanding for a shorter period of time. To generate income and to provide additional funds for lending and liquidity, the Company has from time to time sold, without recourse, par- ticipations in loans and, in limited instances, whole loans, to the Federal Home Loan Mortgage Corporation (FHLMC), the Federal National Mortgage Asso- ciation (FNMA), and to institutional purchasers. Under loan participation sale agreements, the Company usually continues to collect payments on the loans as they become due, and otherwise to service the loans. The Company pays an agreed-upon yield on the participant's portion of the loans. This yield is usually less than the interest agreed to be paid by the borrower, with the difference being retained by the Company as servicing fee income. At December 31, 1993, the Company was engaged in servicing approximately $807 million of loan participations and whole loans for others. For the year ended December 31, 1993, fees received for such servicing activities totalled $3 million, or approximately one-tenth of one percent of total revenues. The Company sold $432 million of loans during 1993 compared to $281 million and $67 million in 1992 and 1991, respectively. The Company recognized pre-tax gains of $5.7 million compared to $1.7 million in 1992 and $381 thousand in 1991. The Company originated $443 million of loans held for sale during 1993 compared to $278 million in 1992 and $77 million in 1991. The loan held for sale portfolio had a balance of $56 million at December 31, 1993, and is carried at the lower of cost or market. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The Company also purchases, on a selective basis and only after a strict underwriting review, residential mortgage whole loans in the secondary market. Loan purchases in 1993, 1992, and 1991 amounted to $14 million, $5 million, and $302 million, respectively. Loan repayments consist of monthly loan amortization, loan payoffs, and loan refinances. During 1993, 1992, and 1991, repayments amounted to $3.8 billion, $4.1 billion, and $2.8 billion, respectively. The decrease in repayments in 1993 over 1992 was due to lower mortgage payoffs within our loan portfolio. The increase in repayments in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates by replacing older, high-cost debt with new, more attractively priced instruments. The Company adopted Statement of Financial Accounting Standards No. 114 (FAS 114), "Accounting by Creditors for Impairment of a Loan," in the fourth quarter of 1993, retroactive to January 1, 1993. FAS 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. As a practical expedient, impairment may be measured based on the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. The valuation allowance and provision for loan losses are adjusted for changes in the present value of impaired loans for which impairment is measured based on the present value of expected future cash flows. The Company had previously measured loan impairment in accordance with the methods prescribed in FAS 114. As a result, no additional loss provisions were required by early adoption of the pronouncement. FAS 114 requires that impaired loans for which foreclosure is probable should be accounted for as loans. As a result, $16 million of in-substance foreclosed loans, with a valuation allowance of $7 million, were reclassified from real estate held for sale to loans receivable. Prior year amounts have not been restated. It is too early to predict with any precision potential losses to the Company resulting from the Northridge (southern California) earthquake in January 1994; however, based on early assessments of severity of damage, borrower equity, and levels of insurance coverage, the Company believes that any potential loss to the Company will not be material to the financial condition and results of operations of the Company. In addition to interest earned on loans, the Company receives fees for originating loans and for making loan commitments. The income represented by such fees varies with the volume and types of loans made. The Company also charges fees for loan prepayments, loan assumptions and modifications, late payments and other miscellaneous services. ITEM 1. BUSINESS (Continued) LENDING ACTIVITIES (continued) The table below sets forth information relat-ing to interest rates and loan fees charged for the years indicated. (a) excludes loans purchased NONPERFORMING ASSETS If a borrower fails to make required payments on a loan, the Company usually takes the steps required under applicable law to foreclose upon the security for the loan. If a delinquency is not cured, the property is generally acquired by the Company in a foreclosure sale or by taking a deed in lieu of foreclosure. If the applicable period of redemption by the borrower (which varies from state to state and by method of foreclosure pursued) has expired, the Company is free to sell the property. The property may then be sold generally with a loan conforming to normal loan requirements, or with a "loan to facilitate sale" involving terms more favorable to the borrower than those normally permitted. Various antideficiency and homeowner protective provisions of state law may limit the remedies available to lenders when a residential mortgage borrower is in default. The effect of these provisions, in most cases, is to limit the Company to foreclosing upon, or otherwise obtaining ownership of, the property securing the loan after default and to prevent the Company from recovering from the borrower any deficiency between the amount real- ized from the sale of such property and the amount owed by the borrower. One measure of the soundness of the Company's portfolio is its ratio of nonperforming assets (NPAs) to total assets. Nonperforming assets include non-accrual loans (loans that are 90 days or more past due) and real estate acquired through foreclosure. Loans in-substance foreclosed were no longer classified as part of the real estate held for sale portfolio upon adoption of FAS 114 during December 1993 and are now included in the Company's total loan portfolio as previously discussed. No interest is recognized on non-accrual loans. ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) The table below sets forth the components of the Company's nonperforming assets and the ratio of nonperforming assets to total assets at December 31. The increase in NPAs in 1993 and 1992 was primarily in single-family loans and foreclosed real estate in California. The continued weak California economy and high unemployment led to a slowdown in the real estate market, resulting in an increase in loan delinquencies and, in cer- tain areas, decreases in real estate prices. The growth in NPAs was also impacted by an increase in bankruptcy filings in 1992 and a continued high level of bankruptcy filings in 1993, which often delay the collection process and extend the length of time a loan remains delinquent. The Company continues to closely monitor all delinquencies and takes appropriate steps to protect its interests. Interest foregone on non- accrual loans amounted to $20 million in 1993, $17 million in 1992, and $17 million in 1991. The tables on the following two pages show the Company's nonperforming assets by state at December 31, 1993, and 1992. ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) (a) Non-accrual loans are 90 days or more past due and have no unpaid interest accrued. ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) (a) Non-accrual loans are 90 days or more past due and have no unpaid interest accrued. The Company's troubled debt restructured (TDRs), which are loans that have been modified due to a weakness in the collateral and/or borrower, were $37 million, or 0.13% of assets, at December 31, 1993, compared to $13 million, or 0.06% of assets, at yearend 1992. The increase is due in part to the FAS 114 reclassification previously discussed, which included loans that had been modified. The great majority of the Company's TDRs have temporary interest rate reductions and have been made primarily to customers negatively impacted by adverse economic conditions. Interest foregone on TDRs amounted to $275 thousand in 1993 compared to $217 thousand in 1992 and $328 thousand in 1991. At December 31, 1993, approximately $310 million of the Company's loans were 30 to 89 days past due and an additional $85 million of loans ITEM 1. BUSINESS (Continued) NONPERFORMING ASSETS (continued) were performing under bankruptcy protection. Management has included its estimate of potential losses on these loans in the allowance for possible loan losses. The Company provides allowances for losses on loans when impaired and real estate owned when any significant and permanent decline in value is identified and based upon trends in the basic portfolio. Additions to and reductions from the allowances are reflected in current earnings. Periodic reviews are made of major loans and real estate owned, and major lending areas are regularly reviewed to determine potential problems. Where indicated, valuation allowances are established or adjusted. In estimating possible losses, consideration is given to the estimated sale price, cost of refurbishing, payment of delinquent taxes, cost of disposal, and cost of holding the property. The table below summarizes the changes in the allowance for loan losses for the years indicated: The Company continues to use a methodology for monitoring and estimating loan losses that is based on both historical experience in the loan portfolio and factors reflecting current economic conditions. This approach utilizes a data base that identifies losses on loans and fore- closed real estate from past years to the present, broken down by year of origination, type of loan and geographical area. Management is then able to estimate a range of loss allowances to cover future losses in the port- folio. The increase in the allowance and the provision in 1993 over 1992 was considered prudent given the slowdown in the California housing market, the increase in the size of the loan portfolio, and the increase in nonper- forming assets and loan losses experienced by the Association in 1993. Chargeoffs increased as a result of the increase in nonperforming loans, the increase in the percentage of nonperforming loans that became real estate owned, and the increased losses on real estate owned primarily due to the weakening of the California housing market. ITEM 1. BUSINESS (Continued) INVESTMENT ACTIVITIES Golden West's investment securities portfolio is composed primarily of federal funds, short-term repurchase agreements collateralized by mortgage-backed securities, and short-term money market instruments. In determining the amounts of assets to invest in each class of securities, the Company considers relative rates, liquidity, and credit quality. When opportunities arise, the Company enters into arbitrage transactions with secured borrowings and short-term investments to profit from the rate differential. The level of the Company's investments position in excess of its liquidity requirements at any time depends on liquidity needs and available arbitrage opportunities. Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (FAS 115), "Accounting for Certain Investments in Debt and Equity Securities." FAS 115 establishes classifications of investments into three categories: held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify investment securities as either held to maturity or available for sale. The Company has no trading securities. Held to maturity securities are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. Securities held to maturity are recorded at cost because the Company has the ability to hold these securities to maturity and because it is Management's intention to hold them to maturity. At December 31, 1993, the Company had no securities held to maturity. Securities available for sale increase the Company's portfolio management flexibility for investments and are reported at fair value. Net unrealized gains and losses are excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had securities available for sale in the amount of $1.6 billion and unrealized gains on securities available for sale included in stockholders' equity of $41 million. Gains or losses on sales of securities are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the security, using specific identification, adjusted for any unamortized premium or discount. The adoption of FAS 115 resulted in the reclassification of certain securities from the investment securities portfolio to the securities available for sale portfolio. The Company has other investments that are not required to be classified under one of the categories of FAS 115 and that are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. Prior to December 31, 1993, securities were classified as either securities held for sale or investment securities. Securities held for sale were recorded at the aggregate portfolio's lower of amortized cost or market, with the unrealized gains and losses included in earnings. Investment securities were recorded at amortized cost. ITEM 1. BUSINESS (Continued) INVESTMENT ACTIVITIES (continued) The table below sets forth the composition of the Company's securities available for sale at December 31. The table below sets forth the composition of the Company's other investments at December 31. The reduction in 1993 versus 1992 resulted from the classification required under FAS 115. The weighted average yield on the other investments portfolio was 3.42% at December 31, 1993. As of December 31, 1993, the entire other investments portfolio matures in 1994. MORTGAGE-BACKED SECURITIES FAS 115 also requires the same three classifications for mortgage- backed securities (MBS): held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify MBS as either held to maturity or available for sale. The Company has no trading MBS. Mortgage- backed securities held to maturity are recorded at cost because the Company has the ability to hold these MBS to maturity and because management intends to hold these securities to maturity. Premiums and discounts on ITEM 1. BUSINESS (Continued) MORTGAGE-BACKED SECURITIES (continued) MBS are amortized or accreted using the interest method, also known as the level yield method, over the life of the security. At December 31, 1993, the Company had mortgage-backed securities held to maturity in the amount of $408 million. MBS available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had mortgage-backed securities available for sale in the amount of $1.1 billion and unrealized gains on mortgage-backed securities included in stockholders' equity of $44 million. Gains or losses on sales of MBS are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the MBS, using specific identification, adjusted for any unamortized premium or discount. Prior to December 31, 1993, all MBS were recorded at amortized cost. Repayments of MBS during the years 1993, 1992, and 1991 amounted to $646 million, $552 million, and $200 million, respectively. The increase in repayments in 1993 over 1992 and in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates. The portion of the Company's loans receivable represented by MBS was 6%, 8%, and 9% at yearends 1993, 1992, and 1991, respectively. STOCKHOLDERS' EQUITY The Company has increased its total stockholders' equity in each of the years 1993, 1992, and 1991 through the retention of a high percentage of net earnings. In addition, stockholders' equity increased in 1993 by $85 million due to the adoption of FAS 115 as of December 31, 1993. The Company has on file a shelf registration statement with the Securities and Exchange Commission to issue up to two million shares of its preferred stock. The preferred stock may be sold from time to time in one or more transactions for total proceeds of up to $200 million. The preferred stock may be issued in one or more series, may have varying provisions and designations, and may be represented by depository shares. The preferred stock is not convertible into common stock. No preferred stock has yet been issued under the registration. The Company's preferred stock has been preliminarily rated a2 by Moody's. On October 28, 1993, the Company's Board of Directors' authorized the purchase by the Company of up to 3.2 million shares of Golden West's common stock. As of December 31, 1993, 204,000 shares had been repurchased and retired. YIELD ON INTEREST-EARNING ASSETS/COST OF FUNDS Information regarding the Company's yield on interest-earning assets and cost of funds at December 31, 1993, 1992, and 1991 is contained in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and is incorporated herein by reference. ITEM 1. BUSINESS (Continued) YIELD ON INTEREST-EARNING ASSETS/COST OF FUNDS (continued) The gap table and related discussion included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, gives information on the repricing characteristics of the Company's interest-earning assets and interest-bearing liabilities at December 31, 1993, and is incorporated herein by reference. The dollar amounts of the Company's interest income and interest expense fluctuate depending both on changes in the respective interest rates and on changes in the respective amounts (volume) of interest-earning assets and interest-bearing liabilities. The following table sets forth certain information with respect to the yields earned and rates paid on the Company's interest-earning assets and interest-bearing liabilities. (a) Includes non-accrual loans (90 days or more past due). The table on the following page presents the changes for 1993 and 1992 from the respective preceding year of the interest income and expense associated with each category of interest-bearing asset and liability as allocated to changes in volume and changes in rates. ITEM 1. BUSINESS (Continued) YIELD ON INTEREST-EARNING ASSETS/COST OF FUNDS (continued) (a) The change in volume is calculated by multiplying the difference between the average balance of the current year and the prior year by the prior year's average yield. The change in rate is calculated by multiplying the difference between the average yield of the current year and the prior year by the prior year's average balance. The mixed changes in rate/volume is calculated by multiplying the difference between the average balance of the current year and the prior year by the difference between the average yield of the current year and the prior year. This amount is then allocated proportionately to the volume and rate changes calculated previously. (b) The effects of hedging activity have been allocated to income and expense of the related assets and liabilities. (c) Includes non-accrual loans (90 days or more past due). ITEM 1. BUSINESS (Continued) COMPETITION AND OTHER MATTERS The Company experiences strong competition in both attracting customer deposits and making real estate loans. Competition for savings deposits has historically come from money market mutual funds, other savings associa- tions, commercial banks, credit unions, and government and corporate debt securities. In addition, traditional financial institutions have found themselves in competition with new entrants into the financial services field, such as securities dealers, insurance companies, and others. The principal methods used by the Company to attract customer deposits, in addition to the interest rates and terms offered, include the offering of a variety of services and the convenience of office locations and hours of public operation. Competition in making real estate loans comes principally from other savings associations, mortgage banking companies, and commercial banks. A weak commercial real estate sector and a reduced volume of speculative transactions, such as leveraged buy-outs, have provided added incentive for banks to deploy their resources in new areas, and, as a result, they are increasing their investments in residential real estate mortgages. In addition, the volume of real estate lending by mortgage banking companies that originate and sell loans immediately has increased significantly. Traditionally privately owned, many mortgage banking companies have gone public and participated heavily in the refinance-driven loan market in recent years. Many of the nation's largest savings associations, mortgage banking companies, and commercial banks are headquartered or have a significant number of branch offices in the areas in which the Company competes. Changes in the government's monetary, tax, or housing financing policies can also affect the ability of lenders to compete profitably. The primary factors in competing for real estate loans are interest rates, loan fee charges, underwriting standards, and the quality of service to borrowers and their real estate brokers. SAVINGS AND LOAN INDUSTRY The operations of savings associations are significantly influenced by general economic conditions, by the related monetary and fiscal policies of the federal government, and by the policies of financial institution regulatory authorities. Customer deposit flows and costs of funds are impacted by interest rates on competing investments and general market rates of interest. Lending and other investment activities are affected by the demand for mortgage financing and for consumer and other types of loans, which in turn are affected by the interest rates at which such financing may be offered and other factors affecting the supply of housing and the availability of funds. REGULATION FEDERAL HOME LOAN BANK SYSTEM. The FHLB system functions in a reserve credit capacity for its members, which may include savings associations, commercial banks and credit unions. As a member, World is required to own capital stock of an FHLB in an amount that depends generally upon its outstanding home mortgage loans or advances from such FHLB and is authorized to borrow funds from such FHLB (see Borrowings). ITEM 1. BUSINESS (Continued) REGULATION (continued) LIQUIDITY. The OTS requires insured institutions, such as World, to maintain a minimum amount of cash and certain qualifying investments for liquidity purposes. The current minimum requirement is equal to a monthly average of 5% of customer deposits and short-term borrowings. For the months ended December 31, 1993, and 1992, World's regulatory average liquidity ratio was 8% and 7%, respectively, consistently exceeding the requirement. FEDERAL DEPOSIT INSURANCE CORPORATION. The customer deposit accounts of World are insured by the FDIC as part of the Savings Association Insurance Fund up to the maximum amount permitted by law, currently $100,000 per insured depositor. As a result, the Association is subject to supervision by regulation and examination by the FDIC. FDIC insurance is required for all federally chartered associations. Such insurance may be terminated by the FDIC under certain circumstances involving violations of regulations or unsound practices. The annual premium charged for FDIC-SAIF insurance is determined by the FDIC using a risk-based system beginning in 1993. Under the system, associations are charged a variable rate ranging from a low of $.23 to a high of $.31 per $100 of deposits. The amount of capital an institution maintains and its examination scores are the most important factors determining the assessment. World qualifies for the lowest premium assessment of $.23 per $100 of deposits under the system. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) generally imposes a moratorium until 1994 on conversions from SAIF membership to Bank Insurance Fund (BIF) membership. However, a savings institution may convert to a bank charter if the resulting bank remains a member of SAIF. After expiration of the moratorium, such conversion requires payment of an exit fee to the insurance fund that the institution leaves and an entrance fee to the insurance fund the institution enters. In addition, bank holding companies, which were previously authorized to acquire savings institutions only in connection with supervisory transactions, may now acquire savings institutions generally. OFFICE OF THRIFT SUPERVISION. As a federally chartered savings and loan association, the principal regulator of World is the OTS. Under various regulations of the OTS, savings and loan associations are required, among other things, to pay assessments to the OTS, maintain required regulatory capital, maintain liquid assets at levels fixed from time to time, and to comply with various limitations on loans to one borrower and limitations on equity investments, investments in real estate, and investments in corporate debt securities that are not investment grade. World is subject to examination by the OTS and is in compliance with its current requirements. FEDERAL RESERVE SYSTEM. Federal Reserve Board regulations require savings institutions to maintain noninterest-earning reserves against their ITEM 1. BUSINESS (Continued) REGULATION (continued) checking accounts. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements. World is currently in compliance with all applicable Federal Reserve Board reserve requirements. Savings and loan associations have authority to borrow from the Federal Reserve Bank "Discount Window," but the Federal Reserve Board requires savings and loan associations to exhaust all FHLB sources before borrowing from the Federal Reserve Bank. REGULATORY CAPITAL. The OTS requires federally insured institutions such as World to meet certain minimum capital requirements. The table below summarizes World's regulatory capital ratios and compares them to the OTS minimum requirements at December 31. The table below summarizes World's regulatory capital ratios and compares them to the fully phased-in OTS minimum requirements at December 31. ITEM 1. BUSINESS (Continued) REGULATION (continued) The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required each federal banking agency to implement prompt corrective actions for institutions that it regulates to resolve the problems of insured depository institutions at the least possible long-term loss to the deposit insurance fund. In response to this requirement, the OTS adopted final rules as to capital adequacy, effective December 19, 1992, based upon FDICIA's five capital tiers. The rules provide that a savings association is "well capitalized" if its total risk-based capital ratio is 10% or greater, its Tier 1 risk-based capital ratio is 6% or greater, its leverage ratio is 5% or greater, and the institution is not subject to a capital directive. A savings association is "adequately capitalized" if its total risk-based capital ratio is 8% or greater, its Tier 1 risk-based capital ratio is 4% or greater, and its leverage ratio is 4% or greater (3% or greater for one-rated institutions). An institution is considered "undercapitalized" if its total risk-based capital ratio is less than 8%, its Tier 1 risk-based capital ratio is less than 4%, or its leverage ratio is less than 4% (less than 3% for one-rated institutions). An institution is "significantly undercapitalized" if its total risk-based capital ratio is less than 6%, its Tier 1 risk-based capital ratio is less than 3%, or its leverage ratio is less than 3%. A savings association is deemed to be "critically undercapitalized" if its ratio of tangible equity to total assets is equal to, or less than, 2%. At its discretion, the OTS may determine that an institution is in a capitalization category that is lower than is indicated by its actual capital position. As used herein, total risk-based capital ratio means the ratio of total capital to risk-weighted assets, Tier 1 risk-based capital ratio means the ratio of core capital to risk-weighted assets, and leverage ratio means the ratio of core capital to adjusted total assets, in each case as calculated in accordance with current OTS capital regulations. World met the "well capitalized" standard as of December 31, 1993. The table below shows a reconciliation of World's equity capital to regulatory capital under FIRREA and FDICIA at December 31, 1993. (1) All goodwill is required to be deducted from tangible capital. Goodwill arising prior to April 12, 1989, in excess of a sliding scale limit (.75% of assets at December 31, 1993), is required to be deducted from all other capital computations on a phased-in basis through December 1994. Goodwill arising after April 12, 1989, must be deducted from all capital computations. (2) All but $2,443 of the Association's positive goodwill arose prior to April 12, 1989. (3) The Association's negative goodwill arose after April 12, 1989. (4) Equity and certain other investments are required to be deducted from total risk-based capital on a phased-in basis (60% at December 31, 1993) through June 1994. The table below shows a reconciliation of World's equity capital to regulatory capital under FIRREA and FDICIA at December 31, 1992. (1) All goodwill is required to be deducted from tangible capital. Goodwill arising prior to April 12, 1989, in excess of a sliding scale limit (1% of assets at December 31, 1992), is required to be deducted from all other capital computations on a phased-in basis through December 1994. Goodwill arising after April 12, 1989, must be deducted from all capital computations. (2) All but $193 of the Association's positive goodwill arose prior to April 12, 1989. (3) The Association's negative goodwill arose after April 12, 1989. (4) Equity and certain other investments are required to be deducted from total risk-based capital on a phased-in basis (40% at December 31, 1992) through June 1994. ITEM 1. BUSINESS (Continued) REGULATION (continued) The table below compares World's regulatory capital to the well capitalized classification of FDICIA's capital standards at December 31. World's leverage, Tier 1 risk-based, and total risk-based capital ratios under the fully phased-in 1995 OTS minimum requirements at December 31, 1993, were 7.27%, 14.17%, and 16.21%, respectively. World's leverage, Tier 1 risk-based, and total risk-based capital ratios under the fully phased-in 1995 OTS minimum requirements at December 31, 1992, were 6.54%, 12.68%, and 14.63%, respectively. CAPITAL DISTRIBUTIONS BY SAVINGS ASSOCIATIONS. The OTS adopted regulations in 1990 with respect to capital distributions by savings associations such as World. Under these regulations, a savings association is classified as either Tier 1, if it meets each of its fully phased-in capital requirements immediately prior to and after giving effect to the proposed capital distribution; Tier 2, if it meets each of its current capital requirements but does not meet one or more of its fully phased-in capital requirements immediately prior to or after giving effect to the proposed capital distribution; or Tier 3, if it does not meet its current capital requirements immediately prior to or after giving effect to the proposed capital distribution. A savings association that would otherwise be classified as Tier 1 is treated as Tier 2 or Tier 3 if the OTS so notifies the association based on OTS' conclusion that the association is in need of more than normal supervision. Under the regulations, a Tier 1 association may make capital distributions during a calendar year up to 100% of its net income to date during the calendar year plus up to one-half of its capital in excess of the fully phased-in requirement at the end of the prior year. A Tier 2 association may make capital distributions from 25% to 75% of its net ITEM 1. BUSINESS (Continued) REGULATION (continued) income over the most recent four quarter period, with the percentage varying based on its level of risk-based capital. Any capital distributions by a Tier 3 association or in excess of the foregoing amounts by a Tier 1 or Tier 2 association are subject to either prior OTS approval or notice must be given to the OTS, which may disapprove the distribution. However, FDICIA legislation prohibits capital distributions by an institution that does not meet its capital requirements. Savings associations are required to give the OTS 30-day advance written notice of all proposed capital distributions. For purposes of capital distributions, the OTS has classified World as a Tier 1 association. LIMITATION ON LOANS TO ONE BORROWER. FIRREA subjects savings associations to the same loans-to-one borrower restrictions that are applicable to national banks with limited provisions for exceptions. In general, the national bank standard restricts loans to a single borrower to no more than 15% of a bank's unimpaired capital and unimpaired surplus, plus an additional 10% if the loan is collateralized by certain readily marketable collateral. (Real estate is not included in the definition of "readily marketable collateral.") At December 31, 1993, the maximum amount that World could have loaned to one borrower (and related entities) was $325 million. At such date, the largest amount of loans that World had outstanding to any one borrower was $39 million. SAVINGS AND LOAN HOLDING COMPANY LAW. The Company is a "savings and loan holding company" under the National Housing Act of 1934. As such, it has registered with the OTS and is subject to OTS regulation and OTS and FDIC examination, supervision, and reporting requirements. Among other things, the OTS has authority to determine that an activity of a savings and loan holding company constitutes a serious risk to the financial safety, soundness, or stability of its subsidiary savings institutions and thereupon may impose, among other things, restrictions on the payment of dividends by the subsidiary institutions and on transactions between the subsidiary institutions, the holding company and subsidiaries or affiliates of either. As World's parent company, Golden West is considered an "affiliate" of the Association for regulatory purposes. Savings associations are subject to the rules relating to transactions with affiliates and loans to insiders generally applicable to commercial banks that are members of the Federal Reserve System set forth in Sections 23A, 23B, and 22(h) of the Federal Reserve Act, as well as additional limitations set forth in FIRREA and as adopted by the OTS. In addition, FIRREA generally prohibits a savings association from lending or otherwise extending credit to an affiliate, other than the association's subsidiaries, unless the affiliate is engaged only in activities that the Federal Reserve Board has determined to be permissible for bank holding companies and that the OTS has not ITEM 1. BUSINESS (Continued) REGULATION (continued) disapproved. In 1991, the OTS adopted regulations to implement the affiliate transactions limitations contained in FIRREA. Among other things, the regulations provide guidance in determining an affiliate of a savings association and in calculating compliance with the quantitative limitations on transactions with affiliates. TAXATION. Savings and loan associations that meet certain definitional tests and other conditions prescribed by the Internal Revenue Code are allowed a bad debt reserve deduction computed as a percentage of taxable income before such deduction. Accordingly, qualifying savings and loan associations are subject to a lower effective federal income tax rate than that applicable to corporations generally. The effective federal income tax rate applicable to qualifying savings and loan associations is approximately 32.2%, depending on the extent of "tax preference" items in addition to the bad debt reserve deduction. The bad debt reserve deduction computed as a percentage of taxable income is available only to the extent that amounts accumulated in the bad debt reserve for certain real estate loans defined as "qualifying real estate loans" do not exceed 6% of such loans at yearend. In addition, the deduction is further limited to the amount by which 12% of customer deposits at yearend exceeds the sum of surplus, undivided profits and reserves at the beginning of the year. At December 31, 1993, the 6% and 12% limitations did not restrict the bad debt reserve deduction of World, and it is expected that such limitations will not be restricting factors in the future. Qualifying savings and loan associations that file income tax returns as members of a consolidated group are required to reduce their bad debt reserve deduction for tax losses attributable to non-savings and loan association members of the group whose activities are functionally related to the activities of the savings and loan association member. If the accumulated bad debt reserves are used for any purpose other than to absorb bad debt losses, federal income taxes may be imposed at the then applicable rates. In addition, if such reserves are used to pay dividends or to make other distributions with respect to a savings and loan association stock (such as redemption or liquidation), special additional taxes would be imposed. Although generally similar, differences exist, with respect to the determination of taxable income, among the Internal Revenue Code and the tax codes of the states in which the Company operates. These states do not allow the special percentage of taxable income method of computing the bad debt reserve, discussed above, which can cause the Company's taxable income, at the state level, to be significantly different from its taxable income at the federal level. ITEM 1. BUSINESS (Continued) REGULATION (continued) Golden West utilizes the accrual method of accounting for income tax purposes and for preparing its published financial statements. For financial reporting purposes only, the Company uses "purchase accounting" in connection with certain assets acquired through mergers. The purchase accounting portion of income is not subject to tax. In the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes." FAS 109 required a change from the deferred to the liability method of computing deferred income taxes. The Company has applied FAS 109 prospectively. The cumulative effect of this change in accounting for income taxes for the periods ending prior to January 1, 1993, is not material. FAS 109 required the Company to adjust its purchase accounting for prior business combinations by increasing deferred tax assets and reducing goodwill by $23 million to reflect the non-taxability of purchase accounting income. This deferred tax asset is being amortized over the remaining lives of the related purchased assets. EMPLOYEE RELATIONS The Company had a total of 3,635 full-time and 741 permanent part-time employees at December 31, 1993. None of the employees of the Company are represented by any collective bargaining group. The management of the Company considers employee relations to be good. ITEM 2.

ITEM 2. PROPERTIES Properties owned by the Company are located in Arizona, California, Colorado, Florida, Kansas, New Jersey, and Texas. The executive offices of the Company are located at 1901 Harrison Street, Oakland, California, in leased facilities. The Company continuously evaluates the suitability and adequacy of the offices of the Company and has a program of relocating or remodel-ing them as necessary to maintain efficient and attractive facilities. The Company is currently building a 300,000 square-foot office complex on an 111-acre site in San Antonio, Texas, which will house its Loan Service, Savings Operations, and Information Systems Departments. The expected completion date is September 1994. The Company owns 175 of its branches, some of which are located on leased land. For further information regarding the Company's investment in premises and equipment and expiration dates of long-term leases, see Note I to the Financial Statements, in Item 14. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Savings and loan associations and other financial institutions that take consumer deposits in California have been named from time to time in class action proceedings that question the legality of certain terms of deposit agreements and the implementation of such agreements. World is named as a defendant in one action that purports to be a class action of this type. This action was dismissed at the trial court level, and, upon appeal, the dismissal was affirmed in part and reversed in part. The action was subsequently remanded to the trial court level, where a class has been certified. However, in the opinion of management, the result of this action will not have a material effect on the Company's consolidated financial condition or results of operations. The Company and its subsid- iaries are parties to other actions arising in the ordinary course of business, none of which, in the opinion of management, is material to the Company's consolidated financial condition or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Inapplicable. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS MARKET PRICES OF STOCK Golden West's stock is listed on the New York Stock Exchange and Pacific Stock Exchange and traded on the Boston and Midwest Stock Exchanges under the ticker symbol GDW. The quarterly price ranges for the Company's common stock during 1993 and 1992 were as follows: ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS (Continued) PER SHARE CASH DIVIDENDS DATA Golden West's cash dividends paid per share for 1993 and 1992 were as follows: The principal sources of funds for the payment by Golden West of cash dividends are cash dividends paid to it by World Savings, investment income, and short-term borrowings. Under OTS regulations, the OTS must be given at least 30 days' advance notice by the Association of any proposed dividend to be paid to the parent. Under OTS regulations, World Savings is classified as a Tier 1 association and is, therefore, allowed to distribute dividends up to 100% of its net income in any year plus one-half of its capital in excess of the OTS fully phased-in capital requirement as of the end of the prior year. At December 31, 1993, $354 million of the Association's retained earnings had not been subjected to federal income taxes due to the application of the bad debt deduction, and $1.8 billion of the Association's retained earnings were available for the payment of cash dividends without the imposition of additional federal income taxes. STOCKHOLDERS At the close of business on March 18, 1994, 63,994,385 shares of Golden West's Common Stock were outstanding and were held by 1,911 stockholders of record. The transfer agent and registrar for the Golden West Common Stock is First Interstate Bank, San Francisco, California 94104. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected consolidated financial and other data for Golden West for the years indicated. Such information is qualified in its entirety by the more detailed financial information set forth in the financial statements and notes thereto appearing in the documents incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA (Continued) ITEM 6. SELECTED FINANCIAL DATA (Continued) ITEM 6. SELECTED FINANCIAL DATA (Continued) (a) Earnings represent income from continuing operations before income taxes and fixed charges. Fixed charges include interest expense and amortization of debt expense. (b) The definition of nonperforming assets includes non-accrual loans (loans that are 90 days or more past due) and real estate owned acquired through foreclosure. (c) The requirements were 1.5%, 3.0%, and 8.0% (7.2% prior to December 31, 1992) for tangible, core, and risk-based capital, respectively, at December 31, 1992, and 1993. World Savings and Loan Association currently meets its fully phased-in capital requirement. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following narrative focuses on the significant financial statement changes that have taken place at Golden West over the past three years and includes a discussion of the Company's financial condition and results of operations during that period. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION The accompanying table summarizes the Company's major asset, liability, and equity components in percentage terms at yearends 1993, 1992, 1991, and 1990. As the table shows, customer deposits represent the majority of the Company's liabilities. On the other side of the balance sheet, the loan portfolio, which consists primarily of long-term mortgages, is the largest asset component. The disparity between the repricing (maturity or interest rate change) of deposits and other liabilities and the repricing of mortgage loans can affect the Company's liquidity and can have a material impact on the Company's results of operations. The difference between the repricing of assets and liabilities is commonly referred to as the gap. The gap table on the following page shows that, as of December 31, 1993, the Company's assets reprice sooner than its liabilities. Consequently, one would expect falling interest rates to lower Golden West's earnings and rising rates to increase the Company's earnings. However, Golden West's earnings are also affected by the built-in lag inherent in the Eleventh District Cost of Funds Index (COFI), which is the benchmark the Company uses to determine the rate on the great majority of its adjustable rate mortgages. Specifically, there is a two-month delay in reporting the COFI because of the time required to gather the data needed to compute the index. As a result, the current COFI actually reflects the Eleventh District's cost of ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) funds at the level it was two months prior. Consequently, when the interest rate environment changes, the COFI reporting lag causes assets to initially reprice more slowly than liabilities, enhancing earnings when rates are falling and holding down income when rates rise. (a) Based on scheduled maturity or scheduled repricing, loans reflect scheduled repayments and projected prepayments of principal. (b) Includes cash in banks, FHLB stock, and loans collateralized by customer deposits. (c) Liabilities with no maturity date, such as passbook and money market deposit accounts, are assigned zero months. CASH AND INVESTMENTS Golden West's investment portfolio is composed primarily of federal funds, short-term repurchase agreements collateralized by mortgage-backed securities, and short-term money market securities. In determining the amounts of assets to invest in each class of investments, the Company considers relative rates, liquidity, and credit quality. When opportunities arise, the Company enters into arbitrage transactions with ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) secured borrowings and short-term investments to profit from the rate differential. The level of the Company's investments position in excess of its liquidity requirements at any time depends on liquidity needs and available arbitrage opportunities. The Office of Thrift Supervision requires insured institutions, such as World Savings, to maintain a minimum amount of cash and certain qualifying investments for liquidity purposes. The current minimum requirement is equal to a monthly average of 5% of customer deposits and short-term borrowings. For the months ended December 31, 1993, 1992, and 1991, World's regulatory average liquidity ratio was 8%, 7%, and 8%, respectively, consistently exceeding the requirement. Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." FAS 115 establishes three investment classifications: held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify investment securities as either held to maturity or available for sale. The Company has no trading securities. Held to maturity securities are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. Securities held to maturity are recorded at cost because the Company has the ability to hold these securities to maturity and because it is Management's intention to hold them to maturity. At December 31, 1993, the Company had no securities held to maturity. Securities available for sale increase the Company's portfolio management flexibility for investments and are reported at fair value. Net unrealized gains and losses are excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had no securities held to maturity or for trading. At December 31, 1993, the Company had securities available for sale in the amount of $1.6 billion and unrealized gains on securities available for sale recorded to stockholders' equity of $41 million. Gains or losses on sales of securities are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the security, using specific identification, adjusted for any unamortized premium or discount. The Company has other investments which are recorded at cost with any discount or premium amortized using a method that is not materially different from the interest method. The adoption of FAS 115 resulted in the reclassification of certain securities from the investment securities portfolio to the securities available for sale portfolio. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) Prior to December 31, 1993, securities were classified as either securities held for sale or investment securities. Securities held for sale were recorded at the aggregate portfolio's lower of amortized cost or market, with the unrealized gains and losses included in earnings. Investment securities were recorded at amortized cost. MORTGAGE-BACKED SECURITIES FAS 115 also requires the same three classifications for mortgage-backed securities: held to maturity, trading, and available for sale. In accordance with FAS 115, the Company modified its accounting policies as of December 31, 1993, to identify MBS as either held to maturity or available for sale. The Company has no trading MBS. Mortgage-backed securities held to maturity are recorded at cost because the Company has the ability to hold these MBS to maturity and because management intends to hold these securities to maturity. Premiums and discounts on MBS are amortized or accreted using the interest method, also known as the level yield method, over the life of the security. At December 31, 1993, the Company had mortgage-backed securities held to maturity in the amount of $408 million. MBS available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of applicable income taxes as a separate component of stockholders' equity until realized. At December 31, 1993, the Company had mortgage-backed securities available for sale in the amount of $1.1 billion and unrealized gains on mortgage-backed securities recorded to stockholders' equity of $44 million. Gains or losses on sales of MBS are realized and recorded in earnings at the time of sale and are determined by the difference between the net sales proceeds and the cost of the MBS, using specific identification, adjusted for any unamortized premium or discount. Prior to December 31, 1993, all MBS were recorded at amortized cost. Repayments of MBS during the years 1993, 1992, and 1991 amounted to $646 million, $552 million, and $200 million, respectively. The increase in repayments in 1993 over 1992 and in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates. The portion of the Company's loans receivable represented by MBS was 6%, 8%, and 9% at yearends 1993, 1992, and 1991, respectively. LOAN PORTFOLIO New loan originations in 1993, 1992, and 1991 amounted to $6.4 billion, $6.5 billion, and $4.9 billion, respectively. Refinanced loans constituted 59% of new loan originations in 1993 compared to 56% in 1992 and 46% in 1991. The 1993 origination volume remained high due to the continued demand in the marketplace for refinancing of existing loans, plus expansion of the Company's loan origination capacity. Although the Company ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) has lending operations in 21 states, the primary mortgage origination focus continues to be on residential property in California. In 1993, 73% of total loan originations were on residential properties in California, compared to 83% and 88% in 1992 and 1991, respectively. Although California originations continue to be a large portion of total originations, the decrease in 1993 as compared to 1992 and 1991 was due to increased penetration by the Company in markets outside California and the slight decrease of originations in California. The percentage of the total loan portfolio (excluding mortgage-backed securities) that is comprised of residential loans in California was 81% at December 31, 1993, and 83% at December 31, 1992, and 1991. The total growth in the portfolio for each of the years ended December 31, 1993, and 1992, was $1.9 billion or 9%. Golden West continues to emphasize adjustable rate mortgages (ARMs)--loans with interest rates that change periodically in accordance with movements in specified indexes. The portion of the mortgage portfolio (excluding MBS) composed of rate-sensitive loans was 87% at yearends 1993, 1992, and 1991. Despite stiff competition from mortgage bankers who aggressively marketed fixed-rate mortgages at the lowest rates seen in the past 20 years, Golden West's ARM originations constituted approximately 75% of new mortgage loans made by the Company in 1993, compared with 80% in 1992 and 89% in 1991. Repayments of loans during the years 1993, 1992, and 1991 amounted to $3.8 billion, $4.1 billion, and $2.8 billion, respectively. The decrease in repayments in 1993 over 1992 was due to lower mortgage payoffs within our loan portfolio. The increase in repayments in 1992 over 1991 was primarily due to an increase in refinance activity as many borrowers took advantage of lower interest rates by replacing older, high-cost debt with new, more attractively priced instruments. The Company adopted Statement of Financial Accounting Standards No. 114 (FAS 114), "Accounting by Creditors for Impairment of a Loan," in the fourth quarter of 1993, retroactive to January 1, 1993. FAS 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. As a practical expedient, impairment may be measured based on the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. The valuation allowance and provision for loan losses are adjusted for changes in the present value of impaired loans for which impairment is measured based on the present value of expected future cash flows. The Company had previously measured loan impairment in accordance with the methods prescribed in FAS 114. As a result, no additional loss provisions were required by early adoption of the pronouncement. FAS 114 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) requires that impaired loans for which foreclosure is probable should be accounted for as loans. As a result, $16 million of in-substance foreclosed loans, with a valuation allowance of $7 million, were reclassified from real estate held for sale to loans receivable. Prior year amounts have not been restated. One measure of the soundness of the Company's portfolio is its ratio of nonperforming assets to total assets. Nonperforming assets include non-accrual loans (loans that are 90 days or more past due) and real estate acquired through foreclosure. In prior years, loans considered in-substance foreclosed were included in real estate held for sale, but upon adoption of FAS 114, impaired loans are now classified with loans receivable. NPAs amounted to $394 million, $330 million, and $282 million at yearends 1993, 1992, and 1991, respectively. The increase in NPAs in 1993 and 1992 was primarily in single-family loans and foreclosed real estate in California. The continued weak California economy and high unemployment rate resulted in an increase in loan delinquencies and, in certain areas, decreases in real estate prices. The growth in NPAs has also been impacted by high levels of bankruptcy filings, which often delay the collection process and extend the length of time a loan remains delinquent. The Company continues to closely monitor all delinquencies and takes appropriate steps to protect its interests. The Company's troubled debt restructured, which are loans that have been modified due to a weakness in the collateral and/or borrower, were $37 million, or 0.13% of assets, at December 31, 1993, compared to $13 million, or 0.06% of assets, at December 31, 1992, and $18 million, or 0.08% of assets, at December 31, 1991. The increase is due in part to the FAS 114 reclassification which included loans that had been modified. A majority of the Company's TDRs have temporary interest rate reductions and have been made primarily to customers negatively impacted by adverse economic conditions. The Company's ratio of NPAs and TDRs to total assets increased to 1.50% at December 31, 1993, from 1.33% and 1.24% at yearends 1992 and 1991, respectively. REAL ESTATE HELD FOR SALE Real estate acquired through foreclosure increased to $63 million at December 31, 1993, from $57 million a year earlier. The increase occurred primarily in one- to four-family properties in California. The Company's total Real Estate Held for Sale portfolio decreased to $64 million at December 31, 1993, from $67 million a year earlier due to the reclassification of loans in-substance foreclosed upon adoption of FAS 114 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) during December 1993. The components of the real estate held for sale portfolio at December 31, 1993, 1992, and 1991, are shown below: (a) All amounts are net of general valuation allowances. ALLOWANCE FOR LOAN LOSSES The Company's allowance for loan losses was $107 million at December 31, 1993, compared to $71 million and $48 million at yearends 1992 and 1991, respectively. The provision for loan losses was $66 million, $43 million, and $35 million in 1993, 1992, and 1991, respectively. The 1993 increase in the allowance and the provision over 1992 was considered prudent given the continued difficulties in the California economy, which led to an increase in nonperforming assets and chargeoffs. CUSTOMER DEPOSITS Customer deposits increased by $880 million, excluding those arising from acquisition and sales activity, compared to a decrease of $255 million in 1992, excluding branch sales, and an increase of $640 million in 1991. Rates paid on deposit accounts dropped steadily in 1993 and 1992, reaching the lowest level in 20 years for most products. Although rates paid on new accounts were lower than they had been in previous years, consumer funds were attracted during 1993 as a result of special promotions in the Company's savings markets. The Company experienced a net outflow of deposits during 1992 because the Company emphasized other, more cost-effective sources of funds, primarily Federal Home Loan Bank advances. In 1993, the Company acquired seven branches in Arizona containing $320 million in deposits and sold all seven of the Ohio branches with $264 million in deposits. The Company has no brokered deposits. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) ADVANCES FROM FEDERAL HOME LOAN BANKS The Company uses Federal Home Loan Bank borrowings, also known as "advances," to supplement cash flow and to provide funds for loan origination activities. Advances offer strategic advantages for asset-liability management including long-term maturities and, in certain cases, prepayment at the Company's option. FHLB advances increased by $782 million in 1993 compared to increases of $1.3 billion and $325 million in 1992 and 1991, respectively. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE The Company borrows funds through transactions in which securities are sold under agreements to repurchase. These funds are used to take advantage of arbitrage investment opportunities and to supplement cash flow. Reverse Repos are entered into with selected major government securities dealers, as well as large banks, typically using MBS from the Company's portfolio. Reverse Repos with dealers and banks amounted to $377 million, $486 million, and $579 million at yearends 1993, 1992, and 1991, respectively. OTHER BORROWINGS At December 31, 1993, Golden West had on file registration statements with the Securities and Exchange Commission for the sale of up to $100 million of subordinated notes. Golden West issued subordinated debt securities of $100 million in January 1993, and $200 million in October 1993, bringing the balance to $1.0 billion at December 31, 1993. As of December 31, 1993, the Company's subordinated debt was rated A3 and A- by Moody's Investors Service (Moody's) and Standard & Poor's Corporation (S&P), respectively. World Savings currently has on file a shelf registration with the OTS for the issuance of $2.0 billion of unsecured medium-term notes. As of December 31, 1993, $1.2 billion was available for issuance. The Association had medium-term notes outstanding under the current and prior registrations with principal amounts of $677 million at December 31, 1993, compared to $81 million at December 31, 1992, and $167 million at December 31, 1991. As of December 31, 1993, the Association's medium-term notes were rated A1 and A+ by Moody's and S&P, respectively. World Savings also has on file a registration statement with the OTS for the sale of up to $250 million of subordinated notes. Under a prior filing with the OTS, $50 million of subordinated notes remain unissued. As of December 31, 1993, World Savings had issued $200 million of subordinated securities. As of December 31, 1993, World Savings' subordinated notes were rated A2 and A by Moody's and S&P, respectively. The subordinated ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) notes are included in World Savings' risk-based regulatory capital as Supplementary Capital. STOCKHOLDERS' EQUITY The Company has increased its total stockholders' equity in each of the years 1993, 1992, and 1991 through the retention of a high percentage of net earnings. In addition, stockholders' equity increased in 1993 by $85 million due to the adoption of FAS 115 as of December 31, 1993. The Company has on file a shelf registration statement with the Securities and Exchange Commission to issue up to two million shares of its Preferred Stock. The Preferred Stock may be sold from time to time in one or more transactions for total proceeds of up to $200 million. The Preferred Stock may be issued in one or more series, may have varying provisions and designations, and may be represented by depository shares. The Preferred Stock is not convertible into Common Stock. No Preferred Stock has yet been issued under the registration. On October 28, 1993, the Company's Board of Directors' authorized the purchase by the Company of up to 3.2 million shares of Golden West's common stock. As of December 31, 1993, 204,000 shares had been repurchased and retired. The OTS requires federally insured institutions, such as World, to meet minimum capital requirements. Under these regulations, a savings institution is required to meet three separate capital requirements. The first requirement is to have tangible capital of 1.5% of adjusted total assets. At December 31, 1993, World Savings had tangible capital of $2.0 billion, or 7.27% of adjusted total assets, $1.6 billion in excess of the regulatory requirement. The second requirement is to have core capital of 3% of adjusted total assets. Core capital is defined as tangible capital plus certain allowable amounts of supervisory goodwill and direct investments. However, the amount of supervisory goodwill and direct investments that can be counted as core capital will be phased-down to zero by January 1, 1995. At December 31, 1993, World Savings had core capital of $2.2 billion, or 8.02% of adjusted total assets, $1.4 billion in excess of the regulatory requirement. The third capital requirement is to have risk-based capital equal to 8.0% of risk-weighted assets. At December 31, 1993, World Savings had risk-based capital in the amount of $2.5 billion, or 17.42% of risk-weighted assets, exceeding the current requirement by $1.4 billion. It should be noted that World Savings also continues to exceed all three capital requirements on a fully phased-in basis. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) The Federal Deposit Insurance Corporation Improvement Act of 1991 required each federal banking agency to implement prompt corrective actions for capital deficient institutions that it regulates. In response to this requirement, the OTS adopted final rules, effective December 19, 1992, based upon FDICIA's five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The determination of whether an association falls into a certain classification depends primarily on its capital ratios. The following table summarizes the capital ratios for each of the five classifications and shows that World Savings met the "well capitalized" standard as of December 31, 1993. (a) Core capital divided by adjusted total assets. (b) Core capital divided by risk-weighted assets. (c) Total capital is the same as risk-based capital and consists of such items as qualifying subordinated debt, cumulative perpetual and intermediate-term preferred stock, certain convertible debt securities, and general allowances for loan losses. The OTS limits capital distributions by savings and loan associations. For purposes of capital distributions, the OTS has classified World Savings as a Tier 1 association; thus, the Association may pay dividends during a calendar year of up to 100% of net income to date during the calendar year plus up to one-half of capital in excess of the fully phased-in requirement ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL CONDITION (continued) at the end of the prior year subject to thirty days' advance notice to the OTS. RESULTS OF OPERATIONS PROFIT MARGINS/SPREADS An important determinant of Golden West's earnings is its primary spread--the difference between its yield on earning assets and its cost of funds. The Company's primary spread is somewhat dependent on changes in interest rates because Golden West's liabilities tend to respond more rapidly to rate movements than do its assets. Because of the relatively stable interest rate environment during 1993, the benefit from the COFI timing lag was significantly smaller, resulting in a lower spread than a year ago. The primary spread was unusually high during 1992 because, during that year's falling interest rate environment, the cost of deposits and borrowings declined much faster than the yield on the Company's major earning asset, the loan portfolio, in large part due to the two month reporting lag of the Eleventh District Cost of Funds Index to which $19.5 billion of Golden West's assets are tied. YIELD ON EARNING ASSETS Golden West originates ARMs to manage the rate sensitivity of the asset side of the balance sheet. Most of the Company's ARMs have interest rates that change monthly in accordance with an index based on the cost of deposits and borrowings of savings institutions that are members of the FHLB of San Francisco (the COFI). Consequently, when interest rates de- creased in 1991 and 1992, the yield on the Company's loan portfolio also decreased. During 1993, although interest rates were more stable, the index continued to decline somewhat. In addition, during 1992 and 1993, the Company experienced large payoffs of high-rate fixed loans and MBS, which also contributed to the decrease in the yield on loans. The yield on earning assets showed a decline throughout 1991, 1992, and 1993 from a high of 10.22% in January 1991 to 6.61% at December 31, 1993, due in large part to decreases in the COFI during the period. COST OF FUNDS Approximately 81% of Golden West's liabilities are subject to repricing in less than one year. Because the cost of these liabilities is affected by short-term interest rates, a fall in the general level of interest rates led to a decrease in the Company's cost of funds during 1993, 1992, and 1991. The effect of these changes on asset yields and liability costs may be seen in the following table, which shows the components of the Company's primary spread at the end of the years 1991 through 1993. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) INTEREST ON LOANS In 1993 and 1992, interest on loans decreased due to a decline in the average portfolio yield partially offset by an increase in the average portfolio balance. INTEREST ON MBS In 1993 and 1992, interest on MBS decreased due to a decline in the average portfolio yield and a decrease in the average portfolio balance. INTEREST AND DIVIDENDS ON INVESTMENTS The income earned on the investment portfolio fluctuates, depending upon the volume outstanding and the yields available on short-term investments. Income from the Company's investments was higher in 1993 than in 1992 due to a higher average portfolio balance and increased FHLB dividends. Interest and dividends on investments was lower in 1992 than in 1991 due to a lower portfolio yield. INTEREST ON CUSTOMER DEPOSITS The major portion of the Company's customer deposit base consists of savings accounts with remaining maturities of less than one year. Thus, the amount of interest paid on these funds depends upon the level of short-term interest rates and the savings balances outstanding. The decrease in interest on customer deposits in 1993 and 1992 was due to a decrease in the average cost of deposits. INTEREST ON ADVANCES Interest paid on FHLB advances was higher in 1993 than in 1992 due to an increase in the average balance of these liabilities partially offset by a decrease in the average cost. Interest paid on FHLB advances was lower in 1992 than in 1991 due to a decrease in the average cost of these liabilities partially offset by an increase in the average balance of these liabilities. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) OTHER BORROWINGS Interest expense on other borrowings amounted to $158 million, $154 million, and $165 million for the years ended 1993, 1992, and 1991, respectively. The increase in the expense from 1993 over 1992 was due to an increase in the average balance of these liabilities partially offset by a decrease in the average cost. The decrease in the expense from 1992 over 1991 was due to a decrease in the average cost of other borrowings and a decrease in the average balance. PROVISION FOR LOAN LOSSES The provision for loan losses was $66 million, $43 million, and $35 million for the years ended 1993, 1992, and 1991, respectively. The increase in the provision from 1993 over 1992 and 1992 over 1991 reflected increased chargeoffs, increased nonperforming assets, and the continued weak California economy. GAIN (LOSS) ON THE SALE OF SECURITIES AND MORTGAGE-BACKED SECURITIES The gain (loss) on the sale of securities and mortgage-backed securities was a gain of $23 million and $4 million for the years ended 1993 and 1992, respectively, compared to a loss of $1 million for the year ended 1991. The 1993 gain included a $24 million reduction of a valuation allowance on investments charged to income in a previous year compared to a $4 million reduction in 1992. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses increased during the three years under discussion. The primary reasons for the increases for all three years were general inflation, growth of mortgage and deposit balances, the expansion of loan origination capacity, the installation of enhancements to data processing systems, and the expansion at Atlas Mutual Funds. The increase in 1993 was also due to the expansion of savings and loan activity outside of California and the relocation of some of our administrative operations to San Antonio, Texas. General and administrative expense as a percentage of average assets was 0.97%, 0.99%, and 0.99% at December 31, 1993, 1992, and 1991, respectively. TAXES ON INCOME Golden West utilizes the accrual method of accounting for income tax purposes and for preparing its published financial statements. For financial reporting purposes only, the Company uses "purchase accounting" in connection with certain assets acquired through mergers. The purchase accounting portion of income is not subject to tax. In the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) FAS 109 requires a change from the deferred method to the liability method of computing deferred income taxes. The Company has applied FAS 109 prospectively. The cumulative effect of this change in accounting for income taxes for the periods ending prior to January 1, 1993, is not material. FAS 109 required the Company to adjust its purchase accounting for prior business combinations by increasing deferred tax assets and reducing goodwill by $23 million to reflect the non-taxability of purchase accounting income. This deferred tax asset is being amortized over the remaining lives of the related purchased assets. The consolidated financial statements presented for the years prior to 1993 reflect income taxes under the deferred method required by previous accounting standards. Taxes as a percentage of earnings increased in 1993 over 1992 due to the effect of the amortization of the deferred tax asset related to the $23 million adjustment arising from the adoption of FAS 109, as well as the effect of the federal legislation enacted during 1993 that increased the federal corporate income tax rate from 34% to 35%. ACQUISITIONS During 1993, the Company acquired $320 million in deposits and seven branches in Arizona from PriMerit Bank. On July 15, 1991, the Company took title to the common stock of Beach Federal Savings and Loan Association of Boynton Beach, Florida, and its $1.5 billion in assets. The transaction has been accounted for as a purchase, and the results of operations have been included with the Company's results of operations since July 15, 1991. As a result of the Beach acquisition, Golden West recognized, for tax purposes, certain Beach net operating losses that resulted in a $25 million benefit in 1992 and a $103 million benefit in 1991. For financial statement reporting, this benefit has been recorded as negative goodwill and is being amortized into income over ten years. In 1993, 1992, and 1991, $13 million, $12 million, and $5 million, respectively, of the negative goodwill was amortized. On March 31, 1991, World Savings and Loan Association of Ohio, a wholly owned subsidiary of Golden West, was merged into World Savings. In conjunction with Golden West's acquisition of World of Ohio in 1988, the benefits of net operating loss carryforwards resulted in recording $18 million of negative goodwill in 1991. This benefit has been amortized into income over the period 1989 to 1993. In 1993, 1992, and 1991, $3 million, $4 million, and $11 million, respectively, of the negative goodwill was amortized. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS (continued) During 1991, World Savings acquired from the Resolution Trust Corporation (RTC) $355 million of deposits and 11 branches from four separate acquisitions. The acquisitions are not material to the financial position or net earnings of Golden West and pro forma information is not deemed necessary. DIVESTITURES During 1993, the Company sold $133 million of savings in two Ohio branches to Trumbull Savings and Loan and its remaining five Ohio branches with $131 million deposits to Fifth Third Bancorp. During 1992, the Company sold one branch in California containing $40 million in deposits and two branches in the state of Washington containing $37 million in deposits. LIQUIDITY AND CAPITAL RESOURCES The Association's principal sources of funds are cash flows generated from earnings; customer deposits; loan repayments; borrowings from the FHLB; issuance of medium-term notes; and debt collateralized by mortgages, MBS, or securities. In addition, the Association has a number of other alternatives available to provide liquidity or finance operations. These include borrowings from public offerings of debt or equity, sales of loans, negotiable certificates of deposit, issuance of commercial paper, and borrowings from commercial banks. Furthermore, under certain conditions, World Savings may borrow from the Federal Reserve Bank of San Francisco to meet short-term cash needs. The availability of these funds will vary depending upon policies of the FHLB, the Federal Reserve Bank of San Francisco, and the Federal Reserve Board. The principal sources of funds for the Association's parent, Golden West, are dividends from World Savings and the proceeds from the issuance of debt and equity securities. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Index included on page 66 and the financial statements, which begin on page. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Inapplicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors and executive officers of the Company are as follows (see footnote explanations on the following page): Name and Age Position ------------ -------- Herbert M. Sandler, 62 Chairman of the Board and Chief Executive Officer Marion O. Sandler, 63 Chairman of the Board and Chief Executive Officer (a) James T. Judd, 55 Senior Executive Vice President (b) Russell W. Kettell, 50 President (c) J. L. Helvey, 62 Group Senior Vice President (d) David C. Welch, 51 Group Senior Vice President and Treasurer (e) Dirk S. Adams, 42 Group Senior Vice President (f) Robert C. Rowe, 38 Vice President and Secretary (g) Louis J. Galen, 68 Director William P. Kruer, 49 Director William D. McKee, 67 Director Bernard A. Osher, 66 Director Kenneth T. Rosen, 45 Director Paul Sack, 66 Director ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (Continued) Each of the above persons holds the same position with World with the exception of James T. Judd who is President, Chief Operating Officer, and Director of World and Russell W. Kettell who is a Senior Executive Vice President and Director of World. Each executive officer has had the principal occupations shown for the prior five years except as follows: (a) Marion O. Sandler was elected Chairman of the Board of the Company in February 1993. Prior thereto, Mrs. Sandler served as President and Chief Executive Officer since 1980. (b) James T. Judd was elected Senior Executive Vice President of the Company in July 1989. Prior thereto, Mr. Judd served as Executive Vice President since 1984 and Senior Vice President since 1975. (c) Russell W. Kettell was elected President of the Company in February 1993. Prior thereto, Mr. Kettell served as Senior Executive Vice President since 1989, Executive Vice President since 1984, Senior Vice President since 1980, and Treasurer from 1976 until 1984. (d) J. L. Helvey was elected Group Senior Vice President of the Company in November 1988. Prior thereto, Mr. Helvey served as Senior Vice President since 1973. (e) David C. Welch was elected Group Senior Vice President and Treasurer of the Company in November 1988. Prior thereto, Mr. Welch served as Senior Vice President and Treasurer since 1985, Vice President and Treasurer since 1984, and Vice President and Assistant Treasurer since 1980. (f) Dirk S. Adams was elected Group Senior Vice President of the Company in November 1990. Prior thereto, Mr. Adams served as Senior Vice President since 1987. Prior to that, Mr. Adams served as Senior Vice President and General Counsel to the Federal Home Loan Bank of San Francisco since 1983. (g) Robert C. Rowe was elected Vice President and Secretary of the Company in February 1991. Prior thereto, Mr. Rowe served as Assistant Vice President and Secretary since 1989 and as General Counsel since 1988. Prior to that, Mr. Rowe was a legal counsel to the Federal Home Loan Bank of San Francisco since 1984. For further information concerning the directors and executive officers of the Registrant, see pages 2 through 10 of the Registrant's Proxy Statement dated March 14, 1994, which is incorporated herein by reference. ITEM 11.

ITEM 11. MANAGEMENT REMUNERATION The information required by this Item 11 is set forth in Registrant's Proxy Statement dated March 14, 1994, on pages 8 through 10 and is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is set forth on pages 2 through 10 of Registrant's Proxy Statement dated March 14, 1994, and is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Inapplicable. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Index to Financial Statements See Index included on page 66 and the financial statements, which begin on page. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) (a) (2) Index to Financial Statement Schedules Financial statement schedules are omitted because they are not required or because the required information is included in the financial statements or the notes thereto. (3) Index To Exhibits Exhibit No. Description ----------- ----------- 3 (a) Certificate of Incorporation, as amend- ed, and amendments thereto, are incorpo- rated by reference from Exhibit 3(a) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1990. 3 (b) By-Laws, as amended, are incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 4 (a) The Registrant agrees to furnish to the Commission, upon request, a copy of each instrument with respect to issues of long-term debt, the authorized principal amount of which does not exceed 10% of the total assets of the Company. 10 (a) 1978 Stock Option Plan, as amended, is incorporated by reference from Exhibit 10(a) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 10 (b) 1987 Stock Option Plan, as amended, is incorporated by reference from Exhibit 10(b) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1991. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) (a) (3) Index To Exhibits (continued) Exhibit No. Description ----------- ----------- 10 (c) Deferred Compensation Agreement between the Company and James T. Judd is incorporated by reference from Exhibit 10(b) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (d) Deferred Compensation Agreement between the Company and Russell W. Kettell is incorporated by reference from Exhibit 10(c) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (e) Deferred Compensation Agreement between the Company and J. L. Helvey is incorpo- rated by reference from Exhibit 10(d) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (f) Deferred Compensation Agreement between the Company and David C. Welch is incorporated by reference from Exhibit 10(f) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 10 (g) Operating lease on Company headquarters building, 1901 Harrison Street, Oakland, California 94612, is incorporated by reference from Exhibit 10(e) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1986. 10 (h) Form of Supplemental Retirement Agreement between the Company and cer- tain executive officers is incorporated by reference from Exhibit 10(j) to the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1990. 21 (a) Subsidiaries of the Registrant is incorporated by reference from Exhibit 22(a) of the Company's Annual Report on Form 10-K (file No. 1-4629) for the year ended December 31, 1987. 23 (a) Independent Auditors' Consent. ITEM l4. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) (b) Financial Statement Schedules The response to this portion of Item 14 is submitted as a part of section (a), Exhibits. (c) Reports on Form 8-K The Registrant did not file any current reports on Form 8-K with the commission in the fourth quarter. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8 Nos. 2-66913 (filed January 19, 1982) and 33-14833 (filed June 5, 1987): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers, and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit proceeding) is asserted by such director, officer, or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GOLDEN WEST FINANCIAL CORPORATION By: /s/ Herbert M. Sandler ------------------------------- Herbert M. Sandler, Chairman of the Board and Chief Executive Officer By: /s/ Marion O. Sandler ------------------------------- Marion O. Sandler, Chairman of the Board and Chief Executive Officer By: /s/ J. L. Helvey ------------------------------- J. L. Helvey, Group Senior Vice President and Chief Financial and Accounting Officer Dated: March 23, 1994 Pursuant to the requirements of the Securities Exchange Act of l934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated: /s/ Louis J. Galen 3/23/94 /s/ Kenneth T. Rosen 3/23/94 - ---------------------------------- ---------------------------------- Louis J. Galen, Kenneth T. Rosen, Director Director - ---------------------------------- ---------------------------------- William P. Kruer, Paul Sack, Director Director /s/ William D. McKee 3/23/94 /s/ Herbert M. Sandler 3/23/94 - ---------------------------------- ---------------------------------- William D. McKee, Herbert M. Sandler, Director Director /s/ Bernard A. Osher 3/23/94 /s/ Marion O. Sandler 3/23/94 - ---------------------------------- ---------------------------------- Bernard A. Osher, Marion O. Sandler, Director Director Page ---- Independent Auditors' Report Golden West Financial Corporation and Subsidiaries: Consolidated Statement of Financial Condition as of December 31, 1993, and 1992 , Consolidated Statement of Net Earnings for the years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Stockholders' Equity for the years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992, and 1991 , Notes to Consolidated Financial Statements All supplemental schedules are omitted as inapplicable or because the required information is included in the financial statements or notes thereto.

3153_1993.txt

3153

1993

ITEM 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) *Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) *SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2

ITEM 2. PROPERTIES ELECTRIC PROPERTIES The operating affiliates and SEGCO, at December 31, 1993, operated 33 hydroelectric generating stations, 31 fossil fuel generating stations and three nuclear generating stations. The amounts of capacity owned by each company are shown in the table below. I-18 Notes: (1) Owned by ALABAMA and MISSISSIPPI as tenants in common in the proportions of 60% and 40%, respectively. (2) Excludes the capacity owned by AEC. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) (3) Capacity shown is GEORGIA's or GULF's (Unit 3 only) current portion: 8.4% of Units 1 and 2, 75% (25% for GULF) for Unit 3 and 33.1% for Unit 4 of total plant capacity. See Item 2 - PROPERTIES - "Proposed Sales of Property" and "Jointly-Owned Facilities" herein. (4) Capacity shown is GEORGIA's portion (53.5%) of total plant capacity. (5) Represents 50% of the plant which is owned as tenants in common by GULF and MISSISSIPPI. (6) SEGCO is jointly-owned by ALABAMA and GEORGIA. (See Item 1 - BUSINESS herein.) (7) Capacity shown is GEORGIA's portion (50.1%) of total plant capacity. (8) Capacity shown is GEORGIA's portion (45.7%) of total plant capacity. (9) Generation is dedicated to a single industrial customer. Except as discussed below under "Titles to Property", the principal plants and other important units of the SOUTHERN system are owned in fee by the operating affiliates and SEGCO. It is the opinion of management of each such company that its operating properties are adequately maintained and are substantially in good operating condition. MISSISSIPPI owns a 79-mile length of 500-kilovolt transmission line which is leased to Gulf States. The line, completed in 1984, extends from Plant Daniel to the Louisiana state line. Gulf States is paying a use fee over a forty-year period covering all expenses and the amortization of the original $57 million cost of the line. The all-time maximum demand on the SOUTHERN system was 25,936,900 kilowatts and occurred in July 1993. This amount excludes demand served by generation retained by OPC, MEAG and Dalton and excludes demand associated with power purchased from SEPA by its preference customers. At that time, 27,342,700 kilowatts were supplied by SOUTHERN system generation and 1,405,800 kilowatts (net) were sold to other parties through net purchased and interchanged power. The reserve margin for the Southern electric system at that time was 13.2%. For information on the other registrants' peak demands reference is made to Item 6 - SELECTED FINANCIAL DATA herein. ALABAMA and GEORGIA will incur significant costs in decommissioning their nuclear units at the end of their useful lives. (See Item 1 - BUSINESS - I-19 "Regulation - Atomic Energy Act of 1954" and Note 1 to SOUTHERN's, ALABAMA's and GEORGIA's financial statements in Item 8 herein.) OTHER ELECTRIC GENERATION FACILITIES Through special purpose subsidiaries, SOUTHERN owns a 50% interest in Freeport, a 35% interest in Edelnor, a 55.3% interest Alicura and a 33.3% interest in a co-generation facility in Hawaii. For further discussion of other SEI projects, see Item 1 - BUSINESS - "New Business Development" herein. The generating capacity of these utilities (or facilities) at December 31, 1993, was as follows: * Represents a concession contract that provides SEI with the rights to use the generation. I-20 JOINTLY-OWNED FACILITIES ALABAMA has sold an undivided interest in two units of Plant Miller to AEC. GEORGIA has sold undivided interests in certain generating plants and other related facilities to OPC, MEAG, Dalton, FP&L and JEA. The percentages of ownership resulting from these sales are as follows: ALABAMA and GEORGIA have contracted to operate and maintain the respective units in which each has an interest (other than Rocky Mountain, as described below) as agent for the joint owners. See "Proposed Sales of Property" below for a description of the proposed sale of GEORGIA's remaining unsold ownership interest in Plant Scherer Unit 4. In connection with the joint ownership arrangements for Plant Vogtle, GEORGIA has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy until 1994 for Unit 1 and 1996 for Unit 2 and, with regard to a portion of a 5% interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest. The payments for capacity are required whether any capacity is available. The energy cost is a function of each unit's variable operating costs. Except for the portion of the capacity payments related to the 1987 and 1990 write-offs of Plant Vogtle costs, the cost of such capacity and energy is included in purchased power in the Statements of Income in Item 8 herein. In December 1988, GEORGIA and OPC completed a joint ownership agreement for the Rocky Mountain project under which GEORGIA will retain its present investment in the project and OPC will finance, complete and operate the facility. Upon completion (scheduled for 1995), GEORGIA will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). For purposes of the ownership formula, GEORGIA's investment will be expressed in nominal dollars and OPC's investment will be expressed in constant 1987 dollars. Based on current cost estimates, GEORGIA's final ownership is estimated at approximately 25% of the project at completion. GEORGIA has held preliminary discussions regarding the potential disposition of its remaining interest in the project. PROPOSED SALES OF PROPERTY In 1991 and 1993, GEORGIA completed the first two in a series of four separate transactions to sell Unit 4 of Plant Scherer to FP&L and JEA for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4% of this unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to off-system sales contracts with Gulf States that were suspended in 1988. GEORGIA will continue to operate the unit. I-21 The 1991 and 1993 sales and the remaining transactions are scheduled as follows: Plant Scherer, a jointly owned coal-fired generating plant, has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. TITLES TO PROPERTY The operating affiliates' and SEGCO's interests in the principal plants (other than certain pollution control facilities, one small hydroelectric generating station leased by GEORGIA and the land on which four combustion turbine generators of MISSISSIPPI are located, which is held by easement) and other important units of the respective companies are owned in fee by such companies, subject only to the liens of applicable mortgage indentures (except for SEGCO) and to excepted encumbrances as defined therein. The operating affiliates own the fee interests in certain of their principal plants as tenants in common. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) Properties such as electric transmission and distribution lines and steam heating mains are constructed principally on rights-of-way which are maintained under franchise or are held by easement only. A substantial portion of lands submerged by reservoirs is held under flood right easements. In substantially all of its coal reserve lands, SEGCO owns or will own the coal only, with adequate rights for the mining and removal thereof. PROPERTY ADDITIONS AND RETIREMENTS During the period from January 1, 1989, to December 31, 1993, the operating affiliates, SEGCO, and other (i.e. SCS, Southern Nuclear and, beginning in 1993, various of the special purpose subsidiaries) gross property additions and retirements were as follows: (1) Includes approximately $62 million attributable to property sold to AEC in 1992. (2) Includes approximately $480 million attributable to property sold to OPC, FP&L and JEA, but excludes $231 million from the write-off of certain Plant Vogtle costs in 1990. (3) Net of intercompany eliminations. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS (1) STEPAK V. CERTAIN SOUTHERN OFFICIALS (U.S. District Court for the Southern District of Georgia) In April 1991, two SOUTHERN stockholders filed a derivative action suit against certain current and former directors and officers of SOUTHERN. The suit alleges violations of RICO by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages, including treble damages pursuant to RICO, in an unspecified amount, which if awarded, would be payable to SOUTHERN. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that the I-22 SOUTHERN board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs appealed the dismissal to the U.S. Court of Appeals for the Eleventh Circuit. (2) JOHNSON V. ALABAMA (Circuit Court of Shelby County, Alabama) In September 1990, two customers of ALABAMA filed a civil complaint in the Circuit Court of Shelby County, Alabama, against ALABAMA seeking to represent all persons who, prior to June 23, 1989, entered into agreements with ALABAMA for the financing of heat pumps and other merchandise purchased from vendors other than ALABAMA. The plaintiffs contended that ALABAMA was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring ALABAMA to refund all payments, principal and interest, made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered ALABAMA to refund or forfeit interest of approximately $10 million because of ALABAMA's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. ALABAMA has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot be determined; however, in management's opinion, the final outcome will not have a material adverse effect on SOUTHERN's or ALABAMA's financial statements. (3) OHIO RIVER COMPANY, ET AL.VS. GULF, ET AL. (U.S. District Court for Southern District of Ohio, Western Division) In 1993, a complaint against GULF and SCS was filed in federal district court in Ohio by two companies with which GULF had contracted for the transportation by barge for certain GULF coal supplies. The complaint alleges breach of the contract by GULF and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on SOUTHERN's or GULF's financial statements. See Item 1 - BUSINESS - "Construction Programs," "Fuel Supply," "Regulation - - Federal Power Act" and "Rate Matters", for a description of certain other administrative and legal proceedings discussed therein. Additionally, each of the operating affiliates and SEI are, in the normal course of business, engaged in litigation or administrative proceedings that include, but are not limited to, acquisition of property, injuries and damages claims, and complaints by present and former employees. In management's opinion these various actions will not have a material adverse effect on any of the registrants' financial statements. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-23 EXECUTIVE OFFICERS OF SOUTHERN (Inserted in Part I in accordance with Regulation S-K, Item 401(b), Instruction 3) EDWARD L. ADDISON Chairman and CEO Age 63 Elected in 1983; responsible primarily for the formation of overall corporate policy. He was elected Chairman of SOUTHERN effective January 1994. A. W. DAHLBERG President and Director Age 53 Elected in 1985; President and Chief Executive Officer of GEORGIA from 1988 through 1993. He was elected Executive Vice President of SOUTHERN in 1991. He was elected President of SOUTHERN effective January 1994. PAUL J. DENICOLA Executive Vice President and Director Age 45 Elected in 1989; Executive Vice President of SOUTHERN since 1991. Elected President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 to 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. H. ALLEN FRANKLIN Executive Vice President and Director Age 49 Elected in 1988; President and Chief Executive Officer of SCS from 1988 through 1993 and, beginning 1991, Executive Vice President of SOUTHERN. He was elected President and CEO of GEORGIA effective January 1994. ELMER B. HARRIS Executive Vice President and Director Age 54 Elected in 1989; President and Chief Executive Officer of ALABAMA since 1989 and, beginning 1991, Executive Vice President of SOUTHERN. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. W. L. WESTBROOK Financial Vice President Age 54 Elected in 1986; responsible primarily for all aspects of financing for SOUTHERN. He has served as Executive Vice President of SCS since 1986. BILL M. GUTHRIE Vice President Age 60 Elected in 1991; serves as Chief Production Officer for the SOUTHERN system. Senior Executive Vice President of SCS effective January 1994. He has also served as Executive Vice President of ALABAMA since 1988. Each of the above is currently an officer of SOUTHERN, serving a term running from the last annual meeting of the directors (May 26, 1993) for one year until the next annual meeting or until his successor is elected and qualified. I-24 PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The common stock of SOUTHERN is listed and traded on the New York Stock Exchange. The stock is also traded on regional exchanges across the United States. High and low stock prices, per the New York Stock Exchange Composite Tape and as adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994, during each quarter for the past two years were as follows: There is no market for the other registrants' common stock, all of which is owned by SOUTHERN. On February 28, 1994, the closing price of SOUTHERN's common stock was $20-5/8. (b) Number of SOUTHERN's common stockholders at December 31, 1993: 237,105 Each of the other registrants have one common stockholder, SOUTHERN. (c) Common dividends are payable at the discretion of each registrant's board of directors. The common dividends paid by SOUTHERN and the operating affiliates to their stockholder(s) for the past two years were as follows: (in thousands) In January 1994, SOUTHERN's board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. II-1 The dividend paid per share by SOUTHERN was 27.5c. for each quarter of 1992 and 28.5c. for each quarter of 1993. SOUTHERN's common dividend for the first quarter of 1994 was raised to 29.5c. per share. The amount of common dividends that may be paid by the subsidiary registrants is restricted in accordance with their respective first mortgage bond indenture and charter. The amounts of earnings retained in the business and the amounts restricted against the payment of cash dividends on common stock at December 31, 1993, were as follows: ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA SOUTHERN. Reference is made to information under the heading "Selected Consolidated Financial and Operating Data," contained herein at pages II-38 through II-49. ALABAMA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-78 through II-91. GEORGIA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-123 through II-137. GULF. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II- 166 through II-179. MISSISSIPPI. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-207 through II-220. SAVANNAH. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-245 through II-258. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION SOUTHERN. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-8 through II-15. ALABAMA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-53 through II-58. GEORGIA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-95 through II-101. GULF. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-141 through II-147. MISSISSIPPI. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-183 through II-189. SAVANNAH. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-224 through II-230. II-2 ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO 1993 FINANCIAL STATEMENTS II-3 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-4 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES FINANCIAL SECTION II-5 MANAGEMENT'S REPORT The Southern Company and Subsidiary Companies 1993 Annual Report The management of The Southern Company has prepared -- and is responsible for - -- the consolidated financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of three directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of The Southern Company and its subsidiaries in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ E. L. Addison /s/ W. L. Westbrook - ------------------------------------ ---------------------------- Edward L. Addison W. L. Westbrook Chairman and Chief Executive Officer Financial Vice President II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND TO THE STOCKHOLDERS OF THE SOUTHERN COMPANY: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of The Southern Company (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-16 through II-37) referred to above present fairly, in all material respects, the financial position of The Southern Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Southern Company and Subsidiary Companies 1993 Annual Report RESULTS OF OPERATIONS EARNINGS AND DIVIDENDS The Southern Company's 1993 financial performance exceeded the strong results recorded for 1992, and set several new records. The company's financial strength continued to gain momentum for the third consecutive year. In January 1994, The Southern Company board of directors increased the quarterly dividend rate by 3.5 percent, and approved a two-for-one common stock split in the form of a stock distribution. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. For 1993, The Southern Company's net income of $1.0 billion established a new record high and the company's common stock reached an all-time high closing price during the year of 23 3/8 -- surpassing the record of 19 1/2 set in 1992. Also, return on average common equity reached the highest level since 1986. Earnings reported for 1993 totaled $1,002 million or $1.57 per share, an increase of $49 million or 6 cents per share from the previous year. Both 1993 and 1992 earnings were affected by special non-operating or non-recurring items. After excluding these special items in both years, earnings from operations of the ongoing business of selling electricity were $1,016 million or $1.59 per share, an increase of $77 million or 10 cents per share compared with 1992. The special items that affected 1993 and 1992 earnings were as follows: In 1993, several items -- both positive and negative -- had an impact on earnings, which resulted in a net reduction of $14 million. These items were: (1) The conclusion of a settlement agreement -- discussed later -- with Gulf States Utilities (Gulf States) increased earnings. (2) The second in a series of four separate transactions to sell Plant Scherer Unit 4 to two Florida utilities increased earnings. (3) Environmental clean-up costs incurred at sites located in Alabama and Georgia decreased earnings. (4) Costs associated with a transportation fleet reduction program decreased earnings. The improvements in 1993 earnings resulted primarily from increased retail energy sales and continued emphasis on effective cost controls. The special items that increased 1992 earnings were primarily related to additional settlement provisions from Gulf States, and to gains on the sale of Gulf States common stock received in 1991. Returns on average common equity were 13.43 percent in 1993, 13.42 percent in 1992, and 12.74 percent in 1991. Dividends paid on common stock during 1993 were $1.14 per share or 28 1/2 cents per quarter. During 1992 and 1991, dividends paid per share were $1.10 and $1.07, respectively. In January 1994, The Southern Company board of directors raised the quarterly dividend to 29 1/2 cents per share or an annual rate of $1.18 per share. REVENUES Operating revenues increased in 1993 and 1992 and decreased in 1991 as a result of the following factors: II-8 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Retail revenues of $7.3 billion in 1993 increased 7.4 percent from last year, compared with an increase of 1.6 percent in 1992. Under fuel cost recovery provisions, fuel revenues generally equal fuel expense -- including the fuel component of purchased energy -- and do not affect net income. Sales for resale revenues within the service area were $447 million in 1993, up 9.2 percent from the prior year. This increase resulted primarily from the prolonged hot summer weather, which increased the demand for electricity. Revenues from sales for resale within the service area were $409 million in 1992, down 1.9 percent from the prior year. The decrease resulted from certain municipalities and cooperatives in the service area retaining more of their own generation at facilities jointly owned with Georgia Power. Revenues from sales to utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Capacity revenues decreased in 1993 and 1992 because the amount of capacity under contract declined by some 500 megawatts and 300 megawatts, respectively. In 1994, the contracted capacity will decline another 400 megawatts. Changes in revenues are influenced heavily by the amount of energy sold each year. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The rate of growth in 1993 retail energy sales was the highest since 1986. Residential energy sales registered the highest annual increase in two decades as a result of hotter-than-normal summer weather and the addition of 46,000 new customers. Commercial sales were also affected by the warm summer. Industrial energy sales in 1993 and 1992 showed moderate growth, reflecting a recovery in the business and economic conditions in The Southern Company's service area. Energy sales to retail customers are projected to grow at an average annual rate of 1.7 percent during the period 1994 through 2004. Energy sales for resale outside the service area are predominantly unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale outside the service area. Sales to customers outside the service area have decreased for the third consecutive year primarily as a result of the scheduled decline in megawatts of capacity under contract. In addition, the decline in 1992 and 1991 sales was also influenced by fluctuations in prices for oil and natural gas, the primary fuel sources for utilities with which the company has long-term contracts. When oil and gas prices fall below a certain level, these customers can generate electricity to meet their requirements more economically. However, the fluctuation in these energy sales, excluding the impact of contractual declines, had minimal effect on earnings because The Southern Company is paid for dedicating specific amounts of its generating capacity to these utilities. EXPENSES Total operating expenses of $6.7 billion for 1993 were up 6.5 percent compared with the prior year. The increase was attributable to higher production expenses of $75 million to meet increased energy demands and an additional $50 million in depreciation expenses and property taxes resulting from additional utility plant being placed into service. The transportation fleet reduction program and environmental clean-up costs discussed earlier increased expenses by some $62 million. Also, a $67 million change in deferred Plant Vogtle expenses compared with the amount in 1992 contributed to the rise in total operating expenses. In 1992, total operating expenses of $6.3 billion were at the same level reported for 1991. The costs to produce and deliver electricity in 1992 declined by $165 million primarily as a result of less energy being sold and continued effective cost controls. However, expenses in 1991 were reduced by proceeds from a settlement II-9 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report agreement with Gulf States that more than offset the decline in 1992 expenses when compared with 1991. Deferred expenses related to Plant Vogtle in 1992 increased by $47 million when compared with the prior year. Fuel costs constitute the single largest expense for The Southern Company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. The amount and sources of generation and the average cost of fuel per net kilowatt-hour generated were as follows: Fuel and purchased power expenses of $2.6 billion in 1993 increased 1.3 percent compared with the prior year because of increased energy demands and slightly higher average cost of fuel per net kilowatt-hour generated. Fuel and purchased power costs in 1992 decreased $137 million or 5.0 percent compared with 1991 primarily because 1.1 billion fewer kilowatt-hours were needed to meet customer requirements. Also, the decrease in these costs was attributable to a lower average cost of fuel per net kilowatt-hour generated. Income taxes for 1993 increased $69 million compared with the prior year. The increase is attributable to a number of factors, including a 1 percent increase in the corporate federal income tax rate effective January 1993, the second sale of additional ownership interest in Plant Scherer Unit 4, and the increase in taxable income from operations. For 1992, income taxes rose $11 million or 1.7 percent above the amount reported for 1991. For the fifth consecutive year, total gross interest charges and preferred stock dividends declined from amounts reported in the previous year. The declines are attributable to lower interest rates and significant refinancing activities during the past two years. In 1993, these costs were $831 million - -- down $21 million or 2.3 percent. These costs for 1992 decreased $71 million. As a result of favorable market conditions during 1993, some $3.0 billion of senior securities was issued for the primary purpose of retiring higher-cost debt and preferred stock. EFFECTS OF INFLATION The Southern Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on The Southern Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, Georgia Power could realize an after-tax gain currently estimated to total approximately $20 million. See Note 7 to the financial statements for additional information. In early 1994, Georgia Power and the system service company announced work force reduction programs that are estimated to reduce 1994 earnings by some $55 million. These actions will assist in efforts to control the growth in operating expenses. II-10 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report See Note 4 to the financial statements for information on an uncertainty regarding full recovery of an investment in the Rocky Mountain pumped storage hydroelectric project. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The Southern Company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If The Southern Company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. An important part of the Energy Act was to amend the Public Utility Holding Company Act of 1935 (PUHCA) and allow holding companies to form exempt wholesale generators and foreign utility companies to sell power largely free of regulation under PUHCA. These new entities are able to sell power to affiliates -- under certain restrictions -- and to own and operate power generating facilities in other domestic and international markets. To take advantage of these opportunities, Southern Electric International (Southern Electric) -- founded in 1981 -- is focusing on international and domestic cogeneration, the independent power market, and the privatization of generating facilities in the international market. During 1993, investments of some $315 million were made in entities that own and operate generating facilities in various international markets. In the near term, Southern Electric is expected to have minimal effect on earnings, but the possibility exists that it could be a prime contributor to future earnings growth. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been implemented by some of the system operating companies and are a significant part of integrated resource planning. See Note 3 to the financial statements under "Georgia Power's Demand-Side Conservation Programs" for information concerning the recovery of certain costs. Customers can receive cash incentives for participating in these programs as well as reduce their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the utility. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects in conjunction with precertification approval processes of such projects by the respective state public service commissions in Alabama, Georgia, and Mississippi will diminish the possible exposure to prudency disallowances and the resulting impact on earnings. In addition, Georgia Power has conducted a competitive bidding process for additional peaking capacity needed in 1996 and 1997. To meet expected requirements for 1996, Georgia Power has filed a plan with the state public service commission for certification of a four-year purchase power contract and for an ownership interest in a combustion turbine peaking unit. Rates to retail customers served by the system operating companies are regulated by the respective state public service commissions in Alabama, Florida, Georgia, and Mississippi. Rates for Alabama Power and Mississippi Power are adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that The Southern Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in some of these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." II-11 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, The Southern Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Southern Company adopted the new rules January 1, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The Southern Company's financial condition is now the strongest since the mid-1980s. Record levels of performance were set in 1993 related to earnings, market price of common stock, and energy sold to retail customers. In January 1994, The Southern Company board of directors increased the common stock dividend for the third consecutive year, and approved a two-for-one common stock split in the form of a stock distribution. Another major change in The Southern Company's financial condition was gross property additions of $1.4 billion to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Consolidated Statements of Cash Flows provide additional details. On January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 9 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company achieved a ratio of common equity to total capitalization -- including short-term debt -- of 43.5 percent in 1993, compared with 42.8 percent in 1992 and 41.5 percent in 1991. The company's goal is to maintain the common equity ratio generally within a range of 40 percent to 45 percent. During 1993, the operating companies sold $2.2 billion of first mortgage bonds and, through public authorities, $385 million of pollution control revenue bonds, at a combined weighted interest rate of 6.5 percent. Preferred stock of $426 million was issued at a weighted dividend rate of 5.7 percent. The operating companies continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $2.5 billion during 1993, $2.8 billion during 1992, and $1.0 billion during 1991. Retirements of preferred stock totaled $516 million during 1993, $326 million during 1992, and $125 million during 1991. As a result, the composite interest rate on long-term debt decreased from 9.2 percent at December 31, 1990, to 7.6 percent at December 31, 1993. During this same period, the composite dividend rate on preferred stock declined from 8.5 percent to 6.4 percent. In 1993, The Southern Company raised $205 million from the issuance of new common stock under the Dividend Reinvestment and Stock Purchase Plan (DRIP) and the Employee Savings Plan. At the close of 1993, the company's common stock had a market value of $22.00 per share, compared with a book value of $11.96 per share. The market-to-book value ratio was 184 percent at the end of 1993, compared with 168 percent at year-end 1992 and 156 percent at year-end 1991. CAPITAL REQUIREMENTS FOR CONSTRUCTION The construction program of the operating companies is budgeted at $1.5 billion for 1994, $1.3 billion for 1995, and $1.5 billion for 1996. The total is $4.3 billion for the three years. Actual construction costs may vary from this estimate because of factors such as changes in environmental regulations; changes in existing nuclear plants to meet new regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The operating companies do not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload facilities until well into the future. However, within the II-12 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts of capacity is planned to be completed by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $789 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of long-term debt. Also, the operating subsidiaries plan to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV II-13 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report requirements, on some Georgia Power plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Southern Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL In early 1994, The Southern Company sold -- through a public offering -- common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. Any portion of the common stock required during 1994 for the DRIP and the employee stock plans that is not provided from the issuance of new stock will be acquired on the open market in accordance with the terms of such plans. The operating subsidiaries plan to obtain the funds required for construction and other purposes from sources similar to those used in the past. However, the type and timing of any financings -- if needed -- will depend on market conditions and regulatory approval. II-14 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Completing the sale of Unit 4 of Plant Scherer will provide some $260 million of cash during the years 1994 and 1995. As required by the Nuclear Regulatory Commission, Alabama Power and Georgia Power established external sinking funds for nuclear decommissioning costs. For 1994 through 2000, the combined amount to be funded for both Alabama Power and Georgia Power totals $36 million annually. The cumulative effect of funding over this period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." To meet short-term cash needs and contingencies, the system companies had approximately $178 million of cash and cash equivalents and $1.1 billion of unused credit arrangements with banks at the beginning of 1994. To issue additional first mortgage bonds and preferred stock, the operating companies must comply with certain earnings coverage requirements designated in their mortgage indentures and corporate charters. The ability to issue securities in the future will depend on coverages at that time. The coverage ratios were, at the end of the respective years, as follows: *Savannah Electric's requirement is 2.50. II-15 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report CONSOLIDATED STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-16 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-17 CONSOLIDATED STATEMENTS OF BALANCE SHEETS At December 31, 1993, and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-18 CONSOLIDATED BALANCE SHEETS (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-19 CONSOLIDATED STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report II-20 CONSOLIDATED STATEMENTS OF CAPITALIZATION (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-21 NOTES TO FINANCIAL STATEMENTS The Southern Company and Subsidiary Companies 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Southern Company is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both the company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The operating companies also are subject to regulation by the FERC and their respective state regulatory commissions. The companies follow generally accepted accounting principles and comply with the accounting policies and practices prescribed by their respective commissions. All material intercompany items have been eliminated in consolidation. Consolidated retained earnings at December 31, 1993, include $2.6 billion of undistributed retained earnings of subsidiaries. Certain prior years' data presented in the consolidated financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The operating companies accrue revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The operating companies' electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $137 million in 1993, $132 million in 1992, and $162 million in 1991. Alabama Power and Georgia Power have contracts with the U.S. Department of Energy (DOE) that provide for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2003 at Plant Hatch, into 2009 at Plant Vogtle, and into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. Georgia Power -- based on its ownership interests -- and Alabama Power currently estimate their liability under this law to be approximately $39 million and $46 million, respectively. These obligations are recorded in the Consolidated Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected costs of decommissioning nuclear facilities. II-22 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. Alabama Power and Georgia Power have established external sinking funds to comply with the NRC's regulations. Prior to the enactment of these regulations, Alabama Power and Georgia Power had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. Alabama Power and Georgia Power have filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amounts prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Alabama Power's Plant Farley and Georgia Power's plants Hatch and Vogtle -- based on its ownership interests -- were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a set period of time as approved by the respective state public service commissions. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the Georgia Public Service Commission (GPSC) ordered that the allowed costs of Plant Vogtle, a two-unit nuclear facility of which Georgia Power owns 45.7 percent, be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. Under these plans, Georgia Power deferred financing costs and depreciation expense until the allowed investment was fully reflected in rates as of October 1991. In 1991, the GPSC modified the Plant Vogtle phase-in plan to begin earlier amortization of the costs deferred under the plan. Also, the GPSC levelized capacity buyback expense from co-owners of Plant Vogtle. See Note 3 for additional information regarding Georgia Power's 1991 rate order. Previously, pursuant to two separate interim accounting orders by the GPSC, Georgia Power deferred substantially all operating expenses and financing costs related to Plant Vogtle. Units 1 and 2 began commercial operation in May 1987 and May 1989, respectively. The accounting orders were for the periods from the date of each unit's commercial operation until October 1987 and 1989, respectively. Under phase-in plans and accounting orders from the GPSC, Georgia Power deferred and began amortizing the costs -- recovered through rates -- related to Plant Vogtle as follows: The unrecovered balance above includes approximately $160 million related to the adoption in 1993 of FASB Statement No. 109, Accounting for Income Taxes. See Note 9 for information about Statement No. 109. II-23 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Each GPSC order calls for recovery of deferred costs within 10 years. Also, the orders authorized Georgia Power to impute a return similar to allowance for funds used during construction (AFUDC) on its investment in Plant Vogtle units 1 and 2 after the units began commercial operation. These deferred returns are included in the above amounts, except for the equity component in the case of the Unit 2 accounting order. INCOME TAXES The companies provide deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 for additional information about Statement No. 109. AFUDC AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the companies to calculate AFUDC during the years 1991 through 1993 ranged from a before-income-tax rate of 4.9 percent to 11.4 percent. Deferred income taxes related to capitalized debt cost were $5 million, $4 million, and $7 million in 1993, 1992, and 1991, respectively. After Plant Vogtle units 1 and 2 began commercial operation in 1987 and 1989, respectively, Georgia Power imputed a deferred return similar to AFUDC on its investment in the units under the short-term cost deferrals and phase-in plans, as discussed earlier. AFUDC and the deferred return, net of income tax, as a percent of consolidated net income were 1.7 percent in 1993, 1.8 percent in 1992, and 6.0 percent in 1991. The deferred return was discontinued in October 1991 after the allowed investment in Plant Vogtle was fully reflected in rates. UTILITY PLANT Utility plant is stated at original cost less regulatory disallowances. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of The Southern Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred II-24 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In 1992, Georgia Power converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that will be amortized as a credit to income over approximately four years. This conversion will not have a material effect on net income. VACATION PAY The operating companies' employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the companies accrue a current liability for earned vacation pay and record a current asset representing the future recoverability of this cost. The amount was $73 million and $70 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 71 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The system companies have defined benefit, trusteed, non-contributory pension plans that cover substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. Primarily, the companies use the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The system companies also provide certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the system companies adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered Georgia Power to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional costs would be expensed in 1993 and the remaining costs would be deferred. An additional one-fifth of the costs would be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The costs deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of regulatory treatment allowed by the operating companies' respective public service commissions, the adoption of Statement No. 106 did not have a material impact on consolidated net income. Prior to 1993, the system companies, except for Georgia Power and Savannah Electric, recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. Consistent with regulatory treatment in these years, Georgia Power and Savannah Electric recognized these costs on a cash basis as payments were made. The total costs of such benefits recognized by system companies in 1992 and 1991 were $42 million and $36 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement II-25 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1 percent would increase the accumulated medical benefit obligation at December 31, 1993, by $129 million and the aggregate of the service and interest cost components of the net retiree medical cost by $14 million. Components of the plans' net cost are shown below: Of the above net pension amounts, pension income of $9 million in 1993 and pension expense of $2 million in 1992 and $11 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $64 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. II-26 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report WORK FORCE REDUCTION PROGRAMS The system companies have incurred additional costs for work force reduction programs. The costs related to these programs were $35 million, $37 million, and $72 million for the years 1993, 1992, and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $19 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected, and this matter is concluded. STOCKHOLDER SUIT In April 1991, two Southern Company stockholders filed a derivative action suit in the U.S. District Court for the Southern District of Georgia against certain current and former directors and officers of The Southern Company. The suit alleges violations of the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages -- including treble damages pursuant to RICO -- in an unspecified amount, which if awarded, would be payable to The Southern Company. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that The Southern Company board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs have appealed the dismissal to the U.S. Court of Appeals for the 11th Circuit. ALABAMA POWER HEAT PUMP FINANCING SUIT In September 1990, two customers of Alabama Power filed a civil complaint in the Circuit Court of Shelby County, Alabama, against Alabama Power seeking to represent all persons who, prior to June 23, 1989, entered into agreements with Alabama Power for the financing of heat pumps and other merchandise purchased from vendors other than Alabama Power. The plaintiffs contended that Alabama Power was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring Alabama Power to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered Alabama Power to refund or forfeit interest of approximately $10 million because of Alabama Power's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. Alabama Power has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GULF POWER COAL BARGE TRANSPORTATION SUIT In 1993, a complaint against Gulf Power and the system service company was filed in federal district court in Ohio by two companies with which Gulf Power had contracted for the transportation by barge for certain Gulf Power coal supplies. The complaint alleges breach of the contract by Gulf Power and seeks damages estimated by the plaintiffs to be in excess of $85 million. II-27 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. ALABAMA POWER RATE ADJUSTMENT PROCEDURES In November 1982, the Alabama Public Service Commission (APSC) adopted rates that provide for periodic adjustments based upon Alabama Power's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement -- amounting to some $60 million -- is being amortized to income to offset the rate reduction in accordance with the APSC's rate order. See Note 8 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. GEORGIA POWER'S DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of Georgia Power's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. Georgia Power suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved Georgia Power's request for an accounting order allowing Georgia Power to defer all current unrecovered and future costs related to these programs until the superior court's decision is reversed or until the next general rate case proceedings. An association of industrial customers has filed a petition for review of the accounting order in superior court. Georgia Power's costs related to these conservation programs through 1993 were $60 million, of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GEORGIA POWER 1991 RATE ORDER; PHASE-IN PLAN MODIFICATIONS Georgia Power received a rate order in 1991 from the GPSC that modified the Plant Vogtle phase-in plans to begin earlier amortization of the costs deferred under the plans. The amortization period began October 1991 -- rather than October 1994 as originally scheduled -- and extends through September 1999. In addition, the GPSC ordered the levelization of capacity buyback expense from the co-owners of Plant Vogtle over a six-year period beginning October 1991. This results in net cost deferrals during the first three years and subsequent amortization of the deferred amounts in the last three years. MISSISSIPPI POWER RETAIL RATE ADJUSTMENT PLAN Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986 with various modifications in 1991 and the latest in 1994. In 1993, the Mississippi Public Service Commission (MPSC) ordered Mississippi Power to review and propose changes that would enhance the plan. Mississippi Power filed a revised plan, and the MPSC approved PEP-2 on January 4, 1994. Under PEP-2, Mississippi Power's rate of return will be measured on retail net investment rather than on common equity, as previously calculated. Also, the number of indicators used to evaluate Mississippi Power's performance was reduced to three with emphasis on price and service to the customer. In addition, PEP-2 provides for the sharing of rate adjustments based on low rates and on the performance rating. The evaluation periods for PEP-2 are semiannual. Any change in rates is limited to 2 percent of retail revenues per period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. II-28 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. 4. CONSTRUCTION PROGRAM GENERAL The operating companies are engaged in continuous construction programs, currently estimated to total some $1.5 billion in 1994, $1.3 billion in 1995, and $1.5 billion in 1996. These estimates include AFUDC of $34 million in 1994, $41 million in 1995, and $35 million in 1996. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The operating companies do not have any new baseload generating plants under construction. However, within the service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 was not economically justifiable and reasonable and withheld authorization for Georgia Power to spend funds from approved securities issuances on that project. In 1988, Georgia Power and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 6. However, full recovery of Georgia Power's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event Georgia Power cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off. At December 31, 1993, Georgia Power's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, Georgia Power's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL In early 1994, The Southern Company sold -- through a public offering -- 5.6 million shares of common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. II-29 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report To the extent possible, the operating companies' construction programs are expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The subsidiary companies may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FOREIGN UTILITY OPERATIONS During 1993, The Southern Company made investments of approximately $315 million in utilities that own and operate generating facilities in various foreign markets. The consolidated financial statements reflect these investments in majority-owned subsidiaries on a consolidated basis and other investments on an equity basis. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with banks totaled $1.1 billion, of which approximately $500 million expires at various times during 1994 and 1995; $130 million expires at May 1, 1996; $400 million expires at June 30, 1996; and $70 million expires at December 1, 1996. Georgia Power's revolving credit agreements of $150 million, of which $130 million remained unused as of December 31, 1993, expire May 1, 1996. During the term of these agreements, Georgia Power may convert short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Georgia Power's option. In connection with these credit arrangements, Georgia Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing The Southern Company, Alabama Power, and Georgia Power up to the total credit amount of $400 million. To provide liquidity support to commercial paper programs, $135 million and $165 million of the $400 million available credit are currently dedicated to the exclusive use of Alabama Power and Georgia Power, respectively. During the term of these agreements, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Mississippi Power has $70 million of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Mississippi Power's option. In connection with these credit arrangements, Mississippi Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. Savannah Electric has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Savannah Electric's option. In connection with these credit arrangements, Savannah Electric agrees to pay commitment fees based on the unused portions of the commitments. In connection with all other lines of credit, the companies have the option of paying fees or maintaining compensating balances, which are substantially all the cash of the companies except for daily working funds and similar items. These balances are not legally restricted from withdrawal. In addition, the companies from time to time borrow under uncommitted lines of credit with banks, and in the case of Alabama Power and Georgia Power, through commercial paper programs that have the liquidity support of committed bank credit arrangements. ASSETS SUBJECT TO LIEN The operating companies' mortgages, which secure the first mortgage bonds issued by the companies, constitute a direct first lien on substantially all of the companies' respective fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of the system's generating plants, the subsidiary companies have II-30 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. Total estimated long-term obligations were approximately $15 billion at December 31, 1993. Additional commitments for coal and nuclear fuel will be required in the future to supply the operating companies' fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 for the payment of $121 million to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Gulf Power and Mississippi Power. Also, in March 1988, Gulf Power made an advance payment of $60 million to a coal supplier under an agreement to lower the cost of future coal purchased under an existing contract. These amounts are being amortized to expense. The remaining unamortized amount included in deferred charges at December 31, 1993, was $70 million. OPERATING LEASES The operating companies have entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $11 million, $9 million, and $7 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated minimum rental commitments for noncancelable operating leases were as follows: 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS In 1992, Alabama Power sold an undivided interest in units 1 and 2 of Plant Miller and related facilities to Alabama Electric Cooperative, Inc. Since 1975, Georgia Power has sold undivided interests in plants Vogtle, Hatch, Scherer, and Wansley in varying amounts, together with transmission facilities, to OPC, the Municipal Electric Authority of Georgia (MEAG), and the city of Dalton, Georgia. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. See Note 7 for additional information concerning these sales. In addition, Georgia Power has entered into a joint ownership agreement with OPC with respect to the Rocky Mountain project, as discussed later. At December 31, 1993, Alabama Power's and Georgia Power's ownership and investment (exclusive of nuclear fuel) in jointly owned facilities with the above entities were as follows: *Estimated ownership at date of completion. Georgia Power and OPC have entered into a joint ownership agreement regarding the 848-megawatt Rocky Mountain pumped storage hydroelectric project. Under the agreement, Georgia Power will retain its present investment in the project and OPC will finance, complete, and operate the facility. Upon completion, Georgia Power will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Based on current cost estimates, Georgia Power's final ownership is estimated at approximately 25 percent of the project at completion. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. II-31 NOTES (continued) THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES 1993 ANNUAL REPORT Alabama Power and Georgia Power have contracted to operate and maintain the jointly owned facilities -- except for the Rocky Mountain project -- as agents for their respective co-owners. The companies' proportionate share of their plant operating expenses is included in the corresponding operating expenses in the Consolidated Statements of Income. In connection with a joint ownership arrangement at Plant Vogtle, Georgia Power has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from this plant for periods of up to 10 years following commercial operation (and, with regard to a portion of the 5 percent additional interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for such capacity are required whether any capacity is available. The energy cost of these purchases is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power in the Consolidated Statements of Income. Capacity payments totaled $183 million, $289 million, and $320 million, for 1993, 1992, and 1991, respectively. Projected capacity payments for the next five years are as follows: $132 million in 1994; $77 million in 1995; $70 million in 1996; $59 million in 1997; and $59 million in 1998. Also, a portion of the above capacity payments relates to Plant Vogtle costs that were written off after being disallowed for retail ratemaking purposes. In 1991, the GPSC ordered that the Plant Vogtle capacity buyback expense be levelized over a six-year period. The amounts deferred and not expensed in the year paid totaled $38 million in 1993, $100 million in 1992, and $30 million in 1991. The projected net amount to be deferred in 1994 is $1 million. The projected net amortization of the deferred expense is $49 million in 1995, $62 million in 1996, and $57 million in 1997. 7. PLANNED SALES OF INTEREST IN PLANT SCHERER Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FP&L) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to long-term power sales contracts with Gulf States that were suspended in 1988. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Plant Scherer -- a jointly owned coal-fired generating plant -- has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. See Note 6 for information regarding current plant ownership. 8. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from specific generating plants is currently being sold to FP&L, FPC, JEA, and the city of Tallahassee, Florida. Under these agreements, an average II-32 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report of 1,700 megawatts of capacity is scheduled to be sold during 1994 and 1995. Thereafter, these sales will decline to some 1,600 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts to be refunded to customers and the amounts previously included in income -- The Southern Company recorded an increase in consolidated net income of $114 million, or 18 cents per share, in November 1991. With respect to Alabama Power's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. 9. INCOME TAXES Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on consolidated net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $1.5 billion are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $1.1 billion are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows: II-33 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Consolidated Statements of Income. Credits amortized in this manner amounted to $29 million in 1993, $41 million in 1992, and $48 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. COMMON STOCK STOCK DISTRIBUTION In January 1994, The Southern Company board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. SHARES RESERVED At December 31, 1993, a total of 24 million shares was reserved for issuance pursuant to the Dividend Reinvestment and Stock Purchase Plan, the Employee Savings Plan, and the Executive Stock Option Plan. EXECUTIVE STOCK OPTION PLAN The Southern Company's Executive Stock Option Plan authorizes the granting of non-qualified stock options to key employees of The Southern Company, including officers. Currently, 34 employees are eligible to participate in the plan. As of December 31, 1993, 38 current and former employees participated in the plan. The maximum number of shares of common stock that may be issued under the Executive Stock Option Plan may not exceed 6 million. The price of options granted to date has been at the fair market value of the shares on the date of grant. Options granted to date become exercisable pro rata over a maximum period of four years from date of grant, such that all options generally are exercisable by 1997. Options outstanding will expire upon termination of the plan, which will occur on December 7, 1997, unless terminated earlier by the board of directors. Stock option activity in 1992 and 1993 is summarized below: II-34 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 11. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: With respect to the collateralized pollution control revenue bonds, the operating companies have authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under installment sale or loan agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. Assets acquired under capital leases are recorded as utility plant in service, and the related obligation is classified as other long-term debt. The net book value of capitalized leases was $217 million and $236 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the composite interest rates for nuclear fuel, buildings, and other were 3.6 percent, 9.7 percent, and 12.0 percent, respectively. Sinking fund requirements and/or serial maturities through 1998 applicable to other long-term debt are as follows: $89 million in 1994; $154 million in 1995; $58 million in 1996; $26 million in 1997; and $7 million in 1998. 12. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 166 2/3 percent of such requirements. II-35 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 13. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, Alabama Power and Georgia Power maintain agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the companies' nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for Alabama Power and Georgia Power -- based on its ownership and buyback interests -- is $159 million and $171 million, respectively, per incident but not more than an aggregate of $20 million and $22 million, respectively, to be paid for each incident in any one year. Alabama Power and Georgia Power are members of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. Alabama Power's and Georgia Power's maximum annual assessments are limited to $14 million and $18 million, respectively, under current policies. Additionally, both companies have policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments under current policies for Alabama Power and Georgia Power for excess property damage would be $16 million and $15 million, respectively. The replacement power assessments are $9 million for Alabama Power and $13 million for Georgia Power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. Alabama Power and Georgia Power participate in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Alabama Power and Georgia Power could be subject to a maximum total assessment of $6 million and $7 million, respectively. II-36 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 14. COMMON STOCK DIVIDEND RESTRICTIONS The income of The Southern Company is derived primarily from equity in earnings of its operating subsidiaries. At December 31, 1993, $1.6 billion of consolidated retained earnings was restricted against the payment by the operating companies of cash dividends on common stock under terms of bond indentures or charters. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: *Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. The company's business is influenced by seasonal weather conditions and the timing of rate changes. II-37 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) Note: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. II-38 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) II-39 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-40 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-41 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-42 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-43 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-44 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-45 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-46 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-47 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-48 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-49 ALABAMA POWER COMPANY FINANCIAL SECTION II-50 MANAGEMENT'S REPORT Alabama Power Company 1993 Annual Report The management of Alabama Power Company has prepared -- and is responsible for - -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Alabama Power Company in conformity with generally accepted accounting principles. /s/ Elmer B. Harris /s/ William B. Hutchins, III - -------------------------- ------------------------------ Elmer B. Harris William B. Hutchins III President Senior Vice President and Chief Executive Officer and Chief Financial Officer II-51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF ALABAMA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Alabama Power Company (an Alabama corporation and wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-59 through II-77) referred to above present fairly, in all material respects, the financial position of Alabama Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 II-52 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Alabama Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS The company's 1993 net income after dividends on preferred stock was $346 million, representing a 2.3 percent increase over the prior year. This improvement can be attributed to higher retail energy sales and lower financing costs. Retail energy sales increased 5.1 percent from 1992 levels. This was primarily due to the extreme weather during 1993, especially when compared to the unusually mild weather of 1992. Long-term debt interest expense and preferred stock dividends decreased in 1993 reflecting the continued redemption and refinancing of higher cost debt and preferred stock. These positive factors were partially offset by higher operating costs and a scheduled reduction in capacity sales to non-affiliated utilities. When comparing 1992 earnings with the prior year, it should be noted that 1991 earnings included an unusual item -- the settlement of litigation with Gulf States Utilities Company (Gulf States) that resulted in an after-tax gain of $9 million. A comparison of 1992 to 1991, excluding this unusual item, would reflect a 1992 increase in earnings of $8 million. The return on average common equity for 1993 was 13.9 percent compared to 14.0 percent in 1992, and 14.6 percent in 1991. REVENUES The following table summarizes the principal factors that affected operating revenues for the past three years: Retail revenues of $2.4 billion in 1993 increased $180 million (8.0 percent) over the prior year, compared with no increase in 1992. The extreme weather during 1993 and sales growth contributed to the increase in retail revenues over 1992. Fuel revenues increased substantially during 1993. However, changes in fuel revenues are offset with corresponding changes in recoverable fuel expenses and have no effect on net income. Gains in 1992 retail revenues, due to higher rates and sales growth, were partially offset by lower fuel cost recovery revenues. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: II-53 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report Capacity revenues decreased in 1993 due to a scheduled reduction in capacity dedicated to unit power sales customers for the first five months of the year. The major factor contributing to the increase in capacity revenues in 1992 and 1991 was a new generating unit, Plant Miller Unit 4, that was placed in commercial service in March 1991 and dedicated to unit power sales. This unit's fixed costs are higher than those of the unit it replaced, which previously provided energy to unit power sales customers. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: EXPENSES Total operating expenses of $2.4 billion for 1993 were up 7.0 percent compared with the prior year. The increase was mainly attributable to higher production expenses of $95 million to meet increased energy demands. Total operating expenses for 1992 increased moderately over those recorded in 1991. However, absent the Gulf States settlement, which reduced 1991 operating expenses, total operating expenses would have decreased $6 million. Fuel costs are the single largest expense for the company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. Fuel expense increases in 1993 represent $83 million of the production expense increase mentioned above. Fuel expense decreased in 1992 as a result of the reduction in the cost of both coal and nuclear fuel, offset somewhat by a small increase in generation. Fuel cost per kilowatt-hour generated was 1.73 cents in 1993, 1.64 cents in 1992 and 1.69 cents in 1991. Purchased power expenses decreased in 1992 primarily due to less purchased energy and a decrease in the price of such energy. Other operation expenses increased 6.0 percent in 1993 following a minimal increase in 1992. The increase in 1993 is primarily the result of environmental cleanup costs, net expenses of a March snowstorm, and the one-time cost of a transportation fleet reduction program, which together totaled $16.1 million. Depreciation and amortization expense increased 3.4 percent in 1993 and 3.5 percent in 1992. This is principally due to continued growth in depreciable plant in service. Taxes other than income taxes increased 4.0 percent in 1993 and 1.4 percent in 1992. These increases were the result of the addition of new facilities and higher revenue-related taxes. The increase in income tax expense of 2.6 percent for 1993 is primarily attributable to a one percent increase in the corporate federal income tax rate effective January 1, 1993. Interest expense and dividends on preferred stock decreased $7.5 million (2.8 percent) and $7.2 million (2.6 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. II - 54 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report EFFECTS OF INFLATION The company is subject to rate regulation that is based on the recovery of historical costs and, therefore is subject to economic losses caused by inflation. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will also depend upon growth in electric sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. In addition, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as any new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Rates to retail customers served by the company are regulated by the Alabama Public Service Commission (APSC). Rates for the company can be adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The company adopted the new rules January 1, 1994, with no material effect on the financial statements. II-55 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report FINANCIAL CONDITION OVERVIEW The company's financial condition remained stable in 1993. Growth in energy sales combined with a significant lowering of the cost of capital, achieved through the refinancing and/or redemption of higher-cost long-term debt and preferred stock contributed to this stability. The company had gross property additions of $436 million in 1993. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Statements of Cash Flows provide additional details. On January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company's ratio of common equity to total capitalization was 47.4 percent in 1993, compared with 47.6 percent in 1992, and 45.4 percent in 1991. In 1993, the company issued $860 million of first mortgage bonds, $158 million of preferred stock and, through public authorities, $144 million of pollution control revenue bonds. The company continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $835 million, and preferred stock retirements totaled $207 million. Composite financing rates as of year-end for 1991 through 1993 were as follows: The company's current securities ratings are as follows: CAPITAL REQUIREMENTS Capital expenditures are estimated to be $588 million for 1994, $572 million for 1995, and $531 million for 1996. The total is $1.7 billion for the three years. Actual capital costs may vary from this estimate because of factors such as changes in environmental regulations; changes in the existing nuclear plant to meet new regulations; revised load projections; increasing costs of labor, equipment, and materials; and the cost of capital. The company does not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload generating units until well into the future. However, the construction of combustion turbine peaking units of approximately 720 megawatts of capacity is planned by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will continue. In addition to the funds needed for the capital budget, approximately $80 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of first mortgage bonds. Also, the company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 II-56 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the company's portion is approximately $30 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company, of which the company's portion is approximately $225 million to $350 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in annual revenue requirements from customers could be necessary to fully recover the company's cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard II-57 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Southern electric system. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL It is anticipated that the funds required will be derived from sources in form and quantity similar to those used in the past. To issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements designated in its mortgage indenture and corporate charter. The company's coverages are at a level that would permit any necessary amount of security sales at current interest and dividend rates. As required by the Nuclear Regulatory Commission and as ordered by the APSC, the company has established external trust funds for nuclear decommissioning costs. Also, during 1993, the APSC issued a policy statement which will require external funding of postretirement benefits. The cumulative effect of funding these items over a long period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." II-58 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-59 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-60 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-61 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-62 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-63 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-64 NOTES TO FINANCIAL STATEMENTS Alabama Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The company is a wholly owned subsidiary of The Southern Company which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly-owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services upon request to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The company is also regulated by the FERC and the Alabama Public Service Commission (APSC). The company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The company's electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $62 million in 1993, $48 million in 1992, and $69 million in 1991. The company has a contract with the U.S. Department of Energy (DOE) that provides for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The company currently estimates its liability under this law to be approximately $46 million. This obligation is recognized in the accompanying Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected cost of decommissioning nuclear facilities. II-65 NOTES (continued) Alabama Power Company 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external trust fund, a surety method, or prepayment. The company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the company had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The company has filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amount prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Plant Farley were as follows: The amount in the internal reserve is being transferred into the external trust funds over the remaining life of the license for Plant Farley as approved by the APSC. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. INCOME TAXES The company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the company adopted Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rate used to determine the amount of allowance, net of deferred income tax, was 6.2 percent in 1991. Such method of computing AFUDC ceased upon the commercial operation of Plant Miller Unit 4 in March 1991. For construction projects begun after 1986, deferral of taxes related to capitalized interest is no longer permitted. For those projects, the composite rate used to determine the amount of allowance was 7.8 percent in 1993, 7.9 percent in 1992, and 8.3 percent in 1991. AFUDC, net of income tax, as a percent of net income after dividends on preferred stock was 1.5 percent in 1993, 1.1 percent in 1992, and 2.0 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs and replacements of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive II-66 NOTES (continued) Alabama Power Company 1993 Annual Report of minor items of property) is charged to utility plant. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the company accrues a current liability for earned vacation pay and records a current asset representing future recoverability of this cost. The amount was $23 million and $22 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 65 percent of the 1993 deferred vacation cost will be expensed and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. However, in December 1993, the APSC issued an accounting policy statement which requires the company to externally fund all postretirement benefits. It is expected that an external funding program will begin in 1994. Effective January 1, 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-67 NOTES (continued) Alabama Power Company 1993 Annual Report Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, the company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the company in 1992 and 1991 were $15.2 million and $15.4 million, respectively. Status and Cost of Benefits Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $32.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $3.4 million. II-68 NOTES(continued) Alabama Power Company 1993 Annual Report Components of the plans' net cost are shown below: Of the above net pension amounts, $(8.9) million in 1993, $(5.1) million in 1992, and $0.7 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $22 million was charged to operating expenses and the remainder was charged to construction and other accounts. WORK FORCE REDUCTION PROGRAM The company has incurred additional costs for work force reduction programs. The costs related to these programs were $16.1 million, $13.4 million and $6.7 million for the years 1993, 1992 and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $15.3 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATE ADJUSTMENT PROCEDURES In November 1982, the APSC adopted rates that provide for periodic adjustments based upon the company's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement amounting to approximately $60 million is being amortized to revenues to offset the rate reduction in accordance with the APSC's rate order. See Note 7 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. In February 1993, the APSC ordered - at the company's request - a moratorium on rate increases for the first two quarters of 1993, which facilitated the transition of an accounting change. This accounting change permitted the accrual of estimated operation and maintenance expenses related to nuclear refueling outages during the period between outages rather than at the time the expenses are incurred. HEAT PUMP FINANCING SUIT In September 1990, two customers of the company filed a civil complaint in the Circuit Court of Shelby County, Alabama, against the company seeking to represent all II-69 NOTES(continued) Alabama Power Company 1993 Annual Report persons who, prior to June 23, 1989, entered into agreements with the company for the financing of heat pumps and other merchandise purchased from vendors other than the company. The plaintiffs contended that the company was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring the company to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June, 1993, the court ordered the company to refund or forfeit interest of approximately $10 million because of the company's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. The company has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. 4. CAPITAL BUDGET The company's capital expenditures are currently estimated to total $588 million in 1994, $572 million in 1995 and $531 million in 1996. The estimates include AFUDC of $10 million in 1994, $11 million in 1995 and $12 million in 1996. The estimates for property additions for the three-year period includes $36.5 million committed to meeting the requirements of the Clean Air Act. The capital budget is subject to periodic review and revision, and actual capital cost incurred may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth projections; changes in environmental regulations; changes in the existing nuclear plant to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The company does not have any new baseload generating plants under construction. However, the construction of combustion turbine peaking units of approximately 720 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL To the extent possible, the company's construction program is expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FINANCING The ability of the company to finance its capital budget depends on the amount of funds generated internally and the funds it can raise by external financing. The II-70 NOTES(continued) Alabama Power Company 1993 Annual Report company's primary sources of external financing are sales of first mortgage bonds and preferred stock to the public, receipt of additional paid-in capital from The Southern Company, and leasing of nuclear material. In order to issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements contained in its mortgage indenture and corporate charter. The most restrictive of these provisions requires, for the issuance of additional first mortgage bonds, that before-income-tax earnings, as defined, cover pro forma annual interest charges on outstanding first mortgage bonds at least twice; and for the issuance of additional preferred stock, that gross income available for interest cover pro forma annual interest charges and preferred stock dividends at least one and one-half times. These coverages, for first mortgage bonds and for preferred stock for the year ended December 31, 1993, were 5.70 and 2.71, respectively. BANK CREDIT ARRANGEMENTS The company, along with The Southern Company and Georgia Power Company, has entered into agreements with several banks outside the service area to provide $400 million of revolving credit to the companies through June 30, 1996. To provide liquidity support for commercial paper programs, the company and Georgia Power Company have exclusive right to $135 million and $165 million, respectively, of the available credit. The companies have the option of converting the short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements provide for payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Additionally, the company maintains committed lines of credit in the amount of $350 million which expire at various times during 1994 and, in certain cases, provide for average annual compensating balances. Because the arrangements are based on an average balance, the company does not consider any of its cash balances to be restricted as of any specific date. Moreover, the company borrows from time to time pursuant to arrangements with banks for uncommitted lines of credit. In connection with all other lines of credit, the company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. At December 31, 1993, the company had regulatory approval to have outstanding up to $450 million of short-term borrowings. ASSETS SUBJECT TO LIEN The company's mortgage, as amended and supplemented, securing the first mortgage bonds issued by the company, constitutes a direct lien on substantially all of the company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations through the year 2013 were approximately $8 billion at December 31, 1993. In addition, a contract with a certain coal contractor requires reimbursement or purchase, at net book value, of the investment in the mine or equipment upon termination of the contract. At December 31, 1993, such net book value was approximately $13 million. Additional commitments for coal and for nuclear fuel will be required in the future to supply the company's fuel needs. 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS The company and Georgia Power Company own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,019,680 kilowatts, together with associated transmission facilities. The capacity of these units is sold equally to the company and Georgia Power Company under a contract expiring in 1994 which, in substance, requires payments sufficient to provide for the operating expenses, taxes, interest expense II-71 NOTES(continued) Alabama Power Company 1993 Annual Report and a return on equity, whether or not SEGCO has any capacity and energy available. The company's share of expenses totaled $86 million in 1993, $73 million in 1992 and $82 million in 1991, and is included in "Purchased power from affiliates" in the Statements of Income. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two years' notice. In addition, the company has guaranteed unconditionally the obligation of SEGCO under an installment sale agreement for the purchase of certain pollution control facilities at SEGCO's generating units, pursuant to which $24.5 million principal amount of pollution control revenue bonds are outstanding. Georgia Power Company has agreed to reimburse the company for the pro rata portion of such obligation corresponding to its then proportionate ownership of stock of SEGCO if the company is called upon to make such payment under its guaranty. At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. SEGCO paid dividends totaling $11.3 million in 1993, $12.0 million in 1992, and $4.5 million in 1991, of which one-half of each was paid to the company. SEGCO's net income was $8.3 million, $9.3 million and $9.2 million for 1993, 1992 and 1991, respectively. In June 1992 the company completed the sale of a portion of Plant Miller Units 1 and 2 to Alabama Electric Cooperative, Inc. (AEC). The company's percentage ownership and investment in jointly-owned generating plants at December 31, 1993, follows: (1) Jointly owned with an affiliate, Mississippi Power Company. (2) Jointly owned with AEC. 7. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company, including the company, have entered into long-term and short-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The company's portion of off-system capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from Plant Miller is being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA) and the City of Tallahassee, Florida (Tallahassee). Under these agreements, an average of 1,100 megawatts of capacity is scheduled to be II-72 NOTES(continued) Alabama Power Company 1993 Annual Report sold during 1994. Thereafter, these sales will increase to some 1,200 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. With respect to the company's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. ALABAMA MUNICIPAL ELECTRIC AUTHORITY (AMEA) CAPACITY CONTRACTS In August 1986, the company entered into a firm power purchase contract with AMEA entitling AMEA to scheduled amounts of capacity (to a maximum 100 megawatts) for a period of 15 years commencing September 1, 1986 (1986 Contract). In October 1991, the company entered into a second firm power purchase contract with AMEA entitling AMEA to scheduled amounts of additional capacity (to a maximum 80 megawatts) for a period of 15 years commencing October 1, 1991 (1991 Contract). In both contracts the power will be sold to AMEA for its member municipalities that previously were served directly by the company as wholesale customers. Under the terms of the contracts, the company received payments from AMEA representing the net present value of the revenues associated with the respective capacity entitlements, discounted at effective annual rates of 9.96 percent and 11.19 percent for the 1986 and 1991 Contracts, respectively. These payments are being recognized as operating revenues and the discounts are being amortized to other interest expense as scheduled capacity is made available over the terms of the contracts. In order to secure AMEA's advance payments and the company's performance obligation under the contracts, the company issued and delivered to an escrow agent first mortgage bonds representing the maximum amount of liquidated damages payable by the company in the event of a default under the contracts. No principal or interest is payable on such bonds unless and until a default by the company occurs. As the liquidated damages decline under the contracts, a portion of the bonds equal to the decreases are returned to the company. At December 31, 1993, $153 million of such bonds were held by the escrow agent under the contracts. 8. INCOME TAXES Effective January 1, 1993, the company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $469 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $441 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-73 NOTES (continued) Alabama Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $13 million in 1993, $18 million in 1992, and $16 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-74 NOTES (continued) Alabama Power Company 1993 Annual Report 9. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: Pollution control obligations represent installment purchases of pollution control facilities financed by funds derived from sales by public authorities of revenue bonds. The company is required to make payments sufficient for the authorities to meet principal and interest requirements of such bonds. With respect to $154.5 million of such pollution control obligations, the company has authenticated and delivered to the trustees a like principal amount of first mortgage bonds as security for its obligations under the installment purchase agreements. No principal or interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase agreements. The company has capitalized leased nuclear material and recorded the related lease obligations. The arrangement provides for the payment of interest at varying rates and times dependent on options selected by the company from types of loans available under the arrangement. At the end of 1993 the effective rate of this lease arrangement, including applicable fees, was 3.58 percent. Principal payments are required under the arrangement based on the cost of fuel burned. The company has also capitalized certain office building leases and a street light lease. Monthly principal payments plus interest are required, and at December 31, 1993, the interest rate was 9.5 percent for office buildings and 13.0 percent for street lights. The net book value of capitalized leases included in utility plant in service was $94.7 million and $103.0 million at December 31, 1993 and 1992, respectively. The estimated aggregate annual maturities of other long-term debt through 1998 are as follows: $38.9 million in 1994, $33.3 million in 1995, $18.7 million in 1996, $6.4 million in 1997 and $3.0 million in 1998. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The annual first mortgage bond improvement fund requirement is one percent of the aggregate principal amount of bonds of each series authenticated, so long as a portion of that series is outstanding, and may be satisfied by the deposit of cash and/or reacquired bonds, the certification of unfunded property additions or a combination thereof. The 1994 requirement of $20.1 million was satisfied by the deposit of cash in 1994, which was used for the partial redemption of various series of outstanding bonds. In addition, maturing in 1994 are other long-term debt of $38.9 million consisting primarily of capitalized nuclear fuel obligations. II-75 NOTES (continued) Alabama Power Company 1993 Annual Report 11. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988 (Act), the company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at Plant Farley. The Act limits to $9.4 billion, public liability claims that could arise from a single nuclear incident. Plant Farley is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums which could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for the company is $159 million per incident but not more than an aggregate of $20 million to be paid for each incident in any one year. The company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The company's maximum annual assessment per incident is limited to $14 million under the current policy. Additionally, the company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional cost that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased cost of replacement power in an amount up to $3.5 million per week (starting 21 weeks after the outage) for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments per incident under current policies for the company would be $16 million for excess property damage and $9 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and then, any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under applicable trust indentures. The company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the company could be subject to a maximum total assessment of $6.4 million. II-76 NOTES (continued) Alabama Power Company 1993 Annual Report 12. COMMON STOCK DIVIDEND RESTRICTIONS The company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $653 million of retained earnings was restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: The company's business is influenced by seasonal weather conditions and the timing of rate adjustments. II-77 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-78 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-79 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company Notes: (1) Generating capacity and fuel data includes Alabama Power Company's 50% portion of SEGCO. (2) Includes Southeastern Power Administration allotment. * Less than one-tenth of one percent. II-80 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company II-81 STATEMENTS OF INCOME Alabama Power Company * Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-82 STATEMENTS OF INCOME Alabama Power Company II-83 STATEMENTS OF CASH FLOWS Alabama Power Company ( ) Denotes use of cash. II-84 STATEMENTS OF CASH FLOWS Alabama Power Company II-85 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-86 BALANCE SHEETS Alabama Power Company II-87 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-88 BALANCE SHEETS Alabama Power Company II-89 ALABAMA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-90 ALABAMA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS II-91 GEORGIA POWER COMPANY FINANCIAL SECTION II-92 MANAGEMENT'S REPORT Georgia Power Company 1993 Annual Report The management of Georgia Power Company has prepared this annual report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls based upon the recognition that the cost of the system should not exceed its benefits. The Company believes that its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, which is composed of five directors who are not employees, provides a broad overview of management's financial reporting and control functions. At least three times a year this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal control and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly the financial position, results of operations and cash flows of Georgia Power Company in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ H. Allen Franklin /s/ Warren Y. Jobe - --------------------- -------------------------- H. Allen Franklin Warren Y. Jobe President and Chief Executive Vice President, Executive Officer Treasurer and Chief Financial Officer II-93 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GEORGIA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Georgia Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-102 through II-122) referred to above present fairly, in all material respects, the financial position of Georgia Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding the recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-94 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Georgia Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Georgia Power Company's 1993 earnings totaled $570 million, representing a $49 million (9.5 percent) increase over the prior year. This improvement is primarily a result of higher retail revenues and lower financing costs. Also, during the period, the Company had an $18 million after-tax gain on the sale of a portion of Plant Scherer Unit 4. Higher retail revenues reflect growth in energy sales of 6.1 percent from 1992 levels primarily due to exceptionally hot summer weather during 1993. Interest expense and preferred stock dividends decreased in 1993 due to the redemption and refinancing of higher-cost debt and preferred stock. These positive events were partially offset by higher operating expenses. In comparing 1992 earnings to the prior year, it should be noted that 1991 earnings included two unusual items that significantly affect this comparison. Earnings in 1991 were $89 million higher due to the completion of a settlement agreement with Gulf States Utilities Company (Gulf States) related to power sales contracts. This increase was partially offset by an after-tax charge of $33 million in 1991 for a work force reduction program. A comparison of 1992 to 1991 -- excluding these unusual items -- would reflect a 1992 increase in earnings of $102 million. REVENUES The following table summarizes the factors impacting operating revenues for the 1991-1993 period: Retail revenues of $3.8 billion in 1993 increased $262 million (7.4 percent) over the prior year, compared with an increase of $87 million (2.5 percent) in 1992. The exceptionally hot weather during the summer of 1993 was the primary factor affecting the increase in retail revenues over 1992. The increase in retail revenues for 1992 was a result of higher retail rates and sales growth, partially offset by mild weather and lower fuel revenues. Fuel revenues generally represent the direct recovery of fuel expense, including the fuel component of purchased energy, and do not affect net income. Revenues from demand-side options programs generally represent the direct recovery of program costs. See Note 3 to the financial statements for further information on these programs. Revenues from sales to non-affiliated utilities decreased in both 1993 and 1992. Contractual unit power sales to Florida utilities for 1993 and 1992 are down compared with prior years, primarily due to scheduled reductions that corresponded with the sales to these utilities of portions of Plant Scherer Unit 4 in July 1991 and June II-95 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report 1993. Sales to municipalities and cooperatives increased slightly in 1993 due to the hot summer weather. Generally, these sales have been decreasing as these customers retain more of their own generation at facilities jointly owned with the Company. Revenues from sales to non-affiliated utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Revenues from sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. Sales to affiliated companies do not have a significant impact on earnings. Changes in revenues are a function of the amount of energy sold each year. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: The hot summer weather during 1993 contributed primarily to the sales growth in the residential and commercial classes. Continued improvement in economic conditions positively impacted sales growth in the commercial and industrial classes. Residential energy sales growth in 1992 reflected mild weather. Commercial and industrial sales growth in 1992 is attributable to improved economic conditions. The decrease in energy sales to non-affiliated utilities reflects scheduled reductions in contractual power sales. EXPENSES Fuel expense increased 2.3 percent in 1993 due to higher generation, which was partially offset by lower nuclear fuel costs. In 1992, fuel expense decreased 6.9 percent due to lower generation and lower fuel costs. Purchased power expense has decreased significantly since 1991, reflecting declining contractual capacity purchases from the co-owners of plants Vogtle and Scherer. Purchased power expense decreased $88 million in 1993 and $43 million in 1992. The declines in Plant Vogtle contractual capacity purchases did not have a significant impact on earnings in 1993 or 1992 as these costs are being levelized over six years under the terms of the 1991 Georgia Public Service Commission (GPSC) retail rate order. The levelization is reflected in the amortization of deferred Plant Vogtle expenses in the income statements. See Note 3 to the financial statements for additional information. Other Operation and Maintenance (O & M) expenses increased 9.0 percent in 1993 after remaining relatively flat in 1992. The increase in 1993 is primarily the result of environmental remediation costs at various current and former operating sites, the one- time costs of an automotive fleet reduction program and the recognition of higher employee benefit costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information concerning these new rules. Also, during 1993, O & M expenses reflect costs associated with new demand-side option programs. These costs were offset by increases in retail revenues. See Note 3 to the financial statements for additional information on the recovery of demand-side option program costs. Depreciation and amortization expense increased slightly due to additional plant investment. The 1992 decrease is due to the effects of lower depreciation rates effective in October 1991. Taxes other than income taxes increased 7.4 percent in 1993 and 3.8 percent in 1992. II-96 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report These increases reflect higher ad valorem taxes. The 1993 increase also includes higher taxes paid to municipalities as a result of increased sales. Income tax expense increased $62 million in 1993 due primarily to higher earnings and the effect of a one percent increase in the federal tax rate effective January, 1993. Also, the Company incurred $27 million of tax expense in connection with the second in a series of four separate transactions to sell Plant Scherer Unit 4. The sale resulted in an after-tax gain of $18 million. Interest expense and dividends on preferred stock decreased $19 million (4.0 percent) and $49 million (9.3 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. The Company refinanced $1.7 billion of securities in both 1993 and 1992. In addition, the Company has retired $544 million of long-term debt with the proceeds from the 1991 and 1993 Plant Scherer Unit 4 sales. Other interest charges in 1993 include interest related to the settlement of an Internal Revenue Service audit. The settlement, in total, did not have an effect on 1993 net income. The Company has deferred certain expenses and recorded a deferred return related to Plant Vogtle under phase-in plans. See Note 3 to the financial statements under "Plant Vogtle Phase-In-Plans" for information regarding the deferral and subsequent amortization of costs related to Plant Vogtle. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize either this economic loss or the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Growth in energy sales is subject to a number of factors which traditionally have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. Assuming normal weather, retail sales growth is projected to be approximately 2 percent annually on average during 1994 through 1996. The scheduled addition of four combustion turbine generating units in 1994, four units in 1995 and one unit in 1996, as well as the Rocky Mountain pumped storage hydroelectric project in 1995, will increase related O & M and depreciation expenses. See Note 4 to the financial statements for information on regulatory uncertainties related to the Rocky Mountain project. The GPSC has certified the construction of the 1994 and 1995 combustion turbine generating units for meeting peak generating needs. In addition, the Company has completed a demonstration competitive bidding process for its supply-side requirements expected for 1996. The Company has filed with the GPSC for certification of a four-year purchase power agreement beginning in 1996, and for construction of a jointly owned combustion turbine to be completed in 1996 to meet these needs. As part of efforts to curtail growth in operating expenses, the Company is reducing its work force through an early-retirement program announced in January 1994. The program resulted in a first quarter 1994 after-tax charge to earnings of $39 million. The program has an expected payback period of approximately two years. Pursuant to an Integrated Resource Plan approved by the GPSC in 1992, the Company has implemented various demand-side option programs and has been authorized by the GPSC to recover associated program costs through rate riders. On October 15, 1993, a superior court judge ruled that recovery of these costs through rate riders is unlawful. The Company has ceased collection of the rate riders and is deferring program costs as ordered by the II-97 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report GPSC pending the final outcome of this matter. See Note 3 to the financial statements for additional information. The Company has completed two in a series of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, the Company would realize an additional after-tax gain estimated to total approximately $20 million. See Note 5 to the financial statements for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs cannot be billed to customers. The Clean Air Act is discussed later under "Environmental Issues." The Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition among electric utilities. The law also includes provisions to streamline the licensing process for new nuclear generating plants. The Energy Act marks the beginning of a major change in the traditional business practices of selling electricity. The Energy Act allows Independent Power Producers (IPPs) and other electric suppliers access to a utility's transmission lines to sell their electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. If the Company does not remain a low cost producer and provide quality service, the Company's sales growth could be limited and this could significantly erode earnings. The Company continues to compete with other electric suppliers within the state. In Georgia, most new retail customers with more than 900 kilowatts of connected load may choose their electricity supplier. In addition, the bulk power market has become very competitive as utilities, IPPs and cogenerators seek to supply future capacity needs. Competition can create new business opportunities, but it increases risk and has the potential to adversely affect earnings. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Review of Equity Returns" for additional information. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be adopted by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which will be effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules in January, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition in 1993 were gross utility plant additions of $674 million and the lowering of the cost of capital achieved through the refinancing or retirement of $1.7 billion of long-term debt and preferred stock. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See Notes 2 and 7 to the financial statements regarding the impact of these changes. The funds needed for gross property additions are currently provided from operations. The Statements of Cash Flows provide additional details. II-98 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report FINANCING ACTIVITIES In 1993, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring or repaying high-cost issues. New issues during 1991 through 1993 totaled $3.0 billion and retirement or repayment of securities totaled $4.2 billion. The retirements included the redemption of $253 million and $291 million in 1993 and 1991, respectively, of first mortgage bonds with the proceeds from the Plant Scherer Unit 4 sales. Composite financing rates for the years 1991 through 1993, as of year-end, were as follows: The Company's current securities ratings are as follows: * Not rated by Duff & Phelps LIQUIDITY AND CAPITAL REQUIREMENTS Cash provided from operations increased by $236 million in 1993, primarily due to higher retail sales, lower interest costs, decreasing capacity purchases from the co-owners of plants Vogtle and Scherer and the receipt of cash payments from Gulf States that completed the settlement of litigation. The Company estimates that construction expenditures for the years 1994 through 1996 will total $688 million, $555 million and $629 million, respectively. The Company will continue to invest in transmission and distribution facilities and enhance existing generating plants. These expenditures also include amounts for nine combustion turbine generating units and equipment that will be required to comply with the provisions of the Clean Air Act. The Company's contractual capacity purchases will decline by $113 million over the next three years. Cash requirements for sinking fund requirements, redemptions announced, and maturities of long-term debt are expected to total $377 million during 1994 through 1996. As a result of requirements by the Nuclear Regulatory Commission, the Company has established external sinking funds for the purpose of funding nuclear decommissioning costs. For 1994 through 1996, the amount to be funded for the Company totals $16 million annually. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Nuclear Decommissioning." SOURCES OF CAPITAL The Company expects to meet future capital requirements primarily using funds generated from operations and, if needed, by the issuance of new debt and equity securities, term loans, and short-term borrowings. To meet short-term cash needs and contingencies, the Company had approximately $540 million of unused credit arrangements with banks at the beginning of 1994. See Note 8 to the financial statements for additional information. Completing the remaining two transactions for the sale of Plant Scherer Unit 4 will generate approximately $130 million in both 1994 and in 1995. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's ability to satisfy all coverage requirements is such that it could issue new first mortgage bonds and preferred stock to provide sufficient funds for all anticipated requirements. ENVIRONMENTAL ISSUES In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts II-99 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, Georgia Power's construction expenditures are estimated to total approximately $150 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total Georgia Power construction expenditures ranging from approximately $150 million to $325 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in Georgia Power's annual revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV requirements, on some Company plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a II-100 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standards will depend on the level chosen for the standards and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the nonhazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either nonhazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. These laws include the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA or Superfund). Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized costs to clean-up known sites in the financial statements. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. II-101 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-102 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-103 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-104 STATEMENTS OF CAPITALIZATION AT December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report II-105 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-106 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-107 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-108 NOTES TO FINANCIAL STATEMENTS Georgia Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), and Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Intracompany contracts dealing with jointly owned generating facilities, transmission lines and exchange of electric power are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and each of the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides support services for nuclear power plants in the Southern electric system. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935. Both The Southern Company and its subsidiaries are subject to the regulatory provisions of this act. The Company is also subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective regulatory commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company is authorized by state law and FERC regulations to recover fuel costs and the fuel component of purchased energy costs through fuel cost recovery provisions, which are periodically adjusted to reflect increases or decreases in such costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel costs were under recovered by $79 million and $4 million at December 31, 1993, and 1992, respectively. These amounts are included in customer accounts receivable on the balance sheets. The fuel cost recovery rate was increased effective December 6, 1993. The cost of nuclear fuel is amortized to fuel expense based on estimated thermal units used to generate electric energy and includes a provision for the disposal of spent fuel. Total charges for nuclear fuel amortized to expense were $75 million in 1993, $84 million in 1992, and $93 million in 1991. The Company has contracted with the U.S. Department of Energy (DOE) for permanent disposal of spent fuel beginning in 1998; however, the actual year this service will begin is uncertain. Pending permanent disposition of the spent fuel, sufficient storage capacity is available at Plant Hatch into 2003 and at Plant Vogtle into 2009. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund which is to be funded, in part, by a special assessment on utilities with nuclear plants. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The Company -- based on its ownership interest -- estimates its total assessment under this law to be approximately $42 million to be paid over a 15-year period beginning in 1993. This obligation is recognized in the accompanying Balance Sheets and is being recovered through the fuel cost recovery provisions. The remaining liability at December 31, 1993, is $39 million. II-109 NOTES (continued) Georgia Power Company 1993 Annual Report NUCLEAR REFUELING OUTAGE COSTS Prior to 1992, the Company expensed nuclear refueling outage costs as incurred during the outage period. Pursuant to the 1991 GPSC retail rate order, the Company began accounting for these costs on a normalized basis in 1992. Under this method of accounting, refueling outage costs are deferred and subsequently amortized to expense over the operating cycle of each unit, which is normally 18 months. Deferred nuclear outage costs were $17 million and $6 million at December 31, 1993 and 1992, respectively. DEPRECIATION Depreciation is provided on the cost of depreciable utility plant in service and is calculated primarily on the straight-line basis over the estimated composite service life of the property. The composite rate of depreciation was 3.1 percent in 1993 and 1992, and 3.2 percent in 1991. Effective October 1991, the Company adopted lower depreciation rates consistent with the 1991 GPSC retail rate order. When a property unit is retired or otherwise disposed of in the normal course of business, its costs and the costs of removal, less salvage, are charged to the accumulated provision for depreciation. Minor items of property included in the cost of the plant are retired when the related property unit is retired. NUCLEAR DECOMMISSIONING In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial nuclear power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. The Company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the Company had internally reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for the Company's ownership interest in plants Hatch and Vogtle were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a period of approximately nine years as approved by the GPSC in its 1991 retail rate order. The estimates approved by the GPSC for ratemaking exclude costs of non-radiated structures and site contingency costs. The actual decommissioning cost may vary from the above estimates because of regulatory requirements, changes in technology, and increased costs of labor, materials, and equipment. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The Company expects the GPSC to periodically review and adjust, if necessary, the amounts collected in rates for the anticipated cost of decommissioning. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the GPSC ordered that the costs of Plant Vogtle Units 1 and 2 be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. In 1991, the GPSC modified the phase-in plans. In addition, the Company deferred certain Plant Vogtle operating expenses and financing costs under accounting orders issued by the GPSC. See Note 3 for further information. II-110 NOTES (continued) Georgia Power Company 1993 Annual Report INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See Note 7 to the financial statements for further information. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. For the years 1993, 1992 and 1991, the average AFUDC rates were 4.87 percent, 7.16 percent and 9.90 percent, respectively. The reduction in the average AFUDC rate since 1991 reflects the Company's greater use of lower cost short-term debt. The Company also imputed a return on its investment in Plant Vogtle Units 1 and 2 after they began commercial operation, under short-term cost deferrals and phase-in plans as described in Note 3. AFUDC and the Vogtle deferred returns, net of taxes, as a percentage of net income after dividends on preferred stock, amounted to 1.4 percent, 2.1 percent and 9.2 percent for 1993, 1992 and 1991, respectively. UTILITY PLANT Utility plant is stated at original cost with the exception of Plant Vogtle, which is stated at cost less regulatory disallowances. Original cost includes materials; labor; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS All financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In December 1992, the Company converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that is being amortized as credits to income over II-111 NOTES (continued) Georgia Power Company 1993 Annual Report approximately four years. This conversion will not have a material effect on income in any year. VACATION PAY Company employees earn vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. This amount was $42 million at December 31, 1993, and $40 million at December 31, 1992. In 1994, approximately 72 percent of the 1993 deferred vacation costs will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan covering substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the projected unit credit actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. For medical care benefits, a qualified trust has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered the Company to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional expense was recognized -- approximately $6 million -- in 1993 and the remaining additional expense was deferred. An additional one-fifth of the costs will be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The cost deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of the regulatory treatment allowed by the GPSC, the adoption of Statement No. 106 did not have a material impact on net income. Prior to 1993, the Company recognized these cost on a cash basis as payments were made. The total costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $56 million, $13 million, and $9 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as II-112 NOTES (continued) Georgia Power Company 1993 Annual Report of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: Weighted average rates used in actuarial calculations: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $68 million and the aggregate of the service and interest cost components of the net retiree medical cost by $7 million. The components of the plans' net costs are shown below: Of net pension costs (income) recorded, $(6) million in 1993 and $5 million in 1991, were recorded to operating expense, with the balance being recorded to construction and other accounts. II-113 NOTES (continued) Georgia Power Company 1993 Annual Report Of the above net postretirement medical and life insurance costs recorded in 1993, $21 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of the Company's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. The Company has suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved the Company's request for an accounting order allowing the Company to defer all current unrecovered and future costs related to these programs until the court's decision is reversed or until the next general rate case proceeding. An association of industrial customers has filed a petition for review of such accounting order in the Superior Court of Fulton County, Georgia. The Company's costs related to these conservation programs through 1993 were $60 million of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on these financial statements. RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected. This matter is now concluded. GULF STATES SETTLEMENT On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received, the Company recorded increases of $3 million in 1992 and $89 million in 1991 net income. FERC REVIEW OF EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. II-114 NOTES (continued) Georgia Power Company 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. PLANT VOGTLE PHASE-IN PLANS Pursuant to orders from the GPSC, the Company recorded a deferred return under phase-in plans for Plant Vogtle Units 1 and 2 until October 1991 when the allowed investment was fully reflected in rates. In addition, the GPSC issued two separate accounting orders that required the Company to defer substantially all operating and financing costs related to both units until rate orders addressed these costs. These GPSC orders provide for the recovery of deferred costs within 10 years. The GPSC modified the phase-in plans in 1991 to accelerate the recognition of costs previously deferred under the Plant Vogtle Unit 2 phase-in plan and to levelize the remaining Plant Vogtle declining capacity buyback expenses. Under these orders, the Company has deferred and begun amortizing these costs (as recovered through rates) as follows: NUCLEAR PERFORMANCE STANDARDS In October 1989, the GPSC adopted a nuclear performance standard for the Company's nuclear generating units under which the performance of plants Hatch and Vogtle will be evaluated every three years. The performance standard is based on each unit's capacity factor as compared to the average of all U.S. nuclear units operating at a capacity factor of 50% or higher during the three-year period of evaluation. Depending on the performance of the units, the Company could receive a monetary reward or penalty under the performance standards criteria. The first evaluation was conducted in 1993 for performance during the 1990-92 period. During this three-year period, the Company's units performed at an average capacity factor of 81 percent compared to an industry average of approximately 73 percent. Based on these results, the GPSC approved a performance reward of approximately $8.5 million for the Company. This reward is being collected through the retail fuel cost recovery provision and recognized in income over a 36- month period beginning November, 1993. 4. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program and currently estimates property additions to be approximately $688 million in 1994, $555 million in 1995 and $629 million in 1996. These estimated additions include AFUDC of $19 million in 1994, $27 million in 1995, and $18 million in 1996. The estimates for property additions for the three-year period include $88 million committed to meeting the requirements of the Clean Air Act. While the Company has no new baseload generating plants under construction, the construction of nine combustion turbine peaking units is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities, and upgrading and extending the useful life of generating plants will continue. The construction program is subject to periodic review and revision, and actual construction costs may vary from estimates because of numerous factors, including, but not limited to, changes in business conditions, load growth estimates, environmental regulations, and regulatory requirements. II-115 NOTES (continued) Georgia Power Company 1993 Annual Report FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $4.8 billion at December 31, 1993. Additional commitments for coal and for nuclear fuel will be required in the future to supply the Company's fuel needs. OPERATING LEASES The Company has entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $8 million, $7 million, and $5 million for 1993, 1992, and 1991, respectively. Minimum annual rental commitments for noncancellable rail car leases are $9 million annually for years 1994 through 1998, and total approximately $191 million thereafter. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 as then planned was not economically justifiable and reasonable and withheld authorization for the Company to spend funds from approved securities issuances on that project. In 1988, the Company and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 5. The joint ownership agreement significantly reduces the risk of the project being canceled. However, full recovery of the Company's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event the Company cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off in accordance with FASB Statement No. 90, Accounting for Abandonments and Disallowed Plant Costs. At December 31, 1993, the Company's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, the Company's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. The Company has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, the Company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the Company's nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment for the Company -- based on its ownership and buyback interests -- is $171 million per incident but not more than an aggregate of $22 million to be paid for each incident in any one year. The Company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The Company's maximum assessment per incident is limited to $18 million under current policies. Additionally, the Company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric II-116 NOTES (continued) Georgia Power Company 1993 Annual Report Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum assessments per incident under the current policies for the Company would be $15 million for excess property damage and $13 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the Company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the Company could be subject to a maximum total assessment of $7 million. 5. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS Since 1975, the Company has sold undivided interests in plants Hatch, Wansley, Vogtle, and Scherer Units 1 and 2, together with transmission facilities, to OPC, an electric membership generation and transmission corporation; the Municipal Electric Authority of Georgia (MEAG), a public corporation and an instrumentality of the state of Georgia; and the City of Dalton, Georgia. The Company has sold an interest in Plant Scherer Unit 3 to Gulf Power, an affiliate. Additionally, the Company has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FPL) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FPL will eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Except as otherwise noted, the Company has contracted to operate and maintain all jointly owned facilities. The Company includes its proportionate share of plant operating expenses in the corresponding operating expenses in the Statements of Income. As discussed in Note 4, the Company and OPC have a joint ownership arrangement for the Rocky Mountain pumped storage hydroelectric project under which the Company will retain its present investment in the project and OPC will finance and complete the remainder of the project and operate the completed facility. Based on current cost estimates the Company's ownership will be approximately 25% of the project (194 megawatts of capacity) at completion. The Company will own six of eight 80 megawatt combustion turbine generating units and 75% of the related common facilities being jointly constructed with Savannah Electric, an affiliate. The Company's investment in the project at December 31, 1993, was $100 million and is expected to total approximately $182 million when the project is completed. All units are II-117 NOTES (continued) Georgia Power Company 1993 Annual Report expected to be completed by June, 1995. Savannah Electric will operate these units. In connection with the joint ownership arrangements for plants Vogtle and Scherer, the Company has made commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from these units. These commitments are in effect during periods of up to 10 years following commercial operation (and with regard to a portion of a 5 percent interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for capacity are required whether or not any capacity is available. The energy cost is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power from non-affiliates in the Company's Statements of Income. Capacity payments totaled $183 million, $289 million and $320 million in 1993, 1992 and 1991, respectively. The Plant Scherer buyback agreements ended in 1993. The current projected Plant Vogtle capacity payments for the next five years are as follows: $132 million in 1994, $77 million in 1995, $70 million in 1996, $59 million in 1997 and $59 million in 1998. Portions of the payments noted above relate to costs in excess of Plant Vogtle's allowed investment for ratemaking purposes. The present value of these portions was written off in 1987 and 1990. Additionally, the Plant Vogtle declining capacity buyback expense is being levelized over a six-year period. See Note 3 for further information. At December 31, 1993, the Company's percentage ownership and investment (exclusive of nuclear fuel) in jointly owned facilities in commercial operation, were as follows: (1) Investment net of write-offs. The Company and an affiliate, Alabama Power, own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,020 megawatts, as well as associated transmission facilities. The capacity of the units has been sold equally to the Company and Alabama Power under a contract expiring in 1994, which, in substance, requires payments sufficient to provide for the operating expenses, taxes, debt service and return on investment, whether or not SEGCO has any capacity and energy available. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two year's notice. The Company's share of expenses included in purchased power from affiliates in the Statements of II-118 NOTES (continued) Georgia Power Company 1993 Annual Report Income, is as follows: At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. 6. LONG-TERM POWER SALES AGREEMENTS The Company and the operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service territory. Certain of these agreements are non-firm and are based on the capacity of the Southern system. Other agreements are firm and pertain to capacity related to specific generating units. Because energy is generally sold at cost under these agreements, it is primarily the capacity revenues that affect the Company's profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). This amount decreases to 200 megawatts in 1994 and the contract expires at year-end. Sales under these long-term non-firm power sales agreements are made from available power pool energy, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is being sold to FPL, JEA, and the City of Tallahassee, Florida and beginning in 1994 to FPC. Under these agreements, the Company sold approximately 830 megawatts of capacity in 1993 and is scheduled to sell approximately 403 megawatts of capacity in 1994. Thereafter, these sales will decline to an estimated 157 megawatts by the end of 1996 and will remain at that approximate level through 1999. After 2000, capacity sales will decline to approximately 101 megawatts -- unless reduced by FPL and JEA -- until the expiration of the contracts in 2010. 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $993 million are revenues to be received from customers. These assets are attributable to tax benefits flowed-through to customers in prior years, and taxes applicable to capitalized AFUDC. The related liabilities of $453 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: II-119 NOTES (continued) Georgia Power Company 1993 Annual Report The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax basis, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $19 million in 1993, $19 million in 1992, and $27 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory tax rate to effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 8. CAPITALIZATION COMMON STOCK DIVIDEND RESTRICTIONS The Company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $742 million of retained earnings were restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. The Company's charter limits cash dividends on common stock to the lesser of the retained earnings balance or 75 percent of net income available for such stock during a prior period of 12 months if the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend, is below 25 percent, and to 50 percent of such net income if such ratio is less than 20 percent. At December 31, 1993, the ratio as defined was 46.1 percent. II-120 NOTES (continued) Georgia Power Company 1993 Annual Report REMARKETED BONDS In 1992, the Company issued two series of variable rate first mortgage bonds each with principal amounts of $100 million due 2032. The current composite interest rate on the bonds is 6.20 percent and is fixed for the first three years of the issues. POLLUTION CONTROL BONDS The Company has incurred obligations in connection with the sale by public authorities of tax-exempt pollution control and industrial development revenue bonds. The Company has authenticated and delivered to trustees an aggregate of $407.7 million of its first mortgage bonds, which are pledged as security for its obligations under pollution control and industrial development contracts. No interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase or loan agreements. An aggregate of approximately $1.3 billion of the pollution control and industrial development bonds is secured by a subordinated interest in specific property of the Company. Details of pollution control bonds are as follows: BANK CREDIT ARRANGEMENTS At the beginning of 1994, the Company had unused credit arrangements with banks totaling $540 million, of which $10 million expires June 30, 1994, $130 million expires at May 1, 1996, and $400 million expires at June 30, 1996. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing the Company, Alabama Power, and The Southern Company up to a total credit amount of $400 million. To provide liquidity support for commercial paper programs and for other short-term cash needs, $165 million and $135 million of the $400 million available credit are currently dedicated for the Company and Alabama Power, respectively. However, the allocations can be changed among the borrowers by notifying the respective banks. During the term of the agreements expiring in 1996, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. The $10 million credit arrangement expiring in 1994 allows borrowings for up to 90 days. Commitment fees are based on the unused portion of the commitment. In addition, the Company borrows under uncommitted lines of credit with banks and through a $150 million commercial paper program that has the liquidity support of committed bank credit arrangements. Average compensating balances held under these committed facilities were not material in 1993. OTHER LONG-TERM DEBT Assets acquired under capital leases are recorded in the Balance Sheets as utility plant in service, and the related obligations are classified as long-term debt. At December 31, 1993, the Company had a capitalized lease obligation for its corporate headquarters building of $88 million with an interest rate of 8.1 percent. Other capitalized lease obligations were $137 thousand with a composite interest rate of 6.8 percent. The maturities of capital lease obligations through 1998 are approximately as follows: $423 thousand in 1994, $309 thousand in 1995, $335 thousand in 1996, $362 thousand in 1997, and $392 thousand in 1998. The lease agreement for the corporate headquarters building provides for payments that are minimal in early years and escalate through the first 21 years of the lease. For ratemaking purposes, the GPSC has treated the lease as an operating lease and has allowed only the lease II-121 NOTES (continued) Georgia Power Company 1993 Annual Report payments in cost of service. The difference between the accrued expense and the lease payments allowed for ratemaking purposes is being deferred as a cost to be recovered in the future as ordered by the GPSC. At December 31, 1993, and 1992, the interest and lease amortization deferred on the Balance Sheets are $47 million and $48 million, respectively. In December 1993, the Company borrowed $37 million through a long-term note due in 1995. ASSETS SUBJECT TO LIEN The Company's mortgage dated as of March 1, 1941, as amended and supplemented, securing the first mortgage bonds issued by the Company, constitutes a direct lien on substantially all of the Company's fixed property and franchises. LONG-TERM DEBT DUE WITHIN ONE YEAR The current portion of the Company's long-term debt is as follows: *Less than .1 million The indenture's first mortgage bond improvement fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash or reacquired bonds, or by pledging additional property equal to 1 2/3 times the requirement. The 1993 and 1992 requirements were met in the first quarter of each year by depositing cash subsequently used to redeem bonds. The 1994 requirement was funded in December 1993. REDEMPTION OF HIGH-COST SECURITIES The Company plans to continue a program of redeeming or replacing high-cost debt and preferred stock in cases where opportunities exist to reduce financing costs. High-cost issues may be repurchased in the open market or called at premiums as specified under terms of the issue. They may also be redeemed at face value to meet improvement fund and sinking fund requirements, to meet replacement provisions of the mortgage, or by use of proceeds from the sale of property pledged under the mortgage. In general, for the first five years a series is outstanding the Company is prohibited from redeeming for improvement fund purposes more than 1 percent annually of the original issue amount. 9. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate increases. II-122 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-123 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-124 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report Note: As of 9/1/91, Georgia Power Company's sales to Oglethorpe Power Company are not included in Peak-Hour Demand * Less than one-tenth of one percent. II-125 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report II-126 STATEMENTS OF INCOME Georgia Power Company Note: Reflects major sales of facilities to Jacksonville Electric Authority, Florida Power & Light Company, OPC, MEAG, and Dalton. Increases in net income, after total taxes, from these sales were $18,391,000 in 1993, $14,542,000 in 1991, $6,336,000 in 1990, $3,851,000 in 1987, and $21,250,000 in 1984. II-127 STATEMENTS OF INCOME Georgia Power Company II-128 STATEMENTS OF CASH FLOWS Georgia Power Company ( ) Denotes use of cash. II-129 STATEMENTS OF CASH FLOWS Georgia Power Company II-130 BALANCE SHEETS Georgia Power Company II-131 BALANCE SHEETS Georgia Power Company II-132 BALANCE SHEETS Georgia Power Company II-133 BALANCE SHEETS Georgia Power Company II-134 GEORGIA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-135 GEORGIA POWER COMPANY OUTSTANDING SECURITIES (Continued) AT DECEMBER 31, 1993 (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. II-136 GEORGIA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. * Less than $500. II-137 GULF POWER COMPANY FINANCIAL SECTION II-138 MANAGEMENT'S REPORT Gulf Power Company 1993 Annual Report The management of Gulf Power Company has prepared and is responsible for the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of the directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Gulf Power Company in conformity with generally accepted accounting principles. /s/ D. L. McCrary /s/ A. E. Scarbrough - -------------------------- ------------------------ Douglas L. McCrary Arlan E. Scarbrough Chairman of the Board Vice President - Finance and Chief Executive Officer II-139 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GULF POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Gulf Power Company (a Maine corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-148 through II-165) referred to above present fairly, in all material respects, the financial position of Gulf Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, Gulf Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-140 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Gulf Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Gulf Power Company's net income after preferred stock dividends was $54.3 million for 1993, a $0.2 million increase over 1992 net income. Earnings reflect a $2.3 million gain on the sale of Gulf States Utilities Company (Gulf States) stock and the reversal of a $1.7 million wholesale rate refund as the result of a court order which is further discussed in Note 3 to the financial statements under "Recovery of Contract Buyout Costs". The company also experienced growth in residential and commercial sales and a decrease in interest expense on long-term debt as a result of security refinancings, offset by higher operation and maintenance expense, and decreased industrial sales reflecting the loss of the Company's largest industrial customer, Monsanto, which began cogeneration in August of 1993. The Company's 1992 net income after dividends on preferred stock decreased $3.7 million compared to the prior year. The 1991 earnings included an after-tax gain of $12.7 million representing the settlement of litigation with Gulf States. See Note 7 to the financial statements under "Gulf States Settlement Completed" for further details. Excluding this settlement from 1991, earnings for 1992 increased $8.4 million -- or approximately -- 18.7 percent over 1991. This improvement was due to increased energy sales; lower interest expense and preferred dividends as a result of security refinancings; and continued emphasis on cost controls. The Company's return on average common equity was 13.29 percent for 1993, a slight decrease from the 13.62 percent return earned in 1992, which was up from the 12.03 percent earned in 1991 (excluding the Gulf States settlement). REVENUES Changes in operating revenues over the last three years are the result of the following factors: * Includes the non-interest portion of the wholesale rate refund reversal discussed in "Earnings." Retail revenues of $471.7 million in 1993 increased $10.2 million or 2.2 percent from last year, compared with an increase of 1.2 percent in 1992 and 4.9 percent in 1991. Revenues increased in the residential and commercial classes primarily due to customer growth, and favorable weather and economic conditions. Revenues in the industrial class declined due to the loss of the Company's largest industrial customer, Monsanto, which began operating its cogeneration facility in August 1993. See "Future Earnings Potential" for further details. The change in base rates for 1993 and 1992 reflects the expiration of a retail rate penalty in September 1992. Sales for resale were $95.4 million in 1993, increasing $1.2 million or 1.3 percent over 1992. Sales to affiliated companies vary from year to year depending on demand and the availability and cost of generating resources at each company. The majority of non-affiliated energy sales arise from long-term contractual agreements. Non-affiliated long-term contracts include capacity and energy components. Capacity revenues reflect the recovery of II-141 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report fixed costs and return on investment. Energy is sold at its variable cost. The capacity and energy components under these long-term contracts were as follows: Beginning in June 1992, all the capacity from the Company's ownership portion of Plant Scherer Unit No. 3 was sold through unit power sales, resulting in increased capacity revenues. In 1993, changes in other operating revenues are primarily due to the recognition of $2.6 million under the Environmental Cost Recovery (ECR) clause which is fully discussed in Note 3 to the financial statements under "Environmental Cost Recovery", which is offset by true-ups of other regulatory cost recovery clauses. The increase in other operating revenues in 1992 was primarily due to true-ups of regulatory cost recovery clauses and the changes in franchise fee collections and Florida gross receipts taxes (discussed under "Expenses") which had no effect on earnings. Energy sales for 1993 and percent changes in sales since 1991 are reported below. Overall retail sales remained relatively flat in 1993. Increases in residential and commercial sales -- reflecting customer growth, favorable weather and an improving economy -- were offset by the decreased sales in the industrial class reflecting the loss of Monsanto. Retail sales increased 3.8 percent in 1992 primarily due to an increase in the number of customers served and a moderately improving economy. Energy sales for resale to non-affiliates increased 2.0 percent and are predominantly unit power sales under long-term contracts to Florida utilities which are discussed above. Energy sales to affiliated companies vary from year to year as mentioned above. EXPENSES Total operating expenses for 1993 increased $16.6 million or 3.5 percent over 1992 primarily due to increased operation and maintenance expenses and higher taxes. Other operation expenses increased $10.9 million or 11.1 percent from the 1992 level. The increase is attributable to additional costs of $7.4 million related to increases in the buyout of coal supply contracts and $1.4 million of environmental clean-up costs. Also, higher employee benefit costs and the costs of an automotive fleet reduction program increased expenses by $2.1 million. Operating expenses for 1992 increased by approximately $16 million over 1991. Excluding the Gulf States settlement, an after-tax reduction of $0.6 million in 1992 and $12.7 million in 1991, 1992 total operating expenses increased $4.3 million or 0.9 percent over 1991. Fuel and purchased power expenses decreased $3.8 million or 1.8 percent from 1992 reflecting the lower cost of fuel. Total 1992 fuel and purchased power increased $1.4 million or 0.7 percent from 1991. Maintenance expense increased $4.1 million or 9.7 percent over 1992 due to scheduled maintenance of production facilities. The 1992 maintenance expense was down $3.5 million or 7.7 percent from 1991 due to a decrease in scheduled maintenance. Federal income taxes increased $0.7 million primarily due to a corporate federal income tax rate increase from 34 percent to 35 percent effective January 1993. Taxes other than income taxes increased $2.3 million in 1993, an increase of 6.1 percent over the 1992 expense II-142 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report primarily due to increases in property taxes and gross receipt taxes. Taxes other than income taxes decreased $4.5 million, or 10.5 percent in 1992 compared to 1991 due primarily to the Company discontinuing the collection of franchise fees for two Florida counties which was partially offset by an increase in gross receipt taxes. Changes in franchise fee collections and gross receipt taxes had no impact on earnings. Interest expense decreased $3.2 million or 8.1 percent from the 1992 level and 1992 interest expense decreased $5.6 million or 12.5 percent from 1991. The decrease in both years is primarily attributable to refinancing some of the Company's higher cost securities. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its cost of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on a number of factors. It is expected that higher operating costs and carrying charges on increased investment in plant, if not offset by proportionate increases in operating revenues (either by periodic rate increases or increases in sales), will adversely affect future earnings. Growth in energy sales will be subject to a number of factors, including the volume of sales to neighboring utilities, energy conservation practiced by customers, the elasticity of demand, customer growth, weather, competition, and the rate of economic growth in the service area. In addition to the traditional factors discussed above, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Company is preparing to meet the challenges of a major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access the Company's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for the Company's large industrial and commercial customers and sell excess energy generation to the Company or other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, its ability to retain large industrial and commercial customers, and obtain new long-term contracts for energy sales outside the Company's service area, could be limited, and this could significantly erode earnings. The future effect of cogeneration and small-power production facilities cannot be fully determined at this time, but may be adverse. One effect of cogeneration which the Company has experienced is the loss of its largest industrial customer, Monsanto, in August of 1993. The loss of the Monsanto load reduced revenues, and will result in a reduction in net income of approximately $3 million in the first twelve months. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts that have a return on common equity of 13.75 percent or greater, and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters". II-143 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Also, recently enacted legislation that provides for recovery of prudent environmental compliance costs is discussed in Note 3 to the financial statements under "Environmental Cost Recovery." The Company filed a notice with the Florida Public Service Commission (FPSC) of its intent to obtain rate relief in February 1993. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case. The stipulation also allowed the Company to retain, for the next four years, its existing method for calculating accruals for future power plant dismantlement costs. The existing method provides a more even allocation of expenses over the life of the plants and results in an avoided increase in expenses of about $6 million annually over the next four years when compared to the FPSC method. The stipulation also provided for the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. After the February 1993 filing date, interest rates continued to remain low, resulting in lower cost of capital. Also, the Florida legislature adopted legislation which allows utilities to petition the FPSC for recovery of environmental costs through an adjustment clause if these costs are not being recovered in base rates. See Note 3 to the financial statements under "Environmental Cost Recovery" for further details. The combination of the circumstances discussed above, placed the Company in a better position to manage its finances without an increase in base rates while still providing a fair return for the Company's investors. Consequently, the Company agreed, as a part of this stipulation, to cancel the filing of the rate case. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, which resulted in a decrease in earnings of $0.3 million. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company does not have any investments that qualify for FASB Statement No. 115 treatment. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition during 1993 were gross property additions of $79 million. Funds for these additions were provided by internal sources. The Company continued to refinance higher cost securities to lower the Company's cost of capital. See "Financing Activities" below and the Statements of Cash Flows for further details. On January 1, 1993, the Company changed its method of calculating the accruals for postretirement benefits other than pensions and its method of accounting for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. FINANCING ACTIVITIES As mentioned above, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring higher-cost issues in 1993. The Company sold $75 million of first mortgage bonds and, through public authorities, $53.4 million of pollution control revenue bonds, issued $35 million of preferred stock, and obtained $25 million with a long-term bank note. Retirements, including maturities during 1993, totaled $88.8 million of first mortgage bonds, $40.7 million of pollution control revenue bonds, and $21.1 million of preferred stock. (See the Statements of Cash Flows for further details.) II-144 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Composite financing rates for the years 1991 through 1993 as of year end were as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's gross property additions, including those amounts related to environmental compliance, are budgeted at $200 million for the three years beginning 1994 ($77 million in 1994, $55 million in 1995, and $68 million in 1996). The estimates of property additions for the three-year period include $25 million committed to meeting the requirements of the Clean Air Act, the cost of which is expected to be recovered through the ECR clause which is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Actual construction costs may vary from this estimate because of factors such as the granting of timely and adequate rate increases; changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The Company does not have any baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. Significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $86 million will be required by the end of 1996 in connection with maturities of long-term debt and preferred stock subject to mandatory redemption. Also, the Company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million for The Southern Company including $34 million for Gulf Power Company through 1995. II-145 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company including approximately $30 million to $40 million for Gulf Power Company. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. Following adoption of legislation in April of 1992, allowing electric utilities in Florida to seek FPSC approval of their Clean Air Act Compliance Plans, the Company filed its petition for approval. The Commission approved the Company's plan for Phase I compliance, deferring until a later date approval of its Phase II Plan. An average increase of up to 4 percent in annual revenue requirements from Gulf Power Company customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. The Florida Legislature recently adopted legislation that allows a utility to petition the FPSC for recovery of prudent environmental compliance costs through an ECR clause without lengthy regulatory full revenue requirements rate proceedings. The legislation is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Gulf Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. II-146 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of Gulf Power Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect Gulf Power Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. COAL STOCKPILE DECREASES To reduce the working capital invested in the coal stockpile inventory, the Company implemented a coal stockpile reduction program in 1992. The Company's actual year end inventory at December 31, 1993 was $20.7 million which is considerably lower than the desired level of $31.4 million. This situation exists because a limited supply of coal was available at competitive prices primarily due to the United Mine Workers strike from July to December 1993. In addition, barge transportation was stranded due to floods in the Midwest. As a result of these circumstances, management chose to allow the existing coal inventory to decline until coal prices stabilized. Current market conditions indicate that substantial coal supplies at competitive prices are now available. Therefore, the Company plans to increase purchases and return the coal stockpile inventory to the desired level by the end of the third quarter, 1994. SOURCES OF CAPITAL At December 31, 1993, the Company had $5.6 million of cash and cash equivalents to meet its short-term cash needs. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations; the sale of additional first mortgage bonds, pollution control bonds, and preferred stock; and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficient to permit, at present interest and preferred dividend levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-147 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-148 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-149 BALANCE SHEETS At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-150 BALANCE SHEETS (continued) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-151 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report II-152 STATEMENTS OF CAPITALIZATION (CONTINUED) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-153 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-154 NOTES TO FINANCIAL STATEMENTS At December 31, 1993, 1992 and 1991 Gulf Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: GENERAL Gulf Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services, Inc. (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear) and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company is also subject to regulation by the FERC and the Florida Public Service Commission (FPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by these commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company's electric rates include provisions to periodically adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. The FPSC has also approved the recovery of purchased power capacity costs, energy conservation costs, and environmental compliance costs in cost recovery clauses that are similar to the method used to recover fuel costs. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily using composite straight-line rates which approximated 3.8 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. The Company is included in the consolidated federal income tax return of The Southern Company. II-155 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of certain new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of plant through a higher rate base and higher depreciation expense. The FPSC-approved composite rate used to calculate AFUDC was 7.27 percent effective on July 1, 1993 and 8.03 percent for the first half of 1993, and for 1992, and 1991. AFUDC amounts for 1993, 1992, and 1991 were $966 thousand, $60 thousand, and $149 thousand, respectively. The increase in 1993 is due to an increase in construction projects at Plant Daniel. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The Company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. The amount was $4.0 million and $3.8 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 84 percent of the 1993 deferred vacation cost II-156 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report will be expensed and the balance will be charged to construction. PROVISION FOR INJURIES AND DAMAGES The Company is subject to claims and suits arising in the ordinary course of business. As permitted by regulatory authorities, the Company is providing for the uninsured costs of injuries and damages by charges to income amounting to $1.2 million annually. The expense of settling claims is charged to the provision to the extent available. The accumulated provision of $2.2 million and $2.5 million at December 31, 1993 and 1992, respectively, is included in miscellaneous current liabilities in the accompanying Balance Sheets. PROVISION FOR PROPERTY DAMAGE Due to a significant increase in the cost of traditional insurance, effective in 1993, the Company became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provides for the estimated cost of uninsured property damage by charges to income amounting to $1.2 million annually. At December 31, 1993 and 1992, the accumulated provision for property damage amounted to $10.5 million and $9.7 million, respectively. The expense of repairing such damage as occurs from time to time is charged to the provision to the extent it is available. 2. RETIREMENT BENEFITS: PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension trust fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Prior to the adoption of Statement No. 106, Gulf Power Company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $3.9 million, $3.1 million, and $2.7 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. II-157 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $4.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $543 thousand. Components of the plans' net cost are shown below: Of the above net pension amounts, $(601) thousand in 1993, $3 thousand in 1992, and $518 thousand in 1991, were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance amounts recorded in 1993, $3.0 million was recorded in operating expenses, and the remainder was recorded in construction and other accounts. II-158 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 3. LITIGATION AND REGULATORY MATTERS: COAL BARGE TRANSPORTATION SUIT On August 19, 1993, a complaint against the Company and Southern Company Services, an affiliate, was filed in federal district court in Ohio by two companies with which the Company had contracted for the transportation by barge for certain of the Company's coal supplies. The complaint alleges breach of the contract by the Company and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on the Company's financial statements. FPSC APPROVES STIPULATION In February 1993, the Company filed a notice with the FPSC of its intent to obtain rate relief. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case and to allow the Company to retain for the next four years its existing method for calculating accruals for future power plant dismantlement costs. The stipulation also required the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. See Management's Discussion and Analysis under "Future Earnings Potential" for further details of circumstances that contributed to the company canceling the rate case. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. RECOVERY OF CONTRACT BUYOUT COSTS In July 1990, the Company filed a request for waiver of FERC's fuel adjustment charge regulation to permit recovery of coal contract buyout costs from wholesale customers. On April 4, 1991, the FERC issued an order granting recovery of the buyout costs from wholesale customers from July 19, 1990, forward, but denying retroactive recovery of the buyout costs from January 1, 1987 through July 18, 1990. The Company's request for rehearing was denied by the FERC. The Company refunded $2.7 million (including interest) in June 1991 to its wholesale customers. On July 31, 1991, the Company filed a petition for review of the FERC's decision to the U.S. Court of Appeals for the District of Columbia Circuit. On January 22, 1993, the Court vacated the Commission's order, finding FERC's denial of the Company's request for a retroactive waiver to be arbitrary and capricious. The Court remanded the matter to FERC for consideration consistent with its opinion. Management expects that the commission will ultimately allow the Company to recover the amount refunded plus interest. Accordingly, the Company recorded the reversal of the $2.7 million refund to income in 1993. ENVIRONMENTAL COST RECOVERY In April 1993, the Florida Legislature adopted legislation for an Environmental Cost Recovery (ECR) clause, which allows a utility to petition the FPSC for recovery of all prudent environmental compliance costs that are not being recovered through base rates or any other rate-adjustment clause. Such environmental costs include operation and maintenance expense, depreciation, and a return on invested capital. II-159 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report On January 12, 1994, the FPSC approved the Company's petition under the ECR clause for recovery of environmental costs that were projected to be incurred from July 1993 through September 1994. The order allows the recovery from customers of such costs amounting to $7.8 million during the period, February through September 1994. Thereafter, recovery under ECR will be determined semi-annually and will include a true-up of the prior period and a projection of the ensuing six-month period. In December 1993, the Company recorded $2.6 million as additional revenue for the portion of costs incurred during 1993. 4. CONSTRUCTION PROGRAM: The Company is engaged in a continuous construction program, the cost of which is currently estimated to total $77 million in 1994, $55 million in 1995, and $68 million in 1996. These estimates include AFUDC of approximately $0.7 million, $0.3 million, and $0.2 million, in 1994, 1995, and 1996, respectively. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. 5. FINANCING AND COMMITMENTS: GENERAL Current projections indicate that funds required for construction and other purposes, including compliance with environmental regulations will be derived primarily from internal sources. Requirements not met from internal sources will be financed from the sale of additional first mortgage bonds, preferred stock, and capital contributions from The Southern Company. In addition, the Company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and redemptions of higher-cost securities. Because of the attractiveness of current short term interest rates, the Company may maintain a higher level of short term indebtedness than has historically been true. At December 31, 1993, the Company had $49 million of lines of credit with banks of which $6.1 million was committed to cover checks presented for payment. These credit arrangements are subject to renewal June 1 of each year. In connection with these committed lines of credit, the Company has agreed to pay certain fees and/or maintain compensating balances with the banks. The compensating balances, which represent substantially all the cash of the Company except for daily working funds and like items, are not legally restricted from withdrawal. In addition, the Company has bid-loan facilities with eight major money center banks that total $180 million, of which, none was committed at December 31, 1993. ASSETS SUBJECT TO LIEN The Company's mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $1.4 billion at December 31, 1993. Additional commitments will be required in the future to supply the Company's fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 to terminate two long-term contracts for the supply of coal to Plant Daniel, which is jointly owned by the Company and Mississippi Power, an operating affiliate. The Company's portion of II-160 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report this payment was some $60 million. This amount is being amortized to expense on a per ton basis over a nine-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $18 million at December 31, 1993. In 1988, the Company made an advance payment of $60 million to another coal supplier under an arrangement to lower the cost of future coal purchased under an existing contract. This amount is being amortized to expense on a per ton basis over a ten-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $36 million at December 31, 1993. Also, in 1993 the Company made a payment of $16.4 million to a coal supplier under an arrangement to suspend the purchase of coal under an existing contract for one year. This amount is being amortized to expense on a per ton basis over a one year period. The remaining unamortized amount, which is included in current assets, was $11 million at December 31, 1993. The amortization of these payments is being recovered through the fuel cost recovery clause discussed under "Revenues and Fuel Costs" in Note 1. LEASE AGREEMENT In 1989, the Company entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Mississippi Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million in 1992 and $1.3 million in 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option, after three years from the date of the original contract, to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, the Company has the option to renew the lease. 6. JOINT OWNERSHIP AGREEMENTS: The Company and Mississippi Power jointly own Plant Daniel, a steam-electric generating plant, located in Jackson County, Mississippi. In accordance with an operating agreement, Mississippi Power acts as the Company's agent with respect to the construction, operation, and maintenance of the plant. The Company and Georgia Power jointly own Plant Scherer Unit No. 3, a steam-electric generating plant, located near Forsyth, Georgia. In accordance with an operating agreement, Georgia Power acts as the Company's agent with respect to the construction, operation, and maintenance of the unit. The Company's pro rata share of expenses related to both plants is included in the corresponding operating expense accounts in the Statements of Income. At December 31, 1993, the Company's percentage ownership and its amount of investment in these jointly owned facilities were as follows: (1) Includes net plant acquisition adjustment. (2) Total megawatt nameplate capacity: Plant Scherer Unit No. 3: 818 Plant Daniel: 1,000 II-161 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL The Company and the other operating affiliates of The Southern Company have contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Certain of these agreements are non-firm and are based on the capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, the capacity revenues from these sales primarily affect profitability. The Company's capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC) by the Southern electric system. In 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end 1994. Capacity and energy sales under these long-term non-firm power sales agreements are made from available power pool capacity, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is currently being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA), and the City of Tallahassee, Florida. Under these agreements, 209 megawatts of net dependable capacity were sold by the Company during 1993, and sales will remain at that approximate level until the expiration of the contracts in 2010, unless reduced by FPC, FP&L and JEA after 1999. Capacity and energy sales to FP&L, the Company's largest single customer, provided revenues of $39.5 million in 1993, $46.2 million in 1992, and $42.1 million in 1991, or 6.8 percent, 8.1 percent, and 7.5 percent of operating revenues, respectively. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, the subsidiaries of The Southern Company entered into a settlement agreement with Gulf States Utilities Company (Gulf States) that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received - less the amounts previously included in income - the Company recorded increases in net income of approximately $0.6 million in 1992 and $12.7 million in 1991. In 1993, the Company sold all of its remaining Gulf States common stock received in the settlement, resulting in a gain of $2.3 million after tax. 8. INCOME TAXES: Effective January 1, 1993, Gulf Power Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $31.3 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $76.9 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-162 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $2.3 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: Gulf Power Company and the other subsidiaries of The Southern Company file a consolidated federal tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-163 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 9. LONG-TERM DEBT: POLLUTION CONTROL OBLIGATIONS Obligations incurred in connection with the sale by public authorities of tax-exempt pollution control revenue bonds are as follows: * Sinking fund requirement applicable to the 6 percent pollution control bonds is $100 thousand for 1994 with increasing increments thereafter through 2005, with the remaining balance due in 2006. With respect to the collateralized pollution control revenue bonds, the Company has authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. OTHER LONG-TERM DEBT Long-term debt also includes $17.5 million for the Company's portion of notes payable issued in connection with the termination of Plant Daniel coal contracts (see Note 5 for information on fuel commitments). The notes bear interest at 8.25 percent with the principal being amortized through 1995. Also included in long-term debt is a 30-month note payable for $25 million which was obtained to refinance higher cost securities. The principal is due in June 1996 and bears interest at 4.69 percent which is payable quarterly beginning March 1994. The estimated annual maturities of the notes payable through 1996 are as follows: $8.4 million in 1994, $9.1 million in 1995, and $25 million in 1996. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirement and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash, reacquiring bonds, or by pledging additional property equal to 1 and 2/3 times the requirement. In 1994, $12 million of 4 5/8 percent First Mortgage Bonds due October 1, 1994 and $15 million of 6 percent First Mortgage Bonds due June 1, 1996 are scheduled to be redeemed. II-164 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 11. COMMON STOCK DIVIDEND RESTRICTIONS: The Company's first mortgage bond indenture contains various common stock dividend restrictions which remain in effect as long as the bonds are outstanding. At December 31, 1993, $101 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the mortgage indenture. The Company's charter limits cash dividends on common stock to 50 percent of net income available for such stock during a prior period if the capitalization ratio is below 20 percent and to 75 percent of such net income if such ratio is 20 percent or more but less than 25 percent. The capitalization ratio is defined as the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend. At December 31, 1993, the ratio was 44.4 percent. 12. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate changes, among other factors. II-165 SELECTED FINANCIAL AND OPERATING DATA Gulf Power Company 1993 Annual Report II-166 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-167 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-168 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-169 STATEMENTS OF INCOME Gulf Power Company II-170 STATEMENTS OF INCOME Gulf Power Company II-171 STATEMENTS OF CASH FLOWS Gulf Power Company II-172 STATEMENTS OF CASH FLOWS Gulf Power Company II-173 BALANCE SHEETS Gulf Power Company II-174 BALANCE SHEETS Gulf Power Company II-175 BALANCE SHEETS Gulf Power Company II-176 BALANCE SHEETS Gulf Power Company II-177 GULF POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK (1) Subject to mandatory redemption of 5% annually on or before February 1. II-178 GULF POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-179 MISSISSIPPI POWER COMPANY FINANCIAL SECTION II-180 MANAGEMENT'S REPORT Mississippi Power Company 1993 Annual Report The management of Mississippi Power Company has prepared--and is responsible for--the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist, however, in any system of internal control, based upon a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting control maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Mississippi Power Company in conformity with generally accepted accounting principles. /s/ David M. Ratcliffe -------------------------------------------------- David M. Ratcliffe President and Chief Executive Officer /s/ Thomas A. Fanning -------------------------------------------------- Thomas A. Fanning Vice President and Chief Financial Officer II-181 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF MISSISSIPPI POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Mississippi Power Company (a Mississippi corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-190 through II-206) referred to above present fairly, in all material respects, the financial position of Mississippi Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, Mississippi Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16 , 1994 II-182 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Mississippi Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Mississippi Power Company's net income after dividends on preferred stock for 1993 totaled $42.4 million, an increase of $5.6 million over the prior year. This improvement is attributable primarily to increased energy sales and retail rate increases. A retail rate increase under the Company's Performance Evaluation Plan (PEP-1A) of $6.4 million annually became effective in July 1993. Under the Environmental Compliance Overview Plan (ECO Plan) retail rates increased by $2.6 million annually effective April 1993. A comparison of 1992 to 1991 - excluding the events occurring in 1991 discussed below - would reflect a 1992 increase in earnings of $4.9 million or 15.5 percent. The Company's financial performance in 1991 reflected the after-tax operating and disposal losses of $11.9 million recorded by the Company's former merchandise subsidiary. These losses were partially offset by a $2.6 million positive impact on earnings from the settlement of the contract dispute with Gulf States Utilities Company (Gulf States). REVENUES The following table summarizes the factors impacting operating revenues for the past three years: *Includes the effect of the retail rate increase approved under the ECO Plan. Retail revenues of $368 million in 1993 increased 9.0 percent over the prior year, compared with an increase of 2.2 percent for 1992 and a decrease of 1.5 percent in 1991. The increase in retail revenues for 1993 was a result of growth in energy sales and customers, the favorable impact of weather, and retail rate increases. Changes in base rates reflect rate changes made under the PEP plans and the ECO Plan as approved by the Mississippi Public Service Commission (MPSC). The increase in revenues for the recovery of fuel costs for 1993 reversed two years of decline. Under the fuel cost recovery provision, recorded fuel revenues are equal to recorded fuel expenses, including the fuel component and the operation and maintenance component of purchased energy. Therefore, changes in recoverable fuel expenses are offset with corresponding changes in fuel revenues and have no effect on net income. II-183 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Included in sales for resale to non-affiliates are revenues from rural electric cooperative associations and municipalities located in southeastern Mississippi. Energy sales to these customers in 1993 increased 9.0 percent over the prior year with the related revenues rising 14.1 percent. The customer demand experienced by these utilities is determined by factors very similar to Mississippi Power's. Sales for resale to non-affiliated non-territorial utilities are primarily under long-term contracts consisting of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Capacity revenues for Mississippi Power increased in 1993 and 1992 due to a change in the allocation of transmission capacity revenues throughout the Southern electric system. Most of the Company's capacity revenues are derived from transmission charges. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. The increase in other operating revenues for 1993 was due to increased rents collected from microwave equipment use and the transmission of non-associated companies' electricity. Below is a breakdown of kilowatt-hour sales for 1993 and the percent change for the last three years: Total retail energy sales in 1993 increased compared to the previous year, due primarily to weather influences and the improvement in the economy. The increase in commercial energy sales also reflects the impact of recently established casinos within the Company's service area. Industrial sales increased in 1992 as a result of new contracts with two large industrial customers. The decrease in energy sales for resale to non-affiliates is predominantly due to reductions in unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale to non-affiliates. Sales for resale to non-affiliates are influenced by those utilities' own customer demand, plant availability, and the cost of their predominant fuels -- oil and natural gas. EXPENSES Total operating expenses for 1993 were higher than the previous year because of higher production expenses, which reflects increased demand, an increase in the federal income tax rate, and higher employee-related costs. (See Note 2 to the financial statements for information regarding employee and retiree benefits.) Additionally, included in other operation expenses are increased costs associated with environmental remediation of a Southern electric system research facility. Expenses in 1992 were lower than 1991, excluding the Gulf States settlement, primarily because of lower production expenses stemming from decreased demand. II-184 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Fuel costs constitute the single largest expense for Mississippi Power. These costs increased in 1993 due to an 11.0 percent increase in generation, which reflects higher demand. Fuel expenses in 1992, compared to 1991, were lower because of less generation and the negotiation of new coal contracts. Generation decreased primarily because of the availability of lower cost generation elsewhere within the Southern electric system. Purchased power consists primarily of energy purchases from the affiliates of the Southern electric system. Purchased power transactions (both sales and purchases) among Mississippi Power and its affiliates will vary from period to period depending on demand and the availability and variable production cost at each generating unit in the Southern electric system. Taxes other than income taxes increased in 1993 because of higher ad valorem taxes, which are property based, and municipal franchise taxes, which are revenue based. The decline in 1992 was attributable to lower franchise taxes. Income tax expense in 1993 increased because of the enactment of a higher corporate income tax rate retroactive to January 1, 1993, coupled with higher earnings. The change in income taxes for 1992 and 1991 reflected the change in operating income. EFFECTS OF INFLATION Mississippi Power is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical costs does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from regulatory matters to growth in energy sales. Expenses are subject to constant review and cost control programs. Among the efforts to control costs are utilizing employees more effectively through a functionalization program for the Southern electric system, redesigning compensation and benefit packages, and re- engineering work processes. Mississippi Power is also maximizing the utility of invested capital and minimizing the need for capital by refinancing, decreasing the average fuel stockpile, raising generating plant availability and efficiency, and curbing the construction budget. Operating revenues will be affected by any changes in rates under the PEP-2, the Company's revised performance based ratemaking plan. The PEP plans have proved to be a stabilizing force on electric rates, with only moderate changes in rates taking place. The ECO Plan, approved by the MPSC in 1992, provides for recovery of costs associated with environmental projects approved by the MPSC, most of which are required to comply with Clean Air Act Amendments of 1990 regulations. The ECO Plan is operated independently of PEP-2. The FERC regulates wholesale rate schedules and power sales contracts that Mississippi Power has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. Also, pending before the FERC is the Company's request for a $3.6 million wholesale rate increase. Further discussion of the PEP plans, the ECO Plan, and proceedings before the FERC is made in Note 3 to the financial statements herein. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in Mississippi Power's service area. However, the Energy II-185 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive of IPPs to build cogeneration plants for a utility's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. Mississippi Power is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. If Mississippi Power does not remain a low-cost producer and provider of quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, which could significantly reduce earnings. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, Mississippi Power adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. In January 1994, Mississippi Power adopted the new rules, with no material effect on the financial statements. On January 1, 1993, Mississippi Power changed its methods of accounting for postretirement benefits other than pensions and income taxes. See Notes 2 and 9 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal changes in Mississippi Power's financial condition during 1993 were gross property additions of $140 million to utility plant, a significant lowering of cost of capital through refinancings, and the resolution of PEP and ratepayer litigation. Funding for gross property additions came primarily from capital contributions from The Southern Company, earnings and other operating cash flows. The Statements of Cash Flows provide additional details. FINANCING ACTIVITY Mississippi Power continued to lower its financing costs in 1993 by issuing new debt and equity securities and retiring high- cost issues. The Company sold $132 million of first mortgage bonds, preferred stock and, through public authorities, pollution control revenue bonds. Retirements, including maturities during 1993, totaled some $101 million of such securities. (See the Statements of Cash Flows for further details.) Composite financing rates for the years 1991 through 1993 as of year-end were as follows: II-186 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report CAPITAL STRUCTURE At year-end 1993, the Company's ratio of common equity to total capitalization was 49.8 percent, compared to 47.3 percent in 1992 and 44.4 percent in 1991. The increase in the ratio in 1993 can be attributed primarily to the receipt of $30 million of capital contributions from The Southern Company. CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $256 million ($96 million in 1994, $62 million in 1995, and $98 million in 1996). The major emphasis within the construction program will be on complying with Clean Air Act regulations, completion of a 78-megawatt combustion turbine, and upgrading existing facilities. The estimates for property additions for the three-year period include $39 million committed to meeting the requirements of Clean Air Act regulations. Revisions may be necessary because of factors such as revised load projections, the availability and cost of capital, and changes in environmental regulations. OTHER CAPITAL REQUIREMENTS In addition to the funds required for the Company's construction program, approximately $51 million will be required by the end of 1996 for present sinking fund requirements and maturities of long-term debt. Mississippi Power plans to continue, when economically feasible, to retire high-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act Amendments of 1990 (Clean Air Act) were signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on Mississippi Power and the other operating companies of The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10 thousand megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing more slowly than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which Mississippi Power's portion is approximately $60 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance for The Southern Company could require total construction expenditures ranging from approximately $450 million to $800 million, II-187 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report of which Mississippi Power's portion is approximately $25 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover The Southern Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. Mississippi Power's ECO Plan is designed to allow recovery of costs of compliance with the Clean Air Act, as well as other environmental statutes and regulations. The MPSC reviews environmental projects and the Company's environmental policy through the ECO Plan. Under the ECO Plan, any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. Mississippi Power's management believes that the ECO Plan will provide for recovery of the Clean Air Act costs. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standard could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provisions of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the II-188 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $70 million of committed credit in revolving credit agreements and also had $21 million of committed short-term credit lines. The $40 million of notes payable outstanding at year end 1993 were apart from the committed credit facilities. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations will be derived from operations, the sale of additional first mortgage bonds, pollution control obligations, and preferred stock, and the receipt of additional capital contributions from The Southern Company. Mississippi Power is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest rate levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-189 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-190 STATEMENTS OF CASH FLOWS For the Years ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-191 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-192 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report II-193 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-194 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-195 NOTES TO FINANCIAL STATEMENTS Mississippi Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Mississippi Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Contracts among the companies--dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power--are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. Mississippi Power is also subject to regulation by the FERC and the Mississippi Public Service Commission (MPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. The 1991 financial statements of the Company included the accounts of Electric City Merchandise Company, Inc. (Electric City), which discontinued operations in 1991. All significant intercompany transactions were eliminated in consolidation. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES Mississippi Power accrues revenues for service rendered but unbilled at the end of each fiscal period. The Company's retail and wholesale rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power. Retail rates also include provisions to adjust billings for fluctuations in costs for ad valorem taxes. Revenues are adjusted for differences between the recoverable fuel and ad valorem expenses and the amounts actually recovered in current rates. DEPRECIATION Depreciation of the original cost of depreciable utility plant in service is provided by using composite straight-line rates which approximated 3.1 percent in 1993 and 3.3 percent in 1992 and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES Mississippi Power provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 to the financial statements for additional information about Statement No. 109. II-196 NOTES (continued) Mississippi Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used to capitalize the cost of funds devoted to construction were 6.8 percent in 1993, 8.2 percent in 1992, and 9.8 percent in 1991. AFUDC (net of income taxes), as a percent of net income after dividends on preferred stock, was 3.5 percent in 1993, 2.7 percent in 1992, and 4.8 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. This cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repair, and replacement of minor items of property is charged to maintenance expense except for the maintenance of coal cars and a portion of the railway track maintenance, which are charged to fuel stock. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair value of investment securities was based on listed closing market prices. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when used or installed. VACATION PAY Mississippi Power's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. Such amounts were $4.8 million and $4.7 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 80 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. II-197 NOTES (continued) Mississippi Power Company 1993 Annual Report PROVISION FOR PROPERTY DAMAGE Due to the significant increase in the cost of traditional insurance, effective in 1993, Mississippi Power became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provided for the cost of storm, fire and other uninsured casualty damage by charges to income of $1.5 million in 1993, 1992, and 1991. The cost of repairing damage resulting from such events that individually exceed $50 thousand is charged to the accumulated provision to the extent it is available. As of December 31, 1993, the accumulated provision amounted to $10.5 million. Regulatory treatment by the MPSC allows a maximum accumulated provision of $10.9 million. DISCONTINUED OPERATIONS Electric City began operating as a subsidiary of Mississippi Power in October 1987 and was formally dissolved as of December 31, 1991. Under an agreement reached in October 1991, a portion of Electric City's assets, including inventory and fixed assets, was sold to a concern independent of Mississippi Power. The remaining assets and liabilities, which were not material, were transferred to the Company. The impact of Electric City on Mississippi Power's consolidated earnings in 1991 consisted of (a) a pretax operating loss of $10.2 million ($6.4 million after income taxes) and (b) the pretax loss of $8.7 million ($5.5 million after income taxes) resulting from the disposal of Electric City. 2. RETIREMENT BENEFITS: PENSION PLAN Mississippi Power has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS Mississippi Power also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, Mississippi Power recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the Company in 1992 and 1991 were $3.6 million and $3.0 million, respectively. II-198 NOTES (continued) Mississippi Power Company 1993 Annual Report STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $6.4 million and the aggregate of the service and interest cost components of the net retiree medical cost by $722 thousand. Components of the plans' net cost are shown below: II-199 NOTES (continued) Mississippi Power Company 1993 Annual Report Of the above net pension amounts recorded, ($170 thousand) in 1993, $269 thousand in 1992, and $576 thousand in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $3.9 million was charged to operating expense and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS: RETAIL RATE ADJUSTMENT PLANS Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986. During 1993, all matters related to the original PEP case were finally resolved when the Supreme Court of Mississippi granted a joint motion to dismiss pending appeals. Also in 1993, the MPSC ordered Mississippi Power to review and propose changes to the plan that would reduce the impact of rate changes on the customer and provide incentives for Mississippi Power to keep customer prices low. In response, Mississippi Power filed a revised plan and, on January 4, 1994, the MPSC approved PEP-2. The revised plan includes a mechanism for sharing rate adjustments based on the Company's ability to maintain low rates for customers and on the Company's performance as measured by three performance indicators that emphasize those factors which most directly impact the customers. PEP-2 provides for semiannual evaluations of Mississippi's performance-based return on investment, rather than on common equity as previously calculated. As in previous plans, any change in rates is limited to 2 percent of retail revenues per evaluation period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. ENVIRONMENTAL COMPLIANCE OVERVIEW PLAN The MPSC approved Mississippi Power's ECO Plan in 1992. The plan establishes procedures to facilitate the MPSC's overview of the Company's environmental strategy and provides for recovery of costs associated with environmental projects approved by the MPSC. Under the ECO Plan any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. The ECO Plan resulted in an annual retail rate increase of $2.6 million effective April 1993. FERC REVIEWS EQUITY RETURNS AND OTHER REGULATORY MATTERS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts, including the Company's Transmission Facilities Agreement (TFA) discussed in Note 8 under "Lease Agreements." Any changes in rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, an administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on Mississippi Power's financial statements. In 1988, the Company and its operating affiliates filed with the FERC a contract governing the pricing and other aspects of power transactions among the companies. In 1989, the FERC ordered hearings on the contract and made revenues collected under the contract subject to refund. In 1992, the II-200 NOTES (continued) Mississippi Power Company 1993 Annual Report FERC ruled that certain production costs under the contract had not been properly classified and ordered that the contract be revised and that refunds be made. Under reconsideration, the FERC determined that refunds were not necessary and ordered that its mandated changes in computing certain expenses under the system interchange contract become effective in August 1993. The changes mandated by the FERC will not materially affect the Company's net income. WHOLESALE RATE FILING On September 1, 1993, Mississippi Power filed a $3.6 million wholesale rate increase request with the FERC. Prior to this filing, the Company conferred and negotiated a settlement with all of its wholesale all requirements customers, who have executed a Settlement Agreement and Certificates of Concurrence to be included in this filing with the FERC. The Company is awaiting a response from the FERC. RETAIL RATEPAYERS' SUITS CONCLUDED In 1989, three retail ratepayers of the Company filed a civil complaint in the U.S. District Court for the Southern District of Mississippi against Mississippi Power and other parties. The complaint alleged that Mississippi Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated to be at least $10 million, plus treble and punitive damages, on behalf of all retail ratepayers of the Company for alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act, federal and state antitrust laws, other federal and state statutes, and common law fraud. Mississippi Power also was named as a defendant, together with other parties in a similar civil action filed in the U.S. District Court for the Northern District of Florida. The defendants' motions for dismissal were granted by the courts, resolving these suits. 4. CONSTRUCTION PROGRAM: Mississippi Power is engaged in continuous construction programs, the costs of which are currently estimated to total some $96 million in 1994, $62 million in 1995, and $98 million in 1996. These estimates include AFUDC of $1.6 million in 1994, $1.6 million in 1995, and $2.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the construction of a combustion turbine generation unit of 78 megawatts was completed in February 1994. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act and other environmental matters. 5. FINANCING AND COMMITMENTS: FINANCING Mississippi Power's construction program is expected to be financed from internal and other sources, such as the issuance of additional long-term debt and preferred stock and the receipt of capital contributions from The Southern Company. The amounts of first mortgage bonds and preferred stock which can be issued in the future will be contingent upon market conditions, adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis under "Sources of Capital" for information regarding the Company's coverage requirements. At December 31, 1993, Mississippi Power had committed credit agreements (360 day committed lines) with banks for $21 million. Additionally, Mississippi Power had $70 million of unused committed credit agreements in the form of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. As of December 31, 1993, Mississippi Power had $40 million in short-term bank borrowings all of which were made apart from committed credit arrangements. II-201 NOTES (continued) Mississippi Power Company 1993 Annual Report ASSETS SUBJECT TO LIEN Mississippi Power's mortgage indenture dated as of September 1, 1941, as amended and supplemented, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, Mississippi Power has entered into various long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum production levels, and other financial commitments. Total estimated obligations were approximately $243 million at December 31, 1993. Additional commitments for fuel will be required in the future to supply the Company's fuel needs. In order to take advantage of lower cost coal supplies, agreements were reached in December 1986 to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Mississippi Power and Gulf Power, an operating affiliate. The Company's portion of this payment was about $60 million. In accordance with the ratemaking treatment, the cost to terminate the contracts is being amortized through 1995 to match costs with savings achieved. The remaining unamortized amount of Mississippi Power's share of principal payments to the suppliers including the current portion totaled $18 million at December 31, 1993. 6. JOINT OWNERSHIP AGREEMENTS: Mississippi Power and Alabama Power own as tenants in common Greene County Electric Generating Plant (coal) located in Alabama; and Mississippi Power and Gulf Power own as tenants in common Daniel Electric Generating Plant (coal) located in Mississippi. At December 31, 1993, Mississippi Power's percentage ownership and investment in these jointly owned facilities were as follows: Mississippi Power's share of plant operating expenses is included in the corresponding operating expenses in the Statements of Income. 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL Mississippi Power and the other operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Some of these agreements (unit power sales) are firm commitments and pertain to capacity related to specific generating units. Mississippi Power's participation in firm production capacity unit power sales ended in January 1989. However, the Company continues to participate in transmission and energy sales under the unit power sales agreements. The other agreements (other long-term sales) are non-firm commitments and are based on capacity of the system in general. Because the energy is generally sold at variable costs under these agreements, only revenues from capacity sales affect profitability. Off-system capacity revenues for the Company have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 by the Southern electric system to Florida Power Corporation. In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-202 NOTES (continued) Mississippi Power Company 1993 Annual Report GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts previously included in income -- Mississippi Power recorded an increase in net income of approximately $2.6 million in 1991. 8. LEASE AGREEMENTS: In 1984, Mississippi Power and Gulf States entered into a forty-year transmission facilities agreement whereby Gulf States began paying a use fee to the Company covering all expenses relative to ownership and operation and maintenance of a 500 kV line, including amortization of its original $57 million cost. In 1993, 1992, and 1991 the use fees collected under the agreement, net of related expenses, amounted to $3.9 million, $3.9 million and $4.0 million, respectively, and are included with other income, net, in the Statements of Income. For other information see Note 3 under "FERC Reviews Equity Returns and Other Regulatory Matters." In 1989, Mississippi Power entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Gulf Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million for 1992 and $1.3 million for 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and in 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option after three years to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, Mississippi Power has the option to renew the lease. 9. INCOME TAXES: Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $48 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-203 NOTES (continued) Mississippi Power Company 1993 Annual Report Details of the federal and state income tax provisions are shown below: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: In 1989, under order of the MPSC, Mississippi Power began amortizing deferred income taxes not covered by the Internal Revenue Service normalization requirements, that had been recorded at rates higher than those specified by the current statutory income tax rules. This amortization occurred over a 60-month period, the effect of which was a reduction of income tax expense of approximately $2.7 million per year. At December 31, 1993, this tax rate differential was fully amortized. Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.5 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. II-204 NOTES (continued) Mississippi Power Company 1993 Annual Report The total provision for income taxes as a percentage of pre-tax income and the differences between those effective rates and the statutory federal tax rates were as follows: Mississippi Power and its affiliates file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. OTHER LONG-TERM DEBT: Details of other long-term debt are as follows: Pollution control obligations represent installment or lease purchases of pollution control facilities financed by application of funds derived from sales by public authorities of tax-exempt revenue bonds. Mississippi Power has authenticated and delivered to the Trustee a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under these agreements. The 5.8% Series of pollution control obligations has a cash sinking fund requirement of $10 thousand annually through 1997 and $20 thousand in 1998. At December 31, 1993, under "Other Property and Investments" approximately $6 million related to the 6.20% Series of Pollution Control Obligations remains available for completion of certain solid waste disposal facilities. The 8.25 percent notes payable relate to the termination of two coal contracts. See Note 5 under "Fuel Commitments" for information on these coal contracts. The annual estimated maturities of total notes payable are $8.8 million in 1994 and $10.8 million in 1995. II-205 NOTES (continued) Mississippi Power Company 1993 Annual Report 11. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement fund requirement is one percent of each outstanding series authenticated under the indenture of Mississippi Power prior to January 1 of each year, other than first mortgage bonds issued as collateral security for certain pollution control obligations. The requirement must be satisfied by June 1 of each year by depositing cash or reacquiring bonds, or by pledging additional property equal to 166-2/3 percent of such requirement. 12. COMMON STOCK DIVIDEND RESTRICTIONS: Mississippi Power's first mortgage bond indenture and the Articles of Incorporation contain various common stock dividend restrictions. At December 31, 1993, $86 million of retained earnings was restricted against the payment of cash dividends on common stock under the most restrictive terms of the mortgage indenture or Articles of Incorporation. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: Mississippi Power's business is influenced by seasonal weather conditions and the timing of rate changes. II-206 SELECTED FINANCIAL AND OPERATING DATA Mississippi Power Company 1993 Annual Report II-207 II-208 II-209 II-210 STATEMENTS OF INCOME Mississippi Power Company II-211 STATEMENTS OF INCOME Mississippi Power Company II-212 STATEMENTS OF CASH FLOWS Mississippi Power Company II-213 STATEMENTS OF CASH FLOWS Mississippi Power Company II-214 BALANCE SHEETS Mississippi Power Company II-215 BALANCE SHEETS Mississippi Power Company II-216 BALANCE SHEETS Mississippi Power Company II-217 BALANCE SHEETS Mississippi Power Company II-218 MISSISSIPPI POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-219 MISSISSIPPI POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-220 SAVANNAH ELECTRIC AND POWER COMPANY FINANCIAL SECTION II-221 MANAGEMENT'S REPORT Savannah Electric and Power Company 1993 Annual Report The management of Savannah Electric and Power Company has prepared -- and is responsible for -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Savannah Electric and Power Company in conformity with generally accepted accounting principles. /s/ Arthur M. Gignilliat, Jr. /s/ K. R. Willis - -------------------------------- ------------------------------------- Arthur M. Gignilliat, Jr. K. R. Willis President Vice-President and Chief Executive Officer Treasurer and Chief Financial Officer II-222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF SAVANNAH ELECTRIC AND POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Savannah Electric and Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (pages II-231 through II-244) referred to above present fairly, in all material respects, the financial position of Savannah Electric and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia, February 16, 1994 II-223 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Savannah Electric and Power Company 1993 Annual Report RESULTS OF OPERATIONS Earnings Savannah Electric and Power Company's net income after dividends on preferred stock for 1993 totaled $21.5 million, representing a $1.0 million (4.6 percent) increase from the prior year. The revenue impact of an increase in retail energy sales due to exceptionally hot summer weather was partially offset by the implementation of a work force reduction program which resulted in a one-time charge to operating expenses of approximately $4.5 million. In 1992, earnings were $20.5 million, representing a $3.5 million (14.6 percent) decrease from the prior year. This decrease resulted primarily from increases in maintenance and administrative and general expenses, partially offset by a 4.6 percent increase in retail operating revenues. Operating revenues increased despite the negative impact of a $2.8 million annual reduction in retail base rates effective in June 1992, and mild weather. REVENUES Total revenues for 1993 were $218.4 million, reflecting a 10.5 percent increase over 1992, primarily due to an increase in retail energy sales. The following table summarizes the factors impacting operating revenues compared to the prior year for the 1991-1993 period: Total retail revenues increased 11.5 percent in 1993, compared to a 4.6 percent increase in 1992. The increase in 1993 retail revenues attributable to growth in both retail customers and average use per customer was enhanced by exceptionally hot weather during the summer. The substantial increase in fuel cost recovery and other revenues reflects increases in net generation and the unit cost of purchased power. The increase in 1992 retail revenues resulted from growth in both retail customers and average use per customer, but was substantially offset by mild weather and the June 1992 base rate reduction. II-224 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Under the Company's fuel cost recovery provisions, fuel revenues equal fuel expense, including the fuel and capacity components of purchased energy, and have no effect on earnings. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Sales to affiliated companies within the Southern electric system vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have little impact on earnings. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The increases in energy sales in 1993 and 1992 continue to reflect a growing customer base, an increase in average energy sales per customer, and improved economic conditions in the Company's service area. Sales were enhanced in 1993 by temperature extremes in the summer months and in December. EXPENSES Total operating expenses for 1993 increased $20.3 million (12.4 percent) over the prior year. This increase includes a $10.8 million increase in fuel expense, and an $8.7 million increase in other operation expenses. Fuel expenses increased primarily because of higher generation due to extremely hot weather and higher cost fuel sources. In 1992 an increase in purchased power reflected a 15.4 percent decrease in generation compared to 1991. Despite the decrease in generation, total 1992 fuel expenses were substantially unchanged from the prior year reflecting generation from higher cost fuel sources. The increase in other operation expenses reflects a $4.5 million cost associated with a one-time charge related to a work force reduction program. The Company also recognized higher employee benefits costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information on these new rules. In 1992, the increase in other operation expenses was primarily a result of increases in outside services and administrative and general expenses, which reflected higher employee training and benefits expenses. Total interest expense on long-term debt was reduced by 5.4 percent in 1992, as the Company refinanced higher-cost debt. II-225 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The mix of energy supply is determined primarily by system load, the unit cost of fuel consumed and the availability of units. The amount and sources of energy supply and the average cost of fuel per net kilowatt-hour generated and purchased power were as follows: EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will depend upon growth in energy sales, which is subject to a number of factors. Traditionally, these factors included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network to sell electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. The Company is preparing now to meet the challenge of these major changes in the traditional business practices of selling electricity. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been initiated by the Company and are a significant part of integrated resource planning. Customers can receive cash incentives for participating in these programs in addition to reducing their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the Company. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects, in conjunction with the precertification approval process for such projects by the Georgia Public Service Commission (GPSC), will II-226 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report diminish the possible exposure to prudency disallowances and the resulting impact on earnings. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." Rates to retail customers served by the Company are regulated by the GPSC. In May 1992, the Company requested, and subsequently received, approval by the GPSC to reduce annual base revenues by $2.8 million, effective June 1992. The reduction includes a base rate reduction of approximately $2.5 million spread among all classes of retail customers. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers. As part of this rate settlement, it was informally agreed that the Company's earned rate of return on common equity should be 12.95 percent. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be implemented by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115, supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules January 1, 1994, with no material effect on the financial statements. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 7 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal change in the Company's financial condition in 1993 was additions of $73 million to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. See Statements of Cash Flows for additional information. CAPITAL STRUCTURE As of December 31, 1993, the Company's capital structure consisted of 45.3 percent common equity, 10.3 percent preferred stock and 44.4 percent long-term debt, excluding amounts due within one year. The Company's long-term financial objective for capitalization ratios is to maintain a capital structure of common equity at 45 percent, preferred stock at 10 percent and debt at 45 percent. Maturities and retirements of long-term debt were $4 million in 1993, $53 million in 1992 and $23 million in 1991. In November 1993, the Company issued 1,400,000 shares of 6.64 percent series preferred stock. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent series preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. The composite interest rates for the years 1991 through 1993 as of year-end were as follows: II-227 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The Company's current securities ratings are as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $98 million ($33 million in 1994, $32 million in 1995, and $33 million in 1996). Actual construction costs may vary from this estimate because of such factors as changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment and materials; and the cost of capital. The largest project during this period is the addition of two 80 megawatt combustion turbine units, to be placed into service in 1994. The estimated cost of this project is $61 million. The Company is also constructing six combustion turbine units for Georgia Power Company. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $5.9 million will be needed by the end of 1996 for present sinking fund requirements and maturities. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the new law -- will have a significant impact on the Company and other subsidiaries of the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this would require some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the Company's portion is approximately $2 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I and increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 through 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million of which the Company's portion is expected to be approximately $25 million. However, the full impact of II-228 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 5 percent in annual revenue requirements from customers could be necessary to fully recover the Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any - -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matters, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes--coal ash and other utility wastes--as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Savannah Electric and Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and will recognize in the financial statements any costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act, the Comprehensive Environmental Response, Compensation, and Liability Act, and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $3.9 million of cash and $14.5 million of unused credit arrangements with banks to meet its short-term cash needs. The Company had $3 million of short-term bank borrowings at December 31, 1993. In January 1994, the Company renegotiated a two-year revolving credit arrangement with four of its II-229 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report existing banks for a total credit line of $20 million. The primary purpose of this additional credit is to provide interim funding for the Company's combustion turbine construction program. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations and the sale of additional first mortgage bonds and preferred stock and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-230 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-231 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-232 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-233 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-234 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-235 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-236 NOTES TO FINANCIAL STATEMENTS Savannah Electric and Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Savannah Electric and Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company also is subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the GPSC. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The Company's electric rates include provisions to adjust billings for fluctuations in capacity and the energy components of purchased power costs. Revenues include the actual cost of fuel and purchased power incurred. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 2.9 percent in 1993 and 3.2 percent in 1992, and 1991. The decrease in 1993 reflects the Company's implementation of new depreciation rates approved by the GPSC. These new rates provide for a timely recovery of the investments in the Company's depreciable properties. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company, which is included in the consolidated federal income tax return filed by The Southern Company, provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 7 for additional information about Statement No. 109. II-237 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the Company to calculate AFUDC were 8.77 percent in 1993, 11.27 percent in 1992, and 11.38 percent in 1991. UTILITY PLANT Utility plant is stated at original cost, which includes materials, labor, minor items of property, appropriate administrative and general costs, payroll-related costs such as taxes, pensions and other benefits and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, items for which the carrying amount does not approximate fair value must be disclosed. At December 31, 1993, the fair value of long-term debt was $164 million and the carrying amount was $154 million. The fair value of long-term debt was $117 million and the carrying amount was $109 million at December 31, 1992. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. 2. RETIREMENT BENEFITS PENSION PLANS The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits under this plan reflect the employee's years of service, age at retirement and average compensation for the three years immediately preceding retirement. The Company uses the projected unit credit actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and debt securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-238 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Consistent with regulatory treatment, the Company recognized these costs on a cash basis as payments were made in 1992 and 1991. The total costs of such benefits recognized by the Company amounted to $375 thousand in 1992 and $487 thousand in 1991. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statements Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown for 1993 only because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: In accordance with Statement No. 87, an additional liability related to under-funded accumulated benefit obligations was recognized at December 31, 1993. A corresponding net-of-tax charge of $2.1 million was recognized as a separate component of Common Stock Equity in the Statements of Capitalization. The assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $1.7 million and the aggregate of the service and interest cost components of the net retiree medical cost by $0.2 million. II-239 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Components of the plans' net costs are shown below: Of the above net pension amounts, $2.0 million in 1993, $1.7 million in 1992 and $1.5 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Net postretirement medical and life insurance costs of $1.8 million in 1993 were charged to operating expenses. The Company has a supplemental retirement plan for certain executive employees. The plan is unfunded and payable from the general funds of the Company. The Company has purchased life insurance on participating executives, and plans to use these policies to satisfy this obligation. Benefit costs associated with this plan for 1993, 1992 and 1991 were $980 thousand, $316 thousand and $338 thousand, respectively. The 1993 benefit costs reflect a one-time expense related to employees who were part of the work force reduction program. WORK FORCE REDUCTION PROGRAM The Company has incurred additional costs for a one-time charge related to the implementation of a work force reduction program. In 1993, $4.5 million was charged to operating expenses and $0.6 million was charged to other income (expense). 3. REGULATORY MATTERS RATE MATTERS In May 1992, the Company filed for, and subsequently received, GPSC approval to implement new base rates designed to decrease base operating revenues by $2.8 million annually. The reduction included a base rate reduction of approximately $2.5 million spread among all classes of customers, effective June 1992. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers in August 1992. 4. CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program, currently estimated to total $33 million in 1994, $32 million in 1995 and $33 million in 1996. The estimates include AFUDC of $1.6 million in 1994, $0.6 million in 1995 and $0.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include: changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing cost of labor, equipment and materials; and cost of capital. The construction of two combustion turbine peaking units totaling 160 megawatts is planned to be completed in mid 1994. The Company is also constructing six combustion turbine peaking units owned by Georgia Power Company. The construction is to be completed in 1996. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. II-240 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 5. FINANCING AND COMMITMENTS GENERAL To the extent possible, the Company's construction program is expected to be financed from internal sources and from the issuance of additional long-term debt and preferred stock and capital contributions from The Southern Company. Should the Company be unable to obtain funds from these sources, the Company would have to use short-term indebtedness or other alternative, and possibly costlier, means of financing. The amounts of long-term debt and preferred stock that can be issued in the future will be contingent on market conditions, the maintenance of adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis for information regarding the Company's earnings coverage requirements. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with four banks totaled $14.5 million, and expire at various times during 1994. The Company has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitments fees based on the unused portions of the commitments. In connection with all other lines of credit, the Company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the Company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. ASSETS SUBJECT TO LIEN As amended and supplemented, the Company's Indenture of Mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. OPERATING LEASES The Company has rental agreements with various terms and expiration dates. Rental expenses totaled $1.5 million, $1.5 million, and $1.4 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated future minimum lease payments for non-cancelable operating leases were as follows: 6. LONG-TERM POWER SALES AGREEMENTS The operating subsidiaries of The Southern Company, including the Company, have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to the capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The Company's portion of capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-241 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $26 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $0.7 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the effective income tax rate to the statutory tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-242 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 8. CUMULATIVE PREFERRED STOCK In November 1993, the Company issued 1,400,000 shares of 6.64 percent Series Preferred stock which has redemption provisions of $26.66 per share plus accrued dividends if on or prior to November 1, 1998, and at $25 per share plus accrued dividends thereafter. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent Series Preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. Cumulative preferred stock dividends are preferential to the payment of dividends on common stock. 9. LONG-TERM DEBT The Company's Indenture related to its First Mortgage Bonds is unlimited as to the authorized amount of bonds which may be issued, provided that required property additions, earnings and other provisions of such Indenture are met. On February 19, 1993, the Company refunded its $4.1 million, 6.25 percent Series Pollution Control Bonds, due 1998 with $4.1 million of variable rate Series Pollution Control Bonds due 2016. In 1994, there is a first mortgage bond maturity of $3.7 million. The sinking fund requirements of first mortgage bonds are being satisfied by certification of property additions. See Note 10 "Long-Term Debt Due Within One Year" for details. Details of other long-term debt are as follows: Sinking fund requirements and /or maturities through 1998 applicable to long-term debt are as follows: $4.5 million in 1994; $0.7 million in 1995; $0.7 million in 1996; $0.1 million in 1997 and no requirement is needed for 1998. Assets acquired under capital leases are recorded as utility plant in service and the related obligation is classified as other long-term debt. Leases are capitalized at the net present value of the future lease payments. However, for ratemaking purposes, these obligations are treated as operating leases, and as such, lease payments are charged to expense as incurred. The Company leases combustion turbine generating equipment under a non-cancelable lease expiring in 1995, with renewal options extending until 2010. The Company also leases a portion of its transportation fleet. Under the terms of these leases, the Company is responsible for taxes, insurance and other expenses. II-243 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund/sinking fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 1 2/3 times the requirements. 11. COMMON STOCK DIVIDEND RESTRICTIONS The Company's Charter and Indentures contain certain limitations on the payment of cash dividends on the preferred and common stocks. At December 31, 1993, approximately $55 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the Mortgage Indenture. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands): The Company's business is influenced by seasonal weather conditions, a seasonal rate structure and the timing of rate changes, among other factors. II-244 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report Note: NR = Not Rated II-245 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report II-246 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-247 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-248 STATEMENTS OF INCOME Savannah Electric and Power Company * Tax-free common stock/bond exchange II-249 STATEMENTS OF INCOME Savannah Electric and Power Company II-250 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-251 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-252 BALANCE SHEETS Savannah Electric and Power Company II-253 BALANCE SHEETS Savannah Electric and Power Company II-254 BALANCE SHEETS Savannah Electric and Power Company II-255 BALANCE SHEETS Savannah Electric and Power Company II-256 SAVANNAH ELECTRIC AND POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-257 SAVANNAH ELECTRIC AND POWER COMPANY SECURITIES RETIRED DURING 1993 POLLUTION CONTROL BONDS II-258 PART III Items 10, 11, 12 and 13 for SOUTHERN are incorporated by reference to ELECTION OF DIRECTORS in SOUTHERN's definitive Proxy Statement relating to the 1994 annual meeting of stockholders. Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS ALABAMA (a) (1) Identification of directors of ALABAMA. ELMER B. HARRIS (1) President and Chief Executive Officer of ALABAMA Age 54 Served as Director since 3-1-89. BILL M. GUTHRIE Executive Vice President of ALABAMA Age 60 Served as Director since 12-16-88 EDWARD L. ADDISON (2) Age 63 Served as Director since 11-1-83 WHIT ARMSTRONG (2) Age 46 Served as Director since 9-24-82 PHILIP E. AUSTIN (2) Age 52 Served as Director since 1-25-91 MARGARET A. CARPENTER (2) Age 69 Served as Director since 2-26-93 PETER V. GREGERSON, SR. (2) Age 65 Served as Director since 10-22-93 CRAWFORD T. JOHNSON, III (2) Age 68 Served as Director since 4-18-69 CARL E. JONES, JR. (2) Age 53 Served as Director since 4-22-88 WALLACE D. MALONE, JR. (2) Age 57 Served as Director since 6-22-90 WILLIAM V. MUSE (2) Age 54 Served as Director since 2-26-93 JOHN T. PORTER (2) Age 62 Served as Director since 10-22-93 GERALD H. POWELL (2) Age 67 Served as Director since 2-28-86 ROBERT D. POWERS (2) Age 43 Served as Director since 1-24-92 JOHN W. ROUSE (2) Age 56 Served as Director since 4-22-88 WILLIAM J. RUSHTON, III (2) Age 64 Served as Director Since 9-18-70 JAMES H. SANFORD (2) Age 49 Served as Director since 8-1-83 JOHN C. WEBB, IV (2) Age 51 Served as Director since 4-22-77 LOUIS J. WILLIE (2) Age 70 Served as Director since 3-23-84 JOHN W. WOODS (2) Age 62 Served as Director since 4-20-73 (1) Previously served as Director of ALABAMA from 1980 to 1985. (2) No position other than Director. Each of the above is currently a director of ALABAMA, serving a term running from the last annual meeting of ALABAMA's stockholder (April 23, 1993) for III-1 meeting of ALABAMA's stockholder (April 23, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for the individuals elected in October 1993. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of ALABAMA acting solely in their capacities as such. (b)(1) Identification of executive officers of ALABAMA. ELMER B. HARRIS (1) President, Chief Executive Officer and Director Age 54 Served as Executive Officer since 3-1-89 BANKS H. FARRIS Senior Vice President Age 59 Served as Executive Officer since 12-3-91 WILLIAM B. HUTCHINS, III Senior Vice President and Chief Financial Officer Age 50 Served as Executive Officer since 12-3-91 T. HAROLD JONES Senior Vice President Age 63 Served as Executive Officer since 12-1-91 CHARLES D. MCCRARY Senior Vice President Age 42 Served as Executive Officer since 1-1-91 (1) Previously served as executive officer of ALABAMA from 1979 to 1985. Each of the above is currently an executive officer of ALABAMA, serving a term running from the last annual meeting of the directors (April 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of ALABAMA acting solely in their capacities as such. (c)(1) Identification of certain significant employees. None. (d)(1) Family relationships. None. (e)(1) Business experience. ELMER B. HARRIS - Elected in 1989; Chief Executive Officer. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. Director of SOUTHERN and AmSouth Bancorporation. BILL M. GUTHRIE - Elected in 1988; also served since 1991 as Chief Production Officer of SOUTHERN system and Executive Vice President and Chief Production Officer of SCS; Vice President of SOUTHERN, GULF, MISSISSIPPI and SAVANNAH and Executive Vice President of GEORGIA. Responsible primarily for providing overall management of materials management, fuel services, operating and planning services, fossil, hydro and bulk power operations of the Southern electric system. EDWARD L. ADDISON - Elected in 1983; President of SOUTHERN from 1983 until elected Chairman of the Board in 1994. Director of SOUTHERN, GEORGIA, Phelps Dodge Corporation, Protective Life Corporation, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia and CSX Corporation. WHIT ARMSTRONG - President, Chairman and Chief Executive Officer of The Citizens Bank, Enterprise, Alabama. Also, President and Chairman of the Board of Enterprise Capital Corporation, Inc. PHILIP E. AUSTIN - Chancellor, The University of Alabama System. Previously President and Chancellor of Colorado State University. MARGARET A. CARPENTER - President, Compos-it, Inc. (typographics), Montgomery, Alabama. PETER V. GREGERSON, SR. - Chairman Emeritus of Gregerson's Foods, Inc. (retail groceries), Gadsden, Alabama. Director of AmSouth Bank of Gadsden, Alabama. III-2 CRAWFORD T. JOHNSON, III - Chairman of Coca-Cola Bottling Company United, Inc., Birmingham, Alabama. Director of Protective Life Corporation, AmSouth Bancorporation and Russell Corporation. CARL E. JONES, JR. - Chairman and Chief Executive Officer of First Alabama Bank, Mobile, Alabama. WALLACE D. MALONE, JR. - Chairman and Chief Executive Officer of SouthTrust Corporation, bank holding company, Birmingham, Alabama. WILLIAM V. MUSE - President and Chief Executive Officer of Auburn University. He previously served as President of the University of Akron from 1984 to 1992. JOHN T. PORTER - Pastor of Sixth Avenue Baptist Church, Birmingham, Alabama. Director of Citizen Federal Bank. GERALD H. POWELL - President, Dixie Clay Company of Alabama, Inc. (refractory clay producer), Jacksonville, Alabama. ROBERT D. POWERS - President, The Eufaula Agency, Inc. (real estate and insurance), Eufaula, Alabama. JOHN W. ROUSE - President and Chief Executive Officer of Southern Research Institute (non-profit research institute), Birmingham, Alabama. Director of Protective Life Corporation. WILLIAM J. RUSHTON, III - Chairman of the Board, Protective Life Corporation (insurance holding company), Birmingham, Alabama. Director of SOUTHERN and AmSouth Bancorporation. JAMES H. SANFORD - President, HOME Place Farms Inc. (diversified farmers and ginners), Prattville, Alabama. JOHN C. WEBB, IV - President, Webb Lumber Company, Inc. (wholesale lumber), Demopolis, Alabama. LOUIS J. WILLIE - Chairman of the Board and President of Booker T. Washington Insurance Co. Director of SOUTHERN. JOHN W. WOODS - Chairman and Chief Executive Officer, AmSouth Bancorporation (multi-bank holding company), Birmingham, Alabama. Director of Protective Life Corporation. BANKS H. FARRIS - Elected in 1991; responsible primarily for providing the overall management of the Human Resources, Information Resources, Power Delivery and Marketing Departments and the six geographic divisions. He previously served as Vice President - Human Resources from 1989 to 1991 and Division Vice President from 1985 to 1989. WILLIAM B. HUTCHINS, III - Elected in 1991; Chief Financial Officer, responsible primarily for providing the overall management of accounting and financial planning activities. He previously served as Vice President and Treasurer from 1983 to 1991. T. HAROLD JONES - Elected in 1991; responsible primarily for providing the overall management of the Fossil Generation, Hydro Generation, Power Generation Services and Fuels Departments. He previously served as Vice President - Fossil Generation from 1986 to 1991. CHARLES D. MCCRARY - Elected in 1991; responsible for the External Relations Department, Operating Services and Corporate Services. Also, assumes responsibility for financial matters while Mr. Hutchins is on medical leave. He previously served as Vice President of Administrative Services - Nuclear of SCS from 1988 to 1991. (f)(1) Involvement in certain legal proceedings. None. III-3 GEORGIA (a)(2) Identification of directors of GEORGIA. H. ALLEN FRANKLIN President and Chief Executive Officer. Age 49 Served as Director since 1-1-94. WARREN Y. JOBE Executive Vice President, Treasurer and Chief Financial Officer. Age 53 Served as Director since 8-1-82 EDWARD L. ADDISON (1) Age 63 Served as Director since 11-1-83 BENNETT A. BROWN (1) Age 64 Served as Director since 5-15-80 WILLIAM P. COPENHAVER (1) Age 69 Served as Director since 6-18-86 A. W. DAHLBERG (1) Age 53 Served as Director since 6-1-88 WILLIAM A. FICKLING, JR. (1) Age 61 Served as Director since 4-18-73 L. G. HARDMAN, III (1) Age 54 Served as Director since 6-25-79 JAMES R. LIENTZ, JR. (1) Age 50 Served as Director since 7-1-93 WILLIAM A. PARKER, JR. (1) Age 66 Served as Director since 5-19-65 G. JOSEPH PRENDERGAST (1) Age 48 Served as Director since 1-20-93 HERMAN J. RUSSELL (1) AGE 63 Served as Director since 5-18-88 GLORIA M. SHATTO (1) Age 62 Served as Director since 2-20-80 ROBERT STRICKLAND (1) Age 66 Served as Director since 11-21-79 WILLIAM JERRY VEREEN (1) Age 53 Served as Director since 5-18-88 THOMAS R. WILLIAMS (1) Age 65 Served as Director since 3-17-82 (1) No position other than Director. Each of the above is currently a director of GEORGIA, serving a term running from the last annual meeting of GEORGIA's stockholder (May 19, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except Messrs. Franklin and Lientz. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GEORGIA acting solely in their capacities as such. (b)(2) Identification of executive officers of GEORGIA. H. ALLEN FRANKLIN President, Chief Executive Officer and Director Age 49 Served as Executive Officer since 1-1-94 WARREN Y. JOBE Executive Vice President, Treasurer, Chief Financial Officer and Director Age 53 Served as Executive Officer since 5-19-82 III-4 DWIGHT H. EVANS Executive Vice President - External Affairs Age 45 Served as Executive Officer since 4-19-89 GENE R. HODGES Executive Vice President - Customer Operations Age 55 Served as Executive Officer since 11-19-86 KERRY E. ADAMS Senior Vice President - Fossil and Hydro Power Age 49 Served as Executive Officer since 5-1-89 WAYNE T. DAHLKE Senior Vice President - Power Delivery Age 53 Served as Executive Officer since 4-19-89 JAMES K. DAVIS Senior Vice President - Corporate Relations Age 53 Served as Executive Officer since 10-1-93 ROBERT H. HAUBEIN Senior Vice President - Administrative Services Age 54 Served as Executive Officer since 2-19-92 GALE E. KLAPPA Senior Vice President - Marketing Age 43 Served as Executive Officer since 2-19-92 FRED D. WILLIAMS Senior Vice President - Bulk Power Markets Age 49 Served as Executive Officer since 11-18-92 Each of the above is currently an executive officer of GEORGIA, serving a term running from the last annual meeting of the directors (May 19,1993) for one year until the next annual meeting or until his successor is elected and qualified, except Messrs. Franklin and Davis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GEORGIA acting solely in their capacities as such. (c)(2) Identification of certain significant employees. None. (d)(2) Family relationships. None. (e)(2) Business experience. H. ALLEN FRANKLIN - President and Chief Executive Officer since January 1994. He previously served as President and Chief Executive Officer of SCS from 1988 through 1993. Director of SOUTHERN and SouthTrust Bank. WARREN Y. JOBE - Executive Vice President and Chief Financial Officer since 1982 and Treasurer since 1992. Responsible for financial and accounting operations and planning, internal auditing, procurement, corporate secretary and treasury operations. EDWARD L. ADDISON - President of SOUTHERN from 1983 until his election as Chairman of Board in 1994. Director of SOUTHERN, ALABAMA, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia, Phelps Dodge Corporation, Protective Life Corporation and CSX Corporation. BENNETT A. BROWN - Retired from serving as Chairman of the Board of NationsBank on December 31, 1992. Previously Chairman of the Board and Chief Executive Officer of C&S/Sovran Corporation. Director of Confederation Life Insurance Company. WILLIAM P. COPENHAVER - Director, Arcadian Fertilizer, L.P. (agricultural and industrial chemicals). Director of SOUTHERN and Georgia Bank & Trust Company. A. W. DAHLBERG - President of SOUTHERN effective in 1994. He previously served as President and Chief Executive Officer of GEORGIA from 1988 through 1993. Director of SOUTHERN, Trust Company Bank, Trust Company of Georgia, Protective Life Corporation and Equifax, Inc. WILLIAM A. FICKLING, JR. - Chairman of the Board, Mulberry Street Investment Company, Macon, Georgia, and Co-chairman of Beech Street Corporation (insurance). III-5 L. G. HARDMAN, III - Chairman of the Board of First National Bank of Commerce, Georgia and Chairman of the Board and Chief Executive Officer of First Commerce Bancorp. Chairman of the Board, President and Treasurer of Harmony Grove Mills, Inc. (real estate investments). Director of SOUTHERN. JAMES R. LIENTZ, JR. - President of NationsBank of Georgia since 1993. He previously served as President and Chief Executive Officer of former Citizens & Southern Bank of South Carolina (now NationsBank) from 1990 to 1993, and from 1987 to 1990, he was head of Corporate Bank Group of NationsBank of Georgia, N.A. WILLIAM A. PARKER, JR. - Chairman of the Board, Cherokee Investment Company, Inc. (private investments), Atlanta, Georgia. Director of SOUTHERN, Genuine Parts Company, Life Insurance Company of Georgia, First Union Real Estate Investment Trust, Atlantic Realty Company, ING North America Insurance Company, Post Properties, Inc. and Haverty Furniture Companies, Inc. G. JOSEPH PRENDERGAST - President and Chief Executive Officer, Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. since 1993. From 1988 to 1993, he served as Executive Vice President of Wachovia Corporation and President of Wachovia Corporate Services, Inc. HERMAN J. RUSSELL - Chairman of the Board and Chief Executive Officer, H. J. Russell & Company (construction), Atlanta, Georgia. Chairman of the Board, Citizens Trust Bank, and Citizens Bancshares Corporation Atlanta, Georgia. Director of Wachovia Corporation. GLORIA M. SHATTO - President, Berry College, Mount Berry, Georgia. Director of SOUTHERN, Becton Dickinson & Company, Kmart Corporation and Texas Instruments, Inc. ROBERT STRICKLAND - Retired Chairman of the Board and Chief Executive Officer of SunTrust Banks, Inc. Director of Georgia US Corporation, Equifax, Inc., Life Insurance Company of Georgia, Oxford Industries, Inc. and The Investment Centre. WILLIAM JERRY VEREEN - President and Chief Executive Officer of Riverside Manufacturing Company (manufacture and sale of uniforms), Moultrie, Georgia. Director of Gerber Garment Technology, Inc. and Textile Clothing Technology Corp. THOMAS R. WILLIAMS - President of The Wales Group, Inc. (investments) Atlanta, Georgia. Director of ConAgra, Inc., BellSouth Corporation, National Life Insurance Company of Vermont, AppleSouth, Inc., and American Software, Inc. DWIGHT H. EVANS - Executive Vice President - External Affairs since 1989. Senior Vice President - Public Affairs from 1988 to 1989. GENE R. HODGES - Executive Vice President - Customer Operations since 1992. Senior Vice President - Region/Land Operations from 1990 to 1992. Senior Vice President - Division Operations from 1986 to 1990. KERRY E. ADAMS - Senior Vice President - Fossil and Hydro Power since 1989. WAYNE T. DAHLKE - Senior Vice President - Power Delivery since February 1992. Senior Vice President - Marketing from 1989 to 1992. JAMES K. DAVIS - Senior Vice President - Corporate Relations since October 1993. Vice President of Corporate Relations from 1988 to 1993. ROBERT H. HAUBEIN - Senior Vice President - Administrative Services since 1992. Vice President - Northern Region from 1990 to 1992. Division Vice President of ALABAMA from 1985 to 1990. GALE E. KLAPPA - Senior Vice President - Marketing since 1992. Vice President - - Public Relations of SCS from 1981 to 1992. FRED D. WILLIAMS - Senior Vice President - Bulk Markets since 1992. Vice President - Bulk Power Markets from 1984 to 1992. (f)(2) Involvement in certain legal proceedings. None. III-6 GULF (a)(3) Identification of directors of GULF. D. L. MCCRARY (1) Chairman of the Board and Chief Executive Officer Age 64 Served as Director since 4-28-83 TRAVIS J. BOWDEN President Age 55 Served as Director since 2-1-94 PAUL J. DENICOLA (2) Age 45 Served as Director since 4-19-91 REED BELL, SR., M.D. (2) Age 67 Served as Director since 1-17-86 FRED C. DONOVAN, SR. (2) Age 53 Served as Director since 1-18-91 W. D. HULL, JR. (2) Age 61 Served as Director since 10-14-83 C. W. RUCKEL (2) Age 66 Served as Director since 4-20-62 J. K. TANNEHILL (2) Age 60 Served as Director since 7-19-85 (1) Retires May 1, 1994. (2) No position other than Director. Each of the above is currently a director of GULF, serving a term running from the last annual meeting of GULF's stockholder (June 29, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for Mr. Bowden. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GULF acting solely in their capacities as such. (b)(3) Identification of executive officers of GULF. D. L. MCCRARY Chairman of the Board and Chief Executive Officer Age 64 Served as Executive Officer since 5-1-83 TRAVIS J. BOWDEN President Age 55 Served as Executive Officer since 2-1-94 F. M. FISHER, JR. Vice President - Employee and External Relations Age 45 Served as Executive Officer since 5-19-89 JOHN E. HODGES, JR. Vice President - Customer Operations Age 50 Served as Executive Officer since 5-19-89 G. EDISON HOLLAND, JR. Vice President and Corporate Counsel Age 41 Served as Executive Officer since 4-25-92 EARL B. PARSONS, JR. Vice President - Power Generation and Transmission Age 55 Served as Executive Officer since 4-14-78 A. E. SCARBROUGH Vice President - Finance Age 57 Served as Executive Officer since 9-21-77 Each of the above is currently an executive officer of GULF, serving a term running from the last annual meeting of the directors (July 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except for Mr. Bowden. III-7 There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GULF acting solely in their capacities as such. (c)(3) Identification of certain significant employees. None. (d)(3) Family relationships. None. (e)(3) Business experience. D. L. MCCRARY - Elected Chairman of the Board effective February 1994. He previously served as President and Chief Executive Officer from 1983 to 1994; responsible primarily for formation of overall corporate policy. TRAVIS J. BOWDEN - Elected President effective February 1994 and, upon Mr. McCrary's retirement May 1994, Chief Executive Officer. He previously served as Executive Vice President of ALABAMA from 1985 to 1994. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 through 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, MISSISSIPPI and SAVANNAH. REED BELL, SR., M.D. - Medical Doctor and since 1989, employee of the State of Florida. He serves as Medical Director of Children's Medical Services, District 1. He previously served as Medical Director of the Escambia County Public Health Unit until July 1992. He also previously maintained a private medical practice and served as Medical Director of Children's Medical Services from 1988 to 1989. FRED C. DONOVAN, SR. - President of Baskerville - Donovan, Inc., Pensacola, Florida, an architectural and engineering firm. Director of Baptist Health Care, Inc. W. D. HULL, JR. - Vice Chairman of the Sun Bank/West Florida, Panama City, Florida. He previously served as President and Chief Executive Officer and Director of the Sun Commercial Bank, Panama City, Florida from 1987 to 1992. C. W. RUCKEL - Chairman of the Board of The Vanguard Bank and Trust Company, Valparaiso, Florida. President and owner of Ruckel Properties, Inc., Valparaiso, Florida. J. K. TANNEHILL - President and Chief Executive Officer of Tannehill International Industries, Lynn Haven, Florida. He previously served as President and Chief Executive Officer of Stock Equipment Company, Chagrin Falls, Ohio, until 1991. Director of Sun Bank/West Florida, Panama City, Florida. F. M. FISHER, JR. - Elected Vice President - Employee and External Relations in 1989. He previously served as General Manager of Central Division from 1988 to 1989. JOHN E. HODGES, JR. - Elected Vice President - Customer Operations in 1989. He previously served as General Manager of Western Division from 1986 to 1989. G. EDISON HOLLAND, JR. - Elected Vice President and Corporate Counsel in 1992; responsible for all legal matters associated with GULF and serves as compliance officer. Also served, since 1982, as a partner in the law firm, Beggs & Lane. EARL B. PARSONS, JR. - Elected Vice President - Power Generation and Transmission in 1989; responsible for generation and transmission of electrical energy. He previously served as Vice President - Electric Operations from 1978 to 1989. A. E. SCARBROUGH - Elected Vice President - Finance in 1980; responsible for all accounting and financial services of GULF. (f)(3) Involvement in certain legal proceedings. None. III-8 MISSISSIPPI (a)(4) Identification of directors of MISSISSIPPI. DAVID M. RATCLIFFE President and Chief Executive Officer Age 45 Served as Director since 4-24-91 PAUL J. DENICOLA (1) Age 45 Served as Director since 5-1-89 EDWIN E. DOWNER (1) Age 62 Served as Director since 4-24-84 ROBERT S. GADDIS (1) Age 62 Served as Director since 1-21-86 WALTER H. HURT, III (1) Age 58 Served as Director since 4-6-82 AUBREY K. LUCAS (1) Age 59 Served as Director since 4-24-84 EARL D. MCLEAN, JR. (1) Age 68 Served as Director since 10-21-78 GERALD J. ST. Pe (1) Age 54 Served as Director since 1-21-86 LEO W. SEAL, JR. (1) Age 69 Served as Director since 4-4-67 N. EUGENE WARR (1) Age 58 Served as Director since 1-21-86 (1) No position other than Director. Each of the above is currently a director of MISSISSIPPI, serving a term running from the last annual meeting of MISSISSIPPI's stockholder (April 6, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he or she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of MISSISSIPPI acting solely in their capacities as such. (b)(4) Identification of executive officers of MISSISSIPPI. DAVID M. RATCLIFFE President, Chief Executive Officer and Director Age 45 Served as Executive Officer since 4-24-91 H. E. BLAKESLEE Vice President - Customer Services and Marketing Age 53 Served as Executive Officer since 1-25-84 THOMAS A. FANNING Vice President and Chief Financial Officer Age 37 Served as Executive Officer since 4-1-92 DON E. MASON Vice President - External Affairs and Corporate Services Age 52 Served as Executive Officer since 7-27-83 Each of the above is currently an executive officer of MISSISSIPPI, serving a term running from the last annual meeting of the directors (April 28, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of MISSISSIPPI acting solely in their capacities as such. (c)(4) Identification of certain significant employees. None. (d)(4) Family relationships. None. (e)(4) Business experience. III-9 DAVID M. RATCLIFFE - President and Chief Executive Officer since 1991. He previously served as Executive Vice President of SCS from 1989 to 1991 and Vice President of SCS from 1985 to 1989. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, SAVANNAH and GULF. EDWIN E. DOWNER - Business consultant specializing in economic analysis, management controls and procedural studies since 1990. President and Chief Executive Officer, Unifirst Bank for Savings, F.A., Midland Division, Meridian, Mississippi from 1985 to 1990. ROBERT S. GADDIS - President of the Trustmark National Bank - Laurel, Mississippi. WALTER H. HURT, III - President and Director of NPC Inc. (Investments). Vicar, All Saints Church, Inverness, Mississippi, and St. Thomas Church, Belzoni, Mississippi. Retired newspaper editor and publisher. AUBREY K. LUCAS - President of the University of Southern Mississippi, Hattiesburg, Mississippi. EARL D. MCLEAN, JR. - Co-owner of the T. C. Griffith Insurance Agency, Inc. (insurance and real estate), Columbia, Mississippi. Director of SOUTHERN. GERALD J. ST. Pe - President of Ingalls Shipbuilding and Corporate Vice President of Litton Industries, Inc. since 1985. Director of Merchants and Marine Bank, Pascagoula, Mississippi. LEO W. SEAL, JR. - Chairman of the Board and Chief Executive Officer of Hancock Bank, Gulfport, Mississippi, and Chairman of the Board of Harrison Life Insurance Company. Director of Hancock Bank and Bank of Wiggins. N. EUGENE WARR - Retailer (Biloxi and Gulfport, Mississippi.) Chairman of the Board of First Jefferson Corporation and the Jefferson Bank of Biloxi, Mississippi. H. E. BLAKESLEE - Elected Vice President in 1984. Primarily responsible for rate design, economic analysis and revenue forecasting, economic development, marketing and district operations. THOMAS A. FANNING - Elected Vice President in 1992; responsible primarily for accounting, treasury, finance, information resources and risk management. He previously served as Treasurer of SEI from 1986 to 1992 and Director of Corporate Finance of SCS from 1988 to 1992. DON E. MASON - Elected Vice President in 1983. Primarily responsible for the external affairs functions, including governmental and regulatory affairs, corporate communications, security, materials and general services, as well as the human resources function. (f)(4) Involvement in certain legal proceedings. None. SAVANNAH (a)(5) Identification of directors of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President and Chief Executive Officer Age 61 Served as Director since 8-31-82 HELEN QUATTLEBAUM ARTLEY (1) Age 66 Served as Director since 5-17-77 PAUL J. DENICOLA (1) Age 45 Served as Director since 3-14-91 BRIAN R. FOSTER (1) Age 44 Served as Director since 5-16-89 WALTER D. GNANN (1) Age 58 Served as Director since 5-17-83 JOHN M. MCINTOSH (1) Age 69 Served as Director since 2-27-68 III-10 ROBERT B. MILLER, III (1) Age 48 Served as Director since 5-17-83 JAMES M. PIETTE (1) Age 69 Served as Director since 6-12-73 ARNOLD M. TENEBAUM (1) Age 57 Served as Director since 5-17-77 FREDERICK F. WILLIAMS, JR. (1) Age 66 Served as Director since 7-2-75 (1) No Position other than Director. Each of the above is currently a director of SAVANNAH, serving a term running from the last annual meeting of SAVANNAH's stockholder (May 18, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of SAVANNAH acting solely in their capacities as such. (b)(5) Identification of executive officers of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President, Chief Executive Officer and Director Age 61 Served as Executive Officer since 2-15-72 W. MILES GREER Vice President - Marketing and Customer Services Age 50 Served as Executive Officer since 11-20-85 LARRY M. PORTER Vice President - Operations Age 49 Served as Executive Officer since 7-1-91 KIRBY R. WILLIS Vice President, Treasurer and Chief Financial Officer Age 42 Served as Executive Officer since 1-1-94 Each of the above is currently an executive officer of SAVANNAH, serving a term running from the last annual meeting of the directors (May 18, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except Mr. Willis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of SAVANNAH acting solely in their capacities as such. (c)(5) Identification of certain significant employees. None. (d)(5) Family relationships. None. (e)(5) Business experience. ARTHUR M. GIGNILLIAT, JR. - Elected President and Chief Executive Officer in 1985. Director of Savannah Foods and Industries, Inc. HELEN QUATTLEBAUM ARTLEY - Homemaker and Civic Worker. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, GULF and MISSISSIPPI. BRIAN R. FOSTER - President of NationsBank of Georgia, N.A., in Savannah since 1988. WALTER D. GNANN - President of Walt's TV, Appliance and Furniture Co., Inc., Springfield, Georgia. Past Chairman of the Development Authority of Effingham County, Georgia. III-11 JOHN M. MCINTOSH - Chairman of the Executive Committee, SAVANNAH; retired Chairman of the Board of Directors and Chief Executive Officer, SAVANNAH from 1974 to 1984. Director of SOUTHERN. ROBERT B. MILLER, III - President of American Builders of Savannah. JAMES M. PIETTE - Vice President - Special Projects, Union Camp Corporation, since 1989. Retired Vice Chairman, Board of Directors, Union Camp Corporation from 1987 to 1989. ARNOLD M. TENENBAUM - President of Chatham Steel Corporation. Director of First Union National Bank of Georgia and Savannah Foods and Industries, Inc. FREDERICK F. WILLIAMS, JR. - Retired Partner and Consultant, Hilb, Rogal and Hamilton Employee Benefits, Incorporated (Insurance Brokers), formerly Jones, Hill & Mercer. W. MILES GREER - Vice President - Marketing and Customer Services effective January 1994. Formerly served as Vice President - Economic Development and Corporate Services from 1989 through 1993 and Vice President - Economic Development and Governmental Affairs from 1985 to 1989. LARRY M. PORTER - Vice President - Operations since 1991. Responsible for managing the areas of fuel procurement, power production, transmission and distribution, engineering and system operation. Previously he served as Assistant Plant Manager of GEORGIA's Plant Scherer from 1984 to 1991. KIRBY R. WILLIS - Vice President, Treasurer and Chief Financial Officer effective January 1994. Responsible for all financial activities, Information Resources, Human Resources, Corporate Services, and Environmental Affairs and Safety. He previously served as Treasurer, Controller and Assistant Secretary from 1991 to 1993 and Treasurer and Secretary from 1987 to 1991. (f)(5) Involvement in certain legal proceedings. None. III-12 ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION (A) SUMMARY COMPENSATION TABLES. The following tables set forth information concerning the Chief Executive Officer and the four most highly compensated executive officers for each of the operating affiliates (ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH), serving as of December 31, 1993 whose total annual salary and bonus exceeded $100,000. No information is provided for any person for any year in which such person did not serve as an executive officer of the operating affiliate. The number of SOUTHERN common shares do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. KEY TERMS used in this Item will have the following meanings:- AME........... ABOVE-MARKET EARNINGS ON DEFERRED COMPENSATION ESP........... EMPLOYEE SAVINGS PLAN ESOP.......... EMPLOYEE STOCK OWNERSHIP PLAN SBP........... SUPPLEMENTAL BENEFIT PLAN VBP........... VEHICLE BUYOUT PROGRAM ALABAMA SUMMARY COMPENSATION TABLE III-13 ALABAMA SUMMARY COMPENSATION TABLE (CONTINUED) (1) Tax reimbursement by ALABAMA and certain personal benefits, including membership fee of $28,402 for Mr. Jones in 1992. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) ALABAMA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans), and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- E. B. Harris $6,746 $1,709 $12,933 $18,000 T. J. Bowden 8,369 1,709 3,193 18,000 B. H. Farris 7,193 1,499 726 18,000 T. H. Jones 6,908 1,331 754 5,100 W. B. Hutchins, III 6,746 1,400 671 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective January 31, 1994, Mr. Bowden resigned to become president of GULF. III-14 GEORGIA SUMMARY COMPENSATION TABLE (1) Due to the pay schedules at GEORGIA, 1992 salary reflects one additional pay period compared with 1991. (2) Tax reimbursement by GEORGIA on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (3) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (4) GEORGIA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- A. W. Dahlberg $6,746 $1,709 $18,092 $18,000 D. H. Evans 8,592 1,709 1,218 18,000 W. Y. Jobe 7,667 1,709 1,882 18,000 G. R. Hodges 7,349 1,620 3,660 18,000 K. E. Adams 7,204 1,634 1,462 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (5) Effective December 31, 1993, Mr. Dahlberg resigned to become president of SOUTHERN. III-15 GULF SUMMARY COMPENSATION TABLE (1) Tax reimbursement by GULF on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) GULF contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- D. L. McCrary $9,300 $1,709 $6,057 $ 2,788 G. E. Holland, Jr. 4,652 - - 16,363 E. B. Parsons, Jr 6,948 1,709 410 16,363 A. E. Scarbrough 6,746 1,338 282 16,363 J. E. Hodges, Jr. 6,651 1,313 - 16,363 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Employee and executive officer of GULF since April 25, 1992. Not eligible to participate in the Long-Term Incentive Plan until January 1, 1993. (5) "All Other Compensation" previously reported as $4,149 for Mr. Holland in the Form 10-K for the year ended December 31, 1992, should have been $0 since Mr. Holland was not yet eligible to participate in ESP and ESOP. III-16 MISSISSIPPI SUMMARY COMPENSATION TABLE (1) Tax reimbursement by MISSISSIPPI on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) MISSISSIPPI contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- David M. Ratcliffe $7,895 $1,709 $2,774 $5,509 R. G. Dawson 6,746 1,252 - 7,045 H. E. Blakeslee 6,843 1,355 - 7,452 D. E. Mason 6,671 1,286 - 7,452 T. A. Fanning 5,520 1,019 - 8,116 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective March 1, 1994, Mr. Dawson resigned to become a vice president of SEI. (5) Benefits under MISSISSIPPI's VBP for 1992 in the amounts of $13,169 and $12,425 to Messrs. Dawson and Fanning, respectively, previously reported in the Form 10-K for the year ended December 31, 1992, under the "Other Annual Compensation" column have been moved to the "All Other Compensation" column. III-17 SAVANNAH SUMMARY COMPENSATION TABLE (1) Tax reimbursement by SAVANNAH on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) SAVANNAH contributions to the ESP, under Section 401(k) of the Internal Revenue Code, ESOP, AME and payments under a VBP for the following:- Name ESP ESOP AME VBP - ---- --- ---- --- --- A. M. Gignilliat $6,746 $3,092 $7,479 $14,195 E. O. Veale 6,163 2,359 5,702 - L. M. Porter 4,943 1,774 658 14,195 W. M. Greer 5,045 1,764 877 14,195 J. L. Rayburn 2,284 1,650 1,911 14,195 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Retired effective December 31, 1993. (5) Not eligible for Long-term Incentive Payout until January 1, 1994. (6) Resigned effective December 31, 1993. III-18 STOCK OPTION GRANTS IN 1993 (B) STOCK OPTION GRANTS. The following table sets forth all stock option grants to the named executive officers of each operating subsidiary during the year ending December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-19 STOCK OPTION GRANTS IN 1993 (1) Grants were made on July 19, 1993, and vest 25% per year on the anniversary date of the grant. Grants fully vest upon termination incident to death, disability, or retirement. The exercise price is the average of the high and low fair market value of SOUTHERN's common stock on the date granted. In accordance with the terms of the Executive Stock Plan, Mr. Jones' unexercised options expire on April 1, 1998, three years after his normal retirement date; Mr. McCrary's unexercised options expire on May 1, 1997, three years after his normal retirement date; and Mr. Gignilliat's unexercised options expire on September 3, 2000, three years after his normal retirement date. (2) A total of 179,746 stock options were granted in 1993 to key executives participating in SOUTHERN's Executive Stock Plan. (3) Based on the Black-Scholes option valuation model. The actual value, if any, an executive officer may realize ultimately depends on the market value of SOUTHERN's common stock at a future date. This valuation is provided pursuant to SEC disclosure rules and there is no assurance that the value realized will be at or near the value estimated by the Black-Scholes model. Assumptions used to calculate this value: price volatility - 12.45%; risk-free rate of return - 5.81%; dividend yield - 5.37%; and time to exercise - ten years. III-20 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (C) AGGREGATED STOCK OPTION EXERCISES. The following table sets forth information concerning options exercised during the year ending December 31, 1993, by the named executive officers and the value of unexercised options held by them as of December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-21 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (1) This represents the excess of the fair market value of SOUTHERN's common stock of $44.125 per share, as of December 31, 1993, above the exercise price of the options. One column reports the "value" of options that are vested and therefore could be exercised; the other "value" of options that are not vested and therefore could not be exercised as of December 31, 1993. (2) The "Value Realized" is ordinary income, before taxes, and represents the amount equal to the excess of the fair market value of the shares at the time of exercise over the exercise price. III-22 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 (D) LONG-TERM INCENTIVE PLANS. The following table sets forth the long-term incentive plan awards made to the named executive officers for the performance period January 1, 1993 through December 31, 1996. See next page for footnotes. III-23 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 III-24 PENSION PLAN TABLE (e)(1) The following table sets forth the estimated combined annual pension benefits under the pension and supplemental defined benefit plans in effect during 1993 for ALABAMA, GEORGIA, GULF and MISSISSIPPI. Employee compensation covered by the pension and supplemental benefit plans for pension purposes is limited to the average of the highest three of the final 10 years' base salary and wages (reported under column titled "Salary" in the Summary Compensation Tables on pages III-13 through III-18). The amounts shown in the table were calculated according to the final average pay formula and are based on a single life annuity without reduction for joint and survivor annuities (although married employees are required to have their pension benefits paid in one of various joint and survivor annuity forms, unless the employee elects otherwise with the spouse's consent) or computation of the Social Security offset which would apply in most cases. This offset amounts to one-half of the estimated Social Security benefit (primary insurance amount) in excess of $3,000 per year times the number of years of accredited service, divided by the total possible years of accredited service to normal retirement age. As of December 31, 1993, the applicable compensation levels and years of accredited service are presented in the following tables: III-25 SAVANNAH has in effect a qualified, trusteed, noncontributory, defined benefit pension plan which provides pension benefits to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. The plan provides pension benefits under a formula which includes each participant's years of service with the Southern system and average annual earnings of the highest three of the final ten years of service with the Southern system preceding retirement. Plan benefits are reduced by a portion of the benefits participants are entitled to receive under Social Security. The plan provides for reduced early retirement benefits at age 55 and a pension for the surviving spouse equal to one-half of the deceased retiree's pension. The following table sets forth the estimated annual pension benefits under the pension plan in effect during 1993 which are payable by SAVANNAH to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. (1)The number of accredited years of service includes ten years credited to Mr. Holland pursuant to a supplemental pension agreement. III-26 As of December 31, 1993, the applicable compensation levels and years of accredited service is presented in the following table: (e)(2) DEFERRED COMPENSATION PLAN; SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN. SAVANNAH has in effect a voluntary deferred compensation plan for certain executive employees pursuant to which such employees may defer a portion of their respective annual salaries. In addition, SAVANNAH has a supplemental executive retirement plan for certain of its executive employees which became effective January 1, 1984. The deferred compensation plan is designed to provide supplemental retirement or survivor benefit payments. The supplemental executive retirement plan is also designed to provide retiring executives of SAVANNAH with a supplemental retirement benefit, which, in conjunction with social security and benefits under SAVANNAH's qualified pension plan, will equal 70 percent of the highest three of the final ten years average annual compensation (including deferrals under the deferred compensation plan). Both of these plans are unfunded and the liability is payable from general funds of SAVANNAH. The deferred compensation plan became effective December 1, 1983, and all of SAVANNAH's executive officers are participating in the plan. In addition, all executives are participating in the supplemental executive retirement plan. In order to provide for its liabilities under the deferred compensation plan and the supplemental executive retirement plan, SAVANNAH has purchased life insurance on participating executive employees in actuarially determined amounts which, based upon assumptions as to mortality experience, policy dividends, tax effects, and other factors which, if realized, along with compensation deferred by employees and the death benefits payable to (1) The plan benefits are subject to the maximum benefit limitations set forth in Section 415 of the Internal Revenue Code. III-27 SAVANNAH, are expected to cover all such insurance premium payments, and all benefit payments to participants, plus a factor for the cost of funds of SAVANNAH. (f) COMPENSATION OF DIRECTORS. (1) Standard Arrangements. The following table presents compensation paid to the directors, during 1993 for service as a member of the board of directors and any board committee(s), except that employee directors received no fees or compensation for service as a member of the board of directors or any board committee. All or a portion of these fees may be deferred until membership on the board is terminated. ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH also provide retirement benefits to non-employee directors who are credited with a minimum of 60 months of service on the board of directors of one or more system companies, under the Outside Directors Pension Plan. Eligible directors are entitled to benefits under the Plan upon retirement from the board on the retirement date designated in the respective companies by-laws. The annual benefit payable ranges from 75 to 100 percent of the annual retainer fee in effect on the date of retirement, based upon length of service. Payments continue for the greater of the lifetime of the participant or 10 years. (2) Other Arrangements. No director received other compensation for services as a director during the year ending December 31, 1993 in addition to or in lieu of that specified by the standard arrangements specified above. (1) Committee Chairmen receive an additional $500 per year fee. (2) Established for period September 15, 1993 through May 31, 1994. (3) Chairman of Executive Committee receives an additional $3,000 per month fee. III-28 (g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS. None. (h) REPORT ON REPRICING OF OPTIONS. None. (i) ADDITIONAL INFORMATION WITH RESPECT TO COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISION. ALABAMA Elmer B. Harris serves on the Compensation Committee of AmSouth Bancorporation. John W. Woods, a director of ALABAMA is an executive officer of AmSouth Bancorporation. GULF Messrs. Paul J. DeNicola and Douglas L. McCrary are ex officio members of its Compensation Committee. III-29 ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. SOUTHERN is the beneficial owner of 100% of the outstanding common stock of registrants ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH. (B) SECURITY OWNERSHIP OF MANAGEMENT. The following table shows the number of shares of SOUTHERN common stock and operating subsidiary preferred stock owned by the directors, nominees and executive officers as of December 31, 1993. It is based on information furnished by the directors, nominees and executive officers. The shares owned by all directors, nominees and executive officers as a group constitute less than one percent of the total number of shares of the respective classes outstanding on December 31, 1993. The number of SOUTHERN common shares shown do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN'S board of directors in January, 1994. III-30 III-31 III-32 III-33 (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). (2) The shares shown include shares of common stock of which certain directors and executive officers have the right to acquire beneficial ownership within 60 days pursuant to the Executive Stock Plan, as follows: Mr. Addison, 86,357 shares; Mr. Blakeslee, 660 shares; Mr. Bowden, 5,763 shares; Mr. Dahlberg, 4,278 shares; Mr. Farris, 863 shares; Mr. Gignilliat, 8,556 shares; Mr. Guthrie 15,720 shares; Mr. Harris, 14,215 shares; Mr. Haubein, 835 shares; Mr. Hodges, 5,429 shares; Mr. Holland, 698 shares; Mr. Hutchins, 706 shares; Mr. Jones, 848 shares; Mr. Klappa, 671 shares, Mr. C. D. McCrary, 691 shares; Mr. D. L. McCrary, 9,668 shares; and Mr. Ratcliffe, 5,643 shares. Also included are shares of SOUTHERN common stock held by the spouses of the following directors: Mr. Addison, 670 shares; Mr. Copenhaver, 350 shares; Mr. Harris, 155 shares; Mr. Parker, 22 shares; and Dr. Shatto, 5,067 shares. III-34 (C) CHANGES IN CONTROL. The operating affiliates know of no arrangements which may at a subsequent date result in any change in control. GEORGIA'S Mr. Russell failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MISSISSIPPI'S Messrs. McLean, Jr., Hurt and Seal, Jr. each failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. SAVANNAH'S Mr. Gnann failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MR. DENICOLA, a director of GULF, MISSISSIPPI and SAVANNAH, failed to file on a timely basis a single report, disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. III-35 ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALABAMA (a) Transactions with management and others. During 1993, ALABAMA, in the ordinary course of business, paid premiums amounting to approximately $400,000 for various types of insurance policies purchased from Protective Life Insurance Company, a subsidiary of Protective Life Corporation, a company in which Mr. William J. Rushton, III, a director of ALABAMA, owns an interest and of which he serves as Chairman. The firm of Inzer, Stivender, Haney & Johnson, P.A., performed certain legal services for ALABAMA during 1993. Mr. James C. Inzer, Jr., partner in this firm, is also a director of ALABAMA. ALABAMA purchased automobiles and parts in the amount of approximately $200,000 from companies in which Mr. Blount, a director of ALABAMA, owns 85% interests. ALABAMA purchased electrical supplies in the amount of approximately $200,000 from L & K Electric Supply Company, Ltd. during 1993. Mr. Willie, director of ALABAMA and SOUTHERN, owns an interest in and serves as president of this firm. ALABAMA believes that these transactions have been on terms representing competitive market prices that are no less favorable than those available from others. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GEORGIA (a) Transactions with management and others. In 1993, GEORGIA was indebted in a maximum amount of $105 million to Wachovia Bank and its affiliates, of which G. Joseph Prendergast serves as President and Chief Executive Officer of Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. In 1993, GEORGIA was indebted in a maximum amount of $285 million to NationsBank and its affiliates of which Mr. James R. Lientz, Jr. serves as President of NationsBank of Georgia. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GULF (a) Transactions with management and others. The firm of Beggs & Lane, P.A. serves as local counsel for GULF and received from GULF approximately $800,000 for services rendered. Mr. G. Edison Holland, Jr. is a partner in the firm and also serves as Vice President and Corporate Counsel of GULF. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. MISSISSIPPI (a) Certain business relationships. During 1993, MISSISSIPPI was indebted in a maximum amount of $12.4 million to Hancock Bank, of which Leo W. Seal, Jr. serves as Chairman of the Board and Chief Executive Officer. (b) Certain business relationships. None. (c) Indebtedness of management. None. III-36 (d) Transactions with promoters. None. SAVANNAH (a) Transactions with management and others. Mr. Tenenbaum is a Director of First Union national Bank of Georgia, and Mr. Foster is President of NationsBank of Georgia, N.A., in Savannah. During 1993, these banks furnished a number of regular banking services in the ordinary course of business to SAVANNAH. SAVANNAH intends to maintain normal banking relations with all of the aforesaid banks in the future. (b) Certain business relationships. (c) Indebtedness of management. None. (d) Transactions with promoters. None. III-37 PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report on this Form 10-K: (1) Financial Statements: Reports of Independent Public Accountants on the financial statements for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. The financial statements filed as a part of this report for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. (2) Financial Statement Schedules: Reports of Independent Public Accountants as to Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are included herein on pages IV-12 through IV-17. Financial Statement Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Index to the Financial Statement Schedules at page S-1. (3) Exhibits: Exhibits for SOUTHERN, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Exhibit Index at page E-1. (b) Reports on Form 8-K: During the fourth quarter of 1993 the registrants filed Current Reports on Form 8-K as follows: ALABAMA filed Forms 8-K dated October 27, 1993, and November 16, 1993, to facilitate security sales. GEORGIA filed a Form 8-K dated October 20, 1993, to facilitate a security sale. GULF filed a Form 8-K dated November 3, 1993, to facilitate a security sale. SAVANNAH filed a Form 8-K dated November 9, 1993, to facilitate a security sale. IV-1 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE SOUTHERN COMPANY By Edward L. Addison, Chairman By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Edward L. Addison Chairman of the Board (Principal Executive Officer) W. L. Westbrook Financial Vice President (Principal Financial and Accounting Officer) Directors: W. P. Copenhaver John M. McIntosh. A. W. Dahlberg Earl D. McLean, Jr. Paul J. DeNicola William A. Parker Jack Edwards William J. Rushton, III H. Allen Franklin Gloria M. Shatto L. G. Hardman, III Herbert Stockham Elmer B. Harris Louis J. Willie By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALABAMA POWER COMPANY By Elmer B. Harris, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Elmer B. Harris President, Chief Executive Officer and Director (Principal Executive Officer) Charles D. McCrary Senior Vice President (Principal Financial Officer) David L. Whitson Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison William V. Muse Whit Armstrong John T. Porter Philip E. Austin Gerald H. Powell Margaret A. Carpenter Robert D. Powers Peter V. Gregerson, Sr. John W. Rouse Bill M. Guthrie James H. Sanford Crawford T. Johnson, III John Cox Webb, IV Carl E. Jones, Jr. Louis J. Willie Wallace D. Malone, Jr. John W. Woods By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-2 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GEORGIA POWER COMPANY By H. Allen Franklin, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. H. Allen Franklin President, Chief Executive Officer and Director (Principal Executive Officer) Warren Y. Jobe Executive Vice President, Treasurer, Chief Financial Officer and Director (Principal Financial Officer) C. B. Harreld Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison G. Joseph Prendergast Bennett A. Brown Herman J. Russell William P. Copenhaver Gloria M. Shatto A. W. Dahlberg Robert Strickland William A. Fickling, Jr. William Jerry Vereen L. G. Hardman, III Thomas R. Williams James R. Lientz, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF POWER COMPANY By D. L. McCrary, Chairman of the Board By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. D. L. McCrary Chairman of the Board and Chief Executive Officer (Principal Executive Officer) A. E. Scarbrough Vice President - Finance (Principal Financial and Accounting Officer) Directors: Reed Bell Travis J. Bowden Paul J. DeNicola Fred C. Donovan W. D. Hull, Jr. C. W. Ruckel J. K. Tannehill By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25,1994 IV-3 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER COMPANY By David M. Ratcliffe, President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. David M. Ratcliffe President, Chief Executive Officer and Director (Principal Executive Officer) Thomas A. Fanning Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Paul J. DeNicola Edwin E. Downer Robert S. Gaddis Walter H. Hurt, III Aubrey K. Lucas Earl D. McLean, Jr. Gerald J. St. Pe' Leo W. Seal, Jr. N. Eugene Warr By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SAVANNAH ELECTRIC AND POWER COMPANY By Arthur M. Gignilliat, Jr., President By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Arthur M. Gignilliat, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Kirby R. Willis Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Helen Q. Artley Paul J. DeNicola Brian R. Foster Walter D. Gnann John M. McIntosh Robert B. Miller, III James M. Piette Arnold M. Tenenbaum Frederick F. Williams, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-4 EXHIBIT 21. SUBSIDIARIES OF THE REGISTRANTS. (1) Owned by Alabama Power Company. (2) Owned by Georgia Power Company. (3) Owned by SEI Holdings, Inc. (4) 94% owned jointly by Asociados de Electricidad, S. A. (14%) and SEI Holdings, Inc. (80%) (5) 59% owned by SEI y Asociados de Argentina, S. A. (6) Owned by SEI Holdings III, Inc. (7) 36% owned by SEI Chile, S. A. (8) Owned by SEI Holdings IV, Inc. (9) Owned jointly by Inversores de Electricidad, S. A. (15%) and SEI Bahamas Argentina I, Inc. (85%) (10) Owned by Southern Electric Bahamas Holdings, Ltd. (11) 50% owned by Southern Electric Bahamas, Ltd. (12) Owned equally by Alabama Power Company and Georgia Power Company. (13) Owned by Southern Electric International, Inc. (14) Owned by Southern Electric Wholesale Generators, Inc. IV-5 ARTHUR ANDERSEN & CO. Exhibit 23(a) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of The Southern Company and its subsidiaries and the related financial statement schedules, included in this Form 10-K, into The Southern Company's previously filed Registration Statement File Nos. 2-78617, 33-3546, 33-23152, 33-30171, 33-23153 and 33-51433. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-6 ARTHUR ANDERSEN & CO. Exhibit 23(b) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Alabama Power Company and the related financial statement schedules, included in this Form 10-K, into Alabama Power Company's previously filed Registration Statement File No. 33-49653. /s/ Arthur Andersen & Co. Birmingham, Alabama March 25, 1994 IV-7 ARTHUR ANDERSEN & CO. Exhibit 23(c) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Georgia Power Company and the related financial statement schedules, included in this Form 10-K, into Georgia Power Company's previously filed Registration Statement File No. 33-49661. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-8 ARTHUR ANDERSEN & CO. Exhibit 23(d) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Gulf Power Company and the related financial statement schedules, included in this Form 10-K, into Gulf Power Company's previously filed Registration Statement File No. 33-50165. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-9 ARTHUR ANDERSEN & CO. Exhibit 23(e) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Mississippi Power Company and the related financial statement schedules, included in this Form 10-K, into Mississippi Power Company's previously filed Registration Statement File Nos. 33-49320 and 33-49649. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-10 ARTHUR ANDERSEN & CO. Exhibit 23(f) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Savannah Electric and Power Company and the related financial statement schedules, included in this Form 10-K, into Savannah Electric and Power Company's previously filed Registration Statement File Nos. 33-45757 and 33-52509. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-11 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To The Southern Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of The Southern Company and its subsidiaries included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the consolidated financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to The Southern Company's consolidated financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to The Southern Company and its subsidiaries (pages S-2 and S-3, S-11 through S-14, S-35 through S-37, S-53, and S-59) are the responsibility of The Southern Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-12 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Alabama Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Alabama Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Alabama Power Company (pages S-4, S-15 through S-18, S-38 through S-40, S-54, and S-60) are the responsibility of Alabama Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 IV-13 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Georgia Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Georgia Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding the recoverability of Georgia Power Company's investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to Georgia Power Company's financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Georgia Power Company (pages S-5, S-19 through S-22, S-41 through S-43, S-55, and S-61) are the responsibility of Georgia Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-14 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Gulf Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Gulf Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Gulf Power Company (pages S-6, S-23 through S-26, S-44 through S-46, S-56, and S-62) are the responsibility of Gulf Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-15 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Mississippi Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Mississippi Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Mississippi Power Company (pages S-7 and S-8, S-27 through S-30, S-47 through S-49, S-57, and S-63) are the responsibility of Mississippi Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-16 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Savannah Electric and Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Savannah Electric and Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Savannah Electric and Power Company (pages S-9 and S-10, S-31 through S-34, S-50 through S-52, S-58, and S-64) are the responsibility of Savannah Electric and Power Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-17 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules I through XIV not listed above are omitted as not applicable or not required. Columns omitted from schedules filed have been omitted because the information is not applicable or not required. S-1 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) See Summary of Transactions and Notes on Page S-3 S-2 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of retirements to acquisition adjustments. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. (NOTE 1) OTHER CHANGES INCLUDE THE FOLLOWING (STATED IN THOUSANDS OF DOLLARS) S-3 ALABAMA POWER COMPANY SCHEDULE V -- UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements below include non-depreciable plant retirements. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes include a reduction to utility plant of $61,960,000 for the partial sale of Miller Steam Plant in 1992. S-4 GEORGIA POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of Plant Scherer acquisition adjustment retired for sales in 1991 and 1993. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes for 1993, include an increase to plant of $46,473,000 for the taxes applicable to capitalized AFUDC debt. S-5 GULF POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-6 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-8. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-7 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31,1993 (STATED IN THOUSANDS OF DOLLARS) S-8 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-10. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-9 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) S-10 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-11 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-12 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-13 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-14 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-15 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-16 ALABAMA POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-17 ALABAMA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-18 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-19 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-20 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-21 GEORGIA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-22 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-23 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-24 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-25 GULF POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-26 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-27 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-28 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-29 MISSISSIPPI POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PL FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-30 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-31 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-32 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-33 SAVANNAH ELECTRIC AND POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-34 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (3) See Note 1 to SOUTHERN's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (4) Represents additional funding to reserve. (5) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-35 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. (4) Capitalized. S-36 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 8 to SOUTHERN's financial statements in Item 8 herein for a description of the Gulf States settlement. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (4) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-37 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------ Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-38 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further Information. S-39 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) See Note 7 to the financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-40 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-41 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-42 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Note: (1) See Note 3 to GEORGIA's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible accounts was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. S-43 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-44 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - -------------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-45 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 7 to GULF's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-46 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-47 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ------------------ Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-48 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in thousands of Dollars) - ----------------- Notes: (1) See Note 7 to MISSISSIPPI's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-49 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-50 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ---------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-51 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-52 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end. (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) This note payable is an obligation of SEI and does not include borrowings from SOUTHERN. (4) See Note 5 to SOUTHERN's financial statements in Item 8 herein for details regarding SOUTHERN's and its subsidiaries lines of credit and general terms of commitment agreements. S-53 ALABAMA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992, 1991 (Stated in Thousands of Dollars) - ----------------- Notes: (1) At month-end. (2) Average based on daily borrowings during the period (averages and rates quoted on an actual day year basis). (3) ALABAMA also issued commercial paper during 1993, although none was outstanding at year-end. The data shown reflects the issuance of commercial paper. (4) See Note 5 to ALABAMA's financial statements in Item 8 herein for details regarding ALABAMA's lines of credit. S-54 GEORGIA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - -------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 8 to GEORGIA's financial statements in Item 8 herein for details regarding GEORGIA's lines of credit and general terms of its commitment agreements. S-55 GULF POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to GULF's financial statements in Item 8 herein for a description of this short-term indebtedness. (4) See Note 5 to GULF's financial statements in Item 8 herein for details regarding GULF's lines of credit and general terms of its commitment agreements. S-56 MISSISSIPPI POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to MISSISSIPPI's financial statements in Item 8 herein for details regarding MISSISSIPPI's lines of credit and general terms of its commitment agreements. S-57 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to SAVANNAH's financial statements in Item 8 herein for details regarding SAVANNAH's lines of credit and general terms of its commitment agreements. S-58 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-59 ALABAMA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-60 GEORGIA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-61 GULF POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-62 MISSISSIPPI POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-63 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-64 EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the SEC, respectively, as the exhibits and in the file numbers indicated and are incorporated herein by reference. Reference is made to a duplicate list of exhibits being filed as a part of this Form 10-K, which list, prepared in accordance with Item 601 of Regulation S-K of the SEC, immediately precedes the exhibits being physically filed with this Form 10-K. (3) ARTICLES OF INCORPORATION AND BY-LAWS SOUTHERN (a) 1 - Composite Certificate of Incorporation of SOUTHERN, reflecting all amendments to date. (Designated in Registration No. 33-3546 as Exhibit 4(a), in Certificate of Notification, File No. 70-7341, as Exhibit A and in Certificate of Notification, File No. 70-8181, as Exhibit A.) (a) 2 - By-laws of SOUTHERN as amended effective October 21, 1991, and as presently in effect. (Designated in Form U-1, File No. 70-8181 as Exhibit A-2.) ALABAMA (b) 1 - Charter of ALABAMA and amendments thereto through November 19, 1993. (Designated in Registration Nos. 2-59634 as Exhibit 2(b), 2-60209 as Exhibit 2(c), 2-60484 as Exhibit 2(b), 2-70838 as Exhibit 4(a)-2, 2-85987 as Exhibit 4(a)-2, 33-25539 as Exhibit 4(a)-2, 33-43917 as Exhibit 4(a)-2, in Form 8-K dated February 5, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated July 8, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated October 27, 1993, File No. 1-3164, as Exhibits 4(a) and 4(b) and in Form 8-K dated November 16, 1993, File No. 1-3164, as Exhibit 4(a).) (b) 2 - By-laws of ALABAMA as amended effective April 24, 1992, and as presently in effect. (Designated in Registration No. 33-48885 as Exhibit 4(c).) GEORGIA (c) 1 - Charter of GEORGIA and amendments thereto through October 25, 1993. (Designated in Registration Nos. 2-63392 as Exhibit 2(a)-2, 2-78913 as Exhibits 4(a)-(2) and 4(a)-(3), 2-93039 as Exhibit 4(a)-(2), 2-96810 as Exhibit 4(a)-2, 33-141 as Exhibit 4(a)-(2), 33-1359 as Exhibit 4(a)(2), 33-5405 as Exhibit 4(b)(2), 33-14367 as Exhibits 4(b)-(2) and 4(b)-(3), 33-22504 as Exhibits 4(b)-(2), 4(b)-(3) and 4(b)-(4), in GEORGIA's Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibits 4(a)(2) and 4(a)(3), in Registration No. 33-48895 as Exhibits 4(b)-(2) and 4(b)-(3), in Form 8-K dated December 10, 1992, File No. 1-6468 as Exhibit 4(b), in Form 8-K dated June 17, 1993, File No. 1-6468, as Exhibit 4(b) and in Form 8-K dated October 20, 1993, File No. 1-6468, as Exhibit 4(b).) E-1 (c) 2 - By-laws of GEORGIA as amended effective July 18, 1990, and as presently in effect. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No.1-6468, as Exhibit 3.) GULF (d) 1 - Restated Articles of Incorporation of GULF and amendments thereto through November 8, 1993. (Designated in Registration No. 33-43739 as Exhibit 4(b)-1, in Form 8-K dated January 15, 1992, File No. 0-2429, as Exhibit 1(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(b)-2, in Form 8-K dated September 22, 1993, File No. 0-2429, as Exhibit 4 and in Form 8-K dated November 3, 1993, File No. 0-2429, as Exhibit 4.) *(d) 2 - By-laws of GULF as amended effective February 25, 1994, and as presently in effect. MISSISSIPPI (e) 1 - Articles of incorporation of MISSISSIPPI, articles of merger of Mississippi Power Company (a Maine corporation) into MISSISSIPPI and articles of amendment to the articles of incorporation of MISSISSIPPI through August 19, 1993. (Designated in Registration No. 2-71540 as Exhibit 4(a)-1, in Form U5S for 1987, File No. 30-222-2, as Exhibit B-10, in Registration No. 33-49320 as Exhibit 4(b)-(1), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibits 4(b)-2 and 4(b)-3, in Form 8-K dated August 4, 1993, File No. 0-6849, as Exhibit 4(b)-3 and in Form 8-K dated August 18, 1993, File No. 0-6849, as Exhibit 4(b)-3.) (e) 2 - By-laws of MISSISSIPPI as amended effective August 22, 1989, and as presently in effect. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1989, as Exhibit 3(b).) SAVANNAH (f) 1 - Charter of SAVANNAH and amendments thereto through November 10, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(b)-(1), 33-45757 as Exhibit 4(b)-(2) and in Form 8-K dated November 9, 1993, File No. 1-5072, as Exhibit 4(b).) *(f) 2 - By-laws of SAVANNAH as amended effective February 16, 1994, and as presently in effect. (4) INSTRUMENTS DESCRIBING RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES ALABAMA (b) - Indenture dated as of January 1, 1942, between ALABAMA and Chemical Bank, as Trustee, and indentures supplemental thereto through that dated as of January 1, 1994. (Designated in Registration Nos. 2-59843 as Exhibit 2(a)-2, 2-60484 as Exhibits 2(a)-3 and 2(a)-4, 2-60716 as Exhibit 2(c), 2-67574 as E-2 Exhibit 2(c), 2-68687 as Exhibit 2(c), 2-69599 as Exhibit 4(a)-2, 2-71364 as Exhibit 4(a)-2, 2- 73727 as Exhibit 4(a)-2, 33-5079 as Exhibit 4(a)-2, 33-17083 as Exhibit 4(a)-2, 33-22090 as Exhibit 4(a)-2, in ALABAMA's Form 10-K for the year ended December 31, 1990, File No. 1-3164, as Exhibit 4(c), in Registration Nos. 33-43917 as Exhibit 4(a)-2, 33-45492 as Exhibit 4(a)-2, 33- 48885 as Exhibit 4(a)-2, 33-48917 as Exhibit 4(a)-2, in Form 8-K dated January 20, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Form 8-K dated February 17, 1993, File No.1-3436, as Exhibit 4(a)-3, in Form 8-K dated March 10, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Certificate of Notification, File No. 70-8069, as Exhibits A and B, in Form 8-K dated June 24, 1993, File No. 1- 3436, as Exhibit 4, in Certificate of Notification, File No. 70-8069, as Exhibit A, in Form 8-K dated November 16, 1993, File No. 1-3436, as Exhibit 4(b) and in Certificate of Notification, File No. 70-8069, as Exhibits A and B.) GEORGIA (d) - Indenture dated as of March 1, 1941, between GEORGIA and Chemical Bank, as Trustee, and indentures supplemental thereto dated as of March 1, 1941, March 3, 1941 (3 indentures), March 6, 1941 (139 indentures), March 1, 1946 (88 indentures) and December 1, 1947, through January 1, 1994. (Designated in Registration Nos. 2-4663 as Exhibits B-3 and B-3(a), 2-7299 as Exhibit 7(a)-2, 2- 61116 as Exhibit 2(a)-3 and 2(a)-4, 2-62488 as Exhibit 2(a)-3, 2-63393 as Exhibit 2(a)-4, 2-63705 as Exhibit 2(a)-3, 2-68973 as Exhibit 2(a)-3, 2-70679 as Exhibit 4(a)-(2), 2-72324 as Exhibit 4(a)-2, 2-73987 as Exhibit 4(a)-(2), 2-77941 as Exhibits 4(a)-(2) and 4(a)-(3), 2-79336 as Exhibit 4(a)-(2), 2-81303 as Exhibit 4(a)-(2), 2-90105 as Exhibit 4(a)-(2), 33-5405 as Exhibit 4(a)-(2), 33-14367 as Exhibits 4(a)-(2) and 4(a)-(3), 33-22504 as Exhibits 4(a)-(2), 4(a)-(3) and 4(a)-(4), 33-32420 as Exhibit 4(a)-(2), 33-35683 as Exhibit 4(a)-(2), in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 4(a)(3), in Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibit 4(a)(5), in Registration No. 33-48895 as Exhibit 4(a)-(2), in Form 8-K dated August 26, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-K dated September 9, 1992, File No. 1-6468, as Exhibits 4(a)-(3) and 4(a)-(4), in Form 8-K dated September 23, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-A dated October 12, 1992, as Exhibit 2(b), in Form 8-K dated January 27, 1993, File No. 1-6468, as Exhibit 4(a)-(3), in Registration No. 33-49661 as Exhibit 4(a)-(2), in Form 8-K dated July 26, 1993, File No. 1-6468, as Exhibit 4, in Certificate of Notification, File No. 70-7832, as Exhibit M and in Certificate of Notification, File No. 70-7832, as Exhibit C.) GULF (e) - Indenture dated as of September 1, 1941, between GULF and The Chase Manhattan Bank (National Association) and The Citizens & Peoples National Bank of Pensacola, as Trustees, and indentures supplemental thereto through E-3 November 1, 1993. (Designated in Registration Nos. 2-4833 as Exhibit B-3, 2-62319 as Exhibit 2(a)-3, 2-63765 as Exhibit 2(a)-3, 2-66260 as Exhibit 2(a)-3, 33-2809 as Exhibit 4(a)-2, 33-43739 as Exhibit 4(a)-2, in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 4(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(a)-3, in Registration No. 33-50165 as Exhibit 4(a)-2, in Form 8-K dated July 12, 1993, File No. 0-2429, as Exhibit 4 and in Certificate of Notification, File No. 70-8229, as Exhibit A.) MISSISSIPPI (f) - Indenture dated as of September 1, 1941, between MISSISSIPPI and Morgan Guaranty Trust Company of New York, as Trustee, and indentures supplemental thereto through November 1, 1993. (Designated in Registration Nos. 2-4834 as Exhibit B-3, 2-62965 as Exhibit 2(b)-2, 2-66845 as Exhibit 2(b)-2, 2-71537 as Exhibit 4(a)-(2), 33-5414 as Exhibit 4(a)-(2), 33-39833 as Exhibit 4(a)-2, in MISSISSIPPI's Form 10-K for the year ended December 31, 1991, File No. 0-6849, as Exhibit 4(b), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibit 4(a)-2, in Second Certificate of Notification, File No. 70-7941, as Exhibit I, in MISSISSIPPI's Form 8-K dated February 26, 1993, File No. 0-6849, as Exhibit 4(a)-2, in Certificate of Notification, File No. 70-8127, as Exhibit A, in Form 8-K dated June 22, 1993, File No. 0-6849, as Exhibit 1 and in Certificate of Notification, File No. 70-8127, as Exhibit A.) SAVANNAH (g) - Indenture dated as of March 1, 1945, between SAVANNAH and NationsBank of Georgia, National Association, as Trustee, and indentures supplemental thereto through July 1, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(a)-(1), 33-41496 as Exhibit 4(a)-(2), 33-45757 as Exhibit 4(a)-(2), in SAVANNAH's Form 10-K for the year ended December 31, 1991, File No. 1-5072, as Exhibit 4(b), in Form 8-K dated July 8, 1992, File No. 1-5072, as Exhibit 4(a)-3, in Registration No. 33-50587 as Exhibit 4(a)-(2) and in Form 8-K dated July 22, 1993, File No. 1-5072, as Exhibit 4.) (10) MATERIAL CONTRACTS SOUTHERN (a) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(a) and in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(3).) (a) 2 - Service contract dated as of July 17, 1981, between SCS and SEI. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(2).) E-4 (a) 3 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1987, File No. 1-5072, as Exhibit 10-p.) (a) 4 - Service contract dated as of January 15, 1991, between SCS and Southern Nuclear. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1991, File No. 1-3526, as Exhibit 10(a)(4).) (a) 5 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(b).) (a) 6 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. (Designated in Registration No. 2-59634 as Exhibit 5(c) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(d)(2).) (a) 7 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Registration No. 2-61116 as Exhibit 5(d).) (a) 8 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(1).) (a) 9 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(3).) (a) 10 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(g).) (a) 11 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit A.) (a) 12 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit B.) (a) 13 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(1).) E-5 (a) 14 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-1 and in Form 8-K for January 1977, File No. 1-6468, as Exhibit (B)(3).) (a) 16 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-2.) (a) 17 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1983, File No. 1-6468, as Exhibit 10(k)(4).) (a) 18 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 19 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 20 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(8).) (a) 21 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 22 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(3).) (a) 23 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(7).) (a) 24 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-3, in SOUTHERN's Form 10-K for the year ended December 31, 1987, File E-6 No. 1-3526, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, File No. 1-3526, as Exhibit 10(n)(2).) (a) 25 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-4 and in SOUTHERN's Form 10-K for the year ended December 31, 1987, File No. 1-3526, as Exhibit 10(o)(4).) (a) 26 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. (Designated in Form U-1, File No. 70-6481, as Exhibit B-1.) (a) 27 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-2.) (a) 28 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-4, in SOUTHERN's Form 10-K for the year ended December 31, 1987, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, as Exhibit 10(n)(2).) (a) 29 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-5.) (a) 30 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-1.) (a) 31 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-2.) (a) 32 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(c)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(r)(3).) (a) 33 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in GEORGIA's Form 10-K for the year E-7 ended December 31, 1982, File No. 1-6468, as Exhibit 10(s)(2), in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(r)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468 as Exhibit 10(s)(2).) (a) 34 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(d).) (a) 35 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(e).) (a) 36 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(f).) (a) 37 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(x).) (a) 38 - The Southern Company Executive Stock Plan For the Southern Electric System and the First Amendment thereto. (Designated in Registration No. 33-30171 as Exhibit 4(c).) (a) 39 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(1).) (a) 40 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(m).) (a) 41 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(x).) (a) 42 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(y).) E-8 (a) 43 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-1.) (a) 44 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-2.) (a) 45 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(f), in MISSISSIPPI's Form 10-K for the year ended December 31, 1982, File No. 0-6849, as Exhibit 10(f)(2) and in MISSISSIPPI's Form 10-K for the year ended December 31, 1983, File No. 0-6849, as Exhibit 10(f)(3).) (a) 46 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. (Designated in Form U-1, File No. 70-7738, as Exhibit A-5 and in Form U-1, File No. 70-7937, as A-5(b).) (a) 47 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(cc).) (a) 48 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(dd).) *(a) 49 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. (a) 50 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(ff).) (a) 51 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(gg).) (a) 52 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(hh).) E-9 (a) 53 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1992, File No. 1-3526, as Exhibit 10(a)53.) *(a) 54 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. *(a) 55 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. *(a) 56 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. *(a) 57 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 58 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 59 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. ALABAMA (b) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. (Designated in Registration No. 2-59843 as Exhibit 2(a)-8.) (b) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (b) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (b) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (b) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. E-10 (b) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2, dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (b) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)34 herein. (b) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)35 herein. (b) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)36 herein. (b) 10 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (b) 11 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)39 herein. (b) 12 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)40 herein. (b) 13 - Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Certificate of Notification, File No. 70-7212, as Exhibit B.) (b) 14 - 1991 Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Form U-1, File No. 70- 7873, as Exhibit B-1.) (b) 15 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)43 herein. (b) 16 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)44 herein. (b) 17 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. E-11 (b) 18 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. GEORGIA (c) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. See Exhibit 10(b)1 herein. (c) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIP PI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (c) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (c) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (c) 5 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)7 herein. (c) 6 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)8 herein. (c) 7 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)9 herein. (c) 8 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. See Exhibit 10(a)10 herein. (c) 9 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a) 11 herein. (c) 10 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a)12 herein. (c) 11 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)13 herein. (c) 12 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)14 herein. E-12 (c) 13 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)15 herein. (c) 14 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)16 herein. (c) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. See Exhibit 10(a)17 herein. (c) 16 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)18 herein. (c) 17 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)19 herein. (c) 18 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. See Exhibit 10(a)20 herein. (c) 19 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)21 herein. (c) 20 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)22 herein. (c) 21 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)23 herein. (c) 22 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)24 herein. (c) 23 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)25 herein. (c) 24 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. See Exhibit 10(a)26 herein. (c) 25 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. See Exhibit 10(a)27 herein. E-13 (c) 26 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (c) 27 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (c) 28 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a) 30 herein. (c) 29 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a)31 herein. (c) 30 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (c) 31 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (c) 32 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (c) 33 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (c) 34 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (c) 35 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. *(c) 36 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. See Exhibit 10(a) 59 herein. (c) 37 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. E-14 (c) 38 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (c) 39 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)41 herein. (c) 40 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)42 herein. (c) 41 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (c) 42 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)47 herein. (c) 43 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)48 herein. *(c) 44 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. See Exhibit 10(a)49 herein. (c) 45 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)50 herein. (c) 46 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. See Exhibit 10(a)51 herein. (c) 47 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. See Exhibit 10(a)52 herein. *(c) 48 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. See Exhibit 10(a)54 herein. *(a) 49 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. See Exhibit 10(a)55 herein. *(c) 50 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. See Exhibit 10(a)56 herein. E-15 *(c) 51 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)57 herein. *(c) 52 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)58 herein. GULF (d) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (d) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (d) 3 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (d) 4 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (d) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (d) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (d) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (d) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (d) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-16 (d) 10 - Agreement between GULF and AEC, effective August 1, 1985. (Designated in GULF's Form 10-K for the year ended December 31, 1985, File No. 0-2429, as Exhibit 10(g).) (d) 11 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (d) 12 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (d) 13 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. MISSISSIPPI (e) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (e) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (e) 3 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (e) 4 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984, and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (e) 5 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (e) 6 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (e) 7 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-17 (e) 8 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (e) 9 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (e) 10 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (e) 11 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. See Exhibit 10(a)45 herein. (e) 12 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (e) 13 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. SAVANNAH (f) 1 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. See Exhibit 10(a)3 herein. (f) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (f) 3 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (f) 4 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (f) 5 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (f) 6 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. E-18 (f) 7 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (f) 8 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. *(f) 9 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a) 57 herein. *(f) 10 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated December 15, 1992. See Exhibit 10(a)58 herein. (21) *SUBSIDIARIES OF REGISTRANTS - Contained herein at page IV-5. (23) CONSENTS OF EXPERTS AND COUNSEL SOUTHERN *(a) - The consent of Arthur Andersen & Co. is contained herein at page IV-6. ALABAMA *(b) - The consent of Arthur Andersen & Co. is contained herein at page IV-7. GEORGIA *(c) - The consent of Arthur Andersen & Co. is contained herein at page IV-8. GULF *(d) - The consent of Arthur Andersen & Co. is contained herein at page IV-9. MISSISSIPPI *(e) - The consent of Arthur Andersen & Co. is contained herein at page IV-10. SAVANNAH *(f) - The consent of Arthur Andersen & Co. is contained herein at page IV-11. E-19 (24) POWERS OF ATTORNEY AND RESOLUTIONS SOUTHERN *(a) - Power of Attorney and resolution. ALABAMA *(b) - Power of Attorney and resolution. GEORGIA *(c) - Power of Attorney and resolution. GULF *(d) - Power of Attorney and resolution. MISSISSIPPI *(e) - Power of Attorney and resolution. SAVANNAH *(f) - Power of Attorney and resolution. E-20

9548_1993.txt

9548

1993

ITEM 3 LEGAL PROCEEDINGS - ------ ----------------- See "Financial Difficulties of Significant Customer" above and Note 9 to the Company's Financial Statements, which are incorporated herein by reference, for a discussion of bankruptcy proceedings relating to a large customer of the Company. See Note 9 to the Company's Financial Statements for a discussion of potential liabilities under the Comprehensive Environmental Response, Compensation, and Liability Act. ITEM 4

ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------ --------------------------------------------------- Not applicable. PART II - ------- ITEM 5

ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------ --------------------------------------------------- As of December 31, 1993, there were 7,511 holders of record of the Company's common stock. The Company's common stock is traded on the New York Stock Exchange ("NYSE") under the symbol "BGR". The following table sets forth the high and low prices for the Common Stock as reported by the NYSE. The prices shown do not include commissions. Dividends are declared quarterly. DIVIDENDS DECLARED FISCAL PERIOD HIGH LOW PER SHARE - ------------- ------ ------- --------- - ---- First Quarter................ $18 1/8 $17 1/4 $.33 Second Quarter............... 18 1/4 17 1/4 .33 Third Quarter................ 19 7/8 17 3/4 .33 Fourth Quarter............... 20 1/4 18 1/4 .33 - ---- First Quarter................ $24 1/8 $17 7/8 $.33 Second Quarter............... 23 5/8 19 5/8 .33 Third Quarter................ 23 1/8 20 7/8 .33 Fourth Quarter............... 21 3/8 18 1/8 .33 - ---- First Quarter (through March 21, 1994)... $19 $16 3/4 $.33 NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION The Consolidated Financial Statements of Bangor Hydro-Electric Company (the "Company") include its wholly owned subsidiaries, Penobscot Hydro Co., Inc. ("PHC"), and Bangor Var Co., Inc. ("BVC"). The operations of PHC consist solely of a 50% interest in Bangor-Pacific Hydro Associates ("BPHA"), the owner and operator of the redeveloped West Enfield hydroelectric station. PHC accounts for its investment in BPHA under the equity method. BVC was incorporated in 1990 to own the Company's 50% interest in a partnership which owns certain facilities used in the Hydro-Quebec Phase II transmission project in which the Company is a participant. BVC accounts for its investment in the partnership under the equity method. All significant intercompany balances and transactions have been eliminated. The accounts of the Company are maintained in accordance with the Uniform System of Accounts prescribed by the regulatory bodies having jurisdiction. EQUITY METHOD OF ACCOUNTING The Company accounts for its investments in the common stock of Maine Yankee Atomic Power Company ("Maine Yankee") and Maine Electric Power Company, Inc. ("MEPCO") under the equity method of accounting, and records its proportionate share of the net earnings of these companies (substantially all of these earnings are paid out in dividends) as a reduction of purchased power capacity costs. See Note 7 for additional information with respect to these investments. ELECTRIC OPERATING REVENUE Electric Operating Revenue consists primarily of amounts charged for electricity delivered to customers during the period. The Company records unbilled revenue, based on estimates of electric service rendered and not billed at the end of an accounting period, in order to match revenue with related costs. The Federal Energy Regulatory Commission ("FERC") requires utilities to reclassify to operating revenue sales transactions related to power pool and interconnection agreements and resales of purchased power previously netted within fuel and purchased power expense. The reclassification increased total operating fuel revenue by $15.3 million in 1993, $13.8 million in 1992 and $15.7 million in 1991, while increasing fuel and purchased power expense by the same amounts. DEFERRED FUEL AND PURCHASED POWER CAPACITY ACCOUNTING The Company utilizes deferred fuel accounting. Under this accounting method, retail fuel costs are expensed when recovered through rates and recognized as revenue. Retail fuel costs not yet expensed are classified on the Consolidated Balance Sheets ("Balance Sheets") as deferred fuel costs. The fuel cost adjustment rate in- cludes a factor calculated to reimburse the Company or its customers, as appropriate, for the carrying cost of funds used to finance under- or over-collected fuel costs, respectively. Under the Maine Public Utilities Commission ("MPUC") fuel cost adjustment regulations effective through December 31, 1993, the Company is allowed to recover its fuel costs on a current basis. The fuel charge is based on the Company's projected cost of fuel for a twelve-month period. Under- or over-collections resulting from differences between estimated and actual fuel costs for a period are included in the computation of the estimated fuel costs of the succeeding fuel adjustment period. Commencing January 1, 1988, in accordance with an agreement approved by the MPUC, the Company began to phase-in increased fuel costs (primarily the cost of power purchased from small power producers see Note 7). The fuel rates are being designed so that all fuel costs incurred during that period will be billed in 1994. Prior to 1992, the MPUC allowed the Company to defer for future collection from, or payback to, customers the difference between actual purchased power costs incurred and those costs billed. As with fuel, the deferred purchased power capacity amounts were, for these years, considered when setting the fuel cost adjustment rate for the forthcoming year. The portion of purchased power capacity costs which is included in fuel revenue is classified as purchased power capacity expense in the Statements of Income. Effective November 15, 1992, the collection of the remaining balance of deferred purchased power costs is being recorded on the Statements of Income as fuel expense. The base rates, which became effective on January 1, 1992, excluded all purchased power capacity costs from this deferral process. DEPRECIATION OF ELECTRIC PLANT AND MAINTENANCE POLICY Depreciation of electric plant is provided using the straight-line method at rates designed to allocate the original cost of the properties over their estimated service lives. The composite depreciation rate, expressed as a percentage of average depreciable plant in service, and considering the amortization of the over-accrued depreciation which is discussed below, was approximately 2.1% in 1993, 1992 and 1991. A study conducted in 1989 by an independent firm determined that, as a group, the actual lives of the Company's property, plant and equipment are longer than the lives represented by the depreciation rates that the Company had been using to compute its depreciation expense for accounting purposes. In addition, the study also determined that the reserve for depreciation was over-accumulated. The agreement on base rates which became effective on October 1, 1990, contained a provision to amortize the remaining balance of the over-accumulated reserve for depreciation account ($11.4 million at October 1) over a six-year period and adopted the longer depreciable lives as determined by the aforementioned study. The Company follows the practice of charging to maintenance the cost of repairs, replacements and renewals of minor items considered to be less than a unit of property. Costs of additions, replacements and renewals of items considered to be units of property are charged to the utility plant accounts, and any items retired are removed from such accounts. The original costs of units of property retired and removal costs, less salvage, are charged to the reserve for depreciation. Depreciation, local property taxes and other taxes not based on income, which were charged to operating expenses, are stated separately in the Statements of Income. Rents and advertising costs are not significant. No royalty or research and development expenses were incurred. Maintenance expense was $6.5 million in 1993, $5.6 million in 1992 and $6.4 million in 1991. EQUITY RESERVE FOR LICENSED HYDRO PROJECTS The FERC requires that a reserve be maintained equal to one-half of the earnings in excess of a prescribed rate of return on the Company's investment in licensed hydro property, beginning with the twenty-first year of the project operation under license. The required reserve for licensed hydro projects is classified in retained earnings and has a balance of $584,942 at December 31, 1993. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION ("AFDC") In accordance with regulatory requirements of the MPUC, the Company capitalizes as AFDC financing costs related to portions of its construction work in progress at a rate equal to its weighted cost of capital and is capitalized into utility plant with offsetting credits to other income and interest. This cost is not an item of current cash income, but is recovered over the service life of plant in the form of increased revenue collected as a result of higher depreciation expense. In addition, carrying costs on certain regulatory assets are also capitalized and included in AFDC in the Statements of Income. The average AFDC (and carrying cost) rates computed by the Company were 10.0% in 1993, 10.6% for 1991 and 11.1% 1991. CASH AND CASH EQUIVALENTS The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be temporary cash investments. RECLASSIFICATIONS Prior year amounts have been reclassified to conform with the presentation used in the 1993 Consolidated Financial Statements. SIGNIFICANT CUSTOMER The Company has one industrial customer, LCP Chemicals ("LCP"), that accounted for 4.8%, 4.9% and 5.4% of total revenue (excluding AR 14 reclassifications) in 1993, 1992 and 1991, respectively. In 1988, with approval of the MPUC, the Company entered into an agreement with this customer by which its base rates for services were reduced and a "revenue-sharing" plan was instituted. Under the revenue-sharing plan, the amounts billed to this customer were adjusted up or down to reflect changes in the customer's per unit product price and electricity costs. The revenue-sharing rate continued for part of 1992 when it was replaced by a new rate that had a higher contribution to base revenue. In June 1993, LCP returned to the revenue-sharing rate. The Company recorded, as other income, approximately $513,000 in 1993, 206,000 in 1992, and $1.8 million in 1991 pursuant to the revenue-sharing rate. NOTE 2. INCOME TAXES The Company adopted Financial Accounting Standard Board Statement No. 109 "Accounting for Income Taxes" ("FAS 109") effective January 1, 1993. FAS 109 required a change in the accounting for income taxes from the deferred method to an asset and liability approach, which requires the recognition of deferred tax liabilities and assets for the future tax effects of temporary differences between the tax basis and carrying amounts of assets and liabilites. In accordance with FAS 109, the Company recorded net additional deferred income tax liabilities of approximately $23.1 million as of December 31, 1993. These additional deferred income tax liabilities have resulted from the accrual of deferred taxes on temporary differences on which deferred taxes had not been previously accrued ($32.5 million), offset by the effect of the 1987 change to lower income tax rates (reduced by the 1% increase in the federal income tax rate in 1993) that will be refunded to customers over time ($8.1 million) and the establishment of deferred tax assets on unamortized investment tax credits ($1.3 million). These latter amounts have been recorded as deferred regulatory liabilities at December 31, 1993. The accrual of the additional amount of deferred tax liabilities has been offset by a regulatory asset which represents the customers' future payment of these income taxes when the taxes are, in fact, expensed. As a result of this accounting, the consolidated statement of income for the year ended December 31, 1993 is not affected by the implementation of FAS 109. The rate-making practices followed by the MPUC permit the Company to recover federal and state income taxes payable currently, and to recover some, but not all, deferred taxes that would otherwise be recorded in accordance with FAS 109 in the absence of regulatory accounting. The individual components of other accumulated deferred income taxes are as follows at December 31, 1993: Deferred income tax liabilities: Excess book over tax basis of electric plant in service $43,023,222 Costs to terminate purchased power contract 4,553,166 Deferred FERC licensing costs 3,431,075 Deferred fuel, purchased power and interest costs 1,616,491 Deferred demand-side management program costs 1,055,030 Prepaid pension costs 1,028,179 Investment in jointly-owned companies 790,881 Other 2,434,532 ----------- $57,932,576 ----------- Deferred income tax assets: Deferred taxes provided on alternative minimum tax ($3,175,718) Provision for Basin Mills investment (3,137,895) Deferred state income tax benefit (1,561,137) Unamortized investment tax credit (1,286,156) Reserve for bad debts (797,696) Other (973,195) ------------- ($10,931,797) ------------- Total other accumulated deferred income taxes $ 47,000,779 ============= The individual components of federal and state income taxes reflected in the Consolidated Statements of Income for 1993, 1992 and 1991 are as stated in the table below. Year Ended December 31, ---------------------------------------- 1993 1992 1991 ---------------------------------------- Current: Federal $ - $6,274,554 $1,064,754 State - 2,739,089 485,586 ----------------------------------------- $ - $9,013,643 $1,550,340 ----------------------------------------- Deferred - Short-Term: Federal $ 114,674 $4,330,124 (1,803,480) State 68,216 213,745 (93,018) ------------------------------------------ $ 182,890 $4,543,869 (1,896,498) ------------------------------------------ Deferred - Long-Term: Federal - Other $ 2,512,026 $(5,741,329) $4,360,251 State - Other (21,507) (1,806,238) 418,052 Federal - Seabrook (341,917) (653,060) (705,036) State - Seabrook (72,730) (139,336) (150,297) ----------------------------------------- $2,075,872 $(8,339,963) $3,922,970 ----------------------------------------- Investment Tax Credits, Net $ (178,176) $ 672,798 $ 214,345 ----------------------------------------- Total Provision $2,080,586 $ 5,890,347 $3,791,157 Allocated to Other Income 2,682,359 (288,575) (940,793) ----------------------------------------- Charged to Operating Expense $4,762,945 $ 5,601,772 $2,850,364 ========================================= The table below reconciles an income tax provision, calculated by multiplying income before federal income taxes (as reported on the Statements of Income) by the statutory federal income tax rate to the federal income tax expense reported on the Statements of Income. The difference is represented by the temporary differences for which deferred taxes are not provided. 1993 1992 1991 ---- ---- ---- Amount % Amount % Amount % ------------------------------------------- (Dollars in Thousands) Federal income tax provisions at statutory rate $2,522 34% $5,489 34% $4,077 34% Less (Plus) temporary reductions in tax expense resulting from statutory exclusions from taxable income: Dividend received deduction related to earnings of associated companies 133 2 142 1 179 2 Equity component of AFDC 496 6 306 2 277 2 Amortization of equity component of AFDC on recoverable Seabrook investment (155) (2) (187) (2) (191) (2) Other (24) - 4 - (34) - ------ ---- ------ ---- ------ ---- Federal income tax provision before effect of temporary differences $2,072 28% $5,224 33% $3,846 32% Less (Plus) timing differences that are flowed through for ratemaking and accounting purposes: Amortization of debt component of AFDC and capitalized overheads on recoverable Seabrook investment (146) (2)% (193) (2)% (196) (2)% Book depreciation greater than tax depreciation on assets acquired before 1971 (292) (4) (293) (2) - - State income tax liability deducted for federal income tax purposes 116 2 467 4 351 3 Reversal of excess deferred income taxes 34 - 221 2 284 3 Life insurance flow-through in prior years - - - - 178 2 Other 253 4 139 1 98 1 ------- ---- ------ ---- ------ --- Federal income tax provision $2,107 28% $4,883 30% $3,131 25% ======= ==== ====== ==== ====== === The differences between the federal and state income tax expense reported on the Consolidated Statements of Income, and the federal and state income tax liability as reflected on the Company's tax returns, are caused by temporary differences on which deferred taxes are provided and recovered through rates. The table below shows the components of deferred tax expense as reported in the Statements of Income. 1993 1992 1991 ----------- ----------- ------------ Costs to terminate purchased power contract $4,553,166 $ - $ - Provision for Basin Mills (3,137,895) - - Seabrook Nuclear Project (414,647) (792,396) (855,333) Tax depreciation in excess of book depreciation 852,187 3,787,047 5,958,182 Deferred fuel and purchased power costs 163,665 (8,443,906) (2,843,764) State taxes provided for rate- making purposes but not paid (124,217) 146,702 (932,197) Deferred taxes provided on the AMT - 268,254 (551,503) Deferred interest costs 59,214 (209,149) (52,476) Costs of removal 84,203 227,649 204,179 Deferred demand-side management costs 97,672 284,297 198,677 FERC licensing costs 277,574 835,487 912,903 Other (152,160) 99,921 (12,196) ----------- ------------ ----------- Total deferred income tax expense (benefit) $2,258,762 $(3,796,094) $2,026,472 =========== ============ =========== Under the federal income tax laws, the Company received investment tax credits on qualified property additions through 1986. Investment tax credits utilized were deferred and are being amortized over the life of the related property. Investment tax credits available of about $4.8 million ($2.5 million of which is attributable to PHC and $900,000 to BVC) have not been utilized or recorded and, subject to review by the Internal Revenue Service ("IRS"), may be used prior to their expiration, which occurs between 1996 and 2005. At December 31, 1993, the Company had, for income tax purposes, alternative minimum tax credits ("AMT") of approximately $3.2 million for the reduction of future tax liabilities. At December 31, 1993, the Company had, for income tax reporting purposes, approximately $21 million of net operating loss carryforwards that expire in 2008. NOTE 3. COMMON AND PREFERRED STOCK COMMON STOCK In June of 1993 the Company issued and sold for cash 745,000 common shares (for proceeds of $14.8 million). The proceeds were utilized to finance construction expenditures, reduce short-term debt, and fund a portion of the buyout of the power purchase agreement with the Beaver Wood Joint Venture, which is more fully described in Note 7. The Company issued and sold for cash 920,000 common shares (for proceeds of approximately $13.1 million) in June of 1991. The proceeds were used to reduce outstanding short-term debt. Prior to 1992, stockholders had been able to invest their dividends and optional cash payments in common stock of the Company acquired by an independent agent in the open market through the Company's Dividend Reinvestment and Common Stock Purchase Plan ("the Plan"). In 1992 the Company amended the Plan to enable it to issue original shares in return for the reinvested dividends and optional cash payments. The common stock has general voting rights of one vote per twelve shares owned. PREFERRED STOCK Authorized preferred stock consists of 400,000 shares, par value $100 per share, of which there are 197,340 shares outstanding. The remaining 202,660 authorized but unissued shares (plus additional shares equal in number to such presently outstanding shares as may be retired) may be issued with such preferences, restrictions or qualifications as the Board of Directors may determine. Any new shares so issued will be required to be issued with per share voting rights no greater than that of the common stock. The callable preferred stock may be called in whole or in part upon any dividend date by appropriate resolution of the Board of Directors. Except for the holders of the 8.76% issue, which does not carry general voting rights, the currently outstanding preferred stock has general voting rights of one vote per share. With regard to payment of dividends or assets available in the event of liquidation, preferred stock ranks prior to common stock. REDEEMABLE PREFERRED SHARES Call premiums on preferred stock redeemed in 1986 and 1987 were deferred and were being amortized to earnings over a ten-year period. In compliance with an audit by FERC, the remaining balance of these deferred call premiums ($449,700 at December 31, 1990) were charged directly to retained earnings in 1991. On December 27, 1989, the Company issued to an institutional investor $15 million of non-voting preferred stock carrying a dividend rate of 8.76%. These shares have a maturity of fifteen years with a mandatory sinking fund of $1.5 million per year starting in 1995. The agreement to issue this series of preferred stock contains a provision whereby, if the Copany pays a dividend that is considered a return of capital for federal income tax purposes, the Company is required to make a payment to the stockholder in order to restore the stockholder's after-tax yield to the level it would have been had the dividend not been considered a return of capital. Since 100% of the dividends paid in 1990 and 1993, pending any review by the IRS, are to be considered a return of capital, the Company has become obligated to pay this stockholder approximately $969,000 at the time the stock is either sold or redeemed. This obligation is being recognized over the remaining life of the issue through a direct charge to retained earnings of $72,862 per year. NOTE 4. LONG-TERM DEBT Under the provisions of the first mortgage bond indenture, substantially all of the Company's plant and property has been mortgaged to secure the Company's first mortgage bonds. Sinking fund requirements and current maturities of the first mortgage bonds for the five years subsequent to December 31, 1993 aggregate $10,536,507 as follows: Sinking Fund Current Requirements Maturities Total 1994 $1,297,448 $ - $ 1,297,448 1995 1,461,253 - 1,461,253 1996 1,645,737 - 1,645,737 1997 1,853,515 - 1,853,515 1998 1,778,554 2,500,000 4,278,554 ----------- ----------- ----------- $8,036,507 $2,500,000 $10,536,507 =========== =========== =========== In 1993 the Company issued $15 million of 7.3% first mortgage bonds to an institutional investor for a period of 10 years. Also in 1993, in connection with the termination of the purchased power contract (which is discussed in Note 7), the Company issued $14.3 million of 12.25% mortgage bonds to the holders of Beaver Wood's debt in substitution for the Beaver Wood's pre- viously outstanding 12.25% secured notes. In September 1993 the Company redeemed the 8.25%, 8.6%, and 9.25% series of first mortgage bonds. The redemptions of these issues resulted in call premiums of $29,563, and $31,011, respectively. The Company completed two first mortgage bond financings during 1992. The first was issued in April for $20 million at an interest rate of 8.98% for a period of 20 years. The second was issued in October for $20 million at an interest rate of 7.38% for a period of 10 years. In 1992, the Company redeemed the 10.5%, 10.25% and the 17.35% series of first mortgage bonds. The redemption of these issues resulted in call premiums of $88,200, $170,765 and $88,000, respectively. The call premiums in 1993 and 1992 were deferred and have been included in the Company's current base rate filing on which a final decision was reached in February 1994. The Company is allowed to amortize these costs over a ten-year period with the unamortized balance included in the rate base. NOTE 5. SHORT-TERM BORROWINGS The Company has an unsecured revolving credit agreement ("Credit Agreement") with a group of four banks providing for loans of up to $25 million. The Credit Agreement expires on May 26, 1994 but may be extended through May 26, 1995 with unanimous consent of the participating banks. The Credit Agreement has a term loan arrangement whereby the loan balance at the date of termination can be paid in equal quarterly installments over a two-year period. The Company may borrow at rates, as defined within the Credit Agreement, based on certificate of deposit loan rates, Eurodollar loan rates or the agent bank's reference rate. A commitment fee of 1/4 of 1% per annum is required on the amount not borrowed under any of these borrowing options. A fourth borrowing option under the Credit Agreement is in the form of "bid loans" whereby the Company can borrow at "money market" rates independently set by each of the four banks participating in the Credit Agreement. This form of borrowing does not reduce the commitment fee but does reduce the credit available under the Credit Agreement. The Credit Agreement allows the Company to incur an additional $30 million in unsecured debt outside of the agreement. The Company maintains lines of credit with banks which it utilizes when the borrowing costs under the lines of credit are more favorable than those under the Credit Agreement. Certain of these lines of credit have commitment fees ranging from 1/8 of 1% to 1/4 of 1% of the line while others have no commitment fees. Certain information related to total short-term borrowings under the Credit Agreement and the lines of credit is as follows: 1993 1992 1991 - ---------------------------------------------------------------------------- Total credit available at end of period $55,000,000 $55,000,000 $42,000,000 Unused credit at end of period $19,000,000 $40,000,000 $13,500,000 Borrowings outstanding at end of period $36,000,000 $15,000,000 $28,500,000 Effective interest rate (exclusive of fees) on borrowings out- standing at end of period 3.7% 4.4% 5.4% Average daily outstanding bor- rowings for the period $22,754,205 $22,448,087 $23,297,260 Weighted daily average annual interest rate 3.7% 4.5% 6.6% Highest level of borrowings outstanding at any month- end during the period $36,000,000 $31,000,000 $28,500,000 The average daily borrowings outstanding for the period represent the sum of daily borrowings outstanding, divided by the number of days in the period. The weighted daily average annual interest rate is determined by dividing the annual interest expense by the average daily borrowings outstanding for the period. Commitment and agent fees for the revolving credit agreement of $40,000, $68,000 and $27,000 were paid in 1993, 1992 and 1991, respectively, and are excluded from the calculation of the weighted daily average annual interest rate. NOTE 6. PENSION AND OTHER POST-EMPLOYMENT BENEFITS The Company has noncontributory pension plans covering substantially all of its employees. On July 17, 1987, the Company created separate union and nonunion plans from an original plan. Benefits under the plans are generally based on the employee's years of service and compensation during the years preceding retirement. The Company's general policy is to contribute to the funds the amounts deductible for federal income tax purposes. The Company recorded pension income of $12,000, $348,214 and $263,700 for 1993, 1992 and 1991, respectively. The tables below and on the following page detail the components of pension income for 1993, 1992 and 1991, the funded status of the plans, the amounts recognized in the Company's Financial Statements and the major assumptions used to determine these amounts. The plan's assets are composed of fixed income securities, equity securities and cash equivalents. Total pension income included the following components: 1993 1992 1991 - ----------------------------------------------------------------------------- Service cost - benefits earned during the period $ 1,085,419 $ 1,037,419 $ 982,180 Interest cost on projected benefit obligation 2,244,706 1,996,491 1,605,246 Actual return on plan assets (4,633,435) (2,366,341) (6,595,692) Total of amortized obligations and the net gain (loss) deferred $ 1,291,310 $(1,015,783) $ 3,744,566 ------------ ------------ ------------ Total pension (income) $ (12,000) $ (348,214) $ (263,700) ============ ============ ============ Significant assumptions used were - Discount rate 7.0% 8.0% 8.0% Rate of increase in future compensation levels 5.0% 6.0% 6.0% Expected long-term rate of return on plan assets 9.0% 9.0% 8.0% The following table sets forth the plans' funded status and amounts recognized in the Balance Sheets at December 31, 1993 and 1992: 1993 1992 ------------- ------------ Actuarial present value of accumulated benefit obligation Vested $ 22,730,655 $ 16,294,432 Non-vested 2,669,955 1,686,977 ------------- ------------ Total $ 25,400,610 $ 17,981,409 ------------- ------------ Projected benefit obligation $(32,484,893) $(28,182,601) Plan assets at fair value 37,810,748 35,081,512 ------------- ------------ Excess of plan assets over projected benefit obligation $ 5,325,855 $ 6,898,911 Items not yet recognized in earnings - Net (asset) at transition (6,916,450) (7,848,775) Prior service cost 4,597,483 4,206,141 Unrecognized net gain from past experience and changes in assumptions (608,390) (869,779) ------------- ------------ Net pension asset recognized $ 2,398,498 2,386,498 ============= ============ In addition to pension benefits, the Company provides certain health care and life insurance benefits to its retired employees. Substantially all of the Company's employees may become eligible for retiree benefits if they reach normal retirement age while working for the Company. The Company has adopted Financial Accounting Standards Board Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106") as of January 1, 1993. This standard requires the accrual of postretirement benefits, including medical and life insurance coverage, during the years an employee provides services to the Company. Prior to 1993, the cost of health care benefits were expensed as benefits were paid. The MPUC issued a final accounting rule in connection with FAS 106 which adopted this pronouncement for ratemaking purposes and provides the Company with the accounting and regulatory framework required to defer the excess ($604,529, which is net of capitalized amounts at December 31, 1993) of the net periodic postretirement benefit cost recognized under FAS 106 over the pay-as-you-go amount in 1993 and to record such excess as a regulatory asset pending inclusion in future rates, subject to the same level of review for prudence and reasonableness as are all other utility expenses. The Company, in accordance with the ruling and FAS 106, is amortizing the unrecognized transition obligation of $10,023,200 over a 20-year period. The Company will begin recovering the deferred FAS 106 costs with the implementation of new base rates on March 1, 1994 and amortize the deferred balance over a ten-year period. In accordance with the provisions of FAS 106, the actuarially determined net periodic postretirement benefit cost for 1993 and the major assumptions used to determine these amounts are shown below. Net periodic postretirement benefit cost for 1993 includes the following components: Service cost of benefits earned $ 359,600 Interest cost on accumulated post- retirement benefit obligation 683,200 Amortization of unrecognized transition obligation over 20 years 501,200 ---------- Net periodic postretirement benefit cost $1,544,000 Expense on a pay-as-you-go basis (534,900) Amounts capitalized into construction work in progress (404,571) ---------- Regulatory asset recorded at December 31, 1993 $ 604,529 ========== The following table sets forth the benefit plan's unfunded status and amounts recognized in the Company's Balance Sheet at December 31, 1993: Accumulated postretirement benefit obligation: Retirees $ 5,640,000 Fully eligible active plan participants 773,000 Other active participants 4,196,000 ------------ $10,609,000 Unrecognized net transition obligation (9,522,000) Unrecognized net loss 457,000 ------------ Accrued postretirement benefit cost 1,544,000 Less: Expense recognized on a pay-as-you-go basis 534,900 ------------ Net liability recorded at December 31, 1993 (included in Other Reserves) $ 1,009,100 =========== For measuring the expected postretirement benefit obligation, a 12.4% annual rate of increase in the per capita claims cost ("trend rate") for participants who have not reached the age of 65 was assumed for 1992. This rate was assumed to decrease annually to 6% in 2050 and remain at that level thereafter. For those participants who are 65 or older, the trend rate was assumed to be 8.3% in 1992, 9.7% in 1993 and then decrease until 2050 when it is assumed to be 5.8%. If the health care cost trend rate was increased one percent, the accumulated postretirement benefit obligation as of January 1, 1993 would have increased by 11%. The effect of such change on the aggregate of service and interest cost for 1993 would be an increase of 12%. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1993. In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"). The Company is required to adopt this standard no later than January 1, 1994. FAS 112 applies to postemployment benefits provided to former or inactive employees, their beneficiaries, and covered dependents after employment but before retirement. FAS 112 will change the current methods of accounting for postemployment benefits from recognizing costs as benefits are paid, to accruing the expected costs of providing these benefits if certain conditions are met. Management is currently evaluating the financial impact of this accounting standard. However, the effect of FAS 112 on the Company's results of operations and financial position is not expected to be significant. NOTE 7. JOINTLY OWNED FACILITIES AND POWER SUPPLY COMMITMENTS MAINE YANKEE The Company owns 7% of the common stock of Maine Yankee which owns and operates a nuclear power plant in Wiscasset, Maine. Under purchased power arrangements, the Company is entitled to purchase an amount approximately equal to its ownership share of the output of Maine Yankee, an entitlement of approximately 62 MW. The Company is obligated to pay its pro rata share of Maine Yankee's operating expenses, fuel costs, capital costs and decommissioning costs. MEPCO The Company owns 14.2% of the common stock of MEPCO. MEPCO owns and operates electric transmission facilities from Wiscasset, Maine to the Maine-New Brunswick border. Several New England utilities, including the Company and MEPCO's other stockholders (two other Maine utiities), are parties to a transmission support agreement pursuant to which such utilities have agreed to pay MEPCO's costs, based on their relative system peaks, if MEPCO's revenues from transmission services are not sufficient to meet its expenses. Information relating to the operations and financial position of Maine Yankee and MEPCO appears at the bottom of page 40. WYMAN 4 The Company owns 8.33% (50 MW) of the oil-fired 600 MW Wyman No. 4 unit. The Company's proportionate share of the direct expenses of this unit is included in the corresponding operating expenses in the Statements of Income. Included in the Company's utility plant are the following amounts with respect to this unit: 1993 1992 1991 ----------- ----------- ----------- Electric plant in service $16,767,909 $16,760,816 $16,642,989 Accumulated depreciation (7,539,591) (7,025,278) (6,512,562) ----------- ----------- ----------- $ 9,228,318 $ 9,735,538 $10,130,427 =========== =========== =========== NEPOOL/HYDRO-QUEBEC PROJECT The Company is a 1.6% participant in the NEPOOL/Hydro-Quebec Phase 1 project ("Phase 1"), a 690 MW DC intertie between the New England utilities and Hydro-Quebec constructed by a subsidiary of another New England utility at a cost of about $140 million. The participants receive their respective share of savings from energy transactions with Hydro-Quebec, and are obliged to pay for their respective shares of the costs of ownership and operation whether or not any savings are realized. The Company is also a 1.5% participant in the NEPOOL/Hydro-Quebec Phase 2 project ("Phase 2"), which involves an increase to the capacity of the Phase 1 intertie to 2,000 MW. As in the Phase 1 project, the Company receives a share of the anticipated energy cost savings derived from purchases from Hydro-Quebec and capacity benefits provided by the intertie and is required to pay its share of the costs of ownership and operation whether or not any savings are obtained. MAINE YANKEE (Dollars in Thousands) -------------------------------------------------------- 1993 1992 1991 ---- ---- ---- OPERATIONS: As reported by investee - Operating Revenue $193,102 $187,259 $166,471 ---------------------------- Depreciation $ 25,458 $ 24,462 $ 23,729 Interest and Preferred Dividends 14,407 14,092 16,015 Other expenses, net 145,861 140,311 118,358 ---------------------------- Operating expenses $185,726 $178,865 $158,102 ---------------------------- Earnings Applicable to Common Stock $ 7,376 $ 8,394 $ 8,369 ============================ Amounts Reported by the Company - Purchased power costs $ 11,265 $10,830 $ 9,416 Equity in net income (542) (592) (581) ---------------------------- Net purchased power expense $ 10,723 $10,238 $ 8,835 ============================ FINANCIAL POSITION: As reported by investee - Plant in service $396,133 $384,664 $368,952 Accumulated depreciation (175,996) (163,887) (149,625) Other assets 314,680 300,416 267,554 ---------------------------- Total assets $534,817 $521,193 $486,881 Less - Preferred stock 19,800 21,000 6,600 Long-term debt 115,333 110,390 124,633 Other liabilities and deferred credits 332,030 322,900 287,734 ---------------------------- Net assets $ 67,654 $ 67,503 $ 67,914 ============================ Company's reported equity - Equity in net assets $ 4,736 $ 4,725 $ 4,754 Adjust Company's estimate to actual 20 11 (16) ---------------------------- Equity in net assets as reported $ 4,756 $ 4,736 $ 4,738 ============================ MEPCO (Dollars in Thousands) -------------------------------------------------------- 1993 1992 1991 ---- ---- ---- OPERATIONS: As reported by investee - Operating Revenue $ 12,809 $ 11,608 $ 14,918 ---------------------------- Depreciation $ 1,395 1,250 1,231 Interest and Preferred Dividends 124 186 336 Other expenses, net 11,185 10,067 13,246 ---------------------------- Operating expenses $ 12,704 $ 11,503 $ 14,813 ---------------------------- Earnings Applicable to Common Stock $ 105 $ 105 $ 105 ============================= Amounts Reported by the Company - Purchased power costs $ - $ - $ - Equity in net income (15) (15) (15) ---------------------------- Net purchased power expense $ (15) (15) (15) ============================= FINANCIAL POSITION: As reported by investee - Plant in service $ 23,123 $ 22,915 $ 22,775 Accumulated depreciation (19,174) (17,891) (16,841) Other assets 2,414 1,815 4,281 ----------------------------- Total assets $ 6,363 6,839 10,215 Less - Preferred stock - - - Long-term debt 2,590 3,450 4,310 Other liabilities and deferred credits 2,895 2,511 5,026 ----------------------------- Net assets $ 878 $ 878 $ 879 ============================= Company's reported equity - Equity in net assets $ 125 $ 125 $ 125 Adjust Company's estimate to actual - - - ----------------------------- Equity in net assets $ 125 $ 125 $ 125 as reported ============================= In 1990, the Company formed Bangor Var Co., Inc. whose sole function is to be a 50% general partner in the Chester SVC Partnership ("Chester"), a partnership which owns the static var compensator ("SVC"), which is electrical equipment that supports the Phase 2 transmission line. A wholly-owned subsidiary of Central Maine Power Company owns the other 50% interest in Chester. Chester has financed the acquisition and construction of the SVC through the issuance of $33 million in principal amount of 10.48% senior notes due 2020, and up to $3.25 million principal amount of additional notes due 2020 (collectively, the "SVC Notes"). The holders of the SVC Notes are without recourse against the partners or their parent companies and may only look to Chester and to the collateral for payment. The New England utilities which participate in Phase 2 have agreed under a FERC-approved contract to bear the cost of Chester, on a cost of service basis, which includes a return on and of all capital costs. SMALL POWER PRODUCTION FACILITIES As of the beginning of 1993, the Company had contracts with ten independent, non-utility power producers known as "small power production facilities." The West Enfield Project, described below, is one such facility. There are five other relatively small hydroelectic facilities. The remainder are larger (15-25 MW) facilities, three fueled by biomass (primarily wood chips) and one by municipal solid waste. The cost of power from the small power production facilities is more than the Company would incur if it were not obligated under these contracts, and, in the case of the biomass and solid waste plants, substantially more. The prices were negotiated at a time when oil prices were much higher than at present, and when forecasts for the costs of the Company's long-term power supply were higher than current forecasts. In the Company's 1987 rate proceeding, the MPUC investigated the events surrounding the contract negotiations but reached no conclusion about the Company's prudence in entering into these contracts. The fuel cost adjustment approved by the MPUC effective November 1, 1993 includes projected costs for small power production facilities. In order to lower the overall cost of power to its customers, the Company negotiated an agreement to cancel its long-term purchased power agreement with one of the biomass plants, the Beaver Wood Joint Venture ("Beaver Wood"), in June 1993. In connection with the cancellation the Company paid Beaver Wood $24 million in cash and issued a new series of 12.25% First Mortgage Bonds due July 15, 2001 to the holders of Beaver Wood's debt in the amount of $14.3 million in substitution for Beaver Wood's previously outstanding 12.25% Secured Notes. Also, in connection with the cancellation agreement, a reconstituted Beaver Wood partnership paid the Company $1 million at the time of settling the transaction and has agreed to pay the Company $1 million annually for the next six years in return for retaining the ownership and the option of operating the plant. The payments are secured by a mortgage on the property of the Beaver Wood facility. The Company believes this contract buyout transaction will result in significant savings to its customers compared to the continuation of payments under the purchased power contract. In May 1993 the Company received an accounting order from the MPUC related to the purchased power contract buyout. The order stipulated that the Company may seek recovery of the costs associated with the buyout in a future base rate case, and could also record carrying costs on the deferred balance. Consequently, a regulatory asset of $40.3 million has been recorded as of December 31, 1993. Effective with the implementation of new base rates on March 1, 1994, the Company will begin recovering over a nine-year period the deferred balance, net of the $6 million anticipated from Beaver Wood. The agreements with the other two biomass plants, located in the Company's service territory in West Enfield and Jonesboro, are also long-term (30-year) contracts. The West Enfield and Jonesboro facilities, plants of 24.5 MW each constructed by the same developer, commenced operation in November 1987. The Company has contracted to resell a portion of the capacity from these two projects to another utility. The cost to the Company of these contracts (net of revenues from the foregoing resale) is approximately $26 million annually. The Company also has a 30-year contract with the municipal solid waste facility, a 20 MW waste-to-energy plant in the Company's service territory in Orrington, completed in 1988. The Company has also contracted to resell a portion of the capacity for fifteen years from this facility to the other utility referred to earlier. The cost to the Company of the power delivered by this facility (net of revenues from the foregoing resale) is projected to be $14 million annally. WEST ENFIELD PROJECT In 1986, the Company entered into a joint venture with a development subsidiary of Pacific Lighting Corporation for the purpose of financing and constructing the redevelopment of an old 3.8 MW hydroelectric plant which the Company owned on the Penobscot River in Enfield and Howland, Maine, into a 13 MW facility (the "West Enfield Project") for the purpose of operating the facility once it was completed. Commercial operation of the redeveloped project began in April 1988. A wholly-owned corporate subsidiary, Penobscot Hydro Co., Inc. ("PHC") was formed to own the Company's 50% interest in the joint venture, Bangor-Pacific Hydro Associates ("Bangor Pacific"). Bangor-Pacific financed the $45 million estimated cost of the redevelopment through the issuance in a privately placed transaction of $40 million of fixed rate term notes and a commitment for up to $5 million of floating rate notes. The notes are secured by a mortgage on the project and a security interest in a 50-year purchased power contract, and the revenues expected thereunder, between the Company and Bangor-Pacific. Except as described below, the holders of the notes issued by Bangor-Pacific are without recourse to the joint venture partners or their parent companies. In the event Bangor-Pacific fails to pay when due amounts payable pursuant to the loan agreement, each partner has agreed to make capital contributions to Bangor-Pacific in an amount equal to 50% of such amounts due and payable, but not exceeding an amount equal to distributions from Bangor-Pacific received by such partner in the preceding twelve-month period. The Company is obliged to provide funds necessary to support the foregoing limited financial commitment to the project undertaken by PHC as the partner. Under the purchased power contract, if the project operates as anticipated, payments by the Company to Bangor-Pacific are estimated to be about $7.5 million annually (without consideration of any distributions by the joint venture to the partners). It is possible that the Company would be required to make payments under the contract regardless of whether any power is delivered, in an amount of approximately $4 million per year. However, the Company has the right to terminate the contract if the failure to deliver power continues for a period of 12 consecutive months. The fuel cost adjustment approved by the MPUC effective November 1, 1993, includes projected costs for power delivered to the Company by Bangor Pacific. BASIN MILLS AND VEAZIE PROJECTS As a result of increased uncertainty (discussed below) about the recoverability of amounts invested through 1993 in licensing activities for proposed additional hydroelectric facilities, the Company established a reserve against those investments in the amount of $8.7 million as of December 31, 1993. Further, the Company plans to expense all future amounts related to these licensing activities. The projects for which the reserve has been established are a proposed 38 megawatt generating facility located at the so-called Basin Mills site on the Penobscot River at Orono and Bradley, Maine and an 8 megawatt addition to the Company's existing dam and power station on the Penobscot River in Veazie and Eddington, Maine. The projects would require a total investment of $140 million. The Company has been pursuing the permitting of these facilities since the early 1980's. In November 1993 the Maine Board of Environmental Protection ("BEP") approved the projects under State environmental laws and issued the water quality certificate required by the Federal Clean Water Act. The BEP's order is subject to a number of conditions, some of which could prove to be costly if the projects are developed. The BEP's decision is being appealed by the projects' opponents, and the Company cannot predict the outcome of these proceedings. If the projects continue, further significant licensing activities can be expected at the FERC, the U.S. Army Corps of Engineers, the MPUC, the BEP and possibly other agencies. The Company cannot predict the outcome of the licensing and permitting activities that are required in order for these projects to be constructed. In addition to the Company's inability to predict the outcome of the requisite licensing activities, other uncertainties have arisen as a result of changes that have developed and are continuing to develop in the electric utility industry. In general, these changes are occurring as a result of the infusion of competition into the industry. As a consequence, even if these projects continue to be the least-cost alternatives for power supply, the increasing concern about the impact of competition raises uncertainty about the timely recovery of the investment required to construct the projects. Accordingly, although the projects are not being abandoned and licensing activities are continuing, there is now less certainty that they will be constructed or that the costs for the completed projects could be recovered. The Company also believes that the recoverability of the costs incurred to date is subject to increasing uncertainty. Under Maine law and regulation, the MPUC can authorize the recovery of prudently incurred utility investment in abandoned or cancelled projects. However, under current MPUC policy, recovery of plant investment cannot begin until either it becomes operational or it is abandoned or cancelled. Since neither of these events has occurred and since the Company cannot predict when either of them might occur, it is impossible to forecast when a final regulatory decision on the recoverability of these costs might be made. Moreover, given the concerns about competitiveness described above, at the time when recovery of those costs might be requested, the Company would likely take into consideration the impact of the inclusion of those costs in its rates, and could conclude that it would not be in the Company's best interests to pursue cost recovery. NOTE 8. RECOVERY OF SEABROOK INVESTMENT AND SALE OF SEABROOK INTEREST The Company was a participant in he Seabrook nuclear project in Seabrook, New Hampshire. On December 31, 1984, the Company had almost $87 million invested in Seabrook, but because the uncertainties arising out of the Seabrook Project were having an adverse impact on the Company's financial condition, an agreement for the sale of Seabrook was reached in mid-1985 and was finally consummated in November 1986. During 1985, a comprehensive agreement was negotiated among the Company, the MPUC staff, and the Maine Public Advocate addressing the recovery through rates of the Company's investment in Seabrook (the "Seabrook Stipulation"). This negotiated agreement was approved by the MPUC in late 1985. Although the implementation of the Seabrook Stipulation significantly improved the Company's financial condition, substantial write-offs were required as a result of the determination that a portion of the Company's investment in Seabrook would not be recovered. In addition to the disallowance of certain Seabrook costs, the Seabrook Stipulation also provided for the recovery through customer rates of 70% of the Company's year-end 1984 investment in Seabrook Unit 1 over 30 years, and 60% of the Company's investment in Unit 2 over seven years, with base rate treatment of the unamortized balances. As of December 31, 1992, the Company's investment in Seabrook Unit 2 was fully amortized. NOTE 9. CONTINGENCIES BANKRUPTCY OF LARGEST CUSTOMER LCP filed for protection under Chapter 11 of the bankruptcy law in July 1991. At the time of the bankruptcy filing, LCP owed $719,642 for electric service, for which the Company has a general, unsecured claim. In addition, LCP is seeking to recover from the Company certain payments for electric service made prior to the filing as preference payments under the bankruptcy law. Since the filing, pursuant to arrangements approved by the Bankruptcy Court, LCP must pay for service weekly in arrears and the Company may curtail deliveries of power three days after the presentation of a weekly bill. Furthermore, the Company has been permitted to collect a deposit to secure the value of approximately one week of service. As a result, the LCP account for service rendered after the date for bankruptcy filing is current. ENVIRONMENTAL MATTERS The Company has received a notice of potential liability under the Comprehensive Environmental Response, Compensation, and Liability Act as a generator of hazardous substances that the United States Environmental Protection Agency alleges may have been disposed of at a waste disposal facility in Connecticut. The Company is only one of several hundreds of potentially responsible parties at the site. The Company has received a notice from the Maine Department of Environmental Protection under similar Maine legislation relating to several facilities in Maine. The Company is not yet aware of the extent of potential clean-up necessary or the number of potentially responsible parties involved. In management's opinion, the resolution of these matters are not expected to have a material adverse impact on the Company's financial condition. NOTE 10. UNAUDITED QUARTERLY FINANCIAL DATA Unaudited quarterly financial data pertaining to the results of operations are shown below: Quarter Ended --------- --------- --------- -------- March 31 June 30 Sept. 30 Dec.31 --------- --------- --------- ------- (Dollars in thousands except per share amounts) ---- Electric Operating Revenue $46,679 $40,548 $43,476 $ 44,269 Operating Income 4,779 4,486 4,396 3,138 Net Income (Loss) 2,908 2,766 3,244 (3,582)* Earnings (Loss) Per Share of Common Stock $ .46 $ .42 $ .46 $(.64)* ======= ======== ======== ======== ---- Electric Operating Revenue $48,013 $39,722 $41,877 $ 47,177 Operating Income 4,472 4,370 5,050 4,624 Net Income 2,555 2,224 2,885 2,591 Earnings Per Share of Common Stock $ .40 $ .34 $ .46 $ .40 ======== ======== ======== ========= ---- Electric Operating Revenue $44,142 $35,256 $37,966 $44,879 Operating Income 4,526 3,500 4,119 4,300 Net Income 2,275 1,462 2,068 2,394 Earnings Per Share of Common Stock $ .42 $ .23 $ .31 $ .37 ========= ======== ======== ======== * Includes the provision for Basin Mills of $5.7 million after-tax or $.95 per common share. NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value at December 31, 1993 of each class of financial instruments for which it is practical to estimate the value: Cash and cash equivalents: The carrying amount of $2,387,156 approximates fair value. The fair values of mandatory redeemable cumulative preferred stock, first mortgage bonds and pollution control revenue bonds at December 31, 1993 based upon similar issues of comparable companies are as follows: In Thousands ------------------- Carrying Fair Amount Value ------------------- Mandatory redeemable cumulative preferred stock $ 15,168 $ 16,022 First Mortgage Bonds 116,223 137,735 Pollution Control Revenue Bonds 4,200 4,200 =================== REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Stockholders and Directors of Bangor Hydro-Electric Company: We have audited the accompanying consolidated balance sheets and statements of capitalization of Bangor Hydro-Electric Company and subsidiaries (the "Company") as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company s management. Our responsiblity is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 2 to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes. Coopers & Lybrand Portland, Maine February 17, 1994 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH AUDIT FIRMS ON FINANCIAL DISCLOSURE - ------ ------------------------------------------------ There have been no changes in or disagreements with audit firms on financial disclosure. PART III - -------- ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------- -------------------------------------------------- See Part I above, and see the information under "Election of Directors" in the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. ITEM 11 EXECUTIVE COMPENSATION - ------- ---------------------- See the information under "Executive Compensation" in the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------- ----------------------------------------------- (a) Security Ownership of Certain Beneficial Owners See the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. (b) Security Ownership of Management See the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. (c) Changes in Control Not applicable. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------- ---------------------------------------------- See the information under "Election of Directors" in the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. PART IV - ------- ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ------- ---------------------------------------------------- (a) Consolidated Financial Statements of the Company (See Item 8) Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and Consolidated Statements of Retained Earnings for the Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization - December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants (b) Schedules Report of Independent Accountants Schedule V - Property, Plant and Equipment and and Construction in Progress Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Reserves for Doubtful Accounts and Insurance All other schedules are omitted as the required information is inapplicable or the information is presented in the Company's consolidated financial statements or related notes. (c) Exhibits See Exhibit Index, page (d) Reports on Form 8-K A Current Report on Form 8-K dated December 15, 1993 was filed in the fourth quarter of 1993, regarding the establishment of a reserve against investments in certain hydroelectric facilities. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Robert S. Briggs ------------------------- Robert S. Briggs President and Chairman of the Board (Chief Executive Officer) Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Robert S. Briggs Helen Sloane Dudman - ------------------------ ------------------------ Robert S. Briggs Helen Sloane Dudman President and Director Chairman of the Board G. Clifton Eames - ------------------------ ------------------------ William C. Bullock, Jr. G. Clifton Eames Director Director Jane J. Bush Robert H. Foster - ------------------------ ------------------------ Jane J. Bush Robert H. Foster Director Director David M. Carlisle Carroll R. Lee - ------------------------ ------------------------ David M. Carlisle Carroll R. Lee Director Director, Vice President- Operations John P. O'Sullivan - ------------------------ ------------------------ Alton E. Cianchette John P. O'Sullivan Director Director, Vice President- Finance & Administration (Chief Financial Officer) David R. Black ----------------------- David R. Black Controller (Chief Accounting Officer) Each of the above signatures is affixed as of March 23, 1994. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors Bangor Hydro-Electric Company: Our report on the financial statements of Bangor Hydro-Electric Company is included Item 8

311871_1993.txt

311871

1993

Item 1. Business INTRODUCTION AND DEVELOPMENTS IN 1993 Pope & Talbot is engaged principally in the wood products and pulp and paper businesses. The Company's wood products business involves the manufacture and sale of standardized and specialty lumber and wood chips. In its pulp and paper business, the Company manufactures and sells a full line of private label consumer tissue and disposable diaper products, bleached kraft pulp for newsprint and writing paper, and brokers wood chips. During 1993, wood products accounted for approximately 48 percent of the Company's revenues, consumer tissue accounted for 17 percent, disposable diapers 27 percent and bleached kraft pulp and brokered wood chips 8 percent. The Company, a Delaware corporation, was originally incorporated as a California corporation in 1940. It is the successor to a partnership formed in San Francisco, California in 1849 that acquired its first timberlands and opened a lumber mill in the Seattle, Washington area in 1853. Subsequently, the Company developed a lumber business based on timberland and facilities in the U.S. Pacific Northwest, British Columbia, Canada, and the Black Hills region of South Dakota and Wyoming. Since the mid-1980s, the Company has reduced its dependency on timber from the Pacific Northwest, where environmental concerns about the preservation of old-growth forests have sharply restricted the availability and increased the cost of public timber. At the same time, the Company has increased its operations in regions of more stable timber supplies, particularly in British Columbia and the Black Hills region of South Dakota and Wyoming. In 1985, the Company distributed its timber and land development properties in the State of Washington to its stockholders through interests in a newly formed master limited partnership. In 1990, the Company sold its Oregon sawmill, and the Company has since sold its remaining Oregon timberlands. In 1992, the Company acquired a 225 million board feet capacity sawmill and related timber cutting rights in Castlegar, British Columbia. The Company currently operates six sawmills with an estimated annual capacity of 785 million board feet, of which approximately 80% is located in British Columbia and the Black Hills. In order to expand and broaden its sources of revenue, the Company acquired its pulp, consumer tissue and disposable diaper businesses in the late 1970s and 1980s. The Halsey, Oregon pulp mill produces bleached kraft pulp which is sold in the open market and to newsprint and writing paper manufacturers in the Pacific Northwest. The Company's private label tissue business manufactures towels, napkins, bathroom tissue and facial tissue from recycled paper at two mills in the U.S. Disposable diapers are produced by the Company at four mills in the U.S. The Company sells its tissue and diaper products under private labels to supermarkets, drugstores, mass merchandisers and food and drug distribution companies. In 1992, the Company commenced a program to reduce costs and improve operating efficiencies in these businesses, resulting in the consolidation of one tissue mill and one diaper plant. The Company is also presently in the process of making significant product and cost improvements to its pulp mill. The businesses in which the Company is engaged are extremely competitive, and a number of the Company's competitors are substantially larger than the Company with correspondingly greater resources. In particular, competition in the tissue products and disposable diaper markets is extremely strong, both in terms of price and product innovation. See "Pulp and Paper Products Business - Paper Products." Environmental regulations to which the Company is subject require the Company from time to time to incur significant expenditures. In addition, as discussed herein, environmental concerns have in the past materially affected the availability and cost of raw materials used in the Company's business. See "Wood Products Business." WOOD PRODUCTS BUSINESS The Company's wood products business involves the manufacture and sale of standardized and specialty lumber and wood chips. The Company's principal wood product categories and the sales generated by each over the past three years are set forth in the following table: In 1993, lumber revenues increased $80.3 million, or 45 percent, compared with 1992. These increased revenues in 1993 were due mainly to higher lumber sales prices, but also to greater lumber sales volumes due to operating the Castlegar, British Columbia sawmill throughout 1993. In 1992, lumber revenues increased $56.2 million, or 47 percent, compared with 1991. These increased revenues were due to higher lumber sales volume, primarily from the second quarter acquisition of the Castlegar, British Columbia sawmill, combined with higher lumber sales prices. The Company's lumber products consist principally of boards and dimension lumber, some of which are specialty, value-added items, such as stress-rated lumber. Wood chips and other similar materials are obtained as a by-product of the Company's lumber operations. Wood chips are also obtained from direct chipping of whole logs. The principal sources of raw material for the Company's wood products operations are timber obtained through long-term cutting licenses on public lands, logs purchased in open log markets, timber offered for sale via competitive bidding by federal and state agencies and private sources, and timber purchased under long-term contracts to cut timber on private and public lands. Approximately 80% of the Company's current lumber capacity is located in regions of relatively stable timber supply, namely Canada and the Black Hills region of South Dakota and Wyoming. In Canada, timber requirements are obtained primarily from the Provincial Government of British Columbia under long-term timber harvesting licenses which allow the Company to remove timber from defined areas annually on a sustained yield basis. Approximately 15 percent of the Company's Canadian log requirements are satisfied through open market log purchases. In the Black Hills, the Company obtains its timber from various public and private sources under long-term timber harvesting contracts in addition to buying logs on open markets. Under these licenses and contracts, prices are subject to periodic adjustment based upon formulas set forth therein. Additionally, the Provincial Government of British Columbia has the authority to modify prices and harvest volumes at any time. In the Northwest, the Company obtains its timber primarily via competitive bidding on timber offered by federal and state agencies and private sources. Decreased availability of federal timber caused primarily by pressures from environmental groups to curtail harvests from public lands, thereby protecting old-growth forests, combined with strong export demand for logs, has resulted in reduced wood supplies in Oregon and Washington, particularly affecting the Company's Port Gamble sawmill. The Northwest's highly competitive log supply environment caused the Company to reduce production at its Port Gamble sawmill to 74% of capacity in 1993. Although no assurances can be given, the Company believes that purchases from public agencies and private sources, in addition to its existing long-term cutting rights, will be adequate to sustain current lumber production levels at the Company's sawmills, with the exception of Port Gamble which will continue to operate based upon log availability. Marketing and Distribution. The Company's lumber products are sold primarily to wholesalers. Wood chips produced by the Company's sawmills are sold to manufacturers of pulp and paper in the U.S. and Canada. Sales of logs are made to other domestic forest products companies and to international trading companies. Marketing of the Company's wood products is centralized in its Portland, Oregon offices. The Company does not have distribution facilities at the wholesale or retail level. The Company sold wood products to numerous customers during 1993, the ten largest of which accounted for approximately 32% of total wood products sales. No wood products customer accounted for more than 10% of the Company's revenues in 1993. Backlog. The Company maintains a minimal finished goods inventory of wood products. At December 31, 1993, orders were approximately $11.2 million, compared with approximately $8.9 million at December 31, 1992. This was an average order file for the Company and generally would be shipped in two weeks to one month. The increase from 1992 to 1993 reflects increased lumber sales prices. Competition. The wood products industry is highly competitive, with a large number of companies producing products that are reasonably standardized. There are numerous competitors of the Company that are of comparable size or larger, none of which is believed to be dominant. With the 1992 Castlegar sawmill acquisition, the Company believes it is one of the larger lumber producers in North America. The principal means of competition in the Company's wood products business are pricing and an ability to satisfy customer demands for various types and grades of lumber and other finished products. For further information regarding amounts of revenue, operating profit and loss and identifiable assets attributable to the wood products industry segment, see Note 11 of "Notes to Consolidated Financial Statements" in the Company's 1993 Annual Report to Shareholders. PULP AND PAPER PRODUCTS BUSINESS The Company's principal pulp and paper products categories and the sales generated by each over the last three years are set forth in the following table: Pulp and paper revenues were essentially unchanged from 1992 to 1993 as increased disposable diaper revenues were offset by lower tissue and pulp revenues. The improved diaper revenues resulted from a 21 percent increase in sales volume. Tissue and pulp volumes were off approximately 8 percent and 28 percent, respectively, from 1992 to 1993, while tissue prices dropped 1 percent and pulp prices fell 12 percent during this same period. Pulp and paper revenues decreased $19.1 million, or 5 percent, from 1991 to 1992, due mainly to tissue and pulp volume and price reductions. From 1991 to 1992, tissue and pulp volumes fell approximately 12 percent and 8 percent, respectively, while prices dropped 6 percent for tissue and 9 percent for pulp. Diaper improvements from 1991 to 1992 only partially offset the tissue and pulp reductions as diaper volumes and average prices increased 10 percent and 6 percent, respectively. 1. PAPER PRODUCTS The Company produces a full line of private label consumer tissue products including towels, napkins, bathroom tissue, and facial tissue. The Company also produces disposable diapers. All of these products are sold under private and controlled labels. The raw material for the Company's tissue mills is wastepaper purchased from wastepaper dealers located in the upper Midwest, mid- Atlantic and, to a lesser extent, on the East Coast. The principal raw material for disposable diapers is fluff pulp, which is produced by pulp and paper manufacturers throughout the United States. The Company believes that there will continue to be an adequate supply of wastepaper and fluff pulp in the foreseeable future. Marketing and Distribution. The Company utilizes its own sales force and some retail consumer products brokers to sell its products to supermarkets, drugstores, mass merchandisers and food and drug distribution companies. The Company's products enjoy national distribution; however, the majority are sold east of the Rocky Mountains. Sales to the Company's ten largest paper products customers represented 54 percent of tissue products and diaper sales in 1993. No single paper products customer accounted for 10 percent or more of total Company revenues in 1993. Backlog. The Company carries a minimal finished goods inventory in tissue products and disposable diapers. At the end of 1993 the order file was approximately $13.3 million compared to a backlog of approximately $7.9 million at December 31, 1992. The higher order backlog at year-end 1993 than year-end 1992 relates to timing of order receipts and is not indicative of a business trend. This backlog is generally shipped in less than one month. Competition. The tissue market is extremely competitive, with approximately 10 major producers. Of these, James River Corporation, Scott Paper Company, Procter & Gamble Corporation and Fort Howard Paper Company are dominant and account for approximately 64 percent of the market. Within the tissue market, the Company estimates that the private label tissue segment accounts for approximately 9 percent to 22 percent of the total, depending on the product. In the tissue business, continued low industry operating rates resulting from industry capacity increases in recent years which have exceeded demand growth, coupled with aggressive pricing by tissue producers, has resulted in an extremely competitive tissue pricing environment. The Company's tissue mills operated at 97 percent of capacity in 1993. Overall, prices for the Company's tissue have fallen an average 13 percent from 1989 when tissue prices first began to decline. This 13 percent price reduction includes decreases of 6 percent in 1992 and 1 percent in 1993. Of the disposable diaper market, the Company estimates that approximately 82 percent is in branded products, with the remaining 18 percent relating to private label products. There are four major producers in the disposable diaper business. Procter & Gamble and Kimberly- Clark are dominant with a combined 76 percent of the market, all of which is in branded products. Paragon Trade Brands, Inc. is the largest producer in the private label market segment, followed by the Company with approximately 4 percent of the disposable diaper market. National branded manufacturers have introduced numerous and frequent product innovations that have resulted in major improvements in infant disposable diaper absorbency, leakage prevention and fit. The national branded manufacturers have substantially larger research and development budgets than the Company and are able to develop product innovations more rapidly than the Company and may thereby gain market share at the Company's expense. While in recent years the Company has been able to introduce product enhancements comparable to those introduced by the national branded manufacturers, there can be no assurance that the Company will be able to continue to introduce comparable product innovations on a profitable basis or that the Company will continue to be able to introduce such product innovations at the pace required to remain competitive with the national branded manufacturers. The Company believes that its national distribution capabilities, its full product line and its reputation as a private label supplier enhance its market efforts. 2. PULP PRODUCTS The Company owns a pulp mill and supporting facilities at Halsey, Oregon. This mill produces bleached kraft pulp which is sold in various forms in the open market and to newsprint and writing paper manufacturers in the Pacific Northwest. The mill also produces a flash dried pulp which is sold in the open market. In conjunction with the fiber acquisition program for the pulp mill, the Company brokers pulp chips for sale primarily into the export market. The total annual capacity of the mill is 180,000 air dry metric tons; 109,000 metric tons were produced in 1993 and 152,000 metric tons were produced in 1992. The Company's pulp business was affected in 1992 and to a greater extent in 1993 by high wood chip costs, weak demand, and declining pulp prices. During 1992 construction began at Halsey on a $24 million oxygen delignification project to reduce both the use of chlorine in the bleaching process and dioxin discharges. This multi-year project, which was necessary to comply with an agreement entered into with the Oregon Department of Environmental Quality on meeting target emission levels, was completed in late 1993. Since 1985 the Company has had a pulp supply contract with James River Corporation ("James River") to supply pulp in slush form to a tissue facility owned by James River adjacent to the Company's pulp mill. James River began production of its own recycled pulp at Halsey in 1992, and correspondingly reduced its consumption of pulp from the Company's pulp mill in 1992 and completely phased out of its Halsey pulp consumption in 1993. Approximately 10,000 metric tons were sold to James River in early 1993 compared to 31,000 in 1992. As a result of depressed world pulp prices, selective downtime was taken in lieu of selling pulp in the open market to replace the lost James River tonnage. Because of the lost James River volume and the related decision to take selective downtime, the Halsey pulp mill operated at 60 percent of capacity in 1993. Weyerhaeuser Company ("Weyerhaeuser") presently owns a pulp mill, which it has announced it intends to upgrade and expand, located adjacent to the North Pacific Paper Company ("Norpac") newspaper manufacturing facility in Longview, Washington. Weyerhaeuser is a part owner of Norpac. The Company believes that completion of the upgrade and expansion project by Weyerhaeuser at its pulp mill will occur in 1995 or later. At that time, there is a significant possibility that Norpac will begin to satisfy a portion of its pulp needs from the Weyerhaeuser mill, and at the same time substantially reduce the quantity of pulp it purchases from the Company at the Halsey mill. In 1993, Norpac purchased approximately 46,000 metric tons of pulp from the Company. In order to provide additional sales flexibility and attempt to improve margins through higher value products, the Company initiated mill modifications in 1993 totaling $41 million, which will be completed in early 1994 to improve pulp quality and expand pulp drying capabilities. These modifications are in addition to the $24 million oxygen delignification project. These mill improvements will allow the Company to expand its pulp product offerings and to dry its total pulp production, thus providing greater access to new pulp markets within and outside the Pacific Northwest, which has historically been the Company's primary pulp market region. Given these mill improvements, management does not anticipate that elimination of the James River sales volume will have a material adverse effect on the Company's pulp business. The pulp mill modifications mentioned previously made it possible for the Company to enter into a significant pulp supply agreement in the third quarter of 1993. Under this agreement, late in the fourth quarter of 1993 the Company began supplying pulp to a writing grade paper mill which reopened in January 1994. The paper mill was recently purchased from its former owners by a group of private investors. All output from the paper mill will be sold to one customer. It has been anticipated that ultimately the paper mill would purchase pulp from the Company in significant quantities, depending on sales by the paper mill to its customer. However, to date pulp purchases have not been at this level. In the event that the paper mill's sales to its customer are adversely impacted for any reason, sales of the Company's pulp may be adversely impacted. It is also anticipated that a portion of the pulp sold to the paper mill will be produced from sawdust and hardwood chips, which have historically been less expensive than softwood chips, which has been the primary raw material for the pulp mill. Pricing for this pulp will be computed using a formula based on prices for white paper. Based on prices in effect for white paper at the end of 1993, the price that pulp would be sold under this agreement would be 8 percent higher than the average pulp price the Company obtained for its pulp at the end of 1993. Substantially all of the Company's wood chip and sawdust requirements for the Halsey pulp mill are satisfied through purchases by the Company from third parties. The Company has long-term chip supply contracts with sawmills in the Pacific Northwest. Environmental concerns over timber harvests, which have caused high log costs for the Company's Port Gamble sawmill, have also caused higher chip costs and reduced chip availability from historic sources at the Halsey pulp mill over the last three years. In order to maintain an adequate supply of wood fiber for the mill, the Company has expanded its geographic base from which it obtains the softwood chips normally used as the primary raw material for the pulp mill. The Company has also expanded the capability of using sawdust and hardwood chips, which historically have been less expensive than softwood chips, as raw materials for a portion of the production. In order to maintain an adequate supply of chips for the anticipated 60 percent of the pulp mill's production which will remain based on softwood chips, the Company will continue to use an expanded geographic base to obtain chips, adding to their cost. Unless environmental restrictions on timber harvests are relaxed, chip prices likely will remain high, and sawdust and hardwood chip prices may also increase. The Company believes that these third-party chip purchases, in addition to its whole-log chipping capabilities, will be adequate for the Halsey pulp mill in the foreseeable future. Marketing and Distribution. The Company utilizes its own sales force and pulp brokers to sell its pulp products. Substantially all of the Company's pulp products are sold in the Northwest. In 1993, sales to Norpac represented 46 percent of the Company's pulp revenues, sales to James River represented 7 percent of the Company's pulp revenues, and the remaining eight largest customers accounted for an additional 37 percent of pulp revenues. No single pulp customer accounted for 10 percent or more of total Company revenues in 1993. Backlog. The Company's pulp customers typically enter into one- to three-year contracts and provide the Company with annual estimates of their requirements. More definite orders are placed by these customers on a quarterly basis. As of December 31, 1993, the Company's backlog of orders for pulp products for delivery during the first quarter of 1994 was $19 million, compared to a backlog of approximately $15 million at December 31, 1992. This increase was due primarily to scheduled pulp sales volume resulting from the third quarter 1993 pulp supply agreement mentioned previously. Competition. The pulp industry is highly competitive, with a substantial number of competitors having extensive financial resources, manufacturing expertise and sales and distribution organizations, most of which are larger than the Company, but none of which is believed to be dominant. The principal methods of competition in the pulp market are price, quality, volume, reliability of supply and customer service. For further information regarding amounts of revenue, operating profit and loss and identifiable assets attributable to the pulp and paper products industry segment, see Note 11 of "Notes to Consolidated Financial Statements" in the Company's 1993 Annual Report to Shareholders. ENVIRONMENTAL MATTERS The Company's wood products and pulp and paper businesses are subject to federal, state and Canadian pollution control regulations that have required, and are expected to continue to require, significant expenditures. During the fiscal year ended December 31, 1993, the Company's capital expenditures for environmental control amounted to approximately $23.4 million. Additionally, expenditures for such purposes are expected to be $2 million and $4 million for the years ending December 31, 1994 and 1995, respectively. The expenditures in 1993 represent primarily the costs necessary to complete the oxygen delignification project at the Halsey, Oregon pulp mill. $16 million of the oxygen delignification project was financed by a note payable to the State of Oregon under the State's Small Scale Energy Loan Program (SELP). In response to environmental concerns in Western Oregon and Western Washington, specifically the preservation of old-growth forests, substantial amounts of federal timberlands have been set aside as wilderness areas. This has affected and may continue to affect the amount and cost of timber obtainable from public agencies in this region. Currently, the Company's exposure in this region is the Port Gamble, Washington sawmill and the Halsey, Oregon pulp mill. The carrying value of the Port Gamble sawmill was written down in 1990 as a result of its inability to obtain adequate timber supply; the sawmill now operates based upon log availability. The Halsey pulp mill is also affected by the decrease in timber availability, since its primary raw materials, wood chips and to a greater extent beginning in 1994, sawdust and hardwood chips, are by-products of the lumber manufacturing process. It is management's opinion that, based on existing wood chip and sawdust availability both within the Willamette Valley region of Oregon and from other sources discussed previously, wood chip and sawdust resources will be adequate for the Company's requirements at the Halsey pulp mill in the foreseeable future. It is also management's opinion that the reduced availability of public timber in Western Washington will have little, if any, additional impact on the Company's Port Gamble operations. In 1992, the Company was contacted by the local governmental owner of a vacant industrial site in Oregon on which Pope & Talbot previously conducted business. The owner informed the Company that the site has been identified as one containing creosote and coal tar, and that it plans to undertake a voluntary clean-up effort of the site. The owner has requested that the Company participate in the cost of the cleanup. The Company, in conjunction with an environmental consultant, performed in 1993 a preliminary assessment of soil contamination on the site. The results of this study indicate there is some soil contamination present from creosote and coal tar as well as pollutants from other sources, and that the responsibility for the contamination is not clear. The estimated cost of cleaning up this site and the Company's liability, if any, has yet to be determined. EMPLOYEES The Company currently employs approximately 3,100 employees of whom 2,600 are paid hourly and a majority of which are members of various labor unions. Approximately 47 percent of the Company's employees are associated with the Company's wood products business, 51 percent are associated with the Company's pulp and paper business and 2 percent are corporate management and administration personnel. FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES The Company's foreign manufacturing operations consist of three lumber mills located in Canada. The Company's primary exports are disposable diapers sold to Canada and brokered wood chips sold to Japan. The Company's export sales from the United States were $29.1 million for 1993, $19.3 million for 1992 and $19.4 million for 1991. Of the 1993 export sales, 56 percent were to Canada and 32 percent were to Japan. Financial information regarding the Company's domestic and foreign operations is included in Note 11 of "Notes to Consolidated Financial State-ments" on page 32 of the Company's 1993 Annual Report to Shareholders. Item 2.

Item 2. Properties WOOD PRODUCTS PROPERTIES 1. Mills and Plants The following tabulation briefly states the location, character, capacity and 1993 production of the Company's primary wood products manufacturing facilities: ________________________________________________________________________ (1) Based on normal industry practice of operating two shifts, five days per week for lumber mills except for the Newcastle, Wyoming mill which is based upon one shift, five days per week. Assumes two shifts, five days per week for the alder chip facility. (2) Wood chips are also produced as a result of the operation of the Company's lumber mills. It is estimated that the aggregate annual capacity for such production is 440,000 bone dry units. In 1993, 396,000 bone dry units were produced. The Company believes that its wood products manufacturing facilities are adequate and suitable for current operations. Nevertheless, the Company is committed to continually improving its manufacturing facilities as evidenced by the Castlegar lumber mill modernization completed in 1993. The Company owns all of its wood products manufacturing facilities except that it leases the ground on which the Port Gamble facilities are located from Pope Resources, A Delaware Limited Partnership, pursuant to a 20-year lease entered into in December 1985. 2. Timber and Timberland Restructuring activities in 1992 resulted in the sale of approximately 21,800 acres of primarily immature timber in Oregon. The Company no longer owns any timberland in the Pacific Northwest. PULP AND PAPER PROPERTIES 1. Tissue and Diaper Mills The following table briefly states the location, character, capacity and 1993 production of the Company's tissue and diaper products manufacturing facilities: _____________________________________________________________________ (1) Based on normal industry practice of operating three shifts per day, seven days per week, less scheduled downtime. The Company believes that its tissue and diaper manufacturing facilities are adequate and suitable for current operations. The Company completed installation of equipment in 1993 to produce diaper training pants at its Shenandoah, Georgia diaper facilities. The Company owns all of its tissue and diaper production facilities, except that it leases the building which contains the Shenandoah diaper and incontinent production facilities. 2. Pulp Mill The Company owns a bleached kraft pulp mill near Halsey, Oregon. In 1993, 109,000 air dry metric tons of pulp were produced, compared with an estimated annual capacity of 180,000 metric tons. During 1993 the Company (1) began installation of a conventional Flakt pulp dryer costing approximately $37 million which will be completed in the first quarter of 1994 and will allow the mill to produce market pulp in a form suitable for shipping to markets outside the Pacific Northwest, (2) completed the installation of an oxygen delignification system which, in addition to permitting the Company to meet the Oregon State Department of Environmental Quality dioxin discharge limitations, will improve pulp quality and slightly improve brightness, and (3) made certain modifications to its bleach plant at the Halsey mill which will also result in pulp quality and brightness improvements. The Flakt pulp dryer will require additional 1994 spending of approximately $13 million. With the completion of the above mentioned capital projects, the Company believes that its pulp facility is adequate and suitable for current operations. Item 3.

Item 3. Legal Proceedings In 1985, stockholders of the Company approved a Plan of Distribution pursuant to which all of the Company's timber properties and development properties and related assets and liabilities in the State of Washington were transferred to newly-formed Pope Resources, A Delaware Limited Partnership, with interests in the partnership distributed to the Company's stockholders on a pro rata basis. The Company assigned to the assets transferred a distribution value for federal income tax purposes based upon the public trading price of the partnership interests at the time of distribution. The Internal Revenue Service has asserted that the Company owes additional federal income tax in the amount of approximately $14 million (plus applicable interest) in connection with this transaction and the Company has disputed this asserted tax liability. The issue is scheduled to be heard in U.S. Tax Court during the third quarter 1994. The Company will vigorously contest the assessed tax liability through independent tax counsel. It is management's opinion, based upon consultation with independent tax counsel, that the additional tax due in this matter, if any, will ultimately be significantly less than the assessed amount and will not have a material adverse effect on the Company's financial position. The final tax settlement, if any, will be recognized as a reduction in equity with respect to the partnership transaction. In September 1992, Kimberly-Clark sued in the U.S. District Court for the Western District of Washington, alleging that diapers manufactured by the Company infringe a U.S. patent that has been assigned to Kimberly-Clark. The Company is vigorously defending the litigation, on the basis that the patent is invalid and unenforceable. The Company is also defending on the basis that its products do not infringe the patent (even if it is determined to be valid and enforceable). The Company has significant arguments to defend its position of non-infringement, and has already prevailed on a motion for partial summary judgment that substantially narrowed the scope of the asserted patent. If the patent is found to be both valid and infringed, damages could consist of a reasonable royalty on the sales of infringing products and/or profits lost by Kimberly-Clark as a result of infringement. Kimberly-Clark has also requested an injunction to prohibit future sales of any products ultimately found to infringe the patent if the Company declines to accept Kimberly-Clark's offer to license the patent. The impact of any such injunction could be limited by accepting a patent license from Kimberly-Clark. The Company does not expect that the ultimate resolution of this matter will have a material adverse impact on the financial position or results of operations of the Company. Kimberly-Clark has also threatened additional litigation with respect to a related patent, which may issue from the U.S. Patent & Trademark Office. The patent that is the basis for the threatened litigation has not yet been issued and its scope has not yet been determined. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT WHO ARE NOT DIRECTORS In addition to the executive officers who are also directors of the Company, there are the following executive officers who are not directors. CARLOS M. LAMADRID, 58, Senior Vice President - Finance, Secretary, Treasurer and Chief Financial Officer since August 1987. MICHAEL FLANNERY, 50, Group Vice President - Wood Products Division since August 1987. WILLIAM G. FROHNMAYER, 55, Group Vice President - Fiber Products since August 1987. ROBERT L. VANDERSELT, 47, Group Vice President - Consumer Products Division since September 1991; August 1990 to September 1991 President, CKI Consulting (a management consulting firm); September 1988 to August 1990 President, Scott Worldwide Food Service, Scott Paper Company (a diversified consumer paper company). RICHARD N. MOFFITT, 46, Vice President - Human Resources since June 1987. All officers hold office at the pleasure of the Board of Directors. PART II ITEM 5.

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS Pope & Talbot, Inc. common stock is traded on the New York and Pacific stock exchanges under the symbol POP. The number of shareholders at year-end 1993 and 1992 were 1,398 and 1,576, respectively. The high and low sales prices for the common stock on the New York Stock Exchange and the dividends paid per common share for each quarter in the last two fiscal years are shown below: ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Information required by Item 6 of Part II is presented in the table entitled "Five Year Summary of Selected Financial Data" on page 14 of the Company's 1993 Annual Report to Shareholders. Such information is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview An exceptionally strong lumber market and record earnings in diapers more than offset losses in tissue and pulp to return Pope & Talbot to profitability in 1993, after two years of losses. Pope & Talbot's earnings for 1993 were $21.0 million, or $1.80 per share ($1.67 on a fully diluted basis), up from 1992's loss of $2.3 million, or $.19 per share. Operations contributed $21.6 million, or $1.85 per share in 1993; however, also included was a net charge of $562,000, or $.05 per share, reflecting the cumulative effect of accounting changes adopted in 1993. See Note 1 of Notes to Consolidated Financial Statements for an explanation of the accounting changes. Widely divergent business environments affected Pope & Talbot's businesses during 1993. An improving housing industry, combined with sharply curtailed timber harvests in the Pacific Northwest as a result of environmental pressures, produced lumber prices that were 34 percent higher on average in 1993 than 1992, resulting in the best wood products earnings in the Company's history. Demand for the Company's disposable diapers remained strong in 1993 and, combined with only minor price reductions as a result of competitors' price reduction efforts, resulted in record profits for the diaper business. Conversely, tissue produced a loss for the second year in a row, as extremely competitive conditions in the tissue industry continued, and world pulp markets remained poor, resulting in losses from our pulp business for the third consecutive year. Revenues reached a record $628.9 million in 1993, a 16 percent increase from $544.3 million in 1992. Higher lumber sales prices in wood products was the most significant factor impacting the revenue increase. In pulp and paper, revenue gains from higher diaper sales volumes were largely offset by poor pricing and demand for tissue and pulp. Liquidity and Capital Resources Capital spending, largely to expand drying capabilities, improve pulp quality and to meet environmental requirements at the Company's Halsey, Oregon pulp mill, increased the debt-to-total-capitalization ratio to 42 percent at year-end 1993, from 34 percent at the end of 1992. The Company continues to have available $95 million under existing credit agreements, of which $11 million was borrowed at December 31, 1993. The Company's primary sources of internally generated cash are operating income plus depreciation; the principal external source of cash is debt financing. Cash generated from operations was $36.9 million in 1993. Additionally, during 1993 the Company completed an offering of $75 million of 8 3/8 percent, 20-year debentures, and received $16 million at 6.55 percent from the State of Oregon under the State's Small Scale Energy Loan Program. See Note 4 of Notes to Consolidated Financial Statements for further long-term debt information and subsequent years' debt repayment schedules. These cash resources were used to finance $82.6 million of capital expenditures, $8.9 million for the payment of dividends, and to reduce borrowings on the Company's lines of credit including repayment of $45.0 million on the Company's unsecured revolving-credit agreement. Scheduled long-term debt repayments were $500,000 in 1993 and are anticipated to be $901,000 in 1994. The most significant capital improvement projects included $47 million to improve pulp quality, expand drying capabilities and reduce both the use of chlorine in the bleaching process and the discharge of dioxins from the Halsey pulp mill. The project to reduce chlorine usage and dioxin discharges is necessary to comply with an agreement entered into with the Oregon Department of Environmental Quality on meeting target dioxin emission levels. Other significant projects during 1993 included completion of the first phase of a project to improve raw material utilization at the Castlegar, B.C. sawmill, installation of equipment to produce diaper training pants and other cost reduction and product improvement projects for the Company's diaper business. At December 31, 1993, the Company had numerous capital projects in process at its facilities. It is expected that $25 million will be required to complete approved projects, including those in progress at year-end. The principal projects included in this amount are for completion of the pulp drying improvements at Halsey and the completion of diaper cost reduction projects. In addition, the Company anticipates that additional capital projects will be undertaken during 1994, primarily to sustain existing operations. Projected 1994 capital spending is expected to be funded with internally generated cash, supplemented with borrowings on the Company's lines of credit. The December 31, 1993 current ratio remained essentially unchanged from year-end 1992 at 1.7 to 1. Significant changes in the components of working capital included increases in accounts receivable, inventories, and income taxes payable. Accounts receivable increased primarily due to a $6.1 million United States income tax refund receivable. Inventories increased approximately $21.6 million. Significant changes in inventory balances include a change in accounting for supplies inventories and higher log volumes from taking advantage of buying opportunities. Income taxes payable increased approximately $9.2 million reflecting higher current income taxes payable on higher earnings in Canada. The impact of fluctuations in foreign currency exchange rates have not had, and are not expected to have, a significant effect on the Company's liquidity or results of operations. Results of Operations Wood Products The Company's wood products business, which in 1993 comprised 48 percent of consolidated revenues, generated operating profit of $62.1 million in 1993, a sharp increase over earnings of $15.3 million in 1992, and a loss of $1.1 million in 1991. The 1993 earnings were more than double the previous best wood products earnings of $29.9 million reported in 1979. Housing starts, which historically have been a significant factor in the profitability of the wood products business, have improved in conjunction with the general economy and lower interest rates. Housing starts have increased from 1.0 million in 1991 to 1.2 million in 1992 and 1.28 million in 1993. Although these improvements in the housing market were a factor in the improved lumber sales prices, this alone was not adequate to generate the sales price increases and earnings improvements realized in 1993. A more significant factor continues to be the significantly curtailed harvest levels for timber from federal lands in the Pacific Northwest as a result of continuing environmental pressures to reduce timber harvests. During 1991, log costs increased as a result of constricting supply from federal lands. During 1992, lumber sales prices increased to offset these log cost increases and returned the relationship of log costs to sales prices to more historic levels. As log supplies, and consequently lumber supplies, tightened further in 1993, sales prices rose substantially. During 1993, log costs for the Company's United States sawmills increased generally with the increase in lumber sales prices. The Company has shifted much of its timber dependency out of Western Washington and Western Oregon where the environmental concerns over timber harvests have sharply restricted the volume of public timber available, and increased the cost of remaining timber, into regions of more stable timber supplies such as the Black Hills region of South Dakota and Wyoming and British Columbia. Currently, 80 percent of the Company's lumber capacity is in the Black Hills and British Columbia, with the remaining 20 percent representing the Company's Port Gamble, Washington sawmill. In the second quarter of this year, a Presidential Commission issued a proposal for resolving the timber supply situation in the Pacific Northwest. The proposal has been criticized by various environmental and industry groups. At this point, it is uncertain whether the proposal will be adopted. Until a solution is adopted, it is likely that timber supplies will remain restricted in the Pacific Northwest. When an agreement ultimately is reached, it is likely that the ultimately agreed upon harvest levels will be less than historic levels, but more than is currently available. During 1992, the United States government imposed a 6.51 percent tariff on Canadian lumber sold in the United States. During 1993, the Company paid approximately $9.2 million under this tariff resulting in higher costs for the approximately 425 million board feet of Canadian lumber sold in the United States. In December 1993, a bi-national commission ruled that there is no basis for this duty. However, this decision may be appealed by the United States Government. At this time, it is unknown if the United States Government will make such an appeal, or if any adjustment to the tariff would be made, either upward or downward, and if any such adjustment would be made retroactive to March 1992, when the tariff was first imposed. Lumber sales volume increased to 726 million board feet in 1993, up 9 percent from 669 million board feet in 1992 and 496 million board feet in 1991. The increased lumber volume over the three-year period was due primarily to the mid 1992 acquisition of the 225 million board-feet-per-year Castlegar, B.C. sawmill. With the acquisition of this sawmill, lumber capacity for the Company is now approximately 785 million board feet. The Company's sawmills operated essentially at capacity for 1993, except for the Port Gamble sawmill, which reduced production during the year as a result of lack of acceptably priced timber in relation to end-product prices. Port Gamble is the only Company sawmill in the high-priced timber regions of the Pacific Northwest and the Company, recognizing the limitation on acquiring adequate, acceptably priced timber supplies for the mill, has previously reduced its carrying value to its estimated recoverable value. Wood Products revenues climbed to a record $300 million in 1993 from $214.2 million in 1992 and $153 million in 1991. Both 1992 and 1993 revenue increases were a combination of volume increases and higher sales prices. Sales volumes were up 35 percent in 1992 and 9 percent in 1993 primarily from having the Castlegar sawmill for part of 1992, and for a full year in 1993. Lumber sales prices were up an average of 40 percent for the Company's Canadian sawmills and Port Gamble. These mills, which comprised approximately 80 percent of the Company's total lumber production, compete primarily in the home construction markets which have seen the greatest lumber supply reductions from the Pacific Northwest timber harvest restrictions. The remaining 20 percent of the Company's lumber production comes from two mills located in the Black Hills region of South Dakota and Wyoming. Lumber from these mills goes principally into remodeling markets and competes less directly with Pacific Northwest lumber. Prices for these products rose an average of 17 percent during 1993. Overall, sales prices were up an average of 34 percent in 1993 and 13 percent in 1992. Pulp and Paper Products The pulp and paper segment, which produces private label tissue and disposable diapers as well as market pulp, generated 52 percent of 1993 revenues. Operating profits from pulp and paper have declined from $6.2 million in 1991 to losses of $4.6 million in 1992 and $9.8 million in 1993. Disposable diapers have been increasingly profitable from 1991 through 1993; however, losses in tissue products and market pulp in 1992 and 1993 more than offset diaper profits. Pulp and paper revenues have remained essentially flat over the last three years, with 1993 sales of $328.9 million, 1992 sales of $330.2 million and 1991 sales of $349.3 million. Tissue products and market pulp revenues declined in 1992 and again in 1993 on lower pricing and volumes. Diaper sales volume and selling prices improved in 1992 and in 1993 volume again improved while prices declined slightly. Losses in the Company's market pulp business were the most significant factor in the pulp and paper segment's 1993 loss. A combination of an extremely depressed pulp market and the high cost of wood chips, the primary raw material for pulp, resulted in the increasing losses for 1991 through 1993. As a result of the weak markets, many pulp mills in the industry experienced significantly curtailed production rates during 1993. The Company's pulp mill at Halsey operated at 60 percent of capacity in 1993 and 83 percent of capacity in 1992. Historically, the Company had sold pulp to an adjacent tissue facility owned by James River Corporation. Beginning in 1992, James River began producing recycled pulp at Halsey and began phasing out of purchases of the Company's pulp. By mid 1993, James River no longer was purchasing any of the Company's pulp. As a result of depressed world pulp prices, selective downtime was taken in lieu of selling pulp in the open market to replace this lost tonnage. Consistent with world pulp pricing, the Company's sales prices in 1993 were approximately 12 percent below 1992's already depressed prices. Overall, pulp revenues decreased 36 percent to $40.3 million in 1993. Of this decline, approximately $17 million was due to volume reductions, and approximately $6 million was due to price declines. Based on a long-term pulp supply arrangement entered into in 1993, the Company began supplying, in December 1993, pulp to a printing and writing grade paper mill which opened at the beginning of 1994. The mill was purchased recently from its former owners by a group of private investors. The total output of this paper mill will be sold to one customer who will re-market the paper to outside customers. It has been anticipated that ultimately the paper mill would purchase pulp from the Company in significant quantities, depending on sales by the paper mill to its customer. However, to date pulp purchases have not been at this level. In the event that the paper mill's sales to its customer are adversely impacted for any reason, sales of the Company's pulp may be adversely impacted. Pricing for this pulp will be computed using a formula based on prices for white paper. Based on the prices in effect for white paper at the end of 1993, the price that pulp would be sold under this agreement would be 8 percent higher than the average pulp price the Company obtained for its pulp at the end of 1993. Environmental concerns over timber harvests, which have caused high log costs for the Company's Port Gamble sawmill, have also caused higher chip costs and reduced chip availability from historic sources at the Halsey pulp mill over the last three years. In order to maintain an adequate supply of wood fiber to the mill, the Company has expanded its geographic base from which it obtains softwood chips and has developed the capability of using sawdust and hardwood chips as raw materials for a portion of the production, which historically have been less expensive than the softwood chips normally used as the primary raw material for the pulp mill. It is anticipated that a portion of the pulp sold to the paper mill will be produced from sawdust and hardwood chips. In order to maintain an adequate supply of chips for the anticipated 60 percent of the pulp mill's production which will remain based on these softwood chips, the Company will continue to use an expanded geographic base to obtain chips, adding to their cost. Unless environmental restrictions on timber harvests are relaxed, chip prices likely will remain high, and sawdust and hardwood chip prices may also increase. In the tissue business, continued low industry operating rates resulting from industry capacity increases in recent years which have exceeded demand growth, coupled with aggressive pricing by tissue producers, resulted in a second consecutive loss year for the Company's tissue business. Overall, tissue operated at approximately 97 percent of capacity in 1993. Prices for the Company's tissue products declined in 1992 an average of 6 percent from the already depressed 1991 levels and declined by another 1 percent in 1993. Overall, prices for the Company's tissue have declined an average 13 percent from 1989, when tissue prices first began to decline. During 1992, the Company permanently closed one high-cost tissue facility and instituted cost reduction measures which reduced tissue operating costs in 1993; however, these savings were partially offset by increases in prices paid for wastepaper, the primary raw material for the Company's tissue products. Diaper earnings improved substantially in 1993 over already strong earnings in 1992 and 1991. Diaper sales volumes in 1992 were 10 percent greater than 1991. This sales growth continued in 1993, with sales volumes 21 percent ahead of 1992 at a record 1.1 billion diapers. Based on the existing mix of diaper sales, the Company's diaper business operated essentially at capacity in 1993. During 1992, Procter & Gamble, a significant producer of branded disposable diapers, instituted an everyday low price program intended to reduce the shelf package prices to the consumer. Private label disposable diapers, including the Company's, are priced under the pricing umbrella of branded products; however, the Company was generally able to maintain its diaper sales prices in 1993 at 1992 levels, which were on average 6 percent above 1991 levels. In November 1992, the Company closed one of its five diaper facilities and transferred the diaper machines to the remaining facilities. This eliminated the overhead of operating one additional facility while leaving diaper capacity essentially unchanged. Other Matters In 1993, the Company adopted Financial Accounting Standards Board Statement No. 109 on accounting for income taxes. The charge to earnings for adopting this new standard was $2.3 million ($.20 per share) and is reflected as part of the cumulative effect of accounting changes in the Consolidated Statements of Income. In 1993, expendable supplies on hand, which previously were charged to expense as purchased, were included in supplies inventories as of January 1, 1993. The cumulative effect of this change in accounting method amounted to $1.8 million ($.15 per share), net of tax, and is reflected as part of the cumulative effect of accounting changes in the Consolidated Statements of Income. In November 1992, the Financial Accounting Standards Board issued a pronouncement on Employers' Accounting for Postemployment Benefits. This statement must be adopted by the Company no later than 1994. The Company will adopt the new standard in the first quarter of 1994. The Company has reviewed the pronouncement and does not expect its implementation to have a material effect on the Company's financial position or results of operations. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 of Part II is presented on pages 20 through 33 of the Company's 1993 Annual Report to Shareholders. Such information is incorporated herein by reference. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The information required by Item 10 of Part III is presented on page 13 as a separate item entitled "Executive Officers of the Registrant Who are Not Directors" in Part I of this Report on Form 10-K and on pages 2-5 (under the item entitled "Certain Information Regarding Directors and Officers") of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such information is incorporated herein by reference. ITEM 11.

ITEM 11. MANAGEMENT REMUNERATION The information required by Item 11 of Part III is presented on pages 5-13 of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such information is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 of Part III is presented on pages 2-4 and on page 6 (beginning just after the title "Beneficial Ownership of Over Five Percent of Pope & Talbot Common Stock" on page 6) of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such information is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 of Part III is presented on page 14 (beginning just after the title "Certain Relationships and Related Transactions" on page 14) of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such information is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Financial Statements -------------------- The financial statements listed in the accompanying Index to Financial Statements and Financial Statement Schedules are filed as part of this annual report. (a) (2) Schedules --------- The financial statement schedules listed in the accompanying Index to Financial Statements and Financial Statement schedules are filed as part of this annual report. (a) (3) Exhibits -------- The following exhibits are filed as part of this annual report. Exhibit No. - ----------- (3) (a) Certificate of Incorporation, as amended. (Incorporated herein by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (b) Bylaws. (Incorporated herein by reference to Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (4) (a) Indenture dated June 2, 1993, between the Company and Chemical Trust Company of California as Trustee with respect to the Company's 8-3/8% Debentures due 2013. (Incorporated herein by reference to Exhibit 4.1 to the Company's registration statement on Form S-3 filed April 6, 1993.) (b) A Revolving Credit Agreement with United States National Bank of Oregon dated July 18, 1990. (Incorporated herein by reference to Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990.) (c) A Revolving Credit Agreement dated May 6, 1992 with United States National Bank of Oregon; CIBC, Inc.; ABN AMRO Bank N.V.; Continental Bank N.A.; and Wachovia Bank of Georgia, National Association. (Incorporated herein by reference to Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992.) (d) Indenture dated March 1, 1987 between the Company and the Bank of California, National Association as Trustee with respect to the Company's 6% Convertible Subordinated Debentures due March 1, 2012. (Incorporated herein by reference to Exhibit 4(d) to the Company's registration statement on Form S-3 filed February 23, 1987.) (e) Instrument of Resignation, Appointment and Acceptance dated July 5, 1989 appointing Manufacturers Hanover Trust Company of California as successor trustee with respect to the Company's 6% Convertible Subordinated Debentures due March 1, 2012. (Incorporated herein by reference to Exhibit 4(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (f) Rights Agreement between Pope & Talbot, Inc. and The Bank of California, as rights agent, dated as of April 13, 1988. (Incorporated herein by reference to Exhibit 4(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (10) Executive Compensation Plans and Arrangements --------------------------------------------- (a) Stock Option and Appreciation Plan. (Incorporated herein by reference to Exhibit 10(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (b) Executive Incentive Plan. (Incorporated herein by reference to Exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (c) Restricted Stock Bonus Plan. (Incorporated herein by reference to Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (d) Deferral Election Plan. (Incorporated herein by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (e) Supplemental Executive Retirement Income Plan. (Incorporated herein by reference to Exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (f) Form of Severance Pay Agreement between the Corporation and certain of its executive officers. (Incorporated herein by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) ______________________________ (g) Lease agreement with Pope Resources dated December 20, 1985 for Port Gamble, Washington sawmill site. (Incorporated herein by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (h) Lease agreement with Shenandoah Development Group, Ltd. dated March 14, 1988 for Atlanta diaper mill site as amended September 1, 1988 and August 30, 1989. (Incorporated herein by reference to Exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (i) Lease agreement with Shenandoah Development Group, Ltd. dated July 31, 1989 for additional facilities at Atlanta diaper mill as amended August 30, 1989 and February 1990. (Incorporated herein by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (j) Grays Harbor Industrial, Inc. Pulp Sales Supply Contract. (Incorporated herein by reference to Exhibit 10(j) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993.) (11) Statement showing computation of per share earnings. (13) Portions of the annual report to shareholders for the year ended December 31, 1993 which have been incorporated by reference in this report. (18) Letter re change in accounting principles. (Incorporated herein by reference to Exhibit 18 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993.) (22) Listing of parents and subsidiaries. (Incorporated herein by reference to Exhibit 22 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (b) Reports on Form 8-K ------------------- No reports on Form 8-K were filed during the three months ended December 31, 1993. AND FINANCIAL STATEMENT SCHEDULES All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements and notes thereto. The consolidated financial statements listed in the above index which are included in the Annual Report to Shareholders of Pope & Talbot, Inc. for the year ended December 31, 1993 are hereby incorporated by reference. With the exception of the pages listed in the above index and the items referred to in Items 1, 6 and 8, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Stockholders of Pope & Talbot, Inc.: We have audited in accordance with generally accepted auditing standards the consolidated financial statements included in the Pope & Talbot, Inc. and subsidiaries' annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 20, 1994 (except with respect to the matter discussed in Note 12, as to which the date is January 24, 1994). Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and financial statement schedules are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Portland, Oregon, January 20, 1994 POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE V - CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Years ended December 31, 1991, 1992 and 1993 (Thousands) NOTES: (a) Includes $14.9 million for new converting facilities at and modernization of Ransom, Pennsylvania tissue mill. (b) Includes $23.8 million for Flakt pulp dryer and $19.1 million for oxygen delignification project at the Halsey, Oregon pulp mill. Also includes $6.4 million for Castlegar, British Columbia sawmill modernization. (c) Includes $13.4 million related to the sale of the Ladysmith, Wisconsin tissue facilities. DEPRECIATION AND AMORTIZATION: The annual provisions for depreciation have been computed principally in accordance with the following ranges of rates applied on the straight-line method: POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE VI - CONSOLIDATED ACCUMULATED DEPRECIATION OF PLANT AND EQUIPMENT Years ended December 31, 1991, 1992 and 1993 (Thousands) Notes: (a) Amount relates to write-down of tissue machines removed from production and building held for sale. (b) Amount relates to write-down of the Company's Ladysmith, Wisconsin tissue plant and Maryville, Missouri diaper plant. (c) Includes $10.7 million related to the sale of the Ladysmith, Wisconsin tissue facilities. POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE IX - CONSOLIDATED SHORT-TERM BORROWINGS Years ended December 31, 1991, 1992 and 1993 Notes payable to banks: The Company has available from a bank a short-term line of credit totaling $20,000,000 with interest based on a negotiated rate. As of December 31, 1993, there was $11,000,000 outstanding on this line. Notes: (a) The average amount outstanding during the period is computed by dividing the total of daily outstanding principal balances by 365. (b) The weighted average interest rate during the period was computed by dividing the average amount of short-term debt outstanding during the period into the actual interest expense on short-term borrowings. POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE X - CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 (Thousands) For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the 1933 Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of the expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered on the Form S-8's identified below, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the 1933 Act and will be governed by the final adjudication of such issue. The preceding undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 No. 33-34996 (filed May 21, 1990) and No. 33-64764 (filed June 21, 1993). CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K into the Company's previously filed Registration Statement No. 33-34996 on Form S-8, Registration Statement No. 33-64764 on Form S-8 and Registration Statement No. 33-52305 on Form S-3. ARTHUR ANDERSEN & CO. Portland, Oregon March 29, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Portland, State of Oregon, on this 29th day of March, 1993. POPE & TALBOT, INC. BY: \s\ Peter T. Pope ------------------------------ Peter T. Pope Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EXHIBIT INDEX

354396_1993.txt

354396

1993

Item 1. Description of Business 1.1. General 1 1.2. Business Segments 1 1.3. Distribution Systems 5 1.4. Competition 6 1.5. Investments 6 1.6. Property/Casualty Loss Reserves 7 1.7. Life Benefit Reserves 11 1.8. Geographical Distribution 11 1.9. Executive Officers of the Registrant 12 Item 2.

Item 2. Business Properties Real estate owned and used in the regular conduct of business consists of 12 business properties located in various cities throughout the United States. The Corporation's Mount Washington Center, located in Baltimore, Maryland, is the principal owned property. This is the headquarters for the life insurance operations, and the location of the information systems and training and development complexes. In addition, the Corporation leases approximately 120 offices in various cities in the regular course of business. See Note 5 of Notes to the Consolidated Financial Statements. The principal leased property is a 40-story home office building in Baltimore, Maryland, sold in 1984 and leased back by the Corporation. Item 3.

Item 3. Legal Proceedings The Corporation's insurance subsidiaries are routinely engaged in litigation in the normal course of their business, including defending claims for punitive damages. As a liability insurer, they defend third-party claims brought against their insureds. As an insurer, they defend themselves against coverage claims. In the opinion of management the litigation described herein is not expected to have a material adverse effect on USF&G Corporation's consolidated financial position, although it is possible that the results of operations in a particular quarter or annual period would be materially affected by an unfavorable outcome. 3.1. Shareholder Class Action Suits During 1990 and 1991, twelve class action complaints were filed against the Corporation in the United States District Court for the District of Maryland and the United States District Court for the Eastern District of Pennsylvania. The Corporation moved to dismiss all twelve complaints. The complaints refer to the Corporation's public announcement on November 7, 1990, concerning a reduction in its dividend and related matters. All class action suits were consolidated for all purposes, under the caption IN RE USF&G CORPORATION SECURITIES LITIGATION in the United States District Court for the District of Maryland. By an order dated February 11, 1993, the court dismissed eleven of the class action complaints and on April 23, 1993, the court dismissed the remaining action. The plaintiffs have appealed these rulings and on January 6, 1994, the Fourth Circuit of Appeals affirmed the dismissal of all twelve suits. The plaintiffs have not yet indicated whether they will seek review from the United States Supreme Court. While the outcome cannot be predicted with any certainty, management believes the lawsuits are without merit and the outcome is unlikely to have a material adverse effect on the Corporation's financial position. 3.2. Maine "Fresh Start" litigation. In 1987, the State of Maine adopted workers compensation reform legislation which was intended to rectify historic rate inadequacies and encourage insurance companies to reenter the Maine voluntary workers compensation market. This legislation, which was popularly known as "Fresh Start," required the Maine Superintendent of Insurance to annually determine whether the premiums collected for policies written in the involuntary market and related investment income were adequate on a policy-year basis. The Superintendent was required to assess a surcharge on policies written in later policy years if it was determined that rates were inadequate. Assessments were to be borne by workers compensation policyholders, except that for policy years beginning in 1989 the Superintendent could require insurance carriers to absorb up to 50 percent of any deficits if the Superintendent found that insurance carriers failed to make good faith efforts to expand the voluntary market and depopulate the residual market. Insurance carriers which served as servicing carriers for the involuntary market would be obligated to pay 90 percent of the insurance industry's share. The Maine Fresh Start statute requires the Superintendent to annually estimate each year's deficit for seven years before making a final determination with respect to that year. In March 1993, the Superintendent affirmed a prior Decision and Order (known as "1992 Fresh Start Order") in which he, among other things, found that there were deficits for the 1988, 1989, and 1990 policy years, and that insurance carriers had not made a good faith effort to expand the voluntary market and consequently were required to bear 50 percent of any deficits relating to the 1989 and 1990 policy years. The Superintendent further found that a portion of these deficits were attributable to servicing carrier inefficiencies and poor investment practices and ordered that these costs be absorbed by insurance carriers. Also, in May 1993 the Superintendent found that insurance carriers would be liable for 50 percent of any deficits relating to the 1991 policy year (the "1993 Fresh Start Order"), but indicated that he would make no further determinations regarding the portions of any deficits attributable to alleged servicing carrier inefficiencies and poor investment practices until his authority to make such determinations was clarified in the various suits involving prior Fresh Start orders. USF&G Company was a servicing carrier for the Maine residual market in 1988, 1989, 1990, and 1991. The Corporation withdrew from the Maine voluntary market and as a servicing carrier effective December 31, 1991. The Corporation has joined in an appeal of the 1992 Fresh Start Order which was filed April 5, 1993, in a case captioned THE HARTFORD ACCIDENT AND INDEMNITY COMPANY, ET AL., V. SUPERINTENDENT OF INSURANCE filed in Superior Court, State of Maine, Kennebec. In addition to The Hartford Accident and Indemnity Company and USF&G Company, the National Council of Compensation Insurance ("NCCI") and seven other insurance companies which were servicing carriers during this time frame have instituted similar appeals. These appeals will be heard on a consolidated basis, in a case captioned, NATIONAL COUNCIL OF COMPENSATION INSURANCE, ET AL., V. ATCHINSON. USF&G Company is seeking, among other things, to have the court set aside the Superintendent's findings that the industry did not make a good faith effort to expand the voluntary market and is responsible for deficiencies resulting from alleged poor servicing and investments. Similar appeals of the Superintendent's 1993 Fresh Start Order have been filed by USF&G Company, the NCCI, and several other servicing carriers in the same court. The appeals of the 1993 Fresh Start Order will be heard on a consolidated basis in a case captioned THE NATIONAL COUNCIL OF COMPENSATION INSURANCE, ET AL., V. ATCHINSON. Estimates of the potential deficits vary widely and are continuously revised as loss and claims data matures. If the Superintendent were to prevail on all issues, then the range of liability for USF&G Company, based on the most recent estimates provided by the Superintendent and the NCCI, respectively, could range from approximately $12 million to approximately $19 million. However, USF&G Company believes that it has meritorious defenses and has determined to defend the actions vigorously. 3.3. Arkansas Servicing Carrier Litigation On September 14, 1993, Interstate Contractors, Inc. and two other Arkansas corporations filed a class action in the U.S. District Court for the Eastern District of Arkansas, Little Rock, against the National Council on Compensation Insurance ("NCCI"), USF&G and ten other insurance companies which served as servicing carriers for the Arkansas involuntary workers compensation market. The case, which is captioned INTERSTATE CONTRACTORS, INC., ET AL. V. NATIONAL COUNCIL ON COMPENSATION INSURANCE, ET AL., alleges that the defendants failed to provide safety and loss control services, claim management services, and assistance in moving insureds from the involuntary market to the voluntary market. The plaintiffs are pursuing their claims under various legal theories, including breach of contract, breach of fiduciary duty, and negligence. The plaintiffs seek unspecified compensatory damages based on the premiums attributable to services allegedly not performed and damages allegedly incurred as a result of the alleged failure to provide such services. USF&G Company believes that it has meritorious defenses and has determined to defend the action vigorously. Management believes that it is unlikely such claims will have a material adverse effect on USF&G Corporation's financial position. 3.4. North Carolina workers compensation Litigation On November 24, 1993, N.C. Steel, Inc. and six other North Carolina employers filed a class action in the General Court of Justice, Superior Court Division, Wake County, North Carolina, against the NCCI, North Carolina Rate Bureau, USF&G Company and eleven other insurance companies which served as servicing carriers for the North Carolina involuntary workers compensation market. On January 20, 1994, the plaintiffs filed an amended complaint seeking to certify a class of all employers who purchased workers compensation insurance in the State of North Carolina after November 24, 1989. The amended complaint, which is captioned N.C. STEEL INC. ET AL., V. NATIONAL COUNCIL ON COMPENSATION INSURANCE, ET AL., alleges that the defendants conspired to suppress competition with respect to the North Carolina voluntary and involuntary workers compensation business, thereby artificially inflating the rates in such markets and the fees payable to the insurers. The complaint also alleges that the carriers agreed to improperly deny qualified companies from acting as servicing carriers, improperly encouraged agents to place employers in the assigned risk pool, and improperly promoted inefficient claims handling. USF&G Company has acted as a servicing carrier in North Carolina since 1990. The plaintiffs are pursuing their claims under various legal theories, including violations of the North Carolina antitrust laws, unlawful conspiracy, breach of fiduciary duty, breach of implied covenant of good faith and fair dealing, unfair competition, constructive fraud, and unfair and deceptive trade practices. The plaintiffs seek unspecified compensatory damages, punitive damages for the alleged construction fraud, and treble damages under the North Carolina antitrust laws. USF&G Company believes that it has meritorious defenses and has determined to defend the action vigorously. Management believes that it is unlikely such claims will have a material adverse effect on USF&G Corporation's financial position. 3.5. Proposition 103 In November 1988, California voters passed Proposition 103, which required insurers doing business in that state to rollback property/ casualty premium prices in effect between November 1988 and November 1989 to 1987 levels, less an additional 20 percent discount, unless an insurer could establish that such rate levels threatened its solvency. As a result of a court challenge, the California Supreme Court ruled in May 1989 that an insurer does not have to face insolvency in order to qualify for exemption from the rollback requirements and is entitled to a "fair and reasonable return." Significant controversy has surrounded the numerous regulations proposed by the California Insurance Department, which would be used to determine whether rate rollbacks and premium refunds are required by insurers. Some of the Insurance Department's proposals were disapproved by the California Office of Administrative Law ("OAL"), which is responsible for the review and approval of such regulations. The most recent regulations proposed by the Insurance Department have not yet been reviewed by the OAL, pending a recent court challenge by various insurers to the Department's authority to issue such regulations. On February 25, 1993, the trial judge presiding over that court challenge voided substantial parts of the regulations proposed by the Insurance Department. The court held that the Insurance Department's regulations exceeded the Department's authority by setting rates based upon an across-the-board formula. The court indicated that rates and what constitutes a reasonable return would have to be determined individually for each insurer and that the Department's authority was to approve or disapprove rates proposed by insurers rather than setting rates which cannot vary from a prescribed formula. An appeal is currently pending before the California Supreme Court. During 1989, less than five percent of USF&G's total premiums were written in the State of California. USF&G believes that the returns it received, both during and since the one-year rollback period, have not exceeded the "fair and reasonable return" standard. Additionally, based on the long history of events and the significant uncertainty about the Insurance Department's regulations, management does not believe it is probable that the revenue recognized during the rollback period will be subject to a material refund. Management believes that no premium refund should be required for any period after November 8, 1988, but that any rate rollbacks and premium refunds, if ultimately required, would not have a material adverse effect on USF&G Corporation's financial position. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of 1993. USF&G Corporation Part II Item 5.

Item 5. Market for Registrant's Common Equity and Related Shareholder Matters Market and dividend information for the Corporation's common stock on page 88 of the Annual Report to Shareholders for 1993 is incorporated herein by reference. Item 6.

Item 6. Selected Financial Data Selected financial data of the Corporation on pages 56 and 57 of the Annual Report to Shareholders for 1993 is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis on pages 34 through 55 of the Annual Report to Shareholders for 1993 is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data The consolidated financial statements of the Corporation and notes to such financial statements on pages 58 through 82 of the Annual Report to Shareholders for 1993 are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. USF&G Corporation Part III Item 10.

Item 10. Executive Officers and Directors of the Registrant Information regarding the Corporation's executive officers can be found on page 12 of this Form 10-K. Information regarding the Corporation's directors is incorporated herein by reference to the Election of Directors section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994. Item 11.

Item 11. Executive Compensation See the Compensation of Executive Officers and Directors section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994, which is incorporated herein by reference. To the best of the Corporation's knowledge, there were no late filings under Section 16(a) of the Securities Exchange Act of 1934. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management See the Stock Ownership of Certain Beneficial Owners, Directors and Management section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994, which is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions See the Other Information-Certain Business Relationships section of the Corporation's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994, which is incorporated herein by reference. USF&G Corporation Part IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) Financial Statements The following consolidated financial statements of USF&G Corporation and its subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated Statement of Operations Consolidated Statement of Financial Position Consolidated Statement of Cash Flows Consolidated Statement of Shareholders' Equity Notes to Consolidated Financial Statements Report of Independent Auditors (2) Schedules The following consolidated financial statement schedules of USF&G Corporation and its subsidiaries are included in Item 14(d): Page 24 Schedule I. Summary of Investments-Other than Investments in Related Parties 25-27 Schedule III. Condensed Financial Information of Registrant 28 Schedule V. Supplementary Insurance Information 29 Schedule VI. Reinsurance 30 Schedule IX. Short-term Borrowings 31 Schedule X. Supplemental Information Concerning Consolidated Property/Casualty Insurance Operations All other schedules specified by Article 7 of Regulation S-X are not required pursuant to the related instructions or are inapplicable and, therefore, have been omitted. (3) Exhibits The following exhibits are included in Item 14: Page __ Exhibit 11 Computation of Earnings Per Share __ Exhibit 12 Computation of Ratio of Consolidated Earnings to Fixed Charges and Preferred Stock Dividends A copy of all other exhibits not included with this Form 10-K may be obtained without charge upon written request to the Secretary at the address shown on page ___ of this Form 10-K. Exhibit 3A Charter of USF&G Corporation. Exhibit 3B Amended By-laws of USF&G Corporation. Incorporated by reference to Exhibit 3B, 1985 Annual Report on Form 10-K. Exhibit 4A Rights agreement dated as of September 18, 1987, between USF&G Corporation and First Chicago Trust Company of New York (successor to Morgan Shareholder's Service Trust Company) including Form of Rights Certificate. Incorporated by reference to Exhibits 1 and 2 to the Registrant's Form 8-A filed September 31, 1987, File No. 1-8233. Exhibit 4B Indenture dated as of October 15, 1986, between USF&G Corporation and Chemical Bank (Delaware). Incorporated by reference to Exhibit 4.1 to the Registrant's Form 10-Q for the quarter ended September 30, 1986, File No. 1-8233. Exhibit 4C Officer's certificate dated November 19, 1986, classifying 8 7/8% Notes of USF&G Corporation. Incorporated by reference to Exhibit 4.1 to the Registrant's Form 8-K dated November 19, 1986, File No. 1-8233. Exhibit 4D Bond issuance and payment agreement dated November 16, 1987, for Swiss Franc Public Issue of 5 1/2% Bonds 1988-1996 of Swiss Francs 120,000,000. Incorporated by reference to Exhibit 4M to the Registrant's Form 10-K for the year ended December 31, 1987, File No. 1-8233. Exhibit 4E Indenture dated as of January 28, 1994, between USF&G Corporation and Chemical Bank. Exhibit 4F Form of Note dated March 3, 1994, for Zero Coupon Convertible Subordinated Notes due 2009. Incorporated by reference to Exhibit 4 to the Registrant's Form 8-K dated March 3, 1994, File No. 1-8233. Exhibit 10A Credit Agreement dated as of March 20, 1990, as amended on April 15, 1991, among USF&G Corporation, Morgan Guaranty Trust Company of New York, and Swiss Bank Corporation as agents. Incorporated by reference to Exhibit 4F to the Registrant's Form 10-K for the year ended December 31, 1991, File No. 1-8233. Exhibit 10B Stock Option Plan of 1987. Incorporated by reference to Exhibit 4.1 to the Registrant's Form S-8 dated July 28, 1987, File No. 33-16111. Exhibit 10C Employment Agreement dated November 20, 1990, between the Registrant and Norman P. Blake, Jr. Incorporated by reference to Exhibit 10A to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10D USF&G Supplemental Executive Retirement Agreement between the Registrant and Norman P. Blake, Jr., dated November 20, 1990. Incorporated by reference to Exhibit 10B to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10E Stock Option Plan of 1990. Incorporated by reference to Exhibit 4 to the Registrant's Form S-8 Registration Statement as filed December 7, 1990, File No. 33-38113. Certified Copy of the Board Resolution adopted on December 6, 1990, amending the Stock Option Plan of 1990. Incorporated by reference to Exhibit 10G to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. USF&G Corporation Part IV Exhibit 10F Description of Management Incentive Plan. Incorporated by reference to Exhibit 10J to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10G Description of Long-Term Incentive Compensation Plan. Incorporated by reference to Exhibit 10K to the Registrant's Form 10-K for the year ended December 31, 1990, File No. 1-8233. Exhibit 10H Stock Incentive Plan of 1991. Incorporated by reference to Exhibit 4(a) to the Registrant's Form S-8 Registration Statement as filed February 11, 1992, File No. 33-45664. Exhibit 10I Form of Stock Option Agreement used in connection with the Stock Option Plan of 1987, Stock Option Plan of 1990, and Stock Incentive Plan of 1991. Exhibit 10J 1993 Stock Plan for Non-Employee Directors. Incorporated by reference to Exhibit 10N to the Registrant's Form 10-K for the year ended December 31, 1992, File No. 1-8233. Exhibit 10K Employment Agreement dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10L Stock Option Agreement dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10M Stock Option Agreement dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10N Waiver dated November 10, 1993, between the Registrant and Norman P. Blake, Jr. Exhibit 10O First Amendment to USF&G Supplemental Executive Retirement Agreement between the registrant and Norman P. Blake, Jr. dated November 10, 1993. Exhibit 10P Letter dated November 19, 1992, describing Employment Arrangement between the Registrant and Gary C. Dunton. Exhibit 10Q USF&G Supplemental Retirement Plan. Exhibit 11 Computation of ratio of consolidated earnings to fixed charges and preferred stock dividends. Exhibit 12 Computation of earnings per share. Exhibit 13 1993 Annual Report to Shareholders. Exhibit 21 Subsidiaries of the registrant. Exhibit 23 Consent of independent auditors. Exhibit 28 Information from reports furnished to state insurance regulatory authorities. All other exhibits specified by Item 601 of Regulation S-K are not required pursuant to the related instructions or are inapplicable and, therefore, have been omitted. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter 1993. The registrant filed a Form 8-K on February 14, 1994, reporting under Item 5, Other Events, audited financial statements for the year ended December 31, 1993, and a related Management's Discussion and Analysis, and other related financial information. The registrant filed a Form 8-K March 3, 1994, reporting under Item 5, Other Events, related to the sale of Zero Coupon Subordinated Notes. USF&G Corporation Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. USF&G CORPORATION BY NORMAN P. BLAKE, JR. Norman P. Blake, Jr. Chairman of the Board, President, and Chief Executive Officer Dated at Baltimore, Maryland March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Principal Executive Officer: NORMAN P. BLAKE, JR. Norman P. Blake, Jr. Chairman of the Board, President, Chief Executive Officer, and Director Principal Financial and Accounting Officer: DAN L. HALE Dan L. Hale Executive Vice President and Chief Financial Officer Dated at Baltimore, Maryland March 30, 1994 Directors H. FURLONG BALDWIN ROBERT J. HURST H. Furlong Baldwin Robert J. Hurst MICHAEL J. BIRCK WILBUR G. LEWELLEN Michael J. Birck Wilbur G. Lewellen GEORGE L. BUNTING, JR. HENRY A. ROSENBERG, JR. George L. Bunting, Jr. Henry A. Rosenberg, Jr. ROBERT E. DAVIS LARRY P. SCRIGGINS Robert E. Davis Larry P. Scriggins RHODA M. DORSEY ANNE MARIE WHITTEMORE Rhoda M. Dorsey Anne Marie Whittemore DALE F. FREY GEORGE S. WILLS Dale F. Frey George S. Wills ROBERT E. GREGORY, JR. Robert E. Gregory, Jr. USF&G Corporation Schedule I. Summary of Investments - Other Than Investments in Related Parties USF&G Corporation Schedule III. Condensed Financial Information of Registrant - Statement of Financial Position (Parent Company) USF&G Corporation Schedule III. Condensed Financial Information of Registrant - Statement of Operations (Parent Company) USF&G Corporation Schedule III. Condensed Financial Information of Registrant - Statement of Cash Flows (Parent Company) Note to Condensed Financial Statements The accompanying condensed financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto of the 1993 Annual Report to Shareholders incorporated herein by reference. Certain amounts have been reclassified to conform to the 1993 presentation. The parent company's provision for income taxes is based on the Corporation+s consolidated federal income tax allocation policy. USF&G Corporation Schedule V. Supplementary Insurance Information USF&G Corporation Schedule VI. Reinsurance USF&G Corporation Schedule IX. Short-Term Borrowings USF&G Corporation Schedule X. Supplemental Information Concerning Consolidated Property/Casualty Insurance Operations

96943_1993.txt

96943

1993

ITEM 1. BUSINESS The Company* was incorporated in 1943 as a manufacturer of precision mechanical push/pull controls for military aircraft. From this original single market, single product orientation, the Company began to emphasize products and services in a broader range of economically diverse markets to reduce its vulnerability to economic cycles. Since the mid-1970s, the Company's investments have been directed toward specific market niches employing its technical capabilities to provide solutions to specific engineering problems. The continuing stream of new products and value-added product improvements that have resulted from this strategy have enabled the Company to participate in larger market segments. Several of these new products and product improvements were developed by means of an unusual investment program of the Company called the New Venture Fund. Established in 1972, the Fund directs monies representing one-half percent of sales into the development of new products and services. This concept allows for entrepreneurial risk taking in new areas by encouraging innovation and competition among the Company's managers for funds to pursue new programs and activities independent of their operating budgets. Examples of New Venture projects include the initial funding of SermeTel research and most of the early seed money for certain medical products. The Company's business is separated into three segments -- Aerospace Products and Services, Medical Products and Commercial Products. AEROSPACE PRODUCTS AND SERVICES SEGMENT The Aerospace Products and Services Segment serves the aerospace, defense and turbine engine markets. Its businesses design and manufacture precision controls and systems for both military and commercial applications; provide sophisticated coating and repair services for turbine engine manufacturers, operators and overhaulers; and manufacture airfoils for both flight and land-based turbine engines. These products and services, many of which are proprietary, require a high degree of engineering sophistication and are often custom designed. External economic influences on these products and services relate primarily to spending patterns in the worldwide aerospace and defense industry. The Aerospace Products and Services Segment consists of the Aerospace/Defense Group and Sermatech International. Within the Aerospace/Defense Group, the Company designs and manufactures advanced mechanical and electromechanical controls, actuators, valves, control systems and other components for the aerospace and defense industries for application on commercial and military aircraft and helicopters, commuter aircraft, missiles, space vehicles, naval vessels, ground support equipment and ordnance. Many of these controls and control systems are based on the principle of mechanically transmitting, by flexible cable, a push-pull or rotary thrust. By advanced engineering techniques, this simple concept is employed in components and systems capable of transmitting force with precision to control and actuate functions at remote locations. Aircraft controls and control systems include highly complex engine controls, aerodynamic surface controls and cargo handling systems. The principal products consist of throttle and thrust-reverser/feedback control systems for use on various fixed and rotary-wing aircraft and numerous other critical mechanical and electromechanical control systems. Controls and actuators designed and manufactured by the Company over the last several years include the canopy actuators for military fighter aircraft and missile launch components, specialized mechanical control systems for naval vessels, and alternate flap actuators and cargo systems for commercial aircraft. The Company's design engineers work with design personnel from the major aircraft and jet engine manufacturers in the development of products for use on new aircraft. In addition, the Company supplies spare parts to aircraft operators. This spare parts business extends as long as the particular type of aircraft continues in service. - --------------- * As used herein the "Company" refers to Teleflex Incorporated and its consolidated subsidiaries. In the early 1960s, aircraft manufacturers began to encounter high temperature lubrication problems in connection with mechanical controls for aircraft jet engines. Through its subsidiary, Sermatech International, the Company utilized its aerospace experience and engineering capabilities to develop a series of formulations of inorganic coatings to solve these high temperature lubrication problems. These products were further developed by the Company and sold under the trademark SermeTel(R) to provide anti-corrosion protection for compressor blades and other airfoils. The Company, through an international network of Sermatech facilities in five countries, provides a variety of sophisticated protective coatings and other services for gas turbine engine components; highly-specialized repairs for critical components such as fan blades and airfoils; and manufacturing and high quality dimensional finishing of airfoils. Through the years the Company has added other technologies through acquisition and internal development and now offers a diverse range of technical services and materials technologies to turbine markets throughout the world. In 1993 the Company acquired Mal Tool & Engineering, a manufacturer of fan blades for flight turbines, and airfoils for both flight and land-based gas turbines and steam turbines. The acquisition broadens the Company's product offering including turnkey manufactured and coated airfoils and provides another entree to major international turbine manufacturers. MEDICAL PRODUCTS SEGMENT In the late 1970s, the Company decided to apply its polymer technologies to the medical market, and began by extruding intravenous catheter tubing which it sold to original equipment manufacturers. Through the TFX Medical Group, the Company produces standard and custom-designed semi-finished components for other medical device manufacturers using polymer materials and processing technology. Through acquisitions, the Company established the other two product lines of this segment: hospital supply and surgical devices. In 1989, the acquisition of Willy Rusch AG and affiliates in Germany brought with it an established manufacturing base and distribution network, particularly in Europe. The Company conducts its hospital supply business under the name of Rusch International. This business includes the manufacture and sale of invasive disposable and reusable devices for the urological, gastroenterological and anesthesiological markets worldwide. The Rusch International product offerings include among others latex catheters, endotracheal tubes, laryngoscopes, face masks and tracheostomy tubes. The acquisition of the Pilling Company in 1991 and Edward Weck Incorporated in December 1993 further expanded the Company's medical device manufacturing and distribution capabilities. Weck manufactures manual ligation devices and general surgical instruments and is being consolidated with Pilling Company, a manufacturer of general and specialty surgical instruments. The combination of Pilling and Weck significantly expands the product offerings, marketing opportunities and selling capabilities in the surgical devices market in the United States; and provides opportunities for increasing international sales. Pilling Weck manufactures and distributes primarily through its own sales force instruments used in both traditional (open) and minimally-invasive surgical procedures including general and specialized surgical instruments such as scissors, forceps, vascular clamps, needle holders, retractors, ligation clips, appliers, skin staples and electrosurgery products. COMMERCIAL PRODUCTS SEGMENT The Commercial Products Segment involves the design and manufacture of mechanical, electrical, and hydraulic controls and electronic products for the pleasure marine market; proprietary mechanical controls for the automotive market; and certain innovative proprietary products for the fluid transfer and outdoor power equipment markets. Products in the Commercial Products Segment are generally produced in higher unit volume and are manufactured for general distribution and custom fabricated to meet individual customer needs. Consumer spending patterns generally influence the market trends for these products. The Commercial Products Segment consists of three major product lines: Marine, Automotive and Industrial. The Company is a leading domestic producer of mechanical steering systems for pleasure power boats. It also manufactures hydraulic steering systems, engine throttle and shift controls, electrical instrumentation and recently has expanded into electronic navigation, location and communication systems. In 1991 the Company acquired Marinex Industries, Ltd., a British manufacturer of marine electronics. Its Cetrek autopilots and navigational equipment complement Teleflex's hydraulic steering products which together can be sold to both the commercial and pleasure marine markets. The Marinex acquisition also enhanced the Company's access to the international marine market. Techsonic Industries, Inc., a manufacturer of marine information systems (electronic navigation, communication and fish location devices) sold through mass merchandisers under the Humminbird brand name became a wholly owned subsidiary in 1992. Aside from the Humminbird products, the Company's marine products are sold principally to boat builders, in the aftermarket, and are used principally on pleasure craft but also have application on commercial vessels. The Company is a major supplier of mechanical controls to the domestic automotive market. The principal products in this market are accelerator, transmission, shift, park lock, window regulator controls and a new heat resistant flexible fuel line. In the mid-1970s the Company initiated development programs which addressed customer needs for reduced weight and installation costs and as a result, the Company became a major supplier of mechanical controls to the domestic automotive market. Acceptance by the automobile manufacturers of a Company-developed control for use on a new model ordinarily assures the Company a large, but not exclusive, market share for the supply of that control. The sales of mechanical automotive controls were $95,516,000, $123,390,000 and $139,128,000 in 1991, 1992 and 1993, respectively. Industrial controls and electrical instrumentation products are also manufactured for use in other applications, including agricultural equipment, outdoor power equipment, leisure vehicles and other on- and off-road vehicles. In addition, the Company produces stainless steel overbraided fluoroplastic hose for fluid transfer in such markets as the chemical, petroleum and food processing industries. MARKETING In 1993, the percentages of the Company's consolidated net sales represented by its major markets were as follows: aerospace -- 30%; medical -- 27%; marine and industrial -- 22%; and automotive -- 21%. The major portion of the Company's products are sold to original equipment manufacturers. Generally, products sold to the aerospace and automotive markets are sold through the Company's own force of field engineers. Products sold to the marine, medical and general industrial markets are sold both through the Company's own sales forces and through independent representatives and independent distributor networks. For information on foreign operations, export sales, and principal customers, see text under the heading "Business segments and other information" on page 26 of the Company's 1993 Annual Report to Shareholders, which information is incorporated herein by reference. COMPETITION The Company has varying degrees of competition in all elements of its business. None of the Company's competitors offers products for all the markets served by the Company. The Company believes that its competitive position depends on the technical competence and creative ability of its engineering and development personnel, the know-how and skill of its manufacturing personnel as well as its plants, tooling and other resources. PATENTS The Company owns a number of patents and has a number of patent applications pending. The Company does not believe that its business is materially dependent on patent protection. SUPPLIERS Materials used in the manufacture of the Company's products are purchased from a large number of suppliers. The Company is not dependent upon any single supplier for a substantial amount of the materials it uses. BACKLOG As of December 26, 1993 the Company's backlog of firm orders for the Aerospace Products and Services Segment was $94 million, of which it is anticipated that approximately three-fourths will be filled in 1994. The Company's backlog for Aerospace Products and Services on December 27, 1992 was $73 million. As of December 26, 1993 the Company's backlog of firm orders for the Medical Products and Commercial Products segments was $23 million and $54 million, respectively. This compares with $15 million and $47 million, respectively as of December 27, 1992. Substantially all of the December 26, 1993 backlog will be filled in 1994. Most of the Company's medical and commercial products are sold on orders calling for delivery within no more than a few months so that the backlog of such orders is not indicative of probable net sales in any future 12-month period. EMPLOYEES The Company had approximately 8,000 employees at December 26, 1993. EXECUTIVE OFFICERS The names and ages of all executive officers of the Company as of March 1, 1994 and the positions and offices with the Company held by each such officer are as follows: Mr. Boyer was elected as a director on December 6, 1993. Mr. Sickler was elected Senior Vice President and President of TFX Equities Inc. on December 3, 1990. Prior to that date he was President and Chief Operating Officer -- Aerospace/Defense Group. Dr. Roy C. Carriker was named President -- Teleflex Aerospace Products and Services Group on January 3, 1994. Prior to that date he was President -- Sermatech International. Mr. Woodfield was elected President -- Teleflex Medical Products Group on March 9, 1992. Prior to that date, he was President of Empire Abrasive Equipment Corporation. Mr. Zuber was named to the position of Vice President, Chief Financial Officer and Controller on February 5, 1990. Prior to that date he was Vice President and Controller. Mr. Chance was elected to the position of Secretary on December 3, 1990. He was named to the position of General Counsel on September 1, 1989. Mr. Horvath was named to the position of Vice President -- Quality Management on January 3, 1989. Prior to that date he was Manager, Corporate Product Quality Assurance at Eaton Corporation. Mr. Boldt was named to the position of Vice President -- Human Resources on March 9, 1992. From October 13, 1989 to March 9, 1992 he was Director of Human Resources. Prior to that date he was Vice President of Human Resources at First Pennsylvania Bank. Ms. Dusossoit was named to the position of Vice President -- Investor Relations on March 1, 1993. From April 1, 1992 to March 1, 1993 she was Director of Investor Relations. From June 1, 1989 to April 1, 1992 she was a business consultant. Prior to that date she was the Director of Corporate Communications for General Cinema Corporation. Mr. Byrne was elected Assistant Treasurer on December 3, 1990. Prior to that date, he was Director of Internal Auditing. Officers are elected by the Board of Directors for one year terms. No family relationship exists between any of the executive officers of the Company. ITEM 2.

ITEM 2. PROPERTIES The Company's operations have approximately 85 owned and leased properties consisting of plants, engineering and research centers, distribution warehouses and other facilities. The properties are maintained in good operating condition. All the plants are suitably equipped and utilized, and have space available for the activities currently conducted therein and the increased volume expected in the foreseeable future. The following are the Company's major facilities: - --------------- (1) The Company is the beneficial owner of these facilities under installment sale or similar financing agreements. In addition to the above, the Company owns or leases approximately 530,000 square feet of warehousing, manufacturing and office space located in the United States, Canada and Europe. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Two subsidiaries of the Company have been identified as potentially responsible parties (PRPs) in connection with the Casmalia Resources Hazardous Waste Management Facility. The Company has joined a group of other PRPs, predominately in the aerospace defense industry, to negotiate with the United States Environmental Protection Agency a good faith offer to take over responsibility for a program of closure and post-closure care of the site. The PRPs from the aerospace defense industry are currently engaged in negotiations with a second PRP group with the aim of providing a common negotiating front with the Environmental Protection Agency. In the opinion of the Company's management, based on the current allocation formula and the facts presently known, the ultimate outcome of this environmental matter will not result in a liability material to the Company's consolidated financial condition or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS See "Quarterly Financial Data" on page 27 of the Company's 1993 Annual Report to Shareholders for market price and dividend information. Also see the Note entitled "Borrowings and Leases" on page 24 of such Annual Report for certain dividend restrictions under loan agreements, all of which information is incorporated herein by reference. The Company had approximately 1,600 registered shareholders at February 1, 1994. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA See pages 28 through 31 of the Company's 1993 Annual Report to Shareholders, which pages are incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See the text under the heading "Financial Review" on pages 32 through 37 of the Company's 1993 Annual Report to Shareholders, which information is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See pages 19 through 27 of the Company's 1993 Annual Report to Shareholders, which pages are incorporated herein by reference. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information with respect to the Company's Directors and Director nominees, see "Election Of Directors" and "Additional Information About The Board Of Directors" on pages 2 through 4 of the Company's Proxy Statement for its 1994 Annual Meeting, which information is incorporated herein by reference. For information with respect to the Company's Executive Officers, see Part I of this report on pages 4 and 5, which information is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION See "Additional Information About The Board of Directors", "Board Compensation Committee", "Five-Year Shareholder Return Comparison" and "Executive Compensation and Other Information" on pages 4 through 9 of the Company's Proxy Statement for its 1994 Annual Meeting, which information is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Security Ownership of Certain Beneficial Owners and Management" on pages 1 and 2 and "Election Of Directors" on pages 2 and 3 of the Company's Proxy Statement for its 1994 Annual Meeting, which information is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Additional Information About The Board Of Directors", "Board Compensation Committee" and "Executive Compensation and Other Information" on pages 4 through 9 of the Company's Proxy Statement for its 1994 Annual Meeting, which information is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Consolidated Financial Statements: The index to Consolidated Financial Statements and Schedules is set forth on page 10 hereof. (b) Reports on Form 8-K: A Form 8-K was filed on January 5, 1994, as amended February 24, 1994 in connection with the acquisition of certain assets and the assumption of certain liabilities of Edward Weck Incorporated. (c) Exhibits: The Exhibits are listed in the Index to Exhibits. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 2-84148 (filed June 28, 1989), 2-98715 (filed May 11, 1987) and 33-34753 (filed May 10, 1990): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized as of the date indicated below. TELEFLEX INCORPORATED By LENNOX K. BLACK ------------------------------------ Lennox K. Black Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and as of the date indicated below. By LENNOX K. BLACK ------------------------------------ Lennox K. Black (Principal Executive Officer) By HAROLD L. ZUBER, JR. ------------------------------------ Harold L. Zuber, Jr. (Principal Financial and Accounting Officer) Pursuant to General Instruction D to Form 10-K, this report has been signed by Steven K. Chance as Attorney-in-Fact for a majority of the Board of Directors as of the date indicated below. By STEVEN K. CHANCE ------------------------------------ Steven K. Chance Attorney-in-Fact Dated: March 25, 1994 TELEFLEX INCORPORATED INDEX TO CONSOLIDATED FINANCIAL STATEMENTS The consolidated financial statements together with the report thereon of Price Waterhouse dated February 9, 1994 on pages 19 to 27 of the accompanying 1993 Annual Report to Shareholders are incorporated in this Annual Report on Form 10-K. With the exception of the aforementioned information, and those portions incorporated by specific reference in this document, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. The following Financial Statement Schedules together with the report thereon of Price Waterhouse dated February 9, 1994 on page 11 should be read in conjunction with the consolidated financial statements in such 1993 Annual Report to Shareholders. Financial Statement Schedules not included in this Form 10-K Annual Report have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. FINANCIAL STATEMENT SCHEDULES Schedules: REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Teleflex Incorporated Our audits of the consolidated financial statements referred to in our report dated February 9, 1994 appearing on page 27 of the 1993 Annual Report to Shareholders of Teleflex Incorporated (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 February 9, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-8 (No. 2-84148, No. 2-98715 and No. 33-34753) of Teleflex Incorporated of our report dated February 9, 1994 appearing on page 27 of the 1993 Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears above. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 March 25, 1994 TELEFLEX INCORPORATED SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 26, 1993 - --------------- * Includes $64,037,400 in connection with acquisitions. FOR THE YEAR ENDED DECEMBER 27, 1992 - --------------- * Includes $25,676,200 in connection with acquisitions. FOR THE YEAR ENDED DECEMBER 29, 1991 - --------------- * Includes $19,457,000 in connection with acquisitions. TELEFLEX INCORPORATED SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS ALLOWANCE FOR DOUBTFUL ACCOUNTS SCHEDULE IX -- SHORT-TERM BORROWINGS - --------------- * Determined using average of month-end balances. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION

728586_1993.txt

728586

1993

ITEM 1. BUSINESS GENERAL As used herein, "LBI" or the "Registrant" means Lehman Brothers Inc., a Delaware corporation incorporated on January 21, 1965. LBI and its subsidiaries are collectively referred to as "Lehman Brothers" or the "Company." LBI is a wholly owned subsidiary of Lehman Brothers Holdings Inc., a Delaware corporation, which (together with its subsidiaries, where appropriate) is referred to herein as "Holdings." American Express Company, a New York corporation ("American Express") owns 100 percent of the outstanding common stock of Holdings, par value $.10 per share (the "Holdings Common Stock"), which represents approximately 93% of Holdings' issued and outstanding voting stock. The remainder of Holdings' voting stock, the 5% Cumulative Convertible Voting Preferred Stock, Series A (the "Series A Preferred Stock") is owned by Nippon Life Insurance Company ("Nippon Life"). Assuming the exercise by Nippon Life of a warrant to purchase shares of Holdings Common Stock (the "Warrant"), American Express' ownership percentage of Holdings' voting stock would be 88 percent. The Company is one of the leading global investment banks serving institutional, corporate, government and high net worth individual clients and customers. The Company's executive offices are located at 3 World Financial Center, New York, New York 10285 and its telephone number is (212) 298-2000. Distribution of Holdings Common Stock On January 24, 1994, American Express announced plans to issue a special dividend to its common shareholders consisting of all of Holdings Common Stock (the "Distribution"). Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file a Registration Statement on Form S-1 (the "Registration Statement") with the Securities and Exchange Commission (the "Commission") with respect to the Distribution during the second quarter of 1994. Change of Fiscal Year On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. Reduction in Personnel During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $25 million pre-tax in the first quarter of 1994 as a result of these terminations. The Primerica Transaction On July 31, 1993, pursuant to an asset purchase agreement (the "Primerica Agreement"), the Company completed the sale (the "Primerica Transaction") of its domestic retail brokerage business (except for such business conducted under the Lehman Brothers name) and substantially all of its asset management business (collectively, "Shearson") to Primerica Corporation (now known as Travelers Corporation) ("Travelers") and its subsidiary Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Also included in the Primerica Transaction were the operations and data processing functions that support these businesses, as well as certain of the assets and liabilities related to these operations. LBI received approximately $1.2 billion in cash and a $586 million interest bearing note from Smith Barney which was repaid in January 1994 (the "Smith Barney Note"). The Smith Barney Note was issued as partial payment for certain Shearson assets in excess of $600 million which were sold to Smith Barney. The proceeds received at July 31, 1993, were based on the estimated net assets of Shearson, which exceeded the minimum net assets of $600 million prescribed in the Primerica Agreement. As further consideration for the sale of Shearson, Smith Barney agreed to pay future contingent amounts based upon the combined performance of Smith Barney and Shearson, consisting of up to $50 million per year for three years based on revenues, plus 10% of after-tax profits in excess of $250 million per year over a five-year period (the "Participation Rights"). In contemplation of the Distribution, American Express received the first Participation Right payment in the first quarter of 1994. It is anticipated that all of the Participation Rights will be assigned to American Express prior to the Distribution. As further consideration for the sale of Shearson, LBI received 2,500,000 shares of 5.50% Convertible Preferred Stock, Series B, of Travelers and a warrant to purchase 3,749,466 shares of common stock of Travelers at an exercise price of $39.00 per share. In August 1993, American Express purchased such preferred stock and warrant from LBI for aggregate consideration of $150 million. The Company recognized a 1993 first quarter loss related to the Primerica Transaction of approximately $630 million after-tax ($535 million pre-tax), which amount includes a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. The Mellon Transaction On May 21, 1993, pursuant to a stock purchase agreement (the "Mellon Agreement") between LBI and Mellon Bank Corporation ("Mellon Bank"), LBI sold to Mellon Bank (the "Mellon Transaction"), The Boston Company, Inc. ("The Boston Company") which through subsidiaries is engaged in the private banking, trust and custody, institutional investment management and mutual fund administration businesses. Under the terms of the Mellon Agreement, LBI received approximately $1.3 billion in cash, 2,500,000 shares of Mellon Bank common stock and ten year warrants to purchase an additional 3,000,000 shares of Mellon Bank's common stock at an exercise price of $50.00 per share. In June 1993, such shares and warrants were sold by LBI to American Express for an aggregate purchase price of $169 million. After accounting for transaction costs for the Mellon Transaction and certain adjustments, the Company recognized a 1993 first quarter after-tax gain of $165 million. Shearson Lehman Hutton Mortgage Corporation Transaction LBI completed the sale of its wholly owned subsidiary, Shearson Lehman Hutton Mortgage Corporation ("SLHMC"), to GE Capital Corporation on August 31, 1993. The sales price, net of proceeds used to retire indebtedness of SLHMC, was approximately $70 million. During the first quarter of 1993, the Company provided $120 million of pre-tax reserves in anticipation of the sale of SLHMC. After accounting for these reserves, the sale did not have a material effect on the Company's results of operations. Lehman Brothers is one of the leading global investment banks serving institutional, corporate, government and high net worth individual clients and customers. The Company's worldwide headquarters in New York are complemented by offices in 19 additional locations in the United States, 11 in Europe and the Middle East, four in Latin and South America and three in the Asia Pacific region. Lehman Brothers also operates a commodities trading and sales operation in London. Holdings provides investment banking and capital markets services in Europe and Asia. The Company is engaged primarily in providing financial services. Other businesses in which the Company is engaged represent less than 10 percent of consolidated assets, revenues or pre-tax income. The Company's business includes capital raising for clients through securities underwriting and direct placements; corporate finance and strategic advisory services; merchant banking; securities sales and trading; asset management; research; and the trading of foreign exchange, derivative products and certain commodities. The Company acts as a market maker in all major equity and fixed income products in both the domestic and certain international markets. Lehman Brothers is a member of all principal securities and commodities exchanges in the United States, as well as the National Association of Securities Dealers, Inc. ("NASD"). Holdings holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt and Milan stock exchanges. Since 1990, Lehman Brothers has followed a "client/customer-driven" strategy. Under this strategy, Lehman Brothers concentrates on serving the needs of major issuing and advisory clients and investing customers worldwide to build an increasing "flow" of business that leverages the Company's capabilities and generates a majority of the Company's revenues and profits. Developing lead relationships with issuing clients and investing customers is a central premise of the Company's client/customer-driven strategy. Based on management's belief that each client and customer directs a majority of its financial transactions to a limited number of investment banks, Lehman Brothers' investment banking and sales professionals work together with global products and services professionals to identify and develop lead relationships with priority clients and customers worldwide. The Company believes that such relationships position Lehman Brothers to receive a substantial portion of its clients' and customers' financial business and lessen the volatility of revenues generally associated with the securities industry. Holdings' strategy, of which Lehman Brothers is an integral part, consists of the following four key elements: (1) Focused coverage of major issuing clients and institutional and high net worth individual investing customers. The Company's Investment Banking and Sales areas develop and maintain relationships with clients and customers to understand and meet their financial needs. Business volume generated through these relationships accounts for the majority of Lehman Brothers' business. (2) Comprehensive product and service capabilities. Lehman Brothers has built capabilities in major product and service categories to enable the Company to develop lead relationships with its clients and customers, meet their diverse needs and increase the Company's overall volume of business. Each of these product and service capabilities is provided to clients and customers by Investment Banking and Sales. (3) Global scope of business activities. Lehman Brothers pursues a global strategy in order to: (i) enhance the Company's product and service capabilities; (ii) position the Company to increase its flow of business as the international markets continue to expand; (iii) leverage the Company's infrastructure to benefit from economies of scale; and (iv) geographically diversify the Company's revenues. (4) Organizational structure that enables and encourages the Company's business units to act in a coordinated fashion as "One Firm." The Company is organized to provide the delivery of products and services through teams comprised of professionals with specialized expertise focused on meeting the financial objectives of the Company's clients and customers. Lehman Brothers also engages in activities such as arbitrage and proprietary trading that leverage the Company's expertise and infrastructure and provide attractive profit opportunities, but generally entail a higher degree of risk as the Company makes investments for its own account. FOCUSED CLIENT AND CUSTOMER COVERAGE Investment Banking Lehman Brothers is a leading underwriter of equity and equity-related securities in the equity capital markets and of taxable and tax-exempt fixed income securities denominated in U.S. dollars. The Company also engages in project and real estate financings around the world. According to Securities Data Company, Inc., Lehman Brothers was the third ranked underwriter of debt and equity securities in the United States in 1993. During 1993, Lehman Brothers lead managed 667 offerings of debt and equity securities in the United States with a total volume of $114.9 billion. Investment Banking professionals are responsible for developing and maintaining relationships with issuing clients, gaining a thorough understanding of their specific needs and bringing together the full resources of Lehman Brothers and Holdings to accomplish their financial objectives. Investment Banking is organized into industry and geographic coverage groups, enabling individual bankers to develop specific expertise in particular industries and markets. Industry coverage groups include consumer products, financial institutions, health care, industrial, media, merchandising, natural resources, real estate, technology, telecommunications, transportation and utilities. Where appropriate, professionals with specialized expertise in Strategic Advisory, Equities, Fixed Income, Foreign Exchange, Commodities, Derivatives and Project Finance are integrated into the client coverage teams. Lehman Brothers has a long history of providing strategic advisory services to corporate, institutional and government clients around the world on a wide range of financial matters, including mergers and acquisitions, divestitures, leveraged transactions, takeover defenses, spin-offs, corporate reorganizations and recapitalizations, tender and exchange offers, privatizations, opinion letters and valuations. The Company's Strategic Advisory Group works closely with industry and geographic coverage investment bankers and product specialists around the world. As mergers and acquisitions activity has become increasingly global, Lehman Brothers has maintained its position as a leader in cross-border transactions. In 1993, Lehman Brothers was ranked third in terms of mergers and acquisitions transactions in the United States according to Securities Data Company, Inc. In 1993, the Company advised clients in the United States on transactions totaling $20.8 billion. Institutional Sales Institutional Sales serves the investing and liquidity needs of major institutional investors worldwide and provides the distribution mechanism for new issues and secondary market securities. Lehman Brothers maintains a network of sales professionals around the world. Institutional Sales focuses on the major institutional investors that constitute the major share of global buying power in the financial markets. Lehman Brothers' goal is to be considered one of the top three investment banks by such institutional investors. By serving the needs of these customers, the Company also gains insight into investor sentiment worldwide regarding new issues and secondary products and markets, which in turn benefits the Company's issuing clients. Institutional Sales is organized into four distinct sales forces specialized by the following product types: Equities, Fixed Income, Foreign Exchange/Commodities and Asset Management. Institutional Sales professionals work together to coordinate coverage of major institutional investors through customer teams. Depending on the size and investment objectives of the institutional investor, a customer team can be comprised of from two to five sales professionals, each specializing in a specific product. This approach positions Lehman Brothers to understand and to deliver the full resources of the Company to its customer base. High Net Worth and Middle Market Sales The Company's Financial Services Division serves the investment needs of high net worth individual investors and small and mid-sized institutions. This division has one of the largest sales forces of its kind among major investment banks, with over 500 investment representatives located in seven offices in the major financial centers of the United States and offices in major financial centers worldwide. The Company's investment representatives provide investing customers with ready access to Lehman Brothers' equity and fixed income research, execution capabilities and global product offerings. The Financial Services Division also enables the Company's issuing clients to access a diverse investor base throughout the world. The global network of investment representatives is supported by the Investor Services Group located in New York, London and Hong Kong. This group provides an integrated, global approach to transaction execution, marketing support, asset allocation strategies, and product development. The Investor Services Group also works closely with Lehman Brothers Global Asset Management to develop proprietary product offerings for investing customers. Through Lehman Brothers Bank (Switzerland) S.A. (the "Bank"), an affiliate of LBI, the Financial Services Division provides high net worth investors the traditional personalized services of a Swiss bank, combined with the global resources of a leading securities company. The Bank's services include deposit facilities, international investment products, multi-currency secured lending and global custodial services. COMPREHENSIVE PRODUCT AND SERVICE CAPABILITIES Lehman Brothers provides equity, fixed income, foreign exchange, commodities, asset management and merchant banking products and services to clients and customers. Each area is organized to meet more effectively the needs of clients and customers, and professionals are integrated into teams, supported by a dedicated administrative and operations staff, to provide the highest quality products and services. Equities Lehman Brothers combines professionals from the sales, trading, financing, derivatives and research areas of Equities, together with investment bankers, into teams to serve the financial needs of the Company's equity clients and customers. The integrated nature of the Company's operations and the equity expertise delivered through the Company's client and customer teams enable Lehman Brothers to structure and execute global equity transactions for clients worldwide. The Company is a leading underwriter of initial public and secondary offerings of equity and equity-related securities. Lehman Brothers also makes markets in these and other securities, and executes block trades on behalf of clients and customers. The Company also actively participates in assisting governments around the world in raising equity capital as part of their privatization programs. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed equity and equity-related securities offerings in the United States in 1993. During 1993, the Company lead managed 87 equity offerings in the United States totaling $8.6 billion. The Equities product group is responsible for the Company's equity operations and dollar and non-dollar equity and equity-related products. These products include listed and over-the-counter ("OTC") securities, American Depository Receipts, convertibles, options, warrants and derivatives. During 1993, Lehman Brothers made markets in the top 300 NASDAQ stocks as measured by volume. The Company also makes markets in major European large capitalization stocks. In addition, the Company's convertible securities trading professionals make markets in convertible debenture issues and convertible preferred stock issues. Derivative Products. Lehman Brothers, in conjunction with its affiliates, offers equity derivative capabilities across a wide spectrum of products and currencies, including listed options and futures, portfolio trading and similar products. In 1993, Lehman Brothers developed and marketed several innovative products designed to help investors establish or hedge positions in global markets and currencies. These included products such as certain call and put warrants that use major stock indices as a benchmark. In addition, Lehman Brothers lead managed the largest ever stand-alone U.S. corporate warrant issue in 1993. Equities Research. The Equities research department is integrated with and supports the Company's investment banking, sales and trading activities. An important objective of Equities research is to have in place high quality research analysts covering industry and geographic sectors that support the activities of the Company's clients and customers. The Equities research department is comprised of regional teams staffed by industry specialists, covering industry sectors and companies worldwide. During 1993, the Company expanded its global economics coverage and technical market analysis capabilities. Equity Finance. Lehman Brothers operates a comprehensive equity finance business to support the funding, sales and trading activities of the Company and its clients and customers. Margin lending for the purchase of equities and equity derivatives, securities lending and short sale facilitation are among the main functions of the equity finance group. This group also engages in a conduit business, whereby the Company seeks to earn a positive net spread on matched security borrowing and lending activities. Fixed Income Lehman Brothers actively participates in all major fixed income product areas. The Company combines professionals from the sales, trading, financing, derivatives and research areas of Fixed Income, together with investment bankers, into teams to serve the financial needs of the Company's clients and customers. The Company is a leading underwriter of new issues, and also makes markets in these and other fixed income securities. The Company's global presence facilitates client and customer transactions and provides liquidity in marketable fixed and floating rate debt securities. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed fixed income securities offerings in the United States in 1993. During 1993, the Company lead managed 580 offerings in the United States for a total of $106.3 billion of fixed income securities. Fixed Income products consist of government, sovereign and supranational agency obligations; money market products; corporate debt securities; mortgage and asset-backed securities; emerging market securities; municipal and tax-exempt securities; derivative products and research. In addition, the Company's central funding operation provides access to cost efficient debt financing sources, including repurchase agreements, for the Company and its clients and customers. Government and Agency Obligations. Lehman Brothers is one of the leading 39 primary dealers in U.S. Government securities, as designated by the Federal Reserve Bank of New York, and participates in the underwriting of, and maintains positions in, U.S. Treasury bills, notes and bonds, and securities of federal agencies. Money Market Products. Lehman Brothers is a global market leader in the origination and distribution of short-term debt obligations, including commercial paper, short-term notes, preferred stock and Money Market Preferred Stock(R). The Company is an appointed dealer for approximately 480 commercial paper programs on behalf of companies and government agencies. Corporate Debt Securities. Lehman Brothers is a leader in the underwriting and market making of fixed and floating dollar investment grade debt and trades approximately $1.5 billion of these securities on a daily basis. According to Securities Data Company, Inc., during 1993, Lehman Brothers ranked third in new issue domestic investment grade debt. The Company also underwrites and makes markets in non-investment grade debt securities and bank loans. Lehman Brothers trades in excess of $2.0 billion of high yield securities on a monthly basis. Mortgage and Asset-Backed Securities. The Company is a leading underwriter of and market maker in mortgage and asset-backed securities. The Company's trading activity in the secondary mortgage market exceeds $3.0 billion on a daily basis. Municipal and Tax-Exempt Securities. Lehman Brothers is a leading dealer in municipal and tax-exempt securities, including general obligation and revenue bonds, notes issued by states, counties, cities, and state and local governmental agencies, municipal leases, tax-exempt commercial paper and put bonds. Lehman Brothers is also a leader in the structuring, underwriting and sale of tax-exempt and taxable securities and derivative products for city, state, not-for-profit and other public sector clients. The Company's Public Finance group advises state and local governments on the issuance of municipal securities, and works closely with the municipal sales and trading area to underwrite both negotiated and competitive short-and long-term offerings. According to Securities Data Company, Inc., Lehman Brothers ranked third in lead managed municipal securities offerings in 1993 with a total volume of $29.3 billion. Derivative Products. The Company offers a broad range of derivative product services. Derivatives professionals are integrated into all of the Company's major fixed income product areas. In 1993, Lehman Brothers assisted over 1,000 clients and customers worldwide, in the execution of over 3,900 transactions aggregating approximately $265 billion (notional amount). In 1993, the Company introduced several new derivative products to meet the needs of both issuers and investors, including Step-Up Recovery Floating Rate Notes and Range Floaters. These innovative products are designed to offer issuers and investors the opportunity to diversify their investment and liability portfolios. In late 1993, Lehman Brothers incorporated Lehman Brothers Financial Products Inc. ("LBFP"), a separately capitalized triple-A rated derivatives subsidiary. Lehman Brothers established LBFP to increase the volume of its derivatives business and capture additional underwriting and trading business. It is expected that LBFP will commence its derivatives activities in the third quarter of 1994. Central Funding. The central funding unit engages in two major activities, matched book funding and secured financing. Matched book funding involves lending cash on a short-term basis to institutional customers collateralized by marketable securities, typically government or government agency securities. These arrangements are classified on the Company's balance sheet as "securities purchased under agreements to resell." The Company may also enter into short-term contractual agreements, referred to as "securities sold under agreements to repurchase," whereby securities are pledged as collateral in exchange for cash. The Company enters into these agreements in various currencies and seeks to generate profits from the difference between interest earned and interest paid. Central funding works with the Company's institutional sales force to identify customers that have cash to invest and/or securities to pledge to meet the financing and investment objectives of the Company and its customers. Central funding also coordinates with the Company's treasury area to provide collateralized financing for a large portion of the Company's securities and other financial instruments owned. Fixed Income Research. Fixed Income research at Lehman Brothers encompasses a broad range of research disciplines: quantitative, economic, strategic, credit, portfolio and market-specific analysis. Fixed Income research is integrated with and supports the Company's investment banking, sales and trading activities. An important objective of Fixed Income research is to have in place high quality research analysts covering industry, geographic and economic sectors that support the activities of the Company's clients and customers. Their expertise includes U.S. government and agency securities, corporate securities, high yield, asset and mortgage-backed securities and emerging market debt. Fixed Income research expanded its quantitative capabilities and its coverage of the commercial real estate market during 1993. Foreign Exchange According to a leading market research firm, Lehman Brothers is one of the top two global investment banks that trade foreign exchange for clients and customers. Through its foreign exchange operations, Lehman Brothers seeks to provide its clients and customers with superior trading execution, price protection and hedging strategies to manage volatility. The Company and its affiliates, through operations in New York, London, and Hong Kong, engage in trading activities in all major currencies and maintain a 24-hour foreign exchange market making capability for clients and customers worldwide. In 1993, Lehman Brothers enhanced its foreign exchange capabilities by becoming the first U.S. investment bank to join the Electronic Broking Service in Europe. In addition to the Company's traditional client/customer-driven foreign exchange activities, Lehman Brothers also trades foreign exchange for its own account. Commodities and Futures Lehman Brothers engages in commodities and futures trading in three business lines: market making in metals, exchange futures execution services, and managed futures. The Company seeks to provide clients and customers with innovative investment and hedging strategies to satisfy their investing and risk management objectives. In 1993, professionals from Commodities, Investment Banking and Equities worked together to structure and issue gold-denominated preferred stock, which was the first commodity-linked equity security to be listed on the New York Stock Exchange. Asset Management Lehman Brothers Global Asset Management ("LBGAM") provides discretionary and non-discretionary investment management services to institutional and high net worth investors worldwide. LBGAM's asset management philosophy combines fundamental research with quantitative techniques to identify investment opportunities that span the global equity, fixed income and currency markets. During 1993, LBGAM launched the Lehman Brothers Institutional Funds, a family of funds directed toward U.S. institutional investors, and expanded its managed futures funds for investors throughout the world. Merchant Banking Fund Management Since 1989, Holdings' principal method of making merchant banking investments has been through a series of partnerships (the "1989 Partnerships"), for which subsidiaries of Holdings act as general partner, and in some cases as a limited partner. Merchant banking activities have consisted principally of making equity and certain other investments in merger, acquisition, restructuring and leveraged capital transactions, including leveraged buyouts, either independently or in partnership with the Company's clients. Current merchant banking investments include both publicly traded and privately held companies diversified on a geographic and industry basis. The 1989 Partnerships have a 10-year life with capital available for investment for only the first five years, which period ended in March 1994. Accordingly, during the remaining life of the Partnerships, Holdings' merchant banking activities, with respect to investments made by the 1989 Partnerships, will be directed toward selling or otherwise monetizing such investments. Holdings is currently considering the establishment of a new merchant banking fund and participation in other merchant banking opportunities. Other Business Activities While Lehman Brothers concentrates on its client/customer-driven strategy, the Company also participates in business opportunities such as arbitrage and proprietary trading that leverage the Company's expertise, infrastructure and resources. These businesses may generate substantial revenues but generally entail a higher degree of risk as the Company trades for its own account. Arbitrage. Lehman Brothers engages in a variety of arbitrage activities. In traditional or "riskless" arbitrage, the Company seeks to benefit from temporary price discrepancies that occur when a security is traded in two or more markets, or when a convertible or derivative security is trading at a price disparate from its underlying security. The Company's "risk" arbitrage activities involve the purchase of securities at discounts from the expected values that would be realized if certain proposed or anticipated corporate transactions (such as mergers, acquisitions, recapitalizations, exchange offers, reorganizations, bankruptcies, liquidations or spin-offs) were to occur. To the extent that these anticipated transactions do not materialize in a manner consistent with the Company's expectations, the Company is subject to the risk that the value of these investments will decline in value. Lehman Brothers' arbitrage activities benefit from the Company's presence in the global capital markets, access to advanced information technology, in-depth market research, proprietary risk management tools and general experience in assessing rapidly changing market conditions. Proprietary Trading. Lehman Brothers engages in the trading of various securities, derivatives, currencies and commodities for its own account. The Company's proprietary trading activities bring together various research and trading disciplines allowing it to take market positions, which at times may be significant, consistent with the Company's expectations of future events (such as movements in the level of interest rates, changes in the shape of yield curves and changes in the value of currencies). The Company is subject to the risk that actual market events will be different from the Company's expectations, which may result in significant losses associated with such proprietary positions. The Company's proprietary trading activities are generally carried out in consultation with personnel from the relevant major product area (e.g., mortgages, derivatives and foreign exchange). ADMINISTRATION AND OPERATIONS The Company's administration and operations staff supports its businesses through the processing of certain securities and commodities transactions; receipt, identification and delivery of funds and securities; internal financial controls; safeguarding of customers' securities; and compliance with regulatory and legal requirements. In addition, this staff is responsible for information systems, communications, facilities, legal, internal audit, treasury, tax, accounting and other support functions. In response to the needs of certain of its domestic and international businesses, the Company has acquired sophisticated data processing and telecommunications equipment. The Company believes such acquisition was necessary to provide the high level of technological and analytical support required to process, settle and account for transactions in a worldwide marketplace. Automated systems also provide sophisticated decision support which enhances trading capability and the management of the Company's cash and collateral resources. There is considerable fluctuation within each year and from year to year in the volume of business that the Company must process, clear and settle. GLOBAL SCOPE OF BUSINESS ACTIVITIES Through its network of offices around the world, Lehman Brothers pursues a global strategy to meet more effectively the needs of clients and customers and to generate increased business volume for the Company. The Company's headquarters in New York provides support for and is closely linked to its regional offices. Because Lehman Brothers' global strategy is based on a unified team approach to serving the financial needs of its clients and customers, the Company's regional offices enable Investment Banking and Sales to develop more effectively relationships and deliver products and services to clients and customers whose businesses are located in a given area or who predominantly transact business in that region. Based on the growth in international business activities over the past several years and the continued development of a more integrated global financial economy, Lehman Brothers expects international business activities to continue to grow in the future. The Company believes that its global presence and operating strategy position it to continue to increase the Company's flow of business, and thereby continue to realize greater benefits from economies of scale. ORGANIZATION The organization and culture of Lehman Brothers represent the fourth element of the Company's overall strategy. This strategy requires close integration of investment bankers and sales professionals and product and service professionals to maximize the Company's effectiveness in developing client and customer relationships. To effect this strategy, Lehman Brothers is managed as an integrated global operation. Business planning and execution is coordinated between regional locations and product heads. The Company's 18-member Operating Committee is the principal governing body of Lehman Brothers, and is comprised of representatives from every major area of the organization, including the senior managers from the European and Asia Pacific regions. This structure promotes communication and cooperation, enabling Lehman Brothers to identify and address rapidly opportunities and issues on a global, firm-wide level. The Operating Committee facilitates management's ability to run the business as a whole, as opposed to managing the business units separately. This structure is reinforced with a culture and operating practices that promote integration through the implementation and communication of organizational values and principles consistent with the Company's "One Firm" philosophy. An example of one of these operating practices is the Company's approach to compensation, whereby employees are compensated to a significant extent on the overall performance of the Company and to a lesser extent on the performance of any individual business area. RISK MANAGEMENT Risk is an inherent part of all of Lehman Brothers' businesses and activities. The extent to which Lehman Brothers properly and effectively identifies, assesses, monitors and manages each of the various types of risks involved in its trading, brokerage and investment banking activities is critical to the success and profitability of the Company. The principal types of risk involved in Lehman Brothers' activities are market risks, credit or counterparty risks and transaction risks. Lehman Brothers has developed a control infrastructure to monitor and manage each type of risk on a global basis throughout the Company. Market Risk In its trading, market making and underwriting activities, Lehman Brothers is subject to risks relating to fluctuations in market prices and liquidity of specific securities, instruments and derivative products, as well as volatility in market conditions in general. The markets for these securities and products are affected by many factors, including the financial performance and prospects of specific companies and industries, domestic and international economic conditions (including inflation, interest and currency exchange rates and volatility), the availability of capital and credit, political events (including proposed and enacted legislation) and the perceptions of participants in these markets. Lehman Brothers has developed a multi-level approach for monitoring and managing its market risk. The base level control is at the trading desks where various risk management functions are performed, including daily mark to market by traders and on-going monitoring of inventory aging and pricing by trading desk managers, product area management and the independent risk managers for each product area. The next level of management of market risk occurs in the Trade Analysis department, which independently reviews the prices of the Company's trading positions and regularly monitors the aging of inventory positions. The final level of the risk management process is the Senior Risk Management Committee, which is composed of senior management from the various product areas and from credit, trade analysis and risk management. In addition, when appropriate, Lehman Brothers employs hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Credit or Counterparty Risks Lehman Brothers is exposed to credit risks in its trading activities from the possibility that a counterparty to a transaction could fail to perform under its contractual commitment, resulting in Lehman Brothers incurring losses in liquidating or covering its position in the open market. The responsibility for managing these credit risks rests with the Corporate Credit department. The department, which is organized along both industry and geographic lines, is independent from any of Lehman Brothers' product areas. Corporate Credit manages the Company's credit risks by establishing and monitoring counterparty limits, structuring and approving specific transactions, actively managing credit exposures and participating in the new product review process. In addition, Lehman Brothers, when appropriate, may require collateral from the counterparty to secure its obligations to the Company or seek some other form of credit enhancement (such as financial covenants, guarantees or letters of credit) to support the counterparty's contractual commitment. Transaction Risk In connection with its investment banking and product origination activities, Lehman Brothers is exposed to risks relating to the merits of proposed transactions. These risks involve not only the market and credit risks associated with underwriting securities and developing derivative products, but also potential liabilities under applicable securities and other laws which may result from Lehman Brothers' role in the transaction. Each proposed transaction involving the underwriting or placement of securities by Lehman Brothers is reviewed by the Company's Commitment Committee. The Commitment Committee is staffed by senior members of the Company with extensive experience in the securities industry. The principal function of the Commitment Committee is to determine whether Lehman Brothers should participate in a transaction in which the Company's capital and reputation will be at risk. Fairness opinions and valuation letters to be delivered by Lehman Brothers must be reviewed and approved by the Company's Fairness Opinion Committee, which is composed of senior investment bankers who provide an independent evaluation of the opinions and conclusions to be rendered to the Company's clients. In connection with its investment banking or merchant banking activities, the Company may from time to time make proprietary investments in securities that are not readily marketable. These investments primarily result from the Company's efforts to help clients achieve their financial and strategic objectives. Any such proposed investment which falls within established criteria with respect to the amount of capital invested, the anticipated holding period and the degree of liquidity of the securities must be reviewed and approved by the Company's Investment Committee, which is composed of senior investment bankers. The Investment Committee reviews in detail the proposed investment and applies relevant valuation methodologies to evaluate the risk of loss of capital compared to the anticipated returns from the investment and determine whether to proceed with the transaction. Lehman Brothers recently established a New Products and Business Committee (the "NPBC") for new products developed by Lehman Brothers or new businesses to be entered into by the Company. The NPBC will work in cooperation with the originators or sponsors of a new product or business to evaluate its feasibility, assess its potential risks and liabilities and analyze its costs and benefits. NON-CORE ASSETS Prior to 1990, the Company participated in a number of activities that are not central to its current business as an institutional investment banking firm. As a result of these activities, the Company carries on its balance sheet a number of relatively illiquid assets (the "Non-Core Assets"), including a number of individual real estate assets, limited partnership interests and a number of smaller investments. Subsequent to their purchase, the values of certain of these Non-Core Assets declined below the recorded values on the Company's balance sheet, which necessitated the write-down of the carrying values of these assets and corresponding charges to the Company's income statement. Certain of these activities have resulted in various legal proceedings. Since 1990, management has devoted substantial resources to reducing the Company's Non-Core Assets. Between December 31, 1990 and December 31, 1993, the Company's Non-Core Assets decreased from $1.1 billion in 1990 to approximately $79 million in 1993, with Non-Core Assets defined as carrying value plus contingent exposures net of reserves. Management's intention with regard to these Non-Core Assets is the prudent liquidation of these investments as and when possible. RELATIONSHIP WITH SMITH BARNEY On July 31, 1993, the Company completed the sale of Shearson which consisted of LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers name), substantially all of its asset management business, the operations and data processing functions that supported those business and certain related assets and liabilities. Securities Clearing, Data Services and General Services Agreements Pursuant to a clearing agreement (the "Clearing Agreement"), Smith Barney carries and clears, on a fully disclosed basis, all accounts introduced to it by Lehman Brothers, and performs all clearing and settlement functions for equities, municipal securities and corporate debt which were previously performed by Shearson. Lehman Brothers also conducts certain securities lending activities as agent for Smith Barney under the Clearing Agreement. Pursuant to Data Services and General Services Agreements, Smith Barney provides to the Company all of the same data processing and related services that it previously received from Shearson. Charges for services under these three agreements are generally calculated using the intercompany transfer pricing methodology in effect prior to the Primerica Transaction. These agreements expire on December 31, 1994, but may be extended for up to an additional six months upon payment by the Company of up to $5 million. The Company has been reviewing alternative clearing, data processing and other servicing arrangements to take effect after the expiration of its arrangements with Smith Barney. Certain Arrangements Revolving Cash Subordination Agreement. Holdings has agreed to lend to Smith Barney up to $150 million to cover capital charges in excess of $50 million incurred by Smith Barney as a result of carrying LBI's customer and proprietary positions (the "Lehman Capital Charges"). Holdings will lend additional amounts to Smith Barney in the event that the Lehman Capital Charges increase above $200 million. As of March 28, 1994, $150 million was outstanding. Under certain circumstances, Travelers is required to purchase all or part of Smith Barney's indebtedness to Holdings under the facility up to $250 million. Holdings is only required to fund in excess of $250 million under this facility if Travelers agrees to a corresponding increase in its purchase obligation; provided that, without such agreement, the Company may not engage in any activity which results in the Lehman Capital Charges exceeding $300 million. Revolving Credit Agreements. Pursuant to a Revolving Credit Agreement, Smith Barney may borrow funds from LBI secured by securities having a market value equal to not less than 130% of the aggregate unpaid principal amount borrowed for the purpose of funding customer margin debits carried by Smith Barney. As of March 28, 1994, there were no amounts outstanding under this facility. Pursuant to an Unsecured Revolving Credit Agreement, Holdings has agreed to advance funds to Smith Barney in order to finance, in part, certain of the cash demands of the securities lending activities conducted under the Clearing Agreement. As of March 28, 1994, $756 million was outstanding under this facility. These facilities will terminate upon the termination of the Clearing Agreement. Non-Solicitation. In connection with the Primerica Transaction, both LBI and Smith Barney agreed that they would refrain from soliciting each other's employees and certain customers for varying periods of time after July 31, 1993. The majority of the customer-related non-solicitation provisions have expired. Shearson Related Litigation. LBI and Smith Barney agreed to a division of litigation relating to Shearson pursuant to which, subject to certain exceptions, Smith Barney is liable for such litigations arising after April 11, 1993. With respect to matters arising on or before April 11, 1993, LBI transferred to Smith Barney a $50 million reserve. If such reserve is exhausted, the parties have agreed to share liability on the matters arising on or before April 11, 1993. LBI retained liability for regulatory matters. COMPETITION All aspects of the Company's business are highly competitive. The Company competes in domestic and international markets directly with numerous other brokers and dealers in securities and commodities, investment banking firms, investment advisors and certain commercial banks and, indirectly for investment funds, with insurance companies and others. The financial services industry has become considerably more concentrated as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. In addition, several small and specialized securities firms have been successful in raising significant amounts of capital for their merger and acquisition activities and merchant banking investment vehicles and for their own accounts. These developments have increased competition from firms, many of whom have significantly greater equity capital than the Company. REGULATION The securities industry in the United States is subject to extensive regulation under both federal and state laws. LBI and certain other subsidiaries of Holdings are registered as broker-dealers and investment advisers with the Commission and as such are subject to regulation by the Commission and by self-regulatory organizations, principally the NASD and national securities exchanges such as the NYSE, which has been designated by the Commission as LBI's primary regulator, and the Municipal Securities Rulemaking Board. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. LBI is a registered broker-dealer in all 50 states, the District of Columbia and the Commonwealth of Puerto Rico. The Commission, self-regulatory organizations and state securities commissions may conduct administrative proceedings, which may result in censure, fine, the issuance of cease-and-desist orders or suspension or expulsion of a broker-dealer or an investment adviser, its officers or employees. LBI is registered with the CFTC as a futures commission merchant and is subject to regulation as such by the CFTC and various domestic boards of trade and other commodity exchanges. The Company's U.S. commodity futures and options business is also regulated by the National Futures Association, a not-for-profit membership corporation which has been designated as a registered futures association by the CFTC. Holdings and the Company do business in the international fixed income, equity and commodity markets and undertakes investment banking activities through Holdings' subsidiaries. The U.K. Financial Services Act of 1986 (the "Financial Services Act") governs all aspects of the United Kingdom investment business, including regulatory capital, sales and trading practices, use and safekeeping of customer funds and securities, record keeping, margin practices and procedures, registration standards for individuals, periodic reporting and settlement procedures. Pursuant to the Financial Services Act, Holdings and the Company are subject to regulations administered by The Securities and Futures Authority Limited, a self regulatory organization of financial services companies (which regulates their equity, fixed income, commodities and investment banking activities) and the Bank of England (which regulates their wholesale money market, bullion and foreign exchange businesses). The Company anticipates regulation of the securities and commodities industries to increase at all levels and for compliance therewith to become more difficult. Monetary penalties and restrictions on business activities by regulators resulting from compliance deficiencies are also expected to become more severe. The Company believes that it is in material compliance with regulations described herein. CAPITAL REQUIREMENTS As registered broker-dealers LBI and Lehman Government Securities Inc. ("LGSI"), a wholly owned subsidiary of LBI, are subject to the Commission's net capital rule (Rule 15c3-1, the "Net Capital Rule") promulgated under the Exchange Act. The NYSE and the NASD monitor the application of the Net Capital Rule by LBI and LGSI, respectively. LBI and LGSI compute net capital under the alternative method of the Net Capital Rule which requires the maintenance of minimum net capital, as defined. A broker-dealer may be required to reduce its business if its net capital is less than 4% of aggregate debit balances and may also be prohibited from expanding its business or paying cash dividends if resulting net capital would be less than 5% of aggregate debit balances. In addition, the Net Capital Rule does not allow withdrawal of subordinated capital if net capital would be less than 5% of such debit balances. The Net Capital Rule also limits the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Under the Net Capital Rule, equity capital cannot be withdrawn from a broker-dealer without the prior approval of the Commission when net capital after the withdrawal would be less than 25% of its securities position haircuts (which are deductions from capital of certain specified percentages of the market value of securities to reflect the possibility of a market decline prior to disposition). In addition, the Net Capital Rule requires broker-dealers to notify the Commission and the appropriate self-regulatory organization two business days before a withdrawal of excess net capital if the withdrawal would exceed the greater of $500,000, or 30% of the broker-dealer's excess net capital, and two business days after a withdrawal that exceeds the greater of $500,000, or 20% of excess net capital. Finally, the Net Capital Rule authorizes the Commission to order a freeze on the transfer of capital if a broker-dealer plans a withdrawal of more than 30% of its excess net capital and the Commission believes that such a withdrawal would be detrimental to the financial integrity of the Company or would jeopardize the broker-dealer's ability to pay its customers. Certain of LBI's other subsidiaries are also subject to the Net Capital Rule. Compliance with the Net Capital Rule could limit those operations of LBI that require the intensive use of capital, such as underwriting and trading activities and the financing of customer account balances, and also could restrict the ability of Holdings to withdraw capital from LBI, which in turn could limit the ability of Holdings to pay dividends, repay debt and redeem or purchase shares of its outstanding capital stock. See Footnote 16 of Notes to Consolidated Financial Statements. EMPLOYEES As of December 31, 1993, the Company employed approximately 7,500 persons. The Company considers its relationship with its employees to be good. ITEM 2.

ITEM 2. PROPERTIES The Company's headquarters occupy approximately 915,000 square feet of space at 3 World Financial Center in New York, New York, which is owned by the Company as tenants-in-common with American Express and various other American Express subsidiaries. Holdings expects to relocate on or about August 1994, certain administrative personnel from 388 and 390 Greenwich Street to five floors in the World Financial Center which are currently occupied by subsidiaries of American Express. These five floors will result in total occupancy of approximately 1,147,000 square feet by Holdings and the Company. Holdings entered into a lease for approximately 392,000 square feet for offices located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"). The Operations Center will be used by systems, operations, and certain administrative personnel and contains certain back-up trading facilities. The lease term is approximately 16 years and is expected to commence in August 1994. Holdings and the Company occupy 14 floors at 388 and 390 Greenwich Street which they expect to vacate by July 31, 1994 and will relocate the personnel to the Operations Center and the World Financial Center. Most of the Company's other offices are located in leased premises, the leases for which expire at various dates through the year 2007. Facilities owned or occupied by the Company and its subsidiaries are believed to be adequate for the purposes for which they are currently used and are well maintained. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its business. Such proceedings include actions brought against the Company and others with respect to transactions in which the Company acted as an underwriter or financial advisor, actions arising out of the Company's activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities and commodities firms of which the Company is one. Although there can be no assurance as to the ultimate outcome, the Company has denied, or believes it has a meritorious defense and will deny, liability in all significant cases pending against it including the matters described below, and intends to defend vigorously each such case. Although there can be no assurance as to the ultimate outcome, based on information currently available and established reserves, the Company believes that the eventual outcome of the actions against it, including the matters described below, will not, in the aggregate, have a material adverse effect on the business or consolidated financial condition of the Company. GENERAL ACQUISITION, INC. ET AL. V. GENCORP, INC. ET AL. V. WAGNER & BROWN, ET AL. AND SHEARSON LEHMAN BROTHERS INC. AND SHEARSON LEHMAN BROTHERS HOLDINGS INC. This litigation in the United States District Court for the Southern District of Ohio (the "Ohio Court") arose out of the Company's representation of Wagner & Brown and AFG Industries, Inc. ("AFG") in connection with their effort to acquire GenCorp, Inc. ("GenCorp") in March 1986. In response to the tender offer and the litigation commenced by Wagner & Brown and AFG on March 17, 1986, GenCorp amended its answer and counterclaims on April 2, 1986 to assert claims against LBI and Holdings. Only GenCorp's counterclaims against LBI remain pending. GenCorp asserted common law claims for breach of fiduciary duty, fraud, negligence and unjust enrichment against Lehman Brothers. The claims are based on prior contacts between LBI and GenCorp and LBI's subsequent role in advising and assisting Wagner & Brown and AFG with respect to the tender offer. GenCorp seeks $258 million in damages and the imposition of a constructive trust on the fees and profits the Company earned in the transaction. On or about October 2, 1992, the Ohio Court granted LBI's motion for summary judgment and dismissed GenCorp's claim for compensatory damages. GenCorp has appealed this decision to the United States Court of Appeals for the Sixth Circuit. No decision has been rendered. GenCorp's claim for disgorgement of the fees that LBI received has been stayed pending the appeal. BAMAODAH V. E.F. HUTTON & COMPANY INC. In April 1986, Ahmed and Saleh Bamaodah commenced an action against E.F. Hutton & Company Inc. ("EFH"), a subsidiary of The E.F. Hutton Group Inc. ("Hutton"), to recover all losses the Bamaodahs had incurred since May 1981 in the trading of commodity futures contracts in a nondiscretionary EFH trading account. The Dubai Civil Court ruled that the trading of commodity futures contracts constituted illegal gambling under Islamic law and that therefore the brokerage contract was void. In January 1987, a judgment was rendered against EFH in the amount of $48,656,000. On January 5, 1991, the Dubai Court of Appeals affirmed the judgment. On March 22, 1992, the Court of Cassation, Dubai's highest court, revoked and quashed the decision of the Court of Appeals and ordered that the case be remanded to the Court of Appeals for a further review. FDIC V. CHENG, ET AL. On or about February 16, 1990, the Federal Deposit Insurance Corporation (the "FDIC"), as manager of the Federal Savings and Loan Insurance Corporation ("FSLIC") Resolution Fund (the "FSLIC Resolution Fund"), which is the receiver of Guaranty Federal Savings and Loan Association ("Guaranty Federal"), filed a complaint in the U.S. District Court for the Northern District of Texas (the "Texas District Court") in an action entitled Federal Deposit Insurance Corporation v. Paul Sau-Ki Cheng, et al. On or about February 2, 1993, the FDIC served a Third Amended Complaint naming EFH, Holdings, LBI, four former EFH brokers, Drexel Burnham Lambert Inc. and a subsidiary of it (collectively "Drexel"), a former Drexel broker, Paul Sau-Ki Cheng and Simon Edward Heath, both former directors and co-chairmen of the board of directors of Guaranty Federal and certain other parties not affiliated with Lehman Brothers as defendants. On or about February 11, 1993, the Company filed its answer to the Third Amended Complaint, denying all material allegations and asserting several affirmative defenses. The FDIC's claims related to trading losses and other alleged damages suffered by Guaranty Federal, its creditors, stockholders and depositors, the FSLIC and the FSLIC Resolution Fund as a result of U.S. government bond trading by Cheng and Heath through EFH and Drexel, as well as alleged violations of the Commodities Exchange Act. As a result, the FDIC sought $129,980,000 in alleged actual damages against all defendants and $387.6 million in punitive damages against all defendants except EFH, Holdings and LBI. On October 25, 1993, the Company and the FDIC entered into a settlement agreement, and on November 16, 1993, the Texas District Court entered an order and dismissed all claims with prejudice. PAUL WILLIAMS AND BEVERLY KENNEDY, ET AL. V. BALCOR PENSION INVESTORS ET AL. In February 1990, a purported class action complaint was filed in the United States District Court for the Northern District of Illinois. The complaint names eight separate limited partnerships originated by The Balcor Company ("Balcor"), which was then a wholly owned subsidiary of LBI, known as the Balcor Pension Investors series. Also named as defendants were the general partner of each named limited partnership, Balcor, and Balcor Securities Co., LBI and American Express. The complaint which was amended on October 10, 1990 alleges that the named entities violated certain federal securities laws with regard to the adequacy and accuracy of disclosure of information in connection with the offering of limited partnership interests. The complaint also alleges breach of fiduciary duty, fraud, negligence and violations of the Racketeer Influenced and Corrupt Organizations Act ("RICO"). The complaint seeks compensatory damages and punitive damages. Defendants' Amended Counterclaim filed on September 19, 1990, asserts common law claims of fraud and breach of warranty against plaintiffs. Defendants seek to recover for the alleged damage to their reputation and business as well as their costs and attorneys fees in defending against the claims brought by plaintiffs. On November 29, 1990, W.B. Copeland, Trustee, Ploof Truck Lines, Inc. Profit Sharing Plan and Allan Hirschfield filed a class action counterclaim against defendants which is identical to the Amended Complaint seeking, among other things, leave to join this action as named plaintiffs. On September 8, 1993, the plaintiffs filed a Third Amended Complaint adding additional named plaintiffs and an amended motion for class certification which motions had previously been denied. No plaintiff class has yet been certified and no judicial determination has been made. No merits discovery has been conducted. RALPH MAJESKI, ET AL. V. BALCOR ENTERTAINMENT COMPANY, LTD. ET AL.; ROBERT ECKSTEIN, ET AL. V. BALCOR FILM INVESTORS, ET AL. These two actions were filed in United States District Court for the Eastern District of Wisconsin (the "Wisconsin District Court"). LBI is a defendant only in the Majeski case. Plaintiffs allege that the named defendants in the lawsuits violated certain federal securities laws with regard to the adequacy and accuracy of disclosure of information in respect of the offering of limited partnership interests in Balcor Film Investors, a partnership of which a Balcor subsidiary is the general partner. The Majeski complaint also alleges, in general, breach of fiduciary duty, common law fraud, misrepresentation, breach of contract and a cause of action in the nature of a derivative action. On January 18, 1991, the Wisconsin District Court entered an order certifying a plaintiffs class of all persons who purchased or currently own interests in the Partnership which were purchased from January 8, 1985 through December 31, 1985. The Wisconsin District Court also consolidated the Eckstein and Majeski actions for the remainder of the pretrial proceedings and trial, but did not merge such actions. On March 11, 1992, the Wisconsin District Court granted defendants' motions to dismiss on statute of limitations grounds in both actions. In August 1993, the U.S. Court of Appeals for the Seventh Circuit (the "Court of Appeals") issued an opinion which reversed the order of the Wisconsin District Court and remanded the cases to such court for further proceedings. The defendants sought a writ of certiorari in the U.S. Supreme Court which was denied in January 1994. Upon remand to the Wisconsin District Court, plaintiffs filed a motion to amend the complaint to assert a RICO claim; defendants opposed this amendment, and the motion is pending. In addition, defendants have renewed their motions to dismiss. These motions are pending before the Wisconsin District Court. On or about March 8, 1993, the Majeski plaintiffs filed an action in the Circuit Court for Milwaukee County, Wisconsin. The allegations, including damages, in this complaint are essentially the same as in their federal court action, described above. Plaintiff's counsel has represented that this state court action will be dismissed. GLYNWILL INVESTMENT, LTD. V. SHEARSON LEHMAN BROTHERS INC. Glynwill Investment, Ltd. ("Glynwill"), a corporation chartered in Curacao, N.A., commenced an action against LBI "as successor in interest to E.F. Hutton & Co., Inc." in May of 1990 in the Supreme Court of the State of New York (the "New York Court"), alleging fraud and breach of contract on the part of E.F. Hutton & Co. Inc. in overcharging Glynwill for foreign exchange transactions executed for Glynwill. The New York Court, on LBI's motion to dismiss, held that the release signed by Glynwill after Glynwill's repayment of approximately one half of the $10 million unsecured debit created in Glynwill's account was not a general release encompassing the claims raised by Glynwill in this action and denied LBI's motion. Discovery is ongoing. SANFORD F. KAPLAN V. THE E.F. HUTTON GROUP INC., ET AL; CHRISTOPHER J. HARRIS V. THE E.F. HUTTON GROUP INC., ET AL. On or about December 30, 1987 and January 11, 1988, the Kaplan and Harris complaints were filed as purported class actions. The complaints in these two actions, brought in New York State Supreme Court (the "State Court") and the United States District Court for the Southern District of New York (the "District Court"), respectively, name as defendants Hutton, LBI and SLBP Acquisition Corp., and purport to be brought on behalf of classes of certain holders of nonvested employee stock options or equity grants awarded under Hutton's Equity Ownership Plan (the "Plan"). Plaintiffs alleged, among other things, that as a result of the execution of the Agreement and Plan of Merger between Hutton, SLBP Acquisition Corp. and LBI and the acquisition by LBI of a majority of the shares of Hutton, their stock options and equity grams vested. They sought compensatory damages, declaratory relief and, in the case of Kaplan, injunctive relief. Classes were certified in each action. On December 29, 1993, the District Court issued a final judgment and order approving a settlement and dismissing the Harris action. On January 13, 1993, the State Court issued a final judgment and order approving the settlement and dismissing the Kaplan case. ACTIONS RELATING TO FIRST CAPITAL HOLDINGS INC. FCH Derivative Actions. On or about March 29, 1991, two identical purported shareholder derivative actions were filed, entitled Mentch v. Weingarten, et al. and Isaacs v. Weingarten, et al. The complaints in these two actions, pending in the Superior Court of the State of California, County of Los Angeles, are filed allegedly on behalf of and naming as a nominal defendant FCH. Other defendants include Holdings, two former officers and directors of FCH, Robert Weingarten and Gerry Ginsberg, the four outside directors of FCH, Peter Cohen, Richard DeScherer, William L. Mack and Jerome H. Miller (collectively, the "Outside Directors"), and Michael Milken. The complaints allege generally breaches of fiduciary duty, gross corporate mismanagement and waste of assets in connection with FCH's purchase of non-rated bonds underwritten by Drexel Burnham Lambert Inc. and seek damages for losses suffered by FCH, punitive damages and attorneys' fees. The actions have been stayed pursuant to the bankruptcy of FCH. Concurrent with the bankruptcy filing of FCH and the conservatorship and receivership of its two life insurance subsidiaries, First Capital Life Insurance Company ("First Capital Life") and Fidelity Bankers Life Insurance Company ("Fidelity Bankers Life") (First Capital Life and Fidelity Bankers Life collectively, the "Insurance Subsidiaries"), a number of additional actions were instituted, naming one or more of Holdings, LBI and American Express as defendants (individually or collectively, as the case may be, the "American Express Defendants"). FCH Shareholder and Agent Actions. Three actions were commenced in the United States District Courts for the Southern District of New York and the Central District of California allegedly as class actions on behalf of the purchasers of FCH securities during certain specified periods, commencing no earlier than May 4, 1988 and ending no later than May 31, 1991 (the "Shareholder Class"). The complaints are captioned Larkin, et al. v. First Capital Holdings Corp., et al., amended on May 15, 1991 to add American Express as a defendant, Zachary v. American Express Company, et al., filed on May 20, 1991, and Morse v. Weingarten, et al., filed on June 13, 1991 (the "Shareholder Class Actions"). The complaints raise claims under the federal securities laws and allege that the defendants concealed adverse material information regarding the finances, financial condition and future prospects of FCH and made material misstatements regarding these matters. On July 1, 1991 an action was filed in the United States District Court for the Southern District of Ohio entitled Benndorf v. American Express Company, et al. The action is brought purportedly on behalf of three classes. The first class is similar to the Shareholder Class; the second consists of managing general agents and general agents who marketed various First Capital Life products from April 2, 1990 to the filing of the suit and to whom it is alleged misrepresentations were made concerning FCH (the "Agent Class"); and the third class consists of Agents who purchased common stock of FCH through the First Capital Life Non Qualified Stock Purchase Plan ("FSPP") and who have an interest in the Stock Purchase Account under the FSPP (the "FSPP Class"). The complaint raises claims similar to those asserted in the other Shareholder Class Actions, along with additional claims relating to the FSPP Class and the Agent Class alleging damages in marketing the products. In addition, on August 15, 1991, Kruthoffer v. American Express Company, et al. was filed in the United States District Court for the Eastern District of Kentucky, whose complaint is nearly identical to the Benndorf complaint (collectively the "Agent Class Actions"). On November 14, 1991, the Judicial Panel on Multidistrict Litigation issued an order transferring and coordinating for all pretrial purposes all related actions concerning the sale of FCH securities, including the Shareholder Class Action and Agent Class Actions, and any future filed "tag-along" actions, to Judge John G. Davies of the United States District Court for the Central District of California (the "California District Court"). The cases are captioned In Re: First Capital Holdings Corporation Financial Products Securities Litigation, MDL Docket No.-901 (the "MDL Action"). On January 18, 1993, an amended consolidated complaint (the "Third Amended Complaint") was filed on behalf of the Shareholder Class and the Agent Class. The Third Complaint names as defendants the American Express Defendants, Weingarten and his wife, Palomba Weingarten, Ginsberg, Philip A. Fitzpatrick (FCH's Chief Financial Officer), the Outside Directors and former FCH outside directors Jeffrey B. Lane and Robert Druskin (the "Former Outside Directors"), Fred Buck (President of First Capital Life) and Peat Marwick. The complaint raises claims under the federal securities law and the common law of fraud and negligence. On March 10, 1993, the American Express defendants answered the Third Amended Complaint, denying its material allegations. On March 11, 1993, the California District Court entered an order granting class certification to the Shareholder Class. The class consists of all persons, except defendants, who purchased FCH common stock, preferred stock and debentures during the period May 4, 1988 to and including May 10, 1991. It also issued an order denying class certification to the Agent Class. The FSPP Class action had been previously dropped by the plaintiffs. The American Express Shareholder Action. On or about May 20, 1991, a purported class action was filed on behalf of all shareholders of American Express who purchased American Express common shares during the period beginning August 16, 1990 to and including May 10, 1991. The case is captioned Steiner v. American Express Company, et al. and was commenced in the United States District Court for the Eastern District of New York. The defendants are Holdings, American Express, James D. Robinson, III, Howard L. Clark, Jr., Harvey Golub and Aldo Papone. The complaint alleges generally that the defendants failed to disclose material information in their possession with respect to FCH which artificially inflated the price of the common shares of American Express from August 16, 1990 to and including May 10, 1991 and that such nondisclosure allegedly caused damages to the purported shareholder class. The action has been transferred to California and is now part of the MDL Action. The defendants have answered the complaint, denying its material allegations. The Bankruptcy Court Action. In the FCH bankruptcy, pending in the United States Bankruptcy Court for the Central District of California (the "Bankruptcy Court"), on February 11, 1992, the Official Committee of Creditors Holding Unsecured Claims (the "Creditors' Committee") obtained permission from the Bankruptcy Court to file an action for and on behalf of FCH and the parent corporations of the Insurance Subsidiaries. On March 3, 1992, the Creditors' Committee initiated an adversary proceeding in the Bankruptcy Court, Case No. AD 92-01723, in which they assert claims for breach of fiduciary duty and waste of corporate assets against Holdings; fraudulent transfer against both Holdings and LBI; and breach of contract against LBI. Also named as defendants are the Outside Directors, the Former Outside Directors, Weingarten and Ginsberg. Holdings and LBI have answered this complaint, denying the material allegations. Fact discovery has been completed and the contract claim has been dropped by plaintiffs. No trial date has been set. The Virginia Commissioner of Insurance Action. On December 9, 1992, a complaint was filed in federal court in the Eastern District of Virginia by Steven Foster, the Virginia Commissioner of Insurance as Deputy Receiver of Fidelity Bankers Life. The Complaint names Holdings and Weingarten, Ginsberg and Leonard Gubar, a former director of FCH and Fidelity Bankers Life, as defendants. The action was subsequently transferred to California to be part of the MDL Action. The Complaint alleges that Holdings acquiesced in and approved the continued mismanagement of Fidelity Bankers Life and that it participated in directing the investment of Fidelity Bankers Life assets. The complaint asserts claims under the federal securities laws and asserts common law claims including fraud, negligence and breach of fiduciary duty and alleges violations of the Virginia Securities laws by Holdings. It allegedly seeks no less than $220 million in damages to Fidelity Bankers Life and its present and former policyholders and creditors and punitive damages. Holdings has answered the complaint, denying its material allegations. IN RE COMPUTERVISION CORPORATION SECURITIES LITIGATION In connection with public offerings of notes and common stock of Computervision, actions were commenced in federal district court in Massachusetts against Computervision, certain of its executive officers, the directors of Computervision, LBI, Donaldson, Lufkin & Jenrette Securities Corporation, The First Boston Corporation and Hambrecht & Quist Incorporated, Holdings and J.H. Whitney & Co. in the United States District Court for the District of Massachusetts (collectively the "Massachusetts Case"). These actions have been consolidated in a consolidated amended class action complaint which alleges in substance that the registration statement and prospectus used in connection with the offerings contained materially false and misleading statements and material omissions related to Computervision's anticipated operating results for 1992 and 1993. The plaintiffs purport to represent a class of individuals who purchased in the public offering or in the aftermarket. The complaint seeks damages for negligent misrepresentation and under Sections 11, 12 and 15 of the Securities Act. In addition, three suits were filed in the United States District Court for the Southern District of New York. The suits raise claims similar to those in the Massachusetts Case against the same defendants. The Judicial Panel on Multidistrict Litigation has ordered these cases consolidated with the Massachusetts Case. State Court Action. LBI was named as the sole defendant in a putative class action, Greenwald v. Lehman Brothers Inc., brought in New York State Supreme Court (the "State Court"). The complaint alleges in substance that LBI breached a fiduciary duty owed to its customers in selling them the common stock, senior notes and senior subordinated notes of Computervision during the class period, as defined in the complaint. The State Court dismissed the complaint. SIMS V. SHEARSON LEHMAN BROTHERS HUTTON INC. In March 1990, LBI was sued in the United States District Court for the Northern District of Texas (the "Texas District Court") on behalf of a purported class of all purchasers of limited partnership interests in a limited partnership offering called Kanland Associates. The partnership was sold by EFH in 1982 and raised approximately $20 million. In 1987, the partnership's property was lost in a foreclosure. On May 29, 1992, a second Amended Complaint was filed against LBI alleging claims under Section 10(b) of the Exchange Act, common law fraud, breach of fiduciary duty and RICO relating to disclosures made in connection with the sale of the partnership and alleged breaches of fiduciary duty subsequent to the foreclosure. On August 10, 1992, the Texas District Court issued an order certifying a class of all persons who purchased limited partnership interests in Kanland pursuant to the offering materials distributed by EFH. On November 29, 1993, the Texas District Court signed a final judgment and order approving the class action settlement agreed to by the parties, and dismissed the action with prejudice. CC&F MEDFORD III INVESTMENT COMPANY V. THE BOSTON COMPANY, INC. AND WELLINGTON-MEDFORD III PROPERTIES, INC. In September 1992, Wellington-Medford Properties, Inc. ("W-M III"), then a subsidiary of The Boston Company, Inc. and now a subsidiary of LBI, and The Boston Company, then a subsidiary of LBI, were sued in Superior Court of the Commonwealth of Massachusetts by a limited partner in a partnership (the "Partnership") of which W-M III is the general partner. The Partnership's principal asset is an office building which is leased to The Boston Company. Financing in the amount of $74 million provided to the Partnership by The Sanwa Bank, Ltd. ("Sanwa") is secured by the office building and the lease with The Boston Company. The financing matured in December 1992 and Sanwa has initiated a foreclosure process. The complaint alleges that W-M III has breached its obligation to secure successor financing in order to prevent The Boston Company from being required to pay increased rental pursuant to a rental formula in its lease. The complaint seeks damages in an unspecified amount and a declaration regarding The Boston Company's lease obligations and W-M III's obligations to secure successor financing. W-M III and The Boston Company have answered, denying the material allegations of the complaint. In April 1993, The Boston Company filed a third-party complaint against Sanwa seeking a declaration as to The Boston Company's obligations pursuant to its lease of the office building. Sanwa answered and asserted claims against The Boston Company and W-M III, including claims for treble damages based on alleged breaches of the construction loan agreement. In December 1993, the parties entered into a stay of proceedings for purposes of facilitating negotiations of a possible settlement. Those negotiations are ongoing but have not resulted in agreement. The stay has been extended and now expires on April 15, 1994, with trial scheduled to commence on or after May 16, 1994. EASTON & CO. V. MUTUAL BENEFIT LIFE INSURANCE CO., ET AL.; EASTON & CO. V. LEHMAN BROTHERS INC. LBI has been named as a defendant in two consolidated class action complaints pending in the United States District Court for the District of New Jersey (the "N.J. District Court"). Easton & Co. v. Mutual Benefit Life Insurance Co., et al. ("Easton I"), and Easton & Co. v. Lehman Brothers Inc. ("Easton II"). The plaintiff in both of these actions is Easton & Co., which is a broker-dealer located in Fort Lee, New Jersey. Both of these actions allege federal securities law claims and pendent common law claims in connection with the sale of certain municipal bonds as to which Mutual Benefit Life Insurance Company ("MBLI") has guaranteed the payment of principal and interest. MBLI is an insurance company which was placed in rehabilitation proceedings under the supervision of the New Jersey Insurance Department on or about July 16, 1991. In the Matter of the Rehabilitation of Mutual Benefit Life Insurance Company, (Sup. Ct. N.J. Mercer County.) Easton I was commenced on or about September 17, 1991. In addition to LBI, the defendants named in this complaint are MBLI, Henry E. Kates (MBLI's former Chief Executive Officer) and Ernst & Young (MBLI's accountants). The litigation is purportedly brought on behalf of a class consisting of all persons and entities who purchased DeKalb, Georgia Housing Authority Multi-Family Housing Revenue Refunding Bonds (North Hill Ltd. Project), Series 1991, due November 30, 1994 (the "DeKalb Bonds") during the period from May 3, 1991 (when the DeKalb bonds were issued) through July 16, 1991. LBI acted as underwriter for this bond issue, which was in the aggregate principal amount of $18.7 million. The complaint alleges that LBI violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and seeks damages in an unspecified amount or rescission. The complaint also alleges a common law negligent misrepresentation claim against LBI and the other defendants. Easton II was commenced on or about May 18, 1992, and names LBI as the only defendant. Plaintiff purports to bring this second lawsuit on behalf of a class composed of all persons who purchased "MBLI-backed Bonds" from LBI during the period April 19, 1991 through July 16, 1991. The complaint alleges that LBI violated Section 10(b) and Rule 10b-5, and seeks monetary damages in an unspecified amount, or rescission pursuant to Section 29(b) of the Exchange Act. The complaint also contains a common law claim of alleged breach of duty and negligence. On or about February 9, 1993, the New Jersey District Court granted plaintiffs' motion for class certification in Easton I. The parties have agreed to certification of a class in Easton II for purchases of certain fixed-rate MBLI-backed bonds during the class period. MAXWELL RELATED LITIGATION Certain of Holdings' subsidiaries are defendants in several lawsuits arising out of transactions entered into with the late Robert Maxwell or entities controlled by Maxwell interests. These actions are described below. Berlitz International Inc. v. Macmillan Inc. et al. This interpleader action was commenced in Supreme Court, New York County (the "Court") on or about January 2, 1992, by Berlitz International Inc. ("Berlitz") against Macmillan Inc. ("Macmillan"), Lehman Brothers Holdings PLC ("PLC"), Lehman Brothers International Limited (now known as Lehman Brothers International (Europe), "LBIE") and seven other named defendants. The interpleader complaint seeks a declaration of the rightful ownership of approximately 10.6 million shares of Berlitz common stock, including 1.9 million shares then registered in PLC's name, alleging that Macmillan claimed to be the beneficial owner of all 10.6 million shares, while the defendants did or might claim ownership to some or all of the shares. As a result of its bankruptcy filing, Macmillan sought to remove this case to the Bankruptcy Court for the Southern District of New York. LBIE and PLC have moved to remand the case back to the Court. MGN Pension Trustees Limited v. Invesco MIM Management Limited, Capel-Cure Myers Capital Management Limited and Lehman Brothers International Limited. This action was commenced by issuance of a writ in the High Court of Justice, London, England on or about June 5, 1992. It was alleged that LBIE knew or should have known that certain securities received by it as collateral on a stock loan account held by Bishopsgate Investment Management were in fact beneficially owned by the Mirror Group Pension Scheme ("MGPS") or by MGN Pension Trustees Limited (the trustee of MGPS). On this basis, the plaintiff sought a declaration that LBIE holds or held a portfolio of securities in constructive trust for plaintiff. According to the writ, LBIE sold certain of these securities for L32,024,918, and that LBIE still holds certain of these securities, allegedly worth approximately L1,604,240. The plaintiff sought return of the securities still held and the value of the securities liquidated in connection with the stock loan account. On January 31, 1994, the Company, along with the other defendants, settled the case. Macmillan, Inc. v. Bishopsgate Investment Trust, Shearson Lehman Brothers Holdings PLC et al. This action was commenced by issuance of a writ in the High Court of Justice in London, England on or about December 9, 1991. In this action, Macmillan sought a declaration that it is the legal and beneficial owner of approximately 10.6 million shares of Berlitz International Inc. common stock, including 1.9 million shares then registered. (The same shares that are at issue in the Berlitz case in New York discussed above.) After a trial, on December 10, 1993, the High Court of Justice handed down a judgment finding for the Company on all aspects of its defense and dismissing Macmillan's claims. Bishopsgate Investment Management Limited (in liquidation) v. Lehman Brothers International (Europe) and Lehman Brothers Holdings PLC. In August 1993, Bishopsgate Investment Management Limited ("BIM") served a Writ and Statement of Claim against Lehman Brothers International (Europe) ("LBIE") and PLC. The Statement of Claim alleges that LBIE and PLC knew or should have known that certain securities received by them, either for sale or as collateral in connection with BIM's stock loan activities, were in fact, beneficially owned by various pension funds associated with the Maxwell Group entities. BIM seeks recovery of any securities still held by LBIE and PLC or recovery of any proceeds from securities sold by them. The total value of the securities is alleged to be L100 million. BIM also commenced certain proceedings for summary disposition of its claims relating to certain of the securities with a value of approximately L30 million. On January 11, 1994, the parties agreed to a settlement of that portion of the claim relating to BIM's request for summary disposition with respect to certain securities. Under this agreement, two securities holdings were delivered to BIM. The Company continues to defend the balance of BIM's claim for recovery of other assets alleged to be worth approximately L70 million. The case is scheduled for trial in April 1995. MELLON BANK CORPORATION V. LEHMAN BROTHERS INC., ET AL. In September 1993, Mellon Bank filed a complaint in the U.S. District Court for the Western District of Pennsylvania against LBI and American Express. The complaint alleges that LBI, through the conduct of Smith Barney and Primerica, breached certain covenants contained in the Mellon Agreement. The covenants, which relate to the provision of custodial and administrative services to certain mutual funds, were assumed by Smith Barney in connection with the Primerica Transaction. In a separate action, Smith Barney and Primerica were also sued by Mellon Bank in connection therewith. By order dated January 26, 1994, the action against LBI and American Express was dismissed. WARREN D. CHISUM, ET AL. V. LEHMAN BROTHERS INC. ET AL. On February 28, 1994 a purported class action was filed in the United States District Court for the Northern District of Texas. The complaint names LBI and two former E. F. Hutton & Company Inc. employees as defendants. The complaint alleges that defendants violated Section 10b of the Exchange Act and RICO, breached their fiduciary duties and the limited partners' contract and committed fraud in connection with the origination, sale and operation of four EFH net lease real estate limited partnerships. Plaintiffs seek: (i) to certify a class of all persons who purchased limited partnership interests in the four partnerships at issue, (ii) damages in excess of $140 million plus interest or rescission, (iii) punitive damages and (iv) accounting and attorneys' fees. The Company believes it has several meritorious defenses and intends to vigorously defend this case. OTHER MATTERS In connection with the regulatory attention focused on the U.S. treasury market, LGSI received from the Commission and the U.S. Department of Justice, Antitrust Division, subpoenas and letters requesting information and testimony in connection with a review of the activities of various participants in the government securities market. LGSI has responded to the subpoenas and letters. The Company continues to cooperate and supply documents and testimony requested. As of the date hereof, the Company does not believe that the investigations will have a material adverse effect on the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Pursuant to General Instruction J of Form 10-K, the information required by Item 4 is omitted. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the outstanding common stock of the Company is owned by Holdings. American Express owns 100 percent of the common stock of Holdings, representing approximately 93% of the issued and outstanding voting stock of Holdings. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Pursuant to General Instruction J of Form 10-K, the information required by Item 6 is omitted. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to General Instruction J of Form 10-K, the information required by Item 7 is omitted. Set forth on the following pages is Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS ENVIRONMENT The Company's principal business activities, investment banking and securities trading and sales are, by their nature, subject to volatility, primarily due to changes in interest and foreign exchange rates, global economic and political trends and industry competition. As a result, revenues and earnings may vary significantly from quarter to quarter and from year to year. In 1993, the Company's operating results were achieved in an environment of declining interest rates in the United States, mixed economic trends around the world and continued globalization of the capital markets. The general decline in interest rates in the United States, which began in 1990, continued in 1993 with interest rates declining to their lowest levels in more than 10 years. Investors, seeking higher returns, reduced their holdings of short-term fixed income securities in favor of longer term debt and equity securities in U.S. and non-U.S. markets. Corporate issuers took advantage of this environment and the pools of capital available for investment to restructure their balance sheets through the issuance of equity, repayment of debt and refinancing of debt at lower interest rates. These factors resulted in record levels of debt and equity issuances in 1993. RESULTS OF OPERATIONS During 1993, the Company completed the sales of three businesses: The Boston Company on May 21; Shearson on July 31; and SLHMC on August 31. In the Company's audited historical consolidated financial statements, the operating results of The Boston Company are accounted for as a discontinued operation while the operating results of Shearson and SLHMC are included in the Company's results from continuing operations through their respective sale dates. Because of the significant sale transactions completed during 1993, the Company's historical financial statements are not fully comparable for all years presented. To facilitate an understanding of the Company's results, the following discussion is segregated into three sections and provides financial tables that serve as the basis for the review of results. These sections are as follows: - Historical Results: the results of the Company's ongoing businesses; the results of Shearson and SLHMC through their respective sale dates; the loss on the sale of Shearson; the reserves for non-core businesses; the results of The Boston Company (accounted for as a discontinued operation); and the cumulative effect of changes in accounting principles. - The Lehman Businesses: the results of the ongoing businesses of the Company. - The Businesses Sold: the results of Shearson and SLHMC; the loss on the sale of Shearson; and the reserves for non-core businesses related to the sale of SLHMC. HISTORICAL RESULTS (CONTINUING, SOLD AND DISCONTINUED BUSINESSES) HISTORICAL RESULTS (CONTINUING, SOLD AND DISCONTINUED BUSINESSES) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Net revenues decreased 12% to $4,346 million in 1993 from $4,947 million in 1992 due to the sale of Shearson and SLHMC, offset in part by a 13% increase in net revenues of the Lehman Businesses. Net revenues of $4,947 million in 1992 increased 11% over 1991 net revenues of $4,457 million with net revenues of the Lehman Businesses and the Businesses Sold increasing by 12% and 10%, respectively. Non-interest expenses decreased 3% to $4,492 million in 1993 from $4,628 million in 1992 due to the sale of Shearson and SLHMC. Non-interest expenses of $4,628 million in 1992 increased 11% over 1991 non-interest expenses of $4,174 million due primarily to a 13% increase in compensation and benefits expense, (including a 15% increase in compensation and benefits expenses related to the Businesses Sold) and higher levels of provisions for legal settlements and bad debts. The Company reported a net loss of $259 million for the year ended December 31, 1993, compared to net income of $173 million in 1992 and net income of $160 million in 1991. Included in the 1993 net loss of $259 million was an after-tax loss on the sale of Shearson of $630 million ($535 million pre-tax) and an after-tax charge of $92 million ($141 million pre-tax) related to certain non-core businesses, including a $79 million ($120 million pre-tax) charge related to the sale of SLHMC and a $13 million ($21 million pre-tax) charge related to certain partnership syndication activities in which the Company is no longer actively engaged. The 1993 net loss also included income from discontinued operations of The Boston Company of $189 million, which included an after-tax gain of $165 million on the sale and after-tax operating earnings of $24 million. The 1992 net income of $173 million included a $22 million ($33 million pre-tax) write-down in the carrying value of certain real estate investments, income from discontinued operations of $77 million and a charge of $8 million related to the cumulative effect of the changes in accounting for non-pension postretirement benefits and income taxes. Net income of $160 million in 1991 included income from discontinued operations of $10 million and a $71 million tax benefit on previously reported losses for which no financial statement benefit had been permitted. Included in the table below are the specific revenue and expense categories comprising the historical results as segregated between the Lehman Businesses and the Businesses Sold. The historical amounts for the Lehman Businesses do not include pro forma adjustments for the effects of the Distribution. THE LEHMAN BUSINESSES FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 Summary. For the Lehman Businesses, income from continuing operations increased 122% to $266 million in 1993 from $120 million in 1992. The 1993 results consisted of $279 million of income from the continuing businesses decreased by a $14 million reserve ($21 million pre-tax) for certain non-core partnership syndication activities in which the Company is no longer actively engaged. The 1992 results include a $22 million after-tax ($33 million pre-tax) write-down in the carrying value of certain real estate investments. Net Revenues. Net revenues increased 13% to $2,595 million in 1993 from $2,304 million in 1992. Revenues related to market making and principal transactions and investment banking were the primary sources of the increase. Market Making and Principal Transactions. Market making and principal transactions include the results of the Company's market making and trading related to customer activities, as well as proprietary trading for the Company's own account. Revenues from these activities encompass net realized and mark-to- market gains and (losses) on securities and other financial instruments owned as well as securities and other financial instruments sold but not yet purchased. The Company utilizes various hedging strategies as it deems appropriate to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets. Market making and principal transactions revenues increased 13% to $1,053 million in 1993 from $934 million in 1992, reflecting greater activity and strong customer order flow across all business lines. The following discussion provides an analysis of the Company's market making and principal transactions revenues based upon the various product groups which generated these revenues. Market Making & Principal Transactions Revenues (in millions): Fixed income revenues decreased 20% to $462 million in 1993 from $580 million in 1992. This decrease was due principally to decreased revenues from mortgage-related securities and money market instruments. Equity revenues include net gains on market making and trading in listed and over-the-counter equity securities. Equity revenues increased 28% to $288 million from $225 million in 1992, primarily as a result of higher revenues from the Company's proprietary trading activities. Derivative products revenues include net revenues primarily from the trading and market making activities of the Company's fixed income derivative products group. These products include interest rate and currency swaps, caps, collars, floors and similar instruments. Derivative products revenues increased 213% to $222 million in 1993 from $71 million in 1992. The increased revenues were primarily a result of increased Company activity in these markets and increased usage of these products by the Company's clients and customers. At December 31, 1993, the notional value of the Company's fixed income derivatives contracts increased to over $270 billion from approximately $110 billion at December 31, 1992. Notional amounts do not represent a quantification of the market or credit risk of the positions; rather, notional amounts represent the amounts used to calculate contractual cash flows to be exchanged and are generally not actually paid or received. During 1994, the Company will commence derivative trading and market making activities through Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary is expected to increase the Company's customer base and the volume of activity in its fixed income derivatives business and capture additional underwriting business. Foreign exchange and commodities revenues include revenues derived from market making and trading in spot and forward foreign currency contracts, foreign currency futures contracts and other commodity futures contracts. Revenues from these sources increased 40% to $81 million in 1993 from $58 million in 1992. Included in these results were foreign exchange revenues of $70 million and $56 million for 1993 and 1992, respectively, reflecting an increase of 25%. This increase was due primarily to increased customer-related and proprietary trading activities throughout 1993. Revenues from commodity trading activities increased to $11 million in 1993 from approximately $2 million in 1992, due primarily to increased customer-related trading activities throughout 1993. Foreign exchange contracts outstanding, including forward commitments to purchase and forward commitments to sell, at December 31, 1993 and 1992 were $234 billion and $97 billion, respectively. Investment Banking. Investment banking revenues increased 24% to $624 million in 1993 from $502 million in 1992. The 1993 results were driven primarily by a 39% increase in underwriting revenues to $477 million in 1993 from $343 million in 1992. Underwriting revenues increased as a result of significantly higher underwriting volumes in both equity and fixed income products, with the increase in equity underwriting the primary component. Commissions. Commission revenues increased 7% to $437 million in 1993 from $410 million in 1992, primarily as a result of higher volumes of customer trading of securities and commodities on exchanges. Commission revenues are generated from the Company's agency activities on behalf of corporations, institutions and high net worth individuals. Interest and Dividends. Interest and dividend revenues increased 3% to $4,868 million in 1993 from $4,717 million in 1992. Net interest and dividend income increased 6% to $426 million in 1993 from $401 million in 1992. Net interest and dividend revenue amounts are closely related to the Company's trading activities. A significant portion of net interest revenue is due to trading decisions and strategies, the results of which are reflected in market making and principal transactions. The Company evaluates these strategies on a total return basis. Therefore, changes in net interest revenue from period to period should not be viewed in isolation but should be viewed in conjunction with revenues from market making and principal transactions. Other Revenues. Other revenues decreased 4% to $55 million in 1993 from $57 million in 1992. Asset management and related advisory fees increased 15% to $23 million in 1993 from $20 million in 1992, offset by a decrease in certain other revenue sources. Non-interest Expense. Compensation and benefits expense increased 14% to $1,400 million in 1993 from $1,223 million in 1992, reflecting higher compensation due to increases in revenues and profitability. However, compensation and benefits expense as a percentage of net revenues increased only moderately to 54.0% in 1993 from 53.1% in 1992. Excluding compensation and benefits expense, non-interest expenses decreased 8% to $803 million in 1993 from $869 million in 1992. Included in the 1993 amount was a charge of $21 million ($14 million after-tax) related to certain non-core partnership syndication activities in which the Company is no longer actively engaged. The 1992 results included a $33 million write down ($22 million after-tax) in the carrying value of certain real estate investments. Excluding these charges, as well as compensation and benefits, non-interest expenses declined 6% to $782 million in 1993 from $836 million in 1992. This decrease was due primarily to lower levels of provisions for legal settlements and bad debts and reduced operating expenses. Cost Reduction Effort. In August 1993, the Company announced an expense reduction program with the objective of reducing costs by $170 million on an annualized basis by the end of the first quarter of 1994. The Company's expense structure for the first half of 1993, adjusted for changes in the volume and mix of revenues as well as for additional costs due to external factors such as inflation or new legislation, is the basis against which these goals are being measured. As of March 31, 1994, the Company had taken the following actions which it believes will result in $170 million of cost reductions on an annualized basis: (i) reduced certain purchased costs by lowering the volume of goods and services purchased, renegotiating rates with vendors and strengthening internal compliance with established policies and procedures; (ii) consolidated certain administrative and support functions; (iii) strengthened compliance and control functions; and (iv) completed its annual review of personnel, the objective of which is to upgrade personnel and eliminate positions to improve the Company's overall productivity. During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $25 million pre-tax in the first quarter of 1994 as a result of these terminations. In addition to these actions, the Company has identified a variety of actions that are expected to reduce expenses further, such as (i) additional reductions in certain purchased expenses and (ii) the relocation in the summer of 1994 of certain administrative, operations and other support personnel to newly leased facilities in New Jersey. See "Properties." Distribution of Holdings Common Stock On January 24, 1994, American Express announced the Distribution. Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file the Registration Statement with the Commission with respect to the Distribution during the second quarter of 1994. THE LEHMAN BUSINESSES FOR THE YEARS ENDED DECEMBER 31, 1992 AND 1991 Summary. For the Lehman Businesses, income from continuing operations decreased 37% to $120 million in 1992 from $190 million in 1991, primarily as a result of a higher effective tax rate in 1992 as compared to 1991, due to the recognition in 1991 of $71 million of tax benefits under Statement of Financial Accounting Standards ("SFAS") No. 96. The 1992 results reflect higher revenues in virtually all of the Company's major revenue categories and improved net interest margins resulting in a 12% increase in net revenues. Also contributing to the 1992 results was a 14% increase in non-interest expense primarily due to a 10% increase in compensation and benefits expense in line with the improved net revenues and a $22 million after-tax ($33 million pre-tax) write-down in the carrying value of certain real estate investments. Net Revenues. Net revenues increased 12% to $2,304 million in 1992 from $2,051 million in 1991. Investment banking revenues were the primary source of the improvement, increasing 42% to $502 million in 1992 from $354 million in 1991. Market Making and Principal Transactions. Market making and principal transactions include the results of the Company's market making and trading related to customer activities and proprietary trading for the Company's own account. Revenues from these activities encompass net realized and mark-to-market gains and (losses) on securities and other financial instruments owned as well as securities and other financial instruments sold but not yet purchased. The Company uses various hedging strategies to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets as it deems appropriate. Market making and principal transactions revenues increased 10% in 1992 to $934 million from $846 million in 1991. The following discussion provides an analysis of the Company's market making and principal transactions revenues based upon the various product groups which generated these revenues. Revenues from fixed income products increased 36% to $580 million in 1992 from $427 million in 1991, with mortgage-related securities and money market instruments contributing most of the increase. Equity revenues include net gains on market making and trading in listed and over-the-counter equity securities. Equity revenues decreased 29% to $225 million in 1992 from $318 million in 1991, primarily as a result of lower revenues from the Company's proprietary trading activities. Derivative products revenues include net revenues primarily from the trading and market making activities of the Company's fixed income derivatives group. These products include interest rate and currency swaps, caps, collars, floors and similar instruments. Derivative products revenues increased 78% to $71 million in 1992 from $40 million in 1991, primarily as a result of increased Company activity in these markets and increased usage of these products by the Company's clients and customers. At December 31, 1992, the notional value of the Company's fixed income derivatives contracts increased to approximately $110 billion from approximately $45 billion at December 31, 1991. Foreign exchange and commodities revenues include revenues derived from market making and trading in spot and forward foreign currency contracts, foreign currency futures contracts and other commodity futures contracts. Revenues from these sources decreased 5% to $58 million in 1992 from $61 million in 1991. Foreign exchange revenues increased 19% to $56 million in 1992 from $47 million in 1991, primarily due to an expansion of the Company's proprietary trading activities during 1992. Commodity trading revenues decreased to approximately $2 million in 1992 from approximately $14 million in 1991. Foreign exchange contracts outstanding, including forward commitments to purchase and forward commitments to sell, at December 31, 1992 and 1991 were $97 billion and $53 billion, respectively. Investment Banking. Investment banking revenues increased 42% to $502 million in 1992 from $354 million in 1991. This increase was due to a 61% increase in underwriting revenues to $343 million in 1992 from $213 million in 1991. Commissions. Commission revenues decreased 10% to $410 million in 1992 from $458 million in 1991. This decrease was due primarily to the strategic deemphasis of the Company's institutional futures sales activities in 1992. Commission revenues are generated from the Company's agency activities on behalf of corporations, institutions and high net worth individuals. Interest and Dividends. Interest and dividend revenues increased 10% to $4,717 million in 1992 from $4,283 million in 1991. Net interest and dividend income increased 18% to $401 million in 1992 from $340 million in 1991. Net interest and dividend revenue amounts are closely related to the Company's trading activities. A significant portion of net interest revenue results from trading decisions and strategies, the results of which are reflected in market making and principal transactions. The Company evaluates these strategies on a total return basis. Therefore, changes in net interest revenue from period to period should not be viewed in isolation but should be viewed in conjunction with revenues from market making and principal transactions. Other Revenues. Other revenues increased 8% to $57 million in 1992 from $53 million in 1991. The growth in asset management fees was the primary source of this increase. Asset management and related advisory fees increased 33% to $20 million in 1992 from $15 million in 1991. Non-interest Expense. Compensation and benefits expense increased 10% to $1,223 million in 1992 from $1,114 million in 1991. Compensation and benefits expense as a percent of net revenues decreased to 53.1% in 1992 from 54.3% in 1991, due to improvements in productivity. Excluding compensation and benefits, non-interest expenses increased 21% to $869 million in 1992 from $719 million in 1991. As previously discussed, 1992 results included a $33 million write-down in the carrying value of certain real estate investments. Excluding this charge, as well as compensation and benefits expense, other non-interest expenses increased 16% to $836 million in 1992 from $719 million in 1991. The increase in expenses was due primarily to higher provisions for legal settlements and bad debts as well as increased operating expenses related to the Company's investments in the expansion of its foreign exchange and derivatives businesses. THE LEHMAN BUSINESSES INCOME TAXES -- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 In 1993, the Lehman Businesses had an income tax provision of $126 million which consisted of a provision of $133 million for continuing businesses and a tax benefit of $7 million related to non-core business reserves. The effective tax rate for the continuing businesses was 32%, which is less than the statutory U.S. federal income tax rate principally due to benefits attributable to income subject to preferential tax treatment partially offset by state and local income taxes. During the third quarter of 1993, the statutory U.S. federal income tax rate was increased to 35% from 34%, effective January 1, 1993. The Company's 1993 tax provision includes a one-time benefit of approximately $8 million from the impact of the federal rate change on the Company's net deferred tax assets. The Company's effective tax rate for continuing businesses is expected to increase slightly in 1994, subject to changes in the level and geographic mix of the Company's profits. The Company had a net deferred tax liability of $36 million in 1992 as compared to a net deferred tax asset of $148 million in 1991. The elimination of the net deferred tax asset was primarily related to the utilization of net operating loss carryforwards ("NOLs") which resulted in cash savings to the Company. In addition, the Company had, as of December 31, 1993, approximately $145 million of tax NOLs available to offset future taxable income, the benefits of which have not yet been reflected in the financial statements. Although the benefit related to these NOLs does not currently meet the recognition criteria of SFAS No. 109, strategies are being implemented to increase the likelihood of realization. It is anticipated that approximately $15 million of these NOLs will be transferred to American Express in connection with the Distribution. In 1992, the Lehman Businesses had an income tax provision of $92 million which consisted of a provision of $103 million from continuing businesses and a tax benefit of $11 million related to the $33 million write-down in certain real estate investments previously discussed. Excluding this tax benefit, the effective tax rate for the continuing businesses was 42%, which was higher than the statutory U.S. federal income tax rate primarily due to state and local taxes. Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Previously, the Company accounted for income taxes in accordance with SFAS No. 96. As a result of the adoption, the Company recorded a $68 million increase in consolidated net income from the cumulative effect of this change in accounting principles, $64 million of which related to discontinued operations. In addition, the Company reduced goodwill by $258 million related to the recognition of deferred tax benefits attributable to the Company's 1988 acquisition of The E. F. Hutton Group Inc. The Company established a deferred tax asset of $326 million in the first quarter of 1992 related to tax benefits previously unrecorded under SFAS No. 96. The 1991 tax provision of $28 million includes $71 million for the recognition of benefits on previously reported losses for which no financial statement benefit had been permitted. Excluding the recognition of these benefits, the 1991 effective tax rate was 46%, which was higher than the statutory U.S. federal income tax rate due primarily to state and local income taxes and the non-deductibility of goodwill amortization. THE BUSINESSES SOLD FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 This discussion is provided to analyze the operating results of the Businesses Sold. For purposes of this discussion, the amounts described as the Businesses Sold include the results of operations of Shearson and SLHMC, the loss on sale of Shearson and the reserve for non-core businesses related to the sale of SLHMC. All 1993 amounts for the Businesses Sold include results through their dates of sale and therefore reported results for 1993 are not fully comparable with prior years' results. Net revenues related to the Businesses Sold were $1,751 million in 1993 and $2,643 in 1992. Excluding the loss on the sale of Shearson and the reserve for non-core businesses related to SLHMC, non-interest expenses of the Businesses Sold were $1,634 million in 1993 and $2,536 million in 1992. Compensation and benefits expense were $1,164 million in 1993 and $1,759 million in 1992. The Businesses Sold recorded a net loss of $646 million in 1993 compared to net income of $52 million in 1992. The 1993 results include a loss on sale of Shearson of $630 million and a $79 million charge recorded in the first quarter as a reserve for non-core businesses in anticipation of the sale of SLHMC. The loss on the sale of Shearson included a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. Excluding the $630 million after-tax loss on sale, Shearson's net income was $63 million in 1993 compared to $55 million in 1992. Excluding the $79 million after-tax charge discussed above, SLHMC operations were break-even in 1993 compared to a net loss of $3 million in 1992. THE BUSINESSES SOLD FOR THE YEARS ENDED DECEMBER 31, 1992 AND 1991 Net revenues related to the Businesses Sold increased 10% to $2,643 million in 1992 from $2,406 million in 1991, due primarily to increases in other revenues and commissions. The growth in other revenues was due to increases in investment advisory and custodial fees, reflecting growth in the Company's managed asset products. An increase in the volume of customer directed trading activity was the primary source of the increased level of commission revenues. Non-interest expenses of the Businesses Sold increased 8% to $2,536 million in 1992 from $2,341 million in 1991. Compensation and benefits increased 15% to $1,759 million in 1992 from $1,529 million in 1991, reflecting higher compensation due to increased revenues. Net income for the Businesses Sold increased 86% to $52 million in 1992 from $28 million in 1991. Shearson net income was $55 million in 1992 and $29 million in 1991. THE BUSINESSES SOLD INCOME TAXES -- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The 1993 tax provision of $108 million for Businesses Sold included (i) expenses of $54 million related to the operating results of Shearson; (ii) an expense of $95 million from the sale of Shearson and (iii) a tax benefit of $41 million related to the $120 million reserve for non-core businesses recorded in anticipation of the sale of SLHMC. The provision related to the sale of Shearson primarily resulted from the write-off of $750 million of goodwill which was not deductible for tax purposes. For 1992 and 1991 the tax expense related principally to the Shearson operations. The effective tax rate for the Businesses Sold was 51% in 1992 and 57% in 1991, with the excess over the statutory U.S. federal income tax rate primarily resulting from state and local taxes and the non-deductibility of goodwill amortization. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, total assets were $57.8 billion, compared to $74.0 billion at December 31, 1992. The composition of the Company's assets changed significantly during 1993 due to the sales of The Boston Company, Shearson and SLHMC. The Company's asset base now consists primarily of cash and cash equivalents, and assets which can be sold within one year, including securities and other financial instruments owned, collateralized short-term agreements and receivables. At December 31, 1993, these assets comprised approximately 97% of the Company's balance sheet. Long-term assets consist primarily of other receivables, property, equipment and leasehold improvements, deferred expenses and other assets, and excess of cost over fair value of net assets acquired. Daily Funding Activities. The Company finances its short-term assets primarily on a secured basis through the use of securities sold under agreements to repurchase, securities and other financial instruments sold but not yet purchased, advances from Holdings and other affiliates, securities loaned and other collateralized liability structures. Repurchase agreements and other types of collateralized borrowings historically have been a more stable financing source under all market conditions. Because of their secured nature, these collateralized financing sources are less credit sensitive and also provide the Company access to lower cost funding. The Company uses short-term unsecured borrowing sources to fund short-term assets not financed on a secured basis. The Company's primary sources of short-term, unsecured general purpose funding include commercial paper and short-term debt, including master notes and bank borrowings under uncommitted lines of credit. Commercial paper and short-term debt outstanding totalled $2.6 billion at December 31, 1993, compared to $6.6 billion at December 31, 1992. Of these amounts, commercial paper outstanding totalled $0.4 billion at December 31, 1993, with an average maturity of 14 days, compared to $3.2 billion at December 31, 1992, with an average maturity of 11 days. The 1993 year-end balances reflected the repayment of commercial paper and short-term debt obligations with the proceeds from the sales of The Boston Company, Shearson and SLHMC. To reduce liquidity risk, the Company carefully manages its commercial paper and master note maturities to avoid large refinancings on any given day. In addition, the Company limits its exposure to any single commercial paper investor to avoid concentration risk. LBI's access to short-term and long-term debt financing is highly dependent on its debt ratings. LBI's current long-term senior subordinated/short-term debt ratings are as follows: S&P A/A-1; Moody's A3/P-1 and IBCA -- /A1. As of the Distribution Date, LBI expects to receive a long-term senior debt rating of A and a short-term debt rating of from Fitch Investor Services. The Company's uncommitted lines of credit provide an additional source of short-term financing. As of December 31, 1993, the Company had $5.7 billion in uncommitted lines of credit, provided by 51 banks, consisting of facilities that the Company has been advised are available but for which no contractual lending obligation exists. Long-term assets are financed with a combination of long-term debt and equity. The Company issues subordinated indebtedness as an integral component of its regulatory capital base. The Company maintains long-term debt in excess of its long-term assets to provide additional liquidity, which the Company uses to meet its short-term funding requirements and reduce its reliance on commercial paper and short-term debt. During 1993, the Company issued $722 million in long-term debt, compared to $239 million in 1992. In addition to refinancing long-term debt, these issuances strengthened the Company's capital base, which consists of long-term debt plus equity. The Company staggers the maturities of its long-term debt to minimize refunding risk. At December 31, 1993, the Company had long-term debt outstanding of $3.7 billion with an average life of 2.6 years, compared to $4.4 billion outstanding at December 31, 1992, with an average life of 3.1 years. For long-term debt with a maturity of greater than one year, the Company had $2.4 billion outstanding with an average life of 3.7 years at December 31, 1993, compared to $3.5 billion outstanding with an average life of 3.7 years at December 31, 1992. The Company anticipates that 1994 long-term debt issuances will exceed those of 1993. The proceeds of these issuances primarily will be used to refinance long-term debt maturing in 1994 and to meet regulatory capital objectives. The Company enters into a variety of financial and derivative products agreements as an end user to hedge and/or modify its exposure to foreign exchange and interest rate risk of certain assets and liabilities. These agreements are not part of the Company's trading portfolio of derivative products. The Company primarily enters into interest rate swaps and caps to modify the interest characteristics of its long-term debt obligations. The Company recognizes the net interest expense or income related to these agreements on an accrual basis, including the amortization of premiums, over the life of the contracts. At December 31, 1993 and 1992, the Company had outstanding interest rate swap and cap agreements for the above purposes of approximately $2.7 billion and $2.9 billion, respectively. Included in these amounts were approximately $2.3 billion of interest rate swaps and caps, maturing in 1995 and 1997, which serve to reduce the Company's overall fixed rate debt to a lower fixed rate. Of the remaining interest rate swaps, the most significant serve to convert a portion of the Company's fixed rate debt to a floating rate. The Company has matched substantially all of the maturities of its remaining interest rate swaps to the terms of its underlying borrowings. The $2.7 billion of notional amount of interest rate swap and cap agreements mature as follows: The effect of interest rate swap and cap agreements was to decrease interest expense by approximately $54 million, $53 million and $15 million in 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, the unrecorded net gain on these agreements was approximately $55 million and $84 million, respectively. The Company has no deferred gains or losses related to terminated agreements. The Company expects to continue using interest rate swap and cap agreements to modify the effective interest cost associated with its long-term indebtedness. The $2.3 billion of interest rate swaps and caps described above, which reduce the Company's rate on its fixed rate debt to a lower fixed rate, will lower 1994 and 1995 interest expense by approximately $25 million and $15 million, respectively. The effect of the remaining interest rate swaps is dependent on the level of interest rates in the future. Liquidity Management. The maintenance of the liability structure and balance sheet liquidity as discussed above is achieved through the daily execution of the following financing policies: (i) match funding the Company's assets and liabilities; (ii) maximizing the use of collateralized borrowing sources; and (iii) diversifying and expanding borrowing sources. (i) The Company's first financing policy focuses on funding the Company's assets with liabilities which have maturities similar to the anticipated holding period of the assets to minimize refunding risk. The anticipated holding period of assets financed on an unsecured basis is determined by the expected time it would take to obtain financing for these assets on a collateralized basis. (ii) The Company's second financing policy is to maximize that portion of its balance sheet that is funded through collateralized borrowing sources, which include repurchase agreements, securities loaned, securities sold but not yet purchased and other collateralized liability structures. The Company currently funds over 68% of its assets on a collateralized basis. As discussed above, repurchase agreements and other types of collateralized borrowings historically have been a more reliable financing source under all market conditions. (iii) The Company's third financing policy is to diversify and expand its borrowing sources in an effort to maximize liquidity and reduce concentration risk. Through its institutional sales force, the Company seeks financing from a global investor base with the goal of broadening the availability of its funding sources. The Company incorporates these policies in its liquidity contingency planning process, which is designed to enhance the availability of alternative sources of funding in a period of financial stress. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. The Company's liquidity contingency plan is based on an estimate of its ability to meet its funding requirements with collateralized financing. To help achieve this objective, the Company would rely on the additional liquidity created by its policy of issuing long-term debt in excess of long-term assets and its ability to pledge its unencumbered marketable securities as collateral to obtain financing rather than on a sale of these securities. The Company's liquidity contingency plan is continually reviewed and updated as the Company's asset/liability mix and liquidity requirements change. The Company believes that these policies, combined with the maintenance of sufficient capital levels, position the Company to meet its liquidity requirements in periods of financial stress. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES In addition to financial instruments recorded on the consolidated balance sheet, the Company enters into off-balance sheet financial instruments primarily consisting of derivative contracts and credit-related arrangements. Derivative products include futures, forwards, swaps, options, caps, collars, floors, swaptions, forward rate agreements, foreign exchange contracts and similar instruments. Derivative products are generally based on notional amounts, while credit-related arrangements are based upon contractual amounts. The notional values of these instruments are generally not recorded on the balance sheet. Off-balance-sheet treatment is generally considered appropriate when the exchange of the underlying asset or liability has not occurred or is not assured, or where the notional amounts are utilized solely as a basis for determining cash flows to be exchanged. Therefore, the notional amounts of these instruments do not reflect the Company's market or credit risk amount. The Company conducts its derivative activities through wholly owned subsidiaries. In late 1993, the Company established a new subsidiary, Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary, which is expected to commence activities during the third quarter of 1994, was established to increase the volume of the Company's derivatives business related to customer-driven derivative activities. The Company records derivatives from dealer-related and proprietary trading activities at market or fair value, with unrealized gains and losses, recognized in the consolidated statement of operations as market making and principal transactions revenue. While the notional value of these instruments is not reflected in the consolidated balance sheet, the mark to market value of trading-related derivatives is reflected on a net basis in the December 31, 1993 and 1992 balance sheets as securities and other financial instruments owned or securities and other financial instruments sold not yet purchased, as applicable. Derivative products, like all financial instruments, include various elements of risk which must be actively managed. General types of risk from derivative products include market risk, liquidity risk and credit risk. Market risk from derivatives results from the potential for changes in interest and foreign exchange rates and fluctuations in commodity or equity prices. The market risk for derivatives is similar to that of cash instruments. The Company may employ hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Liquidity risk from derivatives represents the cost to the Company of adjusting its positions in times of high volatility and financial stress. The liquidity of derivative products is highly related to the liquidity of the underlying cash instruments. As with on-balance sheet financial instruments, the Company's valuation policies for derivatives include consideration of liquidity factors. The Company incorporates these policies in its liquidity contingency planning process, which is designed to enhance the availability of alternative sources of funding in a period of financial stress. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. The Company's liquidity contingency plan is based on an estimate of its ability to meet its funding requirements with collateralized financing. To help achieve this objective, the Company would rely on the additional liquidity created by its policy of issuing long-term debt in excess of long-term assets and its ability to pledge its unencumbered marketable securities as collateral to obtain financing rather than on a sale of these securities. The Company's liquidity contingency plan is continually reviewed and updated as the Company's asset/liability mix and liquidity requirements change. The Company believes that these policies, combined with the maintenance of sufficient capital levels, position the Company to meet its liquidity requirements in periods of financial stress. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES In addition to financial instruments recorded on the consolidated balance sheet, the Company enters into off-balance sheet financial instruments primarily consisting of derivative contracts and credit-related arrangements. Derivative products include futures, forwards, swaps, options, caps, collars, floors, swaptions, forward rate agreements, foreign exchange contracts and similar instruments. Derivative products are generally based on notional amounts, while credit-related arrangements are based upon contractual amounts. The notional values of these instruments are generally not recorded on the balance sheet. Off-balance-sheet treatment is generally considered appropriate when the exchange of the underlying asset or liability has not occurred or is not assured, or where the notional amounts are utilized solely as a basis for determining cash flows to be exchanged. Therefore, the notional amounts of these instruments do not reflect the Company's market or credit risk amount. The Company conducts its derivative activities through wholly owned subsidiaries. In late 1993, the Company established a new subsidiary, Lehman Brothers Financial Products Inc., a separately capitalized triple-A rated derivatives subsidiary. This subsidiary, which is expected to commence activities during the third quarter of 1994, was established to increase the volume of the Company's derivatives business related to customer-driven derivative activities. The Company records derivatives from dealer-related and proprietary trading activities at market or fair value, with unrealized gains and losses, recognized in the consolidated statement of operations as market making and principal transactions revenue. While the notional value of these instruments is not reflected in the consolidated balance sheet, the mark to market value of trading-related derivatives is reflected on a net basis in the December 31, 1993 and 1992 balance sheets as securities and other financial instruments owned or securities and other financial instruments sold not yet purchased, as applicable. Derivative products, like all financial instruments, include various elements of risk which must be actively managed. General types of risk from derivative products include market risk, liquidity risk and credit risk. Market risk from derivatives results from the potential for changes in interest and foreign exchange rates and fluctuations in commodity or equity prices. The market risk for derivatives is similar to that of cash instruments. The Company may employ hedging strategies to reduce its exposure to fluctuations in market prices of securities and volatility in interest or foreign exchange rates. Liquidity risk from derivatives represents the cost to the Company of adjusting its positions in times of high volatility and financial stress. The liquidity of derivative products is highly related to the liquidity of the underlying cash instruments. As with on-balance sheet financial instruments, the Company's valuation policies for derivatives include consideration of liquidity factors. Credit risk from derivatives relates to the potential for a counterparty defaulting on its contractual agreement. The Company manages its counterparty credit risk through a process similar to its other trading-related activities. This process includes an evaluation of the counterparty's credit worthiness at the inception of the transaction, periodic review of credit standing and various credit enhancements in certain circumstances. In addition, the Company attempts to execute master netting agreements which provide for net settlement of contracts with the same counterparty in the event of cancellation or default when appropriate or when allowable under relevant law. For a discussion of the Company's policies and procedures regarding risk, see "Business -- Risk Management." Cash Flows. Cash and cash equivalents increased $21 million in 1993 to $316 million, as the net cash provided by operating and investing activities exceeded the net cash used in financing activities. In addition, cash and cash equivalents for discontinued operations increased $42 million in 1993. Net cash provided by operating activities of $1,312 million included the loss from continuing operations adjusted for non-cash items of approximately $464 million for the year ended December 31, 1993. Net cash used in financing activities was $3,784 million in 1993. Net cash provided by investing activities of $2,535 million in 1993 included cash proceeds from the sales of The Boston Company, Shearson and SLHMC of $2,570 million. Cash and cash equivalents decreased $120 million in 1992 to $295 million, as the net cash used in operating and investing activities exceeded the net cash provided by financing activities. In addition, cash and cash equivalents for discontinued operations decreased $1,082 million. Net cash used in operating activities of $5,194 million included income from continuing operations adjusted for non-cash items of approximately $564 million for the year ended December 31, 1992. Net cash used in investing activities was $25 million in 1993. Net cash provided by financing activities was $4,017 million. Cash and cash equivalents decreased $388 million in 1991 to $415 million as the net cash provided by financing and investing activities was exceeded by net cash used and operating activities. In addition, cash and cash equivalents for discontinued operations increased $706 million. Net cash used in operating activities of $3,365 million included income from continuing operations adjusted for non-cash items of approximately $538 million for the year ended December 31, 1991. Net cash provided by financing and investing activities was $879 million and $2,804 million, respectively. SPECIFIC BUSINESS ACTIVITIES AND TRANSACTIONS The following sections include information on specific business activities of the Company which affect overall liquidity and capital resources: Westinghouse. In May 1993, the Company and Westinghouse Electric Corporation ("Westinghouse") entered into a partnership to facilitate the disposition of Westinghouse's commercial real estate portfolio valued at approximately $1.1 billion, which will be accomplished substantially by securitizations and asset sales. The Company invested approximately $154 million in the partnership, and also made collateralized loans to the partnership of $752 million. During the third quarter of 1993, Lennar Inc. was appointed portfolio servicer and purchased a 10% limited partnership interest from the Company and Westinghouse. At December 31, 1993, the carrying value of the Company's investment in the partnership was $154 million and the outstanding balance of the collateralized loan, including accrued interest, was $539 million. The remaining loan balance is expected to be repaid in 1994 through a combination of mortgage remittances, securitizations, asset sales and refinancings by third parties. High Yield Securities. The Company underwrites, trades, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade companies. For purposes of this discussion, high yield debt securities are defined as securities of or loans to companies rated below BBB- by S&P and below Baa3 by Moody's, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. High yield debt securities are carried at market value and unrealized gains or losses for these securities are reflected in the Company's Consolidated Statement of Operations. The Company's portfolio of such securities at December 31, 1993 and 1992 included long positions with an aggregate market value of approximately $661 million and $895 million, respectively, and short positions with an aggregate market value of approximately $75 million and $47 million, respectively. The portfolio may from time to time contain concentrated holdings of selected issues. The Company's two largest high yield positions were $61 million and $56 million at December 31, 1993 and $128 million and $123 million at December 31, 1992. Change in Facilities. In 1993, Holdings agreed to lease approximately 392,000 square feet of office space located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"). The lease term will commence in August 1994 and provides for minimum rental payments of approximately $87 million over its 16-year term. Concurrently, Holdings announced it would relocate certain administrative employees to five additional floors at 3 World Financial Center in New York, New York. These floors will be purchased by Holdings from American Express for approximately $44 million by Holdings. In connection with the relocation to the Operations Center and the additional space at the World Financial Center, Holdings anticipates incremental fixed asset additions of approximately $112 million. Upon commencement of the relocation, a substantial portion of the lease and depreciation charges will be allocated to the Company based upon the Parent's method of allocating certain intercompany charges. Non-Core Activities and Investments. In March 1990, the Company discontinued the origination of partnerships (whose assets are primarily real estate) and investments in real estate. Currently, the Company acts as a general partner for approximately $4.2 billion of partnership investment capital and manages a real estate investment portfolio with an aggregate investment basis of approximately $108 million. The Company provided additional reserves for these activities of $21 million and $33 million in 1993 and 1992, respectively. At December 31, 1993 and 1992, the Company had remaining net exposure to these investments (defined as the remaining unreserved investment balance plus outstanding commitments and contingent liabilities under guarantees and credit enhancements) of $71 million and $201 million, respectively. In certain circumstances, the Company provides financial and other support and assistance to such investments to maintain investment values. Except as described above, there is no contractual requirement that the Company continue to provide this support. Although a decline in the real estate market or the economy in general or a change in the Company's disposition strategy could result in additional real estate reserves, the Company believes that it is adequately reserved. CHANGE OF FISCAL YEAR On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year-end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. EFFECTS OF INFLATION Because the Company's assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects the Company's expenses, such as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the price of services offered by the Company. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, it may adversely affect the Company's financial position and results of operations in certain businesses. NEW ACCOUNTING PRONOUNCEMENTS Financial Accounting Standards Board Interpretation No. 39, "Offsetting of Amounts related to Certain Contracts" ("FIN No. 39"), was issued in March 1992. Effective for balance sheets after January 1, 1994, FIN No. 39 restricts the current industry practice of offsetting certain receivables and payables. Although the implementation of this standard is expected to substantially increase gross assets and liabilities, the Company believes that its results of operations and overall financial condition will not be affected. The FASB has instructed its staff to explore modifying FIN No. 39 to create certain exceptions, which, if enacted, would substantially mitigate the increase in the Company's gross assets and liabilities expected to initially result from the implementation of FIN No. 39. In November 1992, the FASB issued Statement of Financial Standards ("SFAS") No. 112, "Employers Accounting for Postemployment Benefits." This statement requires the accrual of obligations associated with services rendered to date for employee benefits accumulated or vested for which payment is probable and can be reasonably estimated. The Company will record a charge to reflect a cumulative effect of a change in accounting principle of approximately $13 million after-tax in the first quarter of 1994. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company records substantially all its securities at market value. No adjustment is anticipated to be recorded as a result of this accounting pronouncement. RISK MANAGEMENT Risk management is an integral part of the Company's business. The Company has established extensive policies and procedures to identify, monitor, assess and manage risk effectively. For a discussion of these policies and procedures, see "Business -- Risk Management." ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary financial information required by this Item and included in this Report are listed in the Index to Financial Statements and Schedules appearing on page and are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction J of Form 10-K, the information required by Item 10 is omitted. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction J of Form 10-K, the information required by Item 11 is omitted. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction J of Form 10-K, the information required by Item 12 is omitted. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction J of Form 10-K, the information required by Item 13 is omitted. PART IV ITEM 14.

ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: See Index to Consolidated Financial Statements and Schedules appearing on Page. 2. Financial Statement Schedules: See Index to Consolidated Financial Statements and Schedules appearing on Page. 3. Exhibits - --------------- * Filed herewith. SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. LEHMAN BROTHERS INC. (Registrant) March 31, 1994 By: /s/ THOMAS A. RUSSO ------------------------------------ Title: Managing Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. LEHMAN BROTHERS INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Schedules other than those listed above are omitted since they are not required or are not applicable or the information is furnished elsewhere in the consolidated financial statements or the notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder of Lehman Brothers Inc. We have audited the accompanying consolidated balance sheet of Lehman Brothers Inc. and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Inc. and Subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 11 to the consolidated financial statements, in 1992 the Company changed its methods of accounting for postretirement benefits and income taxes. ERNST & YOUNG New York, New York February 3, 1994 except for Note 2, as to which the date is March 28, 1994 LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN MILLIONS) ASSETS See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET -- (CONTINUED) (IN MILLIONS, EXCEPT SHARE DATA) LIABILITIES AND STOCKHOLDER'S EQUITY See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY THREE YEAR PERIOD ENDED DECEMBER 31, 1993 (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS) See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) (IN MILLIONS) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS) (INCLUDING THE BOSTON COMPANY) Interest paid (net of amount capitalized) totaled $4,796 in 1993, $5,047 in 1992 and $5,029 in 1991. Income taxes paid totaled $265 in 1993, $20 in 1992 and $13 in 1991. SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITY The Company completed three sale transactions during the current year, the sale of The Boston Company, Shearson and SLHMC. The cash proceeds related to these sales have been separately reported in the above statement. Excluded from the statement are the individual balance sheet changes related to the net assets sold as well as the noncash proceeds received related to these sales. See Notes 3, 4 and 5. See notes to consolidated financial statements. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Basis of Presentation The consolidated financial statements include the accounts of Lehman Brothers Inc., a registered broker-dealer (formerly Shearson Lehman Brothers Inc., "LBI") and subsidiaries (LBI together with its subsidiaries, the "Company" unless the context otherwise requires). LBI is a wholly owned subsidiary of Lehman Brothers Holdings Inc. (formerly Shearson Lehman Brothers Holdings Inc., "Holdings"). American Express Company ("American Express") owns 100% of Holdings' common stock, which represents approximately 93% of Holdings' voting stock. The remainder of Holdings' voting stock is owned by Nippon Life Insurance Company ("Nippon Life"). See Note 2. All material intercompany transactions and accounts have been eliminated. The Consolidated Statement of Operations includes the results of operations of Shearson and SLHMC, which were sold on July 31, 1993 and August 31, 1993, respectively. See Notes 4 and 5. The balance sheet accounts of the Company's foreign subsidiaries are translated using the exchange rates at the balance sheet date. Revenues and expenses are translated at average exchange rates during the year. The resulting translation adjustments, net of hedging gains or losses are included in stockholder's equity. Gains or losses resulting from foreign currency transactions are included in the Consolidated Statement of Operations. The Company uses the trade date basis of accounting for recording principal transactions. Customer accounts reflect transactions on a settlement date basis. Certain amounts reflect reclassifications to conform to the current period's presentation. Discontinued Operations As described in Note 3, the Company completed the sale of The Boston Company, Inc. ("The Boston Company"), on May 21, 1993. The accompanying consolidated financial statements and notes to consolidated financial statements reflect The Boston Company as a discontinued operation. Securities and Other Financial Instruments Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased, including interest rate and currency swaps, caps, collars, floors, swaptions, forwards, options and similar instruments are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in market making and principal transactions in the Consolidated Statement of Operations. Market value is generally based on listed market prices. If listed market prices are not available, market value is determined based on other relevant factors, including broker or dealer price quotations, and valuation pricing models which take into account time value and volatility factors underlying the financial instruments. In addition to trading and market making activities, the Company enters into a variety of financial instruments and derivative products as an end user to hedge and/or modify its exposure to foreign exchange and interest rate risk of certain assets and liabilities. As an end user, the Company primarily enters into interest rate swaps and caps to modify the interest characteristics of its long-term debt obligations. The Company recognizes the net interest expense/revenue related to these instruments on an accrual basis, including the amortization of premiums, over the life of the contracts. Other than in connection with its debt related hedging programs, the Company's other hedging activities are immaterial. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Repurchase and Resale Agreements Securities purchased under agreements to resell and Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government and government agency securities and are carried at the amounts at which the securities will be subsequently resold or repurchased plus accrued interest. It is the policy of the Company to take possession of securities purchased under agreements to resell and to value the securities on a daily basis to protect the Company in the event of default by the counterparty. In addition, provisions are made to obtain additional collateral if the market value of the underlying assets is not sufficient to protect the Company. Securities and other financial instruments owned which are sold under repurchase agreements are carried at market value with changes in market value reflected in the Consolidated Statement of Operations. Securities purchased under agreements to resell and Securities sold under agreements to repurchase for which the resale/repurchase date corresponds to the maturity date of the underlying securities are accounted for as purchases and sales, respectively. At December 31, 1993, such resale and repurchase agreements aggregated $5.5 billion and $5.2 billion. Securities Borrowed and Loaned Securities borrowed and Securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. It is the Company's policy to value the securities borrowed and loaned on a daily basis, and to obtain additional cash as necessary to ensure such transactions are adequately collateralized. Income Taxes The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". Prior to January 1, 1992, the Company accounted for income taxes under the provisions of SFAS No. 96. Fixed Assets and Intangibles Property and equipment is depreciated on a straight-line basis over the estimated useful lives of the related assets. Leasehold improvements are amortized over the lesser of their economic useful lives or the terms of the underlying leases. The Company capitalizes interest costs during construction and amortizes the interest costs based on the useful lives of the assets. Excess of cost over fair value of net assets acquired is amortized using the straight-line method over a period of 35 years. Statement of Cash Flows The Company defines cash equivalents as highly liquid investments with original maturities of three months or less, other than those held for sale in the ordinary course of business. 2. SUBSEQUENT EVENTS: The Distribution On January 24, 1994, American Express announced plans to issue a special dividend to its common shareholders consisting of all the Holdings Common Stock (the "Distribution"). Prior to the Distribution, which is subject to certain conditions, an additional equity investment of approximately $1.25 billion will be made in Holdings, most significantly by American Express. Holdings currently expects to file a Registration LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Statement on Form S-1 (the "Registration Statement") with the Securities and Exchange Commission (the "Commission") with respect to the Distribution during the second quarter of 1994. Change of Fiscal Year-End On March 28, 1994, the Board of Directors of Holdings approved, subject to the Distribution, a change in the Company's fiscal year-end from December 31 to November 30. Such a change to a non-calendar cycle will shift certain year-end administrative activities to a time period that conflicts less with the business needs of the Company's institutional customers. Reduction in Personnel During the first quarter of 1994, the Company completed a review of personnel needs, which will result in the termination of certain personnel. The Company anticipates that it will record a severance charge of approximately $25 million pre-tax in the first quarter of 1994 as a result of these terminations. 3. SALE OF THE BOSTON COMPANY: On May 21, 1993, pursuant to a stock purchase agreement (the "Mellon Agreement") between the Company and Mellon Bank Corporation ("Mellon Bank"), LBI sold to Mellon Bank (the "Mellon Transaction") The Boston Company, which through subsidiaries is engaged in the private banking, trust and custody, institutional investment management and mutual fund administration businesses. Under the terms of the Mellon Agreement, LBI received approximately $1.3 billion in cash, 2,500,000 shares of Mellon Bank common stock and ten-year warrants to purchase an additional 3,000,000 shares of Mellon Bank's common stock at an exercise price of $50 per share. In June 1993, such shares and warrants were sold by LBI to American Express for an aggregate purchase price of $169 million. After accounting for transaction costs and certain adjustments, the Company recognized a 1993 first quarter after-tax gain of $165 million for the Mellon Transaction. In connection with the completion of the Mellon Transaction, the Company paid a $300 million dividend to Holdings. As a result of the Mellon Transaction, the Company has treated The Boston Company as a discontinued operation. Accordingly, the Company's financial statements segregate the net assets of The Boston Company, as of December 31, 1992, and operating results of The Boston Company for the three years ended December 31, 1993. Presented below are the results of operations and the gain on disposal of The Boston Company included in Income from discontinued operations (in millions): LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 4. SALE OF SHEARSON: On July 31, 1993, pursuant to an asset purchase agreement (the "Primerica Agreement"), the Company completed the sale (the "Primerica Transaction") of LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers name) and substantially all of its asset management business (collectively, "Shearson") to Primerica Corporation (now known as Travelers Corporation) ("Travelers") and its subsidiary Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Also included in the Primerica Transaction were the operations and data processing functions that support these businesses, as well as certain of the assets and liabilities related to these operations. LBI received approximately $1.2 billion in cash and a $586 million interest bearing note from Smith Barney which was repaid in January 1994 (the "Smith Barney Note"). The Smith Barney Note was issued as partial payment for certain Shearson assets in excess of $600 million which were sold to Smith Barney. The proceeds received at July 31, 1993, were based on the estimated net assets of Shearson, which exceeded the minimum net assets of $600 million prescribed in the Primerica Agreement. As further consideration for the sale of Shearson, Smith Barney agreed to pay future contingent amounts based upon the combined performance of Smith Barney and Shearson, consisting of up to $50 million per year for three years based on revenues, plus 10% of after-tax profits in excess of $250 million per year over a five-year period (the "Participation Rights"). In contemplation of the Distribution, American Express received the first Participation Right payment in the first quarter of 1994. It is anticipated that all of the Participation Rights will be assigned to American Express prior to the Distribution. As further consideration for the sale of Shearson, the Company received 2,500,000 shares of 5.50% Convertible Preferred Stock, Series B, of Travelers and a warrant to purchase 3,749,466 shares of common stock of Travelers at an exercise price of $39 per share. In August 1993, American Express purchased such preferred stock and warrant from LBI for aggregate consideration of $150 million. The Company recognized a 1993 first quarter loss related to the Primerica Transaction of approximately $630 million after-tax ($535 million pre-tax), which amount includes a reduction in goodwill of $750 million and transaction-related costs such as relocation, systems and operations modifications and severance. Presented below are the results of operations and the loss on the sale of Shearson (in millions): Shearson operating results reflect allocated interest expense of $72 million, $102 million, and $112 million for the years ended December 31, 1993, 1992 and 1991, respectively. 5. SALE OF SHEARSON LEHMAN HUTTON MORTGAGE CORPORATION: The Company completed the sale of its wholly owned subsidiary, Shearson Lehman Hutton Mortgage Corporation ("SLHMC") to GE Capital Corporation on August 31, 1993. The sales price, net of proceeds used to retire debt of SLHMC, was approximately $70 million. During the first quarter of 1993, the Company provided $120 million of pre-tax reserves in anticipation of the sale of SLHMC, which are included in the LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $141 million of pre-tax reserves for non-core businesses on the Consolidated Statement of Operations. After accounting for these reserves, the sale did not have a material effect on the Company's results of operations. 6. SECURITIES AND OTHER FINANCIAL INSTRUMENTS: Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased are summarized as follows (in millions): 7. CASH AND SECURITIES SEGREGATED AND ON DEPOSIT FOR REGULATORY AND OTHER PURPOSES: In addition to amounts presented in the accompanying Consolidated Balance Sheet as Cash and securities segregated and on deposit for regulatory and other purposes, securities with a market value of approximately $890 million and $341 million at December 31, 1993 and 1992, respectively, primarily collateralizing resale agreements, have been segregated in a special reserve bank account for the exclusive benefit of customers pursuant to the Reserve Formula requirements of Commission Rule 15c3-3. 8. COMMERCIAL PAPER AND SHORT-TERM DEBT: Short-term debt consists primarily of bank loans, master notes and payables to banks. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. SENIOR NOTES: As of December 31, 1993 the Company had $490 million of fixed rate senior notes outstanding. Contractual interest rates on these notes ranged from 7.86% to 12.20% as of December 31, 1993, with a contractual weighted average interest rate of 10.60%. The Company utilized a series of fixed rate basis swaps totalling $341 million to lower this fixed rate to an effective weighted average interest rate of 9.61%. As of December 31, 1993 the Company had $163 million of floating rate senior notes outstanding. Contractual interest rates on these notes ranged from 3.87% to 4.43% as of December 31, 1993, with a contractual weighted average interest rate of 4.38%. Included in floating rate senior notes outstanding were $148 million of borrowings from a subsidiary of Holdings, the recourse of which is limited to certain fixed assets. Interest rates on these related party borrowings are based on the subsidiary's cost of funds. As of December 31, 1993, the effective weighted average interest rate on these related party borrowings was 4.43%. The Company's interest in 3 World Financial Center is financed with fixed rate senior notes totalling $384 million as of December 31, 1993. Of this amount, $301 million is guaranteed by American Express with a portion of these notes being collateralized by certain mortgage obligations. The remaining $83 million of debt supporting the Company's interest in 3 World Financial Center was loaned to the Company by American Express, the recourse of which is limited to certain fixed assets. During 1993, the Company utilized proceeds from the sale of Shearson to repay $570 million of sole recourse notes from a subsidiary of Holdings, which supported buildings and certain fixed assets sold to Travelers. Of the fixed rate senior notes maturing in 1996, $102 million are an obligation of a subsidiary of LBI and are guaranteed by Holdings. As of December 31, 1993, the fair value of the Company's senior notes was approximately $678 million ($1,335 million in 1992) which exceeded the aggregate carrying value of the notes outstanding by approximately $25 million ($58 million in 1992). For purposes of this fair value calculation, the carrying value of variable rate debt that reprices within a year and fixed rate debt which matures in less than six months approximates fair value. For the remaining portfolio, fair value was estimated using either quoted market prices or discounted cash flow analyses based on the Company's current borrowing rates for similar types of borrowing arrangements. Unrecognized gains on interest rate swaps and other transactions used by the Company to manage its interest rate risk within the senior notes portfolio were $6 million and $7 million as of December 31, 1993 and 1992, respectively. The unrecognized gains on these transactions reflect the estimated amounts the Company would receive if the agreements were terminated as calculated based upon market rates as of December 31, 1993 and 1992, respectively. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 10. SUBORDINATED INDEBTEDNESS: As of December 31, 1993, the Company had $2,660 million of fixed rate subordinated indebtedness outstanding. Contractual interest rates on this indebtedness ranged from 5.75% to 13.13% as of December 31, 1993, with an effective weighted average rate of 8.52%. The Company entered into interest rate swap contracts which effectively converted $425 million of this debt to floating rates based on the London Interbank Offered Rate "LIBOR". Exclusive of this $425 million, the Company utilized a series of fixed rate basis swaps totalling $1,949 million to lower the fixed rate of this portfolio to an effective weighted average interest rate of 7.45% as of December 31, 1993. As of December 31, 1993, the Company had $393 million of floating rate subordinated indebtedness outstanding. Contractual interest rates on this indebtedness are primarily based on LIBOR and ranged from 2.91% to 4.13% as of December 31, 1993, with an effective weighted average rate of 3.75%. Including the effect of the $425 million of fixed rate indebtedness swapped to floating rates at an effective weighted average rate of 3.58%, the effective weighted average rate of the Company's floating rate subordinated indebtedness was 3.66%. Of the Company's subordinated indebtedness outstanding as of December 31, 1993, $160 million is repayable prior to maturity at the option of the holder. This obligation is reflected in the above table as maturing in 1996, the year in which the holder has the option to redeem the debt at par value, rather than its contractual maturity of 2003. Subordinated borrowings from Holdings and subsidiaries of Holdings were $1,183 million as of December 31, 1993, all of which were at a fixed rate. Interest rates on these related party borrowings are based on Holdings', and subsidiaries of Holdings' cost of funds and ranged from 6.12% to 13.13% as of December 31, 1993, with an effective weighted average rate of 7.57%. Of this amount, $100 million (which is included in the $425 million swapped indebtedness discussed previously) was swapped to floating rates based on LIBOR, with an effective weighted average rate of 3.09%. Excluding this $100 million, the effective weighted average rate of related party borrowings was 7.07%. As of December 31, 1993, $2,211 million of the total subordinated indebtedness outstanding was senior subordinated indebtedness. As of December 31, 1993 the fair value of the Company's subordinated indebtedness was approximately $3,198 million ($3,212 million in 1992) which exceeded the aggregate carrying value of the notes outstanding by approximately $145 million ($117 million in 1992). Unrecognized gains on interest rate swaps and other transactions used by the Company to manage its interest rate risk on the debt was $49 million and $77 million at December 31, 1993 and 1992, respectively. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 11. CHANGE IN ACCOUNTING PRINCIPLES: Accounting for Postretirement Benefits Effective January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," for the Company's retiree health and other welfare benefit plans. This accounting pronouncement requires the current recognition of these benefits as expenses based upon actuarially determined projections of the benefits provided. The cumulative effect of adopting SFAS No. 106 reduced 1992 net income by $76 million (net of taxes of $52 million). Of this amount, $5 million (net of taxes of $3 million) related to discontinued operations. Prior to the adoption of this accounting principle, the Company recorded these benefits as they were paid. Accounting for Income Taxes The Financial Accounting Standards Board ("FASB") issued SFAS No. 109, "Accounting for Income Taxes," which superseded SFAS No. 96, the accounting standard that the Company had followed since 1987. The primary difference between this accounting standard and SFAS No. 96, lies in the manner in which income tax expense is determined. SFAS No. 96 provided for significantly more restrictive criteria prior to the recognition of deferred tax assets. Under the provisions of SFAS No. 109, deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carryforwards, if, in the opinion of management, it is more likely than not that the tax benefit will be realized. A valuation allowance is recognized, as a reduction of the deferred tax asset, for that component of the net deferred tax asset which does not meet the more likely than not criterion for realization. The Company adopted SFAS No. 109 as of January 1, 1992 and recorded a $68 million increase in consolidated net income from the Cumulative effect of a change in accounting principle, $64 million of which related to discontinued operations. In addition, the Company reduced goodwill by $258 million related to the recognition of deferred tax benefits attributable to the Company's 1988 acquisition of The E.F. Hutton Group Inc. (now known as LB I Group Inc., "Hutton"). 12. PENSION PLANS: The Company participates in several noncontributory defined benefit pension plans sponsored by Holdings. The cost of pension benefits for eligible employees, measured by length of service, compensation and other factors, is currently being funded through trusts established under the plans. Funding of retirement costs for the applicable plans complies with the minimum funding requirements specified by the Employee Retirement Income Security Act of 1974, as amended. Plan assets consist principally of equities and bonds. Total expense related to pension benefits amounted to $16 million, $23 million and $27 million for the years ended December 31, 1993, 1992 and 1991, respectively, and consisted of the following components (in millions): LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the funded status of the Company's defined benefit plans (in millions): The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation for the Company's plans was 7.25% for 1993 and 8.25% for 1992. The rate of increase in future compensation levels used was 5.5% and 6.0% for 1993 and 1992, respectively. The expected long-term rate of return on assets was 9.75% for 1993 and 1992. During 1993, the Company incurred a settlement and curtailment in relation to the Primerica Transaction. The net gain of approximately $26 million (pre-tax) is included in the loss on sale of Shearson. 13. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS: The Company participates in several defined benefit health care plans sponsored by Holdings that provide health care, life insurance and other postretirement benefits to retired employees. The health care plans include participant contributions, deductibles, co-insurance provisions and service-related eligibility requirements. The Company funds the cost of these benefits as they are incurred. Net periodic postretirement benefit cost for the years ending December 31, 1993 and 1992 consisted of the following components (in millions): The Company previously accounted for the cost of these benefits by expensing the amount the Company paid. For the year ending December 31, 1991, $2.5 million was paid for such benefits. During 1993, the Company incurred a curtailment in relation to the Primerica Transaction. The net gain of approximately $56 million (pre-tax) is included in the loss on sale of Shearson. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the amount recognized in the Consolidated Balance Sheet for the Company's postretirement benefit plans (other than pension plans) at December 31, 1993 and 1992 (in millions): The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% in 1993 and 8.5% in 1992. The weighted average annual assumed health care cost trend rate is 13% in 1994 and is assumed to decrease at the rate of 1% per year to 7% in 2000 and remain at that level thereafter. An increase in the assumed health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $1.4 million. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This statement requires the accrual of obligations associated with services rendered to date for employee benefits accumulated or vested for which payment is probable and can be reasonably estimated. The Company will record a charge to reflect a cumulative effect of a change in accounting principle of approximately $13 million after-tax in the first quarter of 1994. 14. INCOME TAXES: The Company's taxable income is included in the consolidated U.S. federal income tax return of American Express and in combined state and local tax returns with other affiliates of American Express. The income tax provision is computed in accordance with the income tax allocation agreement among Holdings, the Company and American Express. Under the agreement, the Company receives income tax benefits for net operating losses ("NOLs"), future tax deductions and foreign tax credits that are recognizable on a stand-alone basis, or a share, derived by formula, of such losses, deductions and credits that are recognizable on American Express' consolidated income tax return. Intercompany taxes are remitted to or from American Express when they are otherwise due to or from the relevant taxing authority. The balances due to Holdings at December 31, 1993 and 1992 were $180 million and $54 million, respectively, and are included in Accrued liabilities and other payables in the accompanying Consolidated Balance Sheet. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The provision (benefit) for income taxes from continuing operations consists of the following (in millions): During the third quarter of 1993, the U.S. federal income tax rate was increased to 35% from 34%, effective January 1, 1993. The Company's 1993 tax provision includes a one-time benefit of approximately $8 million from the impact of the rate change on the Company's net deferred tax assets as of January 1, 1993. Income from continuing operations before taxes included $41 million, $1 million and $11 million that is subject to income taxes of foreign jurisdictions for 1993, 1992 and 1991, respectively. The income tax provision differs from that computed by using the statutory federal income tax rate for the reasons shown below (in millions): Deferred income tax assets and liabilities result from the recognition of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements that will result in differences between income for tax purposes and income for consolidated financial statement purposes in future years. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993 and 1992, the Company's net deferred tax (liabilities) assets from continuing operations consisted of the following (in millions): At December 31, 1993 and 1992, deferred tax assets consisted primarily of reserves not yet deducted for tax purposes of $78 million and $144 million, respectively, and tax return NOLs of $38 million and $220 million, respectively. At December 31, 1993 and 1992, deferred tax liabilities consist primarily of unrealized trading and investment gains of $33 million and $44 million, respectively. During 1993, the Company increased deferred tax assets by approximately $65 million related to transactions arising from the sale of The Boston Company. In addition, in accordance with the tax sharing agreement with Holdings, the Company was reimbursed for $169 million and $99 million of net deferred tax assets in 1993 and 1992, respectively. The net deferred tax (liability) asset is included in Deferred expenses and other assets in the accompanying Consolidated Balance Sheet. At December 31, 1993, the valuation allowance recorded against deferred tax assets from continuing operations was $116 million as compared to $174 million at December 31, 1992. The reduction in the valuation allowance was primarily attributable to 1993 utilization of tax return NOLs for which a valuation allowance was previously established. Of the $116 million valuation allowance at December 31, 1993, approximately $100 million will reduce goodwill if future circumstances permit recognition. For tax return purposes, the Company has approximately $145 million of NOL carryforwards, all of which are attributable to the 1988 acquisition of Hutton. Substantially all of the NOLs are scheduled to expire in the years 1999 through 2007. A portion of the valuation allowance discussed above relates to these NOLs. It is anticipated that approximately $15 million of these NOLs will be transferred to American Express in connection with the Distribution discussed in Note 2, the benefit of which had not been reflected in the financial statements. 15. EMPLOYEE STOCK OWNERSHIP PLAN During 1993, Lehman Brothers established the Lehman Brothers Inc. Employee Ownership Plan (the "Employee Ownership Plan") pursuant to which certain key employees of Holdings deferred a percentage of their 1993 salary and bonus for the purchase of certain Phantom Units of Holdings. Each Phantom Unit is comprised of a phantom equity interest representing a notional interest in a share of common stock, $.10 par value per share ("Common Stock"), of Holdings ("Phantom Share") and the right to receive a certain amount in cash with respect to a Phantom Share ("Cash Right"). Phantom Shares were available for "purchase" through voluntary and mandatory deferrals of 1993 compensation. In accordance with the terms of the Plan, Phantom Units will be converted to the Common Stock contemporaneously with the effectiveness of the Distribution. See Note 2. The Company will recognize compensation expense in 1994 equal to (i) the increase in book value attributable to the Phantom Shares and (ii) the excess, if any, of the market value of the Common Stock on LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the Distribution Date issued pursuant to the Phantom Share conversion over the price paid by employees for the Phantom Shares. 16. CAPITAL REQUIREMENTS: As registered broker-dealers, LBI and certain of its subsidiaries are subject to the Net Capital Rule (Rule 15c3-1, the "Rule") promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The New York Stock Exchange, Inc. and the National Association of Securities Dealers, Inc. monitor the application of the Rule by LBI and such subsidiaries, as the case may be. LBI and such subsidiaries compute net capital under the alternative method of the Rule which requires the maintenance of minimum net capital, as defined. A broker-dealer may be required to reduce its business if net capital is less than 4% of aggregate debit balances or 6% of the funds required to be segregated pursuant to the Commodity Exchange Act (the "Commodity Act") and the regulations thereunder, if greater. A broker-dealer may also be prohibited from expanding its business or paying cash dividends if resulting net capital would be less than 5% of aggregate debit balances or 7% of the funds required to be segregated pursuant to the Commodity Act and the regulations thereunder, if greater. In addition, the Rule does not allow withdrawal of subordinated capital if net capital would be less than 5% of such debit balances or 7% of the funds required to be segregated pursuant to the Commodity Act and the regulations, thereunder, if greater. The Rule also limits the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Under the Rule, equity capital cannot be withdrawn from a broker-dealer without the prior approval of the Commission when net capital after the withdrawal would be less than 25% of its securities positions haircuts (which are deductions from capital of certain specified percentages of the market value of securities to reflect the possibility of a market decline prior to disposition). In addition, the Rule requires broker-dealers to notify the Commission and the appropriate self-regulatory organization two business days before the withdrawal of excess net capital if the withdrawal would exceed the greater of $500,000 or 30% of the broker-dealer's excess net capital, and two business days after a withdrawal that exceeds the greater of $500,000 or 20% of excess net capital. Finally, the Rule authorizes the Commission to order a freeze on the transfer of capital if a broker-dealer plans a withdrawal of more than 30% of its excess net capital and the Commission believes that such a withdrawal would be detrimental to the financial integrity of the firm or would jeopardize the broker-dealer's ability to pay its customers. At December 31, 1993, LBI's net capital aggregated $1,339 million and was $1,293 million in excess of minimum requirement. Also at December 31, 1993, Lehman Government Securities Inc., a wholly owned subsidiary of LBI, had net capital which aggregated $184 million and was $161 million in excess of minimum requirement. The Company is subject to other domestic and international regulatory requirements. As of December 31, 1993, the Company believes it is in material compliance with all such requirements. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 17. COMMITMENTS AND CONTINGENCIES: The Company leases office space and equipment and has entered into ground leases with the City of New York or its agencies. For each of the years ended December 31, 1993, 1992 and 1991, total rent expense was $163 million, $248 million and $246 million, respectively. Minimum future rental commitments under noncancellable operating leases (net of subleases of $660 million) are as follows (in millions): Certain leases on office space contain escalation clauses providing for additional rentals based upon maintenance, utility and tax increases. On October 13, 1993, Holdings executed a 16 year lease at 101 Hudson Street in Jersey City, New Jersey. The lease, which commences in August 1994, obligates Holdings to make minimum lease payments of approximately $87 million over its term. Upon commencement, a substantial portion of these lease payments will be allocated to the Company based upon Holdings' method for allocating certain intercompany charges. The lease commitment amounts presented above do not reflect these allocations which have yet to be finalized. In the normal course of its business, the Company has been named a defendant in a number of lawsuits and other legal proceedings. After considering all relevant facts, available insurance coverage and the opinions of outside counsel, in the opinion of the Company such litigation will not, in the aggregate, have a material adverse effect on the Company's consolidated financial statements. Financial Instruments with Off-Balance-Sheet Risk In the normal course of business, the Company enters into financial instrument transactions to conduct its trading activities, to satisfy the financial needs of its clients and to manage its own exposure to credit and market risks. Many of these financial instruments typically have off-balance-sheet risk resulting from their nature including the terms of settlement. These instruments can be broadly categorized as interest rate and currency swaps, caps, collars, floors, swaptions and similar instruments (collectively "Swap Products"), foreign currency products, equity related products, commitments and guarantees and certain other instruments. Market risk arises from the possibility that market changes, including interest and foreign exchange rate movements, may make financial instruments less valuable. Credit risk results from the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract. The Company has extensive control procedures regarding the extent of the Company's transactions with specific counterparties, the manner in which transactions are settled and the ongoing assessment of counterparty creditworthiness. The notional or contract amounts disclosed below provide a measure of the Company's involvement in such instruments but are not indicative of potential loss. Management does not anticipate any material adverse effect to its financial position or results of operations as a result of its involvement in these instruments. In many cases, these financial instruments serve to reduce, rather than increase, market risk. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company enters into interest rate contracts as principal in its trading operations or as an integral part of its interest rate risk management. These contracts include Swap Products, financial future contracts and forward security contracts. The notional or contractual amounts of these instruments are set forth below (in millions): The majority of the Company's off-balance-sheet transactions are short-term in duration with a weighted average maturity of approximately 1.83 years as of December 31, 1993 and 1.69 years as of December 31, 1992. Presented below is a maturity schedule for the notional/contractual amounts outstanding for Swap Products and other off-balance-sheet instruments (in millions): At December 31, 1993, the replacement cost of contracts in a gain position not recorded on the Company's Consolidated Balance Sheet is as follows (in millions): As of December 31, 1993 and 1992, the Company was contingently liable for $463 million and $822 million, respectively, of letters of credit primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges and other financial guarantees. As of December 31, 1993 and 1992, the Company had pledged or otherwise transferred securities, primarily fixed income, having a market value of $21.3 billion and $14.5 billion, respectively, as collateral for securities borrowed or otherwise received having a market value of $21.1 billion and $14.2 billion, respectively. LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Securities sold but not yet purchased represent obligations of the Company to purchase the securities at prevailing market prices. Therefore, the future satisfaction of such obligations may be for an amount greater or less than the amount recorded. The Company's customer activities may expose it to off-balance-sheet credit risk. The Company may be required to purchase or sell financial instruments at prevailing market prices in the event of the failure of a customer to settle trades on their original terms, or in the event cash and securities in customer accounts are not sufficient to fully cover customer losses. The Company seeks to control the risks associated with customer activities through the use of systems and procedures for financial instruments with off-balance-sheet risk. Subsidiaries of the Company, as general partner, are contingently liable for the obligations of certain public and private limited partnerships organized as pooled investment funds or engaged primarily in real estate activities. In the opinion of the Company, contingent liabilities, if any, for the obligations of such partnerships will not in the aggregate have a material adverse effect on the Company's consolidated financial position or results of operations. Concentrations of Credit Risk As a major securities firm, the Company is actively involved in securities underwriting, distribution and trading. These and other related services are provided on a worldwide basis to a large and diversified group of clients and customers, including multinational corporations, governments, emerging growth companies, financial institutions and individual investors. A substantial portion of the Company's securities and commodities transactions is collateralized and is executed with and on behalf of commercial banks and other institutional investors, including other brokers and dealers. The Company's exposure to credit risk associated with the non-performance of these customers and counterparties in fulfilling their contractual obligations pursuant to securities transactions can be directly impacted by volatile or illiquid trading markets which may impair the ability of customers and counterparties to satisfy their obligations to the Company. Securities and other financial instruments owned by the Company include U.S. government and agency securities and securities issued by U.S. governments which, in the aggregate, represented 18.9% of the Company's total assets at December 31, 1993. In addition, substantially all of the collateral held by the Company for resale agreements or bonds borrowed, which together represented 47.5% of total assets at December 31, 1993, consisted of securities issued by the U.S. government and federal agencies. In addition to these specific exposures, the Company's most significant concentration is financial institutions, which include other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of the Company's business. Financial Accounting Standards Board Interpretation No. 39, "Offsetting of Amounts related to Certain Contracts" ("FIN No. 39"), was issued in March 1992. Effective for balance sheets after January 1, 1994, FIN No. 39 restricts the current industry practice of offsetting certain receivables and payables. Although the implementation of this standard is expected to substantially increase gross assets and liabilities, the Company believes that its results of operations and overall financial condition will not be affected. The FASB has instructed its staff to explore modifying FIN No. 39 to create certain exceptions, which, if enacted, would substantially mitigate the increase in the Company's gross assets and liabilities expected to initially result from the implementation of FIN No. 39. 18. FAIR VALUE OF FINANCIAL INSTRUMENTS: In 1992, the Company adopted SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," which requires disclosure of the fair values of most on- and off-balance-sheet financial instruments for which it is practicable to estimate that value. The scope of SFAS No. 107 excludes certain financial instruments, such LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) as trade receivables and payables when the carrying value approximates the fair value, employee benefit obligations and all non-financial instruments, such as land, buildings and equipment and goodwill. The fair values of the financial instruments are estimates based upon current market conditions and perceived risks and require varying degrees of management judgment. For the majority of the Company's assets and liabilities which fall under the scope of SFAS No. 107, book value approximates fair value, with the exception of senior notes and subordinated indebtedness. See Notes 9 and 10. 19. RELATED PARTY TRANSACTIONS: In the normal course of business, the Company engages in various securities trading, investment banking and financing activities with Holdings, American Express and many of their affiliates (the "Related Parties"). In addition, various charges, such as occupancy, administration and computer processing are allocated between the Related Parties, based upon specific identification and allocation methods. In addition, Holdings and other subsidiaries of Holdings raise money through short and long term funding in the capital markets, which it uses to fund the operations of certain of the Company's wholly owned subsidiaries. Advances from Holdings and other affiliates were $5,063 million and $4,523 million at December 31, 1993 and 1992, respectively. In connection therewith, advances from Holdings aggregating approximately $3.6 billion and $4.1 billion at December 31, 1993 and 1992, respectively, are generally payable on demand, and the average rate of interest charged, which is computed primarily based on Holdings' average daily cost of funds, was 3.6% and 4.1% for the years ended December 31, 1993 and 1992, respectively. Interest charges incurred during 1993, 1992 and 1991 from Holdings, including interest charges on subordinated and senior debt issued to Holdings, amounted to $227 million, $214 million and $273 million, respectively. In addition, the Company has advances from other affiliates of Holdings aggregating approximately $1.5 billion and $442 million, at December 31, 1993 and 1992, respectively, with various repayment terms. The Company also has notes and other receivables due from Holdings and other subsidiaries of Holdings aggregating approximately $1.6 billion and $1.1 billion at December 31, 1993 and 1992, respectively, with various repayment terms. In 1992, the Company issued one share of its common stock to Holdings for $100 million. During 1993, the Company issued an additional three shares of its common stock to Holdings for $430 million. A wholly owned subsidiary of the Company has outstanding 1,000 shares of its 9% Cumulative Preferred Stock, Series A (the "Preferred Stock"), which it issued for an aggregate purchase price of $750,000,000 to a wholly owned subsidiary of Holdings for $1,000 in cash and a promissory note of $749,999,000 bearing interest at a rate equal to the holder's cost of funds (the "Note"). Interest income for the years ended December 31, 1993, 1992 and 1991 includes $28 million, $36 million and $50 million, respectively, from the Note. The dividend requirement on the Preferred Stock, as reflected on the Company's Consolidated Statement of Operations was $68 million for each of the years ended December 31, 1993, 1992 and 1991. The Company believes that amounts arising through related party transactions, including those allocated expenses referred to above, are reasonable and approximate the amounts that would have been recorded if the Company operated as an unaffiliated entity. 20. OTHER CHARGES: During the first quarter of 1993, the Company provided $141 million pre-tax ($93 million after-tax) of non-core business reserves. Of this amount, $21 million pre-tax ($14 million after-tax) relates to certain non-core partnership syndication activities in which the Company is no longer actively engaged. The remaining LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $120 million pre-tax ($79 million after-tax) relates to reserves recorded in anticipation of the sale of SLHMC. Such sale was completed during the third quarter of 1993. 21. QUARTERLY INFORMATION (UNAUDITED): Selected quarterly results for year ended December 31, 1993 were as follows (in millions): The results for the first quarter of 1993 reflect a loss on the Primerica Transaction of $630 million ($535 million pre-tax) and reserves for non-core businesses of $93 million ($141 million pre-tax). LEHMAN BROTHERS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Quarterly results for year ended December 31, 1992 were as follows (in millions): The results for the fourth quarter reflect a $22 million after-tax ($33 million pre-tax) write-down in the carrying value of certain real estate investments, and $19 million after-tax ($29 million pre-tax) net revenues primarily from asset management fees, the basis for the calculation of which was revised during the quarter retroactive to January 1, 1992. SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 See notes to Schedule II on page SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES, CONTINUED FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES, CONTINUED FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE II LEHMAN BROTHERS INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES, CONTINUED FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTES TO PAGE OF SCHEDULE II (1) Note is payable by March 1994. Interest accrues at the Company's margin rate. (2) Notes are payable February 1994 vs. bonus. Interest accrues at the Company's margin rate. (3) Note is payable February 1994 vs. bonus. Interest accrues at the Company's margin rate. (4) Notes are payable February 1995 vs. bonus. Interest accrues at the Company's margin rate. (5) Note is payable by payroll deductions of 10% of gross commissions up to $50,000 and all net commissions over $50,000, plus deferred compensation and investment banking fees. Interest accrues at the Company's margin rate. (6) Note is payable by monthly payments of $1,000 plus 50% of any net bonus payable February 1994. Interest accrues at the Company's margin rate. (7) Note is payable February 1994 vs. bonus. Note is noninterest bearing. (8) Other includes employees who transferred to Smith Barney on July 31, 1993. In connection with this transfer Smith Barney paid the Company $2,263,202 for loans related to these individuals. The balance in other also represents loans to individuals who terminated employment and are outstanding at December 31, 1993. SCHEDULE IX LEHMAN BROTHERS INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS Information pertaining to aggregate short-term borrowings during each of the three years in the period ended December 31, 1993 was as follows (dollars in billions): - --------------- (1) The maximum amount outstanding was based on month end balances. (2) The average borrowings were computed using the monthly amounts outstanding. (3) Interest rates were determined by dividing the actual interest expense for the year by the average monthly amounts outstanding. EXHIBIT INDEX - --------------- * Filed herewith.

93542_1993.txt

93542

1993

ITEM 1. BUSINESS. The Company and its subsidiaries are engaged in three primary lines of business worldwide: (1) the design and sale through independent retailers of collectible figurines and ornaments, action musicals, and other giftware, (2) the direct response marketing and sale of collectible plates and dolls, jewelry, and other giftware, and (3) the manufacture or purchase, sale, and distribution through the direct selling method known as the "Famous Stanley Hostess Party Plan" of home and personal care products and giftware. Giftware The Company's Enesco Worldwide Giftware Group is led by Enesco Corporation ("Enesco"), a subsidiary of the Company, with its headquarters, principal showroom, and large warehouse and distribution center complex located in Elk Grove Village, Illinois. Enesco is a leading importer and distributor of creatively designed giftware items, including licensed lines and collectibles. Its products include diverse lines of porcelain and cold cast figurines, musicals and music boxes, dolls, ornaments, waterballs, decoupage, miniatures, jack-in-the-boxes, tinware, gift bags, and other giftware primarily produced by independent manufacturers in the Far East, with production in some cases being exclusively devoted to Enesco products. As part of a previously announced restructuring, Enesco has consolidated the assets of its Tomorrow-Today Corporation subsidiary into its warehouse and distribution facility, and is in the process of closing its retail store at the Gurnee Mills Mall in Gurnee, Illinois and converting its Australian operations into a distributorship. Enesco's domestic affiliates within the Worldwide Giftware Group now include Sports Impressions, Inc. which sells sports memorabilia and other licensed sports-oriented giftware, and Via Vermont Ltd. which produces a line of etched glass and brass ornaments, picture frames, jewelry boxes, and other giftware. Enesco displays the Worldwide Giftware Group products continuously in ten showrooms located in the United States as well as at periodic trade and private shows held in major U.S. and foreign cities. These products are marketed principally in the U.S. through more than 30,000 independent retail outlets, including gift stores, greeting card shops, national chains, mail order houses, and department stores, each of which is typically serviced by representatives of one or both of Enesco's sales organizations that are comprised of independent sales representatives who cover established sales territories. Foreign affiliates and distributors of the Worldwide Giftware Group are located in Australia, Brazil, Canada, Germany, Hong Kong, Italy, Japan, The Netherlands, Taiwan, and the United Kingdom. The product lines of the Worldwide Giftware Group are based partially on Enesco's collection of proprietary designs and partially on products produced under license from independent creative designers. Many of its products, whether proprietary or produced under license, are protected by trademark and/or copyright registrations in the U.S. and many foreign countries. Principal product trademarks of members of the Worldwide Giftware Group include ENESCO, COUNTRY COUSINS, TREASURED MEMORIES, GROWING UP, PINE HOLLOW, LAURA'S ATTIC, SUN SHELLS, ENESCO SMALL WONDERS, SMALL WORLD OF MUSIC, ELUSIVE LEGEND, THE ENESCO TREASURY OF CHRISTMAS ORNAMENTS, CHERISHED TEDDIES, MAGNAMARKER, VIA VERMONT, and SPORTS IMPRESSIONS. Among its important licensed lines are PRECIOUS MOMENTS, GARFIELD, MEMORIES OF YESTERDAY, LUCY AND ME, CALICO KITTENS, PADDINGTON BEAR, BARBIE, PENNYWHISTLE LANE, A CELEBRATION OF LIFE, SISTERS & BEST FRIENDS, MICKEY & CO./DISNEY, THE NORTH POLE VILLAGE, COCA COLA, FROSTY THE SNOWMAN, CURRIER & IVES, THE WORLD OF SINTERKLAAS, THE GOLDEN LEAGUE, SESAME STREET, McDONALD'S, RUDOLPH THE RED NOSED REINDEER, IVORY CATS, CHERISHED TEDDIES, MAUD HUMPHREY BOGART, BESSIE PEASE GUTMANN, LOUIS ICART, ROSE O'NEIL KEWPIE COLLECTION, ELVIS PRESLEY, THE BEATLES, SATURDAY NIGHT LIVE, STAR TREK, and WIZARD OF OZ. While the development and innovation of new product designs lessens Enesco's dependency on existing trademark or copyright protection, such protection is important to the Company's business, and Enesco has maintained an aggressive and visible program to identify and challenge companies and individuals who infringe its copyrighted designs. The rights with respect to the licensed lines are materially important to Enesco because of the substantial volume of sales represented by these products, especially the PRECIOUS MOMENTS product line which accounted for approximately 24% of the Company's consolidated revenue during 1993. The Enesco affiliate in Hong Kong, Enesco International (H.K.) Limited, assists Enesco by overseeing the ordering and production of Enesco products by independent manufacturers, which are located for the most part in China, as well as in Hong Kong and Taiwan and, to a lesser extent, in Indonesia and Thailand. In addition, this affiliate assists the Company's direct selling operations in the U.S. and Europe by sourcing premium items and giftware manufactured in the Far East. N.C. Cameron & Sons Limited, a subsidiary of the Company and a member of the Worldwide Giftware Group located in Ontario, Canada, sources its products not only through Enesco International (H.K.) Limited but also from other Far Eastern, European, and Canadian manufacturers. Enesco and its affiliates require all manufacturing sources to comply with the Company's established quality standards. Competition in the giftware business in North America, Europe, and the Far East is highly fragmented among a diversity of collectible and giftware product categories. The principal factors affecting success in the marketplace are originality of product design, quality, marketing ability, customer service, and price. The Company believes that Enesco, together with its U.S.-based affiliated companies, is a significant factor in the U.S. giftware business among a small number of sizable, and largely privately-held, competitors within the industry, which businesses include Hallmark, Department 56, Lladro, Silvestri, and Schmid, among others. The Worldwide Giftware Group sales tend to peak in the third and fourth quarters. As of the end of 1993, the Worldwide Giftware Group had a backlog of firm orders totaling $91,800,000, as compared to $93,000,000 as of the end of 1992. The Company expects that substantially all of the existing order backlog will be fulfilled during 1994. It is a standard practice within the giftware industry, however, that orders are subject to amendment or cancellation by customers prior to shipment. Because of the multiplicity of external factors that can impact the status of unshipped orders at any particular time, the comparison of backlog orders in a given year with those at the same date in a prior year is not necessarily indicative of sales performance for that year or for prospective sales results in future years. Backlog orders can also be affected by various programs employed by the Company to induce its customers to place orders and accept shipments at specified times in the year. In addition, extended credit and payment terms have been and will continue to be key marketing tools. The Worldwide Giftware Group plans to utilize similar sales promotions in 1994 to those it employed in 1993 and 1992. Direct Response The Company's Hamilton Worldwide Direct Response Group consists of The Hamilton Collection, Inc. ("Hamilton"), a subsidiary of the Company, which has its headquarters and warehouse facilities located in Jacksonville, Florida along with its parent, The Hamilton Group Limited, Inc. Hamilton sells giftware and manufactured collectibles directly to consumers through print advertising and direct mail marketing in the U.S., Canada, and the United Kingdom. Hamilton's direct mail promotions and media advertisements offer approximately sixty new products each year, primarily collectible plates, dolls, and porcelain figurines. The artwork incorporated in these items is, for the most part, licensed from well known artists and many feature television and motion picture properties. In 1992, limited-edition dolls accounted for 49% of Hamilton's worldwide sales. In 1993, however, its collectible plates, hand-painted sculptures, and other non-doll product categories grew substantially and accounted for over 62% of total sales of the Worldwide Direct Response Group. The principal trademarks of Hamilton include THE HAMILTON COLLECTION, RIVERSHORE, CHILDREN SERIES, and HAMLITE. Most of Hamilton's products are advertised and sold as part of a collection series. Generally, the consumer is offered the opportunity to purchase a single limited-edition item for which the Company has planned or anticipated related follow-up items. After the initial purchase, the collector may be offered additional products over a period of time based upon the same theme as the first product purchased. Advertising costs total approximately 46% of all Worldwide Direct Response Group sales. A key factor in achieving continued sales growth for Hamilton, especially in the collectible plate category during 1993, has been the sale of product with no down payment and, particularly in the case of dolls, on installment payments. The collector may typically purchase a product with either little or no down payment and a small number of interest-free installment payments, depending on the price of the product. Hamilton sources its products in the U.S., Great Britain, Germany, Italy, and the Far East from numerous manufacturers that comply with the Company's established quality standards. It has an expanding customer mailing list of over 1,000,000 buyers and collectors. Hamilton's principal licensed properties include: PRECIOUS MOMENTS, THE WIZARD OF OZ, CHERISHED TEDDIES, STAR WARS, ELVIS PRESLEY, I LOVE LUCY, HONEYMOONERS, THE GIFTED LINE, and STAR TREK. Well known artists include Chuck Ren, Chuck Dehaan, Connie Walser Derek, Donald Zolan, Sandra Kuck, Thomas Blackshear, Jim Lamb, Helen Kish, Samuel J. Butcher, and Ted Xaras. The Worldwide Direct Response Group is faced with substantial competition in all its North American and United Kingdom markets. Competition in direct response marketing exists with respect to price, product design and innovation, quality, advertising and marketing ability, and customer service. The Company believes that Hamilton is a growing factor in the U.S. among the handful of prominent giftware and manufactured collectibles companies whose products are sold to the public through direct response media and mail. These industry leaders include Danbury Mint, Franklin Mint, Bradford Exchange, and Lenox Collection, most of which have significantly larger sales volumes than Hamilton. The volume of sales of the Worldwide Direct Response Group peaks in the third and fourth quarters. Traditionally, mail order companies, such as Hamilton, have not been obligated to collect states sales taxes on the sales of their products to customers located in the various states unless they had a physical presence sufficient to permit the state to impose this obligation under the previously accepted guidelines established by the U.S. Supreme Court in the National Bellas Hess case decided in 1967. Over the past few years various states have sought to interpret these guidelines in such a way as to permit them to impose the obligation to collect those taxes on mail order companies based upon economic presence and in certain cases have even enacted special legislation to such effect. As a result, these companies, including Hamilton, would face a significant administrative burden in complying with the position of these states. Some states have also asserted a retroactive liability for uncollected taxes for past periods. In response to a particular challenge by the State of North Dakota, the U.S. Supreme Court reviewed and upheld National Bellas Hess in 1992 based on the Commerce Clause of the U.S. Constitution. However, in this new decision the Court noted that its continuing application of the Commerce Clause - to a situation which in fact went beyond that of National Bellas Hess - could be modified by the U.S. Congress. In view of the subsequent failure of an industry trade association to reach a practical resolution of this matter with representatives of two state tax organizations, it is generally expected that this issue will be pursued by both sides before the U.S. Congress. In fact, legislation has been introduced in the U.S. Senate to override the prior U.S. Supreme Court decisions. Direct Selling The Company's Stanhome Worldwide Direct Selling Group is composed of direct selling operations conducted by subsidiaries of the Company in France, Italy, Mexico, Puerto Rico, Slovenia, Spain, and Venezuela and the Stanley Home Products Division in the United States. Some of these operations manufacture, as well as distribute and sell, a broad line of home care items and personal care and other products, including specialty chemical products for household use, mops, brooms, brushes, and other similar household cleaning equipment, pesticides for domestic use, air deodorants, cosmetics and toiletries, and general giftware. The Company is presently undergoing a major restructuring of its direct selling operations which commenced in the latter half of 1993 and will result in the closing and consolidation of several domestic and foreign facilities and operations, including Germany and Portugal, and the elimination of approximately ten percent of its worldwide work force upon its substantial completion in 1994. Among the impacts were the termination of the Gift Gallery Division in the U.S., the planned sale of certain Industrial Division assets, and the planned cessation of manufacturing at the Company's Easthampton, Massachusetts plant. Worldwide sales of home care items and personal care products to consumers generally result from the direct selling method known as the "Famous Stanley Hostess Party Plan". Under this method a homemaker, or hostess, invites her friends and neighbors to her home to view a demonstration of Stanhome products by an independent Stanhome dealer, in return for which she usually receives premium prizes or gifts. After the demonstration, the dealer solicits orders from those present. In Italy and France, the local affiliate of the Company sells the ordered products directly to the consumer, pays a commission to the dealer on those sales, and distributes the premiums to the hostess. In the U.S. and other countries, the dealer purchases products at wholesale from the local affiliate of the Company to fill her orders and resells the products at retail to the consumers who placed the orders either at the home demonstration or through catalog solicitations, door-to-door and other non- party sales, or over the telephone. The dealer may also purchase premiums from the local affiliate to distribute to the hostess as prizes or gifts for hosting the demonstration. These premium prizes or gifts generally consist of cookware and other useful or decorative household items that are purchased from multiple independent suppliers located around the world. The independent contractor relationship between the independent Stanhome dealers and the Worldwide Direct Selling Group has proven adaptable in most of the foreign jurisdictions in which the Company conducts its direct selling business and in the past has been well established in the U.S., where the Company has not been subject to either social security or unemployment compensation tax with respect to them. In some overseas countries, for example Italy, there is proposed legislation and government efforts to broaden social benefit coverage as well as the prior imposition of a registration tax and minimum income taxes on occupations including dealers, which affects the local affiliates' recruiting and marketing approach and results, in some cases, in additional expense for them. In Italy, the Company has previously reported that independent dealers have received personal tax assessments in connection with the distribution of hostess gifts as a part of the Stanhome Party Plan Sales System. Some dealers have elected to use an amnesty settlement procedure to resolve their pending claims, a procedure made available to taxpayers by the Italian government for certain years up to and including 1990. Because of the effect on dealer recruitment and retention, Stanhome Italy is continuing to assist dealers in the defense of their individual tax claims by making payments of legal expenses, advancing amounts for tax deposits, and making payments of settlements where this is more cost effective than potential litigation costs. These payments have not been material. This continued to be a problem for the Italian subsidiary in 1993 and into 1994. Wholesale products sold in Mexico, Spain, and Venezuela are largely supplied by manufacturing plants owned by subsidiaries operating in those countries. The remaining foreign operations are supplied by these manufacturing plants or by the Company's Easthampton, Massachusetts plant, which is scheduled to discontinue its manufacturing operations by mid-1994 as part of the Company's worldwide restructuring effort, and, in France, Italy, and Venezuela, partially by independent local manufacturing licensees. Most wholesale products in the direct selling line sold in the U.S. which have been manufactured in the Company's Easthampton, Massachusetts plant are now planned to be produced by independent U.S. third-party manufacturers. The remainder will continue to be purchased from foreign subsidiary operations or from other independent sources. All wholesale products sold in the U.S., and the premium items used as prizes and gifts for U.S. hostesses, are distributed through four regional Customer Care Centers. The Worldwide Direct Selling Group also has arrangements with independent distributors in Brazil, Canada, the Caribbean area, Chile, Cyprus, Peru, Portugal, Singapore, and Thailand. The Company's products are manufactured under license by its distributors in Brazil and Jamaica. The direct selling operations of the Company are faced with substantial competition in all markets in which they are engaged. In the U.S., the Company has further segmented its market into Hispanic and Anglo sales territories. The Hispanic territories traditionally cover the southwestern U.S. border regions, southern Florida, New York City and other metropolitan areas having high percentages of Hispanic population, which have been actively growing sales territories for the Company's Hispanic sales organization over the past few years. Competition in direct selling worldwide exists not only with respect to price, warranty, product performance, and parties or demonstrations, but also with respect to obtaining and retaining an adequate number of dealers, which is of material importance to the success of the direct selling business. Like other direct selling companies, there is a substantial turnover in dealers, particularly with respect to individuals who engage in this independent business activity only on a part-time and occasional basis. The recruiting process is therefore a continuous one. The retention of key sales personnel is highly dependent on interpersonal relationships and loyalties as well as on competitive remuneration systems. While adequate figures are not available for precise comparisons, the Company believes that the Worldwide Direct Selling Group is a major factor outside the U.S. among the large group of companies whose products are sold to the public via the party plan sales method in those principal foreign markets where affiliates of the Worldwide Direct Selling Group are doing business. The Worldwide Direct Selling Group is a lesser factor in the U.S. among those companies. The party plan companies form one part of the larger market of all direct selling companies with similar products and which compete in the recruitment of their sales forces. While there are several, non-party plan direct selling companies whose worldwide sales are much greater than the Company, the Company's direct selling subsidiaries are among the market leading party plan businesses in each of Italy, France, Spain, Slovenia, Mexico, and Venezuela. The direct selling operations of the Company and its subsidiaries tend to have seasonal characteristics with sales that peak in the fourth quarter and, to a lesser degree, in the second quarter. All products of the Worldwide Direct Selling Group, whether manufactured by the Company's foreign subsidiaries, the Stanley Home Products Division, or by contract manufacturers in the U.S. or abroad, comply with quality standards established and enforced by the Company and its subsidiaries. There are no significant problems in the availability of raw materials, which are purchased from numerous suppliers and which will be used by the Company's subsidiaries and independent third-party manufacturers in manufacturing the line of wholesale products for the Worldwide Direct Selling Group. The Company's trademarks are generally protected by registrations in the U.S. and foreign countries where its product line is marketed and by registrations of its major trademarks in many other countries throughout the world. A principal trademark is the STANHOME name and design. These marks play a substantial role in the identification and acceptance of the Company's products by consumers. The Company's direct selling business is not materially dependent on patents or patent protection. Similarly, while the Company owns a large number of formulae and regards many of its manufacturing processes as secret, it does not believe that its business is materially dependent upon the maintenance of secrecy with respect to such formulae or processes. Other Information As of March 31, 1994, the Company will have discontinued the manufacturing and distribution operations of its Industrial Division which sold cleaning products for commercial use. These products were sold directly to its customers in the food service, industrial, and institutional fields, and also indirectly through independent distributors. As part of the Company's worldwide restructuring, certain assets of the Industrial Division are planned to be sold. As of December 31, 1993, the Company and its U.S. subsidiaries, including Enesco, Hamilton and their affiliates, employed approximately 1,760 persons, and there were approximately 37,900 Stanley dealers, group leaders, and district managers and Enesco sales representatives engaged in selling the Company's products in the U.S., all of whom are treated as independent contractors. As of the same date, the Company's foreign subsidiaries employed approximately 2,370 persons on a full-time basis. There were approximately 49,800 Stanhome dealers engaged in direct selling abroad at the end of 1993, most of whom are recognized as independent contractors. Over the years, there has been an ongoing issue in the U.S. as to the correct classification of workers as employees or independent contractors, with resulting tax and other legal consequences to the worker and company involved. The U.S. Internal Revenue Service and Congress have expressed renewed interest in this area in general, and some states have challenged from time to time the classification of positions within the Company's operating Groups. This area will in all likelihood receive increased attention from the federal and state governments in the future. In addition to changes in political climate, foreign operations are subject to certain other risks inherent in carrying on business abroad, including the risk of foreign currency fluctuations and restraints, different rates of inflation and economic growth, and U.S. and foreign restrictions affecting international trade with, and investment and operations in, various foreign countries. An example of such risk is the ongoing economic and political turmoil engendered by the apparent instability of the existing Italian government as a result of continuing corruption probes into alleged kickback payments and illegal political party financing schemes. Moreover, the Italian lire continued to devalue against the U.S. dollar throughout the year and by approximately 19% in the fourth quarter of 1993 as compared to the fourth quarter of 1992, negatively impacting the financial results in the fourth quarter of the Company's Italian subsidiary when stated in U.S. dollars. This foreign currency fluctuation and Italy's unsettled political situation is particularly important for the Company because its Italian subsidiary accounted for approximately 38% of the Worldwide Direct Selling Group's total 1993 sales and substantially all of the 1993 operating profits, inclusive of the restructuring charges of the Worldwide Direct Selling Group. In the case of both the Worldwide Giftware and Direct Response Groups, while the vast majority of their respective total 1993 sales and operating profits resulted from U.S. operations, similar risks associated with foreign economic conditions exist because of the predominance of foreign-sourced product in each of their product lines. Much of the Worldwide Giftware Group, and a substantial portion of the Worldwide Direct Response Group, lines are produced in the Far East. The last several years have seen renewed interest by some U.S. government officials in the imposition of trade sanctions, most notably increased tariffs, on imported goods from countries located there, such as the People's Republic of China, where many Enesco and Hamilton products originate. For financial information about industry segments, including financial information regarding foreign and domestic operations, see Note 5 of "Notes to Consolidated Financial Statements" included on pages 36 and 37 of the 1993 Annual Report to Stockholders, which is incorporated herein by reference. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" commencing on page 17 of the 1993 Annual Report to Stockholders, which is incorporated herein by reference, for a comparison and discussion of the results of operations and operating profit from foreign and domestic sources. ITEM 2.

ITEM 2. PROPERTIES. The principal physical properties of the Company and its subsidiaries in the United States, all of which are owned unless otherwise noted, consist of the following: Corporate Headquarters - 333 Western Avenue, Westfield, Massachusetts; office, manufacturing, and warehouse facilities in Easthampton, Massachusetts and four warehouse and distribution centers situated across the United States for the direct selling business; and headquarters, showroom, and distribution facilities for its Enesco giftware business in Elk Grove Village, Illinois. Enesco also leases or maintains a retail gift shop and showrooms in various other locations in the United States for the display of its products. Via Vermont Ltd. leases office and distribution facilities in Wilder, Vermont. The Hamilton Group Limited, Inc. leases office headquarters, parking, and warehouse space in Jacksonville, Florida. The principal physical properties of the Company's direct selling subsidiaries outside the U.S. consist of 8 major manufacturing and/or distribution facilities located in France, Italy, Mexico, Puerto Rico, Spain, and Venezuela. Two of these facilities are leased. In addition, the various foreign subsidiaries maintain numerous sales and administrative offices as well as smaller distribution facilities, most of which are leased. Except for Via Vermont, S.A. de C.V., which owns an assembly and warehouse facility in San Miguel de Allende, Guanajuato, Mexico, all of the foreign subsidiaries of the Company's Enesco Worldwide Giftware Group and the Company's Hamilton Worldwide Direct Response Group lease their office and warehouse space. The Company's manufacturing plant in Easthampton, Massachusetts, which is planned to discontinue its manufacturing operations by mid-1994, and some of the foreign manufacturing plants have additional capacity available. As part of the Company's worldwide restructuring, one former U.S. warehouse and distribution center has been sold and one is planned to be sold. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. There are various legal proceedings pending against the Company and its subsidiaries which have arisen during the course of business. While Management cannot predict the eventual outcome of these proceedings, it believes that none of these proceedings will have a material adverse impact upon the consolidated financial statements of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information required by this item is set forth in the Sections entitled "Financial Highlights" and "Stock Market, Dividend and Shareholder Information" appearing on page 1 of the 1993 Annual Report to Stockholders, and is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. Information required by this item is set forth in the Section entitled "Financial Highlights Last Ten Years" appearing on pages 42 and 43 of the 1993 Annual Report to Stockholders, and is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. Information required by this item is set forth in the Section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing on pages 17 through 22 of the 1993 Annual Report to Stockholders, and is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Information required by this item is set forth in the Report of Independent Public Accountants and the Financial Statements together with Notes appearing on pages 24 through 41 of the 1993 Annual Report to Stockholders, and is incorporated herein by reference. Also incorporated herein by reference are the Quarterly results (unaudited) during 1993, 1992 and 1991 set forth on page 23 of the 1993 Annual Report to Stockholders. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information required by this item regarding the directors of the Company is set forth under the captions "Election of Directors" and "Information as to Board of Directors and Nominees" in the Company's proxy statement dated March 18, 1994, and is incorporated herein by reference. Information required by this item regarding the executive officers of the Company is included under a separate caption in Part I hereof, and is incorporated herein by reference, in accordance with General Instruction G(3) to Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Information required by this item is set forth under the captions "Executive Compensation", "Compensation and Stock Option Committee Report on Executive Compensation", and "Remuneration of Non-Employee Directors" in the Company's proxy statement dated March 18, 1994, and is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by this item is set forth under the caption "Voting Securities and Principal Holders Thereof" in the Company's proxy statement dated March 18, 1994, and is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required by this item is set forth under the captions "Compensation Committee Interlocks and Insider Participation" and "Certain Relationships and Related Transactions" in the Company's proxy statement dated March 18, 1994, and is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) and (2) Financial Statements and Schedules. The financial statements and schedules required by this item are listed in the Index to Financial Statements and Schedules of Stanhome Inc. on page 14 of this Form 10-K. (a)(3) Exhibits. The exhibits required by this item are listed in the Exhibit Index on pages 19 - 20 of this Form 10-K. The management contracts and compensatory plans or arrangements required to be filed as an exhibit to this Form 10-K are listed as Exhibits 10(a) to 10(r) in the Exhibit Index. (b) No reports on Form 8-K were filed by the Company during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 1994. STANHOME INC. (Registrant) By: /s/ G. William Seawright G. William Seawright President and Chief Executive Officer By: /s/ Allan G. Keirstead Allan G. Keirstead Executive Vice President, Chief Administrative & Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the 29th day of March, 1994 by the following persons on behalf of the registrant and in the capacities indicated. Signature Title /s/ H. L. Tower * H. L. Tower Director /s/ Homer G. Perkins * Homer G. Perkins Director /s/ Alla O'Brien * Alla O'Brien Director /s/ Allan G. Keirstead Allan G. Keirstead Director, Executive Vice President, and Chief Administrative & Financial Officer /s/ John F. Cauley, Jr. * John F. Cauley, Jr. Director /s/ Janet M. Clarke * Janet M. Clarke Director /s/ Alejandro Diaz * Alejandro Diaz Director, Executive Vice President /s/ G. William Seawright G. William Seawright Director, President, and Chief Executive Officer /s/ Thomas R. Horton * Thomas R. Horton Director /s/ Anne-Lee Verville * Anne-Lee Verville Director /s/ Judith R. Haberkorn * Judith R. Haberkorn Director *By: /s/ G. William Seawright G. William Seawright Attorney-In-Fact STANHOME INC. INDEX TO FINANCIAL STATEMENTS AND SCHEDULES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - Incorporated herein by reference to "Report of Independent Public Accountants" on page 41 of Stanhome's 1993 Annual Report to Stockholders. FINANCIAL STATEMENTS - All of which are incorporated herein by reference to Stanhome's 1993 Annual Report to Stockholders. Consolidated Balance Sheet - December 31, 1993 and 1992 Consolidated Statement of Income For the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Retained Earnings For the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows For the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements - December 31, 1993, 1992 and 1991 Quarterly results (unaudited) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES SCHEDULES SUPPORTING FINANCIAL STATEMENTS: NOTES: (a) All other schedules are not submitted because they are not applicable, not required or because the required information is included in the consolidated financial statements or notes thereto. (b) Individual financial statements of the Company have been omitted since (1) consolidated statements of the Company and its subsidiaries are filed and (2) the Company is primarily an operating company and all subsidiaries included in the consolidated financial statements filed are wholly-owned and do not have a material amount of debt to outside persons. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES ----------------------------------------------------- To Stanhome Inc.: We have audited, in accordance with generally accepted auditing standards, the financial statements included in Stanhome Inc.'s annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 18, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the accompanying index are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Hartford, Connecticut February 18, 1994 SCHEDULE VIII STANHOME INC. ------------- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES ---------------------------------------------- FOR THE THREE YEARS ENDED DECEMBER 31, 1993 -------------------------------------------- Note: (a) Represents recorded reserves at dates of acquisitions. (b) Represents balance sheet reclassifications related to prior acquisitions. SCHEDULE IX STANHOME INC. ------------- SHORT-TERM BORROWINGS --------------------- FOR THE THREE YEARS ENDED DECEMBER 31, 1993 ------------------------------------------- The short-term borrowings represent corporate notes payable as well as notes payable by international subsidiaries. The bank borrowings are under lines of credit and credit arrangements. The average amounts outstanding and the weighted average interest rates for the period are based on the average monthly balances totaled and divided by twelve. Due to reclassifications made in 1993 to the prior years' financial statements, the information for 1992 and 1991 has been adjusted to be comparable to 1993. SCHEDULE X NOTE: (a) All other items as called for by Rule 12-11 are less than 1% of net sales for each year. GRAPHICS APPENDIX LIST

96638_1993.txt

96638

1993

ITEM 1. BUSINESS. OVERVIEW Advanta Corp. (the "Company") is a highly focused direct marketer of select consumer financial services. The Company primarily originates and services credit cards and mortgage loans. Other businesses include small ticket equipment leasing, credit insurance and deposit products. At year end 1993, assets under management totalled over $6.1 billion. Approximately 75% of total revenues are derived from credit cards marketed through carefully targeted direct mail campaigns. By focusing primarily on the no fee gold card, the Company has successfully grown to one of the ten largest issuers of gold cards. Mortgage services contribute 10% of total revenues with a managed loan portfolio of $1.15 billion. Mortgage loans are originated through a network of branch offices, a direct originations center and an expanding number of correspondent relationships. The Company was incorporated in Delaware in 1974 as Teachers Service Organization, Inc., the successor to a business originally founded in 1951. In January 1988, the Company's name was changed from TSO Financial Corp. to Advanta Corp. The Company's principal executive office is located at Brandywine Corporate Center, 650 Naamans Road, Claymont, Delaware 19703. Its principal operating office is located at Five Horsham Business Center, 300 Welsh Road, Horsham, Pennsylvania 19044-0749. The Company's telephone numbers at its principal executive and operating offices are, respectively, (302) 791-4400 and (215) 657-4000. References to the Company in this Report include its consolidated subsidiaries unless the context otherwise requires. CREDIT CARDS The Company, which has been in the credit card business since 1983, issues gold and standard MasterCard and VISA credit cards nationwide. The Company has built a substantial cardholder base which, as of December 31, 1993, totalled nearly 2.7 million accounts and $3.9 billion in managed receivables. According to industry statistics, the Company is one of the ten largest issuers of gold cards. Both gold and standard accounts undergo the same credit analysis, but gold accounts have higher initial credit limits because of the cardholders' higher incomes. In addition, gold accounts generally offer a wider variety of services to cardholders. The primary method of account acquisition is direct mail solicitation. The Company generally uses credit scoring by independent third parties and a proprietary market segmentation and targeting model to target its mailings to profitable segments of the market. In 1982, the Company acquired Colonial National Bank USA ("Colonial National"). As a national bank, Colonial National has the ability to make loans to consumers without many of the restrictions found in various state usury and licensing laws, to negotiate variable rate loans, to generate funds economically in the form of deposits insured by the Federal Deposit Insurance Corporation ("FDIC"), and to include in its product mix a MasterCard and VISA credit card program. Substantially all of the Company's credit card receivables and bank deposits, and most of its mortgage loan receivables, are held by Colonial National. MasterCard and VISA license banks, such as Colonial National and other financial institutions, to issue credit cards using their trademarks and to utilize their interchange networks. Cardholders may use their cards to make purchases at participating merchants or to obtain cash advances at participating financial institutions. The purchase is submitted to a merchant bank which remits to the merchant the purchase amount less a merchant discount fee, and submits the purchase to the card issuing bank for payment through the interchange system. The card issuing bank receives an interchange fee as compensation for the funding and credit risk that it takes when its customers use its credit card. MasterCard or VISA sets the interchange fee as a percentage of each card transaction (currently approximately 1.4%). The Company generates interest and other income from its credit card business through finance charges assessed on outstanding loans, interchange income, cash advance and other credit card fees, and securitization income as described below. Credit Card income also includes fees paid by credit card customers for product enhancements they may select, and revenues paid to Colonial National by third parties for the right to market their products to the Company's credit card customers. Most of the Company's MasterCard and VISA credit cards carry no annual fee, and those credit cards which do include an annual fee generally have lower fees than those charged by many of the Company's competitors. The Company believes that this characteristic of no or low annual fee credit cards has appealed to consumers, and that the Company's credit cards have also appealed to consumers because of their competitive interest rates, quality service, payment terms and credit lines. While the Company believes that its credit card offers will continue to appeal to consumers for the reasons stated, the Company also notes that competition is increasing in the credit card industry. At the same time, the American people are becoming generally more sophisticated and demanding users of credit. These forces are likely to produce significant changes in the industry; in recent years they have resulted in slower growth and lower yields for the industry, and these trends may continue. The Company is devoting substantial resources to meeting the challenges, and taking advantage of the opportunities, which management sees emerging in the industry. In 1993, this included significant focus on balance transfer initiatives, in which the Company encouraged consumers to transfer account balances they were maintaining with other credit card issuers to a Colonial National account with a lower interest rate. Approximately one-half of the growth in the Company's managed credit card receivables in 1993 resulted from balance transfers. The Company intends to continue exploring new approaches to the credit card market. The interest rates on the majority of the Company's credit card receivables are variable, tied to the prime rate. This helps the Company maintain net interest margins in both rising and declining interest rate environments. As Delaware, Colonial National's state of domicile, does not have a usury ceiling applicable to banks, there is no statutory maximum interest rate that the Company may charge its credit cardholders, nor does Delaware law limit the amount of any annual fees, late charges and other ancillary charges which may be assessed. While the state in which an individual cardholder resides may seek to regulate the annual fees and ancillary charges which Colonial National may charge to that state's residents, the enforceability of such regulation is unclear and is currently the subject of litigation in certain states. At the present time, the only Federal appellate decision addressing this issue held such regulation to be unenforceable. See "Government Regulation--Colonial National." Since 1988, Colonial National has been active in the credit card securitization market, securitizing $1.0 billion of credit card receivables in 1993 and $3.2 billion since 1988. The Company continues to recognize income on a monthly basis from the securitized receivables. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 1 and 3 of the Notes to Consolidated Financial Statements. Colonial National's securitization program provides a number of benefits: diversifying its funding base, providing liquidity, reducing the bank's regulatory capital requirements, lowering its cost of funds, providing a source of variable rate funding to complement the variable rate credit card portfolio and helping to limit the on-balance sheet growth of Colonial National to not more than 7% per annum. See "Government Regulation--The Company." Furthermore, Colonial National continues to own the credit card accounts and customer relationships, which the Company believes continue to build significant long-term value. While the Company believes that securitization will continue to be a reliable source of funding, there is no assurance that the Company will be able to continue securitizations in amounts or under terms comparable to its securitizations to date. A securitization involves the transfer by the Company of the receivables generated by a pool of credit card accounts to a securitization trust. Certificates issued by the trust and sold to investors represent undivided ownership interests in receivables transferred to the trust. The securitization results in removal of receivables from the Company's balance sheet for financial and regulatory accounting purposes. For tax purposes, the investor certificates are characterized as a collateralized debt financing of the Company. The trust receives finance and other charges paid by the credit card customers and pays a rate of return on a monthly basis to the certificate holders. While in most cases the rate of return paid to investors is variable in order to match the pricing dynamics of the underlying receivables, the Company also uses fixed rate securitizations where appropriate to balance interest rate exposure on its assets and liabilities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset/Liability Management." Credit losses on the securitized receivables are paid from the funds in the trust. The Company continues to service the accounts for a fee, generally two percent per annum of the securitized receivables. Excess funds (defined as finance charges plus miscellaneous fees less interest paid to certificate holders, credit losses and servicing fees) are first retained to build up a reserve fund to a certain level, after which amounts are remitted to the Company. The Company's relationship with its credit card customers is not affected by the securitization. Investors in the trust receive payments of interest only during the first three to four years of the trust. Thereafter, an amortization period (generally between six and ten months) commences, during which the certificate holders are entitled to payment of principal and interest. Acceleration of the commencement of the amortization period (which may occur in limited circumstances) on a securitization would accelerate the Company's funding requirement. Upon full repayment of principal to the certificate holders, whether as a result of normal or accelerated amortization, the trust's lien on the accounts terminates and all related receivables and funds held in the trust, including the reserve fund, are transferred to the Company. MORTGAGE LOANS The Company's subsidiary, Advanta Mortgage Corp. USA ("Advanta Mortgage"), originates and services closed end mortgage loans for itself and for Colonial National's "Advanta Mortgage USA" Division, primarily through a broker network serviced by selected sales locations, a centralized direct origination center, and correspondent relationships. Closed end mortgage loans involve the loan of a fixed amount of funds to a residential borrower repayable over a contractual period of generally fifteen years. The Company does not extend mortgage lines of credit, which involve the extension of a revolving amount of credit to a borrower. Advanta Mortgage and Colonial National also purchase portfolios of mortgage loan receivables. Portfolio acquisitions totalled $6 million in 1991, $32 million in 1992 and $42 million in 1993. Advanta Mortgage and Colonial National operate the Company's mortgage loan business as a mortgage banking enterprise, i.e., they originate or purchase loans and then sell or securitize them, generally retaining servicing rights and the related excess cash flows. Consequently, the mortgage loan receivables on the Company's balance sheet are generally its most recently originated loans being held for sale. Thus, while mortgage loan receivables owned at December 31, 1993 were $91 million, during 1993 the Company originated or purchased $510 million and securitized $608 million of such receivables. At the time the receivables are sold or securitized, the Company recognizes a gain which is included in its mortgage banking income. See Note 1 to the Consolidated Financial Statements. Thus, Advanta Mortgage packages its loans for sale and customarily enters into agreements with the purchasers to continue to service the loans for a fee. Advanta Mortgage also services Colonial National's mortgage loan portfolio, packages Colonial National's mortgage loans for sale, and performs the servicing on loans sold by Colonial National where Colonial National retains the servicing rights and obligations. In addition, Advanta Mortgage performs fee-based servicing on loans originated and owned by unrelated third party mortgage lenders. Therefore, Advanta Mortgage and Colonial National's Advanta Mortgage USA Division have the following basic sources of income: net interest income on loans outstanding pending their sale, gains on sales of loans, loan servicing fees and loan origination fees ("points"). Points are deferred and amortized over the contractual life of a loan, and on sale or securitization of the loan are included in the computation of the gain on sale. Interest income earned on loans prior to their sale or securitization is included in the Company's interest revenues, as detailed in "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Net Interest Income." Advanta Mortgage and Colonial National began securitizing home loans in 1988, when they privately placed with institutional investors $72 million of certificates representing fractional ownership interests in securitization trusts. In February 1991, Advanta Mortgage and Colonial National securitized $108 million of loans in their first publicly offered mortgage securitization transaction and securitized approximately $193 million of additional loans in public offerings during the balance of 1991. They publicly securitized $385 million of loans in 1992, and $608 million in 1993. Securitizations of mortgage loans are similar to credit card securitizations as described above. The Company transfers a specified pool of mortgage loans to a trust which issues certificates representing undivided ownership interests in the loans. The Company acts as servicing agent for the trust, providing customer service and collection efforts, and receives loan servicing fees equal to .5% per annum of the securitized receivables. Finance and other charges paid to the trust are used to pay the investors interest on their certificates and premiums on an insurance contract issued by a third party guaranteeing full repayment of principal and interest to the investors. Excess amounts generally go into a reserve account, and after that account reaches a specified level, are paid to the Company. Credit losses on the securitized loans reduce the amount of these payments to the Company. Significant differences from the Company's credit card securitizations, however, include: (1) while in most cases the credit card securitization certificates pay a variable interest rate (which complements the variable rate pricing on the Company's credit cards), the mortgage securitization certificates generally carry a fixed rate of interest (as generally do each of the mortgage loans held by the trust), and (2) payments to investors in the mortgage loan securitizations include both principal and interest from the outset, since the loans held by the trust are not revolving credit lines. At December 31, 1993, Advanta Mortgage and Colonial National had approximately $91 million of mortgage loan receivables outstanding secured by mortgages on properties located in 30 states plus the District of Columbia. Additionally, as of that date, Advanta Mortgage was servicing approximately $1.1 billion in mortgage loans sold by the Company's subsidiaries, as well as $125 million of "contract servicing" receivables. Contract servicing receivables are not included in the Company's "managed portfolio," as the performance of such loans does not have a material impact on either the Company's net income or its credit risk profile. In contrast, the performance of the managed portfolio, including loans sold by the Company, can materially impact ongoing mortgage banking income. See Note 1 to the Consolidated Financial Statements. In 1993, loan loss and prepayment experience depressed mortgage banking income, resulted in higher charge-off rates and necessitated an increase in off-balance sheet mortgage loan recourse reserves. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - - Provision for Credit Losses" and "-- Credit Risk Management -- Asset Quality." As indicated by these higher off-balance sheet reserves, in 1994 the Company expects to experience a higher relative managed mortgage charge-off rate compared to 1993. A majority of this experience is due to a class of loan which the Company has not actively solicited since 1991, as well as to softening real estate values in certain areas in which the Company operates. Approximately 43% of the managed portfolio is secured by second mortgages and the balance is secured by non-purchase money first mortgages. At December 31, 1993, total mortgage loans managed, and the nonperforming loans included in those totals, are concentrated in the following regions: Geographic concentration carries a risk of increased delinquency and/or loss if an area suffers an economic downturn. Advanta Mortgage monitors economic conditions in those regions through market and trend analyses. A Credit Policy Committee meets through the year to update lending policies based on the results of analyses, which may include abandoning lending activities in economically unstable areas of the country. The Company believes that the concentrations of nonperforming loans reflected in the preceding table are not necessarily reflective of general economic conditions in each region, but rather reflect the credit risk inherent in the different grades of loans originated in each area. The interest rate charged and the maximum loan-to-value ratio permitted with respect to each grade of loans are adjusted to compensate for the credit risk inherent in that loan grade. The Company generally limits the total dollar amount of all loans secured by a property, including both the Company's mortgage loan and any other lender's first mortgage, to between 60% and 80% (depending upon the creditworthiness of the borrower) of the appraised value of the property. The average total loan-to-value ratio is 68% (calculated based upon the appraised values of the properties at the time of origination). However, a substantial depreciation in home values may impair the Company's security for these loans. As a result of substantial refinancing activity by consumers as market interest rates declined, in 1992 over 60% and in 1993 over 70% of the mortgage loans originated by the Company were first lien loans. EQUIPMENT LEASING The Company's leasing subsidiary, Advanta Leasing Corp. ("Advanta Leasing"), engages primarily in non-cancelable financing leases of equipment, including computers, fax machines, copiers and commercial cleaning equipment, primarily to professionals and small businesses. Most of the equipment leased has an initial value of less than $150,000, while the average initial value of leased equipment is approximately $7,000. Costs relating to equipment maintenance, insurance and personal property taxes are the responsibility of the lessee. In October 1991, Advanta Leasing closed its first securitization of lease receivables with a private placement of $74.5 million of certificates and closed a similar transaction in the amount of $53 million in September 1992. In 1993, Advanta Leasing securitized $68 million of lease receivables. Securitization of lease receivables is substantially similar to mortgage loan securitization as described above, except that the servicing fee payable to Advanta Leasing is 1.25% per annum of the securitized lease receivables. Including $138 million of remaining securitized receivables, at December 31, 1993 Advanta Leasing managed a portfolio of $189 million of net lease receivables. The small ticket equipment leasing industry is experiencing change as many smaller companies' funding sources have retrenched. This has provided Advanta Leasing with attractive direct marketing and portfolio acquisition opportunities, as Advanta Leasing's funding capacity remains strong. Consequently, the Company anticipates Advanta Leasing's origination volume increasing in 1994. CREDIT INSURANCE AND CREDIT PROTECTION Through unaffiliated insurance carriers, the Company offers credit life, disability and unemployment insurance to its credit cardholders and credit life insurance and a limited life/disability/unemployment insurance product to its mortgage loan customers. The unaffiliated insurers reinsure 100% of the risk on the credit card credit life, disability and unemployment insurance (but not the mortgage loan credit life insurance) with one or more of the Company's insurance subsidiaries. Such subsidiaries receive reinsurance premiums approximating 94% of the net premiums written. The subsidiaries are obligated to pay all losses and refunds, and to maintain reserve amounts equal to all statutory reserves for the benefit of the unaffiliated insurance carriers. In 1992, the insurance subsidiaries began direct underwriting of the property insurance provided for the Company's equipment leasing customers. The insurance subsidiaries are domiciled in Arizona, and are subject to regulation by the Arizona Department of Insurance and other insurance departments in states where they are licensed. The credit card credit life insurance insures the life of the borrower (and any joint borrower) in an amount equal to the unpaid loan balance and accrued interest (subject to a maximum amount of $5,000) and provides for payment to the lender of the borrower's obligation in the event of death. The credit disability insurance and credit unemployment insurance pay the minimum monthly payments required by the credit card loan with respect to the debt outstanding at the commencement of a period of disability or unemployment, up to a maximum of $5,000. Through Colonial National, the Company offers to some of its credit cardholders in certain states a card enhancement program named Credit Protection PlusR which provides benefits similar to those provided to other customers by the credit life, disability and unemployment insurance coverages offered by the unaffiliated insurance carriers. Colonial National, which insures its excess risk of loss on this product with the Company's insurance subsidiaries, began expanding its offering of Credit Protection PlusR in 1993. DEPOSIT, SAVINGS AND INVESTMENT PRODUCTS The Company offers a range of insured savings and transaction accounts through Colonial National, and offers uninsured investment products through the direct and brokered public sale of its senior and subordinated debt securities. Bank deposit services include demand deposits, money market savings accounts, statement savings accounts, retail certificates of deposit, large denomination certificates of deposit (certificates of $100,000 or more) and individual retirement accounts. During 1993, both the senior debt securities of Advanta Corp. and the senior debt securities and deposits of Colonial National achieved investment-grade ratings from the nationally recognized rating agencies. These ratings have allowed the Company to further diversify its funding sources. In November 1993, the Company filed a shelf registration statement with the Securities and Exchange Commission for $1 billion of senior debt securities, and subsequently sold $150 million of three-year notes in an underwritten transaction as well as $90 million (as of March 1, 1994) of medium-term notes of varying maturities pursuant to its $500 million medium-term note program established under this registration statement. In addition, the Company's subordinated debt securities historically have been and continue to be offered to investors with a variety of maturities (ranging from demand to ten years) and yield options. Further, a wholly-owned subsidiary of the Company, Colonial National Financial Corp. ("CNF"), began taking deposits in the form of certificates of deposit in January 1992. CNF is an FDIC insured industrial loan corporation organized under the laws of the State of Utah. The activities of CNF are not currently material to the Company's business. Consumer deposit business at Colonial National is generated from repeat sales to existing customers and new deposits from individuals attracted by newspaper, direct mail and radio advertisements. Also, Colonial National offers retail certificates of deposit to customers through several nationally recognized broker/dealer firms which offer "Master Certificate of Deposit" programs to banks throughout the nation. Under these programs, the customers of the broker/dealer firms may purchase Colonial National certificates of deposit in $1,000 increments, from $1,000 to $100,000. The award of investment grade ratings to Colonial National's senior debt securities has allowed the bank to acquire additional sources of institutional funds throuogh both deposit and non-deposit products. Together, these various programs provide Colonial National with cost effective sources of funding which are geographically diverse and improve control in managing interest rate sensitivity. Investments in the Company's senior debt securities are marketed primarily to institutional investors through underwritten offerings as well as direct placements pursuant to the Company's medium-term note program. Investments in the Company's subordinated debt securities are generated from newspaper advertisements, from direct mail marketing efforts to existing and prospective investors, and through broker/dealer firms. GOVERNMENT REGULATION THE COMPANY. The Company is not required to register as a bank holding Company under the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Company owns Colonial National, which is a "bank" as defined under the BHCA as amended by the Competitive Equality Banking Act of 1987 ("CEBA"). However, under certain grandfathering provisions of CEBA, the Company is not required to register as a bank holding Company under the BHCA, because Colonial National, which takes demand deposits but does not make commercial loans, did not come within the BHCA's definition of the term "bank" prior to the enactment of CEBA and it complies with certain restrictions set forth in CEBA, such as limiting its activities to those in which it was engaged prior to March 5, 1987 and limiting its growth rate to not more than 7% per annum. Such restrictions also prohibit Colonial National from cross-marketing products or services of an affiliate that are not permissible for bank holding companies under the BHCA. In addition, the Company complies with certain other restrictions set forth in CEBA, such as not acquiring control of more than 5% of the stock or assets of an additional "bank" or "savings association" as defined for these purposes under the BHCA. Consequently, the Company is not subject to examination by the Federal Reserve Board (other than for purposes of assuring continued compliance with the CEBA restrictions referenced in this paragraph). Should the Company or Colonial National cease complying with the restrictions set forth in CEBA, registration as a bank holding Company under the BHCA would be required. Registration as a bank holding Company is not automatic. The Federal Reserve Board may deny an application if it determines that control of a bank by a particular Company will cause undue interference with competition or that such Company lacks the financial or managerial resources to serve as a source of strength to its subsidiary bank. While the Company believes that it meets the Federal Reserve Board's managerial standards and that its ownership of Colonial National has improved the bank's competitiveness, should the Company be required to apply to become a bank holding Company the outcome of any such application cannot be certain. Registration as a bank holding Company would subject the Company and its subsidiaries to inspection and regulation by the Federal Reserve Board. Although the Company has no plans to register as a bank holding Company at this time, the Company believes that registration would not restrict, curtail, or eliminate any of its activities at current levels, except that some portions of the current business operations of the Company's insurance subsidiaries would have to be discontinued, the effects of which would not be material. COLONIAL NATIONAL. The Company conducts substantially all its deposit-taking activities and credit card lending business, as well as a large portion of its mortgage lending business, through Colonial National. Under Federal law, Colonial National may "export" (i.e., charge its customers resident in other states) the finance charges permissible under the law of its state of domicile, Delaware, which state has no usury statute applicable to banks. Consistent with prevailing industry practice, the Company also exports credit card fees (including, for example, annual fees, late charges and fees for exceeding credit limits) permitted under Delaware law. There is no precedent clearly applicable to Colonial National as to the permissibility of exporting such fees. In a case involving this issue (to which the Company was not a party), the United States Court of Appeals for the First Circuit ruled that the Commonwealth of Massachusetts did not have the power to prevent a Delaware state-chartered financial institution from charging Massachusetts residents credit card fees in excess of those allowed under Massachusetts law. The United States Supreme Court declined to consider an appeal of the First Circuit's decision, and so that decision became final in 1992. However, litigation involving this issue has been initiated against other credit card issuers in several states, and it is possible that a contrary decision could be reached in a jurisdiction where the judgment of the First Circuit Court of Appeals is not binding. The Company cannot quantify the impact on its business, as a result of possible loss of fees, penalties or other sanctions, that could result from an adverse determination on this issue in one or more states. Colonial National is subject primarily to regulation and periodic examination by the Office of the Comptroller of the Currency (the "Comptroller"). Such regulation relates to the maintenance of reserves for certain types of deposits, the maintenance of certain financial ratios, transactions with affiliates and a broad range of other banking practices. As a national bank, Colonial National is subject to provisions of federal law which restrict its ability to extend credit to its affiliates or pay dividends to its parent Company. See "Dividends and Transfers of Funds." Colonial National is subject to capital adequacy guidelines approved by the Comptroller. These guidelines make regulatory capital requirements more sensitive to differences in risk profiles among banking organizations and consider off-balance sheet exposures in determining capital adequacy. As of December 31, 1993, the minimum ratio of total capital to risk-weighted assets (including certain off- balance sheet items) was 8%. At least half of the total capital is to be comprised of common equity, retained earnings and a limited amount of non-cumulative perpetual preferred stock ("Tier 1 capital"). The remainder may consist of other preferred stock, certain hybrid debt/equity instruments, a limited amount of term subordinated debt or a limited amount of the reserve for possible credit losses ("Tier 2 capital"). In addition, the Comptroller has also adopted a minimum leverage ratio (Tier 1 capital divided by total average assets) of 3% for national banks that meet certain specified criteria, including that they have the highest regulatory rating. Under this guideline, the minimum leverage ratio would be at least 1 or 2 percentage points higher for national banks that do not have the highest regulatory rating, for national banks undertaking major expansion programs, and for other national banks in certain circumstances. As of December 31, 1993, Colonial National's Tier 1 capital ratio was 7.19%, its combined Tier 1 and Tier 2 capital ratio was 12.06%, and its leverage ratio was 6.03%. Recognizing that the risk-based capital standards address only credit risk (i.e., not interest rate, liquidity, operational or other risks), the Comptroller has indicated that many national banks will be expected to maintain capital in excess of the minimum standards. As indicated above, Colonial National's capital levels currently exceed the minimum standards. To date, the Comptroller has not required Colonial National to maintain capital in excess of the minimum standards. However, there can be no assurance that such a requirement will not be imposed in the future, or if it is, what higher standard will be applicable. In addition, pursuant to certain provisions of the FDIC Improvements Act of 1991 ("FDICIA") and regulations promulgated thereunder, FDIC insured institutions such as Colonial National may only accept brokered deposits without FDIC permission if they meet certain capital standards, and are subject to restrictions with respect to the interest they may pay on deposits unless they are "well-capitalized." To be "well-capitalized," a bank must have a ratio of total capital to risk-weighted assets of not less than 10%, Tier 1 capital to risk-weighted assets of not less than 6%, and a Tier 1 leverage ratio of not less than 5%. Based on the applicable standards under these regulations, Colonial National is currently "well-capitalized," and the Company intends to maintain Colonial National as a "well-capitalized" institution. LENDING AND LEASING ACTIVITIES. The Company's activities as a lender are also subject to regulation under various federal and state laws including the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, the Electronic Funds Transfer Act, and the Fair Credit Reporting Act. Provisions of those statutes, and related regulations, among other matters, require disclosure to borrowers of finance charges in terms of an annual percentage rate, prohibit certain discriminatory practices in extending credit, and regulate the dissemination and use of information relating to a borrower's creditworthiness. Certain of these statutes and regulations also apply to the Company's leasing activities. In addition, Advanta Mortgage and its subsidiaries are subject to licensure and regulation in various states as mortgage bankers, mortgage brokers, and originators, sellers and servicers of mortgage mortgage loans. DIVIDENDS AND TRANSFERS OF FUNDS. There are various legal limitations on the extent to which Colonial National can finance or otherwise supply funds through dividends, loans or otherwise to the Company and its affiliates. The prior approval of the Comptroller is required if the total of all dividends declared by Colonial National in any calendar year exceeds its net profits (as defined) for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus accounts. In addition, Colonial National may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts. The Comptroller also has authority under the Financial Institutions Supervisory Act to prohibit a national bank from engaging in any unsafe or unsound practice in conducting its business. It is possible, depending upon the financial condition of the bank in question and other factors, that the Comptroller could claim that a dividend payment might under some circumstances be an unsafe or unsound practice. Colonial National is also subject to restrictions under Sections 23A and 23B of the Federal Reserve Act. These restrictions limit the transfer of funds to the Company and certain other affiliates, as defined in that Act, in the form of loans, extensions of credit, investments or purchases of assets, and they require generally that Colonial National's transactions with its affiliates be on terms no less favorable to the bank than comparable transactions with unrelated third parties. These transfers by Colonial National to the Company or any single affiliate are limited in amount to 10% of Colonial National's capital and surplus and transfers to all affiliates are limited in the aggregate to 20% of Colonial National's capital and surplus. Furthermore, such loans and extensions of credit are also subject to various collateral requirements. In addition, in order for the Company to maintain its grandfathered exemption under CEBA, Colonial National may not make any loans to the Company or any of its subsidiaries. The Company's insurance subsidiaries are insurance companies organized under and regulated by Arizona law. Arizona insurance regulations restrict the amount of dividends which an insurance Company may distribute without the prior consent of the Director of Insurance. GENERAL. Because the banking and finance businesses in general are the subject of such extensive regulation at both the state and federal levels, and because numerous legislative and regulatory proposals are advanced each year which, if adopted, could affect the Company's profitability or the manner in which the Company conducts its activities, the Company cannot now predict the extent of the impact of any such new laws or regulations. Various legislative proposals have been introduced in Congress in recent years, including, among others, proposals relating to imposing a statutory cap on credit card interest rates, permitting interstate branching by banks, permitting affiliations between banks and commercial or securities firms, and proposals which would place new restrictions on a lender's ability to utilize pre-screening of consumers' credit reports through credit reporting agencies (credit bureaus) in connection with the lender's direct marketing efforts. It is impossible to determine whether any of these proposals will become law and, if so, what impact they will have on the Company. In September 1992, the Federal Communications Commission established rules implementing the Telephone Consumer Protective Act of 1991 which limits telephone solicitations to residences. Because the statute exempts telemarketing to existing or former customers, it will not materially impact the Company's current business operations. COMPETITION As a marketer of credit products, the Company faces intense competition from numerous providers of financial services. Many of these companies are substantially larger and have more capital and other resources than the Company. Competition among lenders can take many forms including convenience in obtaining a loan, customer service, size of loans, interest rates and other types of finance or service charges, duration of loans, the nature of the risk which the lender is willing to assume and the type of security, if any, required by the lender. Although the Company believes it is generally competitive in most of the geographic areas in which it offers its services, there can be no assurance that its ability to market its services successfully or to obtain an adequate yield on its loans will not be impacted by the nature of the competition that now exists or may develop. In seeking investment funds from the public, the Company faces competition from banks, savings institutions, money market funds, credit unions and a wide variety of private and public entities which sell debt securities, some of which are publicly traded. Many of the competitors are larger and have more capital and other resources than the Company. Competition relates to such matters as rate of return, collateral, insurance or guarantees applicable to the investment (if any), the amount required to be invested, convenience and the cost to and conditions imposed upon the investor in investing and liquidating his investment (including any commissions which must be paid or interest forfeited on funds withdrawn), customer service, service charges, if any, and the taxability of interest. EMPLOYEES As of December 31, 1993, the Company had 1,614 employees, up from 1,327 employees at the end of 1992. The Company believes that it has good relationships with its employees. None of its employees is represented by a collective bargaining unit. ITEM 2.

ITEM 2. PROPERTIES. The Company leases an aggregate of approximately 189,000 square feet of office space in six office buildings located in Horsham, Pennsylvania, a Philadelphia suburb, and owns a 95,000 square foot building in Horsham. The Company also leases an aggregate of approximately 75,000 square feet of office space for its Advanta Mortgage offices in California, New Jersey, New York and Maryland, and 41,000 square feet of office space for its Advanta Leasing offices in New Jersey. The Company's principal executive and Colonial National's principal operating offices are currently located in approximately 81,000 square feet of leased space in two office buildings in Delaware. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Each of the executive officers of the Company listed below was elected by the Board of Directors, to serve at the pleasure of the Board in the capacities indicated. Mr. Alter became Executive Vice President and a director of the Company in 1967. He was elected President and Chief Executive Officer in 1972, and Chairman of the Board of Directors in August 1985. In February 1986, he relinquished the title of President. Mr. Hart joined the Company in March 1994 as Executive Vice Chairman. For the five years prior to that he had been President and Chief Executive Officer of MasterCard International, Inc., a worldwide association of over 29,000 member financial institutions. Prior to joining MasterCard in November 1988, Mr. Hart was Executive Vice President of First Interstate Bancorp, Los Angeles, California. Mr. Greenawalt was elected President and Chief Operating Officer of the Company in November 1987. Prior to joining the Company, Mr. Greenawalt served as President of Transamerica Financial Corp., Los Angeles, California, from May 1986. For the 15 years prior to that, Mr. Greenawalt served in various capacities with Citicorp, including most recently as Chairman and Chief Executive Officer of Citicorp Person-to-Person, Inc., St. Louis, Missouri, and, prior to that, as President and Chief Executive Officer of Citicorp Retail Services, Inc., New York, New York. Mr. Kantor became a Senior Vice President of the Company in April 1986, a director in May 1986, Chief Financial Officer in September 1986 and Executive Vice President in December 1986. In November 1993, he was promoted to the position of Vice Chairman, and he relinquished the title of Chief Financial Officer. Prior to joining the Company, Mr. Kantor was the partner in charge of the Financial Services Division of Arthur Andersen & Co. in Philadelphia, Pennsylvania where he served for more than ten years, and was also the audit partner assigned to the Company's account. Mr. Wesselink joined the Company in November 1993 as Senior Vice President and Chief Financial Officer. Prior to joining the Company, Mr. Wesselink was Vice President and Treasurer of Household International. Previous positions held at Household include Vice President-Director of Research, Group Vice President-Chief Financial Officer of Household Finance Corporation (HFC) and Senior Vice President-Chief Financial Officer of HFC. Mr. Marshall joined the Company in January 1988 and was elected Senior Vice President in February 1988. Prior to joining the Company, from July 1987 he was Chief Operations Officer of a Scudder, Stevens & Clark joint venture. Prior to that, Mr. Marshall served in various capacities at Citibank from 1976. At the time he left Citibank, he was a Senior Vice President of Citicorp Retail Services, managing a major portion of its client relationships. Mr. Riseman came to the Company in June 1992 as Senior Vice President, Administration. He was appointed to his present position in February 1994. Prior to joining the Company, Mr. Riseman had 27 years experience with Citicorp, most recently as Director of Training and Development. Prior to that he held Citicorp positions as Business Manager for the Long Island Region, Head of Policy and Administration for New York's Retail Bank, and Chairman of Citicorp Acceptance Co. which was involved in the financing and leasing of autos and financing of mobile homes. Mr. Lindenberg had been the Chairman of the Board and President of an equipment leasing business, LeaseComm Financial Corporation, from that Company's inception in June 1985 until its purchase by the Company. Following the acquisition, Mr. Lindenberg was elected President and Chief Executive Officer of Advanta Leasing Corp., the successor to LeaseComm. Prior to starting LeaseComm, Mr. Lindenberg had been with First Pennsylvania Bank, Philadelphia, Pennsylvania since 1982, where he had served in various capacities, most recently as Vice President of the national division responsible for that bank's commercial lending activities in leasing and electronics. Mr. Averett came to the Company as Vice President in January 1988. Prior to joining the Company, Mr. Averett worked with Citicorp from 1980 to 1987. Most of this tenure was in a retail credit card division (CRS) holding a wide array of positions from financial analyst to credit cycle manager and eventually Regional Collections Manager. Mr. Beck joined the Company in 1986 as Senior Vice President of Colonial National and was elected Vice President and Treasurer in 1992. Prior to joining the Company, he was Vice President, Fidelity Bank, N.A., responsible for asset/liability planning, as well as for managing a portfolio of investment securities held at the bank. From 1970 through 1980, he served in various treasury and planning capacities for Wilmington Trust Company. Mr. Calamari joined the Company in May 1988. From May 1985 through April 1988, Mr. Calamari served in various capacities in the accounting departments of Chase Manhattan Bank, N.A. and its subsidiaries, culminating in the position of Chief Financial Officer of Chase Manhattan of Maryland. From 1976 until May 1985, Mr. Calamari was an accountant with the public accounting firm of Peat, Marwick, Mitchell in New York. Ms. Dyer joined the Company as Vice President, Marketing in 1992. Prior to joining the Company, she was Vice President and Director of Marketing for the Retail Finance Division of MNC Financial. From 1985 to 1989, she was Director, Product Development and Management at the Student Loan Marketing Association and had previously held marketing management positions with Citicorp in their credit card, mortgage and consumer finance businesses. Mr. Fread joined the Company in 1986 as Director of Internal Audit, and was elected to the office of Vice President, Asset Quality in June 1987. Prior to joining the Company, he was an audit manager for Arthur Andersen & Co. where he was responsible for audit and consulting engagements for a variety of financial service companies. Mr. Fried joined the Company as Vice President, Strategic Planning and Business Development in 1992. Prior to joining the Company, he was Vice President, New Business Development for Chase Manhattan's Direct Response Banking Sector. Prior to that position, Mr. Fried had 11 years of senior level marketing, planning and development experience in the Credit Card, Consumer Branch Banking and Private Label Retail Credit Divisions at Citicorp. Mr. Girman joined the Company as Vice President, Accounting Operations, Policies and Procedures in July 1988, and was elected Vice President, Audit and Control, in April 1991. Prior thereto, Mr. Girman served as Vice President, Management Accounting and Accounting Policies and Procedures for The Chase Manhattan Bank (USA), N.A. from April 1985 until joining the Company. Mr. Hofmann came to the Company as Director of Human Resources in November 1986 and was elected Vice President, Human Resources in March 1987. Prior to joining the Company, he was Manager, Human Resources Planning and Development for Subaru of America, Inc. from October 1984, and Manager, Management and Organization Development for Shared Medical Systems Corporation from March 1981 until October 1984. Mr. Millman joined the Company in September 1989 and was elected Assistant Treasurer in July 1990 and Vice President, Corporate Funds Management in August 1991. In November 1993, he became Chief Financial Officer of the Consumer Financial Services unit. Prior to joining the Company, Mr. Millman served as Director of Financial Planning for Knight Ridder, Inc. from March 1987 to January 1988, and as Chief Financial Officer of Osteotech, Inc. from January 1988 to September 1989. Mr. Perlet joined the Company in November 1987, and was elected as Vice President, Insurance in June 1988. Prior to joining the Company, Mr. Perlet was with Colonial Penn Group, Inc. for 13 years, where he served in a variety of capacities, most recently as Senior Vice President. Mr. Schneyer joined the Company as Associate General Counsel in September 1986 and was elected to the offices of Vice President, Secretary and General Counsel in March 1989. Prior to joining the Company, from October 1983, Mr. Schneyer was an attorney in the Legal Department of Allied-Signal, Inc., Morristown, New Jersey. ADVANTA CORP. AND SUBSIDIARIES PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. At December 31, 1993, the Company had approximately 1,000 and 850 holders of record of Class B and Class A common stock, respectively. ADVANTA CORP. AND SUBSIDIARIES ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. FINANCIAL HIGHLIGHTS ADVANTA CORP. AND SUBSIDIARIES ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Overview Net income for 1993 rose to $76.6 million or $1.92 per share. This reflects increases of 60% and 39%, respectively, from the $48.0 million or $1.38 per share reported in 1992. Net income before extraordinary item was $77.9 million or $1.95 per share, increases of 62% and 41%, respectively, from 1992. Earnings per share for 1993 incorporated a 15% increase in the number of common shares outstanding versus 1992, reflecting an equity offering by the Company in March 1993. Earnings per share for 1992 have been adjusted to reflect an effective three-for-two stock split as a result of the October 15, 1993 stock dividend. Earnings for 1993 increased primarily as a result of a $1.1 billion or 34% increase in average managed receivables, continued improvement in credit quality with the total managed charge-off rate decreasing from 3.4% in 1992 to 2.9% in 1993, and controlled growth in operating expenses. The Company continues to securitize a majority of the growth in its receivables and to report the performance of the securitized receivables as noninterest revenues. Consequently, the 34% increase in average managed receivables resulted in a $62.5 million or 32% increase in noninterest revenues to $255.6 million in 1993, from $193.1 million in 1992. As a result of improved credit quality, the provision for credit losses in 1993 fell to $29.8 million from $47.1 million in 1992. Despite a lower provision, reserve coverage of impaired owned assets was higher at December 31, 1993 compared to a year ago. Disciplined cost management resulted in operating expenses increasing only 27%, while average managed receivables grew 34% and the operating expense ratio fell to 4.1% for 1993 compared to 4.4% in 1992. Net interest income of $72.1 million for 1993 increased $3.4 million or 5% from 1992 as a result of a $170 million increase in average earning asset balances, offset by a 22 basis point drop in the owned net interest margin. The Company is executing a strategy to market a "risk-adjusted" credit card product in which credit cards are issued with lower rates to customers whose credit quality is expected to result in a lower rate of credit losses (the "risk-adjusted" strategy). This strategy resulted in a drop in credit card yields thereby lowering the owned net interest margin. Over the last three years, average managed receivables have grown at a compound annual rate of 34%. This receivable growth has generated higher financial returns, net income and earnings per share. The Company intends to continue pursuing a strategy of receivable growth with a goal of increasing average managed receivables by 30% or more in 1994. Net income for 1992 of $48.0 million or $1.38 per share increased 91% and 72%, respectively, from $25.2 million or $.81 per share in 1991. Earnings increased in 1992 primarily as a result of an $807 million or 34% increase in average managed receivables and a 51 basis point increase in the managed net interest margin. Average securitized assets rose 67% in 1992 increasing noninterest revenues $59.8 million or 45%. The largest single component of noninterest revenues, credit card securitization income, rose $38.3 million or 90% as average securitized credit card receivables increased 85%. The provision for credit losses was down 15% in 1992 compared to 1991 as a result of lower charge-offs and delinquency levels on owned receivables. Operating expenses increased 28% with a 34% increase in average managed receivables, while operating expenses as a percentage of average managed receivables fell to 4.4% in 1992 from 4.6% in 1991. (1)See Note 1 to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES The owned net interest margin fell to 4.85% in 1993 from 5.07% in 1992, due to a 173 basis point decrease in the yield on interest earning assets partially offset by a 151 basis point improvement in the cost of funding those assets. In 1993, the owned net interest margin of 4.85% reflects the benefit of the March 1993 equity offering and increased retained earnings. Credit card, mortgage and lease receivable securitization activity shifts revenues from interest income to noninterest revenues. This ongoing securitization activity reduces the level of higher-yielding receivables on the balance sheet while increasing the quantity of lower-yielding money market assets. While the money market assets are subsequently replaced with new receivables, the active securitization program reduces the average yield of the on-balance sheet portfolio. Net interest income on securitized credit card balances is reflected in credit card securitization income. Net interest income on securitized mortgage loans is reflected in income from mortgage banking activities, and net interest income on securitized lease receivables is reflected in leasing revenues, net. All securitization income is included in noninterest revenues. See Note 1 to Consolidated Financial Statements. Average managed credit card receivables of $3.0 billion for 1993 increased $755 million or 34% from 1992. This increase can be attributed to several successful credit card campaigns which generated approximately 853,000 new accounts and a large volume of balance transfers by card- holders. Owned receivable balances would have been higher in both years had it not been for the securitization of $1.0 billion of credit card receivables in 1993 and $950 million in 1992. The 241 basis point decline in the yield on owned credit card receivables was the result of the Company's "risk-adjusted" strategy and the influence of a predominance of newer, lower-yielding accounts in the owned portfolio. It is anticipated that these accounts will start repricing upwards in 1994. Average managed mortgage loans increased to $1.0 billion in 1993, a 34% increase from $786.3 million in 1992. The average balance of owned mortgage loans de-creased to $154.2 million in 1993 from $185.6 million in 1992 primarily due to the securitization of $608 million of receivables in 1993. Mortgage loan originations of $510 million in 1993 were up $84 million or 20% from 1992. Yields on owned mortgage loans decreased to 9.91% from 11.40% in 1992 reflecting the lower rate environment and a significant increase in the proportion of first lien mortgage loans in the portfolio. Average managed lease receivables of $154.8 million increased $45 million or 42% from 1992. Average owned balances on leases increased $12.7 million during 1993 due to increased originations and portfolio purchases. Yields on owned leases increased from 17.46% in 1992 to 18.70% in 1993 due to a higher amount of late fees. A significant decline in the owned average cost of funds was experienced in 1993 as the cost of funds fell to 5.18% from 6.39% in 1992. The rollover of deposits in a lower rate environment, lower money market rates, and the Company's entrance into funding markets not previously available to them with a newly acquired investment-grade rating were the primary reasons for this decline. Net interest income of $68.7 million in 1992 dropped slightly from $69.3 million in 1991 primarily as a result of a 61 basis point decline in the owned net interest margin. This decline in the owned net interest margin was a result of a 218 basis point decline in yields on interest earning assets partially offset by a 157 basis point improvement in the cost of funding those assets. Offsetting this decline in the owned net interest margin was a $96 million increase in average interest earning asset balances. The following table provides an analysis of both owned and managed interest income and expense data, average balance sheet data, net interest spread (the difference between the yield on interest earning assets and the average rate paid on interest-bearing liabilities), and net interest margin (the difference between the yield on interest earning assets and the average rate paid to fund interest earning assets) for 1991 through 1993. Average owned loan and lease receivables and the related interest revenues exclude deferred origination costs and the amortization thereof (see Note 1 to Consolidated Financial Statements) and include certain loan fees. ADVANTA CORP. AND SUBSIDIARIES INTEREST RATE ANALYSIS ADVANTA CORP. AND SUBSIDIARIES INTEREST VARIANCE ANALYSIS: ON-BALANCE SHEET - - - --------------------------------------------- The following table presents the effects of changes in average volume and interest rates on individual financial statement line items on a tax equivalent basis, excluding the amortization of deferred origination costs and including certain loan fees. Changes not solely due to volume or rate have been allocated on a pro rata basis between volume and rate. The effects on individual financial statement line items are not necessarily indicative of the overall effect on net interest income. (1) Includes income from assets held and available for sale. PROVISION FOR CREDIT LOSSES - - - --------------------------- The provision for credit losses of $29.8 million in 1993 decreased $17.3 million or 37% from $47.1 million in 1992. This decrease can be attributed to lower charge-offs on owned receivables, which on a consolidated basis were 2.4% of average receivables compared to 3.9% in 1992, and to lower levels of impaired assets. The owned impaired asset level fell to $22.5 million at December 31, 1993, from $31.6 million a year ago. Lower delinquency levels helped to strengthen the Company's reserve coverage of impaired assets to 138.6% at December 31, 1993, from 127.4% a year ago. During 1993, the Company transferred $11 million of on-balance sheet unallocated loan loss reserves to increase off-balance sheet mortgage loan recourse reserves, which reserves are netted against excess mortgage servicing rights. The provision for credit losses of $47.1 million in 1992 decreased $8.4 million or 15% from $55.5 million in 1991. This decrease was primarily due to lower charge-offs on owned receivables and lower impaired asset levels. A description of the credit performance of the loan portfolio is set forth under the section entitled "Credit Risk Management." ADVANTA CORP. AND SUBSIDIARIES Noninterest revenues of $255.6 million in 1993 increased $62.5 million or 32% from $193.1 million in 1992. Due to the securitization of credit card receivables, activity from securitized account balances normally reported as net interest income and charge-offs is reported in securitization income and servicing income, both of which are included in noninterest revenues. Credit card securitization income increased 68% to $135.8 million from $80.8 million in 1992 while average securitized credit card receivables increased 46% to $2.1 billion in 1993 from $1.5 billion in the prior year. Securitization income as a percentage of average securitized receivables was 6.4% in 1993 compared with 5.6% for 1992. See Note 1 to Con-solidated Financial Statements for further description of securitization income. Credit card securitization income is the revenue collected on the securitized receivables, including interest, interchange income and certain fees, less the related ex-penses, including interest payments to investors in the trusts, charge-offs, servicing costs and transaction expenses. Credit card servicing income increased to $41.6 million in 1993 from $28.6 million in 1992. Servicing income represents fees paid to the Company for continuing to service accounts which have been securitized. Such fees approximate 2% of securitized receivables. Total interchange income earned represents approximately 1.4% of credit card purchases. The amount of inter-change paid to the securitization trusts ranges from 1% to 2% of securitized balances and is included in credit card securitization income. Interchange income decreased 39% to $18.8 million in 1993 from $30.7 million in 1992 due to a larger proportion of interchange revenues being included in securitization income. Other credit card revenues, which include credit insurance, cash advance fees and other credit card related revenues, were basically flat year-to-year due to an increasing proportion of credit card revenues becoming part of securitization income. Additionally, the amortization of annual fee income on owned credit card receivables previously had been included in other credit card revenues; beginning in 1993, this amoritization is included as a com-ponent of net interest income. During 1993, the Company securitized $608 million of mortgage loans compared to $385 million in 1992. In 1993, increased credit losses on the securitized portfolio decreased income from mortgage banking activities by approximately $14 million. Increased prepayments also de-creased income from mortgage banking activities by $14 million in 1993. Consequently, mortgage banking income of $24.1 million was relatively flat compared with 1992. See Note 1 to Consolidated Financial Statements for a description of mortgage banking income. Noninterest revenues of $193.1 million in 1992 increased $59.7 million or 45% from $133.4 million in 1991 primarily due to increases in credit card securitization and servicing income. ADVANTA CORP. AND SUBSIDIARIES Operating expenses of $174.6 million for 1993 increased $37.0 million or 27% from $137.6 million in 1992, driven by a 34% growth in average managed receivables. The increase in operating expenses can be primarily attrib-uted to: (a) a $13.9 million, or 27%, increase in salaries and employee benefits with a 22% increase in the number of employees from 1992, (b) a $4.9 million increase in marketing expenses as the Company promoted its finan-cial products as well as enhanced its general public visibility, (c) a $3.6 million increase in external processing resulting primarily from a 26% increase in the number of accounts managed year-to-year, (d) a $5.1 million increase in professional fees as the Company invested in long-term planning projects, and (e) an overall increase in credit card related costs due to a 27% increase in the number of accounts managed. Operating expenses of $137.6 million for 1992 were up $29.8 million or 28% from $107.8 million in 1991 while average managed receivables grew 34%. This increase in operating expenses can be primarily attributed to: (a) a $9.0 million, or 21%, increase in salaries and employee benefits with a 23% increase in the number of employees year-to-year, (b) a $5.7 million increase in marketing expenses to market the Company's financial products and enhance its general visibility, (c) a $2.3 million increase in credit card fraud losses, due to the growth in managed credit card receivables and a higher incidence of fraud, and (d) an overall increase in credit card related costs due to a 15% increase in the number of accounts managed. In 1991, credit card fraud losses included $3.9 million related to the acceleration of charge-offs (see discussion in "Asset Quality" on page 30). The operating expense ratio fell to 4.4% in 1992 from 4.6% in 1991. INCOME TAXES The Company's consolidated income tax expense was $45.3 million for 1993, or an effective tax rate of 37%, compared to tax expense of $29.1 million, or 38%, in 1992 and tax expense of $14.2 million, or 36%, in 1991. The decrease in the effective tax rate from 1992 to 1993 resulted from a higher level of tax-free income, while the increase in the effective tax rate from 1991 to 1992 resulted from higher pretax income and less tax-free income year-to-year. ASSET/LIABILITY MANAGEMENT - - - ------------------------------------------------------------------------------- The financial condition of Advanta Corp. is managed with a focus on maintaining high credit quality standards, disci-plined interest rate risk management and prudent levels of leverage and liquidity. INTEREST RATE SENSIVITY Interest rate sensitivity refers to the net interest income volatility resulting from changes in interest rates, product spread variability and mismatches in the repricing intervals between interest-rate-sensitive assets and liabilities. The Company attempts to minimize the impact of market interest rate fluctuations on net interest income and net income by regularly evaluating the risk inherent in its asset and liability structure, including securitized assets. This risk arises from continuous changes in the Company's asset/liability mix, market interest rates, the yield curve, prepayment trends and the timing of cash flows. Computer simulations are used to evaluate net interest income volatility under varying rate, spread and volume projections over monthly time periods of up to two years. In managing its interest rate sensitivity position, the Company periodically securitizes, sells and purchases assets, alters the mix and term structure of its retail and institutional funding base and complements its basic business activities by changing the investment portfolio and short- ADVANTA CORP. AND SUBSIDIARIES term asset positions. The Company has primarily utilized variable rate funding in pricing its credit card securitization transactions in an attempt to match the pricing dynamics of the underlying receivables sold to the trusts. Although credit card receivables are priced at a spread over the prime rate, they generally contain interest rate floors. These floors have the impact of converting the credit card receivables to fixed rate receivables in a low interest rate environment. In instances when a significant portion of credit card receivables are at their floors, the Company may convert part of the underlying funding to a fixed rate by using interest rate hedges, swaps and fixed rate securitizations. In pricing mortgage and lease securitizations, primarily fixed rate fund-ing is used as nearly all of the receivables sold to investors carry a fixed rate. Interest rate fluctuations affect net interest income at virtually all financial institutions. While interest rate volatility does have an effect on net interest income, other factors also contribute significantly to changes in net inter-est income. Specifically, within the credit card portfolio, pricing decisions and customer behavior regarding convenience usage affect the yield on the portfolio. These factors may counteract or exacerbate income changes due to fluc-tuating interest rates. The Company closely monitors interest rate movements, competitor pricing and consumer behavioral changes in its ongoing analysis of net interest income sensitivity. LIQUIDITY, FUNDING, AND CAPITAL RESOURCES The Company's goal is to maintain an adequate level of liquidity, both long- and short-term, through active management of both assets and liabilities. During 1993, the Company, through its subsidiaries, securitized $1.0 billion of credit card receivables, $608 million of mortgage loans and $68 million of lease receivables. Cash generated from these transactions was temporarily invested in short-term, high quality investments at money market rates awaiting redeployment to pay down deposits and to fund future credit card, mortgage loan and lease receivable growth. See Consolidated Statements of Cash Flows for more information regarding liquidity, funding and capital resources. In addition, see Note 5 to Consolidated Financial Statements and Supplemental Schedules thereto for additional information regarding the Company's investment portfolio. Over the last six years, the Company has accessed the securitization market to efficiently support its growth strate-gy. While securitization should continue to be a reliable source of funding for the Company, other funding sources are available and include deposits, subordinated debt, medium-term notes and the ability to sell assets and raise additional equity. At December 31, 1993, the Company was carrying $668 million of loans available for sale. The fair value of such loans was in excess of their carrying value at year end. In connection with managing liquidity and asset/liability management, the Company had $308 million of investments available for sale at December 31, 1993. See Note 18 to Consolidated Financial Statements for fair value disclosures. In August 1993, the Company's principal subsidiary, Colonial National Bank USA ("Colonial National" or the "Bank"), sold $50 million of subordinated notes which had received an investment-grade rating and qualified as Tier 2 capital. The following table details the composition of the deposit base at year end for each of the past five years. ADVANTA CORP. AND SUBSIDIARIES It is expected that deposits will increase slightly in 1994, as the Bank is likely to expand its asset base within the limits permitted under the Competitive Equality Banking Act of 1987 ("CEBA"). As a grandfathered institution under CEBA, the Company must limit the Bank's asset growth to 7% per annum. For the fiscal CEBA year ended September 30, 1993, the Bank's average assets did not exceed the allowable amount and, accordingly, the Bank was in full compliance with CEBA growth limits. Deposits at December 31, 1993 include $38 million of deposits at Colonial National Financial Corp. ("CNF"), a Utah state-chartered, FDIC- insured industrial loan corporation (a wholly-owned subsidiary of the Company). CNF's assets or operations are not currently material to the Company, and the Company does not expect them to become material in the near term. During 1993, the debt securities of Advanta Corp. achieved investment-grade ratings from the nationally recognized rating agencies. These ratings have allowed the Company to further diversify its funding sources. In November 1993, the Company filed a shelf registration statement with the Securities and Exchange Commission for $1 billion of debt securities, and subsequently sold $150 million of three-year notes under this registration statement. The Company also anticipates selling up to an additional $500 million of medium-term notes as needed. In addition, steady building of liquidity and capital in 1993 and 1992 was achieved as a result of $76.5 million of dividends from subsidiaries in 1993 and $40.0 million in 1992, and retained earnings of $69.3 million in 1993 and $44.0 million in 1992. The Board of Directors currently intends to have the Company pay regular quarterly dividends to its shareholders, maintaining a 20% premium on the dividend paid on the Class B shares; however, the Company plans to reinvest the majority of its earnings to support future growth. During 1993, the Company raised $90 million in new equity through a 3.0 million share (pre-split) Class B common stock offering. Proceeds were used to support future growth. Other elements contributed to liquidity at the subsidiary level (other than the Bank) in 1993. Advanta Mortgage Corp. USA ("Advanta Mortgage") had lines of credit totaling $190 million, which, because of other available funding sources, were not renewed when they expired in December 1993. Advanta Leasing Corp. ("Advanta Leasing") also has lines of credit totaling approximately $86 million. While there are no specific capital requirements for Advanta Corp., the Office of the Comptroller of the Currency requires that Colonial National maintain a risk-based capital ratio of at least 8%. Colonial National's risk-based capital ratio of 12.06% at December 31, 1993 was in excess of the required level and, in fact, exceeded the mini-mum required capital level of 10% for designation as a "well capitalized" depository institution. The Company intends to take the necessary actions to maintain Colonial National as a "well capitalized" bank. In addition, the Company is subject to various rate setting rules and capital regulations related to the Advanta Insurance Companies. At December 31, 1993, the Company was in full compliance with these rules and regulations. CAPITAL EXPENDITURES The Company spent $11.3 million for capital expenditures in 1993, primarily for the purchase of a building, improvements to that building and additional space in other build-ings, office and voice communication equipment and furniture and fixtures. This compared to $5.3 million for capital expenditures in 1992 and $4.2 million in 1991. In 1994, the Company anticipates capital expenditures to exceed those of 1993 as its facilities are expanding and the Company is continuing to upgrade its voice and comm-unication systems. In 1994, the Company anticipates that its marketing expenditures will exceed those of 1993 as the Company continues to manage account retention, originate new accounts and develop new consumer products for its customers. CREDIT RISK MANAGEMENT - - - ------------------------------------------------------------------------------- Management regularly reviews the loan portfolio in order to evaluate the adequacy of the reserve for credit losses. The evaluation includes such factors as the inherent credit quality of the loan portfolio, past experience, current eco-nomic conditions, projected credit losses and changes in the composition of the loan portfolio. The reserve for credit losses is maintained for on-balance sheet receivables. The on-balance sheet reserve is intended to cover all credit losses inherent in the owned loan portfolio. With regard to securitized assets, anticipated losses and related recourse reserves are reflected in the calculations of Securitization Income and Amounts Due From Securitizations. Recourse reserves are intended to cover all probable credit losses over the life of the securitized receivables. ADVANTA CORP. AND SUBSIDIARIES The reserve for credit losses on a consolidated basis was $31.2 million, or 2.4% of receivables, at December 31, 1993, down from $40.2 million, or 4.0% of receivables, in 1992. Due to improved credit quality, this reserve level resulted in higher reserve coverage of impaired assets (nonperforming assets and accruing loans past due 90 days or more on credit cards) of 138.6% at December 31, 1993, compared to 127.4% at December 31, 1992. Reserve cover-age of impaired credit card assets was 183.7% at December 31, 1993, down slightly from 187.6% at year end 1992. The reserve for credit losses on a consolidated basis increased to $40.2 million, or 4.0% of receivables, in 1992 up from $36.4 million, or 2.9% of receivables, in 1991. This reserve level and a decrease in impaired assets resulted in higher reserve coverage of impaired assets. ASSET QUALITY Impaired assets include both nonperforming assets (mortgage loans and leases past due 90 days or more, real estate owned, credit card receivables due from cardholders in bankruptcy, and off-lease equipment) and accruing loans past due 90 days or more on credit cards. The carrying values for both real estate owned and equipment held for lease or sale are based on net realizable value after taking into account holding costs and costs of disposition and are reflected in other assets. On the total managed portfolio, impaired assets were $95.1 million, or 1.8% of receivables, at year end 1993 compared to $92.7 million, or 2.5% of receivables, in 1992. Nonperforming assets on the total managed portfolio were $63.6 million, or 1.2% of receivables, compared to $57.8 million, or 1.6%, in 1992. A key credit quality statistic, the 30-plus-day delinquency rate on managed credit cards, dropped to 2.4% from 3.7% a year ago. The total managed charge-off rate for 1993 was 2.9%, compared to 3.4% for 1992. The charge-off rate on managed credit cards was 3.5% for 1993, down from 4.5% for 1992. On the total owned portfolio, impaired assets were $22.5 million, or 1.8% of receivables, in 1993 compared to $31.6 million, or 3.2%, in 1992. Gross interest income that would have been recorded in 1993 and 1992 for owned nonperforming assets, had interest been accrued through-out the year in accordance with the assets' original terms, was approximately $1.5 million and $1.8 million, respectively. The amount of interest on nonperforming assets included in income for 1993 and 1992 was $.3 million and $.5 million, respectively. Past due loans represent accruing loans that are past due 90 days or more as to collection of principal and interest. Credit card receivables, except those on bankrupt, decedent and fraudulent accounts, continue to accrue interest until the time they are charged off at 186 days contractual delinquency. In contrast, all mortgage loans and leases are put on nonaccrual when they become 90 days past due. Owned credit card receivables past due 90 days or more and still accruing interest were $11.0 million or 1.0% of receivables at December 31, 1993, compared to $16.3 million, or 2.2% of receivables, a year ago. Through 1990, when the Company received notice that a credit cardholder had filed a bankruptcy petition or was deceased, the Company established a reserve equal to the full balance of the receivable. The receivable, if not paid, would be charged off in accordance with the Com-pany's normal credit card charge-off policy at 186 days contractual delinquency. Likewise, receivables in accounts identified as fraudulent would be reserved against and written off (as an operating expense) when they became 186 days contractually delinquent. These policies are consistent with many leading competitors in the credit card industry. During 1991, the Company adopted a new policy for the charge-off of bankrupt, decedent and fraudulent credit card accounts. Under the new policy, the Company charges off bankrupt or decedent accounts within 30 days of notification and accounts suspected of being fraudulent after a 90-day investigation period, unless the investigation shows no evidence of fraud. Consequently, in 1991, both newly identified bankrupt, decedent and fraudulent accounts, as well as those previously identified, were written off. The 1991 charge-off rates included in the following tables exclude the effect of this acceleration. With respect to the mortgage loan business, in 1993 the Company continued to face several difficult challenges: softening real estate values, increased prepayments and a higher level of charge-offs. The managed charge-off rate on mortgage loans increased from .8% in 1992 to 1.3% in 1993. The 1993 charge-off amount includes $3.0 million of accelerated charge-offs. The managed mortgage charge-off rate in 1994 is anticipated to stay at a high level. ADVANTA CORP. AND SUBSIDIARIES The following tables provide a summary of reserves, impaired assets, delinquencies and charge-offs for the past five years: (1) Restated, where necessary, to exclude interest advances on the serviced mortgage portfolio to be consistent with presentation of owned portfolio. (2) The 1991 charge-off rates are normalized to exclude the acceleration of the charge-off of bankrupt and decedent accounts related to the adoption of a new credit card charge-off policy in 1991. Including these amounts, the charge-off rates for 1991 were 3.8% and 5.3% on a consolidated-managed and credit card-managed basis, respectively. ADVANTA CORP. AND SUBSIDIARIES (1) The 1991 charge-off rates are normalized to exclude the acceleration of the charge-off of bankrupt and decedent accounts related to the adoption of a new credit card charge-off policy in 1991. Including these amounts, the charge-off rates for 1991 were 4.7% and 5.8% on a consolidated-owned and credit card-ownedbasis, respectively. ADVANTA CORP. AND SUBSIDIARIES ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES CONSOLIDATED INCOME STATEMENTS See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - - - --------------------------------------------------- PRINCIPLES OF CONSOLIDATION The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include the accounts of Advanta Corp. (the "Company") and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. RECLASSIFICATION Certain prior-period amounts have been reclassified to conform with current-year classifications. CREDIT CARD ORIGINATION COSTS, SECURITIZATION INCOME AND FEES CREDIT CARD ORIGINATION COSTS The Company accounts for credit card origination costs under Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases" ("SFAS 91"). This accounting standard requires certain loan and lease origination fees and costs to be deferred and amortized over the life of a loan or lease as an adjustment to interest income. Origination costs are defined under this standard to include costs of loan origination associated with transactions with independent third parties and certain costs relating to underwriting activities and preparing and processing loan documents. The Company engages third parties to solicit and originate credit card account relationships. Amounts deferred under these arrangements approximated $29.5 million in 1993, $20.3 million in 1992 and $24.4 million in 1991. For credit card receivables, deferred origination costs have been amortized over 60 months. At the May 20, 1993 meeting of the Emerging Issues Task Force ("EITF") of the Financial Accounting Standards Board, the task force reached a consensus regarding the acquisition of individual credit card accounts from independent third parties (EITF Issue 93-1). The consensus was that credit card accounts acquired individually should be accounted for as originations under SFAS 91 and EITF Issue 92-5. Amounts paid to a third party to acquire indi-vidual credit card accounts should be deferred and netted against the related credit card fee, if any, and the net amount should be amortized on a straight-line basis over the privilege period. If a significant fee is charged, the privilege period is the period that the fee entitles the cardholder to use the card. If there is no significant fee, the privilege period should be one year. In accordance with this recent consensus, direct origi-nation costs incurred related to credit card originations initiated after the May 20, 1993 consensus date are deferred and amortized over 12 months. Costs incurred for originations which were initiated prior to May 20, 1993 will continue to be amortized over a 60 month period. Prior to the EITF Issue 93-1 consensus, it was the Company's practice to write off deferred origination costs related to credit card receivables that have been securitized. This practice had effectively written off credit card origination costs much more quickly than the 60 month period previously utilized. In connection with the prospective adoption of a 12 month amortization period for deferred credit card origination costs, the Company will no longer write off deferred origination costs related to credit card receivables being securitized, as under the EITF Issue 93-1 consensus such costs are not directly associated with the receivables. CREDIT CARD SECURITIZATION INCOME Since 1988, the Company, through its subsidiary Colonial National Bank USA ("Colonial National" or "CNB") has completed 16 credit card securitizations totalling $3.2 billion in receivables. See Note 3 and Note 16. In each transaction, credit card receivables were transferred to a trust and interests in the trust were sold to investors for cash. The Company records excess servicing income on credit card securitizations representing additional cash flow from the receivables initially sold based on the repayment term, including prepayments. Prior to the EITF Issue 93-1 consensus, net gains were not recorded at the time each transaction was completed as excess servicing income was offset by the write off of deferred origination costs and the establishment of recourse reserves. Subsequent to the prospective adoption discussed above, excess servicing income has been recorded at a lower level at the time of each transaction, and is predominantly offset by the establishment of recourse reserves. The lower level of excess servicing income corresponds with the discontinuance of ADVANTA CORP. AND SUBSIDIARIES deferred origination cost write-offs upon securitization of receivables as discussed above. During the "revolving period" of each trust, income is recorded based on additional cash flows from the new receivables which are sold to the trusts on a continual basis to replenish the investors' interest in trust receivables which have been repaid by the credit cardholders. CREDIT CARD FEES Annual fees on credit cards are deferred and amortized on a straight-line basis over the fiscal year of the account. The changes relating to origination costs and securitization income, as discussed above, in the aggregate did not have a material effect on the Company's 1993 financial statements. MORTGAGE LOAN ORIGINATION FEES The Company generally charges origination fees ("points") for mortgage loans where permitted under state law. Origi-nation fees are deferred and amortized over the contractual life of the loan. However, upon the sale or securitization of the loans, the unamortized portion of such fees is recognized and included in the computation of the gain on sale. LOAN AND LEASE RECEIVABLES AVAILABLE FOR SALE Loan and lease receivables available for sale represent receivables that the Company generally intends to sell or securitize within the next six months. These assets are reported at the lower of cost or fair market value. INVESTMENTS HELD TO MATURITY Investments held to maturity include those investments that the Company has the positive intent and ability to hold to maturity. These investments are reported at cost, adjusted for amortization of premiums or accretions of discounts. INVESTMENTS AVAILABLE FOR SALE Investments available for sale include securities that the Company sells from time to time to provide liquidity and in response to changes in the market. In 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). This statement requires that debt and equity securities classified as Available for Sale be reported at market value. This Statement is effective for fiscal years beginning after December 15, 1993, although a company may elect earlier adoption as of the end of a fiscal year for which annual statements have not been previously issued. The Company has elected to adopt this statement as of December 31, 1993, and as such, these securities are recorded at market value at that date. Unrealized holding gains and losses on these securities are reported as a separate component of stockholders' equity and included in retained earnings. These securities are reported at the lower of cost or market value at December 31, 1992. The market value was $202,708 at December 31, 1992. FORWARD CONTRACTS A short sale of U.S. Treasury securities for forward settlement involves an agreement between two parties to sell Treasury securities at a specified future date and at a speci-fied future price. The Company periodically sells U.S. Treasury securities short for forward settlement for the purpose of hedging the pricing of anticipated mortgage loan securitizations. Gains or losses are deferred and included in the measurement of the dollar basis of the assets sold. The contractual amounts of forward contracts at December 31, 1993 and 1992 were $72 million and $165 million, respectively. FINANCIAL FUTURES A financial future is a contract to take or make delivery of the underlying financial instrument at a specified price at a future date. The Company periodically sells financial futures contracts expressly for the purpose of managing and reducing interest rate risk specifically related to the reset of one-month LIBOR on outstanding credit card securitiza-tions. Gains or losses are included in securitization income. At December 31, 1993 and 1992, there were no futures contracts outstanding. INTEREST RATE SWAPS An interest rate swap is a contract between two counter-parties to exchange interest payments on a specified notion-al amount at agreed upon rates. The Company enters into these agreements for the primary purpose of managing its interest rate risk. At December 31, 1993, the Company had $500 million notional amount of interest rate swap agreements fixed at a 4.95% weighted average rate and $150 million notional amount of floating rate swaps priced at one-month LIBOR. The fixed rate contracts mature throughout 1994 and the floating rate contracts mature in 1996. INCOME FROM MORTGAGE BANKING ACTIVITIES The Company, through its subsidiaries, sells mortgage loans through both secondary market securitizations and whole loan sales, typically with servicing retained. Income is ADVANTA CORP. AND SUBSIDIARIES recognized at the time of sale approximately equal to the present value of the anticipated future cash flows resulting from the retained yield adjusted for an assumed prepayment rate, net of any anticipated charge-offs, and allowing for a normal servicing fee. Changes in the anticipated future cash flows, as well as the receipt of cash flows which differ from those projected, affect the recognition of current and future mortgage banking income. Also included in this income is any difference between the net sales proceeds and the carrying value of the mortgage loans sold at the time of the transaction. See Note 3 and Note 16. The carrying value includes deferred loan origination fees and costs which in-clude certain fees and costs related to acquiring and pro-cessing a loan held for resale. These deferred origination fees and costs are netted against income from mortgage banking activities when the loans are sold. Mortgage banking income also includes loan servicing fees equal to .5% of the outstanding balance of securitized loans and, beginning in 1992, loan servicing fees on mortgage loan portfolios which were never owned by the Company ("contract servicing"). INCOME FROM LEASE SECURITIZATIONS The Company, through its subsidiaries, sells equipment lease receivables through secondary market securitizations. Income is recorded at the time of sale approximately equal to the present value of the anticipated future cash flows net of anticipated charge-offs, partially offset by deferred initial direct costs, transaction expenses and estimated credit losses under certain recourse requirements of the trust. Also included in income is the difference between the net sales proceeds and the carrying amount of the receivables sold. Subsequent to the initial sale, securitization income is recorded in proportion to the actual cash flows received from the trusts. INSURANCE Insurance premiums, net of commissions on credit life, disability and unemployment policies on credit cards, are earned monthly based upon the outstanding balance of the underlying receivables. The cost of acquiring new rein-surance is deferred and amortized over the reinsurance period in order to match the expense with the anticipated premium revenue. Insurance claim reserves are based on estimated settlement amounts for both reported and incurred but not reported losses. CREDIT LOSSES During 1991, the Company adopted a new charge-off policy related to bankrupt, decedent and fraudulent credit card accounts. Under the previous policy, whenever the Company received notification that a credit cardholder had filed a bankruptcy petition or was deceased, a reserve was established equal to the full balance of the receivable. The receivable, if not paid, would be charged off at 186 days contractual delinquency. Likewise, receivables in accounts identified as fraudulent would be reserved against and written off (as an operating expense) when they became 186 days contractually delinquent. Under the policy adopted in 1991, bankrupt and decedent accounts are written off within 30 days of notification, and accounts suspected of being fraudulent are written off after a 90 day investigation period, unless the investigation shows no evidence of fraud. During the 1991 transition period, both newly identified bankrupt, decedent and fraudulent accounts, as well as those previously identified, were written off. PREMISES AND EQUIPMENT Premises, equipment, computers and software are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. Repairs and maintenance are charged to expense as incurred. GOODWILL Goodwill, representing the cost of investments in subsidiaries and affiliated companies in excess of net assets acquired at acquisition, is being amortized on a straight-line basis over 25 years. INCOME TAXES Effective January 1, 1993, the Company implemented the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") with no material effect on the financial statements. SFAS 109 utilizes the liability method and deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of the enacted tax laws. Prior to the implementation of SFAS 109, the Company accounted for income taxes using Accounting Principles Board Opinion No. 11. EARNINGS PER SHARE Earnings per common share are computed by dividing net earnings after preferred stock dividends by the average number of shares of common stock and common stock equivalents outstanding during each year. The outstanding preferred stock is not a common stock equivalent. Earnings ADVANTA CORP. AND SUBSIDIARIES per share in 1992 and 1991 have been adjusted to reflect the effective three-for-two stock split as a result of the October 15, 1993 stock dividend. See Note 7. CASH FLOW REPORTING For purposes of reporting cash flows, cash includes cash on hand and amounts due from banks. Cash paid during 1993, 1992 and 1991 for interest was $78.8 million, $94.4 million and $107.7 million, respectively. Cash paid for taxes during these periods was $30.0 million, $17.7 million and $8.7 million, respectively. (A) Includes credit card receivables available for sale of $564 million and $250 million in 1993 and 1992, respectively. (B) Includes mortgage loan receivables available for sale of $74.6 million and $190.5 million in 1993 and 1992, respectively. (C) Includes lease receivables available for sale of $28.6 million and $31.5 million in 1993 and 1992, respectively, and is net of unearned income of $11.9 million and $10.8 million in 1993 and 1992, respectively, and also includes residual interest for both years. (D) Includes approximately $.6 million and $1.7 million in 1993 and 1992, respectively, related to loan and lease receivables available for sale. Receivables serviced for others consisted of the following items: The geographic concentration of managed receivables was as follows: In the normal course of business, the Company makes commitments to extend credit to its credit card customers. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any conditions established in the contract. The Company does not require collateral to support this financial commitment. At December 31, 1993 and 1992, the Company had $16.0 billion and $11.7 billion, respectively, of commitments to extend credit outstanding for which there is potential credit risk. The Company believes that its customers' utilization of these lines of credit will continue to be substantially less than the amount of the commitments, as has been the Company's experience to date. At December 31, 1993 and 1992, out-standing managed credit card receivables represented 24% and 23%, respectively, of outstanding commitments. ADVANTA CORP. AND SUBSIDIARIES NOTE 3. CREDIT CARD, MORTGAGE LOAN AND EQUIPMENT LEASE SECURITIZATIONS - - - --------------------------------------- Colonial National has completed 16 sales of credit card receivables through asset-backed securitizations aggregating $3.2 billion. In each transaction, credit card receivables were transferred to a trust which issued certificates representing ownership interests in the trust to institutional investors. Colonial National retained a participation interest in each trust, reflecting the excess of the total amount of receivables transferred to the trust over the portion represented by certificates sold to investors. The retained participation interests in the credit card trusts were $371.8 million and $393.5 million at December 31, 1993 and 1992, respectively. Although Colonial National continues to service the underlying credit card accounts and maintain the customer relationships, these transactions are treated as sales for financial reporting purposes to the extent of the investors' interests in the trusts. According-ly, the associated receivables are not reflected on the balance sheet. Colonial National is subject to certain recourse provi-sions in connection with these securitizations. At December 31, 1993 and 1992, Colonial National had reserves of $96.4 million and $108.8 million, respectively, related to these recourse provisions. These reserves are netted against the excess servicing-credit card securitization. See Note 16. At December 31, 1993, the Company had amounts receivable from credit card securitizations, which include the related interest-bearing deposits, excess servicing and other amounts related to securitization of $191.0 million, $104.7 million of which was subject to liens by the providers of the credit enhancement facilities for the individual securitizations. At December 31, 1992, the amounts receivable and amounts subject to lien were $192.0 million and $106.5 million, respectively. Through December 31, 1993, the Company had sold, through securitizations and whole loan sales, approximately $1.7 billion of mortgage loan receivables which sales are subject to certain recourse provisions. The Company had reserves of $32.1 million and $10.1 million at year end 1993 and 1992, respectively, related to these recourse provisions which are netted against the excess mortgage servicing rights. See Note 16. At December 31, 1993, the Company had amounts receivable from mortgage loan sales and securitizations of $102.8 million, $39.7 million of which was subject to liens. At December 31, 1992, the amounts receivable and amounts subject to lien were $82.0 million and $32.8 million, respectively. Through December 31, 1993, the Company had securitized approximately $196 million of equipment lease receiv-ables which are subject to certain recourse provisions. The asset-backed certificates carry a fixed rate to investors. There were reserves of $5.3 million and $3.1 million at year end 1993 and 1992, respectively, related to these recourse provisions which are netted against the excess servicing-lease securitizations. See Note 16. The Company had accounts receivable from lease securitizations of $9.7 million at year end 1993 and $4.0 million at year end 1992, of which $5.9 million and $1.7 million, respectively, were subject to liens by the providers of the credit enhancement facility. Total interest in residuals for lease assets sold was $9.6 million and $7.7 million at December 31, 1993 and 1992, respectively, and is also subject to recourse provisions. NOTE 4. RESERVE FOR CREDIT LOSSES - - - -------------------------------------- The reserve for credit losses for lending and leasing transactions is established to reflect losses anticipated from delinquencies that have already occurred. Any adjustments to the reserves are reported in the Income Statements in the periods they become known. During 1993, the Company used $11 million of its on-balance sheet unallocated reserves to increase its off-balance sheet mortgage loan recourse reserves, which are a component of excess mortgage servicing rights. In 1992, the Company used $3.3 million of its on-balance sheet unallocated reserves to increase its off-balance sheet mortgage loan recourse reserves. ADVANTA CORP. AND SUBSIDIARIES The following table displays five years of reserve history: ADVANTA CORP. AND SUBSIDIARIES At December 31, 1993, investment securities with a book value of $17,473 were pledged as collateral for swap and hedge transactions. At December 31, 1991, investment securities with a book value of $101,847 were pledged as collateral for repurchase transactions. There were no investment securities pledged as collateral at December 31, 1992. At December 31, 1993, 1992 and 1991, investment securities with a book value of $7,927, $9,147 and $8,748, respectively, were deposited with insurance regu-latory authorities to meet statutory requirements or held by a trustee for the benefit of primary insurance carriers. At December 31, 1993, $806 of net unrealized gains on securities was included in investments available for sale. During 1993, the net change in unrealized gains on available for sale securities included as a separate component of stockholders' equity was $563. Maturity of investments available for sale at December 31, 1993: Proceeds from sales of available for sale securities during 1993 were $841,000. Gross gains of $3,430 and losses of $888 were realized on these sales. Proceeds during 1992 were $353,000. Gross gains of $2,414 and losses of $427 were realized on these sales. Proceeds during 1991 were $147,000. Gross gains of $1,085 and losses of $508 were realized on these sales. The specific identification method was the basis on which cost was determined in computing realized gains and losses. Equity securities primarily includes FRB, FHLB and FNMA stock that the Company is required to hold. The annual maturities of long-term debt at December 31, 1993 for the years ending December 31 are as follows: $70.4 million in 1995; $180.7 million in 1996; $51.4 million in 1997; $10.4 million in 1998; and $55.5 million thereafter. The average interest cost of the Company's debt during 1993, 1992 and 1991 was 7.59%, 9.01% and 10.27%, respectively. NOTE 7. STOCK DIVIDENDS - - - ------------------------------------ On April 24, 1992, the Company's shareholders approved a dual class stock plan pursuant to which the Company's Common Stock was reclassified as Class A Common Stock and a new class of non-voting stock, Class B Common Stock, was authorized. Promptly following shareholder approval, the Board of Directors declared a dividend of one share of Class B Common Stock on each outstanding share of Class A Common Stock to shareholders of record as of April 24, 1992, which dividend was paid on May 5, 1992. ADVANTA CORP. AND SUBSIDIARIES On September 23, 1993, the Board of Directors approved a three-for-two stock split in the form of a 50% stock dividend on both the Class A and Class B Common Stock to shareholders of record as of October 4, 1993, which dividend was paid on October 15, 1993. All share and per share amounts have been adjusted to reflect the three-for-two stock split as a result of the stock dividend. The balance sheet presentation of stockholders' equity for prior years and earnings per share for the years ended December 31, 1992 and 1991, have been adjusted to reflect the impact of this dividend, as if it had already occurred at such respective dates. The Class A Preferred Stock is entitled to 1/2 vote per share and a non-cumulative dividend of $140 per share per year, which must be paid prior to any dividend on the common stock. Dividends were declared on the Class A Preferred Stock for the first time in 1989 and have continued through 1993 as the Company paid dividends on its common stock. The redemption price of the Class A Preferred Stock is equivalent to the par value. NOTE 9. ISSUANCE OF COMMON STOCK - - - ------------------------------------ On March 24, 1993, in a public offering, the Company sold 2,575,000 shares (pre-split) of Class B Common Stock. Proceeds from the offering, net of the underwriting discount, were $77.5 million. On April 21, 1993, the underwriters of the offering purchased an additional 450,000 shares (pre-split) of Class B Common Stock, pursuant to the overallotment option granted to them by the Company. This brought the Company's total proceeds of the offering, net of related expenses, to approximately $90 million. The Company used the proceeds of the offering for general corporate purposes, including to finance the growth of its subsidiaries. NOTE 10. EXTRAORDINARY ITEM - - - ------------------------------------ In April of 1993, the Company repurchased the remaining $33.2 million of its 12 3/4% Senior Subordinated Debentures at a price equal to 104% of par. This transaction resulted in an extraordinary loss of $1.3 million (net of a tax benefit of $.7 million) or $.03 per share for the year ended December 31, 1993. Current tax payable includes earnings of certain subsidiaries which are not included in the consolidated federal income tax return. In 1993 and 1992, the tax provision includes $2.0 million and $6.5 million of direct entries to equity accounts, respectively. ADVANTA CORP. AND SUBSIDIARIES In 1991, the Company's consolidated tax return reflects alternative minimum taxes payable. The reconciliation of the statutory federal income tax to the consolidated tax expense is as follows: Deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of the enacted tax laws. The net deferred tax liability is comprised of the following: The Company did not record any valuation allowances against deferred tax assets at December 31, 1993. The tax effect of significant temporary differences representing deferred tax assets and liabilities is as follows: NOTE 12. BENEFIT PLANS - - - ---------------------------------- In 1991, the Company adopted the Advanta Management Incentive Plan With Stock Election II ("AMIPWISE II"), which plan was designed to provide incentives to participating employees to remain in the employ of the Company and devote themselves to its success. Under the plan, employees eligible to participate in the Advanta Management Incentive Plan (a bonus program) were given the opportunity to elect to take portions of their anticipated or "target" bonus payments for 1993, 1994 and 1995 in the form of restricted shares of common stock. To the extent such elections were made, restricted shares were issued to the employees, with the number of shares granted to each employee determined by dividing the amount of future bonus payments the employee had elected to receive in stock by the market price of the stock on February 7, 1991 ($4.75). The restricted shares are subject to forfeiture should the employee terminate employment with the Company prior to vesting. Restricted shares vest 10 years from the date of grant, but vesting was and will be accelerated annually with respect to one-third of an employee's restricted shares, to the extent that the employee and the Company met or meet their respective performance goals for each of 1993, 1994 and 1995. When newly eligible employees elect to participate in AMIPWISE II, the number of restricted shares issued to them with respect to their "target" bonus payments for the relevant years is determined based on the average market price of the stock for the 90 days prior to eligibility. Under the plan, 1,062,009 shares of restricted stock have been issued, of which 283,130 shares were vested as the result of 1993 performance bonus awards. ADVANTA CORP. AND SUBSIDIARIES In 1992, the Company implemented a plan similar to AMIPWISE II, for key employees below the management level, under which eligible employees were awarded shares of restricted Class B common stock with respect to "target" bonus payments for 1992, 1993, 1994 and 1995. The num-ber of shares issued to them with respect to their "target" bonus payments for the relevant years was determined based on the average market price of the stock for the year ended December 31, 1991 ($7.07). Under this plan, a total of 83,853 restricted shares of Class B common stock have been issued, of which 35,531 shares have vested as the result of 1992 and 1993 bonus awards. In 1993, the Company adopted a plan substantially similar to AMIPWISE II ("AMIPWISE III") under which elections were made to take "target" bonus payments for 1996, 1997 and 1998 in shares of Class B common stock. The number of shares was determined using the market price of the stock on the election date ($17.00). Under this plan, 386,304 shares of restricted Class B common stock have been issued. At December 31, 1993, a total of 1,229,829 shares issued under these plans and under the predecessor plan to AMIPWISE II (with respect to which employees made elections with respect to "target" bonuses for 1990, 1991 and 1992) were subject to restrictions and were included in the number of shares outstanding. These shares are considered common stock equivalents in the calculation of earnings per share. Deferred compensation of $11.0 million and $5.1 million related to these plans is reflected as a reduction of equity at December 31, 1993 and 1992, respectively. The Company has an Employee Stock Purchase Plan which allows employees and directors to purchase Advanta common stock at a 15% discount from the market price without paying brokerage fees. The Company reports this 15% discount as compensation expense. During 1993, shares were issued under the plan from unissued stock at the average market price on the day of purchase. Effective with the stock dividend on May 5, 1992, only Class B shares are issued for this plan. The Company has two Stock Option Plans which together authorize the grant to employees and directors, of options to purchase an aggregate of 7,425,000 shares of common stock. In connection with the implementation of the dual class stock plan described in Note 7, each option granted prior to the May 5, 1992 stock dividend was converted into two options, each covering an equal number of Class A common shares and Class B common shares as were covered by the original option, and each with an exercise price per share equal to one-half the original exercise price. In connection with the October 15, 1993 stock dividend, the number of options and the exercise price of each option were modified to reflect the three-for-two stock split. Although under these plans options issued after the May 5, 1992 dividend date may be for either Class A or Class B common stock, the Company presently intends only to issue options to purchase Class B common stock. Beginning in 1992, options generally vest over a four-year period, and expire 10 years after the date of grant. Shares available for future grant aggregated 2,051,508 at December 31, 1993, and 2,629,209 at December 31, 1992. Transactions under the plans for the two years ended December 31, 1993, were as follows: The Company also has outstanding, options to purchase 718,500 shares of common stock at a price range of $1.52 to $11.00 per share, which were not issued pursuant to either of the predecessor plans and generally vest over a three-year period. At December 31, 1993, 1,547,115 of the 3,039,000 out-standing options issued under the Stock Options Plans had vested and 709,500 of the 718,500 issued outside the Plans had vested. The Company has a tax-deferred employee savings plan which provides employees savings and investment opportunities, including the ability to invest in the Company's common stock. The employee savings plan provides for discretionary Company contributions equal to a portion of the first 5% of an employee's compensation contributed to the plan. For the three years ended December 31, 1993, 1992 and 1991, the Company contributions equalled 100% of the first 5% of participating employees' compensation contributed to the plan. The expense for this plan totalled ADVANTA CORP. AND SUBSIDIARIES $1,189, $882 and $753 in 1993, 1992 and 1991, respectively. At December 31, 1993, 133,018 of the 337,500 shares of common stock reserved for issuance under the employee savings plan had been purchased by the plan from the Company at the market price on each purchase date. All other shares purchased by the plan for the three years ended December 31, 1993, 1992 and 1991 were purchased on the open market. NOTE 13. COMMITMENTS AND CONTINGENCIES - - - -------------------------------------------- The Company leases office space in several states under leases accounted for as operating leases. Total rent expense for all of the Company's locations for the years ended December 31, 1993, 1992 and 1991 was $4.8 million, $3.5 million and $3.1 million, respectively. The future minimum lease payments of all non-cancellable operating leases are as follows: In January 1994, the Company hired a new senior executive and agreed to the following compensation arrangement. In addition to a base salary, the executive received 200,000 restricted shares of Class B common stock and an option to purchase 100,000 shares of Class B common stock at $27.75 per share. The restricted shares, which as of the date of the grant had a market value of $5.6 million, will vest at the rate of 25% per annum for four years, and the options will become exercisable at the same rate. Should the executive leave the Company's employ before four years have passed, these benefits will vest upon the departure, except in certain limited circumstances. The executive is also to receive a guaranteed one-time bonus of $525, other annual benefits and perquisites estimated at $250, and will also be eligible to receive annual bonuses under AMIPWISE II and AMIPWISE III (see Note 12). NOTE 14. OTHER BORROWINGS - - - --------------------------------- The Company had lines of credit and term funding arrangements of $63.5 million at December 31, 1993, which were collateralized by lease receivables, as well as equipment under operating lease. At December 31, 1992, the Company had lines of credit and term funding arrangements of $208.7 million which were collateralized by lease receivables and mortgage loans. These facilities carry variable interest rates which range from 1 1/4 % above LIBOR to 1 1/4% above the prime rate. There is a quarterly facility fee of 1/4 to 1/2 of 1% of the average unused portion on the lines of credit. The composition of other borrowings was as follows: The following table displays information related to selected types of short-term borrowings: ADVANTA CORP. AND SUBSIDIARIES The weighted average interest rates were calculated by dividing the interest expense for the period for such borrowings by the average amount outstanding during the period. (A) Represents initial deposits and subsequent excess collections up to the required amount on each of the credit card, mortgage and leasing securitizations. (A) Carried at the lower of cost or fair market value. ADVANTA CORP. AND SUBSIDIARIES NOTE 17. CASH, DIVIDEND AND LOAN RESTRICTIONS - - - ------------------------------------------------- In the normal course of business, the Company and its subsidiaries enter into agreements, or are subject to regulatory requirements, that result in cash, debt and dividend restrictions. At December 31, 1992, Advanta Leasing had $6.3 million of cash related to its securitizations which is restric-ted as to its use. This cash represents the initial deposits and subsequent excess collections up to the required amount on each of the equipment lease-backed securitizations. In 1993, this amount is included in interest-bearing deposits. The Federal Reserve Act imposes various legal limitations on the extent to which banks that are members of the Federal Reserve System can finance or otherwise supply funds to certain of their affiliates. In particular, Colonial National is subject to certain restrictions on any extensions of credit to, or other covered transactions, such as certain purchases of assets, with the Company or its affiliates. Such restrictions prevent Colonial National from lending to the Company and its affiliates unless such extensions of credit are secured by U.S. Government obligations or other specified collateral. Further, such secured extensions of credit by Colonial National are limited in amount: (a) as to the Company or any such affiliate, to 10 percent of Colonial National's capital and surplus, and (b) as to the Com-pany and all such affiliates in the aggregate, to 20 percent of Colonial National's capital and surplus. Under certain grandfathering provisions of the Competitive Equality Banking Act of 1987, the Company is not required to register as a bank holding company under the Bank Holding Company Act of 1956, as amended (the "BHCA"), so long as the Company and Colonial National continue to comply with certain restrictions on their activities. With respect to Colonial National, these restric-tions include limiting the scope of its activities to those in which it was engaged prior to March 5, 1987. Since Colonial National was not making commercial loans at that time, it must continue to refrain from making commercial loans--which would include any loans to the Company or any of its subsidiaries--in order for the Company to maintain its grandfathered exemption under the BHCA. The Company has no present plans to register as a bank holding company under the BHCA. Colonial National is subject to various legal limitations on the amount of dividends that can be paid to its parent, Advanta Corp. Colonial National is eligible to declare a dividend provided that it is not greater than the current year's net profits plus net profits of the preceding two years, as defined. During 1993, Colonial National paid $75.0 million of dividends to Advanta Corp., while $30.5 million of dividends were paid during 1992. The Office of the Comptroller of the Currency requires that Colonial National maintain a risk-based capital ratio of at least 8%. Colonial National's risk-based capital ratio of 12.06% at December 31, 1993 was in excess of the required level and exceeded the minimum required capital level of 10% for designation as a "well capitalized" depository institution. ADVANTA CORP. AND SUBSIDIARIES NOTE 18. FAIR VALUE OF FINANCIAL INSTRUMENTS - - - ------------------------------------------------ The estimated fair values of the Company's financial instruments are as follows: The above values do not necessarily reflect the premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular instrument. In addition, these values, derived from the methods and assumptions described below, do not consider the potential income taxes or other expenses that would be incurred on an actual sale of an asset or settlement of a liability. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. CASH, FEDERAL FUNDS SOLD AND INTEREST-BEARING DEPOSITS For these short-term instruments, the carrying amount is a reasonable estimate of the fair value. INVESTMENTS For investment securities held to maturity and those available for sale, fair values are based on quoted market prices, dealer quotes or estimated using quoted market prices for similar securities. LOANS, NET OF RESERVE FOR CREDIT LOSSES For credit card receivables and mortgage loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value for credit card receivables and mortgage loans also includes the estimated value of the portion of the interest payments and fees which are not sold with the securities backed by these types of loans. The value of the retained interest payments (i.e., excess servicing) is estimated by discounting the future cash flows, adjusted for prepayments, net of anticipated charge-offs and allowing for the value of the servicing. The value of direct finance lease receivables and other loans are estimated based on the market prices of similar receivables with similar characteristics. EXCESS SERVICING-CREDIT CARD AND MORTGAGE SERVICING RIGHTS The fair values of excess mortgage servicing rights and credit card excess servicing rights are estimated by dis-counting the future cash flows at rates which management believes to be reasonable. However, because there is no active market for these financial instruments, management ADVANTA CORP. AND SUBSIDIARIES has no basis to determine whether the fair values presented above would be indicative of the value negotiated in an actual sale. The future cash flows used to estimate the fair values of these financial instruments are adjusted for prepayments, net of anticipated charge-offs under recourse provisions, and allow for the value of servicing. DEMAND AND SAVINGS DEPOSITS The fair value of demand deposits, savings accounts, and money market deposits is the amount payable on demand at the reporting date. This fair value does not include the benefit that results from the low cost of funding provided by these deposits compared to the cost of borrowing funds in the market. TIME DEPOSITS AND DEBT The fair value of fixed-maturity certificates of deposit and notes are estimated using the rates currently offered for deposits and notes of similar remaining maturities. SENIOR SUBORDINATED DEBENTURES The fair value of the senior subordinated debentures is based on dealer quotations. OTHER BORROWINGS The other borrowings are all at variable interest rates and therefore the carrying value approximates a reasonable estimate of the fair value. INTEREST RATE SWAPS AND FORWARD CONTRACTS The fair value of interest rate swaps and forward contracts (used for hedging purposes) is the estimated amount that the Company would pay to terminate the agreement at the reporting date, taking into account current interest rates and the current creditworthiness of the counterparty. CUSTOMER RELATIONSHIPS (BOTH ON- AND OFF-BALANCE SHEET) The fair value of the credit card relationships, which are not financial instruments, is estimated using a credit card valuation model which considers the value of the existing receivables together with the value of new receivables and the associated fees generated from existing cardholders over the remaining life of the portfolio. COMMITMENTS TO EXTEND CREDIT Although the Company had $12.1 billion of unused commitments to extend credit, there is no market value associated with these financial instruments, as any fees charged are consistent with the fees charged by other companies at the reporting date to enter into similar agreements. NOTE 19. CALCULATION OF EARNINGS PER COMMON SHARE - - - -------------------------------------------------------- The following table shows the calculation of earnings per common share for the years ended December 31, 1993, 1992 and 1991: ADVANTA CORP. AND SUBSIDIARIES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of Advanta Corp.: We have audited the accompanying consolidated balance sheets of Advanta Corp. (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Advanta Corp. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /S/ ARTHUR ANDERSEN & CO. ------------------------- Philadelphia, PA January 25, 1994 REPORT OF MANAGEMENT ON RESPONSIBILITY FOR FINANCIAL REPORTING To the Stockholders of Advanta Corp.: The management of Advanta Corp. and its subsidiaries is responsible for the preparation, content, integrity and objectivity of the financial statements contained in this Annual Report. These financial statements have been pre-pared in accordance with generally accepted accounting principles and as such, must, by necessity, include amounts based upon estimates and judgments made by management. The other financial information in the Annual Report was also prepared by management and is consistent with the financial statements. Management maintains a system of internal controls that provides reasonable assurance as to the integrity and reliability of the financial statements. This control system includes: (l) organizational and budgetary arrangements which provide reasonable assurance that errors or irregularities would be detected promptly, (2) careful selection of personnel and communications programs aimed at assuring that policies and standards are understood by employees, (3) a program of internal audits, and (4) continuing review and evaluation of the control program itself. The financial statements in this Annual Report have been audited by Arthur Andersen & Co., independent public accountants. Their audits were conducted in accordance with generally accepted auditing standards and considered the Company's system of internal controls to the extent they deemed necessary to determine the nature, timing and extent of their audit tests. Their report is printed herewith. ADVANTA CORP. AND SUBSIDIARIES QUARTERLY DATA (UNAUDITED) ADVANTA CORP. AND SUBSIDIARIES SUPPLEMENTAL SCHEDULES Allocation of Reserve for Credit Losses COMPOSITION OF GROSS RECEIVABLES (A) Yield computed on a taxable equivalent basis using a statutory rate of 35% in 1993. ADVANTA CORP. AND SUBSIDIARIES SUPPLEMENTAL SCHEDULES MATURITY OF TIME DEPOSITS OF $100,000 OR MORE ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The text of the Proxy Statement under the caption "Election of Directors" and the last paragraph under the caption "Security Ownership of Management" are hereby incorporated herein by reference, as is the text in Part I of this Report under the caption, "Executive Officers of the Registrant". Graeme K. Howard, Jr., age 61, who has served as a director of the Company since 1985, will not stand for re-election when his term expires in May 1994. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The text of the Proxy Statement under the captions "Executive Compensation" and "Committees, Meetings and Compensation of the Board of Directors" are hereby incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The text of the Proxy Statement under the captions, "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" are hereby incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The text of the third paragraph under the caption "Election of Directors -- Nominees for Election for a Term Expiring in 1997" in the Proxy Statement is hereby incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. The following Financial Statements, Schedules, and Other Information of the Registrant and its subsidiaries are included in this Form 10-K: (a) (1) Financial Statements 1. Consolidated Balance Sheets at December 31, 1993 and 1992. 2. Consolidated Income Statements for each of the three years for the period ended December 31, 1993. 3. Consolidated Statements of Changes in Stockholders' Equity for each of the three years for the period ended December 31, 1993. 4. Consolidated Statements of Cash Flows for each of the three years for the period ended December 31, 1993. 5. Notes to Consolidated Financial Statements. (a) (2) Schedules 1. Schedule I -- Marketable Securities. 2. Schedule III -- Condensed Financial Information of Registrant 3. Schedule VIII -- Valuation and Qualifying Accounts. 4. Schedule IX -- Short-Term Borrowings. 5. Report of Independent Public Accountants on Supplemental Schedules. Other statements and schedules are not being presented either because they are not required or the information required by such statements and schedules is presented elsewhere in the financial statements. (a) (3) Exhibits. 3-a Restated Certificate of Incorporation of Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988 and Exhibit 3 to the Company's Quarterly Report on Form 10- Q for the period ended March 31, 1992). 3-b By-Laws of the Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989). 4-a* Trust Indenture dated April 22, 1981 between Registrant and CoreStates Bank, N.A. (formerly, The Philadelphia National Bank), as Trustee, including Form of Debenture. 4-b Specimen of Class A Common Stock Certificate and specimen of Class B Common Stock Certificate (incorporated by reference to Exhibit 1 of the Registrant's Amendment No. 1 to Form 8 and Exhibit 1 to Registrant's Form 8-A, respectively, both dated April 22, 1992). 4-c Trust Indenture dated as of November 15, 1993 between the Registrant and The Chase Manhattan Bank (National Association), as Trustee (incorporated by reference to Exhibit 4 of the Registrant's Registration Statement on Form S-3 (No. 33-50883), filed November 2, 1993. 9 Inapplicable. 10-a Registrant's Stock Option Plan, as amended (incorporated by reference to Exhibit 10-b to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989).** 10-b Advanta Corp. 1992 Stock Option Plan (incorporated by reference to Exhibit 10-t to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-c Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of May 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-40368), filed with Amendment No.1 thereto on May 21, 1991) 10-d Registrant's Advanta Management Incentive Plan (incorporated by reference to Exhibit 10-n to the Registrant's Registration Statement on Form S-2, Registration No.33-39343, filed March 8, 1991).** 10-e* Application for membership in VISA U.S.A. Inc. and Membership Agreement executed by Colonial National Bank USA on March 25, 1983. 10-f* Application for membership in MasterCard International, Inc. and Card Member License Agreement executed by Colonial National Bank USA on March 25, 1983. 10-g* Indenture of Trust dated May 11, 1984 between Linda M. Ominsky, as settlor, and Dennis Alter, as trustee. 10-g(i) Agreement dated October 20, 1992 among Dennis Alter, as Trustee of the trust established by the Indenture of Trust filed as Exhibit 10-g (the "Indenture"), Dennis Alter in his individual capacity, Linda A. Ominsky, and Michael Stolper, which Agreement modifies the Indenture (incorporated by reference to Exhibit 10-g(i) to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-h Agreement dated as of January 21, 1994 betweenn the Registrant and Alex W. "Pete" Hart (filed herewith).** 10-i Advanta Management Incentive Plan with Stock Election (incorporated by reference to Exhibit 4-c to Amendment No. 1 to the Registrant's Registration Statement on Form S-8 (No. 33-33350) filed February 21, 1990).** 10-j Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of August 1, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed September 11, 1990). 10-k Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of November 15, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed November 30, 1990). 10-l Registrant's Advanta Management Incentive Plan With Stock Election II (incorporated by reference to Exhibit 10-o to the Registrant's Registration Statement on Form S-2, Registration No. 33-39343, filed March 8, 1991).** 10-m Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of September 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No.33- 42682), filed with Amendment No. 1 thereto on September 23, 1991). 10-n Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of February 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No.33- 45306), filed with Amendment No.1 thereto on February 3, 1992). 10-o Amended and Restated Master Pooling and Servicing Agreement between Colonial National Bank USA and Chemical Bank, as Trustee, dated as of April 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-49602), filed with Amendment No. 1 thereto on August 19, 1992). 10-p Advanta Management Incentive Plan with Stock Election III (incorporated by reference to Exhibit 10-s to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-q Life Insurance Benefit for Certain Key Executives and Directors (incorporated by reference to Exhibit 10-u to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-r $122.5 Million 364-day Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 10-s $122.5 Million 3-year Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 11 Inapplicable. 12 Inapplicable. 13 Inapplicable. 16 Inapplicable. 18 Inapplicable. 21. Subsidiaries of the Registrant (filed herewith). 22 Inapplicable. 23 Consent of independent public accountants (filed herewith). 24 Powers of Attorney of Messrs. Bellis, Botel, Braemer, Brenner, Dunkelberg and Naples (filed herewith). 28 Inapplicable. 99 Inapplicable. _________ *Incorporated by reference to the Exhibit with corresponding number constituting part of the Registrant's Registration Statement on Form S-2 (No. 33-00071), filed on September 4, 1985. **Management contract or compensatory plan or arrangement. (b) Reports on Form 8-K 1. A Report Form 8-K was filed by the Registrant on October 25, 1993 regarding consolidated earnings of the Registrant and its subsidiaries for the fiscal quarter ended September 30, 1993. Summary earnings and balance sheet information as of that date were filed with such report. 2. A Report Form 8-K was filed by the Registrant on December 3, 1993 regarding the commencement of the Registrant's $500,000,000 medium-term note program. No financial statements were filed with such Report. 3. A Report Form 8-K was filed by the Registrant on January 20, 1994 regarding consolidated earnings for the Registrant and its subsidiaries for the fiscal quarter ended and fiscal year ended December 31, 1993. Summary earnings and balance sheet information as of that date were filed with such report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ADVANTA Corp. Dated: March 28, 1994 By: /S/ Dennis Alter ------------------- Dennis Alter, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 28th day of March, 1994. FINANCIAL SCHEDULES AND INDEPENDENT PUBLIC ACCOUNTANTS' REPORT THEREON Schedule I ADVANTA CORP. & SUBSIDIARIES Marketable Securities December 31, 1993 (Dollars in thousands) ADVANTA CORP. & SUBSIDIARIES December 31, 1993 Schedule III - Condensed Financial Information of Registrant Parent Company Only CONDENSED BALANCE SHEETS (Dollars in thousands) Schedule III (cont'd) Parent Company Only CONDENSED STATEMENT OF INCOME (Dollars in thousands) Schedule III (Cont'd) Parent Company Only Statement of Cash Flows Schedule VIII ADVANTA Corp. & Subsidiaries Valuation & Qualifying Accounts ($000's) (1) Amounts netted against securitization income. (2) Includes $11.0MM transferred from on-balance sheet unallocated reserves. (3) Relates to net charge-offs. (4) Includes $3.3MM transferred from on-balance sheet unallocated reserves. Schedule IX ADVANTA CORP. & SUBSIDIARIES Short-Term Borrowings ($000's) [ARTHUR ANDERSEN LETTERHEAD] REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To Advanta Corp.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The supplemental schedules are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial stataments. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /S/ ARTHUR ANDERSEN & CO. Philadelphia, PA January 25, 1994 EXHIBIT INDEX 3-a Restated Certificate of Incorporation of Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988 and Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1992). 3-b By-Laws of the Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989). 4-a* Trust Indenture dated April 22, 1981 between Registrant and CoreStates Bank, N.A. (formerly, The Philadelphia National Bank), as Trustee, including Form of Debenture. 4-b Specimen of Class A Common Stock Certificate and specimen of Class B Common Stock Certificate (incorporated by reference to Exhibit 1 of the Registrant's Amendment No. 1 to Form 8 and Exhibit 1 to Registrant's Form 8-A, respectively, both dated April 22, 1992). 4-c Trust Indenture dated as of November 15, 1993 between the Registrant and The Chase Manhattan Bank (National Association), as Trustee (incorporated by reference to Exhibit 4 of the Registrant's Registration Statement on Form S-3 (No. 33-50883), filed November 2, 1993. 9 Inapplicable. 10-a Registrant's Stock Option Plan, as amended (incorporated by reference to Exhibit 10-b to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989).** 10-b Advanta Corp. 1992 Stock Option Plan (incorporated by reference to Exhibit 10-t to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-c Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of May 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-40368), filed with Amendment No.1 thereto on May 21, 1991) 10-d Registrant's Advanta Management Incentive Plan (incorporated by reference to Exhibit 10-n to the Registrant's Registration Statement on Form S-2, Registration No.33-39343, filed March 8, 1991).** 10-e* Application for membership in VISA U.S.A. Inc. and Membership Agreement executed by Colonial National Bank USA on March 25, 1983. 10-f* Application for membership in MasterCard International, Inc. and Card Member License Agreement executed by Colonial National Bank USA on March 25, 1983. 10-g* Indenture of Trust dated May 11, 1984 between Linda M. Ominsky, as settlor, and Dennis Alter, as trustee. 10-g(i) Agreement dated October 20, 1992 among Dennis Alter, as Trustee of the trust established by the Indenture of Trust filed as Exhibit 10-g (the "Indenture"), Dennis Alter in his individual capacity, Linda A. Ominsky, and Michael Stolper, which Agreement modifies the Indenture (incorporated by reference to Exhibit 10-g(i) to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-h Agreement dated as of January 21, 1994 betweenn the Registrant and Alex W. "Pete" Hart (filed herewith).** 10-i Advanta Management Incentive Plan with Stock Election (incorporated by reference to Exhibit 4-c to Amendment No. 1 to the Registrant's Registration Statement on Form S-8 (No. 33-33350) filed February 21, 1990).** 10-j Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of August 1, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed September 11, 1990). 10-k Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of November 15, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed November 30, 1990). 10-l Registrant's Advanta Management Incentive Plan With Stock Election II (incorporated by reference to Exhibit 10-o to the Registrant's Registration Statement on Form S-2, Registration No. 33-39343, filed March 8, 1991).** 10-m Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of September 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No.33-42682), filed with Amendment No. 1 thereto on September 23, 1991). 10-n Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of February 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1(No.33-45306), filed with Amendment No.1 thereto on February 3, 1992). 10-o Amended and Restated Master Pooling and Servicing Agreement between Colonial National Bank USA and Chemical Bank, as Trustee, dated as of April 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-49602), filed with Amendment No. 1 thereto on August 19, 1992). 10-p Advanta Management Incentive Plan with Stock Election III (incorporated by reference to Exhibit 10-s to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-q Life Insurance Benefit for Certain Key Executives and Directors (incorporated by reference to Exhibit 10-u to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-r $122.5 Million 364-day Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 10-s $122.5 Million 3-year Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 11 Inapplicable. 12 Inapplicable. 13 Inapplicable. 16 Inapplicable. 18 Inapplicable. 21. Subsidiaries of the Registrant (filed herewith). 22 Inapplicable. 23 Consent of independent public accountants (filed herewith). 24 Powers of Attorney of Messrs. Bellis, Botel, Braemer, Brenner, Dunkelberg and Naples (filed herewith). 28 Inapplicable. 99 Inapplicable. _________ *Incorporated by reference to the Exhibit with corresponding number constituting part of the Registrant's Registration Statement on Form S-2 (No. 33-00071), filed on September 4, 1985. **Management contract or compensatory plan or arrangement.

99193_1993.txt

99193

1993

ITEM 1. BUSINESS THE COMPANY Transamerica Finance Corporation, a wholly owned subsidiary of Transamerica Finance Group, Inc. ("TFG") which is a wholly owned subsidiary of Transamerica Corporation, is principally engaged in consumer lending, commercial lending and leasing operations. Unless the context indicates otherwise, the terms "Company" and "Registrant" as used herein refer to Transamerica Finance Corporation and its subsidiaries. Transamerica Corporation (Transamerica) is a financial services organization which engages through its subsidiaries in consumer lending, commercial lending, leasing, real estate services, life insurance and asset management. Transamerica was incorporated in Delaware in 1928. The Company was incorporated in Delaware in 1931 under the name Pacific Finance Corporation, as successor to a California corporation of the same name organized in 1920. In 1961, the Company became a wholly owned subsidiary of Transamerica Corporation, which in 1990 formed TFG to own all the Company's outstanding capital stock. On July 17, 1990, the Company acquired FIFSI, Inc. (dba NOVA Financial Services), a consumer lending subsidiary of First Interstate Bancorp, for $117,455,000 in cash and the assumption of $445,400,000 of liabilities. The transaction was accounted for as a purchase and the operations of NOVA Financial Services have been included in the Consolidated Statement of Operations from the date of acquisition. The Company provides funding for its subsidiaries' consumer lending, commercial lending and leasing operations and for the operations of certain wholly owned subsidiaries of TFG. Capital is allocated among the operations based on their capital needs. The operations are required to maintain prudent financial ratios consistent with other companies in their respective industries. The Company's total notes and loans payable were $7,031,503,000 at December 31, 1993 and $6,589,576,000 at December 31, 1992. Variable rate debt was $3,970,484,000 at December 31, 1993 and $3,492,842,000 at December 31, 1992. The ratio of debt to debt plus equity was 83% at December 31, 1993 and 82% at December 31, 1992. Transamerica Finance Corporation offers publicly, from time to time, senior or subordinated debt securities. Public debt issued totaled approximately $407,000,000 in 1993, $538,700,000 in 1992 and $1,107,800,000 in 1991. Under a shelf registration filed with the Securities and Exchange Commission in 1991 to offer publicly up to $1,500,000,000 of senior or subordinated debt securities with varying terms, debt securities totaling $1,400,000,000 had been sold through December 31, 1993. In addition, under a registration statement filed in July 1993, the Company may offer up to $2,000,000,000 of senior or subordinated debt securities (which may include medium-term notes,) with varying terms, of which $1,853,000,000 remained unsold as of December 31, 1993. Liquidity is a characteristic of the Company's operations since the majority of the assets consist of finance receivables. Principal cash collections of finance receivables totaled $11,535,766,000 during 1993, $9,415,231,000 during 1992 and $8,375,018,000 during 1991.CONSUMER LENDING GENERAL The Company's consumer lending services are provided by Transamerica Financial Services, headquartered in Los Angeles, California, which has 561 branch lending offices. Branch offices are located in the United States (548 in 41 states), Canada (11) and United Kingdom (2). Transamerica Financial Services makes both real estate secured and unsecured loans to individuals. The company's customers typically borrow to consolidate debt, finance home remodeling, pay for their children's college educations, make major purchases, take vacations, and for other personal uses. Transamerica Financial Services offers three principal loan products: fixed rate real estate secured loans, revolving real estate secured lines of credit and personal loans. The company's primary business is making fixed rate, home equity loans that generally range up to $200,000. Approximately 83% of the net finance receivables outstanding at December 31, 1993 are secured by residential properties. Of the Company's real estate portfolio, 50% is secured by first mortgages. Since 1991, the company has continued to broaden its receivable portfolio by expanding its revolving real estate secured lines of credit, its unsecured personal loan business and its purchase of retail finance contracts from dealers (i.e., appliances, furniture and services). When permitted by law, the consumer lending services offer to arrange credit life and disability insurance in connection with consumer instalment loans and generally require that property securing consumer loans be insured. The consumer lending operation receives a fee if it arranges such insurance. Credit life insurance satisfies the obligation of the borrower in the event of death, while credit disability insurance satisfies the borrower's obligation to pay instalments during a period of disability. Property insurance insures the collateral against damage or loss. Beginning in April 1991, substantially all such insurance arranged for by the consumer lending operation was underwritten by subsidiaries of the Company's commercial lending operation. Nonearning Receivables Nonearning consumer finance receivables, which are defined as those past due more than 29 days, amounted to $156,542,000 and $140,763,000 at December 31, 1993 and 1992. Payments received on nonearning receivables are applied to principal and interest according to the terms of the loan; however, accrued interest receivable and amortization of other finance charges are recognized in income only on accounts past due less than 30 days. During 1993, the gross amount of interest income that would have been recorded on receivables classified as nonearning at year end was $25,496,000 and the amount of interest on those loans that was recognized in income was $15,234,000. Accounts in Foreclosure and Assets Held for Sale Generally, by the time an account secured by residential real estate becomes past due 90 days, foreclosure proceedings have begun, at which time the account is moved from finance receivables to other assets and is written down to the estimated realizable value of the collateral if less than the account balance. After foreclosure, repossessed assets are carried at the lower of cost or fair value less estimated selling costs and are reclassified to assets held for sale. Accounts in foreclosure and repossessed assets held for sale totaled $214,665,000 at December 31, 1993 compared to $176,054,000 at December 31, 1992. The increase primarily reflects increased repossessions in California and longer disposal times due to its weak real estate market. Offices and Employees The number of offices and employees of the Company in connection with its consumer lending operation as of the dates indicated were as follows: As of December 31, ------------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Offices 561 509 464 448 428 Employees 2,381 2,256 2,148 2,093 1,861 The following table sets forth the geographical distribution of the Company's consumer lending offices at December 31, 1993: No. of No. of Offices Offices ------- ------- United States: United States: Alabama 15 New Jersey 5 Arizona 20 New Mexico 6 California 174 New York 26 Colorado 9 North Carolina 12 Connecticut 2 Ohio 21 Delaware 2 Oklahoma 6 Florida 21 Oregon 10 Georgia 14 Pennsylvania 23 Hawaii 4 Rhode Island 1 Idaho 4 South Carolina 7 Illinois 29 Tennessee 7 Indiana 12 Texas 5 Iowa 6 Utah 4 Kansas 2 Virginia 10 Kentucky 8 Washington 22 Louisiana 8 Wisconsin 10 Maryland 9 Wyoming 1 Massachusetts 3 --- Michigan 8 Minnesota 5 Canada 548 Mississippi 1 United Kingdom 11 Missouri 11 2 Nebraska 2 --- Nevada 3 Total 561 === Competition The Company's consumer lending subsidiaries operate in a highly competitive industry, in many cases competing with companies and financial institutions with long established operating histories and substantial financial resources. Regulation The Company's consumer lending operation is subject to various state and federal laws. Depending upon the type of lending, these laws may require licensing and certain disclosures and may limit the amounts, terms and interest rates that may be offered.COMMERCIAL LENDING General The Company's commercial lending services are provided by Transamerica Commercial Finance Corporation ("Transamerica Commercial Finance"). Transamerica Commercial Finance operates from its executive office in Chicago, Illinois, as well as from 72 branch lending offices. Branch offices are located in the United States (47), Puerto Rico (15), Canada (6) and Europe (4). Transamerica Commercial Finance made a decision late in the fourth quarter of 1991 to exit the rent-to-own finance business, reduce lending to certain asset based lending lines, accelerate disposal of repossessed assets and liquidate receivables remaining from previously sold businesses. As a result of this action the commercial lending operation recognized a special after tax charge of $130,000,000. In conjunction with the decisions discussed above, Transamerica Commercial Finance's operations were reorganized into two core business units: inventory finance and business credit. The lending activities of these core businesses are discussed below. Inventory Finance Inventory finance (also known as wholesale financing or floor plan financing) consists principally of financing dealers' purchases from distributors or manufacturers of goods for inventory. The products financed primarily include boats and other recreational equipment, television and stereo equipment, major appliances such as refrigerators, washers, dryers and air conditioners, and manufactured housing. Loan terms typically provide for repayment within 30 days following sale of the inventory by the borrower. After initial review of a borrower's credit worthiness, the ongoing management of credit risk in this area may include various monitoring techniques, such as periodic physical inventory checks and review of the borrower's sales, as well as maintenance of repurchase agreements with manufacturers which provides a degree of security in the event of slow moving or obsolete inventory. Business Credit Business credit consists of secured loans, primarily revolving, to manufacturers, distributors and selected service businesses, including financial service companies. The loans are fully collateralized, with credit lines typically from $5,000,000 to $25,000,000 and terms ranging from three to five years. Actual borrowings are limited to specified percentages of the borrower's inventory, receivables and other eligible collateral which are regularly monitored to ascertain that outstandings are within approved limits and that the borrower is otherwise in compliance with the terms of the arrangement. The loans to financial service companies are secured by their respective finance receivable portfolios. The company manages its credit risk in this area by monitoring the quality of the borrower's loan portfolio and compliance with financial covenants. Other The "Other" category of receivables includes furniture and appliance retail and finance operations in Puerto Rico and the liquidating portfolios of businesses the company has exited. Transamerica Commercial Finance also offers credit life and credit disability insurance in connection with the financing activities of both the consumer and commercial lending operations and to unrelated third party lenders. The unrelated insurance accounted for substantially all of the insurance subsidiaries' total premium volume in 1990, 64% in 1991, 45% in 1992 and 7% in 1993.Interest Rate Sensitivity As a result of the relatively short-term nature of its financings, Transamerica Commercial Finance is able to adjust its finance charges rather quickly in response to competitive factors and changes in its costs. However, the interest rates at which Transamerica Commercial Finance borrows funds for its businesses generally move more quickly than the rates at which it lends to customers. As a result, in rising interest rate environments, margins are normally compressed until interest rates restabilize. Conversely, in declining interest rate environments, margins are generally enhanced. Acquisitions and Divestitures In March 1992, the commercial lending operation purchased for cash a business credit portfolio consisting of twelve manufacturer/distributor accounts with a net outstanding balance of $134,000,000. In September 1991, an inventory finance portfolio was purchased for cash, which comprised lending arrangements with over 700 manufactured housing and recreational product dealers with a net balance outstanding of $290,604,000. These transactions were funded with short-term debt. The commercial lending operation sold its automobile fleet leasing operation in 1990 and its commercial leasing and wholesale automobile financing operations in 1989. Finance receivables included in the assets sold totaled $45,478,000 in 1990 and $534,734,000 in 1989. Also in 1990, the insurance finance operations were dividended to TFG. Commercial Finance Receivables The following tables set forth the volume of commercial finance receivables acquired during the years indicated and the amount of commercial finance receivables outstanding at the end of each such year: Earned finance charges as a percentage of the average amount of net finance receivables outstanding during each of the years 1989 through 1993 were 14.9%, 14.7%, 13.3%, 12.1% and 11.3%. Delinquent Receivables Effective in 1993, the policy used for determining delinquent receivables was revised to provide greater consistency among the company's receivable portfolios. It is management's view that the new methodology provides a better and more meaningful assessment of the condition of the portfolio. Delinquent receivables are now defined as the instalment balance for inventory finance and business credit receivables and the receivable balance for all other receivables over 60 days past due. Previously, delinquent receivables were generally defined as financed inventory sold but unpaid 30 days or more, the portion of business credit loans in excess of the approved lending limit and all other receivable balances contractually past due 60 days or more. The following table shows the ratio of deliquent commercial finance receivables to finance receivables outstanding for each category and in total as of the end of each of the years indicated. Delinquency ratios for 1992 and prior years have not been restated for the change in policy outlined above. As of December 31, ---------------------------------------------- 1993 1992 1991 1990 1989 ------ ------ ------ ------ ----- Inventory finance(1) 0.13% 0.82% 1.31% 3.42% 2.95% Insurance finance(2) 1.78 Business credit(1)(3) 0.21 0.88 10.34 2.35 ------ ------ ------ ------ ----- Core businesses 0.10 0.68 1.25 5.78 2.63 Other(4) 19.14 22.42 25.84 12.79 9.54 ------ ------ ------ ------ ----- Total(5) 1.02% 2.38% 5.64% 6.65% 3.61% ====== ====== ====== ====== ====== - --------------- (1)The decreases in 1992 and 1991 reflect write offs of delinquent accounts (and accounting reclassifications - see note 3 on preceding table), implementation of stronger portfolio management procedures and general improvement in the economy. Increased delinquency in 1990 reflected the overall weak economy. This trend began in 1989 when consumer spending, which supports these businesses, began to decline. Particularly affected were the marine industry (inventory finance), and the appliance and furniture rental and Canadian computer markets (business credit). (2)See note 2 on preceding table. (3)The decline in 1991 was due principally to rent-to-own finance receivables being reclassified to assets held for sale, and certain finance receivables being reclassified to the "other" category. These reclassifications resulted from the company's decision to exit the rent-to-own finance business and reduce its lending to certain asset based lending lines. Prior year data has not been restated. (4)Represents finance receivables retained from businesses sold or exited which are being liquidated and receivables reclassified in 1991 due to the company's decision to reduce lending to certain asset based lending lines (see note 3 on preceding table). (5)Delinquency statistics exclude assets held for sale (see discussion on page 13). -------------------- Nonearning Receivables Effective in 1993, the policy used for determining nonearning receivables was revised to provide greater consistency among the company's receivable portfolios. It is management's view that the new methodology provides a better and more meaningful assessment of the condition of the portfolio. Nonearning receivables are now defined as balances from borrowers that are over 90 days delinquent or at such earlier time as full collectibility becomes doubtful. Previously, nonearning receivables were defined as balances from borrowers in bankruptcy or litigation and other accounts for which full collectibility was doubtful. Accrual of finance charges is suspended on nonearning receivables until such time as past due amounts are collected. Nonearning receivables were $31,763,000 (1.20% of receivables outstanding) and $90,919,000 (3.42% of receivables outstanding) at December 31, 1993 and 1992; the 1992 data has not been restated. Those amounts exclude nonearning rent-to-own finance receivables which have been reclassified to assets held for sale (see page 13). During 1993, the gross amount of interest income that would have been recorded on receivables classified as nonearning at year end was $4,649,000 and the amount of interest on those loans that was recognized in income was $2,423,000.Assets Held for Sale Assets held for sale at December 31, 1993 totaled $90,114,000, net of a $156,985,000 valuation allowance and consisted of rent-to-own finance receivables of $120,469,000, repossessed rent-to-own stores of $107,227,000 and other repossessed assets of $19,403,000. Assets held for sale at December 31, 1992 totaled $191,515,000, net of a $121,549,000 valuation allowance, and comprised rent-to-own finance receivables of $179,013,000, repossessed rent-to-own stores of $103,418,000 and other repossessed assets of $30,633,000. At December 31, 1993, $27,489,000 of the rent-to-own finance receivables were classified as both delinquent and nonearning. At December 31, 1992, delinquent rent-to-own finance receivables were $15,397,000 and nonearning rent-to-own finance receivables were $32,615,000. Delinquent and nonearning receivables as of December 31, 1992 have not be restated for the change in policies effective in 1993 as outlined above. Credit Loss Experience Certain information regarding credit losses on finance receivables for the commercial lending operation during the years indicated is set forth in the following table: [CAPTION] Offices and Employees The number of offices and employees of the Company in connection with its commercial lending operation as of the dates indicated were as follows: As of December 31, --------------------------------------------- 1993 1992 1991 1990 1989 ------ ------ ------ ------ ------ Offices 72 108 130 152 231 Employees 1,899 1,993 2,114 2,292 3,011 The following table sets forth the geographical distribution of the Company's commercial lending offices at December 31, 1993: No. of No. of Offices Offices ------- ------- United States: United States: Alabama 1 South Dakota 1 California 3 Tennessee 2 Colorado 1 Texas 4 Florida 1 Virginia 1 Georgia 2 Wisconsin 2 Hawaii 1 --- Illinois 10 47 Indiana 1 --- Iowa 1 Puerto Rico 15 Kansas 1 --- Minnesota 2 Canada: Mississippi 1 Alberta 1 Missouri 1 British Columbia 1 New Hampshire 1 Ontario 3 New Jersey 2 Quebec 1 New York 3 --- North Carolina 2 6 Ohio 1 --- Oregon 1 Europe: Pennsylvania 1 France 1 Netherlands 1 United Kingdom 2 --- --- Total 7 === Competition The Company's commercial lending subsidiaries operate in a highly competitive industry, in many cases competing with companies with long established operating histories and substantial financial resources. Regulation The Company's commercial lending operation is subject to various state and federal laws. Depending upon the type of lending, these laws may require licensing and certain disclosures and may limit the amounts, terms and interest rates that may be offered.LEASING OPERATION General Transamerica Leasing Inc. ("Transamerica Leasing") leases, services and manages containers, chassis and trailers around the world. The company is based in Purchase, New York and maintains 386 offices, depots and other facilities in 44 countries. The company specializes in intermodal transportation equipment, which allows goods to travel by road, rail or ship. The company's customers include railroads, steamship lines and motor carriers. At December 31, 1993, Transamerica Leasing's fleet consisted of standard containers, refrigerated containers, domestic containers, tank containers and chassis totaling 316,000 units which are owned or managed, and leased from 347 depots worldwide, 36,500 rail trailers leased to all major United States railroads and to roll on/roll off steamship operators, shippers, shippers' agents and regional truckers, and 3,800 over-the-road trailers in Europe. Transamerica Leasing began leasing tank containers for carrying bulk liquids in 1990 and had 1,900 tank containers in its fleet at December 31, 1993. In November 1992, the company sold its domestic over-the-road trailer business. Proceeds from the sale totaled $191,000,000 and resulted in no gain or loss. Approximately 49% of the standard container, refrigerated container, domestic container, tank container and chassis fleet is on term lease or service contract minimum lease for periods of one to five years. Also, 34% of the rail trailer fleet is on term lease or service contract minimum lease for periods of one to five years. The following table sets forth Transamerica Leasing's fleet size in units as of the end of each of the years indicated: As of December 31, --------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Containers and 316,000 280,000 255,100 244,400 235,900 chassis Rail trailers 36,500 34,400 36,800 40,500 43,300 European trailers 3,800 2,900 1,700 800 The following table sets forth Transamerica Leasing's fleet utilization for the years indicated: Years Ended December 31, -------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Containers and chassis 83% 85% 89% 90% 93% Rail trailers 91% 84% 75% 79% 83% European trailers 89% 84% 83% 81% The 1993 container and chassis utilization decline was due to slow economic growth in key European economies and Japan; the 1992 decline was due to higher than expected industry-wide supply of equipment. The 1991 and 1990 reductions resulted from a small decline in the rate of growth of world trade and a less favorable geographic balance of business. The rail trailer utilization increased in 1993 and 1992 due to a smaller industry fleet, higher domestic economic activity and because many shippers are moving from trucks to rail transport for long- haul shipments; the 1991 and 1990 declines were due to reduced domestic economic activity. Revenues of the domestic leasing operation derived from foreign customers were $210,301,000 in 1993, $176,172,000 in 1992 and $137,127,000 in 1991, of which European customers accounted for 41%, 42% and 40%. Revenues of foreign-domiciled leasing operations were less than 10% of the consolidated total in each of the three years in the period ended December 31, 1993.Offices and Employees The number of offices, depots and other facilities, and employees of the Company in connection with its leasing operation as of the dates indicated were as follows: As of December 31, ------------------------------------ 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Offices, depots and other facilities 386 386 301 306 322 Employees 765 796 946 1,026 1,055 Competition Transamerica Leasing operates in a highly competitive industry, in many cases competing with companies with long established operating histories and substantial financial resources. Subsequent Event On March 15, 1994, the Company completed the purchase of substantially all of the assets of the container rental division of Tiphook plc for approximately $1,100,000,000 in cash. BORROWING OPERATIONS Funds employed in the Company's operations are obtained from invested capital, retained earnings and the sale of short and long-term debt. Capitalization of the Company as of the dates indicated was as follows: Short-term borrowings before reclassification to long-term debt (see Note G of Notes to Financial Statements, Item 8) are primarily in the form of commercial paper notes issued by the Company. Such commercial paper is continuously offered, with maturities not exceeding 270 days in the U.S. and 365 days in Canada, at prevailing rates for major finance companies. Bank loans are an additional source of short-term borrowings. At December 31, 1993, $721,814,000 of bank credit lines were available to the Company, $75,000,000 of which were also available to Transamerica Corporation. At December 31, 1993, all borrowings under these lines were made by the Company and amounted to $240,927,000. The cost of short-term borrowings is directly related to prevailing rates of interest in the money market; such rates are subject to fluctuation. Interest rates on borrowings during the years indicated were as follows: Years Ended December 31, ----------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Weighted average annual interest rate during year:(1) Short-term borrowings 3.41% 3.93% 6.47% 8.23% 9.26% Long-term borrowings 8.24% 8.71% 9.77% 9.23% 9.69% Total borrowings 6.00% 6.87% 8.28% 9.22% 9.68% (1) Excludes the cost of maintaining credit lines and the effect of interest rates on borrowings denominated in foreign currencies. Return on Assets and Equity Certain information regarding the Company's consolidated return on assets and equity, and certain other ratios, are set forth below: Years Ended December 31, ---------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Return on assets(1) 1.1% 1.9% (1.2)% 1.4% 2.1% Return on equity(2) 6.9% 11.7% (7.6)% 8.2% 12.3% Dividend payout ratio(3) 75.2% 55.7% N.A. 136.3% 64.8% Equity to assets ratio(4) 16.2% 16.2% 16.2 % 16.7% 16.8% (1) Net income divided by simple average total assets. (2) Net income divided by simple average equity. (3) Cash dividends declared (excluding cash dividends in connection with corporate restructuring in 1990) divided by net income. (4) Simple average equity divided by simple average total assets. Ratio of Earnings to Fixed Charges The following table sets forth the consolidated ratios of earnings to fixed charges for the years indicated. The ratios are computed by dividing income from continuing operations before income taxes, extraordinary loss on early extinguishment of debt and cumulative effect of change in accounting, and before fixed charges, by the fixed charges. Fixed charges consist of interest and debt expense, and one-third of rent expense (which approximates the interest factor). Years Ended December 31, -------------------------------------------- 1993 1992 1991 1990 1989 Ratio of earnings 1.50 1.59 0.77 1.28 1.42 to fixed charges Excluding the effect of the previously discussed special charge ($130,000,000 after tax) reported by the commercial lending operation, the ratio of earnings to fixed charges would have been 1.14 for 1991. ITEM 2.

ITEM 2. PROPERTIES Transamerica Finance Corporation leases its principal executive offices at 1150 South Olive Street, Los Angeles, California, from an affiliated company under a lease expiring in November 1994 at an annual rental of approximately $2,000,000. The Company and its subsidiaries have noncancelable lease agreements expiring mainly through 1998. These agreements are principally operating leases for facilities used in the Company's operations.ITEM 3.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Omitted in accordance with General Instruction J. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Not applicable. All of the outstanding shares of the Registrant's capital stock are owned by Transamerica Finance Group, Inc., which is wholly owned by Transamerica Corporation. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Omitted in accordance with General Instruction J. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Omitted in accordance with General Instruction J. See "Management's Discussion and Analysis of the Results of Operations" following the Notes to Financial Statements (Item 8). ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this Item is submitted as a separate section of this report. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Omitted in accordance with General Instruction J. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Omitted in accordance with General Instruction J. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Omitted in accordance with General Instruction J. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Omitted in accordance with General Instruction J. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) and (2) The response to this portion of Item 14 is submitted as a separate section of this report. (3) List of Exhibits: EX-2 Assets Purchase Agreement dated as of February 13, 1994 between Transamerica Container Acquisition Corporation and Tiphook plc and certain of its affiliated companies. EX-2.1 Amendment and Supplement to Asset Purchase Agreement dated as of March 15, 1994 between Transamerica Container Acquisition Corporation and the Container Rental Division of Tiphook plc. EX-3(i).1 Transamerica Finance Corporation Restated Certificate of Incorporation as filed with the Secretary of State of Delaware on December 12, 1988 (incorporated by reference to Exhibit 3.1 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1988). EX-3(i).2 Transamerica Finance Corporation Certificate of Amendment of Certificate of Incorporation as filed with the Secretary of State of Delaware on February 19, 1991 (incorporated by reference to Exhibit 3.1a to Registrant's Form 10-K Annual Report (File No. 1- 6798) for the year ended December 31, 1990). EX-3(ii) Transamerica Finance Corporation By-Laws, as amended, last amendment - December 12, 1988 (incorporated by reference to Exhibit 3.2 to Registrant's Form 10-K Annual Report (File No. 1- 6798) for the year ended December 31, 1988). EX 4 Indenture dated as of November 1, 1987 between Registrant and Harris Trust and Savings Bank, as Trustee (incorporated by reference to Exhibit 4.2 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1988). EX-10.1 Lease dated October 31, 1984 between Transamerica Occidental Life Insurance Company, as lessor, and Registrant, as lessee, and Addendums thereto dated November 14, 1984 and November 7, 1989 (incorporated by reference to Exhibit 10.1 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1989). EX-10.2 Loan Sales Agreement dated as of November 1, 1990 between Transamerica Financial Services and Transamerica Financial Services Finance Co. (incorporated by reference to Exhibit 10.2 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-10.3.a Corporate Separateness Agreement dated as of December 17, 1990 between Transamerica Financial Services and Transamerica Financial Services Finance Co. (incorporated by reference to Exhibit 10.3.a to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-10.3.b Corporate Separateness Agreement dated as of December 17, 1990 between Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation] and Transamerica Financial Services Finance Co. (incorporated by reference to Exhibit 10.3.b. to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990).EX-10.4 Pooling and Servicing Agreement dated as of November 1, 1990 among Transamerica Financial Services, as servicer, Transamerica Financial Services Finance Co., as seller, and The First National Bank of Chicago, as Trustee (incorporated by reference to Exhibit 2 to Form 8-A Registration Statement re: TFG Home Loan Trust 1990- 1 dated March 26, 1991 - Registration No. 33-36431-01). EX-10.5 Investment Agreement dated December 17, 1990 among Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation], Transamerica Financial Services Finance Co., as seller, and The First National Bank of Chicago, as Trustee (incorporated by reference to Exhibit 2 to Form 8-A Registration Statement re: TFG Home Loan Trust 1990-1 dated March 26, 1991 - Registration No. 33-36431-01). EX-10.6 Guaranty dated July 31, 1990 by Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation], in favor of Corporate Asset Funding Company, Inc. et. al. re: certain obligations of Transamerica Insurance Finance Corporation, California (incorporated by reference to Exhibit 10.6 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-10.7 Guaranty dated July 31, 1990 by Transamerica Finance Group, Inc. [subsequently renamed Transamerica Finance Corporation], in favor of Corporate Asset Funding Company, Inc. et. al. re: certain obligations of Transamerica Insurance Finance Corporation (incorporated by reference to Exhibit 10.7 to Registrant's Form 10-K Annual Report (File No. 1-6798) for the year ended December 31, 1990). EX-12 Computation of Ratio of Earnings to Fixed Charges. EX-23 Consent of Ernst & Young to the incorporation by reference of their report dated February 16, 1994 in the Registrant's Registration Statements on Form S-3, File Nos. 33-40236 and 33- 49763. Pursuant to the instructions as to exhibits, the registrant is not filing certain instruments with respect to long-term debt since the total amount of securities currently authorized under each of such instruments does not exceed 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. The registrant hereby agrees to furnish a copy of any such instrument to the Commission upon request. (b) Reports on Form 8-K filed in the fourth quarter of 1993: A report on Form 8-K was filed on November 19, 1993 relating to the proposed acquisition by the Registrant or one of its subsidiaries of Tiphook plc, a London-based container, trailer, and rail equipment lessor. (c) Exhibits: The response to this portion of Item 14 is submitted as a separate section of this report. (d) Financial Statement Schedules: The response to this portion of Item 14 is submitted as a separate section of this report.SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TRANSAMERICA FINANCE CORPORATION (Registrant) By RAYMOND A. GOLAN (Raymond A. Golan, Vice President and Controller) Date: March 15, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 15, 1994. Signature Title Principal Executive Officer and Director: RICHARD H. FINN Chief Executive Officer and Director - ---------------------------- (Richard H. Finn) Principal Financial Officer and Director: Senior Vice President, Treasurer and DAVID H. HAWKINS Director - ---------------------------- (David H. Hawkins) Principal Accounting Officer: RAYMOND A. GOLAN - ---------------------------- (Raymond A. Golan) Vice President and Controller Directors: - ---------------------------- (David R. Carpenter) Director KENT L. COLWELL - ---------------------------- (Kent L. Colwell) Director EDGAR H. GRUBB - ---------------------------- (Edgar H. Grubb) Director FRANK C. HERRINGER - ---------------------------- (Frank C. Herringer) Director ROBERT R. LINDBERG - ---------------------------- (Robert R. Lindberg) Director ALLEN C. MIECH - ---------------------------- (Allen C. Miech) Director CHARLES E. TINGLEY - ---------------------------- (Charles E. Tingley) Director (THIS PAGE INTENTIONALLY LEFT BLANK) ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14(a)(1) and (2), (c) and (d) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES Year Ended December 31, 1993 TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES LOS ANGELES, CALIFORNIA (THIS PAGE INTENTIONALLY LEFT BLANK) FORM 10-K - ITEM 8, ITEM 14(a)(1) and (2) TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following financial statements of Transamerica Finance Corporation and subsidiaries, together with the report of the independent auditors, are included in Item 8: Report of Independent Auditors Consolidated Balance Sheet -- December 31, 1993 and 1992 Consolidated Statement of Operations -- Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows -- Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Shareholder's Equity -- Years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Management's Discussion and Analysis of the Results of Operations -- Year ended December 31, 1993 Supplementary Financial Information -- Years ended December 31, 1993 and 1992 The following consolidated financial statement schedules of Transamerica Finance Corporation and subsidiaries are included in Item 14(d): VIII - Valuation and Qualifying Accounts -- Years ended December 31, 1993, 1992 and 1991 IX - Short-Term Borrowings -- Years ended December 31, 1993, 1992 and 1991 X - Supplementary Income Statement Information -- Years ended December 31, 1993, 1992 and 1991 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. REPORT OF INDEPENDENT AUDITORS Shareholder and Board of Directors Transamerica Finance Corporation We have audited the accompanying consolidated balance sheet of Transamerica Finance Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and shareholder's equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Transamerica Finance Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note J to the consolidated financial statements, effective January 1, 1991 the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. ERNST & YOUNG Los Angeles, California February 16, 1994, except for Note N, as to which the date is March 15, 1994 See notes to financial statements. TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (dollar amounts in thousands) Note A - Significant Accounting Policies Transamerica Finance Corporation (together with its consolidated subsidiaries, the "Company") is principally engaged in consumer lending, commercial lending and leasing operations. The Company is a wholly owned subsidiary of Transamerica Finance Group, Inc., which is a wholly owned subsidiary of Transamerica Corporation. Certain amounts for prior years have been reclassified to conform with the 1993 presentation. The significant accounting policies followed by the Company and its subsidiaries are: Consolidation - The consolidated financial statements include the accounts of Transamerica Finance Corporation and all its majority owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. The Company's nonvoting preferred stock ownership interest in the distributable earnings of Transamerica Financial Services Finance Co. ("TFSFC"), which is the Company's only significant non-majority owned investee, is accounted for by the equity method after elimination of intercompany transactions (see Note M.) Cash and Cash Equivalents - Cash and cash equivalents include all highly liquid investments with original maturities of three months or less except for such securities held by the Company's credit insurance subsidiaries which are included in investments. Depreciation and Amortization - Property and equipment, which are stated on the basis of cost, are depreciated by use of the straight- line method over their estimated useful lives, which range from eight to 15 years (with residual values of 10% to 20%) for equipment held for lease, three to 10 years for administrative and service equipment, and 20 years for buildings. Other intangible assets, principally renewal, referral and other rights incident to businesses acquired, are amortized over estimated future benefit periods ranging from five to 25 years in proportion to estimated revenues. Goodwill is amortized over 40 years. Foreign Currency Translation - The net assets and operations of foreign subsidiaries included in the consolidated financial statements are attributable to Canadian and European operations. The accounts of these subsidiaries have been converted at rates of exchange in effect at year end as to balance sheet accounts and at average rates for the year as to operations. The effect of changes in exchange rates in translating foreign subsidiaries' financial statements is accumulated in a separate component of shareholder's equity. The effect of transaction gains and losses on the Consolidated Statement of Operations is insignificant for all years presented. Transactions with Affiliates - In the normal course of operations, the Company has various transactions with Transamerica Corporation and certain of its other subsidiaries. In addition to the filing of consolidated income tax returns and the transactions discussed in Notes J and M, these transactions include computer and other specialized services, various types of insurance coverage and pension administration, the effects of which are insignificant for all years presented.Finance Charges - Finance charges, including loan origination fees, offset by direct loan origination costs, are generally recognized as earned on an accrual basis under an effective yield method, except that accrual of finance charges is suspended on accounts that become past due in excess of 29 days in the case of consumer loans or 60 days for commercial loans. At December 31, 1993 and 1992, finance receivables for which the accrual of finance charges was suspended approximated $188,300 and $231,700. Charges collected in advance, including renewal charges, on inventory finance receivables are taken into income on a straight-line basis over the periods to which the charges relate. Allowance for Losses - The allowance for losses is maintained in an amount sufficient to cover estimated uncollectible receivables. Such estimates are based on percentages of net finance receivables outstanding developed from historical credit loss experience and, if appropriate, provision for deviation from historical averages, supplemented in the case of commercial loans by specific reserves for accounts known to be impaired. The allowance is provided through charges against current income. Accounts are charged against the allowance when they are deemed to be uncollectible. When foreclosure proceedings are begun in the case of a real estate secured consumer loan, the account is written down to the estimated realizable value of the collateral if less than the account balance. After foreclosure, repossessed assets are carried at the lower cost or fair value less estimated selling costs and are reclassified to assets held for sale. Additionally, accounts are generally charged against the allowance when no payment has been received for six months for consumer lending and when all avenues for repayment have been exhausted for commercial lending. Leasing Revenues - Leasing revenues include income from operating, finance and sales-type leases. Operating lease income is recognized on the straight-line method over the lease term. Finance lease income, represented by the excess of the total lease receivable (reduced by the amount attributable to contract maintenance) over the net cost of the related equipment, is deferred and amortized over the noncancelable term of the lease using an accelerated method which provides a level rate of return on the outstanding lease contract receivable. Dealer profit on sales-type leases, represented by the excess of the total fair market value of the equipment over its cost or carrying value, is recognized at the inception of the lease. Unearned income is amortized over the term of the lease in the same manner described above. Contract maintenance revenues are credited to income on a straight-line basis over the term of the related leases. Income Taxes - Taxable results of the Company's operations are included in the consolidated federal and certain state income tax returns filed by Transamerica Corporation, which by the terms of a tax sharing agreement generally requires the Company to accrue and settle income tax obligations as if it filed separate returns with the applicable taxing authorities. The Company provides deferred income taxes based on enacted rates in effect on the dates temporary differences between the book and tax bases of assets and liabilities reverse. In 1988, the Company adopted the liability method of accounting for income taxes and the adoption of Financial Accounting Standard No. 109, Accounting for Income Taxes, in 1992 had no effect on the financial statements. New Accounting Standards - In May 1993, the Financial Accounting Standards Board issued a new standard on accounting for impairment of loans which the Company must adopt by the first quarter of 1995. The new standard requires that impaired loans be measured based on either the fair value of the loan, if discernible, the present value of expected cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent. When adopted, the new standard is not expected to have a material effect on the consolidated financial statements of the Company. Also in May 1993, the Financial Accounting Standards Board issued a new standard on accounting for certain investments in debt and equity securities which the Company will adopt in the first quarter of 1994. Under the new standard the Company will report at fair value its investments in debt securities for which the Company does not have the positive intent and ability to hold to maturity. Unrealized gains and losses will be reported on an after tax basis in a separate component of shareholder's equity.When adopted, the new standard is not expected to have a material effect on the consolidated financial statements of the Company. Note B - Investments Investments are summarized as: 1993 1992 ---- ---- Fixed maturities, at amortized cost (market value: $103,035 $ 92,004 $111,621 in 1993 and $97,903 in1992) Equity securities, at market value 765 (cost: $683 in 1992) Short-term investments 7,043 4,933 -------- -------- Total $110,078 $ 97,702 Investments totaling $4,175 at December 31, 1993 and 1992 were on deposit with various states to meet requirements of state insurance and financial codes. In addition, various state insurance codes require that the Company's credit insurance subsidiaries hold an amount equal to their statutory unearned premium reserve ($36,069 and $42,442 at December 31, 1993 and 1992) as cash or in suitable investments for the protection of policyholders. Such assets are not available for distribution until all liabilities on insurance policies have been discharged. There were no unrealized gains or losses on marketable equity securities at December 31, 1993. Note C - Concentration of Risk During the normal conduct of its operations, the Company engages in the extension of credit to homeowners, electronics and appliance dealers, retail recreational product and computer stores, appliance and furniture rental operations and others. The risk associated with that credit is subject to economic, competitive and other influences. While a substantial portion of the risk is diversified, certain operations are concentrated in one industry or geographic area. The Company's finance receivables at December 31, 1993 included $3,046,579, net of unearned finance charges and insurance premiums, of real estate secured loans, principally first and second mortgages secured by residential properties, of which approximately 49% are located in California. The commercial finance receivables portfolio represents lending arrangements with over 120,000 customers. At December 31, 1993, the portfolio included 11 customers with individual balances in excess of $15,000. These accounts represented 9% of commercial gross finance receivables outstanding at December 31, 1993.Note D - Finance Receivables The carrying amounts and estimated fair values of the finance receivable portfolio at December 31, 1993 and 1992 are as follows: 1993 1992 ------------------------ ------------------------ Estimated Estimated Carrying Fair Carrying Fair Value Value Value Value --------- ----------- --------- -------- Fixed rate receivables: Consumer $3,547,210 $4,307,048 $3,478,148 $4,216,770 Commercial 134,040 132,662 144,881 143,927 Variable rate receivables: Commercial 2,390,328 2,390,328 2,371,483 2,371,483 ---------- ---------- ---------- ---------- $6,071,578 $6,830,038 $5,994,512 $6,732,180 ========== ========== ========== ========== The estimated fair values of consumer finance receivables, substantially all of which are fixed rate instalment loans collateralized by residential real estate, and the fixed rate commercial finance loans are based on the discounted value of the future cash flows expected to be received using available secondary market prices for securities backed by similar loans after adjustment for differences in loan characteristics. In the absence of readily available market prices, the expected future cash flows are discounted at effective rates currently offered by the Company for similar loans. For variable rate commercial loans, which comprise the majority of the commercial loan portfolio, the carrying amount represents a reasonable estimate of fair value. Additional information pertaining to finance receivables outstanding follows: Contractual maturities of finance receivables outstanding, before deduction of unearned finance charges and insurance premiums, at December 31, 1993 are: Experience of the Company has shown that a substantial majority of the consumer finance receivables will be renewed or prepaid many months prior to contractual maturity dates. Accordingly, the above schedule is not to be regarded as a forecast of future cash collections. For 1993 and 1992, the ratio for consumer finance receivables of principal cash collections (excluding balances refinanced) to average net finance receivables was 29% and 26%. The commercial lending operation's business credit unit provides revolving lines of credit, letters of credit and standby letters of credit. At December 31, 1993 and 1992, borrowers' unused credit availability under such arrangements totaled $533,781 and $416,200, and the estimated amount the Company would have to pay another financial institution to assume the possible future obligation to fund them was $1,591 and $,2080. Note E - Allowance for Losses Changes in the allowance for losses on finance receivables are: Consumer Commercial Total --------- ----------- -------- Balance at January 1, 1991 $ 88,535 $ 99,402 $ 187,937 Provision charged to income 42,214 245,190 287,404 Receivables charged off (34,920) (177,083) (212,003) Recoveries 1,934 4,469 6,403 Other 422 (2,449) (2,027) --------- ---------- ---------- Balance at December 31, 1991 98,185 169,529 267,714 Provision charged to income 47,985 36,830 84,815 Receivables charged off (44,448) (122,974) (167,422) Recoveries 1,487 5,922 7,409 Other (2,014) (2,138) (4,152) --------- ---------- ---------- Balance at December 31, 1992 101,195 87,169 188,364 Provision charged to income 62,349 31,793 94,142 Receivables charged off (62,524) (51,832) (114,356) Recoveries 1,871 9,122 10,993 Other 422 (173) 249 --------- ---------- ---------- Balance at December 31, 1993 $ 103,313 $ 76,079 $ 179,392 ========= ========== ========== Note F - Commercial Lending Special Charges and Assets Held for Sale The commercial lending operation made a decision late in the fourth quarter of 1991 to exit the rent-to-own finance business, reduce lending to certain asset based lending lines, accelerate disposal of repossessed assets and liquidate receivables remaining from previously sold businesses. As a result of this action, the commercial lending operation recognized a special pretax charge of $200,220 ($130,000 after tax). The $200,220 special charge comprised $137,404 included in the provision for losses on assets held for sale and $62,816 included in the provision for losses on receivables. The $137,404 provision consisted of $117,304 for anticipated losses on disposition of the assets, generally comprising rent-to-own finance receivables and repossessed collateral, including rent-to-own stores, and $20,100 for implementation costs. The 1991 provision for losses on assets held for sale of $141,225 comprises the $137,404 portion of the special charge referred to above plus an additional provision of $3,821. In 1993, an additional provision of $50,000,000 ($35,960 after tax) was made to reduce the net carrying value of repossessed rent-to-own stores to their estimated realizable value. Assets held for sale are: 1993 1992 ---- ---- Consumer: Repossessed residential properties $137,455 $ 89,405 Other repossessed assets 1,746 2,787 -------- -------- 139,201 92,192 Less valuation allowance 2,547 2,206 -------- -------- 136,654 89,986 -------- -------- Commercial: Rent-to-own finance receivables 120,469 179,013 Repossessed rent-to-own stores 107,227 103,418 Other repossessed assets 19,403 30,633 -------- -------- 247,099 313,064 Less valuation allowance 156,985 121,549 -------- -------- 90,114 191,515 -------- -------- Total $226,768 $281,501 ======== ======== Note G - Debt Debt consists of: 1993 1992 ----- ----- Unsubordinated Short-term debt: Commercial paper $3,585,249 $2,748,766 Other 84,644 64,342 ---------- ---------- 3,669,893 2,813,108 Less classified as long-term debt 2,505,000 2,813,108 ---------- ---------- Total unsubordinated short-term debt 1,164,893 -- ---------- ---------- Long-term debt: Short-term debt supported by noncancelable credit agreements 2,505,000 2,813,108 4.48% to 9.10% notes and debentures due 1994 to 2002 2,323,110 2,673,847 Loans due to Transamerica Corporation and its subsidiaries, at various interest rates, maturing through 1994 67,491 101,376 Zero to 6.50% notes and debentures due 1994 to 2012 issued at a discount to yield 13.80% to 13.88%; with benefit from deferred taxes, effective cost of 8.79% to 12.35%; maturity value of $722,760 274,884 444,200 ---------- ---------- Total unsubordinated long-term debt 5,170,485 6,032,531 ---------- ---------- Total unsubordinated debt 6,335,378 6,032,531 ---------- ---------- Subordinated 6.75% to 12.75% notes due 1994 to 2003 696,125 557,045 ---------- ---------- Total debt $7,031,503 $6,589,576 ========== ========== The estimated fair value of debt, using rates currently available for debt with similar terms and maturities, at December 31, 1993 and 1992 was $7,407,000 and $6,805,000. In 1993, the Company redeemed $125,000 of deep discount long-term debt with a book value of $90,710, which resulted in a $23,084 extraordinary loss, after related taxes of $11,447. Commercial paper notes are issued for maturities up to 270 days in the U.S. and 365 days in Canada. At December 31, 1993, $200,000 of the outstanding commercial paper, which matured January 24, 1994, was held by Transamerica Corporation. In support of its commercial paper operations, bank credit lines aggregating $721,814 at December 31, 1993 were available to the Company, $75,000 of which were also available to Transamerica Corporation. At December 31, 1993, all borrowings under these lines were made by the Company and amounted to $240,927, of which $156,283 is long-term. In support of the short-term debt classified as long-term debt at December 31, 1993, the Company has unsubordinated noncancelable credit agreements totaling $3,433,000 with 55 banks, of which $2,505,000 matures after one year. Fees are paid on the average unused commitment. The Company uses interest rate exchange agreements to hedge the interest rate sensitivity of its outstanding indebtedness. Certain of these agreements call for the payment of fixed rate interest by the Company in return for the assumption by other contracting parties of the variable rate cost. At December 31, 1993, such agreements covering the notional amount of $214,400 at a weighted average fixed interest rate of 8.25% expiring through 1999 and $840,000 of one year agreements expiring in 1994 with an average interest rate of 3.78% were outstanding. Additionally at December 31, 1993, exchange agreements covering the notional amount of $216,000 expiring through 1997 were outstanding, in which the Company receives interest from other contracting parties at a weighted average fixed interest rate of 6.98% and pays interest at variable rates to those parties. While the Company is exposed to credit risk in the event of nonperformance by the other party, nonperformance is not anticipated due to the credit rating of the counter parties. At December 31, 1993, the interest rate exchange agreements are with banks rated A or better by one or more of the major credit rating agencies.The estimated fair value of the interest rate exchange agreements, determined on a net present value basis, at December 31, 1993 and 1992 was a negative $5,320 and $9,067. The fair value represents the estimated amount that the Company would be required to pay to terminate the exchange agreements, taking into account current interest rates. Long-term debt outstanding at December 31, 1993, other than the $2,505,000 supported by noncancelable credit agreements, matures as follows: Unsubordinated Subordinated Total -------------- ------------- ------------ 1994 $ 900,056 $113,350 $1,013,406 1995 703,414 40,000 743,414 1996 469,813 79,195 549,008 1997 198,900 87,100 286,000 1998 196,005 235,480 431,485 Thereafter 197,297 141,000 338,297 ---------- -------- ----------- $2,665,485 $696,125 $3,361,610* ========== ======== =========== *Includes the accreted values at December 31, 1993 on original issue discount debt and not the amount due at maturity. Interest payments, net of amounts received from interest rate exchange agreements, totaled $513,541 in 1993, $558,997 in 1992 and $481,200 in 1991. Note H - Dividend and Other Restrictions Consolidated equity is restricted by the provisions of debt agreements. At December 31, 1993, $180,127 was available for dividends and other stock payments. Under certain circumstances, the provisions of loan agreements and statutory requirements place limitations on the amount of funds which can be remitted to the Company by its consolidated subsidiaries. Of the net assets of the Company's consolidated subsidiaries, as adjusted for intercompany account balances, at December 31, 1993, $51,985 is so restricted. Note I - Income Taxes The provision for income taxes comprises: 1993 1992 1991 Current taxes: Federal $41,544 $ 95,239 $ 13,606 State 15,427 18,391 20,368 Foreign 88 (14,637) 12,722 ------- -------- -------- 57,059 98,993 46,696 ------- -------- -------- Deferred taxes Federal 32,461 588 (53,963) State 5,034 6,533 (8,443) Foreign 803 14,938 (14,378) ------- -------- -------- 38,298 22,059 (76,784) ------- -------- -------- Total income taxes (benefit) $95,357 $121,052 $(30,088) ======= ======== =========The difference between federal income taxes computed at the statutory rate and the total provision for income taxes is: 1993 1992 1991 --------- -------- ------- Federal income taxes (benefit) at statutory rate $76,967 $96,467 $(42,024) State income taxes, net of federal income tax benefit 13,986 16,449 7,953 Book and tax basis difference of assets acquired 2,999 5,026 6,341 Settlement of disputed items (4,224) Dividends from affiliates (663) (2,109) Other 5,629 3,773 (249) -------- -------- --------- Total income taxes (benefit) $95,357 $121,052 $ (30,088) ======= ======== ========= Deferred tax liabilities (assets) are comprised of the following at December 31: 1993 1992 ---- ---- Depreciation $197,196 $190,462 Amortization of bond discount and interest 66,071 65,380 Direct finance and sales type leases 7,865 34,134 Insurance reserves and acquisition costs 9,698 7,785 Other 35,475 10,410 -------- -------- Gross deferred tax liabilities 316,305 308,171 -------- -------- Allowances for losses on finance receivables and other assets (113,331) (104,221) Post employment benefits other than pensions (8,166) (8,343) Net operating loss and foreign tax credit carryforwards (10,683) (33,263) Other (15,993) (21,855) -------- -------- Gross deferred tax assets (148,173) (167,682) -------- -------- Net deferred tax liability $168,132 $140,489 ======== ======== Pretax income (loss) from foreign operations totaled $4,236 in 1993, $4,332 in 1992 and $(25,960) in 1991. Income tax payments totaled $77,089 in 1993, $92,190 in 1992 and $27,802 in 1991. Note J- Pension and Stock Savings Plans and Other Post Employment Benefits The Company participates in the Retirement Plan for Salaried Employees of Transamerica Corporation and Affiliates (the pension plan). The pension plan is a noncontributory defined benefit plan covering substantially all employees. Pension benefits are based on the employee's compensation during the highest paid 60 consecutive months during the 120 months before retirement. Pension costs are allocated to the Company based on the number of participants. The Company also participates in the Transamerica Corporation Employee Stock Savings Plan (the 401(k) plan). The 401(k) plan is a contributory defined contribution plan covering eligible employees who elect to participate. Currently, the Company matches 75 cents for every dollar contributed up to six percent of eligible compensation. The Company matching portion is always invested in Transamerica Corporation common stock. Employees are 25% vested in the matching contributions after three years, 50% vested after four years and 100% vested after five years of service. The Company's total costs for both the pension plan and the 401(k) plan were $9,163 in 1993, $7,913 in 1992 and $9,045 in 1991. The Company also participates in various programs sponsored by Transamerica Corporation that provide medical and certain other benefits to eligible retirees. Effective January 1, 1991, Transamerica Corporation and its subsidiaries elected early adoption of FASB Statement No. 106 on accounting for post employment benefits other than pensions. Adoption of the statement increased the Company's loss before the cumulative effect of the accounting change and net loss for the year ended December 31, 1991 by $377 and $11,252.Note K - Commitments and Contingencies The Company and its subsidiaries have noncancelable lease agreements expiring mainly through 1998. These agreements are principally operating leases for facilities used in the Company's operations. Total rental expense amounted to $54,799 in 1993, $60,286 in 1992 and $62,899 in 1991. Contingent liabilities arising from litigation, income taxes and other matters are not considered material in relation to the consolidated financial position of the Company and its subsidiaries. Note L - Business Segment Information Business segment information is: Note M - Transactions With Affiliates On November 1, 1990, the Company sold without recourse a pool of real estate secured receivables to TFSFC for cash of $547,655 plus interest of $9,661 to the closing date of December 17, 1990. The purchase price, which represented the fair value of the receivables sold, was based on an independent appraisal. For financial reporting purposes, the intercompany gain on this sale has been deferred and is being amortized to income as a component of the Company's equity in the distributable earnings of TFSFC. TFSFC subsequently securitized and sold to outside investors a $430,000 participation interest in the receivable pool. The Company continues to service these receivables for a fee. The Company has entered into an agreement whereby it directs the investment of excess funds in the pool pending their distribution and guarantees that such funds will be invested at a certain minimum rate, currently 9.25%. Investments in and advances to affiliates consist of the following at December 31: 1993 1992 ---- ---- Preferred stock of TFSFC $ 72,946 $ 82,665 Unamortized deferred gain on sale of (18,729) (31,571) receivables to TFSFC Unsecured receivable from BWAC Twelve, 308,858 238,595 Inc. Unsecured receivable from Transamerica HomeFirst, Inc. 7,937 551 -------- -------- $371,012 $290,240 ======== ======== The receivables from BWAC Twelve, Inc. and Transamerica HomeFirst, Inc. are payable on demand and bear interest at a rate that varies based on the Company's average cost of borrowings. The weighted average interest rate was 4.21% in 1993, 4.04% in 1992 and 7.18% in 1991. Under the terms of certain debt agreements, the Company may maintain investments in and advances to affiliates up to $649,621 at December 31, 1993. Income from affiliates comprises the following for the years ended December 31: 1993 1992 1991 ---- ---- ---- Interest income $11,572 $13,486 $14,299 Servicing fees 833 861 866 Amortization of deferred gain and equity in earnings of TFSFC 5,616 6,901 14,359 ------- ------- ------- $18,021 $21,248 $29,524 ======= ======= ======= Note N - Subsequent Event On March 15, 1994, the Company completed the purchase of substantially all of the assets of the container rental division of Tiphook plc for approximately $1,100,000 in cash. TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF THE RESULTS OF OPERATIONS The following table sets forth revenues and income by line of business for the periods indicated (in thousands): Income (Loss) Before Revenues Extraordinary Item ------------------ --------------------- 1993 1992 1993 1992 ------- -------- ------- ------- Consumer lending $651,218 $654,078 $91,742 $99,210 Commercial lending 333,297 356,275 (12,775) 17,938 Leasing 407,774 420,512 53,641 58,068 Other operations (163) 18 1,931 (888) Amortization of goodwill (11,658) (11,656) ---------- ---------- --------- --------- Total $1,392,126 $1,430,883 $122,881 $162,672 ========== ========== ======== ======== The following discussion should be read in conjunction with the information presented under Item 1, Business. Consumer Lending Consumer lending income, before the amortization of goodwill, in 1993 decreased $7,468,000 (8%) from 1992. The decrease was principally due to increased operating expenses, an increased provision for losses on receivables and lower revenues that more than offset lower interest expense and a $5,269,000 benefit included in operating expenses from a reversal of reserves related to a 1990 sales of receivables to Transamerica Financial Services Finance Co. which subsequently were securitized. Revenues in 1993 decreased $2,860,000 (%) from 1992 principally because of lower income from affiliates and servicing fees related to the run off of the receivables that Transamerica Financial Services Finance Co. securitized in 1990 and lower fees due to reduced volume of real estate secured loans. Operating expenses increased in 1993 mainly due to investments in new branches and losses on the disposal of repossessed assets. With the adoption in the fourth quarter of 1992 of a required new accounting rule, losses on the disposal of repossessed assets, which were $5,952,000 for 1993 and $3,021,000 in the fourth quarter of 1992, were classified as operating expenses rather than as credit losses. Data for periods prior to the fourth quarter of 1992 have not been reclassified. The provision for losses on receivables increased $14,364,000 (30%) in 1993 over 1992 due to increased credit losses. Credit losses, net of recoveries, as a percentage of average consumer finance receivables outstanding, net of unearned finance charges and insurance premiums, were 1.67% in 1993 compared to 1.22% in 1992. Credit losses increased partly due to continued sluggishness in the domestic economy and a weak California real estate market. Interest expense declined $24,449,000 (9%) in 1993 from 1992 due to a lower average interest rate which more than offset the effect of higher borrowings due to increased average receivables outstanding. Net consumer finance receivables outstanding increased $71,180,000 (2%) in 1993. Net consumer finance receivables at December 31, 1993 included $3,046,579 of real estate secured loans, principally first and second mortgages secured by residential properties, of which approximately 49% are located in California. Company policy generally limits the amount of cash advanced on any one loan, plus any existing mortgage, to between 70% and 80% (depending on location) of the appraised value of the mortgaged property, as determined by qualified independent appraisers at the time ofloan origination. Delinquent real estate secured loans, which are defined as loans contractually past due 60 days or more, totaled $59,767 (1.86% of total real estate secured loans outstanding) at December 31, 1993 compared to $60,211,000 (1.84% of total real estate secured loans outstanding) at December 31, 1992. Management has established an allowance for losses equal to 2.83% of net consumer finance receivables outstanding at December 31, 1993 and 1992. Generally, by the time an account secured by residential real estate becomes past due 90 days, foreclosure proceedings have begun, at which time the account is moved from finance receivables to other assets and is written down to the estimated realizable value of the collateral if less than the account balance. After foreclosure, repossessed assets are carried at the lower of cost or fair value less estimated selling costs and are reclassified to assets held for sale. Accounts in foreclosure and repossessed assets held for sale totaled $214,665,000 at December 31, 1993 compared to $176,054,000 at December 31, 1992. The increase primarily reflects increased repossessions in California and longer disposal times due to its weak real estate market. Commercial Lending Commercial lending results, before the amortization of goodwill and a $23,084,000 after tax extraordinary loss on the early extinguishment of $125,000,000 deep discount long-term debt in 1993, were a a loss of $12,775,000 for 1993 compared to income in 1992 of $17,938,000. The 1993 loss was due primarily to the inclusion of a $50,000,000 ($35,960,000 after tax) provision to reduce the net carrying value of repossessed rent-to-own stores to their estimated realizable value. Information received during the year from prospective buyers of the repossessed rent-to-own stores held for sale indicated that the realizable value of the business had declined below its carrying value. The 1993 results also included an $8,799,000 after tax charge for the restructuring of the commercial lending unit's infrastructure, a $4,224,000 after tax provision for anticipated legal and other costs associated with the runoff of the liquidating portfolios and a $4,224,000 tax benefit from the resolution of prior years' tax matters. Excluding the aforementioned items, commercial lending income, before the amortization of goodwill and the extraordinary loss on the early extinguishment of debt, increased $14,046,000 (78%) in 1993 over 1992. This improvement was primarily due to lower operating expenses, a lower provision for losses on receivables and stronger margins brought about by the declining interest rate environment. The interest rates at which commercial lending borrows funds for its businesses have moved more quickly than the rates at which it lends to its customers. As a result, margins have been enhanced by the declining interest rate environment. Revenues in 1993 decreased $22,978,000 (6%) from 1992 primarily as a result of reduced yields attributable to the current low interest rate environment. Interest expense declined $25,459,000 (19%) in 1993 from 1992 as a result of lower average interest rates. Operating expenses increased $14,127,000 (9%) during 1993 over 1992 due to the restructuring charge and provision for anticipated legal and other costs associated with the runoff of the liquidating portfolios described above, aggregating $21,500,000, partially offset by cost reduction efforts in the inventory finance and business credit core businesses. The provision for losses on receivables in 1993 was $5,037,000 (14%) less than in 1992 primarily due to lower credit losses. Credit losses, net of recoveries, as a percentage of average commerical finance receivables outstanding, net of unearned finance charges, were 1.64% in 1993 compared to 4.53% in 1992. Credit losses declined in 1993 primarily due to lower losses in the liquidating portfolios. In March 1992, the commercial lending operation purchased for cash a business credit portfolio consisting of twelve manufacturer/distributor accounts with a net outstanding balance of $134,000,000. Net commercial finance receivables outstanding decreased $3,086,000 (%) from December 31, 1992. Growth in the inventory finance portfolio was more than offset by a decline in the liquidating and business credit portfolios. Management has established an allowance for credit losses equal to 2.93% of net commercial finance receivables outstanding as of December 31, 1993 compared to 3.35% at December 31, 1992. Effective in 1993, the policies used for the determination of delinquent and nonearning receivables have been revised to provide greater consistency among the company's receivable portfolios. It is management's view that the new methodology provides a better and more meaningful assessment of the condition of the portfolio. Delinquent receivables, which were generally defined as financed inventory sold but unpaid 30 days or more, the portion of business credit loans in excess of the approved lending limit and all other receivable balances contractually past due 60 days or more, are now defined as the instalment balance for inventory finance and business credit receivables and the receivable balance for all other receivables over 60 days past due. Nonearning receivables, which were defined as receivables from borrowers in bankruptcy or litigation and other accounts for which full collectibility was doubtful, are now defined as receivables from borrowers that are over 90 days delinquent or at such earlier time as full collectibility becomes doubtful. At December 31, 1993, delinquent receivables were $26,940,000 (1.02% of receivables outstanding) and nonearning receivables were $31,763,000 (1.20% of receivables outstanding). At December 31, 1992, delinquent receivables were $63,384,000 (2.38% of receivables outstanding) and nonearning receivables were $90,919,000 (3.42% of receivables outstanding). Delinquency and nonearning data as of December 31, 1992 has not been restated. Assets held for sale as of December 31, 1993 totaled $90,114,000, net of a $156,985,000 valuation allowance, and consisted of rent-to-own finance receivables of $120,469,000, repossessed rent-to-own stores of $107,227,000 and other repossessed assets of $19,403,000. Assets held for sale at December 31, 1992 totaled $191,515,000, net of a $121,549,000 valuation allowance, and comprised rent-to-own finance receivables of $179,013,000, repossessed rent-to-own stores of $103,418,000 and other repossessed assets of $30,633,000. At December 31, 1993, $27,489,000 of the rent-to-own finance receivables were classified as both delinquent and nonearning. At December 31, 1992, delinquent rent-to-own finance receivables were $15,397,000 and nonearning rent-to-own finance receivables were $32,615,000. Delinquency and nonearning data as of December 31, 1992 has not been restated. Leasing Leasing income, before the amortization of goodwill, decreased $4,427,000 (8%) in 1993 due primarily to an additional tax provision of $4,300,000 caused by the revaluation of deferred income tax liability for the 1993 federal tax rate increase. Excluding the additional tax provision, results for 1993 were comparable to 1992 as higher fleet utilization and per diem rates in the rail trailer business, a larger finance lease portfolio and a larger fleet of refrigerated containers were offset by a decline in standard container utilization. In November 1992, the company sold its domestic over-the-road trailer business. Proceeds from the sale totaled $191,000,000 and resulted in no gain or loss. Revenues for 1993 decreased $12,738,000 (3%) from 1992. The decline was mainly due to the sale of the domestic over-the-road trailer business in November 1992 and a decline in standard container utilization. The decrease was partially offset by higher fleet utilization and per diem rates in the rail trailer business, an increased finance lease portfolio, and a larger fleet of standard containers, refrigerated containers and European trailers. Expenses decreased $12,135,000 (4%) in 1993 from 1992 due to the sale of the domestic over-the-road trailer business. The decrease was partially offset by higher ownership cost due to a larger fleet. The combined utilization of standard containers, refrigerated containers, domestic containers, tank containers and chassis averaged 83% in 1993 compared to 85% in 1992. Rail trailer utilization was 91% in 1993 compared to 84% in 1992. European trailer utilization was 89% in 1993 compared to 84% in 1992. The company's standard container, refrigerated container, domestic container, tank container and chassis fleet of 316,000 units increased by 36,000 units (13%) in 1993. The rail trailer fleet of 36,500 units increased by 2,100 units (6%) in 1993. At December 31, 1993, the company also operated a fleet of 3,800 over-the-road trailers in Europe. Other Operations The other operations represent principally unallocated interest expense and certain financing activities of Transamerica Equipment Leasing Company, Inc. which are not related to the leasing operations of Transamerica Leasing Inc. and are therefore not combined with such operations. TRANSAMERICA FINANCE CORPORATION AND SUBSIDIARIES Financial Statement Schedules

52477_1993.txt

52477

1993

ITEM 3. LEGAL PROCEEDINGS Incorporated by reference from the Annual Report, page 18, section entitled "Notes to Consolidated Financial Statements," at note "J. Commitments and Contingencies." ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of IBP's security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Age at Positions With IBP and January 26, Five-Year Employment Name 1994 History Richard L. Bond 46 Group Vice President -- Beef Sales and Marketing since 1989; 1982-1989, Vice President -- Boxed Beef Sales and Marketing Kenneth W. Browning, Jr. 45 Senior Vice President - Hide Division since 1989; 1982-1989, Vice President-Hides Lonnie O. Grigsby 54 Executive Vice President -- Finance & Administration since 1988; Secretary since 1985; General Counsel 1985- 1990 and since 1993; 1987- 1988, Senior Vice President; 1985-1987, Vice President David C. Layhee 49 Group Vice President -- Design Products since 1989; 1983-1989, Group Vice President -- Sales & Marketing Eugene D. Leman 51 Director since 1989; Executive Vice President -- Pork Division since 1986; 1981-1986, Group Vice President -- Pork Division James V. Lochner 41 Senior Vice President - Technical Services since 1993; 1989- 1993, Vice President--Technical Services; 1986-1989, Assistant Vice President-Quality Control--Beef; 1984-1986, Director- Quality Control Robert L. Peterson 61 Chairman of the Board of Directors since 1982; Chief Executive Officer since 1980; President since 1977; Director since 1976 Kenneth L. Rose 49 Senior Vice President -- Logistics Services since 1989; 1982-1989, Vice President-Transportation PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated by reference from Annual Report, page 13, section entitled "Consolidated Statements of Stockholders' Equity"; from page 19, section entitled "Notes to Consolidated Financial Statements," at note "K. Quarterly Financial Data (Unaudited)"; and from page 21, section entitled "Stockholders and Market Data." Those pages incorporated by reference from the Annual Report are part of the exhibits to this Form 10-K. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference from Annual Report, page 22, section entitled "Selected Financial Data." ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference from the Annual Report, pages 20-21, section entitled "Management's Discussion and Analysis." ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated by reference from the Annual Report, pages 8-19, sections entitled "Report of Independent Accountants", "Consolidated Financial Statements," and "Notes to Consolidated Financial Statements." ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Incorporated by reference from the Proxy Statement, page 17, section entitled "INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS." (Reference is made to the Report on Form 8-K dated September 14, 1992 and filed September 16, 1992.) PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference from the Proxy Statement, pages 3-5, section entitled "ELECTION OF DIRECTORS" and reference is also made to the information regarding executive officers set forth in "EXECUTIVE OFFICERS OF THE REGISTRANT" in Part I of this report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from the Proxy Statement, pages 8-11, section entitled "SUMMARY COMPENSATION TABLE"; "OPTION GRANTS TABLE", "AGGREGATED OPTION EXERCISES AND YEAR-END OPTION VALUE TABLE" and "PERFORMANCE GRAPH" and from page 5, section entitled "ELECTION OF DIRECTORS," subsection "Information Regarding Director's Compensation." ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the Proxy Statement, pages 2 and 6, sections entitled "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" and "SECURITY OWNERSHIP OF MANAGEMENT." ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from the Proxy Statement, pages 4-5, sections entitled "ELECTION OF DIRECTORS," subsection "Information Regarding the Board of Directors and its Committees" and from page 8, section entitled "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISIONS." PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this report. The following financial information is incorporated by reference from the Annual Report, as identified below, or is found in this report. 1. Consolidated Financial Location Statements Reports of Independent Accountants Annual Report, page 8 and pages 16-17 of this report Consolidated Statements of Earnings Annual Report, page 9 Consolidated Balance Sheets Annual Report, pages 10-11 Consolidated Statements of Cash Flows Annual Report, page 12 Consolidated Statements of Stockholders' Equity Annual Report, page 13 Notes to Consolidated Financial Statements Annual Report, pages 14-19 2. Financial Statement Schedules Reports of Independent Accountants on Financial Statement Schedules Schedule V Property, Plant and Equipment Schedule VI Accumulated Depreciation of Property, Plant and Equipment Schedule VIII Valuation and Qualifying Accounts and Reserves Schedule IX Short-Term Borrowings All other schedules are omitted because they are not applicable or not required. 3. Exhibits 3.1* Restated Certificate of Incorporation of IBP (filed as Exhibit No. 2A to IBP's Registration Statement on Form 8-A, dated March 9, 1988, File No. 1-6085). 3.2* By-laws of IBP (filed as Exhibit No. 2B to IBP's Registration Statement on Form 8-A, dated March 9, 1988, File No. 1-6085). 10.5* IBP's 1987 Stock Option Plan (filed as Exhibit No. 28(a) to IBP's Registration Statement on Form S-8, January 5, 1988, File No. 33-19441). (Executive Compensation Plan) 10.5.1* Form of Stock Option Agreement (10/1/87) (filed as Exhibit No. 28(b) to IBP's Registration Statement on Form S-8, dated January 5, 1988, File No. 33-19441). 10.5.2* Form of Stock Option Agreement (12/31/87) (filed as Exhibit No. 28(c) to IBP's Registration Statement on Form S-8, dated January 5, 1988, File No. 33-19441). 10.5.3 IBP Officer Long-Term Stock Plan 10.5.4 IBP Directors Stock Option Plan 10.5.5 IBP 1993 Stock Option Plan 10.19* Note Agreement for 9.82% Senior Notes Due September 15, 2000, dated as of September 26, 1990 between IBP, inc. and various lenders (filed as Exhibit No. 10.19 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 29, 1990, File No. 1-6085). 10.20* Debenture Purchase Agreement for 10.39% Senior Subordinated Debentures due September 15, 2002, dated September 26, 1990 between IBP, inc. and various lenders (filed as Exhibit No. 10.20 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 29, 1990, File No. 1-6085). 10.21* Credit Agreement (Revolving/Term Credit Facility) dated as of November 13, 1990 between IBP, inc. and various lenders with First Bank National Association as Administrative Agent and Bank of America National Trust and Savings Association as Co-Agent (filed as Exhibit No. 10.21 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 29, 1990, File No. 1-6085). 10.22* Credit Agreement (Short-Term Revolving Credit Facility) dated as of November 13, 1990 between IBP, inc. and various lenders with First Bank National Association as Administrative Agent (filed as Exhibit No. 10.22 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 29, 1990, File No. 1-6085). 10.23* Intercompany Agreement, dated as of September 4, 1991 between IBP and Occidental Petroleum Corporation (filed as Exhibit No. 10.23 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 28, 1991, File No. 1-6085). 10.24* Employment Agreement, dated as of October 9, 1992, between IBP and Lonnie O. Grigsby (filed as Exhibit No. 10.24 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 26, 1992, File No. 1-6085). 10.25* Employment Agreement, dated as of October 9, 1992, between IBP and Perry V. Haines (filed as Exhibit 10.25 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 26, 1992, File No. 1-6085). 10.26* Employment Agreement, dated as of October 9, 1992, between IBP and Eugene D. Leman (filed as Exhibit 10.26 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 26, 1992, File No. 1-6085). 10.27* Employment Agreement, dated as of October 9, 1992, between IBP and David C. Layhee (filed as Exhibit 10.27 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 26, 1992, File No. 1-6085). 10.28* Text of Retirement Income Plan of IBP, inc. (As Amended and Restated Effective as of January 1, 199 as amended. (Executive Compensation Plan) (filed as Exhibit No. 10.28 to the Annual Report on Form 10-K of IBP for the fiscal year ended December 26, 1992, File No. 1-6085). 10.29 Employment Agreement, effective January 1, 1993, between IBP and Dale Tinstman. 11. Statement regarding computation of earnings per share. 13. Those pages incorporated by reference from the 1993 Annual Report to Stockholders. 21. Subsidiaries of IBP, inc. as of December 25, 1993. 22.* Matters submitted to vote of security holders (filed as Item 4 to the Quarterly Report on Form 10-Q for the 26 weeks ended June 26, 1993, File No. 1-6085). 23.1 Consent of Independent Public Accountants. __________________ * Incorporated herein by reference (b) Reports on Form 8-K Not Applicable. (c) Other Matters With the exception of the information expressly referenced and thereby incorporated in ITEMS 3, 5, 6, 7 and 8, the Annual Report is not to be deemed "filed" with the Securities and Exchange Commission or otherwise subject to the liabilities of Section 18 of the Securities and Exchange Act of 1934. For the purpose of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, IBP hereby undertakes as follows, which undertaking shall be incorporated by reference into IBP's Registration Statement on Form S-8 No. 33-19441 (filed January 5, 1988): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of IBP pursuant to the foregoing provisions, or otherwise, IBP has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by IBP of expenses incurred or paid by a director, officer or controlling person of IBP in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, IBP will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of IBP, inc. Our audit of the consolidated financial statements referred to in our report dated February 4, 1994 appearing on page 8 of the 1993 Annual Report to Stockholders of IBP, inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules at December 25, 1993 and December 26, 1992 and for the years then ended listed in Item 14(a)2 of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse(signature on file) PRICE WATERHOUSE Chicago, Illinois February 4, 1994 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders IBP, inc. Dakota City, Nebraska We have audited the accompanying IBP, inc. and subsidiaries consolidated statements of earnings, stockholders' equity and case flows for the year ended December 28, 1991. Our audit also included the financial statement schedules for the related period listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, IBP, inc. and subsidiaries results of operations and cash flows for the year ended December 28, 1991, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche(signature on file) DELOITTE & TOUCHE Omaha, Nebraska February 7, 1992 IBP, inc. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Fiscal Years 1991, 1992 and 1993 (In thousands) Land Buildings and Land and Contruction Improvements Stockyards Equipment in Progress Total Balance, December 29, 1990 $61,048 $258,170 $575,552 $23,262 $918,032 Additions, at cost 2,966 11,160 20,457 (6,994) 27,589 Retirements (384) (101) (7,887) - (8,372) Other changes (63) (2,670) (9,568) - (12,301) ------ ------- ------- ------ --------- Balance, December 28, 1991 63,567 266,559 578,554 16,268 924,948 Additions, at cost 402 6,454 27,732 923 35,511 Retirements (643) (623) (22,456) - (23,722) Other changes 221 138 (759) - (400) ------ ------- ------- ------ --------- Balance, December 26, 1992 63,547 272,528 583,071 17,191 936,337 Additions, at cost 2,452 3,666 30,675 23,007 59,800 Retirements (607) (1,199) (11,781) - (13,587) Cumulative effect of accounting change (1) 6,336 32,068 65,126 - 103,530 Other changes 1,350 6,698 1,918 - 9,966 ------ ------- ------- ------ --------- Balance, December 25, 1993 $73,078 $313,761 $669,009 $40,198 $1,096,046 ====== ======= ======= ====== ========= (1) Adjustment to fair value from net-of-tax value related to IBP's acquisition in 1981 as required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," which IBP adopted in fiscal 1993. IBP, inc. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT Fiscal Years 1991, 1992 and 1993 (In thousands) Land Buildings and Land and Improvements Stockyards Equipment Total Balance, December 29, 1990 $21,239 $44,210 $239,635 $305,084 Additions charged to costs and expenses 3,506 7,668 44,458 55,632 Retirements (52) (28) (5,648) (5,728) Other changes (57) (1,428) (5,866) (7,351) ------ ------ -------- ------- Balance, December 28, 1991 24,636 50,422 272,579 347,637 Additions charged to costs and expenses 2,759 7,530 43,077 53,366 Retirements (596) (270) (17,498) (18,364) Other changes 252 (175) (579) (502) ------ ------ ------- ------- Balance, December 26, 1992 27,051 57,507 297,579 382,137 Additions charged to costs and expenses 2,724 7,521 39,321 49,566 Retirements (476) (489) (9,351) (10,316) Cumulative effect of accounting change (1) 5,021 10,380 64,758 80,159 Other changes 449 4,320 950 5,719 ------ ------ ------- ------- Balance, December 25, 1993 $34,769 $79,239 $393,257 $507,265 ====== ====== ======= ======= (1) Adjustment to fair value from net-of-tax value related to IBP's acquisition in 1981 as required by Statement of Financial Accounting Standards No. 109,"Accounting for Income Taxes," which IBP adopted in fiscal 1993. IBP, inc. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Fiscal Years 1991, 1992 and 1993 (In thousands) Allowance Accumulated for Doubtful Amortization Accounts of Goodwill Balance, December 29, 1990 $4,778 $72,093 Amounts (credited) charged to costs and expenses (989) 7,686 Recoveries of amounts previously written off 9 - Write-off of uncollectible accounts (744) - ----- ------ Balance, December 28, 1991 3,054 79,779 Amounts charged to costs and expenses 451 7,686 Recoveries of amounts previously written off 45 - Write-off of uncollectible accounts (550) - ----- ------ Balance, December 26, 1992 3,000 87,465 Amounts charged to costs and expenses 1,535 7,779 Recoveries of amounts previously written off 27 - Write-off of uncollectible accounts (364) - ----- ------ Balance, December 25, 1993 $4,198 $95,244 ===== ====== IBP, inc. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS Fiscal Years 1991, 1992 and 1993 (In thousands) Weighted Average Maximum Average Weighted Category of Balance Interest Amount Amount Average Aggregate at End Rate at Outstanding Outstanding Interest Short-Term of End of During the During the Rate During Borrowings Period Period Period Period the Period (A) (B) (A,C) For the year ended December 28, 1991: Notes payable to banks $25,000 5.5% $206,000 $148,890 6.6% For the year ended December 26, 1992: Notes payable to banks 6,000 3.3% 174,000 110,231 4.2% For the year ended December 25, 1993: Notes payable to banks - - 137,000 55,687 3.4% NOTES: (A) Interest rate computed on a 360-day basis. (B) Average computed using daily balances. (C) (Short-term interest expense/weighted average short-term borrowings) x 360/364. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. IBP, inc. By: /s/Robert L. Peterson Robert L. Peterson Chairman of the Board, President and Chief Executive Officer Date: March 23, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title Date /s/Robert L. Peterson Chairman of the Board March 23, 1994 Robert L. Peterson President and Chief Executive Officer (principal executive officer) /s/Lonnie O. Grigsby Executive Vice March 23, 1994 Lonnie O. Grigsby President - Finance and Administration (principal financial officer) /s/Craig J. Hart Controller March 23, 1994 Craig J. Hart /s/John S. Chalsty Director March 23, 1994 John S. Chalsty /s/Alec P. Courtelis Director March 23, 1994 Alec P. Courtelis /s/Wendy L. Gramm Director March 23, 1994 Wendy L. Gramm /s/Eugene D. Leman Director March 23, 1994 Eugene D. Leman /s/JoAnn R. Smith Director March 23, 1994 JoAnn R. Smith /s/Dale C. Tinstman Director March 23, 1994 Dale C. Tinstman EXHIBIT INDEX Exhibit Number Description Sequentially Numbered Page Exhibit 10.5.3 IBP Officer Long Term Stock Plan Exhibit 10.5.4 IBP Director Stock Option Plan Exhibit 10.5.5 IBP 1993 Stock Option Plan Exhibit 10.29 Employment Agreement, dated January 1, 1993, between IBP and Dale Tinstman Exhibit 11 Statement regarding computation of earnings per share. Exhibit 13 1993 Annual Report to Stockholders. Exhibit 21 Subsidiaries of IBP, inc. as of December 25, 1993. Exhibit 23 Consent of Independent Public Accountants. IBP Officer Long-Term Stock Plan 1. Purposes. The purposes of this IBP Officer Long-Term Stock Plan (the "Plan") are to assist IBP and its subsidiaries (unless the context otherwise requires, the "Company") (a) in the attraction and retention of officers and executive officers who have demonstrated superior ability, and (b) to provide the officers with an incentive to exert extraordinary efforts toward the achievement of increased growth and profitability in the operations of the Company in order that the value of the Company's Common Stock may appreciate accordingly. 2. Administration. The Plan shall be administered by a committee consisting of three or more members of the board of directors, all of whom shall not (either while members of the Committee or at any time within one year prior to becoming members of the Committee) be or have been eligible for selection as a person to whom awards may be made under the Plan (the "Committee"). The Committee is authorized to adopt operating rules necessary to implement and administer the Plan. The Committee shall periodically review the performance of the Plan and its rules and make any necessary revisions in such rules to assure the Plan's purposes are met. The interpretation and construction of any provision of the Plan by the Committee shall be final and conclusive. 3. Participants. The Committee shall select as participants in the Plan the officers and executive officers who are in a position directly and significantly to enhance the growth and profitability of the Company's operations and whose continued employment by the Company would favorably affect such operations. 4. Awards. The Plan shall be effective when approved by the affirmative votes of the holders of a majority of the securities of the Company present, or represented, and entitled to vote at a meeting duly held in accordance with the laws of the state of Delaware. All awards made by the Committee prior to such approval are contingent upon that approval. Each participant in the Plan shall be awarded a number of Common Shares ("Deferred Stock" or "Stock") of the Company as determined by the Committee, such shares to be awarded in consideration of services to be rendered to the Company and on its behalf. Upon the making of any award, the Committee shall set by resolution its determination of the fair value in monetary terms of the services to be rendered to the Company and which serves as the employee's consideration for the award. The number of shares of Common Stock awarded as Deferred Stock shall be (a) for awards made on or before January 27, 1993, the result of dividing the fair value of the services so determined by $16.125 (the "Closing Price" of the Company's Common Stock on October 9, 1992), and (b) for awards made after January 27, 1993, the result of dividing the fair value of the services so determined by the "closing price" of the Company's Common Stock on the date of any such award; the "closing price" being that reported for the Company's Common Stock in the New York Stock Exchange Composite Transactions Index, as published in The Wall Street Journal, or in such other national financial press or information service available from time to time over the duration of the Plan. All shares so granted are declared and taken to be fully paid shares of Stock and not liable to any further call, nor shall the holders thereof be liable for any further payment therefor. All shares so awarded will be subject to the restrictions described in Section 5. No more than seven hundred thousand (700,000) shares of Stock (subject to adjustment to reflect any Stock dividend, split-up, combination of shares, reclassification, merger or consolidation) shall be awarded under the Plan, but any shares forfeited prior to the expiration of the Deferral Period as described in Section 5 shall revert to the status of shares not awarded. Shares delivered pursuant to this Plan may be Common Stock acquired by the Company on the open market and held in the treasury of the Company or previously authorized but unissued Common Stock. 5. Restrictions. During the Deferral Period (as determined in the discretion of the Committee and as defined in each stock grant agreement any shares of Stock awarded pursuant to the Plan shall not be sold, assigned, pledged, hypothecated or otherwise transferred or encumbered. At the expiration of the Deferral Period, the certificate representing those shares for which the Deferral Period has expired shall be delivered to the participant, or his legal representative, in a number equal to such shares. Unless otherwise provided in the stock grant agreement to be entered into between the Company and the participant, the Deferral Period with respect of shares of Stock awarded to a participant in the Plan shall terminate at the close of business on the fifth anniversary of the Award Date, provided that if such participant shall cease to perform officer duties for the Company during the Deferral Period with respect to such shares: (a) in the event he shall cease to perform such duties by reason of resignation or discharge by the Company for cause, such Deferred Stock shall be forfeited by the participant; (b) in the event he shall cease to perform such duties for the Company by reason of death, total and permanent disability or retirement at age 65, the Deferral Period shall terminate with respect to all of the remaining shares covered under the Deferred Stock Award; and (c) in the event he shall cease to perform such duties for the Company by reason of discharge otherwise than for cause, the Mandatory Deferral Period shall terminate with respect to a number of shares which bears the same relation to all such shares as the number of full calendar months elapsed since the date of such award bears to 60, and the remaining such shares shall be forfeited by such participant; provided that in cases where the Committee determines that it was for the convenience of the Company that a participant has resigned or otherwise ceased to perform executive duties for the Company, the Committee shall have the power to make a settlement which would have the same result as the one that would obtain under subparagraph (c) of this Section 5 if such participant had ceased to perform such duties of the Company by reason of discharge otherwise than for cause. "Cause" shall mean gross negligence, willful misconduct, refusal to carry out an order of the Company or any disloyal action inimical to the Company. Amounts equal to any dividends declared during the Deferral Period with respect to the number of shares covered by a Deferred Stock Award will be deferred and deemed to be reinvested in additional Deferred Stock. Except as set forth in the preceding sentence, the Participant shall have none of the rights of a stockholder with respect to shares of Common Stock covered by a Deferred Stock Award until the shares of Common Stock are transferred to such Participant at the expiration of the Deferral Period. 6. Tax Withholding. Any Deferred Stock Award granted hereunder shall provide as determined by the Committee for appropriate arrangements for the satisfaction by the Company and the participant of all Federal, state, local or other income, excise or employment taxes or tax withholding requirements applicable to the transfer of Common Stock pursuant to a Deferred Stock Award or other right or payment and all such additional taxes or amounts as determined by the Committee in its discretion, including without limitation, the right of the Company or any subsidiary thereof to receive transfers of shares of Common Stock or other property from the Participant or to deduct or withhold in the form of cash or shares from any transfer of payment to a Participant, in such amount or amounts deemed required or appropriate by the Committee in its discretion. 7. Modifications. The Company's board of directors shall have the power to modify or supplement the Plan in such manner as it may from time to time determine, provided that unless the holders of a majority of shares of capital stock of the Company having voting power present or represented and entitled to vote at a meeting of such holders shall have first given their approval, (a) the number of shares of Stock (adjusted in accordance with Section 4) which may be awarded under the Plan shall not be increased, (b) the benefits accruing to the Participants in the Plan shall not be materially increased and (c) the requirements as to eligibility for participation in the Plan shall not be materially modified. EXHIBIT 10.5.4 IBP 1993 STOCK OPTION PLAN 1. Purpose. The purpose of this IBP 1993 Stock Option Plan (the "Plan") is to enhance the value of the stockholders' investment in IBP, inc. (the "Company") by encouraging key employees, upon whose performance the Company and its subsidiaries is largely dependent for the successful conduct of its operations, to acquire and retain a financial interest in the Company. In addition, the Plan is intended to enable the Company and its subsidiaries to compete effectively for and retain the services of such employees. It is intended that the incentive stock options ("ISOs") (as defined by Section 422 of the Internal Revenue Code of 1990, as amended or superseded (the "Code")), other stock options and stock appreciation rights ("SARs"), may be granted under this Plan. 2. Administration of the Plan. (a) The Plan shall be administered by a committee (the "Committee") consisting of not less than three members of the board of directors designated from time to time by the board of directors, all of whom shall not (either while members of the Committee or at any time within one year prior to becoming members of the Committee) be or have been eligible for selection as a person to whom awards may be made under the Plan. The interpretation and construction of any provision of the Plan or any option or right granted hereunder and all determinations by the Committee in each case shall be final, binding and conclusive with respect to all interested parties, unless otherwise determined by the board of directors. No member of the Committee shall be personally liable for any action, failure to act, determination, interpretation or construction made in good faith with respect to the Plan or any option or right or transaction thereunder. (b) The Committee shall have full power and authority in its discretion to take any and all action required or permitted to be taken under the Plan. Such full power and authority shall include, without limitation, the selection of participants to whom stock options or SARs may be granted pursuant to the Plan; the determination of the number of shares of Commons Stock which may be covered by stock options or SARs granted to any such participant of the Plan and the purchase price thereof; the granting of options and related rights; the right to interpret and construct any provision of the Plan or any option or right granted hereunder; the making of all required or appropriate determinations under the Plan or any option or right granted hereunder; the fixing and determination of the terms, provisions, conditions and restrictions of all option instruments or agreements (and any related rights), which need not be identical, entered into or issued in connection with grants under the Plan; and the adoption, amendment and rescission of such rules related to the Plan as the Committee shall determine in its discretion, subject to the express provisions of the Plan. 3. Participants. Participants in the Plan shall be key employees of the Company or its subsidiaries selected as hereinafter provided. Key employees may include officers of the Company or its subsidiaries who are also directors of the Company but not directors who are not employees of the Company or its subsidiaries. Nothing contained in this Plan, nor in any option or right granted pursuant to the Plan, shall confer upon any employee any right to continue in the employ of the Company or any subsidiary nor limit in any way the right of the Company or any subsidiary to terminate his employment at any time. 4. The Stock. The shares of stock available for issuance pursuant to the grant of options (with or without related SARs) under this Plan shall consist of one million nine hundred fifty thousand (1,950,000) shares of Common Stock, par value $0.05 per share (the "Common Stock"), of the Company, subject to adjustment as provided in Section 8 hereof. Shares may be (a) previously issued Common Stock purchased by the Company in the open market, and held in the treasury of the Company, or (b) previously authorized but unissued Common Stock. Should any option grant (or a portion thereof) be terminated, expire, or be cancelled for any reason without being exercised (e.g., by reason of the exercise of related SARs for stock or for cash), the shares subject to the portion of such option grant not so exercised shall be available for subsequent grants under this Plan. 5. Effective Date and Termination of Plan. The Plan shall be effective when approved by the affirmative votes of the holders of a majority of the securities of the Company present, or represented, and entitled to vote at a meeting duly held in accordance with the laws of the state of Delaware, but in no event later than January 26, 1994. All grants made by the Committee prior to such approval shall be contingent upon such approval. This Plan shall terminate upon the earlier of (i) January 26, 2003; or (ii) the date on which all shares available for issuance under the Plan have been issued pursuant to the exercise of options granted hereunder; or (iii) the determination of the board of directors that the Plan shall terminate. No options may be granted under the Plan after the termination date, provided that the options granted and outstanding on such date shall continue to have force and effect in accordance with the provisions of the instruments evidencing such options. 6. Grant, Terms, and Conditions. Options and SARs may be granted at any time and from time to time prior to the termination of the Plan to such eligible employees and on such terms and conditions as determined by the Committee. All options and SARs shall be granted under the Plan by execution of instruments in writing in the form approved by the Committee. Notwithstanding any contrary provision of this Plan other than Section 9 hereof, with respect to any ISOs granted under any plan of the Company or its subsidiaries or any parent, the aggregate fair market value (determined at the time the option is granted) of the shares with respect to which such ISOs are exercisable for the first time by an optionee during any calendar year (under all such plans of the Company its subsidiaries and any parent) shall not exceed One Hundred Thousand Dollars ($100,000.00) or the maximum amount permitted under the Code. All options and SARs granted pursuant to the Plan shall be subject to the following terms and conditions and such other terms and conditions determined by the Committee which are not inconsistent therewith: (a) Price. The option exercise price per share of each option shall be determined by the Committee, provided that, except as provided below, in no instance shall such price be less than the fair market value of a share of Common Stock (as defined by subsection (j) hereof) on the effective date of the option grant. The option exercise price shall be subject to adjustment only as provided in Section 8 hereof. (b) Term of Options. Options may be granted for terms of up to but not exceeding ten (10) years from date granted. Each grant shall be subject to earlier termination as provided in subsection (f) of this Section 6. (c) Exercise of Options. Options granted under this Plan shall be exercisable on such date or dates and during such period and for such number of shares as shall be determined pursuant to the provisions of the instrument evidencing such grant. No fractional shares shall be issued, and fractional shares remaining in any grant shall be rounded down to the nearest whole number of shares. (d) Alternate Exercise in Case of Hardship. In the case of options other than ISOs, in the event of the imminent expiration of the grant where the optionee is absent from the United States or is otherwise subject to a hardship which renders exercise of the grant by such optionee unreasonable or impossible prior to its expiration date, the Committee in its sole and absolute discretion may issue or cause to have issued to the optionee (in lieu of the exercise of said grant) the number of shares which represent the difference (if any) between the aggregate option exercise price and aggregate fair market value of the shares of the Common Stock with respect to which the grant is then exercisable, determined as of the date of issuance of said shares. In such event the grant shall be deemed fully exercised for all purposes hereof. (e) Notice of Exercise and Payment. To the extent options are exercisable, they shall be exercised by written notice to the Company, stating the number of shares with respect to which options are being exercised and the intended manner of payment. The date of the notice shall be the exercise date. Payment for the shares purchased shall be made in full to the company within ten (10) business days after the exercise date by check payable to the order of the Company equal to the option price for the shares being purchased, in whole shares of Common Stock of the Company owned by the optionee having a fair market value on the exercise date (as defined by subsection (j) hereof) equal to the option price for the shares being purchased, or a combination of Common Stock and check equal in the aggregate to the option price for the shares being purchased. Payments of Common Stock shall be made by delivery of stock certificates properly endorsed for transfer in negotiable form. If other than the optionee, the person or persons exercising shall be required to furnish to the Company appropriate documentation that such person or persons have the full legal right and power to exercise on behalf of and for the optionee. (f) Termination of Employment. (i) Except as otherwise provided in this Plan, an optionee's options (A) are exercisable only by the optionee, (B) are exercisable only while the optionee is in the employ of the Company, and (C) if not exercisable by their terms at the time the optionee ceases to be in the employ of the Company, shall immediately expire on the date of termination of employment. (ii) Except as provided herein, an optionee's options which are exercisable by their terms at the time the optionee ceases to be in the employ of the Company must be exercised on or before the earlier of three months after the date of termination of employment or the fixed expiration date of such options after which period such options shall expire. (iii) In the event of the death of the optionee while in the employ of the Company, all of that optionee's unexercised options (whether or not then exercisable by their terms) shall become immediately exercisable by his estate for a period ending on the earlier of the fixed expiration date of such options or twelve months after the date of death, after which period such options shall expire. For purposes hereof, the estate of an optinee shall be defined to include the legal representatives thereof or any person who has acquired the right to exercise an option by reason of the death of the optionee. (iv) In the case of options other than ISOs, in the event of the termination of employment by reason of the permanent disability (as defined below) of the optionee, all of that optionee's unexercised options (whether or not then exercisable by their terms) shall become exercisable for a period ending on the earlier of the fixed expiration date of such options or twelve months from the date of termination after which period such options shall expire. For purposes hereof "permanent disability" shall be deemed to be the inability of the optionee to perform the duties of his job with the Company because of a physical or mental disability as evidenced by the opinion of a Company-approved doctor of medicine licensed to practice medicine in the United States of America. (v) In the case of options other than ISOs, in the event of the normal retirement of the optionee, all of that optionee's unexercised options (whether or not then exercisable by their terms) granted to that optionee on or before his 65th birthday shall become immediately exercisable for a period ending on the earlier of the fixed expiration date of such options or twelve months after the date of the retirement, after which period such options shall expire. Also, in the event of the normal retirement of the optionee, all of the optionee's unexercised options (whether or not then exercisable by their terms) granted to the optionee after his 65th birthday and held for a period of at least twelve consecutive months of active employment with the Company after the date of grant shall become immediately exercisable for a period ending on the earlier of the fixed expiration date of such options or twelve months after the date of retirement, after which period such options shall expire. For purposes hereof, retirement shall be deemed to be "normal retirement" if the optionee is at least 65 years of age and has completed at least five consecutive years of employment with the Company at the date of retirement. (vi) In the case of ISOs, in the event of the termination of employment by reason of the permanent disability or the normal retirement of the optionee (as defined in (iv) and (v) above), each ISO then held by the optionee shall terminate on the earlier of the period ending three months after the termination of employment or the fixed expiration date of such options; provided however, that if such termination of employment occurs by reason of disability within the meaning of Section 422(c)(6) of the Code said three-month period shall be extended to twelve months. (g) Transferability of Options. Any option granted hereunder shall be transferable only by will or the laws of descent and distribution and shall be exercisable during the lifetime of the optionee only by him. (h) Other Terms and Conditions. Options may contain such other terms, conditions, or provisions, which shall not be inconsistent with this Plan, as the Committee shall deem appropriate. (i) Tax Withholding. Any option and related SAR granted hereunder shall provide, as determined by the Committee, for appropriate arrangements for the satisfaction by the Company and the optionee of all federal, state, local or other income, excise or employment taxes or tax withholding requirements applicable to the exercise of the option or any related SAR or the later disposition of the shares of Common Stock or other property thereby acquired and all such additional taxes or amounts as determined by the Committee in its discretion, including without limitation, the right of the Company or any subsidiary thereof to receive transfers of shares of common Stock or other property from the optionee or, beginning one year after the Company becomes subject to the reporting requirements of Section 13 of the Securities Exchange Act of 1934, to deduct or withhold in the form of cash or shares from any transfer or payment to an optionee, in such amount or amount deemed required or appropriate by the Committee in its discretion. (j) Fair Market Value. The "fair market value" of a share of Common Stock on any relevant date for purposes of any provision of the Plan shall be the closing price reported for the Common Stock in the New York Stock Exchange Composite Transactions Index on such date or, if there were no reported sales on such date, then the closing price reported for the Common Stock in the New York Stock Exchange Composite Index on the next preceding day on which such a sale is transacted, as published in The Wall Street Journal, or such other national financial press or service as may be available from time to time over the duration of the Plan. (k) Cancellation of Option. The Committee shall have the authority to effect, at any time and from time to time, with the consent of the affected optionee or optionees, the cancellation of any or all outstanding options [and related SARs] granted under the Plan and the grant in substitution therefore of new options and related SARs under the Plan (subject to the limitations hereof) covering the same or different number of shares of Common Stock at an option price per share in all events not less than fair market value on the new grant date (as determined under subsection (j) of this Section 6). 7. Stock Appreciation Rights. Any options granted or to be granted under this Plan may, in the sole and absolute discretion of the Committee, include related SARs with respect to all or part of the shares of Common Stock subject to options as determined by the Committee. SARs may be granted at the time options are granted or (in the case of options other than ISOs) at a later date with respect to existing options. Optionees granted SARs may exercise the SARs by written notice to the Company, stating the number of shares with respect to which the SARs are being exercised, to the extent that said SARs are then exercisable. In the event of the exercise of SARs, the obligation of the Company in respect of the options to which the SARs related shall be discharged by payment of the SARs so exercised. (a) SAR Payment. Any SAR granted hereunder shall set forth the method of computation and form of payment of the SAR and such other terms and conditions as determined by the Committee in its discretion or as otherwise required by this Plan, provided that no SAR shall exceed the difference between one hundred percent (100%) of the then fair market value on the date of exercise of the share of Common Stock subject to the option surrendered by the optionee, and the option exercise price of such share. Without limiting the generality of the foregoing, the Committee may provide for the payment of said SAR in cash or in shares of Common Stock valued at fair market value as of the date of exercise, or in any combination thereof as determined by the Committee. (b) Other Provisions. Notwithstanding any contrary provisions hereof, (i) SARs shall be exercisable only to the extent the options to which such SARs relate are then exercisable (further subject to such additional conditions and restrictions as may be imposed by the Committee) and shall expire upon expiration of the options to which such SARs relate, and (ii) in the case of any SARs related to ISOs granted hereunder, said SARs shall be exercisable only when the then fair market value of the shares of Common Stock subject to the options (or portion thereof) surrendered by the optionee exceeds the exercise price of such options (or such portion thereof). (c) "Option." References in this Plan to the term "option" shall, unless the context requires otherwise, include an SAR. 8. Adjustment and Changes in the Common Stock. (a) In the event that the shares of Common Stock as presently constituted shall be changed into or exchanged for a different kind of share of stock or other securities of the Company or of another corporation (whether by reason of merger, consolidation, recapitalization, reclassification, split-up, combination of shares or otherwise) or if the number of such shares of stock shall be increased through the payment of a stock dividend, then unless such change results in the termination of all outstanding options pursuant to the provisions of Section 9 hereof, there shall be substituted for or added to each share of stock of the Company therefore appropriated or thereafter subject or which may become subject to an option under this Plan, the number and kind of shares of stock or other securities into which each outstanding share of stock of the Company shall be so changed, or for which each such share shall be exchanged, or to which each share shall be entitled, as the case may be. Outstanding options shall also be appropriately amended as to price and other terms as may be necessary to reflect the foregoing events. In the event there shall be any other change in the number or kind of the outstanding shares of the stock of the Company of any stock or other securities into which such stock shall have been changed, or for which it shall have been exchanged, then if the Committee shall, in its sole discretion, determine that such change equitably requires an adjustment in any option theretofore granted or which may be granted under the Plan, such adjustment shall be made in accordance with such determination. Fractional shares resulting from any adjustment in options pursuant to this Section 8 shall be rounded down to the nearest whole number of shares. (b) Notwithstanding the foregoing, any and all adjustments in connection with an ISO shall comply in all respects with Sections 422 and 424 of the Code and the regulations thereunder. (c) Notice of any adjustment shall be given by the Company to each holder of an option which shall have been so adjusted, provided that such adjustment (whether or not such notice is given) shall be effective and binding for all purposes of the Plan and any instrument or agreement issued thereunder. 9. Acceleration of Options. (a) In the event that the Company enters into one or more agreements to dispose of all or substantially all of the assets of the Company or the Company's stockholders dispose of or become obligated to dispose of fifty-percent (50%) or more of the outstanding capital stock of the Company other than to the Company or a subsidiary of the Company, in either case by means of sale (whether as a result of a tender offer or otherwise), merger, reorganization or liquidation in one or a series of related transactions ("Acceleration Event"), then each option outstanding under the Plan shall become exercisable during the fifteen (15) days immediately prior to the scheduled consummation of the Acceleration Event with respect to the full number of shares of which such option has been granted. (b) In the event of the occurrence of an Acceleration Event (as defined by subsection (a) of this Section 9), any optionee who is subject to the filing requirements imposed under Section 16(a) of the Securities Exchange Act of 1934 with respect to the Company shall receive a payment of cash equal to the difference between the aggregated Fair Value of the shares of Common Stock subject to such accelerated options and the aggregate option exercise price of such shares. For this purpose, "Fair Value" shall mean the highest aggregate fair market value of the subject shares of Common Stock during the 60-day period immediately preceding the date of the consummation of the Acceleration Event (as determined under Section 6(j) hereof). Payment of said cash shall be made within 10 days after said consummation of the Acceleration Event. The foregoing payments under this subsection (b) shall be made in lieu of and in full discharge of any and all obligations of the Company in respect of all subject options and any related SARs of the optionee. Notwithstanding any of the foregoing, the provisions of this subsection (b) shall not be applicable to ISOs granted under this Plan. (c) The grant of options (or related rights) under this Plan shall in no way affect the right of the Company to adjust, reclassify, reorganize or otherwise change its capital or business structure of to merge, consolidate, dissolve, liquidate or sell or transfer all or any part of its business or assets. 10. Listing and Regulatory Requirement. No options granted pursuant to this Plan shall be exercisable if at any time, including after receipt of notice of exercise, the Committee shall determine in its discretion that the listing, registration, qualification, or acquisition of the shares of Common Stock subject to such options on any securities exchange or under any applicable law, or the consent or approval of any governmental regulatory body is necessary or desirable as a condition of, or in connection with, the granting of such option or the acquisition or issuance of shares by IBP thereunder, unless such listing, registration, qualification, acquisition, consent or approval shall have been effected or obtained free of any conditions not acceptable to the Committee. 11. Amendment of the Plan. The board of directors may from time to time amend or modify or make such changes in and additions to this Plan as it may deem desirable, without further action on the part of the stockholders of the Company; provided, however, that unless the holders of a majority of the securities of the Company present or represented and entitled to vote at a duly held meeting shall have first given their approval, then (a) the maximum number of shares of Common Stock issuable under the Plan shall not be increased (except for permissible adjustments under Section 8 hereof), (b) the benefits accruing to the participants in requirements as to eligibility for participation in the Plan shall not be modified. Subject to and without limiting the generality of the foregoing, the board of directors may amend or modify the Plan and any outstanding options under the Plan to the extent necessary to qualify any or all of such options or future options to be granted for such beneficial federal income tax treatment as may be afforded employee stock options under the Code or any amendments thereto or other statutes or regulations or rules (or any interpretations thereof by any applicable governmental agency or entity) which become effective after the effective date of the Plan (including without limitation any proposed or final Treasury regulations). 12. Stockholder Rights. An optionee shall have none of the rights of a stockholder of the Company with respect to any shares subject to any options granted hereunder until such individual shall have exercised the options and been issued share therefor. 13. Use of Proceeds. The proceeds received by the Company from the sale of shares pursuant to the options granted under this Plan shall be used for general corporate purposes. EXHIBIT 10.5.5 IBP DIRECTORS STOCK OPTION PLAN 1. Purpose. The purpose of this IBP Directors' Stock Option Plan (the "Plan") is to enhance the value of the stockholders' investment in IBP, inc. (the "Company") by enabling the Company and its subsidiaries to compete effectively for and retain the services of non-employee directors on the board of directors. 2. Administration of the Plan. (a) The Plan shall be administered by a committee (the "Directors Plan Committee") consisting of not less than two members of the board of directors designated from time to time by the board of directors, all of whom shall be employees as well as directors of the Company and shall not (either while members of the Committee or at any time within one year prior to becoming members of the Committee) be or have been eligible for selection as a person to whom awards may be made under this Plan. The interpretation and construction of any provision of the Plan or any option or right granted hereunder and all determinations by the Committee in each case shall be final binding and conclusive with respect to all interested parties, unless otherwise determined by the board of directors. No member of the Committee shall be personally liable for any action, failure to act, determination, interpretation or construction made in good faith with respect to the Plan or any option or right or transaction thereunder. (b) The Committee shall have full power and authority in its discretion to take any and all action required or permitted to be taken under the Plan. Such full power and authority shall include, without limitation, the right to interpret and construct any provision of the Plan or any option or right granted hereunder; the making of all required or appropriate determinations under the Plan, the fixing and determination of the terms (other than the timing, quantity and price of option grants), provisions, conditions and restrictions of all option instruments or agreements (and any related rights), which need not be identical, entered into or issued in connection with grants under the Plan; and the adoption, amendment and rescission of such rules related to the Plan as the Committee shall determine in its discretion, subject to the express provisions of the Plan. 3. Participants. Participants in the Plan shall be the non-employee members of the board of directors of the Company. 4. The Stock. The shares of stock available for issuance pursuant to the grant of options under this Plan shall consist of fifty thousand (50,000) shares of Common Stock par value $0.05 per share (the "Common Stock"), of the Company, subject to adjustment as provided in Section 8 hereof. Shares may be (a) previously issued Common Stock purchased by the Company in the open market, and held in the treasury of the Company, or (b) previously authorized but unissued Common Stock. Should any option grant (or a portion thereof) be terminated, expire, or be cancelled for any reason without being exercised, the shares subject to the portion of such option grant not so exercised shall be available for subsequent grants under this Plan. 5. Effective Date and Termination of Plan. The Plan shall be effective when approved by the affirmative votes of the holders of a majority of the securities of the Company present, or represented, and entitled to vote at a meeting duly held in accordance with the laws of the state of Delaware, but in no event later than January 26, 1994. All grants made prior to such approval shall be contingent upon such approval. This Plan shall terminate upon the earlier of (i) January 26, 2003; or (ii) the date on which all shares available for issuance under the Plan have been issued pursuant to the exercise of options granted hereunder; or (iii) the determination of the board of directors that the Plan shall terminate. No options may be granted under the Plan after the termination date, provided that the options granted and outstanding on such date shall continue to have force and effect in accordance with the provisions of the instruments evidencing such options. 6. Grant, Terms, and Conditions. Eligible directors receiving grants before shareholder approval receive an initial grant of option shares equal to one thousand (1,000) shares of Common Stock. Directors who are eligible under the Plan, and who are elected after shareholder approval of the Plan will receive an initial grant of option shares equal to one thousand (1,000) shares of Common Stock at the time of being elected as a director. The option grant will be effective as of the date the director is elected. Each eligible director under the Plan shall receive an annual option grant of option shares equal to five hundred (500) shares of Common Stock for each year that the director continues to serve as a member of the Board of Directors. Such annual option grant will be effective on the date of an incumbent's re-election to IBP's Board of Directors. All options shall be granted under the Plan by execution of instruments in writing in the form approved by the Committee. All options granted pursuant to the Plan shall be subject to the following terms and conditions and such other terms and conditions determined by the Committee which are not inconsistent therewith: (a) Price. The option exercise price per share of each option shall be the fair market value of a share of Common Stock (as defined by subsection (j) hereof) on the effective date of the option grant. The option exercise price shall be subject to adjustment only as provided in Section 7 hereof. (b) Term of Options. Options may be granted for terms of up to but not exceeding ten (10) years from date granted. Each grant shall be subject to earlier termination as provided in subsection (f) of this Section 6. (c) Exercise of Options. Two years from the date of grant, the optionee will have the right to exercise forty-percent (40%) of the number of shares in an option grant and twenty-percent (20%) each additional year thereafter through the fifth year when all options shall be exercisable. All option grants expire ten years from the date of grant. (d) Alternate Exercise in Case of Hardship. In the event of the imminent expiration of the grant where the optionee is absent from the United States or is otherwise subject to a hardship which renders exercise of the grant by such optionee unreasonable or impossible prior to its expiration date, the Committee in its sole and absolute discretion may issue or cause to have issued to the optionee (in lieu of the exercise of said grant) the number of shares which represent the difference (if any) between the aggregate option exercise price and aggregate fair market value of the shares of the Common Stock with respect to which the grant is then exercisable, determined as of the date of issuance of said shares. In such event the grant shall be deemed fully exercised for all purposes hereof. (e) Notice of Exercise and Payment. To the extent options are exercisable, they shall be exercised by written notice to the Company, stating the number of shares with respect to which options are being exercised and the intended manner of payment. The date of the notice shall be the exercise date. Payment for the shares purchased shall be made in full to the company within ten (10) business dates after the exercise date by check payable to the order of the Company equal to the option price for the shares being purchased, in whole shares of Common Stock of the company owned by the optionee having a fair market value on the exercise date (as defined by subsection (j) hereof) equal to the option price for the shares being purchased, or a combination of Common Stock and check equal in the aggregate to the option price for the shares being purchased. Payments of Common Stock shall be made by delivery of stock certificates properly endorsed for transfer in negotiable form. If other than the optionee, the person or persons exercising shall be required to furnish to the Company appropriate documentation that such person or persons have the full legal right and power to exercise on behalf of and for the optionee. (f) Termination as Director. (i) Except as provided herein, an optionee's options which are exercisable by their terms at the time the optionee ceases to be a director of the Company must be exercised on or before the earlier of three months after the date on which such incumbency ends or the fixed expiration date of such options, after which period such options shall expire. (ii) In the event of the death of the optionee while serving as a director of the Company, all of that optionee's unexercised options (whether or not then exercisable by their terms) shall become immediately exercisable by his estate for a period ending on the earlier of the fixed expiration date of such options or twelve months after the date of death, after which period such options shall expire. For purposes hereof, the estate of an optionee shall be defined to include the legal representatives thereof or any person who has acquired the right to exercise an option by reason of the death of the optionee. (iii) In the event of the termination as a director by reason of the permanent disability (as defined below) of the optionee, all of that optionee's unexercised options (whether or not then exercisable by their terms) shall become exercisable for a period ending on the earlier of the fixed expiration date of such options or twelve months from the date of termination after which period such options shall expire. For purposes hereof "permanent disability" shall be deemed to be the inability of the optionee to perform the duties of his job with the Company because of a physical or mental disability as evidenced by the opinion of a Company-approved doctor of medicine licensed to practice medicine in the United States of America. (iv) In the event of the normal retirement of the optionee, all of that optionee's unexercised options (whether or not then exercisable by their terms) granted to that optionee on or before his 65th birthday shall become immediately exercisable for a period ending on the earlier of the fixed expiration date of such options or twelve months after the date of the retirement, after which period such options shall expire. Also, in the event of the normal retirement of the optionee, all of the optionee's unexercised options (whether or not then exercisable by their terms) granted to the optionee after his 65th birthday and held for a period of at least twelve consecutive months of service as a director with the Company after the date of grant shall become immediately exercisable for a period ending on the earlier of the fixed expiration date of such options or twelve months after the date of retirement, after which period such options shall expire. For purposes hereof retirement shall be deemed to be "normal retirement" if the optionee is at least 65 years of age and has completed at least five consecutive years of service as a non-employee director of the Company at the date of retirement. (g) Transferability of Options. Any option granted hereunder shall be transferable only by will or the laws of descent and distribution and shall be exercisable during the lifetime of the optionee only by him. (h) Other Terms and Conditions. may contain such other terms, conditions, or provisions, which shall not be inconsistent with this Plan, as the Committee shall deem appropriate. (i) Tax Withholding. Any option granted hereunder shall provide as determined by the Committee for appropriate arrangements for the satisfaction by the Company and the optionee of all federal, state, local or other income, excise or employment taxes or tax withholding requirements applicable to the exercise of the option or the later disposition of the shares of Common Stock or other property thereby acquired and all such additional taxes or amounts as determined by the Committee in its discretion, including without limitation the right of the Company or any subsidiary thereof to receive transfers of shares of Common Stock or other property from the optionee or, beginning one year after the Company becomes subject to the reporting requirements of Section 13 of the Securities Exchange Act of 1934, to deduct or withhold in the form of cash or shares from any transfer or payment to an optionee, in such amount or amount deemed required or appropriate by the Committee in its discretion. (j) Fair Market Value. The "fair market value" of a share of Common Stock on any relevant date for purposes of any provision of the Plan shall be the closing price reported for the Common Stock in the New York Stock Exchange Composite Transactions Index on such date or, if there were no reported sales on such date, then the closing price reported for the Common Stock in the New York Stock Exchange Composite Transactions Index on the next preceding day on which such a sale is transacted, as published in The Wall Street Journal, or available in or from such other national financial press or service from time to time over the duration of the Plan. (k) Cancellation of Option. The Committee shall have the authority to effect, at any time and from time to time, with the consent of the affected optionee or optionees, the cancellation of any or all outstanding options granted under the Plan and to grant in substitution therefore new options under the Plan (subject to the limitations hereof) covering the same or different number (but in no event a number greater than an amount equivalent to the number of options cancelled) of shares of Common Stock at an option price per share in all events not less than fair market value on the new grant date (as determined under subsection (j) of this Section 6). 7. Adjustment and Changes in the Common Stock. (a) In the event that the shares of Common Stock as presently constituted shall be changed into or exchanged for a different kind of share of stock or other securities of the Company or of another corporation (whether by reason of merger, consolidation, recapitalization, reclassification, split-up, combination of shares or otherwise) or if the number of such shares of stock shall be increased through the payment of a stock dividend, then unless such change results in the termination of all outstanding options pursuant to the provisions of Section 8 hereof, there shall be substituted for or added to each share of stock of the Company therefore appropriated or thereafter subject or which may become subject to an option under this Plan, the number and kind of shares of stock or other securities into which each outstanding share of stock of the Company shall be so changed, or for which each such share shall be exchanged, or to which each share shall be entitled, as the case may be. Outstanding options shall also be appropriately amended as to price and other terms as may be necessary to reflect the foregoing events. In the event there shall be any other change in the number or kind of the outstanding shares of the stock of the Company of any stock or other securities into which such stock shall have been changed, or for which it shall have been exchanged, then if the Committee shall, in its sole discretion, determine that such change equitably requires an adjustment in any option theretofore granted or which may be granted under the Plan, such adjustment shall be made in accordance with such determination. Fractional shares resulting from any adjustment in options pursuant to this Section 7 shall be rounded down to the nearest whole number of shares. (b) Notice of any adjustment shall be given by the Company to each holder of an option which shall have been so adjusted, provided that such adjustment (whether or not such notice is given) shall be effective and binding for all purposes of the Plan and any instrument or agreement issued thereunder. 8. Acceleration of Options. (a) In the event that the Company enters into one or more agreements to dispose of all or substantially all of the assets of the Company or the Company's stockholders dispose of or become obligated to dispose of fifty-percent (50%) or more of the outstanding capital stock of the Company other than to the Company or a subsidiary of the Company, in either case by means of sale (whether as a result of a tender offer or otherwise), merger, reorganization or liquidation in one or a series of related transactions ("Acceleration Event"), then each option outstanding under the Plan shall become exercisable during the fifteen (15) days immediately prior to the scheduled consummation of the Acceleration Event with respect to the full number of shares of which such option has been granted. (b) In the event of the occurrence of an Acceleration Event (as defined by subsection (a) of this Section 8), any optionee who is subject to the filing requirements imposed under Section 16(a) of the Securities Exchange Act of 1934 with respect to the Company shall receive a payment of cash equal to the difference between the aggregated Fair Value of the shares of Common Stock subject to such accelerated options and the aggregate option exercise price of such shares. For this purpose, "Fair Value" shall mean the highest aggregate fair market value of the subject shares of Common Stock during the 60-day period immediately preceding the date of the consummation of the Acceleration Event (as determined under Section 6(j) hereof). Payment of said cash shall be made within 10 days after said consummation of the Acceleration Event. The foregoing payments under this subsection (b) shall be made in lieu of and in full discharge of any and all obligations of the Company in respect of all subject options of the optionee. Notwithstanding any of the foregoing, the provisions of this subsection (b) shall not be applicable to ISOs granted under this Plan. (c) The grant of options (or related rights) under this Plan shall in no way affect the right of the Company to adjust, reclassify, reorganize or otherwise change its capital or business structure of to merge, consolidate, dissolve, liquidate or sell or transfer all or any part of its business or assets. 9. Listing and Regulatory Requirement. No options granted pursuant to this Plan shall be exercisable if at any time, including after receipt of notice of exercise, the Committee shall determine in its discretion that the listing, registration, qualification, or acquisition of the shares of Common Stock subject to such options on any securities exchange or under any applicable law, or the consent or approval of any governmental regulatory body is necessary or desirable as a condition of, or in connection with, the granting of such option or the acquisition or issuance of shares by IBP thereunder, unless such listing, registration, qualification, acquisition, consent or approval shall have been effected or obtained free of any conditions not acceptable to the Committee. 10. Amendment of the Plan. The board of directors may from time to time amend or modify or make such changes in and additions to this Plan as it may deem desirable, however, the board shall not amend the Plan more than once every six (6) months unless the amendment is to comport with changes in the Internal Revenue Code or the Employee Retirement Income Security Act of 1984 (ERISA) without further action on the part of the stockholders of the Company; provided, however, that the holders of a majority of the securities of the Company present or represented and entitled to vote at a duly held meeting shall have first given their approval, when the amendment to the Plan; (a) materially increases the benefits accruing to participants under the Plan; (b) materially increases the number of securities which may be issued under the Plan; and/or (c) materially modifies the requirements as to eligibility for participation in the Plan. 11. Stockholder Rights. An optionee shall have none of the rights of a stockholder of the Company with respect to any shares subject to any options granted hereunder until such individual shall have exercised the options and been issued shares therefor. 12. Use of Proceeds. The proceeds received by the Company from the sale of shares pursuant to the options granted under this Plan shall be used for general corporate purposes. EXHIBIT 10.29 Mr. Dale C. Tinstman January 27, 1993 Suite 605, Lincoln Square 121 South 13th Street Lincoln, NE 68508 Dear Dale: Please be advised that I have met with the Executive Committee of the Board of Directors and received approval for the use of your services. As you and I discussed, you are willing to serve IBP in the following ways: 1. You will report to the Chairman and work on special projects as requested. 2. You will remain on the Credit Committee. 3. You will continue to chair the Retirement Savings Plan Committee. 4. You will, when called on, help IBP with its public affairs. 5. You will attend the Monday noon executive group from time to time for input on Company affairs. For this, IBP will compensate you at the rate of $3,000 per month plus offer you the right to continue the benefits of our health insurance plan as you have done in the past. This agreement is effective January 1, 1993. Either party may cancel this agreement with thirty (30) days written notice. If you have any questions, please do not hesitate to call me. Sincerely, /s/ Robert L. Peterson Exhibit 11 IBP, inc. AND SUBSIDIARIES COMPUTATION OF EARNINGS PER SHARE YEARS ENDED DECEMBER 25, 1993, DECEMBER 26, 1992 AND DECEMBER 28, 1991 (In thousands except per share data) 1993 1992 1991 FINANCIAL STATEMENT COMPUTATIONS Earnings before cumulative effect of accounting change $77,457 $63,616 $1,353 Cumulative effect of accounting change 12,626 - - ------ ------ ----- Net earnings $90,083 $63,616 $1,353 ====== ====== ===== PRIMARY EARNINGS PER SHARE Shares used in this computation: Weighted average shares outstanding 47,495 47,374 47,329 Dilutive effect of shares under employee stock plans 412 268 454 ------ ------ ------ Common and common equivalent shares 47,907 47,642 47,783 ====== ====== ====== Primary earnings per share: Earnings before cumulative effect of accounting change $1.62 $1.34 $ .03 Cumulative effect of accounting change .26 - - ---- ---- ---- Net earnings $1.88 $1.34 $ .03 ==== ==== ==== FULLY-DILUTED EARNINGS PER SHARE Shares used in this computation: Weighted average shares outstanding 47,495 47,374 47,329 Dilutive effect of shares under employee stock plans 678 390 474 ------ ------ ------ Common and common equivalent shares 48,173 47,764 47,803 ====== ====== ====== Fully-diluted earnings per share: Earnings before cumulative effect of accounting change $1.61 $1.33 $ .03 Cumulative effect of accounting change .26 - - ---- ---- ---- Net earnings $1.87 $1.33 $ .03 ==== ==== ==== Exhibit 13 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of IBP, inc. Dakota City, Nebraska We have audited the accompanying consolidated balance sheets of IBP, inc. and its subsidiaries as of December 25, 1993 and December 26, 1992, and the related consolidated statements of earnings, stockholders' equity and of cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of IBP, inc. for the year ended December 28, 1991 were audited by other independent accountants whose report dated February 7, 1992 expressed an unqualified opinion on those statements. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements audited by us present fairly, in all material respects, the financial position of IBP, inc. and its subsidiaries at December 25, 1993 and December 26, 1992, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. As discussed in Note E to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993. /s/ Price Waterhouse PRICE WATERHOUSE February 4, 1994 Chicago, Illinois Management's Report on Financial Information The management of IBP, inc. is responsible for the integrity of the financial data reported by IBP and its subsidiaries. Fulfilling this responsibility requires the preparation and presentation of consolidated financial statements in accordance with generally accepted accounting principles. Management uses internal accounting controls, corporate-wide policies and procedures, estimates and judgements in order that such statements reflect fairly the consolidated financial position, results of operations and cash flows of IBP. IBP, inc. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands except share and per share data) December 25, December 26, 1993 1992 ASSETS CURRENT ASSETS: Cash, including temporary investments of $24,793 and $24,595 $ 25,196 $ 25,029 Accounts receivable, less allowance for doubtful accounts of $4,198 and $3,000 449,570 449,212 Inventories (Note B) 191,716 196,096 Deferred income tax benefit (Note E) 33,668 28,434 Prepaid expenses 3,171 3,291 --------- --------- TOTAL CURRENT ASSETS 703,321 702,062 PROPERTY, PLANT AND EQUIPMENT, at cost (Note F): Land and land improvements 73,078 63,547 Buildings and stockyards 313,761 272,528 Equipment 669,009 583,071 --------- --------- 1,055,848 919,146 Less accumulated depreciation (507,265) (382,137) --------- -------- 548,583 537,009 Construction in progress 40,198 17,191 --------- -------- 588,781 554,200 OTHER ASSETS: Goodwill, net of accumulated amortization of $95,244 and $87,465 222,794 219,962 Other 24,011 23,203 ------- ------- 246,805 243,165 --------- --------- $1,538,907 $1,499,427 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable and accrued expenses (Note D) $ 340,279 $ 357,419 Federal and state income taxes 23,822 6,541 Notes payable (Note C) - 6,000 Other 2,552 2,375 --------- --------- TOTAL CURRENT LIABILITIES 366,653 372,335 LONG-TERM OBLIGATIONS (Notes C and F) 460,723 510,900 DEFERRED CREDITS AND OTHER LIABILITIES: Deferred income taxes (Note E) 79,733 66,157 Other 19,002 15,958 --------- --------- 98,735 82,115 COMMITMENTS AND CONTINGENCIES (Note J) STOCKHOLDERS' EQUITY (Notes F and G): Preferred stock, 25,000,000 shares authorized; none issued Common stock, $.05 par value per share; authorized 100,000,000 shares; issued 47,500,000 shares 2,375 2,375 Additional paid-in capital 441,959 443,638 Retained earnings 168,695 88,112 Treasury stock at cost, 10,237 and 2,729 shares (233) (48) --------- --------- TOTAL STOCKHOLDERS' EQUITY 612,796 534,077 --------- --------- $1,538,907 $1,499,427 ========= ========= See notes to consolidated financial statements. IBP, inc. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS (In thousands except per share data) 52 Weeks Ended ---------------------------------------------- December 25, December 26, December 28, 1993 1992 1991 ------------ ------------ ------------ Net sales (Note A) $11,671,397 $11,128,405 $10,387,686 Cost of products sold 11,400,302 10,880,212 10,242,614 ---------- ---------- ---------- Gross profit 271,095 248,193 145,072 Selling, general and administrative expense 96,626 87,751 84,002 ---------- ---------- ---------- Earnings from operations 174,469 160,442 61,070 Interest: Incurred (45,838) (54,683) (61,344) Capitalized 1,426 1,590 1,881 Income 1,200 1,267 646 ---------- ---------- ---------- (43,212) (51,826) (58,817) ---------- ---------- ---------- Earnings before income taxes and cumulative effect of accounting change 131,257 108,616 2,253 Income taxes (Note E) 53,800 45,000 900 ---------- ---------- ---------- Earnings before cumulative effect of accounting change 77,457 63,616 1,353 Cumulative effect of change in method of accounting for income taxes (Note E) 12,626 - - ---------- ---------- ---------- Net earnings $ 90,083 $ 63,616 $ 1,353 ========== ========== ========== Earnings per share: Earnings before cumulative effect of accounting change $1.62 $1.34 $ .03 Cumulative effect of accounting change .26 - - ---- ---- ---- Net earnings $1.88 $1.34 $ .03 ==== ==== ==== See notes to consolidated financial statements. IBP, inc. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (In thousands except per share data) Common Stock Additional Par Paid-In Retained Treasury Shares Value Capital Earnings Stock ------ ------ -------- -------- -------- Balance, December 29, 1990 47,500 $2,375 $445,698 $ 65,760 $(2,538) Net earnings 1,353 Dividends declared, $.60 per share (28,398) Treasury shares purchased (4,684) Treasury shares delivered under employee stock plans (1,664) 4,741 ------ ----- ------- ------- ------ Balance, December 28, 1991 47,500 2,375 444,034 38,715 (2,481) Net earnings 63,616 Dividends declared, $.30 per share (14,219) Treasury shares purchased (2,320) Treasury shares delivered under employee stock plans (396) 4,753 ------ ----- ------- ------- ------ Balance, December 26, 1992 47,500 2,375 443,638 88,112 (48) Net earnings 90,083 Dividends declared, $.20 per share (9,500) Treasury shares purchased (6,804) Treasury shares delivered under employee stock plans (1,679) 6,619 ------ ----- ------- ------- ------ Balance, December 25, 1993 47,500 $2,375 $441,959 $168,695 $ (233) ====== ===== ======= ======= ====== See notes to consolidated financial statements. IBP, inc. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) 52 Weeks Ended ---------------------------------------- December 25, December 26, December 28, 1993 1992 1991 ------------ ------------ ------------ Inflows (outflows) CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings $ 90,083 $ 63,616 $ 1,353 ------- -------- -------- Adjustments to reconcile net earnings to cash flows from operations: Depreciation and amortization 58,784 62,012 64,646 Cumulative effect of accounting change (12,626) - - Deferred income tax (benefit)/ provision (2,400) 9,100 (7,200) Net loss on disposal of properties 1,713 4,652 5,398 Net changes in: Accounts payable and accrued liabilities 36,961 (9,772) (45,202) Inventories 4,380 (4,759) 24,838 Accounts receivable 3,826 (58,756) 29,795 Other adjustments, net 1,569 (2,151) (8,286) ------- -------- -------- 92,207 326 63,989 Net cash flows from operating ------- -------- -------- activities 182,290 63,942 65,342 ------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (59,584) (35,511) (24,605) Payment for stock of new subsidiary, net of cash acquired (14,628) - - Other investing activities, net 1,399 638 2,058 Net cash flows from investing ------- -------- ------- activities (72,813) (34,873) (22,547) ------- -------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Principal payments on long-term obligations (50,000) (111) (1,001) Net change in checks in process of clearance (41,390) 11,862 10,846 Dividends paid (9,499) (18,945) (28,396) Net change in borrowings under revolving credit agreements (6,000) (19,000) (15,000) Other financing activities, net (2,421) (418) (2,063) ------- ------- ------- Net cash flows from financing activities (109,310) (26,612) (35,614) -------- ------- ------- Net increase in cash and cash equivalents 167 2,457 7,181 Cash and cash equivalents at beginning of year 25,029 22,572 15,391 Cash and cash equivalents at end ------- -------- ------- of year $ 25,196 $ 25,029 $ 22,572 ======= ======== ======= See notes to consolidated financial statements. IBP, inc. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 25, 1993, DECEMBER 26, 1992 AND DECEMBER 28, 1991 A. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: ORGANIZATION AND BASIS OF PRESENTATION - In 1981, IBP, inc. (IBP) became a wholly-owned subsidiary of Occidental Petroleum Corporation (Occidental) through a reorganization and plan of merger. The accompanying financial statements include the assets, liabilities and stockholders' equity of IBP, after giving effect to the allocation of Occidental's acquisition cost to the net assets acquired, as determined under the purchase method of accounting. In October 1987, IBP sold 23,500,000 shares of its common stock in an initial public offering and Occidental's ownership was thereby reduced to a 50.5% interest. Occidental sold all of its remaining IBP shares in October 1991 pursuant to an underwritten rights offering to its stockholders and standby underwriters. As a result, Occidental no longer controls IBP nor has any person acquired control of IBP. Transactions between IBP and Occidental or its affiliates during the periods presented herein were generally insignificant in amount, either individually or in the aggregate. PRINCIPLES OF CONSOLIDATION - All subsidiaries are wholly-owned and are consolidated in the accompanying financial statements. All material intercompany balances, transactions and profits have been eliminated. INVENTORIES - Inventories are valued on the basis of the lower of first-in, first-out cost or market. PROPERTY, PLANT AND EQUIPMENT - Depreciation is provided for property, plant and equipment on the straight-line method over the estimated useful lives of the respective classes of assets as follows: Land improvements..................8 to 20 years Buildings and stockyards..........10 to 40 years Equipment..........................3 to 12 years Leasehold improvements, included in the equipment class, are depreciated over the life of the lease or the life of the asset, whichever is shorter. INCOME TAXES - Effective December 27, 1992, IBP adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." See Note E for a discussion of the impact of this new standard. Income taxes were accounted for in accordance with Accounting Principles Board (APB) Opinion No. 11 for fiscal years 1992 and 1991. For certain periods during Occidental's ownership of IBP, IBP was part of Occidental's consolidated federal and certain state tax returns. IBP had a tax-sharing agreement for these periods and returns that required IBP to pay to Occidental any taxes that would have been paid by IBP if filing separately. This agreement terminated with the sale of Occidental's remaining interest in IBP in October 1991. CAPITAL LEASES - Lease arrangements entered into by IBP that constitute capital lease obligations are capitalized at the present value of future lease payments. The values assigned to leased assets are included in property, plant and equipment and accounted for accordingly. Depreciation on leased assets is included in depreciation and amortization expense. The capital lease obligations are amortized over the lease terms as payments are made. INDUSTRY SEGMENT AND EXPORT SALES INFORMATION - IBP considers its operations to comprise one industry segment. IBP's operations relate to the meat packing industry and principally involve cattle and hog slaughter, beef and pork fabrication and related allied product processing activities. In 1993, 1992 and 1991, net export sales, principally to customers in Asia and North America, amounted to $1,392 million, $1,286 million and $938 million, respectively. GOODWILL - Goodwill is amortized on a straight-line basis over a period of 40 years. EARNINGS PER SHARE - Earnings per share for 1993, 1992 and 1991 were calculated using average common and common equivalent shares of 47,907,000, 47,642,000 and 47,783,000, respectively. STATEMENT OF CASH FLOWS - For purposes of the statement of cash flows, IBP considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Temporary investments, which are carried at cost which approximates market, were comprised primarily of variable-rate municipal bonds and time deposits. RECLASSIFICATIONS - Certain reclassifications have been made to prior financial statements to conform to the current year presentation. B.INVENTORIES: Inventories are comprised of the following: December 25, December 26, 1993 1992 (In thousands) Beef $119,001 $123,454 Pork 23,652 25,486 Supplies 49,063 47,156 ------- ------- $191,716 $196,096 ======= ======= C. CREDIT ARRANGEMENTS: IBP has a $250,000,000 senior revolving/term facility (the Revolving/Term Facility) and a $125,000,000 short-term revolving facility (the Short-Term Revolver). Both committed facilities bear interest, at the Company's option, at varying rates based upon the banks' base rates or an uncommitted bid option. From time to time, IBP also uses uncommitted lines of credit for some or all of its short-term borrowing needs. The Revolving/Term Facility is a revolving facility which may be extended for one-year increments annually during the revolving period with consent of the banks involved. The revolving period has been extended through November 15, 1994. At the end of the revolving period, any outstanding borrowings are converted to a two-year credit facility with equal quarterly payments. Commitment fees are .275 to .375 of 1% on the bid option and the unused portion of the committed facility. The Short-Term Revolver may be extended semi-annually for additional six-month periods with consent of the banks involved. It has been extended through November 10, 1994. Commitment fees are .125 to .25 of 1% on the unused portion of the facility. Borrowings under the Revolving/Term Facility are treated as current liabilities with the exception of $100,000,000 which IBP does not intend to repay within one year. This amount is classified as long- term in the consolidated balance sheet for 1993; the interest rate at December 25, 1993 on such borrowings was 3.6%. During 1993, the maximum amount of short-term borrowings under all of IBP's credit arrangements was $137,000,000. Average short-term borrowings and the weighted average interest rate during 1993 were $55,687,000 and 3.4%. At December 25, 1993, total borrowings outstanding under committed facilities, including the $100,000,000 classified as long-term, were $100,000,000 and the unused portion totaled $275,000,000. D. ACCOUNTS PAYABLE AND ACCRUED EXPENSES: Accounts payable and accrued expenses are comprised of the following: December 25, December 26, 1993 1992 (In thousands) Accounts payable, principally trade creditors $149,784 $148,176 ------- ------- Checks in process of clearance 29,081 70,471 Accrued expenses: ------- ------- Employee benefits 58,734 52,500 Payroll 42,038 40,668 Other 60,642 45,604 ------- ------- 161,414 138,772 ------- ------- $340,279 $357,419 ======= ======= E. INCOME TAXES: Effective December 27, 1992, IBP adopted SFAS No. 109 on a prospective basis. The cumulative effect of adopting this statement was to increase net earnings by $12.6 million in fiscal 1993. SFAS No. 109 requires that prior accounting for business combinations, such as IBP's application of "pushdown accounting" to its acquisition by Occidental in 1981, be adjusted to reflect remaining assets at fair value rather than net-of-tax value as under APB No. 11. Any difference between the adjusted remaining balance and the tax bases are accounted for as temporary differences. The cumulative effect of the accounting change was an increase in property, plant and equipment of $23.4 million, net of accumulated depreciation of $80.2 million, and an increase in net deferred tax liabilities of $10.8 million. Income tax expense consists of the following: 1993 1992 1991 (In thousands) Current: Federal $54,300 $33,300 $ 7,500 State 1,900 2,600 600 Deferred (2,400) 9,100 (7,200) ------ ------ ------- $53,800 $45,000 $ 900 ====== ====== ======= A reconciliation between the actual income tax expense and income taxes computed by applying the statutory federal income tax rate is as follows: Liability Deferred Deferred Method Method Method 1993 1992 1991 (In thousands) Computed tax on pre-tax earnings at federal statutory rate $45,940 $36,925 $ 766 Foreign Sales Corporation benefits (1,243) (1,115) (3,992) Amortization of goodwill 2,723 2,613 2,613 State income taxes, net of federal benefit 1,254 1,716 417 Targeted jobs credits (650) (990) (990) Effect of differences between fair values assigned in purchase accounting and historic tax values - 2,799 2,417 Income tax contingencies and change in effective tax rate 6,067 3,330 - Other, net (291) (278) (331) ------ ------ ------- Income tax provision $53,800 $45,000 $ 900 ====== ====== ======= The Company reached an agreement in 1992 with the Internal Revenue Service (IRS) with respect to income tax examinations involving the years 1987 and 1988. The agreement included adjustments to the Company's Foreign Sales Corporation income tax returns. The IRS is currently examining the years 1989, 1990 and 1991. In management's opinion, adequate provisions for income taxes have been made for all years. Deferred income tax liabilities and assets were comprised of: Beginning End of of 1993 1993 (In thousands) Deferred tax liabilities: Fixed assets basis difference $90,015 $86,126 Other 4,162 4,159 ------ ------ Gross deferred tax liabilities 94,177 90,285 ------ ------ Deferred tax assets: Nondeductible accrued liabilities (42,397) (35,569) State tax credit carryforwards (18,761) (17,542) Safe harbor leases (3,796) (4,773) Bad debt and claims reserves (1,818) (1,333) Federal and state operating loss carryforwards (849) (250) Other (101) (142) ------- ------- Gross deferred tax assets (67,722) (59,609) ------- ------- Valuation allowance 19,610 17,792 ------ ------ $46,065 $48,468 ====== ====== The net change in the valuation allowance for deferred tax assets of $1.8 million relates to acquired net operating loss and earned state tax credit carryforwards for which utilization is not certain. The acquired federal net operating loss carryforwards are subject to various limitations as to use and expire at various dates through 2007. The state net operating loss and state tax credit carryforwards expire primarily from 2002 through 2007. No benefit has been recognized for these net operating loss and state tax credit carryforwards. F. LONG-TERM OBLIGATIONS: Long-term obligations are summarized as follows: December 25, December 26, 1993 1992 (In thousands) 9.82% Senior Notes due 2000 $275,000 $275,000 Revolving/Term Facility 100,000 150,000 10.39% Senior Subordinated Debentures due 2002 75,000 75,000 Present value of minimum capital lease obligations 9,900 9,900 Other 1,000 1,000 ------- ------- 460,900 510,900 Less amounts due within one year 177 - ------- ------- $460,723 $510,900 ======= ======= IBP's loan agreements contain certain restrictive covenants which, among other things, (1) require the maintenance of a minimum current ratio, adjusted net worth and debt service coverage ratio; (2) provide for a maximum funded debt ratio; and (3) place certain restrictions on the declaration and payment of dividends and similar distributions. As of December 25, 1993, approximately $131 million of stockholders' equity was available for the payment of dividends and other similar distributions. Aggregate maturities of long-term obligations for each of the five fiscal years subsequent to 1993 are $177,000, $50,188,000, $105,489,000, $55,517,000 and $70,545,000. Substantially all of the leased assets under capital leases can be purchased by IBP for nominal consideration at the end of the lease terms. Leased assets included with owned property in the consolidated balance sheets consist of: December 25, December 26, 1993 1992 (In thousands) Land and land improvements $ 8,478 $ 8,478 Buildings and stockyards 331 331 Equipment 1,109 1,091 ------- ------ 9,918 9,900 Less accumulated depreciation 2,623 1,995 ------- ------- $ 7,295 $ 7,905 ======= ======= G. CAPITAL STOCK AND STOCK PLANS: The Board of Directors is authorized to issue up to 25,000,000 shares of preferred stock at such time or times, in such series, with such designations, preferences or other special rights as it may determine. IBP has stock option plans under which incentive and non-qualified stock options may be granted to key employees and directors of IBP and its subsidiaries. As of December 25, 1993, the plans provide for the delivery of up to 3,360,000 shares of common stock upon exercise of options granted at no less than the fair market value of the shares on the date of grant. The options may be granted for terms up to but not exceeding ten years from the date granted. Stock options under the plan are summarized as follows: 1993 1992 1991 Shares under option, at beginning of year 1,511,163 1,411,095 1,743,245 Granted 642,197 309,602 317,775 Exercised (275,865) (99,211) (511,424) Cancelled (98,659) (110,323) (138,501) Shares under option, --------- --------- --------- at end of year 1,778,836 1,511,163 1,411,095 ========= ========= ========= Price range of options $10 7/8- $12- $10 7/8- exercised 24 1/4 18 1/2 16 3/8 Options exercisable, at end of year 606,440 291,677 445,577 Price range per share, $12- $10 7/8- $10 7/8- outstanding options 26 25 7/8 25 7/8 At December 25, 1993 and December 26, 1992, there were 1,585,000 and 141,000 shares, respectively, reserved for future grants. IBP also has an officer long-term stock plan which provides for awards to key employees of IBP which, subject to certain restrictions, will vest generally after five years (deferral period) resulting in the delivery of shares of common stock. A maximum of 700,000 shares of common stock are available to be awarded under this plan. Initial awards effective in 1992 were made in 1993, totaling approximately 555,000 shares at $16 1/8 per share. Additional grants are awarded to plan participants during the deferral period, pursuant to the deemed dividend reinvestment provisions of the plan. Shares of common stock to be delivered for approximately 1,360,000 options under the stock option plans must come from shares purchased by IBP in the open market and held in treasury. All other shares of stock to be delivered pursuant to the stock option plans and the officer long-term stock plan may alternatively come from previously authorized but unissued common stock. H. SUPPLEMENTAL CASH FLOW INFORMATION: Supplemental information on cash payments is presented as follows: 1993 1992 1991 (In thousands) Interest, net of amounts capitalized $44,229 $53,507 $57,853 Income taxes 39,797 41,364 5,151 I. FINANCIAL INSTRUMENTS: The following methods and assumptions are used in estimating the fair value of each class of the Company's financial instruments at December 25, 1993: For cash and cash equivalents, short-term investments, accounts receivable and accounts payable, the carrying amount is a reasonable estimate of fair value because of the short-term nature of these instruments. For securities included in other assets, fair value is based upon quoted market prices for these or similar securities. The carrying amount approximates fair value for these securities. The fair value of the Company's long-term debt is estimated by discounting the future cash outlays associated with each debt instrument using interest rates currently available to the Company for debt issues with similar terms and remaining maturities. The estimated fair values of IBP's financial instruments as of December 25, 1993, are as follows: Carrying Fair Amount Value (In thousands) Long-term debt: Current portion $ 177 $ 177 Noncurrent portion 460,723 522,695 J. COMMITMENTS AND CONTINGENCIES: IBP is involved in numerous disputes incident to the ordinary course of its business. In the opinion of management, any liability for which provision has not been made relative to the various lawsuits, claims and administrative proceedings pending against IBP, including that described below, will not have a material adverse effect on its financial position. A complaint filed against IBP in April 1988 by the Department of Labor, Wage and Hour Division, in the United States District Court in Kansas seeks injunctive relief and back wages, plus interest, for certain hourly employees of the Company. The case relates to compensation allegedly due for incidental activities of hourly employees before and after regular working hours. In the liability phase of the case, the district judge has ruled that IBP is required to pay back wages for a portion of the incidental activities. An appeal by the Company is in progress. The Company's management believes it has made adequate provision for any liability, the amount of which, if any, will be determined at a later time. K. QUARTERLY FINANCIAL DATA (UNAUDITED): Quarterly results are summarized as follows: (In thousands except per share data) First Second Third Fourth 1993 Quarter Quarter Quarter Quarter Annual - ---- Net sales $2,745,361 $3,042,882 $3,054,184 $2,828,970 $11,671,397 Gross profit 53,885 70,162 72,657 74,391 271,095 Earnings before accounting change 12,314 20,496 22,247 22,400 77,457 Net earnings 24,940 20,496 22,247 22,400 90,083 Earnings per share: Earnings before accounting change .26 .43 .46 .47 1.62 Net earnings .52 .43 .46 .47 1.88 Dividends per share .05 .05 .05 .05 .20 Market price: High 20 3/8 20 7/8 24 1/8 26 Low 17 3/4 17 1/2 19 3/4 24 1/8 - ---- Net sales $2,652,858 $2,823,808 $2,872,539 $2,779,200 $11,128,405 Gross profit 67,973 57,388 58,309 64,523 248,193 Net earnings 19,408 12,494 13,318 18,396 63,616 Earnings per share .41 .26 .28 .38 1.34 Dividends per share .15 .05 .05 .05 .30 Market price: High 18 19 19 20 1/2 Low 14 3/8 17 16 1/8 15 7/8 MANAGEMENT'S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS IBP's financial results in 1993 were very favorable as record levels of net sales, beef production and net earnings were achieved. The 8.7% increase in earnings from operations was brought about primarily by the beef division, reflecting expanding market-ready cattle supplies and strong demand for IBP's products. Meanwhile, the pork division, when measured against industry performance, was very profitable but it did not meet management expectations for return on assets in 1993. A 1.3% decline from 1992 in industry-wide available hogs put significant pressure on profit margins. According to the United States Department of Agriculture (USDA), U.S. cattle supplies should continue to increase in 1994, while pork supplies will decline through the first half of the year before recovering in the second half of 1994. IBP's selling prices and the prices it pays for live cattle and hogs are determined by constantly changing market forces of supply and demand, over which IBP has little or no control. Therefore, past results are not necessarily indicative of future performance. The pork division made some significant changes in 1993 and early in 1994. The division purchased a pork plant in Logansport, Indiana from Wilson Foods late in 1993. This plant purchase, along with an earlier 1993 purchase of a network of hog-buying stations located through the eastern Corn Belt region, will help expand IBP's presence in this area. IBP currently plans to modernize the plant and begin operations in the second half of 1994 or the first half of 1995. The pork division also announced in January 1994 its tentative decision to close its Perry, Iowa plant which it has operated since 1989. The plant has not been profitable for IBP and may close in April 1994. If the plant closes, the potential adverse impact on 1994 operating earnings is not expected to be significant. IBP's required adoption of SFAS No. 109, "Accounting for Income Taxes," in the first quarter 1993 added $12.6 million or $.26 per share to 1993 net earnings. This earnings increase was primarily attributable to the adjustment of "pushdown accounting" fixed asset bases resulting from IBP's acquisition in 1981. At the same time, net earnings were reduced by pushdown accounting adjustments, consisting primarily of goodwill amortization and depreciation of the higher values assigned to property, plant and equipment, totaling $10.3 million, $11.2 million and $11.0 million for 1993, 1992 and 1991, respectively. COMPARISON OF 1993 TO 1992 SALES In 1993, net sales rose 4.9% from 1992 net sales due to increases in the average selling price of beef and pork and in total pounds of beef products sold. Net export sales continued to grow in 1993, rising 8.2% over 1992 totals. The sales growth was attributable to increased boxed beef and pork sales to Asian countries, Japan in particular. In total, exports accounted for 11.9% of 1993 net sales compared to 11.6% of net sales in 1992. The USDA predicts U.S. beef exports will improve and pork export demand will remain low in 1994. The USDA cites improving overseas economies and reductions in trade barriers as the main reasons for the expected improvement in beef export demand. Meanwhile, U.S. industry production levels, based upon pounds produced, have remained steady for beef and increased approximately 13% for pork in the last decade. COST OF PRODUCTS SOLD The principal factors which caused the 4.8% increase in cost of products sold were increases in the average price paid for hogs and cattle and an increase in pounds of beef products sold. Livestock costs comprised approximately 90% of cost of products sold in 1993 and 1992. Plant costs were also higher in 1993 than in 1992 due mostly to increased labor and related costs. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE Selling expense rose 10.2% in 1993 over 1992 due to higher volume-related warehousing and freezing charges and export-related selling expense. General and administrative expense rose 10.1% largely due to increased incentive compensation accruals, a higher bad debt provision and higher corporate consulting expense. INTEREST EXPENSE Several factors contributed to the lower net interest expense in 1993 compared to 1992. The expiration of interest rate "collars," 9.9% lower average borrowings outstanding and a lower average rate on the Company's borrowings were the most significant factors involved in the decrease. The decrease in borrowing needs was mainly the result of improved profitability and a reduction in dividends paid. INCOME TAXES The principal reason for the higher 1993 income tax provision versus 1992 was the increase in pre-tax earnings. COMPARISON OF 1992 TO 1991 SALES Net export sales in 1992 increased 37.1% from 1991 and accounted for 11.6% of total net sales. Boxed beef, hides and boxed pork accounted for most of the sales volume while the Far East was the most significant destination for export products. Export market growth was achieved in the Americas and Europe as well. COST OF PRODUCTS SOLD The cost of products sold was 6.2% higher in 1992 than in 1991. Cattle supplies were relatively flat in relation to the prior year while hog supplies were higher in 1992 than in 1991. The more plentiful hog supplies brought the average price paid for live hogs down in 1992 versus 1991, reducing somewhat the impact of the increase in cost of products sold. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE The increase in selling, general and administrative expense in 1992 over 1991 was attributable primarily to increased accruals for earnings-based bonuses and higher volume-related selling expense. INTEREST EXPENSE The 10.9% decrease in interest incurred in 1992 versus 1991 resulted from a 5.9% reduction in average borrowings and a half-point decrease in IBP's effective interest rate. The lower borrowings in 1992 were due in part to improved profitability and a reduced dividend rate while the lower 1992 effective interest rate was reflective of the general market interest rate trend. INCOME TAXES The higher income tax provision in 1992 compared to 1991 was principally due to the increase in pre-tax earnings. LIQUIDITY AND CAPITAL RESOURCES The meat processing industry is characterized by high working capital requirements. This is due largely to statutory provisions that generally provide for prompt payment for livestock, while it takes IBP on average about one week to turn its inventory and 14 to 15 days to convert its trade receivables to cash. These factors, combined with fluctuations in production levels, selling prices and prices paid for livestock can impact cash requirements substantially on a day-to-day basis. Accordingly, the current revolving credit facilities (more fully described in Note C to the consolidated financial statements) provide IBP with same-day access to $375 million in potential borrowings. At December 25, 1993, the unused portion of the credit line was $275 million. Although IBP has significant working capital requirements, its accounts receivable and inventories are highly liquid, characterized by rapid turnover. The following are key indicators relating to IBP's working capital and asset- based liquidity: December 25, December 26, 1993 1992 Working capital (in thousands) $336,668 $329,727 Current ratio 1.92:1 1.89:1 Quick ratio 1.29:1 1.27:1 Number of days' sales in accounts receivable 15.4 14.8 Inventory turnover 51.1 50.7 Capital expenditures in 1993 and 1992 totaled $59.6 million and $35.5 million, respectively. The increased 1993 spending was due in part to the purchase of a pork plant in Logansport, Indiana and to several plant capacity expansions. Capital spending is expected to be $90 to $100 million for 1994, which management intends to fund from operating cash flows and available debt facilities. IMPACT OF NEW ACCOUNTING PRONOUNCEMENT Effective December 27, 1992, the Company adopted SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions." Adoption of this new standard had no impact on the Company because IBP does not provide programs for Company-funded postretirement benefits. STOCKHOLDERS AND MARKET DATA IBP's common shares were held by approximately 11,000 stockholders of record at year-end 1993. The common stock is traded on the New York, Midwest, Philadelphia and Pacific Stock Exchanges. IBP, inc. AND SUBSIDIARIES Fiscal Year Ended ---------------------------------------------------------- December December December December December 25, 26, 28, 29, 30, 1993 1992 1991 1990 1989 OPERATIONS: ----------- ----------- ----------- ----------- --------- Net sales $11,671,397 $11,128,405 $10,387,686 $10,185,255 $9,128,596 Gross profit 271,095 248,193 145,072 220,278 189,968 Selling, general and administrative expense 96,626 87,751 84,002 95,578 86,696 Earnings from operations 174,469 160,442 61,070 124,700 103,272 Interest, net (43,212) (51,826) (58,817) (48,973) (48,047) Earnings before income taxes, accounting change and extraordinary item 131,257 108,616 2,253 75,727 55,225 Income taxes 53,800 45,000 900 27,400 19,900 Accounting change (1) 12,626 - - - - Extraordinary loss - - - (5,980) - Net earnings 90,083 63,616 1,353 42,347 35,325 PER SHARE DATA: Earnings per share: Earnings before accounting change and extraordinary item $1.62 $1.34 $.03 $1.01 $.74 Accounting change .26 - - - - Extraordinary loss - - - (.12) - Net earnings 1.88 1.34 .03 .89 .74 Dividends per share .20 .30 .60 .60 .60 FINANCIAL CONDITION: Working capital $ 336,668 $ 329,727 $ 238,163 $ 234,441 $ 182,419 Total assets 1,538,907 1,499,427 1,450,480 1,524,615 1,352,919 Long-term obligations 460,723 510,900 509,901 507,028 416,296 Stockholders' equity 612,796 534,077 482,643 511,295 497,291 (1)Cumulative effect of change in accounting for income taxes. EXHIBIT 21 SUBSIDIARIES OF IBP, inc. December 25, 1993 IBP Foreign Sales Corporation IBP Hog Markets, Inc. IBP International IBP International, Inc. Asia* IBP International, Inc. Europe* IBP Leasing Corporation of Nebraska IBP Properties, Inc. IBP of Wisconsin, inc. IBP Service Center Corp. PBX, inc. Rural Energy Systems, Inc. Texas Transfer, Inc. _______________________ *Stock is 100% owned by IBP International, Inc. EXHIBIT 23 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 33-19441 and 33-51903) relating to the IBP 1987 and 1993 Stock Option Plans of our report dated February 4, 1994 appearing on page 8 of the Annual Report to Stockholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page 16 of this Form 10-K. PRICE WATERHOUSE /s/Price Waterhouse Chicago, Illinois March 23, 1994

277821_1993.txt

277821

1993

ITEM 1. BUSINESS. GENERAL DEVELOPMENT OF THE COMPANY'S BUSINESS National Education Corporation (the "Company") provides training and education to individuals, businesses and governments. The Company was originally incorporated in California in 1954 and reincorporated in Delaware in 1972. Its business is conducted through four operating entities: ICS Learning Systems, Inc. ("ICS"), Steck-Vaughn Publishing Corporation ("Steck-Vaughn"), National Education Centers, Inc. ("Education Centers") and National Education Training Group, Inc. ("NETG"). During 1993, the Company took substantive measures to turn around the operations at NETG and Education Centers. As a result, the Company's operating performance improved in the fourth quarter of 1993 as compared to the fourth quarter of 1992. This improvement reflects the substantial investments the Company made in product development and marketing at NETG. Overall for 1993, the Company reported a net loss of $9.6 million, compared to net income of $515,000 in 1992. The 1993 loss includes a third quarter $32.9 million pretax write-off for the closure of 14 schools at Education Centers, as well as a write-down of certain intangible assets at NETG. The loss was partially offset by a one-time gain of $21.3 million on the initial public offering of Steck-Vaughn shares. In 1993, ICS achieved a 12.2% increase in revenues and a 13.8% increase in operating income. These results are directly related to a 28,692, or 10.1%, increase in enrollments resulting partially from an expanded telesales operation that improved the conversion of prospective students into enrollments, additional advertising spending and new product introductions. ICS' computer and related training is the company's fastest growing product line and has achieved compound annual growth since 1988 of over 30% in revenue and enrollments. ICS has a total of 14 courses that include an IBM compatible computer as part of a total training package. Also during 1993, ICS introduced the following five new courses: Home Inspector, Real Estate Appraiser, Medical Transcriptionist, Child Psychology and DeskTop Publishing and Design. Based on statistics compiled by the National Home Study Council ("NHSC"), the United States Department of Education recognized accrediting body for independent study schools, ICS continues as the industry leader in generating new enrollments. During 1993, more than 35,000 students enrolled in ICS' high school diploma program and more than 27,000 students enrolled in ICS' eleven two-year associate degree programs in business and technology. An additional 250,000 students worldwide pursued courses in other ICS career and hobby-related areas. ICS acquired the Industrial Print business unit from sister subsidiary NETG in 1993. This unit was combined with the English Language Institute, which was acquired in 1992 and renamed ICS Learning Systems, Business and Industrial Training Division. Through renewed marketing efforts, including an expanded sales force and a streamlined course catalog and database marketing system, this unit markets over 1,000 individual courses and 10,000 hours of education and training. More than 2,000 businesses in America use ICS products to train their workforce. ICS Online, which ICS established in 1993, is an electronic campus which is featured on the fastest growing online service in the United States, America Online ("AOL"). ICS was one of the first home study schools to establish this service and currently offers the following online services through links between personal computers: ICS Library, ICS Bookstore, Electronic Bulletin Board, Online Classroom, Online Enrollment, plus the hundreds of features available on the AOL service. Steck-Vaughn completed an initial public offering of 2,668,000 shares of its common stock at $12.00 per share in July 1993, generating approximately $29,775,000 of net proceeds. This initial public offering represents approximately 18% of the stock of the Company's Steck-Vaughn subsidiary. The net proceeds were reduced by expenses of $1,074,000 that were incurred in connection with the initial public offering. On April 1, 1993, Steck-Vaughn declared a $19,999,000 dividend payable to the Company. The dividend and certain intercompany balances were later paid from proceeds from the offering. During 1993, Steck-Vaughn continued its growth with increases in revenues and operating income of 17.8% and 8.0% respectively, with revenue increases outpacing industry averages. The fastest growing segment of Steck-Vaughn was its library division, which continued to introduce a significant number of new titles in 1993. Overall growth was attributable to continued new product introductions, an expanded selling organization and intense marketing efforts. Steck-Vaughn maintained its aggressive product development effort and produced many new titles in all of the market areas it serves. More than 230 new products were released in 1993. In April 1993, Steck-Vaughn paid approximately $5.4 million to acquire THE MAGNETIC WAY(TM) product line from Creative Edge, Inc. THE MAGNETIC WAY(TM) product line, consisting of magnetic boards and overlays, can be integrated with Steck-Vaughn's print products or marketed as a stand-alone teaching tool. This innovative product line increases Steck-Vaughn's presence in the English as a Second Language market. Due to the rapidly expanding number of products offered, Steck-Vaughn reorganized its sales force effective January 2, 1994. During 1993, each salesperson was responsible for the whole product range, which included elementary, high school, library and adult education markets. Beginning in 1994, the sales force will be segmented into two groups. One group will focus on the elementary, junior high school and library markets, while the other group will focus on the high school and adult education markets. This reorganization will allow the two groups to focus their expertise, time and energy in a more productive way. Education Centers is one of the largest operators of private postsecondary schools in the United States. In 1993, it became more difficult for students at a number of locations, especially in urban areas, to obtain access to federally guaranteed student loans. Certain provisions of the Higher Education Act of 1992, as well as the recent Omnibus Budget Reconciliation Act, caused some lenders to terminate participation in federally guaranteed student loan programs. These difficulties prompted Education Centers to restructure its operations. Anticipating that decreased access to funding would result in further operating losses in some of its schools for the year ending December 31, 1993 and future years, Education Centers elected to cease new student enrollments at 15 of its 48 schools. Education Centers' revenues of $133.2 million decreased $23.9 million or 15.2% from revenues of $157.0 million in 1992. Operating losses before unusual items of $5.5 million compared to operating income before unusual items of $10.8 million in 1992. During the third quarter of 1993, Education Centers restructured its operations and ceased new student enrollments at 14 of its schools, while allowing existing students to complete their educational programs at the schools. As a result, Education Centers recorded an unusual charge of $23.6 million, which included a write-down of assets and estimated costs of closing 14 schools. In February 1993, NETG reorganized its structure to stabilize and reposition the operations for turnaround. NEC named Robert Soto as its new president and it strengthened its management team by adding new vice presidents in product development, marketing and sales. The company directed much of its effort toward developing training courses in areas that are significantly growing in demand, such as client/server computer, business process reengineering, desktop computing, and management and professional development. NETG also restructured its United States sales operations, expanded its marketing activities, and made significant expansions of product development capabilities. Additionally, the company completed the sale of its Canadian operations to a subsidiary of SHL Systemhouse Inc., who will become the distributor of NETG products in Canada. NETG's 1993 revenues of $68.3 million decreased $14.3 million, or 17.3% from revenues of $82.6 million in 1992. In 1993, operating losses of $26.0 million before unusual items increased $4.1 million from losses of $21.9 million in 1992. During the third quarter of 1993, NETG recorded an unusual charge of $9.2 million that resulted from the write-down of certain acquired intangible assets. The decrease in revenues and the increase in operating losses at NETG primarily resulted from a lower contract backlog at the beginning of the year and the transfer of the Industrial Print operation to ICS effective January 1, 1993. Additionally, operating losses increased due to an increase of $3.0 million in product development expenditures, or 29% over the prior year. DESCRIPTION OF BUSINESS BY INDUSTRY SEGMENT Revenues and operating income (loss) by industry segment for the past three years are as follows: ICS Learning Systems, Inc. General. The company provides training and education to consumers and companies under the following names: ICS Learning Systems, English Language Institute, International Correspondence Schools, North American Correspondence Schools, and the ICS Center for Degree Studies (collectively referred to as "ICS"). ICS offers more than 50 independent study courses in the United States and more than 100 courses abroad in disciplines ranging from high school completion requirements through occupational training and associate technology degree programs in business and engineering. Curricula and Product Development. Curricula are carefully designed to reflect the most important trends in employment opportunities and consumer interest. New courses introduced during 1993 include Home Inspector, Real Estate Appraiser, Medical Transcriptionist, Child Psychology and DeskTop Publishing and Design. In addition, a major project to convert all existing print-based products to an electronic format continued in 1993 and was complemented by the installation of a digital data network to facilitate online editing, filing and retrieval, and transfer of products. This format also facilitates the transfer of documents directly to high technology printers in digital format, which will eventually allow ICS to reduce inventory requirements, virtually eliminate any material obsolescence, and position the company to move product electronically via any digital transfer mechanism. Traditionally, all independent study courses have been structured around "graded lessons" in which the student receives one section of instructional material at a time, which must be completed before proceeding to the next section. Courses are designed to be completed by the typical student in periods ranging from 12 to 24 months, depending on the course selected. A computerized student information/testing system permits students, through touch-tone telephones or voice response, to obtain immediate testing and feedback on test results. Over 90% of the 1.5 million exams graded by ICS during 1993 were graded electronically by either the information/testing system via telephone or by electronic scanner. With improved technology, the cost of grading an exam is at an all-time low while the speed of correcting an exam and turnaround to the student have never been faster. ICS utilizes a voice activated computer record access system that allows students to obtain key information from their records, 24 hours a day, without operator assistance. These services are a direct result of a published commitment to 100% customer satisfaction. Tuition for ICS' independent study courses ranges from approximately $400 to $2,300. Students generally pay a portion of the tuition upon enrollment and the balance on a monthly basis. ICS estimates that students complete an average of approximately 40% to 65% of lessons, depending on the course. The company's accounting treatment recognizes independent study contract revenues when cash is received, but only to the extent that such cash can be retained under existing refund policies of the National Home Study Council ("NHSC") and applicable state law. ICS is not dependent on financial aid from the federal government. ICS has recently established a domestic telesales department by which in-bound telephone inquiries are answered by its in-house telesales staff. These telesales professionals seek to enroll students over the telephone without needing to send the customer ICS' traditional sales literature. During the past two years, new telesales departments have been established in Canada, the United Kingdom and Australia. Telesales improved the number of prospective students converted into enrollments and, accordingly, contributed to the 10.1% increase in enrollments at ICS. During 1993, ICS created ICS Online, which is an electronic campus now available on America Online. Through this electronic campus, ICS offers real-time instruction, and ICS students can query their instructors, learn from other students, and discuss their lessons with each other. To accommodate future growth, ICS acquired a warehouse during September 1993. The warehouse consists of 82,000 square feet and is located on approximately 31 acres of land in Ransom, Pennsylvania. Advertising and Marketing. ICS markets its independent study courses throughout its United States and international operations utilizing direct response advertising through print, television media and direct mail marketing. Telemarketing is also used in the United States, Canada, United Kingdom, and Australia. During 1993, ICS began using its computer driven predictive dialing system in its United States-based operation to dial back automatically individuals who have previously requested information from ICS. Live operators then speak directly to the consumer about enrolling in the program. This process has improved telemarketing productivity. Also during 1993, ICS increased its handling of inbound marketing calls by establishing more inbound lines directly to the ICS Marketing Call Center. All of ICS' independent study courses in the United States are accredited by the NHSC. ICS also offers courses in many other English- speaking countries throughout the world. During 1993, ICS enrolled students from more than 150 different countries. With the 1993 transfer of NETG's Industrial Print operation to ICS, which ICS combined with the English Language Institute acquired in 1992 and renamed ICS Learning Systems, Business and Industrial Training Division, ICS intends to pursue independent study training opportunities with business and government agencies. ICS has renewed its marketing and sales efforts by expanding its sales force, streamlining its catalog and offering more courses in an effort to expand this division's customer base. Competition. The independent study industry is highly competitive. The company faces direct competition from United States and foreign independent study providers and indirect competition from community colleges, vocational and technical schools, two-year colleges and universities, and, to a lesser extent, governmental entities and other "distance learning" companies and schools, including electronic universities. In recent years, technological changes have increased the variety of choices available to students in selecting the type of education and the manner in which it is delivered, thereby increasing the entities with which ICS competes for student enrollment. Overall, the Company believes that ICS' competitive position is good. Steck-Vaughn Publishing Corporation General. Steck-Vaughn is one of the country's largest publishers of supplemental educational materials and offers educators a broad range of quality products that address educational needs from early childhood through adulthood. The term "supplemental materials" generally refers to softcover, curriculum-based books, workbooks and other support materials that are used in conjunction with or instead of traditional hardcover "basal" textbooks. Steck-Vaughn also publishes reference and nonfiction products for school and public libraries, as well as bookstores. Sales and Marketing. Steck-Vaughn markets all of its products through multiple distribution channels, including a national sales and telesales organization and has an established reputation for meeting the needs of its broad-based markets. Additionally, Steck-Vaughn has a distributor organization which services public libraries, trade outlets, and other nontraditional school markets. Steck-Vaughn has begun to establish a presence in foreign markets where English language curriculum and library products are in demand. Steck-Vaughn's customer service group emphasizes prompt and accurate delivery of published materials. Steck-Vaughn expanded and realigned its sales force, effective January 2, 1994, into two segments. One group will concentrate on the elementary and junior high schools and school and public libraries, and the other group will focus on the high school and adult education markets. This reorganization of what was previously a smaller group calling on all Steck-Vaughn markets will allow the two groups to focus their expertise, time and energy in a more productive way. Product Development. During the past three years, Steck-Vaughn has increased significantly the number of new educational materials created primarily for use in elementary and secondary schools. In 1991, Steck-Vaughn augmented its development of library titles with the addition of the Raintree product line, a highly respected library publisher in the children's library market. Steck-Vaughn has also responded to growing areas of adult education with the introduction of new publications for adult basic education and adult literacy. In 1990 and again in 1993, Steck-Vaughn was awarded the exclusive distribution rights of the Official Practice Test of the GED Testing Service of the American Council for Education. In April 1993, Steck-Vaughn acquired THE MAGNETIC WAY(TM) product line from Creative Edge, Inc. The product line consists of magnetized boards with metallic coated visual overlays. These products are used by teachers and students to build hands-on displays paralleling curriculum topics for social studies, language arts, reading and science. Twelve comprehensive learning packages, which sell for $200-$450 each, are currently available for use with the magnetized board which sells for approximately $85. Steck-Vaughn also introduced a lower-priced, smaller set of similar products in the fall of 1993. Competition. There are many companies that compete with Steck-Vaughn in the educational publishing field. No single company is dominant in the industry segments for which Steck-Vaughn publishes. Overall, the Company believes that Steck-Vaughn's competitive position is good and that growth has occurred due to new products and increased sales and market penetration. National Education Centers, Inc. General. Education Centers operates 33 postsecondary career schools in urban and suburban locations in 16 states. In addition, Education Centers is in the process of closing 15 schools, which are in various stages of teaching existing students until the schools close. The schools provide training for entry-level occupations in five major disciplines: Medical, Electronics, Business, Automotive, and Aviation. Most schools offer multiple curricula, but no school offers every discipline. Hands-on training using labs and some media-based delivery methodologies form the basic curriculum philosophy. Programs ranging in length from 8 to 36 months are offered to individual students as well as government agencies with a training mandate and organizations having employee training needs that are met by Education Centers' curricula. Curricula. The occupations for which Education Centers offers training programs include medical and dental assistants, electronics technicians, computer-aided drafters, computer programmers, commercial artists, aviation mechanics, broadcast technicians, secretaries, personal computer specialists, ophthalmic technicians, automotive mechanics and pilots, among others. Certain schools offer Bachelor degrees in Interior Design and Electronics Engineering Technology. Tuition for the programs ranges from $4,000 to $25,000 depending on length of course and subject matter. Tuition for government and industry training engagements varies from contract to contract as a function of contract training hours. All courses offered by Education Centers were developed internally or with the assistance of consultants. The development process begins with the establishment of criterion-referenced learning objectives based on achieving skills-based competencies demanded by employers. These objectives drive the development of lesson plans for instructors to follow. Specific test-bank items are then prepared to ensure students master the subject matter. Education Centers has emphasized a modular, nonsequential curriculum design structure for newer programs. The modular design enables Education Centers to start students more frequently and reduce costs due to increased efficiencies. National focus group meetings and surveys conducted in 1993 have provided input from employers that will result in a number of initiatives, including major modifications to the electronics and allied health curricula. Also, program opportunities were identified in computerized accounting and secretarial areas. While these two curricula are not new to Education Centers' program directory, they will be considered for new development with a high-technology focus in 1994. An approach emphasizing individual product lines has been incorporated into the curriculum development and maintenance process which will better integrate the various facets of the business. Job Placement. Over the past three years Education Centers has placed almost 32,500 graduates in jobs. Education Centers maintains placement personnel in each school, has fully computerized its job placement tracking system, and has initiated communication and training programs to achieve its placement goals. To ensure fair value to its student clients, Education Centers has increased its focus from simply graduating students to placing and verifying that graduates are experiencing initial success in their positions for at least three months. Education Centers continues to monitor the overall placement rate as an indicator of progress. Completion. Completion is recognized as one of the critical measures of Education Centers' success. The completion rate for 1993 was 59.5%, with significantly better rates in short-term programs. Higher entrance standards, greater focus on each student's commitment at enrollment, enhanced curricula, greater focus on career development skills, better placement information, and increased involvement with placement staff are several initiatives being implemented to increase completion, as well as placement rates. Financial Aid. Education Centers assists its students in assessing their eligibility for financial aid and in procuring available financial aid. Federal and state financial aid represented approximately 85 percent of Education Centers' revenues and approximately 32 percent of consolidated revenues in 1993. Grant programs, principally the Pell grant, entitle certain students to receive funds for tuition and other educational expenses, based on financial need. These grants may be available to students with family incomes of less than $25,000 per year, and historically many students of Education Centers qualified for these grants. There is no assurance that future governmental programs providing financial assistance to Education Centers' students will remain available at levels which have existed in prior fiscal years. Certain provisions of the Higher Education Act of 1992, as well as the recent Omnibus Budget Reconciliation Act, caused some lenders to terminate participation in federally guaranteed loan programs. Students' access to government financial aid programs has become more restricted due to an increasing number of lenders and guarantors declining to serve vocational schools with shorter-term programs or higher default rates. To alleviate the problem, during the third quarter of 1993, Education Centers ceased enrollments at 14 schools and initiated a program to provide internal financing to Education Centers' students. (For more detailed information regarding discussion of financial aid, see the "Liquidity and Capital Resources" section starting on page 21 of the Company's 1993 Annual Report to Stockholders.) Education Centers has instituted a student loan default reduction program which includes information from the Default Management Manual prepared and distributed by the Career College Association. Education Centers has also incorporated information from the Department of Education Default Reduction Initiative federal regulations issued June 5, 1989, into its default program, plus additional default reduction strategies of its own. Additionally, most of Education Centers' schools use an outside consulting group to contact former students who are reported as delinquent in federal loan repayments to provide information and assistance in avoiding a default on their loans. Education Centers anticipates that its current default programs will reduce the number of future student loan defaults. Accreditation. All schools operated by Education Centers are accredited. Of the 33 schools currently enrolling students, 28 are accredited by the Accrediting Commission of Career Schools and Colleges of Technology (formerly known as the Accrediting Commission for Trade and Technical Schools), and five are accredited by the Accrediting Council for Independent Colleges and Schools, formerly known as the Accrediting Commission for Independent Colleges and Schools. Each school voluntarily undergoes periodic accrediting evaluations by teams of qualified examiners. Advertising and Marketing. Education Centers markets its courses to individual students, organizations, and governmental agencies. It utilizes various direct response advertising media including television, direct mail, and newspapers. In addition, Education Centers offers 90 partial-tuition scholarships to high school students in markets where its schools are located and utilizes Education Centers' employees to give public service presentations at these high schools. For organizations and government entities, Education Centers maintains a staff to make sales calls and prepare proposals based on training needs analyses and/or the existing government request for proposal process. Competition. Education Centers encounters active competition in the marketing of vocational and technical training programs from junior colleges and other public institutions, military training programs, and other proprietary schools. The nature and degree of competition largely depend on the courses being offered by Education Centers' locations and the geographical proximity of competing schools. Competitors may vary substantially in the treatment of course subject matter, the amount of tuition or other fees charged, the duration of the course, and the job placement success rate. Overall, the Company believes Education Centers' competitive position is satisfactory. National Education Training Group, Inc. General. Established in the late 1960s, NETG specializes in providing multimedia products to educate, train and transfer skills to corporate and government employees, with specific emphasis on information systems training. Headquartered in Naperville, Illinois, NETG course offerings range from hands-on, skill-based training to courses that build awareness or provide a theoretical understanding of current business developments. Markets, Products and Delivery Media. NETG offers education and training in the areas of information technologies, enterprise systems, desktop computing, management and professional development, and manufacturing and industrial skills. Because each training audience has its own specific needs, NETG has subdivided its curricula into five primary product lines: Desktop Computing. Today's business environment has generated an overwhelming demand for end-user business applications and desktop system training. In response to this demand, NETG has harnessed the enormous potential of current technologies, such as compact disc-read only memory ("CD-ROM"), the 486-based workstation, and sophisticated training and work support system. The end-user courses are built around specific business case scenarios that allow participants to learn relevant skills quickly and immediately apply those skills to their jobs. Information Technologies (Client/Server Computing and Enterprise Systems Product Lines). NETG has a long history of supporting information systems training. Today the course offerings reflect the varied and changing nature of information systems and include topics on a wide range of technologies such as client/server, object-oriented technologies, networking, and open systems technologies. Management and Professional Development. NETG offers effective, relevant management and professional development training that can help organizations meet their business needs and objectives. The courses emphasize productivity and performance issues. They provide the means for improving personal, management and business skills that are essential to developing highly productive and professional employees. Manufacturing and Industrial Skills. Today's manufacturing and industrial organizations are concerned with reducing costs, reducing risks of accidents, complying with regulations and creating an overall healthy work environment. NETG is committed to providing workers with the most accurate, comprehensive and up-to-date training solutions available. The NETG course library features approximately 1,000 courses on a variety of media including: 1) Videotape: Each video course is a training package comprised of one or more videotaped instructional sessions, audio sessions, and associated textual materials, including comprehensive student and coordinator guides. Groups of related video courses in a specified curriculum are taken as needed by the student to develop various job-related skills either at a task level or at a complete topical level. 2) Local Area Network ("LAN"): Organizations are interconnecting more and more personal computers and workstations via LANs to enable individuals to share information and communicate effectively. Training applications conveniently residing on LANs enable individuals to select from a variety of courses for use on their desktop systems. A number of NETG's computer-based products are available for use on LANs, including the SKILL BUILDER(R) courses. 3) Interactive Video Instruction ("IVI"): Many of NETG's courses are available through interactive delivery media, interactive videodiscs and computer diskettes in conjunction with related textual materials and guides. IVI combines the interactivity and control of the personal computer with video, sound and graphics. 4) Computer-Based Training ("CBT"): CBT products use a computer to deliver interactive instruction, drill and practice, simulation and remedial training. Training programs in NETG's mainframe CBT library include information processing skills training, end-user computing and fourth generation languages, and other subjects related to the application of information technologies. Customers can distribute CBT through worldwide networks because the CBT is stored on a mainframe computer and the training may be accessed simultaneously by students in multiple locations. 5) Compact Disc-Read Only Memory ("CD-ROM"): CD-ROM formatted products are interactive and targeted to meet the growing demands of desktop training. NETG's SKILL BUILDER(R) Series offers a unique architecture which provides a method of learning an application program in which different learning paths may be utilized. The digital mass storage capability inherent in CD-ROM creates lower delivery costs and facilitates updating or customizing the content. 6) Instructor-Led Training ("ILT"): NETG's ILT Group provides a network of skilled instructors to conduct courses in data processing, end user computing, human resource development and manufacturing. NETG's instructor-led programs offer tested course materials developed by training experts within each field. Course content is regularly updated to incorporate the latest technological advances. This selection of delivery options allows greater flexibility in designing training programs that are customized to specific resources. Each of these media offer particular strengths that are brought into play by the requirements of individual training programs. Course Production and Acquisition. NETG has significantly increased its investment in product development to expand course offerings in the emerging technology areas of client/server computing, networking, object-oriented technologies, business reengineering, desktop computing, management and professional development, and manufacturing and industrial skills. NETG is providing high quality learning solutions that effectively and efficiently deliver a direct learning payoff to the participant. All NETG courses are designed to introduce the topic, state the purpose, present the subject matter, and provide examples and practice exercises. NETG's new educational instruction system allows an individual to select from three types of content: informational, conceptual and skills-based training: Informational Courses - build awareness about the particular course topic. The student will acquire a high-level understanding of the subjects covered. These courses are primarily descriptive, and their technical content is lower than the other two course types. Conceptual Courses - provide the student with a theoretical understanding of the topic. After completing the course, the student will have an analytical perspective of the subjects covered. Skills-Based Courses - teach proficiency in a topic. After completing these courses, the student will have a practical knowledge of the subject. Acquisitions/Corporate Partners. NETG is actively acquiring products and technology through strategic alliances and co-development agreements with leading software vendors and training organizations that offer expertise on advanced technologies, desktop computing and management and professional development skills. These choices are driven by customer requests and current market trends. As part of a commitment to quality standards, topics are selected and produced with leading subject matter experts, industry authorities and top educators in each subject area. By aligning itself with leading training developers and industry experts on the most sought after topics in today's business environment, NETG can provide its customers with timely and relevant training and education solutions that provide the proficiency and competency organizations are seeking. NETG corporate business partners include: Andersen Consulting Hands On Learning Individual Software Intelecom Intelligent Communications MicroVideo Learning Systems Novell, Inc. Open Systems Training Video Publishing House Wave Technologies Wilson Learning Xebec Multi-Media Solutions Customized Services. NETG-Spectrum in Bedford, Massachusetts, is the consulting and custom development division of NETG. Spectrum specializes in helping companies use the power of multimedia technology to improve the knowledge, skills and performance of people. Spectrum's high quality, practical solutions have supported strategic change and achieved significant business results such as reduced costs, increased sales, enhanced customer satisfaction, decreased turnover, increased span of control and improved timeliness of information. For over a decade, Spectrum has provided a full scope of services in the design of multimedia performance systems, including consulting, instructional systems design, media production and implementation services. Spectrum uses a full range of delivery media and systems encompassing interactive video, desktop multimedia, workshops, print and video. After determining the optimal choice of media and methods to solve the problem and reach the audience, Spectrum serves as the learning system's integrator to ensure improved performance and results. Distribution, Service, Marketing and Sales. NETG is an international organization with 74 offices and production and distribution centers worldwide. The corporate headquarters are in suburban Chicago, Illinois, and international headquarters are in London, England. The company has approximately 600 employees. Wholly owned subsidiaries are located in the United Kingdom, Netherlands, Germany and Austria. NETG Service System. NETG's Product Support Center, located in Naperville, Illinois, provides customers with toll-free technical assistance, answers to software and hardware questions, and assistance in the installation and ongoing use of courseware products. Support analysts are available to address inquiries 24 hours a day, seven days a week. Customers may also log and track inquiries through a bulletin board. In addition to toll-free product support, NETG also provides toll-free customer service for order placement and product descriptions, including course profiles, prerequisites, target audience descriptions, and details on specific components of courses. NETG also conducts progress reviews which measure and evaluate the success of a training program, as well as an inventory tracking system that details which courses were received, installed and returned. Additional services available to customers include: consultative training needs analysis to help customers identify all performance improvement opportunities; training management workshops that provide training administration techniques; and custom training product design and development services to modify existing courses or develop new fully customized courses. NETG Sales Organization and Distribution Channels. NETG's revenues are primarily generated from customer contracts. Customers typically sign annual agreements based on the amount of training they would expect to require in a twelve-month period. Contracts range from approximately $2,000 to over $1,000,000. NETG has a staff of telemarketing and telesales representatives in the United States, and a separate telesales staff in Europe. The telesales groups offer the same products as the direct sales force, but focus their efforts toward companies with revenues between $100 - 200 million. The sales cycles average two to four months and the average contract is $3,000. NETG's products are also available through local distributors or agents in Argentina, Australia, Bolivia, Brazil, Canada, Denmark, Ecuador, Egypt, Finland, France, Ghana, Hong Kong, India, Iran, Israel, Korea, Malaysia, New Zealand, Nigeria, Norway, Peru, Russia, Saudi Arabia, Singapore, Spain, Sweden, Taiwan, Turkey, the United Arab Emirates, and Venezuela. Competition. The Company believes the total training market in North America is in excess of $45 billion annually for industry and government, and that NETG is one of the largest multimedia training companies in this very large, highly fragmented and competitive market. Most training needs are satisfied by instructor-led training. NETG faces active competition from existing or potential client internal training operations, vendor-supplied training operations, other independent training companies offering instructor-led or multimedia training, universities and community college systems. NETG competes in the training market on the basis of: quality and instructional effectiveness of its training programs; quantity, thoroughness and timeliness of its training programs; price; ability to deliver course material in a timely manner; and client services. Overall, the Company believes that its competitive position is good. Major competitors include CBT Systems, SRA and COMSELL, among others. Foreign Operations The following table shows consolidated net revenues of the Company in foreign countries for 1993, 1992 and 1991: Consolidated operating results are reported in United States dollars. Because the foreign subsidiaries of the Company conduct operations in the currencies of the countries in which they are based, all financial statements of the foreign subsidiaries must be translated into United States dollars. As the value of the United States dollar increases or decreases relative to these foreign currencies, the United States dollar value of items on the financial statements of the foreign subsidiaries is reduced or increased, respectively. Therefore, changes in dollar sales of the foreign subsidiaries from year to year are not necessarily indicative of changes in actual revenues recorded in local currency. Financial information about foreign and domestic operations is described in Note 13, page 33 of the Company's 1993 Annual Report to Stockholders, which Note is hereby incorporated by reference in this Annual Report on Form 10-K. The Company's ability to continue operations outside of the Unites States or maintain the profitability of such operations is to some extent subject to control and regulation by the United States government and foreign governments. The Company's foreign operations are primarily located in the United Kingdom, Canada, Australia and Germany, which historically have controlled and regulated businesses in the same manner as the United States. Research and Development The amount spent during 1993, 1992 and 1991 on Company-sponsored research and development activities was approximately $24 million, $20 million, and $18 million, respectively. In 1993, the Company continued to invest in research and development to ensure new product availability for future revenue generation. The Company spends substantial sums primarily in the development of new products at NETG and Steck-Vaughn, and curricula for ICS and Education Centers. Seasonality of the Business Most of Steck-Vaughn's sales are made in the third quarter of the year because most of its customers purchase products in anticipation of classes commencing in the fall. ICS' business is moderately seasonal with more students studying during the latter part of the year. The Education Centers' business is moderately seasonal due to the inclination of its students to commence classes in the fall. NETG's business is seasonal due to the sales cycle from contracts expiring in the latter half of the year. There is no customer to whom sales are made in an amount that exceeds two percent or more of the Company's consolidated annual net revenues. Additional Information Unearned future tuition income for Education Centers and ICS, which represents amounts estimated to be recognized as revenue in subsequent years as services and courseware are provided, is described in Note 10, page 32 of the Company's 1993 Annual Report to Stockholders, which Note is hereby incorporated by reference in this Annual Report on Form 10-K. Financial information about industry segments is described in Note 13, page 33 of the Company's 1993 Annual Report to Stockholders, which Note is hereby incorporated by reference in this Annual Report on Form 10-K. Compliance with federal, state or local provisions concerning the discharge of materials into the environment or otherwise relating to the protection of the environment have no material effect on the Company's capital expenditures, earnings or competitive position. The Company employed approximately 4,200 persons as of January 31, 1994. Executive Officers of the Company The following table provides information regarding executive officers of the Company, including their ages as of March 1, 1994: ITEM 2.

ITEM 2. PROPERTIES. (a) The Company's corporate headquarters are located in leased facilities aggregating 40,000 square feet in Irvine, California. (b) The Company owns real property consisting of approximately 2.2 acres of land with a 22,000 square foot building in Nutley, New Jersey, for a National Education Center. (c) The Company owns an 180,000 square foot building on 15 acres of land and 80,000 square feet of buildings on leased land in Tulsa, Oklahoma, for a National Education Center. (d) The Company owns real property in Scranton, Pennsylvania, for the principal offices of ICS. This building consists of 120,000 square feet of space on 14.3 acres of land. (e) The Company owns an 82,000 square foot building on approximately 31 acres of land in Ransom, Pennsylvania for an ICS warehouse. (f) The Company owns the land and building serving as the warehouse for Steck-Vaughn Company. The building, located in Austin, Texas on approximately 13 acres of land, contains 101,000 square feet of space. (g) The Company owns 28,200 square feet of buildings on approximately 4.7 acres of land in Little Rock, Arkansas, for a National Education Center. (h) The Company owns 22,000 square feet of buildings on approximately 4.8 acres of land in West Des Moines, Iowa, for a National Education Center. (i) The Company owns 60,000 square feet of buildings on approximately 3.1 acres of land in Blairsville, Pennsylvania, for a National Education Center. (j) The Company owns 10,000 square feet of buildings on approximately .5 acres of land in Minneapolis, Minnesota, for a National Education Center. (k) The Company has approximately 130 leases for its operating units and offices, including the following: National Education Centers, Inc.'s headquarters in Irvine, California - approximately 24,000 square feet; National Education Training Group, Inc.'s headquarters in Naperville, Illinois - approximately 30,000 square feet; Steck-Vaughn Company's headquarters in Austin, Texas - approximately 31,000 square feet; and Spectrum's headquarters in Bedford, Massachusetts - approximately 52,500 square feet. Overall, the Company's properties are suitable and adequate for the Company's needs. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Company is a party to litigation matters and claims which are routine in the course of its operations and, while the results of litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a materially adverse effect on the Company's consolidated financial position or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of the Company's stockholders during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The markets on which the Company's Common Stock is traded and the high and low sales prices of the Company's Common Stock during each quarter for the last two years, appears on page 37 of the Company's 1993 Annual Report to Stockholders, which information is hereby incorporated by reference in this Annual Report on Form 10-K. No cash dividends have been declared or paid on the Company's Common Stock during 1993 or 1992. The Company has no present intent to pay cash dividends. The Company's Credit Agreement with its lending institutions restricts the payment of cash dividends. Approximate Number of Equity Security Holders: The number of record holders is based upon the actual number of holders registered on the stock transfer books for the Company at such date and does not include holders of shares in "street names" or persons, partnerships, associations, corporations or other entities identified in security position listings maintained by depository trust companies. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following financial information for the years 1989 through 1993 included in the Company's 1993 Annual Report to Stockholders is incorporated by reference in this Annual Report on Form 10-K: Five-Year Financial Highlights, page 18. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following information included in the Company's 1993 Annual Report to Stockholders is incorporated by reference in this Annual Report on Form 10-K: Management's Discussion and Analysis, pages 19 through 23. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following financial statements and the supplementary financial information included in the Company's 1993 Annual Report to Stockholders are incorporated by reference in this Annual Report on Form 10-K: The consolidated financial statements of the Company, pages 24 through 27 together with the report of Price Waterhouse, dated February 4, 1994 pertaining to the consolidated financial statements as of December 31, 1993 and 1992, and for the three years ended December 31, 1993, page 35. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The Company has no information to report in response to this item. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY. (a) The information required by Item 10 with respect to the directors of the Company is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. (b) The information required by Item 10 with respect to executive officers of the Company is furnished in a separate item captioned "Executive Officers of the Company" and included in Part I of this Annual Report on Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by Item 12 is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Item 13 is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. * Incorporated by reference from the indicated pages of the Company's 1993 Annual Report to Stockholders. **All other financial statement schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (3) Exhibits: See Exhibit Index. (b) No reports on Form 8-K were filed during the fourth quarter of 1993. NATIONAL EDUCATION CORPORATION REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of National Education Corporation Our audits of the consolidated financial statements referred to in our report dated February 4, 1994 appearing on page 35 of the 1993 Annual Report to Stockholders of National Education Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PRICE WATERHOUSE - ------------------------------- PRICE WATERHOUSE Costa Mesa, California February 4, 1994 NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES At December 31, 1993 (dollars in thousands) NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (dollars in thousands) (A) This amount primarily represents the write-off of intangible assets in connection with previous acquisitions for the Company's National Education Training Group of $9,232,000 and National Education Centers of $2,766,000. NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM AND BANK BORROWINGS (dollars in thousands) No short-term or bank borrowings were outstanding during the twelve month period ended December 31, 1992 and 1993. (A) - The average amount outstanding during the period was computed by dividing the total of the daily principal balances by 365. (B) - The weighted average interest rate during the period was computed by dividing the total interest expense by the weighted average principal amounts of borrowings. (C) - These amounts exclude the portion of domestic bank debt which was refinanced by the issuance of the $20,000,000 senior subordinated convertible debentures in February 1991. NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION (dollars in thousands) Taxes other than income and payroll taxes are not presented as the amounts are less than one percent of total revenues. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NATIONAL EDUCATION CORPORATION Date By /s/ JEROME W. CWIERTNIA March 16, 1994 - -------------------------------------- Jerome W. Cwiertnia President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. Date By /s/ JEROME W. CWIERTNIA March 16, 1994 - -------------------------------------- Jerome W. Cwiertnia, Director, President and Chief Executive Officer (Principal Executive Officer) By /s/ KEITH K. OGATA March 16, 1994 - -------------------------------------- Keith K. Ogata, Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) By /s/ CHRISTINE A. GATTENIO March 16, 1994 - -------------------------------------- Christine A. Gattenio, Vice President and Corporate Controller (Principal Accounting Officer) Date By: /s/ RICHARD C. BLUM March 10, 1994 - --------------------------------------------- Richard C. Blum, Director By: /s/ DAVID BONDERMAN March 14, 1994 - --------------------------------------------- David Bonderman, Director By: /s/ LEONARD W. JAFFE March 11, 1994 - --------------------------------------------- Leonard W. Jaffe, Director By: /s/ DAVID C. JONES March 10, 1994 - --------------------------------------------- David C. Jones, Director By: /s/ MICHAEL R. KLEIN March 10, 1994 - --------------------------------------------- Michael R. Klein, Director By: /s/ PAUL B. MACCREADY March 11, 1994 - --------------------------------------------- Paul B. MacCready, Director By: /s/ FREDERIC V. MALEK March 10, 1994 - --------------------------------------------- Frederic V. Malek, Director By: /s/ JOHN J. MCNAUGHTON March 9, 1994 - --------------------------------------------- John J. McNaughton, Director By: /s/ HAROLD SEGAL March 10, 1994 - --------------------------------------------- Harold Segal, Director By: /s/ WILLIAM D. WALSH March 10, 1994 - --------------------------------------------- William D. Walsh, Director INDEX TO EXHIBITS (Item 14(a)) * incorporated by reference from a previously filed document (1) Incorporated by reference to Exhibit (19)-2 filed with the Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1987. (2) Incorporated by reference to Exhibit 10 filed with the Form 10-Q Quarterly Report for the quarterly period ended June 30, 1990. (3) Incorporated by reference to Exhibit 10.1 filed with the Annual Report on Form 10-K for the year ended December 31, 1992, filed March 22, 1993. (4) Incorporated by reference to Exhibit 10(b) filed with Registration Statement on Form S-8 (No. 2-86904), filed October 3, 1983. (5) Incorporated by reference to Exhibit 15 filed with Registration Statement on Form S-8 (No. 2-71650), filed April 7, 1981. (6) Incorporated by reference to Exhibit D filed with the 1983 Proxy Statement dated April 25, 1983, for the annual meeting dated May 19, 1983. (7) Incorporated by reference to Exhibit 10.15 filed with the Annual Report on Form 10-K for the year ended December 31, 1987, filed March 30, 1988. (8) Incorporated by reference to Exhibit 10.17 filed with the Annual Report on Form 10-K for the year ended December 31, 1990, filed April 1, 1991. (9) Incorporated by reference to Exhibit "A" filed with the 1990 Proxy Statement, filed April 2, 1990. (10) Incorporated by reference to Exhibit "A" filed with the 1991 Proxy Statement, filed April 1, 1991. (11) Incorporated by reference to Exhibit 4.1 filed with Form 8-K Current Report, dated October 29, 1986, filed October 30, 1986. (12) Incorporated by reference to Exhibit 4 filed with the Annual Report on Form 10-K for the year ended December 31, 1987, filed March 30, 1988. (13) Incorporated by reference to Exhibit 4.2 filed with Amendment No. 1 to Registration Statement on Form S-3 (No. 33-5552), filed May 16, 1986. (14) Incorporated by reference to Exhibit 4 filed with the Form 10-Q Quarterly Report for the quarterly period ended June 30, 1990. (15) Incorporated by reference to Exhibit 4 filed with Form 8-K Current Report, dated February 20, 1991, filed February 27, 1991. (16) Incorporated by reference to Exhibit 10.17 filed with the Annual Report on Form 10-K for the year ended December 31, 1991, filed April 1, 1992. (17) Incorporated by reference to Exhibit 10.18 filed with the Annual Report on Form 10-K for the year ended December 31, 1991, filed April 1, 1992. (18) Incorporated by reference to Exhibit 10.19 filed with the Annual Report on Form 10-K for the year ended December 31, 1991, filed April 1, 1992. (19) Incorporated by reference to Exhibit 10.8 filed with Amendment No. 1 to the Steck-Vaughn Publishing Corporation Registration Statement on Form S-1, File No. 33-62334, filed June 17, 1993. (20) Incorporated by reference to Exhibit 10.9 filed with Amendment No. 1 to the Steck-Vaughn Publishing Corporation Registration Statement on Form S-1, File No. 33-62334, filed June 17, 1993. (21) Incorporated by reference to Exhibit 10.13 filed with the Steck-Vaughn Publishing Corporation Registration Statement on Form S-1, File No. 33-62334, filed May 7, 1993. (22) Filed herewith.

72903_1993.txt

72903

1993

Item 1 - Business Northern States Power Company (the Company) was incorporated in 1909 under the laws of Minnesota. Its executive offices are located at 414 Nicollet Mall, Minneapolis, Minnesota 55401. (Phone 612-330-5500). The Company has one significant subsidiary, Northern States Power Company, a Wisconsin Corporation (the Wisconsin Company) and several other subsidiaries, including NRG Energy, Inc. (NRG), and Viking Gas Transmission Company (Viking), both Delaware corporations. NRG manages several of the Company's non-regulated energy subsidiaries. Viking is a regulated utility that operates a 500-mile interstate natural gas pipeline. (See "NRG Energy, Inc." and "Other Subsidiaries" herein for further discussion of these two subsidiaries.) The Company and its subsidiaries collectively are referred to herein as NSP. NSP is predominantly an operating public utility engaged in the generation, transmission and distribution of electricity throughout a 49,000 square mile service area and the transportation and distribution of natural gas in approximately 133 communities within this area. The Company formerly supplied telephone service in the Minot, North Dakota, area. The telephone operation was sold on Jan. 31, 1991. (See "Telephone Operations" herein.) For business segment information, see Note 16 of Notes to Financial Statements under Item 8. The Company serves customers in Minnesota, North Dakota and South Dakota. The Wisconsin Company serves customers in Wisconsin and Michigan. Of the approximately 3 million people served by the Company and the Wisconsin Company, the majority is concentrated in the Minneapolis-St. Paul metropolitan area. In 1993, about 62% of NSP's electric retail revenue was derived from sales in the Minneapolis-St. Paul metropolitan area and about 57% of retail gas revenue came from sales in the St. Paul area. NSP's utility businesses are experiencing some of the challenges currently common to regulated electric and gas utility companies, namely, increasing competition for customers, increasing costs to operate and construct facilities, uncertainties in regulatory processes and increasing costs of compliance with environmental laws and regulations. In particular, NSP is experiencing problems with the storage of spent nuclear fuel from the Company's Prairie Island nuclear facility. Without additional storage or significant modification of normal plant operations, the plant will be shutdown in early 1996, which could have a significant financial impact on NSP. (See "Environmental Matters" herein, Management's Discussion and Analysis of Financial Condition and Results of Operations under Item 7 and Note 15 of Notes to Financial Statements under Item 8 for further discussion of this matter.) NSP made three strategically important business acquisitions in 1993 to operate more effectively in an increasingly competitive marketplace. NSP acquired an interstate gas pipeline, purchased assets of a non-regulated gas marketing business and expanded its non-regulated steam business. In 1993, NSP acquired Viking Gas Transmission Company and selected assets of the Centran Corporation. These Centran Corporation assets were reorganized into Cenergy, Inc., which provides NSP a vehicle to offer customized gas and energy services to fit customers' individual needs, both inside and outside the NSP service territory. The Viking pipeline allows NSP to lower its cost and to increase supply and storage flexibility. These two acquisitions together substantially increase our ability to compete in a more competitive business environment created by FERC Order 636. (See discussion at "Gas Operations" herein.) In addition, NRG purchased the Minneapolis Energy Center to position NSP as the major provider of central heating and cooling in Minnesota's largest city. NRG has also been active in the international market through partnership investments. NRG acquired part ownership in the MIBRAG Gmbh coal and power complex and the 900 megawatt (Mw) Schkopau power plant near Leipzig, Germany. In addition, NRG also plans to become the operator and 37.5% owner of the 1680 Mw Gladstone Power Station in Queensland, Australia. (See additional discussions of business acquisitions and partnership investments in the "NRG Energy, Inc." and "Other Subsidiaries" sections, herein, and in Note 4 of Notes to Financial Statements under Item 8.) Business Realignment In order for the Company to be prepared to successfully meet challenges in the changing utility industry and to compete effectively in an increasingly competitive environment, the Company began a functional restructuring of its organization in 1992. During 1993, the Company completed several phases of the functional restructuring. The Company is now organized around three core, customer-focused businesses: electric power generation, electric transmission and distribution, and gas distribution. The new organization will use shared services, agreements or service contracts between all businesses, and centralized support groups throughout the Company. This restructuring is expected to improve the Company's competitive position by reducing costs, expediting decision-making and improving operating efficiencies. REGULATION AND REVENUES General Retail sales rates, services and other aspects of the Company's operations are subject to the jurisdiction of the Minnesota Public Utilities Commission (MPUC), the North Dakota Public Service Commission (NDPSC), and the South Dakota Public Utilities Commission (SDPUC) within their respective states. The MPUC also possesses regulatory authority over aspects of the Company's financial activities including security issuances, property transfers when the asset value is in excess of $100,000, mergers with other utilities, and transactions between the regulated Company and non-regulated affiliates. In addition, the MPUC reviews and approves the Company's electric resource plans for meeting customers' future electric energy needs. The Wisconsin Company is subject to regulation of similar scope by the Public Service Commission of Wisconsin (PSCW) and the Michigan Public Service Commission (MPSC). In addition, each of the state commissions certifies the need for new generating plants and transmission lines of designated capacities to be located within the respective states before the facilities may be sited and built. Wholesale rates for electric energy sold in interstate commerce, wheeling rates for energy transmission in interstate commerce, the wholesale gas transportation rates of Viking, and certain other activities of the Company, the Wisconsin Company and Viking are subject to the jurisdiction of the Federal Energy Regulatory Commission (FERC). NSP also is subject to the jurisdiction of other federal, state and local agencies in many of its activities. (See "Environmental Matters" under Item 1.) The Minnesota Environmental Quality Board (MEQB) is empowered to select and designate sites for new power plants with a capacity of 50 Mw or more and routes for transmission lines with a capacity of 200 kilovolt (Kv) or more, and to evaluate such sites and routes for environmental compatibility. The MEQB may designate sites or routes from those proposed by power suppliers or those developed by the MEQB. No such power plant or transmission line may be constructed in Minnesota except on a site or route designated by the MEQB. NSP is unable to predict the impact on its operating results from the future regulatory activities of any of the above agencies. To the best of its ability, NSP works to understand and comply with all rules issued by the various agencies. Revenues NSP's financial results depend on its ability to obtain adequate and timely rate relief from the various regulatory bodies. NSP's 1993 utility operating revenues, excluding intersystem non-firm electric sales to other utilities of $110 million and miscellaneous revenues of $39 million, were subject to regulatory jurisdiction as follows: Authorized Return on Percent of Total Common Equity @ Revenues December 31, 1993 (Electric & Gas) (Electric Operations) Retail: Minnesota Public Utilities Commission 11.47% 73.4% Public Service Commission of Wisconsin 12.00** 14.7 North Dakota Public Service Commission 11.50 5.6 South Dakota Public Utilities Commission * 3.1 Michigan Public Service Commission 12.25 0.6 Sales for Resale - Wholesale and Interstate Transmission: Federal Energy Regulatory Commission * 2.6 Total 100.0% * Settlement proceeding, based upon revenue levels granted with no specified return. ** Return authorized for 1994 is 11.4%. Rate Programs Rate increases requested and granted in previous years from various jurisdictions were as follows (Note that 1992 and 1993 amounts represent annual increases effective in these years, while previous years represent annual increases requested in those years even if effective in a subsequent year.): Annual Increase Year Requested Granted (Millions of dollars) 1987 $122.0 $ 83.9 1988 4.4 3.0 1989 129.0 8.0 1990 19.5 11.2 1991 118.7 68.0 1992 ----- ----- 1993 166.6 101.5 The following table summarizes the status of rate increases filed during 1992 and 1993 for rates effective in 1993. Annual Increase Updated Requested Request Granted Status (Millions of dollars) Electric Minnesota-Retail $119.1 $112.3 $ 72.2 Order Issued 1/14/94 North Dakota-Retail 8.8 7.1 4.8 Order On Reconsideration Issued 4/7/93 South Dakota-Retail 6.3 4.2 Order Approving Settlement Agreement Issued 12/09/92 Wisconsin-Retail 10.8 8.0 Order Issued 1/14/93 Minnesota Wholesale 2.3 .9 (1) Wisconsin Wholesale .6 .6 (1) Gas Minnesota-Retail 14.9 12.4 10.0 Order Issued 12/30/93 Wisconsin-Retail 1.4 1.1 Order Issued 1/14/93 Viking Wholesale 2.4 (.3) (2) Total 1993 Rate Program $166.6 $101.5 (1) Order filed with a settlement agreement with rates effective in 1993. (2) Rate increase request filed 1991. Rates effective under a settlement agreement in 1993. The following table summarizes the status of rate increases filed in 1993 for rates effective in 1994. Annual Increase Updated Requested Request Granted Status (Millions of dollars) Electric North Dakota-Retail 1.2 1.2 Order Issued 12/29/93 Gas Wisconsin-Retail 1.4 1.7 1.4 Order Issued 12/23/93 Total 1994 Rate Program 2.6 2.6 Rate Matters by Jurisdictions Minnesota Public Utilities Commission (MPUC) In November 1992, the Company filed applications for rate increases totaling $119.1 million and $14.9 million for its Minnesota electric and natural gas customers, respectively. This represented annual increases of approximately 9% and 5.8%, respectively. In December 1992, the MPUC issued orders granting interim rate increases (subject to refund) of $71.2 million (5.4%) for electric service and $8.4 million (3.3%) for gas service, effective Jan. 1, 1993. In June 1993, the Company adjusted its proposed annual electric rate increase to $112.3 million and its gas rate request to $12.4 million. The Company received initial orders from the MPUC in September 1993 allowing an annual retail electric rate increase of $54.3 million (4.1%) and an annual retail gas rate increase of $8.3 million (3.3%). On Nov. 10, 1993, the MPUC reconsidered several issues common to both the electric and gas rate cases and on Dec. 2, 1993, reconsidered a number of other issues in the electric rate order. The Company received a final gas rate order after reconsideration on Dec. 30, 1993, granting an overall gas rate increase of $10.0 million (3.9%). The Company received a final electric rate order after reconsideration on Jan. 14, 1994, granting an overall electric rate increase of $72.2 million (5.4%). The return on equity granted in both cases was 11.47%. Electric rate refunds of interim rates collected are required in the amount of approximately $12 million, which were accrued in 1993 and are expected to be paid in May 1994. No refunds of interim gas rates collected are required. Final rates for gas customers were implemented in March 1994. Implementation of final rates for electric customers is expected in April 1994. The effects of reconsideration were recorded in the fourth quarter 1993, when reconsideration occurred. However, the Company restated its third quarter 1993 earnings for the effects of reconsideration. (See additional discussion in Note 17 of Notes to Financial Statements under Item 8.) On Jan. 31, 1994, an appeal of the MPUC's determination on the allowed return on equity was filed with the Minnesota Court of Appeals by the Minnesota Department of Public Service, the Office of the Minnesota Attorney General and the Minnesota Energy Consumers intervenor groups. The appeal concerns the method of calculating the rate of return on common equity for both the electric and gas cases. The amount at issue is approximately $7 million in annual revenues for the Company. The ultimate financial impact of this appeal, if any, is not determinable at this time. A decision by the court is expected by the end of 1994. No general rate filings are anticipated in Minnesota in 1994. North Dakota Public Service Commission (NDPSC) On May 1, 1992, the Company filed with the NDPSC a general retail electric rate increase of $8.8 million, or 9.7%. The request was later reduced to $7.1 million or 7.9%. The NDPSC issued its order on Dec. 15, 1992, granting an increase of $2.7 million or 3%. On Dec. 31, 1992, the Company filed a petition for reconsideration of several issues contained in the order. On Jan. 27, 1993, the NDPSC agreed to reconsider the issues contained in the Company's reconsideration petition. On April 7, 1993, the NDPSC issued its final order after reconsideration. The final annual rate increase authorized totaled $4.8 million (5.3%) with rates effective April 21, 1993. On Dec. 29, 1993, the Company received approval from the NDPSC to increase base rates $1.2 million, or 1.2%, to recover 1994 cost increases associated with power purchased from the Manitoba-Hydro Electric Board. The additional costs consist of demand charges related to 500 Mw of firm capacity for four months. Eight months of the annual demand costs, which took effect May 1, 1993, were included in the Company's increase granted in April 1993. The $1.2 million annual increase was implemented Jan. 5, 1994. No general rate filings are anticipated in North Dakota in 1994. South Dakota Public Utilities Commission (SDPUC) On June 29, 1992, the Company filed with the SDPUC an application for a general retail electric rate increase of $6.3 million or about 9.8%. A proposed settlement agreement was reached between Company officials and the SDPUC staff and filed with the SDPUC on Nov. 10, 1992. The proposed increase was $4.2 million, or 6.5%. It was effective in two stages: the first stage on Jan. 1, 1993, equal to $3.8 million, or 5.8%; and the second stage on May 1, 1993, equal to $0.4 million, or 0.7%. In addition, the Company agreed to a one-year moratorium on rate increases, which means the Company could not implement further rate increases until Jan. 1, 1995. On Dec. 9, 1992, the SDPUC issued its order approving the settlement. The settlement agreement did not address the rate treatment of accrual accounting for postretirement health care benefits. On Jan. 26, 1993, the SDPUC ordered the Company to continue to use the pay-as-you-go accounting method, and not the accrual method, for ratemaking purposes. The Company requested reconsideration of the Commission's decision on accrued benefits on Feb. 25, 1993. On April 12, 1993, the Commission denied the Company's request for reconsideration. The Company will seek an accounting order to permit the use of deferred accounting for such benefits until such treatment is requested in the next general rate filing. Although the ultimate rate recovery of the accrued benefits is unresolved, the impact is immaterial to the Company's operating results ($620,000 on an annual basis). No general rate filings are anticipated in South Dakota in 1994. Public Service Commission of Wisconsin (PSCW) On June 1, 1992, the Wisconsin Company filed with the PSCW for an overall annual electric rate increase of $10.8 million, or 4.2%, and an overall annual gas rate increase of $1.4 million, or 2.1%. The PSCW issued an order dated Jan. 14, 1993, effective on Jan. 16, 1993 granting an increase in annual electric rates of $8.0 million and an increase in annual gas rates of $1.1 million. These orders represented a 3.1% increase in electric operating revenues and a 1.8% increase in gas operating revenues. The authorized return on common equity in these orders was 12.0%. On June 3, 1993, as a part of its biennial filing requirement, the Wisconsin Company filed with the PSCW for an overall annual gas rate increase of $1.37 million, or 1.9%, and no annual electric rate increase. On Aug. 18, 1993, the Wisconsin Company increased its gas rate request to $1.7 million, or 2.4%, to recover its allocated share of the acquisition cost of Viking. The PSCW issued an order dated Dec. 23, 1993, effective Jan. 1, 1994, granting an increase in annual gas rates of $1.41 million, or 2.0%. The authorized return on common equity in this order was 11.4%. Retail Rate Recovery of Viking Acquisition Costs During 1993, the Company and the Wisconsin Company requested from regulators in Minnesota, North Dakota, and Wisconsin recovery in retail rates of a portion of the acquisition cost paid for Viking in recognition of reduced retail delivered gas costs related to the acquisition of Viking. The PSCW approved in the Wisconsin Company's rates the pass-through from Viking and recovery of $1.8 million, related to NSP's acquisition cost of Viking, over the five-year period 1994-1998. On March 23, 1994, the NDPSC authorized, without any change in rates, the amortization in jurisdictional expenses of approximatley $2 million of Viking acquisition costs over a 15 year period starting June 11, 1993. Recovery of such amortization in base rates would not commence until approval in the next general rate filing for North Dakota gas operations. A request for similar recovery is still pending before the MPUC. If this request is not approved, Viking would continue to expense until 2008 approximately $2 million in acquisition cost amortization each year with partial rate recovery. Transmission Access Tariff and Settlement (FERC) On Oct. 9, 1990, NSP filed an "open access" electric transmission services tariff with the FERC. The filing was contested by several parties, including the FERC staff. In April 1992, the FERC Administrative Law Judge issued an initial decision generally favorable to NSP's positions. On Sept. 21, 1993, the FERC issued an order that affirmed in part, modified in part and reversed in part the April 1992 initial decision of the Administrative Law Judge. On Oct. 21, 1993, NSP requested rehearing of the FERC's order. On Nov. 18, 1993, the FERC granted a tolling order delaying the decision on NSP's request. The case is currently pending rehearing with the FERC. If the order is not reversed by the FERC, refunds to customers would be required. Although the financial impact of this case is immaterial, it is noteworthy because it is one of the first FERC rulings concerning rates and terms of contracts for open access of transmission systems. Minnesota Wholesale Rate Proceedings (FERC) On Feb. 19, 1993, the Company filed with the FERC a request for increase in Minnesota wholesale electric rates of $2.3 million, or about 8.7% (Docket No. ER93-385-000). The Company requested that the new rates become effective on April 19, 1993, subject to refund with interest pending the FERC approval of the overall request. On April 20, 1993, the FERC issued an order accepting the filing and suspending the rate increase for five months. On August 26, 1993 the Company filed a settlement agreement with the FERC. The agreement specifies an increase of $0.9 million or about 3.6% effective Sept. 21, 1993. On Nov. 19, 1993, the FERC issued a final order accepting the settlement agreement and allowing the rates to become effective. The nine customers affected by this rate increase have all provided the Company with notices of termination of their resale power contracts effective in July 1995 (seven customers) and 1996 (two customers) as discussed below. The settlement calls for no further increases for the duration of service under the current contracts. In 1990, 16 of the Company's 19 municipal wholesale customers began reviewing their long-term power supply options. Nine customers created a joint action group, Minnesota Municipal Power Agency (MMPA), to serve their future power supply needs and in 1992 notified the Company of their intent to terminate their power supply agreements with the Company effective July 1995 or July 1996. These nine customers represent approximately $24 million in annual revenues and a maximum demand load of approximately 150 Mw. On Oct. 21, 1993, the MMPA filed a complaint with the FERC under new Section 211 of the Federal Power Act alleging that the Company had not bargained in good faith toward a transmission service agreement which would allow MMPA to deliver power supply to its members starting July 1, 1995, when the municipalities' supply agreements with the Company expire. On Jan. 26, 1994, the FERC ruled that the Company had bargained in good faith, as required by Section 211, but ordered the Company and MMPA to negotiate for sixty days to attempt to resolve remaining issues. If the parties are unable to reach agreement, the dispute will be submitted to the FERC for a hearing. The outcome of the case is not expected to have a material financial impact on the Company's operating results or financial condition. In 1992 and 1993, the Company signed long-term power supply agreements with the remaining 10 of its current 19 municipal customers. The agreements commit the customers to purchase power from the Company for up to 13 years (through 2005) at fixed rates to increase by up to 3% per year. The 10 customers represent a maximum demand load of approximately 55 Mw and provide approximately $8 million in annual revenue. The FERC approved formula rates effective Jan. 1, 1994, by order dated Feb. 23, 1994. Other Wholesale Rate Proceedings (FERC) In January 1993, the Wisconsin Company proposed a settlement offer to increase rates for its 10 municipal wholesale customers. On Feb. 26, 1993, the Wisconsin Company filed with the FERC a settlement agreement with its 10 wholesale customers calling for a general wholesale rate increase. The agreements called for a $600,000, or 3.7% overall increase in wholesale electric rates. FERC accepted the settlement, and the new wholesale electric rate became effective Sept. 1, 1993. On May 6, 1993, Viking filed a settlement agreement with the FERC that called for a $.3 million, or 1.0% overall decrease in wholesale gas transportation rates. FERC accepted the settlement, and the new wholesale gas transportation rates became effective July 1, 1993. Ratemaking Principles in Minnesota and Wisconsin Since the MPUC assumed jurisdiction of Minnesota electric and gas rates in 1975, several significant regulatory precedents have evolved. The MPUC accepts the use of a forecast test year that corresponds to the period when rates are put into effect and allows collection of interim rates subject to refund. The use of a forecast test year and interim rates minimizes regulatory lag. The MPUC must order interim rates within 60 days of a rate case filing. Minnesota statutes allow interim rates to be set using (1) updated expense and rate base items similar to those previously allowed, and (2) a return on equity equal to that granted in the last MPUC order for the utility. The MPUC must make a determination on the application within 10 months after filing. If the final determination does not permit the full amount of the interim rates, the utility must refund the excess revenue collected, with interest. Generally, the Company may not increase its rates more frequently than every 12 months. Minnesota law allows Construction Work in Progress (CWIP) in a utility's rate base instead of recording Allowance for Funds Used During Construction (AFC) in revenue requirements for rate proceedings. The MPUC has exercised this option to a limited extent so that cash earnings are allowed on small and short-term projects that do not qualify for AFC. (For the Company's policy regarding the recording of AFC, see Note 1 of Notes to Financial Statements under Item 8.) The PSCW has a biennial filing requirement for processing rate cases and monitoring utilities' rates. By June 1 of each odd-numbered year, the Wisconsin Company must submit filings for calendar test years beginning the following January 1. The filing procedure and subsequent review generally allow the PSCW sufficient time to issue an order effective with the start of the test year. The PSCW reviews each utility's cash position to determine if a current return on CWIP will be allowed. The PSCW will allow either a return on CWIP or capitalization of AFC at the adjusted overall cost of capital. The Wisconsin Company currently capitalizes AFC on production and transmission CWIP at the FERC formula rate and on all other CWIP at the adjusted overall cost of capital. Fuel and Purchased Gas Adjustment Clauses The Company's wholesale and retail electric rate schedules provide for adjustments to billings and revenues for changes in the cost of fuel and purchased energy. Although the lag in implementing the billing adjustment is approximately 60 days, an estimate of the adjustment is recorded in unbilled revenue in the month costs are incurred. The Wisconsin Company calculates the wholesale electric fuel adjustment factor for the current month based on estimated fuel costs for that month. The estimated fuel cost is adjusted to actual the following month. The Wisconsin Company's automatic retail electric fuel adjustment clause for Wisconsin customers was eliminated effective in 1986. The clause was replaced by a limited-issue filing procedure. Under the procedure, an annual deviation in fuel costs of 2% and a monthly deviation of 8% will allow filing for a change in rates limited to the fuel issue. The adjustment approved is calculated on an annual basis, but applied prospectively. The PSCW will be holding a technical conference and possibly hearings in 1994 to determine the appropriate process to handle fuel costs under the new biennial rate filing process. Gas rate schedules for the Company and the Wisconsin Company include a purchased gas adjustment (PGA) clause that provides for rate adjustments for changes in the current unit cost of purchased gas. The Wisconsin Company's gas and retail electric rate schedules for Michigan customers include Gas Cost Recovery Factors and Power Supply Cost Recovery Factors, which are based on 12 month projections. After each 12 month period, a reconciliation is submitted whereby over-collections are refunded and any under-collections are collected from the customers. Viking is a transportation-only interstate pipeline and provides no sales services. As a result, Viking terminated its PGA clause effective Nov. 1, 1993. Natural gas fuel for compressor operations is provided in-kind by transportation suppliers. ELECTRIC OPERATIONS Capability and Demand Assuming normal weather, NSP expects its 1994 summer peak demand to be 7,218 Mw. NSP's 1994 summer capability is estimated to be 8,866 Mw, including 1,340 Mw (including reserves) of contracted purchases from the Manitoba Hydro-Electric Board, a Canadian Crown Corporation (Manitoba Hydro) and 677 Mw of other contracted purchases. The estimate assumes 7,241 Mw of thermal generating capability and 1,625 Mw of hydro generating capability. Of the total summer capability, NSP has committed 109 Mw for sales to other utilities. Of the estimated net capability, including the interconnection with Manitoba Hydro, 30% has been installed during the last 10 years. NSP's 1993 maximum demand of 6,990 Mw occurred on August 25, 1993. Resources available at that time included 6,816 Mw of Company-owned capability and 1,787 Mw of purchased capability net of contracted sales. The reserve margin for 1993 was 23%. The minimum reserve margin requirement as determined by the members of the Mid-Continent Area Power Pool (MAPP), of which NSP is a member, is 15%. (See Note 15 of Notes to Financial Statements under Item 8 for more discussion of power agreement commitments.) The Company filed an electric resource plan with the MPUC in 1993. The plan shows how the Company intends to meet the increased energy needs of its electric customers and includes an approximate schedule of the timing of such needs. The plan contains: conservation programs to reduce the Company's peak energy demand and conserve overall electricity use; economic purchases of power; and programs for maintaining reliability of existing plants. It also includes an approximate schedule of timing of such needs. The plan does not anticipate the need for additional base-load generating plants during the balance of this century and assumes that the Company's Prairie Island nuclear generating facility will continue operating through its license period. The following resource needs were included in the resource plan. The plan does not specify the precise technology to meet these needs, but does suggest energy source options. Cumulative MW Resource Needs By Type vs. Base of 1993 1996 2000 2004 2008 Peak 0-500 0-500 300-1,100 600-1,800 Intermediate 0-0 0-700 300-1,000 900-1,000 Base 0 0 0-300 200-1,400 DSM 500 1,200 1,700 2,000 Total 300-1,000 1,200-2,400 2,300-4,100 3,700-6,200 The resource plan proposes to satisfy the above resource needs through a combination of the following options: Sources of Energy to Meet Needs - Continued operation of existing generation. - Demand reduction of 2000 Mw by 2008 through conservation and load management. - 100 Mw of wind generation. - Increased reliance on hydro power under contracts from Manitoba Hydro. - Standby generation and cogeneration at customer sites when mutually beneficial to both NSP and the customer. - Installation of 210 Mw of natural gas-fired combustion turbines with an in-service date expected in September 1994. - Purchase of 232 Mw of natural gas-fired combined cycle generation. - Competitive bidding to fill additional needs for new generation. In October 1993, the Company signed a 25-year agreement for the purchase of 25 Mw of wind-generated electric capacity and associated energy to be produced in Minnesota. The wind generating plant is expected to be fully operational by May 1994. This contract is the first phase of the Company's plan to obtain 100 megawatts of wind-generated electricity by 1997. The Company can recover the cost of energy purchases through cost-of-energy adjustment clauses in electric rates. With respect to conservation, NSP is actively involved in numerous demand-side management programs. NSP's operating goals, which go beyond the resource plan guidelines above, are to offset peak electric demand by 1,100 Mw by 1995 and 1,700 Mw by 2000. Competition NSP's electric sales are subject to competition in some areas from municipally owned systems, rural cooperatives and, in certain respects, other private utilities and cogenerators. Electric service also increasingly competes with other forms of energy. The degree of competition may vary from time to time, depending on relative costs and supplies of other forms of energy. Although NSP cannot predict the extent to which its future business may be affected by supply, relative cost or promotion of other electricity or energy suppliers, NSP believes that it will be in a position to compete favorably. NSP has proposed to fill future needs for new generation through competitive bid solicitations. The use of competitive bidding to select future generation sources allows the Company to take advantage of the developing competition in this sector of the industry. The proposal contemplates that NSP's regulated business will not construct new regulated generation facilities within its service area. However, the Company has proposed that its subsidiary, NRG, be allowed to bid in response to Company solicitations for proposals. The Company's competitive bidding proposal is being reviewed by the MPUC along with the 1993 resource plan. The Company anticipates an MPUC decision during the second quarter of 1994. The Company intends to make similar competitive bidding proposal filings in North Dakota and South Dakota during 1994. Management intends to obtain regulatory approval in all retail jurisdictions to use a single bid process to meet resource needs for the entire system. The Wisconsin Commission has approved the use of competitive bidding for new resources for all Wisconsin utilities. On Oct. 24, 1992, President Clinton signed into law the Energy Policy Act of 1992 (Energy Act). The Energy Act amends the Public Utility Holding Company Act of 1935 (1935 Act) and the Federal Power Act. Among many other provisions, the Energy Act is designed to promote competition in the development of wholesale power generation in the electric utility industry. It exempts a new class of independent power producers from regulation under the 1935 Act. The Energy Act also allows the FERC to order wholesale "wheeling" by public utilities to provide utility and non-utility generators access to public utility transmission facilities. The provision allows the FERC to set prices for wheeling, which will allow utilities to recover certain costs. The costs would be recovered from the companies receiving the services, rather than the utilities' retail customers. The market-based power agreement filings with FERC (See discussion in "Regulation and Revenues", herein.) reflect the trend toward increasing transmission access under the Energy Act. The Energy Act's ultimate impact on NSP cannot be predicted. Many states are currently considering retail wheeling. While the topic of retail wheeling has been discussed in NSP jurisdictions, no legislation or regulatory initiatives have been formally introduced. Retail wheeling represents yet another development of a competitive electric industry. Management plans to continue its ongoing efforts to be a low-cost supplier of electricity and an active participant in the more competitive market for electricity expected as a result of the Energy Act. Through the functional restructuring discussed on page 1, the Company has moved responsibility for customer service, product reliability and profitability to the jurisdictional level within each business sector. This restructuring and business realignment will continue within each business sector through 1994. The Customer Operations Delivery system is being streamlined by consolidating similar functions. The Company is continuing an extensive reliability project that includes preventive maintenance on transmission and distribution power lines, improvements to existing equipment, and testing and implementing new technology. Reliability efforts are focusing on reducing the number of outages caused by lightning, human errors, animals and trees. NSP created the Delivery Operations Department in 1993 to consolidate operation of its transmission and distribution systems. This department monitors the flow of electricity on the transmission network in NSP's five- state service area. It directs all switching of the Company's transmission equipment in Minnesota. In the Twin Cities metropolitan area, it monitors the flow of electricity on the distribution network, directs field switching, and directs field personnel to respond to trouble events. Energy Sources For the year ended Dec. 31, 1993, 48 percent of NSP's Kwh requirements was obtained from coal generation and 28 percent was obtained from nuclear generation. Purchased and interchange energy provided 20 percent, including 13 percent from Manitoba Hydro; NSP's hydro and other fuels provided the remaining 4 percent. The fuel resources for NSP's generation based on Kwh were coal (60 percent), nuclear (35 percent), renewable and other fuels (5 percent). The following is a summary of NSP's electric power output in millions of kilowatt-hours for the past three years: 1993 1992 1991 Thermal plants 33 130 30 467 31 335 Hydro plants 1 001 1 024 1 153 Purchased and interchange 8 541 8 187 7 019 Total 42 672 39 678 39 507 Many of NSP's power purchases from other utilities are coordinated through the regional power organization MAPP. NSP is one of 29 participants in MAPP consisting of 10 investor-owned systems, eight generation and transmission cooperatives, three public power districts, seven municipal systems and the Department of Energy's Western Area Power Administration. MAPP membership also includes 15 Liaisons/Associate Participants consisting of two Canadian Crown Corporations, 12 municipal systems, and one investor- owned system, which are members of MAPP, pursuant to an agreement dated March 31, 1972. This agreement provides for the members to coordinate the installation and operation of generating plants and transmission line facilities. The terms and conditions of the MAPP agreement and transactions between MAPP members are subject to the jurisdiction of the FERC. The 1972 MAPP agreement was accepted for filing by the FERC, effective Dec. 1, 1972. As discussed in Note 15 of Notes to Financial Statements in Item 8, significant increases in purchased power may be required beginning in 1995 if the Prairie Island generating facility can not continue operating. Fuel Supply and Costs Coal and nuclear fuel will continue to dominate NSP's fuel requirements for generating electricity. It is expected that approximately 98 percent of NSP's fuel requirements, on a Btu basis, will be provided by these two fuels over the next several years, leaving two percent of NSP's annual fuel requirements for generation to be provided by other fuels (including natural gas, oil, refuse derived fuel, waste materials, renewable sources and wood). The actual fuel mix for 1993 and the estimated fuel mix for 1994 and 1995 are as follows: Fuel Use on Btu Basis (Est) (Est) 1993 1994 1995 Coal 62.3% 62.9% 61.2% Nuclear 36.2% 35.4% 37.1% Other 1.5% 1.7% 1.7% The Company normally maintains approximately 30 days of coal inventory (between 20 and 45 days, depending on plant site). The Company has long-term contracts providing for the delivery of up to 99 percent of its 1994 coal requirements. Coal delivery may be subject to short-term interruptions or reductions due to transportation problems, weather and availability of equipment. The Company expects that more than 96 percent of the coal it burns in 1994 will have a sulfur content of less than 1 percent. The Company has contracts with two Montana coal suppliers, Westmoreland Resources and Western Energy, and three Wyoming suppliers, Rochelle Coal Company, Antelope Coal Company and Black Thunder Coal Company, for a maximum total of 85 million tons of low-sulfur coal for the next 10 years. These arrangements are sufficient to meet the requirements of existing coal-fired plants. They also permit the Company to purchase additional coal when such purchase would improve fuel economics and operations. The Company has options from suppliers for over 100 million tons of coal with a sulfur content of less than 1 percent that could be available for future plants. The plants in the Minneapolis-St. Paul area are about 800 miles from the mines in Montana and 1,000 miles from the mines in Wyoming. Coal delivered by rail provides the Company with an economical source of fuel. The Wisconsin Company's electric generating plants are primarily hydro plants. The estimated coal requirements of the Company at its major existing coal-fired generating plants for the periods indicated and the coal supply for such requirements are as follows: State Sulfur Dioxide Maximum Amount Contract Approximate Emission Limit Annual Covered by Expiration Sulfur Pounds Per Plant Demand Contract Date Content(%)(2) MBTU*Input (Tons) (Tons) Black Dog 1 000 000 1 000 000 (1) 0.5 3.0(3) High Bridge 800 000 800 000 (1) 0.5 3.0 Allen S. King 2 000 000 2 000 000 (1) 0.9 1.6(4) Riverside 1 200 000 1 200 000 (1) 0.7 2.5(5) Sherco 8 000 000 8 000 000 (1) 0.5 0.9(6) 13 000 000 13 000 000(7) *MBTU = Million British Thermal Units Notes: (1) Contract expiration dates vary between 1995 and 2005 for western coal, which can provide more than 95% of the required fuel supply for the designated generating unit. Spot purchases of western and midwestern coal, and other fuels will provide the remaining fuel requirements. The Company is also test burning petroleum coke as a potential fuel. (2) This figure represents the average blended sulfur content of the combination of fuels typically burned at each plant. (3) The Black Dog Fluidized Bed (Unit 2) SO2 limit is 1.2 lb/MBTU. (4) The King Plant SO2 limitation of 1.9 lb/MBTU expired in January 1991, but the Minnesota Pollution Control Agency (MPCA) approved a short- term extension during permit negotiations. This interim limit was lowered to 1.8 lb/MBTU in May 1993. A final decision from the MPCA was reached in February 1994 setting a limit of 1.6 lb/MBTU. (5) The SO2 limitation at Riverside Unit 8 is 2.5 lb/MBTU. The limitation for units 6 and 7 is currently 0.9 lb SO2 /MBTU. (6) Compliance with air pollution control permit and applicable air quality regulations requires use of limestone scrubbers to achieve 70% SO2 removal and to limit SO2 emission to 0.96 lb/MBTU during any 90- day period for Units 1 and 2. For Unit 3, the SO2 emission limit is 0.61 lb/MBTU. (7) Required annual deliveries are no less than 6.0 million tons per year. Annual requirements are expected to range from 11.0 to 12.5 million. NSP's current fuel oil inventory is adequate to meet anticipated 1994 requirements. Additional oil may be provided through spot purchases from two local refineries and other domestic sources. To operate the Company's nuclear generating plants, the Company secures agreements for complete nuclear fuel cycles, which include uranium concentrate (yellowcake), uranium conversion, uranium enrichment services and fuel fabrication. The Company's current nuclear fuel contractual commitments are summarized below: Nuclear Fuel Services Contract Duration Monticello Prairie Island No. 1 Prairie Island No. 2 Yellowcake 1998 (1) 1998 (1) 1998 (1) Conversion 1999 (2) 1999 (2) 1999 (2) Enrichment 2005 (3) 2005 (3) 2005 (3) Fabrication 1998 (4) 2004 2004 (1) The yellowcake requirements are approximately 60% under contract for 1994-1997 and 15% for 1998. (2) The uranium concentrate conversion services are approximately 60% under contract for 1994-1997 and 35% for 1998-1999. (3) 100% of enrichment requirements are under contract for 1994-1995. The enrichment requirements are approximately 45% covered under a combination of firm contracts plus options for 1996-2005. (4) The Company has options to supply its needs through 2001. The Company expects sufficient uranium to be available for the total fuel requirements of its existing plants. The nuclear fuel contract strategy involves a portfolio of long- and medium-term contracts, as well as spot purchases. There are no assurances regarding the ultimate costs of any of the components of the fuel cycle or what impact any governmental legislation may have. However, the Company expects the unit cost of fuel to produce electricity with these nuclear facilities will be lower than the comparable cost of fuel to produce electricity with any other currently available fuel sources for the sustained operation of an electrical generation facility. The cost of nuclear fuel, including disposal, is recovered in the customer price of the electricity sold by the Company. NSP's fuel costs for the past three years are shown below: Fuel Costs * Per Million Btu Year Ended December 31 1991 1992 1993 Coal** $ 1.24 $ 1.22 $1.17 Nuclear*** .47 .43 .41 All Fuels .95 .93 .90 * Fuel adjustment clauses in its electric rate schedules or statutory provisions enable NSP to adjust for fuel cost changes. (See "Regulation and Revenues - Fuel and Purchased Gas Adjustment Clauses" under Item 1.) ** Includes refuse-derived fuel and wood. *** See Note 1 of Notes to Financial Statements under Item 8 for an explanation of the Company's nuclear fuel amortization policies. Nuclear Power Plants - Licensing, Operation and Waste Disposal The Company operates two nuclear generating plants: the single unit, 539 Mw Monticello Nuclear Generating Plant and the Prairie Island Nuclear Generating Plant with two units totaling 1,025 Mw. The Monticello Plant received its 40-year operating license from the Nuclear Regulatory Commission (NRC) on Sept. 8, 1970, and commenced operation on June 30, 1971. Prairie Island Units 1 and 2 received their 40-year operating licenses on Aug. 9, 1973, and Oct. 29, 1974, respectively, and commenced operation on Dec. 16, 1973, and Dec. 21, 1974, respectively. The Prairie Island and Monticello nuclear plants currently hold the Institute of Nuclear Power Operations' (INPO) top rating for plant operations and training. The Company is the only utility in the nation to achieve INPO's top rating simultaneously at all of its nuclear plants. The Company previously operated the Pathfinder Plant near Sioux Falls, SD as a nuclear plant from 1964 until 1967, after which it was converted to an oil and gas-fired peaking plant. The nuclear portions were placed in a safe storage condition in 1971, and the Company began decommissioning them in 1990. Most of the plant's nuclear material, which was contained in the reactor building and fuel handling building, was removed during 1991. Decommissioning activities cost approximately $13 million and have been expensed. A few millicurie of residual contamination remain in the operating plant. Operating nuclear power plants produce gaseous, liquid and solid radioactive wastes. The discharge and handling of such wastes are controlled by federal regulation. For commercial nuclear power plants, high-level radioactive wastes include only spent nuclear fuel. Low-level radioactive wastes are produced from other activities at a nuclear plant. They consist principally of demineralizer resins, paper, protective clothing, rags, tools and equipment that have become contaminated through use in the plant. The primary purpose of in-plant storage of low-level radioactive waste is to accumulate an inventory of material for economical shipment. Low-level waste disposal sites have been licensed in New York, Kentucky, Illinois, South Carolina, Nevada and Washington. At present, only South Carolina has an operating site that accepts commercial wastes from Minnesota. A 1980 federal law places responsibility on each state for disposal of its low-level radioactive waste. The law encourages states to form regional agreements or compacts to dispose of regionally generated waste. Minnesota is a member of the Midwest Interstate Low-Level Radioactive Waste Compact Commission. Following the expulsion of Michigan from the Midwest Compact in 1991 for failing to make progress, Ohio was designated the host state. The 1980 law, as amended in 1985, requires disposal sites to be operational after 1992. The South Carolina site has extended its closure date to out-of-region waste until June 30, 1994. Ohio is projecting completion of the low-level radioactive waste disposal facility in 2001. The Company, along with all other low-level radioactive waste generators in the Midwest Compact, will need to store low-level radioactive waste onsite in the interim. The federal government has the responsibility to dispose of domestic spent nuclear fuel and other high-level radioactive wastes. The Nuclear Waste Policy Act of 1982 requires the Department of Energy (DOE) to implement a program for nuclear waste management including the siting, licensing, construction and operation of repositories for domestically produced spent nuclear fuel from civilian nuclear power reactors and other high-level radioactive wastes. The Company has contracted with the DOE for the disposal of spent nuclear fuel. The DOE charges a quarterly disposal fee based on nuclear electric generation sold. This fee ranges from approximately $10 million to $12 million per year, which NSP recovers from its customers in cost-of-energy rate adjustments. Revisions to the DOE's basis of charging customers will result in fee reductions of $8.3 million, including reductions of $3.7 million already realized in 1992 and $3.6 million in 1993. In 1985, NSP paid the DOE a one-time fee of $95 million for fuel used prior to April 7, 1983. In 1979, the Company began expanding the spent nuclear fuel storage facilities at its Monticello Plant by replacement of the racks in the storage pool. Also, in 1987, the Company completed the shipment of 1,058 spent fuel assemblies from the Monticello Plant to a General Electric storage facility in Morris, Illinois. As a result, the plant now has sufficient pool storage capacity to operate until 2008. For discussion of spent nuclear fuel storage facilities at the Company's Prairie Island Plant, see "Environmental Matters" herein, Management's Discussion and Analysis of Financial Condition and Results of Operations under Item 7 and Note 15 of Notes to Financial Statements under Item 8. During the past several years, the NRC has issued a number of regulations, bulletins and orders that require analyses, modification and additional equipment at commercial nuclear power plants. The Company has spent $523 million since 1971, and expects to expend an additional $9 million for currently required NRC analyses, modification and additional equipment. The NRC is engaged in various ongoing studies and rulemaking activities that may impose additional requirements upon commercial nuclear power plants. Management is unable to predict any new requirements or their impact on the Company's facilities and operations. See Note 15 of Notes to Financial Statements under Item 8 for a discussion of the Company's nuclear insurance and potential liabilities under the Price-Anderson liability provisions of the Atomic Energy Act of 1954. GAS OPERATIONS Capability and Demand NSP catagorizes its gas supply requirements as firm (primarily for space heating customers) or interruptible (commercial/industrial customers with an alternate energy supply). NSP's maximum daily sendout (firm and interruptible) of 642,684 MMBtu for 1993 occurred on Dec. 27, 1993. This was also NSP's all time maximum daily sendout through Dec. 31, 1993. As discussed below, NSP's primary gas supply sources are purchases of third-party gas which are delivered under gas transportation service agreements with interstate pipelines. These agreements provide for firm deliverable pipeline capacity of approximately 511,000 MMBtu/day. In addition, NSP has contracted with four providers of underground natural gas storage services to meet the heating season and peak day requirements of NSP gas customers. Using storage reduces the need for firm gas supplies. These storage agreements provide NSP storage for approximately 15% of annual and 28% of peak daily firm requirements at an annual fixed cost of $5.1 million. NSP also owns and operates three liquefied natural gas (LNG) plants with a storage capacity of 2.53 Bcf equivalent and four propane-air plants with a storage capacity of 1.42 Bcf equivalent to help meet the peak requirements of its firm residential, commercial and industrial customers. These peak shaving facilities have production capacity equivalent to 237,900 Mcf of natural gas per day, or approximately 42% of peak day firm requirements. The Company expanded this daily deliverability by approximately 16,000 Mcf/day in 1993 through minor capital additions to a propane-air peaking plant. Recovery of the capital cost of this addition was included in the Company's Minnesota retail gas rates approved by the MPUC on Dec. 30, 1993. These LNG and propane-air plants provide a cost-effective alternative to annual pipeline transportation charges to meet the "needle peaks" caused by firm space heating demand on extremely cold winter days. The cost of gas supply, transportation service and storage service is recovered through the purchased gas adjustment. The average cost of gas and propane held in inventory for the latest test year is allowed in rate base by the MPUC and the PSCW. A number of NSP's interruptible industrial customers purchase their natural gas requirements directly from producers or brokers for transportation and delivery through NSP's distribution system. The transportation rates have been designed to make NSP economically indifferent as to whether NSP sells and transports gas or only transports gas. However, to the extent contractual terms allow, rates would increase based on changes in transportation and other costs. Competition During 1992 and 1993, the FERC issued a series of orders (together called Order 636) that addressed interstate natural gas pipeline restructuring. This restructuring required all interstate pipelines, including those serving NSP, to "unbundle" each of the services they provide: gathering, transportation, storage, sales and pipeline delivery management. To comply with Order 636, NSP executed new pipeline transportation service and gas supply agreements effective Nov. 1, 1993, as discussed below. While these new agreements create a new form of contractual obligation, NSP believes the new agreements provide flexibility to respond to future changes in the retail natural gas market. NSP expects its financial risk under the new agreements to be no greater than the risk faced under the previous long-term full requirements gas supply contracts. As a result of the changes in the natural gas industry in the last decade, culminating in Order 636, NSP's natural gas supply network has been transformed into an integrated gas supply grid where NSP purchases natural gas from numerous suppliers, directly contracts for transportation service on directly connected and upstream pipelines, and is able to flexibly deliver the supplies to any NSP retail gas service territory. In addition, NSP directly contracted for underground storage and owns and operates several liquified natural gas and propane-air peak shaving facilities. NSP's diversified supply and transportation contracts, as well as underground storage and peak shaving facilities, provide NSP with the ability to meet customer needs with reliable and economic natural gas supply. Order 636 ended the traditional pipeline sales service function effective Nov. 1, 1993. This is a significant change for the natural gas industry. Traditionally, the pipeline sales function met two important needs for local distribution companies (LDCs) such as NSP, which serve primarily weather-sensitive space heating markets: 1) reliability of supply and 2) flexibility to meet varying load conditions in response to day-to-day weather variations. NSP believes some uncertainty remains as to whether the new unbundled services under Order 636 will prove to be as reliable and flexible as the traditional sales service. The implementation of Order 636 will apply additional competitive pressure on all LDCs to keep gas supply and transmission prices for their large customers competitive because of the alternatives now available to these customers. Like gas LDCs, these customers now have expanded ability to buy gas directly from suppliers and arrange pipeline and LDC transportation service. NSP has provided unbundled transportation service since 1987. Transportation service does not currently have an adverse effect on earnings because NSP's sales and transportation rates have been designed to make NSP economically indifferent as to whether it sells or transports gas. However, some transportation customers may have greater opportunities or incentives to physically bypass the LDC's distribution system. NSP has arranged its gas supply and transportation portfolio in anticipation that it may be required to terminate its retail merchant sales function. Overall, NSP expects Order 636 will enhance its ability to remain competitive and allow it to maximize its margins by providing an increased selection of services to its customers. Order 636 allows interstate pipelines to negotiate with customers to recover up to 100 percent of prudently incurred "transition costs" attributable to Order 636 restructuring. Recoverable transition costs can include "buy down" and "buy out" costs for remaining gas supply and upstream pipeline transportation agreements, unrecovered deferred gas purchase costs, and the cost to dispose of regulated assets no longer needed because of the termination of the merchant function (e.g., financial losses on the sale of regulated storage facilities). NSP's primary gas supplier, Northern Natural Gas Company (Northern), is currently in the process of determining the amount of transition costs to be passed on to customers, as a result of Order 636 restructuring. Northern's restructuring has provided for the assignment of a significant portion of Northern's gas supply and upstream contract obligations. This solution was beneficial because Northern's customers contracted directly for obligations, rather than paying to buy out of those obligations and then contracting with the same gas suppliers and pipelines to replace the merchant function. The total transition costs recoverable for the remaining unassigned agreements is limited to $78 million. In addition, Northern may seek transition cost recovery for certain other costs, subject to prudency review. Northern's total Order 636 transition costs, to be passed on to all of its customers, are estimated to be approximately $100 million. Northern will recover the prudent transition costs by amortizing the amount over a period of several years, and including the amortized costs as a component of customer demand charges. NSP estimates that it will be billed for approximately 10 percent of Northern's transition costs, spread over a period of approximately five years. NSP's regulatory commissions have previously approved recovery of similar restructuring charges in retail gas rates. NSP has no Order 636 transition cost responsibilities to its other pipeline suppliers. FERC has ruled that NSP has no transition cost obligation to Williston Basin Interstate Pipeline Company (Williston) since it was never a gas sales customer of that pipeline. Viking incurred no Order 636 transition costs. The gas services available to NSP's customers were expanded in 1993 through the acquisitions of Viking in June 1993 and the assets of a gas marketing business by a new NSP subsidiary, Cenergy, Inc, in October 1993. The acquisition of Viking allows NSP increased access to natural gas transportation. Cenergy's acquisition of a gas marketing business will allow NSP to provide more customized value-added energy services to retail gas customers without increasing costs within the regulated retail gas distribution business. (See Note 4 of Notes to Financial Statements in Item 8 and the Other Subsidiaries section herein for further discussion of Viking and Cenergy.) The NSP gas operations area has taken significant steps to position itself to take on the additional responsibilities and take advantage of the new market opportunities resulting from the restructuring of the natural gas industry. In addition to construction of new pipeline interconnections, modernization of its propane-air peaking facilities, and fundamental changes to its supply portfolio including underground storage, NSP is installing a state-of-the-art delivery management system. Gas Supply and Costs NSP provides retail gas service in portions of eastern North Dakota and northwestern Minnesota, the eastern portions of the Twin Cities metro area, and other regional centers in Minnesota (Mankato, St. Cloud and Winona) and Wisconsin (Eau Claire, La Crosse and Ashland). NSP is directly connected to four interstate natural gas pipelines serving these regions: Northern, Viking, Williston and Great Lakes Transmission Pipeline. Approximately 90 percent of NSP's retail gas customers are served from the Northern pipeline system. As recently as 1987, NSP was able to purchase only "full requirements" pipeline sales supply, where NSP purchased the full requirements of its retail customers in a particular NSP gas service territory from the directly interconnected pipeline, and resold this gas to retail customers. As a result of Order 636 restructuring, NSP's natural gas supply commitments have been unbundled from its gas transportation and storage commitments. NSP's gas utility actively seeks gas supply, transportation and storage alternatives to yield a diversified portfolio that provides increased flexibility, decreased risk and economical rates. This diversification involves numerous domestic and Canadian supply sources, varied contract lengths, and transportation contracts with seven natural gas pipelines. The Company's supply options were enhanced in 1992 with the successful completion of a direct interconnection to the Williston system near Fargo, North Dakota. The addition of this direct connection allows the Company more direct access to additional productive gas supply basins in western North Dakota and Wyoming, and provides the Company an alternative to its two traditional pipeline suppliers (Northern and Viking). Among other things, Order 636 provides for the use of the "straight fixed/variable" rate design that allows pipelines to recover all their fixed costs through demand charges. NSP has firm gas transportation contracts with the following seven pipelines. The contracts expire in various years from 1994 through 2012. Northern Natural Gas Great Lakes Transmission Williston Basin Interstate Northern Border Pipeline Viking Gas Transmission ANR Pipeline TransCanada Gas Pipeline The agreements with Great Lakes, Northern Border, ANR and TransCanada provide for firm transportation service upstream of Northern Natural and Viking, allowing competition among suppliers at supply pooling points, minimizing commodity gas costs. In addition to these fixed transportation charge obligations, NSP has entered into firm gas supply agreements that provide for the payment of monthly or annual reservation charges irrespective of the volume of gas purchased. The total annual obligation is approximately $11.7 million. These agreements are beneficial because they allow NSP to purchase the gas commodity, at a high load factor, at rates below the prevailing market price reducing the total cost per Mcf. NSP has certain gas supply and transportation agreements, which include obligations for the purchase and/or delivery of specified volumes of gas, or to make payments in lieu thereof. At Dec. 31, 1993, NSP was committed to approximately $607 million in such obligations under these contracts, over the remaining contract terms, which range from the years 1994-2013. These obligations include some of the effects of contract revisions made to comply with Order 636. NSP purchases firm gas supply from a total of approximately 20 domestic and Canadian suppliers under contracts with durations of one year to 10 years. NSP purchases no more than 20% of its total daily supply from any single supplier. This diversity of suppliers and contract lengths allows NSP to maintain competition from suppliers and minimize supply costs. NSP's objective is to be able to terminate its retail merchant sales function, if either demanded by the marketplace or mandated by regulatory agencies, with no financial cost to NSP. The state utility commissions in Minnesota, North Dakota, Wisconsin and Michigan allowed NSP to fully recover the costs of these restructured services through purchased gas adjustments to customer rates. The MPUC and the PSCW also have allowed NSP to reflect in rate base the average cost of gas inventory held in underground storage. Purchases of gas supply or services by NSP from its Viking pipeline affiliate and Cenergy gas marketing affiliate are subject to approval by the MPUC. A request for approval of the NSP/Viking transportation agreements is pending approval. NSP currently does not purchase system gas supply or services from Cenergy, but anticipates requesting such authority in 1994. The MPUC has previously approved similar affiliate gas supply transactions between Minnegasco, which is another Minnesota LDC, and Arkla, Inc., an affiliated interstate pipeline and gas marketing company. The following table details selected operating information for NSP's gas distribution business which excludes Viking and Cenergy: Average Total Customers Cost Deliveries * at Per MMBtu Bcf Year-End Minnesota 1990 $2.76 66.1 303,189 1991 $2.50 72.6 311,354 1992 $2.71 68.1 319,673 1993 $3.11 79.8 328,306 Wisconsin 1990 $2.65 14.1 54,966 1991 $2.73 14.4 58,446 1992 $2.80 14.9 62,065 1993 $3.02 17.0 65,155 * Includes sales and transportation services. TELEPHONE OPERATIONS On Jan. 31, 1991, the Company sold its telephone properties and operations located in North Dakota to Rochester Telephone Corporation of Rochester New York for $48 million in cash. The net of tax gain on the sale of $16.8 million (27 cents per average common share) was recorded in the first quarter of 1991. The telephone operations historically accounted for less than 2% of NSP's earnings. NRG ENERGY, INC. NRG Energy, Inc. (NRG) is the Company's subsidiary that develops, builds, acquires, owns and operates several of the Company's non-regulated energy-related businesses. It was incorporated in Delaware on May 29, 1992 and assumed ownership of the assets of NRG Group, Inc., including its subsidiary companies. The businesses that NRG currently owns or operates generated 1993 revenues of $66 million and had assets of $275 million at Dec. 31, 1993. These assets include $37 million of investments in and capitalized development costs for projects NRG is currently pursuing, as discussed in the "New Business Development" section. The subsidiaries of NRG Energy, Inc., which currently conduct business are: NRG International, Inc.; Graystone Corporation; Scoria Incorporated; San Joaquin Valley Energy I, Inc.; San Joaquin Valley Energy IV, Inc.; NRG Energy Jackson Valley I, Inc.; NRG Energy Jackson Valley II, Inc., and NRG Energy Center, Inc. Operating Businesses NRG operates two refuse-derived fuel (RDF) processing plants and an ash disposal site. The ownership of one plant was transferred by the Company to NRG at the end of 1993, while legal transfer of ownership of the Company's 85% share of the other RDF plant and the ash disposal site is pending contract approval by the serviced counties. In 1993, workers at the RDF plants processed more than 820,000 tons of municipal solid waste into approximately 660,000 tons of refuse-derived fuel that was burned at two NSP power plants and at a power plant owned by United Power Association. NRG also owns and operates three steam lines in Minnesota that provide steam from the Company's power plants to the Waldorf Corporation, the Andersen Corporation and the Minnesota Correctional Facility in Stillwater. Scoria Incorporated and Western SynCoal Co., a subsidiary of Montana Power Co., completed construction in January 1992 of a demonstration coal conversion plant designed to improve the heating value of coal by removing moisture, sulfur and ash. The plant, located in Montana, is expected to produce 300,000 tons of clean coal annually which, when burned, produces emissions in compliance with the Clean Air Act. The fuel may be an alternative to scrubbers for some energy companies. Testing of the plant ended in August 1993 and commercial operations began at that time. San Joaquin Valley Energy I, Inc.; San Joaquin Valley Energy IV, Inc., and NRG Energy Jackson Valley II, Inc. own 45% of the San Joaquin Valley Energy partnership, which owns four power plants located near Fresno, California with a total capacity of 45 Mw. The facilities are operating fluidized-bed biomass, waste-fueled cogeneration plants. All four plants have long-term power sales agreements with Pacific Gas & Electric through 2017. NRG Energy Jackson Valley I, Inc., and NRG Energy Jackson Valley II, Inc. own 50% of the Jackson Valley Energy partnership, which owns and operates a 15-Mw cogeneration power plant near Sacramento, California. The plant has a long-term power sales agreement with Pacific Gas & Electric through 2014. On Aug. 20, 1993, NRG Energy Center, Inc. purchased the assets of the Minneapolis Energy Center (MEC), a downtown Minneapolis district heating and cooling system. The system utilizes steam and chilled water generating facilities to heat and cool buildings for approximately 85 heating and 25 cooling customers in downtown Minneapolis. The primary assets include the main plant, three satellite plants, two standby plants, six miles of steam lines and two miles of chilled water distribution lines. The MEC was purchased from Energy Center Partners. Existing long-term contracts with MEC customers will remain in effect under NRG's ownership. The purchase price was $110 million, financed mainly with $84 million of project debt. The purchase price primarily included facilities, long-term service agreements and goodwill. (See Note 4 of Notes to Financial Statements under Item 8 for further discussion). New Business Development NRG is pursuing several energy-related investment opportunities, as discussed below. Many of these opportunities are joint venture projects, which would be financed primarily through debt at the project level. The remaining project costs are expected to be funded through equity investments from NRG and other investors. Depending on NRG's ultimate involvement in such opportunities, these projects could require equity investments of approximately $390 million by NRG for the five year period 1994-1998. Graystone Corporation, with several other companies, continues with permitting plans to build the first privately owned uranium enrichment plant in the United States. Construction of the Louisiana plant, which would provide fuel for the nuclear power industry, could begin in 1995. On June 10, 1993, NRG, together with the International Finance Corporation (an affiliate of the World Bank), CMS Energy Corporation (the parent company of Consumers Power Company) and later Corporation Andina de Fomento (CAF) formed the Scudder Latin American Trust for Independent Power, an investment fund which is intended to invest in the development of new power plants and privatization of existing power plants in Latin America and the Caribbean. The fund has retained Scudder Stevens & Clark as its investment manager. The fund commenced its investment development efforts in September 1993. Each of the investors has committed $25 million which the fund is seeking to invest over the next five years. The fund has commenced private placement activities to obtain additional investors in the fund, particularly other utility affiliates and institutional investors. On Dec. 10, 1993, NRG International, Inc., through a wholly owned foreign subsidiary, acquired a 50% interest in a German corporation, Saale Energie GmbH (Saale). Saale owns a 400 Mw share in the 900 Mw power plant currently under construction in Schkopau, Germany, which is near Leipzig. PowerGen plc of the United Kingdom acquired the remaining 50% interest in Saale. Saale was formed to acquire a 41.1% interest in the power plant. VEBA Kraftwerke Ruhr AG of Gelsen-Kirchen, Germany (VEBA), is the builder of the Schkopau plant. VEBA, which will own the remaining 59.9% interest in the power plant and the remaining 500 Mw share in the plant, will operate the plant. The plant will be fired by brown coal (lignite) mined by MIBRAG GmbH (MIBRAG) under a long-term contract. Saale has a long-term power sales agreement for its 400 Mw share with VEAG of Berlin, Germany, the company that controls the high-voltage transmission of electricity in the former East Germany. The first unit of the plant is due to be completed by the end of 1995 and the second unit is due to be completed in mid-1996. On Dec. 19, 1993, NRG International, Inc., through another wholly owned foreign subsidiary, agreed to acquire a 33% interest in the coal mining, power generation and associated operations of MIBRAG, located south of Leipzig, Germany. MIBRAG is a German corporation newly formed by the German government to hold two open-cast brown coal (lignite) mining operations, a lease on an additional mine, the associated mining rights and rights to future mining reserves, three small industrial power plants and a circulating fluidized bed power plant presently under construction and scheduled for completion in 1994, a district heating system and coal briquetting and dust production facilities. Under the acquisition agreement, Morrison Knudsen Corporation and PowerGen plc each agreed to also acquire a 33% interest in MIBRAG, while the German government retains a one-percent interest in MIBRAG. The acquisition is expected to close in 1994. NRG's equity commitment to the two German projects through 1996 is expected to be no more than $100 million. On March 4, 1993, NRG International, Inc. signed a letter of intent pursuant to which it agrees, on behalf of it or a wholly owned subsidiary, to join an unincorporated joint venture with Comalco Limited of Australia (Comalco) and other parties. The joint venture is currently in negotiations for the acquisition, from the Queensland Electricity Commission, of the Gladstone Power Station, a 1680-Mw coal-fired plant in Gladstone, Queensland, Australia. A large portion of the electricity would be sold to Comalco for use in its aluminum smelter, pursuant to long-term power purchase agreements. NRG International, Inc. expects to acquire a 37.5% interest in the Gladstone plant. A wholly owned subsidiary of NRG International, Inc. will operate the Gladstone plant. Closing of the transaction is expected in 1994. NRG's total equity investment in the Gladstone project is expected to range from approximately $60 million to $70 million. In 1992, NRG had investment writedowns and losses from unsuccessful non-regulated energy projects of $6.8 million before income taxes. This included an investment in Cypress Energy Partners, a limited partnership formed between NRG and Black and Veatch Power Development Corporation. Cypress Energy Partners was denied permission by the Florida Public Service Commission to build two, 400 Mw electric generating plants for Florida Power and Light. An appeal with the Florida Supreme Court against the Commission was filed and subsequently withdrawn. OTHER SUBSIDIARIES Viking Gas Transmission Company On June 10, 1993, the Company acquired 100 percent of the stock of Viking Gas Transmission Company (Viking) from Tenneco Gas, a unit of Tenneco Inc., in Houston, Texas, for $45 million, $32 million of which was financed with project debt. Viking, which is now a wholly owned subsidiary of the Company, owns and operates a 500-mile interstate natural gas pipeline serving portions of Minnesota, Wisconsin and North Dakota with a capacity of 400 million cubic feet per day. The Viking pipeline currently serves 12% of NSP's gas distribution system needs. Approximately 75% of NSP's gas customers are located within 40 miles of the Viking pipeline. Viking currently operates exclusively as a transporter of natural gas for third- party shippers under authority granted by the FERC. Rates for Viking's transportation services are regulated by FERC. (See Note 4 of Notes to Financial Statements under Item 8 for further discussion.) Cenergy, Inc. On Oct. 1, 1993, Cenergy, Inc., a non-regulated subsidiary of the Company, acquired from bankruptcy certain assets of Centran Corporation, a natural gas marketing company, for approximately $4 million. The acquisition was completed to offer a variety of energy options, to increase natural gas supply flexibility for existing NSP customers and to expand NSP's energy services nationwide. The energy services marketing company will offer a broad range of energy services, while focusing on commercial and industrial end-users of natural gas. Cenergy serves approximately 300 customers. (See Note 4 of the Notes to Financial Statements under Item 8 for further discussion.) Eloigne Company In 1993, the Company established a new subsidiary, Eloigne Company (Eloigne), to identify and develop affordable housing investment opportunities. Eloigne's principal business is the acquisition of a broadly diversified portfolio of rental housing projects which qualify for low income housing tax credits under federal tax law. Elogine's capital investments and operating results for 1993 were not material. NEO Corporation During 1993, the Company formed NEO Corporation, a wholly owned subsidiary, which owns a 50% interest in Minnesota Methane LLC. Minnesota Methane LLC is developing small scale waste to energy opportunities utilizing landfill gas. NEO Corporation's capital investments and equity in the 1993 operating results of Minnesota Methane were not material. ENVIRONMENTAL MATTERS NSP's policy is to proactively prevent adverse environmental impacts, regularly monitor operations to ensure the environment is not adversely affected, and take timely corrective actions where past practices have had a negative impact on the environment. Significant resources are dedicated to environmental training, monitoring and compliance matters. NSP believes that it is in compliance, in all material respects, with applicable environmental laws. The Company has spent approximately $685 million on environmental improvements to new and existing facilities since 1968. Historically, the Company has spent an average of approximately $26 million annually in connection with environmental improvements for existing and new facilities. The Company expects to incur approximately $9 million in capital expenditures for compliance with environmental regulations in 1994. In general, the Company has been experiencing a trend toward more environmental monitoring and compliance costs, which has caused and may continue to cause slightly higher operating expenses and capital expenditures. The precise timing and amount of environmental costs are currently unknown. (For further discussion of costs, see Note 15 of Notes to Financial Statements under Item 8.) Permits NSP is required to seek renewals of environmental operating permits for its facilities at least every five years. NSP believes that it is in compliance, in all material respects, with environmental permitting requirements. Waste Disposal The Company has proposed construction of an onsite dry cask (container) storage facility for spent nuclear fuel at its Prairie Island Nuclear Generating Plant (Prairie Island) near Red Wing, Minnesota that will provide additional onsite storage. At current operating levels, the current Prairie Island onsite storage pool will be filled in 1994. Without additional onsite storage, operations at Prairie Island, which supply about 20% of the Company's output, will begin to be curtailed in mid-1995 and the plant will cease operating by early 1996. The design and operation of the proposed facility will be regulated by the Nuclear Regulatory Commission (NRC) and must meet applicable health and safety standards. Application for a Part 72 license was submitted to the NRC in August 1990. The NRC published a favorable Environmental Assessment for the project in June 1992. In October 1993, the NRC issued the Company a 20-year license to store fuel in up to 48 casks at the Prairie Island facility. In addition to the NRC license, the Company is required to obtain state approval for the proposed facility. In May 1991, the Minnesota Environmental Quality Board voted to declare the environmental impact statement prepared for the project, which found no significant environmental impacts, adequate. A Certificate of Need Application (CON) for 48 containers for temporary storage of spent nuclear fuel was filed with the MPUC and hearings were held during the latter part of 1991. A decision to grant the CON was announced by the MPUC in 1992. Seventeen containers for temporary storage of spent nuclear fuel were approved, which would provide adequate storage at least through the year 2001. In November 1992, the Minnesota Court of Appeals received a joint petition from several parties seeking a reversal of the MPUC's decision. In June 1993, the Minnesota Court of Appeals ruled that the Prairie Island spent fuel storage facility falls under the requirements of the Minnesota Radioactive Waste Management Act and, therefore, requires legislative approval before the Company can begin to store fuel. Petitions by the Company, MPUC, and the Minnesota Department of Public Service to the Minnesota Supreme Court to review the Appeals Court decision were denied. Upon denial by the Supreme Court to review the case, the Company immediately halted all construction and fabrication activities in order to bring the Company in compliance with the law. The Company has requested approval for the facility from the Minnesota Legislature during the 1994 session which began on Feb. 22, 1994. The bill allowing NSP to construct an onsite dry cask storage facility at Prairie Island is being considered by two committees of the Minnesota State House of Representatives (House) and two committees of the Minnesota State Senate (Senate). Both the House and Senate energy committees have passed the bill. The Senate environmental committee defeated the bill and refused to refer it to the Senate floor by a 10-8 vote. A hearing of the House environmental committee has not been scheduled. The time limit for consideration of the bill by the House and Senate committees expires March 25, 1994. If these committees do not approve the bill by that time, efforts will be made to obtain approval on the House and Senate floors. The consequences of not receiving legislative approval would include premature shutdown of the Prairie Island plant, the need to obtain replacement power to meet customer needs, and the need to seek rate recovery of the plant investment and decommissioning costs. Specifically, Prairie Island Unit 2 would be shutdown in May 1995 and Prairie Island Unit 1 would be shutdown in February 1996 without significant modification of normal plant operations. If operations at Prairie Island cease, the Company estimates that the present value of the cost of supplying replacement power and recovering its investment in the plant and unrecognized decommissioning costs will be at least $1.8 billion. The Company would request recovery of these costs, including a return on its investment, through utility rates. However, at this time the amount of such costs and the regulators' ultimate response to such a request is unknown. (See Note 15 of Notes to Financial Statements under Item 8 regarding the possible effects on operating results of the potential shutdown of the Company's Prairie Island nuclear power generating facility.) The Company and NRG made contractual commitments to convert municipal solid waste to boiler fuel and burn the fuel to generate electricity. NRG operates resource recovery plants that produce RDF from the waste. The RDF is burned at the Company's Red Wing and Wilmarth plants in the Company's service area, the French Island plant in the Wisconsin Company's service area, and the Elk River plant owned by United Power Association. Processing and burning RDF provides an additional economical source of electric capacity and energy, which is beneficial to NSP's electric customers. The Company's commitment to this program enables counties to meet state-mandated goals to reduce the amount of solid waste now going to landfills. In addition, the program provides for increased materials recovery and increased use of municipal solid waste as an energy source. NSP has met or exceeded the removal and disposal requirements for polychlorinated biphenyl (PCB) equipment as required by state and federal regulations. NSP has removed all known PCB capacitors from its distribution system. NSP also has removed all known network PCB transformers and equipment in power plants containing PCBs. NSP continues to test and dispose of PCB-contaminated mineral oil and equipment in accordance with regulations. PCB-contaminated mineral oil is detoxified and beneficially reused or burned for energy recovery at permitted facilities. Any future cleanup or remediation costs associated with past PCB disposal practices is unknown at this time. Air Emissions Control And Monitoring In July 1986, the Minnesota Pollution Control Agency (MPCA) board voted to accept an Administrative Law Judge's recommendation regarding an acid deposition control plan. The control plan set a sulfur dioxide emissions cap of 1.3 times the Company's 1984 system-wide emissions, commencing in 1990. The plan also required a sulfur dioxide emission rate based upon Reasonably Available Control Technology (RACT) to be determined for the Allen S. King Plant. In 1989, the Company reached agreement with the MPCA on an interim emissions rate of 1.9 lbs/MBTU. This interim rate was lowered to 1.8 lbs/MBTU in May 1993. In September 1993 a hearing before an Administrative Law Judge (ALJ) took place to set a final RACT limit. In December 1993 the ALJ recommended a final RACT limit of 1.6 lbs/MBTU. A final decision from the MPCA was reached in February 1994 adopting the ALJ recommendation. The limit of 1.6 lbs/MBTU may require the Allen S. King Plant to modify its current fuel blend and to conduct more frequent boiler cleanings. The U.S. Environmental Protection Agency (EPA) in 1991 issued waste combustor air quality regulations. As of Feb. 11, 1996, the regulations impose new restrictions on currently permitted emissions. The MPCA expects to issue statewide waste combustor rules in 1994 that would be more restrictive than the new federal requirements beginning in 1997. To meet the new federal and state requirements, the Company must install additional pollution control and monitoring equipment at the Red Wing plant and additional monitoring equipment at the Wilmarth plant. The Company is evaluating equipment to meet the requirements. Equipment may cost between $6 million and $10 million. Further regulations that could affect pollution control equipment are expected to be approved by the EPA in 1995. The Clean Air Act, including the Amendments of 1990, (the "Clean Air Act") impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. The legislation enacted in 1990 is extremely complex and its overall financial impact on NSP will depend on the final interpretation and implementation of rules to be issued by the EPA. NSP is participating in the rulemaking process for the development of regulations that achieve the goals of the legislation in a reasonable and cost-effective manner. NSP has expended significant funds over the years to reduce sulfur dioxide emissions at its plants. Additional construction expenditures may be required to comply with parts of the Clean Air Act. Based on revised emission standards proposed by the EPA in 1993, NSP's excess emission allowances available under the Clean Air Act may be significantly reduced. Because the Company is only beginning to implement some provisions of the Clean Air Act, its overall financial impact is unknown at this time. The majority of the Company's power plants meet state and federal limits for opacity and air quality. Capital expenditures will be required for opacity compliance in 1994-1998 at certain facilities as discussed below. As a part of its Clean Air Act compliance effort, the Company will test a type of air quality control device called a wet electrostatic precipitator at the Sherburne County Generating Plant (Sherco). The equipment will be installed in 1994 inside one of the existing acid gas scrubber modules. Testing, anticipated to be completed by the end of 1995, will determine the equipment's operational requirements and ability to reduce particulate emissions and opacity. The equipment is being examined as one option to lower opacity from Sherco units 1 and 2, as required by the EPA. Until testing is completed, it is unknown whether the equipment will result in full compliance with air quality standards. Total costs for equipment to reduce particulate emissions and opacity range from $90 million for the equipment being tested to $300 million for other technology options. The Company has completed testing for air toxics at its major facilities and shared these results with state and federal agencies. The Company also is engaged in research to reduce levels of mercury emissions. The Clean Air Act requires the EPA to look at issuing rules for air toxics for electric utilities. The MPCA is considering the development of air toxic rules in 1994. There also is interest in the Minnesota Legislature to pass a bill further restricting the emissions of mercury in the state. The Company cannot predict at this time what additional actions, if any, it may need to take if any such rules are passed. Water Quality Monitoring In compliance with federal and state laws and state regulatory permit requirements, and also in conformance with the Company's corporate environmental policy, the Company has installed Environmental Monitoring Systems at all coal and RDF ash landfills and coal stockpiles to assess and monitor the impact of these facilities on the quality of ground and surface waters. Degradation of water quality in the state is prohibited by law and requires remedial action for restoration to an agreed upon acceptable clean- up level. Estimates of present cost of implementation of overall water quality monitoring does not have a material impact on NSP's operating results. The pending reauthorization of the Federal Clean Water Act will probably result in more stringent water quality rules, regulations and standards that will result in slightly greater operating costs for NSP facilities. Site Remediation The Company has been designated by the EPA as a "potentially responsible party" (PRP) for eight waste disposal sites to which the Company sent materials. Under applicable law, the Company, along with each PRP, could be held jointly and severally liable for the total site remediation costs. Those costs have been estimated at $85 million for all eight PRP sites. However the amount could be in excess of $85 million. Settlement with the EPA and other PRPs has been reached for two of these disposal sites for reimbursement of the federal government's past costs of remedial action. One of the sites, South Andover Salvage Yards, in Andover, Minnesota, is contaminated by several chemicals, including PCBs. The contamination was attributed to past disposal by the Company and 13 other PRPs. The Company's total allocation for both sites was approximately $1.4 million, which has already been paid. Of that amount, approximately $1.3 million was paid in 1993 related to the Andover site. By reaching early settlement, the Company avoided litigation costs, increased costs of investigation and remediation and possible penalties that could have resulted and substantially increased the Company's allocation. The Company instituted legal action to recover costs from non-participating PRPs at the South Andover site and recovered a portion of its costs. The Company has reached tentative settlement with the EPA, state agencies and other parties at a third site. The Company's allocation for remediation of this site is estimated to be approximately $150,000. For the remaining five sites, neither the amount of cleanup costs nor the final method of their allocation among all designated PRP's has been determined. However, the current estimate of the Company's share of future remediation costs for all five sites is approximately $0.9 million. Until final settlement, neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs can be determined. While it is not feasible to determine the precise outcome of these matters, amounts accrued represent the best current estimate of the Company's future liability for the cleanup costs of these sites. It is the Company's practice to vigorously pursue and, if necessary, litigate with insurers to recover costs. Through litigation, the Company has recovered from other PRPs a portion of the remedial costs paid to date. Management also believes that costs incurred in connection with the sites, which are not recovered from insurance carriers or other parties, may be recoverable in future ratemaking. The Wisconsin Company has been notified by a group of PRPs of possible responsibility for cleanup of a solid and hazardous waste landfill site. The Wisconsin Company contends that it did not dispose of hazardous wastes in the subject landfill during the time period in question. Because neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined, it is not feasible to determine the outcome of this matter at this time. The Company is continuing to investigate 14 properties either presently or previously owned by the Company that were, at one time, sites of gas manufacturing or storage plants, or coal gas pipelines. The purpose of this investigation is to determine if waste materials are present, if such materials constitute an environmental or health risk, if the Company has any responsibility for remedial action and if recovery under the Company's insurance policies can contribute to any remediation costs. The total cost of remediation of these sites is expected to range from $10 million to approximately $16 million, including $3.1 million which has been paid to date. The Company has commenced remediation efforts at five of the 14 sites. One of the active sites has been completed, while the remaining four are in various stages of remediation. Monitoring continues at the completed site. No agreement or consent order has been negotiated to perform any extensive site investigations or clean-up at the other nine sites. The Company currently estimates its liability for the 14 sites to be approximately $7 million. Based upon information currently available with regard to these sites, management believes that accruals recorded represent the best current estimate of the costs of any required clean-up or remedial actions for former gas operating sites of the Company. Management believes costs incurred in connection with the sites that are not recovered from insurance carriers or other parties may be allowable costs for future ratemaking purposes. The Company has requested approval of deferred accounting of investigation and remediation expenses. The request is pending MPUC approval. NSP has not developed any specific site restoration and exit plans for its fossil fuel plants, hydroelectric plants or substation sites as it currently intends to operate at these sites indefinitely. If such plans were developed in the future, NSP would intend to treat the costs as a removal cost of retirement and include it in depreciation expense. Removal costs are estimated based on historical experience and a amount is currently included in depreciation expense. Contingencies In October 1992, the Company disclosed to the Minnesota Pollution Control Agency (MPCA), the EPA and the NRC that its reports on halogen content of water discharged at the Company's Prairie Island nuclear generating plant were based on estimates of halogen content rather than actual physical samples of water discharged as required by the plant's permit. Even though the water discharges at the plant did not exceed the halogen levels allowed under the permit, the applicable state and federal statutes would permit the imposition of fines, the institution of criminal sanctions, and/or injunctive relief for the reporting violations. Corrective actions were taken by the Company, and the Company cooperated with state and federal authorities in the investigation of the reporting violations. In November 1993, the United States Attorney's Office announced that three chemistry technicians responsible for reporting halogen content in discharge water would be charged with misdemeanor violations of the Federal Clean Water Act. No civil or criminal actions against the Company have been announced. Electric and magnetic fields (sometimes referred to as EMF) surround electric wires and conductors of electricity such as electrical tools, household wiring, appliances, electric distribution lines, electric substations and high-voltage electric transmission lines. NSP owns and operates many of these types of facilities. Some studies have found statistical associations between surrogates of electric and magnetic fields and some forms of cancer. The nation's electric utilities, including NSP, have participated in the sponsorship of more than $50 million in research to determine the possible health effects of electric and magnetic fields. Through its participation with the Electric Power Research Institute, NSP will continue its investigation and research with regard to possible health effects posed by exposure to EMF. No litigation has been commenced or claims asserted against NSP for adverse health effects related to EMF. However, several immaterial claims have been asserted against NSP for diminution of property values due to EMF. No litigation has commenced or is expected from these claims. Both regulatory requirements and environmental technology change rapidly. Accordingly, NSP cannot presently estimate the extent to which it may be required by law, in the future, to make additional capital expenditures or to incur additional operating expenses for environmental purposes. NSP also cannot predict whether future environmental regulations might result in significant reductions in generating capacity or efficiency or otherwise affect NSP's income, operations or facilities. CAPITAL SPENDING AND FINANCING NSP's capital spending program is designed to assure that there will be adequate generating and distribution capacity to meet the future electric and gas needs of its utility service area, and to fund investments in non- regulated businesses. NSP continually reassesses needs and, when necessary, appropriate changes are made in the capital expenditure program. Total NSP capital expenditures (including allowance for funds used during construction and excluding business acquisitions) totaled $362 million in 1993, compared to $428 million and $350 million expended in 1992 and 1991, respectively. These capital expenditures include gross additions to utility property of $357 million (excluding Viking property acquired), $419 million and $339 million for the three years ended 1993, 1992 and 1991 respectively. Internally generated funds provided approximately 99% of the capital expenditures for 1993, 49% for 1992 and 58% for 1991. In addition to capital expenditures, NSP invested $159 million in 1993 to acquire three energy- related businesses. (See Note 4 of Notes to Financial Statements under Item 8.) NSP's utility capital expenditures (including allowance for funds used during construction) are estimated to be $396 million for 1994 and $1.8 billion for the five years ended Dec. 31, 1998. Included in NSP's projected utility capital expenditures is $55 million in 1994 and $282 million during the five years ended Dec. 31, 1998, for nuclear fuel for NSP's three existing nuclear units. The remaining capital expenditures through 1998 are for many utility projects, none of which are extraordinarily large relative to the total capital expenditure program. Approximately 80% of the 1994 utility capital expenditures and approximately 95% of the 1994-1998 utility capital expenditures are expected to be provided by internally generated funds. The foregoing estimates of utility capital expenditures and internally generated funds may be subject to substantial changes due to unforeseen factors, such as changed economic conditions, competitive conditions, resource planning, new government regulations, changed tax laws and rate regulation. Further, the estimates assume the continued operation of the Company's Prairie Island generating facility. (See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations and "Environmental Matters" herein.) Although they may vary depending on the success, timing, and level of involvement in projects currently under consideration, potential capital requirements for NSP's non-regulated projects are estimated to be $130 million in 1994 and $540 million for the five-year period 1994-1998. The majority of these non-regulated capital requirements relate to equity investments (excluding project debt) in NRG's international projects, as discussed previously. The remainder consists mainly of affordable housing investments by Eloigne Company, most of which are expected to be financed through project debt. Equity investments by NRG and Eloigne would be funded through their own internally generated funds or through equity investments by NSP. Such equity investments by NSP are expected to be financed on a long-term basis through NSP's internally generated funds or through NSP's issuance of common stock and debt. NSP continues to evaluate opportunities to enhance shareholder returns through business acquisitions. Long-term financing may be required for acquisitions that NSP consummates. EMPLOYEES AND EMPLOYEE BENEFITS The total number of full- and part-time employees of NSP is approximately 7,880. About 3,150 employees of NSP are represented by five local IBEW labor unions. The labor contracts with the unions expired on Dec. 31, 1993. On March 14, 1994, a three-year contract offer was rejected and an authorization to strike was approved by the IBEW membership by nearly a 2-to-1 margin. Representatives from the union and NSP resumed discussions on March 21, 1994. An interim agreement between NSP and the unions is in place with an expiration date of March 31, 1994. Negotiations are continuing and NSP is unable to predict the outcome of negotiations at this time. In 1993, NSP reviewed employee and retiree benefits and implemented the following changes that are effective for 1994. These changes will support NSP's goal of providing market-based benefits and are expected to keep employee compensation and benefit costs close to 1993 levels. Active nonbargaining medical premium increases: A two-year cost sharing strategy for medical benefits for nonbargaining employees was implemented in 1994. The strategy consisted of employees contributing 10% in 1994 and 20% in 1995 of the total medical cost. Retiree medical premium increases: Retiree medical premiums were increased in 1994 for existing and future retirees. For existing qualifying retirees, pension benefits have been increased to offset some of the premium increase. For future retirees, a six-year cost-sharing strategy was outlined. Nonbargaining pension plan lump sum option changes: Currently, nonbargaining employees have the option to receive their pension in either a lump sum or in monthly installments. Beginning in 1994, nonbargaining employees will be able to choose a lump sum distribution in 25% increments upon termination of employment. Employees taking less than 100 percent will receive the rest of their benefits in monthly installments. Nonbargaining 401(k) changes: NSP currently offers eligible employees a 401(k) Retirement Savings Plan. NSP will match up to $500 of nonbargaining employees pre-tax 401(k) contributions. Nonbargaining wage increases: No base wage scale increases were implemented in January 1994. Effective in 1994, NSP implemented a market- based pay structure for nonbargaining employees. NSP's new pay system uses the latest salary surveys that indicate how local and regional companies pay their employees for comparable positions. EXECUTIVE OFFICERS * Present Positions and Business Experience Name Age During the Past Five Years James J Howard 58 Chairman of the Board and Chief Executive Officer since 7/01/90; and prior thereto Chairman of the Board, President and Chief Executive Officer. Edwin M Theisen 63 President and Chief Operating Officer since 7/01/90; and prior thereto President and Chief Executive Officer of Northern States Power Company (a Wisconsin corporation), a wholly owned subsidiary of the Company. Leon R Eliason 54 President - NSP Generation since 1/01/93; Vice President - Nuclear Generation from 7/01/90 to 12/31/92; and prior thereto General Manager - Nuclear Plants. Keith H Wietecki 44 President - NSP Gas since 1/11/93; Vice President - Corporate Strategy from 1/01/93 to 1/10/93; Vice President - Electric Marketing & Sales from 4/25/90 to 12/31/92; and prior thereto Vice President - Electric Marketing and Customer Service. Douglas D Antony 51 Vice President - Nuclear Generation since 1/01/93; General Manager - Monticello Nuclear Site from 9/01/90 to 12/31/92; Plant Manager - Monticello from 8/15/89 to 8/31/90; and prior thereto General Superintendent - Training Center. Vincent E Beacom 64 Vice President - Minnesota Electric since 1/01/93; Senior Vice President - Gas Operations from 7/01/90 to 12/31/92; and prior thereto Vice President - Commercial and Division Operations Northern States Power Company (a Wisconsin corporation), a wholly owned subsidiary Company. Arland D Brusven 61 Vice President - Finance and Treasurer since 1/01/93; Vice President and Treasurer from 9/01/90 to 12/31/92; and prior thereto Secretary and Financial Counsel. Jackie A Currier 42 Vice President - Corporate Strategy since 1/11/93; Director - Corporate Finance and Assistant Treasurer from 9/17/92 to 1/10/93; Director - Corporate Finance from 6/01/90 to 9/16/92; General Manager - Budget & Control from 4/01/89 to 5/31/90; and prior thereto Manager - Departmental & Capital Budgets. Gary R Johnson 47 Vice President & General Counsel since 11/01/91; and prior thereto Vice President - Law. Cynthia L Lesher 45 Vice President - Human Resources since 3/01/92; Director - Power Supply Human Resources from 8/15/91 to 2/29/92; Manager - White Bear Lake Area from 5/21/90 to 8/14/91; Manager - Metro Credit from 1/15/89 to 5/20/90; and prior thereto Manager - Occupational Health/Safety. Edward J McIntyre 43 Vice President and Chief Financial Officer since 1/01/93; President and Chief Executive Officer of Northern States Power Company (a Wisconsin corporation), a wholly owned subsidiary of the Company from 7/01/90 to 12/31/92; an prior thereto Vice President - Gas Utility. Roger D Sandeen 48 Vice President, Controller and Chief Information Officer since 4/22/92; Vice President and Controller from 7/01/89 to 4/21/92; and prior thereto Vice President and Treasurer of KVI Associates, Inc. (a real estate development company managing assets in excess of $150 million). Robert H Schulte 41 Vice President - Customer Service since 1/01/93; Vice President - Rates and Corporate Strategy from 7/01/90 to 12/31/92; and prior thereto General Manager - South Dakota Region. Loren L Taylor 47 Vice President - Customer Operations since 1/01/93; Vice President - Transmission and Inter-Utility Services from 11/01/89 to 12/31/92; and prior thereto Vice President - Human Resources. *As of 3/01/94 Item 2

Item 2 - Properties The Company's major electric generating facilities consist of the following: Projected Summer Net Capability Station and Unit Fuel Installed (MW) Sherburne Unit 1 Coal 1976 712 Unit 2 Coal 1977 712 Unit 3 Coal 1987 514 Prairie Island Unit 1 Nuclear 1973 513 Unit 2 Nuclear 1974 512 Monticello Nuclear 1971 539 King Coal 1968 567 Black Dog 4 Units Coal 1952-1960 463 High Bridge 2 Units Coal 1956-1959 262 Riverside 2 Units Coal 1964-1987 366 All of NSP's major generating stations are located in Minnesota on land owned by the Company. At December 31, 1993, NSP's electric transmission and distribution system consisted of 6,534 miles of overhead transmission lines, 28,100 miles of overhead distribution pole lines, 396 miles of underground conduit and 13,872 miles of underground cable. The gas properties of NSP include about 6,785 miles of natural gas distribution mains. Viking owns a 500-mile gas pipeline. Manitoba Hydro, Minnesota Power Company and the Company completed the construction of a 500-Kv transmission interconnection Winnipeg, Manitoba, Canada, and the Minneapolis-St Paul, Minnesota, area in May 1980. NSP has a contract with Manitoba Hydro-Electric Board for 500 Mw of firm power utilizing this transmission line. (See Note 15 of Notes to Financial Statements under Item 8.) In addition, the Company is interconnected with Manitoba Hydro through a 230 Kv transmission line completed in 1970. Virtually all of the utility plant of the Company and the Wisconsin Company are subject to the lien of their first mortgage bond indentures pursuant to which they have issued first mortgage bonds. Item 3

Item 3 - Legal Proceedings In the normal course of business, various lawsuits and claims have arisen against NSP. Management, after consultation with legal counsel, has recorded an estimate of the probable cost of settlement or other disposition for such matters. On July 22, 1993, a natural gas explosion occurred on the Company's distribution system in St. Paul, Minn. Total damages are estimated to exceed $1 million. The Company has a self-insured retention deductible of $1 million, with general liability coverage of $150 million, which includes coverage for all injuries and damages. Four personal injury lawsuits have been filed by individuals injured in the explosion with Ramsey County, Minnesota District Court. The litigation is in a preliminary stage and the ultimate costs to the Company are unknown at this time. On July 14, 1993, the Company filed a lawsuit in US District Court for the District of Minnesota. The suit was filed in the interest of the Company's ratepayers against Westinghouse Electric Corp. (Westinghouse), the manufacturer of the Prairie Island steam generators, because of problems with the steam generators susceptibility to corrosion. The Company seeks to recover the past and future costs of inspections, maintenance, modifications and repairs made to the Prairie Island steam generators and related systems as a result of Westinghouse defects. The defects are "serious" in that they have caused the Company to incur significant expenditures in order to ensure that Prairie Island is a safe and economically efficient generating station. The scheduling order requires discovery to be completed by Oct. 1, 1995. NSP and Westinghouse must be ready for trial by Feb. 1, 1996. Safety has not been, nor will be compromised in any way as a result of the defects because the plant has been and continues to be well-maintained. The steam generator problem is less severe at Prairie Island than at most other plants with the same model steam generator. This is due to specific plant design features, including a lower reactor coolant water temperature than most of the other plants. Other reasons are due to the higher standards used at Prairie Island in such areas as water chemistry and preventative maintenance. Based on analysis done, it is the Company's best estimate that the steam generators can be maintained so replacement will not be necessary before the units' 40- year operating licenses expire. For a discussion of environmental proceedings, see "Environmental Matters" under Item 1, incorporated herein by reference. For a discussion of proceedings involving NSP's utility rates, see "Regulation and Revenues" under Item 1, incorporated herein by reference. Item 4

Item 4 - Submission of Matters to a Vote of Security Holders None PART II Item 5

Item 5 - Market for Registrant's Common Equity and Related Stockholder Matters Quarterly Stock Data The Company's common stock is listed on the New York Stock Exchange (NYSE), Chicago Stock Exchange (CHX) and the Pacific Stock Exchange (PSE). Following are the reported high and low sales prices based on the NYSE Composite Transactions for the quarters of 1993 and 1992 and the dividends declared per share during those quarters: 1993 1992 High Low Dividends High Low Dividends First Quarter $47 $42 1/4 $.630 $43 $39 1/4 $.605 Second Quarter 46 7/8 42 7/8 .645 42 38 1/2 .630 Third Quarter 47 7/8 44 3/4 .645 45 5/8 41 .630 Fourth Quarter 46 3/8 40 1/8 .645 45 3/8 41 5/8 .630 The Company's Restated Articles of Incorporation and First Mortgage Bond Trust Indenture provide for certain restrictions on the payment of cash dividends on common stock. At December 31, 1993, the payment of cash dividends on common stock was not restricted. 1993 1992 1991 1990 1989 Shareholders at year-end 86 404 72 525 72 704 73 867 75 396 Book value per share at year-end $27.32 $25.91 $25.21 $24.42 $23.76 Shareholders as of March 18, 1994 were 86,775. Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations Northern States Power Company, a Minnesota corporation (the Company), has one significant subsidiary, Northern States Power Company, a Wisconsin corporation (the Wisconsin Company), and several other subsidiaries, including Viking Gas Transmission Company (Viking) and NRG Energy, Inc. (NRG), both Delaware corporations. The Company and its subsidiaries collectively are referred to herein as NSP. The following discussion and analysis by management focuses on those factors that had a material effect on NSP's financial condition and results of operations during 1993 and 1992 and should be read in connection with the Financial Statements and Notes thereto. Trends and contingencies of a material nature are discussed to the extent known and considered relevant. Liquidity and Capital Resources Financial Condition and Cash Flows - With rate increases granted in 1993, NSP's financial condition remained strong and its cash flows and earnings from operations improved from 1992, despite cooler-than-average summer weather. NSP's 1992 cash flows and earnings before accounting changes were significantly reduced by unusual weather, including the coolest summer in 77 years. The 1992 earnings included $45.5 million from a change in accounting for unbilled revenues, which did not affect cash flows or customer rates. During 1993, NSP continued to meet its long-range objectives for capital structure of approximately 45-50 percent common equity and 40-45 percent debt. The pretax interest coverage ratio before accounting changes, excluding AFC, was 3.9 in 1993 and 3.1 in 1992. NSP's objective range for interest coverage is 3.5-5.0. Financing Requirements - NSP's need for capital funds is primarily related to the construction of plant and equipment to meet the needs of its electric and gas utility customers and to fund equity commitments or other investments in its non-regulated businesses. Total NSP capital expenditures (including AFC and excluding business acquisitions) were $362 million in 1993. Of that amount, $284 million related to replacements and improvements of NSP's electric system and $36 million involved construction of natural gas distribution facilities. Internally generated funds provided 99 percent of NSP's capital expenditures for 1993 and 85 percent of the $1.8 billion in capital expenditures incurred for the five-year period 1989-1993. NSP estimates that its utility capital expenditures will be $396 million in 1994. Of that amount, $316 million is scheduled for electric facilities and $43 million for natural gas facilities. Internally generated funds from utility operations are expected to provide approximately 80 percent of 1994 utility capital expenditures and approximately 95 percent of the $1.8 billion in utility capital expenditures estimated for the five-year period 1994-1998. These utility capital expenditure estimates include approximately $100 million of anticipated expenditures for pollution control facilities required under the Clean Air Act. In addition to utility capital expenditures, expected financing requirements for the 1994-1998 period include approximately $390 million to retire long-term debt and meet first mortgage bond sinking fund requirements. NSP expects to obtain external capital for these requirements by issuing long-term debt, common stock and preferred stock. Utility financing requirements for the period 1994-1998 may be affected by factors such as load growth, changes in capital expenditure levels, rate increases allowed by regulatory agencies, new legislation, changes in environmental regulations and other regulatory requirements. NSP expects to invest significant amounts in non-regulated projects, including domestic and international power projects. Projects currently being pursued include joint ventures to acquire electric generating plants in Australia and Germany, and open-cast coal mining operations in Germany. Non-regulated projects are expected to be financed primarily through project debt. The remaining project costs are expected to be funded through equity investments from NSP and other investors. Over the long-term, NSP's equity investments are expected to be financed through internally generated funds or NSP's issuance of common stock and debt. Although they may vary depending on the success, timing and level of involvement in projects currently under consideration, potential capital requirements for NSP's non-regulated projects are estimated to be approximately $130 million in 1994 and approximately $540 million for the five-year period 1994-1998. These amounts include expected equity investments by NSP of approximately $60 million for the Australia project in 1994 and up to $100 million for the Germany projects through 1996. In addition to capital expenditures, NSP invested $159 million in 1993 to acquire three energy-related businesses. (See Note 4 to the Financial Statements.) NSP continues to evaluate opportunities to enhance shareholder returns through business acquisitions. Long-term financing may be required for such acquisitions. Financing Flexibility - NSP's ability to finance its utility construction program at a reasonable cost and to provide for other capital needs depends on its ability to earn a fair return on investors' capital. Financing flexibility is enhanced by providing working capital needs and a high percentage of total capital requirements from internal sources, and having the ability, if necessary, to issue long-term securities and obtain short-term credit. Access to securities markets at a reasonable cost is determined in a large part by credit quality. The Company's first mortgage bonds are rated AA- by Standard & Poor's Corporation, Aa2 by Moody's Investors Service, Inc., AA- by Duff & Phelps, Inc., and AA by Fitch Investors Service, Inc. Ratings for the Wisconsin Company's first mortgage bonds are generally comparable. These ratings reflect only the views of such organizations and an explanation of the significance of these ratings may be obtained from each agency. The Company's and the Wisconsin Company's first mortgage indentures place limits on the amount of first mortgage bonds that may be issued. The Minnesota Public Utilities Commission (MPUC) and the Public Service Commission of Wisconsin (PSCW) have jurisdiction over securities issuance. At Dec. 31, 1993, with an assumed interest rate of 8 percent, the Company could have issued about $1.8 billion of additional first mortgage bonds under its indenture and the Wisconsin Company could have issued about $280 million of additional first mortgage bonds under its indenture. NSP expects to maintain adequate access to long-term and short-term debt markets in 1994. The Company registered $600 million of first mortgage bonds with the Securities and Exchange Commission (SEC) in December 1993. Depending on capital market conditions, the Company expects to issue approximately $450 million of this debt in 1994, primarily for refinancings, with the remainder issued over the next several years, for the purpose of raising additional capital or redeeming outstanding securities. The Company's Board of Directors has approved short-term borrowing levels up to 10 percent of capitalization. The Company has received regulatory approval for $350 million in short-term borrowing levels. The Company had approximately $106 million in commercial paper debt outstanding as of Dec. 31, 1993. The Company plans to keep its credit lines at or above the level of commercial paper borrowings. Commercial banks presently provide credit lines of approximately $215 million. These credit lines make short-term financing available in the form of bank loans. The Company's Articles of Incorporation authorize the maximum amount of preferred stock that may be issued. Under these provisions, the Company could have issued all $460 million of its remaining authorized, but unissued preferred stock at Dec. 31, 1993, and remained in compliance with all interest and dividend coverage requirements. The level of common stock authorized, under the Company's Articles of Incorporation, is 160 million shares. Registration Statements filed with the SEC provide for the sale of up to 1,650,000 shares of common stock under the Company's Dividend Reinvestment and Stock Purchase Plan, Executive Long-Term Incentive Award Stock Plan, and Employee Stock Ownership Plan (ESOP) as of Dec. 31, 1993. The Company may issue new shares or purchase shares on the open market for its stock plans. (See Note 6 to the Financial Statements for discussion of stock awards outstanding.) As discussed below, the Company issued new common stock in 1993 under a general stock offering and under its shareholder, employee and customer stock programs. At Dec. 31, 1993, the total number of common shares outstanding was 66,879,577. The Company does not plan any general stock offerings for 1994. 1993 Financing Activity - During 1993, NSP engaged in numerous financing activities. The Company issued 4,281,217 shares of common stock. Of these shares, 2.6 million were sold to a group of underwriters on May 20, 1993. The offering price to the public was $43.625 per share, with net proceeds of $110 million to the Company. Of the remaining new shares, 940,000 shares were issued under the Dividend Reinvestment and Stock Purchase Plan, 174,308 shares were issued under the Executive Long-Term Incentive Award Stock Plan and 566,909 shares were issued to the ESOP. On Oct. 30, 1993, the Company redeemed all 350,000 shares of its $7.84 series Cumulative Preferred Stock at $103.12 per share, plus accrued dividends through Oct. 31, 1993. During 1993, the Company issued $350 million, and the Wisconsin Company issued $150 million, of long-term debt to refinance higher rate debt, redeem preferred stock, repay scheduled maturities of debt and extend the term of short-term borrowings. In addition, $116 million of long-term debt was issued by subsidiaries to finance the acquisitions of Viking and the Minneapolis Energy Center. (See Note 4 to the Financial Statements.) In connection with the early redemption of $453 million of long-term debt, NSP incurred approximately $14 million in reacquisition premiums, which will be amortized over the term of the newly issued debt. Results of Operations NSP's results of operations during 1993 and 1992 were primarily dependent on the operations of the Company's and Wisconsin Company's utility businesses consisting of the generation, transmission and sale of electricity and the distribution, transportation and sale of natural gas. NSP's utility revenues are dependent on customer usage which varies with weather conditions, general business conditions, the state of the economy and the cost of energy services, the recovery of which is determined by various regulatory authorities. The historical and future trends of NSP's operating results have been and are expected to be impacted by the following factors: Weather - NSP's earnings can be dramatically impacted by unusual weather. Mild weather, mainly a cool summer, reduced 1993 earnings by an estimated 18 cents. However, this was an improvement over 1992 when a warm winter and the coolest summer in 77 years reduced earnings by an estimated 51 cents. Operating Contingency - The Company is experiencing uncertainty regarding its ability to store used nuclear fuel from its Prairie Island nuclear generating facility. The facility stores its used nuclear fuel on an interim basis in a storage pool in the plant, pending the availability of a U. S. Department of Energy high-level radioactive waste storage or permanent disposal facility, or a private interim storage facility. At current operating levels, the pool will be filled in 1994 so the Company has proposed to augment Prairie Island's interim storage capacity by using steel containers for dry storage of used nuclear fuel on the plant site. Without additional onsite storage or significant modification of normal plant operations, Prairie Island Unit 2 would be shutdown in May 1995 and Prairie Island Unit 1 would be shutdown in February 1996. These two units supply about 20 percent of the Company's output. The Company has obtained a Certificate of Need from the MPUC allowing use of a limited number of steel containers, providing adequate storage at least through the year 2001. The Nuclear Regulatory Commission has also issued a license approving a dry storage facility on the plant site for Prairie Island's used fuel. However, in June 1993, the Minnesota Court of Appeals decided that the additional temporary storage facilities must be approved by the Minnesota Legislature. The Company has requested such approval from the Legislature and expects a decision on this issue during the current session, which began on Feb. 22, 1994. Although hearings have begun, the Company cannot predict what action the Minnesota Legislature will take. If operations at Prairie Island cease, the Company estimates that the present value of the cost of supplying replacement power and recovering its investment in the plant and unrecognized decommissioning costs will be $1.8 billion. The Company would request recovery of these costs, including a return on its investment, through utility rates. However, at this time the need for such costs and the regulators' ultimate response to such a request is unknown. (See Note 15 to the Financial Statements regarding the possible effects on operating results of the potential shutdown of the Company's Prairie Island nuclear power generating facility.) Regulation - NSP's utility rates are approved by the Federal Energy Regulatory Commission (FERC) and state commissions. Rates are designed to recover plant and operating costs and an allowed return, using an annual period upon which rate case filings are based. NSP's utility companies request increases in customers' rates as needed and file them with the governing commissions. The rates charged to retail customers in Wisconsin are reviewed and adjusted biennially. Because rate increases are not requested annually in Minnesota, NSP's primary jurisdiction, the impact of inflation on operating costs continues to be a factor affecting NSP's earnings, shareholders' equity and other financial results. Except for Wisconsin electric operations, NSP's rate schedules provide for cost-of-energy adjustments to billings and revenues for changes in the cost of fuel for electric generation, purchased power and purchased gas. For Wisconsin electric operations, the biennial retail rate review process considers changes in electric fuel and purchased energy costs in lieu of a cost-of-energy adjustment clause. In addition to changes in operating costs, other factors affecting rate filings are sales growth, conservation programs and demand-side management efforts. Rate Increases - During 1992 and 1993, NSP filed for 1993 rate increases in Minnesota, North Dakota, South Dakota and Wisconsin to offset increasing costs for purchased power commitments, depreciation, property taxes, postretirement benefits and other expenses. NSP received approvals for approximately $102 million of annualized rate increases for retail customers in those states as well as wholesale customers in Minnesota and Wisconsin. These rate changes increased 1993 revenues by approximately $83 million; the full impact of these increases will be realized in 1994. On Jan. 31, 1994, three intervenors filed an appeal of the MPUC's decision concerning the method of calculating the rate of return on common equity granted in the Minnesota electric and gas rate cases. The amount at issue is approximately $7 million in annual revenues for the Company. (See Note 2 to the Financial Statements for further discussion of 1993 rate case results.) In 1993, NSP filed for 1994 rate increases for North Dakota retail electric and Wisconsin retail gas customers. NSP received approval for approximately $2.6 million of rate increases in these two jurisdictions, effective January 1994. No significant rate filings in other jurisdictions are expected for 1994. Acquisitions - NSP made three strategically important business acquisitions in 1993. These include a gas pipeline, an energy services marketing business, and a steam heating and chilled water cooling system business. (See Note 4 to the Financial Statements for more discussion of these acquisitions, including the pro forma results of these acquisitions on an annual basis.) Competition - The Energy Policy Act of 1992 (the Act) is expected to bring comprehensive and significant changes to the electric utility industry. Many provisions of the Act are expected to increase competition in the industry in the next few years. The Act's reform of the Public Utility Holding Company Act (PUHCA) promotes creation of wholesale power generators and authorizes the FERC to require utilities to provide wholesale transmission services to third parties. The legislation allows utilities and non-regulated companies to build, own and operate power plants nationally and internationally without being subject to restrictions that previously applied to utilities under the PUHCA. Other producers may compete for NSP's customers as a result of such PUHCA reform. Management believes this legislation will promote the continued trend of increased competition in the electric energy markets. Many states are considering proposals to require "retail wheeling", which is the delivery of power generated by a third party to retail customers. Retail wheeling represents yet another development of a competitive electric industry. NSP management plans to continue its efforts to be a low-cost supplier of electricity and an active participant in the competitive market for electricity. During 1992 and 1993, the FERC issued a series of orders (together called Order 636) addressing interstate natural gas pipeline service restructuring. This restructuring will "unbundle" each of the services - sales, transportation, storage and ancillary services - traditionally provided by the gas pipeline companies. Order 636 ended the traditional pipeline sales service function, which in the past had met local distribution companies' (LDCs) needs for reliability of supply and flexibility for meeting varying load conditions. NSP believes some uncertainty remains as to whether the new unbundled services under Order 636 will prove to be as reliable and flexible as the traditional sales service. The implementation of Order 636 also will apply more pressure on all LDCs to keep gas supply and transmission pricing for large customers competitive in light of the alternatives now available to these customers. Interstate pipelines will be allowed to recover, subject to negotiations with customers, 100 percent of prudently incurred transition costs attributable to Order 636 restructuring. Although negotiations are in process, NSP estimates that it will be responsible for less than $10 million of transition costs, over a proposed five-year period. NSP's regulatory commissions have previously approved recovery of similar restructuring charges in retail gas rates. New service agreements went into effect between NSP and its pipeline transporters on Nov. 1, 1993. NSP does not expect these new agreements under Order 636 to materially affect its cost of gas supply. NSP's acquisitions of Viking and a gas marketing business (as discussed in Note 4 to the Financial Statements) have enhanced the ability to participate in the more competitive gas transportation business. In implementing Order 636, Viking incurred no restructuring costs. Impact of Non-Regulated Investments - NSP expects to invest significant amounts in non-regulated projects, including domestic and international power production projects through NRG, as described previously under "Financing Requirements". Depending on the success and timing of involvement in these projects, NSP's non-regulated earnings are expected to increase materially in the next few years. However, the projects generating the increased earnings may present additional risk. Current and future investments in international projects are subject to uncertainties prior to final legal closing, and continuing operations are subject to foreign government and partnership actions. NRG plans to hedge its exposure to currency fluctuations to the extent permissible by hedge accounting requirements. NRG will use well-established financial instruments of sufficient credit quality to protect the economic value of foreign-currency denominated assets. (With respect to risk of potential losses from unsuccessful non-regulated projects, see Note 1 to the Financial Statements for discussion of capitalized expenditures for projects under development.) Employee Compensation and Benefits - In 1993, NSP conducted an extensive review of its employee compensation and benefits, and retiree benefits. As a result, several changes will be implemented, commencing in 1994, that will support NSP's goal of providing market-based compensation and benefits. These changes, which include no base wage increase for non-union employees in 1994, are expected to keep compensation and benefit costs comparable to 1993 levels. NSP's labor agreements with its five local unions expired on Dec. 31, 1993. An interim agreement with the unions expires March 31, 1994. Although NSP's final offer for settlement (made on Feb. 4, 1994) was rejected by the union membership on March 14, 1994 and an authorization to strike was approved, the parties resumed discussions on March 21, 1994. NSP is not able to predict the outcome of negotiations at this time. Environmental Matters - Like other utilities, the Company has been named as a potentially responsible party at eight waste disposal sites and is in the process of investigating the remediation of 14 former coal-gasification and other sites. The Company has recorded an estimate of the probable costs to be incurred in connection with remediation of these sites. To the extent costs are not recovered from insurers or other parties, the Company expects to seek recovery of such costs in future ratemaking proceedings. In general, NSP has been experiencing a trend toward more environmental monitoring and compliance costs. This trend has caused and may continue to cause slightly higher operating expenses and capital expenditures. The timing and amount of environmental costs, including those for site remediation, are currently unknown. In 1993, 1992 and 1991, the Company spent about $15 million, $20 million and $6 million, respectively, for capital expenditures on environmental improvements at utility facilities. The Company expects to incur approximately $9 million in capital expenditures for compliance with environmental regulations in 1994. (See Note 15 to the Financial Statements for further discussion of these and other environmental contingencies that could affect NSP.) Wholesale Customers - In 1992, nine of the Company's 19 municipal wholesale electric customers created a joint action municipal power agency to serve their future power supply needs and notified the Company of their intent to terminate their power supply agreements with the Company effective in July 1995 or July 1996. These nine customers currently represent approximately $24 million in annual revenues and a maximum demand load of approximately 150 megawatts. In 1992 and 1993, the Company signed long-term power supply agreements with the remaining 10 municipal customers. The agreements commit the customers to purchase power from the Company for up to 13 years (through 2005) at fixed rates rising at up to 3 percent per year. The 10 customers represent approximately $8 million in current annual revenue and a maximum demand load of approximately 55 megawatts. The rates contained in the agreements were accepted by the FERC on Feb. 23, 1994. During October 1993, the Company signed an electric power agreement to provide Michigan's Upper Peninsula Power Company (UPPCO) with up to 90 megawatts of baseload service, peaking service options and load regulation service options for 20 years beginning in January 1998 through December 2017. Load regulation service is designed to change the level of power delivery during each hour to match UPPCO's load requirements. The rates, terms and conditions of the agreement are subject to FERC approval. The Michigan Public Utilities Commission must also approve the transaction. Beginning in 1998, annual revenues of approximately $12 million-$16 million are expected to be provided under the agreement, depending on contract options that UPPCO can exercise. Legislative Changes - The Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law on Aug. 10, 1993. The only provision of the Act that had a significant effect on NSP was the increase in the federal corporate income tax rate from 34 percent to 35 percent retroactive to Jan. 1, 1993. The effect of the higher tax rate was an increase of about $3.2 million in income tax expense. Most of this cost increase was offset by higher revenues from 1993 rate increases approved in Minnesota. (See Note 2 to the Financial Statements.) Deferred tax liabilities were increased for the rate change by approximately $32 million. However, due to regulatory deferral of utility tax adjustments, earnings were reduced only by immaterial adjustments to deferred tax liabilities for non-regulated operations. Wind-Generated Power - In October 1993, the Company signed a 25-year agreement for the purchase of 25 megawatts of wind-generated electric capacity, and associated energy to be produced in Minnesota. The wind generating plant is expected to be fully operational by May 1994. This contract is the first phase of the Company's plan to obtain 100 megawatts of wind-generated electricity by 1997. The Company can recover the cost of energy purchases through cost-of-energy adjustment clauses in electric rates. Accounting Changes - As discussed in Note 13 to the Financial Statements, in 1993, NSP adopted Statement of Financial Accounting Standards (SFAS) No. 106 - - Employers' Accounting for Postretirement Benefits Other than Pensions and began recording postretirement benefits on an accrual basis. NSP's utility companies had previously been allowed rate recovery for postretirement benefits as paid. In the 1993 rate increases discussed above, NSP's utility companies obtained rate recovery for substantially all of the increased costs (approximately $20 million) accrued under SFAS No. 106 in 1993. Due to rate recovery of higher costs, there was no material impact on NSP's operating results from this accounting change. Recent changes in interest rates have resulted in different actuarial assumptions used in the benefit cost calculations for postretirement benefits. Due to offsetting changes in other actuarial assumptions and demographics, NSP's benefit costs for such plans are not expected to increase from these changes in 1994. (See Note 13 to the Financial Statements for more information on changes in actuarial assumptions.) NSP also adopted in 1993 SFAS No. 109 - Accounting for Income Taxes. Because the provisions of SFAS No. 109 are not materially different than the tax accounting procedures previously used by NSP, there was virtually no impact on earnings or financial condition. In 1992, the Company changed its accounting method for recognizing revenue. Earnings in 1992 increased by 88 cents per share, including 73 cents related to prior years, from recording estimated unbilled revenues for utility service in Minnesota, North Dakota and South Dakota. (See Note 3 to the Financial Statements for more information on the effects of this accounting change.) In 1994, NSP will be required to adopt SFAS No. 112 - Employers' Accounting for Postemployment Benefits. This standard will require the accrual of certain postemployment costs (such as injury compensation and severance) that are payable in future periods. The impact of adopting SFAS No. 112 is expected to be immaterial. The Financial Accounting Standards Board (FASB) has announced preliminary plans to change the accounting for stock compensation expense effective in 1997 with disclosure requirements effective in 1994. Also, the FASB has approved a proposed change in employers' accounting for employee stock ownership plans effective in 1994. Based on NSP's review of these future accounting changes, NSP does not expect a material impact on its results of operations or financial condition. NSP currently follows predominant industry practice in recording its environmental liabilities for plant decommissioning and site exit costs as a component of utility plant. The FERC and the SEC currently are evaluating the financial presentation of these obligations, which could require a reporting reclassification as early as 1994. 1993 Compared with 1992 and 1991 NSP's 1993 earnings per share were $3.02, up 71 cents from the $2.31 earned before accounting changes in 1992 and equal to the $3.02 earned from continuing operations in 1991. In addition to the revenue and expense changes discussed below, 1993 earnings were impacted by a higher average number of common and equivalent shares outstanding for earnings-per-share calculations in 1993 due to the stock issuances discussed previously under "1993 Financing Activity." Electric Revenues and Production Expenses Revenues - Sales to retail customers, which account for more than 90 percent of NSP's electric revenue, increased 4.0 percent in 1993 and decreased 2.3 percent in 1992. Cool summer weather reduced sales in 1992 and, to a lesser extent, in 1993. During 1993, NSP added 14,353 retail customers, a 1.1-percent increase. Total sales of electricity, including wholesale, increased 7.3 percent in 1993. On a weather-adjusted basis, sales to retail customers are estimated to have increased 2.1 percent in 1993 and 2.8 percent in 1992. Retail sales growth for 1994 is estimated to be 3.4 percent over 1993, or 2.2 percent on a weather-adjusted basis. Sales to other utilities increased 22.2 percent in 1993 due to higher demand from utilities in flood-stricken Midwestern states. The table below summarizes the principal reasons for the electric revenue changes during the past two years. (Millions of dollars) 1993 vs 1992 1992 vs 1991 Retail sales growth (excluding weather impacts) $32 $34 Estimated impact of weather on retail sales volume 34 (85) Rate changes 74 20 Sales to other utilities 20 (2) Cost of energy clauses and other (8) (7) Total revenue increase (decrease) $152 $(40) The 1992 sales growth is net of a $1.4-million revenue decrease, and 1992 cost-of-energy clause change is net of an $11 million revenue increase from recording unbilled revenues, which were not recorded in 1991. Electric Production Expenses - Fuel expense for electric generation increased $19.4 million, or 6.6 percent, in 1993, compared with a decrease of $20.4 million, or 6.5 percent, in 1992. Total output from NSP's generating plants increased 8.4 percent in 1993 and decreased 3.1 percent in 1992. The fuel expense increase in 1993 was due to higher output to meet sales demand, partially offset by lower cost of fuel. The fuel expense decrease in 1992 was due to lower output (because the cool summer reduced demand) and lower cost of fuel. The lower cost of fuel per megawatt hour of generation in 1993 and 1992 reflects the increased use of low-cost purchases as discussed below. Purchased power costs increased $53.0 million, or 34.1 percent, in 1993 and $20.0 million, or 14.7 percent, in 1992. The increase in 1993 was largely due to a demand expense increase of $42 million for the capacity charges from the power purchase agreements with Manitoba Hydro-Electric Board (MH), as discussed in Note 15 to the Financial Statements. Energy purchased from other utilities increased in both 1993 and 1992 due to economically priced energy available to meet growing retail demand and sales opportunities to other utilities that provided net ratepayer benefit. Demand expenses in 1994 are expected to increase $22 million over 1993 levels due to the MH agreements. Revenues are adjusted for changes in electric fuel and purchased energy costs from amounts currently included in approved base rates through fuel adjustment clauses in all jurisdictions except as noted below for Wisconsin. While the lag in implementing these billing adjustments is approximately 60 days, an estimate of the adjustments is recorded in unbilled revenue in the month costs are incurred. In Wisconsin, the biennial retail rate review process considers changes in electric fuel and purchased energy costs in lieu of a fuel adjustment clause. Gas Revenues and Purchases Revenues - NSP categorizes gas sales as firm (primarily space heating customers) and interruptible (commercial/industrial customers with an alternate energy supply). Firm sales in 1993 increased 17.0 percent over 1992 sales, while firm sales in 1992 decreased 5.6 percent from 1991. Warm weather in the first quarter of 1992 is the main cause for both of these variations. NSP added 11,728 firm gas customers in 1993, a 3.1-percent increase. On a weather-adjusted basis, firm sales are estimated to have increased 7.2 percent in 1993 and 3.6 percent in 1992. NSP estimates 1994 firm gas sales to decrease by 2.9 percent relative to 1993, with a 2.2-percent decrease on a weather-adjusted basis due to an unbilled revenue adjustment in 1993. Without this adjustment, estimated weather-adjusted firm gas sales would have increased 0.9 percent in 1993 and would be estimated to increase 0.7 percent in 1994. Interruptible gas deliveries, including sales of gas purchased for resale and customer-owned gas that NSP transported, increased 15.3 percent in 1993 and decreased 0.9 percent in 1992. The table below summarizes the principal reasons for the gas revenue changes during the past two years. (Millions of dollars) 1993 vs 1992 1992 vs 1991 Sales growth $17 $7 Estimated impact of weather on sales volume 28 (24) Acquisition of Viking Gas 9 Rate changes 9 Purchased gas adjustment and other 30 15 Total revenue increase (decrease) $93 $(2) The 1992 sales growth is net of a $1.5-million decrease from recording unbilled revenues, which were not recorded in 1991. Purchased Gas - The cost of gas purchased and transported increased $61.7 million, or 28.0 percent, in 1993 due to higher sendout and higher purchased gas prices. In 1992, the cost of gas purchased and transported increased $9.0 million, or 4.3 percent, due to higher purchased gas prices, somewhat offset by lower sendout relative to 1991. The average cost per thousand cubic feet (mcf) of gas sold in 1993 was 13.3 percent higher than it was in 1992, when the cost was 7.1 percent higher than it was in 1991. NSP views the increases in 1992 and 1993 as a recovery from unsustainably low wellhead gas prices in the 1990-91 period. Revenues are adjusted for changes in purchased gas costs from amounts currently included in approved base rates through purchased gas adjustment clauses. Other Operating Expenses and Factors Other Operation, Maintenance and Administrative and General - These expenses, in total, decreased by $27.2 million, or 4.0 percent, compared with an increase of 1.8 percent in 1992. The 1993 decrease was the result of fewer scheduled plant maintenance outages, reduced employee levels and lower administrative costs. The 1992 increase was the result of higher levels of scheduled plant and distribution system maintenance and higher employee wages. Wages in 1993 included an accrual of $14 million for incentive compensation. Due to lower earnings as a result of mild weather, compensation in 1992 did not include incentive amounts. (See Note 7 to the Financial Statements for a summary of administrative and general expenses.) Conservation and Energy Management - Costs in 1993 were higher than in 1992 and 1991 because NSP's regulators have approved higher expenditure levels for conservation and demand-side management efforts. Depreciation and Amortization - The increases in depreciation for all periods reflect higher levels of depreciable plant and, in 1993, changes in the depreciable lives of certain property. (See Note 1 to the Financial Statements.) Property and General Taxes - Property and general taxes increased in each of the reported periods primarily as a result of higher property tax rates and property additions. Property taxes in 1992 were reduced by $4.5 million due to revisions to accrued 1991 taxes (payable in 1992) based on final tax statements. Income Taxes - The variations in income taxes are primarily attributable to fluctuations in pretax book income. Taxes in 1993 also increased about $3 million due to a 1-percent increase in the federal tax rate. (See Note 9 to the Financial Statements for a detailed reconciliation of the statutory tax rate to the actual effective tax rate.) Allowance for Funds Used During Construction (AFC) - The differences in AFC for the reported periods are attributable to varying levels of construction work in progress and lower AFC rates associated with increased use of low-cost short-term borrowings. Other Income and Deductions-Net - Other income and deductions increased $9.7 million in 1993 and decreased $0.8 million in 1992. The increase in 1993 was due to higher non-regulated operating income from improved refuse-derived fuel (RDF) operations and acquired businesses. Non-regulated operating income in 1992 reflects one-time expenses from unsuccessful energy projects and reduced profitability of RDF operations. Decreases in interest income and non-regulated operating income in 1992 were offset by lower expenses for regulatory compliance and legal contingencies. Interest income declined in 1992 due to decreases in the amount of investments held. (See Note 7 to the Financial Statements for a summary of amounts included in other income and deductions.) Interest Charges - Interest on long-term debt increased in 1993 due to new debt issued to finance business acquisitions and to refinance short-term borrowings. The increase was partially offset by interest savings from refinancing debt at lower rates. Other interest charges have increased due to amortization of refinancing costs, including debt issuance costs and reacquisition premiums. Item 8 - Financial Statements and Supplementary Data See Item 14(a)-1 in Part IV for financial statements included herein. See Note 17 of Notes to Financial Statements for summarized quarterly financial data. INDEPENDENT AUDITORS' REPORT Northern States Power Company: We have audited the accompanying consolidated financial statements of Northern States Power Company (Minnesota) and its subsidiaries, listed in the accompanying table of contents in Item 14(a)1. Our audits also included the financial statement schedules listed in the accompanying table of contents in Item 14(a)2. These consolidated financial statements and financial statement schedules are the responsibility of the Companies' management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Companies at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 3 to the consolidated financial statements, the Companies changed their method of accounting for postretirement health care costs in 1993 and revenue recognition in 1992. (Deloitte & Touche) DELOITTE & TOUCHE Minneapolis, Minnesota February 7, 1994 Notes to Financial Statements 1. Summary of Accounting Policies System of Accounts - Northern States Power Company, a Minnesota corporation (the Company), and two wholly owned subsidiaries of the Company, Northern States Power Company, a Wisconsin corporation (the Wisconsin Company), and Viking Gas Transmission Company (Viking) maintain accounting records in accordance with either the uniform system of accounts prescribed by the Federal Energy Regulatory Commission (FERC) or those prescribed by state regulatory commissions, whose systems are the same in all material respects. Principles of Consolidation - The consolidated financial statements include all significant subsidiary companies. All significant intercompany transactions and balances have been eliminated in consolidation. The Company and its subsidiaries collectively are referred to herein as NSP. Revenues - Revenues are recognized based on services provided to customers each month. Because customer utility meters are read and billed on a cycle basis, unbilled revenues (and related energy costs) are estimated and recorded for services provided from the monthly meter-reading dates to month-end. In 1991, revenues of the Company were recorded for billings rendered to customers on a monthly cycle billing basis and estimated unbilled revenues were not recorded. (See Note 3 for discussion of accounting change in 1992.) The Company's rate schedules, applicable to substantially all of its customers, include cost-of-energy adjustment clauses, under which rates are adjusted to reflect changes in average costs of fuels, purchased power and gas purchased for resale. As ordered by its primary regulator, Wisconsin Company retail rate schedules include a cost-of-energy adjustment clause for purchased gas but not for electric fuel and purchased power. The biennial retail rate review process for Wisconsin electric operations considers changes in electric fuel and purchased energy costs in lieu of a cost-of-energy adjustment. Utility Plant and Retirements - Utility Plant is stated at original cost. The cost of additions to utility plant includes contracted work, direct labor and materials, allocable overhead costs and allowance for funds used during construction. The cost of units of property retired, plus net removal cost, is charged to the accumulated provision for depreciation and amortization. Maintenance and replacement of items determined to be less than units of property are charged to operating expenses. Allowance for Funds Used during Construction (AFC) - AFC, a non-cash item, is computed by applying a composite pretax rate, representing the cost of capital for construction, to qualified Construction Work in Progress (CWIP). The rates were 7.4 percent in 1993, 8.0 percent in 1992 and 10.0 percent in 1991. The amount of AFC capitalized as a construction cost in CWIP is credited to other income and interest charges. AFC amounts capitalized in CWIP are included in utility rate base for establishing utility service rates. Depreciation - For financial reporting purposes, depreciation is computed by applying the straight-line method over the estimated useful lives of various property classes. The Company files with the Minnesota Public Utilities Commission (MPUC) an annual review of remaining lives for electric and gas production properties. The 1993 study, as approved by the MPUC, recommended an increase of approximately $0.9 million in annual depreciation accruals. The 1992 study, as approved by the MPUC, recommended no change in 1992 depreciation. The Company also submitted in 1993 an average service life filing for transmission, distribution and general properties, which is filed every five years. The filing, as approved by the MPUC, increased depreciation by approximately $4.7 million from 1992 levels. Depreciation provisions, as a percentage of the average balance of depreciable property in service, were 3.47 percent in 1993, 3.36 percent in 1992 and 3.35 percent in 1991. Decommissioning - The annual provision for the estimated decommissioning costs for the Company's nuclear plants has been calculated using an internal/external sinking fund method. The calculation, which results in annual charges to depreciation expense, is designed to provide for full accrual and rate recovery of the future decommissioning costs, including reclamation and removal, over the estimated operating lives of the Company's nuclear plants. Decommissioning of all nuclear facilities is planned to occur in the years 2010-2022 using the prompt dismantlement method, and the total obligation for decommissioning is expected to be funded approximately 45 percent by internal funds and 55 percent by external funds. Based on a 1990 study, the Company estimates total decommissioning costs will approximate $750 million in 1993 dollars, for which the Company has recorded $302 million in the accumulated provision for depreciation; $101 million of this balance has been deposited in external trust funds. An updated study will not be used for recording decommissioning accruals until approved by the MPUC. Such approval is not expected to occur until after the Minnesota Legislature makes its decision on fuel storage at the Company's Prairie Island nuclear plant. (See Note 15.) Decommissioning costs recorded for 1993, 1992 and 1991 were $43 million, $40 million and $40 million, respectively. Nuclear Fuel Expense - The original cost of nuclear fuel is amortized to fuel expense on the basis of energy expended. Nuclear fuel expense also includes a disposal cost of 0.1 cent per kilowatt-hour sold from nuclear generation, as required by the Nuclear Waste Policy Act of 1982. Disposal expenses were $8.7 million, $6.8 million and $11.9 million for 1993, 1992 and 1991, respectively. Disposal expenses reflect reductions of $2.6 million in 1993 and $3.7 million in 1992 due to a change in the basis of charging customers, retroactive to 1983. Nuclear fuel expense in 1993 also includes about $1 million for a portion of the assessment from the U.S. Department of Energy (DOE) for the decommissioning and decontamination of the DOE's uranium enrichment facility. (See Note 8.) Environmental Costs - Costs related to environmental remediation are accrued when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. When a single estimate of the liability cannot be determined, the low end of the estimated range is recorded. Costs are charged to expense (or deferred as a regulatory asset based on expected recovery from customers in future rates) if they relate to the remediation of conditions caused by past operations or if they are not expected to benefit future operations. Where the expenditure relates to facilities currently in use (such as pollution control equipment), the costs are capitalized and depreciated over the future service periods. Estimated costs are recorded at undiscounted amounts, independent of any insurance or rate recovery, based on prior experience. Accrued obligations are regularly adjusted as new information is received. For sites where NSP has been designated as one of several potentially responsible parties, the amount accrued represents NSP's estimated share of the cost. NSP intends to treat any future costs related to decommissioning and restoration of its power plants and substation sites as a removal cost of retirement through plant depreciation expense. Income Taxes - NSP records income taxes in accordance with Statement of Financial Accounting Standards (SFAS) No. 109 - Accounting for Income Taxes. SFAS No. 109 requires the use of the liability method of accounting for deferred income taxes. Before 1993, NSP followed SFAS No. 96 - Accounting for Income Taxes, resulting in substantially the same accounting as SFAS No. 109. Income taxes are deferred for all temporary differences between pretax financial and taxable income and between the book and tax bases of assets and liabilities. Deferred taxes are recorded using the tax rates scheduled by law to be in effect when the temporary differences reverse. Due to the effects of regulation, current income tax expense is provided for the reversal of some temporary differences previously accounted for by the flow-through method. Also, regulation results in the creation of certain regulatory assets and liabilities related to income taxes as discussed in Note 8. Investment tax credits are deferred and amortized over the estimated lives of the related property. Cash Equivalents - NSP considers investments in certain debt instruments (primarily commercial paper) with a remaining maturity of three months or less at the time of purchase to be cash equivalents. Regulatory Deferrals - As regulated utilities, the Company, the Wisconsin Company and Viking account for certain income and expense items under the provisions of SFAS No. 71 - Accounting for the Effects of Regulation. In doing so, certain costs that would otherwise be charged to expense are deferred as regulatory assets based on expected recovery from customers in future rates. Likewise, certain credits that would otherwise be reflected as income are deferred as regulatory liabilities based on expected flowback to customers in future rates. Management's expected recovery of deferred costs and expected flowback of deferred credits are generally based on specific ratemaking decisions or precedent for each item. Regulatory assets and liabilities are being amortized consistent with ratemaking treatment as established by regulators. Note 8 describes in more detail the nature and amounts of these regulatory deferrals. Other Assets - NSP and its various subsidiaries have invested in many non-regulated projects whose earnings are reported on the equity method of accounting. Several of these projects are still in the development stage. Other investments include project development expenditures of $16.5 million as of Dec. 31, 1993, which have been capitalized based on expected recovery from cash flows of future project operations. The purchase of the Minneapolis Energy Center by NRG in 1993 (see Note 4) at a price exceeding the underlying fair value of net assets acquired resulted in goodwill. This goodwill and other intangible assets acquired are being amortized using the straight-line method over 30 years. NSP will periodically evaluate the recovery of goodwill based on an analysis of estimated undiscounted future cash flows. Intangible and other assets also include deferred financing costs of approximately $12.6 million at Dec. 31, 1993, which are being amortized over the remaining maturity period of the related debt. Reclassifications - Certain reclassifications have been made to the 1992 and 1991 income statement to conform with the 1993 presentation. In addition, the 1992 balance sheet has been reclassified to conform with the 1993 presentation of regulatory deferrals. These reclassifications had no effect on net income or earnings per share. 2. Rate Matters - 1993 Rate Increases Minnesota Jurisdiction - In November 1992, the Company filed applications for 1993 rate increases with the MPUC totaling $119.1 million and $14.9 million for Minnesota retail electric and natural gas customers, respectively. This represented annual increases of approximately 9 percent and 5.8 percent, respectively. In December 1992, the MPUC issued orders granting interim increases (subject to refund) of $71.2 million (5.4 percent) for electric service and $8.4 million (3.3 percent) for gas service, effective Jan. 1, 1993. In June 1993, the Company adjusted its proposed electric rate increase to $112.3 million and its gas rate request to $12.4 million. The Company received initial orders from the MPUC in September 1993 for both the gas and electric cases. Final orders came in December 1993 for the gas case and in January 1994 for the electric case, allowing annualized retail rate increases of $10.0 million (3.9 percent) for gas and $72.2 million (5.4 percent) for electric. The return on equity granted in both cases was 11.47 percent. Refunds of interim electric rates collected are required in the amount of approximately $12 million and are expected to be paid in May 1994. No refunds of interim gas rates collected are required. Final gas and electric rates are expected to be implemented in March and April 1994, respectively. On Jan. 31, 1994, an appeal of the MPUC's determination on the allowed return on equity was filed with the Minnesota Court of Appeals by the Minnesota Department of Public Service, the Office of the Minnesota Attorney General and the Minnesota Energy Consumers intervenor groups. The appeal concerns the method of calculating the rate of return on common equity for both the electric and gas cases. The amount at issue is approximately $7 million in annual revenues for the Company. The ultimate financial impact of this appeal, if any, is not determinable at this time. A decision by the court is expected by the end of 1994. Other Jurisdictions - The Wisconsin Company received approval of annualized retail rate increases of $8.0 million (3.1 percent) for Wisconsin electric customers and $1.1 million (1.8 percent) for Wisconsin gas customers. The new rates have been in effect since January 1993. The Company's approved annualized rate increase of $4.8 million (5.3 percent) for North Dakota electric customers was effective April 21, 1993. The Company's approved annualized rate increase of $4.2 million (6.5 percent) for South Dakota electric customers has been in effect since May 1, 1993. Increased annualized wholesale electric rates of $0.9 million (3.6 percent) were accepted by the FERC for nine Minnesota Company wholesale customers, effective Sept. 21, 1993. Increased annualized wholesale electric rates of $0.6 million (3.7 percent) were accepted by the FERC for the Wisconsin Company's 10 wholesale municipal utilities effective Sept. 1, 1993. 3. Accounting Changes Postretirement Benefits - (See Note 13 for discussion of NSP's 1993 change in accounting for postretirement medical and death benefits.) There was no material effect on net income due to rate recovery of the expense increases. Of the $20 million in 1993 cost increases over 1992 due to adoption of SFAS No. 106, about $5 million was capitalized, $12 million was deferred to be amortized over rate recovery periods in 1994-1996 and about $3 million was expensed but essentially offset by rate increases. Income Taxes - As discussed in Note 1, NSP adopted SFAS No. 109 - Accounting for Income Taxes, effective Jan. 1, 1993. Adoption of SFAS No. 109 had no effect on earnings or financial condition due to its similarity to SFAS No. 96 - Accounting for Income Taxes, which NSP adopted in 1988 and which SFAS No. 109 supersedes. Revenue Recognition - Effective Jan. 1, 1992, the Company changed its revenue recognition method to include the accrual of estimated unbilled revenues for electric and gas service in its Minnesota, North Dakota and South Dakota operations. This accounting practice has been used by the Wisconsin Company since 1977. This change resulted in a better matching of revenues and expenses, and is consistent with predominant utility industry practice and the ratemaking principles in NSP's two major jurisdictions (Minnesota and Wisconsin). The effect on 1992 income before accounting changes was an increase of approximately $9.8 million (16 cents per share), while the effect on total 1992 earnings was an increase of approximately $55.3 million (88 cents per share). If the accounting change had been applied retroactively to Jan. 1, 1991, income from continuing operations for 1991 would have been $204.4 million ($2.98 per share). 1994 Changes - In 1994, NSP will adopt SFAS No. 112 - Accounting for Postemployment Benefits and a new accounting standard for employers' transactions with ESOP plans. SFAS No. 112 requires the accrual of certain employee costs (such as injury compensation and severance) to be paid in future periods. The adoption of these new accounting standards is not expected to have a material effect on NSP's results of operations or financial condition. 4. Business Acquisitions Viking Gas Transmission Company - On June 10, 1993, the Company acquired 100 percent of the stock of Viking Gas Transmission Company (Viking) from Tenneco Gas, a unit of Tenneco, Inc., in Houston, Texas, for approximately $45 million, $32 million of which was financed with project debt. Viking, which is now a wholly owned subsidiary of the Company, owns and operates a 500-mile interstate natural gas pipeline serving portions of Minnesota, Wisconsin and North Dakota. Viking presently operates exclusively as a transporter of natural gas for third-party shippers under authority granted by the FERC. Rates for Viking's transportation services are regulated by the FERC. Minneapolis Energy Center - On Aug. 20, 1993, NRG Energy, Inc. (NRG), a wholly owned subsidiary of the Company, acquired the assets of the Minneapolis Energy Center (MEC), a district heating and cooling system in downtown Minneapolis, Minn. The system uses steam and chilled water generating facilities to heat and cool buildings for about 85 heating and 25 cooling customers. The purchase price was $110 million, $84 million of which was financed with project debt. The purchase price primarily included facilities, long-term service agreements and goodwill. Cenergy, Inc. - On Oct. 1, 1993, Cenergy, Inc., a non-regulated subsidiary of the Company, acquired certain assets of Centran Corporation (Centran), a natural gas marketing company. Cenergy, Inc., a national marketer of energy services with approximately 30 employees and approximately 300 customers, is headquartered in Minneapolis, Minn., and has additional offices in Houston and Corpus Christi, Texas; Louisville, Ky.; and Chesapeake, Va. The purchase price was $4 million. Assets purchased included proven oil and gas reserves, office equipment and a customer marketing data base. Operating Results - The following represents unaudited operating results presented on a pro forma basis as if the acquisitions described above occurred on Jan. 1, 1992. Actual results, including Viking since June 10, 1993, MEC since Aug. 20, 1993, and the acquired Centran operations since Oct. 1, 1993, are shown for comparative purposes. Year Ended Dec. 31 (Dollars in millions except EPS) 1993 1992 Actual Results Utility operating revenues $2 404.0 $2 159.5 Non-regulated operating revenues and sales $90.7 $62.6 Net income $211.7 $206.4 Earnings per share $3.02 $3.04 Pro Forma Amounts Utility operating revenues $2 411.9 $2 176.0 Non-regulated operating revenues and sales $161.2 $272.6 Net income $212.6 $204.9* Earnings per share $3.04 $3.01* *Includes pretax writedown of $2.3 million (2 cents per share) of deferred environmental costs for Viking. 5. Cumulative Preferred Stock The Company has two series of adjustable rate preferred stock. The dividend rates are calculated quarterly and based on prevailing rates of certain taxable government debt securities indices. At Dec. 31, 1993, the annualized dividend rates were $5.50 for series A and $5.50 for series B. At Dec. 31, 1993, the various preferred stock series were callable at prices per share ranging from $102.00 to $103.75, plus accrued dividends. In 1993, the Company redeemed all 350,000 shares of its $7.84 series Cumulative Preferred Stock at $103.12 per share. In 1992, the Company redeemed all 250,000 shares of its $8.80 series Cumulative Preferred Stock at $103.35 per share. 6. Common Stock and Incentive Stock Plans The Company's Articles of Incorporation and First Mortgage Indenture provide for certain restrictions on the payment of cash dividends on common stock. At Dec. 31, 1993, the payment of cash dividends on common stock was not restricted. NSP has an Executive Long-Term Incentive Award Stock Plan that permits granting non-qualified stock options. The options currently granted may be exercised one year from the date of grant and are exercisable thereafter for up to nine years. The plan also allows certain employees to receive other awards for restricted stock, stock appreciation rights and other performance awards. Performance awards are valued in dollars, but are paid in shares based on market price at the time of payment. Transactions under the various stock incentive programs, which may result in the issuance of new shares, were as follows: Stock Awards (Thousands of shares) 1993 1992 1991 Outstanding Jan. 1 528.7 403.3 161.0 Options granted 196.9 201.8 232.2 Other stock awards 9.5 .8 16.9 Options and awards exercised (174.3) (57.0) 0 Options and awards forfeited (22.2) (20.1) (6.8) Other (1.5) (.1) 0 Outstanding at Dec. 31 537.1 528.7 403.3 Option price ranges: Unexercised at Dec. 31 $33.25-$43.50 $33.25-$40.94 $33.25-$36.44 Exercised during the year $33.25-$40.94 $33.25-$36.44 Using the treasury stock method of accounting for outstanding stock options, the weighted average number of shares of common stock outstanding for the calculation of primary earnings per share includes any dilutive effects of stock options and other stock awards as common stock equivalents. The differences between shares used for primary and fully diluted earnings per share were not material. 7. Detail of Certain Income and Expense Items Administrative and general (A&G) expense for utility operations consists of the following: (Thousands of dollars) 1993 1992 1991 A&G salaries and wages $52 085 $49 096 $48 710 Pensions and benefits - all utility employees 63 938 65 278 58 306 Information technology, facilities and administrative support 30 504 35 139 33 698 Insurance and claims 18 598 20 512 21 404 Other 17 410 17 950 17 742 Total $182 535 $187 975 $179 860 Other income and deductions - net consist of the following: (Thousands of dollars) 1993 1992 1991 Non-regulated operations: Operating revenues and sales $90 654 $62 616 $76 342 Operating expenses (excluding income taxes) 81 403 65 744* 69 327 Pretax operating income (loss) 9 251 (3 128) 7 015 Interest and investment income 4 522 3 452 6 489 Equity in earnings of non-regulated projects 3 030 2 382 226 Charitable contributions (4 752) (4 585) (4 231) Costs disallowed recovery by regulators (296) (1 603) (6 100) Legal and regulatory contingencies (100) (1 300) (5 100) Other - net (excluding income taxes) (643) (752) (494) Income tax (expense) benefit (2 394) 4 493 1 905 Total $8 618 $(1 041) $(290) *Includes $6.8 million in writedowns and losses from unsuccessful non-regulated projects. 8. Regulatory Assets and Liabilities The following summarizes the individual components of unamortized regulatory assets and liabilities shown on the Balance Sheet at Dec. 31: (Thousands of dollars) 1993 1992 AFC recorded in plant on a net-of-tax basis $165 915 $164 740 Losses on reacquired debt 48 529 33 185 Conservation and energy management programs 46 939 25 754 Environmental costs 45 568 505 Deferred postretirement benefit costs 15 514 2 112 State commission accounting adjustments 6 246 5 954 Unrecovered purchased gas costs and other 5 643 7 237 Total regulatory assets $334 354 $239 487 Excess deferred income taxes collected from customers $113 276 $106 975 Investment tax credit deferrals 120 123 119 847 Pension costs 6 969 2 017 Fuel refunds and other 3 512 3 627 Total regulatory liabilities $243 880 $232 466 The environmental costs item includes an assessment from the DOE for the Company's allocated share of decontamination and decommissioning costs related to the DOE's uranium enrichment facility. The Company's total DOE assessment of $46 million was made in 1993. This assessment will be payable in annual installments (currently $3.1 million) for up to 15 years and will be expensed on a monthly basis in the 12 months following each payment. Future installments are subject to inflation adjustments under DOE rules. The FERC has approved wholesale ratemaking recovery of these assessments as paid through the cost-of-energy adjustment clause. Since the Company's retail regulators currently fully conform to the FERC's cost-of-energy adjustment clause procedures, management also expects recovery of these DOE assessments in retail ratemaking as payments are made each year. The AFC regulatory asset and the tax-related regulatory liabilities result from NSP's income tax accounting practices as discussed in Note 1. The excess deferred income tax liability represents the net amount expected to be reflected in future customer rates based on the collection in prior ratemaking of deferred income tax amounts in excess of the actual liabilities recorded by NSP. This excess is the net effect of the use of flow-through tax accounting in prior ratemaking and the impact of changes in statutory tax rates in 1981, 1986-87 and 1993. This regulatory liability will change each year as the related deferred income tax liabilities change. 9. Income Tax Expense Total income tax expense from operations differs from the amount computed by applying the statutory federal income tax rate (35 percent in 1993 and 34 percent in 1992 and 1991) to net income before income tax expense. The reasons for the difference are as follows: (Thousands of dollars) 1993 1992 1991 Tax Computed at Statutory Federal Rate $119 868 $84 015 $118 829 Increases (decreases) in tax from: State income taxes net of federal income tax benefit 20 838 13 421 20 822 Tax credits recognized (9 545) (8 846) (9 511) Nontaxable AFC - equity included in book income (2 565) (3 058) (2 562) Net-of-tax AFC included in book depreciation 4 403 4 518 4 594 Use of the flow-through method for depreciation in prior years 7 004 5 884 6 163 Effect of tax rate changes for plant-related items (4 648) (5 202) (6 798) Dividends paid on ESOP shares (3 009) (3 245) (3 199) Other - net (1 606) (1 311) (2 888) Total income tax expense from operations $130 740 $86 176 $125 450 Effective federal and state income tax rate 38.2% 34.9% 35.9% Composite federal and state statutory tax rate 40.9% 39.9% 39.9% Income taxes are comprised of the following expense (benefit) items: Included in utility operating expenses: Current federal tax expense $92 099 $69 198 $72 197 Current state tax expense 25 787 18 535 21 081 Deferred federal tax expense 15 010 8 518 25 157 Deferred state tax expense 4 431 2 533 7 779 Tax credits recognized (8 981) (8 115) (8 878) Total 128 346 90 669 117 336 Included in other income and expense: Current federal tax expense 7 853 1 490 3 708 Current state tax expense 2 289 613 1 128 Deferred federal tax expense (6 736) (4 518) (5 580) Deferred state tax expense (449) (1 347) (850) Tax credits recognized (563) (731) (311) Total 2 394 (4 493) (1 905) Included in discontinued operations: Current federal tax expense - operations 129 Current federal tax expense - gain 10 193 Current state tax expense - operations 28 Current state tax expense - gain 2 921 Deferred federal tax expense (2 271) Deferred state tax expense (539) Tax credits recognized (442) Total 10 019 Total income tax expense from operations $130 740 $86 176 $125 450 The components of NSP's net deferred tax liability at Dec. 31 were as follows: (Thousands of dollars) 1993 1992 Deferred tax liabilities: Differences between book and tax bases of property $792 542 $765 957 Regulatory assets 128 991 90 856 Tax benefit transfer leases 87 924 97 852 Other 7 050 5 791 Total deferred tax liabilities $1 016 507 $960 456 Deferred tax assets: Regulatory liabilities $95 504 $92 165 Deferred investment tax credits 73 648 74 047 Deferred compensation, vacation and other accrued liabilities not currently deductible 62 811 29 715 Other 11 341 Total deferred tax assets $243 304 $195 927 Net deferred tax liability $773 203 $764 529 The Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law on Aug. 10, 1993, and increased the federal corporate income tax rate from 34 percent to 35 percent retroactive to Jan. 1, 1993. Deferred tax liabilities were increased for the rate change by approximately $32 million. However, due to regulatory deferral of utility tax adjustments, earnings were reduced by immaterial adjustments to deferred tax liabilities related to non-regulated operations. 10. Long-Term Debt The annual sinking-fund requirements of the Company's and the Wisconsin Company's First Mortgage Indentures are the amounts necessary to redeem 1 percent of the highest principal amount of each series of first mortgage bonds at any time outstanding, excluding those series issued for pollution control and resource recovery financings, and excluding certain other series totaling $320 million. The Company may, and has, applied property additions in lieu of cash payments on all series except for the 91/8 percent Series due July 1, 2019, as permitted by its First Mortgage Indenture. The Wisconsin Company may also apply property additions in lieu of cash on all series as permitted by its First Mortgage Indenture. Except for minor exclusions, all real and personal property is subject to the liens of the first mortgage indentures. The variable rate First Mortgage Bonds Series due March 1, 2011, and the variable rate City of Becker Pollution Control Revenue Bonds Series due March 1, 2019, and Sept. 1, 2019, are redeemable upon seven days' notice at the option of the bondholder. Thus, the principal amount of these bonds outstanding at Dec. 31, 1993, is reported under current liabilities on the balance sheet. Their tax-exempt interest rates are subject to change, weekly or at various periods, and are based on prevailing rates for similar issues. The interest rates applicable to these issues averaged 3.0 percent, 2.6 percent and 2.5 percent, respectively, at Dec. 31, 1993. The Company and the Wisconsin Company have entered into interest rate swap agreements with the underwriters of certain first mortgage bond issues, which effectively convert the interest cost for this debt from fixed to variable rate as summarized below: Amount of Term of Net Effective Swap (millions Swap Interest Cost at Series of dollars) Agreement Dec. 31, 1993 5 7/8% Series due Oct. 1, 1997 $100 Maturity 3.38% 7 1/4% Series due March 1, 2023 $20 March 1, 1998 5.56% The variable rates change semiannually. Interest rate swap transactions are recognized as an adjustment of interest expense over the terms of the agreements. Maturities and sinking-fund requirements on long-term debt are as follows: 1994, $90,618,000; 1995, $41,348,000; 1996, $61,931,000; 1997, $138,401,000; and 1998, $57,352,000. On Jan. 24, 1994, the Company notified bondholders that $150 million of first mortgage bonds would be redeemed on Feb. 24, 1994. These bonds have been classified as long-term debt based on the refinancing of such debt using first mortgage bond proceeds obtained in February 1994. 11. Short-Term Borrowings NSP has approximately $215 million of commercial bank credit lines under commitment fee arrangements. These credit lines make short-term financing available in the form of bank loans and support for commercial paper sales. There were no borrowings against these credit lines at Dec. 31, 1993 and 1992. At Dec. 31, 1993, the Company had $106.2 million in short-term commercial paper borrowings outstanding at interest rates varying from 3.3 to 3.5 percent. 12. Fair Value of Financial Instruments SFAS No. 107 - Disclosures About Fair Value of Financial Instruments requires disclosure of the estimated fair value of financial instruments. For cash, cash equivalents and short-term investments, the carrying amount approximates fair value because of the short maturity of those instruments. The fair values of the Company's long-term investments in an external nuclear decommissioning fund are estimated based on quoted market prices for those or similar investments. The fair value of NSP's long-term debt is estimated based on the quoted market prices for the same or similar issues, or the current rates offered to NSP for debt of the same remaining maturities. The estimated Dec. 31 fair values of NSP's financial instruments are as follows: 1993 1992 Carrying Fair Carrying Fair (Thousands of dollars) Amount Value Amount Value Cash, cash equivalents and short-term investments $57 838 $57 838 $15 840 $15 840 Long-term decommissioning investments $101 378 $110 130 $68 800 $72 180 Long-term debt including current portion $1 524 085 $1 584 435 $1 373 876 $1 437 999 13. Benefit Plans and Other Postretirement Benefits Pension Benefits - NSP has a non-contributory, defined benefit pension plan that covers substantially all employees. Benefits are based on a combination of years of service, the employee's highest average pay for 48 consecutive months and Social Security benefits. For regulatory purposes, the Company's pension expense is determined and recorded under the aggregate-cost method. SFAS No. 87 - Employers' Accounting for Pensions provides that any difference between the pension expense recorded for ratemaking purposes and the amounts determined under SFAS No. 87 should be recorded as assets or liabilities on the balance sheet. Net annual periodic pension cost includes the following components: (Thousands of dollars) 1993 1992 1991 Service cost-benefits earned during the period $25 015 $24 080 $22 097 Interest cost on projected benefit obligation 71 075 69 853 65 557 Actual return on assets (152 019) (115 455) (246 678) Net amortization and deferral 66 299 39 019 181 543 Net periodic pension cost determined under SFAS No. 87 10 370 17 497 22 519 Costs recognized (deferred) due to actions of regulators 5 117 2 741 (1 549) Total pension costs recorded during the period 15 487 20 238 20 970 Less costs recognized for 1988 early retirement program (165) (165) Net periodic pension cost recognized for ratemaking $15 487 $20 073 $20 805 The funded status of the plan as of Dec. 31 is as follows: (Thousands of dollars) 1993 1992 Actuarial present value of benefit obligation: Vested $655 002 $614 446 Nonvested 139 346 129 183 Accumulated benefit obligation $794 348 $743 629 Projected benefit obligation $974 160 $914 019 Plan assets at fair value 1 244 650 1 156 782 Plan assets in excess of projected benefit obligation (270 490) (242 763) Unrecognized prior service cost (22 580) (14 790) Unrecognized net actuarial gain 315 049 269 086 Unrecognized net transitional asset 767 843 Net pension liability included in other liabilities $22 746 $12 376 The weighted average discount rate used in determining the actuarial present value of the projected obligation was 7 percent in 1993 and 8 percent in 1992. The rate of increase in future compensation levels used in determining the actuarial present value of the projected obligation was 5 percent in 1993 and 6 percent in 1992. While the 1993 assumption changes had no effect on 1993 pension costs, the effect of the changes in 1994 is expected to be a cost decrease of approximately $3 million. The assumed long-term rate of return on assets used for cost determinations under SFAS No. 87 was 8 percent in 1993 and 1992 and 8.5 percent in 1991. The effect of the 1992 change in the assumed rate of return was an increase of $4.3 million in the estimated SFAS No. 87 net periodic pension cost in 1992. Plan assets principally consist of common stock of public companies and U.S. government securities. Postretirement Health Care - Effective Jan. 1, 1993, NSP adopted the provisions of SFAS No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS No. 106 requires the actuarially determined obligation for postretirement health care and death benefits to be fully accrued by the date employees attain full eligibility for such benefits, which is generally when they reach retirement age. This is a significant change from NSP's prior policy of recognizing benefit costs on a cash basis after retirement. In conjunction with the adoption of SFAS No. 106, NSP elected to amortize on a straight-line basis over 20 years the unrecognized accumulated postretirement benefit obligation (APBO) of $215.6 million for current and future retirees. This obligation considers anticipated 1994 plan design changes, including Medicare integration, increased retiree cost sharing and managed indemnity measures not in effect in 1993. Prior to 1993, NSP funded benefit payments to retirees internally. While NSP generally prefers to continue using internal funding of benefits paid and accrued, significant levels of external funding have been imposed by NSP's regulators, as discussed below, including the use of tax-advantaged trusts. Plan assets held in such trusts as of Dec. 31, 1993, consisted of investments in equity mutual funds and cash equivalents. The following table sets forth the health care plan's funded status in 1993. (Millions of dollars) Dec. 31, 1993 Jan. 1, 1993 APBO: Retirees $120.2 $105.8 Fully eligible plan participants 18.8 18.8 Other active plan participants 90.8 91.0 Total APBO 229.8 215.6 Plan Assets 6.1 0 APBO in excess of plan assets 223.7 215.6 Unrecognized net actuarial loss (1.3) Unrecognized transition obligation (204.8) (215.6) Postretirement benefit obligation included in other liabilities $17.6 $0 The assumed health care cost trend rate used in measuring the APBO at Dec. 31, 1993, was 14.1 percent for those under age 65 and 8.0 percent for those over age 65. The assumed cost trend rates are expected to decrease each year until they reach 4.5 percent for both age groups in the year 2004, after which they are assumed to remain constant. The trend rates used in the Jan. 1, 1993, calculations were 15.1 percent and 9.0 percent, respectively, eventually decreasing to 5.5 percent in 2004. A 1-percent increase in the assumed health care cost trend rate for each year would increase the APBO as of Dec. 31, 1993, by approximately 17 percent, and service and interest cost components of the net periodic postretirement cost by approximately 20 percent. The assumed discount rate used in determining the APBO was 7 percent for Dec. 31, 1993, and 8 percent for Jan. 1, 1993, compounded annually. The assumed long-term rate of return on assets used for cost determinations under SFAS No. 106 was 8 percent for both measurement dates. While the assumption changes made for the Dec. 31 calculations had no effect on 1993 benefit costs, the effect of the changes in 1994 is expected to be a cost decrease of approximately $2 million. In 1992 and 1991, NSP recognized $12.8 million and $11.2 million, respectively, as the cost attributable to postretirement health care and death benefits based on payments made. The net annual periodic postretirement benefit cost recorded for 1993 consists of the following components: (Millions of dollars) 1993 Service cost-benefits earned during the year $4.4 Interest cost (on service cost and APBO) 17.5 Actual return on assets (.1) Amortization of transition obligation 10.8 Net amortization and deferral .1 Net periodic postretirement health care cost under SFAS No. 106 32.7 Costs deferred due to actions of regulators (12.1) Net periodic postretirement health care cost recognized for ratemaking $20.6 Regulators of NSP's retail rates in Minnesota, Wisconsin and North Dakota have allowed full recovery of increased benefit costs under SFAS No. 106, effective in 1993. Expense recognition and rate recovery of increased 1993 accrual costs for Minnesota have been deferred until 1994 through 1996, consistent with rate orders received. External funding was required in Minnesota and Wisconsin to the extent it is tax advantaged; funding began for Wisconsin in 1993 and must begin by the next general rate filing for Minnesota. Rate increases for Minnesota and Wisconsin wholesale electric customers were approved by the FERC and provided recovery of accrued SFAS No. 106 benefits under new rates beginning in September 1993. A rate increase for Viking wholesale gas customers was approved by the FERC, before Viking's acquisition by the Company, and provided recovery of accrued benefits beginning in July 1993. The FERC has required external funding for all benefits paid and accrued under SFAS No. 106. The impact of adopting SFAS No. 106 on other utility jurisdictions and non-regulated operations was not material. ESOP - NSP also has a leveraged Employee Stock Ownership Plan (ESOP) that covers substantially all employees. Employer contributions to this plan are generally made to the extent NSP realizes a tax savings on its income statement from dividends paid on shares held by the ESOP. Contributions to the ESOP in 1993, 1992 and 1991, which approximate expenses determined under the shares-allocated method, were $6,281,000, $6,415,000 and $6,326,000, respectively. ESOP contributions have no material effect on NSP earnings because the contributions (net of tax) are essentially offset by the tax savings provided by the dividends paid on ESOP shares. (See Note 9.) 14. Joint Plant Ownership The Company is a participant in a jointly owned 855-megawatt coal-fired electric generating unit, Sherburne County Generating Station Unit No. 3 (Sherco 3), which began commercial operation Nov. 1, 1987. Undivided interests in Sherco 3 have been financed and are owned by the Company (59 percent) and Southern Minnesota Municipal Power Agency (41 percent). The Company is the operating agent under the joint ownership agreement. The Company's share of related expenses for Sherco 3 since commercial operations began are included in Utility Operating Expenses. The Company's share of the gross cost recorded in Utility Plant at Dec. 31, 1993 and 1992, was $584,822,000 and $582,799,000, respectively. The corresponding accumulated provisions for depreciation were $114,251,000 and $96,035,000. 15. Commitments and Contingent Liabilities Commitments - NSP estimates utility capital expenditures, including acquisitions of nuclear fuel, will be $396 million in 1994 and $1.8 billion for 1994-1998. There also are contractual commitments for the disposal of spent nuclear fuel. Rentals under operating leases were approximately $27.5 million, $25.1 million and $22.7 million for 1993, 1992 and 1991, respectively. Fuel Contracts - NSP has long-term contracts providing for the purchase and delivery of a significant portion of its current coal, nuclear fuel and natural gas requirements. These contracts, which expire in various years between 1994 and 2013, require minimum contractual purchases and deliveries of fuel, and additional payments for the rights to purchase coal in the future. In total, NSP is committed to the purchase and receipt of approximately $374 million of coal, $129 million of nuclear fuel and $607 million of natural gas, or to make payments in lieu thereof, under these contracts. Because NSP has other sources of fuel available and because suppliers are expected to continue to provide reliable fuel supplies, risk of loss from non-performance under these contracts is not considered significant. In addition, NSP's risk of loss (in the form of increased costs) from market price changes in fuel is mitigated through the cost-of-energy adjustment provision of the ratemaking process, which provides for recovery of nearly all fuel costs. Power Agreements - The Company has executed several agreements with the Manitoba Hydro-Electric Board (MH) for hydroelectricity. A summary of the agreements is as follows: Years Megawatts Participation Power Purchases 1994-2005 500 Seasonal Participation Power Purchase 1994-1996 1994 150 1995-1996 250 Seasonal Peaking Power Purchases 1994-1996 200 Seasonal Diversity Exchanges: Summer exchanges from MH 1994 400 1995-2014 150 1997-2016 200 Winter exchanges to MH 1995-2014 150 1996-2015 200 2015-2017 400 2018 200 The cost of the participation power purchase commitment is based on 80 percent of the costs of owning and operating Sherco 3 (adjusted to 1993 dollars). The total estimated annual costs for all MH agreements are $68.2 million for 1994 and approximately $70 million thereafter. These commitments, which represent about 38 percent of MH's output capability in 1993, account for approximately 13 percent of the Company's 1993 system capability. The risk of loss from non-performance by MH is not considered significant and the risk of loss from market price changes is mitigated through cost-of-energy rate adjustments. The Company and MH jointly have made commitments to provide additional transmission capacity to accomplish the seasonal diversity exchanges and to provide 200 megawatts of transmission capacity for United Power Association. The Company's agreements with MH call for the addition of facilities that will allow the Company's existing 500-kilovolt line from Winnipeg to the Twin Cities to accommodate the additional levels of transactions. The Company and MH began construction in early 1992, received all the necessary approvals in 1993 and expect to complete construction in 1995. The Company has an agreement with Minnkota Power Cooperative (MPC) for the purchase of summer season capacity and energy. From 1994 through 2001, the Company will buy 150 megawatts of summer season capacity for $12.4 million annually. From 2002 through 2015, the Company will purchase 100 megawatts of capacity for $10.0 million annually. Energy under the agreement will be priced against the cost of fuel consumed per megawatt-hour at the Coyote Generating Station in North Dakota. The Company also has three seasonal (summer) purchase power agreements, with MPC, Minnesota Power and Rochester Public Utility, for the purchase of 270 megawatts in 1994 and 250 megawatts in 1995 and 1996. The annual cost of this capacity will be approximately $3 million. The Company has agreements with several non-regulated entities to purchase electric capacity and associated energy. The total annual cost of current commitments for non-regulated installed capacity ranges from approximately $18 million for 119 megawatts in each of the years 1994-2011, decreasing thereafter to $0.8 million in 2033. The Company is negotiating a new power-purchase agreement with an independent power producer, which is expected to provide an additional 232 megawatts of electric capacity and associated energy, beginning in 1997. Nuclear Insurance - The Company's public liability for claims resulting from any nuclear incident is limited to $9.4 billion under the 1988 Price-Anderson amendment to the Atomic Energy Act of 1954. The Company has secured $200 million of coverage for its public liability exposure with a pool of insurance companies. The remaining $9.2 billion of exposure is funded by the Secondary Financial Protection Program, available from assessments by the federal government in case of a nuclear accident. The Company is subject to assessments of $79.3 million for each of its three licensed reactors to be applied for public liability arising from a nuclear incident at any licensed nuclear facility in the United States. The maximum funding requirement is $10 million per reactor during any one year. The Company purchases insurance for property damage and decontamination clean-up costs with coverage limits of $2.35 billion for the Prairie Island nuclear plant site and $2.15 billion for the Monticello nuclear plant site. The Prairie Island coverage consists of $950 million from American Nuclear Insurers/ Mutual Atomic Energy Liability Underwriters (ANI/MAELU) and $1.4 billion from Nuclear Electric Insurance Limited (NEIL). The Monticello coverage consists of $750 million from ANI/MAELU and $1.4 billion from NEIL. Under the insuring agreement with NEIL, the Company is subject to assessments of up to $23.3 million in each calendar year, 7.5 times the amount of its annual premium. NEIL also provides insurance coverage for increased costs of generation and purchased power resulting from an accidental outage of a nuclear generating unit. Under the policy, the Company is subject to assessments of up to $6.7 million in each calendar year, five times the amount of its annual premium. Environmental Contingencies - Other long-term liabilities include an accrual of $48 million at Dec. 31, 1993, for estimated costs associated with environmental reclamation, restoration and cleanup activities. Approximately $40 million of the liability relates to a 1993 DOE assessment as discussed in Note 8 to the Financial Statements. Other estimates have been recorded for expected environmental costs associated with manufactured gas plant sites formerly used by the Company and other waste disposal sites as discussed below. These environmental liabilities do not include accruals recorded (and collected from customers in rates) for future decommissioning costs related to the Company's nuclear generating plants. Consistent with predominant industry practice, the Company's decommissioning accruals are included in Utility Plant-Accumulated Depreciation as discussed in Note 1 of the Financial Statements. The FERC, the FASB and the SEC currently are reviewing the accounting and reporting guidelines for decommissioning cost accruals. Until such guidelines require a different presentation, the Company plans to continue its current reporting of plant decommissioning obligations as accumulated depreciation. NSP has not developed any specific site restoration and exit plans for its fossil fuel plants, hydroelectric plants or substation sites as it currently intends to operate at these sites indefinitely. If such plans were developed in the future, NSP would intend to treat the costs as a removal cost of retirement and include it in depreciation expense. (See Note 1 for discussion of NSP's pre-funding of the federal nuclear fuel disposal program.) NSP has met or exceeded the removal and disposal requirements for polychlorinated biphenyls (PCB) equipment as required by state and federal regulations. NSP has removed nearly all PCB capacitors, transformers and equipment from its distribution system and power plants. Any future cleanup or remediation costs for past PCB disposal is unknown at this time. Minimal costs are expected to be incurred for future removal and disposal of PCB equipment. PCB-contaminated mineral oil is detoxified and beneficially reused or burned for energy recovery at a permitted facility. The Company has been designated by the Environmental Protection Agency (EPA) as a "potentially responsible party" (PRP) for eight waste disposal sites to which the Company sent materials. Under applicable law, the Company, along with each PRP, could be held jointly and severally liable for the total remediation costs of all eight sites, which are estimated to approximate $85 million. However, the amount could be in excess of $85 million. The Company is not aware of the other parties' inability to pay or if responsibility for any of the sites is disputed by any party. The Company's share of the costs associated with these eight sites is approximately $2.5 million. Of this amount, about $1.4 million has already been paid in connection with two of the eight sites for which the Company has settled with the EPA and other PRPs. For the remaining six sites, neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined. However, the Company has recorded an estimate of future costs of approximately $1 million for all six sites. While it is not feasible to determine the outcome of these matters, amounts accrued represent the best current estimate of the Company's future liability for the cleanup costs of these sites. It is the Company's practice to vigorously pursue and, if necessary, litigate with insurers to recover costs. Through litigation, the Company has recovered from other PRPs a portion of the remedial costs paid to date. Management believes costs incurred in connection with the sites, which are not recovered from insurance carriers or other parties, might be allowed recovery in future ratemaking. Until the Company is identified as a PRP, it is not possible for the Company to predict the timing or amount of any costs associated with cleanup sites other than those discussed above. The Wisconsin Company has been notified by a group of PRPs for possible responsibility for cleanup of a solid and hazardous waste landfill site. The Wisconsin Company contends that it did not dispose of hazardous wastes in the subject landfill during the time period in question. Because neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined, it is not feasible to determine the outcome of this matter at this time. The Company also is continuing to investigate 14 properties either presently or previously owned by the Company, which were at one time sites of gas manufacturing, gas storage plants or gas pipelines. The purpose of this investigation is to determine if waste materials are present, if such materials constitute an environmental or health risk, if the Company has any responsibility for remedial action and if recovery under the Company's insurance policies can contribute to any remediation costs. Of the 14 gas sites under investigation, the Company has already remediated one site and is actively taking remedial action at four of the sites. The Company has paid $3.1 million to date on these sites. The one remediated site continues to be monitored. The Company currently estimates its liability for these four sites to be approximately $5 million with payment expected over the next one to five years. The estimate is based on prior experience and includes investigation, remediation and litigation costs. The possible range of the liability for these four sites could be from $5 million to approximately $11 million, depending on the extent of contamination. As for the other nine sites, the Company currently estimates its liability to be approximately $2 million. This estimate assumes the development and remediation of one site with the remaining eight sites requiring only monitoring. The time frame for payment of these costs currently is undeterminable. While it is not feasible to determine the precise outcome of all of these matters, the accruals recorded represent the current best estimate of the costs of any required cleanup or remedial actions at the Company's former gas operating sites. Management also believes that costs incurred in connection with the sites, which are not recovered from insurance carriers or other parties, might be allowed recovery in future ratemaking. The Clean Air Act, including the Amendments of 1990 (the Clean Air Act), imposes stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. The legislation enacted in 1990 is extremely complex and its overall financial impact on NSP will depend on the final interpretation and implementation of rules to be issued by the EPA. NSP is participating in the rulemaking process for the development of regulations that achieve the goals of the legislation in a reasonable and cost-effective manner. NSP has expended significant funds over the years to reduce sulfur dioxide emissions at its plants. Additional construction expenditures may be required to comply with parts of the Clean Air Act. Based on revised emission standards proposed by the EPA in 1993, NSP's excess emission allowances available under the Clean Air Act may be significantly reduced. Because NSP is only beginning to implement some provisions of the Clean Air Act, its overall financial impact is unknown at this time. The majority of NSP's power plants meet state and federal limits for opacity and air quality. Capital expenditures will be required for opacity compliance in 1994-1998 at certain facilities, and such costs are considered in the capital expenditure commitments disclosed previously. NSP plans to seek recovery of these expenditures in future rate proceedings. In October 1992, the Company disclosed to the Minnesota Pollution Control Agency, the EPA and the Nuclear Regulatory Commission that reports on halogen content of water discharged at the Company's Prairie Island nuclear generating plant were based on estimates of halogen content rather than actual physical samples of water discharged as required by the plant's permit. Even though the water discharges at the plant did not exceed the halogen levels allowed under the permit, the applicable state and federal statutes would permit the imposition of fines, the institution of criminal sanctions and/or injunctive relief for the reporting violations. Corrective actions were taken by the Company, and the Company cooperated with state and federal authorities in the investigation of the reporting violations. No civil or criminal actions against the Company have been announced. Environmental liabilities are subject to considerable uncertainties that affect NSP's ability to estimate its share of the ultimate costs of remediation and pollution control efforts. Such uncertainties involve the nature and extent of site contamination, the extent of required cleanup efforts, varying costs of alternative cleanup methods and pollution control technologies, changes in environmental remediation and pollution control requirements, the potential effect of technological improvements, the number and financial strength of other potentially responsible parties at multi-party sites and the identification of new environmental cleanup sites. NSP has recorded and/or disclosed its best estimate of expected future environmental costs and obligations as discussed previously. Legal Claims - In the normal course of business, NSP is a party to routine claims and litigation arising from prior and current operations. NSP is actively defending these matters and has recorded an estimate of the probable cost of settlement or other disposition. On July 22, 1993, a natural gas explosion occurred on the Company's distribution system in St. Paul, Minn. Total damages are estimated to exceed $1 million. The Company has a self-insured retention deductible of $1 million, with general liability coverage of $150 million, which includes coverage for all injuries and damages. While four lawsuits have been filed, the litigation following this incident is in a preliminary stage and the ultimate costs to the Company are unknown at this time. Operating Contingency - The Company is experiencing uncertainty regarding its ability to store used nuclear fuel from its Prairie Island nuclear generating facility. The facility stores its used nuclear fuel on an interim basis in a storage pool in the plant, pending the availability of a U.S. Department of Energy high-level radioactive waste storage or permanent disposal facility, or a private interim storage facility. At current operating levels, the pool will be filled in 1994 so the Company has proposed to augment Prairie Island's interim storage capacity by using steel containers for dry storage of used nuclear fuel on the plant site. Without additional onsite storage or significant modification of normal plant operations, Prairie Island Unit 2 would be shutdown in May 1995 and Prairie Island Unit 1 would be shutdown in February 1996. These two units supply about 20 percent of the Company's output. The Company has obtained a Certificate of Need from the MPUC allowing use of a limited number of steel containers, providing adequate storage at least through the year 2001. The Nuclear Regulatory Commission has also issued a license approving a dry storage facility on the plant site for Prairie Island's used fuel. However, in June 1993, the Minnesota Court of Appeals decided that the additional temporary storage facilities must be approved by the Minnesota Legislature. The Company has requested such approval from the Legislature and expects a decision on this issue during the current session, which began on Feb. 22, 1994. Although hearings have begun, the Company cannot predict what action the Minnesota Legislature will take. The Company's net investment in the Prairie Island generating facility at Dec. 31, 1993, was $520 million. Future plant decommissioning costs in excess of amounts not accrued and collected in rates were $247 million at Dec. 31, 1993. Should the facility need to be shut down due to the full utilization of spent fuel storage capacity, the Company would request recovery of, and a return on, its investment and unrecorded plant decommissioning costs through utility rates. However, at this time the regulators' ultimate response to such a request is unknown. Without the generating capability of the Prairie Island facility, the Company estimates that an incremental increase in purchased power and fuel expenses of at least $200 million per year could be incurred. To the extent such additional costs represent energy purchases, current rate treatment provides recovery through cost-of-energy adjustments to customer rates. The Company will request recovery of costs associated with additional capacity purchases or investments in new plants through general rate filings. However, at this time the need for such costs and the regulators' ultimate response to such a request is unknown. The Company estimates that the present value of the cost of supplying replacement power and recovering its investment in the plant and unrecognized decommissioning costs will be $1.8 billion. 16. Segment Information Year Ended Dec. 31 (Thousands of dollars) 1993 1992 1991 Utility operating revenues Electric $1 974 916 $1 823 316 $1 863 238 Gas 429 076 336 206 337 920 Total operating revenues $2 403 992 $2 159 522 $2 201 158 Utility operating income before income taxes* Electric $393 758 $321 837 $383 049 Gas 38 474 24 848 39 748 Total operating income before income taxes $432 232 $346 685 $422 797 Utility depreciation and amortization Electric $245 200 $225 134 $217 625 Gas 19 317 17 780 16 538 Total depreciation and amortization $264 517 $242 914 $234 163 Capital expenditures Electric $284 239 $367 522 $290 793 Gas 36 312 42 850 32 576 Other 41 144 17 443 26 493 Total capital expenditures $361 695 $427 815 $349 862 Net utility plant Electric $3 834 131 $3 812 688 $3 709 811 Gas 379 968 313 002 287 167 Total net utility plant 4 214 099 4 125 690 3 996 978 Other corporate assets 1 373 619 1 016 771 921 860 Total assets $5 587 718 $5 142 461 $4 918 838 *1992 amounts include an increase from the operating income impact of the 1992 change in accounting for revenues of $9.6 million for electric and $6.8 million for gas. Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure During 1993 there were no changes in or disagreements with the Company's independent public accountants on accounting procedures or accounting and financial disclosures. PART III Item 10 - Directors and Executive Officers of the Registrant Information required under this Item with respect to Directors is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on pages 2 through 7 under the caption "Election of Directors", which is incorporated herein by reference. Information with respect to Executive Officers is included under the caption "Executive Officers" in Item 1 of this report, and is incorporated herein by reference. Item 11 - Executive Compensation Information required under this Item is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on pages 8 through 20 under the caption "Compensation of Executive Officers", which is incorporated herein by reference. Item 12 - Security Ownership of Certain Beneficial Owners and Management Information required under this Item is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on page 7 under the caption "Share Ownership of Directors, Nominees and Named Executive Officers", which is incorporated herein by reference. Item 13 - Certain Relationships and Related Transactions Information required under this Item is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on pages 3 through 5 under the captions "Class I - Directors Whose Terms Expire in 1996", "Class II - Nominees for Terms Expiring in 1997", "Class III - Directors Whose Terms, Expire in 1995", which is incorporated herein by reference. PART IV Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements Included in Part II of this report: Independent Auditors' Report. Consolidated Statements of Income for the three years ended December 31, 1993. Consolidated Statements of Cash Flows for the three years ended December 31, 1993. Consolidated Balance Sheets, December 31, 1993 and 1992. Consolidated Statements of Changes in Common Stockholders' Equity for the three years ended December 31, 1993 Consolidated Statements of Capitalization, December 31, 1993 and 1992. Notes to Financial Statements. (a) 2. Financial Statement Schedules Included in Part IV of this report: Schedules for the three years ended December 31, 1993: V - Utility Plant and Non-regulated Property VI - Accumulated Provision for Depreciation and Amortization of Utility Plant and Non-regulated Property. Notes to Schedules V and VI. IX - Short-Term Borrowings X - Supplementary Income Statement Information Schedules other than those listed above are omitted because of the absence of the conditions under which they are required or because the information required is included in the financial statements or the notes. (a) 3. Exhibits * Indicates incorporation by reference 3.01* Restated Articles of Incorporation and Amendments, effective as of April 2, 1992. (Exhibit 3.01 to Form 10-Q for the quarter ended March 31, 1992, File No. 1-3034). 3.02* Bylaws of the Company as amended January 22, 1992. (Exhibit 3.02 to Form 10-K for the year 1991, File No. 1-3034). 4.01* Trust Indenture, dated February 1, 1937, from the Company to Harris Trust and Savings Bank, as Trustee. (Exhibit B-7 to File No. 2-5290). 4.02* Supplemental and Restated Trust Indenture, dated May 1, 1988, from the Company to Harris Trust and Savings Bank, as Trustee. (Exhibit 4.02 to Form 10-K for the year 1988, File No. 1-3034). Supplemental Indenture between the Company and said Trustee, supplemental to Exhibit 4.01, dated as follows: 4.03* Jun. 1, 1942 (Exhibit B-8 to File No. 2-97667). 4.04* Feb. 1, 1944 (Exhibit B-9 to File No. 2-5290). 4.05* Oct. 1, 1945 (Exhibit 7.09 to File No. 2-5924). 4.06* Jul. 1, 1948 (Exhibit 7.05 to File No. 2-7549). 4.07* Aug. 1, 1949 (Exhibit 7.06 to File No. 2-8047). 4.08* Jun. 1, 1952 (Exhibit 4.08 to File No. 2-9631). 4.09* Oct. 1, 1954 (Exhibit 4.10 to File No. 2-12216). 4.10* Sep. 1, 1956 (Exhibit 2.09 to File No. 2-13463). 4.11* Aug. 1, 1957 (Exhibit 2.10 to File No. 2-14156). 4.12* Jul. 1, 1958 (Exhibit 4.12 to File No. 2-15220). 4.13* Dec. 1, 1960 (Exhibit 2.12 to File No. 2-18355). 4.14* Aug. 1, 1961 (Exhibit 2.13 to File No. 2-20282). 4.15* Jun. 1, 1962 (Exhibit 2.14 to File No. 2-21601). 4.16* Sep. 1, 1963 (Exhibit 4.16 to File No. 2-22476). 4.17* Aug. 1, 1966 (Exhibit 2.16 to File No. 2-26338). 4.18* Jun. 1, 1967 (Exhibit 2.17 to File No. 2-27117). 4.19* Oct. 1, 1967 (Exhibit 2.01R to File No. 2-28447). 4.20* May 1, 1968 (Exhibit 2.01S to File No. 2-34250). 4.21* Oct. 1, 1969 (Exhibit 2.01T to File No. 2-36693). 4.22* Feb. 1, 1971 (Exhibit 2.01U to File No. 2-39144). 4.23* May 1, 1971 (Exhibit 2.01V to File No. 2-39815). 4.24* Feb. 1, 1972 (Exhibit 2.01W to File No. 2-42598). 4.25* Jan. 1, 1973 (Exhibit 2.01X to File No. 2-46434). 4.26* Jan. 1, 1974 (Exhibit 2.01Y to File No. 2-53235). 4.27* Sep. 1, 1974 (Exhibit 2.01Z to File No. 2-53235). 4.28* Apr. 1, 1975 (Exhibit 4.01AA to File No. 2-71259). 4.29* May 1, 1975 (Exhibit 4.01BB to File No. 2-71259). 4.30* Mar. 1, 1976 (Exhibit 4.01CC to File No. 2-71259). 4.31* Jun. 1, 1981 (Exhibit 4.01DD to File No. 2-71259). 4.32* Dec. 1, 1981 (Exhibit 4.01EE to File No. 2-83364). 4.33* May 1, 1983 (Exhibit 4.01FF to File No. 2-97667). 4.34* Dec. 1, 1983 (Exhibit 4.01GG to File No. 2-97667). 4.35* Sep. 1, 1984 (Exhibit 4.01HH to File No. 2-97667). 4.36* Dec. 1, 1984 (Exhibit 4.01II to File No. 2-97667). 4.37* May 1, 1985 (Exhibit 4.36 to Form 10-K for the year 1985, File No. 1-3034). 4.38* Sep. 1, 1985 (Exhibit 4.37 to Form 10-K for the year 1985, File No. 1-3034). 4.39* Jul. 1, 1989 (Exhibit 4.01 to Form 8-K dated July 7, 1989, File No. 1-3034). 4.40* Jun. 1, 1990 (Exhibit 4.01 to Form 8-K dated June 1, 1990, File No. 1-3034). 4.41* Oct. 1, 1992 (Exhibit 4.01 to Form 8-K dated October 13, 1992, File No. 1-3034). 4.42* April 1, 1993 (Exhibit 4.01 to Form 8-K dated March 30, 1993, File No. 1-3034). 4.43* Dec. 1, 1993 (Exhibit 4.01 to Form 8-K dated December 7, 1993, File No. 1-3034). 4.44* Feb. 1, 1994 (Exhibit 4.01 to Form 8-K dated February 10, 1994, File No. 1-3034). 4.45* Trust Indenture, dated April 1, 1947, from the Wisconsin Company to Firstar Trust Company (formerly First Wisconsin Trust Company), as Trustee. (Exhibit 7.01 to File No. 2- 6982). Supplemental Indentures between the Wisconsin Company and said Trustee, supplemental to Exhibit 4.45 dated as follows: 4.46* Mar. 1, 1949 (Exhibit 7.02 to File No. 2-7825). 4.47* Jun. 1, 1957 (Exhibit 2.13 to File No. 2-13463). 4.48* Aug. 1, 1964 (Exhibit 4.20 to File No. 2-23726). 4.49* Dec. 1, 1969 (Exhibit 2.03E to File No. 2-36693). 4.50* Sep. 1, 1973 (Exhibit 2.01F to File No. 2-48805). 4.51* Feb. 1, 1982 (Exhibit 4.01G to File No. 2-76146). 4.52* Mar. 1, 1982 (Exhibit 4.39 to Form 10-K for the year 1982, File No. 10-3140). 4.53* Jun. 1, 1986 (Exhibit 4.01I to File No. 33-6269). 4.54* Mar. 1, 1988 (Exhibit 4.01J to File No. 33-20415). 4.55* Supplemental and Restated Trust Indenture dated March 1, 1991, from the Wisconsin Company to Firstar Trust Company (formerly First Wisconsin Trust Company), as Trustee. (Exhibit 4.01K to File No. 33-39831) 4.56* Apr. 1, 1991 (Exhibit 4.01L to File No. 33-39831). 4.57* Mar. 1, 1993 (Exhibit 4.01 to Form 8-K dated March 4, 1993, File No. 10-3140). 4.58* Oct. 1, 1993 (Exhibit 4.01 to Form 8-K dated September 21, 1993, File No. 10-3140). 10.01* Mid-continent Area Power Pool (MAPP) Agreement, dated March 31, 1972, between the local power suppliers in the North Central States area. (Exhibit 5.06B to File No. 2-44530). 10.02* Facilities agreement, dated July 21, 1976, between the Company and the Manitoba Hydro-Electric Board relating to the interconnection of the 500 Kv Line. (Exhibit 5.06I to file No. 2-54310). 10.03* Transactions agreement, dated July 21, 1976, between the Company and the Manitoba Hydro-Electric Board relating to the interconnection of the 500 Kv Line. (Exhibit 5.06J to File No. 2-54310). 10.04* Co-ordinating agreement, dated July 21, 1976, between the Company and the Manitoba Hydro-Electric Board relating to the interconnection of the 500 Kv Line. (Exhibit 5.06K to File No. 2-54310). 10.05* Ownership and Operating Agreement, dated March 11, 1982, between the Company, Southern Minnesota Municipal Power Agency and United Minnesota Municipal Power Agency concerning Sherburne County Generating Unit No. 3. (Exhibit 10.35 to Form 10-K for the Year 1982, File No. 1-3034). 10.06* Transmission agreement, dated April 27, 1982, and Supplement No. 1, dated July 20, 1982, between the Company and Southern Minnesota Municipal Power Agency. (Exhibit 10.40 to Form 10-K for the Year 1982, File No. 1-3034). 10.07* Power agreement, dated June 14, 1984, between the Company and the Manitoba Hydro-Electric Board, extending the agreement scheduled to terminate on April 30, 1993, to April 30, 2005. (Exhibit 10.45 to Form 10-K for the Year 1984, File No. 1-3034). 10.08* Power Agreement, dated August 1988, between the Company and Minnkota Power Company. (Exhibit 10.08 to Form 10-K for the Year 1988, File No. 1-3034). 10.09 Energy Supply Agreement, dated October 26, 1993, between the Company and Liberty Paper, Inc., relating to the supply of steam and electricity to the LPI container-board facility in Becker, MN. Executive Compensation Arrangements and Benefit Plans Covering Executive Officers 10.10* Executive Long-Term Incentive Award Stock Plan. (Exhibit 10.10 to Form 10-K for 1988, File No. 1-3034). 10.11* Terms and Conditions of Employment - James J Howard, President and Chief Executive Officer, effective February 1, 1987. (Exhibit 10.11 to Form 10-K for the Year 1986, File No. 1-3034). 10.12* NSP Severance Plan (Exhibit 10.14 to Form 10-K for the Year 1992, File No. 1-3034). 10.13* NSP Pension Plan (Exhibit 10.15 to Form 10-K for the Year 1992, File No. 1-3034). 10.14* NSP Employee Stock Ownership Plan (Exhibit 4.03, 4.04, 4.05 and 4.06 to Post-effective Amendment No. 5 to File No. 2- 61264). 10.15* NSP Retirement Savings Plan (Exhibit 10.17 to Form 10-K for the Year 1992, File No. 1-3034). 10.16 NSP Deferred Compensation Plan amended effective January 1, 1993. 12.01 Statement of Computation of Ratio of Earnings to Fixed Charges. 18.01* Independent Auditors' Preferability Letter. (Exhibit 18.01 to Form 10-Q for the quarter ended March 31, 1992, File No. 1-3034). 21.01 Subsidiaries of the Registrant. 23.01 Independent Auditors' Consent. (b) Reports on Form 8-K. The following reports on Form 8-K were filed either during the three months ended December 31, 1993, or between December 31, 1993 and the date of this report: October 1, 1993 (Filed October 8, 1993) - Item 5. Other Events. Re: Disclosure of the purchase of certain assets of Centran Corporation, a natural gas marketing company, by a non-regulated subsidiary of the Company. December 7, 1993 (Filed December 9, 1993) - Item 5. Other Events. Re: Disclosure of Underwriting Agreement and filing of a prospectus supplement relating to $170,000,000 First Mortgage Bonds ($100,000,000, Series due December 1, 2000) ($70,000,000, Series due December 1, 2005). Item 7. -Financial Statements and Exhibits. Filing of Underwriting Agreement between the Company and various underwriters, Supplemental Trust Indenture between the Company and Harris Trust and Savings Bank, as trustee, creating First Mortgage Bonds, Series due December 1, 2000 and Series Due December 1, 2005, and the computation of ratio of earnings to fixed charges. December 10, 1993 (Filed December 27, 1993) - Item 5. Other Events. Re: Disclosure of a partnership agreement, in which a non-regulated subsidiary of the Company is a party of, to purchase a 400-megawatt share of the 900-megawatt Schkopau power plant near Leipzig, Germany. Disclosure of a partnership agreement, in which a non-regulated subsidiary of the Company is a party of, to acquire a portion of the mining, power generation and associated operations of the former state-owned, Mitleldeutsche Vereinigte Braunkohlenwerke Aktiengesellschaft. January 31, 1994 (Filed February 9, 1994) - Item 5. Other Events. Re: Disclosure of an appeal filed with the Minnesota Court of Appeals by rate case intervenors concerning the method of calculating the rate of return on common equity. Disclosure that the Company has been named as a potentially responsible party at a Superfund site. Disclosure of the Company's Unaudited Consolidated Financial Statements for 1993. Item 7. Financial Statements, Pro Forma Financial Information and Exhibits. Filing of the Company's Unaudited Financial Statements for 1993. February 10, 1994 (Filed February 14, 1994) - Item 5. Other Events. Re: Disclosure of Underwriting Agreement and filing of a prospectus supplement relating to $200,000,000 First Mortgage Bonds, Series due February 1, 1999. Item 7. Financial Statements and Exhibits. Filing of Underwriting Agreement between the Company and various underwriters, Supplemental Trust Indenture between the Company and Harris Trust and Savings Bank, as trustee, creating First Mortgage Bonds due February 1, 1999, and the computation of ratio of earnings to fixed charges. March 15, 1994 (Filed March 16, 1994) - Item 5. Other Events. Re: Disclosure of the results of Minnesota State Legislative Committee votes on the Company's plan to store additional spent nuclear fuel at its Prairie Island Nuclear Generating Plant. Disclosure of the International Brotherhood of Electrical Workers rejection of NSP's contract offer and the continuation of negotiations. NORTHERN STATES POWER COMPANY, MINNESOTA AND SUBSIDIARIES NOTES TO SCHEDULES V AND VI (Thousands of dollars) For the year ended December 31, 1993: 1. Represents transfers and adjustments which were charged to the following accounts: Adjustment due to electric and gas meter inventory ($1 157) Adjustment due to gas distribution main inventory (2 252) Miscellaneous adjustments (413) Total ($3 822) 2. Represents transfers and adjustments which were charged to the following accounts: Accumulated depreciation of Viking Gas utility plant acquired $65 087 Adjustment due to gas distribution main inventory (2 252) Miscellaneous adjustments 241 Total $63 076 For the year ended December 31, 1992: 1. Represents transfers and adjustments which were charged to the following accounts: Miscellaneous adjustments ($129) 2. Represents transfers and adjustments which were charged to the following accounts: Miscellaneous adjustments ($634) For the year ended December 31, 1991: 1. Represents transfers and adjustments which were charged to the following accounts: Adjustment due to spare parts inventory ($6 130) Miscellaneous adjustments (151) Total ($6 281) 2. Represents transfers and adjustments which were charged to the following accounts: Miscellaneous adjustments ($29) Depreciation is computed on the straight-line method based on estimated useful lives of the various classes of property. Such provisions as a percentage of the average balance of depreciable property in service were 3.47% in 1993, 3.36% in 1992 and 3.35% in 1991. Nuclear fuel is amortized to fuel expense based on energy expended. SCHEDULE IX NORTHERN STATES POWER COMPANY, MINNESOTA AND SUBSIDIARIES SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Primarily Commercial Paper (Thousands of dollars) 1993 1992 1991 Balance at end of year $106 200 $146 561 $ 0 Weighted average interest rate at end of year 3.3% 3.6% 0 Maximum month-end amount $172 280 $162 000 $ 0 outstanding during the year (1-31-93) (7-31-92) Average amount outstanding during the period (computed on a daily basis) $ 76 966 $ 80 957 $390 Weighted average interest rate during the year (computed on a daily basis) 3.3% 3.6% 6.0% SCHEDULE X NORTHERN STATES POWER COMPANY, MINNESOTA AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 1993 1992 1991 (Thousands of dollars) Taxes other than payroll and income taxes charged to operating expenses: Real and personal property $169 881 $154 060 $148 653 Gross earnings $26 292 $24 264 $24 787 Other $3 842 $3 620 $3 526 The amount of maintenance and depreciation charged to expense accounts other than those set forth in the statement of income are not significant. All other items are less than 1% of total revenues. Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTHERN STATES POWER COMPANY March 23, 1994 (E J McIntyre) E J McIntyre Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. (James J Howard) (E J McIntyre) James J Howard E J McIntyre Chairman of the Board and Director Vice President (Principal Executive Officer) (Principal Financial Officer) (Roger D Sandeen) (H Lyman Bretting) Roger D Sandeen H Lyman Bretting Vice President & Controller Director (Principal Accounting Officer) (David A Christensen) (W John Driscoll) David A Christensen W John Driscoll Director Director (Dale L Haakenstad) (Allen F Jacobson) Dale L Haakenstad Allen F Jacobson Director Director (Richard M Kovacevich) (Douglas W Leatherdale) Richard M Kovacevich Douglas W Leatherdale Director Director (G M Pieschel) (Margaret R Preska) G M Pieschel Margaret R Preska Director Director (A Patricia Sampson) (Edwin M Theisen) A Patricia Sampson Edwin M Theisen Director President and Director EXHIBIT INDEX Method of Exhibit Filing No. Description DT 10.09 Energy Supply Agreement between the Company and Liberty Paper, Inc. DT 10.16 NSP Deferred Compensation Plan DT 12.01 Statement of Computation of Ratio of Earnings to Fixed Charges DT 21.01 Subsidiaries of the Registrant DT 23.01 Independent Auditors' Consent DT = Filed electronically with this direct transmission.

Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations Northern States Power Company, a Minnesota corporation (the Company), has one significant subsidiary, Northern States Power Company, a Wisconsin corporation (the Wisconsin Company), and several other subsidiaries, including Viking Gas Transmission Company (Viking) and NRG Energy, Inc. (NRG), both Delaware corporations. The Company and its subsidiaries collectively are referred to herein as NSP. The following discussion and analysis by management focuses on those factors that had a material effect on NSP's financial condition and results of operations during 1993 and 1992 and should be read in connection with the Financial Statements and Notes thereto. Trends and contingencies of a material nature are discussed to the extent known and considered relevant. Liquidity and Capital Resources Financial Condition and Cash Flows - With rate increases granted in 1993, NSP's financial condition remained strong and its cash flows and earnings from operations improved from 1992, despite cooler-than-average summer weather. NSP's 1992 cash flows and earnings before accounting changes were significantly reduced by unusual weather, including the coolest summer in 77 years. The 1992 earnings included $45.5 million from a change in accounting for unbilled revenues, which did not affect cash flows or customer rates. During 1993, NSP continued to meet its long-range objectives for capital structure of approximately 45-50 percent common equity and 40-45 percent debt. The pretax interest coverage ratio before accounting changes, excluding AFC, was 3.9 in 1993 and 3.1 in 1992. NSP's objective range for interest coverage is 3.5-5.0. Financing Requirements - NSP's need for capital funds is primarily related to the construction of plant and equipment to meet the needs of its electric and gas utility customers and to fund equity commitments or other investments in its non-regulated businesses. Total NSP capital expenditures (including AFC and excluding business acquisitions) were $362 million in 1993. Of that amount, $284 million related to replacements and improvements of NSP's electric system and $36 million involved construction of natural gas distribution facilities. Internally generated funds provided 99 percent of NSP's capital expenditures for 1993 and 85 percent of the $1.8 billion in capital expenditures incurred for the five-year period 1989-1993. NSP estimates that its utility capital expenditures will be $396 million in 1994. Of that amount, $316 million is scheduled for electric facilities and $43 million for natural gas facilities. Internally generated funds from utility operations are expected to provide approximately 80 percent of 1994 utility capital expenditures and approximately 95 percent of the $1.8 billion in utility capital expenditures estimated for the five-year period 1994-1998. These utility capital expenditure estimates include approximately $100 million of anticipated expenditures for pollution control facilities required under the Clean Air Act. In addition to utility capital expenditures, expected financing requirements for the 1994-1998 period include approximately $390 million to retire long-term debt and meet first mortgage bond sinking fund requirements. NSP expects to obtain external capital for these requirements by issuing long-term debt, common stock and preferred stock. Utility financing requirements for the period 1994-1998 may be affected by factors such as load growth, changes in capital expenditure levels, rate increases allowed by regulatory agencies, new legislation, changes in environmental regulations and other regulatory requirements. NSP expects to invest significant amounts in non-regulated projects, including domestic and international power projects. Projects currently being pursued include joint ventures to acquire electric generating plants in Australia and Germany, and open-cast coal mining operations in Germany. Non-regulated projects are expected to be financed primarily through project debt. The remaining project costs are expected to be funded through equity investments from NSP and other investors. Over the long-term, NSP's equity investments are expected to be financed through internally generated funds or NSP's issuance of common stock and debt. Although they may vary depending on the success, timing and level of involvement in projects currently under consideration, potential capital requirements for NSP's non-regulated projects are estimated to be approximately $130 million in 1994 and approximately $540 million for the five-year period 1994-1998. These amounts include expected equity investments by NSP of approximately $60 million for the Australia project in 1994 and up to $100 million for the Germany projects through 1996. In addition to capital expenditures, NSP invested $159 million in 1993 to acquire three energy-related businesses. (See Note 4 to the Financial Statements.) NSP continues to evaluate opportunities to enhance shareholder returns through business acquisitions. Long-term financing may be required for such acquisitions. Financing Flexibility - NSP's ability to finance its utility construction program at a reasonable cost and to provide for other capital needs depends on its ability to earn a fair return on investors' capital. Financing flexibility is enhanced by providing working capital needs and a high percentage of total capital requirements from internal sources, and having the ability, if necessary, to issue long-term securities and obtain short-term credit. Access to securities markets at a reasonable cost is determined in a large part by credit quality. The Company's first mortgage bonds are rated AA- by Standard & Poor's Corporation, Aa2 by Moody's Investors Service, Inc., AA- by Duff & Phelps, Inc., and AA by Fitch Investors Service, Inc. Ratings for the Wisconsin Company's first mortgage bonds are generally comparable. These ratings reflect only the views of such organizations and an explanation of the significance of these ratings may be obtained from each agency. The Company's and the Wisconsin Company's first mortgage indentures place limits on the amount of first mortgage bonds that may be issued. The Minnesota Public Utilities Commission (MPUC) and the Public Service Commission of Wisconsin (PSCW) have jurisdiction over securities issuance. At Dec. 31, 1993, with an assumed interest rate of 8 percent, the Company could have issued about $1.8 billion of additional first mortgage bonds under its indenture and the Wisconsin Company could have issued about $280 million of additional first mortgage bonds under its indenture. NSP expects to maintain adequate access to long-term and short-term debt markets in 1994. The Company registered $600 million of first mortgage bonds with the Securities and Exchange Commission (SEC) in December 1993. Depending on capital market conditions, the Company expects to issue approximately $450 million of this debt in 1994, primarily for refinancings, with the remainder issued over the next several years, for the purpose of raising additional capital or redeeming outstanding securities. The Company's Board of Directors has approved short-term borrowing levels up to 10 percent of capitalization. The Company has received regulatory approval for $350 million in short-term borrowing levels. The Company had approximately $106 million in commercial paper debt outstanding as of Dec. 31, 1993. The Company plans to keep its credit lines at or above the level of commercial paper borrowings. Commercial banks presently provide credit lines of approximately $215 million. These credit lines make short-term financing available in the form of bank loans. The Company's Articles of Incorporation authorize the maximum amount of preferred stock that may be issued. Under these provisions, the Company could have issued all $460 million of its remaining authorized, but unissued preferred stock at Dec. 31, 1993, and remained in compliance with all interest and dividend coverage requirements. The level of common stock authorized, under the Company's Articles of Incorporation, is 160 million shares. Registration Statements filed with the SEC provide for the sale of up to 1,650,000 shares of common stock under the Company's Dividend Reinvestment and Stock Purchase Plan, Executive Long-Term Incentive Award Stock Plan, and Employee Stock Ownership Plan (ESOP) as of Dec. 31, 1993. The Company may issue new shares or purchase shares on the open market for its stock plans. (See Note 6 to the Financial Statements for discussion of stock awards outstanding.) As discussed below, the Company issued new common stock in 1993 under a general stock offering and under its shareholder, employee and customer stock programs. At Dec. 31, 1993, the total number of common shares outstanding was 66,879,577. The Company does not plan any general stock offerings for 1994. 1993 Financing Activity - During 1993, NSP engaged in numerous financing activities. The Company issued 4,281,217 shares of common stock. Of these shares, 2.6 million were sold to a group of underwriters on May 20, 1993. The offering price to the public was $43.625 per share, with net proceeds of $110 million to the Company. Of the remaining new shares, 940,000 shares were issued under the Dividend Reinvestment and Stock Purchase Plan, 174,308 shares were issued under the Executive Long-Term Incentive Award Stock Plan and 566,909 shares were issued to the ESOP. On Oct. 30, 1993, the Company redeemed all 350,000 shares of its $7.84 series Cumulative Preferred Stock at $103.12 per share, plus accrued dividends through Oct. 31, 1993. During 1993, the Company issued $350 million, and the Wisconsin Company issued $150 million, of long-term debt to refinance higher rate debt, redeem preferred stock, repay scheduled maturities of debt and extend the term of short-term borrowings. In addition, $116 million of long-term debt was issued by subsidiaries to finance the acquisitions of Viking and the Minneapolis Energy Center. (See Note 4 to the Financial Statements.) In connection with the early redemption of $453 million of long-term debt, NSP incurred approximately $14 million in reacquisition premiums, which will be amortized over the term of the newly issued debt. Results of Operations NSP's results of operations during 1993 and 1992 were primarily dependent on the operations of the Company's and Wisconsin Company's utility businesses consisting of the generation, transmission and sale of electricity and the distribution, transportation and sale of natural gas. NSP's utility revenues are dependent on customer usage which varies with weather conditions, general business conditions, the state of the economy and the cost of energy services, the recovery of which is determined by various regulatory authorities. The historical and future trends of NSP's operating results have been and are expected to be impacted by the following factors: Weather - NSP's earnings can be dramatically impacted by unusual weather. Mild weather, mainly a cool summer, reduced 1993 earnings by an estimated 18 cents. However, this was an improvement over 1992 when a warm winter and the coolest summer in 77 years reduced earnings by an estimated 51 cents. Operating Contingency - The Company is experiencing uncertainty regarding its ability to store used nuclear fuel from its Prairie Island nuclear generating facility. The facility stores its used nuclear fuel on an interim basis in a storage pool in the plant, pending the availability of a U. S. Department of Energy high-level radioactive waste storage or permanent disposal facility, or a private interim storage facility. At current operating levels, the pool will be filled in 1994 so the Company has proposed to augment Prairie Island's interim storage capacity by using steel containers for dry storage of used nuclear fuel on the plant site. Without additional onsite storage or significant modification of normal plant operations, Prairie Island Unit 2 would be shutdown in May 1995 and Prairie Island Unit 1 would be shutdown in February 1996. These two units supply about 20 percent of the Company's output. The Company has obtained a Certificate of Need from the MPUC allowing use of a limited number of steel containers, providing adequate storage at least through the year 2001. The Nuclear Regulatory Commission has also issued a license approving a dry storage facility on the plant site for Prairie Island's used fuel. However, in June 1993, the Minnesota Court of Appeals decided that the additional temporary storage facilities must be approved by the Minnesota Legislature. The Company has requested such approval from the Legislature and expects a decision on this issue during the current session, which began on Feb. 22, 1994. Although hearings have begun, the Company cannot predict what action the Minnesota Legislature will take. If operations at Prairie Island cease, the Company estimates that the present value of the cost of supplying replacement power and recovering its investment in the plant and unrecognized decommissioning costs will be $1.8 billion. The Company would request recovery of these costs, including a return on its investment, through utility rates. However, at this time the need for such costs and the regulators' ultimate response to such a request is unknown. (See Note 15 to the Financial Statements regarding the possible effects on operating results of the potential shutdown of the Company's Prairie Island nuclear power generating facility.) Regulation - NSP's utility rates are approved by the Federal Energy Regulatory Commission (FERC) and state commissions. Rates are designed to recover plant and operating costs and an allowed return, using an annual period upon which rate case filings are based. NSP's utility companies request increases in customers' rates as needed and file them with the governing commissions. The rates charged to retail customers in Wisconsin are reviewed and adjusted biennially. Because rate increases are not requested annually in Minnesota, NSP's primary jurisdiction, the impact of inflation on operating costs continues to be a factor affecting NSP's earnings, shareholders' equity and other financial results. Except for Wisconsin electric operations, NSP's rate schedules provide for cost-of-energy adjustments to billings and revenues for changes in the cost of fuel for electric generation, purchased power and purchased gas. For Wisconsin electric operations, the biennial retail rate review process considers changes in electric fuel and purchased energy costs in lieu of a cost-of-energy adjustment clause. In addition to changes in operating costs, other factors affecting rate filings are sales growth, conservation programs and demand-side management efforts. Rate Increases - During 1992 and 1993, NSP filed for 1993 rate increases in Minnesota, North Dakota, South Dakota and Wisconsin to offset increasing costs for purchased power commitments, depreciation, property taxes, postretirement benefits and other expenses. NSP received approvals for approximately $102 million of annualized rate increases for retail customers in those states as well as wholesale customers in Minnesota and Wisconsin. These rate changes increased 1993 revenues by approximately $83 million; the full impact of these increases will be realized in 1994. On Jan. 31, 1994, three intervenors filed an appeal of the MPUC's decision concerning the method of calculating the rate of return on common equity granted in the Minnesota electric and gas rate cases. The amount at issue is approximately $7 million in annual revenues for the Company. (See Note 2 to the Financial Statements for further discussion of 1993 rate case results.) In 1993, NSP filed for 1994 rate increases for North Dakota retail electric and Wisconsin retail gas customers. NSP received approval for approximately $2.6 million of rate increases in these two jurisdictions, effective January 1994. No significant rate filings in other jurisdictions are expected for 1994. Acquisitions - NSP made three strategically important business acquisitions in 1993. These include a gas pipeline, an energy services marketing business, and a steam heating and chilled water cooling system business. (See Note 4 to the Financial Statements for more discussion of these acquisitions, including the pro forma results of these acquisitions on an annual basis.) Competition - The Energy Policy Act of 1992 (the Act) is expected to bring comprehensive and significant changes to the electric utility industry. Many provisions of the Act are expected to increase competition in the industry in the next few years. The Act's reform of the Public Utility Holding Company Act (PUHCA) promotes creation of wholesale power generators and authorizes the FERC to require utilities to provide wholesale transmission services to third parties. The legislation allows utilities and non-regulated companies to build, own and operate power plants nationally and internationally without being subject to restrictions that previously applied to utilities under the PUHCA. Other producers may compete for NSP's customers as a result of such PUHCA reform. Management believes this legislation will promote the continued trend of increased competition in the electric energy markets. Many states are considering proposals to require "retail wheeling", which is the delivery of power generated by a third party to retail customers. Retail wheeling represents yet another development of a competitive electric industry. NSP management plans to continue its efforts to be a low-cost supplier of electricity and an active participant in the competitive market for electricity. During 1992 and 1993, the FERC issued a series of orders (together called Order 636) addressing interstate natural gas pipeline service restructuring. This restructuring will "unbundle" each of the services - sales, transportation, storage and ancillary services - traditionally provided by the gas pipeline companies. Order 636 ended the traditional pipeline sales service function, which in the past had met local distribution companies' (LDCs) needs for reliability of supply and flexibility for meeting varying load conditions. NSP believes some uncertainty remains as to whether the new unbundled services under Order 636 will prove to be as reliable and flexible as the traditional sales service. The implementation of Order 636 also will apply more pressure on all LDCs to keep gas supply and transmission pricing for large customers competitive in light of the alternatives now available to these customers. Interstate pipelines will be allowed to recover, subject to negotiations with customers, 100 percent of prudently incurred transition costs attributable to Order 636 restructuring. Although negotiations are in process, NSP estimates that it will be responsible for less than $10 million of transition costs, over a proposed five-year period. NSP's regulatory commissions have previously approved recovery of similar restructuring charges in retail gas rates. New service agreements went into effect between NSP and its pipeline transporters on Nov. 1, 1993. NSP does not expect these new agreements under Order 636 to materially affect its cost of gas supply. NSP's acquisitions of Viking and a gas marketing business (as discussed in Note 4 to the Financial Statements) have enhanced the ability to participate in the more competitive gas transportation business. In implementing Order 636, Viking incurred no restructuring costs. Impact of Non-Regulated Investments - NSP expects to invest significant amounts in non-regulated projects, including domestic and international power production projects through NRG, as described previously under "Financing Requirements". Depending on the success and timing of involvement in these projects, NSP's non-regulated earnings are expected to increase materially in the next few years. However, the projects generating the increased earnings may present additional risk. Current and future investments in international projects are subject to uncertainties prior to final legal closing, and continuing operations are subject to foreign government and partnership actions. NRG plans to hedge its exposure to currency fluctuations to the extent permissible by hedge accounting requirements. NRG will use well-established financial instruments of sufficient credit quality to protect the economic value of foreign-currency denominated assets. (With respect to risk of potential losses from unsuccessful non-regulated projects, see Note 1 to the Financial Statements for discussion of capitalized expenditures for projects under development.) Employee Compensation and Benefits - In 1993, NSP conducted an extensive review of its employee compensation and benefits, and retiree benefits. As a result, several changes will be implemented, commencing in 1994, that will support NSP's goal of providing market-based compensation and benefits. These changes, which include no base wage increase for non-union employees in 1994, are expected to keep compensation and benefit costs comparable to 1993 levels. NSP's labor agreements with its five local unions expired on Dec. 31, 1993. An interim agreement with the unions expires March 31, 1994. Although NSP's final offer for settlement (made on Feb. 4, 1994) was rejected by the union membership on March 14, 1994 and an authorization to strike was approved, the parties resumed discussions on March 21, 1994. NSP is not able to predict the outcome of negotiations at this time. Environmental Matters - Like other utilities, the Company has been named as a potentially responsible party at eight waste disposal sites and is in the process of investigating the remediation of 14 former coal-gasification and other sites. The Company has recorded an estimate of the probable costs to be incurred in connection with remediation of these sites. To the extent costs are not recovered from insurers or other parties, the Company expects to seek recovery of such costs in future ratemaking proceedings. In general, NSP has been experiencing a trend toward more environmental monitoring and compliance costs. This trend has caused and may continue to cause slightly higher operating expenses and capital expenditures. The timing and amount of environmental costs, including those for site remediation, are currently unknown. In 1993, 1992 and 1991, the Company spent about $15 million, $20 million and $6 million, respectively, for capital expenditures on environmental improvements at utility facilities. The Company expects to incur approximately $9 million in capital expenditures for compliance with environmental regulations in 1994. (See Note 15 to the Financial Statements for further discussion of these and other environmental contingencies that could affect NSP.) Wholesale Customers - In 1992, nine of the Company's 19 municipal wholesale electric customers created a joint action municipal power agency to serve their future power supply needs and notified the Company of their intent to terminate their power supply agreements with the Company effective in July 1995 or July 1996. These nine customers currently represent approximately $24 million in annual revenues and a maximum demand load of approximately 150 megawatts. In 1992 and 1993, the Company signed long-term power supply agreements with the remaining 10 municipal customers. The agreements commit the customers to purchase power from the Company for up to 13 years (through 2005) at fixed rates rising at up to 3 percent per year. The 10 customers represent approximately $8 million in current annual revenue and a maximum demand load of approximately 55 megawatts. The rates contained in the agreements were accepted by the FERC on Feb. 23, 1994. During October 1993, the Company signed an electric power agreement to provide Michigan's Upper Peninsula Power Company (UPPCO) with up to 90 megawatts of baseload service, peaking service options and load regulation service options for 20 years beginning in January 1998 through December 2017. Load regulation service is designed to change the level of power delivery during each hour to match UPPCO's load requirements. The rates, terms and conditions of the agreement are subject to FERC approval. The Michigan Public Utilities Commission must also approve the transaction. Beginning in 1998, annual revenues of approximately $12 million-$16 million are expected to be provided under the agreement, depending on contract options that UPPCO can exercise. Legislative Changes - The Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law on Aug. 10, 1993. The only provision of the Act that had a significant effect on NSP was the increase in the federal corporate income tax rate from 34 percent to 35 percent retroactive to Jan. 1, 1993. The effect of the higher tax rate was an increase of about $3.2 million in income tax expense. Most of this cost increase was offset by higher revenues from 1993 rate increases approved in Minnesota. (See Note 2 to the Financial Statements.) Deferred tax liabilities were increased for the rate change by approximately $32 million. However, due to regulatory deferral of utility tax adjustments, earnings were reduced only by immaterial adjustments to deferred tax liabilities for non-regulated operations. Wind-Generated Power - In October 1993, the Company signed a 25-year agreement for the purchase of 25 megawatts of wind-generated electric capacity, and associated energy to be produced in Minnesota. The wind generating plant is expected to be fully operational by May 1994. This contract is the first phase of the Company's plan to obtain 100 megawatts of wind-generated electricity by 1997. The Company can recover the cost of energy purchases through cost-of-energy adjustment clauses in electric rates. Accounting Changes - As discussed in Note 13 to the Financial Statements, in 1993, NSP adopted Statement of Financial Accounting Standards (SFAS) No. 106 - - Employers' Accounting for Postretirement Benefits Other than Pensions and began recording postretirement benefits on an accrual basis. NSP's utility companies had previously been allowed rate recovery for postretirement benefits as paid. In the 1993 rate increases discussed above, NSP's utility companies obtained rate recovery for substantially all of the increased costs (approximately $20 million) accrued under SFAS No. 106 in 1993. Due to rate recovery of higher costs, there was no material impact on NSP's operating results from this accounting change. Recent changes in interest rates have resulted in different actuarial assumptions used in the benefit cost calculations for postretirement benefits. Due to offsetting changes in other actuarial assumptions and demographics, NSP's benefit costs for such plans are not expected to increase from these changes in 1994. (See Note 13 to the Financial Statements for more information on changes in actuarial assumptions.) NSP also adopted in 1993 SFAS No. 109 - Accounting for Income Taxes. Because the provisions of SFAS No. 109 are not materially different than the tax accounting procedures previously used by NSP, there was virtually no impact on earnings or financial condition. In 1992, the Company changed its accounting method for recognizing revenue. Earnings in 1992 increased by 88 cents per share, including 73 cents related to prior years, from recording estimated unbilled revenues for utility service in Minnesota, North Dakota and South Dakota. (See Note 3 to the Financial Statements for more information on the effects of this accounting change.) In 1994, NSP will be required to adopt SFAS No. 112 - Employers' Accounting for Postemployment Benefits. This standard will require the accrual of certain postemployment costs (such as injury compensation and severance) that are payable in future periods. The impact of adopting SFAS No. 112 is expected to be immaterial. The Financial Accounting Standards Board (FASB) has announced preliminary plans to change the accounting for stock compensation expense effective in 1997 with disclosure requirements effective in 1994. Also, the FASB has approved a proposed change in employers' accounting for employee stock ownership plans effective in 1994. Based on NSP's review of these future accounting changes, NSP does not expect a material impact on its results of operations or financial condition. NSP currently follows predominant industry practice in recording its environmental liabilities for plant decommissioning and site exit costs as a component of utility plant. The FERC and the SEC currently are evaluating the financial presentation of these obligations, which could require a reporting reclassification as early as 1994. 1993 Compared with 1992 and 1991 NSP's 1993 earnings per share were $3.02, up 71 cents from the $2.31 earned before accounting changes in 1992 and equal to the $3.02 earned from continuing operations in 1991. In addition to the revenue and expense changes discussed below, 1993 earnings were impacted by a higher average number of common and equivalent shares outstanding for earnings-per-share calculations in 1993 due to the stock issuances discussed previously under "1993 Financing Activity." Electric Revenues and Production Expenses Revenues - Sales to retail customers, which account for more than 90 percent of NSP's electric revenue, increased 4.0 percent in 1993 and decreased 2.3 percent in 1992. Cool summer weather reduced sales in 1992 and, to a lesser extent, in 1993. During 1993, NSP added 14,353 retail customers, a 1.1-percent increase. Total sales of electricity, including wholesale, increased 7.3 percent in 1993. On a weather-adjusted basis, sales to retail customers are estimated to have increased 2.1 percent in 1993 and 2.8 percent in 1992. Retail sales growth for 1994 is estimated to be 3.4 percent over 1993, or 2.2 percent on a weather-adjusted basis. Sales to other utilities increased 22.2 percent in 1993 due to higher demand from utilities in flood-stricken Midwestern states. The table below summarizes the principal reasons for the electric revenue changes during the past two years. (Millions of dollars) 1993 vs 1992 1992 vs 1991 Retail sales growth (excluding weather impacts) $32 $34 Estimated impact of weather on retail sales volume 34 (85) Rate changes 74 20 Sales to other utilities 20 (2) Cost of energy clauses and other (8) (7) Total revenue increase (decrease) $152 $(40) The 1992 sales growth is net of a $1.4-million revenue decrease, and 1992 cost-of-energy clause change is net of an $11 million revenue increase from recording unbilled revenues, which were not recorded in 1991. Electric Production Expenses - Fuel expense for electric generation increased $19.4 million, or 6.6 percent, in 1993, compared with a decrease of $20.4 million, or 6.5 percent, in 1992. Total output from NSP's generating plants increased 8.4 percent in 1993 and decreased 3.1 percent in 1992. The fuel expense increase in 1993 was due to higher output to meet sales demand, partially offset by lower cost of fuel. The fuel expense decrease in 1992 was due to lower output (because the cool summer reduced demand) and lower cost of fuel. The lower cost of fuel per megawatt hour of generation in 1993 and 1992 reflects the increased use of low-cost purchases as discussed below. Purchased power costs increased $53.0 million, or 34.1 percent, in 1993 and $20.0 million, or 14.7 percent, in 1992. The increase in 1993 was largely due to a demand expense increase of $42 million for the capacity charges from the power purchase agreements with Manitoba Hydro-Electric Board (MH), as discussed in Note 15 to the Financial Statements. Energy purchased from other utilities increased in both 1993 and 1992 due to economically priced energy available to meet growing retail demand and sales opportunities to other utilities that provided net ratepayer benefit. Demand expenses in 1994 are expected to increase $22 million over 1993 levels due to the MH agreements. Revenues are adjusted for changes in electric fuel and purchased energy costs from amounts currently included in approved base rates through fuel adjustment clauses in all jurisdictions except as noted below for Wisconsin. While the lag in implementing these billing adjustments is approximately 60 days, an estimate of the adjustments is recorded in unbilled revenue in the month costs are incurred. In Wisconsin, the biennial retail rate review process considers changes in electric fuel and purchased energy costs in lieu of a fuel adjustment clause. Gas Revenues and Purchases Revenues - NSP categorizes gas sales as firm (primarily space heating customers) and interruptible (commercial/industrial customers with an alternate energy supply). Firm sales in 1993 increased 17.0 percent over 1992 sales, while firm sales in 1992 decreased 5.6 percent from 1991. Warm weather in the first quarter of 1992 is the main cause for both of these variations. NSP added 11,728 firm gas customers in 1993, a 3.1-percent increase. On a weather-adjusted basis, firm sales are estimated to have increased 7.2 percent in 1993 and 3.6 percent in 1992. NSP estimates 1994 firm gas sales to decrease by 2.9 percent relative to 1993, with a 2.2-percent decrease on a weather-adjusted basis due to an unbilled revenue adjustment in 1993. Without this adjustment, estimated weather-adjusted firm gas sales would have increased 0.9 percent in 1993 and would be estimated to increase 0.7 percent in 1994. Interruptible gas deliveries, including sales of gas purchased for resale and customer-owned gas that NSP transported, increased 15.3 percent in 1993 and decreased 0.9 percent in 1992. The table below summarizes the principal reasons for the gas revenue changes during the past two years. (Millions of dollars) 1993 vs 1992 1992 vs 1991 Sales growth $17 $7 Estimated impact of weather on sales volume 28 (24) Acquisition of Viking Gas 9 Rate changes 9 Purchased gas adjustment and other 30 15 Total revenue increase (decrease) $93 $(2) The 1992 sales growth is net of a $1.5-million decrease from recording unbilled revenues, which were not recorded in 1991. Purchased Gas - The cost of gas purchased and transported increased $61.7 million, or 28.0 percent, in 1993 due to higher sendout and higher purchased gas prices. In 1992, the cost of gas purchased and transported increased $9.0 million, or 4.3 percent, due to higher purchased gas prices, somewhat offset by lower sendout relative to 1991. The average cost per thousand cubic feet (mcf) of gas sold in 1993 was 13.3 percent higher than it was in 1992, when the cost was 7.1 percent higher than it was in 1991. NSP views the increases in 1992 and 1993 as a recovery from unsustainably low wellhead gas prices in the 1990-91 period. Revenues are adjusted for changes in purchased gas costs from amounts currently included in approved base rates through purchased gas adjustment clauses. Other Operating Expenses and Factors Other Operation, Maintenance and Administrative and General - These expenses, in total, decreased by $27.2 million, or 4.0 percent, compared with an increase of 1.8 percent in 1992. The 1993 decrease was the result of fewer scheduled plant maintenance outages, reduced employee levels and lower administrative costs. The 1992 increase was the result of higher levels of scheduled plant and distribution system maintenance and higher employee wages. Wages in 1993 included an accrual of $14 million for incentive compensation. Due to lower earnings as a result of mild weather, compensation in 1992 did not include incentive amounts. (See Note 7 to the Financial Statements for a summary of administrative and general expenses.) Conservation and Energy Management - Costs in 1993 were higher than in 1992 and 1991 because NSP's regulators have approved higher expenditure levels for conservation and demand-side management efforts. Depreciation and Amortization - The increases in depreciation for all periods reflect higher levels of depreciable plant and, in 1993, changes in the depreciable lives of certain property. (See Note 1 to the Financial Statements.) Property and General Taxes - Property and general taxes increased in each of the reported periods primarily as a result of higher property tax rates and property additions. Property taxes in 1992 were reduced by $4.5 million due to revisions to accrued 1991 taxes (payable in 1992) based on final tax statements. Income Taxes - The variations in income taxes are primarily attributable to fluctuations in pretax book income. Taxes in 1993 also increased about $3 million due to a 1-percent increase in the federal tax rate. (See Note 9 to the Financial Statements for a detailed reconciliation of the statutory tax rate to the actual effective tax rate.) Allowance for Funds Used During Construction (AFC) - The differences in AFC for the reported periods are attributable to varying levels of construction work in progress and lower AFC rates associated with increased use of low-cost short-term borrowings. Other Income and Deductions-Net - Other income and deductions increased $9.7 million in 1993 and decreased $0.8 million in 1992. The increase in 1993 was due to higher non-regulated operating income from improved refuse-derived fuel (RDF) operations and acquired businesses. Non-regulated operating income in 1992 reflects one-time expenses from unsuccessful energy projects and reduced profitability of RDF operations. Decreases in interest income and non-regulated operating income in 1992 were offset by lower expenses for regulatory compliance and legal contingencies. Interest income declined in 1992 due to decreases in the amount of investments held. (See Note 7 to the Financial Statements for a summary of amounts included in other income and deductions.) Interest Charges - Interest on long-term debt increased in 1993 due to new debt issued to finance business acquisitions and to refinance short-term borrowings. The increase was partially offset by interest savings from refinancing debt at lower rates. Other interest charges have increased due to amortization of refinancing costs, including debt issuance costs and reacquisition premiums. Item 8

Item 8 - Financial Statements and Supplementary Data See Item 14(a)-1 in Part IV for financial statements included herein. See Note 17 of Notes to Financial Statements for summarized quarterly financial data. INDEPENDENT AUDITORS' REPORT Northern States Power Company: We have audited the accompanying consolidated financial statements of Northern States Power Company (Minnesota) and its subsidiaries, listed in the accompanying table of contents in Item 14(a)1. Our audits also included the financial statement schedules listed in the accompanying table of contents in Item 14(a)2. These consolidated financial statements and financial statement schedules are the responsibility of the Companies' management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Companies at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 3 to the consolidated financial statements, the Companies changed their method of accounting for postretirement health care costs in 1993 and revenue recognition in 1992. (Deloitte & Touche) DELOITTE & TOUCHE Minneapolis, Minnesota February 7, 1994 Notes to Financial Statements 1. Summary of Accounting Policies System of Accounts - Northern States Power Company, a Minnesota corporation (the Company), and two wholly owned subsidiaries of the Company, Northern States Power Company, a Wisconsin corporation (the Wisconsin Company), and Viking Gas Transmission Company (Viking) maintain accounting records in accordance with either the uniform system of accounts prescribed by the Federal Energy Regulatory Commission (FERC) or those prescribed by state regulatory commissions, whose systems are the same in all material respects. Principles of Consolidation - The consolidated financial statements include all significant subsidiary companies. All significant intercompany transactions and balances have been eliminated in consolidation. The Company and its subsidiaries collectively are referred to herein as NSP. Revenues - Revenues are recognized based on services provided to customers each month. Because customer utility meters are read and billed on a cycle basis, unbilled revenues (and related energy costs) are estimated and recorded for services provided from the monthly meter-reading dates to month-end. In 1991, revenues of the Company were recorded for billings rendered to customers on a monthly cycle billing basis and estimated unbilled revenues were not recorded. (See Note 3 for discussion of accounting change in 1992.) The Company's rate schedules, applicable to substantially all of its customers, include cost-of-energy adjustment clauses, under which rates are adjusted to reflect changes in average costs of fuels, purchased power and gas purchased for resale. As ordered by its primary regulator, Wisconsin Company retail rate schedules include a cost-of-energy adjustment clause for purchased gas but not for electric fuel and purchased power. The biennial retail rate review process for Wisconsin electric operations considers changes in electric fuel and purchased energy costs in lieu of a cost-of-energy adjustment. Utility Plant and Retirements - Utility Plant is stated at original cost. The cost of additions to utility plant includes contracted work, direct labor and materials, allocable overhead costs and allowance for funds used during construction. The cost of units of property retired, plus net removal cost, is charged to the accumulated provision for depreciation and amortization. Maintenance and replacement of items determined to be less than units of property are charged to operating expenses. Allowance for Funds Used during Construction (AFC) - AFC, a non-cash item, is computed by applying a composite pretax rate, representing the cost of capital for construction, to qualified Construction Work in Progress (CWIP). The rates were 7.4 percent in 1993, 8.0 percent in 1992 and 10.0 percent in 1991. The amount of AFC capitalized as a construction cost in CWIP is credited to other income and interest charges. AFC amounts capitalized in CWIP are included in utility rate base for establishing utility service rates. Depreciation - For financial reporting purposes, depreciation is computed by applying the straight-line method over the estimated useful lives of various property classes. The Company files with the Minnesota Public Utilities Commission (MPUC) an annual review of remaining lives for electric and gas production properties. The 1993 study, as approved by the MPUC, recommended an increase of approximately $0.9 million in annual depreciation accruals. The 1992 study, as approved by the MPUC, recommended no change in 1992 depreciation. The Company also submitted in 1993 an average service life filing for transmission, distribution and general properties, which is filed every five years. The filing, as approved by the MPUC, increased depreciation by approximately $4.7 million from 1992 levels. Depreciation provisions, as a percentage of the average balance of depreciable property in service, were 3.47 percent in 1993, 3.36 percent in 1992 and 3.35 percent in 1991. Decommissioning - The annual provision for the estimated decommissioning costs for the Company's nuclear plants has been calculated using an internal/external sinking fund method. The calculation, which results in annual charges to depreciation expense, is designed to provide for full accrual and rate recovery of the future decommissioning costs, including reclamation and removal, over the estimated operating lives of the Company's nuclear plants. Decommissioning of all nuclear facilities is planned to occur in the years 2010-2022 using the prompt dismantlement method, and the total obligation for decommissioning is expected to be funded approximately 45 percent by internal funds and 55 percent by external funds. Based on a 1990 study, the Company estimates total decommissioning costs will approximate $750 million in 1993 dollars, for which the Company has recorded $302 million in the accumulated provision for depreciation; $101 million of this balance has been deposited in external trust funds. An updated study will not be used for recording decommissioning accruals until approved by the MPUC. Such approval is not expected to occur until after the Minnesota Legislature makes its decision on fuel storage at the Company's Prairie Island nuclear plant. (See Note 15.) Decommissioning costs recorded for 1993, 1992 and 1991 were $43 million, $40 million and $40 million, respectively. Nuclear Fuel Expense - The original cost of nuclear fuel is amortized to fuel expense on the basis of energy expended. Nuclear fuel expense also includes a disposal cost of 0.1 cent per kilowatt-hour sold from nuclear generation, as required by the Nuclear Waste Policy Act of 1982. Disposal expenses were $8.7 million, $6.8 million and $11.9 million for 1993, 1992 and 1991, respectively. Disposal expenses reflect reductions of $2.6 million in 1993 and $3.7 million in 1992 due to a change in the basis of charging customers, retroactive to 1983. Nuclear fuel expense in 1993 also includes about $1 million for a portion of the assessment from the U.S. Department of Energy (DOE) for the decommissioning and decontamination of the DOE's uranium enrichment facility. (See Note 8.) Environmental Costs - Costs related to environmental remediation are accrued when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. When a single estimate of the liability cannot be determined, the low end of the estimated range is recorded. Costs are charged to expense (or deferred as a regulatory asset based on expected recovery from customers in future rates) if they relate to the remediation of conditions caused by past operations or if they are not expected to benefit future operations. Where the expenditure relates to facilities currently in use (such as pollution control equipment), the costs are capitalized and depreciated over the future service periods. Estimated costs are recorded at undiscounted amounts, independent of any insurance or rate recovery, based on prior experience. Accrued obligations are regularly adjusted as new information is received. For sites where NSP has been designated as one of several potentially responsible parties, the amount accrued represents NSP's estimated share of the cost. NSP intends to treat any future costs related to decommissioning and restoration of its power plants and substation sites as a removal cost of retirement through plant depreciation expense. Income Taxes - NSP records income taxes in accordance with Statement of Financial Accounting Standards (SFAS) No. 109 - Accounting for Income Taxes. SFAS No. 109 requires the use of the liability method of accounting for deferred income taxes. Before 1993, NSP followed SFAS No. 96 - Accounting for Income Taxes, resulting in substantially the same accounting as SFAS No. 109. Income taxes are deferred for all temporary differences between pretax financial and taxable income and between the book and tax bases of assets and liabilities. Deferred taxes are recorded using the tax rates scheduled by law to be in effect when the temporary differences reverse. Due to the effects of regulation, current income tax expense is provided for the reversal of some temporary differences previously accounted for by the flow-through method. Also, regulation results in the creation of certain regulatory assets and liabilities related to income taxes as discussed in Note 8. Investment tax credits are deferred and amortized over the estimated lives of the related property. Cash Equivalents - NSP considers investments in certain debt instruments (primarily commercial paper) with a remaining maturity of three months or less at the time of purchase to be cash equivalents. Regulatory Deferrals - As regulated utilities, the Company, the Wisconsin Company and Viking account for certain income and expense items under the provisions of SFAS No. 71 - Accounting for the Effects of Regulation. In doing so, certain costs that would otherwise be charged to expense are deferred as regulatory assets based on expected recovery from customers in future rates. Likewise, certain credits that would otherwise be reflected as income are deferred as regulatory liabilities based on expected flowback to customers in future rates. Management's expected recovery of deferred costs and expected flowback of deferred credits are generally based on specific ratemaking decisions or precedent for each item. Regulatory assets and liabilities are being amortized consistent with ratemaking treatment as established by regulators. Note 8 describes in more detail the nature and amounts of these regulatory deferrals. Other Assets - NSP and its various subsidiaries have invested in many non-regulated projects whose earnings are reported on the equity method of accounting. Several of these projects are still in the development stage. Other investments include project development expenditures of $16.5 million as of Dec. 31, 1993, which have been capitalized based on expected recovery from cash flows of future project operations. The purchase of the Minneapolis Energy Center by NRG in 1993 (see Note 4) at a price exceeding the underlying fair value of net assets acquired resulted in goodwill. This goodwill and other intangible assets acquired are being amortized using the straight-line method over 30 years. NSP will periodically evaluate the recovery of goodwill based on an analysis of estimated undiscounted future cash flows. Intangible and other assets also include deferred financing costs of approximately $12.6 million at Dec. 31, 1993, which are being amortized over the remaining maturity period of the related debt. Reclassifications - Certain reclassifications have been made to the 1992 and 1991 income statement to conform with the 1993 presentation. In addition, the 1992 balance sheet has been reclassified to conform with the 1993 presentation of regulatory deferrals. These reclassifications had no effect on net income or earnings per share. 2. Rate Matters - 1993 Rate Increases Minnesota Jurisdiction - In November 1992, the Company filed applications for 1993 rate increases with the MPUC totaling $119.1 million and $14.9 million for Minnesota retail electric and natural gas customers, respectively. This represented annual increases of approximately 9 percent and 5.8 percent, respectively. In December 1992, the MPUC issued orders granting interim increases (subject to refund) of $71.2 million (5.4 percent) for electric service and $8.4 million (3.3 percent) for gas service, effective Jan. 1, 1993. In June 1993, the Company adjusted its proposed electric rate increase to $112.3 million and its gas rate request to $12.4 million. The Company received initial orders from the MPUC in September 1993 for both the gas and electric cases. Final orders came in December 1993 for the gas case and in January 1994 for the electric case, allowing annualized retail rate increases of $10.0 million (3.9 percent) for gas and $72.2 million (5.4 percent) for electric. The return on equity granted in both cases was 11.47 percent. Refunds of interim electric rates collected are required in the amount of approximately $12 million and are expected to be paid in May 1994. No refunds of interim gas rates collected are required. Final gas and electric rates are expected to be implemented in March and April 1994, respectively. On Jan. 31, 1994, an appeal of the MPUC's determination on the allowed return on equity was filed with the Minnesota Court of Appeals by the Minnesota Department of Public Service, the Office of the Minnesota Attorney General and the Minnesota Energy Consumers intervenor groups. The appeal concerns the method of calculating the rate of return on common equity for both the electric and gas cases. The amount at issue is approximately $7 million in annual revenues for the Company. The ultimate financial impact of this appeal, if any, is not determinable at this time. A decision by the court is expected by the end of 1994. Other Jurisdictions - The Wisconsin Company received approval of annualized retail rate increases of $8.0 million (3.1 percent) for Wisconsin electric customers and $1.1 million (1.8 percent) for Wisconsin gas customers. The new rates have been in effect since January 1993. The Company's approved annualized rate increase of $4.8 million (5.3 percent) for North Dakota electric customers was effective April 21, 1993. The Company's approved annualized rate increase of $4.2 million (6.5 percent) for South Dakota electric customers has been in effect since May 1, 1993. Increased annualized wholesale electric rates of $0.9 million (3.6 percent) were accepted by the FERC for nine Minnesota Company wholesale customers, effective Sept. 21, 1993. Increased annualized wholesale electric rates of $0.6 million (3.7 percent) were accepted by the FERC for the Wisconsin Company's 10 wholesale municipal utilities effective Sept. 1, 1993. 3. Accounting Changes Postretirement Benefits - (See Note 13 for discussion of NSP's 1993 change in accounting for postretirement medical and death benefits.) There was no material effect on net income due to rate recovery of the expense increases. Of the $20 million in 1993 cost increases over 1992 due to adoption of SFAS No. 106, about $5 million was capitalized, $12 million was deferred to be amortized over rate recovery periods in 1994-1996 and about $3 million was expensed but essentially offset by rate increases. Income Taxes - As discussed in Note 1, NSP adopted SFAS No. 109 - Accounting for Income Taxes, effective Jan. 1, 1993. Adoption of SFAS No. 109 had no effect on earnings or financial condition due to its similarity to SFAS No. 96 - Accounting for Income Taxes, which NSP adopted in 1988 and which SFAS No. 109 supersedes. Revenue Recognition - Effective Jan. 1, 1992, the Company changed its revenue recognition method to include the accrual of estimated unbilled revenues for electric and gas service in its Minnesota, North Dakota and South Dakota operations. This accounting practice has been used by the Wisconsin Company since 1977. This change resulted in a better matching of revenues and expenses, and is consistent with predominant utility industry practice and the ratemaking principles in NSP's two major jurisdictions (Minnesota and Wisconsin). The effect on 1992 income before accounting changes was an increase of approximately $9.8 million (16 cents per share), while the effect on total 1992 earnings was an increase of approximately $55.3 million (88 cents per share). If the accounting change had been applied retroactively to Jan. 1, 1991, income from continuing operations for 1991 would have been $204.4 million ($2.98 per share). 1994 Changes - In 1994, NSP will adopt SFAS No. 112 - Accounting for Postemployment Benefits and a new accounting standard for employers' transactions with ESOP plans. SFAS No. 112 requires the accrual of certain employee costs (such as injury compensation and severance) to be paid in future periods. The adoption of these new accounting standards is not expected to have a material effect on NSP's results of operations or financial condition. 4. Business Acquisitions Viking Gas Transmission Company - On June 10, 1993, the Company acquired 100 percent of the stock of Viking Gas Transmission Company (Viking) from Tenneco Gas, a unit of Tenneco, Inc., in Houston, Texas, for approximately $45 million, $32 million of which was financed with project debt. Viking, which is now a wholly owned subsidiary of the Company, owns and operates a 500-mile interstate natural gas pipeline serving portions of Minnesota, Wisconsin and North Dakota. Viking presently operates exclusively as a transporter of natural gas for third-party shippers under authority granted by the FERC. Rates for Viking's transportation services are regulated by the FERC. Minneapolis Energy Center - On Aug. 20, 1993, NRG Energy, Inc. (NRG), a wholly owned subsidiary of the Company, acquired the assets of the Minneapolis Energy Center (MEC), a district heating and cooling system in downtown Minneapolis, Minn. The system uses steam and chilled water generating facilities to heat and cool buildings for about 85 heating and 25 cooling customers. The purchase price was $110 million, $84 million of which was financed with project debt. The purchase price primarily included facilities, long-term service agreements and goodwill. Cenergy, Inc. - On Oct. 1, 1993, Cenergy, Inc., a non-regulated subsidiary of the Company, acquired certain assets of Centran Corporation (Centran), a natural gas marketing company. Cenergy, Inc., a national marketer of energy services with approximately 30 employees and approximately 300 customers, is headquartered in Minneapolis, Minn., and has additional offices in Houston and Corpus Christi, Texas; Louisville, Ky.; and Chesapeake, Va. The purchase price was $4 million. Assets purchased included proven oil and gas reserves, office equipment and a customer marketing data base. Operating Results - The following represents unaudited operating results presented on a pro forma basis as if the acquisitions described above occurred on Jan. 1, 1992. Actual results, including Viking since June 10, 1993, MEC since Aug. 20, 1993, and the acquired Centran operations since Oct. 1, 1993, are shown for comparative purposes. Year Ended Dec. 31 (Dollars in millions except EPS) 1993 1992 Actual Results Utility operating revenues $2 404.0 $2 159.5 Non-regulated operating revenues and sales $90.7 $62.6 Net income $211.7 $206.4 Earnings per share $3.02 $3.04 Pro Forma Amounts Utility operating revenues $2 411.9 $2 176.0 Non-regulated operating revenues and sales $161.2 $272.6 Net income $212.6 $204.9* Earnings per share $3.04 $3.01* *Includes pretax writedown of $2.3 million (2 cents per share) of deferred environmental costs for Viking. 5. Cumulative Preferred Stock The Company has two series of adjustable rate preferred stock. The dividend rates are calculated quarterly and based on prevailing rates of certain taxable government debt securities indices. At Dec. 31, 1993, the annualized dividend rates were $5.50 for series A and $5.50 for series B. At Dec. 31, 1993, the various preferred stock series were callable at prices per share ranging from $102.00 to $103.75, plus accrued dividends. In 1993, the Company redeemed all 350,000 shares of its $7.84 series Cumulative Preferred Stock at $103.12 per share. In 1992, the Company redeemed all 250,000 shares of its $8.80 series Cumulative Preferred Stock at $103.35 per share. 6. Common Stock and Incentive Stock Plans The Company's Articles of Incorporation and First Mortgage Indenture provide for certain restrictions on the payment of cash dividends on common stock. At Dec. 31, 1993, the payment of cash dividends on common stock was not restricted. NSP has an Executive Long-Term Incentive Award Stock Plan that permits granting non-qualified stock options. The options currently granted may be exercised one year from the date of grant and are exercisable thereafter for up to nine years. The plan also allows certain employees to receive other awards for restricted stock, stock appreciation rights and other performance awards. Performance awards are valued in dollars, but are paid in shares based on market price at the time of payment. Transactions under the various stock incentive programs, which may result in the issuance of new shares, were as follows: Stock Awards (Thousands of shares) 1993 1992 1991 Outstanding Jan. 1 528.7 403.3 161.0 Options granted 196.9 201.8 232.2 Other stock awards 9.5 .8 16.9 Options and awards exercised (174.3) (57.0) 0 Options and awards forfeited (22.2) (20.1) (6.8) Other (1.5) (.1) 0 Outstanding at Dec. 31 537.1 528.7 403.3 Option price ranges: Unexercised at Dec. 31 $33.25-$43.50 $33.25-$40.94 $33.25-$36.44 Exercised during the year $33.25-$40.94 $33.25-$36.44 Using the treasury stock method of accounting for outstanding stock options, the weighted average number of shares of common stock outstanding for the calculation of primary earnings per share includes any dilutive effects of stock options and other stock awards as common stock equivalents. The differences between shares used for primary and fully diluted earnings per share were not material. 7. Detail of Certain Income and Expense Items Administrative and general (A&G) expense for utility operations consists of the following: (Thousands of dollars) 1993 1992 1991 A&G salaries and wages $52 085 $49 096 $48 710 Pensions and benefits - all utility employees 63 938 65 278 58 306 Information technology, facilities and administrative support 30 504 35 139 33 698 Insurance and claims 18 598 20 512 21 404 Other 17 410 17 950 17 742 Total $182 535 $187 975 $179 860 Other income and deductions - net consist of the following: (Thousands of dollars) 1993 1992 1991 Non-regulated operations: Operating revenues and sales $90 654 $62 616 $76 342 Operating expenses (excluding income taxes) 81 403 65 744* 69 327 Pretax operating income (loss) 9 251 (3 128) 7 015 Interest and investment income 4 522 3 452 6 489 Equity in earnings of non-regulated projects 3 030 2 382 226 Charitable contributions (4 752) (4 585) (4 231) Costs disallowed recovery by regulators (296) (1 603) (6 100) Legal and regulatory contingencies (100) (1 300) (5 100) Other - net (excluding income taxes) (643) (752) (494) Income tax (expense) benefit (2 394) 4 493 1 905 Total $8 618 $(1 041) $(290) *Includes $6.8 million in writedowns and losses from unsuccessful non-regulated projects. 8. Regulatory Assets and Liabilities The following summarizes the individual components of unamortized regulatory assets and liabilities shown on the Balance Sheet at Dec. 31: (Thousands of dollars) 1993 1992 AFC recorded in plant on a net-of-tax basis $165 915 $164 740 Losses on reacquired debt 48 529 33 185 Conservation and energy management programs 46 939 25 754 Environmental costs 45 568 505 Deferred postretirement benefit costs 15 514 2 112 State commission accounting adjustments 6 246 5 954 Unrecovered purchased gas costs and other 5 643 7 237 Total regulatory assets $334 354 $239 487 Excess deferred income taxes collected from customers $113 276 $106 975 Investment tax credit deferrals 120 123 119 847 Pension costs 6 969 2 017 Fuel refunds and other 3 512 3 627 Total regulatory liabilities $243 880 $232 466 The environmental costs item includes an assessment from the DOE for the Company's allocated share of decontamination and decommissioning costs related to the DOE's uranium enrichment facility. The Company's total DOE assessment of $46 million was made in 1993. This assessment will be payable in annual installments (currently $3.1 million) for up to 15 years and will be expensed on a monthly basis in the 12 months following each payment. Future installments are subject to inflation adjustments under DOE rules. The FERC has approved wholesale ratemaking recovery of these assessments as paid through the cost-of-energy adjustment clause. Since the Company's retail regulators currently fully conform to the FERC's cost-of-energy adjustment clause procedures, management also expects recovery of these DOE assessments in retail ratemaking as payments are made each year. The AFC regulatory asset and the tax-related regulatory liabilities result from NSP's income tax accounting practices as discussed in Note 1. The excess deferred income tax liability represents the net amount expected to be reflected in future customer rates based on the collection in prior ratemaking of deferred income tax amounts in excess of the actual liabilities recorded by NSP. This excess is the net effect of the use of flow-through tax accounting in prior ratemaking and the impact of changes in statutory tax rates in 1981, 1986-87 and 1993. This regulatory liability will change each year as the related deferred income tax liabilities change. 9. Income Tax Expense Total income tax expense from operations differs from the amount computed by applying the statutory federal income tax rate (35 percent in 1993 and 34 percent in 1992 and 1991) to net income before income tax expense. The reasons for the difference are as follows: (Thousands of dollars) 1993 1992 1991 Tax Computed at Statutory Federal Rate $119 868 $84 015 $118 829 Increases (decreases) in tax from: State income taxes net of federal income tax benefit 20 838 13 421 20 822 Tax credits recognized (9 545) (8 846) (9 511) Nontaxable AFC - equity included in book income (2 565) (3 058) (2 562) Net-of-tax AFC included in book depreciation 4 403 4 518 4 594 Use of the flow-through method for depreciation in prior years 7 004 5 884 6 163 Effect of tax rate changes for plant-related items (4 648) (5 202) (6 798) Dividends paid on ESOP shares (3 009) (3 245) (3 199) Other - net (1 606) (1 311) (2 888) Total income tax expense from operations $130 740 $86 176 $125 450 Effective federal and state income tax rate 38.2% 34.9% 35.9% Composite federal and state statutory tax rate 40.9% 39.9% 39.9% Income taxes are comprised of the following expense (benefit) items: Included in utility operating expenses: Current federal tax expense $92 099 $69 198 $72 197 Current state tax expense 25 787 18 535 21 081 Deferred federal tax expense 15 010 8 518 25 157 Deferred state tax expense 4 431 2 533 7 779 Tax credits recognized (8 981) (8 115) (8 878) Total 128 346 90 669 117 336 Included in other income and expense: Current federal tax expense 7 853 1 490 3 708 Current state tax expense 2 289 613 1 128 Deferred federal tax expense (6 736) (4 518) (5 580) Deferred state tax expense (449) (1 347) (850) Tax credits recognized (563) (731) (311) Total 2 394 (4 493) (1 905) Included in discontinued operations: Current federal tax expense - operations 129 Current federal tax expense - gain 10 193 Current state tax expense - operations 28 Current state tax expense - gain 2 921 Deferred federal tax expense (2 271) Deferred state tax expense (539) Tax credits recognized (442) Total 10 019 Total income tax expense from operations $130 740 $86 176 $125 450 The components of NSP's net deferred tax liability at Dec. 31 were as follows: (Thousands of dollars) 1993 1992 Deferred tax liabilities: Differences between book and tax bases of property $792 542 $765 957 Regulatory assets 128 991 90 856 Tax benefit transfer leases 87 924 97 852 Other 7 050 5 791 Total deferred tax liabilities $1 016 507 $960 456 Deferred tax assets: Regulatory liabilities $95 504 $92 165 Deferred investment tax credits 73 648 74 047 Deferred compensation, vacation and other accrued liabilities not currently deductible 62 811 29 715 Other 11 341 Total deferred tax assets $243 304 $195 927 Net deferred tax liability $773 203 $764 529 The Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law on Aug. 10, 1993, and increased the federal corporate income tax rate from 34 percent to 35 percent retroactive to Jan. 1, 1993. Deferred tax liabilities were increased for the rate change by approximately $32 million. However, due to regulatory deferral of utility tax adjustments, earnings were reduced by immaterial adjustments to deferred tax liabilities related to non-regulated operations. 10. Long-Term Debt The annual sinking-fund requirements of the Company's and the Wisconsin Company's First Mortgage Indentures are the amounts necessary to redeem 1 percent of the highest principal amount of each series of first mortgage bonds at any time outstanding, excluding those series issued for pollution control and resource recovery financings, and excluding certain other series totaling $320 million. The Company may, and has, applied property additions in lieu of cash payments on all series except for the 91/8 percent Series due July 1, 2019, as permitted by its First Mortgage Indenture. The Wisconsin Company may also apply property additions in lieu of cash on all series as permitted by its First Mortgage Indenture. Except for minor exclusions, all real and personal property is subject to the liens of the first mortgage indentures. The variable rate First Mortgage Bonds Series due March 1, 2011, and the variable rate City of Becker Pollution Control Revenue Bonds Series due March 1, 2019, and Sept. 1, 2019, are redeemable upon seven days' notice at the option of the bondholder. Thus, the principal amount of these bonds outstanding at Dec. 31, 1993, is reported under current liabilities on the balance sheet. Their tax-exempt interest rates are subject to change, weekly or at various periods, and are based on prevailing rates for similar issues. The interest rates applicable to these issues averaged 3.0 percent, 2.6 percent and 2.5 percent, respectively, at Dec. 31, 1993. The Company and the Wisconsin Company have entered into interest rate swap agreements with the underwriters of certain first mortgage bond issues, which effectively convert the interest cost for this debt from fixed to variable rate as summarized below: Amount of Term of Net Effective Swap (millions Swap Interest Cost at Series of dollars) Agreement Dec. 31, 1993 5 7/8% Series due Oct. 1, 1997 $100 Maturity 3.38% 7 1/4% Series due March 1, 2023 $20 March 1, 1998 5.56% The variable rates change semiannually. Interest rate swap transactions are recognized as an adjustment of interest expense over the terms of the agreements. Maturities and sinking-fund requirements on long-term debt are as follows: 1994, $90,618,000; 1995, $41,348,000; 1996, $61,931,000; 1997, $138,401,000; and 1998, $57,352,000. On Jan. 24, 1994, the Company notified bondholders that $150 million of first mortgage bonds would be redeemed on Feb. 24, 1994. These bonds have been classified as long-term debt based on the refinancing of such debt using first mortgage bond proceeds obtained in February 1994. 11. Short-Term Borrowings NSP has approximately $215 million of commercial bank credit lines under commitment fee arrangements. These credit lines make short-term financing available in the form of bank loans and support for commercial paper sales. There were no borrowings against these credit lines at Dec. 31, 1993 and 1992. At Dec. 31, 1993, the Company had $106.2 million in short-term commercial paper borrowings outstanding at interest rates varying from 3.3 to 3.5 percent. 12. Fair Value of Financial Instruments SFAS No. 107 - Disclosures About Fair Value of Financial Instruments requires disclosure of the estimated fair value of financial instruments. For cash, cash equivalents and short-term investments, the carrying amount approximates fair value because of the short maturity of those instruments. The fair values of the Company's long-term investments in an external nuclear decommissioning fund are estimated based on quoted market prices for those or similar investments. The fair value of NSP's long-term debt is estimated based on the quoted market prices for the same or similar issues, or the current rates offered to NSP for debt of the same remaining maturities. The estimated Dec. 31 fair values of NSP's financial instruments are as follows: 1993 1992 Carrying Fair Carrying Fair (Thousands of dollars) Amount Value Amount Value Cash, cash equivalents and short-term investments $57 838 $57 838 $15 840 $15 840 Long-term decommissioning investments $101 378 $110 130 $68 800 $72 180 Long-term debt including current portion $1 524 085 $1 584 435 $1 373 876 $1 437 999 13. Benefit Plans and Other Postretirement Benefits Pension Benefits - NSP has a non-contributory, defined benefit pension plan that covers substantially all employees. Benefits are based on a combination of years of service, the employee's highest average pay for 48 consecutive months and Social Security benefits. For regulatory purposes, the Company's pension expense is determined and recorded under the aggregate-cost method. SFAS No. 87 - Employers' Accounting for Pensions provides that any difference between the pension expense recorded for ratemaking purposes and the amounts determined under SFAS No. 87 should be recorded as assets or liabilities on the balance sheet. Net annual periodic pension cost includes the following components: (Thousands of dollars) 1993 1992 1991 Service cost-benefits earned during the period $25 015 $24 080 $22 097 Interest cost on projected benefit obligation 71 075 69 853 65 557 Actual return on assets (152 019) (115 455) (246 678) Net amortization and deferral 66 299 39 019 181 543 Net periodic pension cost determined under SFAS No. 87 10 370 17 497 22 519 Costs recognized (deferred) due to actions of regulators 5 117 2 741 (1 549) Total pension costs recorded during the period 15 487 20 238 20 970 Less costs recognized for 1988 early retirement program (165) (165) Net periodic pension cost recognized for ratemaking $15 487 $20 073 $20 805 The funded status of the plan as of Dec. 31 is as follows: (Thousands of dollars) 1993 1992 Actuarial present value of benefit obligation: Vested $655 002 $614 446 Nonvested 139 346 129 183 Accumulated benefit obligation $794 348 $743 629 Projected benefit obligation $974 160 $914 019 Plan assets at fair value 1 244 650 1 156 782 Plan assets in excess of projected benefit obligation (270 490) (242 763) Unrecognized prior service cost (22 580) (14 790) Unrecognized net actuarial gain 315 049 269 086 Unrecognized net transitional asset 767 843 Net pension liability included in other liabilities $22 746 $12 376 The weighted average discount rate used in determining the actuarial present value of the projected obligation was 7 percent in 1993 and 8 percent in 1992. The rate of increase in future compensation levels used in determining the actuarial present value of the projected obligation was 5 percent in 1993 and 6 percent in 1992. While the 1993 assumption changes had no effect on 1993 pension costs, the effect of the changes in 1994 is expected to be a cost decrease of approximately $3 million. The assumed long-term rate of return on assets used for cost determinations under SFAS No. 87 was 8 percent in 1993 and 1992 and 8.5 percent in 1991. The effect of the 1992 change in the assumed rate of return was an increase of $4.3 million in the estimated SFAS No. 87 net periodic pension cost in 1992. Plan assets principally consist of common stock of public companies and U.S. government securities. Postretirement Health Care - Effective Jan. 1, 1993, NSP adopted the provisions of SFAS No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS No. 106 requires the actuarially determined obligation for postretirement health care and death benefits to be fully accrued by the date employees attain full eligibility for such benefits, which is generally when they reach retirement age. This is a significant change from NSP's prior policy of recognizing benefit costs on a cash basis after retirement. In conjunction with the adoption of SFAS No. 106, NSP elected to amortize on a straight-line basis over 20 years the unrecognized accumulated postretirement benefit obligation (APBO) of $215.6 million for current and future retirees. This obligation considers anticipated 1994 plan design changes, including Medicare integration, increased retiree cost sharing and managed indemnity measures not in effect in 1993. Prior to 1993, NSP funded benefit payments to retirees internally. While NSP generally prefers to continue using internal funding of benefits paid and accrued, significant levels of external funding have been imposed by NSP's regulators, as discussed below, including the use of tax-advantaged trusts. Plan assets held in such trusts as of Dec. 31, 1993, consisted of investments in equity mutual funds and cash equivalents. The following table sets forth the health care plan's funded status in 1993. (Millions of dollars) Dec. 31, 1993 Jan. 1, 1993 APBO: Retirees $120.2 $105.8 Fully eligible plan participants 18.8 18.8 Other active plan participants 90.8 91.0 Total APBO 229.8 215.6 Plan Assets 6.1 0 APBO in excess of plan assets 223.7 215.6 Unrecognized net actuarial loss (1.3) Unrecognized transition obligation (204.8) (215.6) Postretirement benefit obligation included in other liabilities $17.6 $0 The assumed health care cost trend rate used in measuring the APBO at Dec. 31, 1993, was 14.1 percent for those under age 65 and 8.0 percent for those over age 65. The assumed cost trend rates are expected to decrease each year until they reach 4.5 percent for both age groups in the year 2004, after which they are assumed to remain constant. The trend rates used in the Jan. 1, 1993, calculations were 15.1 percent and 9.0 percent, respectively, eventually decreasing to 5.5 percent in 2004. A 1-percent increase in the assumed health care cost trend rate for each year would increase the APBO as of Dec. 31, 1993, by approximately 17 percent, and service and interest cost components of the net periodic postretirement cost by approximately 20 percent. The assumed discount rate used in determining the APBO was 7 percent for Dec. 31, 1993, and 8 percent for Jan. 1, 1993, compounded annually. The assumed long-term rate of return on assets used for cost determinations under SFAS No. 106 was 8 percent for both measurement dates. While the assumption changes made for the Dec. 31 calculations had no effect on 1993 benefit costs, the effect of the changes in 1994 is expected to be a cost decrease of approximately $2 million. In 1992 and 1991, NSP recognized $12.8 million and $11.2 million, respectively, as the cost attributable to postretirement health care and death benefits based on payments made. The net annual periodic postretirement benefit cost recorded for 1993 consists of the following components: (Millions of dollars) 1993 Service cost-benefits earned during the year $4.4 Interest cost (on service cost and APBO) 17.5 Actual return on assets (.1) Amortization of transition obligation 10.8 Net amortization and deferral .1 Net periodic postretirement health care cost under SFAS No. 106 32.7 Costs deferred due to actions of regulators (12.1) Net periodic postretirement health care cost recognized for ratemaking $20.6 Regulators of NSP's retail rates in Minnesota, Wisconsin and North Dakota have allowed full recovery of increased benefit costs under SFAS No. 106, effective in 1993. Expense recognition and rate recovery of increased 1993 accrual costs for Minnesota have been deferred until 1994 through 1996, consistent with rate orders received. External funding was required in Minnesota and Wisconsin to the extent it is tax advantaged; funding began for Wisconsin in 1993 and must begin by the next general rate filing for Minnesota. Rate increases for Minnesota and Wisconsin wholesale electric customers were approved by the FERC and provided recovery of accrued SFAS No. 106 benefits under new rates beginning in September 1993. A rate increase for Viking wholesale gas customers was approved by the FERC, before Viking's acquisition by the Company, and provided recovery of accrued benefits beginning in July 1993. The FERC has required external funding for all benefits paid and accrued under SFAS No. 106. The impact of adopting SFAS No. 106 on other utility jurisdictions and non-regulated operations was not material. ESOP - NSP also has a leveraged Employee Stock Ownership Plan (ESOP) that covers substantially all employees. Employer contributions to this plan are generally made to the extent NSP realizes a tax savings on its income statement from dividends paid on shares held by the ESOP. Contributions to the ESOP in 1993, 1992 and 1991, which approximate expenses determined under the shares-allocated method, were $6,281,000, $6,415,000 and $6,326,000, respectively. ESOP contributions have no material effect on NSP earnings because the contributions (net of tax) are essentially offset by the tax savings provided by the dividends paid on ESOP shares. (See Note 9.) 14. Joint Plant Ownership The Company is a participant in a jointly owned 855-megawatt coal-fired electric generating unit, Sherburne County Generating Station Unit No. 3 (Sherco 3), which began commercial operation Nov. 1, 1987. Undivided interests in Sherco 3 have been financed and are owned by the Company (59 percent) and Southern Minnesota Municipal Power Agency (41 percent). The Company is the operating agent under the joint ownership agreement. The Company's share of related expenses for Sherco 3 since commercial operations began are included in Utility Operating Expenses. The Company's share of the gross cost recorded in Utility Plant at Dec. 31, 1993 and 1992, was $584,822,000 and $582,799,000, respectively. The corresponding accumulated provisions for depreciation were $114,251,000 and $96,035,000. 15. Commitments and Contingent Liabilities Commitments - NSP estimates utility capital expenditures, including acquisitions of nuclear fuel, will be $396 million in 1994 and $1.8 billion for 1994-1998. There also are contractual commitments for the disposal of spent nuclear fuel. Rentals under operating leases were approximately $27.5 million, $25.1 million and $22.7 million for 1993, 1992 and 1991, respectively. Fuel Contracts - NSP has long-term contracts providing for the purchase and delivery of a significant portion of its current coal, nuclear fuel and natural gas requirements. These contracts, which expire in various years between 1994 and 2013, require minimum contractual purchases and deliveries of fuel, and additional payments for the rights to purchase coal in the future. In total, NSP is committed to the purchase and receipt of approximately $374 million of coal, $129 million of nuclear fuel and $607 million of natural gas, or to make payments in lieu thereof, under these contracts. Because NSP has other sources of fuel available and because suppliers are expected to continue to provide reliable fuel supplies, risk of loss from non-performance under these contracts is not considered significant. In addition, NSP's risk of loss (in the form of increased costs) from market price changes in fuel is mitigated through the cost-of-energy adjustment provision of the ratemaking process, which provides for recovery of nearly all fuel costs. Power Agreements - The Company has executed several agreements with the Manitoba Hydro-Electric Board (MH) for hydroelectricity. A summary of the agreements is as follows: Years Megawatts Participation Power Purchases 1994-2005 500 Seasonal Participation Power Purchase 1994-1996 1994 150 1995-1996 250 Seasonal Peaking Power Purchases 1994-1996 200 Seasonal Diversity Exchanges: Summer exchanges from MH 1994 400 1995-2014 150 1997-2016 200 Winter exchanges to MH 1995-2014 150 1996-2015 200 2015-2017 400 2018 200 The cost of the participation power purchase commitment is based on 80 percent of the costs of owning and operating Sherco 3 (adjusted to 1993 dollars). The total estimated annual costs for all MH agreements are $68.2 million for 1994 and approximately $70 million thereafter. These commitments, which represent about 38 percent of MH's output capability in 1993, account for approximately 13 percent of the Company's 1993 system capability. The risk of loss from non-performance by MH is not considered significant and the risk of loss from market price changes is mitigated through cost-of-energy rate adjustments. The Company and MH jointly have made commitments to provide additional transmission capacity to accomplish the seasonal diversity exchanges and to provide 200 megawatts of transmission capacity for United Power Association. The Company's agreements with MH call for the addition of facilities that will allow the Company's existing 500-kilovolt line from Winnipeg to the Twin Cities to accommodate the additional levels of transactions. The Company and MH began construction in early 1992, received all the necessary approvals in 1993 and expect to complete construction in 1995. The Company has an agreement with Minnkota Power Cooperative (MPC) for the purchase of summer season capacity and energy. From 1994 through 2001, the Company will buy 150 megawatts of summer season capacity for $12.4 million annually. From 2002 through 2015, the Company will purchase 100 megawatts of capacity for $10.0 million annually. Energy under the agreement will be priced against the cost of fuel consumed per megawatt-hour at the Coyote Generating Station in North Dakota. The Company also has three seasonal (summer) purchase power agreements, with MPC, Minnesota Power and Rochester Public Utility, for the purchase of 270 megawatts in 1994 and 250 megawatts in 1995 and 1996. The annual cost of this capacity will be approximately $3 million. The Company has agreements with several non-regulated entities to purchase electric capacity and associated energy. The total annual cost of current commitments for non-regulated installed capacity ranges from approximately $18 million for 119 megawatts in each of the years 1994-2011, decreasing thereafter to $0.8 million in 2033. The Company is negotiating a new power-purchase agreement with an independent power producer, which is expected to provide an additional 232 megawatts of electric capacity and associated energy, beginning in 1997. Nuclear Insurance - The Company's public liability for claims resulting from any nuclear incident is limited to $9.4 billion under the 1988 Price-Anderson amendment to the Atomic Energy Act of 1954. The Company has secured $200 million of coverage for its public liability exposure with a pool of insurance companies. The remaining $9.2 billion of exposure is funded by the Secondary Financial Protection Program, available from assessments by the federal government in case of a nuclear accident. The Company is subject to assessments of $79.3 million for each of its three licensed reactors to be applied for public liability arising from a nuclear incident at any licensed nuclear facility in the United States. The maximum funding requirement is $10 million per reactor during any one year. The Company purchases insurance for property damage and decontamination clean-up costs with coverage limits of $2.35 billion for the Prairie Island nuclear plant site and $2.15 billion for the Monticello nuclear plant site. The Prairie Island coverage consists of $950 million from American Nuclear Insurers/ Mutual Atomic Energy Liability Underwriters (ANI/MAELU) and $1.4 billion from Nuclear Electric Insurance Limited (NEIL). The Monticello coverage consists of $750 million from ANI/MAELU and $1.4 billion from NEIL. Under the insuring agreement with NEIL, the Company is subject to assessments of up to $23.3 million in each calendar year, 7.5 times the amount of its annual premium. NEIL also provides insurance coverage for increased costs of generation and purchased power resulting from an accidental outage of a nuclear generating unit. Under the policy, the Company is subject to assessments of up to $6.7 million in each calendar year, five times the amount of its annual premium. Environmental Contingencies - Other long-term liabilities include an accrual of $48 million at Dec. 31, 1993, for estimated costs associated with environmental reclamation, restoration and cleanup activities. Approximately $40 million of the liability relates to a 1993 DOE assessment as discussed in Note 8 to the Financial Statements. Other estimates have been recorded for expected environmental costs associated with manufactured gas plant sites formerly used by the Company and other waste disposal sites as discussed below. These environmental liabilities do not include accruals recorded (and collected from customers in rates) for future decommissioning costs related to the Company's nuclear generating plants. Consistent with predominant industry practice, the Company's decommissioning accruals are included in Utility Plant-Accumulated Depreciation as discussed in Note 1 of the Financial Statements. The FERC, the FASB and the SEC currently are reviewing the accounting and reporting guidelines for decommissioning cost accruals. Until such guidelines require a different presentation, the Company plans to continue its current reporting of plant decommissioning obligations as accumulated depreciation. NSP has not developed any specific site restoration and exit plans for its fossil fuel plants, hydroelectric plants or substation sites as it currently intends to operate at these sites indefinitely. If such plans were developed in the future, NSP would intend to treat the costs as a removal cost of retirement and include it in depreciation expense. (See Note 1 for discussion of NSP's pre-funding of the federal nuclear fuel disposal program.) NSP has met or exceeded the removal and disposal requirements for polychlorinated biphenyls (PCB) equipment as required by state and federal regulations. NSP has removed nearly all PCB capacitors, transformers and equipment from its distribution system and power plants. Any future cleanup or remediation costs for past PCB disposal is unknown at this time. Minimal costs are expected to be incurred for future removal and disposal of PCB equipment. PCB-contaminated mineral oil is detoxified and beneficially reused or burned for energy recovery at a permitted facility. The Company has been designated by the Environmental Protection Agency (EPA) as a "potentially responsible party" (PRP) for eight waste disposal sites to which the Company sent materials. Under applicable law, the Company, along with each PRP, could be held jointly and severally liable for the total remediation costs of all eight sites, which are estimated to approximate $85 million. However, the amount could be in excess of $85 million. The Company is not aware of the other parties' inability to pay or if responsibility for any of the sites is disputed by any party. The Company's share of the costs associated with these eight sites is approximately $2.5 million. Of this amount, about $1.4 million has already been paid in connection with two of the eight sites for which the Company has settled with the EPA and other PRPs. For the remaining six sites, neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined. However, the Company has recorded an estimate of future costs of approximately $1 million for all six sites. While it is not feasible to determine the outcome of these matters, amounts accrued represent the best current estimate of the Company's future liability for the cleanup costs of these sites. It is the Company's practice to vigorously pursue and, if necessary, litigate with insurers to recover costs. Through litigation, the Company has recovered from other PRPs a portion of the remedial costs paid to date. Management believes costs incurred in connection with the sites, which are not recovered from insurance carriers or other parties, might be allowed recovery in future ratemaking. Until the Company is identified as a PRP, it is not possible for the Company to predict the timing or amount of any costs associated with cleanup sites other than those discussed above. The Wisconsin Company has been notified by a group of PRPs for possible responsibility for cleanup of a solid and hazardous waste landfill site. The Wisconsin Company contends that it did not dispose of hazardous wastes in the subject landfill during the time period in question. Because neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined, it is not feasible to determine the outcome of this matter at this time. The Company also is continuing to investigate 14 properties either presently or previously owned by the Company, which were at one time sites of gas manufacturing, gas storage plants or gas pipelines. The purpose of this investigation is to determine if waste materials are present, if such materials constitute an environmental or health risk, if the Company has any responsibility for remedial action and if recovery under the Company's insurance policies can contribute to any remediation costs. Of the 14 gas sites under investigation, the Company has already remediated one site and is actively taking remedial action at four of the sites. The Company has paid $3.1 million to date on these sites. The one remediated site continues to be monitored. The Company currently estimates its liability for these four sites to be approximately $5 million with payment expected over the next one to five years. The estimate is based on prior experience and includes investigation, remediation and litigation costs. The possible range of the liability for these four sites could be from $5 million to approximately $11 million, depending on the extent of contamination. As for the other nine sites, the Company currently estimates its liability to be approximately $2 million. This estimate assumes the development and remediation of one site with the remaining eight sites requiring only monitoring. The time frame for payment of these costs currently is undeterminable. While it is not feasible to determine the precise outcome of all of these matters, the accruals recorded represent the current best estimate of the costs of any required cleanup or remedial actions at the Company's former gas operating sites. Management also believes that costs incurred in connection with the sites, which are not recovered from insurance carriers or other parties, might be allowed recovery in future ratemaking. The Clean Air Act, including the Amendments of 1990 (the Clean Air Act), imposes stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. The legislation enacted in 1990 is extremely complex and its overall financial impact on NSP will depend on the final interpretation and implementation of rules to be issued by the EPA. NSP is participating in the rulemaking process for the development of regulations that achieve the goals of the legislation in a reasonable and cost-effective manner. NSP has expended significant funds over the years to reduce sulfur dioxide emissions at its plants. Additional construction expenditures may be required to comply with parts of the Clean Air Act. Based on revised emission standards proposed by the EPA in 1993, NSP's excess emission allowances available under the Clean Air Act may be significantly reduced. Because NSP is only beginning to implement some provisions of the Clean Air Act, its overall financial impact is unknown at this time. The majority of NSP's power plants meet state and federal limits for opacity and air quality. Capital expenditures will be required for opacity compliance in 1994-1998 at certain facilities, and such costs are considered in the capital expenditure commitments disclosed previously. NSP plans to seek recovery of these expenditures in future rate proceedings. In October 1992, the Company disclosed to the Minnesota Pollution Control Agency, the EPA and the Nuclear Regulatory Commission that reports on halogen content of water discharged at the Company's Prairie Island nuclear generating plant were based on estimates of halogen content rather than actual physical samples of water discharged as required by the plant's permit. Even though the water discharges at the plant did not exceed the halogen levels allowed under the permit, the applicable state and federal statutes would permit the imposition of fines, the institution of criminal sanctions and/or injunctive relief for the reporting violations. Corrective actions were taken by the Company, and the Company cooperated with state and federal authorities in the investigation of the reporting violations. No civil or criminal actions against the Company have been announced. Environmental liabilities are subject to considerable uncertainties that affect NSP's ability to estimate its share of the ultimate costs of remediation and pollution control efforts. Such uncertainties involve the nature and extent of site contamination, the extent of required cleanup efforts, varying costs of alternative cleanup methods and pollution control technologies, changes in environmental remediation and pollution control requirements, the potential effect of technological improvements, the number and financial strength of other potentially responsible parties at multi-party sites and the identification of new environmental cleanup sites. NSP has recorded and/or disclosed its best estimate of expected future environmental costs and obligations as discussed previously. Legal Claims - In the normal course of business, NSP is a party to routine claims and litigation arising from prior and current operations. NSP is actively defending these matters and has recorded an estimate of the probable cost of settlement or other disposition. On July 22, 1993, a natural gas explosion occurred on the Company's distribution system in St. Paul, Minn. Total damages are estimated to exceed $1 million. The Company has a self-insured retention deductible of $1 million, with general liability coverage of $150 million, which includes coverage for all injuries and damages. While four lawsuits have been filed, the litigation following this incident is in a preliminary stage and the ultimate costs to the Company are unknown at this time. Operating Contingency - The Company is experiencing uncertainty regarding its ability to store used nuclear fuel from its Prairie Island nuclear generating facility. The facility stores its used nuclear fuel on an interim basis in a storage pool in the plant, pending the availability of a U.S. Department of Energy high-level radioactive waste storage or permanent disposal facility, or a private interim storage facility. At current operating levels, the pool will be filled in 1994 so the Company has proposed to augment Prairie Island's interim storage capacity by using steel containers for dry storage of used nuclear fuel on the plant site. Without additional onsite storage or significant modification of normal plant operations, Prairie Island Unit 2 would be shutdown in May 1995 and Prairie Island Unit 1 would be shutdown in February 1996. These two units supply about 20 percent of the Company's output. The Company has obtained a Certificate of Need from the MPUC allowing use of a limited number of steel containers, providing adequate storage at least through the year 2001. The Nuclear Regulatory Commission has also issued a license approving a dry storage facility on the plant site for Prairie Island's used fuel. However, in June 1993, the Minnesota Court of Appeals decided that the additional temporary storage facilities must be approved by the Minnesota Legislature. The Company has requested such approval from the Legislature and expects a decision on this issue during the current session, which began on Feb. 22, 1994. Although hearings have begun, the Company cannot predict what action the Minnesota Legislature will take. The Company's net investment in the Prairie Island generating facility at Dec. 31, 1993, was $520 million. Future plant decommissioning costs in excess of amounts not accrued and collected in rates were $247 million at Dec. 31, 1993. Should the facility need to be shut down due to the full utilization of spent fuel storage capacity, the Company would request recovery of, and a return on, its investment and unrecorded plant decommissioning costs through utility rates. However, at this time the regulators' ultimate response to such a request is unknown. Without the generating capability of the Prairie Island facility, the Company estimates that an incremental increase in purchased power and fuel expenses of at least $200 million per year could be incurred. To the extent such additional costs represent energy purchases, current rate treatment provides recovery through cost-of-energy adjustments to customer rates. The Company will request recovery of costs associated with additional capacity purchases or investments in new plants through general rate filings. However, at this time the need for such costs and the regulators' ultimate response to such a request is unknown. The Company estimates that the present value of the cost of supplying replacement power and recovering its investment in the plant and unrecognized decommissioning costs will be $1.8 billion. 16. Segment Information Year Ended Dec. 31 (Thousands of dollars) 1993 1992 1991 Utility operating revenues Electric $1 974 916 $1 823 316 $1 863 238 Gas 429 076 336 206 337 920 Total operating revenues $2 403 992 $2 159 522 $2 201 158 Utility operating income before income taxes* Electric $393 758 $321 837 $383 049 Gas 38 474 24 848 39 748 Total operating income before income taxes $432 232 $346 685 $422 797 Utility depreciation and amortization Electric $245 200 $225 134 $217 625 Gas 19 317 17 780 16 538 Total depreciation and amortization $264 517 $242 914 $234 163 Capital expenditures Electric $284 239 $367 522 $290 793 Gas 36 312 42 850 32 576 Other 41 144 17 443 26 493 Total capital expenditures $361 695 $427 815 $349 862 Net utility plant Electric $3 834 131 $3 812 688 $3 709 811 Gas 379 968 313 002 287 167 Total net utility plant 4 214 099 4 125 690 3 996 978 Other corporate assets 1 373 619 1 016 771 921 860 Total assets $5 587 718 $5 142 461 $4 918 838 *1992 amounts include an increase from the operating income impact of the 1992 change in accounting for revenues of $9.6 million for electric and $6.8 million for gas. Item 9

Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure During 1993 there were no changes in or disagreements with the Company's independent public accountants on accounting procedures or accounting and financial disclosures. PART III Item 10

Item 10 - Directors and Executive Officers of the Registrant Information required under this Item with respect to Directors is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on pages 2 through 7 under the caption "Election of Directors", which is incorporated herein by reference. Information with respect to Executive Officers is included under the caption "Executive Officers" in Item 1 of this report, and is incorporated herein by reference. Item 11

Item 11 - Executive Compensation Information required under this Item is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on pages 8 through 20 under the caption "Compensation of Executive Officers", which is incorporated herein by reference. Item 12

Item 12 - Security Ownership of Certain Beneficial Owners and Management Information required under this Item is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on page 7 under the caption "Share Ownership of Directors, Nominees and Named Executive Officers", which is incorporated herein by reference. Item 13

Item 13 - Certain Relationships and Related Transactions Information required under this Item is set forth in the Registrant's 1994 Proxy Statement for its Annual Meeting of Shareholders to be held April 27, 1994 on pages 3 through 5 under the captions "Class I - Directors Whose Terms Expire in 1996", "Class II - Nominees for Terms Expiring in 1997", "Class III - Directors Whose Terms, Expire in 1995", which is incorporated herein by reference. PART IV Item 14

Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements Included in Part II of this report: Independent Auditors' Report. Consolidated Statements of Income for the three years ended December 31, 1993. Consolidated Statements of Cash Flows for the three years ended December 31, 1993. Consolidated Balance Sheets, December 31, 1993 and 1992. Consolidated Statements of Changes in Common Stockholders' Equity for the three years ended December 31, 1993 Consolidated Statements of Capitalization, December 31, 1993 and 1992. Notes to Financial Statements. (a) 2. Financial Statement Schedules Included in Part IV of this report: Schedules for the three years ended December 31, 1993: V - Utility Plant and Non-regulated Property VI - Accumulated Provision for Depreciation and Amortization of Utility Plant and Non-regulated Property. Notes to Schedules V and VI. IX - Short-Term Borrowings X - Supplementary Income Statement Information Schedules other than those listed above are omitted because of the absence of the conditions under which they are required or because the information required is included in the financial statements or the notes. (a) 3. Exhibits * Indicates incorporation by reference 3.01* Restated Articles of Incorporation and Amendments, effective as of April 2, 1992. (Exhibit 3.01 to Form 10-Q for the quarter ended March 31, 1992, File No. 1-3034). 3.02* Bylaws of the Company as amended January 22, 1992. (Exhibit 3.02 to Form 10-K for the year 1991, File No. 1-3034). 4.01* Trust Indenture, dated February 1, 1937, from the Company to Harris Trust and Savings Bank, as Trustee. (Exhibit B-7 to File No. 2-5290). 4.02* Supplemental and Restated Trust Indenture, dated May 1, 1988, from the Company to Harris Trust and Savings Bank, as Trustee. (Exhibit 4.02 to Form 10-K for the year 1988, File No. 1-3034). Supplemental Indenture between the Company and said Trustee, supplemental to Exhibit 4.01, dated as follows: 4.03* Jun. 1, 1942 (Exhibit B-8 to File No. 2-97667). 4.04* Feb. 1, 1944 (Exhibit B-9 to File No. 2-5290). 4.05* Oct. 1, 1945 (Exhibit 7.09 to File No. 2-5924). 4.06* Jul. 1, 1948 (Exhibit 7.05 to File No. 2-7549). 4.07* Aug. 1, 1949 (Exhibit 7.06 to File No. 2-8047). 4.08* Jun. 1, 1952 (Exhibit 4.08 to File No. 2-9631). 4.09* Oct. 1, 1954 (Exhibit 4.10 to File No. 2-12216). 4.10* Sep. 1, 1956 (Exhibit 2.09 to File No. 2-13463). 4.11* Aug. 1, 1957 (Exhibit 2.10 to File No. 2-14156). 4.12* Jul. 1, 1958 (Exhibit 4.12 to File No. 2-15220). 4.13* Dec. 1, 1960 (Exhibit 2.12 to File No. 2-18355). 4.14* Aug. 1, 1961 (Exhibit 2.13 to File No. 2-20282). 4.15* Jun. 1, 1962 (Exhibit 2.14 to File No. 2-21601). 4.16* Sep. 1, 1963 (Exhibit 4.16 to File No. 2-22476). 4.17* Aug. 1, 1966 (Exhibit 2.16 to File No. 2-26338). 4.18* Jun. 1, 1967 (Exhibit 2.17 to File No. 2-27117). 4.19* Oct. 1, 1967 (Exhibit 2.01R to File No. 2-28447). 4.20* May 1, 1968 (Exhibit 2.01S to File No. 2-34250). 4.21* Oct. 1, 1969 (Exhibit 2.01T to File No. 2-36693). 4.22* Feb. 1, 1971 (Exhibit 2.01U to File No. 2-39144). 4.23* May 1, 1971 (Exhibit 2.01V to File No. 2-39815). 4.24* Feb. 1, 1972 (Exhibit 2.01W to File No. 2-42598). 4.25* Jan. 1, 1973 (Exhibit 2.01X to File No. 2-46434). 4.26* Jan. 1, 1974 (Exhibit 2.01Y to File No. 2-53235). 4.27* Sep. 1, 1974 (Exhibit 2.01Z to File No. 2-53235). 4.28* Apr. 1, 1975 (Exhibit 4.01AA to File No. 2-71259). 4.29* May 1, 1975 (Exhibit 4.01BB to File No. 2-71259). 4.30* Mar. 1, 1976 (Exhibit 4.01CC to File No. 2-71259). 4.31* Jun. 1, 1981 (Exhibit 4.01DD to File No. 2-71259). 4.32* Dec. 1, 1981 (Exhibit 4.01EE to File No. 2-83364). 4.33* May 1, 1983 (Exhibit 4.01FF to File No. 2-97667). 4.34* Dec. 1, 1983 (Exhibit 4.01GG to File No. 2-97667). 4.35* Sep. 1, 1984 (Exhibit 4.01HH to File No. 2-97667). 4.36* Dec. 1, 1984 (Exhibit 4.01II to File No. 2-97667). 4.37* May 1, 1985 (Exhibit 4.36 to Form 10-K for the year 1985, File No. 1-3034). 4.38* Sep. 1, 1985 (Exhibit 4.37 to Form 10-K for the year 1985, File No. 1-3034). 4.39* Jul. 1, 1989 (Exhibit 4.01 to Form 8-K dated July 7, 1989, File No. 1-3034). 4.40* Jun. 1, 1990 (Exhibit 4.01 to Form 8-K dated June 1, 1990, File No. 1-3034). 4.41* Oct. 1, 1992 (Exhibit 4.01 to Form 8-K dated October 13, 1992, File No. 1-3034). 4.42* April 1, 1993 (Exhibit 4.01 to Form 8-K dated March 30, 1993, File No. 1-3034). 4.43* Dec. 1, 1993 (Exhibit 4.01 to Form 8-K dated December 7, 1993, File No. 1-3034). 4.44* Feb. 1, 1994 (Exhibit 4.01 to Form 8-K dated February 10, 1994, File No. 1-3034). 4.45* Trust Indenture, dated April 1, 1947, from the Wisconsin Company to Firstar Trust Company (formerly First Wisconsin Trust Company), as Trustee. (Exhibit 7.01 to File No. 2- 6982). Supplemental Indentures between the Wisconsin Company and said Trustee, supplemental to Exhibit 4.45 dated as follows: 4.46* Mar. 1, 1949 (Exhibit 7.02 to File No. 2-7825). 4.47* Jun. 1, 1957 (Exhibit 2.13 to File No. 2-13463). 4.48* Aug. 1, 1964 (Exhibit 4.20 to File No. 2-23726). 4.49* Dec. 1, 1969 (Exhibit 2.03E to File No. 2-36693). 4.50* Sep. 1, 1973 (Exhibit 2.01F to File No. 2-48805). 4.51* Feb. 1, 1982 (Exhibit 4.01G to File No. 2-76146). 4.52* Mar. 1, 1982 (Exhibit 4.39 to Form 10-K for the year 1982, File No. 10-3140). 4.53* Jun. 1, 1986 (Exhibit 4.01I to File No. 33-6269). 4.54* Mar. 1, 1988 (Exhibit 4.01J to File No. 33-20415). 4.55* Supplemental and Restated Trust Indenture dated March 1, 1991, from the Wisconsin Company to Firstar Trust Company (formerly First Wisconsin Trust Company), as Trustee. (Exhibit 4.01K to File No. 33-39831) 4.56* Apr. 1, 1991 (Exhibit 4.01L to File No. 33-39831). 4.57* Mar. 1, 1993 (Exhibit 4.01 to Form 8-K dated March 4, 1993, File No. 10-3140). 4.58* Oct. 1, 1993 (Exhibit 4.01 to Form 8-K dated September 21, 1993, File No. 10-3140). 10.01* Mid-continent Area Power Pool (MAPP) Agreement, dated March 31, 1972, between the local power suppliers in the North Central States area. (Exhibit 5.06B to File No. 2-44530). 10.02* Facilities agreement, dated July 21, 1976, between the Company and the Manitoba Hydro-Electric Board relating to the interconnection of the 500 Kv Line. (Exhibit 5.06I to file No. 2-54310). 10.03* Transactions agreement, dated July 21, 1976, between the Company and the Manitoba Hydro-Electric Board relating to the interconnection of the 500 Kv Line. (Exhibit 5.06J to File No. 2-54310). 10.04* Co-ordinating agreement, dated July 21, 1976, between the Company and the Manitoba Hydro-Electric Board relating to the interconnection of the 500 Kv Line. (Exhibit 5.06K to File No. 2-54310). 10.05* Ownership and Operating Agreement, dated March 11, 1982, between the Company, Southern Minnesota Municipal Power Agency and United Minnesota Municipal Power Agency concerning Sherburne County Generating Unit No. 3. (Exhibit 10.35 to Form 10-K for the Year 1982, File No. 1-3034). 10.06* Transmission agreement, dated April 27, 1982, and Supplement No. 1, dated July 20, 1982, between the Company and Southern Minnesota Municipal Power Agency. (Exhibit 10.40 to Form 10-K for the Year 1982, File No. 1-3034). 10.07* Power agreement, dated June 14, 1984, between the Company and the Manitoba Hydro-Electric Board, extending the agreement scheduled to terminate on April 30, 1993, to April 30, 2005. (Exhibit 10.45 to Form 10-K for the Year 1984, File No. 1-3034). 10.08* Power Agreement, dated August 1988, between the Company and Minnkota Power Company. (Exhibit 10.08 to Form 10-K for the Year 1988, File No. 1-3034). 10.09 Energy Supply Agreement, dated October 26, 1993, between the Company and Liberty Paper, Inc., relating to the supply of steam and electricity to the LPI container-board facility in Becker, MN. Executive Compensation Arrangements and Benefit Plans Covering Executive Officers 10.10* Executive Long-Term Incentive Award Stock Plan. (Exhibit 10.10 to Form 10-K for 1988, File No. 1-3034). 10.11* Terms and Conditions of Employment - James J Howard, President and Chief Executive Officer, effective February 1, 1987. (Exhibit 10.11 to Form 10-K for the Year 1986, File No. 1-3034). 10.12* NSP Severance Plan (Exhibit 10.14 to Form 10-K for the Year 1992, File No. 1-3034). 10.13* NSP Pension Plan (Exhibit 10.15 to Form 10-K for the Year 1992, File No. 1-3034). 10.14* NSP Employee Stock Ownership Plan (Exhibit 4.03, 4.04, 4.05 and 4.06 to Post-effective Amendment No. 5 to File No. 2- 61264). 10.15* NSP Retirement Savings Plan (Exhibit 10.17 to Form 10-K for the Year 1992, File No. 1-3034). 10.16 NSP Deferred Compensation Plan amended effective January 1, 1993. 12.01 Statement of Computation of Ratio of Earnings to Fixed Charges. 18.01* Independent Auditors' Preferability Letter. (Exhibit 18.01 to Form 10-Q for the quarter ended March 31, 1992, File No. 1-3034). 21.01 Subsidiaries of the Registrant. 23.01 Independent Auditors' Consent. (b) Reports on Form 8-K. The following reports on Form 8-K were filed either during the three months ended December 31, 1993, or between December 31, 1993 and the date of this report: October 1, 1993 (Filed October 8, 1993) - Item 5. Other Events. Re: Disclosure of the purchase of certain assets of Centran Corporation, a natural gas marketing company, by a non-regulated subsidiary of the Company. December 7, 1993 (Filed December 9, 1993) - Item 5. Other Events. Re: Disclosure of Underwriting Agreement and filing of a prospectus supplement relating to $170,000,000 First Mortgage Bonds ($100,000,000, Series due December 1, 2000) ($70,000,000, Series due December 1, 2005). Item 7. -Financial Statements and Exhibits. Filing of Underwriting Agreement between the Company and various underwriters, Supplemental Trust Indenture between the Company and Harris Trust and Savings Bank, as trustee, creating First Mortgage Bonds, Series due December 1, 2000 and Series Due December 1, 2005, and the computation of ratio of earnings to fixed charges. December 10, 1993 (Filed December 27, 1993) - Item 5. Other Events. Re: Disclosure of a partnership agreement, in which a non-regulated subsidiary of the Company is a party of, to purchase a 400-megawatt share of the 900-megawatt Schkopau power plant near Leipzig, Germany. Disclosure of a partnership agreement, in which a non-regulated subsidiary of the Company is a party of, to acquire a portion of the mining, power generation and associated operations of the former state-owned, Mitleldeutsche Vereinigte Braunkohlenwerke Aktiengesellschaft. January 31, 1994 (Filed February 9, 1994) - Item 5. Other Events. Re: Disclosure of an appeal filed with the Minnesota Court of Appeals by rate case intervenors concerning the method of calculating the rate of return on common equity. Disclosure that the Company has been named as a potentially responsible party at a Superfund site. Disclosure of the Company's Unaudited Consolidated Financial Statements for 1993. Item 7. Financial Statements, Pro Forma Financial Information and Exhibits. Filing of the Company's Unaudited Financial Statements for 1993. February 10, 1994 (Filed February 14, 1994) - Item 5. Other Events. Re: Disclosure of Underwriting Agreement and filing of a prospectus supplement relating to $200,000,000 First Mortgage Bonds, Series due February 1, 1999. Item 7. Financial Statements and Exhibits. Filing of Underwriting Agreement between the Company and various underwriters, Supplemental Trust Indenture between the Company and Harris Trust and Savings Bank, as trustee, creating First Mortgage Bonds due February 1, 1999, and the computation of ratio of earnings to fixed charges. March 15, 1994 (Filed March 16, 1994) - Item 5. Other Events. Re: Disclosure of the results of Minnesota State Legislative Committee votes on the Company's plan to store additional spent nuclear fuel at its Prairie Island Nuclear Generating Plant. Disclosure of the International Brotherhood of Electrical Workers rejection of NSP's contract offer and the continuation of negotiations. NORTHERN STATES POWER COMPANY, MINNESOTA AND SUBSIDIARIES NOTES TO SCHEDULES V AND VI (Thousands of dollars) For the year ended December 31, 1993: 1. Represents transfers and adjustments which were charged to the following accounts: Adjustment due to electric and gas meter inventory ($1 157) Adjustment due to gas distribution main inventory (2 252) Miscellaneous adjustments (413) Total ($3 822) 2. Represents transfers and adjustments which were charged to the following accounts: Accumulated depreciation of Viking Gas utility plant acquired $65 087 Adjustment due to gas distribution main inventory (2 252) Miscellaneous adjustments 241 Total $63 076 For the year ended December 31, 1992: 1. Represents transfers and adjustments which were charged to the following accounts: Miscellaneous adjustments ($129) 2. Represents transfers and adjustments which were charged to the following accounts: Miscellaneous adjustments ($634) For the year ended December 31, 1991: 1. Represents transfers and adjustments which were charged to the following accounts: Adjustment due to spare parts inventory ($6 130) Miscellaneous adjustments (151) Total ($6 281) 2. Represents transfers and adjustments which were charged to the following accounts: Miscellaneous adjustments ($29) Depreciation is computed on the straight-line method based on estimated useful lives of the various classes of property. Such provisions as a percentage of the average balance of depreciable property in service were 3.47% in 1993, 3.36% in 1992 and 3.35% in 1991. Nuclear fuel is amortized to fuel expense based on energy expended. SCHEDULE IX NORTHERN STATES POWER COMPANY, MINNESOTA AND SUBSIDIARIES SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Primarily Commercial Paper (Thousands of dollars) 1993 1992 1991 Balance at end of year $106 200 $146 561 $ 0 Weighted average interest rate at end of year 3.3% 3.6% 0 Maximum month-end amount $172 280 $162 000 $ 0 outstanding during the year (1-31-93) (7-31-92) Average amount outstanding during the period (computed on a daily basis) $ 76 966 $ 80 957 $390 Weighted average interest rate during the year (computed on a daily basis) 3.3% 3.6% 6.0% SCHEDULE X NORTHERN STATES POWER COMPANY, MINNESOTA AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 1993 1992 1991 (Thousands of dollars) Taxes other than payroll and income taxes charged to operating expenses: Real and personal property $169 881 $154 060 $148 653 Gross earnings $26 292 $24 264 $24 787 Other $3 842 $3 620 $3 526 The amount of maintenance and depreciation charged to expense accounts other than those set forth in the statement of income are not significant. All other items are less than 1% of total revenues. Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized. NORTHERN STATES POWER COMPANY March 23, 1994 (E J McIntyre) E J McIntyre Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. (James J Howard) (E J McIntyre) James J Howard E J McIntyre Chairman of the Board and Director Vice President (Principal Executive Officer) (Principal Financial Officer) (Roger D Sandeen) (H Lyman Bretting) Roger D Sandeen H Lyman Bretting Vice President & Controller Director (Principal Accounting Officer) (David A Christensen) (W John Driscoll) David A Christensen W John Driscoll Director Director (Dale L Haakenstad) (Allen F Jacobson) Dale L Haakenstad Allen F Jacobson Director Director (Richard M Kovacevich) (Douglas W Leatherdale) Richard M Kovacevich Douglas W Leatherdale Director Director (G M Pieschel) (Margaret R Preska) G M Pieschel Margaret R Preska Director Director (A Patricia Sampson) (Edwin M Theisen) A Patricia Sampson Edwin M Theisen Director President and Director EXHIBIT INDEX Method of Exhibit Filing No. Description DT 10.09 Energy Supply Agreement between the Company and Liberty Paper, Inc. DT 10.16 NSP Deferred Compensation Plan DT 12.01 Statement of Computation of Ratio of Earnings to Fixed Charges DT 21.01 Subsidiaries of the Registrant DT 23.01 Independent Auditors' Consent DT = Filed electronically with this direct transmission.

86772_1993.txt

86772

1993

ITEM 3. LEGAL PROCEEDINGS The Company, its subsidiaries and other related companies are named defendants in several lawsuits and named parties in certain governmental proceedings arising in the ordinary course of business. For a description of certain proceedings in which the Company is involved, see Items 1 and 2 ' Business and Properties -- Other Business Matters -- Environmental Regulation' and Notes 12 and 13 to the Consolidated Financial Statements. While the outcome of lawsuits or other proceedings against the Company cannot be predicted with certainty, management does not expect these matters to have a material adverse effect on the financial position or results of operations of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF SANTA FE Listed below are the names, ages (as of January 1, 1994) and positions of all executive officers of Santa Fe (excluding executive officers who are also directors of Santa Fe) and their business experience during the past five years. Unless otherwise stated, all offices were held with Santa Fe Energy Company prior to its merger with Santa Fe. Each executive officer holds office until his successor is elected or appointed or until his earlier death, resignation or removal. HUGH L BOYT, 48 Senior Vice President -- Production since March 1, 1990. From 1989 until March 1990, Mr. Boyt served as Corporate Production Manager. From 1983, when Mr. Boyt joined Santa Fe, until 1989 he served as District Production Manager -- Permian Basin. JERRY L BRIDWELL, 50 Senior Vice President -- Exploration and Land since 1986. Mr. Bridwell served in various other capacities, including Vice President -- Exploration, Central Division, since joining Santa Fe in 1974. KEITH P. HENSLER, 62 Senior Vice President -- Marketing since January, 1990. From 1980 when Mr. Hensler joined Santa Fe, until January 1990, he served as Vice President -- Marketing. Mr. Hensler is also Senior Vice President of Energy Products. RICHARD B. BONNEVILLE, 51 Vice President -- Planning and Administration since 1988. Prior to such time Mr. Bonneville served as Secretary of SFP. E. EVERETT DESCHNER, 53 Vice President -- Reservoir Engineering and Evaluation since April 1990. From 1982, when Mr. Deschner joined Santa Fe, until 1990, he served as Manager -- Engineering and Evaluation. C. ED HALL, 51 Vice President -- Public Affairs since March 1991. Prior to such time Mr. Hall served as Director -- Public Affairs since joining Santa Fe in 1984. CHARLES G. HAIN, JR., 47 Vice President -- Employee Relations since 1988. From 1981, when Mr. Hain joined Santa Fe, until 1988, Mr. Hain served as Director -- Employee Relations. DAVID L HICKS, 44 Vice President -- Law and General Counsel since March 1991. From 1988 until March 1991 Mr. Hicks was General Counsel and prior to that time was General Attorney for SFP. MICHAEL J. ROSINSKI, 48 Vice President and Chief Financial Officer since September 1992. Prior to joining Santa Fe, Mr. Rosinski was with Tenneco Inc. and its subsidiaries for 24 years. From 1988 until 1990 he served as Deputy Project Executive for the Colombian Crude Oil Pipeline Project and from 1990 until August 1992 he was Executive Director of Investor Relations. Mr. Rosinski is also a director of Hadson Corporation. JOHN R. WOMACK, 55 Vice President -- Business Development since 1987. From 1982, when Mr. Womack joined Santa Fe, until 1987, Mr. Womack served as Vice President -- Land. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Santa Fe's common stock is listed on the New York Stock Exchange and trades under the symbol SFR. The following table sets forth information as to the last sales price per share of Santa Fe's common stock as quoted on the Consolidated Tape System and cash dividends paid per share for each calendar quarter in 1992 and 1993. [CAPTION] CASH LOW HIGH DIVIDENDS [S] [C] [C] [C] 1st Quarter---------------------- 7 9 3/8 0.04 2nd Quarter---------------------- 7 7/8 9 1/4 0.04 3rd Quarter---------------------- 7 7/8 9 7/8 0.04 4th Quarter---------------------- 7 3/4 9 7/8 0.04 1st Quarter---------------------- 7 3/4 11 0.04 2nd Quarter---------------------- 9 5/8 11 7/8 0.04 3rd Quarter---------------------- 9 1/8 10 5/8 0.04 4th Quarter---------------------- 8 3/8 10 7/8 -- As discussed in Items 1 and 2, Business and Properties -- Corporate Restructuring Program, the Company has eliminated the payment of its $0.04 per share quarterly dividend on its common stock. The determination of the amount of future cash dividends, if any, to be declared and paid is in the sole discretion of Santa Fe's board of directors and will depend on dividend requirements with respect to the Company's convertible preferred stock, the Company's financial condition, earnings and funds from operations, the level of its capital and exploration expenditures, dividend restrictions in its financing agreements, its future business prospects and other matters as the Company's board of directors deems relevant. For a discussion of certain restrictions on Santa Fe's ability to pay dividends, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Financing Activities. At December 31, 1993 the Company had approximately 59,100 shareholders of record. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the year ended December 31, 1993 the Company reported a loss to common shares of $84.1 million, or $0.94 per share. The loss for the year includes a $99.3 million charge for the impairment of oil and gas properties (see ' -- Results of Operations') and a $38.6 million restructuring charge (see Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program'). The restructuring charge is comprised of losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals for certain personnel benefits and related costs of $2.2 million. At December 31, 1993 the Company's long-term debt totalled $449.7 million, a portion of which the Company intends to refinance to reduce required debt amortization in the near-term and provide additional financial flexibility in the current low oil price environment. GENERAL As an independent oil and gas producer, the Company's results of operations are dependent upon the difference between the prices received for oil and gas and the costs of finding and producing such resources. A substantial portion of the Company's crude oil production is from long-lived fields where EOR methods are being utilized. The market price of the heavy (i.e., low gravity, high viscosity) and sour (i.e., high sulfur content) crude oils produced in these fields is lower than sweeter, light (i.e., low sulfur and low viscosity) crude oils, reflecting higher transportation and refining costs. The lower price received for the Company's domestic heavy and sour crude oil is reflected in the average sales price of the Company's domestic crude oil and liquids (excluding the effect of hedging transactions) for 1993 of $12.70 per barrel, compared to $16.94 per barrel for West Texas Intermediate crude oil (an industry posted price generally indicative of spot prices for sweeter light crude oil). In addition, the lifting costs of heavy crude oils are generally higher than the lifting costs of light crude oils. As a result of these narrower margins, even relatively modest changes in crude oil prices may significantly affect the Company's revenues, results of operations, cash flows and proved reserves. In addition, prolonged periods of high or low oil prices may have a material effect on the Company's financial position. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC, the Middle East and other producing countries. (See Items 1 and 2, "Business and Properties -- Current Markets for Oil and Gas"). The period since mid-1990 has included some of the largest fluctuations in oil prices in recent times, primarily due to the political unrest in the Middle East. The actual average sales price (unhedged) received by the Company ranged from a high of $23.92 per barrel in the fourth quarter of 1990 to a low of $9.83 per barrel for the two months ended February 28, 1994. The Company's average sales price for its 1993 oil production was $12.93 per barrel. Based on operating results of 1993, the Company estimates that a $1.00 per barrel increase or decrease in average sales prices would have resulted in a corresponding $21.6 million change in 1993 income from operations and a $16.2 million change in 1993 cash flow from operating activities. The Company also estimates that a $0.10 per Mcf increase or decrease in average sales prices would have resulted in a corresponding $5.8 million change in 1993 income from operations and a $4.4 million change in 1993 cash flow from operating activities. The foregoing estimates do not give effect to changes in any other factors, such as the effect of the Company's hedging program or depreciation and depletion, that would result from a change in oil and natural gas prices. In the third quarter of 1990 the Company initiated a hedging program with respect to its sales of crude oil and in the third quarter of 1992 a similar program was initiated with respect to the Company's sales of natural gas. See Items 1 and 2. 'Business and Properties -- Current Markets for Oil and Gas.' During 1992 and 1993, certain significant events occurred which affect the comparability of prior periods, including the merger of Adobe with and into the Company in May 1992, the formation of the Santa Fe Energy Trust in November 1992 and implementation of the corporate restructuring program adopted in October 1993. The corporate restructuring program includes (i) the concentration of capital spending in the Company's core operating areas, (ii) the disposition of non-core assets, (iii) the elimination of the $0.04 per share quarterly Common Stock dividend and (iv) the recognition of $38.6 million of restructuring charges. See Note 2 to the Consolidated Financial Statements and Items 1 and 2, 'Business and Properties -- Corporate Restructuring Program.' In addition, the Company's results of operations for 1993 include a charge of $99.3 million for the impairment of oil and gas properties. The Company's capital program will be concentrated in three domestic core areas -- the Permian Basin in Texas and New Mexico, the offshore Gulf of Mexico and the San Joaquin Valley of California -- as well as its productive areas in Argentina and Indonesia. The domestic program includes development activities in the Delaware and Cisco-Canyon formations in west Texas and southeast New Mexico, a development drilling program for the offshore Gulf of Mexico natural gas properties and relatively low risk infill drilling in the San Joaquin Valley of California. Internationally, the program includes development of the Company's Sierra Chata discovery in Argentina with gas sales expected to commence in early 1995 and the Salawati Basin Joint Venture in Indonesia. See Items 1 and 2. 'Business and Properties -- Domestic Development Activities' and '--International Development Activities.' The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson (completed in December 1993), the sale to Vintage of certain southern California and Gulf Coast oil and gas producing properties (completed in November 1993) and the sale to Bridge of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage (expected to be completed during April 1994). See Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program' for a description of the transactions with Hadson, Vintage and Bridge. In the first quarter of 1994, the Company sold the remaining 575,000 Depositary Units which it held in Santa Fe Energy Trust (the 'Trust') for $11.3 million and its interest in certain other oil and gas properties for $8.3 million. As a result of the Vintage and Bridge dispositions, the Company has sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and estimated proved reserves of approximately 16.7 MMBOE. The restructuring program also includes an evaluation of the Company's capital and cost structures to examine ways to increase flexibility and strengthen the Company's financial performance. In this respect, in 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. In May, 1992, Adobe, an oil and gas exploration and production company, was merged with and into the Company. The acquisition was accounted for as a purchase and the results of operations of the properties acquired are included in the Company's results of operations effective June 1, 1992. Pursuant to the Adobe Merger, the Company issued 5,000,000 shares of its convertible preferred stock and assumed approximately $175.0 million of long-term debt and other liabilities. Pursuant to the Adobe Merger, the Company also acquired Adobe's proved reserves and inventory of undeveloped acreage. As of December 31, 1991, Adobe's estimated proved reserves totaled approximately 53.2 MMBOE (net of 6.9 MMBOE attributable to Adobe's ownership in certain gas plants), of which approximately 58% was natural gas (approximately 66% of Adobe's estimated domestic proved reserves were natural gas). Approximately 72% of the discounted future net cash flow of Adobe's estimated domestic proved reserves was concentrated in three areas of operation -- offshore Gulf of Mexico, onshore Louisiana and in the Spraberry Trend in west Texas. In addition, Adobe's international operations consisted of certain production sharing arrangements in Indonesia, in respect of which approximately 6.0 MMBOE of estimated proved reserves had been attributed to Adobe's interest as of December 31, 1991. The location of the Adobe Properties enhanced the Company's existing domestic operations and added significant operations to the Company's international program. In November 1992, 5,725,000 Depositary Units consisting of interests in the Trust were sold in a public offering. After payment of certain costs and expenses, the Company received $70.1 million and 575,000 Depositary Units. For any calendar quarter ending on or prior to December 21, 2002, the Trust will receive additional royalty payments to the extent necessary to distribute $0.40 per Depositary Unit per quarter. The source of such payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. The aggregate amount of such payments will be limited to $20.0 million on a revolving basis. The Company was required to make an additional royalty payment of $362,000 with respect to the distribution made by the Trust for operations during the quarter ended December 31, 1993. Based upon current prices, the Company believes that a support payment will be required for the quarter ending March 31, 1994, the amount of which has not been determined. See Items 1 and 2. 'Business and Properties -- Santa Fe Energy Trust.' RESULTS OF OPERATIONS The following table sets forth, on the basis of the BOE produced by the Company during the applicable annual period, certain of the Companys costs and expenses for each of the three years ended December 31, 1993. 1993 1992 1991 Production and operating costs per BOE (a)------------------------------ $ 4.76 $ 5.02 $ 5.17 Exploration, including dry hole costs per BOE---------------------------- 0.90 0.84 0.72 Depletion, depreciation and amortization per BOE--------------- 4.44 4.79 4.09 General and administrative costs per BOE-------------------------------- 0.94 1.01 1.07 Taxes other than income per BOE (b)-------------------------------- 0.79 0.80 1.05 Interest, net, per BOE (c)----------- 0.94 1.58 1.43 (a) Excluding related production, severance and ad valorem taxes. (b) Includes production, severance and ad valorem taxes. (c) Reflects interest expense less amounts capitalized and interest income. 1993 COMPARED WITH 1992 Total revenues increased approximately 2% from $427.5 million in 1992 to $436.9 million in 1993 principally due to an increase in oil and natural gas production offset by a decline in average oil prices. Average daily oil production increased 7% from 62.5 MBbls in 1992 to 66.7 MBbls in 1993, principally due to increased domestic and Indonesian production. The average price realized per Bbl of oil during 1993 was $12.93, a decrease of 14% versus the average price of $14.96 in 1992. Natural gas production increased 31% from 126.3 MMcf per day in 1992 to 165.4 MMcf per day in 1993, primarily reflecting the effect of a full year's production from the Adobe Properties. Average natural gas prices realized increased approximately 11% from $1.70 per Mcf in 1992 to $1.89 per Mcf in 1993. Production and operating costs increased $10.4 million in 1993, primarily reflecting the effect of a full year's costs for the Adobe Properties; however, on a BOE basis such costs declined from $5.02 per barrel in 1992 to $4.76 per barrel in 1993. Exploration costs were $5.5 million higher than in 1992 primarily reflecting higher geological and geophysical costs and higher dry hole costs. Depletion, depreciation and amortization ('DD&A') increased $6.4 million in 1993 primarily reflecting a full year's expense on Adobe Properties partially offset by reduced amortization rates with respect to certain unproved properties. DD&A for 1993 includes $12.1 million with respect to the properties sold to Vintage and Bridge. On a BOE basis, DD&A decreased by $0.35 per Bbl, from $4.79 to $4.44 per Bbl. General and administrative costs increased $1.4 million principally due to a $1.8 million charge related to the adoption of Statement of Financial Standards No. 112 -- 'Employer's Accounting for Postemployment Benefits'. Taxes (other than income) increased by $3.0 million in 1993 primarily reflecting the effect of the Adobe Properties. Costs and expenses for 1993 also include $99.3 million in impairments of oil and gas properties and $38.6 million in restructuring charges. The Company estimates the impairments taken in 1993 will result in a reduction of DD&A in 1994 of approximately $20.0 million. The restructuring charges include losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals of certain personnel benefits and related costs of $2.2 million. In connection with the property dispositions effected during 1993 (See '-- Liquidity and Capital Resources'), the Company sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and combined estimated proved reserves of approximately 16.7 MMBOE. The Company's income from operations for 1993 includes $8.5 million with respect to such operations. Interest income in 1993 includes $6.8 million related to a $10 million refund received as a result of the completion of the audit of the Company's federal income tax returns for 1971 through 1980. The decrease in interest expenses during 1993 reflects a decrease in the Company's debt outstanding and a $5.7 million credit related to a revision to a tax sharing agreement with the Company's former parent. Other income and expenses of 1993 includes a $4.0 million charge related to the accrual of a contingent loss with respect to the operations of a former affiliate of Adobe. 1992 COMPARED WITH 1991 Total revenues increased approximately 13% from $379.8 million in 1991 to $427.5 million in 1992 principally due to an increase of approximately $53.2 million attributable to production from properties acquired in the Adobe Merger and an increase of approximately $10.7 million and $10.2 million in revenues from the Company's domestic and Argentine properties, respectively, offset in part by a decline of $32.0 million in crude oil hedging revenues. Oil production increased 13% from 55.5 MBbls per day in 1991 to 62.5 MBbls per day in 1992, reflecting a 3.4 MBbl per day increase in domestic oil production and a 3.6 MBbl per day increase in production in Argentina and Indonesia. The average price realized per barrel of oil during 1992 decreased to $14.96, a decrease of 7% versus the average price of $16.16 in 1991, primarily reflecting a $32.0 million decrease in hedging revenues. Natural gas production increased 33% from 95.2 MMcf per day in 1991 to 126.3 MMcf per day in 1992 as a result of properties acquired in the Adobe Merger. Average natural gas prices realized increased approximately 14% from $1.49 per Mcf in 1991 to $1.70 per Mcf in 1992. Total operating expenses of the Company increased $54.6 million from $315.4 million in 1991 to $370.0 million in 1992 primarily reflecting costs associated with the Adobe Merger. Production and operating costs in 1992 were $18.8 million higher than in 1991, primarily reflecting costs related to the Adobe Properties and increased fuel costs associated with the Company's EOR projects. On a BOE basis, production and operating costs declined from $5.17 per barrel in 1991 to $5.02 per barrel in 1992, primarily reflecting the lower cost structure of the Adobe Properties. Exploration costs were $6.8 million higher than in 1991 primarily reflecting higher geological and geophysical costs with respect to foreign projects. Depletion, depreciation and amortization costs were $39.7 million higher in 1992 due to the acquisition of the Adobe Properties and, to a lesser extent, adjustments to oil and gas reserves with respect to certain producing properties. General and administrative costs increased $3.1 million principally due to a $1.2 million charge related to certain stock awards which fully vested upon consummation of the Adobe Merger and certain other merger-related costs. Taxes (other than income) decreased by $2.9 million in 1992, as a result of lower accruals with respect to property taxes. The $13.6 million gain on the disposition of properties in 1992 primarily relates to the sale of certain royalty interest properties, in which the Company had no remaining financial basis. The increase in interest expense during 1992 reflects the increase in debt as a result of the Adobe Merger. Other income and expenses for 1992 includes a $10.9 million charge for costs incurred by Adobe in connection with the Adobe Merger and paid by Santa Fe. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company has generally funded capital and exploration expenditures and working capital requirements from cash provided by operating activities. Depending upon the future levels of operating cash flows, which are significantly affected by oil and gas prices, the restrictions on additional borrowings included in certain of the Company's debt agreements, together with debt service requirements and dividends, may limit the cash available for future exploration, development and acquisition activities. Net cash provided by operating activities totaled $160.2 million in 1993, $141.5 million in 1992 and $128.4 million in 1991; net cash used in investing activities in such periods totaled $121.4 million, $15.9 million and $117.2 million, respectively. The Company's cash flow from operating activities is a function of the volumes of oil and gas produced from the Company's properties and the sales prices realized therefor. Crude oil and natural gas are depleting assets. Unless the Company replaces over the long term the oil and natural gas produced from the Company's properties, the Company's assets will be depleted over time and its ability to service and incur debt at constant or declining prices will be reduced. The Company's cash flow from operations for 1993 reflects an average sales price (unhedged) for the Company's 1993 oil production of $12.93 per barrel. For the two months ended February 28, 1994, the average sales price (unhedged) for the Company's 1994 oil production was $9.83 per barrel. If such lower oil prices prevail throughout 1994, the Company's cash flow from operating activities for 1994 will be significantly lower than that for 1993. In October 1993, the Company's Board of Directors adopted a broad corporate restructuring program that focuses on the concentration of capital spending in core areas and the disposition of non-core assets. The Company's asset disposition program adopted in connection with the 1993 restructuring program has been substantially completed by the asset sales to Hadson, Vintage and Bridge (expected to close in April 1994), the sale of the 575,000 Depositary Units in the Trust and the sale of its interest in certain other oil and gas properties. As a result of such sales, the Company sold a total of 16.7 MMBOE of proved reserves and undeveloped acreage for a total of approximately $111.0 million, and sold certain gas gathering and processing facilities for Hadson securities. As a part of the 1993 restructuring program, the Company eliminated its $0.04 per share quarterly dividend on its Common Stock and announced that it might spend up to $240 million in 1994 on an accelerated capital program. However, as a result of the depressed crude oil prices that have prevailed since November 1993, the Company, consistent with industry practice, is considering deferring some of its capital projects in order to prudently manage its cash flow available in the near term. Based on current market conditions, the Company estimates that 1994 capital expenditures may total between $100 million and $160 million, with the actual amount to be determined by the Company based upon numerous factors outside its control, including, without limitation, prevailing oil and natural gas prices and the outlook therefor. The Company is a party to several long-term and short-term credit agreements which restrict the Company's ability to take certain actions, including covenants that restrict the Company's ability to incur additional indebtedness and to pay dividends on its capital stock. For a description of such existing credit agreements, see Note 7 to the Consolidated Financial Statements. Effective March 16, 1994, the Company entered into an Amended and Restated Revolving Credit Agreement (the "Bank Facility") which consists of a five year secured revolving credit agreement maturing December 31, 1998 ("Facility A") and and a three year unsecured revolving credit facility maturing December 31, 1996 ("Facility B"). The aggregate borrowing limits under the terms of the Bank Facility are $125.0 million (up to $90.0 million under Facility A and up to $35.0 million under Facility B). Under certain circumstances, the aggregate borrowing limits under the terms of the Bank Facility may be increased to $175.0 million (up to $90.0 million under Facility A and up to $85.0 million under Facility B). Interest rates under the Bank Facility are tied to LIBOR or the bank's prime rate with the actual interest rate reflecting certain ratios based upon the Company's ability to repay its outstanding debt and the value and projected timing of production of the Company's oil and gas reserves. These and other similar ratios will also affect the Company's ability to borrow under the Bank Facility and the timing and amount of any required repayments and corresponding commitment reductions. The Bank Facility replaces the Revolving and Term Credit Agreement discussed in Note 7 to the Consolidated Financial Statements. EFFECTS OF INFLATION Inflation during the three years ended December 31, 1993 has had little effect on the Company's capital costs and results of operations. ENVIRONMENTAL MATTERS Almost all phases of the Company's oil and gas operations are subject to stringent environmental regulation by governmental authorities. Such regulation has increased the costs of planning, designing, drilling, installing, operating and abandoning oil and gas wells and other facilities. The Company has expended significant financial and managerial resources to comply with such regulations. Although the Company believes its operations and facilities are in general compliance with applicable environmental regulations, risks of substantial costs and liabilities are inherent in oil and gas operations. It is possible that other developments, such as increasingly strict environmental laws, regulations and enforcement policies or claims for damages to property, employees, other persons and the environment resulting from the Company's operations, could result in significant costs and liabilities in the future. As it has done in the past, the Company intends to fund its cost of environmental compliance from operating cash flows. See also, Items 1 and 2. 'Business and Properties -- Other Business Matters -- Environmental Regulation' and Note 12 to the Consolidated Financial Statements. DIVIDENDS Dividends on the Company's convertible preferred stock are cumulative at an annual rate of $1.40 per share. No dividends may be declared or paid with respect to the Company's common stock if any dividends with respect to the convertible preferred stock are in arrears. As described elsewhere herein, the Company has eliminated the payment of its $0.04 per share quarterly dividend on its common stock. The determination of the amount of future cash dividends, if any, to be declared and paid on the Company's common stock is in the sole discretion of the Company's Board of Directors and will depend on dividend requirements with respect to the convertible preferred stock, the Company's financial condition, earnings and funds from operations, the level of capital and exploration expenditures, dividend restrictions in financing agreements, future business prospects and other matters the Board of Directors deems relevant. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Audited Financial Statements Report of Independent Accountants------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991--------------------- 32 Consolidated Balance Sheet -- December 31, 1993 and 1992---- 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991--------------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991---------- 35 Notes to Consolidated Financial Statements---------- 36 Unaudited Financial Information Supplemental Information to the Consolidated Financial Statements-------------------- 55 Financial Statement Schedules: Schedule V --Property, Plant and Equipment------ 65 Schedule VI --Accumulated Depreciation, Depletion and Amortization of Property Plant and Equipment---------------------- 66 Schedule --Valuation and Qualifying VIII Accounts--------------------------- 67 Schedule IX --Short Term Borrowings-------------- 68 --Supplementary Income Statement Schedule X Information------------------------ 69 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11. EXECUTIVE COMPENSATION ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Except for the portion of Item 10 relating to Executive Officers of the Registrant which is included in Part I of this Report, the information called for by Items 10 through 13 is incorporated by reference from the Company's Notice of Annual Meeting and Proxy Statement dated March 21, 1994, which meeting involves the election of directors, in accordance with General Instruction G to the Annual Report on Form 10-K. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: PAGE 1. Financial Statements: Report of Independent Accountants--------------------------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991------------ 32 Consolidated Balance Sheet -- December 31, 1993 and 1992------------------------------------------ 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991---------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991------ 35 Notes to Consolidated Financial Statements------------ 36 2. Financial Statement Schedules: Schedule V -- Property, Plant and Equipment--------- 65 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment---------------- 66 Schedule VIII -- Valuation and Qualifying Accounts---- 67 Schedule IX -- Short Term Borrowings------------------ 68 Schedule X -- Supplementary Income Statement Information------------------------ 69 All other schedules have been omitted because they are not applicable or the required information is presented in the financial statements or the notes to financial statements. 3. Exhibits: See Index to Exhibits on page 70 for a description of the exhibits filed as a part of this report. (b) Reports on Form 8-K [CAPTION] DATE ITEM February 8, 1994 5 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Santa Fe Energy Resources, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 30 present fairly, in all material respects, the financial position of Santa Fe Energy Resources, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Houston, Texas February 18, 1994 SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF OPERATIONS (IN MILLIONS OF DOLLARS, EXCEPT PER SHARE DATA) YEAR ENDED DECEMBER 31, 1993 1992 1991 Revenues Crude oil and liquids------------ $ 307.3 $ 333.6 $ 320.3 Natural gas---------------------- 107.8 74.8 47.9 Natural gas systems-------------- 8.2 7.3 -- Crude oil marketing and trading------------------------ 9.9 5.9 7.2 Other---------------------------- 3.7 5.9 4.4 436.9 427.5 379.8 Costs and Expenses Production and operating--------- 163.8 153.4 134.6 Oil and gas systems and pipelines---------------------- 4.2 3.2 -- Exploration, including dry hole costs-------------------------- 31.0 25.5 18.7 Depletion, depreciation and amortization------------------- 152.7 146.3 106.6 Impairment of oil and gas properties--------------------- 99.3 -- -- General and administrative------- 32.3 30.9 27.8 Taxes (other than income)-------- 27.3 24.3 27.2 Restructuring charges------------ 38.6 -- -- Loss (gain) on disposition of oil and gas properties------------- 0.7 (13.6) 0.5 549.9 370.0 315.4 Income (Loss) from Operations-------- (113.0) 57.5 64.4 Interest income------------------ 9.1 2.3 2.3 Interest expense----------------- (45.8) (55.6) (47.3) Interest capitalized------------- 4.3 4.9 7.7 Other income (expense)----------- (4.8) (10.0) 5.6 Income (Loss) Before Income Taxes---- (150.2) (0.9) 32.7 Income taxes--------------------- 73.1 (0.5) (14.2) Net Income (Loss)-------------------- (77.1) (1.4) 18.5 Preferred dividend requirement------- (7.0) (4.3) -- Earnings (Loss) Attributable to Common Shares---------------------- $ (84.1) $ (5.7) $ 18.5 Earnings (Loss) Attributable to Common Shares Per Share------------ $ (0.94) $ (0.07) $ 0.29 Weighted Average Number of Shares Outstanding (in millions)---------- 89.7 79.0 63.8 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED BALANCE SHEET (IN MILLIONS OF DOLLARS) DECEMBER 31, 1993 1992 ASSETS Current Assets Cash and cash equivalents-------- $ 4.8 $ 83.8 Accounts receivable-------------- 87.4 90.0 Income tax refund receivable----- -- 16.2 Inventories---------------------- 8.7 4.8 Assets held for sale------------- 59.5 -- Other current assets------------- 12.2 10.6 172.6 205.4 Investment in Hadson Corporation----- 56.2 -- Properties and Equipment, at cost Oil and gas (on the basis of successful efforts accounting)-------------------- 2,064.3 2,330.9 Other---------------------------- 27.3 26.8 2,091.6 2,357.7 Accumulated depletion, depreciation, amortization and impairment--------------------- (1,258.9) (1,255.9) 832.7 1,101.8 Other Assets Receivable under gas balancing arrangements------------------- 3.9 7.7 Other---------------------------- 11.5 22.3 15.4 30.0 $ 1,076.9 $ 1,337.2 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable----------------- $ 93.5 $ 90.9 Interest payable----------------- 10.2 11.0 Current portion of long-term debt--------------------------- 44.3 53.4 Other current liabilities-------- 18.1 17.1 166.1 172.4 Long-Term Debt----------------------- 405.4 492.8 Deferred Revenues-------------------- 8.6 13.0 Other Long-Term Obligations---------- 48.8 43.4 Deferred Income Taxes---------------- 44.4 119.0 Commitments and Contingencies (Note 12)-------------------------------- -- -- Convertible Preferred Stock, $0.01 par value, 5.0 million shares authorized, issued and outstanding------------------------ 80.0 80.0 Shareholders' Equity Preferred stock, $0.01 par value, 45.0 million shares authorized, none issued-------------------- -- -- Common stock, $0.01 par value, 200.0 million shares authorized--------------------- 0.9 0.9 Paid-in capital------------------ 496.9 494.3 Unamortized restricted stock awards------------------------- (0.1) (0.4) Accumulated deficit-------------- (173.8) (78.0) Foreign currency translation adjustment--------------------- (0.3) (0.2) 323.6 416.6 $ 1,076.9 $ 1,337.2 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Operating Activities: Net income (loss)---------------- $ (77.1) $ (1.4) $ 18.5 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depletion, depreciation and amortization--------------- 152.7 146.3 106.6 Impairment of oil and gas properties----------------- 99.3 -- -- Restructuring charges-------- 27.8 -- -- Deferred income taxes-------- (71.9) (6.3) 1.5 Net loss (gain) on disposition of properties----------------- 0.7 (13.6) (5.5) Exploratory dry hole costs---------------------- 8.9 4.7 3.8 Expenses related to acquisition of Adobe Resources Corporation------ -- 10.9 -- Other------------------------ 4.2 2.0 0.3 Changes in operating assets and liabilities: Decrease (increase) in accounts receivable-------- 12.4 (8.3) 23.6 Decrease (increase) in inventories---------------- (3.8) 0.3 5.6 Increase (decrease) in accounts payable----------- (2.6) 5.9 (24.9) Increase (decrease) in interest payable----------- (0.8) 0.4 0.2 Decrease in income taxes payable-------------------- (0.6) (0.4) (3.6) Net change in other assets and liabilities------------ 11.0 1.0 2.3 Net Cash Provided by Operating Activities------------------------- 160.2 141.5 128.4 Investing Activities: Capital expenditures, including exploratory dry hole costs----- (127.0) (76.8) (108.1) Acquisitions of producing properties, net of related debt--------------------------- (4.4) (14.2) (28.5) Acquisition of Adobe Resources Corporation-------------------- -- (11.9) -- Acquisition of Santa Fe Energy Partners, L.P.----------------- (28.3) -- -- Net proceeds from sales of properties--------------------- 39.9 89.1 22.1 Increase in partnership interest due to reinvestment------------ (1.6) (2.1) (2.7) Net Cash Used in Investing Activities------------------------- (121.4) (15.9) (117.2) Financing Activities: Net change in short-term debt---- -- (4.6) (4.2) Proceeds from long-term borrowings--------------------- -- 5.0 -- Principal payments on long-term borrowings--------------------- (41.5) (55.5) (16.3) Net change in revolving credit agreement---------------------- (55.0) -- -- Cash dividends paid to others---- (21.3) (14.9) (10.2) Net Cash Used in Financing Activities------------------------- (117.8) (70.0) (30.7) Net Increase (Decrease) in Cash and Cash Equivalents------------------- (79.0) 55.6 (19.5) Cash and Cash Equivalents at Beginning of Year------------------ 83.8 28.2 47.7 Cash and Cash Equivalents at End of Year------------------------------- $ 4.8 $ 83.8 $ 28.2 The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements of Santa Fe Energy Resources, Inc. ('Santa Fe' or the 'Company') and its subsidiaries include the accounts of all wholly owned subsidiaries. The accounts of Santa Fe Energy Partners, L.P., (the 'Partnership') are included on a proportional basis until September 1993 when Santa Fe purchased all the Partnership's outstanding Depositary Units and undeposited LP Units other than those units held by Santa Fe and its affiliates. On September 27, 1993 the Company exercised its right under the Agreement of Limited Partnership to purchase all of the Partnership's outstanding Depositary Units and undeposited LP Units, other than those units held by the Company and its affiliates, at a redemption price of $4.9225 per unit. Consideration for the 5,749,500 outstanding units totalled $28.3 million. The acquisition of the units has been accounted for as a purchase and the results of operations of the Partnership attributable to the units acquired is included in the Company's results of operations with effect from October 1, 1993. The purchase price has been allocated primarily to oil and gas properties. References herein to the 'Company' or 'Santa Fe' relate to Santa Fe Energy Resources, Inc., individually or together with its consolidated subsidiaries; references to the 'Partnership' relate to Santa Fe Energy Partners, L.P. All significant intercompany accounts and transactions have been eliminated. Prior years' financial statements include certain reclassifications to conform to current year's presentation. OIL AND GAS OPERATIONS The Company follows the successful efforts method of accounting for its oil and gas exploration and production activities. Costs (both tangible and intangible) of productive wells and development dry holes, as well as the cost of prospective acreage, are capitalized. The costs of drilling and equipping exploratory wells which do not find proved reserves are expensed upon determination that the well does not justify commercial development. Other exploratory costs, including geological and geophysical costs and delay rentals, are charged to expense as incurred. Depletion and depreciation of proved properties are computed on an individual field basis using the unit-of-production method based upon proved oil and gas reserves attributable to the field. Certain other oil and gas properties are depreciated on a straight-line basis. Individual proved properties are reviewed periodically to determine if the carrying value of the field exceeds the estimated undiscounted future net revenues from proved oil and gas reserves attributable to the field. Based on this review and the continuing evaluation of development plans, economics and other factors, if appropriate, the Company records impairments (additional depletion and depreciation) to the extent that the carrying value exceeds the estimated undiscounted future net revenues. Such impairments totaled $99.3 million in 1993 and there were none in 1992 and 1991. The Company provides for future abandonment and site restoration costs with respect to certain of its oil and gas properties. The Company estimates that with respect to these properties such future costs total approximately $24.7 million and such amount is being accrued over the expected life of the properties. At December 31, 1993 Accumulated Depletion, Depreciation, Amortization and Impairment includes $14.6 million with respect to such costs. The value of undeveloped acreage is aggregated and the portion of such costs estimated to be nonproductive, based on historical experience, is amortized to expense over the average holding period. Additional amortization may be recognized based upon periodic assessment of prospect evaluation results. The cost of properties determined to be productive is transferred to proved SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) properties; the cost of properties determined to be nonproductive is charged to accumulated amortization. Maintenance and repairs are expensed as incurred; major renewals and improvements are capitalized. Gains and losses arising from sales of properties are included in income currently. REVENUE RECOGNITION Revenues from the sale of petroleum produced are generally recognized upon the passage of title, net of royalties and net profits interests. Crude oil revenues include the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Crude Oil Hedging Program. Crude oil revenues also include the value of crude oil consumed in operations with an equal amount charged to operating expenses. Such amounts totalled $15.4 million in 1991, $4.8 million in 1992 and $1.2 million in 1993. Revenues from natural gas production are generally recorded using the entitlement method, net of royalties and net profits interests. Sales proceeds in excess of the Company's entitlement are included in Deferred Revenues and the Company's share of sales taken by others is included in Other Assets. At December 31, 1993 the Company's deferred revenues for sales proceeds received in excess of the Company's entitlement was $6.8 million with respect to 5.2 MMcf and the asset related to the Company's share of sales taken by others was $3.9 million with respect to 2.7 MMcf. Natural gas revenues are net of the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Program. Revenues from crude oil marketing and trading represent the gross margin resulting from such activities. Revenues from such activities are net of costs of sales of $210.5 million in 1991, $247.3 million in 1992 and $225.9 million in 1993. Revenues from natural gas systems are net of the cost of natural gas purchased and resold. Such costs totalled $43.8 million in 1992 and $49.9 million in 1993. EARNINGS PER SHARE Earnings per share are based on the weighted average number of common shares outstanding during the year. ACCOUNTS RECEIVABLE Accounts Receivable relates primarily to sales of oil and gas and amounts due from joint interest partners for expenditures made by the Company on behalf of such partners. The Company reviews the financial condition of potential purchasers and partners prior to signing sales or joint interest agreements. At December 31, 1993 and 1992 the Company's allowance for doubtful accounts receivable, which is reflected in the consolidated balance sheet as a reduction in accounts receivable, totaled $6.3 million and $5.0 million, respectively. Accounts receivable totalling $0.2 million, $1.1 million and $0.1 million were written off as uncollectible in 1991, 1992 and 1993, respectively. INVENTORIES Inventories are valued at the lower of cost (average price or first-in, first-out) or market. Crude oil inventories at December 31, 1993 and 1992 were $1.1 million and $1.5 million, respectively, and materials and supplies inventories at such dates were $7.6 million and $3.3 million, respectively. ENVIRONMENTAL EXPENDITURES Environmental expenditures relating to current operations are expensed or capitalized, as appropriate, depending on whether such expenditures provide future economic benefits. Liabilities are SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) recognized when the expenditures are considered probable and can be reasonably estimated. Measurement of liabilities is based on currently enacted laws and regulations, existing technology and undiscounted site-specific costs. Generally, such recognition coincides with the Company's commitment to a formal plan of action. INCOME TAXES The Company follows the asset and liability approach to accounting for income taxes. Deferred tax assets and liabilities are determined using the tax rate for the period in which those amounts are expected to be received or paid, based on a scheduling of temporary differences between the tax bases of assets and liabilities and their reported amounts. Under this method of accounting for income taxes, any future changes in income tax rates will affect deferred income tax balances and financial results. (2) CORPORATE RESTRUCTURING PROGRAM In October 1993 the Company's Board of Directors endorsed a broad corporate restructuring program that focuses on the disposition of non-core assets, the concentration of capital spending in core areas, the refinancing of certain long-term debt and the elimination of the payment of its $0.04 per share quarterly dividend on common stock. In implementing the restructuring program the Company recorded a nonrecurring charge of $38.6 million in 1993 comprised of (1) losses on property dispositions of $27.8 million: (2) long-term debt repayment penalties of $8.6 million; and (3) accruals for certain personnel benefits and related costs of $2.2 million. The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson Corporation ('Hadson'), the sale to Vintage Petroleum, Inc. of certain southern California and Gulf Coast oil and gas producing properties and the sale to Bridge Oil (U.S.A.) Inc. ('Bridge') of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage. The Company also plans to dispose of other non-core oil and gas properties during 1994. In 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. SALE TO HADSON. In December 1993 the Company completed a transaction with Hadson under the terms of which the Company sold the common stock of Adobe Gas Pipeline Company ('AGPC'), a wholly-owned subsidiary which held the Company's natural gas gathering and processing assets, to Hadson in exchange for Hadson 11.25% preferred stock with a face value of $52.0 million and 40% of Hadson's common stock. In addition, the Company signed a seven-year gas sales contract under the terms of which Hadson will market substantially all of the Company's domestic natural gas production at market prices as defined by published monthly indices for relevant production locations. The Company accounted for the sale as a non-monetary transaction and the investment in Hadson has been valued at $56.2 million, the carrying value of the Company's investment in AGPC. The Company's investment in Hadson is being accounted for on the equity basis. At December 31, 1993 the Company's investment in Hadson's common stock exceeded the net book value attributable to such common shares by approximately $11.3 million. The Company's income from operations for 1993 includes $1.6 million attributable to the assets sold to Hadson. SALE TO VINTAGE. In November 1993 the Company completed the sale of certain southern California and Gulf Coast producing properties for net proceeds totalling $41.3 million in cash, $31.5 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) million of which was collected in 1993. The Company's income from operations for 1993 includes $2.7 million attributable to the assets sold to Vintage. SALE TO BRIDGE. In December 1993 the Company signed a Purchase and Sales Agreement with Bridge under the terms of which Bridge will purchase certain Mid-Continent and Rocky Mountain producing and nonproducing oil and gas properties. The sale price of $51.0 million, subject to certain adjustments, will be received by the Company either in the form of cash plus 10% of the outstanding shares of Bridge, following the contemplated public offering of that stock in the first quarter of 1994, or entirely in cash. The transaction is expected to close in the second quarter of 1994. The net book value of these assets is included in Assets Held for Sale at December 31, 1993. The Company's income from operations for 1993 includes $5.8 million attributable to the assets to be sold to Bridge. OTHER DISPOSITIONS. The Company has identified certain other oil and gas properties which it plans to dispose of in 1994. The estimated realizable value of these properties, $1.0 million, is included in Assets Held for Sale at December 31, 1993. In the first quarter of 1994 the Company sold its interest in certain other oil and gas properties for $8.3 million. (3) MERGER WITH ADOBE RESOURCES CORPORATION On May 19, 1992 Adobe Resources Corporation ('Adobe'), an oil and gas exploration and production company, was merged with and into Santa Fe (the 'Merger'). The acquisition has been accounted for as a purchase and the results of operations of the properties acquired (the 'Adobe Properties') are included in Santa Fe's results of operations effective June 1, 1992. To consummate the Merger, the Company issued 24.9 million shares of common stock valued at $205.5 million, 5.0 million shares of convertible preferred stock valued at $80.0 million, assumed long-term bank debt and other liabilities of $140.0 million and $35.0 million, respectively, and incurred $13.8 million in related costs. The Company also recorded a $19.7 million deferred tax liability with respect to the difference between the book and tax basis in the assets acquired. Certain merger-related costs incurred by Adobe and paid by Santa Fe totaling $10.9 million were charged to income in the second quarter of 1992. The Merger constituted a 'change of control' as defined in certain of the Company's employee benefit plans and employment agreements (see Notes 10 and 12). In a separate transaction in January 1992, the Company purchased three producing properties from Adobe for $14.2 million. (4) SANTA FE ENERGY TRUST In November 1992 5,725,000 Depository Units ('Trust Units'), each consisting of beneficial ownership of one unit of undivided beneficial interest in the Santa Fe Energy Trust (the 'Trust') and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation maturing on or about February 15, 2008, were sold in a public offering. The Trust consists of certain oil and gas properties conveyed by Santa Fe. A total of $114.5 million was received from public investors, of which $38.7 million was used to purchase the Treasury obligations and $5.7 million was used to pay underwriting commissions and discounts. Santa Fe received the remaining $70.1 million and 575,000 Trust Units. A portion of the proceeds received by the Company was used to retire $30.0 million of the debt incurred in connection with the Merger and the remainder will be used for general corporate purposes including possible acquisitions. For any calendar quarter ending on or prior to December 31, 2002, the Trust will receive additional royalty payments to the extent that it needs such payments to distribute $0.40 per SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Depository Unit per quarter. The source of such additional royalty payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. If such additional payments are made, certain proceeds otherwise payable to the Trust in subsequent quarters may be reduced to recoup the amount of such additional payments. The aggregate amount of the additional royalty payments (net of any amounts recouped) will be limited to $20.0 million on a revolving basis. At December 31, 1993 the Company held 575,000 Trust Units. At December 31, 1993 Accounts Receivable includes $0.2 million due from the Trust and Accounts Payable includes $1.9 million due to the Trust. In the first quarter of 1994 the Company sold the Trust Units for $11.3 million, the Company's investment in the Trust Units, $10.4 million, is included in Assets Held for Sale at December 31, 1993. (5) ACQUISITIONS OF OIL AND GAS PROPERTIES In January 1991 the Company completed the purchase of Mission Operating Partnership, L.P.'s ('Mission') interest in certain oil and gas properties, effective from November 1, 1990, for approximately $55.0 million. The Company formed a partnership, with an institutional investor as a limited partner, to acquire and operate the properties. The investor contributed $27.5 million for a 50% interest in the partnership, which will be reduced to 15% upon the occurence of payout. Payout will occur when the investor has received distributions from the partnership totalling an amount equal to its original contribution plus a 12% rate of return on such contribution. Prior to payout, the Company will bear 100% of the capital expenditures of the partnership. Under the terms of the partnership agreement a total of $36.8 million must be expended on development of the property by the year 2000, $12.4 million of which had been expended through the end of 1993. The Company funded $16.8 million of its share of the purchase of the properties with the assumption of a term loan and paid the remainder from working capital. The Company has given the lender the equivalent of an overriding royalty interest in certain production from the properties. The royalty is payable only if such production occurs and is limited to a maximum of $3.0 million. In June 1991 the Company acquired a 10% interest in a producing field in Argentina for approximately $18.3 million and in October 1991 purchased an additional 8% interest in the field for approximately $15.7 million. The Company financed $17.8 million of the total purchase price with loans from an Argentine bank. The Company has agreed to spend approximately $16.7 million over a five-year period on development and maintenance of the field. (6) CASH FLOWS The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The Merger included certain non-cash investing and financing activities not reflected in the Statement of Cash Flows as follows (in millions of dollars): Common stock issued------------------ 205.5 Convertible preferred stock issued------------------------------- 80.0 Deferred tax liability--------------- 19.7 Long-term debt----------------------- 140.0 Assets acquired, other than cash, net of liabilities assumed------------- (457.1) Cash paid---------------------------- (11.9) In 1991, the Company sold a producing property for $0.9 million in cash and a note receivable for $1.2 million. In 1991, the Partnership purchased certain surface properties for $6.2 million, SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $5.5 million of which was funded by the issuance of promissory notes and the Company also purchased producing properties for $63.1 million, $34.6 million of which was funded with debt (see Notes 5 and 7). The Company made interest payments of $45.5 million, $49.0 million and $48.0 million in 1991, 1992 and 1993, respectively. In 1991, 1992 and 1993, the Company made tax payments of $18.4 million, $4.4 million and $5.0 million, respectively, and in 1993 received refunds of $4.1 million, primarily related to the audit of prior years' returns. (7) FINANCING AND DEBT Long-term debt at December 31, 1993 and 1992 consisted of (in millions of dollars): Crude oil and liquids and natural gas accounted for more than 95% of revenues in 1991, 1992 and 1993. The following table reflects sales revenues from crude oil purchasers who accounted for more than 10% of the Company's crude oil and liquids revenues (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Texaco Trading and Transportation, Inc-------------------------------- -- 46.8 55.9 Celeron Corporation------------------ 56.8 56.3 45.6 Shell Oil Company-------------------- 86.3 -- -- None of the Company's purchasers of natural gas accounted for more than 10% of revenues in 1991, 1992 or 1993. The Company does not believe the loss of any purchaser would have a material adverse effect on its financial position since the Company believes alternative sales arrangements could be made on relatively comparable terms. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (9) CONVERTIBLE PREFERRED STOCK The convertible preferred stock issued in connection with the Merger is non-voting and entitled to receive cumulative cash dividends at an annual rate equivalent to $1.40 per share. The holders of the convertible preferred shares may, at their option, convert any or all such shares into 1.3913 shares of the Company's common stock. The Company may, at any time after the fifth anniversary of the effective date of the Merger and upon the occurrence of a 'Special Conversion Event', convert all outstanding shares of convertible preferred stock into common stock at the initial conversion rate of 1.3913 shares of common stock, subject to certain adjustments, plus additional shares in respect to accrued and unpaid dividends. A Special Conversion Event is deemed to have occurred when the average daily closing price for a share of the Company's common stock for 20 of 30 consecutive trading days equals or exceeds 125% of the quotient of $20.00 divided by the then applicable conversion rate (approximately $18.00 per share at a conversion rate of 1.3913). Upon the occurrence of the 'First Ownership Change' of Santa Fe, each holder of shares of convertible preferred stock shall have the right, at the holder's option, to elect to have all of such holder's shares redeemed for $20.00 per share plus accrued and unpaid interest and dividends. The First Ownership Change shall be deemed to have occurred when any person or group, together with any affiliates or associates, becomes the beneficial owner of 50% or more of the outstanding common stock of Santa Fe. (10) SHAREHOLDERS' EQUITY COMMON STOCK In 1991, 1992 and 1993 the Company issued 1.1 million previously unissued shares of common stock in connection with certain employee benefit and compensation plans. Also in 1992, the Company issued 24.9 million previously unissued shares of common stock in connection with the Merger. The Company declared dividends to common shares of $0.16 per share in 1991 and 1992 and $0.12 per share in 1993. PREFERRED STOCK The Board of Directors of the Company is empowered, without approval of the shareholders, to cause shares of preferred stock to be issued in one or more series, and to determine the number of shares in each series and the rights, preferences and limitations of each series. Among the specific matters which may be determined by the Board of Directors are: the annual rate of dividends; the redemption price, if any; the terms of a sinking or purchase fund, if any; the amount payable in the event of any voluntary liquidation, dissolution or winding up of the affairs of the Company; conversion rights, if any; and voting powers, if any. ACCUMULATED DEFICIT At December 31, 1993 Accumulated Deficit included dividends in excess of retained earnings of $89.8 million. 1990 INCENTIVE STOCK COMPENSATION PLAN The Company has adopted the Santa Fe Energy Resources 1990 Incentive Stock Compensation Plan (the 'Plan') under the terms of which the Company may grant options and awards with respect to no more than 5,000,000 shares of common stock to officers and key employees. Options granted in 1991 and prior are fully vested and expire in 2000. Options granted in 1992 have a ten year term and vest as to 33.33 percent one year after grant, as to a cumulative 66.67 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) percent two years after grant and as to the entire amount three years after grant. The options granted in 1993 have a ten year term and vest as to 50 percent 5 years after grant, as to a cumulative 75 percent 6 years after grant and as to the entire amount 7 years after grant. The options are exercisable on an accelerated basis beginning one year and ending three years after grant in certain circumstances. If the market value per share of the Company's common stock (sustained in all events for at least 60 days) exceeds $15, 25 percent of the options shall become exercisable; in the event the market value per share exceeds $20, 50 percent of the options shall become exercisable; and in the event the market value exceeds $25, 100 percent shall become exercisable. Unexercised options would be forfeited in the event of voluntary or involuntary termination. Vested options are exercisable for a period of one year following termination due to death, disability or retirement. In the event of termination by the Company for any reason there is no prorata vesting of unvested options. The following table reflects activity with respect to Non-Qualified Stock Options during 1991 through 1993: OPTION OPTIONS PRICE OUTSTANDING PER SHARE Outstanding at December 31, 1990----- 1,803,923 $14.4375 to $24.24 Grants------------------------------- 4,500 $14.625 Cancellations------------------------ (45,332) $14.4375 to $24.24 Outstanding at December 31, 1991----- 1,763,091 $14.4375 to $24.24 Grants------------------------------- 1,099,000 $ 9.5625 Cancellations------------------------ (50,163) $14.4375 to $24.24 Outstanding at December 31, 1992----- 2,811,928 $ 9.5625 to $24.24 Grants------------------------------- 800,000 $ 9.5625 Cancellations------------------------ (95,398) $ 9.5625 to $24.24 Exercises---------------------------- (6,945) $ 9.5625 Outstanding at December 31, 1993----- 3,509,585 $ 9.5625 to $24.24 At December 31, 1993 options on 780,790 shares were available for future grants. A 'Phantom Unit' is the right to receive a cash payment in an amount equal to the average trading price of the shares of common stock at the time the award becomes payable. Awards are made for a specified period and are dependent upon continued employment and the achievement of performance objectives established by the Company. In December 1990 the Company awarded 211,362 Phantom Units and in December 1991 313,262 shares of restricted stock were issued in exchange for such units. Compensation expense is recognized over the period the awards are earned based on the market price of the restricted stock on the date it was issued ($8.00 per share). During 1990 and 1991 $0.2 million and $0.8 million, respectively, were charged to expense with respect to such awards. The unamortized portion of the award at December 31, 1991 ($1.4 million) was reflected in Shareholders' Equity. The consummation of the Merger resulted in a 'change of control' as defined in the Plan and resulted in the vesting of the awards and $1.4 million in compensation expense was recognized in 1992. In 1993 the Company issued 6,432 shares of restricted stock to certain employees and 118,039 common shares in accordance with the terms of certain other employee compensation plans. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (11) PENSION AND OTHER EMPLOYEE BENEFIT PLANS PENSION PLANS Prior to the Spin-Off the Company was included in certain non-contributory pension plans of SFP. The Santa Fe Pacific Corporation Retirement Plan (the 'SFP Plan') covered substantially all of the Company's officers and salaried employees who were not covered by collective bargaining agreements. The Santa Fe Pacific Corporation Supplemental Retirement Plan was an unfunded plan which provided supplementary benefits, primarily to senior management personnel. The Company adopted, effective as of the date of the Spin-Off, a defined benefit retirement plan (the 'SFER Plan') covering substantially all salaried employees not covered by collective bargaining agreements and a nonqualified supplemental retirement plan (the 'Supplemental Plan'). The Supplemental Plan will pay benefits to participants in the SFER Plan in those instances where the SFER Plan formula produces a benefit in excess of limits established by ERISA and the Tax Reform Act of 1986. Benefits payable under the SFER Plan are based on years of service and compensation during the five highest paid years of service during the ten years immediately preceding retirement. Benefits accruing to the Company's employees under the SFP Plan have been assumed by the SFER Plan. The Company's funding policy is to contribute annually not less than the minimum required by ERISA and not more than the maximum amount deductible for income tax purposes. In the fourth quarter of 1993 the Company established a new pension plan with respect to certain persons employed in foreign locations. The following table sets forth the funded status of the SFER Plan and the Supplemental Plan at December 31, 1993 and 1992 (in millions of dollars): SFER PLAN SUPPLEMENTAL PLAN 1993 1992 1993 1992 Plan assets at fair value, primarily invested in common stocks and U.S. and corporate bonds---------------- 30.2 28.9 -- -- Actuarial present value of projected benefit obligations: Accumulated benefit obligations Vested----------------------- (30.9) (24.5) (0.6) (0.5) Nonvested-------------------- (1.5) (1.4) -- -- Effect of projected future salary increases----------- (8.3) (6.4) (0.3) (0.2) Excess of projected benefit obligation over plan assets-------- (10.5) (3.4) (0.9) (0.7) Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions------------------------ 6.4 0.7 0.3 0.2 Unrecognized net (asset) obligation being recognized over plan's average remaining service life----- (1.0) (1.1) 0.2 0.3 Additional minimum liability--------- -- -- (0.3) (0.3) Accrued pension liability------------ (5.1) (3.8) (0.7) (0.5) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% 7.0% 8.25% Long-term asset yield------------ 9.5% 9.5% 9.5% 9.5% Rate of increase in future compensation------------------- 5.25% 5.25% 5.25% 5.25% SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the components of pension expense for the SFER Plan and Supplemental Plan for 1993, 1992 and 1991 (in millions of dollars): The Company also sponsors a pension plan covering certain hourly-rated employees in California (the 'Hourly Plan'). The Hourly Plan provides benefits that are based on a stated amount for each year of service. The Company annually contributes amounts which are actuarially determined to provide the Hourly Plan with sufficient assets to meet future benefit payment requirements. The following table sets forth the components of pension expense for the Hourly Plan for the years 1993, 1992 and 1991 (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Service cost--------------------- 0.2 0.2 0.2 Interest cost-------------------- 0.7 0.7 0.7 Return on plan assets------------ (0.8) (0.1) (0.5) Net amortization and deferral---- 0.4 (0.4) 0.1 0.5 0.4 0.5 The following table sets forth the funded status of the Hourly Plan at December 31, 1993 and 1992 (in millions of dollars): 1993 1992 Plan assets at fair value, primarily invested in fixed-rate securities---- 7.7 7.2 Actual present value of projected benefit obligations Accumulated benefit obligations Vested----------------------- (11.2) (9.1) Nonvested-------------------- (0.4) (0.3) Excess of projected benefit obligation over plan assets-------- (3.9) (2.2) Unrecognized net (gain) loss from past experience different from that assumed and effects of changes in assumptions------------------------ 1.5 (0.3) Unrecognized prior service cost------ 0.5 0.6 Unrecognized net obligation---------- 1.5 1.6 Additional minimum liability--------- (3.5) (2.1) Accrued pension liability-------- (3.9) (2.4) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% Expected long-term rate of return on plan assets----------------- 8.5% 8.5% At December 31, 1993 the Company's additional minimum liability exceeded the total of its unrecognized prior service cost and unrecognized net obligation by $1.5 million. Accordingly, at December 31, 1993 the Company's retained earnings have been reduced by such amount, net of related taxes of $0.6 million. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides health care and life insurance benefits for substantially all employees who retire under the provisions of a Company-sponsored retirement plan and their dependents. Participation in the plans is voluntary and requires a monthly contribution by the employee. Effective January 1, 1993 the Company adopted the provisions of SFAS No. 106 -- 'Employers' Accounting for Postretirement Benefits Other Than Pensions'. The Statement requires the accrual, during the years the employee renders service, of the expected cost of providing postretirement benefits to the employee and the employee's beneficiaries and covered dependents. The following table sets forth the plan's funded status at December 31, 1993 and January 1, 1993 (in millions of dollars): DECEMBER 31, JANUARY 1, 1993 1993 Plan assets, at fair value----------- -- -- Accumulated postretirement benefit obligation Retirees--------------------------- (3.6) (3.1) Eligible active participants------- (1.2) (0.9) Other active participants---------- (1.4) (1.2) Accumulated postretirement benefit obligation in excess of plan assets----------------------------- (6.2) (5.2) Unrecognized transition obligation------------------------- 5.0 5.2 Unrecognized net loss from past experience different from that assumed and from changes in assumptions------------------------ 0.5 -- Accrued postretirement benefit cost------------------------------- (0.7) -- Assumed discount rate---------------- 7.5% 8.25% Assumed rate of compensation increase--------------------------- 5.25% 5.25% The Company's net periodic postretirement benefit cost for 1993 includes the following components (in millions of dollars): Service costs---------------------------------------- 0.3 Interest costs--------------------------------------- 0.4 Amortization of unrecognized transition obligation----------------------------------------- 0.3 1.0 In periods prior to 1993 the cost to the Company of providing health care and life insurance benefits for qualified retired employees was recognized as expenses when claims were paid. Such amounts totalled $0.4 million in 1991 and $0.3 million in 1992. Estimated costs and liabilities have been developed assuming trend rates for growth in future health care costs beginning with 10% for 1993 graded to 6% (5.5% for post age 65) by the year 2000 and remaining constant thereafter. Increasing the assumed health care cost trend rate by one percent each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $0.9 million and the aggregate of the service cost and interest cost components of the net periodic postretirement benefit cost for 1994 by $0.2 million. SAVINGS PLAN The Company has a savings plan, which became effective November 1, 1990, available to substantially all salaried employees and intended to qualify as a deferred compensation plan under Section 401(k) of the Internal Revenue Code (the '401(k) Plan'). The Company will match employee contributions for an amount up to 4% of each employee's base salary. In addition, if at the end of each SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) fiscal year the Company's performance for such year has exceeded certain predetermined criteria, each participant will receive an additional matching contribution equal to 50% of the regular matching contribution. The Company's contributions to the 401(k) Plan, which are charged to expense, totaled $1.2 million in 1991, $1.3 million in 1992 and $1.5 million in 1993. In the fourth quarter of 1993 the Company established a new savings plan with respect to certain personnel employed in foreign locations. OTHER POSTEMPLOYMENT BENEFITS In the fourth quarter of 1993 the Company adopted SFAS No. 112 -- 'Employers' Accounting for Postemployment Benefits'. The Statement requires the accrual of the estimated costs of benefits provided by an employer to former or inactive employees after employment but before retirement. Such benefits include salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits, job training and counseling and continuation of benefits such as health care and life insurance coverage. The adoption of SFAS No. 112 resulted in a charge to earnings of $1.8 million in 1993. (12) COMMITMENTS AND CONTINGENCIES CRUDE OIL HEDGING PROGRAM In the third quarter of 1990, the Company initiated a hedging program designed to provide a certain minimum level of cash flow from its sales of crude oil. Settlements were included in oil revenues in the period the oil is sold. In the year ended December 31, 1990 hedges resulted in a reduction in oil revenues of $10.7 million; in 1991 hedges resulted in an increase in oil revenues of $41.7 million and in 1992 hedges resulted in an increase in oil revenues of $9.7 million. The Company had no open crude oil hedging contracts during 1993. NATURAL GAS HEDGING PROGRAM In the third quarter of 1992 the Company initiated a hedging program with respect to its sales of natural gas. The Company has used various instruments whereby monthly settlements are based on the differences between the price or range of prices specified in the instruments and the settlement price of certain natural gas futures contracts quoted on the New York Mercantile Exchange. In instances where the applicable settlement price is less than the price specified in the contract, the Company receives a settlement based on the difference; in instances where the applicable settlement price is higher than the specified prices the Company pays an amount based on the difference. The instruments utilized by the Company differ from futures contracts in that there is no contractual obligation which requires or allows for the future delivery of the product. In 1992 and 1993 hedges resulted in a reduction in natural gas revenues of $0.5 million and $8.2 million, respectively. At December 31, 1993 the Company had two open natural gas hedging contracts covering approximately 1.2 Bcf during the six month period beginning March 1994. The 'approximate break-even price' (the average of the monthly settlement prices of the applicable futures contracts which would result in no settlement being due to or from the Company) with respect to such contracts is approximately $1.82 per Mcf. In addition, certain parties hold options on contracts covering approximately 4.8 Bcf during the seven month period beginning March 1994 at an approximate break even price of $1.90 per Mcf. The Company has no other outstanding natural gas hedging instruments. INDEMNITY AGREEMENT WITH SFP At the time of the Spin-Off, the Company and SFP entered into an agreement to protect SFP from federal and state income taxes, penalties and interest that would be incurred by SFP if the Spin-off were determined to be a taxable event resulting primarily from actions taken by the Company during a one-year period that ended December 4, 1991. If the Company were required to make SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) payments pursuant to the agreement, such payments could have a material adverse effect on its financial condition; however, the Company does not believe that it took any actions during such one-year period that would have such an effect on the Spin-Off. ENVIRONMENTAL REGULATION Federal, state and local laws and regulations relating to environmental quality control affect the Company in all of its oil and gas operations. The Company has been identified as one of over 250 potentially responsible parties ('PRPs') at a superfund site in Los Angeles County, California. The site was operated by a third party as a waste disposal facility from 1948 until 1983. The Environmental Protection Agency ('EPA') is requiring the PRPs to undertake remediation of the site in several phases, which include site monitoring and leachate control, gas control and final remediation. In 1989, the EPA and a group of the PRPs entered into a consent decree covering the site monitoring and leachate control phases of remediation. The Company is a member of the group that is responsible for carrying out this first phase of work, which is expected to be completed in five to eight years. The maximum liability of the group, which is joint and several for each member of the group, for the first phase is $37.0 million, of which the Company's share is expected to be approximately $2.4 million ($1.3 million after recoveries from working interest participants in the unit at which the wastes were generated) payable over the period that the phase one work is performed. The EPA and a group of PRPs of which the Company is a member have also entered into a subsequent consent decree (which has not been finally entered by the court) with respect to the second phase of work (gas control). The liability of this group has not been capped, but is estimated to be $130.0 million. The Company's share of costs of this phase, however, is expected to be approximately of the same magnitude as that of the first phase because more parties are involved in the settlement. The Company has provided for costs with respect to the first two phases, but it cannot currently estimate the cost of any subsequent phases of work or final remediation which may be required by the EPA. In 1989, Adobe received requests from the EPA for information pursuant to Section 104(e) of CERCLA with respect to the D. L. Mud and Gulf Coast Vacuum Services superfund sites located in Abbeville, Louisiana. The EPA has issued its record of decision at the Gulf Coast Site and on February 9, 1993 the EPA issued to all PRP's at the site a settlement order pursuant to Section 122 of CERCLA. Earlier, an emergency order pursuant to Section 106 of CERLA was issued on December 11, 1992, for purposes of containment due to the Louisiana rainy season. On December 15, 1993 the Company entered into a sharing agreement with other PRP'S to participate in the final remediation of the Gulf Coast site. The Company's share of the remediation is approximately $600,000 and includes its proportionate share of those PRPs who do not have the financial resources to provide their share of the work at the site. A former site owner has already conducted remedial activities at the D. L. Mud Site under a state agency agreement. The extent, if any, of any further necessary remedial activity at the D. L. Mud Site has not been finally determined. EMPLOYMENT AGREEMENTS The Company has entered into employment agreements with certain key employees. The initial term of each agreement expired on December 31, 1990 and, on January 1, 1991 and beginning on each January 1 thereafter, is automatically extended for one-year periods, unless by September 30 of any year the Company gives notice that the agreement will not be extended. The term of the agreements is automatically extended for 24 months following a change of control. The consummation of the Merger constituted a change of control as defined in the agreements. In the event that following a change of control employment is terminated for reasons specified in the agreements, the employee would receive: (i) a lump sum payment equal to two years' base salary; (ii) the maximum possible bonus under the terms of the Company's incentive compensation plan; SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (iii) a lapse of restrictions on any outstanding restricted stock grants and full payout of any outstanding Phantom Units; (iv) cash payment for each outstanding stock option equal to the amount by which the fair market value of the common stock exceeds the exercise price of the option; and, (v) life, disability and health benefits for a period of up to two years. In addition, payments and benefits under certain employment agreements are subject to further limitations based on certain provisions of the Internal Revenue Code. INTEREST RATE SWAPS Prior to the Merger, Adobe had entered into two interest rate swaps with a bank with notional principal amounts of $15.0 mllion and $20.0 million. Under the terms of the $20.0 million swap, which expires in April 1994, during any quarterly period at the beginning of which a floating rate specified in the agreement is less than 7.84%, the Company must pay the bank interest for such period on the principal amount at the difference between the rates. Should the floating rate be in excess of 7.84%, the bank must pay the Company interest for such period on the principal amount at the difference between the rates. For the period from the effective date of the Merger to December 31, 1992 the amount due the bank in accordance with the terms of the $20.0 million swap totalled $0.6 million and the amount due the bank in 1993 totalled $0.9 million. For the quarterly period which ends in April 1994, the amount due the bank is based on a floating rate of 3.375%. The $15.0 million swap, which expired December 31, 1992, had terms similar to the $20.0 million swap and the amount due the bank for the period subsequent to the Merger totaled $0.5 million. OPERATING LEASES The Company has noncancellable agreements with terms ranging from one to ten years to lease office space and equipment. Minimum rental payments due under the terms of these agreements are: 1994 -- $6.1 million, 1995 -- $6.0 million, 1996 -- $5.5 million, 1997 -- $5.2 million, 1998 -- $4.4 million and $4.7 million thereafter. Rental payments made under the terms of noncancellable agreements totaled $4.0 million in 1991,$4.5 million in 1992 and $5.5 million in 1993. OTHER MATTERS The Company has several long-term contracts ranging up to fifteen years for the supply and transportation of approximately 30 million cubic feet per day of natural gas. In the aggregate, these contracts involve a minimum commitment on the part of the Company of approximately $10 million per year. There are other claims and actions, including certain other environmental matters, pending against the Company. In the opinion of management, the amounts, if any, which may be awarded in connection with any of these claims and actions could be significant to the results of operations of any period but would not be material to the Company's consolidated financial position. (13) INCOME TAXES Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109 -- 'Accounting for Income Taxes'. The adoption of SFAS No. 109 had no significant impact on the Company's provision for income taxes. Through the date of the Spin-Off the taxable income or loss of the Company was included in the consolidated federal income tax return filed by SFP. The Company has filed separate consolidated federal income tax returns for periods subsequent to the Spin-Off. The consolidated federal income tax returns of SFP have been examined through 1988 and all years prior to 1981 are closed. Issues relating to the years 1981 through 1985 are being contested through various stages of administrative appeal. The Company is evaluating its position with respect to issues raised in a 1986 through 1988 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) audit. The Company believes adequate provision has been made for any adjustments which might be assessed for all open years. During 1989, the Company received a notice of deficiency for certain state franchise tax returns filed for the years 1978 through 1983 as part of the consolidated tax returns of SFP. The years subsequent to 1983 are still subject to audit. At December 31, 1993 Other Long-Term Obligations includes $20.6 million with respect to this matter. The Company intends to contest this matter. With the Merger of Adobe the Company succeeded to a net operating loss carryforward that is subject to Internal Revenue Code Section 382 limitations which annually limit taxable income that can be offset by such losses. Certain changes in the Company's shareholders may impose additional limitations as well. Losses carrying forward of $133.3 million expire beginning in 1998. At date of the Merger, Adobe had ongoing tax litigation related to a refund claim for carryback of certain net operating losses denied by the Internal Revenue Service. During 1991 Adobe successfully defended its claim in Federal District Court and prevailed again in 1992 in the United States Court of Appeals for the Fifth Circuit. The Internal Revenue Service had no further recourse to litigation and a $16.2 million refund was reflected as Income Tax Refund Receivable at December 31, 1992 and collected in 1993. Pretax income from continuing operations for the years ended December 31, 1993, 1992 and 1991 was taxed under the following jurisdictions: 1993 1992 1991 Domestic----------------------------- (120.9) 2.7 34.8 Foreign------------------------------ (29.3) (3.6) (2.1) (150.2) (0.9) 32.7 The Company's income tax expense (benefit) for the years ended December 31, 1993, 1992 and 1991 consisted of (in millions of dollars): 1993 1992 1991 Current U.S. federal--------------------- (1.3) 3.5 11.0 State---------------------------- (1.2) 1.4 1.7 Foreign-------------------------- 1.3 1.9 -- (1.2) 6.8 12.7 Deferred U.S. federal--------------------- (65.6) (3.5) 0.2 U.S. federal tax rate change----- 2.6 -- -- State---------------------------- (8.0) (2.5) 1.3 Foreign-------------------------- (0.9) (0.3) -- (71.9) (6.3) 1.5 (73.1) 0.5 14.2 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company's deferred income tax liabilities (assets) at December 31, 1993 and 1992 are composed of the following differences between financial and tax reporting (in millions of dollars): 1993 1992 Capitalized costs and write-offs----- 83.0 150.8 Differences in Partnership basis----- 15.1 29.3 State deferred liability------------- 5.8 13.4 Foreign deferred liability----------- 13.7 15.5 Gross deferred liabilities----------- 117.6 209.0 Accruals not currently deductible for tax purposes----------------------- (17.7) (28.3) Alternative minimum tax carryforwards---------------------- (8.3) (5.3) Net operating loss carryforwards----- (46.7) (56.4) Other-------------------------------- (0.5) -- Gross deferred assets---------------- (73.2) (90.0) Deferred tax liability--------------- 44.4 119.0 The Company had no deferred tax asset valuation allowance at December 31, 1993 or 1992. A reconciliation of the Company's U.S. income tax expense (benefit) computed by applying the statutory U.S. federal income tax rate to the Company's income (loss) before income taxes for the years ended December 31, 1993, 1992 and 1991 is presented in the following table (in millions of dollars): 1993 1992 1991 U.S. federal income taxes (benefit) at statutory rate------------------ (52.6) (0.3) 11.1 Increase (reduction) resulting from: State income taxes, net of federal effect--------------------------- (1.0) 1.4 2.2 Foreign income taxes in excess of U.S. rate------------------------ (0.8) 0.3 -- Nondeductible amounts-------------- (0.2) (2.4) -- Effect of increase in statutory rate on deferred taxes----------- 2.6 -- -- Federal audit refund--------------- (3.2) -- -- Amendment to tax sharing agreement with SFP------------------------- (1.2) -- -- Benefit of tax losses-------------- (11.2) -- -- Prior period adjustments----------- (5.5) -- -- Other------------------------------ -- 1.5 0.9 (73.1) 0.5 14.2 The Company increased its deferred tax liability in 1993 as a result of legislation enacted during 1993 increasing the corporate tax rate from 34% to 35% commencing in 1993. (14) FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107 'Disclosure About Fair Value of Financial Instruments' requires the disclosure, to the extent practicable, of the fair value of financial instruments which are recognized or unrecognized in the balance sheet. The fair value of the financial instruments disclosed herein is not representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences, if any, of realization or settlement. The following table reflects the financial SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) instruments for which the fair value differs from the carrying amount of such financial instrument in the Company's December 31, 1993 and 1992 balance sheets (in millions of dollars): The fair value of the Trust Units and convertible preferred stock is based on market prices. The fair value of the Company's fixed-rate long-term debt is based on current borrowing rates available for financings with similar terms and maturities. With respect to the Company's floating-rate debt, the carrying amount approximates fair value. The fair value of the interest rate swap represents the estimated cost to the Company over the remaining life of the contract. At December 31, 1993 the Company had two open natural gas hedging contracts and options outstanding on five additional contracts (see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Contracts). Based on the settlement prices of certain natural gas futures contracts as quoted on the New York Mercantile Exchange on December 30, 1993, assuming all options are exercised, the cost to the Company with respect to such contracts during 1994 would be approximately $0.6 million. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OIL AND GAS RESERVES AND RELATED FINANCIAL DATA Information with respect to the Company's oil and gas producing activities is presented in the following tables. Reserve quantities as well as certain information regarding future production and discounted cash flows were determined by independent petroleum consultants, Ryder Scott Company. OIL AND GAS RESERVES The following table sets forth the Company's net proved oil and gas reserves at December 31, 1990, 1991, 1992 and 1993 and the changes in net proved oil and gas reserves for the years ended December 31, 1991, 1992 and 1993. Proved reserves are estimated quantities of crude oil and natural gas which geological and engineering data indicate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are proved reserves which can be expected to be recovered through existing wells with existing equipment and operating methods. Indonesian reserves represent an entitlement to gross reserves in accordance with a production sharing contract. These reserves include estimated quantities allocable to the Company for recovery of operating costs as well as quantities related to the Company's net equity share after recovery of costs. Accordingly, these quantities are subject to fluctuations with an inverse relationship to the price of oil. If oil prices increase, the reserve quantities attributable to the recovery of operating costs decline. Although this reduction would be offset partially by an increase in the net equity share, the overall effect would be a reduction of reserves attributable to the Company. At December 31, 1993, the quantities include 0.6 million barrels which the Company is contractually obligated to sell for $.20 per barrel. At December 31, 1993 the Company's reserves were 6.9 million barrels of crude oil and liquids and 14.5 Bcf of natural gas lower than at December 31, 1992, reflecting the sale in 1993 of properties with reserves totalling 8.7 million barrels of crude oil and liquids and 47.4 Bcf of natural gas. At December 31, 1993, 1.9 million barrels of crude oil reserves and 19.7 billion cubic feet of natural gas reserves were subject to a 90% net profits interest held by Santa Fe Energy Trust. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) ESTIMATED PRESENT VALUE OF FUTURE NET CASH FLOWS Estimated future net cash flows from the Company's proved oil and gas reserves at December 31, 1991, 1992 and 1993 are presented in the following table (in millions of dollars, except as noted): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) The following tables sets forth the changes in the present value of estimated future net cash flows from proved reserves during 1991, 1992 and 1993 (in millions of dollars): Estimated future cash flows represent an estimate of future net cash flows from the production of proved reserves using estimated sales prices and estimates of the production costs, ad valorem and production taxes, and future development costs necessary to produce such reserves. No deduction has been made for depletion, depreciation or any indirect costs such as general corporate overhead or interest expense. The sales prices used in the calculation of estimated future net cash flows are based on the prices in effect at year end. Such prices have been held constant except for known and determinable escalations. Operating costs and ad valorem and production taxes are estimated based on current costs with respect to producing oil and gas properties. Future development costs are based on the best estimate of such costs assuming current economic and operating conditions. Income tax expense is computed based on applying the appropriate statutory tax rate to the excess of future cash inflows less future production and development costs over the current tax basis of the properties involved. While applicable investment tax credits and other permanent differences are considered in computing taxes, no recognition is given to tax benefits applicable to future exploration costs or the activities of the Company that are unrelated to oil and gas producing activities. The information presented with respect to estimated future net revenues and cash flows and the present value thereof is not intended to represent the fair value of oil and gas reserves. Actual future sales prices and production and development costs may vary significantly from those in effect at year-end and actual future production may not occur in the periods or amounts projected. This information is presented to allow a reasonable comparison of reserve values prepared using standardized measurement criteria and should be used only for that purpose. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) COSTS INCURRED IN OIL AND GAS PRODUCING ACTIVITIES The following table includes all costs incurred, whether capitalized or charged to expense at the time incurred (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) CAPITALIZED COSTS RELATED TO OIL AND GAS PRODUCING ACTIVITIES The following table sets forth information concerning capitalized costs at December 31, 1993 and 1992 related to the Company's oil and gas operations (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) RESULTS OF OPERATIONS FROM OIL AND GAS PRODUCING ACTIVITIES The following table sets forth the Company's results of operations from oil and gas producing activities for the years ended December 31, 1993, 1992 and 1991 (in millions of dollars): Income taxes are computed by applying the appropriate statutory rate to the results of operations before income taxes. Applicable tax credits and allowances related to oil and gas producing activities have been taken into account in computing income tax expenses. No deduction has been made for indirect cost such as corporate overhead or interest expense. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SANTA FE ENERGY RESOURCES, INC. By /s/ MICHAEL J. ROSINSKI MICHAEL J. ROSINSKI VICE PRESIDENT AND CHIEF FINANCIAL OFFICER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) Dated: March 22, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. SIGNATURE AND TITLE JAMES L. PAYNE, Chairman of the Board, President and Chief Executive Officer and Director (PRINCIPAL EXECUTIVE OFFICER) MICHAEL J. ROSINSKI, Vice President and Chief Financial Officer (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) DIRECTORS Rod F. Dammeyer William E. Greehey Melvyn N. Klein Robert D. Krebs Allan V. Martini Michael A. Morphy Reuben F. Richards By: /s/ MICHAEL J. ROSINSKI David M. Schulte MICHAEL J. ROSINSKI Marc J. Shapiro VICE PRESIDENT AND Robert F. Vagt CHIEF FINANCIAL OFFICER Kathryn D. Wriston ATTORNEY IN FACT Dated: March 22, 1994 SANTA FE ENERGY RESOURCES, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) 1993 1992 1991 Accounts receivable Balance at the beginning of period------------------------- 5.0 2.6 2.8 Charge (credit) to income---- -- -- -- Net amounts written off------ (0.1 ) (1.1 ) (.2 ) Other(a)--------------------- 1.4 3.5 -- Balance at the end of period----- 6.3 5.0 2.6 (a) Represents valuation accounts related to accounts receivable acquired in merger with Adobe Resources Corporation. SANTA FE ENERGY RESOURCES, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Maintenance and repairs-------------- 27.1 25.0 22.6 Taxes (other than income) Ad valorem----------------------- 12.0 11.4 17.0 Production and severance--------- 9.5 8.2 6.8 Payroll and other---------------- 5.8 4.7 3.4 27.3 24.3 27.2 INDEX OF EXHIBITS A. EXHIBITS B. REPORTS ON FORM 8-K. DATE ITEM February 8, 1994 5

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the year ended December 31, 1993 the Company reported a loss to common shares of $84.1 million, or $0.94 per share. The loss for the year includes a $99.3 million charge for the impairment of oil and gas properties (see ' -- Results of Operations') and a $38.6 million restructuring charge (see Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program'). The restructuring charge is comprised of losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals for certain personnel benefits and related costs of $2.2 million. At December 31, 1993 the Company's long-term debt totalled $449.7 million, a portion of which the Company intends to refinance to reduce required debt amortization in the near-term and provide additional financial flexibility in the current low oil price environment. GENERAL As an independent oil and gas producer, the Company's results of operations are dependent upon the difference between the prices received for oil and gas and the costs of finding and producing such resources. A substantial portion of the Company's crude oil production is from long-lived fields where EOR methods are being utilized. The market price of the heavy (i.e., low gravity, high viscosity) and sour (i.e., high sulfur content) crude oils produced in these fields is lower than sweeter, light (i.e., low sulfur and low viscosity) crude oils, reflecting higher transportation and refining costs. The lower price received for the Company's domestic heavy and sour crude oil is reflected in the average sales price of the Company's domestic crude oil and liquids (excluding the effect of hedging transactions) for 1993 of $12.70 per barrel, compared to $16.94 per barrel for West Texas Intermediate crude oil (an industry posted price generally indicative of spot prices for sweeter light crude oil). In addition, the lifting costs of heavy crude oils are generally higher than the lifting costs of light crude oils. As a result of these narrower margins, even relatively modest changes in crude oil prices may significantly affect the Company's revenues, results of operations, cash flows and proved reserves. In addition, prolonged periods of high or low oil prices may have a material effect on the Company's financial position. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC, the Middle East and other producing countries. (See Items 1 and 2, "Business and Properties -- Current Markets for Oil and Gas"). The period since mid-1990 has included some of the largest fluctuations in oil prices in recent times, primarily due to the political unrest in the Middle East. The actual average sales price (unhedged) received by the Company ranged from a high of $23.92 per barrel in the fourth quarter of 1990 to a low of $9.83 per barrel for the two months ended February 28, 1994. The Company's average sales price for its 1993 oil production was $12.93 per barrel. Based on operating results of 1993, the Company estimates that a $1.00 per barrel increase or decrease in average sales prices would have resulted in a corresponding $21.6 million change in 1993 income from operations and a $16.2 million change in 1993 cash flow from operating activities. The Company also estimates that a $0.10 per Mcf increase or decrease in average sales prices would have resulted in a corresponding $5.8 million change in 1993 income from operations and a $4.4 million change in 1993 cash flow from operating activities. The foregoing estimates do not give effect to changes in any other factors, such as the effect of the Company's hedging program or depreciation and depletion, that would result from a change in oil and natural gas prices. In the third quarter of 1990 the Company initiated a hedging program with respect to its sales of crude oil and in the third quarter of 1992 a similar program was initiated with respect to the Company's sales of natural gas. See Items 1 and 2. 'Business and Properties -- Current Markets for Oil and Gas.' During 1992 and 1993, certain significant events occurred which affect the comparability of prior periods, including the merger of Adobe with and into the Company in May 1992, the formation of the Santa Fe Energy Trust in November 1992 and implementation of the corporate restructuring program adopted in October 1993. The corporate restructuring program includes (i) the concentration of capital spending in the Company's core operating areas, (ii) the disposition of non-core assets, (iii) the elimination of the $0.04 per share quarterly Common Stock dividend and (iv) the recognition of $38.6 million of restructuring charges. See Note 2 to the Consolidated Financial Statements and Items 1 and 2, 'Business and Properties -- Corporate Restructuring Program.' In addition, the Company's results of operations for 1993 include a charge of $99.3 million for the impairment of oil and gas properties. The Company's capital program will be concentrated in three domestic core areas -- the Permian Basin in Texas and New Mexico, the offshore Gulf of Mexico and the San Joaquin Valley of California -- as well as its productive areas in Argentina and Indonesia. The domestic program includes development activities in the Delaware and Cisco-Canyon formations in west Texas and southeast New Mexico, a development drilling program for the offshore Gulf of Mexico natural gas properties and relatively low risk infill drilling in the San Joaquin Valley of California. Internationally, the program includes development of the Company's Sierra Chata discovery in Argentina with gas sales expected to commence in early 1995 and the Salawati Basin Joint Venture in Indonesia. See Items 1 and 2. 'Business and Properties -- Domestic Development Activities' and '--International Development Activities.' The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson (completed in December 1993), the sale to Vintage of certain southern California and Gulf Coast oil and gas producing properties (completed in November 1993) and the sale to Bridge of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage (expected to be completed during April 1994). See Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program' for a description of the transactions with Hadson, Vintage and Bridge. In the first quarter of 1994, the Company sold the remaining 575,000 Depositary Units which it held in Santa Fe Energy Trust (the 'Trust') for $11.3 million and its interest in certain other oil and gas properties for $8.3 million. As a result of the Vintage and Bridge dispositions, the Company has sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and estimated proved reserves of approximately 16.7 MMBOE. The restructuring program also includes an evaluation of the Company's capital and cost structures to examine ways to increase flexibility and strengthen the Company's financial performance. In this respect, in 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. In May, 1992, Adobe, an oil and gas exploration and production company, was merged with and into the Company. The acquisition was accounted for as a purchase and the results of operations of the properties acquired are included in the Company's results of operations effective June 1, 1992. Pursuant to the Adobe Merger, the Company issued 5,000,000 shares of its convertible preferred stock and assumed approximately $175.0 million of long-term debt and other liabilities. Pursuant to the Adobe Merger, the Company also acquired Adobe's proved reserves and inventory of undeveloped acreage. As of December 31, 1991, Adobe's estimated proved reserves totaled approximately 53.2 MMBOE (net of 6.9 MMBOE attributable to Adobe's ownership in certain gas plants), of which approximately 58% was natural gas (approximately 66% of Adobe's estimated domestic proved reserves were natural gas). Approximately 72% of the discounted future net cash flow of Adobe's estimated domestic proved reserves was concentrated in three areas of operation -- offshore Gulf of Mexico, onshore Louisiana and in the Spraberry Trend in west Texas. In addition, Adobe's international operations consisted of certain production sharing arrangements in Indonesia, in respect of which approximately 6.0 MMBOE of estimated proved reserves had been attributed to Adobe's interest as of December 31, 1991. The location of the Adobe Properties enhanced the Company's existing domestic operations and added significant operations to the Company's international program. In November 1992, 5,725,000 Depositary Units consisting of interests in the Trust were sold in a public offering. After payment of certain costs and expenses, the Company received $70.1 million and 575,000 Depositary Units. For any calendar quarter ending on or prior to December 21, 2002, the Trust will receive additional royalty payments to the extent necessary to distribute $0.40 per Depositary Unit per quarter. The source of such payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. The aggregate amount of such payments will be limited to $20.0 million on a revolving basis. The Company was required to make an additional royalty payment of $362,000 with respect to the distribution made by the Trust for operations during the quarter ended December 31, 1993. Based upon current prices, the Company believes that a support payment will be required for the quarter ending March 31, 1994, the amount of which has not been determined. See Items 1 and 2. 'Business and Properties -- Santa Fe Energy Trust.' RESULTS OF OPERATIONS The following table sets forth, on the basis of the BOE produced by the Company during the applicable annual period, certain of the Companys costs and expenses for each of the three years ended December 31, 1993. 1993 1992 1991 Production and operating costs per BOE (a)------------------------------ $ 4.76 $ 5.02 $ 5.17 Exploration, including dry hole costs per BOE---------------------------- 0.90 0.84 0.72 Depletion, depreciation and amortization per BOE--------------- 4.44 4.79 4.09 General and administrative costs per BOE-------------------------------- 0.94 1.01 1.07 Taxes other than income per BOE (b)-------------------------------- 0.79 0.80 1.05 Interest, net, per BOE (c)----------- 0.94 1.58 1.43 (a) Excluding related production, severance and ad valorem taxes. (b) Includes production, severance and ad valorem taxes. (c) Reflects interest expense less amounts capitalized and interest income. 1993 COMPARED WITH 1992 Total revenues increased approximately 2% from $427.5 million in 1992 to $436.9 million in 1993 principally due to an increase in oil and natural gas production offset by a decline in average oil prices. Average daily oil production increased 7% from 62.5 MBbls in 1992 to 66.7 MBbls in 1993, principally due to increased domestic and Indonesian production. The average price realized per Bbl of oil during 1993 was $12.93, a decrease of 14% versus the average price of $14.96 in 1992. Natural gas production increased 31% from 126.3 MMcf per day in 1992 to 165.4 MMcf per day in 1993, primarily reflecting the effect of a full year's production from the Adobe Properties. Average natural gas prices realized increased approximately 11% from $1.70 per Mcf in 1992 to $1.89 per Mcf in 1993. Production and operating costs increased $10.4 million in 1993, primarily reflecting the effect of a full year's costs for the Adobe Properties; however, on a BOE basis such costs declined from $5.02 per barrel in 1992 to $4.76 per barrel in 1993. Exploration costs were $5.5 million higher than in 1992 primarily reflecting higher geological and geophysical costs and higher dry hole costs. Depletion, depreciation and amortization ('DD&A') increased $6.4 million in 1993 primarily reflecting a full year's expense on Adobe Properties partially offset by reduced amortization rates with respect to certain unproved properties. DD&A for 1993 includes $12.1 million with respect to the properties sold to Vintage and Bridge. On a BOE basis, DD&A decreased by $0.35 per Bbl, from $4.79 to $4.44 per Bbl. General and administrative costs increased $1.4 million principally due to a $1.8 million charge related to the adoption of Statement of Financial Standards No. 112 -- 'Employer's Accounting for Postemployment Benefits'. Taxes (other than income) increased by $3.0 million in 1993 primarily reflecting the effect of the Adobe Properties. Costs and expenses for 1993 also include $99.3 million in impairments of oil and gas properties and $38.6 million in restructuring charges. The Company estimates the impairments taken in 1993 will result in a reduction of DD&A in 1994 of approximately $20.0 million. The restructuring charges include losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals of certain personnel benefits and related costs of $2.2 million. In connection with the property dispositions effected during 1993 (See '-- Liquidity and Capital Resources'), the Company sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and combined estimated proved reserves of approximately 16.7 MMBOE. The Company's income from operations for 1993 includes $8.5 million with respect to such operations. Interest income in 1993 includes $6.8 million related to a $10 million refund received as a result of the completion of the audit of the Company's federal income tax returns for 1971 through 1980. The decrease in interest expenses during 1993 reflects a decrease in the Company's debt outstanding and a $5.7 million credit related to a revision to a tax sharing agreement with the Company's former parent. Other income and expenses of 1993 includes a $4.0 million charge related to the accrual of a contingent loss with respect to the operations of a former affiliate of Adobe. 1992 COMPARED WITH 1991 Total revenues increased approximately 13% from $379.8 million in 1991 to $427.5 million in 1992 principally due to an increase of approximately $53.2 million attributable to production from properties acquired in the Adobe Merger and an increase of approximately $10.7 million and $10.2 million in revenues from the Company's domestic and Argentine properties, respectively, offset in part by a decline of $32.0 million in crude oil hedging revenues. Oil production increased 13% from 55.5 MBbls per day in 1991 to 62.5 MBbls per day in 1992, reflecting a 3.4 MBbl per day increase in domestic oil production and a 3.6 MBbl per day increase in production in Argentina and Indonesia. The average price realized per barrel of oil during 1992 decreased to $14.96, a decrease of 7% versus the average price of $16.16 in 1991, primarily reflecting a $32.0 million decrease in hedging revenues. Natural gas production increased 33% from 95.2 MMcf per day in 1991 to 126.3 MMcf per day in 1992 as a result of properties acquired in the Adobe Merger. Average natural gas prices realized increased approximately 14% from $1.49 per Mcf in 1991 to $1.70 per Mcf in 1992. Total operating expenses of the Company increased $54.6 million from $315.4 million in 1991 to $370.0 million in 1992 primarily reflecting costs associated with the Adobe Merger. Production and operating costs in 1992 were $18.8 million higher than in 1991, primarily reflecting costs related to the Adobe Properties and increased fuel costs associated with the Company's EOR projects. On a BOE basis, production and operating costs declined from $5.17 per barrel in 1991 to $5.02 per barrel in 1992, primarily reflecting the lower cost structure of the Adobe Properties. Exploration costs were $6.8 million higher than in 1991 primarily reflecting higher geological and geophysical costs with respect to foreign projects. Depletion, depreciation and amortization costs were $39.7 million higher in 1992 due to the acquisition of the Adobe Properties and, to a lesser extent, adjustments to oil and gas reserves with respect to certain producing properties. General and administrative costs increased $3.1 million principally due to a $1.2 million charge related to certain stock awards which fully vested upon consummation of the Adobe Merger and certain other merger-related costs. Taxes (other than income) decreased by $2.9 million in 1992, as a result of lower accruals with respect to property taxes. The $13.6 million gain on the disposition of properties in 1992 primarily relates to the sale of certain royalty interest properties, in which the Company had no remaining financial basis. The increase in interest expense during 1992 reflects the increase in debt as a result of the Adobe Merger. Other income and expenses for 1992 includes a $10.9 million charge for costs incurred by Adobe in connection with the Adobe Merger and paid by Santa Fe. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company has generally funded capital and exploration expenditures and working capital requirements from cash provided by operating activities. Depending upon the future levels of operating cash flows, which are significantly affected by oil and gas prices, the restrictions on additional borrowings included in certain of the Company's debt agreements, together with debt service requirements and dividends, may limit the cash available for future exploration, development and acquisition activities. Net cash provided by operating activities totaled $160.2 million in 1993, $141.5 million in 1992 and $128.4 million in 1991; net cash used in investing activities in such periods totaled $121.4 million, $15.9 million and $117.2 million, respectively. The Company's cash flow from operating activities is a function of the volumes of oil and gas produced from the Company's properties and the sales prices realized therefor. Crude oil and natural gas are depleting assets. Unless the Company replaces over the long term the oil and natural gas produced from the Company's properties, the Company's assets will be depleted over time and its ability to service and incur debt at constant or declining prices will be reduced. The Company's cash flow from operations for 1993 reflects an average sales price (unhedged) for the Company's 1993 oil production of $12.93 per barrel. For the two months ended February 28, 1994, the average sales price (unhedged) for the Company's 1994 oil production was $9.83 per barrel. If such lower oil prices prevail throughout 1994, the Company's cash flow from operating activities for 1994 will be significantly lower than that for 1993. In October 1993, the Company's Board of Directors adopted a broad corporate restructuring program that focuses on the concentration of capital spending in core areas and the disposition of non-core assets. The Company's asset disposition program adopted in connection with the 1993 restructuring program has been substantially completed by the asset sales to Hadson, Vintage and Bridge (expected to close in April 1994), the sale of the 575,000 Depositary Units in the Trust and the sale of its interest in certain other oil and gas properties. As a result of such sales, the Company sold a total of 16.7 MMBOE of proved reserves and undeveloped acreage for a total of approximately $111.0 million, and sold certain gas gathering and processing facilities for Hadson securities. As a part of the 1993 restructuring program, the Company eliminated its $0.04 per share quarterly dividend on its Common Stock and announced that it might spend up to $240 million in 1994 on an accelerated capital program. However, as a result of the depressed crude oil prices that have prevailed since November 1993, the Company, consistent with industry practice, is considering deferring some of its capital projects in order to prudently manage its cash flow available in the near term. Based on current market conditions, the Company estimates that 1994 capital expenditures may total between $100 million and $160 million, with the actual amount to be determined by the Company based upon numerous factors outside its control, including, without limitation, prevailing oil and natural gas prices and the outlook therefor. The Company is a party to several long-term and short-term credit agreements which restrict the Company's ability to take certain actions, including covenants that restrict the Company's ability to incur additional indebtedness and to pay dividends on its capital stock. For a description of such existing credit agreements, see Note 7 to the Consolidated Financial Statements. Effective March 16, 1994, the Company entered into an Amended and Restated Revolving Credit Agreement (the "Bank Facility") which consists of a five year secured revolving credit agreement maturing December 31, 1998 ("Facility A") and and a three year unsecured revolving credit facility maturing December 31, 1996 ("Facility B"). The aggregate borrowing limits under the terms of the Bank Facility are $125.0 million (up to $90.0 million under Facility A and up to $35.0 million under Facility B). Under certain circumstances, the aggregate borrowing limits under the terms of the Bank Facility may be increased to $175.0 million (up to $90.0 million under Facility A and up to $85.0 million under Facility B). Interest rates under the Bank Facility are tied to LIBOR or the bank's prime rate with the actual interest rate reflecting certain ratios based upon the Company's ability to repay its outstanding debt and the value and projected timing of production of the Company's oil and gas reserves. These and other similar ratios will also affect the Company's ability to borrow under the Bank Facility and the timing and amount of any required repayments and corresponding commitment reductions. The Bank Facility replaces the Revolving and Term Credit Agreement discussed in Note 7 to the Consolidated Financial Statements. EFFECTS OF INFLATION Inflation during the three years ended December 31, 1993 has had little effect on the Company's capital costs and results of operations. ENVIRONMENTAL MATTERS Almost all phases of the Company's oil and gas operations are subject to stringent environmental regulation by governmental authorities. Such regulation has increased the costs of planning, designing, drilling, installing, operating and abandoning oil and gas wells and other facilities. The Company has expended significant financial and managerial resources to comply with such regulations. Although the Company believes its operations and facilities are in general compliance with applicable environmental regulations, risks of substantial costs and liabilities are inherent in oil and gas operations. It is possible that other developments, such as increasingly strict environmental laws, regulations and enforcement policies or claims for damages to property, employees, other persons and the environment resulting from the Company's operations, could result in significant costs and liabilities in the future. As it has done in the past, the Company intends to fund its cost of environmental compliance from operating cash flows. See also, Items 1 and 2. 'Business and Properties -- Other Business Matters -- Environmental Regulation' and Note 12 to the Consolidated Financial Statements. DIVIDENDS Dividends on the Company's convertible preferred stock are cumulative at an annual rate of $1.40 per share. No dividends may be declared or paid with respect to the Company's common stock if any dividends with respect to the convertible preferred stock are in arrears. As described elsewhere herein, the Company has eliminated the payment of its $0.04 per share quarterly dividend on its common stock. The determination of the amount of future cash dividends, if any, to be declared and paid on the Company's common stock is in the sole discretion of the Company's Board of Directors and will depend on dividend requirements with respect to the convertible preferred stock, the Company's financial condition, earnings and funds from operations, the level of capital and exploration expenditures, dividend restrictions in financing agreements, future business prospects and other matters the Board of Directors deems relevant. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Audited Financial Statements Report of Independent Accountants------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991--------------------- 32 Consolidated Balance Sheet -- December 31, 1993 and 1992---- 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991--------------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991---------- 35 Notes to Consolidated Financial Statements---------- 36 Unaudited Financial Information Supplemental Information to the Consolidated Financial Statements-------------------- 55 Financial Statement Schedules: Schedule V --Property, Plant and Equipment------ 65 Schedule VI --Accumulated Depreciation, Depletion and Amortization of Property Plant and Equipment---------------------- 66 Schedule --Valuation and Qualifying VIII Accounts--------------------------- 67 Schedule IX --Short Term Borrowings-------------- 68 --Supplementary Income Statement Schedule X Information------------------------ 69 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Except for the portion of Item 10 relating to Executive Officers of the Registrant which is included in Part I of this Report, the information called for by Items 10 through 13 is incorporated by reference from the Company's Notice of Annual Meeting and Proxy Statement dated March 21, 1994, which meeting involves the election of directors, in accordance with General Instruction G to the Annual Report on Form 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: PAGE 1. Financial Statements: Report of Independent Accountants--------------------------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991------------ 32 Consolidated Balance Sheet -- December 31, 1993 and 1992------------------------------------------ 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991---------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991------ 35 Notes to Consolidated Financial Statements------------ 36 2. Financial Statement Schedules: Schedule V -- Property, Plant and Equipment--------- 65 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment---------------- 66 Schedule VIII -- Valuation and Qualifying Accounts---- 67 Schedule IX -- Short Term Borrowings------------------ 68 Schedule X -- Supplementary Income Statement Information------------------------ 69 All other schedules have been omitted because they are not applicable or the required information is presented in the financial statements or the notes to financial statements. 3. Exhibits: See Index to Exhibits on page 70 for a description of the exhibits filed as a part of this report. (b) Reports on Form 8-K [CAPTION] DATE ITEM February 8, 1994 5 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Santa Fe Energy Resources, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 30 present fairly, in all material respects, the financial position of Santa Fe Energy Resources, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Houston, Texas February 18, 1994 SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF OPERATIONS (IN MILLIONS OF DOLLARS, EXCEPT PER SHARE DATA) YEAR ENDED DECEMBER 31, 1993 1992 1991 Revenues Crude oil and liquids------------ $ 307.3 $ 333.6 $ 320.3 Natural gas---------------------- 107.8 74.8 47.9 Natural gas systems-------------- 8.2 7.3 -- Crude oil marketing and trading------------------------ 9.9 5.9 7.2 Other---------------------------- 3.7 5.9 4.4 436.9 427.5 379.8 Costs and Expenses Production and operating--------- 163.8 153.4 134.6 Oil and gas systems and pipelines---------------------- 4.2 3.2 -- Exploration, including dry hole costs-------------------------- 31.0 25.5 18.7 Depletion, depreciation and amortization------------------- 152.7 146.3 106.6 Impairment of oil and gas properties--------------------- 99.3 -- -- General and administrative------- 32.3 30.9 27.8 Taxes (other than income)-------- 27.3 24.3 27.2 Restructuring charges------------ 38.6 -- -- Loss (gain) on disposition of oil and gas properties------------- 0.7 (13.6) 0.5 549.9 370.0 315.4 Income (Loss) from Operations-------- (113.0) 57.5 64.4 Interest income------------------ 9.1 2.3 2.3 Interest expense----------------- (45.8) (55.6) (47.3) Interest capitalized------------- 4.3 4.9 7.7 Other income (expense)----------- (4.8) (10.0) 5.6 Income (Loss) Before Income Taxes---- (150.2) (0.9) 32.7 Income taxes--------------------- 73.1 (0.5) (14.2) Net Income (Loss)-------------------- (77.1) (1.4) 18.5 Preferred dividend requirement------- (7.0) (4.3) -- Earnings (Loss) Attributable to Common Shares---------------------- $ (84.1) $ (5.7) $ 18.5 Earnings (Loss) Attributable to Common Shares Per Share------------ $ (0.94) $ (0.07) $ 0.29 Weighted Average Number of Shares Outstanding (in millions)---------- 89.7 79.0 63.8 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED BALANCE SHEET (IN MILLIONS OF DOLLARS) DECEMBER 31, 1993 1992 ASSETS Current Assets Cash and cash equivalents-------- $ 4.8 $ 83.8 Accounts receivable-------------- 87.4 90.0 Income tax refund receivable----- -- 16.2 Inventories---------------------- 8.7 4.8 Assets held for sale------------- 59.5 -- Other current assets------------- 12.2 10.6 172.6 205.4 Investment in Hadson Corporation----- 56.2 -- Properties and Equipment, at cost Oil and gas (on the basis of successful efforts accounting)-------------------- 2,064.3 2,330.9 Other---------------------------- 27.3 26.8 2,091.6 2,357.7 Accumulated depletion, depreciation, amortization and impairment--------------------- (1,258.9) (1,255.9) 832.7 1,101.8 Other Assets Receivable under gas balancing arrangements------------------- 3.9 7.7 Other---------------------------- 11.5 22.3 15.4 30.0 $ 1,076.9 $ 1,337.2 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable----------------- $ 93.5 $ 90.9 Interest payable----------------- 10.2 11.0 Current portion of long-term debt--------------------------- 44.3 53.4 Other current liabilities-------- 18.1 17.1 166.1 172.4 Long-Term Debt----------------------- 405.4 492.8 Deferred Revenues-------------------- 8.6 13.0 Other Long-Term Obligations---------- 48.8 43.4 Deferred Income Taxes---------------- 44.4 119.0 Commitments and Contingencies (Note 12)-------------------------------- -- -- Convertible Preferred Stock, $0.01 par value, 5.0 million shares authorized, issued and outstanding------------------------ 80.0 80.0 Shareholders' Equity Preferred stock, $0.01 par value, 45.0 million shares authorized, none issued-------------------- -- -- Common stock, $0.01 par value, 200.0 million shares authorized--------------------- 0.9 0.9 Paid-in capital------------------ 496.9 494.3 Unamortized restricted stock awards------------------------- (0.1) (0.4) Accumulated deficit-------------- (173.8) (78.0) Foreign currency translation adjustment--------------------- (0.3) (0.2) 323.6 416.6 $ 1,076.9 $ 1,337.2 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Operating Activities: Net income (loss)---------------- $ (77.1) $ (1.4) $ 18.5 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depletion, depreciation and amortization--------------- 152.7 146.3 106.6 Impairment of oil and gas properties----------------- 99.3 -- -- Restructuring charges-------- 27.8 -- -- Deferred income taxes-------- (71.9) (6.3) 1.5 Net loss (gain) on disposition of properties----------------- 0.7 (13.6) (5.5) Exploratory dry hole costs---------------------- 8.9 4.7 3.8 Expenses related to acquisition of Adobe Resources Corporation------ -- 10.9 -- Other------------------------ 4.2 2.0 0.3 Changes in operating assets and liabilities: Decrease (increase) in accounts receivable-------- 12.4 (8.3) 23.6 Decrease (increase) in inventories---------------- (3.8) 0.3 5.6 Increase (decrease) in accounts payable----------- (2.6) 5.9 (24.9) Increase (decrease) in interest payable----------- (0.8) 0.4 0.2 Decrease in income taxes payable-------------------- (0.6) (0.4) (3.6) Net change in other assets and liabilities------------ 11.0 1.0 2.3 Net Cash Provided by Operating Activities------------------------- 160.2 141.5 128.4 Investing Activities: Capital expenditures, including exploratory dry hole costs----- (127.0) (76.8) (108.1) Acquisitions of producing properties, net of related debt--------------------------- (4.4) (14.2) (28.5) Acquisition of Adobe Resources Corporation-------------------- -- (11.9) -- Acquisition of Santa Fe Energy Partners, L.P.----------------- (28.3) -- -- Net proceeds from sales of properties--------------------- 39.9 89.1 22.1 Increase in partnership interest due to reinvestment------------ (1.6) (2.1) (2.7) Net Cash Used in Investing Activities------------------------- (121.4) (15.9) (117.2) Financing Activities: Net change in short-term debt---- -- (4.6) (4.2) Proceeds from long-term borrowings--------------------- -- 5.0 -- Principal payments on long-term borrowings--------------------- (41.5) (55.5) (16.3) Net change in revolving credit agreement---------------------- (55.0) -- -- Cash dividends paid to others---- (21.3) (14.9) (10.2) Net Cash Used in Financing Activities------------------------- (117.8) (70.0) (30.7) Net Increase (Decrease) in Cash and Cash Equivalents------------------- (79.0) 55.6 (19.5) Cash and Cash Equivalents at Beginning of Year------------------ 83.8 28.2 47.7 Cash and Cash Equivalents at End of Year------------------------------- $ 4.8 $ 83.8 $ 28.2 The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements of Santa Fe Energy Resources, Inc. ('Santa Fe' or the 'Company') and its subsidiaries include the accounts of all wholly owned subsidiaries. The accounts of Santa Fe Energy Partners, L.P., (the 'Partnership') are included on a proportional basis until September 1993 when Santa Fe purchased all the Partnership's outstanding Depositary Units and undeposited LP Units other than those units held by Santa Fe and its affiliates. On September 27, 1993 the Company exercised its right under the Agreement of Limited Partnership to purchase all of the Partnership's outstanding Depositary Units and undeposited LP Units, other than those units held by the Company and its affiliates, at a redemption price of $4.9225 per unit. Consideration for the 5,749,500 outstanding units totalled $28.3 million. The acquisition of the units has been accounted for as a purchase and the results of operations of the Partnership attributable to the units acquired is included in the Company's results of operations with effect from October 1, 1993. The purchase price has been allocated primarily to oil and gas properties. References herein to the 'Company' or 'Santa Fe' relate to Santa Fe Energy Resources, Inc., individually or together with its consolidated subsidiaries; references to the 'Partnership' relate to Santa Fe Energy Partners, L.P. All significant intercompany accounts and transactions have been eliminated. Prior years' financial statements include certain reclassifications to conform to current year's presentation. OIL AND GAS OPERATIONS The Company follows the successful efforts method of accounting for its oil and gas exploration and production activities. Costs (both tangible and intangible) of productive wells and development dry holes, as well as the cost of prospective acreage, are capitalized. The costs of drilling and equipping exploratory wells which do not find proved reserves are expensed upon determination that the well does not justify commercial development. Other exploratory costs, including geological and geophysical costs and delay rentals, are charged to expense as incurred. Depletion and depreciation of proved properties are computed on an individual field basis using the unit-of-production method based upon proved oil and gas reserves attributable to the field. Certain other oil and gas properties are depreciated on a straight-line basis. Individual proved properties are reviewed periodically to determine if the carrying value of the field exceeds the estimated undiscounted future net revenues from proved oil and gas reserves attributable to the field. Based on this review and the continuing evaluation of development plans, economics and other factors, if appropriate, the Company records impairments (additional depletion and depreciation) to the extent that the carrying value exceeds the estimated undiscounted future net revenues. Such impairments totaled $99.3 million in 1993 and there were none in 1992 and 1991. The Company provides for future abandonment and site restoration costs with respect to certain of its oil and gas properties. The Company estimates that with respect to these properties such future costs total approximately $24.7 million and such amount is being accrued over the expected life of the properties. At December 31, 1993 Accumulated Depletion, Depreciation, Amortization and Impairment includes $14.6 million with respect to such costs. The value of undeveloped acreage is aggregated and the portion of such costs estimated to be nonproductive, based on historical experience, is amortized to expense over the average holding period. Additional amortization may be recognized based upon periodic assessment of prospect evaluation results. The cost of properties determined to be productive is transferred to proved SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) properties; the cost of properties determined to be nonproductive is charged to accumulated amortization. Maintenance and repairs are expensed as incurred; major renewals and improvements are capitalized. Gains and losses arising from sales of properties are included in income currently. REVENUE RECOGNITION Revenues from the sale of petroleum produced are generally recognized upon the passage of title, net of royalties and net profits interests. Crude oil revenues include the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Crude Oil Hedging Program. Crude oil revenues also include the value of crude oil consumed in operations with an equal amount charged to operating expenses. Such amounts totalled $15.4 million in 1991, $4.8 million in 1992 and $1.2 million in 1993. Revenues from natural gas production are generally recorded using the entitlement method, net of royalties and net profits interests. Sales proceeds in excess of the Company's entitlement are included in Deferred Revenues and the Company's share of sales taken by others is included in Other Assets. At December 31, 1993 the Company's deferred revenues for sales proceeds received in excess of the Company's entitlement was $6.8 million with respect to 5.2 MMcf and the asset related to the Company's share of sales taken by others was $3.9 million with respect to 2.7 MMcf. Natural gas revenues are net of the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Program. Revenues from crude oil marketing and trading represent the gross margin resulting from such activities. Revenues from such activities are net of costs of sales of $210.5 million in 1991, $247.3 million in 1992 and $225.9 million in 1993. Revenues from natural gas systems are net of the cost of natural gas purchased and resold. Such costs totalled $43.8 million in 1992 and $49.9 million in 1993. EARNINGS PER SHARE Earnings per share are based on the weighted average number of common shares outstanding during the year. ACCOUNTS RECEIVABLE Accounts Receivable relates primarily to sales of oil and gas and amounts due from joint interest partners for expenditures made by the Company on behalf of such partners. The Company reviews the financial condition of potential purchasers and partners prior to signing sales or joint interest agreements. At December 31, 1993 and 1992 the Company's allowance for doubtful accounts receivable, which is reflected in the consolidated balance sheet as a reduction in accounts receivable, totaled $6.3 million and $5.0 million, respectively. Accounts receivable totalling $0.2 million, $1.1 million and $0.1 million were written off as uncollectible in 1991, 1992 and 1993, respectively. INVENTORIES Inventories are valued at the lower of cost (average price or first-in, first-out) or market. Crude oil inventories at December 31, 1993 and 1992 were $1.1 million and $1.5 million, respectively, and materials and supplies inventories at such dates were $7.6 million and $3.3 million, respectively. ENVIRONMENTAL EXPENDITURES Environmental expenditures relating to current operations are expensed or capitalized, as appropriate, depending on whether such expenditures provide future economic benefits. Liabilities are SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) recognized when the expenditures are considered probable and can be reasonably estimated. Measurement of liabilities is based on currently enacted laws and regulations, existing technology and undiscounted site-specific costs. Generally, such recognition coincides with the Company's commitment to a formal plan of action. INCOME TAXES The Company follows the asset and liability approach to accounting for income taxes. Deferred tax assets and liabilities are determined using the tax rate for the period in which those amounts are expected to be received or paid, based on a scheduling of temporary differences between the tax bases of assets and liabilities and their reported amounts. Under this method of accounting for income taxes, any future changes in income tax rates will affect deferred income tax balances and financial results. (2) CORPORATE RESTRUCTURING PROGRAM In October 1993 the Company's Board of Directors endorsed a broad corporate restructuring program that focuses on the disposition of non-core assets, the concentration of capital spending in core areas, the refinancing of certain long-term debt and the elimination of the payment of its $0.04 per share quarterly dividend on common stock. In implementing the restructuring program the Company recorded a nonrecurring charge of $38.6 million in 1993 comprised of (1) losses on property dispositions of $27.8 million: (2) long-term debt repayment penalties of $8.6 million; and (3) accruals for certain personnel benefits and related costs of $2.2 million. The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson Corporation ('Hadson'), the sale to Vintage Petroleum, Inc. of certain southern California and Gulf Coast oil and gas producing properties and the sale to Bridge Oil (U.S.A.) Inc. ('Bridge') of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage. The Company also plans to dispose of other non-core oil and gas properties during 1994. In 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. SALE TO HADSON. In December 1993 the Company completed a transaction with Hadson under the terms of which the Company sold the common stock of Adobe Gas Pipeline Company ('AGPC'), a wholly-owned subsidiary which held the Company's natural gas gathering and processing assets, to Hadson in exchange for Hadson 11.25% preferred stock with a face value of $52.0 million and 40% of Hadson's common stock. In addition, the Company signed a seven-year gas sales contract under the terms of which Hadson will market substantially all of the Company's domestic natural gas production at market prices as defined by published monthly indices for relevant production locations. The Company accounted for the sale as a non-monetary transaction and the investment in Hadson has been valued at $56.2 million, the carrying value of the Company's investment in AGPC. The Company's investment in Hadson is being accounted for on the equity basis. At December 31, 1993 the Company's investment in Hadson's common stock exceeded the net book value attributable to such common shares by approximately $11.3 million. The Company's income from operations for 1993 includes $1.6 million attributable to the assets sold to Hadson. SALE TO VINTAGE. In November 1993 the Company completed the sale of certain southern California and Gulf Coast producing properties for net proceeds totalling $41.3 million in cash, $31.5 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) million of which was collected in 1993. The Company's income from operations for 1993 includes $2.7 million attributable to the assets sold to Vintage. SALE TO BRIDGE. In December 1993 the Company signed a Purchase and Sales Agreement with Bridge under the terms of which Bridge will purchase certain Mid-Continent and Rocky Mountain producing and nonproducing oil and gas properties. The sale price of $51.0 million, subject to certain adjustments, will be received by the Company either in the form of cash plus 10% of the outstanding shares of Bridge, following the contemplated public offering of that stock in the first quarter of 1994, or entirely in cash. The transaction is expected to close in the second quarter of 1994. The net book value of these assets is included in Assets Held for Sale at December 31, 1993. The Company's income from operations for 1993 includes $5.8 million attributable to the assets to be sold to Bridge. OTHER DISPOSITIONS. The Company has identified certain other oil and gas properties which it plans to dispose of in 1994. The estimated realizable value of these properties, $1.0 million, is included in Assets Held for Sale at December 31, 1993. In the first quarter of 1994 the Company sold its interest in certain other oil and gas properties for $8.3 million. (3) MERGER WITH ADOBE RESOURCES CORPORATION On May 19, 1992 Adobe Resources Corporation ('Adobe'), an oil and gas exploration and production company, was merged with and into Santa Fe (the 'Merger'). The acquisition has been accounted for as a purchase and the results of operations of the properties acquired (the 'Adobe Properties') are included in Santa Fe's results of operations effective June 1, 1992. To consummate the Merger, the Company issued 24.9 million shares of common stock valued at $205.5 million, 5.0 million shares of convertible preferred stock valued at $80.0 million, assumed long-term bank debt and other liabilities of $140.0 million and $35.0 million, respectively, and incurred $13.8 million in related costs. The Company also recorded a $19.7 million deferred tax liability with respect to the difference between the book and tax basis in the assets acquired. Certain merger-related costs incurred by Adobe and paid by Santa Fe totaling $10.9 million were charged to income in the second quarter of 1992. The Merger constituted a 'change of control' as defined in certain of the Company's employee benefit plans and employment agreements (see Notes 10 and 12). In a separate transaction in January 1992, the Company purchased three producing properties from Adobe for $14.2 million. (4) SANTA FE ENERGY TRUST In November 1992 5,725,000 Depository Units ('Trust Units'), each consisting of beneficial ownership of one unit of undivided beneficial interest in the Santa Fe Energy Trust (the 'Trust') and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation maturing on or about February 15, 2008, were sold in a public offering. The Trust consists of certain oil and gas properties conveyed by Santa Fe. A total of $114.5 million was received from public investors, of which $38.7 million was used to purchase the Treasury obligations and $5.7 million was used to pay underwriting commissions and discounts. Santa Fe received the remaining $70.1 million and 575,000 Trust Units. A portion of the proceeds received by the Company was used to retire $30.0 million of the debt incurred in connection with the Merger and the remainder will be used for general corporate purposes including possible acquisitions. For any calendar quarter ending on or prior to December 31, 2002, the Trust will receive additional royalty payments to the extent that it needs such payments to distribute $0.40 per SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Depository Unit per quarter. The source of such additional royalty payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. If such additional payments are made, certain proceeds otherwise payable to the Trust in subsequent quarters may be reduced to recoup the amount of such additional payments. The aggregate amount of the additional royalty payments (net of any amounts recouped) will be limited to $20.0 million on a revolving basis. At December 31, 1993 the Company held 575,000 Trust Units. At December 31, 1993 Accounts Receivable includes $0.2 million due from the Trust and Accounts Payable includes $1.9 million due to the Trust. In the first quarter of 1994 the Company sold the Trust Units for $11.3 million, the Company's investment in the Trust Units, $10.4 million, is included in Assets Held for Sale at December 31, 1993. (5) ACQUISITIONS OF OIL AND GAS PROPERTIES In January 1991 the Company completed the purchase of Mission Operating Partnership, L.P.'s ('Mission') interest in certain oil and gas properties, effective from November 1, 1990, for approximately $55.0 million. The Company formed a partnership, with an institutional investor as a limited partner, to acquire and operate the properties. The investor contributed $27.5 million for a 50% interest in the partnership, which will be reduced to 15% upon the occurence of payout. Payout will occur when the investor has received distributions from the partnership totalling an amount equal to its original contribution plus a 12% rate of return on such contribution. Prior to payout, the Company will bear 100% of the capital expenditures of the partnership. Under the terms of the partnership agreement a total of $36.8 million must be expended on development of the property by the year 2000, $12.4 million of which had been expended through the end of 1993. The Company funded $16.8 million of its share of the purchase of the properties with the assumption of a term loan and paid the remainder from working capital. The Company has given the lender the equivalent of an overriding royalty interest in certain production from the properties. The royalty is payable only if such production occurs and is limited to a maximum of $3.0 million. In June 1991 the Company acquired a 10% interest in a producing field in Argentina for approximately $18.3 million and in October 1991 purchased an additional 8% interest in the field for approximately $15.7 million. The Company financed $17.8 million of the total purchase price with loans from an Argentine bank. The Company has agreed to spend approximately $16.7 million over a five-year period on development and maintenance of the field. (6) CASH FLOWS The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The Merger included certain non-cash investing and financing activities not reflected in the Statement of Cash Flows as follows (in millions of dollars): Common stock issued------------------ 205.5 Convertible preferred stock issued------------------------------- 80.0 Deferred tax liability--------------- 19.7 Long-term debt----------------------- 140.0 Assets acquired, other than cash, net of liabilities assumed------------- (457.1) Cash paid---------------------------- (11.9) In 1991, the Company sold a producing property for $0.9 million in cash and a note receivable for $1.2 million. In 1991, the Partnership purchased certain surface properties for $6.2 million, SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $5.5 million of which was funded by the issuance of promissory notes and the Company also purchased producing properties for $63.1 million, $34.6 million of which was funded with debt (see Notes 5 and 7). The Company made interest payments of $45.5 million, $49.0 million and $48.0 million in 1991, 1992 and 1993, respectively. In 1991, 1992 and 1993, the Company made tax payments of $18.4 million, $4.4 million and $5.0 million, respectively, and in 1993 received refunds of $4.1 million, primarily related to the audit of prior years' returns. (7) FINANCING AND DEBT Long-term debt at December 31, 1993 and 1992 consisted of (in millions of dollars): Crude oil and liquids and natural gas accounted for more than 95% of revenues in 1991, 1992 and 1993. The following table reflects sales revenues from crude oil purchasers who accounted for more than 10% of the Company's crude oil and liquids revenues (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Texaco Trading and Transportation, Inc-------------------------------- -- 46.8 55.9 Celeron Corporation------------------ 56.8 56.3 45.6 Shell Oil Company-------------------- 86.3 -- -- None of the Company's purchasers of natural gas accounted for more than 10% of revenues in 1991, 1992 or 1993. The Company does not believe the loss of any purchaser would have a material adverse effect on its financial position since the Company believes alternative sales arrangements could be made on relatively comparable terms. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (9) CONVERTIBLE PREFERRED STOCK The convertible preferred stock issued in connection with the Merger is non-voting and entitled to receive cumulative cash dividends at an annual rate equivalent to $1.40 per share. The holders of the convertible preferred shares may, at their option, convert any or all such shares into 1.3913 shares of the Company's common stock. The Company may, at any time after the fifth anniversary of the effective date of the Merger and upon the occurrence of a 'Special Conversion Event', convert all outstanding shares of convertible preferred stock into common stock at the initial conversion rate of 1.3913 shares of common stock, subject to certain adjustments, plus additional shares in respect to accrued and unpaid dividends. A Special Conversion Event is deemed to have occurred when the average daily closing price for a share of the Company's common stock for 20 of 30 consecutive trading days equals or exceeds 125% of the quotient of $20.00 divided by the then applicable conversion rate (approximately $18.00 per share at a conversion rate of 1.3913). Upon the occurrence of the 'First Ownership Change' of Santa Fe, each holder of shares of convertible preferred stock shall have the right, at the holder's option, to elect to have all of such holder's shares redeemed for $20.00 per share plus accrued and unpaid interest and dividends. The First Ownership Change shall be deemed to have occurred when any person or group, together with any affiliates or associates, becomes the beneficial owner of 50% or more of the outstanding common stock of Santa Fe. (10) SHAREHOLDERS' EQUITY COMMON STOCK In 1991, 1992 and 1993 the Company issued 1.1 million previously unissued shares of common stock in connection with certain employee benefit and compensation plans. Also in 1992, the Company issued 24.9 million previously unissued shares of common stock in connection with the Merger. The Company declared dividends to common shares of $0.16 per share in 1991 and 1992 and $0.12 per share in 1993. PREFERRED STOCK The Board of Directors of the Company is empowered, without approval of the shareholders, to cause shares of preferred stock to be issued in one or more series, and to determine the number of shares in each series and the rights, preferences and limitations of each series. Among the specific matters which may be determined by the Board of Directors are: the annual rate of dividends; the redemption price, if any; the terms of a sinking or purchase fund, if any; the amount payable in the event of any voluntary liquidation, dissolution or winding up of the affairs of the Company; conversion rights, if any; and voting powers, if any. ACCUMULATED DEFICIT At December 31, 1993 Accumulated Deficit included dividends in excess of retained earnings of $89.8 million. 1990 INCENTIVE STOCK COMPENSATION PLAN The Company has adopted the Santa Fe Energy Resources 1990 Incentive Stock Compensation Plan (the 'Plan') under the terms of which the Company may grant options and awards with respect to no more than 5,000,000 shares of common stock to officers and key employees. Options granted in 1991 and prior are fully vested and expire in 2000. Options granted in 1992 have a ten year term and vest as to 33.33 percent one year after grant, as to a cumulative 66.67 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) percent two years after grant and as to the entire amount three years after grant. The options granted in 1993 have a ten year term and vest as to 50 percent 5 years after grant, as to a cumulative 75 percent 6 years after grant and as to the entire amount 7 years after grant. The options are exercisable on an accelerated basis beginning one year and ending three years after grant in certain circumstances. If the market value per share of the Company's common stock (sustained in all events for at least 60 days) exceeds $15, 25 percent of the options shall become exercisable; in the event the market value per share exceeds $20, 50 percent of the options shall become exercisable; and in the event the market value exceeds $25, 100 percent shall become exercisable. Unexercised options would be forfeited in the event of voluntary or involuntary termination. Vested options are exercisable for a period of one year following termination due to death, disability or retirement. In the event of termination by the Company for any reason there is no prorata vesting of unvested options. The following table reflects activity with respect to Non-Qualified Stock Options during 1991 through 1993: OPTION OPTIONS PRICE OUTSTANDING PER SHARE Outstanding at December 31, 1990----- 1,803,923 $14.4375 to $24.24 Grants------------------------------- 4,500 $14.625 Cancellations------------------------ (45,332) $14.4375 to $24.24 Outstanding at December 31, 1991----- 1,763,091 $14.4375 to $24.24 Grants------------------------------- 1,099,000 $ 9.5625 Cancellations------------------------ (50,163) $14.4375 to $24.24 Outstanding at December 31, 1992----- 2,811,928 $ 9.5625 to $24.24 Grants------------------------------- 800,000 $ 9.5625 Cancellations------------------------ (95,398) $ 9.5625 to $24.24 Exercises---------------------------- (6,945) $ 9.5625 Outstanding at December 31, 1993----- 3,509,585 $ 9.5625 to $24.24 At December 31, 1993 options on 780,790 shares were available for future grants. A 'Phantom Unit' is the right to receive a cash payment in an amount equal to the average trading price of the shares of common stock at the time the award becomes payable. Awards are made for a specified period and are dependent upon continued employment and the achievement of performance objectives established by the Company. In December 1990 the Company awarded 211,362 Phantom Units and in December 1991 313,262 shares of restricted stock were issued in exchange for such units. Compensation expense is recognized over the period the awards are earned based on the market price of the restricted stock on the date it was issued ($8.00 per share). During 1990 and 1991 $0.2 million and $0.8 million, respectively, were charged to expense with respect to such awards. The unamortized portion of the award at December 31, 1991 ($1.4 million) was reflected in Shareholders' Equity. The consummation of the Merger resulted in a 'change of control' as defined in the Plan and resulted in the vesting of the awards and $1.4 million in compensation expense was recognized in 1992. In 1993 the Company issued 6,432 shares of restricted stock to certain employees and 118,039 common shares in accordance with the terms of certain other employee compensation plans. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (11) PENSION AND OTHER EMPLOYEE BENEFIT PLANS PENSION PLANS Prior to the Spin-Off the Company was included in certain non-contributory pension plans of SFP. The Santa Fe Pacific Corporation Retirement Plan (the 'SFP Plan') covered substantially all of the Company's officers and salaried employees who were not covered by collective bargaining agreements. The Santa Fe Pacific Corporation Supplemental Retirement Plan was an unfunded plan which provided supplementary benefits, primarily to senior management personnel. The Company adopted, effective as of the date of the Spin-Off, a defined benefit retirement plan (the 'SFER Plan') covering substantially all salaried employees not covered by collective bargaining agreements and a nonqualified supplemental retirement plan (the 'Supplemental Plan'). The Supplemental Plan will pay benefits to participants in the SFER Plan in those instances where the SFER Plan formula produces a benefit in excess of limits established by ERISA and the Tax Reform Act of 1986. Benefits payable under the SFER Plan are based on years of service and compensation during the five highest paid years of service during the ten years immediately preceding retirement. Benefits accruing to the Company's employees under the SFP Plan have been assumed by the SFER Plan. The Company's funding policy is to contribute annually not less than the minimum required by ERISA and not more than the maximum amount deductible for income tax purposes. In the fourth quarter of 1993 the Company established a new pension plan with respect to certain persons employed in foreign locations. The following table sets forth the funded status of the SFER Plan and the Supplemental Plan at December 31, 1993 and 1992 (in millions of dollars): SFER PLAN SUPPLEMENTAL PLAN 1993 1992 1993 1992 Plan assets at fair value, primarily invested in common stocks and U.S. and corporate bonds---------------- 30.2 28.9 -- -- Actuarial present value of projected benefit obligations: Accumulated benefit obligations Vested----------------------- (30.9) (24.5) (0.6) (0.5) Nonvested-------------------- (1.5) (1.4) -- -- Effect of projected future salary increases----------- (8.3) (6.4) (0.3) (0.2) Excess of projected benefit obligation over plan assets-------- (10.5) (3.4) (0.9) (0.7) Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions------------------------ 6.4 0.7 0.3 0.2 Unrecognized net (asset) obligation being recognized over plan's average remaining service life----- (1.0) (1.1) 0.2 0.3 Additional minimum liability--------- -- -- (0.3) (0.3) Accrued pension liability------------ (5.1) (3.8) (0.7) (0.5) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% 7.0% 8.25% Long-term asset yield------------ 9.5% 9.5% 9.5% 9.5% Rate of increase in future compensation------------------- 5.25% 5.25% 5.25% 5.25% SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the components of pension expense for the SFER Plan and Supplemental Plan for 1993, 1992 and 1991 (in millions of dollars): The Company also sponsors a pension plan covering certain hourly-rated employees in California (the 'Hourly Plan'). The Hourly Plan provides benefits that are based on a stated amount for each year of service. The Company annually contributes amounts which are actuarially determined to provide the Hourly Plan with sufficient assets to meet future benefit payment requirements. The following table sets forth the components of pension expense for the Hourly Plan for the years 1993, 1992 and 1991 (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Service cost--------------------- 0.2 0.2 0.2 Interest cost-------------------- 0.7 0.7 0.7 Return on plan assets------------ (0.8) (0.1) (0.5) Net amortization and deferral---- 0.4 (0.4) 0.1 0.5 0.4 0.5 The following table sets forth the funded status of the Hourly Plan at December 31, 1993 and 1992 (in millions of dollars): 1993 1992 Plan assets at fair value, primarily invested in fixed-rate securities---- 7.7 7.2 Actual present value of projected benefit obligations Accumulated benefit obligations Vested----------------------- (11.2) (9.1) Nonvested-------------------- (0.4) (0.3) Excess of projected benefit obligation over plan assets-------- (3.9) (2.2) Unrecognized net (gain) loss from past experience different from that assumed and effects of changes in assumptions------------------------ 1.5 (0.3) Unrecognized prior service cost------ 0.5 0.6 Unrecognized net obligation---------- 1.5 1.6 Additional minimum liability--------- (3.5) (2.1) Accrued pension liability-------- (3.9) (2.4) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% Expected long-term rate of return on plan assets----------------- 8.5% 8.5% At December 31, 1993 the Company's additional minimum liability exceeded the total of its unrecognized prior service cost and unrecognized net obligation by $1.5 million. Accordingly, at December 31, 1993 the Company's retained earnings have been reduced by such amount, net of related taxes of $0.6 million. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides health care and life insurance benefits for substantially all employees who retire under the provisions of a Company-sponsored retirement plan and their dependents. Participation in the plans is voluntary and requires a monthly contribution by the employee. Effective January 1, 1993 the Company adopted the provisions of SFAS No. 106 -- 'Employers' Accounting for Postretirement Benefits Other Than Pensions'. The Statement requires the accrual, during the years the employee renders service, of the expected cost of providing postretirement benefits to the employee and the employee's beneficiaries and covered dependents. The following table sets forth the plan's funded status at December 31, 1993 and January 1, 1993 (in millions of dollars): DECEMBER 31, JANUARY 1, 1993 1993 Plan assets, at fair value----------- -- -- Accumulated postretirement benefit obligation Retirees--------------------------- (3.6) (3.1) Eligible active participants------- (1.2) (0.9) Other active participants---------- (1.4) (1.2) Accumulated postretirement benefit obligation in excess of plan assets----------------------------- (6.2) (5.2) Unrecognized transition obligation------------------------- 5.0 5.2 Unrecognized net loss from past experience different from that assumed and from changes in assumptions------------------------ 0.5 -- Accrued postretirement benefit cost------------------------------- (0.7) -- Assumed discount rate---------------- 7.5% 8.25% Assumed rate of compensation increase--------------------------- 5.25% 5.25% The Company's net periodic postretirement benefit cost for 1993 includes the following components (in millions of dollars): Service costs---------------------------------------- 0.3 Interest costs--------------------------------------- 0.4 Amortization of unrecognized transition obligation----------------------------------------- 0.3 1.0 In periods prior to 1993 the cost to the Company of providing health care and life insurance benefits for qualified retired employees was recognized as expenses when claims were paid. Such amounts totalled $0.4 million in 1991 and $0.3 million in 1992. Estimated costs and liabilities have been developed assuming trend rates for growth in future health care costs beginning with 10% for 1993 graded to 6% (5.5% for post age 65) by the year 2000 and remaining constant thereafter. Increasing the assumed health care cost trend rate by one percent each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $0.9 million and the aggregate of the service cost and interest cost components of the net periodic postretirement benefit cost for 1994 by $0.2 million. SAVINGS PLAN The Company has a savings plan, which became effective November 1, 1990, available to substantially all salaried employees and intended to qualify as a deferred compensation plan under Section 401(k) of the Internal Revenue Code (the '401(k) Plan'). The Company will match employee contributions for an amount up to 4% of each employee's base salary. In addition, if at the end of each SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) fiscal year the Company's performance for such year has exceeded certain predetermined criteria, each participant will receive an additional matching contribution equal to 50% of the regular matching contribution. The Company's contributions to the 401(k) Plan, which are charged to expense, totaled $1.2 million in 1991, $1.3 million in 1992 and $1.5 million in 1993. In the fourth quarter of 1993 the Company established a new savings plan with respect to certain personnel employed in foreign locations. OTHER POSTEMPLOYMENT BENEFITS In the fourth quarter of 1993 the Company adopted SFAS No. 112 -- 'Employers' Accounting for Postemployment Benefits'. The Statement requires the accrual of the estimated costs of benefits provided by an employer to former or inactive employees after employment but before retirement. Such benefits include salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits, job training and counseling and continuation of benefits such as health care and life insurance coverage. The adoption of SFAS No. 112 resulted in a charge to earnings of $1.8 million in 1993. (12) COMMITMENTS AND CONTINGENCIES CRUDE OIL HEDGING PROGRAM In the third quarter of 1990, the Company initiated a hedging program designed to provide a certain minimum level of cash flow from its sales of crude oil. Settlements were included in oil revenues in the period the oil is sold. In the year ended December 31, 1990 hedges resulted in a reduction in oil revenues of $10.7 million; in 1991 hedges resulted in an increase in oil revenues of $41.7 million and in 1992 hedges resulted in an increase in oil revenues of $9.7 million. The Company had no open crude oil hedging contracts during 1993. NATURAL GAS HEDGING PROGRAM In the third quarter of 1992 the Company initiated a hedging program with respect to its sales of natural gas. The Company has used various instruments whereby monthly settlements are based on the differences between the price or range of prices specified in the instruments and the settlement price of certain natural gas futures contracts quoted on the New York Mercantile Exchange. In instances where the applicable settlement price is less than the price specified in the contract, the Company receives a settlement based on the difference; in instances where the applicable settlement price is higher than the specified prices the Company pays an amount based on the difference. The instruments utilized by the Company differ from futures contracts in that there is no contractual obligation which requires or allows for the future delivery of the product. In 1992 and 1993 hedges resulted in a reduction in natural gas revenues of $0.5 million and $8.2 million, respectively. At December 31, 1993 the Company had two open natural gas hedging contracts covering approximately 1.2 Bcf during the six month period beginning March 1994. The 'approximate break-even price' (the average of the monthly settlement prices of the applicable futures contracts which would result in no settlement being due to or from the Company) with respect to such contracts is approximately $1.82 per Mcf. In addition, certain parties hold options on contracts covering approximately 4.8 Bcf during the seven month period beginning March 1994 at an approximate break even price of $1.90 per Mcf. The Company has no other outstanding natural gas hedging instruments. INDEMNITY AGREEMENT WITH SFP At the time of the Spin-Off, the Company and SFP entered into an agreement to protect SFP from federal and state income taxes, penalties and interest that would be incurred by SFP if the Spin-off were determined to be a taxable event resulting primarily from actions taken by the Company during a one-year period that ended December 4, 1991. If the Company were required to make SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) payments pursuant to the agreement, such payments could have a material adverse effect on its financial condition; however, the Company does not believe that it took any actions during such one-year period that would have such an effect on the Spin-Off. ENVIRONMENTAL REGULATION Federal, state and local laws and regulations relating to environmental quality control affect the Company in all of its oil and gas operations. The Company has been identified as one of over 250 potentially responsible parties ('PRPs') at a superfund site in Los Angeles County, California. The site was operated by a third party as a waste disposal facility from 1948 until 1983. The Environmental Protection Agency ('EPA') is requiring the PRPs to undertake remediation of the site in several phases, which include site monitoring and leachate control, gas control and final remediation. In 1989, the EPA and a group of the PRPs entered into a consent decree covering the site monitoring and leachate control phases of remediation. The Company is a member of the group that is responsible for carrying out this first phase of work, which is expected to be completed in five to eight years. The maximum liability of the group, which is joint and several for each member of the group, for the first phase is $37.0 million, of which the Company's share is expected to be approximately $2.4 million ($1.3 million after recoveries from working interest participants in the unit at which the wastes were generated) payable over the period that the phase one work is performed. The EPA and a group of PRPs of which the Company is a member have also entered into a subsequent consent decree (which has not been finally entered by the court) with respect to the second phase of work (gas control). The liability of this group has not been capped, but is estimated to be $130.0 million. The Company's share of costs of this phase, however, is expected to be approximately of the same magnitude as that of the first phase because more parties are involved in the settlement. The Company has provided for costs with respect to the first two phases, but it cannot currently estimate the cost of any subsequent phases of work or final remediation which may be required by the EPA. In 1989, Adobe received requests from the EPA for information pursuant to Section 104(e) of CERCLA with respect to the D. L. Mud and Gulf Coast Vacuum Services superfund sites located in Abbeville, Louisiana. The EPA has issued its record of decision at the Gulf Coast Site and on February 9, 1993 the EPA issued to all PRP's at the site a settlement order pursuant to Section 122 of CERCLA. Earlier, an emergency order pursuant to Section 106 of CERLA was issued on December 11, 1992, for purposes of containment due to the Louisiana rainy season. On December 15, 1993 the Company entered into a sharing agreement with other PRP'S to participate in the final remediation of the Gulf Coast site. The Company's share of the remediation is approximately $600,000 and includes its proportionate share of those PRPs who do not have the financial resources to provide their share of the work at the site. A former site owner has already conducted remedial activities at the D. L. Mud Site under a state agency agreement. The extent, if any, of any further necessary remedial activity at the D. L. Mud Site has not been finally determined. EMPLOYMENT AGREEMENTS The Company has entered into employment agreements with certain key employees. The initial term of each agreement expired on December 31, 1990 and, on January 1, 1991 and beginning on each January 1 thereafter, is automatically extended for one-year periods, unless by September 30 of any year the Company gives notice that the agreement will not be extended. The term of the agreements is automatically extended for 24 months following a change of control. The consummation of the Merger constituted a change of control as defined in the agreements. In the event that following a change of control employment is terminated for reasons specified in the agreements, the employee would receive: (i) a lump sum payment equal to two years' base salary; (ii) the maximum possible bonus under the terms of the Company's incentive compensation plan; SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (iii) a lapse of restrictions on any outstanding restricted stock grants and full payout of any outstanding Phantom Units; (iv) cash payment for each outstanding stock option equal to the amount by which the fair market value of the common stock exceeds the exercise price of the option; and, (v) life, disability and health benefits for a period of up to two years. In addition, payments and benefits under certain employment agreements are subject to further limitations based on certain provisions of the Internal Revenue Code. INTEREST RATE SWAPS Prior to the Merger, Adobe had entered into two interest rate swaps with a bank with notional principal amounts of $15.0 mllion and $20.0 million. Under the terms of the $20.0 million swap, which expires in April 1994, during any quarterly period at the beginning of which a floating rate specified in the agreement is less than 7.84%, the Company must pay the bank interest for such period on the principal amount at the difference between the rates. Should the floating rate be in excess of 7.84%, the bank must pay the Company interest for such period on the principal amount at the difference between the rates. For the period from the effective date of the Merger to December 31, 1992 the amount due the bank in accordance with the terms of the $20.0 million swap totalled $0.6 million and the amount due the bank in 1993 totalled $0.9 million. For the quarterly period which ends in April 1994, the amount due the bank is based on a floating rate of 3.375%. The $15.0 million swap, which expired December 31, 1992, had terms similar to the $20.0 million swap and the amount due the bank for the period subsequent to the Merger totaled $0.5 million. OPERATING LEASES The Company has noncancellable agreements with terms ranging from one to ten years to lease office space and equipment. Minimum rental payments due under the terms of these agreements are: 1994 -- $6.1 million, 1995 -- $6.0 million, 1996 -- $5.5 million, 1997 -- $5.2 million, 1998 -- $4.4 million and $4.7 million thereafter. Rental payments made under the terms of noncancellable agreements totaled $4.0 million in 1991,$4.5 million in 1992 and $5.5 million in 1993. OTHER MATTERS The Company has several long-term contracts ranging up to fifteen years for the supply and transportation of approximately 30 million cubic feet per day of natural gas. In the aggregate, these contracts involve a minimum commitment on the part of the Company of approximately $10 million per year. There are other claims and actions, including certain other environmental matters, pending against the Company. In the opinion of management, the amounts, if any, which may be awarded in connection with any of these claims and actions could be significant to the results of operations of any period but would not be material to the Company's consolidated financial position. (13) INCOME TAXES Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109 -- 'Accounting for Income Taxes'. The adoption of SFAS No. 109 had no significant impact on the Company's provision for income taxes. Through the date of the Spin-Off the taxable income or loss of the Company was included in the consolidated federal income tax return filed by SFP. The Company has filed separate consolidated federal income tax returns for periods subsequent to the Spin-Off. The consolidated federal income tax returns of SFP have been examined through 1988 and all years prior to 1981 are closed. Issues relating to the years 1981 through 1985 are being contested through various stages of administrative appeal. The Company is evaluating its position with respect to issues raised in a 1986 through 1988 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) audit. The Company believes adequate provision has been made for any adjustments which might be assessed for all open years. During 1989, the Company received a notice of deficiency for certain state franchise tax returns filed for the years 1978 through 1983 as part of the consolidated tax returns of SFP. The years subsequent to 1983 are still subject to audit. At December 31, 1993 Other Long-Term Obligations includes $20.6 million with respect to this matter. The Company intends to contest this matter. With the Merger of Adobe the Company succeeded to a net operating loss carryforward that is subject to Internal Revenue Code Section 382 limitations which annually limit taxable income that can be offset by such losses. Certain changes in the Company's shareholders may impose additional limitations as well. Losses carrying forward of $133.3 million expire beginning in 1998. At date of the Merger, Adobe had ongoing tax litigation related to a refund claim for carryback of certain net operating losses denied by the Internal Revenue Service. During 1991 Adobe successfully defended its claim in Federal District Court and prevailed again in 1992 in the United States Court of Appeals for the Fifth Circuit. The Internal Revenue Service had no further recourse to litigation and a $16.2 million refund was reflected as Income Tax Refund Receivable at December 31, 1992 and collected in 1993. Pretax income from continuing operations for the years ended December 31, 1993, 1992 and 1991 was taxed under the following jurisdictions: 1993 1992 1991 Domestic----------------------------- (120.9) 2.7 34.8 Foreign------------------------------ (29.3) (3.6) (2.1) (150.2) (0.9) 32.7 The Company's income tax expense (benefit) for the years ended December 31, 1993, 1992 and 1991 consisted of (in millions of dollars): 1993 1992 1991 Current U.S. federal--------------------- (1.3) 3.5 11.0 State---------------------------- (1.2) 1.4 1.7 Foreign-------------------------- 1.3 1.9 -- (1.2) 6.8 12.7 Deferred U.S. federal--------------------- (65.6) (3.5) 0.2 U.S. federal tax rate change----- 2.6 -- -- State---------------------------- (8.0) (2.5) 1.3 Foreign-------------------------- (0.9) (0.3) -- (71.9) (6.3) 1.5 (73.1) 0.5 14.2 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company's deferred income tax liabilities (assets) at December 31, 1993 and 1992 are composed of the following differences between financial and tax reporting (in millions of dollars): 1993 1992 Capitalized costs and write-offs----- 83.0 150.8 Differences in Partnership basis----- 15.1 29.3 State deferred liability------------- 5.8 13.4 Foreign deferred liability----------- 13.7 15.5 Gross deferred liabilities----------- 117.6 209.0 Accruals not currently deductible for tax purposes----------------------- (17.7) (28.3) Alternative minimum tax carryforwards---------------------- (8.3) (5.3) Net operating loss carryforwards----- (46.7) (56.4) Other-------------------------------- (0.5) -- Gross deferred assets---------------- (73.2) (90.0) Deferred tax liability--------------- 44.4 119.0 The Company had no deferred tax asset valuation allowance at December 31, 1993 or 1992. A reconciliation of the Company's U.S. income tax expense (benefit) computed by applying the statutory U.S. federal income tax rate to the Company's income (loss) before income taxes for the years ended December 31, 1993, 1992 and 1991 is presented in the following table (in millions of dollars): 1993 1992 1991 U.S. federal income taxes (benefit) at statutory rate------------------ (52.6) (0.3) 11.1 Increase (reduction) resulting from: State income taxes, net of federal effect--------------------------- (1.0) 1.4 2.2 Foreign income taxes in excess of U.S. rate------------------------ (0.8) 0.3 -- Nondeductible amounts-------------- (0.2) (2.4) -- Effect of increase in statutory rate on deferred taxes----------- 2.6 -- -- Federal audit refund--------------- (3.2) -- -- Amendment to tax sharing agreement with SFP------------------------- (1.2) -- -- Benefit of tax losses-------------- (11.2) -- -- Prior period adjustments----------- (5.5) -- -- Other------------------------------ -- 1.5 0.9 (73.1) 0.5 14.2 The Company increased its deferred tax liability in 1993 as a result of legislation enacted during 1993 increasing the corporate tax rate from 34% to 35% commencing in 1993. (14) FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107 'Disclosure About Fair Value of Financial Instruments' requires the disclosure, to the extent practicable, of the fair value of financial instruments which are recognized or unrecognized in the balance sheet. The fair value of the financial instruments disclosed herein is not representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences, if any, of realization or settlement. The following table reflects the financial SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) instruments for which the fair value differs from the carrying amount of such financial instrument in the Company's December 31, 1993 and 1992 balance sheets (in millions of dollars): The fair value of the Trust Units and convertible preferred stock is based on market prices. The fair value of the Company's fixed-rate long-term debt is based on current borrowing rates available for financings with similar terms and maturities. With respect to the Company's floating-rate debt, the carrying amount approximates fair value. The fair value of the interest rate swap represents the estimated cost to the Company over the remaining life of the contract. At December 31, 1993 the Company had two open natural gas hedging contracts and options outstanding on five additional contracts (see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Contracts). Based on the settlement prices of certain natural gas futures contracts as quoted on the New York Mercantile Exchange on December 30, 1993, assuming all options are exercised, the cost to the Company with respect to such contracts during 1994 would be approximately $0.6 million. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OIL AND GAS RESERVES AND RELATED FINANCIAL DATA Information with respect to the Company's oil and gas producing activities is presented in the following tables. Reserve quantities as well as certain information regarding future production and discounted cash flows were determined by independent petroleum consultants, Ryder Scott Company. OIL AND GAS RESERVES The following table sets forth the Company's net proved oil and gas reserves at December 31, 1990, 1991, 1992 and 1993 and the changes in net proved oil and gas reserves for the years ended December 31, 1991, 1992 and 1993. Proved reserves are estimated quantities of crude oil and natural gas which geological and engineering data indicate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are proved reserves which can be expected to be recovered through existing wells with existing equipment and operating methods. Indonesian reserves represent an entitlement to gross reserves in accordance with a production sharing contract. These reserves include estimated quantities allocable to the Company for recovery of operating costs as well as quantities related to the Company's net equity share after recovery of costs. Accordingly, these quantities are subject to fluctuations with an inverse relationship to the price of oil. If oil prices increase, the reserve quantities attributable to the recovery of operating costs decline. Although this reduction would be offset partially by an increase in the net equity share, the overall effect would be a reduction of reserves attributable to the Company. At December 31, 1993, the quantities include 0.6 million barrels which the Company is contractually obligated to sell for $.20 per barrel. At December 31, 1993 the Company's reserves were 6.9 million barrels of crude oil and liquids and 14.5 Bcf of natural gas lower than at December 31, 1992, reflecting the sale in 1993 of properties with reserves totalling 8.7 million barrels of crude oil and liquids and 47.4 Bcf of natural gas. At December 31, 1993, 1.9 million barrels of crude oil reserves and 19.7 billion cubic feet of natural gas reserves were subject to a 90% net profits interest held by Santa Fe Energy Trust. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) ESTIMATED PRESENT VALUE OF FUTURE NET CASH FLOWS Estimated future net cash flows from the Company's proved oil and gas reserves at December 31, 1991, 1992 and 1993 are presented in the following table (in millions of dollars, except as noted): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) The following tables sets forth the changes in the present value of estimated future net cash flows from proved reserves during 1991, 1992 and 1993 (in millions of dollars): Estimated future cash flows represent an estimate of future net cash flows from the production of proved reserves using estimated sales prices and estimates of the production costs, ad valorem and production taxes, and future development costs necessary to produce such reserves. No deduction has been made for depletion, depreciation or any indirect costs such as general corporate overhead or interest expense. The sales prices used in the calculation of estimated future net cash flows are based on the prices in effect at year end. Such prices have been held constant except for known and determinable escalations. Operating costs and ad valorem and production taxes are estimated based on current costs with respect to producing oil and gas properties. Future development costs are based on the best estimate of such costs assuming current economic and operating conditions. Income tax expense is computed based on applying the appropriate statutory tax rate to the excess of future cash inflows less future production and development costs over the current tax basis of the properties involved. While applicable investment tax credits and other permanent differences are considered in computing taxes, no recognition is given to tax benefits applicable to future exploration costs or the activities of the Company that are unrelated to oil and gas producing activities. The information presented with respect to estimated future net revenues and cash flows and the present value thereof is not intended to represent the fair value of oil and gas reserves. Actual future sales prices and production and development costs may vary significantly from those in effect at year-end and actual future production may not occur in the periods or amounts projected. This information is presented to allow a reasonable comparison of reserve values prepared using standardized measurement criteria and should be used only for that purpose. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) COSTS INCURRED IN OIL AND GAS PRODUCING ACTIVITIES The following table includes all costs incurred, whether capitalized or charged to expense at the time incurred (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) CAPITALIZED COSTS RELATED TO OIL AND GAS PRODUCING ACTIVITIES The following table sets forth information concerning capitalized costs at December 31, 1993 and 1992 related to the Company's oil and gas operations (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) RESULTS OF OPERATIONS FROM OIL AND GAS PRODUCING ACTIVITIES The following table sets forth the Company's results of operations from oil and gas producing activities for the years ended December 31, 1993, 1992 and 1991 (in millions of dollars): Income taxes are computed by applying the appropriate statutory rate to the results of operations before income taxes. Applicable tax credits and allowances related to oil and gas producing activities have been taken into account in computing income tax expenses. No deduction has been made for indirect cost such as corporate overhead or interest expense. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SANTA FE ENERGY RESOURCES, INC. By /s/ MICHAEL J. ROSINSKI MICHAEL J. ROSINSKI VICE PRESIDENT AND CHIEF FINANCIAL OFFICER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) Dated: March 22, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. SIGNATURE AND TITLE JAMES L. PAYNE, Chairman of the Board, President and Chief Executive Officer and Director (PRINCIPAL EXECUTIVE OFFICER) MICHAEL J. ROSINSKI, Vice President and Chief Financial Officer (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) DIRECTORS Rod F. Dammeyer William E. Greehey Melvyn N. Klein Robert D. Krebs Allan V. Martini Michael A. Morphy Reuben F. Richards By: /s/ MICHAEL J. ROSINSKI David M. Schulte MICHAEL J. ROSINSKI Marc J. Shapiro VICE PRESIDENT AND Robert F. Vagt CHIEF FINANCIAL OFFICER Kathryn D. Wriston ATTORNEY IN FACT Dated: March 22, 1994 SANTA FE ENERGY RESOURCES, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) 1993 1992 1991 Accounts receivable Balance at the beginning of period------------------------- 5.0 2.6 2.8 Charge (credit) to income---- -- -- -- Net amounts written off------ (0.1 ) (1.1 ) (.2 ) Other(a)--------------------- 1.4 3.5 -- Balance at the end of period----- 6.3 5.0 2.6 (a) Represents valuation accounts related to accounts receivable acquired in merger with Adobe Resources Corporation. SANTA FE ENERGY RESOURCES, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Maintenance and repairs-------------- 27.1 25.0 22.6 Taxes (other than income) Ad valorem----------------------- 12.0 11.4 17.0 Production and severance--------- 9.5 8.2 6.8 Payroll and other---------------- 5.8 4.7 3.4 27.3 24.3 27.2 INDEX OF EXHIBITS A. EXHIBITS B. REPORTS ON FORM 8-K. DATE ITEM February 8, 1994 5

30554_1993.txt

30554

1993

ITEM 1. BUSINESS DuPont was founded in 1802 and was incorporated in Delaware in 1915. The company is the largest United States chemical producer and is one of the leading chemical producers worldwide. The company conducts fully integrated petroleum operations primarily through its wholly owned subsidiary Conoco Inc. and, in 1992, ranked eighth in the worldwide production of petroleum liquids by U.S.-based companies and tenth in the production of natural gas. Conoco Inc. and other subsidiaries and affiliates of DuPont conduct exploration, production, mining, manufacturing or selling activities, and some are distributors of products manufactured by the company. During 1993, the company significantly changed the way it was organized. Large business sectors were eliminated and replaced by approximately twenty strategic business units. Within the strategic business units approximately 85 businesses manufacture and sell a wide range of products to many different markets, including the energy, transportation, textile, construction, automotive, agricultural, printing, health care, packaging and electronics markets. The company and its subsidiaries have operations in about 70 nations worldwide and, as a result, about 45% of consolidated sales are derived from sales outside the United States, based on the location of the corporate unit making the sale. Total worldwide employment at year-end 1993 was about 114,000 people. The company is organized for financial reporting purposes into five principal industry segments--Chemicals, Fibers, Polymers, Petroleum, and Diversified Businesses. The following information describing the businesses of the company can be found on the indicated pages of Exhibit 13: - -------- * Exclude photograph and related caption on page 4. SOURCES OF SUPPLY The company utilizes numerous firms as well as internal sources to supply a wide range of raw materials, energy, supplies, services and equipment. To assure availability, the company maintains multiple sources for most raw materials, including hydrocarbon feedstocks, and for fuels. Large volume purchases are generally procured under competitively priced supply contracts. A majority of sales in the Chemicals, Fibers, and Polymers segments' businesses is dependent on hydrocarbon feedstocks derived from crude oil and natural gas. Current hydrocarbon feedstock requirements are met by Conoco and other major oil companies. A joint venture with OxyChem, a subsidiary of Occidental Petroleum Corporation, manufactures and supplies a significant portion of the company's requirements for ethylene glycol. A joint venture with subsidiaries of RWE AG supplies the company's requirements for coal. A significant portion of the company's caustic/chlorine needs is supplied by a joint venture with Olin Corporation. The major purchased commodities, raw materials, and supplies for the following industry segments in 1993 are listed below: In the Petroleum segment, the major commodities and raw materials purchased are the same as those produced. Approximately 59% of the crude oil processed in the company's U.S. refineries in 1993 came from U.S. sources. In 1993, the company's refineries outside the United States processed principally North Sea and Middle East crude oils. In addition, during 1993, the company consumed substantial amounts of electricity and natural gas. PATENTS AND TRADEMARKS The company owns and is licensed under various patents, which expire from time to time, covering many products, processes and product uses. No individual patent is of material importance to any of the industry segments, although taken as a whole, the rights of the company and the products made and sold under patents and licenses are important to the company's business. During 1993, the company was granted 591 U.S. and 1,828 non-U.S. patents. The company also has about 900 registered trademarks for its products. Ownership rights in trademarks continue indefinitely if the trademarks are continued in use and properly protected. SEASONALITY In general, sales of the company's products are not substantially affected by seasonality. However, the Diversified Businesses segment is impacted by seasonality of sales of agricultural products with highest sales in the first half of the year, particularly the second quarter. Within the Petroleum segment, the mix of refined products, natural gas and natural gas liquids varies because of increased demand for gasoline in the summer months and natural gas, heating oil and propane during the winter months. MAJOR CUSTOMERS The company's sales are not materially dependent on a single customer or small group of customers. The Fibers and Polymers segments, however, have several large customers in their respective industries that are important to these segments' operating results. COMPETITION Principal competitors in the chemical industry include major chemical companies based in the United States, Europe, Japan, the Republic of China and other Asian nations. Competitors offer a comparable range of products from agricultural, commodity and specialty chemicals to plastics, fibers and medical products. The company also competes in certain product markets with smaller, more specialized firms. Principal competitors in the petroleum industry are integrated oil companies, many of which also have substantial petrochemical operations, and a variety of other firms including independent oil and gas producers, pipeline companies, and large and small refiners and marketers. In addition, the company competes with the growing petrochemical operations in oil-producing countries. Businesses in the Chemicals, Fibers, Polymers, and Diversified Businesses segments compete on a variety of factors such as price, product quality or specifications, customer service and breadth of product line, depending on the characteristics of the particular market involved. The Petroleum segment business is highly price-competitive and competes as well on quality and reliability of supply. Further information relating to competition is included in two areas of Exhibit 13 (1) the "Letter to Stockholders" on pages 2, 4*, 5, 7 and (2) Industry Segment Reviews on pages 20-28. RESEARCH AND DEVELOPMENT The company's substantial research and development activities are primarily funded with internal resources and conducted at over 60 domestic sites in 21 states at both dedicated research facilities and manufacturing plants. DuPont operates several large research centers near Wilmington, Delaware supporting strategic business units in its Chemicals, Fibers, Polymers and Diversified Businesses segments. Among these, the Experimental Station laboratories engage in fundamental, exploratory and applied research, and the Stine-Haskell Research Center conducts agricultural product research and toxicological research of company products to assure they are safe for manufacture and use. At its facility in Ponca City, Oklahoma, the company conducts research for new products and technologies for petroleum operations as well as other segments of the business. DuPont also operates research facilities at a number of locations outside the United States in Belgium, Canada, France, Germany, Japan, Luxembourg, Mexico, Netherlands, Switzerland and the United Kingdom reflecting the company's growing global business interests. Research and development activities include exploratory studies to advance scientific knowledge in fields of interest to the company; basic and applied work to support and improve existing products and processes; and scouting work to identify and develop new business opportunities in relevant fields. Each strategic business unit of the company funds research and development activities to support its business mission. The corporate laboratories are responsible for assuring that leading-edge science and engineering concepts are identified and diffused throughout the DuPont technical community. All R&D activities are coordinated by senior R&D management to insure that business and corporate technical activities are integrated and that the core technical competencies underlying DuPont's current and future businesses remain healthy and continue to provide competitive advantages. Further information regarding research and development is in Exhibit 13 on page 4 of the "Letter to Stockholders." Annual research and development expense and such expense shown "As Percent of Combined Segment Sales" for the five years 1989 through 1993 are included under the heading "General" of the Five- Year Financial Review on page 65 of Exhibit 13. - -------- * Exclude photograph and related caption on page 4. ENVIRONMENTAL MATTERS Information relating to environmental matters is included in two areas of Exhibit 13 (1) the "Letter to Stockholders" on page 5 and (2) "Management's Discussion and Analysis" on pages 33-34. RISKS ATTENDANT TO FOREIGN OPERATIONS The company's petroleum exploration and production operations outside the United States are exposed to risks due to possible actions by host governments such as increases or variations in tax and royalty payments, participation in the company's concessions, limited or embargoed production, mandatory exploration or production controls, nationalization, and export controls. Civil unrest and changes in government are also potential hazards. Under certain circumstances, the company has attempted to minimize its exposure by carrying political risk insurance. The profitability of the company's worldwide exploration and production operations is also exposed to risks due to actions of the United States government through tax legislation, executive order, and commercial restrictions. Actions by both the United States and host governments have affected operations significantly in the past, and may continue to impact operations in the future. ITEM 2.

ITEM 2. PROPERTIES The company owns and operates manufacturing, processing, production, refining, marketing, research and development facilities worldwide. In addition, the company owns and leases petroleum properties worldwide. DuPont's corporate headquarters is located in Wilmington, Delaware, and the company's petroleum businesses are headquartered in Houston, Texas. In addition, the company operates sales offices, regional purchasing offices, distribution centers and various other specialized service locations. Further information regarding properties is included in Exhibit 13 in the Industry Segment Reviews on pages 20-28. Information regarding research and development facilities is incorporated by reference to Item 1, Business-- Research and Development on page 5 of this report. Additional information with respect to the company's property, plant and equipment, and leases is incorporated by reference to Schedules V and VI on pages 20-22 of this report, and is contained in Notes 14 and 21 to the company's consolidated financial statements on pages 46 and 50 of Exhibit 13. CHEMICALS, FIBERS, POLYMERS, AND DIVERSIFIED BUSINESSES Approximately 75% of the property, plant and equipment related to operations in the Chemicals, Fibers, Polymers, and Diversified Businesses is located in the United States and Puerto Rico. This investment is located at some 85 sites, principally in Texas, Delaware, Virginia, North Carolina, Tennessee, West Virginia, South Carolina, and New Jersey. The principal locations within these states are as follows: Property, plant and equipment outside the United States and Puerto Rico is located at about 70 sites, principally in Canada, the United Kingdom, Germany, Netherlands, Luxembourg, Singapore, Taiwan, Mexico, France, Japan, Spain, Brazil, Republic of Korea, Argentina and Belgium. Products from more than one business are frequently produced at the same location. The company's plants and equipment are well maintained and in good operating condition. Sales as a percent of capacity were 85% in 1993, 88% in 1992, and 86% in 1991. These properties are directly owned by the company except for some auxiliary facilities and miscellaneous properties, such as certain buildings and transportation equipment, which are leased. Although no title examination of the properties has been made for the purpose of this report, the company knows of no material defects in title to any of these properties. PETROLEUM BUSINESSES The company owns and leases oil and gas properties worldwide. Exploration, production, and natural gas and gas products properties are described generally on pages 24-26 and 58-63 of Exhibit 13. Estimated proved reserves of oil and gas are found on page 58 of Exhibit 13. Information regarding the company's refining, marketing, supply, and transportation properties is also provided on pages 24-26 of Exhibit 13. PETROLEUM PRODUCTION The following tables show the company's interests in petroleum production and natural gas deliveries. Petroleum liquids production comprises crude oil and condensate and natural gas liquids (NGL) removed for the company's account from its natural gas deliveries. Natural gas deliveries represent Conoco's share of deliveries from leases in which the company has an ownership interest. NGL's extracted from purchased natural gas by the company's gas processing plants are discussed under the topic "Natural Gas and Gas Products" on pages 9 and 10. AVERAGE PRODUCTION COSTS AND SALES PRICES The following table presents data as prescribed by the Securities and Exchange Commission (SEC). Accordingly, the unit costs do not include income taxes and exploration, development and general overhead costs. Since these excluded costs are material, the following data should not be interpreted as measures of profitability or relative profitability. See Results of Operations for Oil- and Gas-Producing Activities on page 59 of Exhibit 13 for a more complete disclosure of revenues and expenses. See also the references to crude oil and natural gas prices and volumes in business review of the Petroleum segment on pages 24-26 of Exhibit 13. - -------- (a) Average production costs per barrel of equivalent liquids, with natural gas converted to liquids at a ratio of 6 MCF of gas to one barrel of liquids. (b) Excludes proceeds from sales of interest in oil and gas properties. PRESENT ACTIVITIES - -------- *Includes wells being completed. **Approximately 186 gross (72 net) oil wells and 602 gross (177 net) gas wells, all in the United States, have multiple completions. DEVELOPED AND UNDEVELOPED PETROLEUM ACREAGE ESTIMATES OF TOTAL PROVED RESERVES FILED WITH OTHER FEDERAL AGENCIES COVERING THE YEAR 1993 The company is not required to file, and has not filed on a recurring basis, estimates of its total proved net oil and gas reserves with any U.S. or non- U.S. governmental regulatory authority or agency other than the Department of Energy (DOE) and the SEC. The estimates furnished to the DOE have been consistent with those furnished to the SEC. They are not necessarily directly comparable, however, due to special DOE reporting requirements such as requirements to report in some instances on a gross, net or total operator basis, and requirements to report in terms of smaller units. In no instance have the estimates for the DOE differed by more than 5% from the corresponding estimates reflected in total reserves reported to the SEC. NATURAL GAS AND GAS PRODUCTS The company has interests in 30 natural gas processing plants in the United States. Natural gas liquids extracted for the company's account from produced and purchased gas averaged 68,631 barrels per day in 1993 and 60,901 barrels per day in 1992. The company operates 16 of the gas plants: 1 in Colorado, 3 in Louisiana, 2 in New Mexico, 4 in Oklahoma, and 6 in Texas. Other natural gas facilities include an 800-mile intrastate natural gas pipeline system in Louisiana, owned by Louisiana Gas System, Inc., a wholly owned subsidiary, and natural gas and natural gas liquids pipelines in several states. C&L Processors Partnership, a 50% owned equity affiliate, has an additional 13 natural gas liquids plants in Oklahoma and Texas, and Conoco's pro rata share of NGL production is 7,885 barrels per day. In May 1993, Conoco acquired a 22.5% interest in Gulf Coast Fractionators, a natural gas fractionator located in Mt. Belvieu, Texas, which is currently expanding from a capacity of 64,000 barrels per day to 104,000 barrels per day. Outside the United States, the company operates a 50% owned gas processing facility at Theddlethorpe, England, and owns a 41% interest in Phoenix Park Gas Processors, whose gas processing facility at Point Lisas, Trinidad, provided a net NGL production of 3,661 barrels per day to Conoco in 1993. REFINING The company currently owns and operates four refineries in the United States located at Lake Charles, Louisiana; Ponca City, Oklahoma; Billings, Montana; and Denver, Colorado. The company also owns and operates the Humber refinery in the United Kingdom and has a 25% interest in a refinery at Karlsruhe in Germany. Capacities at year-end 1993 as well as inputs processed during 1993 are summarized in the following table: - -------- * Represents 25% interest in the Karlsruhe refinery. Utilization of refinery capacity depends on the market demand for petroleum products and the availability of crude oil and other feedstocks. MARKETING In the United States, the company sells refined products at retail in 38 states, principally under the "Conoco" brand. In addition, the company markets a wide range of products other than at retail in all 50 states and the District of Columbia. Refined products are also sold in Austria, Germany and the United Kingdom under the "Jet" and "Conoco" brands; in Belgium, France and Luxembourg under the "Seca" brand; and in Switzerland under the "OK Coop" brand. The "Jet" brand is used for marketing in the Czech Republic, Denmark, Finland, Hungary, Ireland, Norway, Poland, Sweden, and Thailand. The company has commenced operations in Spain through a 50% equity affiliate. SUPPLY AND TRANSPORTATION The company has an extensive pipeline system for crude oil and refined products. Information concerning daily pipeline shipments is presented below: Conoco Pipe Line Company (CPL), a wholly owned subsidiary and operator of the company's U.S. petroleum pipeline system, transported approximately 722 thousand barrels per day of crude oil and refined products in 1993. In addition to pipeline facilities, CPL operates, under a management contract, four marine terminals, one coke-exporting facility and 52 product terminals located throughout the United States. These facilities are wholly or jointly owned by the company. Crude oil is gathered in the Rocky Mountain, mid-continent and southern Louisiana areas primarily for delivery to local refiners. Refined products pipelines are located in the Rocky Mountain and mid-continent areas to serve regional demand centers. Other U.S. transportation assets include numerous tank cars, barges, tank trucks and other motor vehicles. The company also operates a fleet of seagoing crude oil tankers. These vessels, principally of Liberian registry, are described as follows: ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Because of the size and nature of its business, the company is subject to numerous lawsuits and claims with respect to such matters as product liabilities, governmental regulations and other actions arising out of the normal course of business. While the effect on future financial results is not subject to reasonable estimation because considerable uncertainty exists, in the opinion of company counsel, the ultimate liabilities resulting from such lawsuits and claims will not materially affect the consolidated financial position of the company. To date, DuPont has been served with more than 500 lawsuits in several jurisdictions, principally Florida, Hawaii and Puerto Rico, by growers who allege plant damage from using "Benlate" DF 50 fungicide. Seventy (70) of these suits have been disposed of: 12 by dismissal, 3 by summary judgment, 52 by settlement, 1 by directed verdict in DuPont's favor at trial, and 2 by jury verdict in DuPont's favor. Additionally, DuPont obtained summary judgment in 7 Florida cases, based on the economic loss doctrine which limits damages to breach of warranty. In our most recent trial (2 cases), a Florida jury returned a verdict in DuPont's favor. In 5 other trials, jury verdicts have been returned against DuPont, but for an average of less than a third of the compensatory damages claimed by the plaintiffs. In 4 of these trials, the juries also allocated liability to the plaintiffs. DuPont has appealed these jury verdicts. DuPont also had one jury verdict for the company. DuPont believes that "Benlate" DF 50 fungicide did not cause the alleged damages. DuPont had earlier paid claims based on the belief that, at the time, "Benlate" DF 50 would be found to be a contributor to the reported plant damage. In 1992, after eighteen months of extensive research, DuPont scientists concluded that "Benlate" DF 50 was not responsible for plant damage reports received since March 1991. Concurrent with these research findings, DuPont stopped paying claims relating to those reports. Since 1989, DuPont has been served with approximately fifty-two, lawsuits in several jurisdictions, principally in Texas, Florida, Maryland and Arizona alleging damages as a result of leaks in certain polybutylene plumbing systems. A nationwide class action has been filed in state and federal court in Houston, Texas, but the class has not been certified as of this date. In most cases, DuPont is a codefendant with Shell, Hoechst-Celanese and other parts manufacturers. The polybutylene plumbing systems consist of flexible pipe extruded from polybutylene connected by plastic fittings made from acetal. Shell Chemical is the sole producer of polybutylene; the acetals are provided by Hoechst-Celanese and DuPont. DuPont entered the market in 1983, and it is not known as to the number of commercial or dwelling units that have polybutylene plumbing systems, or the number of commercial or dwelling units that have DuPont's product in their plumbing systems. Presently, DuPont is active in twenty-four suits. There have been twenty-four lawsuits of which the company has disposed of twenty-three by pretrial settlements and one by dismissal. DuPont has not been to trial in any case. On October 24, 1988, the Louisiana Department of Environmental Quality (LDEQ) issued a Compliance Order and Notice of Proposed Penalty to Conoco Inc. for alleged violations of the Louisiana Hazardous Waste Regulations. Following an inspection, LDEQ proposed a penalty of $165,000 for alleged violations related to the handling of by-product caustic and other refinery waste management practices. The company's legal counsel believes that the allegations are generally without factual basis, and that the penalty will be significantly reduced. On April 3, 1991, the Environmental Protection Agency (EPA) assessed a civil penalty of $1.3 million pursuant to a Complaint and Notice of Hearing alleging violations of the Federal Insecticide, Fungicide and Rodenticide Act (FIFRA) in connection with the distribution of a company fungicide. The allegations arise out of the discovery that a herbicide may have been introduced inadvertently into some batches of the fungicide during formulation at contractor sites in 1988 and 1989. The company was made aware of the potential problem by complaints from growers and notified EPA in August 1989 that it was undertaking a voluntary recall of suspect batches. EPA issued a stop sale order in September 1989 accompanied by a formal request for a product recall. The company has reviewed its recall with EPA and they have expressed satisfaction with the company's efforts. The company intends to seek a settlement of the Complaint and expects that the assessed penalty will be reduced. On October 15, 1993, EPA filed a complaint in the U.S. District Court, Eastern District of Texas (Beaumont), against DuPont alleging various violations of the Clean Water Act at the Sabine River Works. Included are alleged unauthorized discharges, effluent limitation violations, and monitoring and reporting violations under the plant's NPDES permit. The government is seeking a civil penalty of $1.4 million. DuPont's legal counsel believes that most of the allegations are legally without merit and that the case will ultimately settle for a significantly smaller amount. DuPont has entered into a voluntary agreement with the EPA to conduct an audit of the U.S. sites under the Toxic Substance Control Act (TSCA). Agreement participation is not an admission of TSCA noncompliance. Maximum stipulated penalties which DuPont could pay under the agreement are capped at $1 million. The first phase of the audit was completed, but no findings have been issued. Subject to EPA's issuance of new reporting criteria, the second phase of its audit is scheduled to begin in mid-1994. On October 18, 1991, EPA issued an Administrative Order under the Resource Conservation and Recovery Act (RCRA) directing Conoco Pipe Line Company (CPLC) to undertake specific remedial measures related to a former oil reprocessing facility in Converse County, Wyoming. CPLC contested the Administrative Order, and has taken voluntary measures at the site together with other interested parties. On February 19, 1993, the U.S. Department of Justice (DOJ) filed a lawsuit against 10 entities, including CPLC, to enforce the Order and collect penalties. The DOJ calculates CPLC's maximum penalties as of April 1, 1993 at approximately $2.6 million. The lawsuit is in the discovery phase, and CPLC intends to vigorously defend this matter. On July 1, 1993, EPA filed an administrative complaint against DuPont. EPA alleged that DuPont violated the premanufacturing notification regulations of the U.S. Toxic Substances Control Act (TSCA) and sought a $158,375 penalty. DuPont and EPA have signed an agreement to settle the complaint. Under the settlement, DuPont paid EPA $80,000, but did not admit that EPA's legal conclusions were true. On December 21, 1993, Conoco's Denver Refinery received a Notice of Violation from EPA, Region VIII, and the Colorado Department of Health requesting a civil penalty of $169,500 in a dispute over proper scope and scheduling of certain RCRA on-site investigation activities. The investigation activities have previously been the subject of a settlement with EPA and the Colorado Department of Health, and the work performed has been in compliance with such agreement in the opinion of company counsel. As such, it is anticipated that the fine will be significantly reduced pursuant to negotiations between the parties. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list, as of March 1, 1994, of the company's executive officers. - -------- (1) Member of the Board of Directors. The Company's executive officers are elected or appointed for the ensuing year or for an indefinite term, and until their successors are elected or appointed. Each officer named above has been an officer or an executive of DuPont or its subsidiaries during the past five years. PART II Information with respect to the following Items can be found on the indicated pages of Exhibit 13 if not otherwise included herein. ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The company's common stock is listed on the New York Stock Exchange, Inc. (symbol DD) and certain non-U.S. exchanges. The number of record holders of common stock was 181,264 at December 31, 1993 and 179,171 at March 1, 1994. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. - -------- * Exclude photograph and related caption on page 4. PART III Information with respect to the following Items is incorporated by reference to the pages indicated in the company's 1994 Annual Meeting Proxy Statement dated March 18, 1994, filed in connection with the Annual Meeting of Stockholders to be held April 27, 1994. However, information regarding executive officers is contained in Part I of this report (page 13) pursuant to General Instruction G of this form. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements, Financial Statement Schedules and Exhibits 1. Financial Statements (See listing at Part II, Item 8 of this report regarding financial statements, which are incorporated by reference to Exhibit 13.) 2. Financial Statement Schedules The following should be read in conjunction with the previously referenced Financial Statements: Financial Statement Schedules listed under SEC rules but not included in this report are omitted because: a) they are not applicable; b) they are not required under the provisions of Regulation S-X; or c) the required information is shown in the financial statements or notes thereto incorporated by reference. Condensed financial information of the parent company is omitted because restricted net assets of consolidated subsidiaries do not exceed 25% of consolidated net assets. Footnote disclosure of restrictions on the ability of subsidiaries and affiliates to transfer funds is omitted because the restricted net assets of subsidiaries combined with the company's equity in the undistributed earnings of affiliated companies does not exceed 25% of consolidated net assets at December 31, 1993. Separate financial statements of affiliated companies accounted for by the equity method are omitted because no such affiliate individually constitutes a 20% significant subsidiary. 3. EXHIBITS The following list of exhibits includes both exhibits submitted with this Form 10-K as filed with the SEC and those incorporated by reference to other filings: - -------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K. (b) Reports on Form 8-K The following Current Report on Form 8-K was filed during the quarter ended December 31, 1993. (1) On October 27, 1993, a Current Report on Form 8-K was filed in connection with Debt Securities that may be offered on a delayed or continuous basis under its Registration Statements on Form S-3 (No. 33- 39161 and No. 33-48128). Under Item 7, "Financial Statements and Exhibits," the Registrant's Earnings Press Release, dated October 27, 1993 was filed. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED AND IN THE CAPACITIES INDICATED, ON THE 18TH DAY OF MARCH, 1994. E. I. DU PONT DE NEMOURS AND COMPANY (Registrant) C. L. Henry By______________________________________ C. L. HENRY SENIOR VICE PRESIDENT--DUPONT FINANCE (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED ON THE 18TH DAY OF MARCH 1994, BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT IN THE CAPACITIES INDICATED: CHAIRMAN AND DIRECTOR (PRINCIPAL EXECUTIVE OFFICER): E. S. Woolard, Jr. - ------------------------- E. S. WOOLARD, JR. VICE CHAIRMAN AND VICE CHAIRMAN AND DIRECTOR: DIRECTOR: J. A. Krol C. S. Nicandros - ------------------------- ------------------------- J. A. KROL C. S. NICANDROS DIRECTORS: P. N. Barnevik L. C. Duemling M. P. MacKimm - ------------------------- ------------------------- ------------------------- P. N. BARNEVIK L. C. DUEMLING M. P. MACKIMM E. P. Blanchard, Jr. E. B. Du Pont W. K. Reilly - ------------------------- ------------------------- ------------------------- E. P. BLANCHARD, JR. E. B. DU PONT W. K. REILLY A. F. Brimmer C. M. Harper H. R. Sharp, III - ------------------------- ------------------------- ------------------------- A F. BRIMMER C. M. HARPER H. R. SHARP, III C. R. Bronfman R. E. Heckert C. M. Vest - ------------------------- ------------------------- ------------------------- C. R. BRONFMAN R. E. HECKERT C. M. VEST E. M. Bronfman H. W. Johnson J. L. Weinberg - ------------------------- ------------------------- ------------------------- E. M. BRONFMAN H. W. JOHNSON J. L. WEINBERG E. Bronfman, Jr. E. L. Kolber - ------------------------- ------------------------- E. BRONFMAN, JR. E. L. KOLBER REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and the Board of Directors of E. I. du Pont de Nemours and Company Our audits of the consolidated financial statements referred to in our report dated February 17, 1994 appearing on page 36 of the 1993 Annual Report to Stockholders of E. I. du Pont de Nemours and Company, (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 February 17, 1994 E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT(a) FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- See page 22 for footnotes. E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT(a) FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- See page 22 for footnotes. E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES (DOLLARS IN MILLIONS) SCHEDULE V--FOOTNOTES (a) See Property, Plant and Equipment (PP&E) in Note 1 to the company's Consolidated Financial Statements on page 41 of Exhibit 13 for accounting policy with respect to certain additions and retirements. (b) Principally reflects intersegment transfers. In addition, 1991 reflects restructuring of the coal business described in Note 6 on page 43 of Exhibit 13. SCHEDULE VI--FOOTNOTES (a) See Property, Plant and Equipment in Note 1 to the company's Consolidated Financial Statements on page 41 of Exhibit 13 for accounting policy with respect to the methods and rates used for depreciation, depletion and amortization. (b) The following reconciles the amounts shown herein as Additions Charged to Cost and Expenses and the amounts shown as Depreciation, Depletion and Amortization in the Consolidated Income Statement on page 37 of Exhibit 13. (c) Principally reflects intersegment transfers. In addition, 1991 reflects restructuring the coal business described in Note 6 on page 43 of Exhibit 13. E.I DUPONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS AS OF DECEMBER 31, 1993 (DOLLARS IN MILLIONS) - -------- Note: Columns D, E and G have been omitted as the answers thereto were "none." (a) The annual aggregate amount of interest guaranteed is approximately $22. (b) DuPont has received a cross-guarantee for 50% of this amount from another party. E. I. DU PONT DE NEMOURS AND COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (a) Indicated interest rates exclude the effect of interest rate swap agreements that effectively convert floating rate borrowings to fixed rate borrowings. (b) Based on month-end data, except for commercial paper and master notes which are based on daily data, and certain non-U.S. subsidiary bank borrowings which are based on quarterly data. (c) Unsecured promissory notes with maturities not in excess of 270 days. (d) Includes 1,173 million Norwegian Krone borrowings (U.S. $158) with an average interest rate of 5.9%. (e) Average interest rates include the effect of borrowings in certain currencies where local inflation has resulted in relatively high interest rates. (f) Master notes were issued to U.S. banks and are payable on demand. (g) Includes $157 with a floating money market based interest rate. (h) Includes 200 million Australian dollar borrowings (U.S. $140) with a floating money market based interest rate. (i) Interest rates include the effect of a subsidiary's 0% interest export incentive financing. E. I. DU PONT DE NEMOURS AND COMPANY INDEX OF EXHIBITS - -------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K.

276999_1993.txt

276999

1993

ITEM 1. BUSINESS - - ----------------- The Company is engaged in the formulation, manufacture and sale of a broad line of coatings, consisting of water-thinnable and solvent-thinnable general purpose coatings (paints, stains and clear finishes) for use by the general public, painting contractors and industrial and commercial users, primarily for the decoration and preservation of the interiors and exteriors of residential, commercial, institutional and industrial buildings and allied structures (collectively referred to as "trade sales coatings"), and production finishes coatings which are usually produced to conform to the specific requirements of manufacturers who utilize such coatings in the manufacturing process (collectively referred to as "production finishes coatings"). The production finishes coatings are primarily used in the manufacture of various types of flexible packages, beverage and food containers, tanks, roof decking, coils, furniture and shelving, window blinds and flatwood products. The production finishes coatings, like the trade sales coatings, serve both decorative and preservative functions. The Company believes that it is one of the leading manufacturers of coatings in the United States and Canada. It has never been engaged in any other type of business. Marketing and Distribution - - -------------------------- It has always been the Company's policy to actively support the continued growth and prosperity of independently owned distributors and retail outlets, through which the trade sales coatings are sold. In furtherance of that policy, the Company provides financing to such enterprises under circumstances where it is deemed to be in the best interests of the Company to do so (see, e.g., Note 4 to the Notes to Consolidated Financial Statements, Part II, Item 8 hereof). The trade sales coatings are sold under such tradmarks as Moore's -House Paint, Moorglo-, Moorgard- Latex House Paint, Moorwood-, Moorwhite- Primer, Impervo- Enamel, Moorcraft-, Impervex-, Regal- Wall Satin-, Satin Impervo-, AquaGlo-, AquaPearl-, AquaVelvet-, Regal Aquagrip-, Enhance-, Moorlife-, A Stroke of Brilliance -, Pro-Saver-, Benwood-, Utilac- and Ironclad-. Although a large variety of ready-mixed colors is available in all of these products, a substantially wider selection can be obtained through the Company's Moor-O-Matic- III Color System, which provides in-store machine capability to tint formulated bases with colorants which are manufactured by the Company. The Company believes its Moor-O-Matic- III Color System has been of significant value in promoting the sales of its trade sales coatings. Moore's- Video Color Planner and Moore's- Computer Color Matching System provide the ability to plan color schemes and to quickly match almost any color by computer. Production finishes coatings are customarily sold by the Company directly to the ultimate user. Sales - - ----- The Company considers itself to be engaged in a single line of business; i.e. the formulation, manufacture and sale of coatings. Reference is made to the information set forth under the caption, "SELECTED FINANCIAL DATA", Part II, Item 6 hereof, with respect to net sales of each of the two classes of products which comprise the aforementioned line of business. During 1993, no one customer accounted for as much as 1% of the Company's net sales. Geographic Segment Information - - ------------------------------ The Company manufactures and sells coatings in the United States, Canada and New Zealand. Transfers between geographic areas are not significant and are eliminated in consolidation. Reference is made to the information set forth in Note 8 to the Notes to Consolidated Financial Statements, Part II, Item 8 hereof, with respect to assets and operating results by geographic area. Foreign Operations - - ------------------ The Company operates in Canada and New Zealand. The Company's Canadian operations are carried on through Benjamin Moore & Co., Limited, which is an approximately 82% owned subsidiary of the Company, and Technical Coatings Co. Limited, which is a wholly-owned subsidiary of the Canadian company. The Company's New Zealand operations are carried on through Benjamin Moore & Co (NZ) Limited, which is a wholly-owned subsidiary of the Company. During 1993, revenues and profits from operations attributable to those companies (which are included in the Company's consolidated financial statements) were approximately $57,736,000 and $4,188,000, respectively. Approximately 8% of the outstanding shares of the Canadian subsidiary are owned by persons who are associated with the Company, including employees of such subsidiary. Research and Development; Quality Control - - ----------------------------------------- The Company considers its research and development and quality control activities to be among the most advanced in the industry, and of significant importance in enabling it to achieve and maintain its position as one of the leading companies in the coatings industry. The Company maintains several laboratory facilities for the development of new products and processes, the improvement of existing products and the special formulation of products to meet the specific requirements of its customers. The Central Laboratories, which is the principal such facility, is located in Flanders, New Jersey. Quality control activities are carried out in laboratories located at each manufacturing facility. The Company also maintains outdoor testing facilities at Lebanon, New Jersey, where its products, as well as those of its competitors, are evaluated for performance under varying weather conditions. Independent commercial facilities are also utilized for this purpose. As of December 31, 1993, 189 chemists and technicians were employed by the Company in research and development and quality control activities. In 1993, the Company expended approximately $13,988,000 for such activities. Competition - - ----------- The coatings industry is highly competitive and has historically been subject to intense price competition. It is estimated that there are approximately 900 coatings manufacturers in the United States, many of which are small companies which provide intense competition within regional and local markets, especially with respect to lower priced coatings and custom made specialty items which are required on a short-time delivery basis. Other manufacturers are large diversified corporations, the assets of which are substantially greater than those of the Company, which compete on a nationwide basis. The competition which the Company encounters in Canada and New Zealand is similar in nature to that which it encounters in the United States. The Company estimates that it is one of the largest manufacturers of trade sales coatings in the United States and Canada. With respect to sales of production finishes coatings, the Company's overall position in the industry is relatively small. Seasonal Aspects - - ---------------- Historically, sales of trade sales coatings have been seasonal in nature, with the heaviest concentration of such sales occurring in the second and third quarters of the year. Sales of production finishes coatings have been relatively stable throughout the year. During 1993, the percentages of the Company's sales of trade sales coatings which were made in the first, second, third and fourth quarters of the year were 20.8%, 29.2%, 29.2% and 20.8%, respectively. Production and inventory schedules are timed to coincide with the aforementioned variations. Employees - - --------- As of December 31, 1993, the Company had approximately 1,962 employees, of whom approximately 26% were salaried personnel, approximately 14% were sales representatives, and approximately 60% were hourly employees. The Company considers its relations with its employees to be excellent. Raw Materials and Supplies - - -------------------------- The Company purchases its raw material and supplies from a wide variety of sources, and does not consider its business to be dependent upon any one source of supply. However, the price and supply of some petrochemical intermediate products, which are important ingredients in the manufacture of coatings, are subject to world political and economic conditions. Certain raw materials are converted into synthetic resins which, when combined with pigments, are used in the production of both the trade sales coatings and the production finishes coatings. Patent and Trademarks - - --------------------- The Company does not rely on patents in its business. The Company does, however, rely upon formulas developed by it, and upon its technical expertise and experience in meeting the requirements of its customers. The Company owns a - 4 - large number of registered trademarks and trade names, several of which are referred to elsewhere herein, which it considers to be of significance in identifying the Company and its products. Backlog - - ------- As is typical in the industry, backlog of orders is not significant in the business of the Company. Environmental Affairs and Governmental Regulation - - ------------------------------------------------- The operations of the Company, like those of other companies engaged in similar businesses, involve the use and disposal of substances regulated under environmental protection laws. The Company believes that its operations are in compliance with applicable federal, state and local laws and regulations relating to the discharge of materials into the environment, or otherwise relating to the protection of the environment. Such laws and regulations have not had any material adverse effect upon the Company's capital expenditures, earnings or competitive position. The Company places importance on environmental responsibility. Its capital expenditures at new and existing facilities constructed or modified in the normal course of business incorporate designs to minimize waste. To date the Company has entered into full or partial settlement agreements with governmental authorities or private parties with respect to twelve sites under federal and state laws. Total settlement costs have been approximately $2 million. The Company is involved in thirty unsettled sites. In all cases the Company believes its share of liability for environmental clean up costs are less than 1% of such costs for each site. A total of approximately $2,312,000 has been accrued as a reserve against such future costs. These cost estimates are carefully reviewed and revised where necessary each quarter during the year. Possible insurance recoveries are not considered in estimating liabilities. Also, the Company is involved in remedial activities at three of its owned facilities as follows: 1. A water monitoring program continues at the Company's plant in Cuyahoga Heights, Ohio. No remediation activities are being conducted now. Total costs to date are $160,000. 2. Soil and shallow ground water contamination has been detected at the Company's facility at Milford, MA. The affected soils have been excavated and an interim ground water pumping extraction and treatment system has been installed. Further studies are being undertaken to assess the full extent of the water contamination. However, preliminary results indicate that the problem is moderate and is being remediated with traditional technologies. Expenditures to date have been less than $300,000. 3. The Company has expended nearly $5 million over the last nine years to assess and remediate contamination of soil and water at the Company's facility at Santa Clara, California, operated by its subsidiary, Technical Coatings Co. The Company has installed an underground trench along two sides of its property. This trench is capable of capturing the contamination and preventing its migration off the plant site. A biological treatment system treats the pumped water to acceptable cleanup levels. The treated water is used in the paint manufacturing process as cooling water before being discharged to the municipal sewer system or reinjected to the ground for recirculation. There are ongoing engineering studies to identify and develop additonal remediation techniques to address soil contamination and to clean up contaminated water more rapidly. Current operating and maintenance costs are $100,000 per year. Adjoining landowners filed suits against the Company claiming damages due to the migration, or potential migration, of the contamination located at the Company's facility at Santa Clara. In each case the plaintiff or his predecessor in title has conducted activities on its own property which resulted in contamination there. One of these suits was settled during 1993 for $75,000 and an undertaking by the Company to continue the remediation activities at the site. The anticipated liability of the Company in the other suit is not material. Accrued costs against future cleanup expenses for these three facilities are approximately $700,000. Federal and state laws require that potentially responsible parties fund remedial actions regardless of fault, legality of original disposal or ownership of a disposal site. In 1993 the Company spent approximately $571,000 on remedial cleanups and related studies compared with approximately $1,113,000 spent for such purposes in 1992. It is difficult to estimate the ultimate level of future environmental expenditures due to a number of uncertainties, including uncertainties about the current status of the law and regulations, remedial technologies and insurance recoveries of Company costs, as well as information relating to individual sites. Subject to the foregoing, Company management believes its estimates of its liability is reliable and anticipates that capital expenditures and the cost of remedial actions to comply with the current laws governing environmental protection will not have a material adverse effect upon its capital expenditures, earnings or financial position. ITEM 2.

ITEM 2. PROPERTIES - - ------------------- Set forth below is certain information with respect to the Company's principal facilities: Approximate Location Principal Use Square Feet Owned/Leased - - -------- ------------- ----------- ------------ Newark, NJ Plant 267,570 Owned Melrose Park, IL Executive Offices- 145,200 Owned Central Division; Plant Toronto, ON Executive Offices- 118,792 Owned Subsidiary; Plant Milford, MA Plant 110,500 Owned Cuyahoga Heights, OH Plant 106,000 Owned Colonial Heights, VA Plant 92,800 Owned Jacksonville, FL Plant 82,400 Owned Flanders, NJ Central Laboratories, 78,000 Owned Information Resource Center, Executive Offices - Subsidiary St. Louis, MO Plant 76,750 Owned Denver, CO Plant 73,450 Owned Johnstown, NY Plant 66,400 Owned Houston, TX Plant 64,900 Owned Montreal, PQ Plant 63,500 Owned Pell City, AL Plant 62,500 Leased (1) Commerce, CA Executive Offices- 59,000 Owned Western Division; Plant Montvale, NJ Corporate Offices; 57,000 Owned Executive Offices- Eastern Division Nutley, NJ Plant 50,000 Owned Burlington, ON Plant 45,351 Owned Santa Clara, CA Plant; Warehouse 38,507 Owned __________________________________ (1) Lease expires August 1995 at which time the facility may be purchased by the Company for $1,000. The Company has a continuing option to purchase the facility at an earlier date. Approximate Location Principal Use Square Feet Owned/Leased - - -------- ------------- ----------- ------------ Aldergrove, BC Plant 36,900 Owned Mesquite, TX Plant 29,346 Owned The Company owns 9.32 acres of land in Lebanon, New Jersey, which is used as a testing facility, and maintains a New York City sales office and an administrative office in Montvale, New Jersey in rented premises. The Company also leases warehouse facilities in North Kansas City, Missouri; Golden Valley, Minnesota; Auckland and Christchurch, New Zealand and in Concord, Edmonton, Saskatoon, Calgary, Winnipeg, Dartmouth and Mount Pearl, Canada. Warehouse arrangements also exist in Portland, Oregon. All of the other facilities which are stated above as being owned by the Company are owned in fee, free and clear of any mortgages or other material encumbrances. The Company believes that its properties and equipment are well maintained and in good condition, and that the rentals paid by it for its leased properties are at competitive rates. The Company also believes that its facilities are adequate for its existing needs. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS - - -------------------------- The Company is involved in a number of legal actions in which substantial monetary damages are sought. Management believes that the outcome of all such legal actions, individually and in the aggregate, will not have a material effect on the Company's consolidated financial position or results of operations. Also, see "Environmental Affairs and Governmental Regulation" above. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - ------------------------------------------------------------ There was no submission of matters to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET PRICE OF THE REGISTRANT'S COMMON STOCK AND RELATED - - ------------------------------------------------------------------ SECURITY HOLDER MATTERS ----------------------- There is no established public trading market for shares of the Company's common stock. The Company and its Employees' Stock Ownership Benefit Plan, although under no obligation to do so, have in the past purchased shares of the Company's common stock from shareholders in privately negotiated transactions. Usually such purchases are made at the then current fair value of the shares as determined by an independent appraisal firm engaged by the Company. There can be no assurance that such purchases will be continued. As of March 1, 1994, the Company had approximately 1,450 shareholders. The following table sets forth the high and low price for such shares in each quarter during 1993 and 1992 and the dividends paid in each such quarter. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - - -------------------------------- Selected Income Statement Data: Selected Balance Sheet Data: ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION - - -------------------------------------------------------------------- AND RESULTS OF OPERATIONS - - ------------------------- OPERATING RESULTS 1993 VS. 1992 Net Sales in 1993 showed strength throughout the year and produced total sales revenues of $511,951,000, which exceeded the previous year by $28,019,000 or 5.8%. Unit gains were generated both in the United States and Canada. Upward selling price movements which were limited had little effect on the year's total sales. Except for small geographical pockets indicative of specific local conditions, the sales momentum extended to areas which had been affected by adverse economic conditions in the last few years. Most noteworthy were the recoveries in New England and other sections of the Northeast and the business upsurge in southern Florida attributable to the rebuilding following the aftermath of Hurricane Andrew. Production finishes also reflected unit growth although this market segment represents less than 10% of total sales. Cost of products sold in 1993 was $267,494,000 which was 5.2% above the prior year. Slightly lower raw material cost levels and production efficiencies were beneficial in keeping the percentage increase .6% lower than the sales increase percentage. However, selling, administrative and general expenses of $184,255,000 rose $14,164,000 or 8.3%. The largest single increase was for postretirement health benefits. An additional amount of approximately $2,529,000 was charged to earnings consisting of the annual service cost and the amortization of the transition liability as required by SFAS No. 106. In addition to general inflationary increases and other factors attributable to higher sales volume, two other significant factors contributing to the increase in expenses were the second year of a renewed emphasis on media advertising amounting to approximately $1,000,000 and start-up costs of $1,491,000 associated with the introduction of a broad new line of industrial maintenance products. Sales of the new product line were limited to a market test in 1993. A broadening of distribution is planned in 1994. Dealer business closures and slow collection continued to be prevalent and, despite tighter credit controls, resulted in high bad debt writeoffs similar to the previous year. In recent months business growth by the Company's Dealers suggest an optimistic outlook for 1994. Other income in 1993 declined $171,000 from 1992 mostly due to reduced interest income on lower short-term investments. Income before taxes and minority interest was $60,951,000, up $552,000 or .9% over 1992. The effective income tax rate in 1993 was 39.2% compared with 38.9% in 1992. Higher profits and the 1993 tax rate increase accounted for the increased provision for income taxes of $379,000 or 1.6%. - 11- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- Net income of $36,511,000 represented an improvement of $204,000 or .6% over 1992. Earnings per share in 1993 were $3.75, up $.09 over the prior year. Dividends declared per share edged upward by $.01 to $1.68 in 1993. The Company's New Zealand subsidiary which consists of a warehouse operation continued to concentrate on sales development in it first full year. Since its initial market test in 1991, there has been little effect on total sales and income. If the economic recoveries in the Northeast and New England continue into 1994 and inflationary pressures are maintained under control, optimism should prevail for growth in both sales and income. OPERATING RESULTS 1992 VS. 1991 Net Sales of $483,933,000 in 1992 surpassed the prior year by $20,961,000 or 4.5%. Without a general selling price adjustment in trade sales coatings, the increase was generated by unit gains both in the United States and Canada. The sales gains in the United States began late in the first half of the year, leveled off for a short period and resumed momentum especially in the fourth quarter. Most areas of the country showed upward movement with noticeable improvement in the southern region, the Midwest, the Northwest, and portions of the Northeast. New England indicated an end of its slide by recovering some of the volume lost in prior years. Slow areas continued to be in the Greater New York market and in California where the economies remained sluggish. Sales in Canada reflected gains throughout the year. Production finishes sales in the U.S. experienced good growth in 1992 largely due to the acquisition of a general industrial coatings line late in 1991. The acquired product line supplemented existing volume in production finishes coatings and has had no significant change in product mix. Sales of production finishes coatings in Canada were slow. Cost of products sold was $254,362,000 in 1992 which was $7,747,000 or 3.1% above 1991. As a percent of sales, cost of products sold was 52.6% in 1992 compared with 53.3% in 1991. The unit sales gains were accompanied by a decrease of approximately 3% in raw material cost levels to account for the decline in the percentage. Selling, administrative and general expenses of $170,091,000 rose $12,246,000 or 7.8% over the prior year. In addition to an inflationary effect of nearly 3.5% in operating expenses, bad debt writeoffs represented a significant increase of $1,162,000 or 17.0% over 1991. Business failures and slow collections were prevalent during the two year period. Close monitoring of accounts Receivable along with the writeoffs resulted in an improvement in the quality of the outstanding Receivables. Another major reason for the increase in expenses was the commencement of a renewed national advertising thrust directed toward MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- the consumer especially in large metropolitan areas. The relocation of private label production from Gibbsboro, New Jersey to Newark, New Jersey in the latter part of 1992 also accounted for a one-time charge of approximately $500,000. Other income in 1992 declined $759,000 from the previous year. Reduced interest rates earned on short-term securities combined with lesser amounts available for temporary investments occasioned the decrease. Net income before taxes and minority interest was $60,399,000, up $208,000 over 1991. The Company's effective income tax rate was 38.9% in 1992 as compared with 39.4% in 1991. The provision for income taxes decreased by $189,000 or .8%. Net income of $36,307,000 in 1992 was $370,000 or 1% above 1991. Earnings per share were $3.66 in 1992, and improvement of $.12 over 1991. Dividends declared per share were $1.67 compared with $1.62 in the prior year. The Company's warehouse operation in New Zealand which opened in 1991 showed some indication of growth but had little effect on either net sales or net income. FINANCIAL POSITION AND LIQUIDITY During 1993 the financial strenth of the Company continued to be evidenced in the ability of the cash flows from operations to meet operating and capital requirements. Net cash flows provided by operating activities amounted to $32,282,000 in 1993 compared with $39,972,000 in 1992 and $33,772,000 in 1991. The decrease in operating cash flows of 1993 vs. 1992 was attributable to the additional support required for accounts and notes receivable and for the higher inventories of merchandising material which is reflected in prepaid expenses. Net cash flows used in investing activities showed a significant increase in 1993 over the prior year. The completion of the property renovation for a corporate technical and administrative center in Flanders, New Jersey accounted for the increase of over $2,017,000 in capital expenditures of 1993 compared with 1992. The continued reduction in short-term investments was a reflection of the use of internal funds for the Flanders building project as well as, in part, the accounts receivable support. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- The cash flows used in financing activities declined over $4,800,000 principally due to lower requirements for the acquisition of treasury stock. Generally, the Company finances its stock repurchases from its working capital in accordance with the conditions described at Part II, Item 5 above. It is expected that any future purchases will be similarly financed. During the three years ended December 31, 1993 the Company purchased 141,048; 218,110 and 178,683 shares, respectively, of its common stock. In addition, a capital contribution of 42,000 shares was received by the Company in 1991 through a bequest of a deceased senior executive. Sales of treasury stock are made to employees under an Employees' Stock Purchase Plan. During 1992 and 1991, the Company sold 300 and 229,100 shares, respectively, to employees. In addition, the Company distributed 876; 1,432 and 2,004 shares to non-executive sales employees in 1993, 1992 and 1991, respectively. During 1993 borrowing by the Company was largely limited to short-term line of credit uses by the Canadian subsidiary. The subsidiary in New Zealand also utilized local bank loans for a majority of its capital requirements. In 1994 the Company will continue with a major expansion of its production and warehouse facility at Mesquite, Texas. The project which is expected to amount to $8,500,000, is anticipated to consist of several phases with completion in 1995. The closing of the Houston plant and the transfer of production to the Mesquite facility is planned upon completion of the building project at Mesquite. A warehouse addition at an estimated cost of $800,000 is also in progress at the Pell City, Alabama plant. The renovation of the interior offices at the general administrative offices location in Montvale, New Jersey, at a cost of approximately $1,000,000, is expected to be completed by mid 1994. In addition, the relocation of the Company's Jacksonville, Florida plant, which is located adjacent to the Gator Bowl, will commence within the next year due to the awarding of an NFL football franchise to the city. The property occupied by the plant is included in the local development project. Negotiations are being conducted with the appropriate authorities for property appraisals and a determination of relocation costs. It is likely that a limited amount of short-term bank borrowing may be necessary to supplement funds from operating cash flows to finance the several construction projects. OTHER MATTERS The Company places importance on its environmental responsibilites. Compliance with current laws concerning environmental protection has not resulted in significant capital expenditures and has MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- not had a material adverse effect on the Company's earnings or its financial postion. The Company does not anticipate that future costs associated with current laws governing environmental protection will have a material effect upon its capital expenditures, earnings or competitive postion. For information regarding Financial Accounting Standards that have been issued but not yet adopted by the Company refer to Note 6 of the Notes to Consolidated Financial Statements. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - - ---------------------------------------------------- The consolidated financial statements of the registrant and its subsidiaries, together with notes thereto and the auditors' report, are set forth on pages 17 through 34. The additional financial information set forth in Part IV and included herein should be read in conjunction with the consolidated financial statements. DELOITTE & TOUCHE - - ---------- ---------------------------------------------- Two Hilton Court Telephone: (201) 631-7000 P.O. Box 319 Facsimilie: (201) 631-7459 Parsippany, New Jersey 07054-0319 INDEPENDENT AUDITORS' REPORT Benjamin Moore & Co.: We have audited the accompanying consolidated financial statements of Benjamin Moore & Co. and its subsidiaries, listed in the index at Item 14. Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Benjamin Moore & Co. and subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes to Consolidated Financial Statements listed in the Index at Item 14, the Company changed both its method of accounting for income taxes to conform with Statement of Financial Accounting Standards ("SFAS") No. 109 and its method of accounting for postretirement benefits other than pensions to conform with SFAS No. 106. /s/ Deloitte & Touche Deloitte & Touche March 1, 1994 - - --------------- DELOITTE TOUCHE TOHMATSU INTERNATIONAL - - --------------- BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation --------------------- The financial statements include all majority-owned subsidiaries except for Temporary Co-Ownerships as explained in Note 4 below. All balances and transactions between subsidiaries are eliminated in consolidation. Foreign Currency Translation ---------------------------- All balance sheet accounts of foreign subsidiaries are translated to United States dollars at current exchange rates. The income statements are translated using the average exchange rates for the period. Adjustments for currency exchange rate fluctuations are excluded from net income and reflected as a separate component of shareholders' equity. Short-Term Investments ---------------------- Short-term investments consist of United States treasury bills of $14,422,837 in 1993 and $20,850,732 in 1992, stated at cost, which approximates market value, and a mutual fund of short duration portfolio of $6,260,577 in 1993 and $6,024,634 in 1992, carried at the lower of cost or market value. The carrying amount of these investments approximates fair value. Inventory --------- Inventories are valued at lower of cost, determined by the use of the last-in, first-out (LIFO) method, or market. Property, Plant and Equipment ----------------------------- The major classes of property along with the depreciation and amortization methods and estimated useful lives used are set forth below: Major expenditures for renewals and improvements are capitalized; maintenance and repairs are expensed. The cost of property retired or sold is eliminated from the asset account and, after deducting the related accumulated depreciation, any profit or loss is included in income. Intangible Assets ----------------- Intangible assets acquired during 1993 and 1991, amounting to $1,083,561 and $4,080,000, respectively, are valued at cost and are being amortized over their estimated useful lives. During 1993 and 1992 amortization of such intangibles amounted to $942,685 and $642,632, respectively. Provision for Income Taxes -------------------------- The Company and its subsidiaries file separate tax returns. The Company provides deferred income taxes on temporary differences between amounts of assets NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) and liabilities for financial reporting purposes and such amounts as measured by enacted tax laws. Tax credits are included as a reduction of income tax expense in the year the credits arise. Pension Expense --------------- It is the Company's policy to fund all qualified pension costs based on calculations made by independent actuaries. Pension expense is determined in accordance with Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions. Unrecognized net assets are being amortized over 16-2/3 years for the United States plan and 15 years for the Canadian plan. Research and Development Costs ------------------------------ Research and development and quality control expenditures are charged to income in the year incurred and amounted to $13,987,537, $12,417,319 and $11,300,763 in 1993, 1992 and 1991, respectively. Quality control expenditures aggregated $5,001,518, $4,716,561 and $4,054,769, respectively, and are included herein because a substantial portion of such expenditures is related to development projects. Accounting Change ----------------- Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The net unrecorded liability at the date of adoption is being amortized over 20 years (See Note 6). As of the same date, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Prior year financial statements have not been restated. The adoption of SFAS No. 109 resulted in an additional income tax expense of approximately $700,000 in 1993 (See Note 13). Reclassifications ----------------- Certain reclassifications have been made in the 1991 financial statements to conform to the method of presentation used in 1993. 2. ACCOUNTS AND NOTES RECEIVABLE December 31, ----------------------- 1993 1992 Trade .................................. $88,940,829 $81,337,135 Other .................................. 1,493,077 1,049,161 ----------- ----------- Total ............................. 90,433,906 82,386,296 Less allowance for doubtful accounts ... 9,674,679 7,836,301 ----------- ----------- Net ............................... $80,759,227 $74,549,995 ----------- ----------- ----------- ----------- Notes receivable due after one year amounted to $12,614,376 and $11,904,207 at December 31, 1993 and 1992, respectively, and are included in Other Assets in the accompanying balance sheet. The carrying amount of notes receivable approximates fair value. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 3. INVENTORY December 31, ----------------------- 1993 1992 Finished goods ......................... $31,223,724 $27,979,303 Raw materials .......................... 20,253,750 21,204,848 ----------- ----------- Total ............................. $51,477,474 $49,184,151 ----------- ----------- ----------- ----------- If the first-in, first-out (FIFO) method of inventory accounting, which approximates current cost, had been used, inventory would have been $15,601,000, $13,142,000 and $15,235,000 higher than reported at December 31, 1993, 1992 and 1991, respectively. Work-in-process is not significant, due to the brief production cycle, and is included with raw materials. 4. INVESTMENTS IN TEMPORARY CO-OWNERSHIPS Investments in Temporary Co-Ownerships are carried at cost. These investments, in the capital stock of retail paint stores, are non- interest bearing financing arrangements. All increases in equity from earnings accrue solely to the benefit of the independent co-owners. The Company sells its products to Temporary Co-Ownerships at the same prices and terms used in transactions with all other customers. A reasonable estimate of fair value of the investments in Temporary Co- Ownerships could not be made without incurring excessive costs. 5. PROPERTY, PLANT AND EQUIPMENT December 31, ----------------------- 1993 1992 Land................................... $ 6,985,753 $ 6,135,827 Buildings.............................. 53,769,421 46,909,858 Machinery, equipment and leasehold improvements......................... 75,353,810 71,572,295 ----------- ----------- Total............................. 136,108,984 124,617,980 Less accumulated depreciation and amortization......................... 75,839,326 69,693,745 ----------- ----------- Property, plant and equipment-net. $60,269,658 $54,924,235 ----------- ----------- ----------- ----------- Capital leases included in the above are as follows: Classes of Property December 31, ----------------------- 1993 1992 Land................................... $ 96,000 $ 96,000 Buildings.............................. 1,616,902 1,616,902 Machinery, equipment and leasehold improvements............... 3,511,123 3,406,402 ---------- ---------- Total.............................. 5,224,025 5,119,304 Less accumulated depreciation and amortization..................... 3,811,492 3,456,342 ---------- ---------- Net............................... $1,412,533 $1,662,962 ---------- ---------- ---------- ---------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 6. EMPLOYEE BENEFIT PLANS Pension Plans ------------- The Company and its subsidiaries have retirement income plans covering substantially all employees. The benefits are based upon years of service and the employee's highest average compensation during any thirty-six consecutive full calendar months of employment. The funded status and amounts recognized in the Company's balance sheet at December 31, 1993 and 1992, as determined by independent actuaries, are presented below: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Net pension costs include the following components: The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7 percent and 4 percent, respectively in 1993 and 8 1/2 percent and 6 1/2 percent, respectively in 1992 and 1991. The expected long-term rate of return on assets, net of expenses, was 8.5 percent in 1993 and 9 percent in 1992 and 1991. Postretirement Medical and Life Insurance Plans ----------------------------------------------- The Company and its subsidiaries have two defined benefit postretirement plans that cover substantially all of the United States employees of the Company and its subsidiaries. One plan provides medical benefits, and the other provides life insurance benefits. The postretirement health care plan is contributory for employees retiring on or after January 1, 1993, with retiree contributions adjusted annually; the life insurance plan is noncontributory. The accounting for the health care plan anticipates future cost-sharing changes to the written plan that are consistent with the Company's expressed intent to increase retiree contributions each year by the same percent increase experienced by the Net Incurred Charges through 1998, after which all future cost increases will be passed onto the retirees. As of December 31, 1993, the Company has not established any specific funding policy. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following table sets forth the plans' funded status reconciled with the amount shown in the Company's statement of financial position at December 31, 1993. Net periodic postretirement benefit cost for 1993 included the following components: Service cost-benefits attributed to service during the period ............. $ 368,000 Interest cost on accumulated postretirement benefit obligation ........ 1,822,000 Net amortization and deferral .............. 1,107,000 ---------- Net periodic postretirement benefit cost ... $3,297,000 For measurement purposes, the 1994 annual rate of increase in the per capita cost of covered health care benefits was assumed to be 14% for costs under age 65 and 11.1% for costs over age 65; the rates were assumed to decrease gradually to 6% for 2020 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $957,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $61,000. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The weighted-average discount rate used in determing the accumulated postretirement benefit obligation was 7 percent. During 1993, the Company's Canadian subsidiary continued to provide certain health care and life insurance benefits for retired employees as were previously provided to substantially all employees of the Company. Substantially all of the employees of the Company's Canadian subsidiary became eligible for those benefits upon retirement at the normal retirement age. The benefits are provided through insurance companies whose premiums are based upon the benefits paid during the year. The Company recognized the cost of providing those benefits by expensing the annual insurance premiums, which amounted to approximately $54,000, $822,000 and $703,000 in 1993, 1992 and 1991, respectively. Postemployment Benefits ----------------------- In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). This new statement requires an accrual of benefits provided to former or inactive employees after employment but before retirement. The cost of these benefits is currently expensed on a pay-as-you-go basis by the Company. The Company is required to adopt this statement in 1994. It is estimated that adoption of SFAS No. 112 will result in the accrual of a liability of approximately $1,300,000 as of January 1, 1994. Employees' Stock Ownership Benefit Plan --------------------------------------- The Company also maintains a qualified Employees' Stock Ownership Benefit Plan (ESOP), covering substantially all of its United States employees. The Board of Directors of the Company is authorized to make contributions from time to time to the plan trust fund. In 1989, the Company and its ESOP entered into a leveraged transaction whereby the Company borrowed $10,000,000 from a bank and loaned such funds to the ESOP. The ESOP used the loan proceeds to purchase, as restated to reflect the 1990 stock dividend, 239,792.236 shares of the Company's common stock; 87,590 shares from estates and 152,202.236 shares from the Company's treasury stock account. The bank loan bears interest at 7.85% and is payable in ten graduated annual installments through June 30, 1999. Based upon the borrowing rates currently available to the Company for bank loans with similar terms and average maturities, the carrying value of the bank loan approximates its current fair value. The common stock purchased by the ESOP is held by the ESOP trustees as collateral for the loan from the Company to the ESOP in a restricted account. Each year the Company will make contributions to the plan, which the plan's trustees will use to repay the loan from the Company in an amount sufficient for the Company to make interest and principal payments on the loan. The collateralized shares of common stock will be released from restriction and allocated to participating employees annually, as of December 31, based upon the percentage of debt service paid during the year then ended to the projected total amount of debt service to be paid under the loan agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Contributions to the ESOP amounted to $1,160,599, $1,140,564 and $1,096,272 in 1993, 1992 and 1991, respectively. The Company's Canadian subsidiary maintains a similar plan which covers substantially all of the Company's Canadian employees. The Canadian subsidiary contributed approximately $144,000, $141,000 and $135,000 to the Canadian plan trust fund in 1993, 1992 and 1991, respectively. Stock Option Plan ----------------- During 1993 the Company adopted a Stock Option Plan. The Plan provides for the granting of non-statutory stock options to officers and other employees of the Company. Options for the purchase of 400,000 shares of common stock, par value $10 per share, may be granted. The options become fully vested over a period of up to four years. During 1993 the Company granted options to purchase 233,785 shares at an option price of $73.26 per share, which is the fair value at the date of grant as determined by independent appraisal. At December 31, 1993 none of the options were exercisable. 7. OTHER LIABILITIES AND ACCRUED EXPENSES December 31, ----------------------- 1993 1992 Income taxes payable ...................... $ 2,392,051 $ 2,382,132 Salaries, wages and commissions ........... 3,962,768 4,011,129 Customer discounts and allowances ......... 2,757,399 2,625,168 Environmental remediation costs ........... 2,311,094 2,177,619 Other ..................................... 12,672,232 10,362,003 ------------ ------------ Total ............................... $ 24,095,544 $ 21,558,051 ------------ ------------ ------------ ------------ 8. GEOGRAPHIC SEGMENT INFORMATION The Company manufactures and sells coatings for use by the general public and industrial and commercial users in the United States, Canada and New Zealand. Transfers between geographic areas are not significant and are eliminated in consolidation. Assets and operating results by geographic area are as follows: NET SALES: United States Foreign Consolidated ------------- ----------- ------------ 1993 .......... $454,215,349 $57,736,116 $511,951,465 1992 .......... $426,409,378 $57,523,335 $483,932,713 1991 .......... $404,834,192 $58,137,893 $462,972,085 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) INCOME BEFORE TAXES AND MINORITY INTEREST: United States Foreign Consolidated ------------- ----------- ------------ 1993 .......... $56,762,454 $4,188,481 $60,950,935 1992 .......... $56,342,273 $4,056,698 $60,398,971 1991 .......... $55,162,304 $5,028,192 $60,190,496 IDENTIFIABLE ASSETS: 1993 .......... $237,810,998 $38,229,141 $276,040,139 1992 .......... $228,204,051 $35,405,527 $263,609,578 1991 .......... $220,322,784 $35,251,911 $255,574,695 9. SHORT-TERM BORROWINGS Information regarding the Company's arrangements with banks in the United States, Canada and New Zealand for short-term lines of credit follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) There are no significant compensating cash balances or commitment fees that relate to the above arrangements. Due to the short maturity of these borrowings, the carrying amount approximates fair value. 10. LONG-TERM OBLIGATIONS December 31, ----------------------- 1993 1992 Loan payable (See Note 6)...................... $ 6,925,000 $ 7,775,000 Capital leases (See Note 11)................... 1,024,191 1,400,000 Total........................................ 7,949,191 9,175,000 Less payments due within one year.............. 1,471,981 1,350,000 Long-term obligations........................ $ 6,477,210 $ 7,825,000 Principal payments of $1,471,981, $1,450,806, $1,126,405, $1,200,000 and $1,300,000 are due in 1994, 1995, 1996, 1997 and 1998, respectively. 11. LEASES During 1985, the Industrial Development Board of the City of Pell City, Alabama, issued $5,000,000 ten year, First Mortgage Industrial Revenue Bonds, guaranteed by the Company, to an Alabama Bank under a mortgage and trust indenture of which the Bank is the trustee. The bonds bear interest at a floating rate equal to 79% of the Bank's lending rate. The proceeds of the bonds were used by the Industrial Development Board to finance the construction of a plant facility in Pell City, Alabama, which is being leased to the Company for a ten- year period ending September 1, 1995. At the end of the lease term, or earlier in the event of prepayment of this obligation, the plant facility which has been recorded as a capital lease, may be purchased by the Company for $1,000. The Company also leases data processing equipment, buildings, transportation equipment, autos and miscellaneous equipment under operating leases expiring at various dates. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Minimum future obligations under leases as of December 31, 1993 are as follows: Rental expense on operating leases (including amounts based on equipment usage) was approximately $8,255,642, $6,912,552 and $6,479,948 for the years ended December 31, 1993, 1992 and 1991, respectively. 12. SHAREHOLDERS' EQUITY In 1978 the Board of Directors, with shareholder approval, adopted an Employees' Stock Purchase Plan (ESPP). Under the Plan, as restated to reflect stock dividends, up to an aggregate of 800,000 shares of Common Stock held in the treasury may be offered and sold from time to time to employees of the Company and its subsidiaries at the fair value price per share as determined by an independent appraisal firm, at the date of offering. Since 1979, 509,965 shares have been sold to employees. During 1992, the Company sold 300 shares to employees. Notes receivable outstanding with respect to the above referenced Plan, as well as the ESOP note receivable, as of December 31, 1993 and 1992 are reflected in the Balance Sheets as reductions in shareholders' equity. The notes received by the Company relative to the 1991 ESPP offering are non-interest bearing. Treasury stock is reflected at acquisition value, determined by the use of the first-in, first-out (FIFO) method. Sales and distributions of treasury shares are recorded at fair value price per share. Any excess of such fair value proceeds over the FIFO cost is reflected as additional paid-in capital. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) During 1993 and 1991, the Company received capital contributions of $20,515 and 42,000 shares, respectively, through the bequest of a deceased senior executive. A reconciliation of the number of common shares outstanding is as follows: 13. INCOME TAXES The composition of the income tax provision is as follows: 1993 1992 1991 State and local income taxes .... $ 4,595,010 $ 4,749,421 $ 4,412,758 Foreign income taxes ........... 1,946,324 1,732,755 2,112,240 Federal income taxes: Current ....................... 18,310,612 17,751,496 17,984,412 Deferred ...................... (954,885) (715,644) (802,519) Total ...................... $23,897,061 $23,518,028 $23,706,891 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Deferred income taxes represent the tax effects of recognizing certain expenses in different periods for tax and financial reporting, none of which are individually significant in any year. A reconciliation of the statutory federal tax rate and effective tax rate is as follows: 1993 1992 1991 Statutory tax rate................. 35.0% 34.0% 34.0% Effect of: State and local income taxes.. 4.9 5.2 4.8 Other - net................... (.7) (.3) .6 ---- ---- ---- Effective tax rate................. 39.2% 38.9% 39.4% ---- ---- ---- ---- ---- ---- The Company does not accrue Federal income taxes on its equity in the undistributed earnings of its Canadian subsidiary, which amounted to $23,902,094, $22,358,291 and $21,429,758 at December 31, 1993, 1992 and 1991, respectively, because the Company intends to reinvest such earnings indefinitely. 14. OTHER (INCOME) EXPENSE, NET The components of other (income) and expense, net are as follows: ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING - - ---------------------------------------------------------------------- AND FINANCIAL DISCLOSURE - - ------------------------ Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - - ------------------------------------------------------------ Reference is made to the information set forth under the captions (i) "ELECTION OF DIRECTORS" at pages 3, 4 and 5 and "Compliance with Section 16(a) of the Securities Exchange Act" at page 21 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference, and (ii) "EXECUTIVE OFFICERS" at page 36 of this Annual Report on Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION - - -------------------------------- Reference is made to the information set forth under the caption "DIRECTOR COMPENSATION" and "EXECUTIVE COMPENSATION" at pages 8, 9 and 10 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND - - ---------------------------------------------------------------------- MANAGEMENT - - ---------- (a) Security Ownership of Certain Beneficial Owners Reference is made to the information set forth under the caption "PRINCIPAL SHAREHOLDERS" at pages 2 and 3 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. (b) Security Ownership of Management Reference is made to the information set forth under the caption "ELECTION OF DIRECTORS - Ownership of Securities by Nominees and Directors" at pages 5, 6 and 7 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. (c) Changes in Control To the knowledge of the Company, there are no arrangements the operation of which may at a subsequent date result in a change in control of the Company. EXECUTIVE OFFICERS ------------------ The executive officers of the Company are elected each year by the directors of the Company, and are as follows: Name Office Age - - ---- ------ --- Richard Roob....................Chairman of the Board of Directors........... 61 Maurice C. Workman.........................President.................................... 65 Benjamin M. Belcher, Jr.........Executive Vice President..................... 59 Ward C. Belcher.................Vice President-Operations.................... 47 Richard H. Delventhal...........Controller................................... 57 Yvan Dupuy......................Vice President-Sales and Marketing........... 42 William J. Fritz................Vice President-Finance and Treasurer......... 63 John J. Oberle..................Vice President-Manufacturing and Technology.. 64 John T. Rafferty................Secretary and General Counsel................ 61 Charles C. Vail.................Vice President-Human Resources............... 50 _____________________________________ All of the executive officers of the Company have during a period in excess of the past five years, been actively engaged in the business and affairs of the Company in various senior management capacities. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - - -------------------------------------------------------- Reference is made to the information set forth under the caption "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" at pages 10 and 11 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS - - ------------------------------------------------------------- ON FORM 8-K ----------- (a)(1) List of Financial Statements Included Under Item 8 -------------------------------------------------- of this Report. --------------- Independent Auditors' Report................................... 17 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991............................ 18 Consolidated Balance Sheets, December 31, 1993 and 1992.................................................... 19 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991............................................... 20 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991...................... 21 Notes to Consolidated Financial Statements for the Years Ended December 31, 1993, 1992 and 1991...................... 22-34 (2) Financial Statement Supplemental Schedule. ------------------------------------------ I.... Short-Term Investments, December 31, 1993.............. 43 II... Amounts Receivable From Related Parties, and Underwriters, Promoters and Employees Other Than Related Parties For the Year Ended December 31, 1993...................................... 44-46 VIII. Consolidated Valuation and Qualifying Accounts For the Years Ended December 31, 1993, 1992 and 1991.................................... 47 X.... Supplementary Consolidated Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991.......................... 48 All other schedules for which provision is made in the applicable regulations of the Securities and Exchange Commission are omitted because of the absence of conditions under which they are required or because the information required thereby is shown in the financial statements or notes thereto. The individual financial statements of the Company have been omitted because the Company is primarily an operating company and all subsidiaries are included in the consolidated financial statements being filed. In addition, in the aggregate, such subsidiaries do not have minority equity interests and/or indebtedness to any person other than the Company or its consolidated subsidiaries in amounts which together exceed 5 percent of the total assets of the Company at December 31, 1993 and 1992. (b) Reports on Form 8-K ------------------- No reports on Form 8-K have been filed by the Company during the last quarter of the fiscal year ended December 31, 1993. (c) List of Exhibits ---------------- (3) Restated Certificate of Incorporation and Bylaws of the Company. (i) Restated Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3(a) of the Company's Registration Statement under the Securities Act of 1933, as amended, on Form S-1 - Registration No. 2-62626). Reference is made to the information set forth under the caption "Amendment of the Restated Certificate of Incorporation" at pages 10 and 11 of the Company's Proxy Statement dated March 22, 1985, for use in connection with its 1985 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Limitation of Liability of Directors and Officers to the Maximum Extent Permitted by New Jersey Law" at pages 10, 11, 12 and 13 of the Company's Proxy Statement dated March 28, 1988, for use in connection with its 1988 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Amendment of the Restated Certificate of Incorporation" at pages 11 and 12 of the Company's Proxy Statement dated March 21, 1989, for use in connection with its 1989 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Amendment of the Certificate of Incorporation" at pages 15, 16 and 17 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. (ii) Bylaws of the Company (incorporated herein by reference to Exhibit 3(b) of the Company's Registration Statement under the Securities Act of 1933, as amended, on Form S-1 - Registration No. 2-62626). Reference is made to the information set forth under the caption "Indemnification of Directors, Officers and Employees" at pages 13 and 14 of the Company's Proxy Statement dated March 28, 1988, for use in connection with its 1988 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Approval of Amendments of the Company Bylaws" at pages 17 through 21 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. (10) Material Contracts (iii) (A) Employees' Stock Purchase Plan of the Company (incorporated herein by reference to Exhibit 4(a) of the Company's Registration Statement under the Securities Act of 1933, as amended, on Form S-8 - Registration No. 33-2694). Reference is made to the information set forth under the caption "Amendment of Employees' Stock Purchase Plan" at pages 11 and 12 of the Company's Proxy Statement dated March 25, 1991, for use in connection with its 1991 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Approval of the Stock Option Plan" at pages 13, 14 and 15 of the Company's Proxy Statement dated March 22, 1993, for use in connection with its 1993 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. (22) Subsidiaries of the Company..................Page 49 (24) Consent of Experts and Counsel...............Page 50 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in Montvale, New Jersey, on the 30th day of March, 1994. BENJAMIN MOORE & CO. By /s/ Maurice C. Workman -------------------------- Maurice C. Workman President POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each individual whose signature appears below constitutes and appoints Maurice C. Workman and Richard Roob, and each of them, his true and lawful attorneys-in- fact and agents with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto, and all documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. _________________ Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- Chairman of the Board of Directors (Principal /s/ Richard Roob Executive Officer); --------------------- Richard Roob Director March 30, 1994 President (Principal /s/ Maurice C. Workman Executive Officer); ----------------------- Maurice C. Workman Director March 30, 1994 Vice President - Finance and Treasurer (Principal Financial Officer and Principal /s/ W.J. Fritz Accounting Officer); ----------------------- William J. Fritz Director March 30, 1994 /s/ Benjamin M. Belcher, Jr. Director March 30, 1994 ---------------------------- Benjamin M. Belcher, Jr. /s/ W.C. Belcher Director March 30, 1994 ----------------------- Ward C. Belcher /s/ Charles H. Bergmann Director March 30, 1994 -------------------------- Charles H. Bergmann /s/ Yvan Dupuy Director March 30, 1994 ------------------------- Yvan Dupuy /s/ Ralph W. Lettieri Director March 30, 1994 ------------------------- Ralph W. Lettieri /s/ Lee C. McAlister Director March 30, 1994 ------------------------- Lee C. McAlister /s/ John C. Moore Director March 30, 1994 ------------------------- John C. Moore /s/ Michael C. Quaid Director March 30, 1994 ------------------------- Michael C. Quaid /s/ J. Sobie Director March 30, 1994 ------------------------- Joseph Sobie Signature Title Date --------- ----- ---- /s/ Charles C. Vail Director March 30, 1994 ------------------------- Charles C. Vail /s/ Ward B. Wack Director March 30, 1994 ------------------------- Ward B. Wack /s/ Sara B. Wardell Director March 30, 1994 ------------------------- Sara B. Wardell SCHEDULE I BENJAMIN MOORE & CO. and Subsidiaries SHORT-TERM INVESTMENTS December 31, 1993 Col. A Col. B Col. C Number of Shares or Name of Issuer and Units - Principal Amount Cost of Title of Each Issue of Bonds and Notes Each Issue - - -------------------------------------------------------------------------------- United States treasury bills ..... $ 14,422,837 $14,422,837 Infinity Mutual Funds ............ 1,251,019.018 shares 6,260,577 ----------- $20,683,414 ----------- ----------- Information required by Columns D & E is omitted since short-term investments are valued at cost, and such cost approximates market value. Schedule II BENJAMIN MOORE & CO. and Subsidiaries AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 COL. A COL. B COL. C COL. D COL. E Balance at end of period ------------------------ Balance at beginning Amounts Name of debtor of period Additions collected Current Not Current - - -------------------------------------------------------------------------------- Benjamin M. Belcher, Jr.: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 13,288 5,276 5,276 2,736 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 2,540 2,540 7,256 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Ward C. Belcher: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 14,454 5,276 5,276 3,902 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 41,120 8,468 8,468 24,184 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 5% Stock Purchase Plan Note dated 5/2/88, due in 9 annual installments 15,451 3,615 3,104 8,732 Yvan Dupuy: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 5,316 2,110 2,110 1,096 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 16,448 16,448 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Schedule II BENJAMIN MOORE & CO. and Subsidiaries AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 COL. A COL. B COL. C COL. D COL. E Balance at end of period ------------------------ Balance at beginning Amounts Name of debtor of period Additions collected Current Not Current - - -------------------------------------------------------------------------------- Yvan Dupuy: Continued Non-Interest Bearing Stock Purchase Plan Note dated 2/3/92, due in 10 annual installments 44,546 5,211 2,299 37,036 Richard H. Delventhal: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 5,316 2,110 2,110 1,096 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 2,540 2,540 7,256 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Joel J. Mayor: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 5,782 2,110 2,110 1,562 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 21,454 4,234 4,234 12,986 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 John T. Rafferty: 5% Stock Purchase Plan Note dated 8/8/89, due in 9 annual installments 38,141 6,509 6,509 25,123 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Schedule II BENJAMIN MOORE & CO. and Subsidiaries AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 COL. A COL. B COL. C COL. D COL. E Balance at end of period ------------------------ Balance at beginning Amounts Name of debtor of period Additions collected Current Not Current - - -------------------------------------------------------------------------------- Richard Roob: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 13,288 5,276 5,276 2,736 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 41,120 8,468 8,468 24,184 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 5% Stock Purchase Plan Note dated 5/2/88, due in 9 installments 15,451 3,615 3,104 8,732 Charles C. Vail: 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 12,336 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Maurice C. Workman: 5% Stock Purchase Plan Note dated 2/28/86, due in 7 annual installments 4,244 4,244 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 4,540 2,540 7,256 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 SCHEDULE VIII SCHEDULE X BENJAMIN MOORE & CO. and Subsidiaries SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - - -------------------------------------------------------------------------------- COLUMN A COLUMN B - - -------------------------------------------------------------------------------- Item Charges to Costs and Expenses ---- ----------------------------- 1993 1992 1991 ---- ---- ---- Advertising costs......................$30,508,550 $27,716,894 $26,456,383

73902_1993.txt

73902

1993

Item 1. BUSINESS Ogden Corporation (hereafter together with its consolidated subsidiaries referred to as "Ogden" or the "Company") has its offices located at Two Pennsylvania Plaza, New York, New York 10121, pursuant to a lease that expires on April 30, 1998 and which contains an option by Ogden to renew for an additional five years. Ogden is a diversified company primarily engaged in providing services through subsidiaries within each of its Operating Services and Waste-to-Energy Operations as described below: I. OPERATING SERVICES Ogden Services Corporation ("Ogden Services"), a wholly owned subsidiary of Ogden, provides services through each of its operating groups. The principal groups and services provided by each are as follows: (i) Ogden Aviation Services provides ground services, catering and fueling of aircraft at domestic and foreign airports; (ii) Ogden Entertainment Services provides facility management, concert promotions, food, beverage and novelty concession services and maintenance services at amphitheaters, stadiums, arenas and other venues; (iii) Ogden Environmental and Energy Services provides independent power generation, engineering and consulting services in the environmental and energy markets; (iv) Ogden Government Services and Atlantic Design Company provides engineering design, drafting and technical services; building and repairing electronic systems; and a broad range of technical support, logistics, and operation and maintenance services; and (v) Ogden Facility Services provides a broad range of turnkey facility management, housekeeping, mechanical maintenance, energy management, security, warehousing, shipping and receiving services. In addition, Ogden Services provides the removal or encapsulation of asbestos from office buildings and other structures and, through its 50% ownership in Universal Ogden Services, provides food and housekeeping services to offshore drilling rigs and logistical support services to remote industrial campsites in the United States and abroad. II. Waste-to-Energy Operations Ogden Projects, Inc. ("OPI"), an 84.2% owned subsidiary of Ogden, through its wholly owned subsidiaries, provides waste disposal services throughout the United States. Its principal business, conducted largely through its wholly owned subsidiary, Ogden Martin Systems, Inc. ("OMS") provides waste-to-energy services through designing, permitting, constructing, assisting in financing and operating and maintaining waste-to-energy facilities. These waste-to-energy facilities combust municipal solid waste to make saleable energy in the form of electricity or steam. OMS holds the exclusive rights to market a proprietary mass-burn technology, the principal feature of which is the reverse-reciprocating stoker grate upon which the waste is burned. This technology is used by OPI in most of the waste-to-energy facilities it designs and constructs in the United States and abroad. OPI is also pursuing opportunities to develop independent power projects that utilize fuels other than waste, as well as pursuing opportunities to operate and maintain wastes and wastewater processing facilities. - ------------------------------------------------------------------- The amounts of revenue from sales and services to unaffiliated customers, operating profit or loss, and identifiable assets attributable to each of Ogden's two major operating areas and foreign operations, if any, for each of the last three fiscal years are set forth on pages 41 and 42 of Ogden's 1993 Annual Report to Shareholders certain specified portions of which are incorporated herein by reference. OPERATING SERVICES The operations of Ogden's Operating Services are performed by Ogden Services Corporation ("Ogden Services") through its five major operating groups as follows: Ogden Aviation Services; Ogden Entertainment Services; Ogden Environmental and Energy Services; Atlantic Design Company and Ogden Government Services; and Ogden Facility Services. This organizational structure is described in more detail below. Ogden Services, through wholly-owned subsidiaries within each of the foregoing major operating groups, provides a wide range of services to private and public facilities. Its principal customers include airlines, transportation terminals, sports arenas, stadiums, banks, owners and tenants of office buildings, state, local and Federal governments, universities and other institutions and large industrial organizations that are leaders in such fields as plastics, chemicals, drugs, tires, petroleum and electronics. Ogden Services' bills most of its work on a cost-plus or fixed-price and time and material basis. Where services are performed on a cost-plus basis, the customer reimburses the appropriate Ogden Services' group for all reimbursable expenditures made in connection with the job (in some instances with a limit on the reimbursed amount) and also pays a fee, which may be a percentage of the reimbursable expenditures, a specific dollar amount, or a combination of the two. Fixed-price contracts, in most cases, contain escalation clauses increasing the fixed price in the event, and to the extent, that there are increases in payroll and related cost. Many of the contracts in the Ogden Aviation Services and Ogden Facility Services areas are written on a month-to-month basis or provide for a longer or indefinite term but are terminable by either party on notice varying from 30 to 180 days. OGDEN AVIATION SERVICES The Ogden Aviation Services group provides specialized support services to over 200 airlines at 90 cities throughout the United States, Canada, Mexico, Germany, Czech Republic, The Netherlands, Brazil, Peru, Chile, Venezuela, New Zealand, Australia and other locations. The specialized support services provided by this group includes comprehensive ground handling, inflight catering and aviation fueling. These services are performed through contracts with individual airlines, through consolidated agreements with several airlines, and contracts with various airport authorities. Within the area of inflight catering, Ogden Aviation Services operates 14 inflight kitchens for over 85 airline customers. Locations include John F. Kennedy International and LaGuardia Airports in New York; Newark International Airport in New Jersey; Los Angeles and San Francisco International Airports in California; Miami International Airport in Florida; Washington Dulles International near Washington, D.C.; McCarren International in Las Vegas, Nevada; and Honolulu International in Hawaii. During 1993, Ogden Aviation Services signed new inflight catering contracts with Aeromexico, British Airways, EVA Airways, Malev Hungarian Airlines and Mexicana Airlines, among others. The Ogden Aviation inflight kitchen at Honolulu International also received a three year contract from NAVATEK, a Hawaiian cruise line, to provide catering services for its two cruise ships. Ogden Aviation Services also operates fueling facilities, including storage and hydrant fueling systems for the fueling of aircraft. This operation assists airlines in designing, arranging financing for, and installing underground fueling systems. These fueling operation services are principally performed in the North American market. However, Ogden Aviation Services will begin providing these services in Latin America following the award of contracts in Puerto Rico and Panama. Ground handling services include diversified ramp operations such as baggage unloading and loading, aircraft cleaning, aircraft maintenance, flight planning, de-icing, cargo warehouse operations and passenger-related services such as ticketing, check-in, porter ("skycap") service, passenger lounge operations and other miscellaneous services. Global expansion by this service group has resulted in the start-up of operations at several international locations over the past several years. For example, in Germany services are performed at eight different airports throughout the country; service at Schiphol International Airport in Amsterdam began in 1993; comprehensive ground handling services are provided at Auckland International Airport in New Zealand under a ten year licensing agreement; and services are provided in the Czech Republic through a 50% interest in a Prague-based airport handling company. In Canada Ogden Aviation Services provides ground handling and other related services at the Pearson International Airport in Toronto and the Mirabel and Dorval Airports in Montreal. During December 1993 Ogden Aviation Services began providing comprehensive ground handling services in Caracas, Venezuela at Simon Bolivar International Airport. Through an 80% owned company Ogden Aviation also began providing ground handling services at the Arturo Merino Benitez Airport in Santiago, Chile. Ogden Aviation continues to perform Air Aruba's aviation ground service operations at Reina Beatrix International Airport in Aruba through a corporation jointly owned by Ogden and Air Aruba with Ogden Aviation Services controlling and performing all day-to-day ground service operations at the airport. OGDEN ENTERTAINMENT SERVICES The Ogden Entertainment Services group provides total facility management services, concert promotions, food, beverage and novelty concessions, janitorial, security, parking, and other maintenance services to a wide variety of public and private facilities located in the United States, Mexico, Canada and the United Kingdom. Many of the operating contracts and concession leases under which this group operates are individually negotiated and vary widely as to duration. Concession contracts usually provide for payment by an Ogden Entertainment Services subsidiary of commissions or rentals based on a stipulated percentage of gross sales or net profits, sometimes with a minimum rental or payment. Facility management contracts are usually on a cost-plus fee basis. Food and beverage service in the United States is provided at more than 100 stadiums, convention and exposition centers, arenas, parks, amphitheaters, fairgrounds and racetracks, including the following: Anaheim Stadium (Anaheim, California); Rich Stadium (Buffalo, New York); the U.S. Air Arena (Landover, Maryland); the Milwaukee Exposition and Convention Center (Milwaukee, Wisconsin); the Los Angeles Convention Center and The Great Western Forum (Los Angeles, California); the Kingdome (Seattle, Washington); Philadelphia Veterans Stadium (Philadelphia, Pennsylvania); Market Square Arena (Indianapolis, Indiana); Target Center (Minneapolis, Minnesota); McNichols Arena (Denver, Colorado); and Cobo Hall (Detroit, Michigan). During 1993 this service group was awarded a ten year contract to provide concession and novelty services at the Tempe Diablo Stadium in Tempe, Arizona; a five year contract to provide food, beverage and novelty services at the University of Oklahoma Stadium, and the Lloyd Noble Center, located in Norman, Oklahoma; a ten year contract to provide food and beverage services at Fiddler's Green Amphitheatre located in Englewood, Colorado; a ten year contract to provide food, beverage and concession services at the MGM Grand Gardens Arena located in Las Vegas, Nevada at the MGM Grand Hotel; and a ten year contract to provide concession and novelty services at the Sandstone Amphitheatre located in Kansas City, Missouri. During 1993 Ogden Entertainment Services also entered a new market pursuant to a ten year contract to provide food and beverage services at the San Jose Swap Meet, the largest open-air market in California. Ogden Entertainment Services also provides food and beverage services at the 20,000 seat Starlake Amphitheater near Pittsburgh, Pennsylvania and concession and catering services at zoos located in Seattle, Washington and Cleveland, Ohio. Various combinations of security, parking, maintenance and janitorial services at accounts such as The Great Western Forum; U.S. Air Arena; and The Palace (Auburn Hills, Michigan) are also provided by this service group. Ogden Entertainment Services has facility management agreements for various convention centers, arenas and public facilities including the Pensacola Civic Center in Pensacola, Florida; the Sullivan Arena and Egan Convention Center in Anchorage, Alaska; and the Rosemont Horizon, near Chicago, Illinois. In each of these facilities, Entertainment Services provides a comprehensive support service program. Facility management agreements are generally billed on a cost-plus fee basis. Ogden Entertainment Services, through long-term management and concession agreements, provides management services, food, beverage and novelty concessions and maintenance services at the Target Center in Minneapolis and The Great Western Forum in Los Angeles. Ogden Entertainment Services through its agreement with the City of Anaheim provides the exclusive operation of the food, beverage and novelty concessions at Anaheim Stadium, a 70,000 seat stadium located in Anaheim, California adjacent to the City's recently opened Arrowhead Pond (see below for further discussion of Arrowhead Pond). In Mexico, this service group has a 27% equity interest in a company which manages the Sports Palace, a 22,000 seat arena, and the Autodrome, a 45,000 seat open air facility, located in Mexico City, as well as the new amphitheater in Monterey Mexico that will be able to accommodate about 18,000 people. Ogden Entertainment also owns a 51% equity interest in a company that provides food and beverage concessions at the Sports Palace, Autodrome and Monterey Amphitheater. In Canada, Ogden Entertainment provides food, beverage and novelty concessions at the Saint John Regional Exhibition Centre located in New Brunswick, Canada and at Lansdowne Park in Ottawa, Canada. The New London Stadium, a 20,000 seat soccer stadium near London, England, for which Ogden acted as design and marketing consultants during construction, was opened during 1993. The Stadium serves as the home stadium for the Millwall Football Club and Ogden Entertainment Services, through a ten year contract, provides food and beverage services at the Stadium. Ogden Entertainment Services also provides design and consulting services at the 18,000 seat Victoria station Arena in Manchester, England which Ogden Entertainment will manage and operate pursuant to a 20- year lease upon its scheduled completion during 1994. Ogden Entertainment Services also leases and operates a thoroughbred and harness racetrack in Illinois and five off-track betting parlors in Illinois where it telecasts races from Fairmount Park and other racing facilities. Restaurants and other food and beverage services are provided by Ogden Entertainment Services at these facilities. Racing days are usually awarded on an annual basis and a large portion of the track's revenue is derived from its share of the pari-mutual handle, which can be adjusted by state legislation. Other income is derived from admission charges, parking, programs and concessions. Pursuant to the Amended and Restated Arena Management Agreement (the "Management Agreement"), between Ogden Facility Management Corporation of Anaheim ("OFMA"), a wholly owned subsidiary of Ogden Services, and the City of Anaheim, California (the "City"), OFMA manages and operates the recently completed Arrowhead Pond which is owned by the City and located within the City of Anaheim. The Pond is a multi-purpose facility capable of accommodating professional basketball and hockey, concerts and other attractions, and has a maximum seating capacity of approximately 19,400. Construction of the Pond was financed through the sale of municipal securities issued by an instrumentality of the City in January, 1991. OFMA has agreed that the Pond, under OFMA's management, will generate a minimum amount of revenues computed in accordance with the 30-year Management Agreement between the City and OFMA. OFMA's obligations under the Management Agreement are guaranteed by Ogden. Ogden Entertainment Services has an agreement with the Walt Disney Company for a 30- year lease at the Pond where The Walt Disney Company's new National Hockey League team, the Mighty Ducks, began playing during the 1993/1994 hockey season. OGDEN ENVIRONMENTAL AND ENERGY SERVICES (OEES) OEES provides a comprehensive range of environmental, infrastructure and energy consulting, engineering and design services to industrial and commercial companies, electric utilities and governmental agencies. Environmental services include analysis and characterization, remedial investigations, analytical testing, engineering and design, data management, project management, and regulatory assistance to detect, evaluate, solve and monitor environmental problems and health and safety risks. Infrastructure services include environmental, civil, geotechnical, transportation and sanitary engineering, urban and regional planning and storm water management. Energy services include regulatory assistance, nuclear safety and engineering, and consulting services relating to nuclear waste management, security engineering and design services, and independent power production. Services are provided to a variety of clients in the public and private sectors in the United States and abroad. Principal clients include major Federal agencies, particularly the Department of Defense and the Department of Energy as well as major corporations in the chemical, petroleum, transportation, public utility and health care industries and Federal and state regulatory authorities. Approximately 30% of OEES's revenues is derived from contracts or subcontracts with departments or agencies of the United States Government. United States Government contracts may be terminated, in whole or in part, at the convenience of the government or for cause. In the event of a convenience termination, the government is obligated to pay the costs incurred by OEES under the contract plus a fee based upon work completed. As of December 31, 1993, OEES's backlog of orders amounted to approximately $120 million, of which approximately $37 million represented government orders that were not yet funded; as of December 31, 1992, the comparable amounts were $87 million and $14 million, respectively. This service group continues to provide professional environmental engineering services, including program management, to the United States Navy CLEAN Program (Comprehensive Long Term Environmental Action Navy) pursuant to a $100 million contract awarded during 1991. Thus far OEES has provided these services in Hawaii and Guam. Through Catalyst New Martinsville Hydroelectric Corporation, OEES manages and operates the New Martinsville Hydroelectric Plant under a long-term lease with the City of New Martinsville, West Virginia. The plant has been in operation since 1988 and rated at approximately 40 megawatts of power. The plant's electrical output is sold to the Monongahela Power Company under a long-term power sales agreement. An OEES subsidiary, as a 50% partner in the Heber Geothermal Company ("HGC"), a partnership with Centennial Geothermal, Inc. leases and operates a 47-megawatt (net) power plant in Heber, California. The power is sold to Southern California Edison. The working interest in the geothermal field, which is adjacent to and supplies fluid to the power plant, is owned by a partnership composed of an OEES subsidiary and Centennial Field, Inc., an unaffiliated company. Separate subsidiaries of OEES have the contracts to operate and maintain both the Well field, which currently produces approximately eight million pounds per hour of fluid, and the power plant. During 1993 OEES received a four year contract from the State of Tennessee's Department of Transportation to survey road and stream bid profiles and perform underwater inspections and sounding around bridge foundations; Air Force bases in Ohio, Michigan and North Carolina were added to OEES' $25.0 million, three year contract with the U.S. Air Force Center for Environmental Excellence for the removal of storage tanks and contaminated soil from Air Force bases across the United States and in U.S. territories; and, OEES was one of four contractors selected by the U.S. Air Force to competitively bid for work valued at $195 million over five years to identify, investigate and remediate environmental contamination problems at the Kelly Air Force Base, Texas. OEES continued the development of its mixed waste analytical business through the modified portion of its analytical laboratory in Fort Collins, Colorado which opened during 1993 and analyzes mixtures of nuclear and non-nuclear hazardous waste. This mixed waste laboratory provides testing services for the Department of Energy and other Federal government agencies involved in the clean up of government facilities. OEES is continuing to examine the European market for long- term expansion of all of its services. During 1993 it acquired a privately-owned environmental, water resources and geotechnical consulting firm in Spain; was awarded an environmental services contract by the U.S. Army Corps of Engineers, Europe District, to provide environmental site assessments in Frankfurt, Germany; and, pursuant to a one year contract is working with the Chevron Overseas Petroleum, Inc.'s Tengizchevroil Joint Venture Project and the Republic of Kazakhstan, Russia to develop an environmental protection public health and safety plan. OGDEN GOVERNMENT SERVICES AND ATLANTIC DESIGN COMPANY Ogden Government Services The Ogden Government Services group functions through five operating groups: W.J. Schafer Associates, Inc. ("WJSA"), the Systems group, the Engineering group, the Biomedical Services group, and Operations Support Services group. Through these operating groups Ogden Government Services offers to private industry and Federal, state and local government agencies a broad range of engineering and technical support services; biomedical research and biological repository services; software design, integration and related services; systems engineering integration, management and logistics support; consulting, total facility management; property management; management support services and software; and maintenance services of all types required to maintain and operate governmental facilities worldwide. The WJSA group currently provides technology and engineering services and consultation in space-based and free electron laser, high energy systems research to the Ballistic Missile Defense Organization as well as technical research to the other agencies within the Department of Defense. During 1993 major awards included a contract by the Ballistic Missile Defense Organization to provide technical support to the Innovative Science Technology Directorate and by the Coleman Research Corporation to provide system engineering and technical assistance support for the Theater High Altitude Area Defense Project. The Engineering and Systems groups provide systems and software engineering and related services to the U.S. Navy, the General Services Administration, the Office of Personnel Management and many other Federal and state agencies. During 1993 these groups were awarded several large contracts ranging from one to five years in duration, including contracts by: The Department of Defense, to assist Unisys Government Systems with its Defense Enterprise Integration Services program; the Naval Command Control and Ocean Surveillance Center, to provide systems engineering, configuration management and other support services for naval combat systems; the State of Wisconsin to provide software systems transfer support to its Kids Information Data System; and the Internal Revenue Service to modernize its tax collection process. The Operations Support Services group provides custodial operations and maintenance, building management, logistical support, construction and repairs, and vehicle maintenance services to many Federal and state government facilities throughout the country. The group currently provides perimeter security in the United States embassies in Panama and the Bahamas as well as logistic functions at various other bases in the United States pursuant to contracts with the Department of Defense as well as a wide variety of operations and maintenance services for the U.S. Army's European Redistribution facilities located at Nahbollenbach and Hanau, Germany. During 1993 this group was awarded a complete facility management contract by the Department of Defense for the National Information Center, its top-secret facility located in Washington, D.C. The Bioservices group operates repositories and provides services in support of the National Institute of Health, the Walter Reed Army Institute of Research, the Federal Drug Administration, the National Institute of Allergy and Infectious Diseases, the National Cancer Institute and other health agencies. Atlantic Design Company, Inc. ("Atlantic Design") Atlantic Design with principal offices located in Charlotte, North Carolina and engineering facilities located in Livingston, New Jersey and New York, provides engineering design, drafting and technical services, as well as turn-key, integrated services in electronics contract manufacturing and assembly and through its Lenzar operation in Florida develops and markets medical products and custom image capturing products. Atlantic Design provides services to various industries, including such customers as IBM, Seiko, Compaq, Diasonics, AT&T, E.Systems, Decision Data, LXE and Pratt and Whitney. Atlantic Design's services also include the design of mechanical, electro-mechanical and electronic equipment; technical writing; engineering analysis; building, testing and repairing electronic assemblies and equipment; and the development of prototype equipment for a variety of industries. Atlantic Design's customers are primarily in the computer, medical and electronic industries located in the Eastern United States. During 1993 Atlantic Design was awarded a contract by Sequoia Pacific Systems to assemble electronic voting booths for the State of Louisiana as well as contracts from Compaq Computer, Seiko and AT&T. OGDEN FACILITY SERVICES The Ogden Facility Services group (formerly Ogden Building Services and Ogden Industrial Services) provides a comprehensive range of facility management, maintenance and manufacturing support services to industrial, commercial, electric utilities, and education and institutional customers throughout the United States and Canada. The range of services provided include total facility management; facility operations and maintenance; operations, maintenance and repair of production equipment; security and protection; housekeeping; landscaping and grounds care; energy management; warehousing and distribution; project and construction management; and skilled craft support services. Ogden Facility Services' commercial and office building customers include the World Trade Center and the American Express Tower in New York, Phillips Petroleum Headquarters in Bartlesville, Oklahoma, and A.T.& T. at several sites in New Jersey. Facility's industrial and manufacturing customers include IBM, Chrysler, Colgate Palmolive, Bridgestone/Firestone, Exxon, Dow Chemical, American Cyanamid and Martin Marietta. The group continues to expand its support to the institutional and educational marketplace. Customers include the University of Miami; New York University; Clark Atlanta University in Georgia; and Concordia University in Montreal, Canada. During 1993 the group was awarded a five year contract by the Orlando Utility Commission (OUC) to provide support services at OUC's Orlando and Titusville, Florida plants. Additional awards included The Bank of New York (Housekeeping Services); Geon Company, formerly B.F. Goodrich (Warehousing and Distribution Services); Ameritech (Facility Management) and Ford Stamping Plant in Chicago Heights, Illinois (Facility Maintenance). Ogden Facility Services, in conjunction with Ogden Projects, Inc., also provides services to the waste-to-energy plants in operation, or being built, by Ogden Martin Systems, Inc. on a cost- plus basis as negotiated between Ogden Martin and Ogden Facility Services. OTHER SERVICES Ogden Services also provides services relating to the removal and encapsulation of asbestos-containing materials from office buildings and other facilities and arranges for the transport of such material to approved disposal sites. Asbestos-remediation jobs are being performed principally in the greater Manhattan-New York metropolitan area. The market for asbestos removal and encapsulation services by office buildings and large residential complexes, industrial plants, airports and other public facilities has been greatly reduced over the past several years and Ogden Services' continued involvement in this industry is reviewed on an annual basis. Through Universal Ogden Services, a joint venture based in Seattle, Washington, services are provided to a wide range of facilities where people live for extended periods of time, such as remote job sites and oil rigs. Food and housekeeping services are currently provided to offshore oil production platforms and drilling rigs in the Gulf of Mexico, the North Sea, the West Coast of Africa and South America, for oil production and drilling companies. Logistical support services, including catering, housing, security, operations, and maintenance are provided to remote industrial campsites located in the United States and abroad. WASTE-TO-ENERGY OPERATIONS OGDEN PROJECTS, INC. Ogden Projects, Inc. ("OPI"), through its wholly-owned subsidiaries, provides waste disposal services throughout the United States. Its principal business, conducted through wholly- owned subsidiaries, including Ogden Martin Systems, Inc. ("OMS"), is providing waste-to-energy services. Waste-to-energy facilities combust municipal solid waste to make saleable energy in the form of electricity or steam. OPI was organized as a wholly-owned subsidiary of Ogden (together with its subsidiaries, "Ogden") in 1984. Through OMS it holds the exclusive rights to use the proprietary technology (the "Martin Technology") of Martin GmbH fur Umwelt - und Energietechnik of Germany ("Martin") in the United States, other Western Hemisphere locations and Israel. In addition, OPI has exclusive rights to use the Martin Technology on a full service design, construct and operate basis in Germany, the Netherlands, Denmark, Norway, Sweden, Finland, Poland, and Italy. The Martin Technology is used in over 150 waste-to-energy facilities operating worldwide, principally in Europe, the Far East and the United States. OPI completed construction of its first waste-to-energy facility in 1986 and currently operates twenty-five waste-to-energy projects at twenty-four locations. Three facilities are under construction. OPI is the owner or lessee of seventeen of these projects. Additional projects are in various stages of development. During early 1993, OPI acquired all of the United States waste-to-energy business of Asea Brown Boveri, Inc. through the acquisition of the stock of one of its indirect, wholly-owned subsidiaries. By virtue of the acquisition, OPI became the operator of these facilities. These three facilities do not employ the Martin Technology. OPI also owns and operates four additional facilities that do not utilize the Martin technology. OPI has taken preliminary steps toward expanding its waste-to- energy business internationally. It is also pursuing opportunities to develop independent power projects that utilize fuels other than waste. In addition, OPI is pursuing opportunities to operate and maintain water and wastewater processing facilities. WASTE-TO-ENERGY SERVICES In most cases, OPI, through wholly-owned subsidiaries ("Operating Subsidiaries"), provides waste-to-energy services pursuant to long term service contracts ("Service Agreements") with local governmental units sponsoring the waste-to-energy project ("Client Communities"). OPI has projects currently under development for which there is no sponsoring Client Communities and may in the future undertake other such projects. (a) Terms and Conditions of Service Agreements. Waste-to- energy projects are generally awarded by Client Communities pursuant to competitive procurement. OPI has also built and is operating projects that were not competitively bid. Following award, the Client Community and the winning vendor must agree upon the final terms of the Service Agreement. Following execution of a Service Agreement between the Operating Subsidiary and the Client Community, several conditions must be met before construction commences. These usually include, among other things, financing the facility, executing an agreement providing for the sale of the energy produced by the facility, purchase or lease of the facility site, and obtaining of required regulatory approvals, including the issuance of environmental and other permits required for construction. In many respects, satisfaction of these conditions are not wholly within OPI's control and accordingly, implementation of an awarded project is not assured or may occur only after substantial delays. OPI incurs substantial costs in preparing bids and, if it is the successful bidder, implementing the project so it meets all conditions precedent to the commencement of construction. In some instances OPI has made contractual arrangements with communities that provide partial recovery of development costs if the project fails to go into construction for reasons beyond OPI's control. Each Service Agreement is different in order to reflect the specific needs and concerns of the Client Community, applicable regulatory requirements and other factors. The following description sets forth terms that are generally common to these agreements. Pursuant to the Service Agreement, the Operating Subsidiary designs the facility, generally applies for the principal permits required for its construction and operation and helps to arrange for financing. The Operating Subsidiary then constructs and equips the facility on a fixed price and schedule basis. The actual construction and installation of equipment is performed by contractors under the supervision of the Operating Subsidiary. The Operating Subsidiary bears the risk of costs exceeding the fixed price of the facility and may be charged liquidated damages for construction delays, unless caused by the Client Community or unforeseen circumstances beyond OPI's control, such as changes of law ("Unforeseen Circumstances"). After the facility successfully completes acceptance testing, the Operating Subsidiary operates and maintains the facility for an extended term, generally 20 years or more. Under the Service Agreement, the Operating Subsidiary generally guarantees that the facility will meet minimum processing capacity and efficiency standards, energy production levels and environmental standards. The Operating Subsidiary's failure to meet these guarantees or to otherwise observe the material terms of the Service Agreement, (unless caused by the Client Community or Unforeseen Circumstances) may result in liquidated damages to the Operating Subsidiary or, if the breach is substantial, continuing and unremedied, the termination of the Services Agreement, in which case the Operating Subsidiary may be obligated to discharge project indebtedness. The Service Agreement requires the Client Community to deliver minimum quantities of municipal solid waste ("MSW") to the facility and, regardless of whether that quantity of waste is delivered to the facility, to pay a service fee. These fees are further described below. Generally, the Client Community also provides or arranges for debt financing. Additionally, the Client Community bears the cost of disposing ash residue from the facility and, in many cases, of transporting the residue to the disposal site. Generally, expenses resulting from the delivery of unacceptable and hazardous waste to the facility and from the presence of hazardous materials on the site are also borne by the Client Community. In addition, the Client Community is also generally responsible to pay increased expenses and capital costs resulting from Unforeseen Circumstances, subject to limits which may be specified in the Service Agreement. Ogden guarantees the Operating Subsidiaries performance of their respective Service Agreements. (b) Other arrangements for providing Waste-to-Energy Services. OPI owns two facilities which are not operated pursuant to Service Agreements with Client Communities, and is currently developing, and may undertake in the future, additional such projects. In such projects, OPI must obtain sufficient waste under contracts with haulers or communities to ensure sufficient project revenues. OPI is subject to risks usually assumed by the Client Community, such as those associated with Unforeseen Circumstances, and the supply and price of municipal waste to the extent not contractually assumed by other parties. OPI's current contracts with waste suppliers for these two facilities provide limited contractual protection for Unforeseen Circumstances. On the other hand, OPI generally retains all of the energy revenues and disposal fees for waste accepted at these facilities. Accordingly, OPI believes that such projects carry both greater risks and greater potential rewards than projects in which there is a Client Community. As a result of the declining number of municipal procurements in the United States, which is anticipated to continue in the near future, such projects are likely to become more common. (c) Project Financing. Financing for projects is generally accomplished through the issuance of a combination of tax-exempt and taxable revenue bonds issued by a public authority. If the facility is owned by an Operating Subsidiary, the authority lends the bond proceeds to the Operating Subsidiary and the Operating Subsidiary contributes additional equity to pay the total cost of the project. For such facilities, project-related debt is included as a liability in OPI's consolidated financial statements. Generally, such debt is secured only by the assets of the Operating Subsidiary and otherwise provides no recourse to OPI. The Operating Subsidiaries are able to realize value from facilities owned by them either by selling the facilities and leasing them from the purchaser for extended terms or by selling limited partnership interests in the entity owning the facility. OPI has taken advantage of these financing mechanisms by selling the interests in Tulsa I and Tulsa II to a leverage lessor and leasing the facility back under a long term lease. In addition, in 1991, limited partnership interests in, and the related tax benefits of, the partnership that owns the Huntington, New York facility were sold to third party investors. In 1992, OPI sold the subsidiary that held the remaining limited partnership interest in, and certain related tax benefits of, that partnership. Under the limited partnership agreement, an Operating Subsidiary is the general partner and retains responsibility for the operation and maintenance of the facility. The Operating Subsidiary retained 85% of the residual value of the facility after the initial term of the Service Agreement. In 1991, OPI acquired a facility from Blount, Inc. which was sold through a sale-leaseback arrangement. An Operating Subsidiary is the owner of the facility under construction in Onondaga, New York and a sale of equity interests in such facility is under consideration. (d) Revenues and Income. During the construction period, for facilities owned by Client Communities, construction income is recognized on the percentage-of-completion method based on the percentage of costs incurred to total estimated costs. Construction revenues also include amounts relating to sales of limited partnership interests and related tax benefits in facilities not yet in commercial operation as well as other amounts received with respect to activities conducted by OPI prior to the commencement of commercial operation. After construction is completed and the facility is accepted, the Client Community pays the Operating Subsidiary a fixed operating fee which escalates in accordance with specified indices; reimburses the Operating Subsidiary for certain costs specified in the Agreement including taxes and governmental impositions (other than income taxes), ash disposal and utility expenses; and shares with the Operating Subsidiary a portion of the energy revenues (generally 10%) generated by the facility. If the facility is owned by the Operating Subsidiary, the Client Community also pays as part of the Service Fee an amount equal to the debt service on the bonds issued to finance the facility. With respect to such facilities OPI recognizes as revenue principal on such bonds on a level basis over the term of the debt. At most facilities, OPI may earn additional fees from accepting waste from the Client Community or others utilizing the capacity of the facility which exceeds the minimum amount of waste committed by the Client Community. For the projects that are not operated pursuant to a Service Agreement, tipping fees which are generally subject to escalation in accordance with specified indices, and energy revenues are paid to OPI. Electricity generated by these projects is sold to public utilities, and in one instance, steam and a portion of the electricity generated is sold to industrial users. Under certain of the contracts under which waste is provided to these facilities, OPI may be entitled to fee adjustments to reflect certain Unforeseen Circumstances. (e) OPI's Waste-to-Energy Projects. Certain information with respect to OPI's projects as of February 28, 1994 is summarized in the following table: (f) Markets and Competition. OPI markets its services principally to governmental entities, including city, county and state governments as well as public authorities or special purpose districts established by one or more local government units for the purpose of managing the collection and/or disposal of MSW. For certain projects, OPI may market its services directly to private firms in the business of MSW collection and/or disposal. MSW generated in the United States is processed in waste-to- energy facilities; incinerated without energy recovery; recycled and landfilled. OPI believes that no single waste disposal technique can properly manage all MSW and that an effective waste management program must include waste minimization, recycling, and waste-to-energy to utilize as much waste as possible for reuse and energy production. Steps to minimize the quantity of MSW produced are being taken at the manufacturing and consumer levels. Some jurisdictions, for example, have banned the use of certain plastic containers. These efforts have not yet had an appreciable impact on the quantities of MSW being generated. Increased recycling is a goal of many state and local governments, and some have legislated ambitious mandatory targets. OPI believes that increased recycling is an important aspect of waste disposal planning in the United States and will continue to grow. However, the inherent limitation on the types of materials that can successfully be recycled will continue to require municipalities to use other disposal methods such as waste-to- energy or landfilling for much of the waste produced. Most of OPI's facilities have been sized to accommodate the accomplishment of communities recycling goals. Waste-to-energy facilities compete with other disposal methods, such as landfills. Compliance with regulations promulgated by the United States Environmental Protection Agency (the "EPA") in 1991 will to some extent increase the cost of landfilling although landfills may be less expensive, in some cases, in the short term, than waste-to-energy facilities. Landfills generally do not commit their capacity for extended periods. Much of the landfilling done in the United States is done on a spot market or through short term contracts. Accordingly, landfill pricing tends to be more volatile as a result of periodic changes in waste generation and available capacity than OPI's pricing, which is based on long term contracts. Another factor effecting the competitiveness of waste-to-energy fees are the additional charges imposed by Client Communities to support recycling programs, household hazardous waste collections, citizen education and similar initiatives. The cost competitiveness of waste-to-energy facilities also depends on the prices at which the facility can sell the energy it generates. Mass-burn waste-to-energy systems compete with various refuse- derived fuel ("RDF") systems in which MSW is preprocessed to remove various non-combustibles and is shredded for sizing prior to burning. OPI believes that the large-scale facilities being contracted for today are primarily mass-burn systems. Although OPI operates four RDF projects, these were all acquired after construction. OPI does not intend to develop any new RDF facilities. Since 1989, there has been a decline in the number of communities requesting proposals for waste-to-energy facilities. OPI believes that this decline has resulted from a number of factors that adversely affected communities willingness to make long term capital commitments to waste disposal projects, including uncertainties about the impact of recycling on the waste stream; concerns arising from the Clean Air Act Amendments of 1990 and the regulatory actions currently being proposed pursuant to its terms. In addition, there was aggressive opposition to proposed waste disposal projects of all types by many individuals and small groups during this period. OPI believes that legislative developments increased public acceptance of the safety and cost effectiveness of waste-to-energy and economic recovery will resolve many of these uncertainties. In response to the decline in the number of requests for proposals, OPI has sought projects for which there are no sponsoring Client Communities. In 1993, OPI negotiated a waste disposal agreement with Clark County, Ohio, for the disposal of MSW at such a project. OPI also completed negotiation of contracts with Ohio Edison Company pursuant to which Ohio Edison leases a site to OPI and purchases steam generated at the proposed waste-to- energy facility. This project is conditional upon obtaining commitments of additional MSW from other sources. There is substantial competition within the waste-to-energy field. OPI competes with a number of firms, some of which have greater financial resources than OPI. Some competitors have licenses or similar contractual arrangements for competing technologies in the waste-to-energy field, and a limited number of competitors have their own proprietary technology. Other technologies utilized in mass-burn-type facilities in the United States include the Von Roll, W+E Umwelltechnik, A.G., Takuma, Volund, Steinmueller, Deutsche Babcock, O'Connor and Detroit Stoker. The principal factors influencing selection of vendors for governmentally sponsored projects are technology, financial strength, performance guarantees, experience, reputation for environmental compliance, service and price. (g) Technology. The principal feature of the Martin Technology is the reverse-reciprocating stoker grate upon which the waste is burned. The patent for the basic stoker grate technology used in the Martin Technology expired in 1989. OPI has no information that would cause it to believe that any other company uses the basic stoker grate technology that was protected by the expired patent. OPI believes that unexpired patents on other portions of the Martin Technology would limit the ability of other companies to effectively use the basic stoker grate technology in competition with OPI. More importantly, it is Martin's know-how in manufacturing grate components and in designing and operating mass- burn facilities and Martin's worldwide reputation in the waste-to- energy field, rather than the use of potential technology, that is important to OPI's competitive position in the waste-to-energy industry in the United States. OPI does not believe that the expiration of the patent covering the basic stoker grate technology will have a material adverse effect on OPI's financial condition or competitive position. (h) The Cooperation Agreement. Under an agreement between OPI and Martin (the "Cooperation Agreement"), OPI has the exclusive right to use the Martin Technology in waste-to-energy facilities in the United States, Canada, Mexico, Bermuda, certain Caribbean countries most of Central and South America and Israel. In addition, in Germany, Turkey, Saudi Arabia, Kuwait, the Netherlands, Denmark, Norway, Sweden, Finland, Poland and Italy, OPI has exclusive rights to use the Martin Technology only on a full service design, construct and operate basis. OPI may not use any other technology to design and construct waste-to-energy refuse incineration facilities without Martin's permission. OPI may, however, acquire, own, commission and/or operate facilities that use technology other than the Martin technology that have been constructed by entities other than OPI. Martin is obligated to assist OPI in installing, operating and maintaining facilities incorporating the Martin Technology. The fifteen year term of the Cooperation Agreement renews automatically each year unless notice of termination is given, in which case the Cooperation Agreement would terminate 15 years after such notice. Additionally, the Cooperation Agreement may be terminated by either party if the other fails to remedy its material default within 90 days of notice. The Cooperation Agreement is also terminable by Martin if there is a "change in control" (as defined in the Cooperation Agreement) of OMS, or any direct or indirect parent of OMS not approved by its respective board of directors. Although termination would not affect the rights of OPI to design, construct, operate, maintain or repair waste-to-energy facilities for which contracts have been entered into or proposals made prior to the date of termination, the loss of OPI's right to use the Martin Technology could have a material adverse effect on OPI's future business and prospects. For example, Germany has enacted legislation which would prevent the landfilling of untreated raw municipal waste by the end of the decade. OPI therefore believes this is an appropriate time to seek to expand its business in these markets. (i) International Business Developments. In 1993, OPI continued the development of its waste-to-energy business in selected international markets. OPI opened an office in Munich, Germany in 1993 and, as indicated above, extended its right to use the Martin technology to develop full service projects in much of Europe. OPI had no operations outside the United States previously. Furthermore, in Europe, waste-to-energy facilities have been built as turn-key construction projects and then operated by local governmental units or by utilities under cost-plus contracts. OPI emphasizes developing projects which it will build and then operate for a fixed fee. Some European countries are seeking to substantially reduce their dependency on landfilling. (j) Backlog. OPI's backlog as of December 31, 1993 is set forth under (e) above. As of the same date of the prior year, the estimated unrecognized construction revenues for projects under construction was $192,935,000, and the estimated construction revenues for projects awarded but not yet under construction was $513,488,000 (includes $99,620,000 expressed in Canadian Dollars). The changes reflect construction progress on four projects. Generally, the construction period for a waste-to-energy facility is approximately 28 to 34 months. The backlog does not reflect the cancellation of projects owned by OPI or the cancellation of the Quonset Point and Johnston Rhode Island projects. OTHER SERVICES OPI operates transfer stations in connection with its Montgomery County, Maryland project, and will use a railway system to transport MSW and ash residue to and from the facility. OPI leases and operates a landfill located at its Haverhill, Massachusetts facility, and leases, but does not operate, a landfill in connection with its Bristol, Connecticut facility. In 1991, OPI announced that it would discontinue the on-site remediation business utilizing a mobile technology then conducted by Ogden Waste Treatment Service, Inc. ("OWTS"). OWTS was formed by Ogden in 1986 to conduct on-site remediation of hazardous wastes using a proprietary incineration process. In 1991, OWTS operated at sites located in Alaska and California. Certain of these operations continued into 1993; and certain contractual obligations resulting from the disposal of assets are expected to conclude in 1994. In 1993, OPI announced that it would discontinue the fixed- site hazardous waste business it had been conducting through American Envirotech, Inc. ("AEI"), an indirect subsidiary. AEI received a permit in 1993 for the construction and operation of a facility near Houston, Texas (the "RCRA Permit"), which is subject to a pending appeal in the state of Texas. Substantial and adverse changes in the market for hazardous waste incineration services such as those proposed to be provided by AEI, and regulatory uncertainty stemming from EPA pronouncements apparently foreshadowing more pervasive regulation, led OPI to conclude that successful commercial development of the project was unlikely. OPI has ceased all development activities and in 1994 intends to dispose of the assets related to this business, primarily a permit to build and operate a hazardous waste incineration facility. OPI, through Ogden Power Systems, Inc., a wholly owned subsidiary, intends to develop, operate and, in some cases, own power projects which cogenerate electricity and steam or generate electricity alone for sale to utilities. These power systems may use, among other fuels, wood, tires, coal, or natural gas as fuel. OPI does not currently operate any power projects. OPI, through Ogden Water Systems, Inc., a wholly owned subsidiary, intends to develop, operate and, in some cases, own projects that purify water, treat wastewater, and treat and manage biosolids and compost organic wastes. As with OPI's waste-to- energy business, water and wastewater projects involve various contractual arrangements with a variety of private and public entities including municipalities, lenders, joint venture partners (which provide financing or technical support), and contractors and subcontractors which build the facilities. OPI also intends to develop, operate and, in some cases, own projects that process recyclable paper products into linerboard for reuse in the commercial sector. As with OPI's waste-to-energy business, such projects involve various contractual arrangements with a variety of private and public entities, including municipalities, lenders, joint venture partners (which provide financing or technical support) and contractors and subcontractors which build the facilities. In addition, such projects require significant amounts of energy in the form of steam, which may be provided by present or future waste-to-energy projects operated by OPI. REGULATION (a) Environmental Regulations. OPI's business activities are pervasively regulated pursuant to Federal, state and local environmental laws. Federal laws, such as the Clean Air Act and Clean Water Act, and their state counterparts govern discharges of pollutants into the air and water. Other Federal, state and local laws such as the Resource Conservation and Recovery Act ("RCRA") comprehensively govern the generation, transportation, storage, treatment and disposal of solid waste, including hazardous waste (such laws and the regulations thereunder, "Environmental Regulatory Laws"). The Environmental Regulatory Laws and other Federal, state and local laws, such as the Comprehensive Environmental Recovery Response Compensation and Liability Act ("CERCLA"), make OPI potentially liable for any environmental contamination which may be associated with its activities or properties (collectively, Environmental Remediation Laws"). Many states have mandated local and regional solid waste planning, and require that new solid waste facilities may be constructed only in conformity with such plans. State laws may authorize the planning agency to require that waste generated within its jurisdiction be brought to a designated facility which may help that facility become economically viable but preclude the development of other facilities in that jurisdiction. Such ordinances are sometimes referred to as legal flow control. Legal flow control has been challenged in a number of law suits on the basis that it is a state regulation of interstate commerce prohibited by the United States Constitution. The decisions on these cases have not been consistent. However, several recent decisions have invalidated ordinances creating legal flow control. In 1993, the United States Supreme Court granted an appeal from a decision of a New York State Court upholding a New York municipality's ordinance requiring that all waste generated within its jurisdiction be disposed of at a transfer station operating under contract with the municipality. The case was argued in December 1993 and a decision is expected during the Court's spring 1994 term. OPI believes that legal flow control is an important tool used by municipalities in fulfilling their obligations to provide safe and environmentally sound waste disposal services to their constituencies. Although a decision invalidating legal flow control would reduce the number of options local government would have in meeting this obligation, OPI does not believe it would materially impact OPI's existing facilities or its ability to develop new ones. Most of the contracts pursuant to which OPI provides disposal services require the Client Community to deliver stated minimum quantities of waste on a put-or-pay basis. OPI does not believe these obligations would be negated by an adverse Supreme Court decision. Furthermore, only a few of the Client Communities served by OPI rely solely on flow control to provide waste to OPI's facilities, a factor influenced in part by past difficulties in enforcing legal flow control ordinances. Although some municipalities may experience temporary difficulties in meeting delivery commitments as they address required changes in their waste disposal plans, such difficulties should not be long- lived as indicated by the experience of municipalities served by OPI which determined that it could not enforce its flow control ordinance and therefore adopted alternative measures. OPI believes that there are other methods for providing incentives to use integrated waste systems incorporating waste to energy that do not entail legal flow control, which incentives should not be affected by the Court's decision. These include mandating that charges for utilization of the system be maintained at competitive levels and that revenue shortfalls be funded from tax revenues or special assessments on residents. This type of incentive will be utilized at the facility being constructed, which will be operated by OPI in Montgomery County Maryland. Furthermore, in most of the municipalities where OPI provides services, information available to OPI indicates that the cost to the Client Community of waste-to-energy is competitive with alternative disposal facilities, and therefore OPI's facilities should be able to compete for waste economically. As indicated, however, certain additional waste disposal services are financed by the Client Community's increasing the cost for disposal at waste- to-energy facilities, and these services may have to be paid for by other mechanisms. A number of bills are presently pending in Congress to authorize legal flow control. Whether Congress will enact legislation on this subject is uncertain. In addition, state laws have been enacted in some jurisdictions that may also restrict the intrastate and interstate movement of solid waste. Restrictions on importation of waste from other states have generally been voided by Federal Courts as invalid restrictions on interstate commerce. Bills proposed in past sessions of Congress would authorized such designations and restrictions. Bills of this nature are expected to be introduced in the current session of Congress. Similar bills have been introduced in previous sessions of Congress and it remains uncertain whether Congress acts to authorize such laws. The Environmental Regulatory Laws require that many permits be obtained before the commencement of construction or operation of any waste-to-energy facility, including: air quality, construction and operating permits, stormwater discharge permits, solid waste facility permits in most cases, and, in many cases, wastewater discharge permits. There can be no assurance that all required permits will be issued, and the process of obtaining such permits can often cause lengthy delays, including delays caused by third party appeals challenging permit issuance. The Environmental Regulatory Laws and regulations and permits issued pursuant to them also establish operational standards, including specific limitations upon emissions of certain air and water pollutants. Failure to meet these standards subjects an Operating Subsidiary to regulatory enforcement actions by the appropriate governmental unit, which could include fines and orders which could limit or prohibit operations. Certain of the Environmental Regulatory Laws also authorize suits by private parties for damages and injunctive relief. Repeated unexcused failure to comply with environmental standards may also constitute a default by the Operating Subsidiary under its Service Agreement. The Environmental Regulatory Laws and governmental policies governing their enforcement are subject to revision. New technology may be required or stricter standards may be established for the control of discharges of air or water pollutants or for solid waste or ash handling and disposal. Most Federal Environmental Regularly Laws encourage development of new technology to achieve increasingly stringent standards; they also often require use of the best technology available at the time a permit is issued. The Federal Prevention of Significant Deterioration of air quality Program requires that new or substantially modified waste-to-energy facilities of the size constructed by OPI that are located in areas of the country that are in compliance with national ambient air quality standards ("NAAQS") employ the Best Available Control Technology ("BACT"). The selection of control technology and the emission limits that must be achieved are made on a case-by-case basis considering economic impacts, energy and other environmental impacts and costs, and may include requirements that certain components of the mixed waste stream be separated for treatment by means other than combustion in the Operating Subsidiary's facility. For facilities developed in areas where NAAQS are not met, Federal law requires that control technology capable of achieving the Lowest Achievable Emission Rate ("LAER") must be employed. LAER means the most stringent emission limit achievable in practice by emission sources similar to the facility in question, which does not involve any consideration of the economic impact or cost to achieve such a limitation. Existing facilities in areas where LAER is now required for new facilities may be required to retro-fit Reasonably Available Control Technology ("RACT") established by EPA applicable to selected pollutants to enhance progress toward these areas achieving the NAAQS. RACT is that technology which EPA or state agencies determine to be available, proven, reliable, and affordable to reduce targeted emissions from specific types of existing sources of air emissions within geographic areas in which NAAQS for the target emissions is not being met. Thus, as new technology is developed and proven, it must be incorporated into new or modified facilities. This new technology may often be more expensive than that used previously. EPA has promulgated regulations establishing New Source Performance Standards ("NSPS") and Emission Guidelines ("EG") applicable to new and existing municipal waste combustion units with a capacity of greater than 250 tons per day, respectively. The EG and NSPS limit the concentrations of carbon monoxide in combustion gases and establish limitations upon the flue gas pollutant concentrations entering the ambient air for particulate matter (opacity), organics (dioxins and furans), carbon monoxide and acid gases (sulfur dioxide and hydrogen chloride). The NSPS also establish emissions limitations for nitrogen oxides. The NSPS apply to facilities beginning construction after December 20, 1989 and the EG will become effective three years after each individual state adopts them but no later than five years after promulgation. Additional air pollution control equipment is likely to be required at three of OPI's existing waste-to-energy facilities to achieve the EG limitations. The Clean Air Act required EPA to re-evaluate the NSPS and EG for particulate matter (total and fine), opacity (as appropriate), sulfur dioxide, hydrogen chloride, oxides of nitrogen, carbon monoxide, dioxins and dibenzofurans and to establish new NSPS and EG for lead, cadmium, and mercury no later than November 15, 1991 for all waste combustion facilities. Such re-evaluation and regulations were not completed by that date. These standards must reflect maximum achievable control technology ("MACT") for both new and existing waste-to-energy units. MACT means the maximum degree of reduction in emissions, considering the cost, energy requirements, and non air quality related health and environmental impacts. OPI cannot predict what standards will be proposed or promulgated, although EPA is reviewing data from existing facilities. The revised standards for new facilities will become effective six months after the date of promulgation of the revised standards. Standards for lead, cadmium and mercury are expected to be proposed in 1994 under a consent order entered in 1993 in connection with litigation commenced by several parties against the EPA. The Clean Air Act also requires each state to implement a state implementation plan in conformity with Federal law that outlines how areas are out of compliance with NAAQs will be returned to compliance. One aspect of the state implementation plan must be an operating permit program. Most states are now in the process of developing or augmenting their implementation plans to meet these requirements. The state implementation plans and the operating permits issued under them may place new requirements on waste-to-energy facilities. Under federal law, the new operating permits may have a term of up to 12 years after issuance or renewal, subject to review every five years. Changes in standards can affect the manner in which OPI operates existing projects and could require significant additional expenditures to achieve compliance. OPI believes that for a majority of the facilities operated by its Operating Subsidiaries, the cost of capital improvements required to meet Clean Air Act Requirements will not exceed $1 million per facility. Those improvements are expected to increase the cost of disposal at those facilities by less than two dollars per ton of MSW processed. Capital Improvements for four of OPI's earlier Facilities, however, are expected to cost between $20 million and $44 million. As a consequence, related cost of disposal increases are expected to range from six dollars to seventeen dollars per ton of MSW processed. OPI's estimates are preliminary and depend on whether Clean Air Act requirements are implemented as currently proposed. Such expenditures are, in most cases, borne by the Client Communities. For Facilities owned by OPI equity contributions of up to 20 percent of the capital costs described herein may be required. For projects not operated pursuant to a Service Agreement, such capital costs are the responsibility of OPI. OPI expects to recover such expenditures through increases in the tipping fee. In certain cases, there are limitations on the total amount or type of costs for complying with changes in law that can be "passed through" to the Client Communities, and if such limits are exceeded, the Client Community may be able to terminate the Service Agreement relating to the affected project, in which case the Client Community would be responsible for retiring or otherwise providing for the outstanding project debt. OPI does not believe that any of its Service Agreements will be terminated for this reason. The Environmental Remediation Laws, including CERCLA, may subject OPI, like other entities that manage waste, to joint and several liability for the costs of remediating contamination at sites, including landfills, which OPI has owned, operated or leased, or at which there has been disposal of residue or other waste handled or processed by OPI. OPI leases and operates a landfill in Haverhill, Massachusetts and leases a landfill in Bristol, Connecticut in connection with its projects at those locations. Some state and local laws also impose liabilities for injury to persons or property caused by site contamination. Some Service Agreements provide for indemnification of the Operating Subsidiaries from some such liabilities. Environmental Regulatory Laws, such as RCRA and state and local solid waste laws, impose significantly more stringent requirements upon disposal of hazardous waste than upon disposal of MSW and other non-hazardous wastes. These laws prohibit disposal of hazardous waste, other than in small, household-generated quantities, at the Company's municipal solid waste facilities and generally makes disposal of hazardous waste more expensive than management of non-hazardous waste. The Service Agreements recognize the potential for improper deliveries of hazardous wastes and specify procedures for dealing with hazardous waste that is delivered to a facility. Although certain Service Agreements require the Operating Subsidiary to be responsible for some costs related to hazardous waste deliveries, to date, no Operating Subsidiary has incurred material hazardous waste disposal costs. No ash residue from a fully operating facility operated by OPI has been characterized as hazardous under the present or past prescribed EPA test procedures, and such ash residue is currently disposed of in permitted landfills as non-hazardous waste. Some state laws or regulations provide that if prescribed test procedures demonstrate that ash residue has hazardous characteristics, it must be treated as hazardous waste. In certain states, ash residue from certain waste-to-energy facilities of other vendors or communities has been found to have hazardous characteristics under these test procedures. There is a conflict between the two Federal courts which have decided whether municipal solid waste ash residue having hazardous characteristics is subject to RCRA'S provisions for management as a hazardous waste. The Second Circuit Court of Appeals has held that it is not. The Seventh Circuit Court of Appeals reached the opposite result. In September 1992, the Administrator of the United States EPA officially stated that EPA policy was that waste-to-energy ash residue was exempt from treatment as a hazardous waste as a matter of law and could be safely disposed of in MSW landfills that met the EPA's criteria. In reaching its decision, the Seventh Circuit Court of Appeals refused to give deference to the EPA's policy. An appeal of this decision was filed in early 1993 in the United States Supreme Court, and a decision is expected during the Court's Spring 1994 session. OPI does not expect that a decision that requires ash residue having hazardous characteristics to be managed as a hazardous waste would have significant impacts on the OPI's business. Eight of the Company's facilities are located in states or dispose of their ash residue in states which require testing to determine whether such residue must be managed as a hazardous waste under state law. Furthermore, ash processing technology is available which could be used to further ensure that ash does not exhibit characteristics of hazardous waste. From time to time, state and federal moratoria on waste to energy have been proposed in legislation, regulation, and by executive action. Generally, such proposals have not been adopted, and where they have, as in the State of New Jersey, following the moratorium, waste to energy has continued to be included in the options available to local municipalities. In 1992, as previously reported, the State of Rhode Island eliminated waste to energy from its unique legislation in which the state's solid waste management plan was enacted as law. As a consequence of this legislation, OPI brought an action against the state challenging the validity of the change in the plan which has been settled by the State's agreement to pay OPI approximately $5.5 million in 1994, a portion of which must be shared with Blount, Inc., the former developer of the Quonset, Rhode Island project. OWTS' business activities are regulated under Federal, state and local environmental laws governing air and water emissions and the generation, transportation, storage, treatment and disposal of solid wastes, and hazardous and toxic materials. In particular, RCRA, its implementing regulations and parallel state laws create a cradle-to-grave system for regulating hazardous waste; and CERCLA and similar state laws create programs for remediation of contaminated sites and for the imposition of liability upon those who owned or operated such sites or who generated or transported hazardous substances disposed of at such sites. OPI believes that OWTS's units and projects were operated in compliance in all material respects with regulatory requirements that apply to its business. OPI's waste-to-energy business is subject to the provisions of the Federal Public Utility Regulatory Policies Act ("PURPA"). Pursuant to PURPA, the Federal Energy Regulatory Commission ("FERC") has promulgated regulations that exempt qualifying facilities (facilities meeting certain size, fuel and ownership requirements) from compliance with certain provisions of the Federal Power Act, the Public Utility Holding Company Act of 1935, and, except under certain limited circumstances, state laws regulating the rates charged by electric utilities. PURPA was promulgated to encourage the development of cogeneration facilities and small facilities making use of non-fossil fuel power sources, including waste-to-energy facilities. The exemptions afforded by PURPA to qualifying facilities from the Federal Power Act and the Public Utility Holding Company Act of 1935 are of great importance to the Company and its competitors in the waste-to-energy industry. State public utility commissions must approve the rates, and in some instances other contract terms, by which public utilities purchase electric power from the Company's projects. PURPA requires that electric utilities purchase electric energy produced by qualifying facilities at negotiated rates or at a price equal to the incremental or "avoided" cost that would have been incurred by the utility if it were to generate power itself or purchase it from another source. While public utilities are not required by PURPA to enter into long-term contracts, PURPA creates a regulatory environment in which such contracts can typically be negotiated. In October, 1992, Congress enacted, and the President signed into law, comprehensive energy legislation, several provisions of which are intended to foster the development of competitive, efficient bulk power generation markets throughout the country. Although the impact of the legislation will not be fully known until any judicial challenges are resolved and Federal and State regulatory agencies develop policies and promulgate implementing regulations, OPI believes that, over the long term, the legislation will create business opportunities both in the waste-to-energy field as well as in other power generation fields. OTHER INFORMATION (a) Raw Materials. The construction of each of OPI's waste-to- energy facilities is generally carried out by a general contractor selected by OPI. The general contractor is usually responsible for the procurement of bulk commodities used in the construction of the facility, such as steel and concrete. These commodities are generally readily available from many suppliers. OPI generally directs the procurement of all major equipment utilized in the facility, which equipment is also generally readily available from may suppliers. The stoker grates utilized in facilities constructed by OPI are required to be obtained from Martin pursuant to the Cooperation Agreement. In connection with the currently operating waste-to-energy facilities, OPI has entered into long-term waste disposal agreements which obligate the relevant Client Communities (or in the case of the Haverhill projects, the private haulers) to deliver specified amounts of waste on an annual basis. OPI believes that sufficient amounts of waste are being produced in the United States to support current and future waste-to-energy projects. Other commodities used in operation of OPI's facilities are readily available from many suppliers. Item 2.

Item 2. PROPERTIES (a) Operating Services The principal physical properties of Ogden Services are the fueling installations at various airports in the United States and Canada and the corporate premises located at Two Pennsylvania Plaza, New York, New York 10121 under lease, which expires on April 30, 1998 and which contains an option by Ogden Services to renew for an additional five years. Atlantic Design Company's corporate offices are located in Charlotte, North Carolina. Atlantic Design owns a 51,000 square foot operating facility on 3.5 acres of land in Vestal, New York. Atlantic Design also leases operating facilities at various locations in Florida, New Jersey and New York. The leases range from a term of one year to as long as ten years. Ogden Services Corporation, through wholly-owned subsidiaries, owns and leases buildings in various areas in the United States which house office, laboratory and warehousing operations. The leases range from a month-to-month term to as long as five years. The Ogden Services Corporation in-flight food service operation facilities, aggregating approximately 600,000 square feet, are leased, except at Newark, New Jersey; Miami, Florida,; and Las Vegas, Nevada which are owned. Ogden Services, through a subsidiary, operates the Fairmount Park racetrack which conducts thoroughbred and harness racing in Collinsville, Illinois, eight miles from downtown St. Louis. The track is on a 150-acre site with a long-term lease expiring in 2017. It also owns a 148-acre site located at East St. Louis, Illinois. Ogden Abatement and Decontamination Services owns a 12,000 square-foot warehouse and office facility located in Long Island City, New York. Ogden Government Services leases most of its facilities, consisting almost entirely of office space. This includes an 11-year lease which began in 1986 for its headquarters facility in Fairfax, Virginia, for approximately 119,000 square feet as well as office space in other locations throughout the United States under lease terms of five years or less. OEES's headquarters is located in Fairfax, Virginia, where OEES currently occupies approximately 27,000 square feet of space in the headquarters building of ERC International, Inc. ("ERCI"), a wholly-owned subsidiary of Ogden. OEES's lease payments include the cost of certain services and allocations which are shared with ERCI. OEES has agreed to continue to occupy and sublease from ERCI not less than 24,000 square feet of space in the building for the remainder of the lease term expiring in 1997. OEES leases an aggregate of approximately 347,000 square feet of office and laboratory space in 40 separate locations in 17 states in the United States. OEES's leases are generally short term in nature, with terms which range from five to ten years or less and include (i) the headquarters office described above, (ii) office and laboratory space in Nashville and Oak Ridge, Tennessee; San Diego, California; Pensacola, Florida; and Phoenix, Arizona, and (iii) laboratory office space owned in Fort Collins, Colorado. In addition to its Fairfax, Virginia headquarters, OEES maintains regional headquarters in San Diego, California and Nashville, Tennessee. Many of the other Ogden Services' facilities operate from leased premises located principally within the United States. (b) Waste-to-Energy Operations OPI's principal executive offices are located in Fairfield, New Jersey in an office building located on a 5.4-acre site owned by OPI. The following table summarizes certain information relating to the locations of the properties owned or leased by OPI or its subsidiaries as of January 31, 1994 (1). OTHER INFORMATION COMPETITION AND GENERAL BUSINESS CONDITIONS Ogden's businesses can be adversely affected by general economic conditions, war, inflation, adverse competitive conditions, governmental restriction and controls, natural disasters, energy shortages, weather, the adverse financial condition of customers and suppliers, various technological changes and other factors over which Ogden has no control. The economic climate can adversely affect several of Ogden's operations, including reduced requests by communities for waste-to- energy facilities at Ogden Projects, Inc., fewer airline flights and flight cancellations in the Ogden Aviation Services group; cost cutting and budget reductions in the Ogden Government Services and Ogden Facility Services groups; and, reduced event attendance in the Ogden Entertainment Services group. EQUAL EMPLOYMENT OPPORTUNITY In recent years, governmental agencies (including the Equal Employment Opportunity Commission) and representatives of minority groups and women have asserted claims against many companies, including some Ogden subsidiaries, alleging that certain persons have been discriminated against in employment, promotions, training, or other matters. Frequently, private actions are brought as class actions, thereby increasing the practical exposure. In some instances, these actions are brought by many plaintiffs against groups of defendants in the same industry, thereby increasing the risk that any defendant may incur liability as a result of activities which are the primary responsibility of other defendants. Although Ogden and its subsidiaries have attempted to provide equal opportunity for all of its employees, the combination of the foregoing factors and others increases the risk of financial exposure. EMPLOYEE AND LABOR RELATIONS As of January 31, 1994, Ogden and its subsidiaries employed approximately 41,800 people. Certain employees at Ogden subsidiaries are covered by collective bargaining agreements with various unions. During 1993, Ogden subsidiaries successfully renegotiated collective bargaining agreements in certain of its business sectors with no strike- related loss of service. Ogden does not anticipate any significant labor disputes in any of its service areas in 1994. INTERNATIONAL TERMINAL OPERATING CO. INC. Since April 1983, Ogden has owned 50% of the outstanding shares of International Terminal Operating Co. Inc. (ITO), which is engaged in providing stevedoring and related terminal services for loading and unloading containerized and breakbulk cargo in the United States. Because of severely depressed industry conditions, as well as the possibility of high pension liabilities under multiemployer plans, it does not appear likely that Ogden will be able to recover its investment in the foreseeable future. Ogden previously recorded a $28.5 million loss to fully reserve its entire investment. Ogden is contingently liable for up to $19.2 million as guarantor under certain of ITO's surety bonds and letters of credit. AVONDALE INDUSTRIES, INC. Pursuant to Ogden's sale of Avondale Industries, Inc., (Avondale) in 1985, Ogden continues as guarantor of tax-exempt Industrial Revenue Bonds (IRBs), amounting to approximately $36,000,000 on behalf of Avondale. The IRBs are secured by a letter of credit which expires June 16, 1994 issued for the account of Ogden. These IRBs are redeemable (unless remarketed) at the option of the bondholders or Avondale on June 1, 1994, and annually thereafter through June 1, 2001. The IRBs are subject to a mandatory call for redemption on June 1, 1994 if the existing letter of credit is not extended or replaced or the IRBs otherwise refinanced. If the IRBs are redeemed, Ogden may be required to purchase Avondale preferred stock. In addition, Ogden may also be required to purchase Avondale preferred stock in connection with certain litigation and income tax matters. Item 3.

Item 3. LEGAL PROCEEDINGS AND ENVIRONMENTAL MATTERS (a) Legal Proceedings Ogden and its subsidiaries are parties to various legal proceedings involving matters arising in the ordinary course of business. Ogden does not believe that there are any pending legal proceedings for damages against Ogden and its subsidiaries, the outcome of which would have a material adverse effect on Ogden and its subsidiaries on a consolidated basis. (b) Environmental Matters Ogden conducts regular inquiries of its subsidiaries regarding litigation and environmental violations which include determining the nature, amount and likelihood of liability for any such claims, potential claims or threatened litigation. In the ordinary course of its business, subsidiaries of Ogden may become involved in Federal, state, and local proceedings relating to the laws regulating the discharge of materials into the environment and the protection of the environment. These include proceedings for the issuance, amendment, or renewal of the licenses and permits pursuant to which the subsidiary operates. Such proceedings also include actions brought by individuals or local governmental authorities seeking to overrule governmental decisions on matters relating to the subsidiaries' operations in which the subsidiary may be, but is not necessarily, a party. Most proceedings brought against an Ogden subsidiary by governmental authorities under these laws relate to alleged technical violations of regulations, licenses, or permits pursuant to which the subsidiary operates. At September 30, 1993, an Ogden subsidiary was involved in one such proceeding in which the subsidiary believes sanctions involved may exceed $100,000. Ogden believes that such proceeding will not have a material adverse effect on Ogden and its subsidiaries on a consolidated basis. Ogden's operations are subject to various Federal, state and local environmental laws and regulations, including the Clean Air Act, the Clean Water Act, the Comprehensive Environmental Response Compensation and Liability Act (CERCLA) and Resource Conservation and Recovery Act (RCRA). Although Ogden's operations are occasionally subject to proceedings and orders pertaining to emissions into the environment and other environmental violations, Ogden believes that it is in substantial compliance with existing environmental laws and regulations and to the best of its knowledge neither Ogden nor any of its operations have been named as a potential responsible party at any site. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders of Ogden during the fourth quarter of 1993. There is no family relationship by blood, marriage or adoption (not more remote than first cousins) between any of the above individuals and any Ogden director, except that R. Richard Ablon, an Ogden director and President and Chief Executive Officer, is the son of Ralph E. Ablon, an Ogden director and Chairman of the Board. The term of office of all officers shall be until the next election of directors and until their respective successors are chosen and qualified. There are no arrangements or understandings between any of the above officers and any other person pursuant to which any of the above was selected as an officer. Except as set forth below, the foregoing table lists the principal occupation and employment of the named individual and the position or similar position that he/she has held since January 1, 1989: Ralph E. Ablon has been Chairman of the Board of Ogden since 1962 and served as its Chief Executive Officer prior to May 1990. R. Richard Ablon has been President and Chief Executive Officer of Ogden since May 1990. From January, 1987 to May 1990, he was President and Chief Operating Officer, Operating Services, Ogden. Mr. Ablon has served as Chairman of the Board and Chief Executive Officer of Ogden Projects, Inc., an 84.2% owned subsidiary, since November 1990. Constantine G. Caras has been Executive Vice President and Chief Administrative Officer since July 1990. Since September 1986 he has served as Executive Vice President of Ogden Services Corporation. Scott G. Mackin was made an Executive Officer of Ogden during 1992. He has been President and Chief Operating Officer of Ogden Projects, Inc. since January 1991. From November 1990 to January 1991, he was Co-President, Co-Chief Operating Officer, General Counsel and Secretary of Ogden Projects, Inc. Between 1987 and 1990 Mr. Mackin served in various executive capacities of Ogden Projects, Inc. Philip G. Husby has been Senior Vice President and Chief Financial Officer of Ogden since January 1, 1991. From April 1987 to December 31, 1990, he served as Senior Vice President and Chief Administrative Officer of Ogden Financial Services, Inc., an Ogden subsidiary. Lynde H. Coit has been a Senior Vice President and General Counsel of Ogden since January 17, 1991. From April 1989 to January 1991, he was Senior Vice President and General Counsel of Ogden Financial Services, Inc., an Ogden subsidiary. From January 1988 to March 1989, he was a partner of the law firm of Nixon, Hargrave, Devans & Doyle and prior thereto he was employed by that firm. Nancy R. Christal has been Vice President - Investor Relations of Ogden since February 1992 and served as Ogden's Director, Investor Relations from January 1991 to February 1992. From April 1990 to January 1991, she was Director, Investor Relations at Ogden Projects, Inc. From 1985 to March 1990 she served first as Manager and then as Assistant Vice President, Investor Relations at Chemical Bank. Part II Item 5.

Item 5. MARKET FOR OGDEN'S COMMON EQUITY & RELATED STOCKHOLDER MATTERS Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Page 47 of Ogden's 1993 Annual Report to Shareholders. As of March 1, 1994, the approximate number of Ogden common stock Shareholders was 12,700. Item 6.

Item 6. SELECTED FINANCIAL DATA Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Page 24 of Ogden's 1993 Annual Report to Shareholders. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Pages 22 and 23 of Ogden's 1993 Annual Report to Shareholders. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pursuant to General Instruction G (2), the information called for by this item is hereby incorporated by reference from Pages 24 through 44 and Page 47 of Ogden's 1993 Annual Report to Shareholders. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF OGDEN Pursuant to General Instruction G (3), the information regarding directors called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. Item 11.

Item 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G (3), the information called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. The information regarding officers called for by this item is included at the end of Part I of this document under the heading "Executive Officers of Ogden." Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G (3), the information called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G (3), the information called for by this item is hereby incorporated by reference from Ogden's 1994 Proxy statement to be filed with the Securities and Exchange Commission. Part IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Listed below are the documents filed as a part of this report: 1). All financial statements contained on pages 25 through 44 and the Independent Auditors' Report on page 45 of Ogden's 1993 Annual Report to Shareholders are incorporated herein by reference. 2). Financial statement schedules as follows: (i) Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees other than Related Parties for the years ended December 31, 1993, 1992 and 1991. (ii) Schedule V - Property, Plant and Equipment for years ended December 31, 1993, 1992 and 1991. (iii) Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991. (iv) Schedule VIII - Valuation and Qualifying Accounts for the years ended December 31, 1993, 1992 and 1991. (v) Schedule IX - Short-Term Borrowings for the year ended December 31, 1991. (vi) Schedule X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991. 3). Those exhibits required to be filed by Item 601 of Regulation S-K: EXHIBITS 3.0 Articles of Incorporation and By-laws. 3.1 Ogden's Restated Certificate of Incorporation as amended.* 3.2 Ogden's By-Laws, as amended through March 17, 1994 transmitted herewith as Exhibit 3.2. 4.0 Instruments Defining Rights of Security Holders. 4.1 Fiscal Agency Agreement between Ogden and Bankers Trust Company, dated as of June 1, 1987, and Offering Memorandum dated June 12, 1987, relating to U.S. $85 million Ogden 6% Convertible Subordinated Debentures, Due 2002.* 4.2 Fiscal Agency Agreement between Ogden and Bankers Trust Company, dated as of October 15, 1987, and Offering Memorandum, dated October 15, 1987, relating to U.S. $75 million Ogden 5-3/4% Convertible Subordinated Debentures, Due 2002.* 4.3 Indenture dated as of March 1, 1992 from Ogden Corporation to The Bank of New York, Trustee, relating to Ogden's $100 million debt offering.* 10.0 Material Contracts 10.1 Agreement and Plan of Merger, dated as of October 31, 1989, among Ogden, ERCI Acquisition Corporation and ERC International, Inc.* 10.2 Credit Agreement by and among Ogden, The Bank of New York, as Agent and the signatory bank Lenders thereto dated as of September 20, 1993. Transmitted herewith as Exhibit 10.2. 10.3 Stock Purchase Agreement, dated May 31, 1988, between Ogden and Ogden Projects, Inc.* 10.4 Tax Sharing Agreement, dated January 1, 1989, between Ogden, Ogden Projects, Inc. and subsidiaries, Ogden Allied Services, Inc. an subsidiaries, and Ogden Financial Services, Inc. and subsidiaries.* 10.5 Stock Purchase Option Agreement, dated June 14, 1989, between Ogden and Ogden Projects, Inc. as amended on November 16, 1989.* 10.6 Preferred Stock Purchase Agreement, dated July 7, 1989, between Ogden Financial Services, Inc. and Image Data Corporation.* 10.7 Rights Agreement between Ogden Corporation and Manufacturers Hanover Trust Company, dated as of September 20, 1990.* 10.8 Executive Compensation Plans and Arrangements (a) Ogden Corporation 1986 Stock Option Plan (Filed as Exhibit (10) (k) to Ogden's Form 10- K for the fiscal year ended December 31, 1985) (b) Ogden Corporation 1990 Stock Option Plan (Filed as Exhibit (10) (j))** (c) Ogden Services Corporation Executive Pension Plan (Filed as Exhibit (10) (k))** (d) Ogden Services Corporation Select Savings Plan (Filed as Exhibit (10) (L))** (e) Ogden Services Corporation Select Savings Plan Trust (Filed as Exhibit (10) (M))** (f) Ogden Services Corporation Executive Pension Plan Trust (Filed as Exhibit (10) (N))** (g) Changes effected to the Ogden Profit Sharing Plan effective January 1, 1990 (Filed as Exhibit (10) (O))** (h) Employment Letter Agreement between Ogden and an Executive officer dated January 30, 1990 (Filed as Exhibit (10) (p))** (i) Employment Agreement between Ogden and R. richard Ablon dated as of May 24, 1990 (Filed as Exhibit (10) (R))** (i) Letter Amendment Employment Agreement between Ogden and R. Richard Ablon dated as of October 11, 1990 (Filed as Exhibit (10) (R) (i))** (j) Employment Agreement between Ogden and C. G. Caras dated as of July 2, 1990 (Filed as Exhibit (10) (S))** (i) Letter Amendment to Employment Agreement between Ogden Corporation and C.G. Caras, dated as of October 11, 1990 (Filed as Exhibit (10) (S) (i).** (k) Employment Agreement between Ogden and Philip G. Husby as of July 2, 1990 (Filed as Exhibit (10) (T))** (l) Termination Letter Agreement between Maria P. Monet and Ogden dated as of October 22, 1990 (Filed as Exhibit (10) (V)** (m) Letter Agreement between Ogden Corporation and Ogden's Chairman of the Board, dated as of January 16, 1992 (Filed as Exhibit (10.2) (P) to Ogden Form 10-K for the fiscal year ended December 31, 1991) (n) Employment Agreement between Ogden and Ogden's Chief Accounting Officer dated as of December 18, 1991 (Filed as Exhibit (10.2) (Q) to Ogden Form 10-K for fiscal year ended December, 1991) (o) Employment Agreement between Scott G. Mackin and Ogden Projects, Inc. dated as of January 1, 1994. Transmitted herewith as Exhibit 10.8 (o). (p) Ogden Corporation Profit Sharing Plan (Filed as Exhibit (10.8) (P))*** (i) Ogden Profit Sharing Plan as amended and restated January 1, 1991 and as in effect through January 1, 1993. Transmitted herewith as Exhibit 10.8 (p) (i). (q) Ogden Corporation Core Executive Benefit Program (Filed as Exhibit 10.8 (Q))*** (r) Ogden Projects Pension Plan (Filed as Exhibit 10.8 (R))*** (s) Ogden Projects Profit Sharing Plan (Filed as Exhibit 10.8 (S))*** (t) Ogden Projects Supplemental Pension and Profit Sharing Plans (Filed as Exhibit 10.8 (T))*** (u) Ogden Projects Employee's Stock Option Plan (Filed as Exhibit 10.8 (U))*** (v) Ogden Projects Core Executive Benefit Program (Filed as Exhibit 10.8 (V))*** (w) Form of amendments to the Ogden Projects, Inc. Pension Plan and Profit Sharing Plans effective as of January 1, 1994. Transmitted herewith as Exhibit 10.8 (w). ** Filed as Exhibits with Ogden's Form 10-K for fiscal year ended December 31, 1990. *** Filed as Exhibits with Ogden's Form 10-K for fiscal year ended December 31, 1992. 10.9 Agreement and Plan of Merger among Ogden Corporation, ERC International, Inc., ERC Acquisition Corporation and ERC Environmental and Energy Services Co., Inc., dated as of January 17, 1991.* 10.10 First Amended and Restated Ogden Corporation Guaranty Agreement made as of January 30, 1992 by Ogden Corporation for the benefit of Mission Funding Zeta and Pitney Bowes Credit Corporation.* 10.11 Ogden Corporation Guaranty Agreement as of January 30, 1992 by Ogden Corporation for the benefit of Allstate Insurance Company and Ogden Martin Systems of Huntington Resource Recovery Nine Corporation.* 11 Ogden Corporation and Subsidiaries Detail of Computation of Earnings Applicable to Common Stock for the years ended December 31, 1993, 1992 and 1991. Transmitted herewith as Exhibit 11. 13 Those portions of the Annual Report to Stockholders for the year ended December 31, 1993, which are incorporated herein by reference. Transmitted herewith as Exhibit 13. 21 Subsidiaries of Ogden. Transmitted herewith as Exhibit 21. 24 Consent of Deloitte & Touche. Transmitted herewith as Exhibit 24. * Incorporated by reference as set forth in the Exhibit Index of this Annual Report on Form 10-K. (b) No Reports on Form 8-K were filed by Ogden during the fourth quarter of 1992. SIGNATURES Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OGDEN CORPORATION March 17, 1994 By /S/ R. Richard Ablon R. Richard Ablon President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 17, 1994. SIGNATURE TITLE /S/ Ralph E. Ablon Chairman of the Board & Director RALPH E. ABLON /S/ R. Richard Ablon President & Chief Executive Officer R. RICHARD ABLON and Director /S/ Philip G. Husby Senior Vice President and Chief PHILIP G. HUSBY Financial Officer /S/ Robert M. DiGia Vice President, Controller and Chief ROBERT M. DIGIA Accounting Officer /S/ David M. Abshire Director DAVID M. ABSHIRE /S/ Norman G. Einspruch Director NORMAN G. EINSPRUCH /S/ Constantine G. Caras Director CONSTANTINE G. CARAS /S/ Rita R. Fraad Director RITA R. FRAAD /S/ Attallah Kappas Director ATTALLAH KAPPAS Director TERRY ALLEN KRAMER /S/ Maria P. Monet Director MARIA P. MONET Director JUDITH D. MOYERS /S/ Homer A. Neal Director HOMER A. NEAL /S/ Stanford S. Penner Director STANFORD S. PENNER /S/ Frederick Seitz Director FREDERICK SEITZ /S/ Robert E. Smith Director ROBERT E. SMITH /S/ Abraham Zaleznik Director ABRAHAM ZALEZNIK INDEPENDENT AUDITOR'S REPORT Ogden Corporation: We have audited the consolidated financial statements of Ogden Corporation and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 2, 1994, which report includes an explanatory paragraph relating to the adoption of Statements of Financial Accounting Standards No. 106 and No. 109; such consolidated financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Ogden Corporation and subsidiaries, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Deloitte & Touche February 2, 1994

774203_1993.txt

774203

1993

Item 1. Business - ----------------- GENERAL Wachovia Corporation ("Wachovia"), a North Carolina corporation, is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, and a savings and loan holding company within the meaning of the Home Owners Loan Act of 1933, as amended by the Financial Institutions Reform, Recovery and Enforcement Act of 1989. Its member companies provide a wide range of banking and bank-related services to customers throughout the United States and abroad. The subsidiaries of Wachovia and its member companies are listed on pages 6 and 7 of this report. On December 6, 1991, pursuant to the Agreement and Plan of Merger, which was approved by the shareholders of South Carolina National Corporation on October 25, 1991, South Carolina National Corporation became a wholly-owned subsidiary of Wachovia Corporation. Wachovia Bank of North Carolina, N.A., provides personal, commercial, trust and institutional banking services through 223 full-service banking offices in 96 North Carolina cities and communities. In addition, it has a foreign branch in Grand Cayman and an Edge Act subsidiary - Wachovia International Banking Corporation, with a branch in New York City. Retail banking is conducted primarily through the statewide branch network, but other services are provided to corporations and institutions across North Carolina, the Southeast, the nation and the world. Wachovia Bank of Georgia, N.A., provides a full range of banking services with a network of 129 offices in Georgia, including 90 in metropolitan Atlanta, and a foreign branch in Grand Cayman. The First National Bank of Atlanta in Wilmington, Delaware, provides credit card services for Wachovia's affiliated banks. South Carolina National Corporation, a bank and savings and loan holding company, provides full-service banking through its principal subsidiary, The South Carolina National Bank. The South Carolina National Bank has 157 offices in 70 South Carolina cities and communities and a foreign branch in Grand Cayman. The South Carolina National Bank plans to change its name to Wachovia Bank of South Carolina, N.A., in May 1994. The action was approved by its board of directors in October 1993. Wachovia Corporate Services, Inc., manages major corporate and institutional relationships in the national and international markets for Wachovia's member banks. Main offices are based in Atlanta, Winston-Salem and Columbia, with representative offices located in Chicago, London, New York City and Tokyo. Wachovia Trust Services, Inc., is the administrative framework for the trust function which offers fiduciary, investment management and related financial services for corporate, institutional and individual clients through Wachovia Bank of North Carolina, N.A., Wachovia Bank of Georgia, N.A., and The South Carolina National Bank. Wachovia Mortgage Company conducts mortgage banking operations in the southeastern United States and has 18 residential loan offices in the states of North Carolina, South Carolina, Florida and Georgia. The company originates and places permanent residential loans, makes interim residential construction loans and services residential and commercial mortgage portfolios for long-term investors including insurance companies, savings institutions and others. Wachovia Operational Services Corporation provides information processing and systems development services for Wachovia's subsidiaries. The company provides operational support for corporate and retail depository and cash management products, as well as information services corporate-wide. Item 1. Business (Continued) - ----------------------------- Wachovia Securities, Inc., provides discount brokerage services to customers primarily in Georgia, North Carolina, and South Carolina. Financial Life Insurance Company of Georgia acts principally as a reinsurer of credit life and accident and health insurance on extensions of credit made by subsidiaries of Wachovia Bank of Georgia, N.A. Wachovia Leasing Corporation provides equipment leasing for commercial and industrial clients of Wachovia's banks. Wachovia Student Financial Services, Inc. was sold on February 3, 1993 to EduServ Technologies, Inc., of St. Paul, Minnesota. At December 31, 1993, Wachovia and its subsidiaries had 15,531 full-time equivalent employees. The financial condition and business growth of Wachovia and subsidiaries are indicated in the condensed balance sheet information presented on page 61 of the 1993 Annual Report to Shareholders (1993 Annual Report). The section of the 1993 Annual Report entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 8 through 34 is incorporated herein by reference. DISTRIBUTION OF BALANCE SHEET; INTEREST RATES AND INTEREST DIFFERENTIAL The daily average statements of condition of Wachovia and subsidiaries for the six years ended December 31, 1993 and an analysis of net interest earnings are included in the 1993 Annual Report on the pages indicated and are herein incorporated by reference. The tables below summarize the changes in interest income (taxable equivalent) and interest expense resulting from changes in rates and changes in volume for the years ended December 31, 1993 and 1992. Changes which are not solely due to rate or to volume are allocated proportionately to rate and volume. Nonaccrual loan balances are included in loans. Additional detail on the changes in interest income and interest expense between 1993 and 1992 is shown in Table 3 on page 11 of the 1993 Annual Report. Item 1. Business (Continued) - ----------------------------- INVESTMENT PORTFOLIO A breakdown of the book and market values of investment securities by type at December 31, 1993, 1992 and 1991 is shown in Table 5 on page 14 of the 1993 Annual Report. This table also reflects the type and maturity with average maturities by type and weighted average yields for each range of maturities for 1993. The standard bond formula was employed in computing the yield at cost. Yields are adjusted to a fully taxable equivalent basis using a 35 percent tax rate for securities exempt from federal taxes for 1993 and a 34 percent tax rate for 1992 and 1991. Wachovia's investment securities portfolio is widely diversified as to the issuer of state, county and municipal securities. There were no obligations of any one issuer exceeding 10 percent of consolidated shareholders' equity at December 31, 1993. Additional data relating to the investment securities portfolio is given in Note D of the notes to consolidated financial statements on page 43 of the 1993 Annual Report. LOAN PORTFOLIO A breakdown of loans by type for the six years ended December 31, 1993 is shown on page 61 of the 1993 Annual Report. Table 4 on page 14 of the 1993 Annual Report shows the maturities and interest sensitivity of selected loans at December 31, 1993. Table 8 on page 20 of the 1993 Annual Report shows the loans on which interest was not being accrued; loans on which the rate had been renegotiated downward; and loans which were contractually past due as to interest or principal at the dates indicated. The interest income which would have been recorded pursuant to the original terms of these loans and the amount of interest income recorded in 1993 and 1992 are shown in Note E of the notes to consolidated financial statements on page 44 of the 1993 Annual Report. Wachovia's policy for placing loans on nonaccrual status is discussed in Note A of the notes to consolidated financial statements on page 40 of the 1993 Annual Report. Item 1. Business (Continued) - ----------------------------- ALLOWANCE FOR LOAN LOSSES AND LOAN LOSS EXPERIENCE The allowance for loan losses is maintained at a level believed to be adequate by management to absorb potential losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current domestic and international economic conditions, volume, growth and composition of the loan portfolio, and other risks inherent in the portfolio. A provision for loan losses is charged to operations based on management's periodic evaluation of these risks. A reconcilement of the allowance for loan losses and the net loan losses for the six years ended December 31, 1993 is shown in Table 9 on page 22 of the 1993 Annual Report. The allowance for loan losses is allocated among major loan categories based on management's best estimate of relevant risk factors from time to time. The allocation of the allowance for loan losses for the six years ended December 31, 1993 is shown on page 61 of the 1993 Annual Report. The allocation of the allowance for loan losses represents only an estimate for each category of loans based upon historical loss experience and management judgment. As of December 31, 1993, approximately 21 percent remains unallocated as a general valuation reserve for the entire portfolio to cover unpredictable variations from historical experience in individual loan categories. The table below shows the percentage of loans in each category to total loans outstanding at December 31 for the last six years. Percentage of Loans in Each Category to Total Loans * See discussion of real estate loans on pages 12 and 13 of the 1993 Annual Report. DEPOSITS Details on average deposits for the six years ended December 31, 1993 are shown in the daily average statements of condition included in the 1993 Annual Report on pages 54 and 55. A statistical summary of average rates paid on deposits for the six years ended December 31, 1993 is presented in the 1993 Annual Report on page 60. Remaining maturities of domestic large denomination certificates of deposit in amounts of $100,000 or more at December 31, 1993 are shown in Table 6 on page 18 of the 1993 Annual Report. The majority of the deposits in foreign offices were in denominations of greater than $100,000. RETURN ON EQUITY AND ASSETS Rates of return on average assets and average equity, the dividend pay-out ratio and the ratio of shareholders' equity to total assets for the last six years are presented on page 60 of the 1993 Annual Report. Item 1. Business (Continued) - ----------------------------- SHORT-TERM BORROWED FUNDS A three-year summary of short-term borrowed funds is shown in Table 7 on page 18 of the 1993 Annual Report. SUBSIDIARIES OF THE REGISTRANT The listings below set forth the subsidiaries of Wachovia Corporation on December 31, 1993. The common stock of each of these subsidiaries is 100 percent owned by its parent. The financial statements of all subsidiaries are included in the consolidated statements of Wachovia Corporation and subsidiaries (the Corporation) incorporated herein. Subsidiaries of Wachovia Corporation Wachovia Bank of North Carolina, N.A. (a) Wachovia International Banking Corporation (j) Wachovia Leasing Corporation (c) Wachovia Auto Leasing Company of North Carolina (c) Wachovia VideoFinancial Services Corporation (c) Greenville Agricultural Credit Corporation (c) City Loans, Inc. (c) Wachovia Bank of Georgia, N.A. (a) First Bank Building Corp. (b) First Atlanta Services Corporation (d) WWTP, Inc. (b) Wachovia Auto Leasing Company of Georgia (b) South Carolina National Corporation (h) The South Carolina National Bank (a) SCN Investment Services, Inc. (h) First National Properties, Inc. (h) Southern Provident Life Insurance Company (i) Atlantic Savings Bank, FSB (a) Atlantic Mortgage Corporation of South Carolina, Inc. (h) Wachovia Mortgage Company (c) ORE, Inc. (c) Wachovia Securities, Inc. (c) Wachovia Corporate Services, Inc. (c) Wachovia Operational Services Corporation (c) Wachovia Trust Services, Inc. (c) The First National Bank of Atlanta (Delaware) (a) First Atlanta Corporation (b) FA Investment Company (b) Financial Life Insurance Company of Georgia (b) KATWO, Ltd. (b) The Wachovia Insurance Agency of Georgia, Inc. (b) FAIRCO Properties, Inc. (b) First Atlanta Lease Liquidating Corporation (b) Wachovia Corporation of Florida (e) Wachovia Bank Card Services, Inc. (d) Wachovia Corporation of Alabama (f) Wachovia Corporation of Tennessee (g) Item 1. Business (Continued) - ---------------------------- Notes to the listing of subsidiaries: (a) Organized under the laws of the United States. (b) Organized under the laws of the State of Georgia. (c) Organized under the laws of the State of North Carolina. (d) Organized under the laws of the State of Delaware. (e) Organized under the laws of the State of Florida. (f) Organized under the laws of the State of Alabama (for legal purposes). (g) Organized under the laws of the State of Tennessee (for legal purposes). (h) Organized under the laws of the State of South Carolina. (i) Organized under the laws of the State of Arizona. (j) Organized under Chapter 25(a) of the Federal Reserve Act of the United States. On March 31, 1993, Wachovia Corporation of North Carolina and Wachovia Corporation of Georgia were merged into Wachovia Corporation. The subsidiaries of these two second tier holding companies became direct subsidiaries of Wachovia Corporation, the surviving Corporation in the merger. SUPERVISION AND REGULATION As a bank holding company, Wachovia is subject to regulation under the Bank Holding Company Act of 1956, as amended (BHC Act), and its examination and reporting requirements. South Carolina National Corporation is likewise subject to the requirements of the BHC Act, which imposes certain limitations and restrictions on the level of interstate banking in which Wachovia may engage, the degree to which Wachovia may conduct non-banking related activities, and the extent to which Wachovia may engage in interstate merger and acquisition activities. In addition to the provisions of the BHC Act, state banking commissions serve in a supervisory and regulatory capacity with respect to bank holding company activities. Wachovia is a savings and loan holding company within the meaning of the Home Owners' Loan Act of 1933 (HOLA), as amended by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). HOLA places certain restrictions on the conduct of unrelated business activities of the subsidiaries of savings and loan holding companies which are not themselves savings and loans. Wachovia is registered with the Office of Thrift Supervision (OTS) and is subject to the examination, supervision and reporting requirements of this agency. Various state and federal laws govern the activities of Wachovia's banking affiliates. As federally insured national banks, Wachovia Bank of North Carolina, N.A., Wachovia Bank of Georgia, N.A., The South Carolina National Bank and The First National Bank of Atlanta are subject to the regulation, supervision and reporting requirements of the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). As a whole, the banking industry is directly affected by the fiscal and monetary policies of government agencies, including the Federal Reserve System. Item 1. Business (Continued) - ----------------------------- Through its conduct of open market securities transactions and control over the discount rate and reserve requirements, the Federal Reserve Board (FRB) exerts considerable influence on the cost and availability of funds used in lending and investment activities. Wachovia's non-banking subsidiaries are subject to a variety of state and federal laws. As mentioned previously, the savings and loan subsidiary is subject to the regulation and supervision of the OTS. Wachovia's brokerage subsidiary is regulated by the Securities and Exchange Commission, the National Association of Securities Dealers, and the various exchanges through which it conducts business. Additionally, it is registered in all states and is thus subject to corresponding state securities laws and regulations. Wachovia's insurance subsidiaries are subject to the insurance laws of the states in which they are active. All non-banking subsidiaries are supervised by the Federal Reserve System. Federal law regulates transactions among Wachovia and its affiliates, including the amount of banking affiliate's loans to, or investments in, nonbank affiliates and the amount of advances to third parties collateralized by securities of an affiliate. In addition, various requirements and restrictions under federal and state laws regulate the operations of Wachovia's banking affiliates, requiring the maintenance of reserves against deposits, limiting the nature of loans and interest that may be charged thereon, restricting investments and other activities, and subjecting the banking affiliates to regulation and examination by the OCC or state banking authorities and the FDIC. There are various legal and regulatory limits on the extent to which Wachovia's subsidiary banks may pay dividends or otherwise supply funds to Wachovia. In addition, federal and state regulatory agencies also have the authority to prevent a bank or bank holding company from paying a dividend or engaging in any other activity that, in the opinion of the agency, would constitute an unsafe or unsound practice. See Note L of the notes to consolidated financial statements on pages 49 and 50 of the 1993 Annual Report. Under FRB policy, Wachovia is expected to act as a source of financial strength to, and commit resources to support, each of its subsidiary banks. In addition, FIRREA provides that a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of a commonly controlled FDIC insured depository institution. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) federal banking regulators are required to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA generally prohibits a depository institution from making any capital distribution or paying management fees to its holding company if the depository institution would thereafter be undercapitalized. In addition, undercapitalized institutions will be subject to restrictions on borrowing from the Federal Reserve System, to growth limitations and to obligations to submit capital restoration plans. In order for a capital restoration to be acceptable, the depository institution's parent holding company must guarantee the institution's compliance with the capital restoration plan up to an amount not exceeding 5% of the depository institution's total assets. Significantly undercapitalized institutions are subject to greater restrictions, and critically undercapitalized institutions are subject to appointment of a receiver. See Shareholder's Equity and Capital Ratios on pages 26 and 27 of the 1993 Annual Report. FDICIA also substantially revises the bank regulatory insurance coverage and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. FDICIA imposes substantial new examination, audit and reporting requirements on insured depository institutions. Under FDICIA, each federal banking agency must prescribe Item 1. Business (Continued) - ----------------------------- standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses and other standards as the agency deems appropriate. The FDIC has adopted or currently proposes to adopt rules pursuant to FDICIA that include: (a) real estate lending standards for banks; (b) revision to the risk-based capital rules; (c) rules requiring depository institutions to develop and implement internal procedures to evaluate and control credit and settlement exposure to their correspondent banks; (d) a rule restricting the ability of depository institutions that are not well capitalized from accepting brokered deposits; (e) rules addressing various "safety and soundness" issues, including operations and managerial standards for asset quality, earnings and stock valuations, and compensation standards for the officers, directors, employees and principal shareholders of the depository institution; and (f) rules mandating enhanced financial reporting and audit requirements. Due to continued changes in the regulatory environment, additional legislation aimed at banking industry reform is likely to continue. While the potential effects of legislation currently under consideration cannot be measured with any degree of certainty, Wachovia is unaware of any pending legislative reforms or regulatory activities which would materially affect its financial position or operating results in the foreseeable future. Item 2.

Item 2. Properties - ------------------- Wachovia's principal executive offices are located at 301 North Main Street, Winston-Salem, North Carolina and 191 Peachtree Street, N.E., Atlanta, Georgia in buildings leased by its subsidiaries. The principal offices of Wachovia and Wachovia Bank of North Carolina, N.A., are located in The Wachovia Building, 301 North Main Street, Winston-Salem, North Carolina, where the company occupies approximately 378,000 square feet of office space under a lease expiring December, 1995. Wachovia Bank of Georgia, N.A., occupies approximately 380,000 square feet of an office tower at 191 Peachtree Street, N.E., Atlanta, Georgia under a lease expiring December, 2008. South Carolina National Corporation and The South Carolina National Bank have their main offices located in the Palmetto Center, 1426 Main Street, Columbia, South Carolina, where they occupy approximately 18,000 square feet of the office building under a lease expiring November, 2003. At December 31, 1993, the Corporation had 509 banking offices with 223 of these located in North Carolina, 129 in Georgia and 157 in South Carolina. The Corporation's banking subsidiaries own in fee 341 of these offices while the others are leased or are located on leased land. The approximate lease terms range from one to thirty years on these properties. In addition, the Corporation's banking subsidiaries own in fee or lease a number of multi-story office buildings which house supporting services. The other subsidiaries of Wachovia maintain leased office space in cities in which they conduct their respective operations. Construction began in January 1994 on an office building in Winston-Salem, North Carolina, which will serve as the new North Carolina headquarters for the holding company and principal office of Wachovia Bank of North Carolina, N.A. The building will be a 28 story office tower with 525,000 usable square feet, all or most of which is expected to be occupied by the Corporation. Construction is expected to be completed by late 1995. Item 2. Properties (Continued) - ------------------------------- For additional disclosure with respect to properties and lease commitments, see Note F of the notes to consolidated financial statements on page 45 of the 1993 Annual Report. Item 3.

Item 3. Legal Proceedings - -------------------------- Wachovia's subsidiaries are involved in ordinary and routine litigation incidental to their businesses. Management and general counsel believe that the ultimate resolution of these matters will not have a material adverse effect on the consolidated financial position and results of operations. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ There were no matters submitted during the fourth quarter of 1993 to be brought to a vote of shareholders. Executive Officers of the Registrant - ------------------------------------ The names, ages and positions of the executive officers of Wachovia as of March 1, 1994 are shown below along with their business experience during the past five years and the year of their employment with Wachovia and subsidiaries. Officers are elected annually by the Board of Directors and hold office for one year or until their successors are chosen and qualified. There are no family relationships between any of them, nor is there any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. Name, Age Business Experience During Past and Position Five Years and Year Employed - ------------ -------------------------------- L. M. Baker, Jr., 51 Chief Executive Officer of Wachovia President and Chief Corporation since January 1994; President Executive Officer Wachovia of Wachovia Corporation since 1993; Chief Corporation; Chairman of Operating Officer of Wachovia Corporation, the Board Wachovia Bank February - December 1993; Executive Vice of North Carolina, N.A.; President of Wachovia Corporation until Director of Wachovia January 1993; President and Chief Corporation, Wachovia Bank Executive Officer of Wachovia Corporation of Georgia, N.A., South of North Carolina, January 1990 - March Carolina National Corporation 1993; President and Chief Executive and The South Carolina National Officer of Wachovia Bank of North Bank Carolina, N.A., January 1990 - April 1993; Executive Vice President of Wachovia Corporation of North Carolina until December 1989; Executive Vice President of Wachovia Bank of North Carolina, N.A. until December 1989. Employed in 1969. Jerry D. Craft, 46 Executive Vice President of Wachovia Executive Vice President Corporation since December 1993; Wachovia Corporation; Executive Vice President of Wachovia Executive Vice President Bank of Georgia, N.A.; President Wachovia Bank of Georgia, of The First National Bank of Atlanta; N.A.; President and Director President of Wachovia Bank Card of The First National Services, Inc. since 1991. Employed Bank of Atlanta; President in 1982. Wachovia Bank Card Services, Inc. Executive Officers of the Registrant (Continued) - ------------------------------------------------ Name, Age Business Experience During Past and Position Five Years and Year Employed - ------------ ------------------------------- Mickey W. Dry, 54 Executive Vice President and Chief Credit Executive Vice President Officer of Wachovia Corporation since and Chief Credit Officer November 1989; Executive Vice President of Wachovia Corporation; Wachovia Bank of North Carolina, N.A. Executive Vice President since October 1989; Senior Vice President/ Wachovia Bank of North Group Executive of Wachovia Bank of North Carolina, N.A. Carolina, N.A. until 1989. Employed in 1961. Hugh M. Durden, 51 Executive Vice President of Wachovia Executive Vice President Corporation and President of Wachovia Wachovia Corporation, Trust Services, Inc. since 1994; Executive Wachovia Bank of North Vice President of Wachovia Bank of North Carolina, N.A.; President Carolina, N.A.; Western Division Wachovia Trust Services, Inc. Executive, Wachovia Bank of North Carolina, N.A., 1991 - 1994; Regional Vice President, Southern Region, Wachovia Bank of North Carolina, N.A., 1989 - 1991. Employed in 1972. Anthony L. Furr, 50 Executive Vice President of Wachovia Executive Vice President Corporation since July 1990; Chairman of Wachovia Corporation; the Board of South Carolina National Chairman of the Board, Corporation and The South Carolina National President and Chief Bank since July 1993; Chief Executive Executive Officer South Officer of South Carolina National Carolina National Corporation Corporation and The South Carolina National and The South Carolina Bank since January 1993; President of South National Bank Carolina National Corporation and The South Carolina National Bank since September 1992; Chief Operating Officer of South Carolina National Corporation and The South Carolina National Bank, September 1992 - January 1993; Chief Financial Officer of Wachovia Corporation, July 1990 - August 1992; Regional Vice President and Manager of Triad Region, Wachovia Bank of North Carolina, N.A., April 1988 - June 1990. Employed in 1969. Walter E. Leonard, Jr. 48 Executive Vice President and Chief Executive Vice President Operations Officer of Wachovia Wachovia Corporation, Corporation since October 1988; Wachovia Bank of Georgia, Executive Vice President of Wachovia N.A.; President Wachovia Bank of Georgia, N.A.; President of Operational Services Wachovia Operational Services Corporation. Corporation Employed in 1965. Kenneth W. McAllister, 45 Executive Vice President of Wachovia Executive Vice President Corporation since January 1994; General and General Counsel Counsel of Wachovia Corporation; Wachovia Corporation Secretary of Wachovia Corporation until October 1992. Employed in 1988. Executive Officers of the Registrant (Continued) - ------------------------------------------------ Name, Age Business Experience During Past and Position Five Years and Year Employed - ------------ ---------------------------- Robert S. McCoy, Jr., 55 Executive Vice President of Wachovia Executive Vice President and Corporation since January 1992; Chief Chief Financial Officer Financial Officer of Wachovia Corporation Wachovia Corporation since September 1992; Comptroller of Wachovia Corporation, January 1992 - August 1992; President of South Carolina National Corporation until 1992; Vice Chairman and Chief Financial Officer of The South Carolina National Bank, 1990 - 1992; Executive Vice President and Chief Financial Officer of The South Carolina National Bank until 1990. Employed in 1984. J. Walter McDowell, 43 Executive Vice President of Wachovia Executive Vice President Corporation since April 1993; President Wachovia Corporation; President and Chief Executive Officer of Wachovia and Chief Executive Officer Bank of North Carolina, N.A. since 1993; Wachovia Bank of North Manager of Retail Support Services Carolina, N.A.; Director for Wachovia Corporation until November of Wachovia Bank of North 1992; Regional Executive for Piedmont Carolina, N.A. Triad Region, Wachovia Bank of North Carolina, N.A., June 1990 - January 1992. Employed in 1973. G. Joseph Prendergast, 48 Executive Vice President of Wachovia Executive Vice President Corporation since October 1988; President Wachovia Corporation; and Chief Executive Officer of Wachovia President and Chief Executive Bank of Georgia, N.A. since January Officer Wachovia Bank of 1993; President and Chief Executive Officer Georgia, N.A.; President of Wachovia Corporation of Georgia, and Chief Executive January 1993 - March 1993; President and Officer Wachovia Corporate Chief Executive Officer of Wachovia Services, Inc.; Director of Corporate Services, Inc.; Executive Vice Wachovia Bank of Georgia, N.A. President of Wachovia Bank of Georgia, N.A., 1989 - 1993; Executive Vice President of Wachovia Bank of North Carolina, N.A. until 1989. Employed in 1973. Richard B. Roberts, 50 Executive Vice President and Treasurer Executive Vice President and of Wachovia Corporation since April Treasurer Wachovia 1990; Executive Vice President of Wachovia Corporation; Executive Vice Bank of North Carolina, N.A. President Wachovia Bank of Employed in 1967. North Carolina, N.A. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related - -------------------------------------------------------------- Stockholder Matters ------------------- Wachovia's common stock is traded on the New York Stock Exchange. Dividends are declared quarterly by the Corporation. Market price and dividend information on pages 62 and 63 of the 1993 Annual Report is incorporated herein by reference. As of December 31, 1993, the number of common stock shareholders of record was 28,079. Item 6.

Item 6. Selected Financial Data - -------------------------------- The selected financial information included in the condensed balance sheet on page 61 of the 1993 Annual Report is incorporated herein by reference. Summarized results of operations may be found in the six-year Summary of Operations on pages 56 and 57 of the 1993 Annual Report. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition - -------------------------------------------------------------------- and Results of Operations ------------------------- "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 8 through 34 of the 1993 Annual Report is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- The report of independent auditors and consolidated financial statements are included on pages 35 through 53 of the 1993 Annual Report and are incorporated herein by reference. Quarterly results of operations in Table 16 on page 29 of the 1993 Annual Report are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting - -------------------------------------------------------------------- and Financial Disclosure ------------------------ None PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant - ------------------------------------------------------------ The information required herein on the directors of Wachovia is included on pages 3 through 7 of the Proxy Statement dated March 18, 1994 and is incorporated herein by reference. Information on Wachovia's executive officers is included in Part I of this report. During the past five years, there have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions material to an evaluation of the ability or integrity of any of Wachovia's executive officers, directors, or any persons nominated to become directors. Item 11.

Item 11. Executive Compensation - -------------------------------- The information required herein is included under the captions "Board Compensation Committee Report on Executive Compensation", "Five Year Stock Performance Comparison Graph", "Compensation", "Stock Options", "Other Executive Compensation Plans and Arrangements" and "Compensation Committee Interlocks and Insider Participation" on pages 20 through 33 of the Proxy Statement dated March 18, 1994 and is incorporated herein by reference in response to this item. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------ The information contained on pages 3, 8 and 9 of the Proxy Statement dated March 18, 1994, with respect to security ownership of certain beneficial owners and management, is incorporated herein by reference in response to this item. Item 13.

Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- The information required herein is included under the subcaption "Certain Transactions Involving Members of the Committee" and the caption "Certain Transactions Involving Other Directors and Executive Officers" on pages 32 through 35 of the Proxy Statement dated March 18, 1994 and is incorporated herein by reference in response to this item. Compliance with Section 16(a) of the Exchange Act - ------------------------------------------------- The information required herein is included under the caption "Compliance with Stock Ownership Reporting Requirements" on page 35 of the Proxy Statement dated March 18, 1994 and is incorporated herein by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on - ---------------------------------------------------------------- Form 8-K -------- (a) 1. Financial Statements The following report of independent auditors and consolidated financial statements of Wachovia Corporation and subsidiaries, included in the 1993 Annual Report, are incorporated by reference in Item 8. Report of Independent Auditors Consolidated Statement of Condition Consolidated Statement of Income Consolidated Statement of Shareholders' Equity Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements 2. Financial Statement Schedules The schedules to the consolidated financial statements of Wachovia Corporation and subsidiaries required by Article 9 of Regulation S-X (Schedules I and II) are not required under the related instructions or are inapplicable and therefore have been omitted. Item 14. Exhibits, Financial Statement Schedules and Reports on - ---------------------------------------------------------------- Form 8-K (Continued) -------------------- Item 14. Exhibits, Financial Statement Schedules and Reports on - ---------------------------------------------------------------- Form 8-K (Continued) -------------------- Item 14. Exhibits, Financial Statement Schedules and Reports on - ---------------------------------------------------------------- Form 8-K (Continued) -------------------- Item 14. Exhibits, Financial Statement Schedules and Reports on - ---------------------------------------------------------------- Form 8-K (Continued) -------------------- * Incorporated by reference. (b) Reports on Form 8-K No reports on Form 8-K were filed during the three months ended December 31, 1993. SIGNATURES Pursuant to the requirements to Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WACHOVIA CORPORATION March 28, 1994 By ROBERT S. McCOY, JR. --------------------------- Robert S. McCoy, Jr. Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 28, 1994. Signature Title - --------- ------ Principal Executive Officer and Director: L. M. BAKER, JR. - ------------------------------ President and L. M. Baker, Jr. Chief Executive Officer Principal Financial Officer: ROBERT S. McCOY, JR. - ----------------------------- Executive Vice President Robert S. McCoy, Jr. and Chief Financial Officer Principal Accounting Officer: JOHN C. McLEAN, JR. - ----------------------------- John C. McLean, Jr. Comptroller SIGNATURES (Continued) A Majority of the Board of Directors: JOHN G. MEDLIN, JR.* Director RUFUS C. BARKLEY, JR.* Director CRANDALL C. BOWLES* Director JOHN L. CLENDENIN* Director LAWRENCE M. GRESSETTE, JR.* Director THOMAS K. HEARN, JR.* Director W. HAYNE HIPP* Director ROBERT M. HOLDER, JR.* Director DONALD R. HUGHES* Director F. KENNETH IVERSON* Director JAMES W. JOHNSTON* Director W. DUKE KIMBRELL* Director JAMES G. LINDLEY* Director JAMES H. MILLIS* Director J. MACK ROBINSON* Director HERMAN J. RUSSELL* Director SHERWOOD H. SMITH, JR.* Director CHARLES McKENZIE TAYLOR* Director *By KENNETH W. McALLISTER --------------------------------------- KENNETH W. McALLISTER, Attorney-in-Fact

7323_1993.txt

7323

1993

Item 1. Business BUSINESS OF ENTERGY General Entergy Corporation was originally incorporated under the laws of the State of Florida on May 27, 1949. On December 31, 1993, in connection with the Merger (see "Entergy Corporation-GSU Merger," below), Entergy Corporation merged with and into Entergy-GSU Holdings, Inc., a Delaware corporation (Holdings), and Holdings was renamed Entergy Corporation. Entergy Corporation is a holding company registered under the Holding Company Act and does not own or operate any physical properties. Entergy Corporation owns all of the outstanding common stock of five retail operating electric utility subsidiaries, AP&L, GSU, LP&L, MP&L, and NOPSI. AP&L was incorporated under the laws of the State of Arkansas in 1926; GSU was incorporated under the laws of the State of Texas in 1925; LP&L and NOPSI were incorporated under the laws of the State of Louisiana in 1974 and 1926, respectively; and MP&L was incorporated under the laws of the State of Mississippi in 1963. As of December 31, 1993, these operating companies provided electric service to approximately 2.3 million customers in the States of Arkansas, Louisiana, Mississippi, Missouri, and Texas. In addition, GSU furnished gas service in the Baton Rouge, Louisiana area, and NOPSI furnished gas service in the City of New Orleans. GSU's steam products department produces and sells, on an unregulated basis, process steam and by- product electricity supplied from its steam electric extraction plant to a large industrial customer. The business of the System is subject to seasonal fluctuations with the peak period occurring during the third quarter. During 1993, the System's (excluding GSU) electricity sales as a percentage of total System energy sales were: residential - 28.1%; commercial - 19.9%; and industrial - 36.9%. Electric revenues from these sectors as a percentage of total System electric revenues were: 36.3% - residential; 24.4% - commercial; and 27.3% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of energy sales. During 1993, GSU's electric department sales as a percentage of total GSU energy sales were: residential - 25.5%; commercial - 20.3%; and industrial - 50.8%. Electric revenues from these sectors as a percentage of total GSU electric revenues were: 33.5% - residential; 23.8% - commercial; and 37.2% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of GSU's energy sales. The System's major industrial customers are in the chemical processing, petroleum refining, paper products, and food products industries. Entergy Corporation also owns all of the outstanding common stock of System Energy, Entergy Services, Entergy Operations, Entergy Power, and Entergy Enterprises. System Energy is a nuclear generating company that was incorporated under the laws of the State of Arkansas in 1974. System Energy sells the capacity and energy at wholesale from its 90% interest in Grand Gulf 1 to its only customers, AP&L, LP&L, MP&L, and NOPSI (see "Capital Requirements and Future Financing - - Certain System Financial and Support Agreements - Unit Power Sales Agreement," below). System Energy has approximately a 78.5% ownership interest and an 11.5% leasehold interest in Grand Gulf 1. Entergy Services provides general executive and advisory services, and accounting, engineering, and other technical services to certain of the System companies, generally at cost. Entergy Operations is a nuclear management company that operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. Entergy Power, an independent power producer, owns 809 MW of generating capacity and markets its capacity and energy in the wholesale market outside Arkansas and Missouri and in markets not otherwise presently served by the System. (For further information on regulatory proceedings related to Entergy Power, see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," below). Entergy Enterprises is a nonutility company that invests in businesses whose products and activities are of benefit to the System's utility business (see "Corporate Development," below). Entergy Enterprises also markets technical expertise developed by the System companies when it is not required in the System's operations. Entergy Enterprises has received SEC approval to provide services to certain nonutility companies in the System. In 1992 and 1993, several new Entergy Corporation subsidiaries were formed to participate in utility projects located outside the System's retail service territory, both domestically and in foreign countries (see "Corporate Development," below). AP&L, LP&L, MP&L, and NOPSI own, in ownership percentages of 35%, 33%, 19%, and 13%, respectively, all of the common stock of System Fuels, a non-profit subsidiary, that implements and/or maintains certain programs to procure, deliver, and store fuel supplies for the System. GSU has four wholly-owned subsidiaries: Varibus Corporation, GSG&T, Inc., Southern Gulf Railway Company, and Prudential Oil & Gas, Inc. Varibus Corporation operates intrastate gas pipelines in Louisiana, which are used primarily to transport fuel to two of GSU's generating stations, and has marketed computer-aided engineering and drafting technologies and related computer equipment and services. GSG&T, Inc. owns the Lewis Creek Station, a 532 MW (as of December 31, 1993) gas-fired generating plant, which is leased and operated by GSU. Southern Gulf Railway Company will own and operate several miles of rail track being constructed in Louisiana for the purpose of transporting coal for use as a boiler fuel at Nelson Unit 6. Prudential Oil & Gas, Inc., which was formerly in the business of exploring, developing, and operating oil and gas properties in Texas and Louisiana, is presently inactive. Entergy Corporation-GSU Merger On December 31, 1993, Entergy Corporation consummated its acquisition of GSU. Entergy Corporation merged with and into Holdings, and Holdings was renamed Entergy Corporation. GSU became a wholly-owned subsidiary of Entergy Corporation and continues to operate as a public utility under the regulation of the PUCT and the LPSC. As consideration to GSU's shareholders, Entergy Corporation paid $250 million in cash and issued 56,667,726 shares of its common stock at a price of $35.8417 per share, in exchange for outstanding shares of GSU common stock. In addition, $33.5 million of transaction costs were capitalized in connection with the Merger. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," for, information on requests for rehearing and appeals of certain regulatory approvals of the Merger. The information contained in this Form 10-K is filed on behalf of all the registrants of Entergy, including GSU. Unless otherwise noted, consolidated financial and statistical information contained in this report that is stated as of December 31, 1993 (such as assets, liabilities, and property), includes the associated GSU amounts, and consolidated financial and statistical information for periods ending before January 1, 1994 (such as revenues, sales, and expenses), does not include GSU amounts; those amounts are presented separately for GSU herein. Certain Industry and System Challenges The System's business is affected by various challenges and issues including those that confront the electric utility industry in general. These issues and challenges include: - an increasingly competitive environment (see "Competition," below); - compliance with regulatory requirements with respect to nuclear operations (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry," below) and environmental matters (see "Rate Matters and Regulation - Regulation - Environmental Regulation," below); - adaptation to structural changes in the electric utility industry, including increased emphasis on least cost planning and changes in the regulation of generation and transmission of electricity (see "Competition - General" and "Competition - Least Cost Planning," below); - continued cost management (particularly in the area of operation and maintenance costs at nuclear units) to improve financial results and to delay or to minimize the need for rate increase requests in light of current rate freezes and rate caps at the System operating companies (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below); - integrating GSU into the System's operations and achieving cost savings (see "Entergy Corporation-GSU Merger," above); - achieving enhanced earnings in light of lower returns and slow growth in the domestic utility business (see "Corporate Development," below); and - resolving GSU's major contingencies, including potential write- offs and refunds related to River Bend (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU," below) and litigation with Cajun relating to its ownership interest in River Bend (see "Rate Matters and Regulation - Regulation - Other Regulation and Litigation - GSU," below). Corporate Development Entergy continues to consider new opportunities to expand its regulated electric utility business, as well as to expand into utility and utility-related businesses that are not regulated by state and local regulatory authorities (nonregulated businesses). Investments in nonregulated businesses are likely to draw upon the System's skills in power generation and customer service as well as its strengths in the fuels area. Entergy Corporation's investment strategy with respect to nonregulated businesses is to invest in nonregulated business opportunities wherein Entergy Corporation has the potential to earn a greater rate of return compared to its regulated utility operations. Entergy Corporation's nonregulated businesses fall into two broad categories: overseas power development and new electro- technologies. Entergy Corporation has made investments in Argentina's electric energy infrastructure, as described below, and is pursuing additional projects in Central America, South America, South Africa, and Asia. Entergy Corporation will also open offices in Buenos Aires, Argentina and Hong Kong in 1994. In addition, Entergy Corporation is seeking to provide telecommunications services based upon its experience with interactive communications systems that allow customers to control energy usage. Entergy Corporation expects to invest approximately $150 million per year in nonregulated businesses. Current investments in nonregulated businesses include the following: (1) Entergy Corporation's subsidiary, Entergy Power Development Corporation (an EWG under the provisions of the Energy Act), through its subsidiary (which is also an EWG) Entergy Richmond Power Corporation, owns a 50% interest in an independent power plant in Richmond, Virginia. The power plant is jointly-owned and operated by the Enron Power Corporation, a developer of independent power projects. The plant owners have a 25-year contract to sell electricity to Virginia Electric & Power Company. Entergy Corporation's investment in the project totals approximately $12.5 million. (2) Entergy Enterprises has a 9.95% equity interest in First Pacific Networks, Inc. (FPN), a communications company, and a license from FPN in connection with utility applications, being jointly developed by Entergy Enterprises and FPN, for FPN's patented communications technology. Entergy Enterprises' investment in FPN is approximately $20.1 million, of which $9.7 million is equity investment. (3) Entergy Enterprises' subsidiary, Entergy Systems and Service, Inc. (Entergy SASI), holds a 9.95% equity interest in Systems and Service International, Inc. (SASI), a manufacturer of efficient lighting products. This subsidiary also made a loan to SASI, acquired the business and assets of SASI's distribution subsidiary, and entered into an agreement to distribute SASI's products. Entergy Enterprises' initial investment in this business was approximately $11 million (of which $2.3 million is invested in SASI common stock). Entergy Corporation has provided to Entergy SASI $6.0 million in loans, as of December 31, 1993, to fund Entergy SASI's installment sale agreements with its customers. (4) Entergy Corporation's subsidiary, Entergy, S.A., participated in a consortium with other nonaffiliated companies that acquired a 60% interest in Argentina's Costanera steam electric generating facility consisting of seven natural gas- and oil-fired generating units, with a total installed capacity of 1,260 MW. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $11 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $22.5 million. (5) In January 1993, Entergy Corporation, through a new subsidiary, Entergy Argentina, S.A., participated in a consortium with other nonaffiliated companies that acquired a 51% interest in a foreign electric distribution company providing service to Buenos Aires, Argentina. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $58 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $77.5 million. (6) In July 1993, Entergy Corporation, through a new subsidiary, Entergy Transener, S.A., participated in a consortium with other nonaffiliated companies that acquired a 65% interest in a foreign transmission system providing service in the country of Argentina. Entergy Corporation's initial investment to acquire its 15% interest in the consortium was $18.5 million. In the near term, these investments are likely to have a minimal effect on earnings; but the possibility exists that they could contribute to future earnings growth. However, due to the absence of an allowed rate of return, these investments involve a higher degree of risk. International operations are subject to certain risks that are inherent in conducting business abroad, including possible nationalization or expropriation, price and exchange controls, limitations on foreign participation in local governmental enterprises, and other restrictive actions. Changes in the relative value of currencies take place from time to time and their effects may be favorable or unfavorable on results of operations. In addition, there are exchange control restrictions in certain countries relating to repatriation of earnings. Selected Data Selected customer and sales data for 1993 are summarized in the following tables: 1993 - Selected Customer Data Customers as of December 31, 1993 ------------------ Area Served Electric Gas ----------- -------- --- AP&L Portions of State of Arkansas 590,862 - GSU Portions of the States of Texas 593,975 85,040 and Louisiana LP&L Portions of State of Louisiana 599,991 - MP&L Portions of State of Mississippi 361,692 - NOPSI City of New Orleans, except Algiers, is provided electric service by LP&L 190,613 154,251 --------- ------- System 2,337,133 239,291 ========= ======= NOPSI sold 17,437,292 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were material for NOPSI, but not material for the System (see "Industry Segments," below, for a description of NOPSI's business segments). GSU sold 6,786,794 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were not material for GSU. See "Entergy Corporation and Subsidiaries Selected Financial Data - - Five-Year Comparison," "AP&L Selected Financial Data - Five-Year Comparison," "GSU Selected Financial Data - Five-Year Comparison," "LP&L Selected Financial Data - Five-Year Comparison," "MP&L Selected Financial Data - Five-Year Comparison," "NOPSI Selected Financial Data - - Five-Year Comparison," and "System Energy Selected Financial Data - Five-Year Comparison," (which follow each company's notes to financial statements herein) incorporated herein by reference, for further information with respect to operating statistics of the System and of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively. Employees As of December 31, 1993, Entergy had 16,679 employees as follows: Full-time: Entergy Corporation 6 AP&L 2,557 GSU (1) 4,765 LP&L 1,727 MP&L 1,236 NOPSI 716 System Energy - Entergy Operations 3,508 Entergy Services (2) 1,986 Other Subsidiaries 24 ------ Total Full-time 16,525 Part-time 154 ------ Total Entergy System 16,679 ====== __________________ (1) As of December 31, 1993, GSU had not been functionally aligned into Entergy. In December 1993, GSU recorded $17 million for an announced early retirement program in connection with the Merger. Of the 503 employees eligible, 369 employees elected to participate in the program. (2) As a result of System realignment of operations along functional lines, certain employees of AP&L, LP&L, MP&L, and NOPSI transferred to Entergy Services during 1993. Competition General. Entergy and the electric utility industry are experiencing increased competitive pressures both in the retail and wholesale markets. The economic, social, and political forces behind these competitive pressures are numerous and complex. They include legislative and regulatory changes, technological advances, consumer demands, greater availability of natural gas, environmental needs, and others. Entergy looks at these competitive pressures both as opportunities to compete for new customers and as risks for loss of customers. On October 24, 1992, Congress passed the Energy Act. The Energy Act addresses a wide range of energy issues and alters the way Entergy and the rest of the electric utility industry will operate in the future. The Energy Act creates exemptions from regulation under the Holding Company Act and creates a class of EWG's consisting of utility affiliates and nonutilities that are owners and operators of facilities for the generation and transmission of power for sales at wholesale. These exemptions offer an incentive for Entergy to participate in the development of wholesale power generation. In addition, the Holding Company Act has been amended to allow utilities to compete on a global scale with foreign entities to own and operate generation, transmission, and distribution facilities. The Energy Act also gives FERC the authority to order investor-owned utilities, including the System operating companies, to transmit power and energy to or for wholesale purchasers and sellers. The law creates the potential for electric utilities and other power producers to gain increased access to the transmission systems of other entities to facilitate wholesale sales. FERC may also require electric utilities to increase their transmission capacity to provide these services. The impact of this provision on the System operating companies should be lessened by their joint filing of open access transmission service tariffs with FERC in 1991 (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters," below). The Energy Act also amends PURPA by requiring states to consider (1) new regulatory standards that would require electric utilities to undertake integrated resource planning, and (2) allowing energy efficiency programs to be at least as profitable as new energy supply options. Entergy is unable to predict the ultimate impact the Energy Act will have on its operations. Wholesale Competition. Entergy has, like other utility systems, generating capacity (most of which is owned by Entergy Power) and energy available for a period of time for sale to other utility systems. The System is in competition with neighboring systems, as well as EWG's, to sell such capacity and energy. Given this competition, the ability of the System to sell this capacity and energy is limited. However, in 1993, the System sold 8,291 million KWH of energy (compared to 7,979 million KWH in 1992) to nonaffiliated utilities. The System also sold 1,234 MW of long-term capacity (compared to 1,048 MW in 1992) to nonaffiliated utilities outside of the System's service area. These capacity sales represent 8% of the System's net capability (excluding GSU) at year-end 1993. Under AP&L's and LP&L's Grand Gulf 1 rate orders, and under GSU's River Bend rate order in Louisiana, a portion of the capacity of Grand Gulf 1 and River Bend represents capacity that is available for sale, subject to regulatory approval, to nonaffiliated parties. In some cases, profits from such sales must be shared between ratepayers and shareholders. As discussed in "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Open Access Transmission," below, Entergy Power and the System operating companies will be permitted by FERC to make wholesale capacity sales in bulk power markets at rates based primarily upon negotiation and market conditions rather than cost of service. In order to receive authorization to make such sales, AP&L, LP&L, MP&L, and NOPSI also filed with FERC open access transmission service tariffs. FERC has approved this filing, subject to certain modifications. Revisions to the tariffs were filed in December 1993 to recognize GSU's inclusion in the Entergy System. When the modified tariffs are made effective, Entergy Power and the System operating companies may engage in sales at market prices. It is anticipated that these tariffs will enable any electric utility (as defined in such tariffs) to use Entergy 's integrated transmission system for the transmission of capacity and energy produced and sold by such electric utility or by third parties. Other similar open access transmission tariffs have also been filed with FERC for several large utility companies or systems and more open access transmission tariffs are anticipated. Concurrently, capacity resources are being developed and used to make wholesale sales from a range of non-traditional sources, including nonutility generators as well as cogenerators and small power producers qualifying under PURPA. These developments simultaneously produce increased marketing opportunities for utility systems such as Entergy and expose the System to loss of load or reduced sales revenues due to displacement of System sales by alternative suppliers with access to the System's primary areas of service. Entergy Power, which owns 809 MW of capacity, was formed to compete with other utilities and independent power producers in the bulk power market. As of December 31, 1993, Entergy Power has accumulated total losses from operations of $52.5 million. Entergy Power has entered into several long-term contracts for the sale of capacity and associated energy from its resources and has also made short-term capacity and energy sales. Entergy Power continues to actively market its capacity and energy in the bulk power market. (See "Corporate Development," above, for information with respect to a wholly-owned subsidiary of Entergy, Entergy Power Development Corporation, organized as an EWG to compete in the wholesale power market.) Retail Competition. Scheduled increases in the price of power sold by the System pursuant to the operation of phase-in plans (see "Rate Matters and Regulation - Rate matters - Retail Rate Matters," below) will affect the competitiveness of certain classes of industrial customers whose costs of production are energy-sensitive. Entergy is constantly working with these customers to address their concerns. It is the practice of the System operating companies to negotiate the renewal of contracts with large industrial customers prior to their expiration. In certain cases (particularly for GSU), contracts or special tariffs that use incentive pricing below total cost have been negotiated with industrial customers to keep these customers on the System. These contracts and tariffs have generally resulted in increased KWH sales at lower margins over incremental cost. While the System operating companies anticipate they will be successful in renegotiating such contracts, they cannot assure that they will be successful or that future revenues will not be lost to other forms of generation. To date, through these efforts, Entergy has been largely successful in retaining its industrial load. This competitive challenge could increase. Cogeneration is generally defined as the combined production of electricity and steam. Cogenerated power may be either sold by its producer to the local utility at its avoided cost under PURPA, or utilized by the cogenerator to displace purchases from the utility. To the extent that cogeneration is used by industrial customers to meet their own power requirements, the System may suffer loss of industrial load. Cogenerated power delivered to the System would be purchased at avoided cost, which for a number of years is expected to be equivalent to avoided energy cost, and as such, the cost of these purchases would not impact earnings. To date, only a few cogeneration facilities have been installed in areas served by the System, excluding GSU. The primary purpose of these facilities is to displace power that was purchased from the System. The economic advantage to the customer is generally due to the customer having waste products that can be used as fuel. Presently, the loss of load to cogeneration and the amount of cogenerated power delivered under PURPA to the System (excluding GSU) is not significant. The System is prepared to participate (subject to regulatory approval) in various phases of the design, construction, procurement, and ownership of cogeneration facilities. The System has entered into several cogeneration deferral agreements with certain of its retail customers, which give the System the right of first refusal to participate in any of such customers' cogeneration activities. Such participation could occur in the event there are individual customers whose long-term interests, along with Entergy's, can best be served by installing cogeneration facilities. No such participation has occurred to date, except by GSU. Existing qualifying facilities in the GSU service territory are estimated to total approximately 2,400 MW's or over 10% of Entergy's total owned and leased generating capability as of December 31, 1993. GSU currently believes that no significant load will be lost to cogeneration projects during the next several years; however, GSU is currently negotiating a contract with a large industrial customer, which is scheduled to expire in 1996. If the contract is not renewed, GSU would lose approximately $40 million in base revenues. Although GSU has competed in the past for various retail and wholesale customers, the System (excluding GSU) generally is not in direct competition with privately-owned or municipally-owned electric utilities for retail sales. However, a few municipalities distribute electricity within their corporate limits and some of these generate all or a portion of their requirements. A number of electric cooperative associations or corporations serve a substantial number of retail customers in or adjacent to areas served by the System . Sales of energy by the System to privately- or municipally-owned utilities amounted to approximately 4.6% of total System energy sales in 1993 (excluding GSU). Legislatures and regulatory commissions in several states have considered, or are considering, retail wheeling, which is the transmission by an electric utility of energy produced by another entity over the utility's transmission and distribution system to a retail customer in the electric utility's service territory. Retail wheeling would permit retail customers to elect to purchase electric capacity and/or energy from the electric utility in whose service area they are located or from any other electric utility or independent power producer. Retail wheeling is not currently required within the Entergy System service area. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," below for information on proceedings brought by Cajun seeking transmission access to certain of GSU's industrial customers. Least Cost Planning. The System continues to pursue least cost planning, also known as integrated resource planning, in order to compete more effectively in both retail and wholesale markets. Least cost planning is the development of strategies to add resources to meet future electricity demands reliably and at the lowest possible cost. The least cost planning process includes the study of electric supply- and demand-side options. The resultant plan uses demand-side options, such as changing customer consumption patterns, to limit electricity usage during times of peak demand, thus delaying the need for new capacity resources. Least cost planning offers the potential for the System to minimize customer costs, while providing an opportunity to earn a return. On December 1, 1992, AP&L, LP&L, MP&L, and NOPSI each filed a Least Cost Plan with its respective regulator, and on July 1, 1993, each company filed a near-term revision to such plan. Each Least Cost Plan details the resources that the System intends to use to provide reasonably priced, reliable electric service to its customers over the next 20 years. Such plan includes 925 MW of DSM resources, such as programs for efficient air conditioning and heating, high efficiency lighting, and CCLM. CCLM is the subject of recent Entergy proposals (filed, or to be filed, by AP&L, LP&L, MP&L, and NOPSI with their respective regulators) requesting the CCLM pilot be withdrawn from consideration in the existing Least Cost Plan dockets on the basis of a new proposal by Entergy to undertake the initial pilot development of CCLM at Entergy stockholder expense. To date, the Council and the LPSC are the only regulators that have addressed the proposal. The System expects to spend a total of approximately $800 million for DSM resources over the next 20 years. Such plan also includes significant resource additions, but does not contemplate construction of any generating facilities at new sites. All incremental supply-side resources will come from either delayed retirements or repowering of existing generating units. The System estimates that, over the next 20 years, least cost planning, if implemented in accordance with the terms of each filed Least Cost Plan, will reduce revenue requirements by approximately $2.3 billion ($600 million on a net present value basis), thereby avoiding the need for related rate increase requests. Each Least Cost Plan includes specific actions that the System will undertake pursuant to regulatory approval, including the recovery of costs associated with DSM (for further information, see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below). CAPITAL REQUIREMENTS AND FUTURE FINANCING Construction expenditures for the System are estimated to aggregate $586 million, $560 million, and $550 million for the years 1994, 1995, and 1996, respectively. No significant costs are expected in connection with the System's generating facilities. Actual construction costs may vary from these estimates because of a number of factors, including changes in load growth estimates, changes in environmental regulations, modifications to nuclear units to meet regulatory requirements, increasing costs of labor, equipment and materials, and cost of capital. Construction expenditures by company (including immaterial environmental expenditures and AFUDC, but excluding nuclear fuel and the impact of the ice storm that occurred in February 1994) for the period 1994-1996 are estimated as follows: 1994 1995 1996 Total ---- ---- ---- ----- (In Millions) AP&L $181 $172 $175 $528 GSU 134 128 119 381 LP&L 156 143 142 441 MP&L 61 63 63 187 NOPSI 26 26 26 78 System Energy 26 22 23 71 Entergy Power 2 6 2 10 System $586 $560 $550 $1,696 In addition to construction expenditure requirements, the estimated amounts required during 1994-1996 to meet scheduled long- term debt and preferred stock maturities and cash sinking fund requirements are: AP&L - $83 million; GSU - $214 million; LP&L - $158 million; MP&L - $212 million; NOPSI - $80 million; and System Energy - $615 million. A substantial portion of the above capital and refinancing requirements is expected to be satisfied from internally generated funds and cash on hand supplemented by the issuance of debt and preferred stock. Certain System companies may also continue with the acquisition or refinancing of all, or a portion of, certain outstanding series of preferred stock and long-term debt. In early February 1994, an ice storm left more than 221,000 Entergy customers without electric power across the System's four- state service area. The storm was the most severe natural disaster ever to affect the System, causing damage to transmission and distribution lines, equipment, poles, and facilities in certain areas, particularly in Mississippi. A substantial portion of the related costs, which are estimated to be $110 million - $140 million, are expected to be capitalized. The MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and the restoration of service resulting from such events. MP&L plans to immediately file for rate recovery of the costs related to the ice storm (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - MP&L," below). Entergy Corporation's current primary capital requirements are to periodically invest in, or make loans to, its subsidiaries. Entergy Corporation has SEC authorization to make additional investments in Entergy Power, Entergy S.A., Entergy Argentina, S.A., Entergy Transener, S.A., Entergy SASI, and FPN. Entergy Corporation expects to meet these requirements in 1994-1996 with internally generated funds and cash on hand. Entergy receives funds through dividend payments from its subsidiaries. Certain restrictions may limit the amount of these distributions. See Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, Note 2, "Rate and Regulatory Matters" and Note 8, "Commitments and Contingencies," incorporated herein by reference, regarding River Bend rate appeals and pending litigation with Cajun. Substantial write- offs or charges resulting from adverse rulings in these matters could adversely affect GSU's ability to continue to pay dividends. Entergy Corporation continues to consider new opportunities to expand its electric energy business, including expansion into related nonregulated businesses. Entergy Corporation expects to invest up to approximately $150 million per year over the next three years in nonregulated business opportunities. Entergy Corporation may finance any such expansion with cash on hand. Further, shareholder and/or regulatory approvals may be required for such acquisitions to take place. Also, Entergy Corporation has SEC authorization to repurchase shares of its outstanding common stock. Market conditions and board authorization determine the amount of repurchases. Entergy Corporation has requested SEC authorization for a $300 million bank line of credit, the proceeds of which are expected to be used for common stock repurchases and other optional activities. (For further information on the capital and refinancing requirements, capital resources, and short-term borrowing arrangements of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively, refer in each case to AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," Note 4 of AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's Notes to Financial Statements, "Lines of Credit and Related Borrowings," Note 5 of AP&L's and NOPSI's Notes to Financial Statements, "Preferred Stock", Note 5 of GSU's Notes to Financial Statements, "Preferred, Preference and Common Stock", Note 5 of LP&L's and MP&L's Notes to Financial Statements, "Preferred and Common Stock," Note 6 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 5 of System Energy's Notes to Financial Statements, "Long-Term Debt," and Note 8 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Capital Requirements and Financing," each incorporated herein by reference. For further information concerning Entergy Corporation's capital requirements and resources, refer to Entergy Corporation and Subsidiaries' "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," and Note 4 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Lines of Credit and Related Borrowings," incorporated herein by reference. For further information on the subsequent event, see Note 12 of AP&L's and Note 11 of MP&L's Notes to Financial Statements, "Subsequent Event (Unaudited)," incorporated herein by reference.) Certain System Financial and Support Agreements Unit Power Sales Agreement. The Unit Power Sales Agreement allocates capacity and energy from System Energy's 90% ownership and leasehold interest in Grand Gulf 1 (and the costs related thereto) to AP&L (36%), LP&L (14%), MP&L (33%), and NOPSI (17%). AP&L, LP&L, MP&L, and NOPSI pay rates to System Energy for their respective entitlements of capacity and energy on a full cost-of-service basis regardless of the quantity of energy delivered, so long as Grand Gulf 1 remains in commercial operation. Payments under the Unit Power Sales Agreement are System Energy's only source of operating revenues. The financial condition of System Energy depends upon the continued commercial operation of Grand Gulf 1 and upon the receipt of payments from AP&L, LP&L, MP&L, and NOPSI. (See "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Energy," below for further information with respect to proceedings relating to the Unit Power Sales Agreement.) Availability Agreement. The Availability Agreement was entered into among System Energy and AP&L, LP&L, MP&L, and NOPSI in 1974 in connection with the financing by System Energy of the Grand Gulf Station. The agreement provided that System Energy would join in the agreement among AP&L, LP&L, MP&L, and NOPSI for the sharing of generating capacity and other capacity and energy resources on or before the date on which Grand Gulf 1 was placed in commercial operation. It also provided that System Energy would make available to AP&L, LP&L, MP&L, and NOPSI all capacity and energy available from System Energy's share of the Grand Gulf Station. System Energy and AP&L, LP&L, MP&L, and NOPSI further agreed that if this agreement were terminated, or if any of the parties thereto withdrew from it, then System Energy would enter into a separate agreement with all of such parties or the withdrawing party, as the case may be, with respect to the purchase of capacity and energy on the same terms as if this agreement were still controlling. AP&L, LP&L, MP&L, and NOPSI also agreed severally to pay System Energy monthly for the right to receive capacity and energy available from the Grand Gulf Station in amounts that (when added to any amounts received by System Energy under the Unit Power Sales Agreement, or otherwise) would be at least equal to System Energy's total operating expenses for the Grand Gulf Station (including depreciation at a specified rate) and interest charges. As amended to date, the Availability Agreement provides that: - the obligation of AP&L, LP&L, MP&L, and NOPSI for payments for Grand Gulf 1 became effective upon commercial operation of Grand Gulf 1 on July 1, 1985; - the sale of capacity and energy generated by the Grand Gulf Station may be governed by a separate power purchase agreement among System Energy and AP&L, LP&L, MP&L, and NOPSI; - the September 1989 write-off of System Energy's investment in Grand Gulf 2, amounting to approximately $900 million, will be amortized for Availability Agreement purposes over 27 years rather than in the month the write-off was recognized on System Energy's books; and - the allocation percentages under the Availability Agreement are fixed as follows: AP&L - 17.1%; LP&L - 26.9%; MP&L - 31.3%; and NOPSI - 24.7%. As noted above, the Unit Power Sales Agreement provides for different allocation percentages for sales of capacity and energy from Grand Gulf 1. However, the allocation percentages under the Availability Agreement remain in effect and would govern payments made thereunder in the event of a shortfall of funds available to System Energy from other sources, including payments by AP&L, LP&L, MP&L, and NOPSI to System Energy under the Unit Power Sales Agreement. System Energy has assigned its rights to payments and advances from AP&L, LP&L, MP&L, and NOPSI under the Availability Agreement as security for its first mortgage bonds and reimbursement obligations to certain banks providing the letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. In these assignments, AP&L, LP&L, MP&L, and NOPSI further agreed that in the event they were prohibited by governmental action from making payments under the Availability Agreement (if, for example, FERC reduced or disallowed such payments as constituting excessive rates; see the second succeeding paragraph), they would then make subordinated advances to System Energy in the same amounts and at the same times as the prohibited payments. System Energy would not be allowed to repay these subordinated advances so long as it remained in default under the related indebtedness or in other similar circumstances. Each of the assignment agreements relating to the Availability Agreement provides that AP&L, LP&L, MP&L, and NOPSI shall make payments directly to System Energy. However, if there is an event of default, AP&L, LP&L, MP&L, and NOPSI shall make those payments directly to the holders of indebtedness secured by such assignment agreements. The payments shall be made pro rata according to the amount of the respective obligations secured. The obligations of AP&L, LP&L, MP&L, and NOPSI to make payments under the Availability Agreement are subject to receipt and continued effectiveness of all necessary regulatory approvals. Sales of capacity and energy under the Availability Agreement would require that the Availability Agreement be submitted to FERC for approval with respect to the terms of such sale. No filing with FERC has been required because sales of capacity and energy from the Grand Gulf Station are being made under the Unit Power Sales Agreement. Other aspects of the Availability Agreement, including the obligations of AP&L, LP&L, MP&L, and NOPSI to make subordinated advances, are subject to the jurisdiction of the SEC under the Holding Company Act, which approval has been obtained. If, for any reason, sales of capacity and energy are made in the future pursuant to the Availability Agreement, the jurisdictional portions of the Availability Agreement would be submitted to FERC for approval. (Refer to the second preceding paragraph.) Amounts that have been received by System Energy under the Unit Power Sales Agreement have exceeded the amounts payable under the Availability Agreement. Consequently, no payments under the Availability Agreement by AP&L, LP&L, MP&L, and NOPSI have ever been required. If AP&L, LP&L, MP&L, or NOPSI became unable in whole or in part to continue making payments to System Energy under the Unit Power Sales Agreement, and System Energy were unable to procure funds from other sources sufficient to cover any potential shortfall between the amount owing under the Availability Agreement and the amount of continuing payments under the Unit Power Sales Agreement plus other funds then available to System Energy, LP&L and NOPSI could become subject to claims or demands by System Energy or its creditors for payments or advances under the Availability Agreement or the assignments thereof for the difference between their required Unit Power Sales Agreement payments and their required Availability Agreement payments. The amount, if any, which these companies would become liable to pay or advance, over and above amounts they would be paying under the Unit Power Sales Agreement for capacity and energy from Grand Gulf 1, would depend on a variety of factors (especially the degree of any such shortfall and System Energy's access to other funds). It cannot be predicted whether any such claims or demands, if made and upheld, could be satisfied. In NOPSI's case, if any such claims or demands were upheld, the holders of certain of NOPSI's outstanding general and refunding mortgage bonds could require redemption of their bonds at par. The ability of AP&L, LP&L, MP&L, and NOPSI to sustain payments under the Availability Agreement and the assignments thereof in material amounts without substantially equivalent recovery from their customers would be limited by their respective available cash resources and financing capabilities at the time. The ability of AP&L, LP&L, MP&L, and NOPSI to recover from their customers payments made under the Availability Agreement, or under the assignments thereof, would depend upon the outcome of regulatory proceedings before the state and local regulatory authorities having jurisdiction. In view of the controversies that arose over the allocation of capacity and energy from Grand Gulf 1 pursuant to the Unit Power Sales Agreement, opposition to recovery would be likely and the outcome of such proceedings, should they occur, is not predictable. Reallocation Agreement. On November 18, 1981, the SEC authorized LP&L, MP&L, and NOPSI to indemnify AP&L against principally its responsibilities and obligations with respect to the Grand Gulf Station contained in the Availability Agreement and the assignments thereof. The revised percentages of allocated capacity of System Energy's share of Grand Gulf 1 and Grand Gulf 2 were, respectively: LP&L - 38.57% and 26.23%; MP&L - 31.63% and 43.97%; and NOPSI - 29.80% and 29.80%. FERC's decision allocating the capacity and energy of Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI supersedes the Reallocation Agreement insofar as it relates to Grand Gulf 1. However, responsibility for any Grand Gulf 2 amortization amounts (see "Availability Agreement," above) has been allocated to LP&L - 26.23%, MP&L - 43.97%, and NOPSI - 29.80% under the terms of the Reallocation Agreement. The Reallocation Agreement does not affect the obligation of AP&L to System Energy's lenders under the assignments referred to in the fifth preceding paragraph, and AP&L would be liable for its share of such amounts if LP&L, MP&L, and NOPSI were unable to meet their contractual obligations. No payments of any amortization amounts will be required as long as amounts paid to System Energy under the Unit Power Sales Agreement, together with other funds available to System Energy, exceed amounts required under the Availability Agreement, which is expected to be the case for the foreseeable future. Capital Funds Agreement. System Energy and Entergy Corporation have entered into the Capital Funds Agreement whereby Entergy Corporation has agreed to supply to System Energy sufficient capital to (1) maintain System Energy's equity capital at an amount equal to a minimum of 35% of its total capitalization (excluding short-term debt), and (2) permit the continuation of commercial operation of Grand Gulf 1 and to pay in full all indebtedness for borrowed money of System Energy when due under any circumstances. Entergy Corporation has entered into various supplements to the Capital Funds Agreement, and System Energy has assigned its rights thereunder as security for its first mortgage bonds and reimbursement obligations to certain banks providing letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. Each such supplement provides that permitted indebtedness for borrowed money incurred by System Energy in connection with the financing of the Grand Gulf Station may be secured by System Energy's rights under the Capital Funds Agreement on a pro rata basis (except for the Specific Payments, as hereinafter defined). In addition, in the particular supplements to the Capital Funds Agreement relating to the specific indebtedness being secured, Entergy Corporation has agreed to make cash capital contributions to System Energy sufficient to enable System Energy to make payments when due on such indebtedness (Specific Payments). Except with respect to the Specific Payments, which have been approved by the SEC under the Holding Company Act, the performance by both Entergy Corporation and System Energy of their obligations under the Capital Funds Agreement, as supplemented, is subject to the receipt and continued effectiveness of all governmental authorizations necessary to permit such performance, including approval by the SEC under the Holding Company Act. Each of the supplemental agreements provides that Entergy Corporation shall make its payments directly to System Energy. However, if there is an event of default, Entergy Corporation shall make those payments directly to the holders of indebtedness secured by the supplemental agreements. The payments (other than the Specific Payments) shall be made pro rata according to the amount of the respective obligations secured by the supplemental agreements. Sale and Leaseback Arrangements LP&L. On September 28, 1989, LP&L entered into arrangements for the sale and leaseback of an approximate aggregate 9.3% ownership interest in Waterford 3. LP&L has options to terminate the leases and to repurchase the sold interests in Waterford 3 at certain intervals during the basic terms of the leases. Further, at the end of the terms of the leases, LP&L has options to renew the leases or to repurchase the interests in Waterford 3. If LP&L does not exercise its options to repurchase the interests in Waterford 3 on the fifth anniversary (September 28, 1994) of the closing date of the sale and leaseback transactions, LP&L will be required to provide collateral to the owner participants for the equity portion of certain amounts payable by LP&L under the lease. The required collateral is either a bank letter or letters of credit or the pledging of new series of first mortgage bonds issued by LP&L under its first mortgage bond indenture. (For further information on LP&L's sale and leaseback arrangements, including the required maintenance by LP&L of specified capitalization and fixed charge coverage ratios, see Note 9 of LP&L's Notes to Financial Statements, "Leases - Waterford 3 Lease Obligations," incorporated herein by reference.) System Energy. On December 28, 1988, System Energy entered into arrangements for the sale and leaseback of an 11.5% ownership interest in Grand Gulf 1. System Energy has options to terminate the leases and to repurchase the undivided interest in Grand Gulf 1 at certain intervals during the basic lease term. Further, System Energy has an option at the end of the basic lease term to renew the leases or to repurchase the undivided interest in Grand Gulf 1. In connection with the equity funding of the sale and leaseback arrangements, letters of credit are required to be maintained by System Energy under the leases to secure certain amounts payable for the benefit of the equity investors. The letters of credit currently maintained are effective until January 15, 1997. Under the provisions of a reimbursement agreement, dated December 1, 1988, as amended, entered into by System Energy and various banks in connection with the sale and leaseback arrangements related to the letters of credit, System Energy has agreed to a number of covenants relating to, among other things, the maintenance of certain capitalization and fixed charge ratios. In connection with an audit of System Energy by FERC, if a decision of FERC issued on August 4, 1992 (August 4 Order) is ultimately sustained and implemented, System Energy would need to obtain the consent of certain banks to waive the capitalization and fixed charge coverage covenants for a limited period of time in order to avoid violation of such covenants. System Energy has obtained the consent of the banks to waive these covenants for the twelve-month period beginning with the earlier of the write-off or the first refund, if the August 4 Order is implemented prior to December 31, 1994. Absent a waiver, failure by System Energy to perform these covenants could give rise to a draw under the letters of credit and/or an early termination of the letters of credit, and, if such letters of credit were not replaced in a timely manner, could result in a default under, or other early termination of, System Energy's leases. (For further information on the potential effects of the August 4 Order on System Energy's financial condition, see Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference, and for a further discussion of the provisions of System Energy's Reimbursement Agreement, see System Energy's Notes to Financial Statements, Note 6, "Dividend Restrictions" and Note 7, "Commitments and Contingencies - Reimbursement Agreement," incorporated herein by reference.) RATE MATTERS AND REGULATION RATE MATTERS The System operating companies' retail rates are regulated by their respective state and/or local regulatory authorities, as described below, and their rates for wholesale sales (including intrasystem sales pursuant to the System Agreement) and interstate transmission of electricity are regulated by FERC. Rates for System Energy's sales of capacity and energy from Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement are also regulated by FERC. Wholesale Rate Matters GSU. For information, see "Retail Rate Matters - GSU," below and "Regulation - Other Regulation and Litigation - GSU," below. System Energy. As described above under "Certain System Financial and Support Agreements," System Energy recovers costs related to its interest in Grand Gulf 1 through rates charged to AP&L, LP&L, MP&L, and NOPSI for Grand Gulf 1 capacity and energy under the Unit Power Sales Agreement. Several proceedings currently pending or recently concluded at FERC affect these rates. In connection with an audit report covering a review of System Energy's books and records for the years 1986-1988, on August 4, 1992, FERC issued an opinion and order (1) finding that System Energy overstated its Grand Gulf 1 utility plant by approximately $95 million for costs included in utility plant that are related to the System's income tax allocation procedures, and (2) requiring System Energy to make adjusting accounting entries and refunds, with interest, to AP&L, LP&L, MP&L, and NOPSI within 90 days from the date of the order. System Energy requested a rehearing of the order, and on October 5, 1992, FERC issued an order allowing additional time for its consideration of such request and deferring System Energy's refund obligation until 30 days following issuance of FERC's order on rehearing. (For further information on FERC's order and its potential effect on System Energy's and Entergy's consolidated financial position, see Note 2 of System Energy's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference.) In a separate proceeding, on August 24, 1992, FERC instituted an investigation of the justness and reasonableness of certain of Entergy's formula wholesale rates, including System Energy's rates under the Unit Power Sales Agreement. Various regulatory authorities intervened in the proceeding. On August 2, 1993, Entergy and the intervenors settled the proceeding and agreed that System Energy's rate of return on equity would be reduced from 13% to 11%, and such rate would remain in effect until at least August 1995. Refunds were payable by System Energy with respect to the period from November 2, 1992, through the effective date of the settlement. FERC approved the settlement on October 25, 1993, and System Energy credited AP&L, LP&L, MP&L, and NOPSI with an aggregate of $29.6 million on their October 1993 bills. This matter is now final. (See Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Return on Equity Case," incorporated herein by reference.) Entergy Power. In 1990, authorizations were obtained from the SEC, FERC, the APSC, and the Public Service Commission of Missouri for Entergy Power to purchase AP&L's interests in Independence 2 and Ritchie 2, and to begin marketing the capacity and energy from the units in certain wholesale markets. The SEC order approving various aspects of the transaction was appealed by various intervenors in the proceeding to the D.C. Circuit, which reversed a portion of the order and remanded the case to the SEC for consideration of the effect of the transfers on the System's future costs of replacement generating capacity and fuel. In response to a June 24, 1993 SEC order setting a procedural schedule for the filing of further pleadings in the proceeding, in July 1993, the Entergy parties filed a post-effective amendment to their application addressing the issues specified in the SEC order. On September 9, 1993, the City of New Orleans and the LPSC each requested a hearing. However, on January 5, 1994, the City of New Orleans withdrew from the proceeding, as agreed in its settlement with NOPSI of various issues related to the Merger. System Agreement. AP&L, LP&L, MP&L, and NOPSI engage in the coordinated planning, construction, and operation of generation and transmission facilities pursuant to the terms of the System Agreement (described under "Property - Generating Stations," below). GSU became a party to the System Agreement upon consummation of the merger of Entergy's and GSU's electric systems, and GSU now participates in this System-wide coordination. For further information, see Note 2 of GSU's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - Merger-Related Rate Agreements." In connection with the Merger, FERC approved certain rate schedule changes to integrate GSU into the System Agreement. Certain commitments were adopted to provide reasonable assurance that the ratepayers of the existing Entergy operating companies will not be allocated higher costs, including, among other things: (1) a tracking mechanism to protect operating companies from certain unexpected increases in fuel costs; (2) excluding GSU from the distribution of profits from power sales contracts entered into prior to the Merger; (3) a methodology to estimate the cost of capital in future FERC proceedings; and (4) a stipulation that the operating companies will be insulated from certain direct effects on capacity equalization payments should GSU, due to a finding of imprudent GSU management prior to the Merger, be required to purchase Cajun's 30% share in River Bend. See "Regulation - Other Regulation and Litigation," for information on requests for rehearing of FERC's approval. On August 20, l990, the City of New Orleans filed a complaint against Entergy Corporation, AP&L, LP&L, MP&L, NOPSI, and System Energy requesting that FERC investigate AP&L's transfer of its interest in Independence 2 and Ritchie 2 to Entergy Power (see "Entergy Power," above) and the effect of the transfer on AP&L, LP&L, MP&L, and NOPSI and their ratepayers. Various parties, including certain of the System's state regulators, intervened in the proceeding. FERC issued an order on March 19, 1991, setting for investigation (l) the question of whether overall billings under the System Agreement will increase as a result of the transfer to Entergy Power, and (2) if so, whether such increased billings reflect prudently incurred costs that may reasonably be charged under the System Agreement. In two separate decisions with respect to these issues, the FERC ALJ assigned to the matter ruled on May 14, l992 and October 30, 1992, respectively, that there was sufficient evidence to show that overall billings would increase as a result of the transfer, but that the transfer was prudent. On December 15, 1993, FERC issued an opinion declining to address the prudence issue until a future time when replacement capacity has been added or planned and finding that, until such time, billings under the System Agreement as affected by the transfer of the two units are reasonable. The Entergy parties and the City of New Orleans each filed a request for rehearing of this order. If FERC's decision were reversed and any refunds were ordered, they would be retroactive to October 19, 1990. Open Access Transmission. On August 2, 1991, Entergy Services, as agent for AP&L, LP&L, MP&L, NOPSI, and Entergy Power, submitted to FERC (1) proposed tariffs that, subject to certain conditions, would provide to electric utilities "open access" to the System's integrated transmission system, and (2) rate schedules providing for sales of wholesale power at market-based rates. Under FERC policy, sales of power at market-based rates would be permitted only if FERC found, among other things, that Entergy did not have market power over transmission. Permitting "open access" to the System's transmission system helps support such a finding. Various parties, including the Council, the APSC, the MPSC, and the LPSC, intervened in the proceeding. On March 3, 1992, FERC approved the filing, with some modifications, and on August 7, l992, FERC denied rehearing of its March 1992 order. On August 24, l992, various parties filed petitions with the D.C. Circuit for review of FERC's 1992 orders, and these petitions have been consolidated. The revised tariffs, submitted by Entergy Services in response to FERC's 1992 orders, were accepted for filing and made effective, subject to further modifications, by order dated April 5, l993. Entergy Services made a further compliance filing on May 5, l993, reflecting these modifications and requesting reconsideration of certain limited matters, which is subject to approval by FERC. On December 31, 1993, Entergy Services filed revisions to the transmission service tariff to recognize GSU's inclusion in the Entergy System. These matters are pending. Retail Rate Matters General. AP&L, LP&L, MP&L, and NOPSI currently have retail rate structures sufficient to recover their costs, including costs associated with their allocated shares of capacity and energy from Grand Gulf 1 under the Unit Power Sales Agreement, and a return on equity. Certain costs related to Grand Gulf 1 (and in LP&L's case, Waterford 3 are being phased-into retail rates over a period of time, in order to avoid the "rate shock" associated with increasing rates to reflect all of such costs at once. The deferral period in which costs are incurred but not currently recovered has expired for all of these programs, and AP&L, LP&L, MP&L, and NOPSI are now recovering those costs that were previously deferred. Also, AP&L and LP&L have retained a portion of their shares of Grand Gulf 1 capacity and GSU is operating under a deregulated asset plan for a portion of its share of River Bend. GSU is involved in several rate proceedings involving recovery, among other things, of costs associated with River Bend. Some rate relief has been received, but GSU has been unable to obtain recognition in rates for a substantial portion of its River Bend investment. Recovery of certain costs has been disallowed, while other costs are being deferred for future recovery, held in abeyance pending further regulatory action, or treated as investments in deregulated assets. There are ongoing rate proceedings and appeals relating to these issues (see "GSU," below). The System is committed to taking actions that will stabilize retail rates and avoid the need for future rate increases. In the short-term, this involves containing costs to the greatest degree practicable, thereby avoiding erosion of earnings and delaying for as long as possible the need for general rate increases. In accordance with this retail rate policy, the System operating companies have agreed to retail rate caps and/or rate freezes for specified periods of time. In the longer term, as discussed in "Business of Entergy - Competition - Least Cost Planning" above, and also as discussed specifically for each applicable company below, the System is pursuing implementation of least cost planning to minimize the cost of future sources of energy. Effective January 1, 1993, the System adopted SFAS No. 106 (SFAS 106), an accounting standard that requires accrual of the costs of postretirement benefits other than pensions prior to the time these costs are actually incurred. In 1992, the System operating companies requested from their retail rate regulators authorization to recognize in rates the costs associated with implementation of SFAS 106. For further information, see Note 10 of Entergy Corporation and Subsidiaries', Note 9 of MP&L's and NOPSI's, and Note 10 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, "Postretirement and Postemployment Benefits," incorporated herein by reference. AP&L Rate Freeze. In connection with the settlement of various issues related to the Merger, AP&L agreed that it will not request any general retail rate increase that would take effect before November 3, 1998, except, among other things, for increases associated with the Least Cost Plan (discussed below); recovery of certain Grand Gulf 1- related costs, excess capacity costs, and costs related to the adoption of SFAS 106 that were previously deferred; recovery of certain taxes; fuel adjustment recoveries; recovery of nuclear decommissioning costs; and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. Under the settlement agreement entered into with the APSC in 1985 and amended in 1988, AP&L agreed to retain a portion of its Grand Gulf l-related costs, recover a portion of such costs currently, and defer a portion of such costs for future recovery. In 1994 and subsequent years, AP&L will retain 7.92% of such costs (stated as a percentage of System Energy's 90% share of the unit) and will recover 28.08% currently. Deferrals ceased in l990, and AP&L is recovering a portion of the previously deferred costs each year through l998. As of December 31, l993, the balance of deferred uncollected costs was $568.0 million. AP&L is permitted to recover on a current basis the incremental costs of financing the unrecovered deferrals. AP&L has the right to sell capacity and energy from its retained share of Grand Gulf 1 to third parties and to sell such energy to its retail customers at a price equal to AP&L's avoided energy cost. Proceeds of sales to third parties of AP&L's retained share of Grand Gulf l capacity and energy generally accrue to the benefit of AP&L's stockholder; however, half of the proceeds of such sales to third parties prior to January 1, 1996, are used to reduce the balance of uncollected deferrals and thus accrue to the benefit of retail ratepayers. If AP&L makes sales to third parties prior to that date in excess of the retained share, the proceeds of such excess are also split between the stockholder and the ratepayers, except that the portion of the sale that accrues to the stockholder's benefit cannot exceed the retained share. Least Cost Planning. On December 1, 1992 and July 1, 1993, AP&L filed with the APSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. AP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. On October 13, 1993, the APSC found AP&L's plan to be complete and directed the APSC staff to conduct a series of public forums in late 1993, including focus groups, town meetings, and collaborative workshops, before it would establish a procedural schedule that would include evidentiary hearings and the issuance of a Least Cost Plan order. Several of these meetings were delayed into 1994, but are expected to be completed by March 1994. At or before that time, AP&L expects the APSC to issue a procedural schedule that will allow the APSC to issue an order before the end of 1994. On January 19, 1994, AP&L filed a request with the APSC for permission to withdraw the CCLM portion of the filing and to continue such programs on a pilot basis at shareholder expense. The APSC has not yet ruled on AP&L's request. Fuel Adjustment Clause. AP&L's retail rate schedules have a fuel adjustment clause that provides for recovery of the excess cost of fuel and purchased power incurred in the second preceding month. The fuel adjustment clause also contains a nuclear reserve fund designed to cover the cost of replacement energy during scheduled maintenance and refueling outages at ANO, and an incentive provision that permits over- or under-recovery of the excess cost of replacement energy when ANO is operating or down for reasons other than refueling. GSU Rate Cap and Other Merger-Related Rate Agreements. The LPSC and the PUCT approved separate regulatory proposals that include the following elements: (1) a five-year rate cap on GSU's retail electric base rates in the respective states, except for force majeure (defined to include, among other things, war, natural catastrophes, and high inflation); (2) a provision for passing through to retail customers in the respective states the jurisdictional portion of the fuel savings created by the Merger; and (3) a mechanism for tracking nonfuel operation and maintenance savings created by the Merger. The LPSC regulatory plan provides that such nonfuel savings will be shared 60% by the shareholder and 40% by ratepayers during the eight years following the Merger. The LPSC plan requires regulatory filings each year by the end of May through 2001. The PUCT regulatory plan provides that such savings will be shared equally by the shareholder and ratepayers, except that the shareholder's portion will be reduced by $2.6 million per year on a total company basis in years four through eight. The PUCT plan also requires a series of regulatory filings, currently anticipated to be in June 1994, and February 1996, 1998, and 2001, to ensure that the ratepayers' share of such savings be reflected in rates on a timely basis and requires Entergy Corporation to hold GSU's Texas retail customers harmless from the effects of the removal by FERC of a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under the FERC tracking mechanism (see "Rate Matters - Wholesale Rate Matters - System Agreement," above). On January 14, 1994, Entergy Corporation filed a request for rehearing of FERC's December 15, 1993 order approving the Merger, requesting that FERC restore the 40% cap provision in the fuel cost protection mechanism (see "Regulation - Other Litigation and Regulation," below). The matter is pending. Recovery of River Bend Costs. GSU deferred approximately $369 million of River Bend operating costs, purchased power costs, and accrued carrying charges pursuant to a 1986 PUCT accounting order. Approximately $182 million of these costs are being amortized over a 20-year period, and the remaining $187 million are not being amortized pending the ultimate outcome of the Rate Appeal (see "Texas Jurisdiction - River Bend," below). As of December 31, 1993, the unamortized balance of these costs was $330.3 million. Further, GSU deferred approximately $400.4 million of similar costs pursuant to a 1986 LPSC accounting order. These costs, of which approximately $160.4 million are unamortized as of December 31, 1993, are being amortized over a 10-year period. In accordance with a phase-in plan approved by the LPSC, GSU deferred $324.7 million of its River Bend costs related to the period December 1987 through February 1991. GSU has amortized $86.6 million through December 31, 1993, and the remainder of $238.1 million will be recovered over approximately 3.8 years. Texas Jurisdiction - River Bend. In May 1988, the PUCT granted GSU a permanent increase in annual revenues of $59.9 million resulting from the inclusion in rate base of approximately $1.6 billion of company-wide River Bend plant investment and approximately $182 million of related Texas retail jurisdiction deferred River Bend costs (Allowed Deferrals). In addition, the PUCT disallowed as imprudent $63.5 million of company-wide River Bend plant costs and placed in abeyance, with no finding of prudency, approximately $1.4 billion of company-wide River Bend plant investment and approximately $157 million of Texas retail jurisdiction deferred River Bend operating and carrying costs. The PUCT affirmed that the ultimate rate treatment of such amounts would be subject to future demonstration of the prudency of such costs. GSU and intervening parties appealed this order (Rate Appeal) and GSU filed a separate rate case asking that the abeyed River Bend plant costs be found prudent (Separate Rate Case). Intervening parties filed suit in district court to prohibit the Separate Rate Case. The district court's decision was ultimately appealed to the Texas Supreme Court which ruled in 1990 that the prudence of the purported abeyed costs could not be relitigated in a separate rate proceeding. Further, the Texas Supreme Court's decision stated that all issues relating to the merits of the original order of the PUCT, including the prudence of all River Bend-related costs, should be addressed in the Rate Appeal. In October 1991, the district court in the Rate Appeal issued an order holding that, while it was clear the PUCT made an error in assuming it could set aside $1.4 billion of the total costs of River Bend and consider them in a later proceeding, the PUCT, nevertheless, found that GSU had not met its burden of proof related to the amounts placed in abeyance. The court also ruled that the Allowed Deferrals should not be included in rate base under a 1991 decision regarding El Paso Electric Company's similar deferred costs (El Paso Case). The court further stated that the PUCT erred in reducing GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988. The court remanded the case to the PUCT with instructions as to the proper handling of the Allowed Deferrals. GSU's motion for rehearing was denied, and in December 1991, GSU filed an appeal of the October 1991 district court order. The PUCT also appealed the October 1991 district court order, which served to supersede the district court's judgment, rendering it unenforceable under Texas law. In August 1992, the court of appeals in the El Paso Case handed down its second opinion on rehearing modifying its previous opinion on deferred accounting. The court's second opinion concluded that the PUCT may lawfully defer operating and maintenance costs and subsequently include them in rate base, but that the Public Utility Regulatory Act prohibits such rate base treatment for deferred carrying costs. The court stated, however, its opinion would not preclude the recovery of deferred carrying costs. The August 1992 court of appeals opinion was appealed to the Texas Supreme Court where arguments were heard in September 1993. The matter is still pending. In September 1993, the Texas Third District Court of Appeals (the Third District Court) remanded the October 1991 district court decision to the PUCT "to reexamine the record evidence to whatever extent necessary to render a final order supported by substantial evidence and not inconsistent with our opinion." The Third District Court specifically addressed the PUCT's treatment of certain costs, stating that the PUCT's order was not based on substantial evidence. The Third District Court also applied its most recent ruling in the El Paso Case to the deferred costs associated with River Bend. However, the Third District Court cautioned the PUCT to confine its deliberations to the evidence addressed in the original rate case. Certain parties to the case have indicated their position that, on remand, the PUCT may change its original order only with respect to matters specifically discussed by the Third District Court which, if allowed, would increase GSU's allowed River Bend investment, net of accumulated depreciation and related taxes, by approximately $48 million as of December 31, 1993. GSU believes that under the Third District Court's decision, the PUCT would be free to reconsider any aspect of its order concerning the abeyed $1.4 billion River Bend investment. GSU has filed a motion for rehearing asking the Third District Court to modify its order so as to permit the PUCT to take additional evidence on remand. The PUCT and other parties have also moved for rehearing on various grounds. The Third District Court has not yet ruled on any of these motions. As of December 31, 1993, the River Bend plant costs disallowed for retail ratemaking purposes in Texas, and the River Bend plant costs held in abeyance and the related cost deferrals totaled (net of taxes) approximately $14 million, $300 million (both net of depreciation), and $171 million, respectively. Allowed Deferrals were approximately $95 million, net of taxes and amortization, as of December 31, 1993. GSU estimates it has collected approximately $139 million of revenues as of December 31, 1993, as a result of the originally ordered rate treatment of these deferred costs. However, if the PUCT adopts the most recent decision in the El Paso Case, the possible refunds approximate $28 million as a result of the inclusion of deferred carrying costs in rate base for the period July 1988 through December 1990. However, if the PUCT reverses its decision to reduce GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988, the potential refund of amounts described above could be reduced by an amount ranging from $7 million to $19 million. No assurance can be given as to the timing or outcome of the remands or appeals described above. Pending further developments in these cases, GSU has made no write-offs for the River Bend related costs. Management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is reasonably possible that the case will be remanded to the PUCT, and the PUCT will be allowed to rule on the prudence of the abeyed River Bend plant costs. Rate caps imposed by the PUCT's regulatory approval of the Merger could result in GSU being unable to use the full amount of a favorable decision to immediately increase rates; however, a favorable decision could permit some increases and/or limit or prevent decreases during the period the rate caps are in effect. At this time, management and legal counsel are unable to predict the amount, if any, of the abeyed and previously disallowed River Bend plant costs that ultimately may be disallowed by the PUCT. A net of tax write-off as of December 31, 1993, of up to $314 million could be required based on the PUCT's ultimate ruling. In prior proceedings, the PUCT has held that the original cost of nuclear power plants will be included in rates to the extent those costs were prudently incurred. Based upon the PUCT's prior decisions, management believes that its River Bend construction costs were prudently incurred and that it is reasonably possible that it will recover in rate base, or otherwise through means such as a deregulated asset plan, all or substantially all of the abeyed River Bend plant costs. However, management also recognizes that it is reasonably possible that not all of the abeyed River Bend plant costs may ultimately be recovered. As part of its direct case in the Separate Rate Case, GSU filed a cost reconciliation study prepared by Sandlin Associates, management consultants with expertise in the cost analysis of nuclear power plants, which supports the reasonableness of the River Bend costs held in abeyance by the PUCT. This reconciliation study determined that approximately 82% of the River Bend cost increase above the amount included by the PUCT in rate base was a result of changes in federal nuclear safety requirements and provided other support for the remainder of the abeyed amounts. There have been four other rate proceedings in Texas involving nuclear power plants. Investment in the plants ultimately disallowed ranged from 0% to 15%. Each case was unique, and the disallowances in each were made on a case-by-case basis for different reasons. Appeals of most, if not all, of these PUCT decisions are currently pending. The following factors support management's position that a loss contingency requiring accrual has not occurred, and its belief that all, or substantially all, of the abeyed plant costs will ultimately be recovered: 1. The $1.4 billion of abeyed River Bend plant costs have never been ruled imprudent and disallowed by the PUCT. 2. Sandlin Associates' analysis which supports the prudence of substantially all of the abeyed construction costs. 3. Historical inclusion by the PUCT of prudent construction costs in rate base. 4. The analysis of GSU's internal legal staff, which has considerable experience in Texas rate case litigation. Additionally, management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is probable that the deferred costs will be allowed. However, assuming the August 1992 court of appeals' opinion in the El Paso Case is upheld and applied to GSU and the deferred River Bend costs currently held in abeyance are not allowed to be recovered in rates as allowable costs, a net-of-tax write-off of up to $171 million could be required. In addition, future revenues based upon the deferred costs previously allowed in rate base could also be lost and no assurance can be given as to whether or not refunds (up to $28 million as of December 31, 1993) of revenue received based upon such deferred costs previously recorded will be required. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquistion contingencies, including a River Bend write-down. Texas Jurisdiction - Fuel Reconciliation. In January 1992, GSU applied with the PUCT for a new fixed fuel factor and requested a final reconciliation of fuel and purchased power costs incurred between December 1, 1986 and September 30, 1991. GSU proposed to recover net underrecoveries and interest (including underrecoveries related to NISCO, discussed below) over a twelve month period. In April 1993, the presiding PUCT ALJ issued a report which concluded that GSU incurred approximately $117 million of nonreimbursable fuel costs on a company-wide basis (approximately $50 million on a Texas retail jurisdictional basis) during the reconciliation period. Included in the nonreimbursable fuel costs were payments above GSU's avoided cost rate for power purchased from NISCO. The PUCT ordered in 1986 that the purchased power costs from NISCO in excess of GSU's avoided costs be disallowed. The PUCT disallowance resulted in approximately $12 million to $15 million of unrecovered purchased power costs on an annual basis, which GSU continued to expense as the costs were incurred. In April 1991, the Texas Supreme Court, in the appeal of such order, ordered the PUCT to allow GSU to recover purchased power payments in excess of its avoided cost in future proceedings, if GSU established to the PUCT's satisfaction that the payments were reasonable and necessary expenses. In June 1993, the PUCT, in the fuel reconciliation case, concluded that the purchased power payments made to NISCO in excess of GSU's avoided cost were not reasonably incurred. As a result of the order, GSU recorded additional fuel expenses (including interest) of $2.8 million for non-NISCO related items. The PUCT's order resulted in no additional expenses related to the NISCO issue, or for overcollections related to the fixed fuel factor, as those charges were expensed by GSU as they were incurred. The PUCT concluded that GSU had over-collected its fuel costs in Texas and ordered GSU to refund approximately $33.8 million to its Texas retail customers, including approximately $7.5 million of interest. The PUCT reduced GSU's fixed fuel factor in Texas from about 2.1 cents per KWH to approximately 1.84 cents per KWH. GSU had requested a new fixed fuel factor of about 2.02 cents per KWH. Based on current sales forecasts, adoption of the PUCT's recommended fixed fuel factor would reduce GSU's revenues by approximately $34 million annually. In October 1993, GSU appealed the PUCT's order to the Travis County District Court. No assurance can be given as to the timing or outcome of the appeal. Texas - Cities Rate Settlement. In June 1993, thirteen cities within GSU's Texas service area instituted an investigation to determine whether GSU's current rates were justified. In October 1993, the general counsel of the PUCT instituted an inquiry into the reasonableness of GSU's rates. In November 1993, a settlement agreement was filed with the PUCT which provides for an initial reduction in annual retail base revenues in Texas of approximately $22.5 million effective for electric usage on or after November 1, 1993, and a second reduction of $20 million to be effective September 1994. Further, the settlement provided for GSU to reduce rates with a $20 million one-time bill credit in December 1993, and to refund approximately $3 million to Texas retail customers on bills rendered in December 1993. The cities rate inquiries had been settled earlier on the same terms. In November 1993, in association with the settlement of the above- described rate inquiries, GSU entered into a settlement covering issues related to a March 1991 non-unanimous settlement in another proceeding. Under this settlement, a $30 million rate increase approved by the PUCT in March 1991, became final and the PUCT's treatment of GSU's federal tax expense was settled, eliminating the possibility of refunds associated with amounts collected resulting from the disputed tax calculation. In December 1993, a large industrial customer of GSU announced its intention to oppose the settlement of the PUCT rate inquiry. The customer's opposition does not affect the cities' rate settlement. The customer's opposition requires the PUCT to conduct a hearing concerning GSU's rates charged in areas outside the corporate limits of the cities in its Texas service territory to determine whether the settlement's rates are just and reasonable. A hearing has been set for July 8, 1994. GSU believes that the PUCT will ultimately approve the settlement, but no assurance can be provided in this regard. Louisiana Jurisdiction - River Bend. Previous rate orders of the LPSC have been appealed, and pending resolution of various appellate proceedings, GSU has made no write-off for the disallowance of $30.6 million of deferred revenue requirement that GSU recorded for the period December 16, 1987 through February 18, 1988. In January 1992, the LPSC ordered a deregulated asset plan for $1.4 billion of River Bend plant costs not allowed in rates. The plan allows GSU to sell the generation from the approximately 22% of River Bend to Louisiana customers at 4.6 cents per KWH, or off-system at higher prices. Incremental revenues from off-system sales above 4.6 cents per KWH will be shared 60% by shareholders and 40% by ratepayers (see GSU's "Management's Financial Discussion and Analysis," incorporated herein by reference, for the effects of the plan on GSU's 1993 results of operations). LPSC - Return on Equity Review. In the June 1993 open session, a preliminary report was made comparing the authorized and actual earned rates of return for electric and gas utilities subject to the LPSC's jurisdiction. The preliminary report indicated that several electric utilities, including GSU, may be over-earning based on current estimated costs of equity. The LPSC requested those utilities to file responses indicating whether they agreed with the preliminary report, and to provide their reasons if they did not agree. GSU provided the LPSC with information that GSU believes supports the current rate level. The LPSC decided at its September 7, 1993 open session to defer review of GSU's base rates until the first earnings analysis after the Merger, scheduled for mid-1994. LPSC Fuel Cost Review. In November 1993, the LPSC ordered a review of GSU's fuel costs. The LPSC stated that fuel costs for the period October 1988 through September 1991 would be reviewed based on the number of outages at River Bend and the findings in the June 1993 PUCT fuel reconciliation case. Hearings are scheduled to begin in March 1994. Least Cost Planning. Currently, the PUCT does not have least cost planning rules in place, and GSU has not filed a Least Cost Plan with the PUCT. However, the PUCT staff has begun a rulemaking process for such rules, and GSU is actively participating in this process. GSU has not yet filed a Least Cost Plan with the LPSC. Fuel Recovery. In January 1993, the PUCT adopted a new rule for setting a fixed fuel factor that is intended to recover projected allowable fuel and purchased power costs not covered by base rates. To the extent actual costs vary from the fixed factor, the PUCT may require refunds of overcharges or permit recovery of undercharges. Under the new rule, fuel factors are to be revised every six months, and GSU is on a schedule providing for revision each March and September. The PUCT is required to act within 60 or 90 days, depending on whether or not a hearing is required, and refunds and surcharges will be required based upon a materiality threshold of 4% of Texas retail fuel revenues. Fuel charges will also be subject to reconciliation proceedings every three years, at which time additional adjustments may be required (see "Texas Jurisdiction - Fuel Reconciliation," above). All of GSU's rate schedules in Louisiana include a fuel adjustment clause to recover the cost of fuel and purchased power energy costs. The fuel adjustment reflects the delivered cost of fuel for the second preceding month. LP&L LPSC Jurisdiction. In a series of LPSC orders, court decisions, and agreements from late 1985 to mid-1988, LP&L was granted rate relief with respect to costs associated with Waterford 3 and LP&L's share of capacity and energy from Grand Gulf l, subject to certain terms and conditions. With respect to Waterford 3, LP&L was granted an increase aggregating $170.9 million over the period 1985-1988, and LP&L agreed to permanently absorb, and not recover from retail ratepayers, $284 million of its investment in the unit and to defer $266 million of its costs related to the years 1985-1988 to be recovered over approximately 8.6 years beginning in April 1988. As of December 31, 1993, LP&L's unrecovered deferral balance was $82.5 million. With respect to Grand Gulf l, LP&L agreed to absorb, and not recover from retail ratepayers, 18% of its 14% share (approximately 2.52%) of the costs of Grand Gulf l capacity and energy. LP&L is allowed to recover, through the fuel adjustment clause, 4.6 cents per KWH (currently 2.55 cents per KWH through May 1994) for the energy related to the permanently absorbed percentage, with LP&L's permanently absorbed retained percentage to be available for sale to non-affiliated parties, subject to LPSC approval. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - Waterford 3 and Grand Gulf 1," incorporated herein by reference, for further information on LP&L's Grand Gulf 1 and Waterford 3-related rates.) In a subsequent rate proceeding, on March 1, l989, the LPSC issued an order providing that, in effect, LP&L was entitled to an approximately $45.9 million annual retail rate increase, but that, in lieu of a rate increase, LP&L would be permitted to retain $188.6 million of the proceeds of a 1988 settlement of litigation with a gas supplier, and to amortize such proceeds into revenues over a period of approximately 5.3 years. The amortization of the proceeds will expire in mid-1994 and this source of revenue will no longer be available to LP&L. LP&L believes that the amortization has resulted in approximately the same amount of additional net income as an annual rate increase of $45.9 million would have provided over the same period. In connection with this order, LP&L agreed to a five-year base rate freeze scheduled to expire in March 1994 at then current levels subject to certain conditions. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - March 1989 Order," incorporated herein by reference, for further information on the terms of this order.) By letter dated July 27, 1993, the LPSC requested LP&L to explain its "relatively high cost of debt" compared to other electric utilities subject to LPSC jurisdiction. LP&L responded to the request on August 11, 1993. On August 14, 1993, the LPSC's consultants acknowledged LP&L's rationale for its cost of debt and suggested that certain aspects of LP&L's cost of debt could be taken up in rate proceedings after the expiration of LP&L's rate freeze. On October 7, 1993, the LPSC approved a schedule to conduct a review of LP&L's rates and rate structure upon the expiration of the rate freeze in March 1994. Council Jurisdiction. Under the Algiers rate settlement entered into with the Council in l989, LP&L was granted rate relief with respect to its Grand Gulf l and Waterford 3-related costs, subject to certain terms and conditions. LP&L was granted an annual rate increase of $9.5 million that was phased-in over the two-year period beginning in July 1989, and was permitted to retain $4.2 million (the Council's jurisdictional portion) of the proceeds of litigation with a gas supplier and to amortize such proceeds plus interest into revenues over the same two-year period. LP&L agreed to absorb and not recover from Algiers retail ratepayers $17 million of fixed costs associated with Grand Gulf l and Waterford 3 incurred prior to the date of the settlement, $5.9 million of its investment in Waterford 3, and 18% of the Algiers portion of LP&L's Grand Gulf l-related costs incurred after the settlement. However, LP&L is allowed to recover 4.6 cents per KWH or the avoided cost, whichever is higher, for the energy related to the permanently absorbed percentage through the fuel adjustment clause, with the permanently absorbed percentage to be available for sale to non-affiliated parties, subject to the Council's right of first refusal. LP&L also agreed to a rate freeze for Algiers customers until July 6, l994, except in the case of catastrophic events, changes in federal tax laws, or changes in LP&L's Grand Gulf l costs resulting from FERC proceedings. Least Cost Planning. On December l, l992, and July 1, l993, LP&L filed with the LPSC and the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. LP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. Discovery in the LPSC review of LP&L's Least Cost Plan filing is continuing, and the current procedural schedule (which maybe extended) contemplates that, after hearings and briefings, a report of the LPSC special counsel will be issued on June 14, 1994. The LPSC could render a decision on the basis of this report. On January 19, 1994, LP&L filed a motion with the LPSC to dismiss or withdraw without prejudice the CCLM and to proceed with a pilot CCLM at shareholder expense. The LPSC granted LP&L's motion on February 2, 1994, subject to LP&L, among other things, keeping the LPSC timely informed as to LP&L's CCLM activities. (See "NOPSI - Least Cost Planning," below, for further information on LP&L's and NOPSI's proceedings pending before the Council.) Fuel Adjustment Clause. LP&L's rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month and purchased power energy costs. The fuel adjustment also reflects a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. LP&L defers on its books fuel costs that will be reflected in customer billings in the future under the fuel adjustment clause. MP&L Rate Freeze. In a stipulation entered into by MP&L in connection with the settlement of various issues related to the Merger, MP&L agreed that (1) for a period of five years beginning on November 9, 1993, retail base rates under the FRP (see "Incentive Rate Plan," below) would not be increased above the level of rates in effect on November 1, 1993, and (2) MP&L would not request any general retail rate increase that would increase retail rates above the level of MP&L's rates in effect as of November l, 1993, and that would become effective in such five-year period except, among other things, for increases associated with the Least Cost Plan (discussed below), recovery of deferred Grand Gulf 1-related costs, recovery under the fuel adjustment clause, adjustments for certain taxes, and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. The MPSC's Final Order on Rehearing, issued in 1985, affirmed by the United States Supreme Court in 1988, and subsequently revised in 1988, granted MP&L an annual base rate increase of approximately $326.5 million in connection with its allocated share of Grand Gulf 1 costs. The Final Order on Rehearing also provided for the deferral of a portion of such costs that were incurred each year through 1992, and recovery of these deferrals over a period of six years ending in 1998. As of December 31, 1993, the uncollected balance of MP&L's deferred costs was approximately $601.4 million. MP&L is permitted to recover the carrying charges on all deferred amounts on a current basis. Incentive Rate Plan. In July 1993, the MPSC ordered MP&L to file a formulary incentive rate plan designed to allow for periodic small adjustments in rates based upon a comparison of earned to benchmark returns and upon performance factors incorporated in the plan. Pursuant to this order, on November 1, 1993, MP&L filed a proposed formula rate plan. MPSC was also expected to conduct a general review of MP&L's current rates in the course of approving an incentive rate plan. On January 28, 1994, MP&L and the Mississippi Public Utilities Staff (MPUS) entered into a Joint Stipulation in this proceeding. Under the Joint Stipulation, MP&L and the MPUS agreed on a number of accounting adjustments for the test year ending June 30, 1993, (June 30 Test Year) that resulted in a reduction to MP&L's base rate revenues in the June 30 Test Year of approximately 4.3%, or $28.1 million. This translates into approximately a 3.7% decrease in overall revenues from sales to retail customers, which include revenues related to fuel, taxes, and Grand Gulf. MP&L and the MPUS agreed on a required return on equity of 11% for the June 30 Test Year. MP&L and the MPUS also stipulated to a revised Formula Rate Plan (FRP). The stipulated FRP is essentially the same as the proposed plan filed by MP&L on November 1, 1993. Certain of the accounting changes agreed to by the MPUS and MP&L for the June 30 Test Year are incorporated into the stipulated FRP. Also, the formula in the stipulated FRP for determining required return on equity would have produced a required return on equity for MP&L of 11.07% for the June 30 Test Year. The stipulated return on equity formula will be applied for the first time in the first Evaluation Report under the stipulated FRP. The first Evaluation Report will be filed in March 1995 for the Evaluation Period ending December 31, 1994. On February 10, 1994, MP&L, the Mississippi Industrial Energy Group (MIEG), and the MPUS entered into and filed with the MPUS, a Joint Stipulation (MIEG Joint Stipulation) resolving the issues raised by the MIEG in the docket. On February 16, 1994, MP&L and the Mississippi Attorney General entered into a Joint Stipulation that resolved the issues raised by the Mississippi Attorney General in the docket. Other parties in the case, including two gas utility intervenors, were not parties to the Joint Stipulations. In late February 1994, the MPSC conducted a general review of MP&L's current rates and on March 1, 1994, issued a final order in which the MPSC approved each of the Joint Stipulations. The MPSC ordered MP&L to file rates designed to provide a reduction of $28.1 million in operating revenues for the June 30 Test Year on or before March 18, 1994, to become effective for service rendered on and after March 25, 1994. The FRP also was approved and will be effective on March 25, 1994, with any initial adjustment to base rates, if any, in May 1995. Under the FRP, a formula will be established under which MP&L's earned rate of return will be calculated automatically every 12 months and compared to a benchmark rate of return calculated under a separate formula within the FRP. If MP&L's earned rate of return falls within a bandwidth around the benchmark rate of return, there will be no adjustment in rates. If MP&L's earnings are above the bandwidth, the FRP will automatically reduce MP&L's base rates. Alternatively, if MP&L's earnings are below the bandwidth, the FRP will automatically increase MP&L's base rates (see "Rate Freeze" above for information on a cap on base rates at November 1993 levels for a period of five years). The reduction or increase in base rates will be an amount representing 50% of the difference between the earned rate of return and the nearest limit of the bandwidth. In no event will the annual adjustment in rates exceed the lesser of 2% of MP&L's aggregate annual retail revenues, or $14.5 million. Under the FRP the benchmark rate of return, and consequently the bandwidth, will be adjusted slightly upward or downward based upon MP&L's performance on three performance factors: customer reliability, customer satisfaction, and customer price. In its Final Order, the MPSC also recognized that on February 9 and 10, 1994, a severe ice storm struck northern Mississippi causing extensive and widespread damage to MP&L's transmission and distribution facilities in approximately 15 counties. Although the MPSC made no findings in the final order as to MP&L's costs associated with the ice storm and restoration of service, the MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and restoration of service. The MPSC stated the recovery of MP&L's ice storm costs should be addressed in a separate docket. MP&L plans to immediately file for rate recovery of the costs related to the ice storm. Least Cost Planning. On December 1, 1992 and July 1, 1993, MP&L filed with the MPSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. MP&L also requested a finding by the MPSC that the plan's cost recovery methodology is reasonable and appropriate. MP&L will request approval of cost recovery mechanisms after the plan has been approved by the MPSC. On October 6, 1993, the MPSC, on its own motion, stayed all proceedings in this docket. The MPSC stay order regarding MP&L's Least Cost Plan filing remains in effect even though MP&L and the MPUS have stipulated to an FRP (see "Incentive Rate Plan," above). Because the stay order remains in effect, MP&L has not yet filed a request that the CCLM portion of the filing be withdrawn and that a pilot CCLM program be implemented. Fuel Adjustment Clause. MP&L's rate schedules include a fuel adjustment clause that permits recovery from customers of changes in the cost of fuel and purchased power. The monthly fuel adjustment rate is based on projected sales and costs for the month, adjusted for differences between actual and estimated costs for the second prior month. NOPSI Electric Retail Rate Reduction. On November 18, 1993, in connection with the settlement of various issues related to the Merger, the Council adopted a resolution requiring NOPSI to reduce its annual electric base rates by $4.8 million on bills rendered on or after November 1, 1993. Recovery of Grand Gulf 1 Costs. Under NOPSI's various Rate Settlements with the Council (which include the 1986 NOPSI Settlement, the February 4 Resolution relating to prudence issues, and the 1991 NOPSI Settlement of the issues raised in the February 4 Resolution), NOPSI agreed to absorb and not recover from ratepayers a total of $186.2 million of its Grand Gulf 1 costs. NOPSI was permitted to implement annual rate increases in decreasing amounts each year through 1995, and to defer certain costs, and related carrying charges, for recovery on a schedule extending from 1991 through 2001. As of December 31, 1993, the uncollected balance of NOPSI's deferred costs was $228.8 million. NOPSI also agreed to a base rate freeze through October 31, 1996, excluding the scheduled increases, certain changes in tax rates, and increases related to catastrophic events. (See Note 2 of NOPSI's Notes to Financial Statements, "Rate and Regulatory Matters - Prudence Settlement and Finalized Phase-In Plan," incorporated herein by reference, for further information.) Gas Rates. In May 1992, NOPSI and the Council settled a pending application for gas rate increases. The settlement provided for annual rate increases of approximately $3.8 million in May 1992 and 1993, and the deferral of an additional $3 million for recovery in the years beginning in May 1993 through May 1996. NOPSI also agreed to a base rate freeze, except for the scheduled increases and certain other exceptions, through October 31, 1996. Least Cost Planning. On December 1, 1992, and July 1, 1993, NOPSI filed with the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. NOPSI also requested authorization to recover development and implementation costs and costs and incentives related to DSM aspects of the plan. After hearings and briefings, the Council issued, on November 22, 1993, a resolution that requires NOPSI and LP&L to provide, within certain time frames, additional information, among other things, on how the seven full scale DSM programs approved by the Council in the resolution will be implemented. Such programs are estimated to cost approximately $13 million over the next three years. The Council provided in the resolution certain assurances regarding recovery of costs associated with these programs. Discovery is proceeding and testimony is being filed, with the second round of hearings to begin in February 1994. After the hearings are concluded and briefs have been filed, the Council will address the second round issues in early April 1994. On February 3, 1994, the Council issued a resolution and order granting the motions of NOPSI and LP&L to dismiss without prejudice the CCLM portion of the filing, authorizing NOPSI and LP&L to proceed with a pilot CCLM (other than the construction of a fiber optics/coaxial cable network) in New Orleans at shareholder expense (subject to certain conditions). The Council also opened a new docket to expeditiously address issues related to the CCLM pilot, and directing NOPSI and LP&L to obtain Council authorization in the new docket before constructing such a fiber optics/coaxial cable network. In connection with the settlement of various issues related to the Merger, the Council adopted a resolution on November 18, 1993, that provides that the Council will not disallow the first $3.5 million of costs incurred by NOPSI through October 31, 1993, in connection with the Least Cost Plan. Fuel Adjustment Clause. NOPSI's electric rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month, adjusted by a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. The adjustment clause, on a monthly basis, also reflects the difference between nonfuel Grand Gulf 1 costs paid by NOPSI and the estimate of such costs provided in NOPSI's Grand Gulf 1 Rate Settlements. NOPSI's gas rate schedules include a gas cost adjustment to reflect gas costs in excess of those collected in rates, adjusted by a surcharge similar to that included in the electric adjustment clause. NOPSI defers on its books fuel and purchased gas costs to be reflected in billings to customers in the future under the fuel adjustment clause. REGULATION Federal Regulation Holding Company Act. Entergy Corporation is a registered public utility holding company under the Holding Company Act. As such, Entergy Corporation and its various direct and indirect subsidiaries (with the exception of its independent power/EWG subsidiaries) are subject to the broad regulatory provisions of that Act. Except with respect to investments in certain EWG projects and foreign utility company projects (see "Business of Entergy - Competition - General," above for a discussion of the Energy Act), Section 11(b)(1) of the Holding Company Act limits the operations of a registered holding company system to a single, integrated public utility system, plus additional systems and businesses as provided by that section. Federal Power Act. The System operating companies, System Energy, and Entergy Power are subject to the Federal Power Act as administered by FERC and the DOE. The Federal Power Act provides for regulatory jurisdiction over the licensing of certain hydroelectric projects, the business of, and facilities for, the transmission and sale at wholesale of electric energy in interstate commerce and certain other activities of the System operating companies, System Energy, and Entergy Power as interstate electric utilities, including accounting policies and practices. Such regulation includes jurisdiction over the rates charged by System Energy for capacity and energy provided to AP&L, LP&L, MP&L, and NOPSI, or others, from Grand Gulf 1. AP&L holds a license for two hydroelectric projects (70 MW) that was renewed on July 2, 1980. This license, granted by FERC, will expire in February 2003. Regulation of the Nuclear Power Industry General. Under the Atomic Energy Act of 1954 and Energy Reorganization Act of 1974, operation of nuclear plants is intensively regulated by the NRC, which has broad power to impose licensing and safety-related requirements. In the event of non-compliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. AP&L, GSU, LP&L, and System Energy, as owners of all or a portion of ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, and Entergy Operations, as the operator of these units, are subject to the jurisdiction of the NRC. Revised safety requirements promulgated by the NRC have, in the past, necessitated substantial capital expenditures at System nuclear plants and additional such expenditures could be required in the future. The nuclear power industry faces uncertainties with respect to the cost and availability of long-term arrangements for disposal of spent nuclear fuel and other radioactive waste, nuclear plant operational issues, the technological and financial aspects of decommissioning plants at the end of their licensed lives, and the effect of certain requirements relating to nuclear insurance. These matters are briefly discussed below. Spent Fuel and Other High-Level Radioactive Waste. Under the Nuclear Waste Policy Act of 1982, the DOE is required, for a specified fee, to construct storage facilities for, and to dispose of, all spent nuclear fuel and other high-level radioactive waste generated by domestic nuclear power reactors. The NRC, pursuant to this Act, also requires operators of nuclear power reactors to enter into spent fuel disposal contracts with the DOE, and the affected System companies have entered into such disposal contracts. However, the DOE has not yet identified a permanent storage repository and, as a result, future expenditures may be required to increase spent fuel storage capacity at the plant sites. (For further information concerning spent fuel disposal contracts with the DOE, schedules for initial shipments of spent nuclear fuel, current on-site storage capacity, and costs of providing additional on-site storage capacity, with respect to AP&L, GSU, LP&L, and System Energy, respectively, see Note 8 of AP&L's, GSU's, and LP&L's, and Note 7 of System Energy's, Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Low-Level Radioactive Waste. The availability and cost of disposal facilities for low-level radioactive waste resulting from normal operation of nuclear units are subject to a number of uncertainties. Under the Low-Level Radioactive Waste Policy Act of 1980, as amended, each state is responsible for disposal of its own waste, and states may join in regional compacts to jointly fulfill their responsibilities. The States of Arkansas and Louisiana participate in the Central States Compact, and the State of Mississippi participates in the Southeast Compact. Two disposal sites are currently operating in the United States, and one of them, which is located in Washington, is closed to out-of-region generators. The second site, the Barnwell Disposal Facility (Barnwell) located in South Carolina, is operated by the Southeast Compact and the State of Mississippi is expected to have access to this site through December 1995. Barnwell had been open to out-of-region generators (including generators in Arkansas and Louisiana) in the past; however, on April 14, 1993, the Southeast Compact voted to deny access to Barnwell to members of the Central States Compact. Such access was reinstated for the period from October 1993 through June 1994, at which time legislative action by the State of South Carolina would be required to permit further access to out-of-region generators. Beginning in July 1994, low-level radioactive waste generators in the Central States Compact, including AP&L, GSU, and LP&L, will be required to store such waste on-site until a Central States Compact facility becomes operational or another site becomes accessible. Both the Central States Compact and the Southeast Compact are working to establish additional disposal sites. The System, along with other waste generators, funds the development costs for new disposal facilities. The System's expenditures to date are approximately $30 million; and future levels of expenditures cannot be predicted. Until such facilities are established, the System will continue to seek access to existing facilities, which may be available at costs that are higher than those incurred in the past, or which may be unavailable. If such access is unavailable, the System will store low-level waste on-site at the affected units. ANO has on-site storage that is estimated to be sufficient until 1999. Construction of on-site storage at the other nuclear units is being considered, along with other alternatives. A coordinated design concept that can be utilized at both Waterford 3 and River Bend is being evaluated. Grand Gulf 1 will have continued disposal access through December 1995; therefore, no immediate plans for on-site storage are needed for Grand Gulf 1. The estimated construction costs for storage sufficient for approximately five years at Grand Gulf 1, Waterford 3, and River Bend are in the range of $2.0 million to $5.0 million for each site. As an alternative to on-site storage, Entergy is working with other industry groups to influence the continued operation of the Barnwell disposal facility for out-of-region generators. Decommissioning. AP&L, GSU, LP&L, and System Energy are recovering portions of their estimated decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively. These amounts are being deposited in external trust funds that, together with the earnings thereon, can only be used for future decommissioning costs. Estimated decommissioning costs are regularly reviewed and updated to reflect inflation and changes in regulatory requirements and technology, and applications will be made to appropriate regulatory authorities to recover in rates any projected increase in decommissioning costs above that currently being recovered. (For additional information with respect to decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, see Note 8 of AP&L's, GSU's, and LP&L's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Uranium Enrichment Decontamination and Decommissioning Fees. The Energy Act requires all electric utilities (including AP&L, GSU, LP&L, and System Energy) that have purchased uranium enrichment services from the DOE to contribute up to a total of $150 million annually, adjusted for inflation, up to a total of $2.25 billion over approximately 15 years, for decommissioning and decontamination of enrichment facilities. AP&L's, GSU's, LP&L's, and System Energy's estimated annual contributions to this fund are $3.3 million, $0.6 million, $1.2 million, and $1.3 million, respectively, in 1993 dollars over approximately 15 years. Contributions to this fund are to be recovered through rates in the same manner as other fuel costs. Nuclear Insurance. The Price-Anderson Act provides for a limit of public liability for a single nuclear incident. As of December 31, 1993, the limit of public liability for such type of incident was approximately $9.4 billion. AP&L, GSU, LP&L, and System Energy have protection with respect to this liability through a combination of private insurance and an industry assessment program, and also have insurance for property damage, costs of replacement power, and other risks relating to nuclear generating units. (For a discussion of insurance applicable to nuclear programs of AP&L, GSU, LP&L, and System Energy, see Note 7 of System Energy's and Note 8 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, and Note 8 of Entergy Corporation and Subsidiaries, Notes to Consolidated Financial Statements, "Commitments and Contingencies - Nuclear Insurance," incorporated herein by reference.) Nuclear Operations General. Entergy Operations operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. AP&L, GSU, LP&L, and System Energy, and the other Grand Gulf 1, Waterford 3, and River Bend co- owners, have retained their ownership interests in their respective nuclear generating units. AP&L, GSU, LP&L, and System Energy have also retained their associated capacity and energy entitlements, and pay directly or reimburse Entergy Operations at cost for its operation of the units. On June 24, 1992, the NRC issued a bulletin requiring all utilities using a certain fire barrier material in a nuclear power plant to take certain actions related to the material. This material may have been used in as many as 87 nuclear plants in the United States, including ANO, River Bend, Waterford 3, and Grand Gulf 1 (see "River Bend," below for additional information). ANO. In 1990, in response to a special diagnostic evaluation report by the NRC, AP&L implemented a comprehensive action plan for ANO designed to correct certain management, organizational, and technical problems, and to improve the long-term operational effectiveness and safety of the units. This action plan was largely completed in 1993. Leaks in certain steam generator tubes at ANO 2 were discovered and repaired during an outage in March 1992; and during a refueling outage in September 1992, a comprehensive inspection of all steam generator tubing was conducted and necessary repairs were made. During a mid-cycle outage in May 1993, a scheduled special inspection of certain steam generator tubing was conducted by Entergy Operations and additional repairs were made. Entergy Operations proposes to operate ANO 2 with no further steam generator inspections until the next refueling outage, which is scheduled for the spring of 1994, and the NRC has concurred with this proposal. The operations and power output of the unit have not been adversely affected to date by these repairs. River Bend. The Nuclear Information and Resource Service petitioned the NRC to shut down the River Bend plant in July 1992 because of alleged defects in a fire barrier material. GSU has used this material in its River Bend plant and is in compliance with the requirements of the bulletin. On August 19, 1992, the NRC denied the petitioner's request. In a December 1993 letter, the NRC requested additional technical information on the use of the material in the plant, and requested GSU's plans and schedules for resolving technical issues associated with the use of the material in certain configurations. GSU has provided the information requested in the NRC letter. On January 13, 1993, in connection with the Merger, GSU filed two applications with the NRC to amend the River Bend operating license. The applications sought the NRC's consent to the Merger and to a change in the licensed operator of the facility from GSU to Entergy Operations. On August 6, 1993, Cajun filed a petition to intervene and request for a hearing in the proceedings. On January 27, 1994, the presiding NRC Atomic Safety and Licensing Board (ASLB) issued an order granting Cajun's petition to intervene and ordered a hearing on one of Cajun's contentions. On February 15, 1994, GSU filed an appeal of the ASLB Order with the NRC. On December 16, 1993, prior to this ASLB ruling, the NRC Staff issued the two license amendments for River Bend, making them effective immediately upon consummation of the Merger. On February 16, 1994, Cajun filed with the D.C. Circuit petitions for review of the two license amendments issued by the NRC. These two amendments are in full force and effect, but are subject to the outcome of the two proceedings. A hearing on the proceeding before the ALSB is not expected to begin prior to the fall of 1994. In February 1993, GSU and the other affected utilities were served with a federal grand jury subpoena to produce documents and other information relating to the fire barrier material used in the plant. Nothing in the subpoena indicates that GSU or any employee is a target of the grand jury investigation. GSU is cooperating fully with the government in its investigation. The requested documentation and other information were produced in March 1993, and no additional requests have been received. On October 25, 1993, the NRC staff began an operational safety team inspection at River Bend that was concluded by mid-November 1993. The NRC held the inspection to verify that the plant is being operated safely and in conformance with regulatory requirements. The team's findings were discussed at a public meeting in November 1993, and a written inspection report was issued in January 1994. The inspection team found apparent violations in two categories: (1) procedure adequacy, and (2) concerns with the corrective action program. Due to the nature of these apparent violations, an enforcement conference was not warranted and no fine was proposed. State Regulation General. Each of the System operating companies is subject to regulation by its respective state and/or local regulatory authorities with jurisdiction over the service areas in which each company operates. Such regulation includes authority to set rates for electric and gas service provided at retail. (See "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," above) AP&L is subject to regulation by the APSC and the Tennessee Public Service Commission (TPSC). APSC regulation includes the authority to set rates, determine reasonable and adequate service, fix the value of property used and useful, require proper accounting, control leasing, control the acquisition or sale of any public utility plant or property constituting an operating unit or system, set rates of depreciation, issue certificates of convenience and necessity and certificates of environmental compatibility and public need, and control the issuance and sale of securities. Regulation by the TPSC includes the authority to set standards of service and rates for service to customers in the state, require proper accounting, control the issuance and sale of securities, and issue certificates of convenience and necessity. GSU is subject to the jurisdiction of the municipal authorities of incorporated cities in Texas as to retail rates and services within their boundaries, with appellate jurisdiction over such matters residing in the PUCT. GSU is also subject to regulation by the PUCT as to retail rates and services in rural areas, certification of new generating plants, and extensions of service into new areas. GSU is subject to regulation by the LPSC as to electric and gas service, rates and charges, certification of generating facilities and power or capacity purchase contracts, and other matters. LP&L is subject to the jurisdiction of the LPSC as to rates and charges, standards of service, depreciation, accounting, and other matters, and is subject to the jurisdiction of the Council with respect to such matters within Algiers. MP&L is subject to regulation as to service, service areas, facilities, and retail rates by the MPSC. MP&L is also subject to regulation by the APSC as to the certificate of environmental compatibility and public need for the Independence Station. NOPSI is subject to regulation as to electric and gas service, rates and charges, standards of service, depreciation, accounting, issuance of certain securities, and other matters by the Council. Franchises. AP&L holds franchises to provide electric service in 301 incorporated cities and towns in Arkansas, all of which are unlimited in duration and terminable by either party. GSU holds non-exclusive franchises, permits, or certificates of convenience and necessity to provide electric and gas service in 55 incorporated villages, cities, and towns in Louisiana and 64 incorporated cities and towns in Texas. GSU ordinarily holds 50-year franchises in Texas towns and 60-year franchises in Louisiana towns. The present terms of GSU's electric franchises will expire in the years 2007-2036 in Texas and in the years 2015-2046 in Louisiana. The natural gas franchise in the City of Baton Rouge will expire in the year 2015. LP&L holds franchises to provide electric service in 116 incorporated villages, cities, and towns. Most of these franchises have 25-year terms expiring during the period 1995-2015. However, six of these municipalities have granted 60-year franchises, with the last one expiring in the year 2040. Of these franchises, none has expired to date, one is scheduled to expire as early as 1995, and 37 are scheduled to expire by year-end 2000. LP&L also supplies electric service in 353 unincorporated communities, all of which are located in parishes (counties) from which LP&L holds franchises to serve the areas in which the unincorporated communities are located. MP&L has received from the MPSC certificates of public convenience and necessity to provide electric service to the areas of Mississippi that MP&L serves, which include a number of municipalities. MP&L continues to serve in such municipalities upon payment of a statutory franchise fee, regardless of whether an original municipal franchise is still in existence. NOPSI provides electric and gas service in the City of New Orleans pursuant to city ordinances, which state, among other things, that the City has a continuing option to purchase NOPSI's electric and gas utility properties. System Energy has no franchises from any municipality or state. Its business is currently limited to wholesale sales of power. Environmental Regulation General. In the areas of air quality, water quality, control of toxic substances and hazardous and solid wastes, and other environmental matters, the System operating companies, System Energy, Entergy Power, and Entergy Operations are subject to regulation by various federal, state, and local authorities. Each of the Entergy companies considers itself to be in substantial compliance with those environmental regulations currently applicable to its business and operations. Entergy has incurred increased costs of construction and other increased costs in meeting environmental protection standards. Because environmental regulations are continually changing, the ultimate compliance costs to Entergy cannot be precisely estimated at any one time. However, Entergy currently estimates that its potential capital expenditures for environmental control purposes, including those discussed in "Clean Air Legislation," below, will not be material for the System as a whole. Clean Air Legislation. The Clean Air Act Amendments of 1990 (the Act) place limits on emissions of sulfur dioxide and nitrogen oxide from fossil-fueled generating plants. Entergy has evaluated the Act to determine the impact on the System's overall cost of emission control and monitoring equipment. Based upon such evaluation in connection with existing generating facilities, the System has determined that no additional control equipment will be required to control sulfur dioxide. In the area served by GSU, control equipment will be required for nitrogen oxide reductions due to the ozone nonattainment status of the Baton Rouge, Louisiana and Beaumont and Houston, Texas air quality control regions no later than May 1995. The cost of such control equipment is estimated at $16.0 million. The remainder of the System may be required to install nitrogen oxide emission controls on its coal units by the year 2000. The EPA is currently drafting rules that will determine the levels of nitrogen oxide emissions that will be allowed by affected units. Under the latest EPA-proposed regulations on nitrogen oxide, Entergy would not have to install additional controls. It is not possible to determine at this time if the final regulations promulgated by EPA would require the System's coal units to install nitrogen oxide emission controls. Should additional controls be required, the overall cost would vary depending on the eventual emission levels that are set. In addition, the System will be required to install additional continuous emission monitoring equipment at its coal units to comply with final EPA regulations. It is estimated that the continuous emission monitoring systems could cost as much as $1.0 million for all of the coal units. Final EPA regulations established the acceptable continuous monitoring methods, as well as alternative monitoring methods, that make it possible to determine the compliance of the units with respect to emission levels through fuel sampling and other estimation methods. Capital expenditures of approximately $11.0 million are estimated for continuous emission monitoring systems at the other fossil-fueled units. The authority to impose permit fees has been delegated to the states by EPA and, depending on the extent of the state program and the fees imposed by each state regulatory authority, permit fees for the System could range from $1.6 to $5.0 million annually. There are several other areas, such as air toxins and visibility, that will require regulatory study and rule promulgation to determine whether pollution control equipment is necessary. Regarding sulfur dioxide emissions, the Act provides "allowances" to most Entergy units based upon past emission levels and operating characteristics. Each unit of allowance is an entitlement to emit one ton of sulfur dioxide per year. Under the Act, utilities will be required to possess allowances for sulfur dioxide emissions from affected units. Based on Entergy's past operating history, it is considered a "clean" utility and as such will receive more allowances than are currently necessary for normal operations. The System believes that it will be able to operate its units efficiently without installing scrubbers or purchasing allowances from outside sources, and the System may have excess allowances available for sale to other utilities. Entergy currently estimates that total capital costs of approximately $39.4 million could be required to comply with the Act. These estimated costs for each legal entity are as follows: Nitrogen Continuous Company Oxide Emissions Control Monitors Total ---------------------- -------- ---------- ----- (In Thousands) AP&L $ 7,275 $ 3,300 $10,575 GSU 16,000 4,900 20,900 LP&L - 2,300 2,300 MP&L 2,500 1,500 4,000 NOPSI - - - System Energy - - - Entergy Power 1,575 - 1,575 ------- ------- ------- Total Entergy System $27,350 $12,000 $39,350 ======= ======= ======= Other Environmental Matters. The provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (Superfund), among other things, authorize the EPA and, indirectly, the states to require the generators and certain transporters of certain hazardous substances released from or at a site, and the owners or operators of such site, to clean up the site or reimburse the costs therefor. This statute has been interpreted to impose joint and several liability on responsible parties. In compliance with applicable laws and regulations at the time, the System operating companies have sent waste materials to various disposal sites over the years. Also, past operating procedures and maintenance practices, which were not subject to regulation at that time, are now regulated by various environmental laws. Some of these sites have been the subject of governmental action, thereby causing one or more of the System operating companies to be involved with site cleanup activities. The System operating companies have participated to various degrees in accordance with their potential liability with these site cleanups and have, therefore, developed experience with cleanup costs. Their experience in these matters, and their judgments related thereto, are utilized by them in evaluating these sites. In addition, the System operating companies have established reserves for environmental clean-up/restoration activities. AP&L. AP&L has received notices from time to time between 1989 and 1993, from the EPA, the Arkansas Department of Pollution Control and Ecology (ADPC&E), and others that it (among numerous others, including various utilities, municipalities and other governmental units, and major corporations) may be a PRP for cleanup costs associated with various sites in Arkansas. Most of these sites are neither owned nor operated by any System company. Contaminants at the sites include principally polychlorinated biphenyls (PCB's), lead, and other hazardous wastes. These sites and others are described below. AP&L received notices from the EPA and ADPC&E in 1990 and 1991, identifying it as one of 30 PRP's (along with LP&L and GSU) at two Saline County sites in Arkansas. Both sites are believed to be contaminated with PCB's and lead. Cleanup costs for both sites are estimated at $6.0 million, with AP&L's total share of the costs being estimated at approximately $2.0 million. AP&L to date has expended approximately $1.0 million for remediation at one of these sites. The total liability cannot be precisely determined until remediation is complete at both sites. AP&L believes its potential liability for these sites will not be material. Reynolds Metals Company (RMC) and AP&L notified the EPA in 1989, of possible PCB contamination at two former RMC plant sites in Arkansas to which AP&L had supplied power. AP&L completed remediation at the substations serving the plant sites at a cost of $1.7 million. Additional PCB contamination was found in a portion of a drainage ditch that flows from the RMC's Patterson facility to the Ouachita River. RMC has demanded that AP&L participate in the remediation efforts with respect to the ditch. AP&L and independent contractors engaged by AP&L conducted an investigation of the ditch contamination and the potential migration of PCB's from the electrical equipment that AP&L maintained at the plant. The investigation concluded that little, if any, of the contamination was caused by AP&L. AP&L's expenditures thus far on the ditch have been approximately $150,000. It is AP&L's understanding that RMC has spent approximately $10.0 million to complete remediation of the ditch contamination. AP&L has not received a notice from the EPA that it may be a PRP with respect to remediation costs for this site. However, RMC is seeking reimbursement of $5.0 million (50% of expenditures) from AP&L. AP&L continues to deny responsibility for any of such remediation costs and believes that its potential liability, if any, for this site will not be material. AP&L entered into a Consent Administrative Order dated February 21, 1991, with the ADPC&E that named AP&L as a PRP for cleanup of contamination associated with the Utilities Services, Inc. state Superfund site located near Rison, Arkansas. Such site was found to have soil contaminated by PCB's and pentachlorophenol (a wood preservative chemical). Also, containers and drums that contained PCB's and other hazardous substances were found at the site. AP&L's share of total remediation costs are estimated to range between $3.0 million and $5.0 million. AP&L is attempting to identify and notify other PRP's. AP&L has received assurances from the ADPC&E that it will use its enforcement authority to allocate remediation expenses among AP&L and any other PRP's that can be identified (approximately 30 - 35 have been identified to date). AP&L has performed the activities necessary to stabilize the site, which to date has cost approximately $114,000. AP&L believes that its potential liability for this site will not be material. AP&L received Notice of Potential Liability and a Demand for Payment in November 1992 from the EPA in conjunction with a contaminated site in Union County, Arkansas. AP&L was identified as one of eleven PRP's, which also include LP&L. The EPA has already completed cleanup of the site. An agreement has been negotiated with the EPA which determined AP&L to be a de minimis party with total liability of approximately $47,000. As a result of an internal investigation, AP&L has discovered soil contamination at two AP&L-owned sites located in Blytheville, Arkansas and Pine Bluff, Arkansas. The contamination appears to be a result of past operating procedures that were performed prior to any applicable environmental regulation. AP&L is still investigating these sites to determine the full extent of the contamination. Until the investigations are complete, AP&L cannot estimate the liabilities associated with these sites. However, AP&L believes its potential liability for both of the sites should not be material. For all of these sites and for certain sites in which remediation has been completed, AP&L has expended approximately $3.2 million for cleanup costs since 1989. GSU. GSU has been notified by the EPA that it has been designated as a PRP for the cleanup of sites on which GSU and others have, or have been alleged to have, disposed of hazardous materials. GSU is currently negotiating with the EPA and various state authorities regarding the cleanup of some of these sites. Several class action and other suits have been filed seeking relief from GSU and others for damages caused by the disposal of hazardous waste and for asbestos-related disease that allegedly occurred from exposure on GSU premises or on premises on which GSU allegedly disposed of materials (see "Other Regulation and Litigation - GSU," below). While the amounts at issue in the cleanup efforts and suits may be very substantial sums, management believes that its financial condition and results of operations will not be materially affected by the outcome of the suits. These environmental liabilities are described below. In 1971, GSU purchased certain property near its Sabine generating station for possible cooling water capability expansion. Although it was not known to GSU at the time of the purchase, the property was utilized by area industries in the 1950's and 1960's as an industrial waste dump. GSU sold the property in 1984. In October 1984 the abandoned waste site on the property was included on the Superfund National Priorities List (NPL) by the EPA. The EPA has indicated that it believes GSU to be a PRP for cleanup of the site based on its past ownership. GSU has advised the EPA that it does not believe that it has such responsibility. GSU has pursued negotiations with the EPA and is a member of a task force made up of other PRP's for the voluntary cleanup of the waste site. A Consent Decree has been signed by all parties. Because additional wastes have been discovered at the site since the original cleanup costs were estimated, the total costs for the voluntary cleanup are unknown. However, it is estimated that cleanup will exceed $15.0 million. GSU has negotiated a responsible share of 2.26% of the estimated cleanup cost. Federal and state agencies are presently examining potential liabilities associated with natural resource damages. This matter is currently under negotiation with the other PRP's and the agencies. Remediation of the site is expected to be completed in 1996. In March 1993, GSU completed its cleanup activities at a site in Houston, Texas, which is included in the NPL. On September 20, 1993, GSU received formal notification from the EPA of its acceptance of the remedial activities conducted at the site. Currently, other parties are conducting cleanup activities at the site. However, these cleanup activities are unrelated to GSU's involvement at the site. Through 1993, GSU incurred cleanup costs of approximately $3.3 million. Pursuant to the Consent Decree, GSU is responsible for oversight costs incurred by the EPA. GSU has not received a reimbursement request for outstanding oversight costs, but anticipates these costs may total between $250,000 and $500,000. GSU is pursuing contribution for the cleanup costs at the site from other parties believed to be potentially responsible. GSU is currently involved in a multi-phased remedial investigation of an abandoned manufactured gas plant (MGP) site located in Lake Charles, Louisiana. The property was the site of an MGP that is believed to have operated during the period from approximately 1916 to 1931. Coal tar, a by-product of the distillation process, was apparently routed to a portion of the property for disposal. Since GSU purchased the property in 1926, the same area has been filled with soil and used as a landfill for miscellaneous items including electrical poles, electrical equipment, and other debris. Under an Order by the Louisiana Department of Environmental Quality (LDEQ), which is currently stayed, GSU was required to investigate and, if necessary, take remedial action at the site. The EPA has notified GSU that it is performing an independent review and ranking of the site to determine whether the site should be listed on the NPL. Another PRP has been identified and is believed to have had a role in the ownership and operation of the MGP. Negotiations with that company for joint participation and any remedial action are expected to continue. GSU currently is awaiting notification from the EPA before initiating additional cleanup negotiations or actions. While studies to determine the location of the coal tar have been conducted, the cleanup costs of the site are unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU has also been advised that it has been named as a PRP, along with a number of other companies (including LP&L), for an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, which is included on the NPL. Although significant remediation has been completed, additional studies are expected to continue in 1994. GSU and LP&L have been named as defendants in a class action lawsuit lodged against a group of PRP's associated with the site. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - GSU," below.) GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU received notification in 1992 from the EPA of potential liability at a site located in Iota, Louisiana. This site accepted a variety of wastes, including medical and chemical wastes. In addition to GSU, over 200 parties have been named as PRP's. The EPA is continuing its investigation of the site and has notified the PRP's of the possibility of this site being linked to another site. To date, GSU has not received notification of liability with regard to the other site. GSU does not presently believe its ultimate responsibility with respect to this site will be material. GSU has also been notified by the EPA of potential liability at two sites located in Saline County, Arkansas. It is believed that both sites served as a salvaging facility for transformers and batteries. In addition to GSU, 32 other parties (including AP&L and LP&L) have been named as PRP's. At this time, GSU's involvement with the site is unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. In November 1993, GSU received informal notification from the Rhode Island Department of Environmental Management regarding a site at which electrical capacitors had been located. The State traced several of these capacitors to GSU. GSU records indicate these capacitors were returned under warranty to the manufacturer in the 1960's due to defects. GSU does not presently believe it is responsible for any alleged activities occurring at this site. As of December 31, 1993, GSU had expended $7.0 million toward the cleanup of such sites. In 1990, GSU received an order from the LDEQ to reduce emissions of nitrogen oxides and reactive hydrocarbons at its Willow Glen and Louisiana Station plants located near Baton Rouge, Louisiana. GSU has requested an adjudicatory hearing on the matter, which the LDEQ secretary has deemed as staying the order. In the interim, GSU has joined several other Baton Rouge industries to develop and submit to LDEQ a comprehensive set of short- and long-range reduction plans. In 1993, LDEQ adopted regulations requiring permanent reductions in nitrogen oxides emissions at Willow Glen and Louisiana Station and is considering requirements for further reductions. The estimates for actions necessary to comply with these regulations are included in the discussion under "Clean Air Legislation," above. GSU believes these regulations implement the intent of the 1990 order, and actions beyond those required by the regulations will not be required. LP&L and NOPSI. LP&L and NOPSI have received notices from time to time between 1986 and 1993 from the EPA and/or the states of Louisiana and Mississippi that each or either of the companies may be a PRP for cleanup costs associated with disposal sites that are currently in various stages of remediation in Arkansas, Illinois, Louisiana, Mississippi, and Missouri that are neither owned nor operated by any System company. As to one Missouri site, LP&L's and NOPSI's aggregate liability is currently estimated not to exceed $558,000, and because of the type and the large number of PRP's (over 700, including many large utilities and national and international corporations), LP&L and NOPSI do not expect liabilities in excess of this amount. For the other Missouri site, LP&L and the other 64 PRP's (including several large, creditworthy utility companies) have received an EPA demand to pay approximately $1.2 million expended by the EPA. In June of 1993, LP&L paid $12,392 in full payment of its share of the cleanup costs. LP&L considers cleanup at this site to be complete. As to the two Saline County, Arkansas sites (involving AP&L, GSU, and LP&L), LP&L has been advised that current estimates for total cleanup are approximately $6.0 million. LP&L believes that, because of the number and nature of the PRP's, its exposure for these sites will not be material. Initial indications are that LP&L was involved in the Saline sites, but LP&L believes that because of the limited scope of its involvement and the number and nature of PRP's, its exposure for these sites will not be material. LP&L received notice from the EPA in November 1992, that it (along with AP&L) was involved in the Union County, Arkansas site. An agreement has been negotiated with the EPA that determined LP&L to be a de minimis party with a total liability of approximately $47,000 (see "AP&L," above.) As to the Mississippi site, LP&L (along with System Energy) understands that EPA has expended approximately $740,000 for this site (three separate locations being treated administratively as one). The State of Mississippi has indicated it intends to have PRP's conduct a cleanup of the site but has not yet taken formal action. LP&L has expended $22,300 to settle with the EPA for its costs for this site and, because there are 44 PRP's for this site (including a number of major oil companies), does not expect its share of future costs to be material. For a Livingston Parish, Louisiana site (involving at least 70 PRP's, including GSU and many other large and creditworthy corporations), LP&L has found in its records no evidence of its involvement. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - LP&L," below.) At a second Louisiana site (also included on the NPL and involving 57 PRP's, including a number of major corporations), NOPSI believes it has no liability for the site because the material it sent to the site was not a hazardous substance. For the Illinois site, NOPSI, upon its review of the site documentation and of its own records, has asserted to the EPA that it has no involvement in this site. However, NOPSI is participating with other PRP's (including many large and creditworthy corporations) as a prudent means of resolving potential liability, if any. For all these sites, LP&L has expended approximately $349,000 and NOPSI has expended approximately $172,000 for cleanup costs (commencing in 1986) to date. During 1993, LP&L performed preliminary site assessments at the locations of two retired power plants previously owned and operated by two Louisiana municipalities. LP&L had purchased the power plants by agreement (as part of the municipal electric systems) after operating them for the last few years of their useful lives. The assessments indicated some subsurface contamination from fuel oil. LP&L and the LDEQ are now reviewing site remediation procedures that LP&L estimates will not exceed $650,000 in the aggregate. During 1993, the LDEQ issued new rules for solid waste regulation, including waste water impoundments. LP&L has determined that certain of its power plant waste water impoundments are affected by these regulations and has chosen to close them rather than retrofit and permit them. The aggregate cost of the impoundment closures, to be completed by 1996, is estimated to be $7.3 million. System Energy. In February 1990, System Energy received an EPA notice that it (among numerous other companies) may be a PRP for cleanup costs associated with the same site in Mississippi in which LP&L is involved. Potential liability is based on the alleged shipment of waste oil to the site from 1981 to 1985. System Energy does not expect its share of the total expenditures to be material because there are 44 PRP's for this site, including a number of major oil companies. Other Regulation and Litigation Entergy Corporation and GSU. In July and August 1992, Entergy Corporation and GSU filed applications with FERC, the LPSC, and the PUCT, and Entergy Corporation, Entergy Operations, and Entergy Services filed an application with the SEC under the Holding Company Act, seeking authorization of various aspects of the Merger. In January 1993, GSU filed two applications with the NRC seeking approval of the change in ownership of GSU and an amendment to the operating license for River Bend to reflect its operation by Entergy Operations. All regulatory approvals were obtained in 1993 and the Merger was consummated on December 31, 1993 (see "Business of Entergy - Entergy Corporation-GSU Merger," above, for further information). Requests for rehearing of certain aspects of the FERC order were filed on January 14, 1994, by 14 parties, including Entergy Corporation, the APSC, the Mississippi Attorney General, the LPSC, the MPSC, the Texas Office of Public Utility Counsel, and the PUCT. Entergy Corporation, the LPSC, the Texas Office of Public Utility Counsel, and the PUCT are requesting FERC to restore a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under a tracking mechanism designed to protect the other companies from certain unexpected increases in fuel costs. The other parties are seeking to overturn FERC's decision on various grounds. Requests for rehearing of the SEC order were filed with the SEC by Houston Industries Incorporated and Houston Lighting & Power Company on December 28, 1993, and petitions for review seeking to set aside the SEC order were filed with the D.C. Circuit by these parties on February 15, 1994 and by Cajun on February 14, 1994. See "Nuclear Operations - River Bend," above for information on challenges to the NRC's approval of GSU's applications. Appeals seeking to set aside the LPSC order related to the Merger were filed in the 19th Judicial District Court for the Parish of East Baton Rouge, Louisiana, by Houston Lighting & Power Company on August 13, 1993, and by the Alliance for Affordable Energy, Inc. on August 20, 1993. Subsequently, on February 9, 1994, Houston Lighting & Power Company filed a motion voluntarily dismissing its appeal. AP&L. Three lawsuits (which have been consolidated) were filed in the Arkansas District Court by numerous plaintiffs against AP&L and Entergy Services in connection with the operation of two dams during a period of heavy rainfall and flooding in May 1990. The consolidated lawsuits sought approximately $14.4 million in property losses and other compensatory damages, and $500 million in punitive damages. In their responses to these complaints, AP&L and Entergy Services asserted, among other things, that AP&L owns flowage easements giving it the permanent right to inundate the lands owned or occupied by the plaintiffs in connection with the operation of the dams. In June 1991, the Arkansas District Court granted summary judgment to AP&L with respect to the enforceability of its flowage easements. In November 1991, the Arkansas District Court ruled that Entergy Services was entitled to the benefit of AP&L's flowage easements, in effect, removing from consideration damages in the approximate amount of $13.5 million alleged to have occurred within the areas covered by the easements. As a result, over 300 plaintiffs claiming damage within the easements were dismissed from the consolidated case in December 1991. Certain plaintiffs appealed these orders to the Eighth Circuit, which appeal was denied in March 1992. Following the Eighth Circuit's denial of their interlocutory appeal from the Arkansas District Court's orders, certain of the plaintiffs, without prejudice to their right to refile, voluntarily dismissed their claims which had not been disposed of in the Arkansas District Court's orders, thus making the orders a final adjudication, and appealed these orders to the Eighth Circuit. The remaining plaintiffs obtained a stay and an administrative termination of their claims, pending the outcome of the appeal. In December 1993, a three-judge panel of the Eighth Circuit filed its opinion affirming the judgment of the Arkansas District Court and entered judgment accordingly. The plaintiffs appealing the Arkansas District Court's orders filed petitions with the Eighth Circuit for a rehearing by the entire Court sitting en banc, which petitions were denied. The plaintiffs may petition the U.S. Supreme Court to issue a writ of certiorari to permit its review of the Eighth Circuit's decisions. Neither AP&L nor Entergy Services can predict whether the U.S. Supreme Court will grant such a petition, if one is filed. GSU. Between 1986 and 1993, GSU and approximately 70 other defendants, including many national and international corporations, including LP&L, have been sued in 17 suits in the Livingston Parish, Louisiana District Court (State District Court) by a number of plaintiffs who allegedly suffered damage or injury, or are survivors of persons who allegedly died, as a result of exposure to "hazardous toxic waste" that emanated from a site in Livingston Parish. The plaintiffs alleged that the defendants generated, transported, or participated in the storage of such wastes at the facility, which was previously operated as a waste oil recycling facility. These State District Court suits, which seek damages in total amounts ranging from $1.0 million to $10.0 billion and are now consolidated in a class action, and three federal suits in three states other than Louisiana involving issues arising from the same facility, have been removed and transferred, respectively, to the U.S. District Court for the Middle District of Louisiana (Federal District Court). Motions to remand the class action to the State District Court have been filed, and procedural issues regarding the federal suits are being considered as well. It is not known what effect any action taken on these motions and issues, whenever taken by the Federal District Court, would have on the April 11, 1994 State District Court trial date that was established before the suits were removed to Federal District Court; but it is unlikely such trial date will be met. The matter is pending. In October 1989, an amended lawsuit petition was filed on behalf of 985 plaintiffs in the District Court of Jefferson County, Texas, 60th Judicial District in Beaumont, Texas, naming 55 defendants including GSU. In February 1990, another amended lawsuit petition was filed in a different state District Court in Jefferson County, Texas, on behalf of over 200 plaintiffs (subsequently amended to include a total of 660) naming 127 defendants including GSU. Possibly 300 to 400 or more of the plaintiffs in Texas may have worked at GSU's premises. At least five other individual suits have been filed in Beaumont against GSU and others, seeking damages for alleged asbestos exposure. All of the plaintiffs in such suits are also suing GSU and all other defendants on a conspiracy count. There are 25 asbestos- related law suits filed in the 14th Judicial District Court of Calcasieu Parish in Lake Charles, Louisiana, on behalf of an aggregate of 53 plaintiffs naming from 16 to 24 defendants including GSU, and GSU is aware of as many as 61 additional cases that may be filed. The suits allege that each plaintiff contracted an asbestos-related disease from exposure to asbestos insulation products on the premises of such defendants. Management believes that GSU has meritorious defenses, but there can be no assurance as to the outcome of these cases or that additional claims may not be asserted. In asbestos- related suits against the manufacturers, very substantial recoveries have been achieved by large groups of claimants. GSU does not presently believe that the ultimate resolution of these cases will materially adversely affect the financial position of GSU. On February 3, 1984, Dow Chemical Company filed a request with the LPSC for a hearing to consider issues related to the purchase of cogenerated power by GSU. Other industries subsequently filed similar requests and the matters were consolidated. In November 1984, the LPSC completed hearings on rules, policies, and pricing methodologies applicable to cogeneration. Key issues were whether or not (1) GSU should be required to pay the industries for avoided capacity costs, and (2) GSU should be required to wheel power to or from the industrial plants. While the matter is still pending before the LPSC, the LPSC did set interim rates, subject to refund by either Dow or GSU, which exclude capacity costs. GSU has significant business relationships with Cajun, primarily co-ownership of River Bend and Big Cajun 2 Unit 3. GSU and Cajun own 70% and 30% of River Bend, respectively, while Big Cajun 2 Unit 3 is owned 42% and 58% by GSU and Cajun, respectively. GSU operates River Bend and Cajun operates Big Cajun 2 Unit 3. GSU was requested by Cajun and Jefferson Davis Electric Cooperative, Inc., (Jefferson Davis) to provide transmission of power over GSU's system for delivery to the Industrial Road area near Lake Charles, Louisiana. GSU provides electric service to industrial and other customers in such area, and Cajun and Jefferson Davis do not. On October 10, 1989, Cajun filed a complaint at FERC contending that GSU wrongfully refused to provide Cajun certain transmission services so that its member, Jefferson Davis, could provide service to certain industrial customers, and it requested FERC to order GSU to provide the service. On October 26, 1989, FERC summarily dismissed Cajun's complaint, but the D.C. Circuit reversed FERC's summary determination and remanded the case to FERC for a hearing. On June 24, 1992, after a hearing, an ALJ issued an Initial Decision, again dismissing Cajun's complaint. The ALJ found that the parties' contract did not require GSU to provide the service and that Cajun's member, Jefferson Davis, had not sought permission from the LPSC to serve the end-use customers in question. If Jefferson Davis secured permission from the LPSC, the ALJ believed (but did not decide) that FERC would require GSU to provide the requested transmission service. Both Cajun and GSU have filed exceptions to the ALJ's decision, and the matter is pending before FERC. Cajun and Jefferson Davis also brought a related action in federal court in the Western District of Louisiana alleging that GSU breached its obligations under the parties' contract and violated the antitrust laws by refusing to provide the transmission service described above. Cajun and Jefferson Davis seek an injunction requiring GSU to provide the requested service and unspecified treble damages for GSU's refusal to provide the service. On November 9, 1989, the district court judge denied Cajun's and Jefferson Davis' motion for a preliminary injunction. On May 3, 1991, the judge stayed the proceeding pending final resolution of the matters still pending before FERC. GSU and Cajun are parties to FERC proceedings regarding certain long-standing disputes relating to transmission service charges. Cajun asserts that GSU has improperly applied the terms of a rate schedule, Service Schedule CTOC, to its billings to Cajun and it seeks an order from FERC directing GSU to recompute the bills. GSU asserts that Cajun underpaid its bills, and it seeks an order directing Cajun to pay surcharges to make up the underpayments. On April 10, 1992, FERC issued an order affirming in part and reversing in part an ALJ's recommendations. Both GSU and Cajun have requested rehearing, and the requests are still pending. In addition, on August 25, 1993, the United States Court of Appeals for the Fifth Circuit reversed portions of FERC's order previously decided adversely to GSU, and remanded the case to FERC for further proceedings. On January 13, 1994, FERC rejected GSU's proposal to collect an interim surcharge while FERC considers the court's remand. GSU interprets FERC's 1992 order and the Court of Appeals decision to mean that Cajun owes GSU approximately $85 million through December 31, 1993. If GSU also prevails on all of the issues raised in its pending request for rehearing of FERC's earlier orders, then GSU estimates that Cajun would owe GSU approximately $118 million through December 31, 1993. If GSU does not prevail on its rehearing request, and Cajun prevails on its rehearing request, and if FERC rejects the modifications GSU interprets the court of appeals to have directed, then GSU would owe Cajun an estimated $76 million through December 31, 1993. Pending FERC's ruling on the May 1992 motions for rehearing, GSU has continued to bill Cajun utilizing the historical billing methodology and has booked underpaid transmission charges, including interest, in the amount of $140.8 million as of December 31, 1993. This amount is reflected in long-term receivables and in other deferred credits, with no effect on net income. On December 7, 1993, Cajun filed a complaint in the Middle District of Louisiana alleging that GSU failed to provide Cajun an opportunity to construct certain facilities that allegedly would have reduced its rates under Service Schedule CTOC, and Cajun seeks an order compelling the conveyance of certain facilities and unspecified damages. GSU has moved to dismiss the complaint on the basis, among others, that FERC has already addressed the matter in the proceedings described above. In May 1990, GSU received a subpoena from the Office of Inspector General - Investigations, United States Department of Agriculture, seeking production of documents relating to the construction costs of River Bend. Such office is authorized to investigate matters relating to programs of the Department of Agriculture. GSU has been sued by Cajun with respect to its participation in River Bend with funds made available through Department programs administered by the REA. GSU has failed in its efforts to have the REA made a party to the Cajun litigation. GSU does not know the purpose of such Office's investigation, but presently assumes that it relates to the Cajun civil litigation since the production of documents sought by such Office is similar to that sought by Cajun in its action against GSU. However, there can be no assurance given by GSU as to the real purpose of such Office's investigation. Among other areas of responsibility, such office is authorized to investigate possible violations of law. GSU believes the subpoena proceeding has been administratively dismissed without prejudice to the parties. On December 2, 1991, Cajun filed a complaint seeking declaratory and injunctive relief from the U. S. District Court for the Middle District of Louisiana. The complaint concerns GSU's position that Cajun is in default with respect to paying its share of certain expenditures to repair corrosion damage in the service water system, to repair a feedwater nozzle crack, and to repair a turbine rotor. Cajun alleges that it has no obligation to pay its share of such costs and seeks a declaration that it may elect not to participate in the funding of such costs and enjoining GSU from demanding payment therefor or attempting to implement default provisions in the Operating Agreement with respect thereto. Cajun alleges that if it is required to pay its share of such costs it would be forced to default on other obligations and would be forced to seek relief in bankruptcy. GSU believes that Cajun is in default under the provisions of the Operating Agreement. No assurance can be given as to the outcome or timing of this action brought by Cajun. On November 25, 1992, Dixie Electric Membership Corporation and Southwest Louisiana Electric Membership Corporation, both members of Cajun, filed suit in the U.S. District Court for the Western District of Louisiana seeking a declaration that the River Bend Joint Ownership Agreement between GSU and Cajun is void because an allegedly required approval of the LPSC was not obtained. This suit has been transferred from the Western District to the Middle District, and is being processed in conjunction with the suit described in the following paragraph. GSU believes the suit is without merit. In June 1989, Cajun filed a civil action against GSU in the U. S. District Court for the Middle District of Louisiana. Cajun stated in its complaint that the object of the suit is to annul, rescind, terminate, and/or dissolve the Joint Ownership Participation and Operating Agreement entered into on August 28, 1979 (Operating Agreement), related to River Bend. Cajun alleges fraud and error by GSU, breach of its fiduciary duties owed to Cajun, and/or GSU's repudiation, renunciation, abandonment, or dissolution of its core obligations under the Operating Agreement, as well as the lack or failure of cause and/or consideration for Cajun's performance under the Operating Agreement. The suit seeks to recover Cajun's alleged $1.6 billion investment in the unit as damages, plus attorneys' fees, interest, and costs. In March 1992, the district court appointed a mediator to engage in settlement discussions and to schedule settlement conferences between the parties. Discussions with the mediator began in July 1992, however, GSU cannot predict what effect, if any, such discussions will have on the timing or outcome of the case. A trial without a jury is set for April 12, 1994, on the portion of the suit by Cajun to rescind the Operating Agreement. GSU believes the suits are without merit and is contesting them vigorously. No assurance can be given as to the outcome of this litigation. If GSU were ultimately unsuccessful in this litigation and were required to make substantial payments, GSU would probably be unable to make such payments and would probably have to seek relief from its creditors under the Bankruptcy Code. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquisition contingencies, including a charge resulting from an adverse resolution of the litigation with Cajun related to River Bend. In July 1992, Cajun notified GSU that it would fund a limited amount of costs related to the fourth refueling outage at River Bend, completed in September 1992. Cajun has also not funded its share of the costs associated with certain additional repairs and improvements at River Bend completed during the refueling outage. GSU has paid the costs associated with such repairs and improvements without waiving any rights against Cajun. GSU believes that Cajun is obligated to pay its share of such costs under the terms of the applicable contract. Cajun has filed a suit seeking a declaration that it does not owe such funds and seeking injunctive relief against GSU. GSU is contesting such suit and is reviewing its available legal remedies. In September 1992, GSU received a letter from Cajun alleging that the operating and maintenance costs for River Bend are "far in excess of industry averages" and that "it would be imprudent for Cajun to fund these excessive costs." Cajun further stated that until it is satisfied it would fund a maximum of $700,000 per week under protest for the remainder of 1992. In a December 1992 letter, Cajun stated that it would also withhold costs associated with certain additional repairs, of which the majority will be incurred during the next refueling outage, currently scheduled for April 1994. GSU believes that Cajun's allegations are without merit and is considering its legal and other remedies available with respect to the underpayments by Cajun. The total resulting from Cajun's failure to fund repair projects, Cajun's funding limitation on the fourth refueling outage, and the weekly funding limitation by Cajun was $33.3 million as of December 31, 1993, compared with a $28.4 million unfunded balance as of December 31, 1992. During 1994, and for the next several years, it is expected that Cajun's share of River Bend-related costs will be in the range of $60 million to $70 million per year. Cajun's weak financial condition could have a material adverse effect on GSU, including a possible NRC action with respect to the operation of River Bend and a need to bear additional costs associated with the co-owned facilities. If GSU were required to fund Cajun's share of costs, there can be no assurance that such payments could be recovered. Cajun's weak financial condition could also affect the ultimate collectibility of amounts owed to GSU. Since 1986, GSU had been in litigation with the Southern Company regarding unit power and long-term power purchase contracts with the Southern Company. GSU entered into a settlement agreement dated December 21, 1990, which was consummated on November 7, 1991, and the settlement obligations were fully satisfied in 1993. In 1986, the PUCT and the LPSC disallowed the pass-through by GSU in its retail rates of the costs of the capacity purchases from the Southern Company, which were being incurred by GSU. GSU appealed the actions of the PUCT and the LPSC disallowing pass-through of Southern Company capacity charges to the appropriate state courts. The appeal from the LPSC is pending. As part of a settlement of a retail rate case in Texas during the fourth quarter of 1993, GSU has discontinued its appeal of the PUCT disallowance. Following the announcement of the execution of the Reorganization Agreement, a purported class action complaint was filed on June 9, 1992, in the District Court 60th Judicial District in Jefferson County, Texas (District Court) against GSU and its directors relating to the then proposed business combination with Entergy Corporation. On June 11, 1992, two additional purported class action complaints were filed against such defendants in the District Court. All three of the complaints (the Shareholder Actions) were filed by persons alleged to be shareholders of GSU and seeking declaration of a class action on behalf of all persons owning common stock of GSU. GSU has executed a Memorandum of Understanding with counsel for the plaintiffs in these suits agreeing in principle to settle such actions subject to execution of an appropriate stipulation of settlement, approval by the court, and certain other conditions. In the Memorandum, the defendants have denied any actionable acts or omissions and state that they have entered into the Memorandum solely to eliminate the burden and expense of further litigation and to facilitate the consummation of the business combination. The Memorandum memorialized certain agreements by GSU and Entergy Corporation for the benefit of shareholders principally in the event the business combination were not consummated, including a covenant to consider reinstitution of dividends on the common stock of GSU in such event. The business combination was consummated on December 31, 1993. Incident to the settlement, the defendants agreed not to oppose an application for attorneys' fees by plaintiffs' counsel that do not exceed $500,000 or for an award of expenses not to exceed $50,000. The individual directors named as defendants in these complaints are entitled to indemnification pursuant to GSU's Restated Articles of Incorporation, By-laws, and individual indemnity agreements, provided that the terms and conditions of the indemnities are satisfied. LP&L. For information regarding litigation in connection with an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, in which LP&L and GSU are defendants, see "GSU," above. LP&L does not believe that it was a generator of any material delivered to this facility and is defending vigorously against the claims in these suits. Since the mid-1980's, LP&L and the tax authorities of St. Charles Parish, Louisiana (Parish), in which Parish Waterford 3 is located, have disputed use taxes paid on nuclear fuel ($4.9 million through 1989) under protest by LP&L. LP&L has been successful in a lawsuit in the Parish with regard to recovering these taxes, plus interest, and also with regard to Parish lease tax issues pertaining to fuel financing arrangements. On the grounds of the previous favorable court decisions, LP&L continues to challenge in the courts additional use tax assessments that it has paid to the Parish and to seek additional interest that LP&L claims it is due. Also, in early procedural stages are (1) suits by LP&L with regard to the state use tax on nuclear fuel, and (2) LP&L's defense (and indemnification, if necessary) of nuclear fuel lessors under LP&L's fuel financing arrangements in the suits filed by the Parish use tax authorities claiming approximately $64.0 million in lease and use taxes. These matters are pending. System Energy. In connection with an IRS audit of Entergy's 1988, 1989, and 1990 consolidated federal income tax returns, the IRS is proposing that adjustments be made to the Grand Gulf 2 abandonment loss deduction claimed on Entergy's 1989 consolidated federal income tax return. If any such adjustments are necessary, the effect on System Energy's net income should be immaterial. Entergy intends to contest the proposed adjustments if finalized by the IRS. The outcome of such proceedings cannot be predicted at this time. EARNINGS RATIOS OF SYSTEM OPERATING COMPANIES AND SYSTEM ENERGY The System operating companies and System Energy have calculated ratios of earnings to fixed charges and ratios of earnings to fixed charges and preferred dividends pursuant to Item 503 of Regulation S-K of the SEC as follows: ____________________ (a) "Earnings" as defined by SEC Regulation S-K represent the aggregate of (1) net income, (2) taxes based on income, (3) investment tax credit adjustments-net, and (4) fixed charges. "Fixed Charges" include interest (whether expensed or capitalized), related amortization, and interest applicable to rentals charged to operating expenses. (b) "Preferred Dividends" as defined by SEC Regulation S-K are computed by dividing the preferred dividend requirement by one hundred percent (100%) minus the income tax rate. (c) System Energy's Amended and Restated Articles of Incorporation do not currently provide for the issuance of preferred stock. (d) "Preferred Dividends" in the case of GSU also include dividends on preference stock. (e) Earnings for the year ended December 31, 1989, include the impact of the write-off of $60 million of deferred Grand Gulf 1-related costs pursuant to an agreement between MP&L and the MPSC. (f) Earnings for the year ended December 31, 1989, were inadequate to cover fixed charges due to System Energy's cancellation and write- off of its investment in Grand Gulf 2 in September 1989. The amount of the coverage deficiency for fixed charges was $745.2 million. (g) Earnings for the year ended December 31, 1991, include the $90 million effect of the 1991 NOPSI Settlement. (h) Earnings for the year ended December 31, 1993, include approximately $81 million, $52 million, and $18 million for AP&L, MP&L, and NOPSI, respectively, related to the change in accounting principle to provide for the accrual of estimated unbilled revenues. (i) Earnings for the year ended December 31, 1990, for GSU were not adequate to cover fixed charges by $60.6 million. Earnings for the years ended December 31, 1990 and 1989, were not adequate to cover fixed charges and preferred dividends by $165.1 million and $190.8 million, respectively. Earnings in 1990 include a $205 million charge for the settlement of a purchased power dispute. INDUSTRY SEGMENTS NOPSI Narrative Description of NOPSI Industry Segments Electric Service. NOPSI supplied electric service to 190,613 customers as of December 31, 1993. During 1993, 36% of electric operating revenues was derived from residential sales, 40% from commercial sales, 6% from industrial sales, 15% from sales to governmental and municipal customers, and 3% from sales to public utilities and other sources. Natural Gas Service. NOPSI supplied natural gas service to 154,251 customers as of December 31, 1993. During 1993, 56% of gas operating revenues was derived from residential sales, 18% from commercial sales, 9% from industrial sales, and 17% from sales to governmental and municipal customers. (See "Fuel Supply - Natural Gas Purchased for Resale," incorporated herein by reference.) Selected Financial Information Relating to Industry Segments For selected financial information relating to NOPSI's industry segments, see NOPSI's financial statements and Note 11 of NOPSI's Notes to Financial Statements, "Business Segment Information," incorporated herein by reference. Employees by Segment NOPSI's full-time employees by industry segment as of December 31, 1993, were as follows: Electric 568 Natural Gas 148 --- Total 716 (For further information with respect to NOPSI's segments, see "Property.") GSU For the year ended December 31, 1993, 96% of GSU's operating revenues were derived from the electric utility business. The remainder of operating revenues were derived 2% from the steam business and 2% from the natural gas business. Segment information for GSU is not provided. PROPERTY Generating Stations The total capability of Entergy 's owned and leased generating stations as of December 31, 1993, by company, is indicated below: _______________________ (1) "Owned and Leased Capability" is the dependable load carrying capability of the stations, as demonstrated under actual operating conditions based on the primary fuel (assuming no curtailments) that each station was designed to utilize. (2) Excludes the capacity of fossil-fueled generating stations placed on extended reserve as follows: AP&L - 506 MW; GSU - 405 MW; LP&L - 19 MW; MP&L - 73 MW; and NOPSI - 143 MW. Generating stations that are not expected to be utilized in the near-term to meet load requirements are placed in extended reserve shutdown in order to minimize operating expenses. (3) Excludes net capability of Entergy Power, which owns 809 MW of fossil-fueled capacity (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," above). (4) Independence 2, a coal unit operated by AP&L and jointly owned 25% by MP&L (210 MW), 31.5% by Entergy Power (265 MW), and the balance by various municipalities and a cooperative. The unit was out of service, due to an explosion from August 11, 1993 to February 18, 1994. (5) GSU's nuclear capability represents its 70% ownership interest in River Bend; Cajun owns the remaining 30% undivided interest. (6) LP&L's nuclear capability represents its 90.7% ownership interest and 9.3% leasehold interest in Waterford 3. (7) System Energy's capability represents its 90% interest in Grand Gulf 1 (78.5% ownership interest and 11.5% leasehold interest). South Mississippi Electric Power Association has the remaining 10% undivided ownership interest in Grand Gulf 1. Entitlement to System Energy's capacity has been allocated to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement. (8) Includes 188 MW of capacity leased by AP&L through 1999. Representatives of the System regularly review load and capacity projections in order to coordinate and recommend the location and time of installation of additional generating capacity and of interconnections in light of the availability of power, the location of new loads, and maximum economy to the System. Based on load and capability projections, the System has no need to install additional generating capacity until 1999. To delay the need for new capacity, the System is engaging in conservation and DSM programs, as discussed in "Business of Entergy - Competition - Least Cost Planning," above. When new generation resources are needed, the System plans to meet this need with a variety of sources other than construction of new base load generating capacity. In the meantime, the System will meet capacity needs by, among other things, removing generating stations from extended reserve shutdown. Generating stations brought out of extended reserve shutdown during 1993 added 248 MW to meet operating requirements. Under the terms of the System Agreement, some of the generating capacity and other power resources are shared among the System operating companies. Among other things, the System Agreement provides that parties having generating capacity greater than their load requirements sell such capacity to those parties having deficiencies in generating capacity and that the purchasers pay to the sellers a charge sufficient to cover certain of the sellers' ownership costs, including operating expenses, fixed charges on debt, dividend requirements on preferred and preference stock, and a fair rate of return on common equity investment. Under the System Agreement, these charges are based on costs associated with the sellers' steam electric generating units fueled by oil or gas. In addition, for all energy to be exchanged among the System operating companies under the System Agreement, the purchasers are required to pay the cost of fuel consumed in generating such energy plus a charge to cover other associated costs (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Agreement," above, for a discussion of FERC proceedings relating to the System Agreement). The System's business is subject to seasonal fluctuations with the peak period occurring in the summer months. Excluding GSU, Entergy 's 1993 peak demand of 12,858 MW occurred on August 19, 1993. The net System capability at the time of peak was 14,029 MW, which reflects a reduction of the System's total 14,765 MW of owned and leased capability by net off-system firm sales of 736 MW. The capacity margin at the time of the peak was approximately 8.4%, not including units placed on extended reserve and capacity owned by Entergy Power. GSU's 1993 peak demand of 5,612 MW occurred on August 18, 1993. The net GSU capability at the time of peak was 6,704 MW, which reflects an increase of GSU's total 6,420 MW of owned and leased capability by net off-system purchases of 284 MW. The capacity margin at the time of the peak was approximately 18.2%, not including units placed on extended reserve. Interconnections The electric power supply facilities of Entergy consist principally of steam-electric production facilities strategically located with reference to availability of fuel, protection of local loads, and other controlling economic factors. These are interconnected by a transmission system operating at various voltages up to 500 KV. Generally, with the exception of Grand Gulf 1, Entergy Power's capacity and a small portion of MP&L's capacity, operating facilities or interests therein are owned by the System operating company serving the area in which the facilities are located. However, all of the System's generating facilities are centrally dispatched and operated with a view to realizing the greatest economy. This operation seeks, among other things, the lowest cost sources of energy from hour to hour. The minimum of investment and the most efficient use of plant are sought to be achieved, in part, through the coordinated scheduling of maintenance, inspection, and overhaul. The System operating companies have direct interconnections with neighboring utilities including, in individual cases, Mississippi Power Company, Southwestern Electric Power Company, Southwest Power Administration, Central Louisiana Electric Company, Inc., Oklahoma Gas and Electric Company, The Empire District Electric Company, Union Electric Company, Arkansas Electric Cooperative Corporation, Tennessee Valley Authority, Cajun, Sam Rayburn Dam Electric Cooperative, Inc., SRG&T, SRMPA, Associated Electric Cooperative, Inc., Municipal Energy Agency of Mississippi, Louisiana Energy and Power Authority, Farmers Electric Cooperative, South Mississippi Electric Power Authority, and the cities of Lafayette, Plaquemine, and New Roads, Louisiana. GSU also has an interconnection agreement with Houston Lighting and Power Company providing a minor amount of emergency service only. The System operating companies also have interchange agreements with Alabama Electric Cooperative, Big Rivers Electric Cooperative, Northeast Texas Electric Cooperative, Inc., Sam Rayburn G&T Electric Cooperative, Inc., Florida Power Corporation, Florida Power & Light Company, Jacksonville Electric Authority, Oglethorpe Power Cooperative, the City of Lafayette, Louisiana, the City of Springfield, Missouri, and East Kentucky Electric Cooperative. The System operating companies are members of the Southwest Power Pool, the primary purpose of which is to ensure the reliability and adequacy of the electric bulk power supply in the southwest region of the United States. The Southwest Power Pool is a member of the North American Electric Reliability Council. AP&L, LP&L, MP&L, and NOPSI are also members of the Western Systems Power Pool. Gas Property As of December 31, 1993, NOPSI distributed and transported natural gas for distribution solely within the limits of the City of New Orleans through a total of 1,422 miles of gas distribution mains and 32 miles of gas transmission lines. NOPSI receives deliveries of natural gas for distribution purposes at 14 separate locations, including deliveries from United Gas Pipe Line Company (United) at six of these locations. Of the remaining delivery points, two are principally served by interstate suppliers and the remaining are served by intrastate suppliers. As of December 31, 1993, the gas property of GSU was not material to GSU. Titles The System's generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System operating companies has been constructed over lands of private owners pursuant to easements or on public highways and streets pursuant to appropriate permits. The rights of each company in the realty on which its properties are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in properties of like size and character exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. The System operating companies generally have the right of eminent domain whereby they may, if necessary, perfect or secure titles to, or easements or servitudes on, privately-held lands used or to be used in their utility operations. Substantially all the physical properties owned by each System operating company and System Energy are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of such company. The Lewis Creek generating station is owned by GSG&T, Inc., and is not subject to the lien of the GSU mortgage securing the first mortgage bonds of GSU, but is leased and operated by GSU. In the case of LP&L, certain properties are subject to the liens of second mortgages securing other obligations of LP&L. In the case of MP&L and NOPSI, substantially all of their properties and assets are subject to the second mortgage lien of their respective general and refunding mortgage bond indentures. FUEL SUPPLY The following tabulation shows the percentages of natural gas, fuel oil, nuclear fuel, and coal used in generation, excluding that of Entergy Power, during the past three years. It also shows the average fuel cost per KWH generated by each type of fuel during that period. The balance of generation, which was immaterial, was provided by hydroelectric power. ENTERGY EXCLUDING GSU GSU The following tabulation shows the percentages of generation by fuel type used in generation, excluding that of Entergy Power, for 1993 (actual) and 1994 (projected). _______________________ (a) The System's 1993 actual generation by fuel type excludes GSU; 1994 estimated generation by fuel type includes GSU. (b) Capacity and energy from System Energy's interest in Grand Gulf 1 is allocated as follows: AP&L - 36%; LP&L - 14%; MP&L - 33%; and NOPSI - 17%. Natural Gas The System operating companies have various long-term gas contracts that will satisfy a significant percentage of each operating company's needs; however, such contracts typically require the operating companies to purchase less than half of their annual gas requirements under such contracts. Additional gas requirements are satisfied under less expensive short-term contracts and spot-market purchases. In November 1992, GSU entered into a transportation service agreement with a gas supplier that obligates such supplier to provide GSU with flexible natural gas swing service to certain generating stations by using such supplier's pipeline and salt dome gas storage facility. Many factors influence the availability and price of natural gas supplies for power plants including wellhead deliverability, storage and pipeline capacity, and the demand requirements of the end users. This demand is closely tied to the severity of the weather conditions in the region. Furthermore, pricing relative to other energy sources (i.e. fuel oil, coal, purchased power, etc.) will affect the demand for natural gas for power plants. Supplies of natural gas are expected to be adequate in 1994. Pursuant to FERC and state regulations, gas supplies may be interrupted to power plants during periods of shortage. To the extent natural gas supplies may be disrupted, the System operating companies will use alternate sources of energy such as fuel oil. Coal AP&L has long-term contracts for the supply of low-sulfur coal for the White Bluff Steam Electric Generating Station and the Independence Steam Electric Station (which is owned 25% by MP&L). Coal for the White Bluff Station is supplied under a contract from a mine in the State of Wyoming. The coal contract provides for the delivery of sufficient coal to operate the White Bluff Station through approximately 2002. Coal for the Independence Station is also supplied under a contract from a mine in the State of Wyoming. Coal supplied under this contract is expected to meet the requirements of the Independence Station through at least 2014. GSU has a contract for a supply of low-sulfur Wyoming coal for Nelson Unit 6, which should be sufficient to satisfy the fuel requirements at Nelson Unit 6 through 2004. Cajun has advised GSU that it has contracts that should provide an adequate supply of coal until 1997 for the operation of Big Cajun 2, Unit 3 (which is operated by Cajun and of which GSU owns 42%). Nuclear Fuel Generally, the supply of fuel for nuclear generating units involves the mining and milling of uranium ore to produce a concentrate, the conversion of uranium concentrate to uranium hexafluoride gas, enrichment of that gas, fabrication of the nuclear fuel assemblies, and disposal of the spent fuel. System Fuels is responsible for contracts to acquire nuclear fuel to be used in AP&L's, LP&L's, and System Energy's nuclear units and for maintaining inventories of such materials during the various stages of processing. Each of these companies is currently responsible for contracting for the fabrication of its own nuclear fuel and for purchasing the required enriched uranium hexafluoride from System Fuels. Currently, the requirements for GSU's River Bend plant are covered by contracts made by GSU. On October 3, 1989, System Fuels entered into a revolving credit agreement with banks permitting it to borrow up to $45 million to finance its nuclear materials and services inventory. AP&L, LP&L, and System Energy agreed to purchase from System Fuels the nuclear materials and services financed under the agreement if System Fuels should default in its obligations thereunder. Such purchases would be allocated based on percentages agreed upon among the parties. In the absence of such agreement, AP&L, LP&L, and System Energy would each be obligated to purchase one-third of the nuclear materials and services. Based upon the planned fuel cycles for the System's nuclear units, the following tabulation shows the years through which existing contracts and inventory will provide materials and services: Acquisition of or Conversion Spent Uranium to Uranium Enrich- Fabri- Fuel Concentrate Hexafluoride ment(3) cation Disposal ----------- ------------ ------- ------ -------- ANO 1 (1) (1) 1995 1997 (4) ANO 2 (1) (1) 1995 1994 (4) River Bend (2) (2) 2000 1995 (4) Waterford 3 (1) (1) 1995 1999 (4) Grand Gulf 1 (1) (1) 1995 1995 (4) __________________________ (1) Current contracts will provide these materials and services through termination dates ranging from 1994-1997. Additional materials and services required beyond these dates are estimated to be available for the foreseeable future. (2) Current GSU contracts will provide a significant percentage of these materials and services for River Bend through 1995. (3) Enrichment services for ANO 1, ANO 2, Waterford 3, and Grand Gulf 1 are provided by a System Fuels contract with the United States Enrichment Corporation (USEC). The contract has been terminated after 1995 to permit flexibility on future pricing and terms that could be obtained. Enrichment services for River Bend are provided by a GSU contract with USEC that may be partially terminated after 1998 and fully terminated after 2000. (See "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Decommissioning," above for information on annual contributions to a federal decontamination and decommissioning fund required by the Energy Act to be made by AP&L, GSU, LP&L, and System Energy as a result of their enrichment contracts with DOE.) (4) The Nuclear Waste Policy Act of 1982 provides for the disposal of spent nuclear fuel or high level waste by the DOE. Under this Act, the DOE was to begin accepting spent fuel in 1998 and to continue until the disposal of all spent fuel from reactor sites has been accomplished. In November 1989, the DOE indicated that the repository program will be delayed. Current on-site spent fuel storage capacity at ANO, River Bend, Waterford 3, and Grand Gulf 1 is estimated to be sufficient to store fuel from normal operations until 1995, 2003, 2000, and 2004, respectively. It is expected that any additional storage capacity required, due to delay of the DOE repository program, will have to be provided by the affected companies (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Spent Fuel and Other High-Level Radioactive Waste," above). The System will require additional arrangements for segments of the nuclear fuel cycle beyond the dates shown above. Except as noted above, Entergy cannot predict the ultimate availability or cost of such arrangements at this time. AP&L, GSU, LP&L, and System Energy currently have nuclear fuel leasing arrangements that provide that AP&L, GSU, LP&L, and System Energy may lease up to $125 million, $105 million, $95 million, and $105 million of nuclear fuel, respectively. As of December 31, 1993, the unrecovered cost base of AP&L's, GSU's, LP&L's, and System Energy's nuclear fuel leases amounted to approximately $93.6 million, $96.5 million, $61.3 million, and $79.7 million, respectively. Each lessor finances its acquisition and ownership of nuclear fuel under a credit agreement and through the issuance of intermediate-term notes. The credit agreements, which were entered into by AP&L in 1988, by LP&L and System Energy in 1989, and GSU in 1993, had initial terms of five years, with the exception of GSU, which has an initial term of three years. These agreements are subject to annual renewal with, in LP&L's and GSU's case, the consent of the lenders. The credit agreements for AP&L, LP&L, and System Energy have all been extended and now have termination dates of December 1996, January 1997, and February 1997, respectively. The credit agreement for GSU was entered into in December 1993 and has a termination date of December 1996. The intermediate-term notes have varying maturities through January 31, 1999. It is expected that the credit agreements will be extended, or alternative financing will be secured by each lessor, based on the particular lessee's nuclear fuel requirements. If extensions or alternative financing cannot be arranged, the particular lessee must purchase sufficient nuclear fuel to allow the lessor to retire such borrowings. Natural Gas Purchased for Resale NOPSI has several suppliers of natural gas for resale. Its system is interconnected with three interstate and three intrastate pipelines. Presently, NOPSI's primary suppliers of natural gas for resale are United, an interstate pipeline, and Bridgeline and Pontchartrain, intrastate pipelines. NOPSI has a firm gas purchase contract with United and receives this service subject to FERC- approved rates pursuant to a certificate granted by FERC. NOPSI also has firm contracts with its two intrastate suppliers and also makes interruptible spot market purchases when economically attractive. In recent years, natural gas deliveries have been subject primarily to weather-related curtailments. However, NOPSI has experienced no such curtailments. In April 1992, FERC issued Order No. 636, which mandated interstate pipeline restructuring. The order requires interstate pipelines to cease selling gas to local distribution customers at the city-gate interconnection although transportation service can be provided in lieu of the former sale. As a result, in the future, NOPSI must substitute sources upstream of the United system for its current gas supply from United. NOPSI is considering purchases from independent intrastate or interstate supply aggregators and/or from intrastate pipeline sources in a manner consistent with its economic and supply reliability objectives. Prior to the effectiveness of Order No. 636, discussed above, in the event of a natural gas shortage on the United system, NOPSI would have received a portion of the available gas supply from United and its other suppliers. After Order No. 636 mandated restructuring (October 31, 1993), curtailments of supply could occur if NOPSI's suppliers failed to perform their obligations to deliver gas under their supply agreements with NOPSI. United could curtail transportation capacity only in the event of pipeline system constraints. Based on the current supply of natural gas, and absent extreme weather related curtailments, NOPSI does not anticipate that there will be any interruptions in natural gas deliveries to its customers. GSU purchases natural gas for resale from a single interstate supplier. Abandonment of service by the present supplier would be subject to abandonment proceedings by FERC. Research AP&L, GSU, LP&L, MP&L, and NOPSI are members of the Electric Power Research Institute (EPRI). EPRI conducts a broad range of research in major technical fields related to the electric utility industry. Entergy participates in various EPRI projects, based on its needs and available resources. During 1991, 1992, and 1993, the System, including GSU, contributed approximately $12 million, $16 million, and $17 million, respectively, for the various research programs in which Entergy was involved. Item 2.

Item 2. Properties Refer to Item 1. "Business - Property," incorporated herein by reference, for information regarding the properties of the registrants. Item 3.

Item 3. Legal Proceedings Refer to Item 1. "Business - Rate Matters and Regulation," incorporated herein by reference, for details of the registrants' material rate proceedings and other regulatory proceedings and litigation that are pending or that terminated in the fourth quarter of 1993. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders A consent in lieu of a special meeting of common stockholders of Entergy-GSU Holdings, Inc. (Holdings) was executed on December 30, 1993, pursuant to a Delaware statute that permits such a procedure. The consent was signed on behalf of Entergy Corporation and GSU, which at that time owned all of the outstanding common stock of Holdings. The common stockholders acted to: (1) increase the number of directors from 2 to 18 upon the occurrence of the combination of Entergy Corporation and GSU, such expanded board to consist of Edwin Lupberger and Joseph Donnelly, who continued as directors, and the following new directors: W. Frank Blount; John A. Cooper, Jr.; Brooke H. Duncan; Lucie J. Fjeldstad; Kaneaster Hodges, Jr.; Robert v.d. Luft; Adm. Kinnaird R. McKee; Paul W. Murrill; James R. Nichols; Eugene H. Owen; John N. Palmer, Sr.; Robert D. Pugh; H. Duke Shackelford; Wm. Clifford Smith; Bismark A. Steinhagen; and Dr. Walter Washington; (2) approve the terms and provisions of certain agreements related to such combination; (3) approve the actions of the officers in connection with those agreements and the transactions contemplated thereby; (4) approve the assumption and adoption by Holdings of certain benefit plans of Entergy Corporation; and (5) approve the taking of actions to issue stock with respect to such plans, including the listing of Holdings' common stock on the New York, Pacific, and Midwest Stock Exchanges and the filing of registration statements with the Securities and Exchange Commission. After the consummation of the transactions involved in the combination, the name of Holdings was changed to Entergy Corporation. On January 22, 1994, Mr. Donnelly resigned from the position of director of Entergy Corporation. PART II Item 5.

Item 5. Market for Registrants' Common Equity and Related Stockholder Matters Entergy Corporation. The shares of Entergy Corporation's common stock are listed on the New York, Midwest, and Pacific Stock Exchanges. The high and low prices for each quarterly period in 1993 and 1992, were as follows: 1993 1992 --------------- ---------------- High Low High Low ------ ------ ------ ------ (In Dollars) First 36 1/2 32 1/2 29 5/8 27 1/8 Second 38 1/4 33 1/4 28 1/2 26 1/8 Third 39 7/8 36 1/4 31 7/8 28 1/4 Fourth 39 1/4 35 1/8 33 5/8 30 1/2 Four consecutive quarterly cash dividends on common stock were paid to stockholders of Entergy Corporation in each of 1993 and 1992. In 1993, dividends of 40 cents per share were paid in each of the first three quarters and dividends of 45 cents per share were paid in the last quarter. Dividends of 35 cents per share were paid in each of the first three quarters of 1992, and dividends of 40 cents per share were paid in the last quarter of 1992. As of February 24, 1994, there were 63,779 stockholders of record of Entergy Corporation. For information with respect to Entergy Corporation's future ability to pay dividends, refer to Note 7 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Dividend Restrictions," incorporated herein by reference. In addition to the restrictions described in Note 7, the Holding Company Act provides that, without approval of the SEC, the unrestricted, undistributed retained earnings of any Entergy Corporation subsidiary are not available for distribution to Entergy Corporation's common stockholders until such earnings are made available to Entergy Corporation through the declaration of dividends by such subsidiaries. AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy. There is no market for the common stock of System Energy and the System operating companies, all of which is owned by Entergy Corporation. Prior to December 31, 1993, GSU's common stock was publicly held. Effective with the Merger, all shares of GSU common stock were acquired by Entergy Corporation. No cash dividends on common stock were paid by GSU to its stockholders in 1992-1993. Cash dividends on common stock paid by AP&L, LP&L, MP&L, NOPSI, and System Energy to Entergy Corporation during 1993 and 1992, were as follows: 1993 1992 ------ ------ (In Millions) AP&L $156.3 $ 75.0 LP&L 167.6 174.6 MP&L 85.8 68.4 NOPSI 43.9 32.2 System Energy 233.1 137.7 For information with respect to restrictions that limit the ability of System Energy and the System operating companies to pay dividends, and for information with respect to dividends paid to Entergy Corporation by its subsidiaries subsequent to December 31, 1993, refer respectively, to Note 6 of System Energy's and Note 7 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's Notes to Financial Statements, "Dividend Restrictions," incorporated herein by reference. Item 6.

Item 6. Selected Financial Data Entergy Corporation. Refer to information under the heading "Entergy Corporation and Subsidiaries Selected Financial Data - Five- Year Comparison," which information is incorporated herein by reference. AP&L. Refer to information under the heading "Arkansas Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. GSU. Refer to information under the heading "Gulf States Utilities Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. LP&L. Refer to information under the heading "Louisiana Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. MP&L. Refer to information under the heading "Mississippi Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. NOPSI. Refer to information under the heading "New Orleans Public Service Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. System Energy. Refer to information under the heading "System Energy Resources, Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. Item 7.

Item 7 "Financial Statements and Exhibits". A current report on Form 8-K, dated January 18, 1994, was filed with the SEC on January 18, 1994, reporting information under Item 5 "Other Materially Important Events". A current report on Form 8-K, dated February 1, 1994, was filed with the SEC on February 8, 1994, reporting information under Items 2 and 7. Entergy Corporation, AP&L, GSU, LP&L, MP&L and NOPSI Current Reports on Form 8-K, dated December 31, 1993, were filed by these companies on January 3, 1994 reporting the consummation of the Entergy Corporation - GSU merger under Item 5 (in the case of AP&L, LP&L, MP&L and NOPSI), Items 2 and 7 (in the case of Entergy Corporation and GSU). EXPERTS All statements in Part I of this Annual Report on Form 10-K as to matters of law and legal conclusions, based on the belief or opinion of System Energy or any System operating company or otherwise, pertaining to the titles to properties, franchises and other operating rights of certain of the registrants filing this Annual Report on Form 10-K, and their subsidiaries, the regulations to which they are subject and any legal proceedings to which they are parties are made on the authority of Friday, Eldredge & Clark, 2000 First Commercial Building, 400 West Capitol, Little Rock, Arkansas, as to AP&L and as to Entergy Services in regards to flood litigation; Monroe & Lemann (A Professional Corporation), 201 St. Charles Avenue, Suite 3300, New Orleans, Louisiana, as to LP&L and NOPSI; and Wise Carter Child & Caraway, Professional Association, Heritage Building, Jackson, Mississippi, as to MP&L and System Energy. The statements attributed to Clark, Thomas & Winters, a professional corporation, as to legal conclusions with respect to GSU's rate regulation in Texas under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters," have been reviewed by such firm and are included herein upon the authority of such firm as experts. The statements attributed to Sandlin Associates regarding the analysis of River Bend Construction costs of GSU under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters", have been reviewed by such firm and are included herein upon the authority of such firm as experts. ENTERGY CORPORATION SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ENTERGY CORPORATION By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); W. Frank Blount, John A. Cooper, Jr., Brooke H. Duncan, Lucie J. Fjeldstad, Kaneaster Hodges, Jr., Robert v.d. Luft, Kinnaird R. McKee, Paul W. Murrill, James R. Nichols, Eugene H. Owen, John N. Palmer, Robert D. Pugh, H. Duke Shackelford, Wm. Clifford Smith, Bismark A. Steinhagen, and Walter Washington (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) ARKANSAS POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ARKANSAS POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John A. Cooper, Jr., Cathy Cunningham, Richard P. Herget, Jr., Tommy H. Hillman, Donald C. Hintz, Kaneaster Hodges, Jr., Jerry D. Jackson, R. Drake Keith, Jerry L. Maulden, Raymond P. Miller, Sr., Roy L. Murphy, William C. Nolan, Jr., Robert D. Pugh, Woodson D. Walker, Gus B. Walton, Jr., Michael E. Wilson (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) GULF STATES UTILITIES COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF STATES UTILITIES COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Robert H. Barrow, Frank F. Gallaher, Frank W. Harrison, Jr., Donald C. Hintz, Jerry L. Maulden, Paul W. Murrill, Eugene H. Owen, M. Bookman Peters, Monroe J. Rathbone, Jr., Sam F. Segnar, Bismark A. Steinhagen, James E. Taussig, II. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) LOUISIANA POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. LOUISIANA POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John J. Cordaro, Donald C. Hintz, William K. Hood, Jerry D. Jackson, Tex R. Kilpatrick, Joseph J. Krebs, Jr., Jerry L. Maulden, H. Duke Shackelford, Wm. Clifford Smith (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) MISSISSIPPI POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, Frank R. Day, John O. Emmerich, Jr., Norman B. Gillis, Jr., Donald C. Hintz, Jerry D. Jackson, Robert E. Kennington, II, Jerry L. Maulden, Donald E. Meiners, John N. Palmer, Sr., Clyda S. Rent, Walter Washington, Robert M. Williams, Jr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) NEW ORLEANS PUBLIC SERVICE INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. NEW ORLEANS PUBLIC SERVICE INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, James M. Cain, John J. Cordaro, Brooke H. Duncan, Norman C. Francis, Donald C. Hintz, Jerry D. Jackson, Jerry L. Maulden, Anne M. Milling, John B. Smallpage, Charles C. Teamer, Sr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) SYSTEM ENERGY RESOURCES, INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SYSTEM ENERGY RESOURCES, INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Donald C. Hintz (President, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Edwin Lupberger (Chairman of the Board), Jerry D. Jackson, Jerry L. Maulden (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) EXHIBIT 23(a) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Post-Effective Amendment Nos. 2, 3, 4A, and 5A on Form S-8 to Registration Statement No. 33-54298 of Entergy Corporation on Form S-4, and the related Prospectuses, of our reports dated February 11, 1994 (which express an unqualified opinion and include explanatory paragraphs as to uncertainties because of certain regulatory and litigation matters), appearing in this Annual Report on Form 10-K of Entergy Corporation for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-36149, 33-48356 and 33-50289 of Arkansas Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Arkansas Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-46085, 33-39221 and 33-50937 of Louisiana Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Louisiana Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-53004, 33-55826 and 33-50507 of Mississippi Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Mississippi Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-57926 of New Orleans Public Service Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of New Orleans Public Service Inc. for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-47662 of System Energy Resources, Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994 (which express an unqualified opinion and include an explanatory paragraph as to an uncertainty resulting from a regulatory proceeding), appearing in this Annual Report on Form 10-K of System Energy Resources, Inc. for the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE New Orleans, Louisiana March 14, 1994 EXHIBIT 23(b) CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Gulf States Utilities Company on Form S-3 (File Numbers 33-49739 and 33-51181) and Form S-8 (File Numbers 2-76551 and 2-98011) of our reports, dated February 11, 1994, on our audits of the financial statements and financial statement schedules of Gulf States Utilities Company as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which reports include explanatory paragraphs related to rate-related contingencies, legal proceedings and changes in accounting for income taxes, postretirement benefits, unbilled revenue and power plant materials and supplies and are included in this Annual Report on Form 10-K. /s/ Coopers & Lybrand Coopers & Lybrand Houston, Texas March 14, 1994 EXHIBIT 23(c) CONSENT OF EXPERTS We consent to the reference to our firm under the heading "Experts" in this Annual Report on Form 10-K. We further consent to the incorporation by reference of such reference to our firm into Arkansas Power & Light Company's ("AP&L") Registration Statements (Form S-3, File Nos. 33-36149, 33-48356 and 33-50289) and related Prospectuses, pertaining to AP&L's First Mortgage Bonds and Preferred Stock. Very truly yours, /s/ Friday, Eldredge & Clark FRIDAY, ELDREDGE & CLARK Date: March 14, 1994 EXHIBIT 23(d) CONSENT We consent to the reference to our firm under the heading "Experts", and to the inclusion in this Annual Report on Form 10-K of Gulf States Utilities Company ("GSU") of the statements of legal conclusions attributed to us herein (the Statements of Legal Conclusions) under Part I, Item 1. Business - "Rate Matters and Regulation" and in the discussion of Texas jurisdictional matters set forth in Note 2 to GSU's Financial Statements and Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements appearing as Item 8.

55785_1993.txt

55785

1993

ITEM 1. BUSINESS Kimberly-Clark Corporation was incorporated in Delaware in 1928. As used in Items 1, 2 and 7 of this Form 10-K Annual Report, the term "Corporation" refers to Kimberly-Clark Corporation and its consolidated subsidiaries. In the remainder of this Form 10-K Annual Report, the terms "Kimberly- Clark" or "Corporation" refer to Kimberly-Clark Corporation. Financial information about product classes and results, and foreign and domestic operations, and information about principal products and markets of the Corporation, contained under the caption "Management's Discussion and Analysis" and in Note 12 to the Financial Statements contained in the 1993 Annual Report to Stockholders, are incorporated in this Item 1 by reference. Description of the Corporation. Kimberly-Clark is principally engaged in the manufacturing and marketing throughout the world of a wide range of products for personal, business and industrial uses. Most of these products are made from natural and synthetic fibers using advanced technologies in absorbency, fibers and nonwovens. The Corporation's products and services are segmented into three classes. Class I includes tissue products for household, commercial, institutional and industrial uses; infant, child, feminine and incontinence care products; industrial and commercial wipers; health care products; and related products. Class I products are sold under a variety of well-known brand names, including Kleenex, Huggies, Pull-Ups, Kotex, New Freedom, Lightdays, Depend, Poise, Hi-Dri, Delsey, Spenco, Kimguard and Kimwipes. Products for home use are sold through supermarkets, mass merchandisers, drugstores, warehouse clubs, home health care stores, variety stores, department stores and other retail outlets, as well as to wholesalers. Other products in this class are sold to distributors, converters and end-users. Pulp produced by the Corporation, including amounts sold to other companies, is included in Class I, except for pulp manufactured for newsprint and certain specialty papers which is included in Class II. Class II includes newsprint, printing papers, premium business and correspondence papers, tobacco industry papers and products, technical papers, and related products. Newsprint and groundwood printing papers are sold directly to newspaper publishers and commercial printers. Other papers and specialty products in this class are sold directly to users, converters, manufacturers, publishers and printers, and through paper merchants, brokers, sales agents and other resale agencies. PART I (Continued) ITEM 1. BUSINESS (Continued) Class III includes aircraft services, commercial air transportation and other products and services. The Corporation owns various patents and trademarks registered domestically and in certain foreign countries. The Corporation considers the patents and trademarks which it owns and the trademarks under which it sells certain of its products, in each instance in the aggregate, to be material to its business. Consequently, the Corporation seeks patent and trademark protection by all available means, including registration. A partial list of the Corporation's trademarks is included under the caption "Trademarks" contained in the 1993 Annual Report to Stockholders and is incorporated herein by reference. EMPLOYEES. In its worldwide consolidated operations, the Corporation had 42,131 employees as of December 31, 1993. RAW MATERIALS. Cellulose fibers in the form of wood pulp are the primary raw material for the Corporation's paper and tissue products and are important components in disposable diapers, training pants, feminine pads and incontinence care products. Certain specialty papers are manufactured with other cellulose fibers such as flax straw and cotton. Large amounts of secondary and recycled fibers are also consumed, primarily in tissue products. Superabsorbent materials are important components in disposable diapers, training pants and incontinence care products. Polypropylene and other synthetics are primary raw materials for manufacturing nonwoven fabrics which are used in disposable diapers, training pants, feminine pads, incontinence and health care products and industrial wipers. Most secondary fibers and all synthetics are purchased. Wood pulp and nonwood cellulose fibers are produced by the Corporation and purchased from others. The Corporation considers the supply of such raw materials to be adequate to meet the needs of its businesses. For its worldwide consolidated operations, the Corporation's pulp mills at Coosa Pines, Alabama, and Terrace Bay, Ontario, had the capacity to supply about two-thirds of the 1993 wood pulp requirements for products other than newsprint. The Corporation's newsprint mill at Coosa Pines produces substantially all of its own pulp requirements. The Corporation owns or controls 5.1 million acres of forestland in North America, primarily as a source of fiber for pulp production. Approximately .4 million acres are owned and 4.7 million acres, principally in Canada, are held under long-term Crown rights or leases. Certain states have adopted laws and entered into agreements with publishers requiring newspapers sold in such states to contain specified amounts of recycled paper. The Corporation provides certain newspaper publishers with newsprint containing specified amounts of recycled paper. COMPETITION. The Corporation competes in numerous domestic and foreign markets. The number of competitors and the Corpora- tion's competitive positions in those markets vary. In general, in the sale of its principal products, the Corporation faces strong competition from other manufacturers, some of which are larger and more diversified than the Corporation. The Corporation has one major competitor, and several regional competitors, in its disposable diaper business and several major competitors in its household and other tissue-based products, and feminine and incontinence care products businesses. During 1993, in the U.S., private label and economy branded competitors continued to expand distribution of their disposable training pants nationally in competition with the Corporation's training pants business, and, in the fourth quarter, a major competitor initiated regional introductions of a branded training pant. In foreign markets, the Corporation has encountered increased competition and expects to encounter significant competition in connection with its introduction of training pants and diapers in Europe. Depending on the characteristics of the market involved, the Corporation com- petes on the basis of product quality and performance, price, service, packaging, distribution, advertising and promotion. RESEARCH AND DEVELOPMENT. At year-end 1993, approximately 1,200 of the Corporation's employees were engaged in research and development activities and were located in Neenah, Wisconsin; Roswell, Georgia; Coosa Pines, Alabama; Troy, Ohio; Munising, Michigan; Waco, Texas; the United Kingdom; and France. A major portion of total research and development expenditures is directed toward new or improved personal care, health care, household products, and nonwoven materials. Consolidated research and development expenditures were $158.5 million in 1993, $156.1 million in 1992 and $148.8 million in 1991. ENVIRONMENTAL MATTERS. Capital expenditures for environmental controls to meet legal requirements and otherwise relating to the protection of the environment at the Corporation's facilities in the United States are estimated to be $54 million in 1994 and $15 million in 1995. Such expenditures are not expected to have a material effect on the Corporation's total capital expenditures, consolidated earnings or competitive position; however, these estimates could be modified as a result of changes in the Corporation's plans, changes in legal requirements or other factors. RISKS FOR FOREIGN OPERATIONS. The products of the Corporation and its equity companies are made in 21 countries outside the U.S. Consumer products made abroad or in the U.S. are marketed in approximately 150 countries. Because these countries are so numerous, it is not feasible to generally characterize the risks involved. Such risks vary from country to country and include such factors as tariffs, trade restrictions, changes in currency value, economic conditions and international relations. INSURANCE. The Corporation maintains coverage consistent with industry practice for most risks that are incident to its operations. ITEM 2.

ITEM 2. PROPERTIES Management believes that the Corporation's production facilities are suitable for their purpose and adequate to support its businesses. The extent of utilization of individual facilities varies, but generally they operate at or near capacity. New facilities of the Corporation are under construction and others are being expanded. Principal facilities and products or groups of products made at these facilities are listed on the following pages. In addition, the principal facilities of the Corporation's equity companies and the products or groups of products made at such facilities are included on the following pages. Products described as consumer, service and/or nonwoven products include tissue products for household, commercial, institutional and industrial uses; infant, child, feminine and incontinence care products; industrial and commercial wipers; health care products; and related products. PART I (Continued) ITEM 2. PROPERTIES (Continued) Headquarters Locations Dallas, Texas Roswell, Georgia Neenah, Wisconsin Administrative Center Knoxville, Tennessee Production and Service Facilities United States Alabama Ashville - Wood chips Coosa Pines - Newsprint, groundwood printing papers, pulp, seedling nursery Goodwater - Lumber Nixburg - Wood chips Roanoke - Wood chips Westover - Lumber Arizona Tucson - Nonwoven products Arkansas Conway - Consumer products Maumelle - Consumer products California Fullerton - Consumer products Connecticut New Milford - Consumer products Georgia LaGrange - Nonwoven materials and products Massachusetts Lee - Tobacco industry papers, thin papers, service products Westfield - Aviation services Michigan Munising - Printing and base papers Mississippi Corinth - Nonwoven materials, service products New Jersey Montvale - Aviation services Spotswood - Tobacco industry papers and products New York Ancram - Tobacco industry papers and products North Carolina Hendersonville - Nonwoven materials and products Lexington - Nonwoven materials and products Ohio Troy - Adhesive-coated products Oklahoma Jenks - Consumer products South Carolina Beech Island - Consumer and service products Tennessee Loudon - Service products Memphis - Consumer and service products Texas Dallas - Aviation services Paris - Consumer products Waco - Consumer and service products Utah Ogden - Consumer products Wisconsin Appleton - Aviation services Milwaukee - Commercial airline service Neenah - Consumer and service products, nonwoven materials, business and correspondence papers Whiting - Business and correspondence papers Outside the United States Australia *Albury - Nonwoven materials and products *Ingleburn (near Sydney) - Consumer products *Lonsdale (near Adelaide) - Consumer products *Millicent - Consumer and service products *Seven Hills (near Sydney) - Consumer and service products *Tantanoola - Pulp *Warwick Farm (near Sydney) - Consumer and service products Brazil Mogi das Cruzes (near Sao Paulo) - Consumer and service products Canada Huntsville, Ontario - Consumer and service products Rexdale, Ontario (near Toronto) - Consumer and service products St. Catharines, Ontario - Consumer and service products, base papers St. Hyacinthe, Quebec - Consumer products Terrace Bay, Ontario - Pulp Winkler, Manitoba (mobile operations) - Flax tow Colombia *Barbosa (near Medellin) - Tobacco industry papers, service products *Guarne (near Medellin) - Consumer and service products *Pereira - Consumer and service products, nonwoven materials Costa Rica Cartago - Consumer products El Salvador Sitio del Nino (near San Salvador) - Consumer and service products France Le Mans - Tobacco industry products Malaucene - Tobacco industry papers Quimperle - Tobacco industry papers Rouen - Consumer products Villey-Saint-Etienne - Consumer products Germany Koblenz - Consumer and service products *Equity company production facility PART I (Continued) ITEM 2. PROPERTIES (Continued) Honduras Cortes - Nonwoven products Indonesia *Medan - Tobacco industry papers Korea Anyang (near Seoul) - Consumer and service products Kimcheon (near Taegu) - Consumer and service products Taejon - Consumer products Malaysia *Petaling Jaya (near Kuala Lumpur) - Consumer and service products Mexico *Bajio (near San Juan del Rio) - Consumer and service products; business, printing and school papers *Cuautitlan (near Mexico City) - Consumer and service products Empalme - Nonwoven products Hermosillo - Nonwoven products Magdalena - Nonwoven products *Naucalpan (near Mexico City) - Consumer and service products; business, printing and school papers; tobacco industry papers; pulp Nogales - Nonwoven products *Orizaba - Consumer and service products; business, printing and school papers; pulp *Ramos Arizpe - Consumer products Santa Ana - Nonwoven products Netherlands Veenendaal - Consumer and service products Panama Panama City - Consumer and service products Philippines San Pedro, Laguna (near Manila) - Consumer and service products, tobacco industry papers Saudi Arabia *Al-Khobar - Consumer and service products Singapore Singapore - Consumer and service products South Africa **Cape Town - Consumer and service products **Germiston (near Johannesburg) - Consumer and service products **Springs (near Johannesburg) - Consumer and service products Thailand Patumthanee (near Bangkok) - Consumer and service products United Kingdom Barton-upon-Humber - Consumer products Flint - Nonwoven materials, service products Larkfield (near Maidstone) - Consumer and service products Prudhoe (near Newcastle-upon-Tyne) - Consumer and service products, recycled fiber Sealand (near Chester) - Consumer products Venezuela Guacara - Consumer products * Equity company production facility ** Other companies ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The following is a brief description of material pending legal proceedings to which the Corporation or any of its subsidiaries is a party or of which any of their properties is subject: A. On March 11, 1993, a class action lawsuit was filed against the Corporation in the United States District Court, Middle District of Tennessee (the "Tennessee District Court"), on behalf of certain retirees who were formerly represented by the United Paperworkers International Union ("UPIU"). The Corporation's Motion to Transfer this action to the Eastern District of Wisconsin was granted. A similar action was filed in the United States District Court, Central District of California, on behalf of retirees who were formerly represented by the Association of Western Pulp and Paper Workers ("AWPPW") at the Corporation's Fullerton, California facility. This second action was voluntarily dismissed and refiled in the Tennessee District Court on March 25, 1993. The Corporation's Motion to Transfer this action to the Central District of California was granted. The parties to both actions have executed settlement agreements, dated March 15, 1994, providing for the voluntary dismissal of such actions, without prejudice, for a period of one year from the date that such agreements are approved by the respective courts, subject to certain conditions and circumstances allowing for the earlier refiling of such actions. On March 23, 1994, the court for the Eastern District of Wisconsin entered an order approving the settlement agreement with respect to the UPIU action. The settlement agreement with respect to the AWPPW action has been submitted to the court for the Central District of California for its consideration. The actions relate to certain changes made by the Corporation to its retiree medical plans effective January 1, 1993. The allegations in each action are that the Corporation's retiree medical benefits were vested and could not be unilaterally amended by the Corporation, and that, therefore, the retirees are entitled to an unalterable level of medical benefits. In the event that the AWPPW settlement agreement is not approved by the court, or the actions are refiled pursuant to the terms of the settlement agreements, management has determined that under Financial Accounting Standard No. 106, and based on prevailing market interest rates, the estimated cost to the Corporation of not being able to make any amendments to its retiree medical plans with respect to the two putative classes of retirees would result in a maximum pretax charge of approximately $5.7 million per year. B. Since September 28, 1990, about 60 employees of contractors who allegedly worked at the Corporation's mill in Coosa Pines, Alabama at some point in their careers filed separate actions in the United States District Court for the Northern District of Texas against the Corporation and approximately 36 other companies. Most of these cases were transferred to the Federal District Court, Northern District of Alabama and subsequently have been consolidated in the Federal District Court, Eastern District of Pennsylvania where all asbestos cases pending at such time in United States Federal District Courts were consolidated. Approximately 4,713 individuals refiled three of such cases in the District Court of Orange County, Texas. The actions allege, with respect to the Corporation, that the ownership of facilities containing asbestos caused the plaintiffs to suffer physical injury. The actions seek unspecified damages. The Corporation has denied the allegations and has asserted, among other things, that the claims fail to state a claim upon which relief can be granted and that such actions are barred by applicable statutes of limitation. These actions presently are in the discovery phase. PART I (Continued) ITEM 3. LEGAL PROCEEDINGS (Continued) C. On September 28, 1992, the Corporation filed an action against Drypers Corporation, Pope & Talbot, Inc. and Pope & Talbot, Wis., Inc. in the United States District Court, Western District of Washington, alleging patent infringement with respect to the defendants' use of containment flaps in disposable diapers. In June 1993, each of the defendants filed counterclaims against the Corporation alleging that the Corporation misused its patent in violation of the federal antitrust laws. The defendants are seeking invalidation of the patent, treble damages based on the defendants' attorneys fees for defending the patent suit, and the defendants' attorney fees for prosecuting the antitrust counterclaim. The case is currently in discovery. A trial date has been set for June 7, 1994. The Corporation also is subject to routine litigation from time to time which individually or in the aggregate is not expected to have a material adverse effect on the Corporation's business or results of operations. Environmental Matters - --------------------- (See the Corporation's 1993 Annual Report to Stockholders under the "Environmental Matters" section of "Management's Discussion and Analysis.") The Corporation has been named a potentially responsible party ("PRP") under the provisions of the federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), or analogous state statute, at 21 waste disposal sites, none of which, in management's opinion, could have a material adverse impact on the Corporation's business or results of operations. Notwithstanding its opinion, management believes it appropriate to disclose the following recent developments concerning three of these sites where the extent of the Corporation's liability cannot yet be established: A. The South 8th Street Landfill Site, located across the Mississippi River from Memphis, Tennessee, in Crittenden County, Arkansas, is a 30-acre site that received municipal and industrial waste from the 1950's to the early 1980's. The site is divided into three separate landfill disposal areas and an oily sludge pit area. A refining company (the "Refiner") apparently used the pit area for the disposal of waste sludge from its oil re-refining process through November 1969. On September 9, 1992, the Environmental Protection Agency (the "EPA") identified Kimberly-Clark's Memphis mill as a PRP at the site. The mill was linked to the site by an affidavit of an employee of the Refiner which alleged that the Refiner picked up waste oil at the mill for re-refining. While Kimberly-Clark did not send hazardous wastes to the site, it did send used oil to the Refiner for reclamation. The EPA recently conducted a Remedial Investigation and Feasibility Study with respect to the site. Based on such study, the EPA's preferred remedial alternative for the landfill area is organic treatment, stabilization and disposal in a licensed, nonhazardous landfill at a cost of $14.8 million to $18.1 million. The EPA's preferred remedial alternative for the oily sludge pit is natural soil cover at a cost of $2.3 million. There are approximately 103 members, including Kimberly-Clark, of the PRP group with respect to the site. The Corporation's estimated share of total site remediation cost, if any, cannot yet be established. B. In August 1992, Kimberly-Clark's Spotswood, New Jersey mill received an information request from the New Jersey Department of Environmental Protection and Energy ("NJDEPE") with respect to the Jones Industrial Service Landfill. Kimberly-Clark currently has no information about the site or the status of the NJDEPE's actions to date. Kimberly- Clark does not have records indicating that the mill used the site. However, the Spotswood mill has used an industrial company for nonhazardous waste disposal services and has received routing sheets from such company which indicate that the company may have sent three loads of Spotswood mill waste to the site in September 1980. Until Kimberly-Clark receives the site information requested from the State of New Jersey, no determination regarding the extent of Kimberly-Clark's liability, if any, can be made. C. On February 6, 1991, the NJDEPE identified the Corporation as a PRP under the provisions of the New Jersey Spill Compensation and Control Act for remediation of the Global Sanitary Landfill waste disposal site located in Old Bridge Township, New Jersey based on the Corporation's disposal of waste at such site. The EPA has designated the disposal site as a state-led site under CERCLA with the NJDEPE acting as lead agency. In May 1991, the Corporation signed a PRP agreement and paid an administrative assessment. In August 1993, a consent decree was executed by the State of New Jersey and the PRPs, pursuant to which the Corporation agreed to pay $575,000 for its share of Phase I cleanup costs. The Corporation's share of Phase II cleanup costs, if any, cannot yet be established. PART I (Continued) ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The names and ages of the executive officers of the Corporation as of March 1, 1994, together with certain biographical information are as follows: JAMES D. BERND, 60, was elected Executive Vice President effective December 1, 1990. Mr. Bernd joined Kimberly-Clark in 1959 as a trainee at the Niagara Falls, New York, mills. He was appointed Marketing Manager for KLEENEX(R) facial tissue in 1973 and Business Manager for Household Products in 1975. Mr. Bernd was appointed Division Vice President in 1976, President of the Household Products Sector in 1985 and assumed his present position in 1990. He is responsible for the Household Products and Service and Industrial Sectors, U.S. Consumer Sales, Consumer Business Services and Safety and Quality Assurance. Mr. Bernd is a member of the University of Wisconsin School of Business Board of Visitors, the Riverside Medical Center - Waupaca Board of Trustees, and the Associated Bank, National Association Board of Directors. He has been a director of the Corporation since 1990. JOHN W. DONEHOWER, 47, was elected Senior Vice President and Chief Financial Officer in 1993. Mr. Donehower joined Kimberly-Clark in 1974. He was appointed Director of Finance - Europe in 1978, Vice President, Marketing and Sales - Nonwovens in 1981, Vice President, Specialty Papers in 1982, Managing Director, Kimberly-Clark Australia Pty. Limited in 1982, and Vice President, Professional Health Care, Medical and Nonwoven Fabrics in 1985. He was appointed President, Specialty Products - U.S. in 1987, and President - World Support Group in 1990. O. GEORGE EVERBACH, 55, was appointed Senior Vice President - Law and Government Affairs in 1988. Mr. Everbach joined Kimberly-Clark in 1984. His responsibilities within the Corporation have included direction of legal, human resources and administrative functions. He was elected Vice President and General Counsel in 1984, Vice President, Secretary and General Counsel in 1985, and Senior Vice President and General Counsel in 1986. THOMAS J. FALK, 35, was elected Group President - Infant and Child Care in 1993. Mr. Falk joined Kimberly-Clark in 1983. His responsibilities within the Corporation have included internal audit, financial and strategic analysis and operations management. He was appointed Vice President - Operations Analysis and Control in 1990 and Senior Vice President - Analysis and Administration in 1992. JAMES G. GROSKLAUS, 58, was elected Executive Vice President effective December 1, 1990. He is responsible for the Pulp and Newsprint, Paper and Specialty Products Sectors, and also is responsible for various staff functions. Employed by the Corporation since 1957, Mr. Grosklaus was appointed Vice President in 1972 and Divisional Vice President in 1975, and was elected Senior Vice President effective January 1, 1979. He was appointed President, K-C Health Care, Nonwoven and Industrial Group in 1981, Senior Staff Vice President in 1982, Senior Vice President in 1983 and President, Technical Paper and Specialty Products in 1985, and elected Executive Vice President in January 1986. In 1988, he was appointed President - - North American Pulp and Paper Sector. He is a member of the Emory University Board of Visitors and the Woodruff Arts Center Board of Trustees. He has been a director of the Corporation since 1987. EXECUTIVE OFFICERS OF THE REGISTRANT (Continued) TIMOTHY E. HOEKSEMA, 47, was appointed President - Transportation Sector in 1988. Mr. Hoeksema joined Kimberly- Clark in 1969. Prior to 1977, Mr. Hoeksema served as Chief Pilot of Kimberly-Clark. He was elected President of K-C Aviation Inc., a wholly owned subsidiary of Kimberly-Clark, in 1977, and President of Midwest Express Airlines, Inc., a wholly owned subsidiary of K-C Aviation Inc., in 1983. JAMES T. MCCAULEY, 55, was elected Executive Vice President in 1990. Mr. McCauley joined Kimberly-Clark in 1969. He was elected Treasurer in 1980, Vice President and Treasurer in 1980, appointed Vice President - Nonwoven Operations in 1984, Senior Vice President, Kimberly-Clark Newsprint & Pulp and Forest Products in 1984, President, North American Pulp and Newsprint Sector in 1985, President, Health Care and Nonwovens Sector in 1987, and President - Nonwovens and Technical Products Sector in 1988. Mr. McCauley was appointed President - Nonwovens, Medical and Technical Products Sector in 1988 and was appointed President - Nonwovens and Professional Health Care Sector, Far East Operations and World Support Group in 1990. WAYNE R. SANDERS, 46, was elected Chief Executive Officer of the Corporation effective December 19, 1991, and Chairman of the Board effective March 31, 1992. He previously had been elected President and Chief Operating Officer in December 1990. Employed by the Corporation in 1975, Mr. Sanders was appointed Vice President of Kimberly-Clark Canada Inc., a wholly owned subsidiary of the Corporation, in 1981. He held various positions in that company, and was appointed Director and President in 1984. Mr. Sanders was elected Senior Vice President of Kimberly-Clark Corporation in 1985 and was appointed President - Infant Care Sector in 1987, President - Personal Care Sector in 1988 and President - World Consumer, Nonwovens and Service and Industrial Operations in 1990. He is a member of the Lawrence University Board of Trustees and the Marquette University Board of Trustees. He has been a director of the Corporation since 1989. KATHI P. SEIFERT, 44, was elected Group President - Feminine and Adult Care effective January 7, 1994. Ms. Seifert joined Kimberly-Clark in 1978. Her responsibilities in the Corporation have included various marketing positions within the Service and Industrial, Consumer Tissue and Feminine Products business sectors. She was appointed President - Feminine Care Sector, in 1991. JOHN A. VAN STEENBERG, 46, was elected President - European Consumer and Service & Industrial Operations effective January 1, 1994. Mr. Van Steenberg joined Kimberly-Clark in 1978. His previous responsibilities have included operations and major project management. He was appointed Managing Director of Kimberly-Clark Australia Pty. Limited in 1990. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The dividend and market price data included in Note 11 to the Financial Statements, and the information covered by the captions "Dividends and Dividend Reinvestment Plan" and "Stock Exchanges" contained in the 1993 Annual Report to Stockholders are incorporated in this Item 5 by reference. As of March 18, 1994, the Corporation had 25,121 stockholders of record. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA PART II (Continued) ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information under the caption "Management's Discussion and Analysis" contained in the 1993 Annual Report to Stockholders is incorporated in this Item 7 by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements of the Corporation and its subsidiaries and independent auditors' report contained in the 1993 Annual Report to Stockholders are incorporated in this Item 8 by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The section of the 1994 Proxy Statement captioned "Certain Information Regarding Directors and Nominees" under "Proposal 1. Election of Directors" identifies members of the board of directors of the Corporation and nominees, and is incorporated in this Item 10 by reference. See also "EXECUTIVE OFFICERS OF THE REGISTRANT" appearing in Part I hereof. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information in the section of the 1994 Proxy Statement captioned "Executive Compensation" under "Proposal 1. Election of Directors" is incorporated in this Item 11 by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the sections of the 1994 Proxy Statement captioned "Security Ownership of Management" and "Other Principal Holder of Voting Securities" under "Proposal 1. Election of Directors" is incorporated in this Item 12 by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the sections captioned "Certain Transactions and Business Relationships" and "Executive Compensation -- Compensation Committee Interlocks and Insider Participation" under "Proposal 1. Election of Directors" of the 1994 Proxy Statement is incorporated in this Item 13 by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS PART OF THIS REPORT. 1. Financial statements: The Consolidated Balance Sheet as of December 31, 1993 and 1992, and the related Consolidated Income Statement and Consolidated Cash Flow Statement for the years ended December 31, 1993, 1992 and 1991, and the related Notes thereto, and the Independent Auditors' Report are incorporated in Part II, Item 8 of this Form 10-K by reference to the Financial Statements contained in the 1993 Annual Report to Stockholders. 2. Financial statement schedules: The following information is filed as part of this Form 10-K and should be read in conjunction with the consolidated financial statements in the 1993 Annual Report to Stockholders. Independent Auditors' Report Schedules for Kimberly-Clark Corporation and Subsidiaries: V Property, Plant and Equipment VI Accumulated Depreciation of Property, Plant and Equipment VIII Valuation and Qualifying Accounts IX Short-Term Borrowings All other schedules have been omitted because they were not applicable or because the required information has been included in the financial statements or notes thereto. 3. Exhibits: Exhibit No.(3)a. Restated Certificate of Incorporation of Kimberly-Clark Corporation, dated April 16, 1987, incorporated by reference to Exhibit No. 4e. of the Kimberly-Clark Corporation Form S-8 filed on February 16, 1993 (File No. 33-58402). Exhibit No.(3)b. By-Laws of Kimberly-Clark Corporation, as amended April 22, 1993, incorporated by reference to Exhibit No.(3) of the Kimberly-Clark Corporation Form 10-Q for the quarterly period ended June 30, 1993. Exhibit No.(4). Copies of instruments defining the rights of holders of long-term debt will be furnished to the Securities and Exchange Commission on request. PART IV (Continued) ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (Continued) Exhibit No.(10)a. Kimberly-Clark Corporation 1976 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No.(10)b. Kimberly-Clark Corporation Management Achievement Award Program, incorporated by reference to Exhibit No. (10)b of the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1990. Exhibit No.(10)c. Kimberly-Clark Corporation Executive Severance Plan, incorporated by reference from the Kimberly- Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No.(10)d. Second Amended and Restated Deferred Compensation Plan for Directors of Kimberly-Clark Corporation, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No.(10)e. Kimberly-Clark Corporation 1986 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992. Exhibit No. (10)f. Kimberly-Clark Corporation 1992 Equity Participation Plan, incorporated by reference to Exhibit No. 4A. of the Kimberly-Clark Corporation Form S-8 filed on June 26, 1992 (File No. 33-49050). Exhibit No.(11). The net income per share of common stock computations for each of the periods included in Part II, Item 6. Selected Financial Data, of this Form 10-K are based on average common shares outstanding during each of the respective periods. The only "common stock equivalents" or other poten- tially dilutive securities or agreements (as defined in Accounting Principles Board Opinion No. 15) in Kimberly-Clark Corporation's capital structure during the periods presented were options outstanding under the Corporation's Equity Participation Plans. Computations of "primary" and "fully diluted" net income per share assume the exercise of outstanding stock options under the "treasury stock method." The table below presents the amounts by which the earnings per share amounts presented in Item 6 would be reduced if the "treasury stock method" had been used. Primary Fully Diluted ------- ------------- 1993 $.01 $.01 1992 - - 1991 .02 .02 1990 .01 .01 1989 .01 .02 Exhibit No.(12). Computation of ratio of earnings to fixed charges for the five years ended December 31, 1993. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (Continued) Exhibit No.(13). Portions of the Kimberly-Clark Corporation 1993 Annual Report to Stockholders incorporated by reference in this Form 10-K. Exhibit No.(21). Consolidated Subsidiaries and Equity Companies of Kimberly-Clark Corporation are identified in the 1993 Annual Report to Stockholders, and such information is incorporated in this Form 10-K by reference. Exhibit No.(23). Independent Auditors' Consent Exhibit No.(24). Powers of Attorney (b) Reports on Form 8-K (i) The Corporation filed a Current Report on Form 8-K dated February 17, 1994, which reported the Corporation's 1993 audited financial statements and management's discussion and analysis. (ii) The Corporation filed a Current Report on Form 8-K dated February 18, 1994 which reported the offering of $100 million principal of debt securities by the Corporation. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Kimberly-Clark Corporation March 24, 1994 By: /s/ John W. Donehower ----------------------------------------- John W. Donehower Senior Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ Wayne R. Sanders Chairman of the Board March 24, 1994 - ---------------------------- Wayne R. Sanders and Chief Executive Officer and Director /s/ John W. Donehower Senior Vice President and March 24, 1994 - ---------------------------- John W. Donehower Chief Financial Officer /s/ Randy J. Vest Vice President - March 24, 1994 - ---------------------------- Randy J. Vest Controller (principal accounting officer) Directors John F. Bergstrom Phala A. Helm, M.D. James D. Bernd William E. LaMothe Pastora San Juan Cafferty Louis E. Levy Paul J. Collins Frank A. McPherson Claudio X. Gonzalez H. Blair White James G. Grosklaus By: /s/ O. George Everbach ------------------------------------ O. George Everbach, Attorney-in-Fact March 24, 1994 INDEPENDENT AUDITORS' REPORT Kimberly-Clark Corporation: We have audited the consolidated financial statements of Kimberly-Clark Corporation as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 28, 1994, which report includes an explanatory paragraph concerning the Corporation's changes in its methods of accounting for income taxes and postretirement benefits other than pensions to conform with Statements of Financial Accounting Standards No. 109 and No. 106, respectively; such consolidated financial statements and report are included in your 1993 Annual Report and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Kimberly-Clark Corporation, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche - --------------------- DELOITTE & TOUCHE Dallas, Texas January 28, 1994 SCHEDULE V Kimberly-Clark Corporation and Subsidiaries PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 (Millions of dollars) SCHEDULE V Kimberly-Clark Corporation and Subsidiaries PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Millions of dollars) SCHEDULE VI Kimberly-Clark Corporation and Subsidiaries ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Millions of dollars) SCHEDULE VIII Kimberly-Clark Corporation and Subsidiaries VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Millions of dollars) SCHEDULE IX Kimberly-Clark Corporation and Subsidiaries SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Millions of dollars) INDEX TO DOCUMENTS FILED AS A PART OF THIS REPORT Description ----------- Consolidated financial statements, incorporated by reference Independent Auditors' Report, incorporated by reference Independent Auditors' Report Schedules for Kimberly-Clark Corporation and Subsidiaries: V Property, Plant and Equipment VI Accumulated Depreciation of Property, Plant and Equipment VIII Valuation and Qualifying Accounts IX Short-Term Borrowings Exhibit No.(3)a. Restated Certificate of Incorporation of Kimberly-Clark Corporation, dated April 16, 1987, incorporated by reference to Exhibit No. 4e. of the Kimberly-Clark Corporation Form S-8 filed on February 16, 1993 (File No. 33-58402) Exhibit No.(3)b. By-Laws of Kimberly-Clark Corporation, as amended April 22, 1993, incorporated by reference to Exhibit No.(3) of the Kimberly-Clark Corporation Form 10-Q for the quarterly period ended June 30, 1993 Exhibit No.(4). Copies of instruments defining the rights of holders of long-term debt will be furnished to the Securities and Exchange Commission on request Exhibit No.(10)a. Kimberly-Clark Corporation 1976 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992 Exhibit No.(10)b. Kimberly-Clark Corporation Management Achievement Award Program, incorporated by reference to Exhibit No.(10)b. of Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1990 Exhibit No.(10)c. Kimberly-Clark Corporation Executive Severance Plan, incorporated by reference from the Kimberly- Clark Corporation Form 10-K for the year ended December 31, Index to Documents Filed as a Part of This Report (Continued) Description ----------- Exhibit No.(10)d. Second Amended and Restated Deferred Compensation Plan for Directors of Kimberly-Clark Corporation, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992 Exhibit No.(10)e. Kimberly-Clark Corporation 1986 Equity Participation Plan, as amended effective May 1, 1987, incorporated by reference from the Kimberly-Clark Corporation Form 10-K for the year ended December 31, 1992 Exhibit No. (10)f. Kimberly-Clark Corporation 1992 Equity Participation Plan, incorporated by reference to Exhibit No. 4A. of the Kimberly-Clark Corporation Form S-8 filed on June 26, 1992 (File No. 33-49050) Exhibit No.(11). Statement re: computation of earnings per share Exhibit No.(12). Computation of ratio of earnings to fixed charges Exhibit No.(13). Portions of the Kimberly-Clark Corporation 1993 Annual Report to Stockholders incorporated by reference in this Form 10-K Exhibit No.(21). Consolidated Subsidiaries and Equity Companies of Kimberly-Clark Corporation are identified in the 1993 Annual Report to Stockholders, and such information is incorporated in this Form 10-K by reference Exhibit No.(23). Independent Auditors' Consent Exhibit No.(24). Powers of Attorney

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1993

ITEM 1. BUSINESS; ITEM 2.

ITEM 3. LEGAL PROCEEDINGS The Company and certain of its current officers and directors are named in four alleged class action lawsuits brought in federal court in Houston on behalf of persons who purchased Cooper stock during the period from February 1, 1993 through January 25, 1994. The complaints appear to allege that the defendants, through certain public statements, misled investors respecting (i) deterioration in certain of the Company's markets and the demand for some of its products, and (ii) the Company's anticipated performance in 1994. The ultimate liability, if any, which may result from these lawsuits cannot be determined at this time. As previously reported, on December 8, 1988, the U.S. Environmental Protection Agency ("EPA"), Region VI, issued an Administrative Order to Cooper Industries, Inc., Flow Control Division concerning alleged federal Clean Water Act violations. The allegations concerned wastewater discharges from the Company's Missouri City, Texas plant to the local sewer system. The EPA sought a civil penalty and the submission of a compliance schedule from the Company. The Company previously submitted a compliance schedule and negotiated a consent decree with the EPA under which the Company agreed to pay a civil penalty of $139,000. The executed consent decree was filed with the court in May 1993 and became effective July 23, 1993. On July 30, 1993 Cooper paid the agreed civil penalty of $139,000. On October 4, 1993, the court issued an order of dismissal for this matter. During November 1992, the Cooper-Bessemer Rotating operation of the Company received a letter from the Ohio Attorney General's office alleging violations of the Ohio Right To Know, Toxic Release Inventory reporting requirements. The allegations arise out of an Ohio EPA audit of the facility on April 30, 1992. The State initially proposed a penalty of $212,240. After negotiations between the Company and the State, the State reduced its proposed penalty to $139,457. In February 1994, the Company requested that the State not proceed with this matter until the EPA issues its decision in a rule-making proceeding currently under review addressing similar federal regulatory issues. The State has indicated that it is interested in renewing settlement negotiations. In March 1993, the Wisconsin Department of Natural Resources (DNR) alleged violations by the Company's Pewaukee, Wisconsin plant of air pollution control regulations concerning organic compound emissions from two coating lines and a rotary tumble coater. In August 1993, the Company proposed a settlement agreement to the DNR under which the Company would test changes in processes and coating materials to lower the amount of emissions. If process and materials changes were found to be insufficient, the Company would assure compliance by other means. The DNR forwarded the matter to the Wisconsin Department of Justice (DOJ). In March 1994, the DOJ orally advised the Company that the State will seek a civil penalty of approximately $150,000 in addition to a compliance schedule such as the one that the Company proposed and penalties during the implementation of the compliance schedule. Negotiations are continuing with the DOJ. The Company is also subject to various other suits, legal proceedings and claims that arise in the normal course of business. While it is not feasible to predict the outcome of these matters with certainty, management is of the opinion that their ultimate disposition should not have a material adverse effect on the Company's financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year covered by this report, no matters were submitted to a vote of the shareholders. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS As of March 8, 1994, there were 36,124 record holders of Cooper's Common Stock and 2,121 record holders of Cooper's $1.60 Convertible Exchangeable Preferred Stock, which is convertible into Cooper Common Stock. Information regarding dividends, trading markets and market prices for Cooper's Stock is incorporated herein by reference to page 24 of Cooper's 1993 Annual Report to Shareholders. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference to pages 36 and 37, Notes 1 through 4, 9 and 13 of Notes to Consolidated Financial Statements on pages 43 through 46, 50 through 51 and 56 through 57, and Earnings Outlook on pages 34 through 35 of Cooper's 1993 Annual Report to Shareholders. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference to pages 10 through 21 and 25 through 35 of Cooper's 1993 Annual Report to Shareholders, excluding the last sentence of the first paragraph on page 25. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated by reference to pages 38 through 62 of Cooper's 1993 Annual Report to Shareholders. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference to pages 3 through 8 and 9 of the Cooper Proxy Statement for the 1994 Annual Meeting of Shareholders. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference to pages 10 through 16 of the Cooper Proxy Statement for the 1994 Annual Meeting of Shareholders. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference to pages 2 and 8 of the Cooper Proxy Statement for the 1994 Annual Meeting of Shareholders. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements and Other Financial Data (incorporated by reference to the pages shown below in Cooper's 1993 Annual Report to Shareholders). With the exception of the financial statements, financial data and other information listed above or incorporated under Items 1, 5, 6, 7 and 8 of this Form 10-K, the 1993 Annual Report to Shareholders is not deemed filed as part of this report. The financial statement schedules listed below should be read in conjunction with the financial statements listed above. Financial statement schedules not included in this Form 10-K Annual Report have been omitted because they are not applicable or the required information is shown in the financial statements or notes hereto. Financial information with respect to subsidiaries not consolidated and 50% or less owned persons accounted for by the equity method has not been included since in the aggregate such subsidiaries and investments do not constitute a significant subsidiary. 2. Financial Statement Schedules (located on the following pages of this Report). Each Schedule is for each of the three years in the period ended December 31, 1993. 3. Exhibits 3.1 Twenty-Fifth Amended Articles of Incorporation of Cooper Industries, Inc. (incorporated herein by reference to Exhibit 3.1 of the Company's Form 10-K for the year ended December 31, 1992). 3.2 Code of Regulations (By-Laws), as amended, of Cooper Industries, Inc. (incorporated herein by reference to Exhibit 3.2 of the Company's Form 10-K for the year ended December 31, 1992). 4.1 Rights Agreement, dated as of February 17, 1987, between Cooper Industries, Inc. and First Chicago Trust Company of New York as Rights Agent, an amendment thereto dated August 14, 1989 (incorporated herein by reference to Exhibit 4.4 to Registration Statement No. 33-31941), and an amendment thereto dated November 6, 1990 (incorporated herein by reference to Exhibit 4.4 to Registration Statement No. 33-38808). 4.2 Rights Agreement, dated as of November 20, 1989, between Cooper Industries, Inc. and First Chicago Trust Company of New York as Rights Agent (incorporated herein by reference to Exhibit A to Registration Statement on Form 8-A filed on November 21, 1989), and an amendment thereto dated November 6, 1990 (incorporated herein by reference to Exhibit 4.5 to Registration Statement No. 33-38808). 10.1 1989 Director Stock Option Plan (incorporated herein by reference to Exhibit 28.1 to Registration Statement No. 2-33-29302). 10.2 Cooper Industries, Inc. Directors Deferred Compensation Plan (incorporated herein by reference to Exhibit 10.2 of the Company's Form 10-K for the year ended December 31, 1992). 10.3 Cooper Industries, Inc. Directors Retirement Plan (incorporated herein by reference to Exhibit 10.3 of the Company's Form 10-K for the year ended December 31, 1992). 10.4 Cooper Industries, Inc. Executive Restricted Stock Incentive Plan (incorporated herein by reference to Exhibit 10.4 of the Company's Form 10-K for the year ended December 31, 1992). 10.5 Cooper Industries, Inc. Supplemental Excess Defined Benefit Plan (incorporated herein by reference to Exhibit 10.6 of the Company's Form 10-K for the year ended December 31, 1992). 10.6 Cooper Industries, Inc. Supplemental Excess Defined Contribution Plan (incorporated herein by reference to Exhibit 10.7 of the Company's Form 10-K for the year ended December 31, 1992). 10.7 Management Incentive Compensation Deferral Plan (incorporated herein by reference to Exhibit 10.8 of the Company's Form 10-K for the year ended December 31, 1992). 10.8 Crouse-Hinds Company Officers' Disability and Supplemental Pension Plan (incorporated herein by reference to Exhibit 10.9 of the Company's Form 10-K for the year ended December 31, 1992). 13.0 Text of Cooper Industries, Inc. 1993 Annual Report to Shareholders incorporated herein by reference. 21.0 List of Cooper Industries, Inc. Subsidiaries. 23.0 Consent of Ernst & Young. 24.0 Powers of Attorney from members of the Board of Directors of Cooper Industries, Inc. Cooper will furnish to the Commission supplementally upon request a copy of any instrument with respect to long-term debt of the Company. Copies of the above Exhibits are available to shareholders of record at a charge of $.25 per page, minimum order of $10.00. Direct requests to: Cooper Industries, Inc. Attn: Corporate Secretary P.O. Box 4446 Houston, Texas 77210 (b) Reports on Form 8-K. No reports on Form 8-K were filed during the last quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. COOPER INDUSTRIES, INC. Date: March 30, 1994 By /s/ROBERT CIZIK --------------------------------- (Robert Cizik, Chairman and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Cooper Industries, Inc. 1993 Annual Report on Form 10-K Cross Reference Sheet COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (millions) (1) Other (transfers to inventory, reclassifications between categories, etc.). (2) Effect of translation in accordance with SFAS No. 52. (3) Assets obtained in business acquisitions and the fair market value adjustments and related activity associated with those assets. (4) Assets reclassified to Net Assets of Businesses Held for Disposition and assets disposed of in business divestitures. (5) Reduction in carrying value of assets related to transformer product line. S-1 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (millions) (1) Other (transfers to inventory, reclassifications between categories, etc.). (2) Effect of translation in accordance with SFAS No. 52. (3) Assets obtained in business acquisitions and the fair market value adjustments and related activity associated with those assets. (4) Effect of adoption of FAS 109. S-2 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (millions) (1) Other (transfers to inventory, reclassifications between categories, etc.). (2) Effect of translation in accordance with SFAS No. 52. (3) Assets obtained in business acquisitions and fair market value adjustments and related activity associated with those assets. (4) Correction of prior year error in translation. S-3 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (millions) (1) Includes change in accumulated depreciation related to "other" asset activity. (2) Effect of translation in accordance with SFAS No. 52. (3) Assets reclassified to Net Assets of Businesses Held for Disposition and assets disposed of in business dispositions. S-4 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (millions) (1) Includes change in accumulated depreciation related to "other" asset activity. (2) Effect of translation in accordance with SFAS No. 52. (3) Effect of adoption of FAS 109. S-5 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (millions) (1) Includes change in accumulated depreciation related to "other" asset activity. (2) Effect of translation in accordance with SFAS No. 52. (3) Correction of prior year error in translation. S-6 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1993 (1) Computed as the sum of the daily aggregate amounts borrowed divided by 365 days. (2) Computed by dividing interest expense for the year for each "category of borrowing" by the amount computed in Column E. (3) At December 31, 1993, $573.7 million of commercial paper and $247.0 million of borrowings payable to banks were reclassified to long-term debt reflecting the Company's intention to refinance these amounts during the twelve-month period following the balance sheet date through either continued short-term borrowings or utilization of available credit facilities. (4) Includes applicable fees. (5) Weighted average interest rates in the table do not include incremental borrowing costs associated with interest rate swaps. During the period, an average of $547.1 million of borrowings were covered under interest rate swaps that converted floating- rate borrowings into fixed-rate borrowings at an interest rate approximately 0.5 percentage points higher than the floating rate. At year end, $500 million of borrowings were covered under interest rate swaps expiring early in 1994 at rates higher than the floating rate by approximately 0.3 percentage points. S-7 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1992 (1) Computed as the sum of the daily aggregate amounts borrowed divided by 366 days. (2) Computed by dividing interest expense for the year for each "category of borrowing" by the amount computed in Column E. (3) At December 31, 1992, $1,080.0 million of commercial paper and $120.0 million of borrowings payable to banks were reclassified to long-term debt reflecting the Company's intention to refinance these amounts during the twelve-month period following the balance sheet date through either continued short-term borrowings or utilization of available credit facilities. (4) Includes applicable fees. (5) Weighted average interest rates in the table do not include incremental borrowing costs associated with interest rate swaps. During the period, an average of $669.9 million of borrowings were covered under interest rate swaps that converted floating- rate borrowings into fixed-rate borrowings at an interest rate approximately 0.8 percentage points higher than the floating rate. At year end, $755 million of borrowings were covered under interest rate swaps expiring early in 1993 at rates higher than the floating rate by approximately 1.1 percentage points. S-8 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1991 (1) Computed as the sum of the daily aggregate amounts borrowed divided by 365 days. (2) Computed by dividing interest expense for the year for each "category of borrowing" by the amount computed in Column E. (3) At December 31, 1991, $758.9 million of borrowings payable to banks were reclassified to long-term debt reflecting the Company's intention to refinance these amounts during the twelve-month period following the balance sheet date through either continued short-term borrowings or utilization of available credit facilities. (4) Includes applicable fees. S-9 COOPER INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 S-10

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313616

1993

79732_1993.txt

79732

1993

Item 1 BUSINESS - ------ -------- GENERAL - ------- Potomac Electric Power Company (Company), which was incorporated in the District of Columbia in 1896 and in the Commonwealth of Virginia in 1949, is engaged in the generation, transmission, distribution and sale of electric energy in the Washington, D.C. metropolitan area. The Company's retail service territory includes the District of Columbia and major portions of Montgomery and Prince George's counties in suburban Maryland. The area served at retail covers approximately 640 square miles and had a population of approximately 1.9 million at the end of 1993 and 1992. The Company also sells electricity, at wholesale, to Southern Maryland Electric Cooperative Inc. (SMECO), which distributes electricity in Calvert, Charles, Prince George's and St. Mary's counties in southern Maryland. During 1993, approximately 59% of the Company's revenues were derived from Maryland sales (including wholesale) and 41% from sales in the District of Columbia. About 30% of the Company's revenues were derived from residential customers, 64% from sales to commercial and government customers and 6% from sales at wholesale. Approximately 14% and 3% of 1993 revenues were derived from sales to the U.S. and D.C. governments, respectively. The Company holds valid franchises, permits and other rights adequate for its business in the territory it serves, and such franchises, permits and other rights contain no unduly burdensome restrictions. The Company is a member of the Pennsylvania-New Jersey-Maryland Interconnection (PJM) pursuant to an agreement under which its generating and transmission facilities are operated on an integrated basis with those of the other PJM member utilities in Pennsylvania, New Jersey, Maryland, Delaware and a small portion of Virginia. The purpose of PJM is to improve the operating economy and reliability of the systems in the group and to provide capital economies by permitting lower reserve requirements than would be required on a system basis. The Company also has direct high voltage connections with the Potomac Edison Company and Virginia Electric and Power Company, neither of which is a member of PJM. SALES - ----- The following data presents the Company's sales and revenue by class of service and by customer type, including data as to sales to the United States and District of Columbia governments. 1993 1992 1991 ---------- ---------- ---------- Electric Energy Sales (Thousands of Kilowatt-hours) --------------------- Kilowatt-hours Sold - Total 25,693,999 24,484,444 24,796,279 ========== ========== ========== By Class of Service - Residential service 6,739,987 6,155,793 6,503,105 General service 10,860,437 10,491,222 10,418,003 Large power service 5,232,380 5,183,560 5,261,308 Street lighting 163,827 163,739 161,577 Rapid transit 370,428 360,432 343,470 Wholesale 2,326,940 2,129,698 2,108,816 By Type of Customer - Residential 6,726,520 6,142,414 6,488,294 Commercial 11,750,542 11,391,337 11,321,344 U.S. Government 3,986,149 3,947,611 4,016,129 D.C. Government 903,848 873,384 861,696 Wholesale 2,326,940 2,129,698 2,108,816 Electric Revenue (Thousands of Dollars) ---------------- Sales of Electricity - Total* $1,696,435 $1,556,098 $1,542,571 ========== ========== ========== By Class of Service - Residential service $ 506,096 $ 433,648 $ 451,048 General service 747,237 705,178 681,182 Large power service 297,228 286,645 280,307 Street lighting 13,605 12,363 12,424 Rapid transit 24,107 22,914 20,913 Wholesale 108,162 95,350 96,697 By Type of Customer - Residential $ 505,173 $ 432,797 $ 450,103 Commercial 791,357 748,550 724,039 U.S. Government 238,192 229,586 223,723 D.C. Government 53,551 49,815 48,009 Wholesale 108,162 95,350 96,697 * Exclusive of Other Electric Revenues of $6,007 in 1993, $6,069 in 1992 and $9,495 in 1991. The Company's sales of electric energy are seasonal, and, accordingly, rates have been designed to closely reflect the daily and seasonal variations in the cost of producing electricity, in part by raising summer rates and lowering winter rates. Mild weather during the summer billing months of June through October, when base rates are high to encourage customer conservation and peak load shifting, has an adverse effect on revenues and, conversely, hot weather during these months has a favorable effect. Effective January 1, 1992, the Company changed its method of revenue recognition to provide for the accrual of revenue for service rendered but unbilled as of the end of the month. This change in accounting method has no significant effect on revenue over a 12-month period. It affects the timing of revenue recognition within the year, principally increasing revenues in the second quarter and decreasing revenues in the fourth quarter. The Company includes in revenues the amounts received for sales to other utilities related to pooling and interconnection agreements. Amounts received for such interchange deliveries are a component of the Company's fuel rates. CAPACITY PLANNING - ----------------- General - ------- During the period 1994 through 2003 the Company estimates that its peak demand will grow at a compound annual rate of approximately 1%. Based upon average weather conditions, the Company expects its compound annual growth in kilowatt-hour sales to range between 1% and 2% over the next decade. The Company's ongoing strategies to meet the increasing energy needs of its customers include conservation and energy use management programs which are designed to curb growth in peak demand. The need for new capacity has been further reduced by programs to maintain older generating units to ensure their continued efficiency over an extended life and the cost-effective purchase of capacity and energy. Conservation and Energy Use Management Programs - ----------------------------------------------- Cost-effective conservation programs have been a major component of the Company's success in limiting the need for new construction during the past decade. The Company's conservation and energy use management programs are designed to curb growth in demand in order to defer the need for construction of additional generating capacity and to cost-effectively increase the efficiency of energy use. The Company offers an extensive array of comprehensive conservation programs for its customers in the District of Columbia and Maryland. The Company's programs for residential customers include various types of incentives to encourage the design of energy-efficient homes and the purchase and installation of energy-efficiency measures. These incentives include customer rebates for energy efficient appliances, bonuses to contractors who build homes that meet high energy-efficiency standards, coupons which offer significant discounts to customers who purchase energy- efficient lights and water heater conservation measures and, commencing in 1993, a program to directly install, at no cost to the customer, lighting and water heater tank wraps in single-family, apartment and condominium residences. During 1993, the Company also initiated an appliance recycling program for customers, by offering payments for inefficient, but still functioning, refrigerators, air conditioners and freezers. The Company's programs for commercial customers offer a variety of approaches to encourage conservation, including design consultation and technical assistance at no fee, equipment rebates to developers and designers, cash incentives to customers who install energy-efficiency measures ranging from lighting to efficient motors and equipment, and, for small commercial customers, direct installation of efficient lighting and other measures at no- cost to the customer. During 1993, as part of the Custom Rebate program, the Company encouraged customers with older chillers to replace them with new high efficiency chillers. Also, the Company began offering loans on a pilot basis to commercial customers for efficiency improvements. The Company continues to aggressively identify, design, and test additional energy efficient conservation measures and technologies. The Company receives rate recognition for the cost of its conservation programs in its Maryland jurisdiction through a rate surcharge which permits the Company to earn a return on its conservation investment while receiving compensation for lost revenues. The cost recovery mechanism also allows the Company to earn a performance bonus for exceeding established goals. The surcharge is adjusted periodically to reflect the Company's growing conservation commitment. The District of Columbia Public Service Commission has established a framework which provides for a return on approved conservation investments and incentives for achieving demand side management goals within base rate cases. During 1993, the Company also continued to operate and expand its energy use management programs. In 1993, approximately 134,000 customers participated in programs which cycle air conditioners and water heaters during peak periods. In addition, the Company operates a commercial load program which provides incentives to customers for reducing energy use during peak periods. Time-of-use rates have been in effect since the early 1980s and currently approximately 60% of the Company's revenues are based on time-of-use rates. It is estimated that peak load reductions of approximately 390 megawatts have been achieved to date from conservation and energy use management programs and that additional peak load reductions of over 500 megawatts will be achieved in the next five years. The Company also estimates that energy savings of more than 450 million kilowatt-hours have been realized through operation of its conservation and energy use management programs through 1993. During the next five years, the Company plans to expend an estimated $525 million to encourage the efficient use of electric energy and to reduce the need to build new generating facilities. Although the Company is expanding its conservation and energy use management efforts, new sources of supply will be needed to assure the future reliability of electric service to the Washington area. These new sources of supply will be provided through the Company's plans for purchases of capacity and energy and through its ongoing construction program. Purchase of Capacity and Energy - ------------------------------- Pursuant to the Company's 1987 long-term capacity purchase agreements with Ohio Edison and Allegheny Power System, the Company is purchasing 450 megawatts of capacity and associated energy through the year 2005. In addition, the Company has a 25-year agreement with SMECO, which began in 1990, to purchase 84 megawatts of capacity supplied by a combustion turbine installed and owned by SMECO at the Company's Chalk Point Generating Station. The Company is responsible for all costs associated with operating and maintaining the facility. The Company has been exploring other cost-effective sources of energy and has entered into contracts for two nonutility generation projects which total 270 megawatts of capacity. In 1991, the Company signed an agreement with Panda Energy Corporation for a 230-megawatt gas-fueled combined-cycle cogeneration project in Prince George's County, Maryland, which is scheduled for service in 1996. The project is currently before the Maryland Public Service Commission for issuance of a certificate of convenience and necessity. In addition, the Company has signed a contract for a 40-megawatt resource recovery facility which is now under construction in Montgomery County, Maryland. In November 1993, after failing to obtain final building permits from the District of Columbia, Dominion Energy terminated its contract to build a 56-megawatt combined-cycle cogeneration facility at Georgetown University. CONSTRUCTION PROGRAM - -------------------- The Company carries on a continuous construction program, the nature and extent of which is determined by the Company's strategic planning process which integrates supply-side and demand-side resource options. From January 1, 1991 to December 31, 1993, the Company made property additions, net of an Allowance for Funds Used During Construction (AFUDC), of $1 billion (of which $300 million were made in 1993) and had property retirements of $122 million (of which $40 million were made in 1993). The Company's current construction program calls for estimated expenditures, excluding AFUDC, of $290 million in 1994, $280 million in 1995, $240 million in 1996, $210 million in 1997 and $245 million in 1998, an aggregate of $1.3 billion for the five-year period. AFUDC is estimated to be $24 million in 1994, $11 million in 1995, $14 million in 1996, $19 million in 1997 and $23 million in 1998. The 1994-1998 construction program includes approximately $618 million for generating facilities (including $203 million for Clean Air Act compliance), $66 million for transmission facilities, $558 million for distribution, service and other facilities, and $23 million associated with the Company's energy use management programs. Making use of the flexibilities in its long-term construction plan, the Company reduced projected expenditures for the five years 1994 through 1998 by a total of $315 million from amounts previously planned. The construction reductions and deferrals were associated with lower rates of projected growth in usage of electricity resulting in large part from implementing economical conservation programs. The Company plans to finance its construction program through funds provided by operations and external financing. The construction program includes amounts for the construction of facilities that will not be completed until after 1998. Although the program includes provision for escalation of construction costs, generally at an annual rate of 4%, the aggregate budget for long lead time projects will increase or decrease depending upon the actual rates of inflation in construction costs. The program is reviewed continuously and revised as appropriate to reflect changes in projections of demand, consumption patterns and economic trends. On June 1, 1993, the Company placed in service the second element of a combined-cycle unit, consisting of a 139-megawatt combustion turbine generating unit, at the Dickerson Generating Station located in Montgomery County, Maryland. The first 139-megawatt combustion turbine generating unit was placed in service on June 1, 1992. The total cost of the two combustion turbine units currently in service was $162 million. These generating units are primarily fueled by natural gas but can also burn No. 2 fuel oil. The Dickerson project plan provides for two combined-cycle units with the capability of adding a coal gasification facility, should future unit price differentials among coal, oil and gas make gasification economically attractive. The Company's construction schedule is flexible in order to accommodate changes in future growth and the addition of nonutility generation. Currently, no additional units are scheduled for the Dickerson combined-cycle project until after the year 2003. The Clean Air Act Amendments of 1990 (CAA) requires utilities to reduce emissions of sulfur dioxide and nitrogen oxides in two phases, January 1995 (Phase I) and January 2000 (Phase II). The Company has developed plans for complying with the CAA to achieve prescribed standards in Phases I and II. The Company anticipates capital expenditures totaling $203 million over the next five years pursuant to these plans. The plans call for replacement of boiler burner equipment for nitrogen oxides emissions control, the use of lower-sulfur fuel and cofiring with natural gas at selected baseload plants. The CAA allows companies to achieve required emission levels by using a market-based emission allowance trading system. If economical, emission allowances may be purchased in lieu of burning lower-sulfur fuel. The Company owns a 9.72% undivided interest in the Conemaugh Generating Station located in western Pennsylvania. As a result of installing flue gas scrubbing equipment to meet Phase I requirements of the CAA, this station will receive additional allowances. The Company's share of these "bonus" allowances may be used to reduce the need for lower-sulfur fuel at its other plants. The Company's share of the construction cost for the flue gas scrubbing equipment is approximately $38 million. Installation of scrubbers is not contemplated for the Company's wholly owned plants. Both the District of Columbia and Maryland commissions have approved the Company's plans for meeting Phase I requirements including cost recovery of investment and inclusion of emission allowance expenses in the Company's fuel adjustment clause. The Company is participating in the construction of the final segments of a 500,000 volt transmission line providing further links in the transmission systems of the Company, Baltimore Gas and Electric Company and Virginia Electric and Power Company (Virginia Power). The Company's construction schedule contemplates completion of the final segments in 1994. FUEL - ---- For customer billing purposes, all of the Company's kilowatt-hour sales are covered by separately stated fuel rates (see Item 8 - Note 2 of "Notes to Consolidated Financial Statements"). The Company's generating units burn only fossil fuels. The principal fuel is coal. The Company owns no nuclear generation facilities and none are planned. The following table sets forth the quantities of each type of fuel used by the Company in the years 1993, 1992 and 1991 and the contribution, on the basis of Btus, of each fuel to energy generated. 1993 1992 1991 -------------- -------------- -------------- % of % of % of Quantity Btu Quantity Btu Quantity Btu -------- ----- -------- ----- -------- ----- Coal (000s net tons) 6,010 79.4 5,926 82.9 6,471 81.7 Residual oil (000s barrels) 4,835 15.9 3,294 11.4 3,895 12.2 Natural gas (000s dekatherms) 6,090 3.2 8,200 4.5 9,933 4.9 No. 2 fuel oil (000s barrels) 480 1.5 376 1.2 407 1.2 The following table sets forth the average cost of each type of fuel burned, for the years shown. 1993 1992 1991 ------ ------ ------ Coal: per ton $43.69 $43.66 $45.37 per million Btu 1.72 1.72 1.78 Residual oil: per barrel 15.09 14.35 15.99 per million Btu 2.39 2.28 2.54 Natural gas: per dekatherm 2.88 2.32 2.18 per million Btu 2.88 2.32 2.18 No. 2 fuel oil: per barrel 24.98 26.70 29.07 per million Btu 4.30 4.60 5.01 The average cost of fuel burned per million Btu was $1.90 in 1993, compared with $1.85 in 1992 and $1.93 in 1991. The increase of approximately 3% in the 1993 system average unit fuel cost compared with the 1992 system average resulted from increased use of major cycling and peaking generation units which burn higher cost fuels. The Company's major cycling and certain peaking units can burn natural gas or oil, adding flexibility in selecting the most cost-effective fuel mix. Ten of the Company's sixteen steam-electric generating units can burn only coal; two can burn only residual oil; two can burn either coal or residual oil or a combination of both and two units can burn either residual oil or natural gas. Those units capable of burning either coal or residual oil normally burn coal as their primary fuel. The Company also has combustion turbines, some of which can burn only No. 2 fuel oil, and others which can burn natural gas or No. 2 fuel oil. During 1993, the new Dickerson combustion turbine units resulted in the displacement of generation from older, less cost-effective units. The following table provides details of the Company's generating capability from the standpoint of plant configuration as well as actual energy generation (see "Item 2

Item 3 LEGAL PROCEEDINGS - ------ ----------------- For information regarding pending environmental legal proceedings, see "Environmental Matters" under Item 1 "Business." The Company was a defendant in employment discrimination litigation which was pending in the United States District Court for the District of Columbia. In February 1993, the parties to the case reached tentative settlement of the claims and, in April 1993, the Company paid $38.26 million into a trust fund pursuant to the terms of the agreement. The funds will be disbursed from the trust fund to certain covered classes of current and former employees and applicants for employment and to cover the plaintiffs' legal and expert fees and costs. The Court approved the settlement agreement effective July 1993. The Company received insurance payments of $13.5 million in October 1993 and $24 million in January 1994, bringing the total recovered from insurance companies to $37.5 million. At December 31, 1993, approximately $.8 million was charged to non-operating expense. Item 4

Item 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------ --------------------------------------------------- None. Part II - ------- Item 5

Item 5 MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER - ------ ----------------------------------------------------------------- MATTERS ------- The following table presents the dividends per share of Common Stock and the high and low of the daily Common Stock transaction prices as reported in The Wall Street Journal during each period. The New York Stock Exchange is the principal market on which the Company's Common Stock is traded. The Company's Common Stock is also traded on the Tokyo Stock Exchange. Dividends Price Range Period Per Share High Low --------------------- --------------- -------- --------- 1993: First Quarter...... $.41 $26-1/2 $23-7/8 Second Quarter..... .41 27-3/8 25-5/8 Third Quarter...... .41 28-7/8 27-1/8 Fourth Quarter..... .41 $1.64 28-3/4 24-5/8 1992: First Quarter...... $.40 $25-1/8 $22-3/4 Second Quarter..... .40 26 23 Third Quarter...... .40 27-1/2 25-1/8 Fourth Quarter..... .40 $1.60 26-3/4 22-5/8 The number of holders of Common Stock was 98,312 at March 8, 1994 and 98,892 at December 31, 1993. There were 117,915,691 and 117,797,652 shares of the Company's $1 par value Common Stock outstanding at March 8, 1994, and December 31, 1993, respectively. A total of 200 million shares is authorized. At its January 1994 meeting, the Company's Board of Directors declared a quarterly dividend on Common Stock of 41 1/2 cents per share, an increase of 1/2 cent per share over the quarterly dividend of 41 cents paid during 1993. The increased dividend is payable March 31, 1994, to shareholders of record on February 25, 1994. Item 6

Item 6 SELECTED FINANCIAL DATA - ------ ----------------------- The information required by Item 6 is incorporated herein by reference to "Selected Consolidated Financial Data" in the Financial Information of the Company's 1993 Annual Report to shareholders. Item 7

Item 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------ --------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- The information required by Item 7 is incorporated herein by reference to the "Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition" in the Financial Information section of the Company's 1993 Annual Report to shareholders. See "Rates" under Item 1 "Business" for an update to the discussion of the Company's base rate proceeding in the District of Columbia. Item 8

Item 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------ ------------------------------------------- The consolidated financial statements, together with the report thereon of Price Waterhouse dated January 21, 1994, and supplementary data from the Company's 1993 Annual Report to shareholders are incorporated herein by reference. With the exception of the aforementioned information and the information incorporated in Items 5, 6, 7, 8 and 9, the 1993 Annual Report to Shareholders is not deemed filed as part of this Form 10-K Annual Report. Item 9

Item 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------ --------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- None. Part III - -------- Item 10

Item 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------- -------------------------------------------------- The information required by Item 10 with regard to Directors of the registrant is incorporated herein by reference to the Company's Notice of Annual Meeting of Shareholders and Proxy Statement dated March 18, 1994. Information with regard to the executive officers of the registrant as of March 8, 1994, is as follows: Served in such position Name Position Age since - -------------------- -------------------------------- --- ------------- Edward F. Mitchell Chairman of the Board and Chief Executive Officer 62 1992 (1) John M. Derrick Jr. President and Chief Operating Officer 53 1992 (2) H. Lowell Davis Vice Chairman and Chief Financial Officer and Director 61 1983 Paul Dragoumis Executive Vice President 59 1989 (3) Dennis R. Wraase Senior Vice President - Finance and Accounting 49 1992 (4) Iraline G. Barnes Vice President - Corporate 46 1990 (5) Relations Earl K. Chism Vice President and Treasurer 58 1989 (6) Susann D. Felton Vice President - Materials 45 1992 (7) William R. Gee Jr. Vice President - System Engineering 53 1991 (8) Robert C. Grantley Vice President - Customer Services 45 1989 (9) Anthony S. Macerollo Vice President - Human Resources 52 1989 (10) Eddie R. Mayberry Vice President - Market Planning and Policy 46 1993 (11) John D. McCallum Vice President - Corporate Tax 44 1992 (12) Served in such position Name Position Age since - -------------------- -------------------------------- --- ------------- James S. Potts Vice President - Environment 48 1993 (13) William J. Sim Vice President - Operations and Construction 49 1991 (14) William T. Torgerson Vice President and General Counsel 49 1989 (15) Andrew W. Williams Vice President - Energy Policy and Development 44 1989 (16) None of the above persons has a "family relationship" with any other officer listed or with any director or nominee for director. The term of office for each of the above persons is from April 28, 1993 to April 27, 1994. (1) Mr. Mitchell was elected to the position of Chairman of the Board on December 21, 1992. He was elected Chief Executive Officer effective September 1, 1989. Prior to that time he held the position of President and Chief Operating Officer, since 1983. (2) Mr. Derrick was elected to the position of President on December 21, 1992. He was elected Executive Vice President and Chief Operating Officer on July 27, 1989. Prior to that time he held the position of Vice President - Customer Services, since 1981. (3) Mr. Dragoumis was elected to his present position on July 27, 1989. Prior to that time he held the position of Senior Vice President. (4) Mr. Wraase was elected to his present position on April 22, 1992. He was elected Senior Vice President and Comptroller on July 27, 1989. Prior to that time he held the position of Vice President and Comptroller, since 1985. (5) Mrs. Barnes was elected to her present position effective April 1, 1990. Prior to that time she served as Associate Judge of the Superior Court of the District of Columbia for ten years. (6) Mr. Chism was elected to his present position on July 27, 1989. Prior to that time he held the positions of Treasurer from 1988 to 1989, and of Assistant Treasurer from 1987 to 1988. (7) Ms. Felton was elected to her present position on April 22, 1992. Prior to that time she held the position of Manager, Materials. (8) Mr. Gee was elected to his present position on April 24, 1991. Prior to that time he held the position of Vice President - Generating Engineering and Construction, since 1989. Prior to 1989, he held the position of Manager, Generating Engineering. (9) Mr. Grantley was elected to his present position on July 27, 1989. Prior to that time he held the position of Manager, Customer Services, since 1987. (10) Mr. Macerollo was elected to his present position on July 27, 1989. Prior to that time he held the position of Manager, Human Resources, since 1986. (11) Dr. Mayberry was elected to his present position on April 28, 1993. Prior to that time he held the position of Manager, Market Planning and Policy, since 1989. Prior to 1989 he held the position of Manager, Rate and Economic Analysis. (12) Mr. McCallum was elected to his present position on April 22, 1992. Prior to that time he held the position of Assistant Comptroller, since 1987. (13) Mr. Potts was elected to his present position on April 28, 1993. Prior to that time he held the position of Manager, Generating Strategic Support since 1991. Prior to 1991 he held the position of Manager, Production Performance. (14) Mr. Sim was elected to his present position on April 24, 1991. Prior to that time he was President of the American Energy division of the Company's nonutility subsidiary, Potomac Capital Investment Corporation, since 1988. Prior to 1988, he held the position of Manager, Generating Construction. (15) Mr. Torgerson was elected to his present position effective January 1, 1989. Prior to that time he held the position of Vice President and Deputy General Counsel, since 1986. (16) Mr. Williams was elected to his present position on July 27, 1989. Prior to that time he held the position of Manager, Financial Planning and Analysis, since 1985. Item 11

Item 11 EXECUTIVE COMPENSATION - ------- ---------------------- The information required by Item 11 is incorporated herein by reference to the Company's Notice of Annual Meeting of Shareholders and Proxy Statement dated March 18, 1994. Item 12

Item 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------- -------------------------------------------------------------- The information required by Item 12 is incorporated herein by reference to the Company's Notice of Annual Meeting of Shareholders and Proxy Statement dated March 18, 1994. Item 13

Item 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------- ---------------------------------------------- None. Part IV - ------- Item 14

Item 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - ------- --------------------------------------------------------------- (a) Documents List -------------- 1. Financial Statements The following documents are filed as part of this report as incorporated herein by reference from the indicated pages of the Company's 1993 Annual Report. Reference (Page) ---------------- Form 10-K Annual Report Annual Report to Shareholders Exhibit 13 --------------- ------------- Consolidated Statements of Earnings - for the years ended December 31, 1993, 1992 and 1991 15 24 Consolidated Balance Sheets - December 31, 1993 and 1992 16-17 25-26 Consolidated Statements of Cash Flows - for the years ended December 31, 1993, 1992 and 1991 18 27 Notes to Consolidated Financial Statements 19-31 28-60 Report of Independent Accountants 14 23 2. Financial Statement Schedules Unaudited supplementary data entitled "Quarterly Financial Summary (Unaudited)" is incorporated herein by reference in Item 8 (included in "Notes to Consolidated Financial Statements" as Note 15). The following financial statement schedules are submitted under Item 14 (d): Report of Independent Accountants on Consolidated Financial Statement Schedules Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-Term Borrowings All other schedules are omitted because they are not applicable, or the required information is presented in the financial statements. 3. Exhibits required by Securities and Exchange Commission Regulation S-K (summarized below). Exhibit No. Description of Exhibit Reference* - ------- ---------------------- ---------- 3-A Charter of the Company.............. Filed herewith. 3-B By-Laws of the Company.............. Exh. 3-B to Form 10-K, 3/26/93. 4 Mortgage and Deed of Trust dated July 1, 1936, of the Company to The Riggs National Bank of Washington, D.C., as Trustee, securing First Mortgage Bonds of the Company, and Supplemental Indenture dated July 1, 1936........................ Exh. B-4 to First Amendment, 6/19/36, to Registration Statement No. 2-2232. Exhibit No. Description of Exhibit Reference* - ------- ---------------------- ---------- 4 Supplemental Indentures, to the (cont.) aforesaid Mortgage and Deed of Trust, dated - December 1, 1939 and December 10, 1939.......................... Exhs. A & B to Form 8-K, 1/3/40. August 1, 1940...................... Exh. A to Form 8-K, 9/25/40. July 15, 1942 and August 10, 1942................................ Exh. B-1 to Amendment No. 2, 8/24/42, and B-3 to Post- Effective Amendment, 8/31/42, to Registration Statement No. 2-5032. August 1, 1942...................... Exh. B-4 to Form 8-A, 10/8/42. October 15, 1942.................... Exh. A to Form 8-K, 12/7/42. October 15, 1947.................... Exh. A to Form 8-K, 12/8/47. January 1, 1948..................... Exh.7-B to Post-Effective Amendment No. 2, 1/28/48, to Registration Statement No. 2-7349. December 31, 1948................... Exh. A-2 to Form 10-K, 4/13/49. May 1, 1949......................... Exh. 7-B to Post-Effective Amendment No. 1, 5/10/49, to Registration Statement No. 2-7948. December 31, 1949................... Exh. (a)-1 to Form 8-K, 2/8/50. May 1, 1950......................... Exh. 7-B to Amendment No. 2, 5/8/50, to Registration Statement No. 2-8430. February 15, 1951................... Exh. (a) to Form 8-K, 3/9/51. March 1, 1952....................... Exh. 4-C to Post-Effective Amendment No. 1, 3/12/52, to Registration Statement No. 2-9435. February 16, 1953................... Exh. (a)-1 to Form 8-K, 3/5/53. May 15, 1953........................ Exh. 4-C to Post-Effective Amendment No. 1, 5/26/53, to Registration Statement No. 2-10246. Exhibit No. Description of Exhibit Reference* - ------- ---------------------- ---------- 4 March 15, 1954 and March 15, (cont.) 1955................................ Exh. 4-B to Registration Statement No. 2-11627, 5/2/55. May 16, 1955........................ Exh. A to Form 8-K, 7/6/55. March 15, 1956...................... Exh. C to Form 10-K, 4/4/56. June 1, 1956........................ Exh. A to Form 8-K, 7/2/56. April 1, 1957....................... Exh. 4-B to Registration Statement No. 2-13884, 2/5/58. May 1, 1958......................... Exh. 2-B to Registration Statement No. 2-14518, 11/10/58. December 1, 1958.................... Exh. A to Form 8-K, 1/2/59. May 1, 1959......................... Exh. 4-B to Amendment No. 1, 5/13/59, to Registration Statement No. 2-15027. November 16, 1959................... Exh. A to Form 8-K, 1/4/60. May 2, 1960......................... Exh. 2-B to Registration Statement No. 2-17286, 11/9/60. December 1, 1960 and April 3, 1961................................ Exh. A-1 to Form 10-K, 4/24/61. May 1, 1962......................... Exh. 2-B to Registration Statement No. 2-21037, 1/25/63. February 15, 1963................... Exh. A to Form 8-K, 3/4/63. May 1, 1963......................... Exh. 4-B to Registration Statement No. 2-21961, 12/19/63. April 23, 1964...................... Exh. 2-B to Registration Statement No. 2-22344, 4/24/64. May 15, 1964........................ Exh. A to Form 8-K, 6/2/64. May 3, 1965......................... Exh. 2-B to Registration Statement No. 2-24655, 3/16/66. April 1, 1966....................... Exh. A to Form 10-K, 4/21/66. June 1, 1966........................ Exh. 1 to Form 10-K, 4/11/67. April 28, 1967...................... Exh. 2-B to Post-Effective Amendment No. 1 to Registration Statement No. 2-26356, 5/3/67. May 1, 1967......................... Exh. A to Form 8-K, 6/1/67. Exhibit No. Description of Exhibit Reference* - ------ ---------------------- ---------- 4 July 3, 1967........................ Exh. 2-B to Registration (cont.) Statement No. 2-28080, 1/25/68. February 15, 1968................... Exh. II-I to Form 8-K, 3/7/68. May 1, 1968......................... Exh. 2-B to Registration Statement No. 2-31896, 2/28/69. March 15, 1969...................... Exh. A-2 to Form 8-K, 4/8/69. June 16, 1969....................... Exh. 2-B to Registration Statement No. 2-36094, 1/27/70. February 15, 1970................... Exh. A-2 to Form 8-K, 3/9/70. May 15, 1970........................ Exh. 2-B to Registration Statement No. 2-38038, 7/27/70. August 15, 1970..................... Exh. 2-D to Registration Statement No. 2-38038, 7/27/70. September 1, 1971................... Exh. 2-C to Registration Statement No. 2-45591, 9/1/72. September 15, 1972.................. Exh. 2-E to Registration Statement No. 2-45591, 9/1/72. April 1, 1973....................... Exh. A to Form 8-K, 5/9/73. January 2, 1974..................... Exh. 2-D to Registration Statement No. 2-49803, 12/5/73. August 15, 1974..................... Exhs. 2-G and 2-H to Amendment No. 1 to Registration Statement No. 2-51698, 8/14/74. June 15, 1977....................... Exh. 4-A to Form 10-K, 3/19/81. July 1, 1979........................ Exh. 4-B to Form 10-K, 3/19/81. June 16, 1981....................... Exh. 4-A to Form 10-K, 3/19/82. June 17, 1981....................... Exh. 2 to Amendment No. 1, 6/18/81, to Form 8-A. December 1, 1981.................... Exh. 4-C to Form 10-K, 3/19/82. August 1, 1982...................... Exh. 4-C to Amendment No. 1 to Registration Statement No. 2-78731, 8/17/82. October 1, 1982..................... Exh. 4 to Form 8-K, 11/8/82. April 15, 1983...................... Exh. 4 to Form 10-K, 3/23/84. November 1, 1985.................... Exh. 2-B to Form 8-A, 11/1/85. Exhibit No. Description of Exhibit Reference* - ------ ---------------------- ---------- 4 March 1, 1986....................... Exh. 4 to Form 10-K, 3/28/86. (cont.) November 1, 1986.................... Exh. 2-B to Form 8-A, 11/5/86. March 1, 1987....................... Exh. 2-B to Form 8-A, 3/2/87. September 16, 1987.................. Exh. 4-B to Registration Statement No. 33-18229, 10/30/87. May 1, 1989......................... Exh. 4-C to Registration Statement No. 33-29382, 6/16/89. August 1, 1989...................... Exh. 4 to Form 10-K, 3/23/90. April 5, 1990....................... Exh. 4 to Form 10-K, 3/29/91. May 21, 1991........................ Exh. 4 to Form 10-K, 3/27/92. May 7, 1992......................... Exh. 4 to Form 10-K, 3/26/93. September 1, 1992................... Exh. 4 to Form 10-K, 3/26/93. November 1, 1992.................... Exh. 4 to Form 10-K, 3/26/93. March 1, 1993....................... Exh. 4 to Form 10-K, 3/26/93. March 2, 1993....................... Exh. 4 to Form 10-K, 3/26/93. July 1, 1993........................ Exh. 4.4 to Registration Statement No. 33-49973, 8/11/93. August 20, 1993..................... Exh. 4.4 to Registration Statement No. 33-50377, 9/23/93. September 29, 1993.................. Filed herewith. September 30, 1993.................. Filed herewith. October 1, 1993..................... Filed herewith. February 10, 1994................... Filed herewith. February 11, 1994................... Filed herewith. 4-A Indenture, dated as of January 15, 1988, between the Company and Centerre Trust Company of St. Louis (now known as Boatmen's Trust Company), Trustee for the Company's $75,000,000 issue of 7% Convertible Debentures due 2018 ................ Exh. 4-A to Form 10-K, 3/25/88. 4-B Indenture, dated as of July 28, 1989, between the Company and The Bank of New York, Trustee, with respect to the Company's Medium-Term Note Program............ Exh. 4 to Form 8-K, 6/21/90. Exhibit No. Description of Exhibit Reference* - ------ ---------------------- ---------- 4C Indenture, dated as of August 15, 1992, between the Company and the Bank of New York, Trustee, for the Company's $115,000,000 issue of 5% Convertible Debentures due 2002..... Exh. 4-C to Form 10-K, 3/26/93. 10 Agreement, effective July 23, 1993, between the Company and the International Brotherhood of Electrical Workers (Local Union #1900).............................. Exh. 10 to Form 10-Q, 7/30/93. **11 Computation of Earnings Per Common Share...................... Filed herewith. **12 Computation of Ratios............... Filed herewith. 13 Financial Information Section of Annual Report .................... Filed herewith. **22 Subsidiaries of the Registrant...... Filed herewith. **24 Consent of Independent Accountants.. Filed herewith. * The exhibits referred to in this column by specific designations and date have heretofore been filed with the Securities and Exchange Commission under such designations and are hereby incorporated herein by reference. The Forms 8-A, 8-K and 10-K referred to were filed by the Company under the Commission's File No. 1-1072 and the Registration Statements referred to are registration statements of the Company. ** These exhibits are submitted under Item 14(c). (b) Reports on Form 8-K ------------------- None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Washington, District of Columbia, on the 25th day of March, 1994. POTOMAC ELECTRIC POWER COMPANY (Registrant) By /s/ E. F. Mitchell -------------------------- (Edward F. Mitchell, Chairman of the Board and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Signature Title Date --------- ----- ---- (i) Principal Executive Officer /s/ E. F. Mitchell --------------------------- Chairman of the Board and (Edward F. Mitchell) Chief Executive Officer (ii) Principal Financial Officer /s/ H. L. Davis --------------------------- Vice Chairman and Chief (H. Lowell Davis) Financial Officer and Director (iii) Principal Accounting Officer /s/ D. R. Wraase --------------------------- Senior Vice President (Dennis R. Wraase) Finance and Accounting March 25, 1994 Signature Title Date --------- ----- ---- (iv) Directors: /s/ Roger R. Blunt ------------------------- Director (Roger R. Blunt Sr.) /s/ A. J. Clark ------------------------- Director (A. James Clark) /s/ Richard E. Marriott ------------------------- Director (Richard E. Marriott) /s/ David O. Maxwell ------------------------ Director (David O. Maxwell) /s/ Floretta D. McKenzie ------------------------- Director (Floretta D. McKenzie) /s/ Ann D. McLaughlin ------------------------- Director (Ann D. McLaughlin) /s/ Peter F. O'Malley ------------------------- Director (Peter F. O'Malley) /s/ Louis A. Simpson ------------------------- Director (Louis A. Simpson) /s/ W. Reid Thompson ------------------------- Director (W. Reid Thompson) Signature Title Date --------- ----- ---- (iv) Directors: /s/ Charls E. Walker ------------------------- Director (Charls E. Walker) March 25, 1994

732714_1993.txt

732714

1993

Item 1. BUSINESS. General NYNEX Corporation ("NYNEX") was incorporated on October 7, 1983 under the laws of the State of Delaware and has its principal executive offices at 1113 Westchester Avenue, White Plains, New York 10604 (telephone number 914-644-6400). NYNEX is a holding company with various subsidiaries engaged in the provision of telecommunications products and services, directory publishing and other business services. NYNEX provides products and services in several industry segments (see "Consolidated Financial Statements and Supplementary Data" below). NYNEX's dominant industry segment is Telecommunications, which includes New York Telephone Company ("New York Telephone"), New England Telephone and Telegraph Company ("New England Telephone") and their subsidiaries (see "Telecommunications" below). In addition to Telecommunications, NYNEX has wholly-owned subsidiaries in the following industry segments: Cellular (NYNEX Mobile Communications Company), Publishing (NYNEX Information Resources Company), Financial Services (NYNEX Credit Company, NYNEX Capital Funding Company and NYNEX Trade Finance Company) and Other Diversified Operations (including NYNEX Network Systems Company and NYNEX CableComms Limited, among others). Each of these segments is described below. Telecommunications The two principal operating subsidiaries of NYNEX are operating telephone companies, New York Telephone and New England Telephone (collectively, the "Telephone Companies"). The Telephone Companies provided NYNEX with 86% of its operating revenues in 1993. Approximately 87% of the Telephone Companies' revenues were derived from operations in New York State and Massachusetts. In 1993, revenues from one customer, American Telephone and Telegraph Company ("AT&T"), accounted for approximately 16% of NYNEX's total operating revenues, primarily in network access and other revenues. New York Telephone is incorporated under the laws of the State of New York and is primarily engaged in providing telecommunications services in a large portion of New York State and a small portion of Connecticut (Greenwich and Byram only). New England Telephone is incorporated under the laws of the State of New York and is primarily engaged in providing telecommunications services in Massachusetts, Maine, New Hampshire, Rhode Island and Vermont. The Telephone Companies are primarily engaged in providing two types of telecommunications services, exchange telecommunications and exchange access, in their respective territories. Exchange telecommunications service is the transmission of telecommunications among customers located within geographical areas (local access and transport areas or "LATAs"). These LATAs are generally centered on a city or other identifiable community of interest and, subject to certain exceptions, each LATA marks an area within which a former Bell System local exchange company ("LEC") operating within such territory may provide telecommunications services (see "Operations Under the Modification of Final Judgment" below). Exchange telecommunications service may include long distance service as well as local service within LATAs. Examples of exchange telecommunications services include switched local residential and business services, private line voice and data services, Wide Area Telecommunications Service ("WATS"), long distance and Centrex services. Exchange access service refers to the link provided by LECs between a customer's premises and the transmission facilities of other telecommunications carriers, generally interLATA carriers. Examples of exchange access services include switched access and special access services. Certain billing and collection services are performed by the Telephone Companies for other carriers, primarily AT&T, and certain information providers that elect to subscribe to these services rather than perform such services themselves. Effective January 1, 1987, such billing and collection services were detariffed on an interstate basis and are offered to interexchange carriers under contract. In addition, many components of billing and collection services in New York State have been detariffed pursuant to orders of the New York State Public Service Commission ("NYSPSC"). The NYSPSC has determined that other components of intrastate billing and collection services shall remain under tariff. In 1993, approximately 1% of NYNEX's operating revenues were derived from billing and collection services. In 1990, the Telephone Companies and AT&T signed a six-year contract extending the Telephone Companies' roles as AT&T long distance billing and collection agents. The agreement allows AT&T the flexibility of gradually assuming certain administrative and billing functions performed by the Telephone Companies. The contract expires on December 31, 1995. There are six LATAs that comprise the area served by New York Telephone and they are referred to as follows: the New York City Metropolitan Area (which includes Westchester, Rockland, Putnam, Nassau and Suffolk Counties in New York and Greenwich and Byram in Connecticut), Poughkeepsie, Albany-Glens Falls, Syracuse-Utica, Buffalo and Binghamton-Elmira. There are six LATAs served by New England Telephone: Eastern Massachusetts, Western Massachusetts, Maine, New Hampshire, Vermont and Rhode Island. Although the Telephone Companies generally are prohibited by the Modification of Final Judgment from providing interLATA service, New York Telephone is permitted to and does provide interLATA service in certain areas, including service between New York City and northern New Jersey (see "Operations Under the Modification of Final Judgment" below). The territories served by the Telephone Companies contain sizeable areas and many localities in which local service is provided by nonaffiliated telephone companies. Rochester, Jamestown, Middletown, Webster and Henrietta, New York are the only cities with a population of more than 25,000 within New York State that are served by such nonaffiliated companies. On December 31, 1993 these nonaffiliated companies had approximately 1,369,000 network access lines in service. In 1990, NYNEX Materiel Enterprises Company was transferred from NYNEX to the Telephone Companies and then merged into another jointly owned subsidiary, NYNEX Service Company, which was renamed Telesector Resources Group, Inc. ("Telesector Resources"). The Telephone Companies have consolidated all or part of many regional service and support functions into Telesector Resources. Regional service functions are interstate access services, operator services, public communications, sales, market area services, corporate services, information services, labor relations, engineering/construction and business planning. Support functions are quality and process re-engineering, marketing, technology and planning, public relations, legal and human resources. In addition, Telesector Resources provides various procurement, procurement support and materials management services to the Telephone Companies, on a nonexclusive basis. These services include product evaluation, contracting, purchasing, materials management and disposition, warehousing, transportation, and equipment repair management. Under a reciprocal services agreement, the Telephone Companies provide certain administrative and other services for Telesector Resources. Each of the seven regional holding companies ("RHCs") formed in connection with the AT&T divestiture owns an equal interest in Bell Communications Research, Inc. ("Bellcore") (see "Operations Under the Modification of Final Judgment" below). Bellcore furnishes to the LECs, including the Telephone Companies, and certain of their subsidiaries technical and support services (that include research and development) relating to exchange telecommunications and exchange access services that can be provided more efficiently on a centralized basis. Bellcore serves as a central point of contact for coordinating the efforts of NYNEX and the other RHCs in meeting the national security and emergency preparedness requirements of the federal government. Cellular NYNEX Mobile Communications Company ("NYNEX Mobile"), through its operating subsidiaries and partnerships, provides a variety of wireless telecommunications services and products, including services and products that incorporate cellular technology, throughout the northeastern United States. Publishing NYNEX Information Resources Company ("Information Resources") produces, publishes and distributes alphabetical (White Pages) and classified (Yellow Pages) directories for the Telephone Companies pursuant to agreements that provide for the payment of fees to the Telephone Companies in exchange for the right to publish such directories. Acting through its subsidiaries, Information Resources also publishes, on its own and in partnership with other entities, other telephone directories, both domestically and internationally. NYNEX Information Technologies Company, a subsidiary of Information Resources, provides on-line electronic directories in the United States and France and also provides CD-ROM directories. Financial Services NYNEX Credit Company is primarily engaged in the business of financing transportation, industrial, and commercial equipment and facilities to a broad range of companies through leasing transactions unrelated to NYNEX's other businesses. NYNEX Capital Funding Company provides a source of funding to NYNEX and its subsidiaries, other than the Telephone Companies, through its ability to issue debt securities in the United States, Europe and other international markets. NYNEX Trade Finance Company evaluates and obtains non-recourse and trade-related financing for NYNEX projects, evaluates and manages foreign currency risk and arranges the repatriation of profits from foreign operations, principally in developing and third-world economies. NYNEX is in the process of exiting the real estate development and management business. Other Diversified Operations NYNEX Network Systems Company provides wireline and wireless network services outside the United States. NYNEX CableComms Limited ("CableComms") builds and operates cable television and telephony networks in the United Kingdom. Information products and services and consulting services are provided both nationally and internationally by other companies within this segment. NYNEX is in the process of exiting the information products and services business. During 1993 and early 1994, NYNEX sold The BIS Group Limited and AGS Computers, Inc. Business Restructuring In the fourth quarter of 1993, NYNEX recorded charges of approximately $2.1 billion for business restructuring. These charges resulted from a comprehensive analysis of operations and work processes, resulting in a strategy to redesign them to improve efficiency and customer service, to implement work force reductions, and to produce cost savings necessary for NYNEX to operate in an increasingly competitive environment. NYNEX's capital expenditures in 1994, excluding capital expenditures resulting from business restructuring, are currently expected to be at a level comparable to 1993 expenditures. Most of such expenditures will be for the Telephone Companies, Telesector Resources, NYNEX Mobile, and CableComms. Operations Under the Modification of Final Judgment The operations of NYNEX and its subsidiaries in all industry segments are subject to the requirements of a consent decree known as the "Modification of Final Judgment" ("MFJ"). The MFJ arose out of an antitrust action brought by the United States Department of Justice ("DOJ") against AT&T. On August 24, 1982, the United States District Court for the District of Columbia (the "MFJ Court") approved the MFJ as in the public interest. On February 28, 1983, the United States Supreme Court affirmed the MFJ Court's action. Pursuant to the MFJ, AT&T divested its 22 wholly-owned LECs, including the Telephone Companies, distributed them to the RHCs, and distributed the stock of the RHCs to AT&T's stockholders on January 1, 1984. As initially approved, the MFJ restricted the RHCs, including NYNEX and its subsidiaries, to the provision of exchange telecommunications service, exchange access and information access services, the provision (but not manufacture) of customer premises equipment ("CPE") and the publishing of printed directory advertising. Although some restrictions placed on RHC operations have been removed or modified since entry of the MFJ, the RHCs are still required to seek MFJ Court approval in order to provide interLATA telecommunications services, to manufacture or provide telecommunications products and to manufacture CPE. Also, the Telephone Companies are still required to offer to all interexchange carriers and information service providers exchange access and information access, at certain locations, which are equal in quality, type and price to that provided to AT&T and its affiliates ("Equal Access"). Included in capital expenditures for the period 1989 through 1993 are costs incurred in connection with the requirement to provide Equal Access (see "Capital Expenditures" above). MFJ Court approval to engage in any of the prohibited activities is normally predicated upon a showing to the MFJ Court that there is no substantial possibility that an RHC could use its monopoly power to impede competition in the market it seeks to enter. The MFJ Court has established procedures for dealing with requests by an RHC to enter new businesses. Such requests must first be submitted to the DOJ for its review. After DOJ review, the RHC seeks approval directly from the MFJ Court. The MFJ Court will consider the recommendation of the DOJ in deciding whether a specific request should be granted. On July 25, 1991, the MFJ Court lifted the MFJ restriction on the provision of the content of information services by the RHCs and LECs, including NYNEX and the Telephone Companies. On May 28, 1993, the United States Court of Appeals for the District of Columbia affirmed that decision. The Court of Appeals decision allows the RHCs and LECs, including NYNEX and the Telephone Companies, to create and own the content of the information they transmit over the telephone lines and to provide data processing services to customers. On November 15, 1993, the United States Supreme Court declined to review the Court of Appeals decision. Regulated Services Various services offered by NYNEX's subsidiaries in the Telecommunications and Cellular segments are subject to the jurisdiction of state and federal regulators. Intrastate communications services offered by these subsidiaries are under the jurisdiction of state public utility commissions (see "State Regulatory Matters" below). Interstate communications services offered by the Telephone Companies and NYNEX Mobile are regulated by the Federal Communications Commission (the "FCC") (see "Federal Regulatory Matters" below). In addition, state and federal regulators review various transactions between these subsidiaries and the other subsidiaries of NYNEX. State Regulatory Matters Set forth below is a description of certain intrastate regulatory proceedings with respect to changes in rates and revenues1/. NYNEX is unable to state with certainty the effective dates of any changes that may be ordered or the actual amounts of revenues that may result from any such changes. New York As an outgrowth of New York Telephone's 1990 general rate case (the "1990 rate case"), in November 1990, the NYSPSC commenced a proceeding to review the financial effects on ratepayers of the transactions in the years 1984 through 1990 between New York Telephone and other NYNEX affiliates. The NYSPSC selected an independent consulting firm to perform an audit of such transactions. The consultant commenced the audit in November 1991 and is expected to complete the audit and submit a report detailing its findings and recommendations in 1994. The NYSPSC may hold hearings on the consultant's audit report. The NYSPSC authorized a $250 million increase in New York Telephone's rates, effective January 1, 1991, of which $47.5 million annually remains subject to refund pending resolution of certain affiliate transactions issues. In September 1992, the NYSPSC issued an order in the Second and Third Stages (the "Second and Third Stages") of the 1990 general rate case that approximately $27 million of revenues attributable to the reduction in ad valorem taxes on central office equipment would be retained to reduce the balance of regulatory assets on New York Telephone's books and the remaining revenues ($15 million in 1992 and $62 million in 1993) would offset rate increases that would otherwise have been required to offset revenue decreases in long distance, carrier access and other revenues. In October 1992, New York Telephone filed a response to the NYSPSC's order in which it updated the Regulatory Asset Recovery Plan. In the updated plan, New York Telephone outlined how certain regulatory assets currently accounted for as deferred charges could be recovered over six years, starting in 1993, by utilizing ad valorem tax savings and other revenues currently being provided in rates. On January 28, 1994, the NYSPSC approved New York Telephone's Regulatory Asset Recovery Plan. 1/ The term "rates" is synonymous with prices. When changes in rates are referred to in the aggregate, the reference is to the aggregate effect of individual price changes multiplied by the volumes of services, assuming no change in volume as a result of the price changes. The term "revenues", on the other hand, refers to the aggregate effect of prices multiplied by volumes of service, with effect given to the change in volume as a result of any price changes. On February 4, 1993, the NYSPSC issued an order with respect to the Second and Third Stages, permitting New York Telephone to retain 1993 earnings above a return on equity of 11.7% and up to 12.7% if it met specified service-quality criteria, with earnings above 12.7% return on equity to be held for the ratepayers' benefit. On February 25, 1994, the NYSPSC preliminarily concluded that there would be no financial penalty based on New York Telephone's 1993 service-quality results. In July 1992, the NYSPSC initiated a proceeding to investigate performance-based incentive regulatory plans for New York Telephone for 1994 and beyond. The NYSPSC noted that incentive regulatory agreements provide incentives to increase efficiency and provide greater consumer benefits by permitting New York Telephone to keep some of its performance gains, i.e., earn a higher rate of return than authorized under traditional rate of return regulation, and by penalizing unsatisfactory performance. In the first phase of the proceeding, the NYSPSC issued Orders on December 24, 1993 and January 28, 1994 for a reduction in New York Telephone's rates of $170 million annually, effective January 1, 1994. An additional $153.3 million of current revenues is to be made available "for the ultimate benefit of customers and New York Telephone's competitive position through earnings incentives for short-term service improvements and a longer term plan for performance-based earning incentives and network improvements." That incentive regulatory plan will be pursued in a second phase of the proceeding during 1994. The Orders required New York Telephone to record a $75 million charge in 1993, representing a reversal of a portion of a regulatory asset related to deferred pension costs that New York Telephone expected to recover through the regulatory process and recorded under the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation". The NYSPSC did not make a final finding on return on equity for 1994. Subject to New York Telephone's achieving net productivity gains, according to the Orders, New York Telephone would have an opportunity to earn above a 10.8% return on equity, with equal sharing with ratepayers of any earnings above a 12% return on equity. On July 13, 1993, the NYSPSC issued an Opinion and Order, subject to comments and a final decision, which would require New York Telephone to provide IntraLATA Presubscription ("ILP") within 18 months of a bona fide request from a carrier. ILP would give a customer the option of designating, in advance, a carrier that would carry the customer's intraLATA toll calls. Currently, absent special dialing arrangements, such calls are carried by New York Telephone. The NYSPSC is considering various options for the recovery by New York Telephone of out-of-pocket costs and lost revenues resulting from ILP. At its February 2, 1994 Public Session, the NYSPSC suggested that certain issues relating to ILP would be made the subject of negotiations and a "collaborative effort" between the parties to the incentive regulatory proceeding. New York Telephone's tariffs to provide for switched interconnection by competitors, as required by the NYSPSC in May 1992, became effective on January 1, 1993. New York Telephone had previously filed tariffs to permit private line collocation arrangements, whereby competitors place their transmission equipment in New York Telephone's central offices. Maine On May 1, 1992, the Maine Public Utilities Commission ("MPUC") issued a Notice of Proceeding to commence a comprehensive investigation regarding New England Telephone's cost of service and rate design. New England Telephone filed its comprehensive rate design proposal with the MPUC on July 6, 1992. Although New England Telephone did not seek to increase the overall revenues it receives, the rate design proposal would affect the rates charged for various services. The rate design proposal seeks a reduction in rates for message telecommunications and related long distance services, a corresponding decrease in access rates and an increase in residence basic exchange service rates. At a March 11, 1994 deliberative session, the MPUC voted to reject New England Telephone's rate design proposal. The MPUC found that New England Telephone had not adequately supported the proposal. Because New England Telephone's proposal was designed to be revenue neutral, there will be no immediate earnings impact from the MPUC's decision. The final order is expected to be released by the end of March. The MPUC expressed an interest in exploring how the rate realignment proposed by New England Telephone might be accomplished through an alternative form of regulation, in lieu of traditional rate of return regulation. The MPUC announced its intention to commence such an investigation upon release of its final order. Massachusetts In June 1990, the Massachusetts Department of Public Utilities ("MDPU") issued an order in Phase III of a proceeding that culminated a five-year investigation into New England Telephone's rates, costs and revenues. The order calls for the gradual restructuring of local and long distance rates within the state, with the objective of moving prices for services closer to the costs of providing them. This is accomplished through an annual transitional filing of new rates by New England Telephone. At the time the rates are established, revenue neutrality is maintained. New England Telephone's first and second transitional filings became effective on November 15, 1991 and January 15, 1993, respectively. On January 13, 1994, the MDPU approved the third transitional filing with minor modifications to become effective April 14, 1994. New Hampshire On March 16, 1993, New England Telephone, the New Hampshire Public Utilities Commission ("NHPUC") staff, the NHPUC Office of Consumer Advocate, various interexchange and local exchange carriers and an association of business customers filed a stipulation for approval by the NHPUC to resolve all matters in the current phase of the generic intraLATA competition docket. On June 10, 1993, the NHPUC issued an order approving in part and modifying in part the stipulation, subject to the acceptance of the parties, to provide that (1) the NHPUC will not initiate a show cause proceeding, for effect prior to October 1, 1995, as to New England Telephone's earnings or cost of capital; (2) New England Telephone will not initiate, prior to April 1, 1995, a request for an increase in basic exchange rates, for effect prior to October 1, 1995, except to reflect changes in exogenous costs; (3) switched access rates for non-800 access service decrease from 20 cents to 16 cents effective October 1, 1993, which resulted in an annual reduction of approximately $3.1 million in 1993, and will decrease 12 cents the following year, 8 cents in the third year, and in the fourth year would be equal to the interstate rate in effect at that time; (4) New England Telephone will have pricing flexibility with respect to its toll services; and (5) the settlements process between New England Telephone and independent carriers will be replaced by access arrangements. On July 29, 1993, the parties resubmitted the stipulation with the NHPUC, as modified by the NHPUC and New England Telephone. On August 2, 1993, the NHPUC approved the stipulation as resubmitted. Rhode Island In August 1992, the Rhode Island Public Utilities Commission approved a Price Regulation Trial ("PRT") that provides New England Telephone with significantly increased pricing and earnings freedom through 1995 and calls for specific investment and service-quality commitments by New England Telephone. As a part of the PRT, New England Telephone makes an annual filing, with overall price increases capped by a formula indexing Rhode Island prices to the Gross National Product Price Index, adjusted for productivity and exogenous factors. New England Telephone's most recent annual filing became effective January 15, 1994. The flexibility afforded by the PRT allows New England Telephone to continue moving the prices of its services closer to the costs of providing them. With respect to 1993 earnings, New England Telephone must apply a one-time credit to customers' bills of 50% of any earnings between 13.25% and 19.25% return on equity and 100% of any return in excess of 19.25%. Vermont New England Telephone filed a petition for a price regulation plan with the Vermont Public Service Board ("VPSB") on October 5, 1993. This proposal provides that (1) New England Telephone would be allowed to adjust its rates annually based on an increase in the Gross Domestic Product Price Index, adjusted for productivity and exogenous factors; (2) New England Telephone would enhance its current quality commitments; (3) New England Telephone would retain the ability to offer new products and services on 15 days' notice, and the ability to offer customer specific contracts, without prior VPSB approval; and (4) New England Telephone's earnings would not be restricted. In a related proceeding, on December 1, 1993, the Vermont Department of Public Service filed a petition seeking to examine New England Telephone's rates and to ensure that rates are at appropriate levels prior to the initiation of a price regulation plan. The petition asserts that New England Telephone may be over-earning and asks the VPSB to direct that any rate reduction be returned to the ratepayers of Vermont in the form of a rebate retroactive to December 1993. A decision in both the incentive regulation and rate dockets is due from the VPSB by August 24, 1994. On February 18, 1994, the VPSB opened an investigation into open network architecture ("ONA"), unbundling and interconnection issues. This is a major competition docket that is expected to continue into 1995. Federal Regulatory Matters Interstate Access Charges Interstate access charges are tariff charges filed with the FCC that compensate LECs, including the Telephone Companies, for services that allow carriers and other customers to originate and terminate interstate telecommunications traffic on the LECs' local distribution networks. Such charges recover the LECs' access-related costs allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's jurisdictional cost allocation rules. With respect to the provision of access to the switched network, separate charges are applied to end users ("End User Common Line Charges") and to interexchange carriers ("switched access"). End User Common Line Charges recover, through a fixed charge, a portion of the Interstate Costs of the line connecting an end user's premises with the LEC's central office. The LECs recover their remaining Interstate Costs through mileage and usage sensitive charges to the interexchange carriers. Special access refers to the provision of nonswitched access for private line services. Between January 1, 1984 and April 1985, the Telephone Companies charged AT&T for special access pursuant to contracts and charged other interexchange carriers pursuant to pre-existing tariffs. In November 1984, pursuant to permission granted by the FCC, the Telephone Companies increased by approximately 20 percent the special access rates to the other interexchange carriers. In April 1985, special access tariffs applicable to all interexchange carriers, including AT&T, became effective. Upon review, the United States Court of Appeals for the District of Columbia Circuit found that the rate increases permitted prior to June 3, 1985 were instituted without the requisite period of notice and, therefore, remanded the case to the FCC for a determination of the appropriate refunds. On July 12, 1993, the FCC issued an order requiring the Telephone Companies to calculate refunds for certain interexchange carriers. Pursuant to that order, which is subject to a pending petition for reconsideration by one of the interexchange carriers, the Telephone Companies provided refunds totalling approximately $150,000 on November 29, 1993. Effective January 1, 1991, the FCC adopted a new system for regulating the interstate rates of the LECs, including the Telephone Companies, and established so called "price caps" that set maximum limits on the prices they can charge. The limits will be adjusted each year to reflect inflation, a productivity factor and certain other cost changes. Price cap regulation does not guarantee that any LEC will earn its authorized rate of return. If the Telephone Companies' earnings in any year fall below 10.25%, the Telephone Companies are permitted to increase their rates in the following year to reflect the difference between their earnings and what earnings would have been at a 10.25% rate of return. On November 1, 1990, the Telephone Companies filed tariffs to comply with the FCC's new price cap rate regulation policy. Effective January 1, 1991, the FCC lowered the interstate access authorized rate of return from 12% to 11.25%. The tariffs, which became effective on January 1, 1991, were based upon the authorized rate of return on overall investment of 11.25%. Under the FCC price cap regulations, each LEC may earn a rate of return above the authorized rate of return, up to 12.25%, which equates to a return on equity of slightly over 15.0% for the Telephone Companies. Above that level, earnings are divided equally between the LEC and customers, until they reach an effective cap on interstate return on equity of approximately 18.7%. Also, if the Telephone Companies choose to set their tariffs in any one year based on a more stringent (4.3% as opposed to 3.3%) productivity standard, the Telephone Companies may earn in that year a rate of return on overall investment of up to 13.25% before earnings are shared with customers, which equates to a correspondingly higher return on equity. On April 2, 1991, the Telephone Companies filed their first annual access tariff revisions under the new price cap rules. These revisions incorporated a 3.3% productivity factor, as well as inflation factor adjustments and other cost changes. The revised tariffs became effective on July 1, 1991 and reduced annual interstate access rates approximately $68 million. In addition, on January 13, 1992, the FCC permitted the Telephone Companies to implement the first step of a transition plan to unify their interstate access rates. The Telephone Companies implemented the second step transition rates on July 1, 1992 and the third and final step on November 24, 1992. On July 1, 1992, the Telephone Companies implemented the second annual update to the price cap rates. These tariff changes, which included the second step transition rates, resulted in a net reduction in the Telephone Companies' annual interstate access rates of approximately $25 million during the tariff period from July 1, 1992 to July 1, 1993. On July 2, 1993, the Telephone Companies implemented the third annual update to the price cap rates. These tariffs will result in a net reduction in the Telephone Companies' annual interstate access rates of approximately $90 million during the tariff period from July 2, 1993 to June 30, 1994. While the unified rate structure is designed to have no impact on the Telephone Companies' aggregate interstate revenues, New York Telephone experienced an interstate rate decrease and New England Telephone experienced an offsetting interstate rate increase. In order to avoid sudden changes in each of the Telephone Company's earnings, the Telephone Companies implemented a transition plan to phase-in the earnings effect of the unified rate structure on each Telephone Company. With unification of interstate rates, the Telephone Companies report one unified interstate rate of return to the FCC, which will be the basis for determining any possible refund obligations due to over-earnings as well as any need to increase interstate rates due to under-earnings under the price cap plan. Previously, each individual Telephone Company's rate of return was used for such purposes. Other Federal Matters On December 5, 1993, the Telephone Companies filed a petition with the FCC for a waiver to implement the Universal Service Preservation Plan ("USPP") in order to compete more effectively with alternative providers of local telephone service. The USPP would reduce the Switched Access rate for multiline business users in zones of high traffic density by approximately 40 percent, and would shift most of the revenues lost from this rate reduction to flat, per-line charges applicable to all access lines. Overall annual access revenues would be reduced by $25 million. On January 27, 1993, NYNEX, together with two other RHCs, requested that the FCC initiate an immediate investigation of the competitive impact on the public interest of the proposed acquisition by AT&T of a 33 percent interest in McCaw Cellular Communications Inc. ("McCaw"), and in particular, on the FCC's policies governing competition in wireless services. The petition urged that the FCC require AT&T and McCaw to disclose fully the terms of their agreement so that the FCC can determine whether control of McCaw is passing to AT&T and whether the proposed transaction is in the public interest. The FCC requested and received comments from interested parties. Subsequently, after AT&T announced its intent to acquire all of McCaw immediately, the FCC commenced a proceeding to examine the proposed transaction. NYNEX and a number of other parties filed petitions in that proceeding on November 1, 1993. NYNEX asked that the FCC impose conditions on any approval of the transaction it might grant, in order to preserve and promote competition in the cellular marketplace. The matter is pending. In September 1992, the FCC adopted rules requiring certain LECs, including the Telephone Companies, to offer physical collocation to interexchange carriers for the provision of special access services under terms and conditions similar to the intrastate collocation arrangements already in existence in Massachusetts and New York. The Telephone Companies filed Special Access Expanded Interconnection tariffs on February 16, 1993. The FCC issued an order on September 2, 1993 requiring certain LECs, including the Telephone Companies, to file Switched Transport Expanded Interconnection tariffs. The Telephone Companies filed their tariffs on November 18, 1993. Although the FCC rejected requests by the LECs to impose contribution charges, the FCC granted the LECs additional pricing flexibility to be effective after expanded interconnection arrangements become available. The financial impact of the FCC rules is not presently determinable. In August 1992, the FCC determined that the LECs may provide video dialtone service, a common carrier platform for transporting and switching video programming from programmers to subscribers, and that neither the LEC providing video dialtone nor its programmer-customers require a local cable franchise. On October 30, 1992, New York Telephone asked the FCC for permission to conduct a trial of video dialtone service in New York City. On June 29, 1993, the FCC granted that request. The trial commenced in mid-January of 1994. The Telephone Companies filed tariffs for their ONA services with the FCC on November 1, 1991. The Telephone Companies requested a waiver of the filing requirement for nine enhanced telecommunications services. On January 1, 1992, the FCC issued orders allowing the tariffs to take effect on February 2, 1992, subject to an investigation of the costs and rates, and granting the requested waivers as to seven services. On December 15, 1993, the FCC issued an order requiring certain revisions in the Telephone Companies' ONA tariffs. The required revisions became effective March 12, 1994. In January 1992, the Telephone Companies entered into a consent decree with the FCC to settle alleged violations of the FCC's accounting rules in connection with transactions with the National Exchange Carrier Association. Under the terms of the decree, each Telephone Company paid $250,000 to the United States Treasury, and the FCC terminated the proceedings without any finding of wrongdoing, violation or liability. The outcome of all refund matters, including those described above under "Regulated Services", as well as the time frame within which each will be resolved, is not presently determinable. As of December 31, 1993, the aggregate amount of revenues that was estimated to be subject to possible refund from all regulatory proceedings was approximately $172.9 million, plus related interest. Competition NYNEX faces competition in each of the industry segments in which it operates. In Telecommunications, advances in technology, as well as regulatory and court decisions, have expanded the types of communications products and services available in the market, as well as the number of alternatives to the telecommunications services provided by NYNEX. Various business alliances and other undertakings were announced in the telecommunications industry in 1993 that indicate an intensifying level of competition, especially with respect to the operations of the Telephone Companies. AT&T intends to acquire McCaw through a merger (see "Other Federal Matters" above). McCaw operates in a number of areas within NYNEX's region in the Northeast. US WEST Inc. acquired a major interest in Time Warner Entertainment Co. L.P., which includes Time Warner Cable. Time Warner Cable has extensive operations in the Northeast, including New York City. Cablevision Systems Corp., which operates in Boston, Long Island, and Westchester County, plans to construct a fiber-optic network to deliver telecommunications and video services. MCI Communications Corp. ("MCI") plans to spend $2 billion to establish local fiber-optic networks in 20 major cities, including New York and Boston, offering a way to bypass the local exchange carrier, including the Telephone Companies, and connect directly to MCI's long-distance network. In certain markets in New York and New England, the Telephone Companies face significant competition from local access providers with substantial resources. The Telephone Companies allowed alternative service providers to place transmission equipment in the Telephone Companies' central offices, under an arrangement known as collocation. The Telephone Companies also face increasing competition in Centrex services, long distance, WATS, billing and collection services, pay telephones, and various other services. In October 1993, the FCC issued rules for the licensing of wireless personal communications services ("PCS") under an auction process scheduled to begin in 1994. NYNEX can participate in the auction for PCS licenses on the same basis as other applicants except that its participation is limited in those PCS service areas where NYNEX Mobile provides cellular service. NYNEX is considering its options for participating in the PCS auction process. NYNEX is implementing a major restructuring of its business and is pursuing strategic alliances in order to meet this competition. NYNEX is aggressively pursuing the enactment of changes to current restrictions on providing certain communication, information, and entertainment services over the network. NYNEX currently provides some of these services overseas, such as cable television and telephony services in the United Kingdom and advanced voice, data, video and cable services in Thailand. If legislation pending before Congress were passed, NYNEX would be able to offer video programming in its own service areas, offer long-distance service and manufacture telecommunications equipment. NYNEX Mobile faces competition in its provision of cellular services and equipment, from both facilities-based cellular service competitors and resellers in its two largest markets (New York City and Boston) as well as in a number of other markets. There is also competition from non-cellular mobile services in some markets. Information Resources competes with various alternative directory publishers in New York and New England. Its directories published in other areas also face competition from other published directories. Directory publishing also competes with other advertising media such as newspapers, magazines, and broadcast media. There is substantial competition in the Financial Services segment. Numerous firms, both large and small, offer various types of financial services. NYNEX's Other Diversified Operations segment also faces substantial competition. In pursuit of business opportunities outside the United States, NYNEX Network Systems Company faces competition from other RHCs and United States interexchange carriers, as well as from multi-national corporations and local entities. CableComms' business opportunity in the United Kingdom is a direct result of Government policy to introduce competition to the dominant carrier. Just as CableComms is providing a competitive service in the local loop, the Government has also licensed alternative long distance operators and a growing number of wireless providers. In entertainment services CableComms competes with direct to home satellite, broadcast television and video cassette rental and retail outlets. The dominant telecommunications carrier in the United Kingdom has also announced an intention to offer a form of entertainment service over its existing network. NYNEX cannot predict the effect of such competition on future revenues, expenses, rates of return, profit or growth of its industry segments. Research and Development Research and development is primarily conducted at NYNEX Science & Technology, Inc.("Science & Technology"), which was formed in June 1991 to continue the activities previously performed within a department of NYNEX. Science & Technology provides NYNEX with technical direction and support that is essential in developing new services, improving current services and increasing operational efficiencies. It focuses on applied research and development of advanced communications, information and network technologies. Another NYNEX business unit, Telesector Resources, performs market research, product development and field trials associated with new services NYNEX plans to introduce. Bellcore conducts research and development in areas relating primarily to exchange telecommunications and exchange access services. Research and development costs charged to expense were approximately $162.8, $131.7, and $108.4 million in 1993, 1992 and 1991, respectively. Employee Relations NYNEX and its subsidiaries had approximately 76,200 employees at December 31, 1993. Approximately 49,800 employees are represented by unions. Of those so represented, approximately 68% are represented by the Communications Workers of America ("CWA") and approximately 32% by the International Brotherhood of Electrical Workers ("IBEW"), both of which are affiliated with the AFL-CIO. In August 1993, pursuant to labor agreements that were to expire in August 1995, employees represented by the CWA and IBEW at New York Telephone and its subsidiary, New England Telephone, Information Resources, Telesector Resources and NYNEX Mobile received wage increases of up to 4.25%. In August 1994, these employees will receive an additional wage increase of up to 4.0%. There may also be a cost-of-living adjustment in August 1994. NYNEX, the CWA and Local 2213 of the IBEW in New York have reached a tentative agreement on a new contract extending the existing contract to August 1998. The tentative agreement is subject to the completion of local bargaining and ratification by the union membership. Talks began on March 21, 1994 in attempts to reach similar agreements with locals of the IBEW in New England. Item 2.

Item 2. PROPERTIES. The properties of NYNEX and its subsidiaries do not lend themselves to simple description by character and location of principal units. At December 31, 1993, the gross book value of property, plant and equipment was $34.0 billion, consisting principally of telephone plant and equipment (84%). Other classifications include: land, land improvements and buildings (9%); furniture and other equipment (4%); and plant under construction and other (3%). Substantially all of the Telephone Companies' central office equipment is located in buildings owned by the Telephone Companies and is situated on land that they own. Many administrative offices of NYNEX and the Telephone Companies, as well as many garages and business offices of the Telephone Companies, are in rented quarters. Substantially all of New York Telephone's assets are subject to lien under New York Telephone's Refunding Mortgage Bond indenture. At December 31, 1993, the principal amount of Refunding Mortgage Bonds outstanding was $1.10 billion. As part of NYNEX's 1993 restructuring associated with re-engineering the way service is delivered to customers, NYNEX intends to consolidate work centers from 300 to approximately 50 by the end of 1996 to build larger work teams in fewer locations. Item 3.

Item 3. LEGAL PROCEEDINGS. Contingent Liabilities Agreement The Plan of Reorganization, which was approved by the MFJ Court in August 1983 in connection with the AT&T divestiture, provides for the recognition and payment of liabilities that are attributable to predivestiture events (including transactions to implement divestiture), but that do not become certain until after divestiture. These contingent liabilities relate principally to predivestiture litigation and other claims against AT&T, its affiliates and the LECs with respect to the environment, rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). With respect to such liabilities, AT&T and the LECs will share the costs of any judgment or other determination of liability entered by a court or administrative agency against any of them, whether or not a given entity is a party to the proceeding and regardless of whether an entity is dismissed from the proceeding by virtue of settlement or otherwise. Other costs to be shared would include the costs of defending the claim (including attorneys' fees and court costs) and the cost of interest or penalties with respect to any such judgment or determination. With certain exceptions, responsibility for such contingent liabilities will generally be divided among AT&T and the LECs on the basis of their relative net investment as of the effective date of divestiture. Under this general rule of allocation, the Telephone Companies pay approximately 10.9% of any judgment or determination of liability. Antitrust Actions On May 25, 1990, Discon Incorporated filed an action in the United States District Court for the Western District of New York alleging, among other things, violations of the Racketeer Influenced and Corrupt Organizations Act ("RICO") and the federal antitrust laws. The defendants include NYNEX, New York Telephone, NYNEX Materiel Enterprises Company, and an officer and director of NYNEX. Plaintiff's allegations relate to, among other things, the removal of equipment from New York Telephone's central offices. On June 25, 1992, the District Court dismissed the original complaint in this case. Discon then filed an amended complaint. A motion to dismiss is pending before the District Court. On October 29, 1990, North American Industries Inc. filed a third party complaint against New York Telephone alleging, among other things, violations of the federal antitrust laws relating to the provision of facilities for pay telephone services. The case is pending in the United States District Court for the Southern District of New York. In 1992, three similar suits were filed in the same court, and one was filed against New England Telephone in the United States District Court for the District of Massachusetts. Other Litigation On November 12, 1993, the Court of Appeals for the District of Columbia Circuit reversed and vacated the February 16, 1993 judgment of the United States District Court for the District of Columbia which had found NYNEX guilty of criminal contempt for an alleged violation of the MFJ's information services prohibition and had ordered NYNEX to pay a fine of $1 million. The Court of Appeals found that the MFJ lacked the necessary clarity and specificity to support a finding of criminal contempt. In an October 1, 1990 decision in the Fifth Stage of New York Telephone's 1984 general rate case, the NYSPSC confirmed New York Telephone's right to retain $152 million in cost savings. In September 1991, two suits were filed in the New York State Supreme Court, challenging the NYSPSC's decision. In anticipation of such challenges, New York Telephone also filed suit in September 1991, asserting that the retention of the revenues was required by the terms of the Moratorium Extension. The NYSPSC's motion to dismiss New York Telephone's suit was granted in May 1992. New York Telephone appealed and on November 10, 1993, the Appellate Division of the New York Supreme Court issued an order affirming the NYSPSC's October 1, 1990 order. On April 24, 1990, Scott J. Rafferty filed a lawsuit against New York Telephone, NYNEX Information Solutions Group, Inc. and various individuals, including an officer and director of NYNEX. The lawsuit, filed in the United States District Court for the Southern District of New York, alleged violations of the RICO and state common law relating to, among other things, the termination of Mr. Rafferty's employment with Telco Research Corporation, then a subsidiary of NYNEX Information Solutions Group, Inc. On July 16, 1991, the Court issued an order dismissing some of the plaintiff's claims and staying the remainder pending dismissal. On November 12, 1993, the Court dismissed the remainder of Mr. Rafferty's claims and issued a final judgment in favor of the defendants. On January 25, 1990, Wegoland Ltd. and Howard Weiner filed an action in the United States District Court for the Southern District of New York on behalf of the telephone ratepayers of New York Telephone and New England Telephone alleging violations of the RICO and various state laws. A substantially identical case was filed by Donna Roazen on March 12, 1990. The defendants in these cases are NYNEX, certain of its subsidiaries and certain present and former officers of those companies. Plaintiffs allege that the Telephone Companies have been charged inflated prices in transactions with their affiliates and that those prices are unlawfully reflected in the Telephone Companies' regulated rates. On November 13, 1992, the District Court granted defendants' motions to dismiss these actions with prejudice. Plaintiffs' appeal is pending before the United States Court of Appeals for the Second Circuit. Fifty-four actions, of which approximately 15 remain, were brought in New York State Supreme Court, New York County, against New York Telephone, Empire City Subway Company (Limited) and others arising out of a power failure in a predominantly commercial section of New York City in August 1983. The actions are predicated on broad and general claims of negligence in excavating and/or installing underground equipment. Several of these cases involve multiple plaintiffs. While counsel cannot give assurance as to the outcome of any of these matters, in the opinion of Management based upon the advice of counsel, the ultimate resolution of these matters in future periods is not expected to have a material effect on NYNEX's financial position or annual operating results but could have a material effect on quarterly operating results. On November 15, 1993, NYNEX and New England Telephone filed suit in the United States District Court for the District of Maine seeking an order declaring that section 533(b) of the Cable Communications Policy Act of 1984 is unconstitutional and permanently enjoining the United States from enforcing section 533(b) against NYNEX. Section 533(b) prohibits NYNEX from providing video programming to subscribers in areas where the Telephone Companies provide service. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of security holders in the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K. Prior to their election as executive officers of NYNEX, all of such officers except Mr. Rubin, Mr. Mulhearn and Mr. Tauke had held, for at least the past five years, high level managerial positions with NYNEX or a subsidiary of NYNEX. Officers are not elected for a fixed term of office, but serve at the discretion of the Board of Directors. Jeffrey S. Rubin was elected Executive Vice President and Chief Financial Officer of NYNEX effective November 1, 1993. From September 1992 through October 1993, he held the position of Senior Vice President and Chief Financial Officer of NYNEX. Commencing August 1, 1990 through August 31, 1992, he held the position of Vice President-Finance and Treasurer of NYNEX. In July 1991, he relinquished the title of Treasurer but remained Vice President-Finance. Prior thereto, he served as Vice President-Finance and Chief Financial Officer (1987-1990); Vice President-Planning and Control (1985-1987); and Vice President-Controller (1984-1985) of Combustion Engineering Inc. Patrick F. X. Mulhearn was elected Vice President-Public Relations effective January 1, 1994. He served as Vice President-Public Affairs and Corporate Communications at New York Telephone (1991-1993) and as Vice President and Chief Operating Officer of NYNEX Information Resources Company (1990-1991). Mr. Mulhearn joined New York Telephone in 1988 as a Director-Business Marketing Operations. Thomas J. Tauke was elected Vice President-Government Affairs effective September 1, 1991. Prior to joining NYNEX, he was founder and senior partner of Tauke, Walgren and Associates, a public policy consulting firm specializing in telecommunications, health, environmental and energy issues. Mr. Tauke was also president and chief executive officer of Home Technology Systems, Inc., a small business specializing in personal emergency systems. From January 1979 to January 1991, Mr. Tauke represented Iowa's Second Congressional District in the United States House of Representatives. PART II Item 5.

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information with respect to quarterly dividends and Common Stock prices appearing on page 49 of the Registrant's Proxy Statement dated March 21, 1994; information with respect to Common Stock exchange listings appearing on the back cover of such Proxy Statement under the caption "Stock Exchange Listings"; and information with respect to the number of stockholders of record of NYNEX Common Stock appearing on page 36 of such Proxy Statement are incorporated herein by reference. During 1993, NYNEX issued approximately 2.3 million shares of Common Stock for the NYNEX Share Owner Dividend Reinvestment and Stock Purchase Plan ("DRISPP"); the NYNEX Corporation Savings Plan for Salaried Employees and the NYNEX Corporation Savings and Security Plan (Non-Salaried Employees) ("Savings Plans"); and other stock incentive programs. On February 1, 1993, NYNEX began open market purchases for shares of Common Stock associated with the DRISPP, Savings Plans, and other stock incentive programs. On November 1, 1993, NYNEX discontinued purchasing shares and began issuing new shares. On January 26, 1993, NYNEX began a repurchase program of shares of Common Stock over a ten-year period related to the NYNEX 1992 Management Stock Option Plan and the NYNEX 1992 Non-Management Stock Option Plan ("Stock Option Plans"). Upon exercise of the stock options, these repurchased shares will be released into the open market. On July 15, 1993, the Board of Directors of NYNEX declared a two-for-one common stock split in the form of a 100 percent stock dividend, payable on September 15, 1993 to holders of record at the close of business on August 16, 1993. On March 17, 1994, the Board of Directors of NYNEX announced a quarterly cash dividend of $.59 per share of Common Stock, which was unchanged from the previous quarter. The dividend is payable on May 1, 1994 to holders of record at the close of business on March 31, 1994. Item 6.

Item 6. SELECTED FINANCIAL DATA. Selected financial data for the five years ended December 31, 1993, appearing on page 32 of the Registrant's Proxy Statement dated March 21, 1994, is incorporated herein by reference. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's Discussion and Analysis of Financial Condition and Results of Operations, appearing on pages 21 through 31 of the Registrant's Proxy Statement dated March 21, 1994, is incorporated herein by reference. Item 8.

Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of the Registrant and its wholly-owned subsidiaries, included in the Registrant's Proxy Statement dated March 21, 1994, are incorporated herein by reference and are listed in Item 14 below. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. During 1993 and 1992, NYNEX did not change its auditors, and there was no disagreement on any matter of accounting principles or practices or consolidated financial statement disclosure that would have required the filing of a Current Report on Form 8-K. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Item 11.

Item 11. EXECUTIVE COMPENSATION. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required under Items 10, 11, 12 and 13 is included in the Registrant's Proxy Statement dated March 21, 1994, on pages 2 (commencing under the caption "Stock Ownership of Directors and Executive Officers") through 5, pages 13 (commencing under the caption "Executive Compensation: Committee on Benefits Report on Executive Compensation") through the bottom of page 19, and page 19 (the first paragraph commencing under the caption "Other Information"). Such information is incorporated herein by reference. There existed no relationship and there were no transactions reportable under Item 13. Information regarding Executive Officers of the Registrant required by Item 401 of Regulation S-K is included in Part I of this Annual Report on Form 10-K following Item 4. PART IV Item 14.

Item 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Annual Report on Form 10-K. (1) Consolidated Financial Statements. The following report and consolidated financial statements, included in the Registrant's Proxy Statement dated March 21, 1994, are incorporated herein by reference in response to Item 8: Page(s) in Registrant's Proxy Statement dated March 21, 1994 Report of Independent Accountants ............. 32 Consolidated Statements of Income for each of the Three Years in the Period Ended December 31, 1993............................ 34 Consolidated Balance Sheets as of December 31, 1993 and 1992................... 35 Consolidated Statements of Changes in Stockholders' Equity for each of the Three Years in the Period Ended December 31, 1993.. 36 Consolidated Statements of Cash Flows for each of the Three Years in the Period Ended December 31, 1993............................ 37 Notes to Consolidated Financial Statements .... 38 Supplementary Information Quarterly Financial Data (Unaudited) ........ 49 Item 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (continued) (2) Consolidated Financial Statement Schedules. The following consolidated financial statement schedules of the Registrant are included herein in response to Item 14: Page(s) in this Annual Report on Form 10-K Report of Independent Accountants .......... 32 V - Property, Plant and Equipment ....... 33-36 VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment .......... 37-40 VIII - Valuation and Qualifying Accounts .... 41 X - Supplementary Income Statement Information ................... 42 Consolidated financial statement schedules other than those listed above have been omitted because the required information is contained in the consolidated financial statements and notes thereto or because such schedules are not required or applicable. (3) Exhibits. Exhibits on file with the Securities and Exchange Commission (the "SEC"), as identified in parentheses below, are incorporated herein by reference as exhibits hereto. Exhibit Number (3)a Restated Certificate of Incorporation of NYNEX Corporation dated May 6, 1987 (Exhibit No. (3)a to the Registrant's filing on Form SE dated March 24, 1988, File No. 1-8608). (3)b By-Laws of NYNEX Corporation dated October 12, 1983, as amended October 17, 1991 (Exhibit No. (3)b to the Registrant's filing on Form 10-Q dated October 31, 1991, File No. 1-8608). (4) No instrument which defines the rights of holders of long-term debt of NYNEX and its subsidiaries is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, NYNEX hereby agrees to furnish a copy of any such instrument to the SEC upon request. Exhibit Number (10)(i)1 Reorganization and Divestiture Agreement among American Telephone and Telegraph Company, NYNEX Corporation and Affiliates dated as of November 1, 1983 (Exhibit No. (10)(i)1 to the Registrant's 1983 Annual Report on Form 10-K, File No. 1-8608). (10)(i)2 Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among American Telephone and Telegraph Company, Bell System Operating Companies, Regional Holding Companies and Affiliates dated as of November 1, 1983 (Exhibit No. (10)(i)8 to the Registrant's 1983 Annual Report on Form 10-K, File No. 1-8608). (10)(i)3 Divestiture Interchange Agreement between American Telephone and Telegraph Company, NYNEX Corporation, other Regional Holding Companies, Central Services Organization, Advanced Mobile Phone Service, Inc., Cincinnati Bell Inc. and The Southern New England Telephone Company dated as of November 1, 1983 (Exhibit No. (10)(i)13 to the Registrant's 1983 Annual Report on Form 10-K, File No. 1-8608). (10)(i)4 Unfunded Post-Retirement Benefits Cost-Sharing Agreement between American Telephone and Telegraph Company, NYNEX Corporation, other Regional Holding Companies, Central Services Organization and Advanced Mobile Phone Service, Inc. dated as of November 1, 1983 (Exhibit No. (10)(i)15 to the Registrant's 1983 Annual Report on Form 10-K, File No. 1-8608). (10)(i)5 Actuarial Services Agreement between American Telephone and Telegraph Company, NYNEX Corporation, other Regional Holding Companies, Central Services Organization and Advanced Mobile Phone Service, Inc. dated as of November 1, 1983 (Exhibit No. (10)(i)16 to the Registrant's 1983 Annual Report on Form 10-K, File No. 1-8608). (10)(i)6 Shared Network Facilities Agreement among American Telephone and Telegraph Company, AT&T Communications of New York, Inc. and New York Telephone Company dated as of November 1, 1983 (Exhibit No. (10)(i)20 to the Registrant's 1983 Annual Report on Form 10-K, File No. 1-8608). (10)(i)7 Shared Network Facilities Agreement among American Telephone and Telegraph Company, AT&T Communications of New England, Inc. and New England Telephone and Telegraph Company dated as of November 1, 1983 (Exhibit No. (10)(i)21 to the Registrant's 1983 Annual Report on Form 10-K, File No. 1-8608). (10)(i)8 Agreement Concerning the Sharing of Contingent Liabilities dated as of January 28, 1985 (Exhibit No. (19)(i)2 to the Registrant's 1984 Annual Report on Form 10-K, File No. 1-8608). (10)(ii)1 Shareholder Services Agreement between The First National Bank of Boston and NYNEX Corporation dated as of September 8, 1992. (10)(ii)2 Preferred Stock Purchase Agreement between NYNEX Corporation and Viacom Inc., dated October 4, 1993, and amendment thereto dated November 19, 1993. (10)(iii)(A)1 NYNEX Senior Management Short Term Incentive Plan (Exhibit No. 10-aa to Registration Statement No. 2-87850). (10)(iii)(A)2 NYNEX Senior Management Long Term Disability and Survivor Protection Plan (Exhibit No. 10-dd to Registration Statement No. 2-87850). (10)(iii)(A)3 NYNEX Senior Management Transfer Program (Exhibit No. 10-ee to Registration Statement No. 2-87850). (10)(iii)(A)4 Description of NYNEX Financial Counseling Service for Senior Managers (Exhibit No. 10-ff to Registration Statement No. 2-87850). (10)(iii)(A)5 NYNEX Corporation Deferred Compensation Plan for Non-Employee Directors (Exhibit No. 10-gg to Registration Statement No. 2-87850). (10)(iii)(A)6 Description of NYNEX Insurance Plan for Directors (Exhibit No. 10-hh to Registration Statement No. 2-87850). (10)(iii)(A)7 Description of NYNEX Plan for Non-Employee Directors' Travel Accident Insurance (Exhibit No. 10-ii to Registration Statement No. 2-87850). (10)(iii)(A)8 NYNEX Senior Management Incentive Award Deferral Plan (Exhibit No. 10-kk to Registration Statement No. 2-87850). (10)(iii)(A)9 Description of NYNEX Mid-Career Hire Program (Exhibit No. 10-ll to Registration Statement No. 2-87850). (10)(iii)(A)10 NYNEX Mid-Career Pension Program (Exhibit No. 10-mm to Registration Statement No. 2-87850). (10)(iii)(A)11 NYNEX Estate Planning Legal Services Program (Exhibit No. 10-nn to Registration Statement No. 2-87850). (10)(iii)(A)12 NYNEX 1984 Stock Option Plan, as amended and restated (Post-Effective Amendment No. 1 to Registration No. 2-97813, dated September 21, 1987). (10)(iii)(A)13 NYNEX Senior Management Long Term Incentive Plan (Exhibit No. (19)(ii)1 to the Registrant's 1984 Annual Report on Form 10-K, File No. 1-8608). (a) Description of certain amendments to the NYNEX Senior Management Long Term Incentive Plan (Exhibit No. (19)(ii)4 to the Registrant's Filing on Form SE dated March 27, 1987, File No. 1-8608). (10)(iii)(A)14 NYNEX Senior Management Non-Qualified Pension Plan (Exhibit No. (19)(ii)2 to the Registrant's 1984 Annual Report on Form 10-K, File No. 1-8608). (a) Description of certain amendments to the NYNEX Senior Management Non-Qualified Pension Plan (Exhibit No. (19)(ii)6 to the Registrant's Filing on Form SE dated March 27, 1987, File No. 1-8608). (b) Description of certain amendments to the NYNEX Non-Qualified Pension Plan (Exhibit No. (19)(ii)7 to the Registrant's Filing on Form SE dated March 27, 1987, File No. 1-8608). (c) Description of certain amendments to the NYNEX Senior Management Non-Qualified Pension Plan (Exhibit No. (19)(ii)1 to the Registrant's 1987 Annual Report on Form 10-K, File No. 1-8608). (d) Description of certain amendments to the NYNEX Senior Management Non-Qualified Pension Plan (Exhibit No. (19)(ii)l to the Registrant's 1991 Annual Report on Form 10-K, File No. 1-8608). (10)(iii)(A)15 Description of NYNEX Corporation Non-Employee Director Pension Plan (Exhibit No. (28)(i)1 to Amendment No. 1 to the Registrant's 1987 Annual Report on Form 10-K, File No. 1-8608). (10)(iii)(A)16 NYNEX Senior Management Non-Qualified Supplemental Savings Plan (Exhibit No. (10)(iii)(A)(18) to the Registrant's 1988 Annual Report on Form 10-K, File No. 1-8608). (10)(iii)(A)17 NYNEX 1987 Restricted Stock Award Plan (Exhibit No. (28)(i)1 to the Registrant's Filing on Form SE dated March 23, 1988, File No. 1-8608). (10)(iii)(A)18 NYNEX 1990 Long Term Incentive Program (Exhibit No. 1 to the Registrant's Proxy Statement dated March 26, 1990). (10)(iii)(A)19 NYNEX 1990 Stock Option Plan (Exhibit No. 2 to the Registrant's Proxy Statement dated March 26, 1990). (10)(iii)(A)20 NYNEX Stock Plan for Non-Employee Directors (Exhibit No. (10)(iii)(A)22 to the Registrant's 1990 Annual Report on Form 10-K, File No. 1-8608). (10)(iii)(A)21 Description of the NYNEX Supplemental Life Insurance Plan (Exhibit No. (19)(i)2 to the Registrant's filing on Form SE, dated March 23, 1993, File No. 1-8608). (10)(iii)(A)22 Description of certain amendments to the NYNEX Senior Management Long Term Incentive Plan (Exhibit No. (19)(ii)1 to the Registrant's filing on Form SE, dated March 23, 1993, File No. 1-8608). (10)(iii)(A)23 Description of certain amendments to the NYNEX Senior Management Non-Qualified Pension Plan (Exhibit No. (19)(ii)2 to the Registrant's filing on Form SE, dated March 23, 1993, File No. 1-8608). (10)(iii)(A)24 NYNEX Executive Retention Agreement. (10)(iii)(A)25 NYNEX Executive Severance Pay Plan. (11) Computation of Earnings Per Share. (12) Computation of Ratio of Earnings to Fixed Charges. (21) Subsidiaries of NYNEX. (23) Consent of Independent Accountants. (24) Powers of attorney. (b) Reports on Form 8-K. The Company's Current Report on Form 8-K, date of report October 4, 1993 and filed October 7, 1993, reporting on Item 5. The Company's Current Report on Form 8-K, date of report November 10, 1993 and filed November 19, 1993, reporting on Item 5. The Company's Current Report on Form 8-K, date of report November 19, 1993 and filed November 24, 1993, reporting on Item 5. The Company's Current Report on Form 8-K, date of report December 24, 1993 and filed January 13, 1994, reporting on Item 5. SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NYNEX CORPORATION By P. M. Ciccone P. M. Ciccone Vice President and Comptroller March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Principal Executive Officer: W. C. Ferguson* Chairman of the Board and Chief Executive Officer Principal Financial Officer: J. S. Rubin* Executive Vice President and Chief Financial Officer Principal Accounting Officer: P. M. Ciccone Vice President and Comptroller Directors: John Brademas* Randolph W. Bromery* John J. Creedon* W. C. Ferguson* Stanley P. Goldstein* Helene L. Kaplan* Elizabeth T. Kennan* David J. Mahoney* *By P. M. Ciccone Edward E. Phillips* (P. M. Ciccone, as attorney-in-fact F. V. Salerno* and on his own behalf as Ivan Seidenberg* Principal Accounting Officer) Walter V. Shipley* John R. Stafford* March 25, 1994 REPORT of INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of NYNEX Corporation and its subsidiaries has been incorporated by reference in this Annual Report on Form 10-K from page 32 of the Proxy Statement dated March 21, 1994 of NYNEX Corporation. In connection with our audits of such consolidated financial statements, we have also audited the related consolidated financial statement schedules listed in the index on pages 25 and 26 of this Annual Report on Form 10-K. In our opinion, the consolidated financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. This information should be read in conjuction with the last paragraph of our report on page 32 of the Proxy Statement. Coopers & Lybrand New York, New York February 9, 1994

352947_1993.txt

352947

1993

Item 1. Business Engelhard Corporation and its Subsidiaries (collectively referred to as the Company) are the successors to the businesses previously operated by Engelhard Minerals & Chemicals Corporation (EMC) through its Engelhard Industries and Minerals & Chemicals Divisions. In 1981, the Company's Common Stock was distributed, as a spin-off, to the shareholders of EMC, and the Company became a separate, publicly-held corporation. The Company's principal executive offices are located at 101 Wood Avenue, Iselin, New Jersey, 08830 (telephone number (908) 205-5000). The Company develops, manufactures and markets technology-based specialty chemical products and engineered materials for a wide spectrum of industrial customers and provides services to precious metals customers. The Company recently announced a plan to realign and consolidate businesses, concentrate resources and better position itself to achieve its strategic growth objectives. See Note 2 "Special charge" to the Consolidated Financial Statements on page 30 of the 1993 Annual Report to Shareholders. This plan resulted in a special charge of $148.0 million ($91.8 million after tax or $.95 per share) which covered a $118.0 million pretax restructure provision for asset writedowns related to product lines or sites being exited together with provisions for facility shutdown, rundown and relocation and for employee reassignment, severance and related benefits and a $30.0 million pretax environmental reserve for sites directly affected by this plan and for the most recent assessment of continuing environmental developments. The plan provides for the closure, relocation or consolidation of five facilities in the U.S. and two sites in Europe currently operated by the Chemical Catalysts and Engineerd Materials Groups. These actions are being taken to ensure that certain product lines stay competitive despite changing market conditions. Further, the plan covers one Specialty Minerals and Colors facility in the U.S. which will be rationalized or idled. The Company expects that these restructuring activities will impact approximately 600 employees. The plan also provides for assets of the Petroleum Catalysts, Paper Pigments and Chemicals and Specialty Minerals and Colors Groups which will become obsolete as a result of the development of new production processes and the reconfiguration of existing production processes or because certain product lines have become uneconomic. A special team has been designated by the Management Committee of the Company to implement the changes and programs contemplated by this plan within the year 1994. The Company employed approximately 5,750 people as of January 1, 1994 and operates on a worldwide basis with corporate and operating headquarters and principal manufacturing facilities and mineral reserves in the United States with other operations conducted in the European Community, the Russian Federation and the Pacific Rim. The Company's businesses are organized into three segments -Catalysts and Chemicals, Pigments and Additives, and Engineered Materials and Precious Metals Management. Information concerning the Company's net sales, operating earnings and identifiable assets by industry segment and by geographic area; inter-area transfers by geographic area; and export sales is included in Note 13 "Industry segment and geographic area data" to the Consolidated Financial Statements on pages 37 and 38 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Catalysts and Chemicals The Catalysts and Chemicals segment is comprised of three principal product groups: the Environmental Catalysts Group, serving the automotive, off-road vehicle, aircraft, industrial power generation and process industries; the Petroleum Catalysts Group, serving the petroleum refining industries; and the Chemical Catalysts Group, serving the chemical, petrochemical, pharmaceutical and food processing industries. Environmental catalysts are used in applications such as the abatement of carbon monoxide, oxides of nitrogen and hydrocarbons from gasoline, diesel and alternate fueled vehicle exhaust gases to meet emission control standards. These catalysts are also used for the removal of odors, fumes and pollutants generated by a variety of process industries including but not limited to the painting of automobiles, appliances and other equipment; printing processes; the manufacture of nitric acid and tires, in the curing of polymers; and power generation sources. The Company also participates in the manufacture and supply of automobile exhaust emissions control catalysts through affiliates serving the Pacific Rim: N.E. Chemcat Corporation (Japan) - 38.8 percent owned; and Hankuk- Engelhard (South Korea) - 49 percent owned, both of which also produce other catalysts and products. In the third quarter of 1992, the Company and Salem Industries, Inc., formed Salem Engelhard, a jointly owned partnership to produce and market products and services to abate, by catalytic and non- catalytic methods, emissions of volatile organic chemicals and other pollutants generated by a variety of process industries. The petroleum refining catalyst products consist of a variety of catalysts and processes used in the petroleum refining industry. The principal products are zeolitic fluid cracking catalysts which are widely used to provide economies in petroleum processing. The Company offers commercially a full line of fluid cracking catalyst based on patented technology including the DYNAMICS (registered trademark) line which can be used to control selectivity and cracking activity virtually independently of one another. This characteristic permits custom catalysts formulation for essentially all users. The Company manufactures petroleum catalysts used for catalytic reforming and isomerization of hydrocarbons to produce higher octane gasoline, for isomerization of xylenes to produce paraxylene and orthoxylene and for selective hydrogenation of alkylation feed stocks. The Company also manufactures hydrotreating catalysts which are used in viscosity improvement and aromatics saturation of lube oil feedstocks and for the removal of contaminant sulfur, nitrogen and metals. These reforming, isomerization and hydrotreating catalysts are marketed in North America and the Caribbean by Acreon Catalysts, a jointly owned partnership formed by the Company and Procatalyse. Process technologies developed by the Company are also offered for license to the petroleum industry. In March 1994, the Company completed its purchase of the assets of the sorbents and moving bed catalysts businesses of Solvay Catalysts, GmbH, in Nienburg Germany. This acquisition expands the Company's moving bed catalysts business and provides complementary product lines serving adsorbents applications. The chemical catalysts products consist of catalysts and sorbents used in the production of a variety of products or intermediates, including synthetic fibers, fragrances, antibiotics, vitamins, polymers, plastics, detergents, fuels and lube oils, solvents, oleochemicals and edible products. These catalysts are generally used in both batch and continuous operations requiring special catalysts for each application. Chemical catalysts utilize the Company's proprietary technology and many times are developed in close cooperation with specific customers. Sorbents are used to purify and decolorize naturally occurring fats and oils for manufacture into shortenings, margarines and cooking oils. In early 1994, the Company and ICC Technologies, Inc. formed Engelhard/ICC, a jointly owned partnership, to develop and commercialize air conditioning and air-treatment systems based on a proprietary new desiccant developed by Engelhard. The partnership will market these systems worldwide. The products of the Catalysts and Chemicals segment compete in the marketplace on the basis of product performance, technical service and price. No single competitor is dominant in the markets in which the Company operates. The manufacturing operations of the Catalysts and Chemicals segment are carried out in seven states in the United States. Wholly-owned foreign facilities are located in Italy, The Netherlands, Germany and the United Kingdom with equity investments located in the U.S., Japan and South Korea. The products are sold principally through the Company's sales organizations or its equity investments, supplemented by independent distributors and representatives. The principal raw materials used by the Catalysts and Chemicals segment include precious metals, procured by the Engineered Materials and Precious Metals Management Segment; kaolin, supplied by the Pigments and Additives Segment; and a variety of minerals and chemicals which are generally readily available. As of January 1, 1994 the Catalysts and Chemicals segment had approximately 1,860 employees worldwide, many of whom are hourly employees covered by collective bargaining agreements. Employee relations have generally been good. Pigments and Additives The Pigments and Additives segment is comprised of two principal product groups: the Paper Pigments and Chemicals Group, serving the paper industry and the Specialty Minerals and Colors Group, serving the plastics, coatings, paint and allied industries. Paper pigments and chemicals products consist primarily of coating and extender pigments. The coating pigments provide whiteness, opacity and improved printing properties for high-quality paper and paperboard. Other products are used as extenders and/or combined with fibers during the manufacture of paper or paperboard. Products for the paper market include Ultra White 90 (registered trademark) pigment, a high-brightness material for high-quality paper coating; Ansilex (registered trademark) pigments that provide the desired opacity, brightness, gloss and printability in paper products; Nuclay (registered trademark) specialized coating pigment for lightweight publication papers; EXSILON (trademark) structured pigment that improves the printability of lightweight coated paper and carbonless forms; and Spectrafil (trademark) pigments for the newsprint and groundwood specialties markets. Specialty minerals and colors kaolin based products are used as pigments and extenders for a variety of purposes in the manufacture of plastic, rubber, ink, ceramic, adhesive products and in paint. Principal products include Satintone (registered trademark) products, ASP (registered trademark) pigments and Translink (registered trademark) surface modified reinforcements. Other specialty minerals and colors products which serve essentially the same end markets as the Company's kaolin-based pigments and extenders comprise a variety of organic and inorganic color pigments. The Group also produces gellants and sorbents for a wide range of applications. The products of the Pigments and Additives segment compete with similar products as well as products made from other materials on the basis of product performance and price. No single competitor is dominant in the markets in which the Company operates. Pigments and Additives operations are carried out in four states in the United States and in Finland. The products are sold principally through the Company's sales organization supplemented by independent distributors and representatives. The principal raw materials used by the Pigments and Additives segment include kaolin and attapulgite from mineral reserves owned or leased by the Company and a variety of minerals and chemicals which are generally readily available. As of January 1, 1994 the Pigments and Additives segment had approximately 1,840 employees worldwide, many of whom are hourly employees covered by collective bargaining agreements. Employee relations have generally been good. Engineered Materials and Precious Metals Management The Engineered Materials and Precious Metals Management segment includes the Engineered Materials Group, serving a broad spectrum of industries and the Precious Metals Management Group, which is responsible for precious metals sourcing and dealing and for managing the precious metals requirements of the Company and its customers. The products of the Engineered Materials Group consist primarily of metal- based materials such as temperature-sensing devices, crucibles, bushings, gauze, precious metals coating and electroplating materials, conductive pastes and powders, brazing alloys and precious metal wire, sheet, and tubing. These products are used in the manufacture of automotive components, industrial devices, glass and glass fiber, ceramics, chemicals, instruments, control devices, fine jewelry, dental and medical supplies, hardware, furniture and air conditioners. The Group also provides refining services to internal and external customers. The products of the Engineered Materials Group compete with similar products as well as products made from other materials on the basis of product performance, technical service and price. No single competitor is dominant in the markets in which the Company operates. Engineered Materials manufacturing and refining operations are carried out in four states in the United States and in facilities located in the United Kingdom, France and Italy. The products are sold principally through the Company's sales organization, supplemented by independent distributors and representatives. The principal raw materials used by these operations are precious metals including those of the platinum group (platinum, palladium, rhodium, iridium and ruthenium), silver and gold, all of which are generally available. In January, 1993 the Company sold its 40 percent interest in M&T Harshaw, an affiliate through which the Company had participated in the base metal plating industry. In the fourth quarter of 1992, the Company formed Heraeus Engelhard Electrochemistry Corp., a venture with Heraeus Inc. The venture, 46 percent owned, markets electrochemical products in the Western Hemisphere. The Precious Metals Management Group is responsible for procuring precious metals requirements of the Company's operations and its customers. Supplies of newly mined platinum group metals are obtained primarily from South Africa and the Russian Federation and to a lesser extent from the United States and Canada, which four regions are the only known significant sources. Most of these platinum group metals are obtained pursuant to a number of contractual arrangements with different durations and terms. Management believes that available supplies of such metals will be adequate to meet the needs of the Company for the foreseeable future. Gold and silver are purchased from various sources. In addition, in the normal course of business, certain customers and suppliers deposit significant quantities of precious metals with the Company under a variety of arrangements. Equivalent quantities of precious metals are returnable as product or in other forms. The Precious Metals Management Group also engages in precious metal dealing operations with industrial consumers, dealers, central banks, miners and refiners. The group does not routinely speculate in the precious metals market. Offices are located in the United States, the United Kingdom, Switzerland, Japan and the Russian Federation. As of January 1, 1994 the Engineered Materials and Precious Metals Management segment had approximately 1,470 employees throughout the world, many of whom are hourly employees covered by collective bargaining agreements. Employee relations have generally been good. Major Customer Approximately 12 percent and 10 percent of the Company's net sales for the years ended December 31, 1992 and 1991, respectively, were generated from a customer of both the Catalysts and Chemicals and Engineered Materials and Precious Metals Management segments. Sales to this customer included both fabricated products and precious metal and were therefore significantly influenced by fluctuations in precious metal prices as well as the quantity of metal purchased. In such cases, the market price fluctuations and quantities purchased can result in material variations in sales reported but do not usually have a direct or substantive effect on earnings. Research and Patents The Company currently employs approximately 300 scientists, technicians and auxiliary personnel engaged in research and development in the field of chemistry and metallurgy. These activities are conducted in the United States and abroad. The Company spent approximately $45 million on research and development in each of the last three years. Research facilities include fully staffed instrument analysis laboratories, which the Company maintains in order to achieve the high level of precision necessary for its various businesses and to assist customers in understanding the performance of Engelhard products in their specific application. The Company owns or is licensed under numerous patents which have been secured over a period of years. It is the policy of the Company to apply for patents whenever it develops new products or processes considered to be commercially viable and, in appropriate circumstances, to seek licenses when such products or processes are developed by others. While the Company deems its various patents and licenses to be important to certain aspects of its operations, it does not consider any significant portion or its business as a whole to be materially dependent on patent protection. Environmental Matters The Company devotes considerable attention to the requirements of environmental compliance. Management believes that compliance programs in effect at all major operations satisfactorily meet the requirements of local, state and federal environmental agencies. However, risks of increased costs and liabilities relating to environmental matters are inherent in certain Company operations, as they are with most other industrial companies. See Note 15 "Environmental costs" in the Notes to the Consolidated Financial Statements on pages 39 and 40 of the 1993 Annual Report to Shareholders. The Company is preparing, has under review, or is implementing with the oversight of cognizant environmental agencies, studies and cleanup plans at several locations, including Salt Lake City, Utah and Plainville, Massachusetts. In addition, the Company is in the process of implementing a cleanup plan approved by the New Jersey Department of Environmental Protection and Energy for the Company's Newark, New Jersey site. In December 1993 in connection with obtaining its operating permit under the Utah Solid and Hazardous Waste Act, the Company entered into an agreement with the Utah Solid and Hazardous Waste Control Board to assess the environmental status of its Salt Lake facility. With respect to the Plainville site, in September 1993, the United States Environmental Protection Agency (EPA) and the Company entered into a Consent Order under which the Company will conduct stabilization measures and further study contamination at the site. This site is also included on the Nuclear Regulatory Commission's (NRC) "Existing Site Decommissioning Management Plan Sites" list and the NRC has approved the Company's proposed plans for additional investigation of the site and an interior cleanup of the plant. The Company is currently identified as a potentially responsible party (PRP) at 16 sites by the EPA under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (CERCLA) or by a state or local equivalent under analogous laws. Subject to outstanding state claims or the reopening of existing settlement agreements for extraordinary circumstances or natural resource damages, the Company has settled a number of other cleanup proceedings. In several additional instances, PRPs named by the EPA or its state equivalent have notified or sued the Company claiming that the Company should have been named a PRP and allocated a share of clean-up costs. The Company has also responded to information requests from the EPA at other CERCLA sites. The Company believes it is a de minimis contributor at most of the sites referenced above and that there is no legal or factual basis for the Company's alleged responsibility for any hazardous substances present at certain of these sites. While it is not possible at this time to predict with certainty the ultimate outcome of all of the matters discussed above, it is the opinion of management, after consultation with counsel and based on existing information, that the resolution of these lawsuits and other matters in the aggregate will not have a material adverse effect on the Company or its business. Item 2.

Item 2. Properties The Company owns approximately 15 acres of land and three buildings with a combined area of approximately 168,000 square feet in Iselin, New Jersey. These buildings serve as the major research and development facilities for the Company's operations. The Company also owns a research facility in the Cleveland, Ohio area. In 1990, the Company entered into a 15 year lease for a 271,000 square foot building in Iselin, New Jersey, proximate to its owned facilities, which serves as the principal executive and administrative offices of the Company and its operating segments. This lease provides for three consecutive five-year-period extensions. The building is owned by a partnership in which the Company holds a significant interest. The Catalysts and Chemicals segment owns and operates a complex of plants in Georgia that manufactures petroleum cracking catalysts, and other domestic plants located in Union, New Jersey; Huntsville, Alabama; Seneca, South Carolina; Little Rock, Arkansas; Elyria, Ohio and Jackson, Mississippi. Foreign manufacturing operations are conducted at owned facilities in Italy, The Netherlands, Germany and the United Kingdom. In addition, the segment owns a mine in Mississippi and leases a mine in Arizona. The Pigments and Additives segment owns and operates five kaolin mines and five milling facilities in middle Georgia which serve an 85 mile network of pipelines to four processing plants. It also owns land containing kaolin clay and leases, on a long-term basis, kaolin mineral rights to additional acreage. The segment also owns and operates an attapulgite processing plant in Attapulgus, Georgia near the area containing its attapulgite reserves. Management believes that the Company's crude kaolin and attapulgite reserves will be sufficient to meet its needs for the foreseeable future. The segment also owns and operates color pigments manufacturing facilities in Louisville, Kentucky, Sylmar, California and Elyria, Ohio. Foreign operations are conducted at owned facilities in Finland. In addition, the segment owns mines in Florida. The Engineered Materials and Precious Metals Management segment owns and operates manufacturing facilities in Carteret and East Newark, New Jersey, Anaheim and Fremont, California, Lincoln Park, Michigan and Warwick, Rhode Island. Other manufacturing operations are conducted at owned facilities in the United Kingdom, France and Italy. The Company announced a plan to realign and consolidate businesses, concentrate resources and better position itself to achieve its strategic growth objectives. (See Item 1 "Business" above and Note 2 "Special charge" in the Notes to the Consolidated Financial Statements on page 30 of the 1993 Annual Report to Shareholders.) Management believes that the resulting configuration will be suitable and have sufficient capacity to meet its normal operating requirements for the foreseeable future. Item 3.

Item 3. Legal Proceedings The Company is a defendant in a number of lawsuits covering a wide range of matters. In some of these pending lawsuits, the remedies sought or damages claimed are substantial. The Company has also received a demand for indemnification from a distributor of the Company's talc products. The Company is vigorously defending against these claims. See also "Environmental Matters" for a discussion about lawsuits and matters concerning environmental compliance. While it is not possible at this time to predict with certainty the ultimate outcome of these lawsuits or the resolution of the environmental contingencies, it is the opinion of management, after consultation with counsel and based on available information that the disposition of these matters should not have a material adverse effect on the Company or its business. Submission of Matters to a Vote of Item 4.

Item 4. Participating Employees At December 31, 1993, there were approximately 2,127 employees participating in the Plan. Item 5.

Item 5. Administration of the Plan (a) The Plan is administered by the Pension and Employee Benefit Plans Committee of the Company (the Committee), the members of which are appointed by the Company to serve until their successors are appointed or until death, resignation or removal. The Committee has full power to determine questions relating to the eligibility of employees to participate in the Plan, to interpret the provisions of the Plan and to adopt regulations for its administration. Any or all members of the Committee who are employees of the Company may be participants in the Plan. The current members of the Committee and their addresses are as follows: James V. Napier 3343 Peachtree Road Chairman of the Committee and East Tower Director of the Company - Suite 1420 Atlanta, GA 30326 Marion H. Antonini 225 High Ridge Road Director of the Company Stamford, CT 06905 Robert L. Guyett Engelhard Corporation Senior Vice President, 101 Wood Avenue Chief Financial Officer and Iselin, NJ 08830 Director of the Company L. Donald LaTorre Engelhard Corporation Senior Vice President, 101 Wood Avenue Chief Operating Officer Iselin, NJ 08830 and Director of the Company Gerald E. Munera One DTC Director of the Company 5251 DTC Parkway Suite 700 Englewood, CO 80111 Norma T. Pace 100 East 42nd Street Director of the Company New York, NY 10017 Reuben F. Richards 250 Park Avenue Chairman of the Board, New York, NY 10177 Director of the Company Orin R. Smith Engelhard Corporation President, Chief Executive 101 Wood Avenue Officer and Director of Iselin, NJ 08830 the Company (b) All expenses of the Plan incidental to its administration are paid by the Company. Effective January 1, 1994, certain administrative fees and brokerage commissions will be charged against each participant's fund unit value. Item 6.

Item 6. Custodian of Investments (a) The Committee has appointed Vanguard Fiduciary Trust Company, P.O. Box 1101 Vanguard Financial Center, Valley Forge, Pennsylvania 19482, as independent Plan Trustee. The Trustee and the Company have entered into a trust agreement setting forth the Trustee's responsibilities under the Plan including maintaining custody of the Plan's investments and records of accounts for participants. (b) The Trustee receives no compensation from the Plan. (c) Vanguard Fiduciary Trust Company meets certain ERISA financial criteria and the Company is not required to secure or provide bonds as evidence of financial guarantee. Item 7.

Item 7. Reports of Participating Employees During each quarter of the plan year, each participant receives an individual participant statement disclosing the status of his or her account during the preceding quarter. Item 8.

Item 8. Investment of Funds The Company pays brokerage commissions only on investments in Engelhard Corporation common stock. Page Item 9.

Item 9. Financial Statements and Exhibits No. (a) Financial Statements Report of Independent Public Accountants 103 Statements of Financial Condition 104 - 105 at December 31, 1993 and 1992 Statements of Income and Changes in Plan Equity 106 - 108 for the three years in the period ended December 31, 1993 Notes to Financial Statements 109 - 112 Supplemental Schedule 113 - 114 Schedule I Schedules II and III have been omitted because the required information is shown in the financial statements or the notes thereto. (b) Exhibits Engelhard Corporation Savings Plan for Hourly * Paid Employees (incorporated by reference to the Engelhard Corporation Registration Statement on Form S-8 dated September 6, 1990). First, Second, Third, and Fourth Amendments * to the Engelhard Corporation Savings Plan for Hourly Paid Employees (Incorporated by reference to the Engelhard Corporation Annual Report Form 10-K for the fiscal year ended December 31, 1992). Fifth, Sixth and Seventh Amendments to the 115 - 118 Engelhard Corporation Savings Plan for Hourly Paid Employees. * Incorporated by reference as indicated Report of Independent Public Accountants To the Pension and Employee Benefit Plans Committee of Engelhard Corporation: We have audited the financial statements and the financial statement schedule of the Engelhard Corporation Savings Plan for Hourly Paid Employees listed in the index on Page 129 of this Form 11-K. These financial statements and the financial statement schedule are the responsibility of the Plan's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Engelhard Corporation Savings Plan for Hourly Paid Employees as of December 31, 1993 and 1992, and the results of its operations for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND New York, New York March 24, 1994 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Financial Condition at December 31, 1992 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Income and Changes in Plan Equity for the year ended December 31, 1993 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Income and Changes in Plan Equity for the year ended December 31, 1992 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Income and Changes in Plan Equity for the year ended December 31, 1991 Notes to Financial Statements Note 1 - Description of the Plan The Engelhard Corporation Savings Plan for Hourly Paid Employees (the Plan), effective as of January, 1991, is designed to provide eligible employees of Engelhard Corporation (the Company) an opportunity to save part of their income by having the Company reduce their compensation and contribute the amount of the reduction to the Plan on a tax deferred basis. The following plan description is provided for general information purposes. Participants of the Plan should refer to the plan document for more detailed and complete information. Eligibility Except as specifically included or excluded by the Board of Directors of the Company (the Board), the hourly paid employees of Engelhard Corporation represented by Locals 223, 237 and 238, Independent Workers of North America, Locals 1668, 1668A and 1668B of the United Automobile Workers, Local 170 of the United Steelworkers of America, and, as of January 1, 1994, Local 8-406 of the Oil, Chemical and Atomic Workers International Union who have completed at least one year of service, as defined, are eligible to participate in the Plan as of the first day of the month in which they meet the year of service requirement. Contributions The Plan permits eligible employees participating in the Plan (the Participants) to elect to reduce their compensation, as defined, by a whole percentage thereof, subject to limitations, and to have that amount contributed to the Plan and the related taxes deferred. Matching Contributions The Company will contribute, on a monthly basis and subject to limitations and exclusions, either cash or common stock of the Company in an amount equal to 10 percent of the amount contributed by the Participants. Investments All contributions to the Plan are held and invested by Vanguard Fiduciary Trust Company (the Trustee). The Trustee maintains four separate investment funds within the Trust: a) The Company Stock Fund, which consists of assets invested or held for investment in the common stock of the Company. In the event the assets cannot be immediately invested in Company common stock, the funds are invested in short- term securities pending investments in Company common stock. b) The Fixed Income Fund, which consists of assets invested in shares of the Vanguard Variable Rate Investment Contract Trust. In the event the assets cannot be immediately invested in such shares or deposited as specified above, the assets are invested in short-term investments at the discretion of the Pension and Employee Benefit Plans Committee (the Committee). c) The Balanced Fund, which consists of assets invested in the Vanguard Asset Allocation Fund, which invests in stocks, bonds and cash reserves for the purpose of maximizing long- term total return with less volatility than a portfolio of common stock. d) The Equity Index Fund, which consists of assets invested in the Vanguard Quantitative Portfolio, which invests primarily in common stocks for the purpose of realizing a total return greater than the Standard & Poor's 500 Index while maintaining fundamental investment characteristics similar to such Index. Participants have the right to elect, subject to restrictions, in which investment fund or funds their contributions are invested. All matching contributions are invested in the Company Stock Fund. The number of Participants in each fund was as follows at December 31: Participants 1993 1992 --------- --------- Common Stock Fund 599 462 Fixed Income Fund 396 342 Balanced Fund 136 104 Equity Index Fund 145 118 The total number of Participants in the Plan was less than the sum of the number of Participants shown above because many were participating in more than one fund. The number of units representing Participant interests in each fund and the related net asset value per unit were as follows at December 31: Vesting Participants at all times have a fully vested and non-forfeitable interest in their contributions and in the matching contributions allocated to their account. Termination Although it expects and intends to continue the Plan indefinitely, the Company has reserved the right of the Board to terminate or amend the Plan. Distributions and Withdrawals All distributions and withdrawals from the Plan are made to Participants in a lump sum cash payment except those amounts distributed from the Company Stock Fund which may, at the Participant's election, be paid in full shares of the Company's Common Stock with cash paid in lieu of fractional shares. Note 2 - Accounting Policies The accounts of the Plan are maintained on an accrual basis. Purchases and sales of investments are reflected on a trade date basis. Assets of the Plan are valued at fair value. Gains and losses on distributions to participants and sales of investments are based on average cost. Certain prior year amounts have been reclassified to conform with the current year presentation. Note 3 - Income Tax Status The Plan and the Trust created thereunder are intended to qualify under Section 401(a) and 501(a) of the Internal Revenue Code of 1986, as amended (the Code) and the Plan includes a cash or deferred arrangement intended to meet the requirements of Section 401(k) of the Code. The Internal Revenue Service has issued a favorable determination letter as to the Plan's qualified status under the Code. Amounts contributed to and earned by the Plan are not taxed to the employee until a distribution from the Plan is made. In addition, any unrealized appreciation on any shares of common stock of the Company distributed to an employee is not taxed until the time of disposition of such shares. Note 4 - Administrative Expenses All expenses of the Plan are paid for by the Company. Investment advisory fees for portfolio management of Vanguard funds are paid directly from fund earnings. Advisory fees are included in the fund expense ratio and will not reduce the assets of the Plan. Brokerage commissions paid to purchase Engelhard Corporation common stock are paid for by the Company. Effective January 1, 1994, certain administrative fees and brokerage commissions will be charged against each participant's unit value. Note 5 - Concentrations of Credit Risk Financial instruments which potentially subject the Plan to concentrations of credit risk consist principally of investment contracts with insurance and other financial institutions. The Plan places its investment contracts with high-credit quality institutions and, by policy, limits the amount of credit exposure to any one financial institutions. Note 6 - Investments Investments in the Common Stock of the Company are valued at the readily-available, quoted market price as of the valuation date and investments in the Vanguard Funds are valued based on the quoted net asset value (redemption value) of the respective investment company as of the valuation date. Schedule I Engelhard Corporation Savings Plan for Hourly Employees Schedule of Investments at December 31, 1993 Approximate Cost Market Value ---------- ------------- Company Stock Fund - ------------------- Common Stock of $1,096,878 $1,308,182 Engelhard Corporation (53,669 shares) Cash equivalents 11,824 11,824 Fixed Income Fund - ------------------ Vanguard Variable Rate 1,285,061 1,285,061 Investment Contract Trust Balanced Fund - -------------- Vanguard Asset Allocation 215,508 224,821 Fund Equity Index Fund - ------------------ Vanguard Quantitative 256,478 254,653 Portfolio ---------- ------------- Total $2,865,749 $3,084,541 ========== ============= Schedule I Engelhard Corporation Savings Plan for Hourly Employees Schedule of Investments at December 31, 1992 Approximate Cost Market Value ---------- ------------- Company Stock Fund - ------------------- Common Stock of $ 481,064 $ 686,469 Engelhard Corporation (19,970 shares) Cash equivalents 3,601 3,601 Fixed Income Fund - ------------------ Vanguard Variable Rate 743,477 743,477 Investment Contract Trust Balanced Fund - -------------- Vanguard Asset Allocation 109,724 113,823 Fund Equity Index Fund - ------------------ Vanguard Quantitative 132,316 135,602 Portfolio ---------- ------------- Total $1,470,182 $1,682,972 =========== ============= FIFTH AMENDMENT TO THE ENGELHARD CORPORATION SAVINGS PLAN FOR HOURLY PAID EMPLOYEES The Engelhard Corporation Savings Plan for Hourly Paid Employees is hereby amended in the following respects, effective as of January 1, 1993: 1. Appendix A to the Plan is amended by adding the following at the end thereof: "4. Hourly-paid employees of Engelhard Corporation represented by Local 170 of the United Steelworkers of America. a. Effective Date (Section 1.13). January 1, 1993. b. Eligibility Requirement (Section 2.01). Employees in the employ of the Employer on or before November 24, 1992 are eligible as of the Effective Date; individuals hired after November 24, 1992 are eligible following completion of one year of Eligibility Service. c. Maximum Deferral Percentage (Section 3.01). 15% d. Matching Percentage (Section 3.02). 0% -- No Matching Contribution. e. Investment Funds (Section 5.02). Fixed Income Fund, Balanced Fund, Equity Index Fund. f. Withdrawals (Section 7.01). Permitted. g. Loans (Section 7.04). Not Permitted." SIXTH AMENDMENT TO THE ENGELHARD CORPORATION SAVINGS PLAN FOR HOURLY PAID EMPLOYEES The Engelhard Corporation Savings Plan for Hourly Paid Employees is hereb amended in the following respects, effective as of the dates set forth below: 1. Effective as of January 1, 1994, Section 5.03 is amended by adding the following sentence at the end thereof: "The Trustee shall be obligated to comply with a Participant's instructions as to investment elections made in accordance with this Section 5.03, except as otherwise provided in Department of Labor Regulations S 2550.404c-1(b) (2) (ii) (B) and (d) (2) (ii), and a Participant shall be given an opportunity to obtain written confirmation of telephonic instructions to the Trustee." 2. Effective as of January 1, 1994, Section 5.05 is amended by adding the following sentence at the end thereof: "The Trustee shall be obligated to comply with a Participant's instructions as to investment elections made in accordance with this Section 5.05, except as otherwise provided in Department of Labor Regulations S 2550.404c-1(b) (2) (ii) (B) and (d) (2) (ii), and a Participant shall be given an opportunity to obtain written confirmation of telephonic instructions to the Trustee." 3. Effective as of August 5, 1993, Section 10.01 is amended by adding at the end thereof the following: "Payments pursuant to a qualified domestic relations order may be made to an alternate payee prior to the Participant's earliest retirement age, within the meaning of Section 414(p) (4) (B) of the Code." 4. Effective as of August 5, 1993, Article XV is amended by adding at the end thereof the following new Section 15.07: "15.07. If a Participant transfers to a position with the Company or an Affiliate which is not covered by the Plan and the Participant, after the transfer, is qualified for participation in the Salary Deferral Savings Plan of Engelhard Corporation (or any other qualified plan maintained by the Company or an Affiliate), then such Participant's entire Account balance may be transferred to the Salary Deferral Savings Plan of Engelhard Corporation (or such other qualified plan), at the sole discretion of the Committee or its delegate, and after such transfer the Participant shall have no further interest in this Plan." 5. Effective as of January 1, 1994, Appendix A to the Plan is amended by adding the following at the end thereof: "5. Hourly-paid employees of Engelhard Corporation represented by Local 8-406 of the Oil, Chemical & Atomic Workers International Union. a. Effective Date (Section 1.13). January 1, 1994 b. Eligibility Requirement (Section 2.01). Employees in the employ of the Employer on or before March 26, 1993 are eligible as of the Effective Date; individuals hired after March 26, 1993 are eligible following completion of one year of Eligibility Service. c. Maximum Deferral Percentage (Section 3.01). 10% d. Matching Percentage (Section 3.02). 10% of Tax Deferred Contributions, up to 0.6% of Compensation. e. Investment Funds (Section 5.02). Fixed Income Fund, Balanced Fund, Equity Index Fund. f. Withdrawals (Section 7.01). Permitted. g. Loans (Section 7.04). Not Permitted." SEVENTH AMENDMENT TO THE ENGELHARD CORPORATION SAVINGS PLAN FOR HOURLY PAID EMPLOYEES The Engelhard Corporation Savings Plan for Hourly Paid Employees is hereby amended in the following respects, effective as of January 1, 1994: 1. Section 1.10 is amended by deleting the last sentence thereof and inserting the following in its place: "Notwithstanding the foregoing, an Employee's Compensation for any Plan Year in excess of $150,000, as such amount shall be increased due to cost of living increases in accordance with regulations issued from time to time by the Secretary of the Treasury under Section 401(a) (17) of the Code, shall be disregarded for all purposes of the Plan." 2. Section 3.03 is amended by adding the following sentence at the end of paragraph (c) (vii) thereof: "Total Compensation taken into account for any Plan Year shall not include any amounts in excess of $150,000, as adjusted for increases in the cost of living in accordance with regulations issued from time to time by the Secretary of the Treasury under Section 401 (a) (17) of the Code." 3. Appendix A to the Plan is amended by deleting part c. of paragraph 5 thereof and inserting the following in its place: "c. Maximum Deferral Percentage (Section 3.01). 15%."

740582_1993.txt

740582

1993

Item 1. Business Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership (the "Registrant") is a limited partnership governed by the laws of the State of Maryland. The Registrant raised $87,037,000 from sales of Limited Partnership Interests. The Registrant's operations consist exclusively of investment in and operation of income-producing real properties, and all financial information included in this report relates to this industry segment. The Registrant utilized the net offering proceeds to acquire fourteen real property investments. Titles to Southern Hills, Rancho Mirage and Highland Ridge apartment complexes were relinquished through foreclosure during January 1990, March 1993 and May 1993, respectively. The Registrant also sold Butterfield Village Apartments in April 1993. As of December 31, 1993, the Registrant owned the remaining ten properties described under "Properties" (Item 2). The Partnership Agreement generally provides that the proceeds of any sale or refinancing of the Registrant's properties will not be reinvested in new acquisitions. During 1993, the multi-family residential real estate industry in certain cities and regions of the country experienced improvements in occupancy levels and rental rates. These improvements are due in part to recoveries in local economies along with low levels of new construction of rental units in recent years, which has led to higher occupancies and increased rental revenues for existing properties. As discussed in Item 7. Liquidity and Capital Resourses, of the Registrant's ten remaining properties, during 1993, eight generated positive cash flow while two generated marginal cash flow deficits. Many rental markets continue to remain extremely competitive; therefore, the general partner's goals are to maintain high occupancy levels, while increasing rents where possible, and to monitor and control operating expenses and capital improvement requirements at the properties. Historically, real estate investments have experienced the same cyclical characteristics affecting most other types of long-term investments. While real estate values have generally risen over time, the cyclical character of real estate investments, together with local, regional and national market conditions, has resulted in periodic devaluations of real estate in particular markets, as has been experienced in the last few years. As a result of these factors, it has become necessary for the Registrant to retain ownership of many of its properties for longer than the holding period for the assets originally described in the prospectus. The General Partner examines the operations of each property and each local market individually when determining the optimal time to sell each of the Registrant's properties. Although investors have received certain tax benefits, the Registrant has not commenced distributions. Future distributions will depend on improved cash flow from the Registrant's remaining properties and proceeds from future property sales, as to both of which there can be no assurances. In light of the results to date and current market conditions, the General Partner does not anticipate that the investors will recover a substantial portion of their investment. The Registrant is largely dependent on loans from the General Partner and owes approximately $7,776,000 to the General Partner at December 31, 1993 in connection with funds advanced for working capital purposes. These loans are expected to be repaid from available cash flow from future property operations, or from proceeds received from the disposition of the Registrant's real estate investments prior to any distributions to the Limited Partners from these sources. The General Partner may continue to provide additional short-term loans to the Registrant or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Registrant would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Registrant may be required to dispose of some of its properties to satisfy these obligations. In instances where the General Partner concludes that the Registrant's investment objectives cannot be met by continuing to own a particular property and fund operating deficits, the Registrant has suspended and may in the future suspend debt service payments or sell the property at a price less than its original cost. Suspension of debt service payments may lead to a renegotiation of terms with lenders which would permit the Registrant to continue to own properties or may lead to foreclosure or other action by lenders which would result in the relinquishment of title to properties in satisfaction of the outstanding mortgage loan balances. In the case of each property, the General Partner will pursue modification of underlying debt, consider suspending debt service payments and/or deferring non-critical repair and maintenance costs and analyze present and projected market conditions and projections for operations prior to determining the disposition of a property. During 1993, the Registrant relinquished titles to the Rancho Mirage and Highland Ridge apartment complexes. See Item 7. Liquidity and Capital Resources for additional information. Effective February 1, 1993, the Registrant suspended debt service payments on the loans collateralized by the Ridgepoint Green and Ridgepoint Way apartment complexes and the lender placed the loans in default. In April 1993, the Registrant, through its subsidiaries owning these properties, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. While the bankruptcy proceedings continue, the Partnership will remit partial debt service payments to the lender equal to monthly net cash flow from the properties. The Registrant and the lender have tentatively agreed on the terms of a modification of the loans and an agreement is expected to be finalized in March 1994. See Item 3. Legal Proceedings for additional information. During April 1993, the Registrant sold the Butterfield Village Apartments located in Tempe, Arizona in all cash sale for $9,385,000. After payment of the underlying mortgage and selling costs, the Registrant received proceeds of approximately $2,950,000 from the sale. See Note 12 of Notes to Financial Statements for additional information. During 1993, the Registrant refinanced the loans collateralized by the Ridgetree II and Meadow Creek apartment complexes and modified the loan collateralized by the Park Colony Apartments. See Item 7. Liquidity and Capital Resourses for additional information. The officers and employees of Balcor Partners-84 II, Inc., the General Partner of the Registrant, and its affiliates perform services for the Registrant. The Registrant currently has 74 full-time and 18 part-time employees engaged in its operations. Item 2.

Item 2. Properties As of December 31, 1993, the Registrant owns the ten properties described below: Location Description of Property Tempe, Arizona La Contenta Apartments: a 274-unit apartment complex located on approximately 13 acres. Pineville, North Carolina * Meadow Creek Apartments: a 250-unit apartment complex located on approximately 23 acres. Gwinnett County, Georgia Park Colony Apartments: a 352-unit apartment complex located on approximately 29 acres. Dallas, Texas Ridgepoint Green Apartments: a 284-unit apartment complex located on approximately 10 acres. Dallas, Texas Ridgepoint Way Apartments: a 310-unit apartment complex located on approximately 12 acres. Dallas, Texas Ridgetree Apartments (Phase II): a 354-unit apartment complex located on approximately 9 acres. Lenexa, Kansas ** Rosehill Pointe Apartments: a 498-unit apartment complex located on approximately 35 acres. Orange County, Florida ** Seabrook Apartments: a 200-unit apartment complex located on approximately 16 acres. Columbus, Ohio Spring Creek Apartments: a 288-unit apartment complex located on approximately 19 acres. Irving, Texas Westwood Village Apartments: a 320-unit apartment complex located on approximately 16 acres. * Owned by the Registrant through a joint venture with the seller. ** Owned by the Registrant through a joint venture with one or more affiliated partnerships. Each of the above properties is held subject to various mortgages and other forms of financing. In the opinion of the General Partner, the Registrant has provided for adequate insurance coverage for its real estate investment properties. See Notes to Financial Statements for other information regarding real property investments. Item 3.

Item 3. Legal Proceedings (a & b) Ridgepoint Green Apartments and Ridgepoint Way Apartments In March 1983, the Registrant acquired, through subsidiary partnerships, the Ridgepoint Green and Ridgepoint Way apartment complexes, utilizing $4,659,620 and $5,007,315 of offering proceeds, respectively. The Registrant acquired the properties subject to first mortgage loans from an unaffiliated lender in the then outstanding amounts of $8,370,000 and $9,118,000, respectively. Effective January 1993, the Registrant suspended debt service payments while negotiating with Travelers Insurance Company, the current holder of the loans ("Travelers"), for loan modifications. Subsequently, in April 1993, the subsidiaries commenced proceedings under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court, Northern District of Texas, In re Ridgepoint Green Investors, Case No.: 393-32455-RCM-11, and In re Ridgepoint Way Investors, Case No.: 393-32456-RCM-11. In May 1993, the cases were consolidated by the Bankruptcy Court and in June 1993, cash collateral orders were entered pursuant to which all cash flow after payment of the operating expenses of the properties is paid to Travelers. The Registrant and Travelers have tentatively agreed on the terms of a modification of the loans and an agreement is expected to be finalized in April 1994. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders (a, b, c & d) No matters were submitted to a vote of the Limited Partners of the Registrant during 1993. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters There has not been an established public market for Limited Partnership Interests and it is not anticipated that one will develop; therefore, the market value of the Limited Partnership Interests cannot reasonably be determined. The Registrant has not made distributions to date to investors. For additional information, see Item 7. - "Management's Discussion and Analysis of Financial Condition and Results of Operations" below. As of December 31, 1993, the number of record holders of Limited Partnership Interests of the Registrant was 8,495. Item 6.

Item 6. Selected Financial Data Year ended December 31, 1993 1992 1991 1990 1989 Rental and service income $17,953,526 $21,494,257 $21,092,058 $20,988,232 $20,779,131 Interest on short- term investments 31,346 161,231 192,197 265,821 265,637 Admin. expenses 679,625 653,998 584,826 438,035 505,203 Gain on sale of property 3,606,825 None None None None Extraordinary items: Gain on forgive- ness of debt 1,234,176 None None None None Gain on fore- closure of properties 8,432,686 None None None None Net income (loss) 9,901,817 (5,099,275) (5,662,553) (5,484,230) (7,509,077) Net income (loss) per Limited Part- nership Interest 112.63 (58.00) (64.41) (62.38) (85.41) Tax income (loss) 19,678,422 (8,936,053) (9,011,828) (7,759,553)(10,053,658) Tax income (loss) per Limited Part- nership Interest 210.88 (70.82) (88.80) (67.70) (105.11) Cash and cash equivalents 1,160,704 223,828 427,569 413,669 353,928 Total investment properties, net of accumulated depreciation 69,892,901 98,081,597 101,655,358 105,218,999 114,405,379 Total assets 73,333,165 100,416,387 104,489,888 110,712,217 117,303,591 Purchase price, promissory and mortgage notes payable 84,130,907 120,086,011 120,708,225 122,370,278 127,406,328 Properties owned on December 31 10 13 13 13 14 Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership (the "Partnership") is a limited partnership formed in 1983 to invest in and operate income-producing real property. The Partnership raised $87,037,000 through the sale of Limited Partnership Interests and utilized these proceeds to acquire fourteen real property investments. Titles to the Southern Hills, Rancho Mirage and Highland Ridge apartment complexes were relinquished through foreclosure during January 1990, March 1993 and May 1993, respectively. The Partnership also sold the Butterfield Village Apartments in April 1993. The Partnership continues to operate the ten remaining properties. Operations Summary of Operations The Partnership sold Butterfield Village Apartments in April 1993 and relinquished titles to the Rancho Mirage and Highland Ridge apartment complexes to the lenders through foreclosure in March and May 1993, respectively. The latter two properties were in receivership in 1993 and, in accordance with the Partnership's accounting policies, no operations were recorded during 1993. Both of these properties generated losses during 1992. This, along with the gain recognized on the sale of Butterfield Village Apartments during 1993, resulted in the recognition of income before extraordinary items during 1993 as compared to a loss during 1992. The Partnership realized further income during 1993 as a result of the extraordinary gains recognized in connection with the foreclosures, as well as the gain recognized in connection with the forgiveness of debt related to the Ridgetree II refinancing in April 1993. During 1992 and the latter part of 1991, the Partnership modified or refinanced loans collateralized by four of its properties. In addition, the Partnership placed two of its properties in substantive foreclosure as of September 30, 1992 whereby interest expense is recognized only to the extent paid. The combined effect of these events resulted in a decrease in interest expense on purchase price, promissory and mortgage notes payable during 1992. This decrease in interest expense was the primary reason for the decrease in the net loss during 1992 as compared to 1991. Further discussion of the Partnership's operations are summarized below. 1993 Compared to 1992 As mentioned above, the Partnership sold the Butterfield Village Apartments in April 1993 and did not record operations during 1993 for the Highland Ridge and Rancho Mirage apartment complexes as a result of their receivership status. As a result, the Partnership experienced decreases in rental and service income, interest expense on purchase price, promissory and mortgage notes payable, depreciation, property operating expense, maintenance and repair expense, real estate taxes and property management fees during 1993 as compared to 1992. Increased occupancy levels and/or rental rates at seven of the Partnership's properties during 1993 partially offset the above decrease in rental and service income, and consequently, property management fees. The loan collateralized by the Seabrook Apartments was originally financed by a bond issuance which matured in 1992. During the third quarter of 1992, the Partnership received interest income from the trustee of the bonds. This, as well as lower interest rates earned on short-term investments in 1993, resulted in a decrease in interest income on short-term investments during 1993 as compared to 1992. In May and June 1992, the Partnership reached settlements with the sellers of the Rosehill Pointe and Ridgetree II apartment complexes. As a result, settlement income of $273,294 was recognized in connection with these transactions during 1992. During July 1992 and April and May 1993, the loans collateralized by the Seabrook, Ridgetree II and Meadow Creek apartment complexes, respectively, were refinanced. In addition, in accordance with the loan agreements, the interest rates on the loans collateralized by the Rosehill Pointe and Westwood Village apartment complexes were adjusted to lower rates during July and October 1993, respectively. These events contributed to the decrease in interest expense on purchase price, promissory and mortgage notes payable discussed above. Due to the sale of the Butterfield Village Apartments and the foreclosure of the Highland Ridge Apartments, as well as the Ridgetree II and Meadow Creek refinancings and the Park Colony modification, the Partnership fully amortized the remaining financing fees related to the corresponding mortgage notes payable during 1993. This resulted in an increase in amortization expense during 1993 as compared to 1992. Increased administrative and maintenance staff payroll expenses at the Rosehill Pointe and Spring Creek apartment complexes during 1993 partially offset the decrease in property operating expense discussed above. During 1992, the Partnership incurred substantial expenditures for painting and cleaning and carpet replacement at the Park Colony Apartments in an effort to lease vacant units. In addition, the Partnership deferred non-critical maintenance and repair costs during 1993 at the Ridgepoint Green and Ridgepoint Way apartment complexes due to the bankruptcy filings. This contributed to the decrease in maintenance and repair expense discussed above. During 1993, higher real estate taxes were incurred at the Meadow Creek, Spring Creek and Westwood Village apartment complexes as a result of increased tax rates and/or assessments. The additional expense partially offset the reduction in real estate tax expense due to the property dispositions discussed above and lower assessments at the La Contenta and Ridgetree II apartment complexes. During 1993, Rosehill Pointe Apartments experienced an increase in rental rates and a decrease in interest expense, as discussed above. This improvement in operations resulted in a decrease in the affiliates' participation in losses from joint ventures during 1993 as compared to 1992. In addition, interest income received during the third quarter of 1992 from the trustee of the bonds, which were collateralized by the Seabrook Apartments and matured in 1992, offset the above decrease. During April 1993, the Partnership recognized a gain of $3,606,825 on the sale of Butterfield Village Apartments located in Tempe, Arizona. During 1993, the Partnership recognized an extraordinary gain on forgiveness of debt of $1,234,276 in connection with the April 1993 refinancing of the Ridgetree II Apartments located in Dallas, Texas. The Partnership also recognized extraordinary gains on foreclosures of $8,432,686 in connection with the March 1993 foreclosure of the Rancho Mirage Apartments located in Phoenix, Arizona and the May 1993 foreclosure of the Highland Ridge Apartments located in Oklahoma City, Oklahoma. These properties were classified as real estate in substantive foreclosure at December 31, 1992. 1992 Compared to 1991 Increased occupancy and/or rental rates at eight of the Partnership's properties resulted in an increase in rental and service income during 1992 as compared to 1991. During the first quarter of 1991, the Partnership was required to have restricted cash invested in short-term interest bearing instruments in connection with letters of credit pledged to lenders relating to certain of the Partnership's properties. These restricted investments were released and used to repay Partnership obligations later in 1991. This, as well as lower interest rates earned on short-term investments during 1992, resulted in a decrease in interest income on short-term investments during 1992 as compared to 1991. The Partnership reached a settlement with the seller of the Ridgetree II Apartments, which was executed in June 1992. Prorations due from the seller pursuant to the terms of the original management and guarantee agreement on this property were previously written off due to uncertain collectibility. Pursuant to the settlement agreement, the parties have released all claims and causes of action against one another, and the Partnership received cash of $157,000 and was relieved of certain other liabilities by the seller. Settlement income of $153,057 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. The Partnership also reached a settlement with the seller of the Rosehill Pointe Apartment for proration amounts the seller owed the Partnership pursuant to the terms of the original management and guarantee agreement. The joint venture which owns the property received $70,266 in June 1992 and $140,554 in December 1992, pursuant to the terms of the settlement which was executed in May 1992. Settlement income of $120,237 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. The principal paydown made during November 1991 on a portion of the loan collateralized by the Meadow Creek Apartments, the July 1992 refinancing of the loan collateralized by the Seabrook Apartments, and the November 1991 modification of the loan collateralized by the Butterfield Village Apartments resulted in a decrease in interest expense on purchase price, promissory and mortgage notes payable during 1992 as compared to 1991. In addition, the placement of the Rancho Mirage and Highland Ridge apartment complexes in substantive foreclosure as of September 30, 1992, whereby the Partnership recognizes interest only to the extent paid, also contributed to the decrease in interest expense. Interest rates incurred on working capital borrowings from the General Partner were lower during 1992 as compared to 1991. This is the primary reason for the decrease in interest expense on short-term loans during 1992 as compared to 1991. As a result of higher expenditures for utilities, insurance and payroll expenses at the Highland Ridge, Park Colony, Rancho Mirage, Ridgepoint Green and Ridgepoint Way apartment complexes, property operating expenses increased during 1992 as compared to 1991. The Partnership incurred higher expenditures in 1992 for roof and structural repairs and carpet replacement at the Butterfield Village, Rancho Mirage, Ridgepoint Green and Ridgepoint Way apartment complexes. In addition, the Partnership incurred expenditures for balcony repairs and floor coverings at the Meadow Creek Apartments, and incurred substantial expenditures for painting and cleaning and carpet replacement at the Park Colony Apartments in an effort to lease certain vacant units. As a result, maintenance and repair expenses increased during 1992 as compared to 1991. Legal fees incurred in connection with the bankruptcy filing for the La Contenta Apartments caused administrative expenses to increase during 1992 as compared to 1991. Interest expense decreased at the Seabrook Apartments during 1992 due to the July 1992 refinancing of the loan collateralized by the property. As a result, the affiliates' participation in losses from joint ventures decreased during 1992 as compared to 1991. Liquidity and Capital Resources The Partnership received funds from investing activities relating to the sale of the Butterfield Village Apartments in April 1993. The Partnership used cash to fund certain of its financing activities which included the repayment of the mortgage note on the Butterfield Village Apartments in connection with the sale, the net repayment of a portion of the borrowings from the General Partner and the payment of principal on the loans collateralized by the Partnership's properties. Proceeds received from the refinancings of the Meadow Creek and Ridgetree II loans were not sufficient to repay the prior loans and related fees, and the Partnership also used its cash reserves to fund the respective shortfalls. In addition, cash was used to fund the Partnership's operating activities. The payment of administrative expenses, interest expense on the General Partner loan and the funding of capital and operating escrows related to the refinancings offset the cash flow generated by the Partnership's properties. The Partnership is largely dependent on loans from the General Partner and owes approximately $7,776,000 to the General Partner at December 31, 1993 in connection with funds advanced for working capital purposes. These loans are expected to be repaid from available cash flow from future property operations, or from proceeds received from the disposition of the Partnership's real estate investments prior to any distributions to the Limited Partners from these sources. The General Partner may continue to provide additional short-term loans to the Partnership or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Partnership would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Partnership may be required to dispose of some of its properties to satisfy these obligations. During 1993, eight of the Partnership's remaining ten properties generated positive cash flow while two generated marginal cash flow deficits. During 1992, five of the Partnership's thirteen properties generated positive cash flow while five generated marginal cash flow deficits and three generated significant cash flow deficits. As discussed above, titles to the Rancho Mirage and Highland Ridge apartment complexes were relinquished to the lenders through foreclosure in March 1993 and May 1993, respectively and the Butterfield Village Apartments were sold in April 1993. The Partnership classifies the cash flow performance of its properties as either positive, a marginal or a significant cash flow deficit, each after consideration of debt service payments unless otherwise indicated. A deficit is considered to be significant if it exceeds $250,000 annually or 20% of the property's rental and service income. The Park Colony Apartments generated a significant cash flow deficit during 1992, whereas during 1993 the property generated a marginal deficit. Substantial expenditures were incurred in 1992 to repair vacant units which has resulted in increased occupancy and improved operations. The La Contenta and Meadow Creek apartment complexes, which generated marginal cash flow deficits during 1992, generated positive cash flow during 1993 due to increased occupancy and/or rental rates, as well as decreased operating expenses. The Ridgetree II Apartments, which also generated a marginal cash flow deficit during 1992, generated positive cash flow during 1993 due to the reduced debt service payments required by the refinancing. The Ridgepoint Green and Ridgepoint Way apartment complexes, which generated significant cash flow deficits during 1992, generated positive cash flow during 1993 due to the suspension of debt service payments by the Partnership effective January 1993. Debt service payments were suspended in an effort to negotiate a modification of the loans collateralized by the properties. The lender subsequently placed the loans in default, and in April 1993, the Partnership, through its subsidiaries owning these properties, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. Had the Partnership paid the suspended debt service payments, both properties would have generated marginal cash flow deficits for 1993. While the bankruptcy proceedings continue, the Partnership will remit partial debt service payments to the lender equal to monthly net cash flow from the property. The Partnership and the lender have tenatively agreed on the terms of a modification of the loans and an agreement is expected to be finalized in March 1994. See Item 3. Legal Proceedings for additional information. Suspension of debt service payments may lead to a renegotiation of terms with lenders which would permit the Partnership to continue to own properties or may lead to foreclosure or other action by lenders which would result in the relinquishment of title to properties in satisfaction of the outstanding mortgage loan balances. While the cash flow of certain of the Partnership's properties has improved, the General Partner continues to pursue a number of actions aimed at improving the cash flow of the Partnership's properties including refinancing of mortgage loans, improving property operating performance, and seeking rent increases where market conditions allow. Despite improvements during 1993 in the local economies and rental markets where certain of the Partnership's properties are located, the General Partner believes that continued ownership of many of the properties is in the best interests of the Partnership in order to maximize potential returns to Limited Partners. As a result, the Partnership will continue to own these properties for longer than the holding period for the assets originally described in the prospectus. Each of the Partnership's properties is owned through the use of third-party mortgage loan financing and, therefore, the Partnership is subject to the financial obligations required by such loans. See Note 3 of Notes to Financial Statements for information concerning outstanding balances, maturity dates, interest rates, etc. related to each of these mortgage loans. During 1994, the $7,100,000 mortgage loan collateralized by the Spring Creek Apartments matures. As a result of the downturn experienced by the real estate industry over the last few years, many banks, savings and loans and other lending institutions have tightened mortgage lending criteria and are generally willing to advance less funds with respect to a property than many lenders were willing to advance during the 1980's. As a result, in certain instances it may be difficult for the Partnership to refinance a property in an amount sufficient to retire in full the current mortgage financing with respect to the property. In the event negotiations with the existing lender for a loan modification or with new lenders for a refinancing are unsuccessful, the Partnership may sell the collateral property or other properties to satisfy an obligation or may relinquish title to the collateral property in satisfaction of the outstanding mortgage loan balance. In July 1991, the Partnership suspended debt service payments on the loan collateralized by the Rancho Mirage Apartments in an effort to negotiate a modification of the loan. Negotiations were unsuccessful, and in March 1993, the Partnership relinquished title to the lender through foreclosure. See Note 13 of Notes to Financial Statements for additional information. In April 1992, the modification period relating to the mortgage loan collateralized by the Highland Ridge Apartments expired and the loan reverted to its previous terms. While negotiating for a further modification of the loan, the Partnership remitted partial debt service payments to the lender equal to monthly net cash flow from the property. During July 1992, the lender filed foreclosure proceedings and a receiver was appointed in September 1992. Negotiations for a modification were unsuccessful, and in May 1993, the Highland Ridge Apartments was relinquished to the lender through foreclosure. See Note 13 of Notes to Financial Statements for additional information. In April 1993, the first mortgage loan collateralized by Ridgetree II Apartments was refinanced with new first and second mortgage loans from an unaffiliated lender. Simultaneously, other first mortgage loans collateralized by properties owned by partnerships affiliated with the General Partner were also refinanced. All of these loans had been held directly or indirectly by the Resolution Trust Corporation and have been purchased by Lexington Mortgage Company, an independent third party. While the mortgage loan collateralized by Ridgetree II Apartments was current, many of the other mortgage loans were in default either with respect to monthly debt service requirements or the loan had matured and the properties were unable to repay the balloon payments that were due. The new loans were deposited into a trust, the beneficial interests of which were sold to unaffiliated investors. Lehman Brothers, an affiliate of the General Partner, acted as firm underwriter for the sale of the beneficial interests in the trust and received underwriting compensation from a third party in accordance with market practices. A subordinated portion of the beneficial interests in the trust continues to be owned by Lehman Brothers. The new loans include, among other things, principal balance or mortgage rate reductions, or maturity extensions, or a combination thereof. The terms of the new loans on Ridgetree II Apartments decreased the interest rate from 11% to 10.05%, extended the maturity date from September 1, 1996 to May 1, 2000, and included a principal reduction which was partially funded by a principal payment by the Partnership and was partially due to forgiveness of debt by the lender or a voluntary contribution from an affiliate of the General Partner. See Note 4 of Notes to Financial Statements for additional information. In May 1993, the first mortgage loan collateralized by Meadow Creek Apartments was refinanced with a new $5,200,000 first mortgage loan from an unaffiliated lender. The original loan bore interest at 10% and was to mature in September 1993, whereas the new loan bears interest at 8.54% and matures on June 1, 1998. See Note 4 of Notes to Financial Statements for additional information. In December 1993, the General Partner completed a modification of the loan collateralized by the Park Colony Apartments, whereby the interest rate was reduced from 10.25% to 9.375% and the maturity date was extended from July 1, 1996 to January 1, 1999. See Note 4 of Notes to Financial Statements for additional information. In April 1993, the Partnership sold the Butterfield Village Apartments located in Tempe, Arizona in an all cash sale for $9,385,000. After payment of the underlying mortgage and selling costs, the Partnership received proceeds of approximately $2,950,000 from the sale. A portion of these proceeds was used to reduce the outstanding short-term borrowings due to the General Partner. See Note 12 of Notes to Financial Statements for additional information. The Westwood Village Apartments is located near the Dallas/Ft. Worth Airport. As previously reported, the airport board is pursuing an expansion plan with the Federal Aviation Authority to build two additional runways on airport property. A proposed plan provides for varying levels of compensation to single family homeowners for the expected loss in value to their homes as a result of increased air traffic and heightened noise levels. However, no similar compensation is planned for the majority of apartment complex owners in the area, including the Partnership. In July 1993, the Partnership, certain affiliates of the General Partner which also own affected properties and other unaffiliated property owners jointly filed a lawsuit to obtain equitable compensation. The plaintiffs expect to file a motion for summary judgement with a hearing expected to be held during the first half of 1994. Although investors have received certain tax benefits, the Partnership has not commenced distributions. Future distributions will depend on improved cash flow from the Partnership's remaining properties and proceeds from future property sales, as to both of which there can be no assurances. In light of the results to date and current market conditions, the General Partner does not anticipate that the investors will recover a substantial portion of their investment. Inflation has several types of potentially conflicting impacts on real estate investments. Short-term inflation can increase real estate operating costs which may or may not be recovered through increased rents depending on general or local economic conditions. In the long-term, inflation will increase operating costs and replacement costs and may lead to increased rental revenues and real estate values. Item 8.

Item 8. Financial Statements and Supplementary Data See Index to Financial Statements and Schedule in this Form 10-K. The supplemental financial information specified by Item 302 of Regulation S-K is not applicable. The net effect of the differences between the financial statements and the tax returns is summarized as follows: December 31, 1993 December 31, 1992 Financial Tax Financial Tax Statements Returns Statements Returns Total assets $ 73,333,165$ 53,841,280 $100,416,387 $72,183,361 Partners' capital accounts (deficit): General Partner (962,524)(10,521,827) (1,061,542) (11,845,474) Limited Partners (19,589,059)(25,523,423) (29,391,858) (43,878,198) Net income (loss): General Partner 99,018 1,323,647 (50,993) (2,771,031) Limited Partners 9,802,799 18,354,775 (5,048,282) (6,165,022) Per Limited Part- nership Interest 112.63 210.88 (58.00) (70.82) Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no changes in or disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant (a) The Registrant does not have a Board of Directors; however, Balcor Partners-84 II, Inc., the General Partner, does have a Board of Directors which consists of Thomas Meador and Allan Wood. The term of office as a director of the General Partner is one year. Directors are elected at the annual meeting of shareholders. (b, c & e) The names, ages and business experiences of the executive officers, directors and significant employees of the General Partner of the Registrant are as follows: Name Title Marvin H. Chudnoff Chairman Thomas E. Meador President and Chief Operating Officer Allan Wood Executive Vice President, Chief Financial Officer and Chief Accounting Officer Alexander J. Darragh Senior Vice President Robert H. Lutz, Jr. Senior Vice President Michael J. O'Hanlon Senior Vice President Gino A. Barra First Vice President Daniel A. Duhig First Vice President David S. Glasner First Vice President Josette V. Goldberg First Vice President G. Dennis Hartsough First Vice President Lawrence B. Klowden First Vice President Alan G. Lieberman First Vice President Lloyd E. O'Brien First Vice President Brian D. Parker First Vice President John K. Powell, Jr. First Vice President Jeffrey D. Rahn First Vice President Reid A. Reynolds First Vice President Marvin H. Chudnoff (April 1941) joined Balcor in March 1990 as Chairman. He has responsibility for all strategic planning and implementation for Balcor, including management of all real estate projects in place and financing and sales for a varied national portfolio valued in excess of $6.5 billion. Mr. Chudnoff also holds the position of Vice Chairman of Edward S. Gordon Company Incorporated, New York, a major national commercial real estate firm, which he joined in 1983. He has also served on the Board of Directors of Skippers, Inc. and Acorn Inc., both publicly held companies, and of Waxman Laboratories of Mt. Sinai Hospital, New York. Mr. Chudnoff has been a guest lecturer at the Association of the New York Bar and at Yale and Columbia Universities. Thomas E. Meador (July 1947) joined Balcor in July 1979. He is President and Chief Operating Officer and has responsibility for all ongoing day-to-day activities at Balcor. He is a Director of The Balcor Company. Prior to joining Balcor, Mr. Meador was employed at the Harris Trust and Savings Bank in the commercial real estate division where he was involved in various lending activities. Mr. Meador received his M.B.A. degree from the Indiana University Graduate School of Business. Allan Wood (January 1949) joined Balcor in August 1983 and, as Balcor's Chief Financial Officer and Chief Accounting Officer, is responsible for all financial and administrative functions. He is directly responsible for all accounting, treasury, data processing, legal, risk management, tax and financial reporting activities. He is also a Director of The Balcor Company. Mr. Wood is a Certified Public Accountant. Prior to joining Balcor, he was employed by Price Waterhouse where he was involved in auditing public and private companies. Alexander J. Darragh (February 1955) joined Balcor in September 1988 and has primary responsibility for the Portfolio Advisory Group. He is responsible for due diligence analysis in support of asset management, institutional advisory and capital markets functions as well as for Balcor Consulting Group, Inc., which provides real estate advisory services to Balcor affiliated entities and third party clients. In addition, Mr. Darragh has supervisory responsibility of Balcor's Investor Services Department. Mr. Darragh received masters' degrees in Urban Geography from Queens's University and in Urban Planning from Northwestern University. Robert H. Lutz, Jr. (September 1949) joined Balcor in October 1991. He is President of Allegiance Realty Group, Inc., formerly known as Balcor Property Management, Inc. and, as such, has primary responsibility for all its management and operations. He is also a Director of The Balcor Company. From March 1991 until he joined Balcor, Mr. Lutz was Executive Vice President of Cousins Properties Incorporated. From March 1986 until January 1991, he was President and Chief Operating Officer of The Landmarks Group, a real estate development and management firm. Mr. Lutz received his M.B.A. from Georgia State University. Michael J. O'Hanlon (April 1951) joined Balcor in February 1992 as Senior Vice President in charge of Asset Management, Investment/Portfolio Management, Transaction Management and the Capital Markets Group which includes sales and refinances. From January 1989 until joining Balcor, Mr. O'Hanlon held executive positions at Citicorp in New York and Dallas, including Senior Credit Officer and Regional Director. He holds a B.S. degree in Accounting from Fordham University, and an M.B.A. in Finance from Columbia University. He is a full member of the Urban Land Institute. Gino A. Barra (December 1954) joined Balcor's Property Sales Group in September 1983. He is First Vice President of Balcor and assists with the supervision of Balcor's Asset Management Group, Transaction Management, Quality Control and Special Projects. Daniel A. Duhig (October 1956) joined Balcor in November 1986 and is responsible for various asset management matters relating to investments made by Balcor and its affiliated partnerships, including negotiations for modifications or refinancings of real estate mortgage investments and the disposition of real estate investments. David S. Glasner (December 1955) joined Balcor in September 1986 and has primary responsibility for special projects relating to investments made by Balcor and its affiliated partnerships and risk management functions. Mr. Glasner received his J.D. degree from DePaul University College of Law in June 1984. Josette V. Goldberg (April 1957) joined Balcor in January 1985 and has primary responsibility for all human resources matters relating to Balcor personnel, including training and development, employment, salary and benefit administration, corporate communications and the development, implementation and interpretation of personnel policy and procedures. Ms. Goldberg also supervises Balcor's payroll operations and Human Resources Information Systems (HRIS). In addition, she has supervisory responsibility for Balcor's Facilities, Corporate and Field Services and Telecommunications Departments. Ms. Goldberg has been designated as a Senior Human Resources Professional (SHRP). G. Dennis Hartsough (October 1942) joined Balcor in July 1991 and is responsible for asset management matters relating to all investments made by Balcor and its affiliated partnerships in office and industrial properties. From July 1989 until joining Balcor, Mr. Hartsough was Senior Vice President of First Office Management (Equity Group) where he directed the firm's property management operations in eastern and central United States. From June 1985 to July 1989, he was Vice President of the Angeles Corp., a real estate management firm, where his primary responsibility was that of overseeing the company's property management operations in eastern and central United States. Lawrence B. Klowden (March 1952) joined Balcor in November 1981 and is responsible for supervising the administration of the investment portfolios of Balcor and its loan and equity partnerships. Mr. Klowden is a Certified Public Accountant and received his M.B.A. degree from DePaul University's Graduate School of Business. Alan G. Lieberman (June 1959) joined Balcor in May 1983 and is responsible for the Property Sales and Capital Markets Groups. Mr. Lieberman is a Certified Public Accountant. Lloyd E. O'Brien (December 1945) joined Balcor in April 1987 and has responsibility for the operations and development of Balcor's Information and Communication systems. Mr. O'Brien received his M.B.A. degree from the University of Chicago in 1984. Brian D. Parker (June 1951) joined Balcor in March 1986 and is responsible for Balcor's corporate and property accounting, treasury, budget activities and corporate purchasing. Mr. Parker is a Certified Public Accountant and holds an M.S. degree in Accountancy from DePaul University and an M.A. degree in Social Service Administration from the University of Illinois. John K. Powell, Jr. (June 1950) joined Balcor in September 1985 and is responsible for Balcor Consulting Group, Inc. which provides real estate advisory services to Balcor affiliated entities and third party clients. Mr. Powell received a Master of Planning degree from the University of Virginia. Jeffrey D. Rahn (June 1954) joined Balcor in February 1983 and has primary responsibility for Balcor's Asset Management Department. He is responsible for the supervision of asset management matters relating to equity and loan investments held by Balcor and its affiliated partnerships. Mr. Rahn received his M.B.A. degree from DePaul University's Graduate School of Business. Reid A. Reynolds (April 1950) joined Balcor in March 1981 and is involved with the asset management of residential properties for Balcor. Mr. Reynolds is a licensed Real Estate Broker in the State of Illinois. The directors of Balcor Partners-84 II, Inc. are directors of the General Partners of two additional limited partnerships each with a class of securities registered pursuant to Section 12 of the Securities Exchange Act of 1934 or subject to the requirements of Section 15 (b) of that Act; however, they are not directors of any company registered as an investment company under the Investment Company Act of 1940. (d) There is no family relationship between any of the foregoing officers or directors. (f) None of the foregoing officers, directors or employees are currently involved in any material legal proceedings nor were any such proceedings terminated during the fourth quarter of 1993. Item 11.

Item 11. Executive Compensation The Registrant has not paid and does not propose to pay any compensation, retirement or other termination of employment benefits to any of the five mostly highly compensated executive officers of the General Partner. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No person owns of record or is known by the Registrant to own beneficially more than 5% of the outstanding Limited Partnership Interests of the Registrant. (b) Balcor Partners-84 II, Inc. and its shareholders and officers own as a group the following Limited Partnership Interests in the Registrant. Amount Beneficially Title of Class Owned Percent of Class Limited Partnership Interests 95 Interests Less than 1% Relatives and affiliates of the partners and officers of the General Partner own 10 Interests. (c) The Registrant is not aware of any arrangements, the operation of which may result in a change of control of the Registrant. Item 13.

Item 13. Certain Relationships and Related Transactions (a & b) See Note 2 of Notes to Financial Statements for information relating to the Partnership Agreement and the allocation of distributions and profits and losses. See Note 11 of Notes to Financial Statements for additional information relating to transactions with affiliates. (c) No management person is indebted to the Registrant. (d) The Registrant has no outstanding agreements with any promoters. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1 & 2) See Index to Financial Statements and Schedule in this Form 10-K. (3) Exhibits: (3) The Amended and Restated Agreement and Certificate of Limited Partnership is set forth as Exhibit 3 to Amendment No. 2 to Registrant's Registration Statement on Form S-11 dated July 6, 1984 (Registration No. 2-89319), and said Agreement and Certificate is incorporated herein by reference. (4) Form of Subscription Agreement set forth as Exhibit 4.1 to Amendment No. 2 of the Registrant's Registration Statement on Form S-11 dated May 16, 1984 (Registration No. 2-89319), and Form of Confirmation regarding Interests in the Registrant set forth as Exhibit 4.2 to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1992 (Commission File No. 0-13334) are incorporated herein by reference. (b) Reports on Form 8-K: No reports were filed on Form 8-K during the quarter ended December 31, 1993. (c) Exhibits: See Item 14(a)(3) above. (d) Financial Statement Schedules: See Index to Financial Statements and Schedules in this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP By: /s/ Allan Wood Allan Wood Executive Vice President, Chief Accounting and Financial Officer and Director (Principal Accounting and Financial Officer) of Balcor Partners-84 II, Inc., the General Partner Date: March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date President, Chief Executive Officer (Principal Executive Officer) and Director of Balcor Partners-84 II, /s/ Thomas E. Meador Inc., the General Partner March 18,1994 Thomas E. Meador Executive Vice President, and Chief Accounting and Financial Officer and Director (Principal Accounting and Financial Officer) of Balcor Partners-84 II, Inc., the General /s/ Allan Wood Partner March 18, 1994 Allan Wood INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE Report of Independent Accountants Financial Statements: Balance Sheets, December 31, 1993 and 1992 Statements of Partners' Capital, for the years ended December 31, 1993, 1992 and 1991 Statements of Income and Expenses, for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows, for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Financial Statement Schedule: XI - Real Estate and Accumulated Depreciation, as of December 31, 1993 Schedules, other than that listed, are omitted for the reason that they are inapplicable or equivalent information has been included elsewhere herein. REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of Balcor Realty Investors 84-Series II A Real Estate Limited Partnership: We have audited the financial statements and the financial statement schedule of Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership (A Maryland Limited Partnership) as listed in the index of this Form 10-K. These financial statements and the financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Balcor Realty Investors 84-Series II, A Real Estate Limited Partnership at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. /s/Coopers & Lybrand COOPERS & LYBRAND Chicago, Illinois March 14, 1994 BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 ------------- ------------- Cash and cash equivalents $ 1,160,704 $ 223,828 Escrow deposits 1,149,671 788,948 Accounts and accrued interest receivable 65,276 230,720 Deferred expenses, net of accumulated amortization of $1,084,192 in 1993 and $1,108,141 in 1992 1,064,613 1,091,294 ------------- ------------- 3,440,264 2,334,790 ------------- ------------- Investment in real estate, at cost: Land 15,412,784 16,496,523 Buildings and improvements 86,867,741 94,111,222 ------------- ------------- 102,280,525 110,607,745 Less accumulated depreciation 32,387,624 32,387,868 ------------- ------------- 69,892,901 78,219,877 Investment in real estate in substantive foreclosure, net of accumulated depreciation of $8,478,201 in 1992 19,861,720 ------------- ------------- Investment in real estate, net of accumulated depreciation 69,892,901 98,081,597 ------------- ------------- $ 73,333,165 $100,416,387 ============= ============= LIABILITIES AND PARTNERS' CAPITAL Loans payable - affiliate $ 7,775,723 $ 8,118,490 Accounts payable 115,493 301,037 Due to affiliates 268,432 168,846 Accrued liabilities, principally interest and real estate taxes 2,274,720 2,648,600 Security deposits 372,855 504,183 Purchase price, promissory and mortgage notes payable 84,130,907 120,086,011 ------------- ------------- Total liabilities 94,938,130 131,827,167 Affiliates' participation in joint ventures (1,053,382) (957,380) Partners' capital (87,037 Limited Partnership Interests issued and outstanding) (20,551,583) (30,453,400) ------------- ------------- $ 73,333,165 $100,416,387 ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) STATEMENTS OF PARTNERS' CAPITAL for the years ended December 31, 1993, 1992 and 1991 Partners' Capital Accounts ----------------------------------------- General Limited Total Partner Partners(A) ------------- ------------- ------------- Balance at December 31, 1990 $(19,691,572) $ (953,923) $(18,737,649) Net loss for the year ended December 31, 1991 (5,662,553) (56,626) (5,605,927) ------------- ------------- ------------- Balance at December 31, 1991 (25,354,125) (1,010,549) (24,343,576) Net loss for the year ended December 31, 1992 (5,099,275) (50,993) (5,048,282) ------------- ------------- ------------- Balance at December 31, 1992 (30,453,400) (1,061,542) (29,391,858) Net income for the year ended December 31, 1993 9,901,817 99,018 9,802,799 ------------- ------------- ------------- Balance at December 31, 1993 $(20,551,583) $ (962,524) $(19,589,059) ============= ============= ============= (A) Includes a $95,000 investment by the General Partner. The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Income: Rental and service $ 17,953,526 $ 21,494,257 $ 21,092,058 Interest on short-term investments 31,346 161,231 192,197 Settlement income 273,294 ------------- ------------- ------------- Total income 17,984,872 21,928,782 21,284,255 ------------- ------------- ------------- Expenses: Interest on purchase price, promissory and mortgage notes payable 8,287,777 10,864,977 11,895,679 Interest on short-term loans 290,389 281,481 395,535 Depreciation 2,712,857 3,573,761 3,568,791 Amortization of deferred expenses 441,513 271,755 271,977 Property operating 4,729,076 6,092,794 5,435,882 Maintenance and repairs 1,838,831 2,613,933 2,136,103 Real estate taxes 1,553,880 1,708,931 1,739,666 Property management fees 893,859 1,047,321 1,049,470 Administrative 679,625 653,998 584,826 ------------- ------------- ------------- Total expenses 21,427,807 27,108,951 27,077,929 ------------- ------------- ------------- Loss before gain on sale of property, participations in joint ventures and extraordinary items (3,442,935) (5,180,169) (5,793,674) Gain on sale of property 3,606,825 Affiliates' participation in losses from joint ventures 70,965 80,894 131,121 ------------- ------------- ------------- Income (loss) before extraordinary items 234,855 (5,099,275) (5,662,553) ------------- ------------- ------------- Extraordinary items: Gain on forgiveness of debt 1,234,276 Gains on foreclosure of properties 8,432,686 ------------- Total extraordinary items 9,666,962 ------------- ------------- ------------- Net income (loss) $ 9,901,817 $ (5,099,275) $ (5,662,553) ============= ============= ============= Income (loss) before extraordinary items allocated to General Partner $ 2,349 $ (50,993) $ (56,626) ============= ============= ============= Income (loss) before extraordinary items allocated to Limited Partners $ 232,506 $ (5,048,282) $ (5,605,927) ============= ============= ============= Income (loss) before extraordinary items per Limited Partnership Interest (87,037 issued and outstanding) $ 2.68 $ (58.00) $ (64.41) ============= ============= ============= Extraordinary items allocated to General Partner $ 96,669 None None ============= ============= ============= Extraordinary items allocated to Limited Partners $ 9,570,293 None None ============= ============= ============= Extraordinary items per Limited Partnership Interest (87,037 issued and outstanding) $ 109.95 None None ============= ============= ============= Net income (loss) allocated to General Partner $ 99,018 $ (50,993) $ (56,626) ============= ============= ============= Net income (loss) allocated to Limited Partners $ 9,802,799 $ (5,048,282) $ (5,605,927) ============= ============= ============= Net income (loss) per Limited Partnership Interest (87,037 issued and outstanding) $ 112.63 $ (58.00) $ (64.41) ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) STATEMENTS OF CASH FLOWS for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Operating activities: Net income (loss) $ 9,901,817 $ (5,099,275) $ (5,662,553) Adjustments to reconcile net income (loss) to net cash used in operating activities: Gain on forgiveness of debt (1,234,276) Gain on foreclosure of properties (8,432,686) Gain on sale of property (3,606,825) Affiliates' participation in losses from joint ventures (70,965) (80,894) (131,121) Depreciation of properties 2,712,857 3,573,761 3,568,791 Amortization of deferred expenses 441,513 271,755 271,977 Deferred interest expense 689,421 870,315 Net change in: Escrow deposits (360,723) 1,166 (288,964) Accounts and accrued interest receivable 165,444 81,663 (44,847) Accounts payable (185,544) (467,175) 554,829 Due to affiliates 99,586 15,662 8,837 Accrued liabilities 341,199 (218,889) 492,315 Security deposits (102,146) (17,016) (22,972) ------------- ------------- ------------- Net cash used in operating activities (330,749) (1,249,821) (383,393) ------------- ------------- ------------- Investing activities: Redemption of restricted investments 2,803,250 Additions to properties (105,150) Reduction of property basis due to seller deficit funding 100,000 Proceeds from sale of property 9,385,000 Costs incurred in connection with sale of real estate (164,056) ------------- ------------- Net cash provided by investing activities 9,220,944 2,798,100 ------------- ------------- Financing activities: Capital contributions by joint venture partners - affiliates 114,741 9,452 Distributions to joint venture partners - affiliates (25,037) (82,416) (63,213) Proceeds from loans payable - affiliate 1,086,469 2,383,975 1,285,186 Repayment of loans payable - affiliate (1,429,236) (1,031,036) Proceeds from issuance of mortgage notes payable 13,236,340 Principal payments on purchase price, promissory and mortgage notes payable (614,974) (1,311,635) (2,532,368) Repayments of mortgage notes payable (19,792,049) Payment of deferred expenses (414,832) (58,585) (68,828) ------------- ------------ ------------ Net cash (used) in or provided by financing activities (7,953,319) 1,046,080 (2,400,807) ------------- ------------ ------------ Net change in cash and cash equivalents 936,876 (203,741) 13,900 Cash and cash equivalents at beginning of year 223,828 427,569 413,669 ------------- ------------- ------------- Cash and cash equivalents at end of year $ 1,160,704 $ 223,828 $ 427,569 ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies: (a) Depreciation expense is computed using the straight-line and accelerated methods. Rates used in the determination of depreciation are based upon the following estimated useful lives: Years Buildings, building appurtenances and land improvements 30 Furniture and fixtures 5 Maintenance and repairs are charged to expense when incurred. Expenditures for improvements are charged to the related asset account. Interest incurred while properties were under construction was capitalized. (b) Deferred expenses consist of loan refinancing and modification fees which are amortized over the terms of the respective loan agreements. (c) Cash equivalents include all highly liquid investments with a maturity of three months or less when purchased. (d) The Partnership is not liable for Federal income taxes and each partner recognizes his proportionate share of the Partnership income or loss in his tax return; therefore, no provision for income taxes is made in the financial statements of the Partnership. (e) Properties are classified in substantive foreclosure when the lender has taken actions that result in the Partnership relinquishing control of the operations of the property, and/or the General Partner anticipates the property may be lost through foreclosure. Once a property has been classified in substantive foreclosure, expenses which are not general obligations of the Partnership, but rather are liabilities collateralized by an interest in the property (such as mortgage interest expense and real estate taxes), are recorded only to the extent such items are paid. The Partnership classified the Rancho Mirage and Highland Ridge apartment complexes in substantive foreclosure as of September 30, 1992. These properties were subsequently lost through foreclosure in March and May 1993, respectively. 2. Partnership Agreement: The Partnership was organized in February 1983. The Partnership Agreement provides for Balcor Partners-84 II, Inc. to be the General Partner and for the admission of Limited Partners through the sale of up to 110,000 Limited Partnership Interests at $1,000 per Interest, 87,037 of which were sold on or prior to September 28, 1984, the termination date of the offering. The Partnership Agreement provides that the General Partner will be allocated 1% of the profits and losses and the Limited Partners will be allocated 99% of the profits and losses. One hundred percent of Net Cash Receipts available for distribution shall be distributed to the holders of Interests in proportion to their participating percentages as of the record date for such distributions. However, there shall be accrued for the benefit of the General Partner as its distributive share from operations, an amount equivalent to approximately 1% of the total Net Cash Receipts being distributed, which will be paid only out of Net Cash Proceeds. Under certain circumstances, the General Partner may participate in the Net Cash Proceeds of the sale or refinancing of Partnership properties. The General Partner's participation is limited to 15% of Net Cash Proceeds, including its share of accrued Net Cash Receipts, and is subordinated to the return of Original Capital plus any deficiency in a Cumulative Distribution of 6% on Adjusted Original Capital to the holders of Interests, as defined in the Partnership Agreement. 3. Purchase Price, Promissory and Mortgage Notes Payable: Purchase price, promissory and mortgage notes payable at December 31,1993 and 1992 consisted of the following: See notes (A) through (O). (A) In April 1993, the Partnership sold this property in an all cash sale. See Note 12 of Notes to Financial Statements for additional information. (B) Title to this property was relinquished to the lender through foreclosure in May 1993. See Note 13 of Notes to Financial Statements for additional information. (C) This loan was modified during August 1992. See Note 4 of Notes to Financial Statements for additional information. (D) The difference between the balloon payments on the previously outstanding interim financing and the assumed balance on the permanent loans is payable in accordance with a non-interest bearing promissory note payable in various years beginning in the year 2000. These amounts on an individual basis do not exceed $109,000, and are reflected in the "Carrying Amount of Notes at December 31, 1993 and 1992." (E) Represents monthly principal and interest payments through the due date of the balloon payment. (F) This balloon payment will require the sale or refinancing of the property. (G) This loan was refinanced during May 1993. See Note 4 of Notes to Financial Statements for additional information. (H) This loan was modified during December 1993. See Note 4 of Notes to Financial Statements for additional information. (I) Represents monthly interest-only payments through January 1, 1996. Thereafter, monthly principal and interest payments of $84,294 are payable through the due date of the balloon payment. (J) Title to this property was relinquished to the lender through foreclosure in March 1993. See Note 13 of Notes to Financial Statements for additional information. (K) Monthly interest-only payments are due through the maturity date. Effective February 1, 1993, debt service payments on this loan were suspended and the lender placed the loan in default in February 1993. In April 1993, the Partnership, through its subsidiaries owning this property, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. While the bankruptcy proceedings continue, the Partnership will remit partial debt service payments to the lender equal to net cash flow from the property. The Partnership and the lender have engaged in discussions in order to reach an agreement on a modification of this loan. A resolution has not been reached as of December 31, 1993. (L) This loan was refinanced during April 1993. See Note 4 of Notes to Financial Statements for additional information. (M) Represents monthly interest-only payments through the due date of the balloon payment. (N) The second mortgage loans on these properties were modified in April 1990. The Partnership did not pay or accrue interest through December 31, 1992, retroactive to August 1, 1988 on the Rosehill Pointe loan and to December 1, 1988 on the Westwood Village loan, and has made interest-only payments at the original contract rate of 9.75% on both loans beginning February 1, 1993 through the extended maturity date of January 1, 1995. (O) This loan originally matured on May 1, 1992. In July 1992, the loan was refinanced and a partial principal paydown of $750,000 was made. The interest rate is adjusted monthly and the rate disclosed is as of December 31, 1993. See Note 4 of Notes to Financial Statements for additional information. Five-year maturities of the purchase price, promissory and notes payable are approximately as follows: 1994 $ 7,657,000 1995 2,107,000 1996 7,631,000 1997 23,704,000 1998 25,496,000 During 1993, 1992 and 1991, the Partnership incurred interest expense on purchase price, promissory and mortgage notes payable of $8,287,777, 10,864,977, and $11,895,679 and paid interest expense of $7,888,588, $10,255,657 and $10,643,001, respectively. 4. Loan Modifications and Refinancings: (a) In December 1993, the General Partner completed a modification of the loan collateralized by the Park Colony Apartments, whereby the interest rate was reduced from 10.25% to 9.375%. The Partnership will make monthly interest-only payments through January 1, 1996. Thereafter, monthly principal and interest payments are payable through the extended maturity date of January 1, 1999. The Partnership paid loan modification fees totaling $142,329 which are being amortized over the term of the loan. (b) In May 1993, the Partnership completed the refinancing of the loan collateralized by the Meadow Creek Apartments. The refinancing resulted in the Partnership obtaining a new first mortgage loan from an unaffiliated lender in the amount of $5,200,000. The loan bears interest at 8.54% per annum and monthly principal and interest payments of $40,131 will be payable through maturity, June 1, 1998. The Partnership used the proceeds from the new mortgage loan to repay the prior loan in the amount of $5,178,672. The Partnership paid refinancing costs of $133,946 which are being amortized over the term of the loan. (c) In April 1993, the first mortgage loan collateralized by the Ridgetree II Apartments was refinanced. The original loan, which had an outstanding balance of $9,578,078, including accrued interest of $95,153, was repaid for a price of $8,343,802 which represents a discount to the Partnership of $1,234,276. The Partnership used proceeds from the new loans of $7,943,500 and made a principal payment of $400,302 to repay the loan. Lehman Brothers, an affiliate of the General Partner, acted as firm underwriter for the sale of the Securities representing ownership of the new loans, and earned underwriting compensation from a third party in accordance with market practices. The new loans from an unaffiliated lender consist of a first mortgage loan of $7,784,630 and a second mortgage loan of $158,870, bear interest at 10.05%, require monthly payments of principal and interest totaling $70,004 and mature on May 1, 2000. The Partnership funded capital and operating reserves of $190,000 and paid related closing costs of $138,557 which are being amortized over the term of the loan. (d) The mortgage loan collateralized by the La Contenta Apartments matured October 1, 1991 and the lender agreed not to take action against the Partnership while an extension of terms was negotiated. In January 1992, the Partnership, through a subsidiary, filed for protection under Chapter 11 of the U.S. Bankruptcy Code. During August 1992, the General Partner completed a modification with the lender, whereby the Partnership will make monthly payments of principal and interest at a rate of 9.5% through the extended maturity date of October 1, 1996. As a result of the agreement with the lender, the Chapter 11 proceedings were dismissed. The Partnership paid loan modification fees of $34,769 which are being amortized over the term of the loan. (e) During July 1992, the General Partner completed the refinancing of the loan collateralized by the Seabrook Apartments. The original loan, in the amount of $5,950,000, which was originally financed by a bond issuance, matured on May 1, 1992. This loan was replaced with a conventional loan from the same lender in the amount of $5,200,000 after a partial paydown of $750,000 was made. The replacement loan bears interest at a floating rate equal to the greater of the lender's prime rate plus 1% or the three-month certificate of deposit rate plus 2% through June 1994, at which time it will increase by .5% annually until maturity, August 15, 1997. Semi-annual payments will be made from a portion of the property's excess cash flow, which will be applied against the outstanding principal balance. The Partnership paid loan refinancing fees totaling $23,816 which are being amortized over the term of the loan. (f) In April 1990, the Partnership completed a modification of the loan collateralized by the Butterfield Village Apartments, whereby the lender granted a nine month extension with a new maturity date of January 18, 1991. The monthly payments were interest-only at an interest rate equal to the preceeding month's three month Treasury Bill rate plus 3%. The Partnership paid a fee of approximately $84,000 relating to this extension during January 1991. During February 1991, the Partnership was granted a second nine month extension by the lender of this loan with a new maturity date of October 1991. Monthly payments continued to include interest equal to the preceeding month's three month Treasury Bill rate plus 3%, but also included principal based on a twenty year amortization period. The Partnership paid a monthly extension fee of approximately $9,300 relating to this second extension, which was included in interest expense. During November 1991, the lender granted a third extension with a new maturity date of October 31, 1994. The Partnership paid a fee of approximately $66,000 relating to this extension together with a principal payment of $100,000. Under the terms of this extension, the Partnership was to pay principal and interest through maturity equal to the prime rate plus 1% with a minimum rate of 8% and a maximum rate of 13%. 5. Management Agreements: As of December 31, 1993, all of the properties owned by the Partnership are under management agreements with Allegiance Realty Group, Inc. (formerly Balcor Property Management, Inc.), an affiliate of the General Partner. These management agreements provide for annual fees of 5% of gross operating receipts. 6. Seller's Participation in Joint Venture: Meadow Creek Apartments located in Pineville, North Carolina is owned by a joint venture between the Partnership and the seller. Consequently, the seller retains an interest in the property through an interest in the joint venture. All assets, liabilities, income and expenses of the joint venture are included in the financial statements of the Partnership with the appropriate deduction from income, if any, for the seller's participation in the joint venture. 7. Affiliates' Participation in Joint Ventures: Rosehill Pointe Apartments is owned by a joint venture between the Partnership and an affiliated partnership. Profits and losses are allocated 61.62% to the Partnership and 38.38% to the affiliate. In addition, Seabrook Apartments is owned by a joint venture between the Partnership and two affiliates of the Partnership. Profits and losses are allocated 83.72% to the Partnership and 16.28% to the affiliates. All assets, liabilities, income and expenses of the joint ventures are included in the financial statements of the Partnership with appropriate adjustment of profit or loss for the affiliate's participation in the joint venture. 8. Settlement Income: (a) In May 1992, the Partnership reached a settlement with the seller of the Rosehill Pointe Apartment for proration amounts the seller owed the Partnership pursuant to the terms of the original management and guarantee agreement. The joint venture which owns the property received $70,266 in June 1992 and $140,554 in December 1992, pursuant to the terms of the settlement. Settlement income of $120,237 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. (b) In June 1992, the Partnership reached a settlement with the seller of the Ridgetree II Apartments. Under the terms of the settlement, the Partnership received cash of $157,000, and was relieved of certain other liabilities by the seller. In addition, the Partnership and seller have released all claims and causes of action against one another. Settlement income of $153,057 was recognized in connection with this transaction. The Partnership and the seller have no further obligations to one another with respect to this property. 9. Tax Accounting: The Partnership keeps its books in accordance with the Internal Revenue Code, rules and regulations promulgated thereunder and existing interpretations thereof. The accompanying financial statements, which are prepared in compliance with generally accepted accounting principles, will differ from the tax returns due to the different treatment of various items as specified in the Internal Revenue Code. The net effect of these accounting differences is that the net income for 1993 in the financial statements is $9,776,605 less than the tax income of the Partnership for the same period. 10. Rentals Under Operating Leases: Minimum rentals under operating leases with lease terms of one year or less expected to be received in 1994 from the following apartment complexes based on December 31, 1993 rental and occupancy rates, are approximately as follows: Occupancy Minimum Property Rate Rentals La Contenta Apartments 97% $ 1,418,000 Meadow Creek Apartments 92% 1,345,000 Park Colony Apartments 97% 2,111,000 Ridgepoint Green Apartments 96% 1,610,000 Ridgepoint Way Apartments 93% 1,706,000 Ridgetree Apartments (Phase II) 92% 1,828,000 Rosehill Pointe Apartments 96% 2,995,000 Seabrook Apartments 98% 1,252,000 Spring Creek Apartments 96% 1,646,000 Westwood Village Apartments 95% 1,697,000 ----------- $17,608,000 =========== The Partnership is subject to the usual business risks regarding the collection of the above-mentioned rentals. 11. Transactions with Affiliates: Fees and expenses paid and payable by the Partnership to affiliates are: Year Ended Year Ended Year Ended 12/31/93 12/31/92 12/31/91 Paid Payable Paid Payable Paid Payable Property manage- ment fees $866,889 $104,097 $976,555 $77,127 $1,053,345 $81,226 Reimbursement of expenses to General Partner at cost: Accounting 64,215 5,310 65,890 4,813 54,315 13,467 Data processing 36,471 6,722 41,631 3,428 50,283 3,666 Investment processing 10,056 831 1,711 125 755 187 Investor com- munications 8,223 680 10,182 744 7,141 1,770 Legal 16,178 1,338 20,582 1,504 17,439 4,324 Portfolio management 73,612 8,332 53,175 12,888 50,053 12,409 Other 15,075 1,246 19,106 1,396 10,033 2,487 As of December 31, 1992, the General Partner had advanced $8,118,490 to the Partnership to provide working capital and meet other Partnership obligations. During 1993, the Partnership borrowed $1,086,469 from the General Partner for additional working capital and repaid $1,429,236 of the loan from a portion of the funds received in connection with the sale of the Butterfield Village Apartments. As of December 31, 1993, $7,775,723 is outstanding to the General Partner. During 1993, 1992 and 1991, the Partnership incurred interest expense of $290,389, $281,481 and $395,535, respectively, in connection with these loans. As of December 31, 1993, interest of $139,876 is payable. Interest expense subsequent to June 30, 1991, was computed at the American Express Company cost of funds rate plus a spread to cover administrative costs. As of December 31, 1993, this rate was 3.93%. This rate is similar to the Shearson Lehman Brothers Holdings Inc. cost of funds rate used to compute interest expense to these loans through June 30, 1991. As of January 1, 1992, the Partnership had outstanding letters of credit in the amount of $508,917 which were guaranteed by an affiliate of the General Partner. These letters of credit were required by the lending institutions of the mortgage loans collateralized by the Highland Ridge, Seabrook and Ridgetree II apartment complexes. During 1992, the lender released a $116,667 letter of credit relating to the Highland Ridge Apartments and the lender on the Seabrook Apartments drew upon the $92,250 letter of credit relating to this loan. During 1993, the $300,000 guarantee relating to the Ridgetree II Apartments was released. The General Partner may continue to provide additional short-term loans to the Partnership or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Partnership would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Partnership may be required to dispose of some of its properties to satisfy these obligations. 12. Property Sale: In April 1993, the Partnership sold the Butterfield Village Apartments located in Tempe, Arizona in an all cash sale for $9,385,000. From the proceeds of the sale, the Partnership paid $6,269,575 in full satisfaction of the first mortgage loan collateralized by the property, $140,775 to an unaffiliated party as a brokerage commission and $23,281 in closing costs. The Partnership received the remaining proceeds of $2,951,369. Neither the General Partner nor its affiliates received a commission in connection with the sale. The basis of the property sold was $5,614,119 (net of accumulated depreciation of $2,713,101). The Partnership recognized a gain on this sale of $3,606,825 in the second quarter financial statements. 13. Extraordinary Items: (a) In April 1993, the Partnership paid $8,343,802 to the lender of the first mortgage loan collateralized by the Ridgetree II Apartments to fully satisfy the Partnership's indebtedness. This transaction produced an extraordinary gain of $1,234,276 on the forgiveness of debt. (b) In March 1993, title to the Rancho Mirage Apartments located in Phoenix, Arizona was relinquished to the lender through foreclosure. The Partnership suspended debt service payments on the mortgage loan collateralized by the property on July 1, 1991 in an effort to negotiate a modification of the loan. In October 1991, the loan was placed in default, and in December 1991, a receiver was appointed. This property was classified as real estate in substantive foreclosure at December 31, 1992. During the first quarter of 1993, the Partnership was released of the obligations through foreclosure and wrote off the mortgage balance of $12,553,714, plus accrued and unpaid interest expense, and real estate taxes of $583,561, security deposits of $29,182 and the property basis of $9,206,393 (net of accumulated depreciation of $4,021,036), resulting in an extraordinary gain on foreclosure of $3,960,064. (c) In April 1992, the modification period relating to the mortgage loan collateralized by the Highland Ridge Apartments located in Oklahoma City, Oklahoma expired and the loan reverted to its previous terms. While negotiating for a further modification of the loan, the Partnership remitted partial debt service payments to the lender equal to monthly net cash flow from the property. During July 1992, the lender filed foreclosure proceedings and subsequently a receiver was appointed. In May 1993, the property was relinquished to the lender through foreclosure. This property was classified as real estate in substantive foreclosure at December 31, 1992. During the second quarter of 1993, the Partnership was released of the obligations through foreclosure and wrote-off the mortgage balance of $15,091,584, plus accrued and unpaid real estate taxes of $36,365, and the property basis of $10,655,327 (net of accumulated depreciation of $4,457,165), resulting in an extraordinary gain on foreclosure of $4,472,622. BALCOR REALTY INVESTORS 84-SERIES II A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) See Notes (a) through (g). BALCOR REALTY INVESTORS 84-SERIES II A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) See Notes (a) through (g). BALCOR REALTY INVESTORS 84-SERIES II, A REAL ESTATE LIMITED PARTNERSHIP (A Maryland Limited Partnership) NOTES TO SCHEDULE XI (a) Consists of legal fees, appraisal fees, title costs, other related professional fees and capitalized construction-period interest. (b) The aggregate cost of land for Federal income tax purposes is $16,253,870 and the aggregate cost of buildings and improvements for Federal income tax purposes is $78,834,377. The total of the above-mentioned is $95,088,247. (c) Reconciliation of Real Estate 1993 1992 1991 Balance at beginning of year $138,947,666 $138,947,666 $138,942,516 Additions during the year: Improvements 105,150 Reductions during the year: Foreclosure of properties (28,339,921) Cost of real estate sold (8,327,220) Seller deficit funding adjustment (100,000) ------------ ------------ ------------ Balance at end of year $102,280,525 $138,947,666 $138,947,666 ============ ============ ============ Reconciliation of Accumulated Depreciation 1993 1992 1991 Balance at beginning of year $40,866,069 $ 37,292,308 $ 33,723,517 Depreciation expense for the year 2,712,857 3,573,761 3,568,791 Foreclosure of properties (8,478,201) Accumulated depreciation of real estate sold (2,713,101) ------------ ------------ ------------ Balance at end of year $ 32,387,624 $ 40,866,069 $ 37,292,308 ============ ============ ============ (d) See description of Purchase Price, Promissory and Mortgage Notes Payable in Note 3 of Notes to Financial Statements. (e) Depreciation expense is computed based upon the following estimated useful lives: Years Buildings, building appurtenances and land improvements 30 Furniture and fixtures 5 (f) Guaranteed income earned on properties under the terms of certain management and guarantee agreements is recorded by the Partnership as a reduction of the basis of the property to which the guaranteed income relates. (g) A reduction of basis was made to write down the property to its December 31, 1988 mortgage liability balance (net of an outstanding letter of credit of $500,000).

74928_1993.txt

74928

1993

ITEM 3 LEGAL PROCEEDINGS The Company is a party to various lawsuits, all of which are of a routine nature and are incidental to the Company's present business activities. These proceedings are not material, nor would the adverse resolution thereof materially affect the business or properties of the Company. ITEM 4

ITEM 4 SUBMISSION OF MATTERS TO A VOTE BY SECURITY HOLDERS No matters were submitted to security holders during the 4th quarter. The annual Meeting of Shareholders of the Registrant has been scheduled for May 9, 1994. The Company will file its definitive proxy material pursuant to Regulation 14, prior to April 30, 1994. PART II ITEM 5

ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Information required by this item is incorporated by reference to the Registrant's 1993 Annual Report to Shareholders. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Information required by this item is incorporated by reference to the Registrant's 1993 Annual Report to Shareholders. ITEM 7

ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW General. The following table sets forth for the periods indicated certain items of the Company's Consolidated Financial Statements expressed as a percentage of the Company's total revenues: Backlog. The following table sets forth the Company's backlog at December 31, 1991, 1992 and 1993 The Company's backlog generally represents units under contract for which a full deposit has been received, any statutory rescission right has expired, and in the case of a borrower, such borrower has been qualified for a mortgage loan. The Company generally fills all backlog within twelve months. The Company estimates that the period between receipt of a sales contract and delivery of the completed home to the purchaser is four to eight months. The Company's backlog historically tends to increase between January and May. Trends in the Company's backlog are subject to change from period to period for a number of economic conditions including consumer confidence levels, interest rates and the availability of mortgages. In 1989, 1990 and throughout part of 1991, the operations of the Company, and the housing industry in general, reflected a nationwide recession. The recession, and resulting lack of consumer confidence, contributed to a decline in the number of new sales contracts received by the Company. During the second quarter of 1991, the Company began to receive a higher level of sales contracts, primarily as a result of increased consumer confidence and lower mortgage rates. This trend has continued through the twelve-month period ended December 31, 1993. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 The Company's revenues from home sales increased $8.9 million (or 9.9%) during the calendar year 1993 as compared to the same period in 1992. The Company delivered 771 homes in 1993 compared to 708 in 1992, with an increase of 1.0% in the average selling price of homes delivered (from $126,300 to $127,500). The number of new contracts signed (788) and the aggregate dollar value of those new contracts ($108.2 million) increased in 1993 from 743 and $91.2 million in 1992. Other operating revenues increased to $3.6 million during 1993 from $3.2 million in 1992 due to larger occupancy rate on our rental apartments. Interest, rentals and other income increased to $3.3 million in 1993 from $2.9 million in 1992 due to additional interest on short term investments and the increased number of units subject to recreation leases. Cost of home sales increased to $80.7 million in 1993 from $70.2 million in 1992 as a result of an increase in the number of homes delivered. As a percentage of home sales, cost of home sales increased to 82.1% from 78.5%. Selling, general and administrative expenses ("S,G & A") increased to $16.0 million in 1993 from $14.5 million in 1992, but as a percentage of total revenues, these expenses remained at 15.1%. The $2.6 million (or 35.2%) increase in the Company's interest cost incurred in 1993 as compared to the same period in 1992 was primarily attributable to the larger outstanding debt following the issuance of the 12 12% Senior Notes due 2003 in January 1993. Net income decreased to $2.6 million in 1993 from $5.1 million in the comparable period in 1992, due mainly to the reduced margins from the sale of homes and the effect of $999,288, net of taxes of an extraordinary item from the write-off of unamortized debenture and loan costs. The reasons for lower margins are the inability to meaningfully increase selling prices, increased competition which resulted in the absorption of higher construction costs and the impact of higher capitalized interest. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 The Company's revenues from home sales increased $19.3 million (or 27.6%) during the calendar year 1992 as compared to the same period in 1991. The Company delivered 708 homes in 1992 compared to 614 in 1991, with an increase of 10.6% in the average selling price of homes delivered (from $114,200 to $126,300). The number of new contracts signed (743) and the aggregate dollar value of those new contracts ($91.2 million) increased in 1992 from 629 and $74.3 million in 1991. Other operating revenues decreased to $3.2 million during 1992 from $3.7 million in 1991, primarily as a result of the absence of revenues from the operation of its golf course sold in January 1992. Interest, rentals and other income decreased to approximately $3.5 million from $7.5 million, reflecting a gain of $4.6 million from the sale of the Company's corporate headquarters building in 1991, and a gain of $500,000 from the sale of the golf course in 1992. Cost of home sales increased to $70.2 million in 1992 from $53.5 million in 1991 as a result of an increase in the number of homes delivered. As a percentage of home sales, cost of home sales increased to 78.5% from 76.3% due to increased competition, the absorption of higher construction costs and the impact of higher previously capitalized interest. Selling, General and Administrative Expenses ("S,G & A") decreased to $14.5 million in 1992 from $14.6 million in 1991 and, as a percentage of total revenues, these expenses decreased to 15.1% from 17.5% in the same period for 1991. The $1.7 million (or 18.5%) decrease in the Company's interest cost incurred in 1992 as compared to the same period in 1991 was primarily attributable to lower interest rates and lower borrowings. Net income decreased to $5.1 million in 1992 from $5.2 million in the comparable period in 1991. The 1991 figure included a $2.9 million after tax gain from the sale of the Company's corporate headquarters building. LIQUIDITY AND CAPITAL RESOURCES The Company's financing needs depend primarily upon sales volume, asset turnover, land acquisition and inventory balances. The Company has financed its working capital need through funds generated by operations, borrowings and the periodic issuance of common stock. During 1991, 1992 and 1993, as a consequence of recessionary conditions and well-publicized real estate problems, many commercial banks, savings and loans and other lending institutions curtailed real estate lending or adopted more stringent lending policies, often as the result of regulatory agency measures. As a result, the availability of borrowed funds, especially for the acquisition and development of land, was greatly reduced. In January 1993, the Company completed the issuance of $70.0 million of its 12 1/2% Senior Notes due 2003. These Notes were offered at the price of 97.242% and, after the underwriting discount, the net proceeds to the Company of $66.0 million were used to repay an existing bank credit facility ($35.0 Million) and the outstanding balance on its 12 7/8 % Subordinated Debentures ($19.4 Million). Under the Indenture, the Company is able to enter into another credit facility which may or may not be secured for up to $20.0 million. The Company believes that the proceeds derived from the sale of the Notes after the debt repayment, additional borrowing permitted under the Indenture and amounts generated from operations provide funds adequate to finance its home building activities and meet its debt service requirements. The Company believes that a strategy of conservative land acquisition and community development should position it to take advantage of the anticipated upturn in the real estate market. The Company does not have any current commitments for capital expenditures and believes the proceeds from its offering will provide adequate liquidity on both a short and long term basis. On November 23, 1993, the Company declared a dividend of $.15 per share on its Class A common stock and $.175 on its Class B common stock to shareholders of record as of December 14, 1993, which dividends were paid on January 11, 1994. The Company intends to reestablish the payment of semi-annual dividends. The payment of cash dividends is at the discretion of the Board of Directors and will depend upon results of operations, capital requirements, the Indenture, the Company's financial condition and such other factors as the Board of Directors of the Company may consider. There can be no assurance as to the amount, if any, or timing of cash dividends. INFLATION The Company, as well as the home building industry in general, may be adversely affected during periods of high inflation, primarily because of higher land and construction costs. In addition, higher mortgage interest rates may significantly affect the affordability of permanent mortgage financing to prospective purchasers. Inflation also increases the Company's cost of labor and materials. The Company attempts to pass through to its customers any increases in its costs through increased selling prices. During the last two years the Company has experienced a reduction in gross margins on the sale of homes. In some part these reduced margins are the result of the Company being unable to raise selling prices and pass on increased construction costs. There is no assurance that inflation will not have a material adverse impact on the Company's future results of operations. ACCOUNTING METHODS During 1987, the Company changed its method of accounting for income taxes to conform to Statement of Financial Accounting Standards No. 96 "Accounting for income Taxes, " which requires the liability method as measured by the provisions of the enacted tax laws. The amount of deferred taxes payable is recognized under the liability method at the date of the Consolidated Financial Statements. During 1992, the Financial Accounting Standards Board adopted Statement of Financial Accounting Standards No. 109, which supersedes Statement of Financial Accounting Standards No. 96, and became effective for fiscal years beginning after December 15, 1992. The effect of the adoption of this Statement did not have a material effect on the Consolidated Financial Statements. ITEM 8

ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ORIOLE HOMES CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, The accompanying notes are an integral part of these statements. ORIOLE HOMES CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, LIABILITIES AND SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these statements. ORIOLE HOMES CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, The accompanying notes are an integral part of these statements. ORIOLE HOMES CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, The accompanying notes are an integral part of these statements. ORIOLE HOMES CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes are an integral part of these statements. ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER INFORMATION Principles of Consolidation The accompanying Consolidated Financial Statements include the accounts of Oriole Homes Corp. and all wholly-owned subsidiaries (the Company). Significant intercompany accounts and transactions have been eliminated in consolidation. Operations The Company, a Florida corporation, is a developer of single and multi-family residential communities in southeast Florida. The Company's receivables are primarily first mortgages which are collateralized by real estate. Revenue Recognition The Company records revenues and profits from sales of real estate in accordance with Statement of Financial Accounting Standards No. 66, "Accounting for Sales of Real Estate." Inventories Land, house and condominium inventories are carried at cost, plus accumulated development and construction costs (including capitalized interest and real estate taxes) and estimated costs of completion. House and condominium inventories which are completed and being held for sale aggregate approximately $11,505,000 in 1993 and $8,165,000 in 1992. The accumulated costs of land, houses and condominiums are not in excess of estimated net realizable value. Interest Capitalization The Company follows the practice of capitalizing, for its homebuilding operations, certain interest costs incurred on land under development and houses and condominiums under construction. Such capitalized interest is included in cost of house and condominium sales when the units are delivered. During the years 1993, 1992, and 1991 respectively, the Company capitalized interest in the amount of $9,997,908, $6,944,173 and $7,147,527 and expensed as a component of cost of goods sold $10,036,456, $7,685,554 and $5,318,689. (continued) ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER INFORMATION - Continued Depreciation The Company provides for depreciation of property and equipment by the straight-line and accelerated methods over the following estimated useful lives of the various classes of depreciable assets: Debt Issuance Costs and Unamortized Discount Costs incurred in connection with obtaining debt have been deferred and are being amortized by the interest method over the term of the debt. Cash Equivalents Cash equivalents consist of highly liquid investments with maturities of three months or less when purchased. Concentration of Credit Risk The Company's cash and cash equivalents are placed mainly with one institution with a high credit rating. The carrying amount approximates fair value due to the short maturity of these instruments. Net Income Per Share Earnings per common share is computed by dividing net income by the weighted average number of shares outstanding during each year: 4,625,524 shares in 1993; 4,334,650 shares in 1992; 3,793,524 shares in 1991. Income Taxes The Company has adopted Statement of Financial Accounting Standards No. 109 (FAS 109), which supersedes FAS 96. The effect of the adoption of this Statement did not have a material effect on the Consolidated Financial Statements. ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE B - RECEIVABLES Mortgage Notes First and second mortgage notes receivable bear interest at rates ranging from 6.25% to 14%. Minimum payments required on the first and second mortgage notes in each of the five years subsequent to December 31, 1993 are: 1994 - $383,972; 1995 - $355,792; 1996 - $273,870; 1997 - $24,308 and 1998 - $24,918. Officers On December 9, 1992 the Company loaned $200,000 in the aggregate to three of its officers. The principal and interest was paid on February 19, 1993. NOTE C - LIFE INSURANCE The Company purchased life insurance on the lives of two of its officers and their spouses (officers) who own significant shares of common stock of the Company. An irrevocably designated trustee of the officers is the beneficiary. The premiums on the above policies during the year ended December 31, 1993 were $213,784 and are classified as other assets. Upon the death of the officers or termination of the policies, the Company shall receive an amount equal to the aggregated premiums paid less any policy loans and unpaid interest or cash withdrawals received by the Company. In connection with the policies, the Company has an option with the officers to acquire all or any part of the Class A or Class B common stock of the Company owned by such individuals at the market price of such securities at the time of his or her death. NOTE D - INVESTMENT IN AND ADVANCES TO JOINT VENTURE On December 31, 1993 the Company entered into a joint venture agreement to construct and sell homes. The joint venture is accounted for using the equity method. The Company's investment and advances are as follows: ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE E - MORTGAGE SUBSIDIARY South Florida Residential Mortgage Company (SFRMC), a wholly-owned subsidiary of the Company, provides mortgage financing services. Summarized financial information for SFRMC is as follows: NOTE F - REVOLVING LOAN AGREEMENT During January 1993, the Company restructured its credit agreement by retiring the outstanding 12 7/8% subordinated debentures and repaid the bank's revolving line of credit and term loan. The restructure was financed through the issuance of the 12 1/2% senior notes (see Note K). In connection with the early retirement of the above debt an extraordinary loss of $999,288, net of a tax benefit of $602,906, was incurred. A new revolving loan agreement (line of credit) was entered into, with a bank which provides up to $10,000,000 of borrowings. Interest on the loan is at prime rate plus 1.5%. The line of credit is collateralized by approximately $20,000,000 of the Company's inventory. The agreement expires June 30, 1996. (continued) ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE F - REVOLVING LOAN AGREEMENT - Continued The line of credit can be used to finance ongoing development and construction of residential real estate and short-term capital needs and will only require monthly interest payments. The credit agreement contains typical restrictions and covenants, the most restrictive of which include the following: a. The Company shall maintain, at all times, its consolidated tangible net worth at not less than $70,000,000. b. The Company's ability to incur additional debt is restricted by covenants in the agreement. The Company has no compensating balance arrangements. Average interest rates and balances outstanding, for revolving lines of credit payable to banks, based on a weighted average are as follows: ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE G - MORTGAGE NOTES PAYABLE Mortgage notes payable at December 31, 1993 and 1992, are summarized as follows: Minimum payments required in periods subsequent to December 31, 1993, are as follows: NOTE H - INCOME TAXES Deferred income taxes and benefits are provided for significant income and expense items recognized in different years for tax and financial reporting purposes. Temporary differences which give rise to significant deferred tax assets (liabilities) follow: (continued) ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE H - INCOME TAXES - Continued The Company files consolidated income tax returns. The components of the provision for income taxes are as follows: The reasons for the difference between the total tax expense and the amount computed by applying the statutory federal income tax rate to income before income taxes are as follows: (continued) ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE H - INCOME TAXES - Continued Deferred income tax provisions result from temporary differences in the recognition of revenues and expenses for tax and financial statement purposes. The sources of these differences are as follows: NOTE I - CUSTOMER DEPOSITS Certain customer deposits, pursuant to statutory regulations of the State of Florida or by agreement between the buyer and seller, are held in segregated bank accounts. At December 31, 1993 and 1992, cash in the amounts of $385,320 and $954,744, respectively, was so restricted. The Company entered into an escrow agreement with a bank and the Division of Florida Land Sales and Condominiums which allowed the Company to use customer deposits which were previously maintained in an escrow account. Deposits of up to $4,000,000 in 1993 and $3,000,000 in 1992, which could be released to the Company, are guaranteed by performance bonds aggregating $4,500,000 for 1993 and $2,500,000 for 1992. ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE J - ACCRUED EXPENSES AND OTHER LIABILITIES Accrued expenses and other liabilities include the following: NOTE K - DEBENTURES AND SENIOR NOTES Debentures are comprised as follows: (a) On January 13, 1993, the Company issued 12 1/2% senior notes ("Notes"), due January 15, 2003. The Notes have a face value $70,000,000 and were issued at a discount of $1,930,000. The notes are senior unsecured obligations of the Company subject to redemption at the Company's option on or after January 15, 1998 at 105% of the principal amount and thereafter at prices declining annually to 100% of the principal amount on or after January 15, 2001. (b) On July 15, 1980, the Company issued 12 7/8% subordinated debentures due July 15, 2000. The debentures had a face value of $25,000,000 and were issued at a discount of $2,412,500. The debentures were subordinated in right of payment to all senior indebtedness and were subject to redemption at 100% of the principal amount. On February 16, 1993, the Company's 12 7/8% subordinated debentures were called for redemption at par (See Note F). (continued) ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE K - DEBENTURES AND SENIOR NOTES - Continued The indenture under which senior notes were issued requires sinking fund payments of $17,500,000 on January 15, 2001 and January 15, 2002. The indenture, contains provisions restricting the amount and type of indebtedness the Company may incur, the purchase by the Company of its stock and the payment of cash dividends. At December 31, 1993, approximately $1,165,376, of consolidated retained earnings were unrestricted as to payment of cash dividends under the indenture. NOTE L - STOCK OPTIONS Under the Company's 1984 Employees' Stock Option Incentive Plan (the "Plan"), 100,000 shares of Class B common stock are reserved for issuance upon exercise of stock options. The Plan is designed as a means to retain and motivate key employees. The Board of Directors administers and interprets the Plan and is authorized to grant options thereunder to all key employees of the Company (approximately 20 persons), including officers and directors who are employees of the Company. The Plan provides for the granting of incentive stock options (as defined in Section 422 of the Internal Revenue Code) on such terms and at such prices as may be determined by the Board of Directors, except that the per share exercise price of incentive stock options cannot be less than the mean between the high and low sales prices of the Class B common stock on the date of the grant. Each option is exercisable after the period or periods specified in the option agreement, but no option may be exercised more than five years after the date of the grant. No participant may be granted options for more than an aggregate of 5,000 shares. Options granted under the Plan are not transferable other than by will or by the laws of descent and distribution. Options under the Plan may not be granted after April 26, 1994. No options have been granted to date under the Plan. NOTE M - COMMON STOCK During the second quarter of 1992 the Company issued 832,000 shares of Class B common stock, par value $.10 per share, for $10.25 per share. The net proceeds from the sales were $7,978,880 after expenses, underwriting discounts and commissions. (continued) ORIOLE HOMES CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE M - COMMON STOCK - Continued Class A common stock and Class B common stock have identical dividend rights with the exception that the Class B common stock is entitled to a $.025 per share additional dividend. Class A common stock is entitled to one vote per share, while Class B common stock is entitled to one-tenth vote per share. Holders of Class B common stock are entitled to elect 25% of the Board of Directors as long as the number of outstanding shares of Class B common stock is at least 10% of the number of outstanding shares of both classes of common stock. At the option of the holder of record, each share of Class A common stock may be converted at any time into one share of Class B common stock. NOTE N - LEASING ARRANGEMENTS Rental properties In connection with certain housing developments, the Company leases recreation facilities. The Company also leases rental units. These leases are accounted for as operating leases. The following schedule provides an analysis of the Company's property under operating leases (included in property and equipment) by major classes as of December 31, 1993 and 1992: The following is a schedule of approximate future minimum rental income required under these leases as of December 31, 1993: Oriole Homes Corp. and Subsidiaries NOTES TO CONOSOLIDATED FINANCIAL STATEMENTS - CONTINUTED NOTE N - LEASING ARRANGEMENTS - Continued Offices and Warehouse The Company leases its offices and warehouse under lease agreements extending through 1997, accounted for as operating leases. The following is a schedule, by years, of the approximate future minimum rental payments as of December 31, 1993: Total rent expense for the years ended December 31, 1993, 1992 and 1991 amounted to $199,922, $199,922 and $113,600, respectively. NOTE O - DEFERRED COMPENSATION PLAN The Company has a defined contribution plan established pursuant to Section 401(K) of the Internal Revenue Code. Employees contribute to the plan a percentage of their salaries, subject to certain dollar limitations, and the Company matches a portion of the employees' contributions. The Company's contribution to the plan amounted to approximately $60,851 in 1993, $56,962 in 1992 and $59,292 in 1991. NOTE P - CONTINGENCIES In January 1993, an action was commenced against the Company, alleging that the Company breached an agreement to pay a commission in connection with the $70,000,000 12 1/2% senior notes debt offering. The complaint seeks up to $350,000 in compensatory damages and up to $500,000 in punitive damages from the Company. The Company believes that the suit is without merit, and the Company intends to litigate vigorously the asserted claims, and, in the opinion of management, this litigation will not have a material effect on the results of operations or the financial condition of the Company. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Directors Oriole Homes Corp. We have audited the accompanying consolidated balance sheets of Oriole Homes Corp. and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to the above present fairly, in all material respects, the consolidated financial position of Oriole Homes Corp. and Subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. GRANT THORNTON Miami, Florida February 4, 1994 ITEM 9

ITEM 9 DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE This item is not applicable. PART III ITEM 10

ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item of this part is incorporated by reference to Registrant's definitive proxy statement for the Annual Meeting of Shareholders. ITEM 11

ITEM 11 EXECUTIVE COMPENSATION The information required by this item of this part is incorporated by reference to Registrant's definitive proxy statement for the Annual Meeting of Shareholders. ITEM 12

ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item of this part is incorporated by reference to Registrant's definitive proxy statement for the Annual Meeting of Shareholders. ITEM 13

ITEM 13 CERTAIN RELATIONSHIP AND RELATED TRANSACTIONS The information required by this item of this part is incorporated by reference to Registrant's definitive proxy statement for the Annual Meeting of Shareholders. PART IV ITEM 14

ITEM 14 EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (1) 1. Financial Statements The following consolidated financial statements of Oriole Homes Corp. and subsidiaries are included in Part II of this annual report and in the Company's 1992 Annual Report to Shareholders. Consolidated balance sheets as of December 31, 1993 and 1992. Consolidated statements of income for the three years ended December 31, 1993. Consolidated statements of cash flows for the three years ended December 31, 1993. Consolidated statements of changes in shareholders' equity for the three years ended December 31, 1993. Notes to consolidated financial statements. Reports of independent certified public accountants. Selected Quarterly Financial Data for the years ended December 31, 1993 and 1992 included in the Company's 1993 Annual Report to Shareholders which is incorporated by reference as Part II of this annual report. 2. Financial Statement Schedules The following financial statement schedules of Oriole Homes Corp. and subsidiaries are included in Part IV of this report: Reports of independent certified public accountants. Schedule X - Supplementary income statement information. All other schedules are omitted because they are not applicable or not required or because the required information is included in the consolidated financial statements or notes thereto. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION ORIOLE HOMES CORP. AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be Signed on its behalf by the undersigned, thereunto duly authorized. ORIOLE HOMES CORP. Pursuant to the requirements of the Securities Exchange Act of 1934 this Annual Report has also been signed by the following persons on behalf of the Registrant in the capacities indicated. MEMBER OF THE BOARD OF DIRECTORS

72971_1993.txt

72971

1993

ITEM 1. BUSINESS Norwest Corporation (the corporation) is a regional bank holding company organized under the laws of Delaware in 1929 and registered under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). As a diversified financial services organization, the corporation operates through subsidiaries engaged in banking and in related businesses. The corporation provides retail, commercial, and corporate banking services to its customers through banks located in Arizona, Colorado, Illinois, Indiana, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Ohio, South Dakota, Texas, Wisconsin, and Wyoming. The corporation provides additional financial services to its customers through subsidiaries engaged in various businesses, principally mortgage banking, consumer finance, equipment leasing, agricultural finance, commercial finance, securities brokerage and investment banking, insurance, computer and data processing services, trust services, and venture capital investments. At December 31, 1993, the corporation and its subsidiaries employed approximately 35,000 persons, had consolidated total assets of $50.8 billion, total deposits of $32.6 billion, and total stockholders' equity of $3.6 billion. Based on total assets at December 31, 1993, the corporation was the 14th largest bank holding company in the United States. As a holding company, the corporation's role is to coordinate the establishment of goals, objectives, policies and strategies, to monitor adherence to policies and to provide capital funds to its subsidiaries. In addition, the corporation provides its subsidiaries with strategic planning support, asset and liability management services, investment administration and portfolio planning, tax planning, new product and business development support, advertising, administrative services and human resources management. The corporation derives substantially all its income from investments in and advances to its subsidiaries and service fees received from its subsidiaries. The Financial Review, which begins on page 17 in the Appendix, discusses developments in the corporation's business during 1993 and provides financial and statistical data relative to the business and operations of the corporation. A brief description of the primary business lines of the corporation follows. Refer to Footnote 14 of the corporation's financial statements for additional information about the corporation's business segments. Banking The corporation's subsidiary banks, serving 15 states with 578 locations, offer diversified financial services including corporate and community banking, trust, capital management, data processing and credit card services. Investment services are provided to customers through Norwest Investment Services, Inc., which operates in 15 states with 111 offices, primarily in banking locations. In addition, Norwest Insurance, Inc. and its subsidiaries operate insurance agencies in 19 states with 102 offices offering complete lines of commercial and personal coverages to customers. Norwest Bank Minnesota, N.A. is the largest bank in the group with total assets of $15.3 billion at December 31, 1993. Eight other banks in the group equaled or exceeded $1.0 billion in total assets: Norwest Bank Iowa, N.A. ($6.3 billion), Norwest Bank South Dakota, N.A. ($2.9 billion), Norwest Bank Nebraska, N.A ($2.9 billion), Norwest Bank Arizona, N.A. ($2.2 billion), Norwest Bank Denver, N.A. ($2.0 billion), Norwest Bank Wisconsin, N.A. ($1.5 billion), Norwest Bank North Dakota, N.A ($1.1 billion) and Norwest Bank Fort Wayne, N.A. ($1.0 billion). Norwest Venture Capital consists of a group of four affiliated companies engaged in making and managing investments in start-up businesses, emerging growth companies, management buy-outs, acquisitions and corporate recapitalizations. Norwest Venture Capital has supported the formation of nearly 300 new businesses with investments of nearly $400 million. Norwest Venture Capital's investments typically range from $750,000 to $5,000,000; however, larger sums may be invested in a single company, sometimes through syndication with other venture capitalists. Most Norwest Venture Capital emerging growth company clients are engaged in technology-related businesses, such as information processing, microelectronics, biotechnology, computer software, medical products, health care delivery, telecommunications, industrial automation, environmental related businesses and non-technology businesses, such as specialty retailing and consumer related business. Financing of management buy-outs is done for a variety of businesses. Mortgage Banking The corporation, through its mortgage banking operations, originates and purchases residential first mortgage loans for sale to various investors and provides servicing of mortgage loans for others where servicing rights have been retained. Income is primarily earned from origination fees, loan servicing fees, interest on mortgages held for sale, and the sale of mortgages and servicing rights. Norwest Mortgage offers a wide range of FHA, VA and conventional loan programs through a network of 633 offices in 577 communities in all 50 states. Approximately 49 percent of the mortgages are FHA and VA mortgages guaranteed by the federal government and sold as GNMA securities. In 1993 the company funded $33.7 billion of mortgages, with the average loan being approximately $97,500. This compares with $21.0 billion of fundings in 1992 and $13.2 billion in 1991. As of December 31, 1993 the mortgage banking servicing portfolio totaled $45.7 billion with a weighted average coupon of 7.22 percent. In 1993 mortgage banking retained $24.1 billion in servicing, or 71.5 percent of fundings, as compared with $13.0 billion or 61.9 percent of fundings and $4.2 billion or 31.8 percent of fundings in 1992 and 1991, respectively. Consumer Finance Consumer finance activities, provided through the corporation's subsidiary, Norwest Financial, Inc. and its subidiaries ("Norwest Financial"), include providing direct installment loans to individuals, purchasing of sales finance contracts, private label and lease accounts receivable and other related products and services. Norwest Financial provides consumer finance products and services through 954 stores in 794 communities in 46 states and in all 10 Canadian provinces. At December 31, 1993, consumer finance receivables accounted for 89 percent of Norwest Financial's total receivables. Direct installment loans to individuals constitute the largest portion of the consumer finance business and, in addition, sales finance contracts are purchased from retailers. The average installment loan made during 1993 was approximately $2,799 while sales finance contracts purchased during the year averaged approximately $976. Comparable amounts in 1992 and 1991 were $2,700 and $900, and $2,500 and $900, respectively. Norwest Financial also has insurance subsidiaries which are primarily engaged in the business of providing, directly or through reinsurance arrangements, credit life and credit disability insurance as a part of Norwest Financial's consumer finance business and the consumer finance business of subsidiaries of the corporation. Property, involuntary unemployment and non-filing insurance is sold as part of Norwest Financial's consumer finance business directly or through a reinsurance arrangement by one of its insurance subsidiaries or on an agency basis. Competition Legislative and regulatory changes coupled with technological advances have significantly increased competition in the financial services industry. The corporation's banks and financial services subsidiaries compete with other commercial banks and financial institutions including savings and loan associations, credit unions, finance companies, mortgage banking companies, brokerage houses and insurance agencies. Government policies, supervision and regulation General As a bank holding company, the corporation is subject to the supervision of the Federal Reserve Board. The corporation's banking subsidiaries are subject to supervision and examination by applicable federal and state banking agencies. All of the corporation's banking subsidiaries are insured, and therefore are subject to regulation, by the FDIC. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board affecting the money supply and credit availability. The corporation is a legal entity separate and distinct from its banking and nonbanking subsidiaries. Accordingly, the right of the corporation, and thus the right of the corporation's creditors, to participate in any distribution of the assets or earnings of any subsidiary is necessarily subject to the prior claims of creditors of such subsidiary, except to the extent that the corporation may be a creditor. Dividend Restrictions Various federal and state statutes and regulations limit the amount of dividends the subsidiary banks can pay to the corporation without regulatory approval. The approval of the OCC is required for any dividend by a national bank if the total of all dividends declared by the bank in any calendar year would exceed the total of its net profits, as defined by regulation, for that year combined with its retained net profits for the preceding two years less any required transfers to surplus or a fund for the retirement of any preferred stock. In addition, a national bank may not pay a dividend in an amount greater than its net profits then on hand after deducting its losses and bad debts. For this purpose, bad debts are defined to include, generally, loans which have matured and are in arrears with respect to interest by six months or more, other than such loans which are well secured and in the process of collection. Under these provisions the corporation's national bank subsidiaries could have declared, as of December 31, 1993, without obtaining prior regulatory approval, aggregate dividends of $483.2 million. The payment of dividends by any subsidiary bank may also be affected by other factors, such as the maintenance of adequate capital for such subsidiary bank. If, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and hearing, that such bank cease and desist from such practice. The Federal Reserve Board, the OCC, and the FDIC have issued policy statements which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings. Holding Company Structure The corporation's banking subsidiaries are subject to restrictions under federal law which limit the transfer of funds by the subsidiary banks to the corporation and its non-bank subsidiaries, whether in the form of loans, extensions of credit, investments, or asset purchases. Such transfers by any subsidiary bank to the corporation or any non-bank subsidiary are limited in amount to 10% of the bank's capital and surplus and, with respect to the corporation and all non-bank subsidiaries, to an aggregate of 20% of the bank's capital and surplus. Further, such loans and extensions of credit are required to be secured in specified amounts. The Federal Reserve Board has a policy to the effect that a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to commit resources to support each subsidiary bank. This support may be required at times when the corporation may not have the resources to provide it. Any capital loans by the corporation to any of the subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of the subsidiary bank. In addition, the Crime Control Act of 1990 provides that in the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. A depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989, in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. "Default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. Federal law (12 U.S.C. Section 55) permits the OCC to order the pro rata assessment of shareholders of a national bank whose capital stock has become impaired, by losses or otherwise, to relieve a deficiency in such national bank's capital stock. This statute also provides for the enforcement of any such pro rata assessment of shareholders of such national bank to cover such impairment of capital stock by sale, to the extent necessary, of the capital stock of any assessed shareholder failing to pay the assessment. Similarly, the laws of certain states provide for such assessment and sale with respect to banks chartered by such states. The corporation, as the sole shareholder of certain of its subsidiary banks, is subject to such provisions. Capital Requirements In January 1989, the Federal Reserve Board issued final risk-based capital guidelines for bank holding companies, such as the corporation. The new guidelines, which became effective December 31, 1990, were phased in over two years. The minimum ratio of total capital to risk-adjusted assets (including certain off-balance sheet items, such as stand-by letters of credit) is 8%. At least half of the total capital is to be composed of common equity, retained earnings, and a limited amount of noncumulative perpetual preferred stock ("Tier 1 capital"). The remainder ("Tier 2 capital") may consist of hybrid capital instruments, perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock, and a limited amount of allowance for credit losses. The Federal Reserve Board has adopted changes to its risk-based and leverage ratio requirements applicable to bank holding companies and state chartered member banks that require that all intangibles, including core deposit intangibles, purchased mortgage servicing rights ("PMSRs"), and purchased credit card relationships ("PCCRs") be deducted from Tier 1 capital. The changes, however, grandfather identifiable assets (other than PMSRs and PCCRs) acquired on or before February 19, 1992, and permit the inclusion of readily marketable PMSRs and PCCRs in Tier 1 capital to the extent that (i) PMSRs and PCCRs do not exceed 50% of Tier 1 capital and (ii) PCCRs do not exceed 25% of Tier 1 capital. For such purposes, PMSRs and PCCRs each would be included in Tier 1 capital only up to the lesser of (a) 90% of their fair market value (which must be determined quarterly) and (b) 100% of the remaining unamortized book value of such assets. The OCC has adopted substantially similar regulations. In addition, the Federal Reserve Board approved in August 1990 final minimum "leverage ratio" (the ratio of Tier 1 capital to quarterly average total assets) guidelines for bank holding companies and state member banks. These guidelines provide for a minimum leverage ratio of 3% for bank holding companies and state member banks that meet certain specified criteria, including that they have the highest regulatory rating. All other bank holding companies and state member banks will be required to maintain a leverage ratio of 3% plus an additional cushion of 1% to 2%. The tangible Tier 1 leverage ratio is the ratio of a banking organization's Tier 1 capital, less all intangibles, to total assets, less all intangibles. Each of the corporation's banking subsidiaries is also subject to capital requirements adopted by applicable regulatory agencies which are substantially similar to the foregoing. At December 31, 1993, the corporation's Tier 1 and total capital (the sum of Tier 1 and Tier 2 capital) to risk-adjusted assets ratios were 9.84% and 12.60%, respectively, and the corporation's leverage ratio was 6.60%. Neither the corporation nor any subsidiary bank has been advised by the appropriate federal regulatory agency of any specific leverage ratio applicable to it. Federal Deposit Insurance Corporation Improvement Act of 1991 In December 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which substantially revises the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking agencies to take "prompt corrective action" in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized", and "critically undercapitalized". A depository institution's capital tier will depend upon where its capital levels are in relation to various relevant capital measures, which will include a risk-based capital measure and a leverage ratio capital measure, and certain other factors. A depository institution is well capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure, adequately capitalized if it meets each such measure, undercapitalized if it fails to meet any such measure, significantly undercapitalized if it is significantly below any such measure, and critically undercapitalized if it fails to meet any critical capital level set forth in regulations. The critical capital level must be a level of tangible equity equal to not less than 2% of total assets and not more than 65% of the minimum leverage ratio to be prescribed by regulation (except to the extent that 2% would be higher than such 65% level). An institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating. Under regulations adopted pursuant to the foregoing provisions, for an institution to be well capitalized it must have a Tier 1 risk-based capital ratio of at least 6%, a total risk-based capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to any specific capital order or directive. For an institution to be adequately capitalized it must have a Tier 1 risk-based capital ratio of at least 4%, a total risk-based capital ratio of at least 8%, and a leverage ratio of at least 4% (and in some cases 3%). As of December 31, 1993, all of the corporation's banking subsidiaries were well capitalized. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to a wide range of limitations on operations and activities, including growth limitations, and are required to submit a capital restoration plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5% of the depository institution's total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator. FDICIA directs that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares, and such other standards as the agency deems appropriate. Although the corporation believes it is in compliance with the above FDICIA standards, the ultimate impact, if any, of such standards on the corporation cannot be ascertained. FDICIA also contains a variety of other provisions that may affect the operations of the corporation, including new reporting requirements, revised regulatory standards for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days' notice to customers and regulatory authorities before closing any branch. Under other regulations promulgated under FDICIA a bank cannot accept brokered deposits (that is, deposits obtained through a person engaged in the business of placing deposits with insured depository institutions or with interest rates significantly higher that prevailing market rates) unless (i) it is "well capitalized" or (ii) it is "adequately capitalized" and receives a waiver from the FDIC. A bank is defined to be well capitalized if it maintains a leverage ratio of at least 5%, a ratio of Tier 1 capital to risk-adjusted assets of at least 6%, and a ratio of total capital to risk-adjusted assets of at least 10%, and is not otherwise in a "troubled condition" as specified by the appropriate federal regulatory agency. A bank is defined to be "adequately capitalized" if it meets all of its minimum capital requirements. A bank that cannot receive brokered deposits also cannot offer "pass-through" insurance on certain employee benefit accounts, unless it provides certain notices to affected depositors. In addition, a bank that is "adequately capitalized" and that has not received a waiver from the FDIC may not pay an interest rate on any deposits in excess of 75 basis points over certain prevailing market rates. There are no such restrictions on a bank that is "well capitalized". At December 31, 1993, all of the corporation's banking subsidiaries were well capitalized and, therefore, were not subject to these restrictions. FDIC Insurance Effective January 1, 1993, the deposit insurance assessment rate for the Bank Insurance Fund ("BIF") and the Savings Association Insurance Fund ("SAIF") increased as part of the adoption by the FDIC of a transitional risk-based assessment system. In June 1993, the FDIC published final regulations making the transitional system permanent effective January 1, 1994, but left open the possibility that it may consider expanding the range between the highest and lowest assessment rates at a later date. An institution's risk category is based upon whether the institution is well capitalized, adequately capitalized, or less than adequately capitalized. Each insured depository institution is also to be assigned to one of the following "supervisory subgroups": Subgroup A, B, or C. Subgroup A institutions are financially sound institutions with few minor weaknesses; Subgroup B institutions are institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration; and Subgroup C institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. Based on its capital and supervisory subgroups, each BIF or SAIF member institution will be assigned an annual FDIC assessment rate ranging from 0.23% per annum (for well capitalized Subgroup A institutions) to 0.31% (for undercapitalized Subgroup C institutions). Adequately capitalized institutions will be assigned assessment rates ranging from 0.26% to 0.30%. The corporation incurred $66.2 million of FDIC assessment expense in 1993 as compared with $62.5 million in 1992 and $57.4 million in 1991. Because of decreases in the reserves of the BIF and SAIF due to the increased number of bank failures in recent years, it is possible the BIF and SAIF premiums will be further increased and it is possible that there may be a special assessment. Any such further increase or special assessment would also decrease net income, and a special assessment could have a material adverse effect on the results of operations of the corporation. ITEM 2.

ITEM 2. PROPERTIES The corporation operates 578 commercial banking locations, of which 382 are owned directly by subsidiary banks and 196 are leased from outside parties. The mortgage banking operation leases its headquarters facilities and servicing center in Des Moines, Iowa, leases a servicing center in Minneapolis, Minnesota, owns an additional servicing center located in Springfield, Ohio, and leases all mortgage production offices nationwide. Norwest Financial owns its headquarters in Des Moines, Iowa, and leases all consumer finance branch locations. The corporation and Norwest Bank Minnesota, N.A. lease their offices in Minneapolis, Minnesota. The accompanying notes to consolidated financial statements on pages 57 and 70 in the Appendix contain additional information with respect to premises and equipment and commitments under noncancellable leases for premises and equipment. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS None ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal trading markets for the corporation's common equity are presented on the cover page of the Form 10-K. The high and low sales prices for the corporation's common stock for each quarter during the past two years and information regarding cash dividends is set forth on pages 62, 82, and 92 in the Appendix. The number of holders of record of the common equity securities of the corporation at January 31, 1994 were: Title of Class Number of Holders 6 3/4 % convertible subordinated debentures due 2003 10 Depositary Shares Representing Cumulative Convertible Preferred Stock, Series B 91 Common stock, par value $1 2/3 per share 25,999 ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The selected financial data begins on page 86 in the Appendix. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The discussion and analysis is presented beginning on page 17 in the Appendix and should be read in conjunction with the related financial statements and notes thereto included under Item 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the corporation and its subsidiaries begin on page 36 in the Appendix. The report of independent certified public accountants on the corporation's consolidated financial statements is presented on page 84 in the Appendix. Selected quarterly financial data is presented on pages 92 and 93 in the Appendix. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required to be submitted in response to this item is omitted because a definitive proxy statement containing such information will be filed with the Securities and Exchange Commission pursuant to Regulation 14A and such information is expressly incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required to be submitted in response to this item is omitted because a definitive proxy statement containing such information will be filed with the Securities and Exchange Commission pursuant to Regulation 14A and such information is expressly incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required to be submitted in response to this item is omitted because a definitive proxy statement containing such information will be filed with the Securities and Exchange Commission pursuant to Regulation 14A and such information is expressly incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required to be submitted in response to this item is omitted because a definitive proxy statement containing such information will be filed with the Securities and Exchange Commission pursuant to Regulation 14A and such information is expressly incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements - See Item 8 above. (2) Financial Statement Schedules All schedules to the consolidated financial statements normally required by Form 10-K are omitted since they are either not applicable or the required information is shown in the financial statements or the notes thereto. (b) Reports on Form 8-K (1) The corporation filed Current Reports on Form 8-K dated October 25, 1993, filing certain documents in connection with the offering of 6.65% Subordinated Debentures Due 2023, and dated December 29, 1993, filing certain documents in connection with the offering of Medium-Term Notes, Series D. (c) Exhibits Page 2. Pro forma combined financial information for the corporation and pending acquisitions at December 31, 1993 and for the years ended December 31, 1993, 1992 and 1991.................................... 94 3(a). Restated Certificate of Incorporation, as amended, incorporated by reference to Exhibit 3(b) to the corporation's Current Report on Form 8-K dated June 28, 1993. 3(b). Certificate of Designations of powers, preferences and rights relating to the corporation's 10.24% Cumulative Preferred Stock incorporated by reference to Exhibit 4(a) to the corporation's Registration Statement No. 33-38806. 3(c). Certificate of Designations of powers, preferences and rights relating to the corporation's Cumulative Convertible Preferred Stock, Series B incorporated by reference to Exhibit 2 to the corporation's Form 8-A, dated August 8, 1991. 3(d). By-Laws, as amended, incorporated by reference to Exhibit 4(c) to the corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991. 4(a). See 3(a), 3(b), 3(c), and 3(d) of Item 14(c), above. 4(b). Rights Agreement, dated as of November 22, 1988, between the corporation and Citibank, N.A. incorporated by reference to Exhibit 1 to the corporation's Form 8-A, dated December 6, 1988, and Certificates of Adjustment pursuant to Section 12 of the Rights Agreement incorporated by reference to Exhibit 3 to the corporation's Form 8, dated July 21, 1989, and to Exhibit 4 to the corporation's Form 8-A/A dated June 29, 1993. 4(c). Copies of instruments with respect to long-term debt will be furnished to the Commission upon request. *10(a). 1983 Stock Option and Restricted Stock Plan incorporated by reference to Exhibit 28(b) to the corporation's Registration Statement No. 2-95331. *10(b). 1985 Long-Term Incentive Compensation Plan, as amended, incorporated by reference to Exhibit 99(a) to the corporation's Registration Statement No. 033-50309. *10(c). Employees' Stock Deferral Plan incorporated by reference to Exhibit 10(c) to the corporation's Annual Report on Form 10-K for the year ended December 31, 1992. *10(d). Executive Incentive Compensation Plan incorporated by reference to Exhibit 19(a) to the corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. Amendment to Executive Incentive Compensation Plan incorporated by reference to Exhibit 19(b) to the corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. *10(e). Supplemental Savings-Investment Plan, as amended, incorporated by reference to Exhibit 10(e) to the corporation's Annual Report on Form 10-K for the year ended December 31, 1992. *10(f). Executive Financial Counseling Plan incorporated by reference to Exhibit 10(f) to the corporation's Annual Report on Form 10-K for the year ended December 31, 1987. *10(g). Supplemental Long Term Disability Plan incorporated by reference to Exhibit 10(f) to the corporation's Annual Report on Form 10-K for the year ended December 31, 1990. Amendment to Supplemental Long Term Disability Plan incorporated by reference to Exhibit 10(g) to the corporation's Annual Report on Form 10-K for the year ended December 31, 1992. *10(h). Deferred Compensation Plan for Non-Employee Directors incorporated by reference to Exhibit 10(g) to the corporation's Annual Report on Form 10-K for the year ended December 31, 1987. *10(i). Retirement Plan for Non-Employee Directors incorporated by reference to Exhibit 10(h) to the corporation's Annual Report on Form 10-K for the year ended December 31, 1987. Amendment to Retirement Plan for Non-Employee Directors incorporated by reference to Exhibit 19 to the corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990. *10(j). Directors' Formula Stock Award Plan, as amended, incorporated by reference to Exhibit 19 to the corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. *10(k). Directors' Stock Deferral Plan incorporated by reference to Exhibit 19 to the corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. *10(l). Agreement between the corporation and Lloyd P. Johnson dated March 11, 1991, incorporated by reference to Exhibit 19(c) to the corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991. *10(m). Agreement between the corporation and Richard M. Kovacevich dated March 18, 1991, incorporated by reference to Exhibit 19(e) to the corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991. *10(n). Form of agreement executed in March 1991, between the corporation and 13 executive officers including two directors, incorporated by reference to Exhibit 19(f) to the corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991. Amendments dated March 16, 1992 to the agreements between the corporation and Lloyd P. Johnson and Richard M. Kovacevich incorporated by reference to Exhibit 19(a) to the corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992. *10(o). Lincoln Financial Corporation Directors' Stock Compensation Plan incorporated by reference to Exhibit 10 to the corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. *10(p). Employees' Deferred Compensation Plan incorporated by reference to Exhibit 99 to the corporation's Registration Statement No. 033-50307. *10(q). Consulting Agreement between the corporation and Gerald J. Ford dated January 19, 1994.................. 102 *10(r). First United Bank Group, Inc. Incentive Stock Option Plan incorporated by reference to the corporation's Registration Statement No. 033-50495. 11. Computation of Earnings Per Share...................... 106 12(a). Computation of Ratio of Earnings to Fixed Charges...... 107 12(b). Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividends.......................... 108 21. Subsidiaries of the Corporation........................ 109 23. Consent of Experts..................................... 115 24. Powers of Attorney..................................... 116 ______________________ * Management contract or compensatory plan or arrangement. Stockholders may obtain a copy of any Exhibit, Item 14(c), none of which are contained herein, upon payment of a reasonable fee, by writing Norwest Corporation, Office of the Secretary, Norwest Center, Sixth and Marquette, Minneapolis, Minnesota 55479-1026. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 22nd day of February 1994. Norwest Corporation (Registrant) By /s/RICHARD M. KOVACEVICH Richard M. Kovacevich President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on the 22nd day of February, 1994, by the following persons on behalf of the registrant and in the capacities indicated. By /s/JOHN T. THORNTON John T. Thornton Executive Vice President and Chief Financial Officer (Principal Financial Officer) By /s/MICHAEL A. GRAF Michael A. Graf Senior Vice President and Controller (Principal Accounting Officer) The Directors of Norwest Corporation listed below have duly executed powers of attorney empowering William A. Hodder to sign this document on their behalf. David A. Christensen Richard S. Levitt Pierson M. Grieve Richard D. McCormick Charles M. Harper Cynthia H. Milligan N. Berne Hart John E. Pearson George C. Howe Ian M. Rolland Lloyd P. Johnson Stephen E. Watson Reatha Clark King Michael W. Wright Richard M. Kovacevich By /s/WILLIAM A. HODDER William A. Hodder Director and Attorney-in-Fact February 22, 1994 Appendix NORWEST CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations, Financial Statements, Report of Independent Auditors and Selected Financial Data Forming a Part of the Annual Report on Form 10-K for the Year Ended December 31, 1993 Contents Page Financial Review ......................................... 17 Financial Statements ..................................... 36 Independent Auditors' Report ............................. 84 Management's Report ...................................... 85 Six-Year Consolidated Financial Summary .................. 86 Consolidated Average Balance Sheets and Related Yields and Rates ............................. 87 Quarterly Condensed Consolidated Financial Information.... 92 FINANCIAL REVIEW This financial review should be read with the consolidated financial statements and accompanying notes presented on pages 36 through 83 and other information presented on pages 86 through 93. EARNINGS PERFORMANCE Norwest Corporation (the "corporation") reported record net income of $653.6 million in 1993, an increase of 79.5 percent over earnings of $364.1 million in 1992 and 63.0 percent over the $400.9 million earned in 1991. Net income per common share was $2.13 in 1993, compared with $1.16 in 1992 and $1.34 in 1991, an increase of 84.4 percent and 59.3 percent, respectively. Return on common equity was 20.9 percent and return on assets was 1.38 percent for 1993, compared with 12.4 percent and 0.85 percent in 1992, respectively, and 15.5 percent and 0.99 percent in 1991, respectively. The 1992 results include a one-time special charge of $76.0 million after tax, or 26 cents per common share, related to the corporation's early adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106). Excluding the cumulative effect of the change in accounting for postretirement medical benefits, 1992 net income was $440.1 million, or $1.42 per common share, return on common equity was 15.2 percent and return on assets was 1.03 percent. Net income per common share amounts for periods prior to 1993 have been restated to reflect the two-for-one split of the outstanding shares of common stock of the corporation effected in the form of a 100 percent stock dividend distributed on June 28, 1993. The corporation's results for periods prior to 1993 have been restated to include the results of Lincoln Financial Corporation (Lincoln) which was acquired by the corporation effective February 9, 1993 and has been accounted for using the pooling of interest method of accounting. Included in 1992 earnings are Lincoln's $60.0 million of additional provision for credit losses for the purpose of conforming Lincoln's credit loss practices and policies to those of the corporation and $33.5 million of merger and transition related expenses and restructuring costs, together totaling $93.5 million before income taxes. Norwest Corporation and Subsidiaries CONSOLIDATED INCOME SUMMARY NM - Not meaningful ORGANIZATIONAL EARNINGS BANKING The Banking Group reported record earnings of $397.2 million in 1993, 74.5 percent over 1992 earnings of $227.7 million and 61.5 percent over 1991 earnings of $246.0 million. Included in the 1992 Banking Group results are Lincoln's additional provision for credit losses, merger and transition related expenses and restructuring costs totaling $93.5 million before income taxes. The Banking Group earnings increases over 1992 and 1991 reflect 7.0 percent and 16.3 percent growth in tax- equivalent net interest income, respectively, primarily due to increases in average earning assets and net interest margin, and 80.5 percent and 87.5 percent decreases in the provision for credit losses, respectively, reflecting continued decreases in net credit losses and non-performing assets. Non-interest income in the Banking Group incresed 11.4 percent over 1992 and 24.5 percent over 1991 primarily due to continued increases in trust fee income, service charges on deposits and insurance revenues. The Banking Group non-interest expense increases of 5.8 percent and 25.7 percent over 1992 and 1991, respectively, are primarily a result of acquisition related charges, writedowns of excess facilities and other assets, and increased charitable contributions. The venture capital subsidiaries realized $59.5 million of net gains in 1993, compared with net gains of $29.7 million in 1992 and net losses of $4.6 million in 1991. Virtually all appreciated securities included in the $59.5 million venture capital gains were contributed to the Norwest Foundation. Contribution amounts of these appreciated securities, which included cost basis, were $69.8 million in 1993. Net unrealized appreciation in the venture capital investment portfolio was $118.3 million at December 31, 1993, an increase of 26.1 percent over December 31, 1992. MORTGAGE BANKING Mortgage banking operations earned $56.3 million in 1993, a 5.5 percent increase over 1992 earnings of $53.4 million, and 79.4 percent over 1991 earnings of $31.4 million. The increase in earnings reflects a 60.2 percent and 155.7 percent increase in residential mortgage fundings over 1992 and 1991, respectively. Fundings were $33.7 billion in 1993, compared with $21.0 billion in 1992 and $13.2 billion in 1991. Approximately 55 percent of the 1993 fundings were due to new loan originations with refinancings accounting for approximately 45 percent. Net gains on the sale of mortgages was $140.5 million in 1993, compared with $19.8 million in 1992 and $13.0 million in 1991. Net servicing retained during 1993 was $24.1 billion, compared with $13.0 billion in 1992 and $4.2 billion in 1991. The servicing portfolio increased to $45.7 billion at December 31, 1993, compared with $21.6 billion at December 31, 1992. In 1993, sales of servicing rights were $2,948 million, under an obligation in a long-term contract, with gains on sales of $61.7 million compared with $7,213 million and $62.4 million, respectively, during 1992 and $9,047 million and $76.5 million, respectively, in 1991. NORWEST FINANCIAL SERVICES Norwest Financial Services, Inc. (Norwest Financial) reported record earnings of $200.1 million in 1993, a 25.9 percent increase over the $159.0 million earned in 1992, and a 62.0 percent increase over the $123.5 million earned in 1991. The increases are primarily due to increases in tax-equivalent net interest income of 27.1 percent and 52.9 percent, respectively, over 1992 and 1991. The increase in tax- equivalent net interest income was due to 17.8 percent and 26.0 percent increases in average finance receivables over 1992 and 1991, respectively, and an increase in net interest margin of 107 basis points over 1992 and 232 basis points over 1991. The increase in net interest margin reflects lower short-term borrowing rates and benefits from refinancing long-term debt at lower interest rates. Norwest Financial's non-interest expenses increased 21.5 percent and 45.6 percent over 1992 and 1991, respectively, primarily due to the acquisition of the consumer finance business of Trans Canada Credit Corporation Limited during the fourth quarter of 1992. Norwest Corporation and Subsidiaries ORGANIZATIONAL EARNINGS* In millions Year ended December 31 1993 1992 1991 1990 1989 Banking $397.2 227.7 246.0 33.0 189.6 Mortgage banking 56.3 53.4 31.4 17.0 5.8 Norwest Financial Services Inc., and subsidiaries 200.1 159.0 123.5 106.3 79.5 Consolidated income before cumulative effect of a change in accounting for postretirement medical benefits 653.6 440.1 400.9 156.3 274.9 Cumulative effect on years prior to December 31, 1992 of a change in accounting for postretirement medical benefits - (76.0) - - - Net income $653.6 364.1 400.9 156.3 274.9 * Earnings of the entities listed are impacted by intercompany revenues and expenses, such as interest on borrowings from the parent company, corporate service fees and allocation of federal income taxes. CONSOLIDATED INCOME STATEMENT ANALYSIS NET INTEREST INCOME Net interest income on a tax-equivalent basis is the difference between interest earned on assets and interest paid on liabilities, with adjustments made to present yields on tax-exempt assets as if such income was fully taxable. Changes in the mix and volume of earning assets and interest-bearing liabilities, their related yields and overall interest rates have a major impact on earnings. In 1993, tax-equivalent net interest income provided 61.0 percent of the corporation's net revenues, compared with 63.2 percent in 1992 and 63.9 percent in 1991. Total tax-equivalent net interest income was $2,408.7 million in 1993, a 13.9 percent increase over the $2,114.7 million reported in 1992. Growth in tax-equivalent net interest income over 1992 was primarily due to an 11.3 percent increase in average earning assets and a 13 basis point increase in net interest margin. The increase in average earning assets is primarily due to an increase in average mortgages held for sale resulting from growth in residential mortgage fundings and an increase in average loans and leases, partially offset by a slight decrease in average total investment securities. The 1992 increase of 16.0 percent over the $1,823.2 million reported in 1991 was due to a 5.9 percent increase in average earning assets and a 47 basis point increase in net interest margin. The increase in earning assets reflects increases in mortgages held for sale and increases in total investment securities. Non-accrual and restructured loans reduced net interest income by $12.3 million in 1993, compared with $17.2 million in 1992 and $24.8 million in 1991. Detailed analysis of net interest income appear on pages 87, 88 and 89. Net interest margin, the ratio of tax-equivalent net interest income divided by average earning assets, was 5.59 percent in 1993, compared with 5.46 percent in 1992 and 4.99 percent in 1991. The increase over 1992 reflects the downward repricing of core deposits, refinancing of long-term debt at lower interest rates and the repurchase of securitized credit card receivables, partially offset by lower yields on earning assets. The 1992 increase over 1991 reflects the downward repricing of core deposits, the refinancing of long-term debt at lower interest rates and the issuance of approximately $412 million of preferred and common stock during 1991, partially offset by an increase in average mortgages held for sale and an increase in average total investment securities on which narrower spreads are earned. PROVISION FOR CREDIT LOSSES The provision for credit losses reflects management's judgment of the cost associated with credit risk inherent in the loan and lease portfolio. The consolidated provision for credit losses was $140.1 million in 1993, a decrease of $126.6 million from 1992 and a decrease of $261.8 million from 1991. The provision for credit losses was 0.56 percent of average loans and leases in 1993, compared with 1.22 percent in 1992 and 1.87 percent in 1991. The decrease from 1992 reflects the continued reduction in the corporation's net credit losses and non-performing assets which are down $89.6 million from December 31, 1992. Also, as previously discussed, the 1992 provision for credit losses includes $60.0 million in additional provisions for credit losses taken by Lincoln. The 1992 decrease from 1991 reflects the reduction in the corporation's net charge-offs and non-performing assets. Net credit losses for 1993 were $173.6 million, a decrease of $44.0 million from 1992, and a decrease of $139.0 million from 1991. Net credit losses as a percentage of average loans and leases were 0.70 percent in 1993, compared with 1.00 percent in 1992 and 1.45 percent in 1991. The decrease in net credit losses in 1993 from 1992 reflects significantly lower commercial, consumer, construction and land development and real estate loan charge-offs resulting from lower levels of non-performing loans. These decreases were partially offset by higher foreign loan charge-offs as a result of Norwest Financial's fourth quarter 1992 acquisition of the consumer finance business of Trans Canada Credit Corporation Limited and higher credit card charge-offs. The decrease in 1992 from 1991 is primarily due to lower commercial and real estate loan charge-offs. NON-INTEREST INCOME Non-interest income is a significant source of the corporation's revenue, representing 39.0 percent of tax-equivalent net revenues in 1993, compared with 36.8 percent in 1992 and 36.1 percent in 1991. Consolidated non-interest income increased 25.5 percent in 1993 to $1,542.5 million, primarily due to increased mortgage banking revenues, venture capital gains and growth in various fee-based services, partially offset by a decrease in credit card fees, trading account gains and net gains on investment/mortgage-backed securities available for sale. During 1993 securities held for investment with a total amortized cost of $29.5 million were sold since they had been called by the issuers, resulting in gains on sales of $0.1 million. Excluding investment/mortgage-backed securities gains, venture capital gains and gains on investment/mortgage-backed securities available for sale, non-interest income was up 26.1 percent from 1992 and 41.4 percent from 1991. The growth in mortgage banking revenues reflects the continued growth in mortgage loan fundings and the servicing portfolio. Credit card revenues decreased $19.9 million from 1992 primarily due to the repurchase of $525 million of credit card receivables from the securitized credit card receivable trusts during 1993 and a reduction in the number of credit card accounts by 19,000 to 1,896,000 as of December 31, 1993. The corporation expects to have repurchased the remaining $333 million of credit card receivables from the securitized credit card receivable trusts by the end of the second quarter of 1994. Revenues on securitized credit card receivables are recorded in non-interest income rather than net interest income. Other non-interest income increased $43.0 million from 1992 primarily due to increases of $36.1 million in trading account securities gains and $9.9 million in gains on sales of student loans available for sale. Consolidated non-interest income increased 19.2 percent in 1992 from 1991, primarily due to growth in mortgage banking revenues, gains on sales of investment/mortgage backed securities available for sale, venture capital gains and growth in various fee-based services, partially offset by a decrease in credit card fees. The 48.1 percent growth in mortgage banking revenues is due to the increase in mortgage fundings over 1991, partially offset by an 18.4 percent decrease in gains on sales of servicing rights. The decrease in credit card fees is primarily due to the repurchase of $254 million of credit card receivables from the securitized credit card receivable trusts during 1992 and a reduction in the number of credit card accounts of 174,000 to 1,915,000 as of December 31, 1992. NON-INTEREST EXPENSES Consolidated non-interest expenses increased 16.6 percent to $2,840.8 million in 1993. The increase is primarily due to increased salaries and benefits at both the mortgage banking operations, to support the large origination and servicing increases in that business, and at Norwest Financial due to its fourth quarter 1992 acquisition of the consumer finance business of Trans Canada Credit Corporation Limited, as well as increased salaries and benefits due to numerous acquisitions completed by the corporation during 1993. Excluding the growth in mortgage banking operations, Norwest Financial, businesses acquired during the year and the impact of the 1993 change in retirement plan assumptions, salaries and benefits expense increased 4.0 percent from 1992. The increase in non-interest expenses also reflects the impact of shortening of depreciable lives on mainframe computers, capping the amortizable life of goodwill at 15 years, increased and accelerated amortization of other intangibles, writedowns of excess facilities and other assets, a $47.1 million increase in charitable contributions and acquisition related charges. Non-interest expenses increased $497.1 million in 1992 over 1991. This increase is primarily attributable to increased salaries and benefits in the mortgage banking operations, reflective of large volume increases in originations and servicing, excess facility and other asset writedowns of approximately $82.0 million, writedowns of intangible assets of approximately $68.0 million, merger and transition related expenses and certain restructuring charges related to the Lincoln acquisition of approximately $33.5 million, a $19.3 million loss on prepayment of Norwest Financial debt and an $18.3 million increase in charitable contributions. POSTEMPLOYMENT BENEFITS In l992, the Financial Accounting Standards Board issued Statement of FInancial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112). Beginning in 1994, FAS 112 requires employers to accrue the cost of postemployment benefits during the employees active service, if the amount of the benefits can be reasonably estimated and payment is probable. Management believes the adoption of FAS 112 will not have a material effect on the consolidated financial statements of the corporation. INCOME TAXES The corporation's income tax planning is based upon the goal of maximizing long-term, after-tax profitability. Income tax expense is significantly impacted by the mix of taxable versus tax-exempt revenues from investment securities and the loan portfolio and the utilization of net operating loss carryforwards. In 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", (FAS 109) effective January 1, 1993. The corporation adopted FAS 109 as of January 1, 1993, with no material impact on the corporation's consolidated financial statements. Prior to adoption of FAS 109, the corporation accounted for income taxes under Statement of Financial Accounting Standards No. 96. The effective income tax rate was 30.3 percent in 1993, compared with 24.5 percent in 1992 and 14.3 percent in 1991. The increase in the effective tax rate in 1993 from 1992 is primarily due to the fact that in 1993 there were no net operating loss tax benefits related to United Banks of Colorado, Inc's. 1990 net operating loss as compared with $31.2 million of benefits in 1992. The increase in the effective tax rate in 1992 from 1991 is primarily due to $31.2 million in net operating loss tax benefits in 1992 as compared with $49.3 million in 1991 related to United. For more information on income taxes see Footnote 12 on page 69. CONSOLIDATED BALANCE SHEET ANALYSIS EARNING ASSETS At December 31, 1993, earning assets were $46.5 billion, compared with $42.4 billion at December 31, 1992. This increase is primarily due to a $4.3 billion increase in loans and leases, and student loans and mortgages held for sale, including $2.6 billion of loans and leases acquired in acquisitions completed during 1993. This increase is partially offset by a $0.4 billion decrease in total investment securities. Average earnings assets were $43.1 billion in 1993, an increase of 11.3 percent over 1992. This increase is primarily due to a 14.4 percent increase in average loans and leases, and a 35.5 percent increase in mortgages held for sale due to increased residential mortgage fundings, partially offset by a 6.6 percent decrease in average total investment securities. Leverage, the ratio of average assets to average stockholders' equity, was 14.2 times during 1993 versus 14.1 times during 1992. This increase is due to a 10.7 percent increase in average assets, partially offset by a 9.6 percent increase in average stockholders' equity. In 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which will be adopted by the corporation in the first quarter of 1994. The Statement requires that investments classified as available for sale be reported at fair value with unrealized gains and losses reported, net of tax, as a separate component of stockholders' equity. The corporation currently accounts for investments classified as available for sale using the lower of cost or market accounting method. As of December 31, 1993, net unrealized gains related to investments and mortgage-backed securities available for sale were $482.7 million before income taxes. In Footnote 16 to the consolidated financial statements on page 74 the corporation has disclosed the estimated fair values of all on and off-balance sheet financial instruments and certain non-financial instruments in accordance with Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments". As of December 31, 1993, the fair value of net financial instruments totaled $3.9 billion, an increase of $1.0 billion from December 31, 1992. This increase was primarily due to growth in mortgages held for sale and loans and leases, which were partially offset by reductions in investment securities, including securities available for sale. During the same period, the net fair value of certain non-financial instruments increased $1.2 billion to $7.1 billion as of December 31, 1993. The fair value of the consumer finance network increased $0.8 billion. The fair value of the mortgage servicing portfolio and the mortgage loan origination/wholesale network increased $0.4 billion in 1993 due to increases in the servicing portfolio, as previously discussed, and growth in the origination and wholesale network. As of December 31, 1992, the fair value of net financial instruments totaled $2.9 billion, an increase of $0.2 billion from December 31, 1991. This increase was primarily due to growth in mortgages held for sale and loans and leases, which were partially offset by reductions in investment securities and mortgage-backed securities, including securities available for sale. During the same period, the net fair value of certain non-financial instruments increased $1.3 billion to $5.9 billion as of December 31, 1992. The fair value of the consumer finance network increased $0.4 billion due to growth in accounts and a widened interest spread on such loans. The fair value of the mortgage servicing portfolio and mortgage loan origination/wholesale network increased $0.6 billion in 1992, due to increases in the servicing portfolio and growth in the origination and wholesale network. CREDIT RISK MANAGEMENT The corporation manages exposure to credit risk through loan portfolio diversification by customer, product, industry and geography. As a result, there is no undue concentration in any single sector. Credit risk management also includes pricing loans to cover anticipated future credit losses, funding and servicing costs and to allow for a profit margin. Loans and leases by type appear in Footnote 5 on page 56. As of December 31, 1993, the corporation's commercial real estate portfolio of loans to investors, developers and builders, including construction and land development loans (development loans), was $1,632.3 million, of which $40.0 million or 2.5 percent, were non-performing, compared with $1,559.0 million at December 31, 1992, of which $76.4 million, or 4.9 percent, were non-performing. These loans do not include loans on owner-occupied real estate which the corporation views as having the same general credit risk as commerical loans. Development loans represent 5.8 percent of the corporation's total loan portfolio. The total number of development loans is approximately 4,000 with an average loan size of approximately $0.3 million. The largest development loan is $16.4 million. The industry composition of development loans consists of office/warehouse (23 percent), retail (23 percent), residential (32 percent) and other (22 percent). The construction and commercial real estate loan problems of many regional bank holding companies in some other parts of the United States have not been as severe in the Midwest. Geograpically, over 96 percent of the development loan portfolio is within the thirteen state area where the corporation has its principal banking franchise. Approximately 43 percent of the total portfolio is secured by property located in the Minneapolis/St. Paul, Minnesota area and Colorado. Within the 13 state area, the Minneapolis/St. Paul area has the largest concentration of developer activity. As noted above, the corporation has spread its construction and commercial real estate loans among numerous borrowers and has limited the size of loans retained on its books. Accordingly, the corporation believes its exposure to future commercial real estate loan losses is limited. The corporation is not aware of any loans classified for regulatory purposes at December 31, 1993, that are expected to have a material impact on the corporation's future operating results, liquidity or capital resources. The corporation is not aware of any material credits about which there is serious doubt as to the ability of borrowers to comply with the loan repayment terms. There are no material commitments to lend additional funds to customers whose loans were classified as non- accrual or restructured at December 31, 1993. ALLOWANCE FOR CREDIT LOSSES At December 31, 1993, the allowance for credit losses was $744.9 million, or 2.76 percent of loans and leases outstanding, compared with $742.7 million or 3.07 percent at December 31, 1992. The ratio of the allowance for credit losses to the total non-performaning assets and 90-day past due loans and leases was 260.9 percent at December 31, 1993, compared with 199.3 percent at December 31, 1992. Although it is impossible for any lender to predict future credit losses with complete accuracy, management monitors the allowance for credit losses with the intent to provide for all losses that can reasonably be anticipated based on current conditions. The corporation maintains the allowance for credit losses as a general allowance available to cover future credit losses within the entire loan and lease portfolio and other credit-related risks. However, management has prepared an allocation of the allowance based on its views of risk characteristics of the portfolio. This allocation of the allowance for credit losses does not represent the total amount available for actual future credit losses in any single category nor does it prohibit future credit losses from being absorbed by portions of the allowance allocated to other categories or by the unallocated portion. The table on page 90 presents the allocation of the allowance for credit losses to major categories of loans. NON-ACCRUAL, RESTRUCTURED AND PAST DUE LOANS AND LEASES AND OTHER REAL ESTATE OWNED The table on page 27 presents data on the corporation's non-accrual, restructured and 90-day past due loans and leases and other real estate owned. Generally, the accrual of interest on a loan or a lease is suspended when the credit becomes 90 days past due unless fully secured and in the process of collection. A restructured loan is generally a loan that is accruing interest, but on which concessions in terms have been made as a result of deterioration in the borrower's financial condition. Non-performing assets, including non-accrual, restructured and other real estate owned, and 90-day past due loans and leases, total $285.5 million, or 0.6 percent of total assets, at December 31, 1993, compared with $372.7 million, or 0.8 percent of total assets at December 31, 1992. This decline is due to decreases in real estate and commercial non- accrual loans of $29.6 million and $23.5 million, respectively, and a $36.2 million decrease in other real estate owned, partially offset by a $5.0 million increase in restructured loans. The reduction in primary earnings per share due to total non-accrual and restructured loans was four cents in 1993, compared with eight cents in 1992 and 12 cents in 1991. In 1993, the Financial Acounting Standards Board issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Imparement of a Loan,"(FAS 114) which must be adopted for the corporation's 1995 financial statements. It requires that impared loans, as defined within FAS 114, be measured based on the present value of expected future cash flow discounted at the loan's effective rate, at the loan's market price, or the fair value of the collateral if the loan is collateral dependent. The adoption of FAS 114 is not expected to have a material effect on the corporation's consolidated financial statements. Norwest Corporation and Subsidiaries NON-ACCRUAL, RESTRUCTURED AND PAST DUE LOANS AND OTHER REAL ESTATE OWNED *Excludes non-accrual and restructured loans and leases. FUNDING SOURCES INTEREST BEARING-LIABILITIES At December 31, 1993, interest-bearing liabilities totaled $36.8 billion, an increase of $1.8 billion over December 31, 1992. The increase is principally due to a $2.3 billion increase in interest bearing deposits primarily as a result of the Citibank (Arizona) and Columbia Savings acquisitions and a $2.3 billion increase in long-term debt, partially offset by a $2.9 billion decrease in short-term borrowings. Average interest-bearing liabilities were $35.7 billion in 1993, compared with $32.9 billion in 1992, primarily due to a 3.5 percent increase in average interest bearing deposits, a 3.7 percent increase in short-term borrowings and a 44.7 percent increase in average long-term debt. CORE DEPOSITS In the corporation's banking subsidiaries, demand deposits, regular savings and NOW accounts, money market checking and savings accounts and consumer savings certificates provide a stable source of low-cost funding. These funds accounted for approximately 61 percent of the corporation's total funding sources during 1993 and approximately 63 percent in 1992. This is a high level of core deposits by industry standards. In the corporation's Banking Group, where these funds are utilized, average core deposits accounted for approximately 64 percent of total funding sources during 1993 compared with 67 percent in 1992. PURCHASED DEPOSITS In addition to core deposits, purchased deposits are an important source of funding for the corporation's banking subsidiaries. Purchased deposits include certificates of deposit with denominations of more than $100,000 and foreign time deposits. Purchased deposits represented approximately 4 percent of the corporation's total funding sources in 1993 and 1992. SHORT-TERM BORROWINGS Short-term borrowings include federal funds purchased, securities sold under agreements to repurchase and commercial paper issued by the corporation and Norwest Financial. Commercial paper is used by the corporation to fund the short-term needs of its subsidiaries, consisting primarily of funding of Norwest Mortgage's inventory of mortgages held for sale which are typically held for 60 to 90 days. Norwest Financial utilizes funds generated through its own commercial paper sales program to fund approximately 23 percent of its average earnings assets in 1993 compared with 22 percent in 1992. On January 6, 1994, Standard & Poor's upgraded the corporation's commercial paper rate from A1 to A1+. In its initial rating of the corporation and Norwest Financial, Fitch Investors Service, Inc. assigned an+ to both the corporation's and Norwest Financial's commercial paper. The corporation's commercial paper/short-term debt is rated A1+, Duff 1+, TBW-1, and P1 by IBCA, Duff & Phelps, Thomson BankWatch, and Moody's, respectively. Norwest Financial's commercial paper/short-term debt is also rated A1+, Duff 1+, TBW-1 and P1 by Standard & Poor's, Duff & Phelps, Thomson BankWatch and Moody's, respectively. On average, total short-term borrowings represented approximately 15 percent of the corporation's total funding sources during 1993 and approximately 17 percent during 1992. At December 31, 1993, the corporation had available lines of credit totaling $1,172.7 million, including lines of credit totaling $972.7 million at Norwest Financial. These financing arrangements require the maintenance of compensating balances or payment of fees, which are not material. LONG-TERM DEBT Long-term debt represents an important funding source for the corporation and for Norwest Financial. Total long-term debt represented approximately 13 percent of the corporation's consolidated average funding sources during 1993 compared with approximately 10 percent in 1992. The corporation utilizes long-term debt primarily to meet the long-term funding requirements of its subsidiaries, with outstandings of $4,060.7 million as of December 31, 1993 compared with $2,083.7 million as of December 31, 1992. Five banking subsidiaries are members of the Federal Home Loan Bank allowing them to receive long-term advances secured by certain loans and investment securities. As of December 31, 1993, these banking subsidiaries had advances outstanding totaling $2,446.6 million, an increase of $1,027.5 million from December 31, 1992. Long-term debt plays an even more significant role at Norwest Financial, which utilizes this source of financing to fund approximately 55 percent of its average earning assets. At December 31, 1993, Norwest Financial's long-term debt outstanding was $2,741.7 million. The table on page 59 presents the corporation's outstanding consolidated long-term debt as of December 31, 1993 and 1992. On January 6, 1994, Standard & Poor's upgraded the corporation's senior debt rating from A+ to AA-, subordinated debt rating from A to A+ and preferred stock rating from A- to A. In addition, on November 3, 1993, Thomson BankWatch upgraded the corporation's senior debt rating from AA to AA+, subordinated debt rating from AA- to AA and preferred stock rating from A+ to AA-. In its initial rating of Norwest Financial, Thomson BankWatch assigned a senior debt rating of AA+ and a subordinated debt rating of AA and also assigned Norwest Financial Thomson BankWatch's highest issuer rating, which is A. Also in November 1993, Fitch Investors Service, Inc., in its initial rating of the corporation's debt, assigned a shelf registration and senior debt rating of AA, a subordinated debt rating of AA- and a preferred stock rating of A+. Duff & Phelps, IBCA and Moody's have currently rated the corporation's senior debt AA-, AA- and A1, respectively. Norwest Financial's senior debt is currently rated AA+ by Thomson BankWatch and Fitch Investors Service, Inc., AA by Duff & Phelps, AA- by Standard & Poor's and Aa3 by Moody's. In early 1993, Thomson BankWatch assigned their highest issuer rating to the corporation, an A rating, which is shared by only four others among the 35 largest domestic bank holding companies, Banc One Corporation, SunTrust Banks, Inc., J.P.Morgan & Co. Incorporated and Wachovia Corporation. ASSET AND LIABILITY MANAGEMENT The goal of the asset and liability management process is to manage the structure of the balance sheet to provide the maximum level of net interest income while maintaining acceptable levels of interest sensitivity risk (as defined below) and liquidity. The focal point of this process is the corporate Asset and Liability Management Committee (ALCO). This committee which meets weekly, forms policies governing investments, funding sources, off-balance sheet commitments, overall interest sensitivity risk and liquidity. These policies form the framework for management of the asset and liability process at the corporate, regional and affiliate levels, and compliance with such policies is monitored at regular intervals by ALCO. DEFINITION OF INTEREST SENSITIVITY RISK Interest sensitivity risk is the risk that future changes in interest rates will reduce net interest income or the market value of the corporation's balance sheet. There are two basic ways of defining interest rate risk in the financial services industry; the risk to reported earnings, sometimes referred to as the accounting perspective, and the risk to the market value of the balance sheet, sometimes referred to as the economic perspective. The accounting perspective focuses on the risk to reported net income over a particular time frame. Differences in the timing of interest rate repricing (repricing or "gap" risk), changing market rate relationships (basis risk) and option positions determine the exposure of net income to changes in interest rates. The economic perspective focuses on the market value of the corporation's balance sheet, the net of which is referred to as the market value of balance sheet equity. The sensitivity of the market value of balance sheet equity to changes in interest rates is an indicator of the level of interest rate risk inherent in an institution's current position and an indicator of longer horizon earnings trends. Assessing interest rate risk from the economic perspective focuses on the risk to net worth arising from all repricing mismatches (gaps) and other interest rate sensitive positions, such as options, across the full maturity spectrum. Both perspectives have their advantages and disadvantages. The corporation believes that the two perspectives are complementary, and should be used together to provide a more complete picture of interest rate risk than would be provided by either perspective alone. MEASUREMENT OF INTEREST RATE RISK Measurement of interest rate risk from the accounting perspective has traditionally taken the form of the gap report, which represents the difference between assets and liabilities that reprice in a given time period. While providing a rough measure of rate risk, the gap report has a number of drawbacks, including the fact that it is a static (i.e. point-in-time) measurement, it does not capture basis risk, and it does not capture risk that varies either asymmetrically or non-proportionately with rate movements, such as option risk. Because of the drawbacks of gap reports, the corporation uses a simulation model as its primary method of measuring earnings risk. The simulation model, because of its dynamic nature, can capture the effects of future balance sheet trends, different patterns of rate movements, and changing relatonships between rates (basis risk). In addition, it can capture the effects of embedded option risk by taking into account the effects of interest rate caps and floors, and varying the level of prepayment rates on assets as a function of interest rates. An example of the difference between the two methods of measurement was the interest rate floors that the corporation purchased in prior years to hedge securities with prepayment options against a decline in rates. The effect of these floors was easy to measure with a simulation model, but difficult to show in a gap report. Another example is the tendency of money market deposit rates to lag substantially behind changes in market interest rates. The lag relationship may depend on a number of factors, such as the direction and speed of rate of movements and the absolute level of rates. This relationship is difficult to show in a gap report, but easy to capture in a simulation model. Measurement of interest rate risk from the economic perspective is accomplished with a market valuation model. The market value of each asset and liability is calculated by computing the present value of all cash flows generated by it. In each case the cash flows are discounted by a market interest rate chosen to reflect as closely as possible the characteristics of the given asset or liability. MANAGEMENT OF INTEREST RATE RISK The managment of interest rate risk is governed by an interest sensitivity policy. The policy places a limit on the amount of earnings that may be put at risk to rate movements. While this determines the limits of the corporation's sensitivity position, the position that is maintained at any given time is a function of balance sheet trends, asset opportunities, and interest rate expectations. The sensitivity position at any given time is normally well within the policy limits, which is the case with the current position. The simulation model is used to determine the one year and three year gap levels which correspond to the limit in which the corporation has placed earnings at risk to interest rate movement, and these gap levels constitute the limits within which the corporation will manage its interest sensitivity position. Thus, gap reports are used, in conjunction with the simulation model, to monitor rate risk, but gaps are not used as the primary measure of rate risk. With regard to market valuation risk, the market valuation model is used to measure the sensitivity of the market value of equity to a wide range of interest rate changes. These results are reviewed with ALCO on a quarterly basis. No specific policy limits have yet been set on market valuation risk. The process of modeling market valuation risk is new to the financial services industry, and no standards exist within the industry for structuring the modeling process or using the results to define policy limits. The process of developing an understanding of all the issues raised in the measurement and interpretation of this risk is still evolving. CHANGES IN INTEREST SENSITIVITY The table on page 32 presents the corporation's interest sensitivity gaps for December, 1993. The cumulative gap within one year was positive $2,126 million, or 4.2 percent of assets. This compares with a one year gap of negative $985 million, or 2.2 percent of assets, in December, 1992. The cumulative gap within three years was positive $1,915 million, or 3.7 percent of assets, in December 1993, compared to negative $1,283 million, or 2.8 percent of assets, in December, 1992. The movement of the gap from negative to a positive was due to a shift in the investment portfolio from fixed rate to variable rate securities, as well as increases in retail deposits and demand deposits, part of which have fixed rate sensitivity. The effect of the current interest sensitivity position is to effectively eliminate vulnerability of the corporation's earnings to rising interest rates while allowing it to benefit from stable rates. The current sensitivity position is well within the risk limits set by the corporation's interest sensitivity policy. Norwest Corporation and Subsidiaries INTEREST RATE SENSITIVITY * [Assets - (liabilities + equity) + swaps and options] The gap includes the effect of off-balance sheet instruments on the corporation's interest sensitity, with the exception of purchased interest rate floors, whose downside risk is limited. LIQUIDITY MANAGEMENT Liquidity management involves planning to meet anticipated funding needs at a reasonable cost, as well as contingency plans to meet unanticipated funding needs or a loss of funding sources. Liquidity management for the corporation is governed by policies formulated and monitored by ALCO, which take into account the marketability of assets, the sources and stability of funding, and the level of unfunded commitments. While each affiliate is responsible for managing its own liquidity position within overall guidelines, ALCO monitors the overall liquidity position. The corporation has a significant liquidity reserve in its investment/mortgage-backed securities portfolio: approximately 88 percent of the $11.3 billion portfolio consists of Treasury or federal agency securities. These securities are highly marketable and currently have a market value well in excess of book value. Several other factors provide a favorable liquidity position for the corporation compared with most large bank holding companies, including the large amount of funding that comes from consumer deposits, which are a more stable source of funding than purchased funds, as well as the geographic diversity of the customer base. CAPITAL MANAGEMENT The corporation believes that a strong capital position is vital to continued profitability and to promote depositor and investor confidence. The corporation's consolidated capital levels are a result of its capital policy which establishes guidelines for each subsidiary based on industry standards, regulatory requirements, perceived risk of the various businesses, and future growth opportunities. The corporation requires its bank affiliates to maintain capital levels above regulatory minimums for Tier 1 capital, total capital (Tier 1 plus Tier 2) to risk-based assets and leverage ratios. The primary source of equity capital available for the affiliates is earnings, with other forms of capital available from the corporation as needed. Earnings above levels required to meet capital policy requirements are paid to the corporation in the form of dividends and are used to support capital needs of other affiliates, the payment of corporate dividends or to reduce the corporation's borrowings. Through the implementation of its capital policies, the corporation has achieved a strong capital position. The corporation's Tier 1 capital ratio at December 31, 1993 was 9.84 percent and its total capital to risk-based assets ratio was 12.60 percent, compared with 10.03 percent and 12.85 percent at December 31, 1992, respectively. The corporation's leverage ratio was 6.60 percent at December 31, 1993, compared with 6.76 percent at December 31, 1992. These ratios compare favorably to the regulatory minimums of 4.0 percent for Tier 1, 8.0 percent for total capital to risk-based assets, and 3.0 percent for leverage ratio. The corporation's common equity capital continued to grow in 1993. Common stockholders' equity increased to $3.2 billion as of December 31, 1993, a 15.3 percent increase over year-end 1992. The corporation's internal capital growth rate (ICGR) in 1993 was 14.7 percent. The ICGR represents the rate at which the corporation's average common equity grew as a result of earnings retained (net income less dividends paid). Since 1986 the corporation has repurchased common stock in the open market in a systematic pattern to meet the common stock issuance requirements of the corporation's Dividend Reinvestment Plan, the Savings-Investment Plans, the 1985 Long Term Incentive Compensation Plan, and other stock issuance requirements other than acquisitions accounted for as a pooling of interests. In January, 1994, the corporation's board of directors authorized additional purchases, at management's discretion, of 8,000,000 shares of the corporation's common stock, bringing the total common stock purchase authority to 12,200,000 shares. In 1992, the corporation stated its intention to engage in open market or privately negotiated purchases of depository shares representing its 10.24% Cumulative Preferred Stock and its Cumulative Convertible Preferred Stock, Series B. The corporation has not established any specific objectives for the amount of the depository shares that it may repurchase. In 1993, the corporation repurchased 25,800 depository shares (representing 6,450 shares of stock), or 0.6 percent of total outstanding shares of the 10.24% Cumulative Preferred Stock. Total depository shares repurchased since 1992 include 75,000, or 1.6 percent of total outstanding shares, and 25,000, or 0.5 percent of total outstanding shares, of the 10.24% Cumulative Preferred Stock and Cumulative Convertible Preferred Stock, Series B, respectively. In the second quarter of 1993, the corporation increased the quarterly cash dividend paid to common stockholders form 14.5 cents per share to 16.5 cents per share. This represents a 13.8 percent increase in the quarterly dividend rate and reflects the corporation's continuing record of strong earnings performance and the corporation's policy of maintaining the dividend payout ratio in a range of 30 to 35 percent. Also during the second quarter 1993, the corporation declared a two-for- one stock split in the form of a 100 percent stock dividend payable June 28, 1993 to holders of record as of June 4, 1993. In January 1994, the corporation increased its dividend 12.1 percent to 18.5 cents per common share. ACQUISITIONS The corporation regularly explores opportunities for acquisitions of financial institutions and related businesses. Generally, management of the corporation does not make a public announcement about an acquisition opportunity until a definitive agreement has been signed. On January 14, 1994, the corporation completed its acquisition of First United Bank Group, Inc. (First United), a multibank holding company headquartered in Albuquerque, New Mexico, with total assets of $3.9 billion. The corporation issued 17,784,916 shares of its common stock in connection with the acquisition. The acquisition will be accounted for using the pooling of interests method. On January 1, 1994, the corporation completed its acquisition of St. Cloud National Bank & Trust Co., a $119 million bank, and on January 6, 1994, closed on St. Cloud Metropolitan Agency, Inc., an insurance agency and issued 1,105,820 and 32,969 common shares, respectively. On December 10, 1993, the corporation completed its acquisition of Winner Banshares, Inc., a $99 million bank holding company headquartered in Winner, South Dakota and issued 530,737 common shares. On October 29, 1993, the corporation completed its acquisition of FirstAmerican Bank, N.A., a $47.6 million bank, located in Colorado Springs, Colorado. On October 7, 1993, the corporation completed its acquisition of Ralston Bancshares, Inc., a $101.1 million bank holding company headquartered in Ralston, Nebraska, and issued 548,981 common shares. October 1, 1993, the corporation completed its acquisition of M & D Holding Company, a $57.1 million bank holding company headquartered in Spring Lake Park, Minnesota, and issued 536,084 common shares. On September 10, 1993, Norwest Bank Denver, N.A., a banking subsidiary of the corporation, completed its acquisition of $1.1 billion in assets of the Columbia Savings division of First Nationwide Bank, a Federal Savings Bank. On September 1, 1993, Norwest Bank Arizona, N.A., a subsidiary of the corporation, completed its acquisition of the $2.1 billion banking business of Citibank (Arizona), a subsidiary of Citicorp. On April 1, 1993, the corporation completed its acquisition of Financial Concepts Bancorp, Inc., a $175.5 million bank holding company headquartered in Green Bay Wisconsin, and issued 847,416 common shares. On February 1, 1993, the corporation completed its acquisitions of Merchants & Miners Bancshares, Inc., a $57 million bank holding company headquartered in Hibbing, Minnesota, and BORIS Systems, Inc., a $6 million data processing/transmission service, headquartered in East Lansing, Michigan, which provides services to more than 100 boards of realtors located throughout the United States, and issued 343,050 and 691,210 common shares, respectively. On January 8, 1993, the corporation completed its acquisition of Rocky Mountain Bankshares, Inc., a $105 million bank holding company with a bank in Aspen, Colorado, and issued 557,084 common shares. The acquisitions of St. Cloud National Bank & Trust Co., Winner Banshares, Inc., Ralston Bancshares, Inc. and Financial Concepts Bancorp, Inc. were accounted for using the pooling of interests method of accounting; however, the financial results of the corporation have not been restated because the effect of these acquisitions on the corporation's financial statements was not material. The acquisitions of St. Cloud Metropolitan Agency, Inc., FirstAmerican, N.A., M & D Holding Company, Columbia Savings, Citibank (Arizona), Merchants & Miners Bancshares, Inc., BORIS Systems, Inc. and Rocky Mountain Bankshares, Inc. were accounted for using the purchase method. On February 9, 1993, the corporation completed its acquisition of Lincoln Financial Corporation (Lincoln), a $2.0 billion bank holding company headquartered in Fort Wayne, Indiana. The corporation issued 8,529,242 shares of its common stock in connection with the acquisition. The acquisition was accounted for using the pooling of interests method of accounting and, accordingly, the corporation's financial statements have been restated for all periods prior to the acquisition to include the accounts and operations of Lincoln. As of January 19, 1994, the corporation had eight other pending acquisitions with total assets of approximately $1.3 billion. The corporation expects to issue approximately 10.4 million common shares upon completion of these acquisitions. These acquisitions, subject to approval by the regulatory agencies, are expected to be completed during 1994 and are not significant to the financial statements of the corporation, either individually or in the aggregate. Norwest Corporation and Subsidiaries CONSOLIDATED BALANCE SHEET In millions, except shares See Notes to consolidated financial statements. Norwest Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF INCOME In millions, except per share amounts (CONTINUED ON PAGE 38) Norwest Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF INCOME (CONTINUED FROM PAGE 37) In millions, except per share amounts See notes to consolidated financial statements Norwest Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS In millions (CONTINUED ON PAGE 40) Norwest Corporation and Subsidiaries CONSOLIDATED STATEMENT OF CASH FLOWS (CONTINUED FROM PAGE 39) In millions (CONTINUED ON PAGE 41) Norwest Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED FROM PAGE 40) In millions See notes to consolidated financial statements. Norwest Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED ON PAGE 43) Norwest Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED FROM PAGE 42) See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Norwest Corporation (the "corporation") is a regional bank holding company organized in 1929 and registered under the Bank Holding Company Act of 1956, as amended. The corporation is a diversified financial services organization which operates through subsidiaries engaged in banking and related businesses. The corporation provides retail, commercial, and corporate banking services to its customers through banks located in Arizona, Colorado, Illinois, Indiana, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Ohio, South Dakota, Texas, Wisconsin and Wyoming. The corporation also owns subsidiaries engaged in various businesses related to banking, principally mortgage banking, equipment leasing, agricultural finance, commercial finance, consumer finance, securities brokerage and investment banking, insurance, computer and data processing services, trust services and venture capital investments. The accounting and reporting policies of the corporation and its subsidiaries conform to generally accepted accounting principles and general practices within the financial services industry. The more significant accounting policies are summarized below. CONSOLIDATION The consolidated financial statements include the accounts of the corporation and all subsidiaries. Significant intercompany accounts and transactions have been eliminated. CHANGE IN ACCOUNTING FOR POSTRETIREMENT MEDICAL BENEFITS Effective January 1, 1992, the corporation adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106). FAS 106 requires employers to accrue the cost of retiree health care benefits and the cost of all other postretirement benefits other than pensions during the employees' active service. In prior years, this expense was recognized when benefits were paid. The cumulative liability for these expenses for years prior to 1992 of $76.0 million after tax, or $0.26 per common share, was recognized as a cumulative effect of accounting change as of January 1, 1992. As a result of applying the new method of accounting for postretirement medical benefits, medical benefits expense increased $9.5 million in 1992. CONSOLIDATED STATEMENTS OF CASH FLOWS For purposes of the consolidated statements of cash flows, the corporation considers cash and due from banks, interest-bearing deposits with banks and federal funds sold and resale agreements to be cash equivalents. Cash paid for interest and income taxes for the years ended December 31 was: In millions 1993 1992 1991 Interest $1,395.4 1,550.3 2,049.2 Income taxes 216.1 196.7 52.4 Loans transferred to other real estate owned totaled $66.8 million in 1993, $104.5 million in 1992, and $113.3 million in 1991. Investment and mortgage-backed securities of $13,878.0 million and student loans of $1,330.3 million were transferred to available for sale in 1992. During 1993 and 1992, the corporation issued 2,127,428 and 899,972 shares of common stock, respectively, in connection with acquisitions accounted for using the purchase method. SECURITIES Investment and mortgage-backed securities which the corporation intends to hold until maturity are stated at cost, adjusted for amorization of premiums and accretion of discounts using a method that approximates level yield. Investment and mortgage-backed securities which the corporation intends to hold for indefinite periods of time, including securities that management intends to use as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, securities on which call options have been written, the need to increase regulatory capital or similar factors, are classified as available for sale. Securities available for sale are stated at the lower of aggregate cost or market value. Investment and mortgage-backed securities are transferred to securities available for sale at their respective carrying value. Gains and losses on the sales of investment and mortgage-backed securities are computed by the specific identification method. Trading account securities are purchased with the intent to earn a profit by trading or selling the security. These securities are stated at market value. Adjustments to the carrying value are reported in other non-interest income. Securities held by the venture capital subsidiaries are included in investment securities available for sale and are stated at the lower of aggregate cost or market value. Gains and losses on the sales of such securities are computed on a specific identification basis. LOANS AND LEASES Loans are stated at their principal amount. Interest income is recognized on an accrual basis except when a loan has been past due for 90 days, unless such loan is in the process of collection and, in management's opinion, is fully secured. When a loan is placed on non- accrual status, uncollected interest accrued in prior years is charged against the allowance for credit losses. A loan is returned to accrual status when principal and interest are no longer past due and collectibility is no longer doubtful. Restructured loans are those on which concessions in terms have been made as a result of deterioration in a borrower's financial condition. Interest on these loans is accrued at the new terms. Lease financing assets include aggregate lease rentals, net of related unearned income, which includes deferred investment tax credits, and related nonrecourse debt. Leasing income is recognized as a constant percentage of outstanding lease financing balances over the lease terms. Unearned discount on consumer loans is recognized by either the interest method or methods for which results are not materially different from the interest method. Loan origination fees and costs incurred to extend credit are deferred and amortized over the term of the loan and the loan commitment period as a yield adjustment. Loan fees representing adjustments of interest rate yield are generally deferred and amortized into interest income over the term of the loan using the interest method. Loan commitment fees are generally deferred and amortized into non-interest income on a straight- line basis over the commitment period. At December 31, 1993 and 1992, the corporation had $1,351.3 and $1,158.6 million, respectively, of student loans available for sale because the corporation does not intend to hold these loans for the forseeable future. Student loans available for sale are stated at the lower of aggregate cost or market value. Student loans were transferred to available for sale at their carrying value. ALLOWANCE FOR CREDIT LOSSES The allowance for credit losses is based upon management's evaluation of a number of factors, including credit loss experience, risk analysis of loan portfolios, as well as current and expected economic conditions. Charge-offs are loans or portions thereof evaluated as uncollectible. Loans made by the consumer finance subsidiaries, unless fully secured by real estate, are generally charged off when the loan is 90 days or more contractually delinquent and no payment has been received for 90 days. Credit card receivables are generally charged off when they become 180 days past due or sooner upon receipt of a bankruptcy notice. Other consumer loans are generally charged off when they become 120 days past due unless fully secured. MORTGAGES HELD FOR SALE Mortgages held for sale are stated at the lower of aggregate cost or market value. The determination of market value includes consideration of all open positions, outstanding commitments from investors, and related fees paid. Gains and losses on sales of mortgages are recognized at settlement dates. Gains and losses are determined by the difference between sales proceeds and the carrying value of the mortgages. PURCHASED MORTGAGE SERVICING RIGHTS The costs of purchased mortgage servicing rights are capitalized and are either deferred, if anticipated to be sold concurrent with the sale of the mortgage, or, if the servicing rights are retained, amortized over the estimated remaining life of the underlying loans using a method which approximates the level yield method. The carrying value of purchased mortgage servicing rights is periodically evaluated in relation to estimated future servicing net revenues. PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation and amortization. Owned properties are depreciated on a straight-line basis over their estimated useful lives. Capital lease assets and leasehold improvements are amortized over lease terms on a straight-line basis. The cost of improvements are capitalized while maintenance and repairs as well as gains and losses on dispositions of premises and equipment are included in non-interest expenses. OTHER REAL ESTATE OWNED Other real estate owned is stated at the lower of cost or 70 percent of current appraised value, which is not materially different from fair value minus estimated costs to sell. When a property is acquired, the excess of the recorded investment in the property over fair value, if any, is charged to the allowance for credit losses. Subsequent declines in the estimated fair value, net operating results and gains or losses on disposition of the property are included in other non-interest expenses. GOODWILL AND OTHER INTANGIBLES Goodwill represents the unamortized cost of acquiring subsidiaries and other net assets in excess of the appraised value of such net assets at the date of acquisition. In 1993, the corporation changed the amortizable life of goodwill to a maximum of 15 years from amortizable lives ranging from 15-30 years. Goodwill is amortized using the straight-line method. Other identifiable intangibles are amortized straight-line over various periods not to exceed 15 years. INTEREST RATE FUTURES, CAPS AND FLOORS, AND FORWARD CONTRACTS The corporation uses interest rate futures, caps and floors and forward contracts as part of its overall interest rate risk management strategy. Realized gains and losses on positions used in the management of specific asset and liability positions in banking operations are deferred and amortized over the terms of the items hedged as adjustments to interest income or interest expense. Realized gains and losses on positions used as hedges in mortgage banking operations are deferred and recognized when the related mortgages are sold. Positions which are not hedges of specific assets, liabilities or commitments are valued at market and the resulting gains or losses are recognized currently. The corporation also uses option agreements as part of its overall risk management strategy. Premiums paid on purchased put options which qualify as hedges are deferred and amortized over the terms of the contracts. Purchased options for uncovered puts are marked to market daily with losses limited to the amount of the option fee. Losses are recognized currently on put options sold when the market value of the underlying security falls below the put price plus the premium received. A premium received on a covered call option sold is deferred until the option matures. If the market value of the related asset is greater than the option strike price, the option will be exercised and the premium recorded as an adjustment of the gain or loss recognized. If the option expires the premium is recorded in other non-interest income. Uncovered calls sold are marked to market daily with the gain limited to the amount of the option fee. INTEREST RATE SWAPS The corporation and its subsidiaries have entered into interest rate swaps as a tool to manage the interest sensitivity of the balance sheet. The contracts represent an exchange of interest payments, and the underlying principal balances of the assets or liabilities are not affected. Net settlement amounts are reported as adjustments to interest income or interest expense. INCOME TAXES The corporation and its United States subsidiaries file a consolidated federal income tax return. The effects of current or deferred taxes are recognized as a current and deferred tax liability or asset based on current tax laws. Accordingly, income tax expense in the consolidated statements of income includes charges or credits to properly reflect the current and deferred tax asset or liability. Foreign taxes paid are applied as credits to reduce federal income taxes payable. In 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (FAS 109) effective January 1, 1993. The corporation adopted FAS 109 as of January 1, 1993, with no material impact on the consolidated financial statements of the corporation. Prior to adoption of FAS 109, the corporation accounted for income taxes under Statement of Financial Accounting Standards No. 96. FOREIGN CURRENCY TRANSLATION The accounts of the corporation's Canadian subsidiary are measured using local currency as the functional currency. Assets and liabilities are translated into United States dollars at period-end exchange rates, and income and expense accounts are translated at average monthly exchange rates. Net exchange gains or losses resulting from such translation are excluded from net income and included as a separate component of stockholders' equity. EARNINGS PER SHARE Income for primary and fully diluted earnings per share is adjusted for preferred stock dividends. Primary earnings per share data is computed based on the weighted average number of common shares outstanding and common stock equivalents arising from the assumed exercise of outstanding stock options. Fully diluted earnings per share data is computed by using such average common shares and equivalents increased by the assumed conversion of the 6 3/4 percent convertible subordinated debentures, the 12 percent convertible notes and the 7 percent convertible preferred stock into common stock. Income for fully diluted earnings per share is also adjusted for interest expense on these debentures and notes, net of the related income tax effect, and preferred stock dividends related to the convertible preferred stock. Weighted average numbers of common and common equivalent shares applied in calculating earnings per share are as follows: 1993 1992 1991 Primary 293,347,385 290,552,332 285,353,846 Fully diluted 306,024,123 304,962,600 292,724,080 2. BUSINESS COMBINATIONS The corporation regularly explores opportunities for acquisitions of financial institutions and related businesses. Generally, management of the corporation does not make a public announcement about an acquisition opportunity until a definitive agreement has been signed. On January 14, 1994, the corporation completed its acquisition of First United Bank Group, Inc. (First United), a multibank holding company headquartered in Albuquerque, New Mexico, with total assets of $3.9 billion. The corporation issued 17,784,916 shares of its common stock in connection with the acquisition. The acquisition will be accounted for using the pooling of interests method. Unaudited pro forma net income and net income per share amounts, representing a combination of the corporation and First United for the years ended December 31, 1993, 1992 and 1991 are: On January 1, 1994, the corporation completed its acquisition of St. Cloud National Bank & Trust Co., a $119 million bank, and on January 6, 1994, closed on St. Cloud Metropolitan Agency, Inc., an insurance agency and issued 1,105,820 and 32,969 common shares, respectively. On December 10, 1993, the corporation completed its acquisition of Winner Banshares, Inc., a $99 billion bank holding company headquartered in Winner, South Dakota, and issued 530,737 common shares. On October 29, 1993, the corporation completed its acquisition of FirstAmerican Bank, N.A., a $47.6 million bank, located in Colorado Springs, Colorado. On October 7, 1993, the corporation completed its acquisition of Ralston Bancshares, Inc., a $101.1 million bank holding company headquartered in Ralston, Nebraska, and issued 548,981 common shares. October 1, 1993, the corporation completed its acquisition of M & D Holding Company, a $57.1 million bank holding company headquartered in Spring Lake Park, Minnesota, and issued 536,084 common shares. On September 10, 1993, Norwest Bank Denver, N.A., a banking subsidiary of the corporation, completed its acquisition of $1.1 billion in assets of the Columbia Savings division of First Nationwide Bank, a Federal Savings Bank. On September 1, 1993, Norwest Bank Arizona, N.A., a subsidiary of the corporation, completed its acquisition of the $2.1 billion banking business of Citibank (Arizona), a subsidiary of Citicorp. On April 1, 1993, the corporation completed its acquisition of Financial Concepts Bancorp, Inc., a $175.5 million bank holding company headquartered in Green Bay Wisconsin, and issued 847,416 common shares. On February 1, 1993, the corporation completed its acquisitions of Merchants & Miners Bancshares, Inc., a $57 million bank holding company headquartered in Hibbing, Minnesota, and BORIS Systems, Inc., a $6 million data processing/transmission service, headquartered in East Lansing, Michigan, which provides services to more than 100 boards of realtors located throughout the United States, and issued 343,050 and 691,210 common shares, respectively. On January 8, 1993, the corporation completed its acquisition of Rocky Mountain Bankshares, Inc., a $105 million bank holding company with a bank in Aspen, Colorado, and issued 557,084 common shares. The acquisitions of St. Cloud National Bank & Trust Co., Winner Banshares, Inc., Ralston Bancshares, Inc. and Financial Concepts Bancorp, Inc. were accounted for using the pooling of interests method of accounting; however, the financial results of the corporation have not been restated because the effect of these acquisitions on the corporation's financial statements was not material. The acquisitions of St. Cloud Metropolitan Agency, Inc., FirstAmerican Bank, N.A., M & D Holding Company, Columbia Savings, Citibank (Arizona), Merchants & Miners Bancshares, Inc., BORIS Systems, Inc. and Rocky Mountain Bankshares, Inc. were accounted for using the purchase method. On February 9, 1993, the corporation completed its acquisition of Lincoln Financial Corporation (Lincoln), a $2.0 billion bank holding company headquartered in Fort Wayne, Indiana. The corporation issued 8,529,242 shares of its common stock in connection with the acquisition. The acquisition was accounted for using the pooling of interests method of accounting and, accordingly, the corporations' financial statements have been restated for all periods prior to the acquisition to include the accounts and operations of Lincoln. Net income and net income per share amounts of the corporation and Lincoln prior to restatement for the years ended December 31, 1992 and 1991 were: In millions, except per share amounts 1992 1991 The corporation Net income $446.7 $422.1 Net income per share Primary 1.48 1.46 Fully diluted 1.47 1.44 Lincoln Net loss $(82.6) (21.2) Net loss per share (11.47) (2.96) As of January 19, 1994, the corporation had eight other pending acquisitions with total assets of approximately $1.3 billion. The corporation expects to issue approximately 10.4 million common shares upon completion of these acquisitions. These acquisitions, subject to approval of regulatory authorities, are expected to be completed during 1994 and are not significant to the financial statements of the corporation, either individually or in the aggregate. On December 29, 1992, the corporation acquired Am-Can Investment, Inc., a $33 million bank holding company headquartered in Moorhead, Minnesota, for cash. On October 2, 1992, the corporation completed its acquisition of United Bancshares, Inc. a $174 million bank holding company headquartered in Lincoln, Nebraska and issued 899,972 common shares. These acquisitions were accounted for using the purchase method. Effective January 19, 1992, Davenport Bank and Trust Company (Davenport Bank), an Iowa banking corporation headquartered in Davenport, Iowa, consolidated with Bettendorf Bank, National Association, a banking subsidiary of the corporation. The corporation issued 19,331,426 shares of its common stock to former Davenport Bank shareholders in connection with the consolidation. The consolidation was accounted for using the pooling of interests method of accounting and, accordingly, the corporation's financial statements have been restated for all periods prior to the consolidation to include the accounts and operations of Davenport Bank. On November 27, 1991, the corporation acquired MIG Insurance Brokers, Inc. (MIG), an insurance brokerage company headquartered in Minneapolis, Minnesota. As provided under the agreement, the corporation issued 230,000 shares of its common stock in exchange for all outstanding shares of MIG common stock. This acquisition was accounted for using the pooling of interests method of accounting. Financial statements prior to the acquisition date were not restated due to immateriality. Effective April 19, 1991, United Banks of Colorado, Inc. (United), a $5.5 billion bank holding company headquartered in Denver, Colorado, merged with the corporation. As provided under the agreement, the corporation issued 38,515,662 shares of its common stock in exchange for all outstanding shares of United's common stock. In addition, each outstanding share of United preferred stock was converted into the right to receive $51.50 in cash plus accrued dividends. The merger was accounted for using the pooling of interest method of accounting and accordingly, the corporation's financial statements have been restated for all periods prior to the acquisition to include the accounts and operations of United. 3. RESTRICTIONS ON CASH AND DUE FROM BANKS The corporation's banking subsidiaries are required to maintain reserve balances in cash with Federal Reserve Banks. The average amount of those reserve balances was approximately $518 million and $433 million for the years ended December 31, 1993 and 1992, respectively. 4. INVESTMENT SECURITIES Information related to the carrying and market values of investment and mortgage-backed securities for the three years ended December 31 is provided in the table on page 51. At December 31, 1991, no investment or mortgage-backed securities were classified as available for sale. CARRYING AND MARKET VALUES OF INVESTMENT AND MORTGAGE-BACKED SECURITIES The gross unrealized gains and losses on investment and mortgage backed securities at December 31 were: The carrying and market values of investments and mortgage-backed securities by maturity at December 31 were: Interest income on investment and mortgage-backed securities for each of the three years ended December 31 was: Investment and mortgage-backed securities (including securities available for sale) carried at $5,807.7 million and $5,365.4 million were pledged to secure public or trust deposits or for other purposes at December 31, 1993 and 1992, respectively. Total gross realized gains and gross realized losses from the sale of securities for each of the three years ended December 31 were: During 1993 securities held for investment with a total amortized cost of $29.5 million were called by the issuer and, therefore, sold by the corporation for a total gain on sales of $0.1 million. 5. LOANS AND LEASES The carrying values of loans and leases at December 31 were: In millions 1993 1992 Commercial $ 7,018.4 6,886.5 Construction and land development 496.2 397.6 Real estate 10,975.8 10,066.4 Consumer 8,258.5 6,759.6 Lease financing 655.4 586.3 Foreign 548.5 502.4 Total loans and leases 27,952.8 25,198.8 Unearned discount (1,007.8) (1,003.1) Loans and leases, net of unearned discount $26,945.0 24,195.7 Changes in the allowance for credit losses were: In millions 1993 1992 1991 Balance at beginning of year $ 742.7 668.1 560.0 Allowances related to assets acquired 35.7 25.5 18.8 Provision for credit losses 140.1 266.7 401.9 Credit losses (303.2) (330.3) (433.1) Recoveries 129.6 112.7 120.5 Net credit losses (173.6) (217.6) (312.6) Balance at end of year $ 744.9 742.7 668.1 Non-accrual, restructured and 90 day past due loans and other real estate owned at December 31 were: In millions 1993 1992 Non-accrual loans $172.9 231.3 Restructured loans 7.9 2.9 Total non-accrual and restructured loans 180.8 234.2 Other real estate owned 54.7 90.9 Total non-performing assets 235.5 325.1 Loans and leases past due 90 days or more* 50.0 47.6 Total non-performing assets and 90-day past due loans and leases $285.5 372.7 * Excludes non-accrual loans and leases. The effect of non-accrual and restructured loans on interest income for each of the three years ended December 31 was: In millions 1993 1992 1991 Interest income As originally contracted $17.3 24.5 38.7 As recognized (5.0) (7.3) (13.9) Reduction of interest income $12.3 17.2 24.8 There are no material commitments to lend additional funds to customers whose loans were classified as non-accrual or restructured at December 31, 1993. Leveraged lease financing amounted to $144.9 million and $131.1 million at December 31, 1993 and 1992, respectively. Deferred income taxes related to leveraged leases amounted to $99.7 million and $83.0 million at the same dates, respectively. Loans and leases totaling $4,082.3 million were pledged to secure Federal Home Loan Bank (FHLB) advances at December 31, 1993. The corporation and its subsidiaries have made loans to the executive officers and directors (and their associates) of the corporation and its significant subsidiaries in the ordinary course of business. Aggregate amounts of these loans (but excluding loans to the immediate families of persons who are solely executive officers and directors of the corporation's significant subsidiaries) were $65.3 million and $61.0 million at December 31, 1993 and 1992, respectively. Activity with respect to these loans during 1993 included advances, repayments and net decreases (due to changes in executive officers and directors) of $203.0 million, and $196.6 million and $2.1 million, respectively. 6. PREMISES AND EQUIPMENT The carrying value of premises and equipment at December 31 was: In millions 1993 1992 Owned Land $ 82.3 71.3 Premises and improvements 585.0 567.9 Furniture, fixtures and equipment 782.3 648.8 Total 1,449.6 1,288.0 Capitalized leases Premises 20.2 19.6 Equipment 14.3 12.5 Total 34.5 32.1 Total premises and equipment 1,484.1 1,320.1 Less accumulated depreciation and amortization (727.6) (656.7) Premises and equipment, net $ 756.5 663.4 7. CERTIFICATES OF DEPOSIT OVER $100,000 The corporation had certificates of deposit over $100,000 of $1,557.0 million and $1,508.4 million at December 31, 1993 and 1992, respectively. Interest expense on certificates of deposit over $100,000 was $80.4 million, $86.5 million and $159.3 million for the years ended December 31, 1993, 1992, and 1991, respectively. Total brokered certificates of deposit over $100,000 were zero at December 31, 1993 and $13.5 million at December 31, 1992. 8. SHORT-TERM BORROWINGS Information related to short-term borrowings for the three years ended December 31 is provided in the table below. At December 31, 1993, the corporation had available lines of credit totaling $1,172.7 million, including $972.7 million at a subsidiary, Norwest Financial, Inc. These financing arrangements require the maintenance of compensating balances or payment of fees, which are not material. At December 31, 1993, the corporation had revolving credit agreements totaling $200.0 million (included in the $1,172.7 million reported in the preceding paragraph). SHORT-TERM BORROWING 1993 1992 1991 In millions Amount Rate Amount Rate Amount Rate At December 31, Commercial Paper $2,711.6 3.65% $2,947.5 3.65% $3,067.2 5.07% Federal funds purchased and securities sold under agreements to repurchase 2,038.2 2.73 4,873.3 2.84 2,134.2 4.19 Other 1,055.3 3.23 848.6 5.27 752.8 4.72 Total $5,805.1 3.21 $8,669.4 3.35 $5,954.2 4.71 For the year ended December 31, Average Daily Balance Commercial Paper $2,657.0 3.37% $2,751.2 4.19% $2,739.4 6.37% Federal funds purchased and securities sold under agreements to repurchase 3,359.7 3.03 3,647.8 3.67 2,590.8 5.60 Other 1,097.1 3.85 480.8 5.09 395.3 5.97 Total $7,131.8 3.28 $6,879.8 3.98 $5,725.5 5.99 Maximum month end balance Commercial Paper $3,084.6 NA $2,947.5 NA $3,067.2 NA Federal funds purchased and securities sold under agreements to repurchase 4,580.5 NA 4,943.2 NA 3,448.1 NA Other 1,587.3 NA 849.6 NA 758.3 NA NA - not applicable 9. LONG-TERM DEBT Long-term debt at December 31 consisted of: In millions 1993 1992 Norwest Corporation (parent company only) Medium-Term Notes Series A, 4.5% to 9.1% due 1994-1998 $ 62.6 85.6 Floating Rate Medium-Term Notes, Series B, due 1995 200.0 - Floating Rate Medium-Term Notes, Series C, due 1995 to 1998 255.4 - Medium-Term Notes, Series C, 4.03% to 5.14%, due 1995 to 1998 44.6 - 12% Convertible Notes due 1993 - 6.7 ESOP Series A due 1996, 8.42% and 8.5% in 1993 and 1992, respectively 31.0 31.0 7 7/8% Notes due 1997 100.0 100.0 9 1/4% Subordinated Capital Notes due 1997 100.0 100.0 Floating Rate Subordinated Capital Notes due 1998 - 78.0 Floating Rate Subordinated Capital Notes due 1999 - 83.0 6 5/8% Subordinated Notes, due 2003 200.0 - ESOP Series B Notes due 1999, 8.52% and 8.6% in 1993 and 1992, respectively 13.3 13.3 7 3/4% Sinking Fund Debentures due 2003 - 51.8 6 3/4% Convertible Subordinated Debentures due 2003 0.3 0.5 6.65% Subordinated Debentures, due 2023 200.0 - Senior Notes, 11.22% to 11.66%, due 1994 to 1995 15.0 30.0 5.75% Senior Notes, due 1998 100.0 - 6% Senior Notes, due 2000 200.0 - Other Notes 6.0 3.8 Total 1,528.2 583.7 Norwest Financial, Inc., and its subsidiaries Senior Notes, 4,625% to 9.75%, due 1994 to 2003 2,479.2 2,141.8 Senior Subordinated Notes, 4.85% to 9.63%, due 1994 to 1998 262.5 262.5 Junior Subordinated Notes, 9.87% to 10%, due 1993 - 1.9 Total 2,741.7 2,406.2 Other consolidated subsidiaries FHLB Notes and Advances, 3.10% to 7.61%, due 1994 through 2012 306.5 309.1 Floating Rate FHLB Advances due 1994 through 2000 2,140.1 1,110.0 10.585% to 12.175% Notes guaranteed by Small Business Administration due 1994 through 1995 4.8 6.8 Other notes and debentures due 1994 through 2003 34.8 29.6 Mortgages payable 27.0 26.6 Capital lease obligations 19.3 17.9 Total 2,532.5 1,500.0 Less 7 3/4% Sinking Fund Debentures due 2003 held by subsidiaries - (8.9) Total $6,802.4 4,481.0 Notes and debentures of the corporation and Norwest Financial Services, Inc. and its subsidiaries are unsecured. During 1993, the corporation issued $100 million of senior notes at 5.75 percent due March 15, 1998 and $200 million of senior notes at 6 percent due March 15, 2000. The corporation issued $200 million of subordinated notes at 6 5/8% due March 15, 2003 and issued $200 million of subordinated debentures at 6.65 percent due October 15, 2023. Also during 1993, the corporation issued a total of $560.3 million of Medium-Term Notes. This includes $60.3 million of Medium-Term Notes, Series A, bearing interest at rates from 4.47 percent to 5.74 percent and maturing from June 14, 1995 to July 2, 1998; $200 million of Medium-Term Notes, Series B, at a floating rate of LIBOR minus five basis points and maturing July 7, 1995, and $300 million of Medium-Term Notes, Series C. The Medium-Term Notes, Series C, have maturity dates ranging from October 5, 1995 to October 22, 1998, and consist of $44.6 million of fixed rate notes and $255.4 million of floating rate notes. The fixed rate Medium- Term Notes, Series C, bear interest at rates ranging from 4.03 percent to 5.14 percent. The floating rate Medium-Term Notes, Series C, reset periodically at interest rates ranging from three month LIBOR to three month LIBOR plus 30 basis points or U.S. Treasury Bills plus 25 basis points. The corporation has entered into $55 million of interest rate swap agreements to exchange the fixed rate interest on the Medium-Term Notes, Series A to a floating rate. The $60.3 million of Medium-Term Notes, Series A, issued in 1993 combined with the interest rate swap agreements provide the corporation with $55 million of funds at an effective net interest rate of three-month LIBOR plus 0.29 percent. In addition, the corporation has entered into $20 million of interest rate swap agreements to exchange the fixed rate interest on the Medium-Term Notes, Series C, to a floating rate. $44.65 million of fixed rate Medium- Term Notes, Series C, coupled with the interest rate swap agreements provide the corporation with $20 million of funds at an effective net interest rate of three-month LIBOR plus 0.09 percent. The 9 1/4 percent Subordinated Capital Notes due 1997 are redeemable at the option of the corporation at the principal amount in exchange for an equivalent market value of common stock, perpetual preferred or other eligible primary capital securities of the organization or cash at the bondholder's election if the corporation determines that the debt no longer constitutes primary capital or ceases to be treated as primary capital by the regulatory authorities. The corporation is required to sell or issue and dedicate common stock, preferred stock or any other capital securities, as determined by the regulatory authorities, and dedicate the proceeds to the retirement or redemption of the principal amount of these subordinated capital notes. Proceeds of equity offerings have been designated to redeem the full amount of the subordinated debentures. The 6.625 percent Subordinated Notes due 2003 are unsecured and subordinated to all present and future senior debt of the corporation. Payment of principal may be accelerated only in the case of bankruptcy of the corporation. There is no right of acceleration in the case of a default in the payment of principal or interest or in the lack of performance of any covenant or agreement of the corporation. The 6.65 percent Subordinated Debentures due 2003 are unsecured and subordinated to all present and future senior debt of the corporation. There is no right of acceleration in the case of a default in the payment of principal or interest or in the lack of performance of any covenant of the corporation. Payment of principal may be accelerated only in the case of bankruptcy of the corporation. The Series A ESOP Notes are due April 26, 1996 and the Series B ESOP Notes are due April 26, 1999. The full principal amounts of the Series A ESOP Notes are due at maturity. The Series B ESOP Notes require payments of $4.4 million on April 25 of 1997 and 1998, with the balance due at maturity. As a result of the increase in the federal tax rate in 1993, the rates on the Series A ESOP Notes and Series B ESOP Notes were adjusted retroactively from 8.5 percent to 8.6 percent, respectively, to 8.42 percent an 8.52 percent, respectively. The 7 7/8 percent Notes due 1997 were redeemed on January 20, 1994, at the principal amounts plus accrued interest. The corporation has entered into interest rate swap agreements to exchange the fixed interest rate on $50 million of the 9 1/4 percent Subordinated Capital Notes for a floating rate through 1997. The 9 1/4 percent Subordinated Capital Notes coupled with the interest rate swap agreements provide the corporation with $50 million of funds at an effective net interest rate of the six-month LIBOR plus 0.44 percent. The 6 3/4 percent Convertible Subordinated Debentures due 2003 can be converted into common stock of the corporation at $5 per share subject to adjustment for certain events. Repayment is subordinated, but only to the extent described in the indenture relating to the debentures, to the prior payment in full of all of the corporation's obligations for borrowed money. The subordinated debentures are redeemable at the principal amount plus a premium ranging from 1.35 percent in 1993 to 0.338 percent in 1997, and thereafter without a premium. During 1993, Norwest Financial, Inc. issued a total of $698 million of senior notes bearing interest at rates from 5.125 percent to 7.0 percent and due dates ranging from December 2, 1996, to August 1, 2003. Norwest Financial also issued $100 million of Senior Subordinated Notes, bearing interest rates ranging from 4.85 percent to 5.2 percent and maturing in 1996. Mortgages payable consist of notes secured by deeds of trust on the premises and certain other real estate owned with a net book value of $16.6 million at December 31, 1993. Interest rates on the mortgages payable range up to 9.25 percent with maturities through the year 1998. The Floating Rate FHLB advances bear interest at rates ranging from LIBOR less 0.20 percent to LIBOR less 0.07 percent, the one month LIBOR less 0.15 percent to the one month LIBOR less 0.12 percent and the three month LIBOR less 0.15 percent to the three month LIBOR less 0.10 percent. The maturities of the FHLB Advances are determined quarterly, based on the outstanding balance, the then current LIBOR rate, and the maximum life of the advance. Based upon these factors and the LIBOR rate in effect at December 31, 1993, the maturity dates range from 1994 to 2000. Maturities of long-term debt at December 31, 1993 were: Parent In Millions Consolidated Company Only 1994 $1,467.3 8.0 1995 984.7 309.8 1996 1,047.0 179.8 1997 631.3 205.1 1998 865.0 218.1 Thereafter 1,807.1 607.4 Total $6,802.4 1,528.2 10. STOCKHOLDERS' EQUITY On April 27, 1993, the stockholders approved an amendment to the corporation's Restated Certificate of Incorporation increasing the authorized shares of common stock to 500,000,000. On April 27, 1993, the Board of Directors approved a two-for-one stock split effected in the form of a 100 percent stock dividend distributed on June 28, 1993 to stockholders of record on June 4, 1993. The stock split resulted in an increase in common stock of 146,549,734 shares and was accounted for by a transfer of $244.2 million to common stock from surplus. All prior year common share and per share disclosures have been restated to reflect the stock split. The corporation has outstanding 1,143,750 shares of Cumulative Convertible Preferred Stock, Series B, $200 stated value per share, in the form of 4,575,000 depositary shares, each of which represents ownership of one quarter of a share of such preferred stock. At December 31, 1993, there were 91 holders of record of the depositary shares. Dividends are cumulative from the date of issue and are payable quarterly at a rate of 7.00 percent per annum. The convertible preferred stock is convertible at the option of the holder at any time, unless previously redeemed, into common stock of the corporation at a conversion price of $18.23 per share of common stock subject to adjustments in certain events. On or after September 1, 1995, the corporation, at its option, may redeem all or part of the outstanding shares at 104.2 percent of its stated value plus accrued and unpaid dividends. The redemption price declines during each 12-month subsequent period to 100.0 percent of the stated value plus accrued and unpaid dividends if redeemed on or after September 1, 2001. The corporation has outstanding 1,131,250 shares of 10.24 percent Cumulative Preferred Stock, $100 stated value per share, in the form of 4,525,000 depository shares, each of which represents ownership of one quarter of a share of such preferred stock. At Deember 31, 1993, there were 1,639 holders of record of the depository shares. Dividends are cumulative from the date of issue and are payable quarterly at 10.24 percent per annum. Prior to January 1, 1996, if the corporation requests the holders of this preferred stock to vote upon or consent to a merger or consolidation, and the corporation shall not have received a favorable vote or consent requisite to the consummaton of the transaction within 60 days, the corporation may redeem, at its option, all outstanding shares of 10.24 percent Cumulative Preferred Stock at the $100 stated value plus accrued and unpaid dividends. On or after January 1, 1996, the corporation, at its option, may redeem all or part of the outstanding shares at the $100 stated value plus accrued and unpaid dividends. In 1993, 1992, and 1991, holders of $6.9 million, $5.0 million and $0.7 million, respectively, of convertible subordinated debentures and the 12 percent convertible notes exchanged such debt for 695,016 shares, 831,710 shares and 92,198 shares, respectively, of the corporation's common stock. At December 31, 1993, there were 11 holders of record of the convertible subordinated debentures. Common stockholders may purchase shares of common stock at market prices with no sales charges through a dividend reinvestment plan. Stockholders may purchase additional shares up to $30,000 per quarter with no sales charges under the terms of the plan. The corporation had reserved shares of authorized but unissued common stock at December 31, as follows: 1993 1992 Stock incentive plans 24,585,027 17,300,750 Convertible subordinated debentures and notes 50,500 858,004 Dividend reinvestment 1,089,842 1,408,874 Invest Norwest Program 1,067,105 249,452 Savings-Investment Plans and Executive Incentive Compensation Plan 5,108,548 1,089,514 Cumulative Convertible Preferred Stock, Series B 12,620,026 12,620,026 Directors' Formula Stock Award and Stock Deferral Plans 386,244 392,820 Employees' deferral plans 1,350,000 - Total 46,257,292 33,919,440 Each share of the corporation's common stock includes one preferred share purchase right. These rights will become exercisable only if a person or group acquires or announces an offer to acquire 25 percent or more of the corporation's common stock. This triggering percentage may be reduced to no less than 15 percent by the Board prior to the time the rights become exercisable. When exercisable, each right will entitle the holder to buy one four-hundredth of a share of a new series of junior participating preferred stock at a price of $175 for each one one-hundredth of a preferred share. In addition, upon the occurrence of certain events, holders of the rights will be entitled to purchase either the corporation's common stock or shares in an "acquiring entity" at one half of the then market value. The corporation will generally be entitled to redeem the rights at one-quarter cent per right at any time before they become exercisable. The rights will expire on November 23, 1998, unless extended, previously redeemed or exercised. The corporaton has reserved one million shares of preferred stock for issuance upon exercise of the rights. 11. EMPLOYEE BENEFIT AND STOCK INCENTIVE PLANS Savings Investment Plans Under the Savings-Investment Plan (SIP), each eligible employee may contribute on a before-tax basis up to twelve percent of his or her salary, and the contributions will be matched 100 percent by the corporation up to six percent of the employee's salary. The corporation's matching contributions vest 25 percent per year of eligibility. All of the corporation's matching contributions are invested in the corporation's common stock. The employee's contributions are invested in a bond, equity, S&P 500 index, stable return or Norwest common stock fund, or a combination thereof, at the employee's direction. The corporation also maintains a Supplemental Savings-Investment Plan under which amounts otherwise available for contribution to the SIP, in excess of the contribution limitations imposed by the Internal Revenue Code of 1986, are credited to an account for the participant. Contribution expense for the plans amounted to $21.8 million, $18.3 million and $19.0 million in 1993, 1992, and 1991, respectively. The corporation's SIP contains Employee Stock Ownership Plan (ESOP) provisions under which the SIP may borrow money to purchase corporation common stock. In 1989, the corporation loaned money to the SIP which was used to purchase shares of the corporation's common stock. The loans from the corporation to the SIP are repayable in monthly installments through April 26, 1999, with interest at rates of 8.35 percent and 8.45 percent. Interest income on these loans was $1.6 million, $1.8 million and $2.3 million in 1993, 1992 and 1991, respectively, and is included as a reduction in salaries and benefits expense. Total interest expense on the Series A and B ESOP Notes was $3.8 million in each of 1993, 1992, and 1991. Each quarter dividends paid to the SIP are used to make loan principal and interest payments. With each principal and interest payment, a portion of the common stock purchased in 1989 is released and allocated to participating employees. The corporation's ESOP loans to the SIP are recorded as a reduction of stockholder's equity. Total dividends paid to the SIP in 1993, 1992, and 1991 were $5.7 million, $4.9 million and $4.3 million, respectively. Norwest Financial Services, Inc. has a thrift and profit sharing plan for its employees in which eligible employees may contribute on a before tax basis up to ten percent of their salary, and the contributions will be matched 25 percent by Norwest Financial up to six percent of the employee's salary. Norwest Financial may also make a profit sharing contribution with the amount determined by the percentage return on consolidated equity of Norwest Financial and its subsidiaries. Contribution expense for the plan was $9.3 million, $7.9 million and $8.1 million in 1993, 1992 and 1991, respectively. RETIREMENT PLANS The corporation's noncontributory defined benefit retirement plans cover substantially all full-time employees. Pension benefits provided are based on the employee's highest compensation in three consecutive years during the last ten years of employment. The corporation's funding policy is to maximize the federal income tax benefits of the contributions while maintaining adequate assets to provide for both benefits earned to date and those expected to be earned in the future. The combined plans' funded status at December 31 is presented below: In millions 1993 1992 Plan assets at fair value* $638.2 516.4 Actuarial present value of benefit obligations Accumulated benefit obligation, including vested benefits of $454.7 and $370.8, respectively 500.8 401.7 Projected benefit obligation for service rendered to date 649.8 512.2 Plan assets (in excess of) less than projected benefit obligation 11.6 (4.2) Unrecognized net gain (loss) from past experience different from that assumed and effects of changes in assumptions (10.5) 31.4 Unrecognized net asset being amortized over approximately 17 years 16.0 22.8 Unrecognized prior service cost (2.7) (5.8) Accrued pension liability included in other liabilities $ 14.4 44.2 *Consists primarily of listed stocks and bonds and obligations of the U.S. Government and its agencies. The components of net pension cost for the years ended December 31 are presented below: In millions 1993 1992 1991 Service cost-benefits earned during the year $30.4 21.7 19.5 Interest cost on projected benefit obligation 41.6 38.6 34.5 Actual return on plan assets (66.1) (38.1) (113.0) Net amortization and deferral* 49.1 (8.3) 73.3 Net pension cost $55.0 13.9 14.3 * Consists primarily of the net effects of the difference between the expected investment return and the actual investment return and the amortization of the unrecognized net gains and losses over five years. The weighted average discount rate and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were seven percent and six percent, respectively, for 1993 and eight percent and six percent, respectively, for 1992. The expected long-term rate of return on assets was six percent for 1993 and nine percent for 1992. Other Postretirement Benefits The corporation sponsors a medical plan for retired employees. Substantially all employees become eligible for these benefits if they retire under the corporation's retirement plans. The corporation's funding policy is to maximize the federal income tax benefits of the contributions while maintaining adequate assets to provide for both benefits earned to date and those expected to be earned in the future. The plan's funded status at December 31 is presented below: The following methods and assumptions are used by the corporation in estimating its fair value disclosures for financial instruments. CASH AND CASH EQUIVALENTS The carrying value of cash and cash equivalents approximates fair value due to the relatively short period of time between the origination of the instruments and their expected realization. TRADING ACCOUNT SECURITIES, INVESTMENT SECURITIES, MORTGAGE-BACKED SECURITIES, INVESTMENTS AND MORTGAGE-BACKED SECURITIES AVAILABLE FOR SALE AND STUDENT LOANS AVAILABLE FOR SALE Fair values of these financial instruments were estimated using quoted market prices, when available. If quoted market prices were not available, fair value was estimated using quoted market prices for similar assets. MORTGAGES HELD FOR SALE Fair value of mortgages held for sale are stated at market. LOANS AND LEASES AND STUDENT LOANS AVAILABLE FOR SALE Fair values of loans and leases are estimated based on contractual cash flows, adjusted for prepayment assumptions and credit risk factors, discounted using the current market rate for loans and leases. Variable rate loans, including student loans available for sale, are valued at carrying value since the loans reprice to market rates over short periods of time. Credit card receivables are valued at carrying value since the receivables are priced near market rates for such receivables and are short-term in life. The fair value of the corporation's consumer finance subsidiaries' loans have been reported at book value since the estimated life, assuming prepayments, is short-term in nature. INTEREST RECEIVABLE AND PAYABLE The carrying value of interest receivable and payable approximates fair value due to the relatively short period of time between accrual and expected realization. EXCESS SERVICING RIGHTS RECEIVABLE Excess servicing rights receivable represents the present value using applicable investor yields of estimated future servicing revenues in excess of normal servicing revenues over the assumed life of the servicing portfolio. DEPOSITS The fair value of fixed-maturity deposits is the present value of the contractual cash flows, including principal and interest, and servicing costs, discounted using an appropriate investor yield. In accordance with FAS 107, the fair value of deposits with no stated maturity, such as demand deposit, savings, NOW and money market accounts, are disclosed as the amount payable on demand. SHORT-TERM BORROWINGS The carrying value of short-term borrowings approximates fair value due to the relatively short period of time between the origination of the instruments and their expected payment. LONG-TERM DEBT The fair value of long-term debt is the present value of the contractual cash flows, discounted by the investor yield which considers the corporation's credit rating. COMMITMENTS TO EXTEND CREDIT, STANDBY LETTERS OF CREDIT AND RECOURSE OBLIGATIONS The majority of the corporation's commitment agreements and letters of credit contain variable interest rates and counter-party credit deterioration clauses and therefore, the carrying value of the corporation's commitments to extend credit and letters of credit approximates fair value. The fair value of the corporation's recourse obligations are valued based on estimated cash flows associated with such obligations. As any potential liabilities under such recourse obligations are recognized on the corporation's balance sheet, the carrying value of such recourse obligations approximates fair value. FORWARD DELIVERY COMMITMENTS, INTEREST RATE SWAPS, FUTURES CONTRACTS, OPTIONS AND INTEREST RATE CAPS AND FLOORS The fair value of forward delivery commitments, interest rate caps, floors, swaps and futures contracts is estimated, using dealer quotes, as the amount that the corporation would receive or pay to execute a new agreement with terms identical to those remaining on the current agreement, considering current interest rates. CERTAIN NON-FINANCIAL INSTRUMENTS Supplemental fair value information for certain non-financial instruments as of December 31 are set forth in the following table and explained below. The supplemental fair value information, combined with the total fair value of net financial instruments from the table on page 75, is presented in the table on page 78 for information purposes. This combination is not necessarily indicative of the "franchise value" or the fair value of the corporation taken as a whole. Certain values of non- financial instruments for 1992 and 1991 have been restated to conform with the non-financial instruments and related methodologies reported in the 1993 information. In millions 1993 1992 1991 Non-financial instrument assets and liabilities: Premises and equipment, net $ 756.5 663.4 623.2 Other assets 1,398.7 1,455.4 1,357.6 Accrued expenses and other liabilities (1,814.1)(1,405.5) (1,345.5) Other values: Non-maturity deposits 1,267.3 1,101.0 1,035.0 Consumer finance network 3,128.5 2,374.0 1,932.2 Credit card 245.3 84.6 109.2 Banking subsidiaries' consumer loans 269.3 224.4 198.3 Mortgage servicing 431.4 187.2 69.7 Mortgage loan origination/ wholesale network 836.4 707.6 180.4 Trust department 606.8 547.4 485.3 Net fair value of certain non-financial instruments 7,126.1 5,939.5 4,645.4 Fair value of financial instruments 3,884.7 2,891.7 2,692.3 Net stockholders' equity at the fair value of net financial instruments and certain non-financial instruments* $11,010.8 8,831.2 7,337.7 * Amounts due not include applicable deferred income tax, if any. The following methods and assumptions were used by the corporation in estimating the fair value of certain non-financial instruments. NON-FINANCIAL INSTRUMENT ASSETS AND LIABILITIES The non-financial instrument assets and liabilities are stated at book value, which approximates fair value. NON-MATURITY DEPOSITS The fair value table of financial instruments on page 75 does not consider the benefit resulting from the low-cost funding provided by deposit liabilities as compared with wholesale funding rates. The fair value of non-maturity deposits, considering these relational benefits, would be $20,670.6 million, $17,276.0 million, and $15,706.3 million at December 31, 1993, 1992 and 1991, respectively. Such amounts are based on a discounted cash flow analysis, assuming a constant balance over ten years and taking into account the interest sensitivity of each deposit category. CONSUMER FINANCE NETWORK The supplemental fair value table includes the estimated fair value associated with the consumer finance network which is estimated to be $3,128.5 million, $2,374.0 million and $1,932.2 million at December 31, 1993, 1992 and 1991, respectively. Such estimates are based on current industry price/earnings ratios for similar networks. These current price/earnings ratios are industry averages and do not consider the higher earnings levels and the value of the data processing business associated with the corporation's consumer finance network. CREDIT CARD The fair value of financial instruments on page 75 excludes the fair value attributed to the expected credit card balances in future years with the holders of such cards. The fair value of such future balances is estimated to exceed book value by $245.3 million, $84.6 million and $109.2 million at December 31, 1993, 1992 and 1991, respectively. This represents the fair value related to such future balances of both securitized and on-balance sheet credit card receivables based on a discounted cash flow analysis, utilizing an assumed investor yield on similar portfolio acquisitions. BANKING SUBSIDIARIES' CONSUMER LOANS For purposes of the table of fair values of financial instruments on page 75, the fair value of the banking subsidiaries' consumer loans is based on the contractual balances and maturities of existing loans. The fair value of such financial instruments does not consider future loans with customers. The fair value related to such future balances is estimated to be $269.3 million, $224.4 million and $198.3 million at December 31, 1993, 1992 and 1991, respectively. This fair value is estimated by cash flow analysis, discounted utilizing an investor yield. The expected balances for such purposes are estimated to extend ten years at a constant rate of replacement. MORTGAGE SERVICING Mortgage servicing represents estimated current value in the servicing portfolio. The corporation estimates that the fair value of its mortgage servicing exceeds book values by $431.4 million, $187.2 million and $69.7 million at December 31, 1993, 1992, and 1991, respectively. MORTGAGE LOAN ORIGINATION/WHOLESALE NETWORK The supplemental fair value table includes the fair value associated with the corporation's origination network for mortgage loans, which is estimated to be $836.4 million, $707.6 million and $180.4 million at December 31, 1993, 1992 and 1991, respectively. Such estimates are based on current industry price/earnings ratios for similar networks. TRUST DEPARTMENT The fair value associated with the corporation's management of trust assets is estimated to be $606.8 million, $547.4 million and $485.3 million at December 31, 1993, 1992 and 1991, respectively. Such estimates are based on current trust revenues using an industry multiple. 17. PARENT COMPANY FINANCIAL INFORMATION Condensed financial information for Norwest Corporation (parent company only) follows: BALANCE SHEETS In millions At December 31, 1993 1992 Assets Interest-bearing deposits with subsidiary banks $ 155.4 146.4 Advances to non-bank subsidiaries 2,313.8 1,556.3 Capital notes and term loans of subsidiaries Banks 353.0 333.0 Non-banks 371.5 237.8 Total capital notes and term loans of subsidiaries 724.5 570.8 Investments in subsidiaries Banks 2,904.1 2,367.2 Non-banks 803.4 837.1 Total investment in subsidiaries 3,707.5 3,204.3 Investment and mortgage-backed securities 211.7 148.2 Investment securities available for sale 91.4 105.9 Other assets 173.0 186.6 Total assets $7,377.3 5,918.5 Liabilities and Stockholders' Equity Short-term borrowings $2,094.1 2,028.7 Accrued expenses and other liabilities 186.6 165.4 Long-term debt with non-affiliates 1,528.2 583.7 Stockholders' equity 3,568.4 3,140.7 Total liabilities and stockholders'equity $7,377.3 5,918.5 STATEMENTS OF INCOME In millions Year ended December 31, 1993 1992 1991 Income Dividends from subsidiaries Banks $395.1 311.5 102.6 Non-banks 215.7 168.8 107.6 Total dividends from subsidiaries 610.8 480.3 210.2 Interest from subsidiaries 91.2 109.1 173.4 Service fees from subsidiaries 58.0 50.0 45.5 Other income 38.2 29.0 21.8 Total income 798.2 668.4 450.9 Expenses Interest to subsidiaries 1.5 1.0 1.7 Other interest 140.0 134.0 191.7 Other expenses 113.0 140.8 56.8 Total expenses 254.5 275.8 250.2 Income before income taxes, equity in undistributed earnings of subsidiaries, and cumulative effect of a change in accounting for postretirement medical benefits 543.7 392.6 200.7 Income tax benefit 24.4 43.3 39.9 Income before equity in undistributed earnings of subsidiaries and cumulative effect of a change in accounting for postretirement medical benefits 568.1 435.9 240.6 Equity in undistributed earnings of subsidiaries 85.5 4.2 160.3 Income before cumulative effect of a change in accounting for postretirement medical benefits 653.6 440.1 400.9 Cumulative effect on years ended prior to December 31, 1992 of a change in accounting for post retirement medical benefits net of tax - (76.0) - Net income $653.6 364.1 400.9 STATEMENTS OF CASH FLOWS In millions 1993 1992 1991 Year ended December 31, Cash Flows From Operating Activities Net income $ 653.6 364.1 400.9 Adjustments to reconcile net income to net cash flows from operating activities: Cumulative effect on years ended prior to December 31, 1992 of a change in accounting for postretirement medical benefits, net of tax - 76.0 - Equity in undistributed earnings of subsidiaries (85.5) (4.2) (160.3) Depreciation and amortization 12.2 12.9 12.9 Other assets, net (3.7) (36.4) 9.4 Accrued expenses and other liabilities, net 32.0 (5.9) (41.3) Net cash flows from operating activities 608.6 406.5 221.6 Cash Flows From Investing Activities Advances to non-bank subsidiaries, net (762.5) 580.8 (328.5) Investment securities, net (63.5) 46.5 (56.9) Investment securities available for sale, net 14.5 (105.9) - Principal collected on capital notes and term loans of subsidiaries 23.3 75.6 383.5 Capital notes and term loans made to subsidiaries (218.2) (143.2) (322.1) Investment in subsidiaries, net (354.0) (241.6) (220.0) Net cash flows from (used for) investing activities (1,360.4) 212.2 (544.0) Cash Flows From Financing Activities Short-term borrowings, net 84.3 (158.8) (20.6) Taxes receivable from affiliates, net 4.7 (4.7) 2.8 Proceeds from issuance of long-term debt with non-affiliates 1,263.2 - 25.0 Repayment of long-term debt with non-affiliates (312.4) (137.5) (148.9) Issuances of common stock 55.6 35.3 222.4 Repurchases of common stock (124.3) (85.9) (5.4) Issuances of preferred stock - - 225.4 Redemption of preferred stock (0.7) (2.9) (30.4) Net decrease in ESOP loans 3.2 3.0 8.1 Dividends paid (212.8) (179.0) (142.4) Net cash flows from (used for) financing activities 760.8 (530.5) 136.0 Net increase (decrease) in cash and cash equivalents 9.0 88.2 (186.4) Cash and cash equivalents Beginning of year 146.4 58.2 244.6 End of year $ 155.4 146.4 58.2 Federal law prevents the corporation from borrowing from its subsidiary banks unless loans are secured by specified assets and with respect to the corporation and any affiliate other than a bank, such secured loans by any subsidiary bank are generally limited to 10 percent of the subsidiary bank's capital and surplus and aggregate loans to the corporation and its non-bank subsidiaries are limited to 20 percent of the subsidiary bank's capital and surplus. The payment of dividends to the corporation by subsidiary banks is subject to various federal and state regulatory limitations. A national bank must obtain the approval of the Comptroller of the Currency if the total of all dividends declared in any calendar year exceeds the bank's net profits for that year combined with its retained net profits for the preceeding two calendar years. Under this formula, at December 31, 1993 the corporation's national banks could have declared $483.2 million of aggregate dividends, in addition to amounts previously paid, without the approval of the Comptroller of the Currency, subject to minimum regulatory capital requirements. In addition, the corporation's non-bank subsidiaries could have declared dividends totaling $803.4 million. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND STOCKHOLDERS OF NORWEST CORPORATION We have audited the consolidated balance sheets of Norwest Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, cash flows and stockholders' equity for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Norwest Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, Norwest Corporation adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1992. By /s/ KPMG Peat Marwick KPMG Peat Marwick Minneapolis, Minnesota January 19, 1994 MANAGEMENT'S REPORT The management of Norwest Corporation has prepared and is responsible for the contents of the financial statements included in this annual report and the information contained in other sections of this annual report, which information is consistent with the content of the financial statements. Management believes that the financial statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances to reflect, in all material respects, the substance of events and transactions that should be included. In preparing the financial statements, management makes judgments and estimates of the expected effects of events and transactions that are accounted for or disclosed. Management has long recognized the importance of the corporation maintaining and reinforcing the highest possible standards of conduct in all of its actions, including the preparation and dissemination of statements fairly presenting the financial condition of the corporation. In this regard, it has developed a system of internal accounting control which plays an important role in assisting management in fulfilling its responsibilities in preparing the corporation's financial statements. The corporation's system of internal accounting control is designed to provide reasonable assurance that assets are safeguarded and that transactions are executed in accordance with management's authorizations. This system is augmented by written policies, operating procedures and accounting manuals, plus a strong program of internal audit carried out by qualified personnel. Management recognizes that estimates and judgments are required to assess and balance the relative costs and expected benefits of the controls and errors or irregularities may nevertheless occur. However, management believes that the corporation's internal accounting control system provides reasonable assurance that errors or irregularities that could be material to the financial statements are prevented or would be detected on a timely basis and corrected in the normal course of business. The board of directors oversees these financial statements through an audit and examination committee comprised of outside directors. The committee meets periodically with management and internal audit to monitor the discharge by each of its responsibilities. The independent auditors, who are engaged to express an opinion on the financial statements, meet periodically with and have free access to the committee or the board, without management present, to discuss internal accounting control, auditing and financial reporting matters. By /s/ Richard M. Kovacevich Richard M. Kovacevich President and Chief Executive Officer By /s/ John T. Thornton John T. Thornton Executive Vice President and Chief Financial Officer By /s/ Michael A. Graf Michael A. Graf Senior Vice President and Controller January 19, 1994 Norwest Corporation and Subsidiaries SIX-YEAR CONSOLIDATED FINANCIAL SUMMARY *Excluding the cumulative effect of a change in accounting for postretirement medical benefits, 1992 primary net income per common share would have been $1.42, fully diluted net income per common share would have been $1.41, return on common equity would have been 15.2%, return on total equity would have been 14.4%, and net income per $100 of average assets would have been $1.03. **Based on average balances and net income for the periods. ***The ratio of average assets to average stockholders' equity. ****Information not available for periods prior to 1990. Norwest Corporation and Subsidiaries CONSOLIDATED AVERAGE BALANCE SHEETS AND RELATED YIELDS AND RATES* *Interest income/expense and yields/rates are calculated on a tax-equivalent basis utilizing a federal incremental tax rate of 35% in 1993 and 34% in each preceding period presented. Non-accrual loans and the related negative income effect has been included in the calculation of average rates. NM-Not meaningful Norwest Corporation and Subsidiaries INCOME STATEMENT DATA *Changes in the average balance/rate are allocated based on the percentage relationship of the change in average balance or average rate to the total increase (decrease). NM-Not meaningful Norwest Corporation and Subsidiaries LOAN INFORMATION Norwest Corporation and Subsidiaries OTHER BALANCE SHEET DATA Maturity of Total Investment Securities* *Based on contracted maturities. **The yield on state, municipal and housing securities is increased by the benefit of tax exemption, assuming a 35% federal income tax rate. For the year ended December 31, 1993, the amount of the increases in the yields for these securities and for total securities available for sale is 2.12% and 0.02%, respectively, and for total securities held for investment is 3.99% and 2.88%, respectively. ***Excludes leases of $655 million and consumer and residential mortgage loans of $16,775 million. ****There were no time deposits of less than $100,000 in 1993. Norwest Corporation and Subsidiaries QUARTERLY CONDENSED CONSOLIDATED FINANCIAL INFORMATION *Excluding the cumulative effect of a change in accounting for postretirement medical benefits, 1992 first quarter primary net income per common share would have been $0.37, fully diluted net income per common share would have been $0.36, 1992 return on assets would have been 1.09%, and 1992 return on common equity would have been 16.7%. **Based on average balances and net income for the periods. ***Restated to reflect the adoption of FAS 106. (CONTINUED ON PAGE 93) Norwest Corporation and Subsidiaries QUARTERLY CONDENSED CONSOLIDATED FINANCIAL INFORMATION (CONTINUED FROM PAGE 92 ) *Restated to reflect the adoption of FAS 106. The financial information on pages 92 and 93 is unaudited. In the opinion of managment, all adjustments necessary (which are of a normal recurring nature) have been included for a fair presentation of the results of operations.

103392_1993.txt

103392

1993

ITEM 1. BUSINESS ----------------- (a) General Development of Business ------------------------------- Continental Can Company, Inc. (the Company) is a publicly traded company incorporated in Delaware in 1970 under the name Viatech, Inc. The name of the Company was changed to Continental Can Company, Inc. in October 1992. The Company is engaged in the packaging business through a number of consolidated operating subsidiaries. The Company's packaging business consists of (i) its 50%-owned domestic subsidiary, Plastic Containers, Inc. (PCI), which owns Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively, CPC), (ii) its wholly owned German operating subsidiary, Dixie Union Verpackungen GmbH (Dixie Union) and (iii) its majority-owned European operating subsidiaries, Ferembal S.A. (Ferembal), which in turn owns 51% of Obalex, A.S. (Obalex), Onena Bolsas de Papel, S.A. (Onena) and Industrias Gomariz, S.A. (Ingosa). PCI is a leading manufacturer of extrusion blow-molded containers in the United States. Ferembal is a manufacturer of rigid packaging, primarily food cans, of which it is the second largest supplier in France. Obalex is a manufacturer of metal cans in the Czech Republic. Dixie Union manufactures plastic films and packaging machines, primarily for the food and pharmaceutical industries. Onena manufactures film, and Onena and Ingosa laminate and print plastic, paper and foil packaging materials for the food and snack food industries in Spain. The Company also owns Lockwood, Kessler & Bartlett, Inc. (LKB) which provides services principally in the fields of mapping and survey, civil and structural engineering, mechanical and electrical engineering, and construction administration and inspection. (b) Financial Information About Industry Segments --------------------------------------------- The Company has one reportable industry segment - packaging, as determined in accordance with the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 13. (c) Narrative Description of Business --------------------------------- The Company manufactures packaging which accounted for 97.5%, 97.3%, and 95.8% of its consolidated revenues in 1993, 1992 and 1991, respectively. CPC - The Company's 50%-owned subsidiary, PCI, acquired CPC in --- November 1991. CPC, headquartered in Norwalk, Connecticut, has fourteen manufacturing plants in the continental United States and one in Puerto Rico. CPC is a leader in the development, manufacture and sale of a wide range of extrusion blow-molded plastic containers for household chemicals, food and beverages, automotive products and motor oil, industrial and agricultural chemicals and cosmetics and toiletries. CPC manufactures single and multi- layer containers, primarily from high density polyethylene and polypropylene resins, ranging in size from two ounces to five gallons. Some of these multi- layer containers include a barrier layer of ethyl vinyl alcohol which renders the container oxygen tight and makes it suitable for use in food products which are subject to spoilage or deterioration if exposed to oxygen. CPC sells containers to national consumer products companies, including Clorox Company, Coca-Cola Foods, Colgate-Palmolive Company, Lever Brothers, Mobil Oil Corp., Pennzoil Products Company, Procter & Gamble Company, Quaker Oats Company and Quaker State Oil Refining Corporation. CPC, in many cases, manufactures substantially all of a customer's container requirements for specific product categories or for particular container sizes. CPC has long- standing relationships with most of its customers and has contracts or agreements of two to seven years in duration with customers representing approximately 70% of its dollar sales volume. Ferembal - The Company acquired a 68% interest in Ferembal in the fourth -------- quarter of 1989, increased its interest to 84% in August, 1991 and at December 31, 1993 owned 85% of Ferembal. Ferembal, headquartered in Paris, has five manufacturing plants located in each of the main agricultural regions of France. The Roye plant, located in Picardie, was built in 1964 and expanded substantially in 1968. Its three main divisions include coil cutting, printing and varnishing; the manufacture of ends and bodies; and assembly. There are five welded lines in operation at Roye and all industrial products are manufactured at this plant. The Moelan plant, located in Brittany, is set up along similar lines as the Roye plant with five welded lines. The Ludres plant, in eastern France, is Ferembal's largest facility. In addition to twelve presses and two easy-open end manufacturing units, Ludres has nine body assembly lines. Ferembal's research and development and technical service departments are also located at Ludres. The Veauche plant was built in 1982 to service southern France. Approximately 50% of the output of the two welded lines is "passed through the wall" to a customer for the canning of pet food. The Ville Neuve sur Lot plant was built in 1991 and went into production with a three piece can line in early 1992. A two piece can line went into production at this facility in mid-1992. Ferembal is the second largest producer of food cans in France and also produces cans for pet foods and industrial products. Ferembal's products include three piece cans for food with over two hundred sets of specifications, two piece cans in several different diameters, easy open ends, stylized and "hi-white enamel" cans, and a large number of can products for industrial end uses. Ferembal's production for the food and pet food markets accounts for approximately 80% of its sales with remaining sales coming from cans produced for industrial products. Ferembal's customers are primarily vegetable and prepared food processors, pet food processors, and paint and other industrial can users. Obalex - The Company, through Ferembal, owns 51% of the outstanding stock ------ of Obalex. Obalex is headquartered in a three building complex on a 5 acre site in Znojmo, Czech Republic, which also serves as its sole manufacturing facility. Obalex manufacturers both two and three piece cans for food which account for approximately 80% of its sales and a number of can products for industrial end users. Dixie Union - The Company, through its wholly owned subsidiary, Viatech ----------- Holding GmbH, owns all of the outstanding stock of Dixie Union. Dixie Union is headquartered in Kempten, Germany and has subsidiary companies in France and the United Kingdom, which function as a sales, distribution and customer service network. Dixie Union manufactures three main product lines for the packaging industry: multi-layer shrink bags, composite plastic films and packaging machines and slicers. Most of Dixie Union's customers are in the food and pharmaceutical industries. Onena - The Company owns 80% of the stock of Onena located in Pamplona, ----- Spain. Onena manufactures plastic film and prints and laminates paper, plastic and foil packaging material for the food and snack food industries in Spain. Ingosa - The Company owns 99.97% of the stock of Ingosa located in ------ Pamplona, Spain. Ingosa prints and laminates paper, plastic and foil packaging material for the food and snack food industries in Spain. During 1994 the Company intends to merge Onena and Ingosa and locate all of their operations at Ingosa's current manufacturing facility. See Note 2(a) of the Notes to the Consolidated Financial Statements. LKB - The Company owns 100% of LKB, a consulting engineering firm, --- located in Syosset, New York. LKB provides services to clients in the fields of transportation, site, municipal, electrical and mechanical, and environmental engineering. Most of LKB's clients are public sector state and municipal agencies, utilities, financial institutions and developers. Most of its projects involve infra-structure design and rehabilitation, environmental reports and services, and utility substation design. Other Matters - The primary users of products manufactured by the ------------- Company are firms in the food and snack food, pet food, household chemical, motor oil and pharmaceutical industries. The raw materials used in the production of plastic containers, cans and packaging films are readily available commodity materials and chemicals produced by a large number of manufacturers. It is the practice of the Company to obtain these raw materials from several sources in order to ensure an economical, adequate and timely supply. Some of the products manufactured by the Company are manufactured pursuant to license. With regard to composite films, a fully paid up license from the American National Can Company is in effect. With regard to shrink bags and film, a license from the American National Can Company is in effect. Present patents under this license expire at various times through 2000. The license will expire on the date the last of the licensed patents expire. This license is non-exclusive as to manufacture and sale of shrink bags and film in Europe and non-exclusive as to sales to the rest of the world. Sales may not be made in the Western Hemisphere. The Company does not believe these licenses are material to its packaging business taken as a whole. The Company's business is seasonal insofar as the sales of Ferembal and Obalex to the vegetable packaging industry is dependent on agricultural production and occurs primarily in the second and third quarters. The Company's remaining products are not seasonal. The Company is not dependent upon a single customer or a few customers. Sales to no single customer exceeded 10% of the Company's consolidated revenues in 1993. As of December 31, 1993, the Company's backlog was approximately $19,868,000 (compared to $19,149,000, at December 31, 1992). All backlog is expected to be filled within the current fiscal year. Ferembal, Obalex, and Plastic Containers, Inc. produce most of their products under open orders. As a result, none of the foregoing backlog is attributable to them. The Company's business in total is highly competitive with a large number of competitors. The main competitors include Owens Illinois, Inc. and Graham Packaging with regard to plastic containers, CMB Packaging with regard to cans, W. R. Grace & Co. with regard to barrier shrink films, and Multi-Vac with regard to packaging machinery. The principal methods of competition are price, quality and service. The amount spent on research and development activities amounted to approximately $12,862,000 in 1993, $14,603,000 in 1992, and $4,194,000 in 1991. The number of persons employed by the Company as of December 31, 1993 and 1992 was 3,712 and 3,182, respectively. (d) Foreign and Domestic Operations ------------------------------- Sales to unaffiliated customers are set out below: Information regarding the operating profit and the identifiable assets attributable to the Company's foreign operations is incorporated herein by reference to Note 16 of the Consolidated Financial Statements appearing in the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 2.

ITEM 2. PROPERTIES ------------------- The Company believes its facilities are suitable, adequate, and properly sized to provide the capacity necessary to meet its sales. The Company's production facilities are utilized for the manufacture and storage of the Company's products. The extent of utilization in each of the Company's facilities varies based on a number of factors but primarily on sales and inventory levels for specific products. The location of the customer also affects utilization since shipment costs beyond a certain distance can make production of some products at a remote facility uneconomic. Seasonality affects utilization substantially at Ferembal and Obalex with very high utilization in the pre-harvest and harvest season and substantially lower utilization during the late fall and winter. The Company adjusts labor levels and capital investment at each of its facilities in order to optimize their utilization. The Company's general corporate offices and the main production facility for LKB are located in Syosset, New York in a 25,000 square foot building owned by the Company. This steel and concrete block building was constructed in 1955 on a 2-1/2 acre lot. CPC is headquartered in 10,415 square feet of leased office space in Norwalk, Connecticut. CPC also leases its technical center in Elk Grove, Illinois (78,840 sq. ft.) and sales offices in Montvale, New Jersey (2,042 sq. ft.), Cincinnati, Ohio (1,266 sq. ft.), Houston, Texas (703 sq. ft.) and Des Plaines, Illinois (1,655 sq. ft.). The following table sets forth the location and square footage of CPC's production facilities which are used for both manufacture and warehousing of finished goods: CPC owns the plants in Santa Ana, Fairfield, Oil City, Baltimore and Puerto Rico; all others are leased. Ferembal is headquartered in 20,000 square feet of office space subject to a capital lease in Clichy, a suburb of Paris. Ferembal operates five manufacturing facilities in five locations in France. Ferembal owns a 384,000 square foot manufacturing facility on a 21 acre site in Roye for the production of food and industrial cans. Ferembal owns a 42,000 square foot manufacturing facility for the production of food cans at Veauche on a 5 acre site. The facility at Veauche is located next to a customer's plant and food can production is "passed through the wall" to the customer. Ferembal has a capital lease with regard to several buildings totaling 229,000 square feet on a 23 acre site in Ludres. In addition, Ferembal owns a 29,000 square foot building on a 3 acre site. These facilities are used for the manufacture of food cans and for research and development activities. Ferembal has a capital lease with regard to several buildings totaling 252,000 square feet on an 18 acre site in Moelan which are used for the manufacture of food cans. Ferembal operates a manufacturing facility for food cans in a 42,000 square foot building on a 4 acre site in Villeneuve sur Lot under a rental agreement. Each of the manufacturing facilities utilizes a portion of its building space for warehousing its finished goods. Obalex is located in several buildings with approximately 182,000 square feet on an 8.4 acre site in Znojmo, Czech Republic. This facility is the sole manufacturing site for Obalex which also uses the complex for the storage of its finished goods. Dixie Union is headquartered in a three-story, 108,000 square foot manufacturing facility on a 5 acre site in Kempten, Germany, leased through 2004. In addition, two small facilities are leased as sales and distribution centers in Milton Keynes, England and Redon, France. Onena is headquartered in a manufacturing facility in Pamplona, Spain consisting of several owned buildings encompassing 89,200 square feet on a 3.7 acre site. Ingosa owns two buildings totaling 358,000 square feet located on a 3.5 acre site in Pamplona, Spain, which also serve as its headquarters, manufacturing and warehousing facility. The Company intends to merge the operations of Ingosa and Onena in 1994 and it is expected that Ingosa's manufacturing facility will be expanded by approximately 96,000 square feet at a cost of approximately $1 million during 1994. After the merger the Company intends to sell Onena's facility. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS -------------------------- The Company's subsidiaries are defendants in a number of actions which arose in the normal course of business. In the opinion of management, the eventual outcome of these actions will not have a significant effect on the Company's financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------------------------------------------------------------ On November 29, 1993 a Special Meeting of Stockholders was held to consider a proposal to approve the possible issuance of 887,500 shares of the Company's Common Stock to Merrywood, Inc. pursuant to an Agreement dated September 10, 1992, as amended, among the Company, Plastic Containers, Inc., Merrywood Inc., and Plaza, Inc. Such proposal was approved by a vote of 1,321,713 shares (86%) cast in favor, 84,390 shares (5%) cast against and 126,754 shares (9%) abstaining. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER -------------------------------------------------------------------------- MATTERS ------- The information required by this item is incorporated herein by reference to the section entitled "Common Stock Prices and Related Matters" of the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA(1) ----------------------------------- (1) In thousands, except per share amounts and current ratio. (2) In 1993, includes sales of $10,682 and net income of $238 related to the purchase of Obalex. In 1991, includes sales of $17,030 and a net loss of $1,045 related to the purchase of PCI. In 1989, includes sales of $34,538 and net income of $150 related to the purchase of Ferembal. (3) Includes income for the cumulative effect of accounting change of $460 ($.15 per share primary and $.14 per share fully-diluted) and an extraordinary charge of $1,502 ($.49 per share primary and $.44 per share fully-diluted) in 1992. Includes income for an extraordinary item of $22 ($.01 per share both primary and fully-diluted), and $127 ($.10 per share primary and $.08 per share fully-diluted) in 1990 and 1989, respectively. (4) The 1991 weighted average shares outstanding include 1,020 shares and 255 warrants to purchase shares sold in June 1991 for net proceeds of $29,453. The 1990 weighted average shares outstanding include 460 shares sold in January 1990 for net proceeds of $6,756. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ------------------------------------------------------------------------ RESULTS OF OPERATIONS --------------------- The information required by this item is incorporated herein by reference to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ---------------------------------------------------- The information required by this item is incorporated by reference to the Company's consolidated financial statements and related notes, together with the independent auditors' report in the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND ------------------------------------------------------------------------ FINANCIAL DISCLOSURE -------------------- There have been no changes in nor disagreements with the Company's accountants on accounting and financial disclosure during the twenty-four month period ended December 31, 1993. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ----------------------------------------------------------- The information required by this item, with respect to directors of the registrant, will be included under the caption "Election of Directors" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. Executive officers of the registrant include Messrs. Donald J. Bainton and Abdo Yazgi who are also directors of the registrant and for whom information required by this item is included in the Proxy Statement as previously mentioned. Information for other executive officers, is as follows: (1) The term of office of all executive officers is indefinite, at the pleasure of the Board of Directors. The business experience of each executive officer is as follows: Mr. Andreas has served as Vice President of Manufacturing since April 1992. Prior to that time, he was an independent business consultant. Prior to his retirement in 1988, Mr. Andreas was employed by the former Continental Can Company, Inc. for 33 years, most recently as General Manager. Mr. L'Hommedieu has served as Treasurer or Assistant Treasurer of the Company and its subsidiary, Lockwood, Kessler & Bartlett, Inc., since 1963. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION -------------------------------- The information required by this item is included under the caption "Executive Compensation" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ----------------------------------------------------------------------- The information required by this item is included under the caption "Stock Ownership" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ------------------------------------------------------- The information required by this item is included under the caption "Transactions with Management" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K -------------------------------------------------------------------------- (a) 1. Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Earnings for the years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements for the years ended December 31, 1993, 1992 and 1991 Independent Auditors' Report The above financial statements are included under Item 8 of Part II of this report. 2. Financial Statement Schedules: See index to financial statement schedules for Continental Can Company, Inc. and subsidiaries on page 11. * Management contract or compensatory plan or arrangement. (1) These documents have been previously filed with the Commission as Exhibits to 1992 Quarterly Reports on Form 10-Q for Plastic Containers, Inc. (2) These documents have previously been filed with the Commission as Exhibits to 1993 Quarterly Reports on Form 10-Q for Continental Can Company, Inc. All other items for which provision is made in the applicable regulations of the Securities and Exchange Commission have been omitted as they are not required under the related instructions or they are inapplicable. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CONTINENTAL CAN COMPANY, INC. By: /s/ Abdo Yazgi Date: March 18, 1994 ------------------------------------------ -------------- Abdo Yazgi, Executive Vice President (Principal Financial & Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ Donald J. Bainton Date: March 18, 1994 ------------------------------------------ -------------- Donald J. Bainton, Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer) Date: ------------------------------------------ -------------- Kenneth Bainton, Director /s/ Robert L.. Bainton Date: March 18, 1994 ------------------------------------------ -------------- Robert L. Bainton, Director /s/ Nils E. Benson Date: March 18, 1994 ------------------------------------------ -------------- Nils E. Benson, Director /s/ Rainer N. Greeven Date: March 18, 1994 ------------------------------------------ -------------- Rainer N. Greeven, Director /s/ Ronald H. Hoenig Date: March 18, 1994 ------------------------------------------ -------------- Ronald H. Hoenig, Director /s/ Ferdinand W. Metternich Date: March 18, 1994 ------------------------------------------ -------------- Ferdinand W. Metternich, Director /s/ Charles M. Marquardt Date: March 18, 1994 ------------------------------------------ -------------- Charles M. Marquardt, Director Date: ------------------------------------------ -------------- Donald F. Othmer, Director /s/ V. Henry O'Neill Date: March 18, 1994 ------------------------------------------ -------------- V. Henry O'Neill, Director /s/ John J. Serrell Date: March 18, 1994 ------------------------------------------ -------------- John J. Serrell, Director /s/ Robert A. Utting Date: March 18, 1994 ------------------------------------------ -------------- Robert A. Utting, Director /s/ Abdo Yazgi Date: March 18, 1994 ------------------------------------------ -------------- Abdo Yazgi, Director /s/ Cayo Zapata Date: March 18, 1994 ------------------------------------------ -------------- Cayo Zapata, Director /s/ Jose Luis Zapata Date: March 18, 1994 ------------------------------------------ -------------- Jose Luis Zapata, Director Index to Financial Statement Schedules for Continental Can Company, Inc. and Subsidiaries Years ended December 31, 1993, 1992 and 1991 Subsidiaries of the Registrant Page 12 Independent Auditors' Report on Schedules Page 13 Consent of Independent Auditors Page 14 FINANCIAL STATEMENT SCHEDULES: ----------------------------- II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties Page 15 III - Condensed Financial Information of Registrant Page 16 V - Property, Plant and Equipment Page 18 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Page 19 VIII - Allowance for Doubtful Accounts Page 19 IX - Short-Term Borrowings Page 20 X - Supplementary Income Statement Information Page 20 All other schedules are omitted because they are not applicable, not required, or the information is given in the financial statements or the notes thereto. EXHIBITS ATTACHED: - - ----------------- 1993 Annual Report to Stockholders Page 21 (22) Subsidiaries of the Registrant The following listed companies represent the significant subsidiaries of the Company, all of which are included in the Company's consolidated financial statements: (1) Subsidiary of Ferembal (2) Subsidiary of Viatech Holding GmbH (3) Subsidiary of Plastic Containers, Inc. * The Company, pursuant to a proxy, has voting rights over 51% of the shares of Plastic Containers, Inc. INDEPENDENT AUDITORS' REPORT ON SCHEDULES ----------------------------------------- The Board of Directors and Stockholders Continental Can Company, Inc.: Under date of March 9, 1994, we reported on the consolidated balance sheets of Continental Can Company, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Stockholders. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in the accompanying index. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in notes 1 (h) and 13 and notes 1 (d) and 10 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Nos. 106, "Employer's Accounting for Post-Retirement Benefits Other Than Pensions" and 109, "Accounting for Income Taxes", respectively, on a prospective basis in 1992. /s/ KPMG PEAT MARWICK Jericho, New York March 9, 1994 CONSENT OF INDEPENDENT AUDITORS ------------------------------- The Board of Directors Continental Can Company, Inc.: We consent to incorporation by reference in the Registration Statements Nos. 33-7783, 33-37163, 33-37164 and 33-37165 on Form S-8 of Viatech, Inc. (now known as Continental Can Company, Inc.) of our reports dated March 9, 1994 relating to the consolidated balance sheets of Continental Can Company, Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated statements of earnings, stockholders' equity and cash flows and related schedules for each of the years in the three year period ended December 31, 1993, which reports are either incorporated by reference or appear in the December 31, 1993 Annual Report on Form 10-K of Continental Can Company, Inc. As discussed in notes 1 (h) and 13 and notes 1 (d) and 10 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Nos. 106, "Employer's Accounting for Post-Retirement Benefits Other Than Pensions" and 109, "Accounting for Income Taxes", respectively, on a prospective basis in 1992. /s/ KPMG PEAT MARWICK Jericho, New York March 21, 1994 Continental Can Company, Inc. and Subsidiaries Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties Years ended December 31, 1993, 1992 and 1991 All balances shown reflect loans by the Company to Mr. Donald J. Bainton, Chairman of the Board and Chief Executive Officer. Schedule III - Condensed Financial Information of Registrant Continental Can Company, Inc. Balance Sheets Years Ended December 31, 1993 and 1992 (in thousands) (a) See Note 9, Items (a) and (b) of Notes to Consolidated Financial Statements of Continental Can Company, Inc. and Subsidiaries. At December 31, 1993, current liabilities include $1,164 of Convertible Subordinated Debentures due in 1994. Continental Can Company, Inc. Statements of Earnings Years Ended December 31, 1993, 1992 and 1991 Schedule III - Condensed Financial Information of Registrant (Continued) Continental Can Company, Inc. Statements of Cash Flows Years Ended December 31, 1993, 1992 and 1991 Continental Can Company, Inc. and Subsidiaries Schedule V - Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 Continental Can Company, Inc. and Subsidiaries Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 Continental Can Company, Inc. and Subsidiaries Schedule VIII - Allowance for Doubtful Accounts Years Ended December 31, 1993, 1992 and 1991 (1) Represents uncollectible accounts written-off. (2) Represents $1,411 from the consolidation of acquired subsidiary in 1991. (3) Represents $418 from the consolidation of acquired subsidiary in 1993. Continental Can Company, Inc. and Subsidiaries Schedule IX - Short-Term Borrowings Years ended December 31, 1993, 1992 and 1991 Amounts payable to banks for short term borrowings: Continental Can Company, Inc. and Subsidiaries Schedule X - Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 CONTINENTAL CAN COMPANY, INC. 1993 ANNUAL REPORT CORPORATE PROFILE Continental Can Company, Inc., through its subsidiaries, manufactures extrusion blow-molded plastic containers, metal cans, films and equipment for the packaging industry, and prints and laminates flexible packaging for the food and snack food industries. The Company also owns Lockwood, Kessler & Bartlett, Inc., an engineering firm located in the United States. REPORT TO STOCKHOLDERS: - - ----------------------- Last year was a challenging one for our company. European economies failed to emerge from their recessionary slump which had a negative impact on the sales and profitability of our subsidiaries in Europe. Since most of our sales are generated in Europe, the ongoing recession had a significant impact. Due to high levels of inventory, several of Ferembal's vegetable-can customers shuttered their packing plants for the season, thereby reducing orders for food cans. Finally, the dollar strengthened against European currencies throughout 1993, resulting in a $19.8 million reduction in reported sales due to currency translation rate differences. To partially offset the declines resulting from sluggish European economies, cost-cutting measures were implemented at each of our European subsidiaries. These actions served to reduce somewhat the negative impact of the recession. In addition, this cost-cutting program has placed our Company in a good position to increase profitability when the European economic situation improves. On the domestic side the performance of Plastic Containers, Inc., (PCI) improved with an increase in sales and an improvement in overall results. In 1993, sales rose by $6.3 million over 1992. This improvement was a result of the renewed sales and marketing efforts which began in 1992 and are continuing. These marketing efforts were coupled with a detailed examination of our manufacturing operations which has enabled us to respond quickly to changing customer demands. This is a crucial component in our ability to introduce new products quickly, keep up with our increasing sales volume, and to provide "just-in-time" delivery to our customers. Because we believe that carefully chosen acquisitions are of vital strategic importance to the growth of our Company, we have continued to acquire those companies that can increase our sales and profitability. In 1993, we increased our stake in Obalex, A.S., our Czech can manufacturer in which we had purchased a 34% interest at the end of 1992. Obalex had sales of $10.7 million and net income of approximately $677,000 which added $238,000 in net income to our 1993 consolidated results. In addition to the increased position in Obalex, we acquired Industrias Gomariz S.A. (Ingosa) for a nominal consideration in late 1993. Like Onena, Ingosa is located in Pamplona, Spain, and is a flexible packaging manufacturer. Because both companies share similar products and markets, we intend to merge these companies into one operating entity in 1994. Once these companies are merged, we anticipate a boost in sales and an enhancement of profitability. Our agreement with the Spanish provincial government to exchange amounts due it by Ingosa for a portion of the equity of the merged entity, and other favorable terms of that agreement, significantly strengthens the financial condition of the new firm. The formation of this new entity will allow us to expand our current markets and to weather more easily the difficult economic conditions which continue in Spain. In 1993, our cash flow remained strong, enabling our Company to reduce debt while continuing to invest in machinery and equipment to expand our manufacturing capacity, capability, and efficiency. In 1994, we look forward to increases in our sales, profitability, and cash flow. We believe that European economies will improve somewhat during the coming year. Foreign currency rates, while potentially still negative, are not expected to be a major factor in our reported results in 1994. Given the swings between the dollar and European currencies, PCI's improving performance is an important factor both for the Company's revenues and for its long-term growth and profitability. For 1994 and beyond, we expect PCI to continue to build on the base it has established, to increase its sales, and to improve its operating results. During the ten rewarding years that I have been Chairman and CEO of Continental Can Company, Inc. (formerly Viatech, Inc.), our Company has enjoyed tremendous growth and success by nearly every financial measure. However, change is inevitable and growth essential, especially in today's marketplace. We are committed to continuing our growth internally and through acquisitions, so that the next ten years will prove to be as successful and rewarding as the last ten years have been. Donald J. Bainton Chairman & Chief Executive Officer March 18, 1994 DESCRIPTION OF BUSINESS Continental Can Company, Inc. is a holding company primarily engaged in the packaging business through a number of consolidated operating subsidiaries. The Company's packaging business consists of its 50%-owned domestic subsidiary, Plastic Containers, Inc. (PCI), which owns Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively, CPC), which is a leading manufacturer of extrusion blow-molded containers in the United States. Its wholly-owned German operating subsidiary is Dixie Union Verpackungen GmbH (Dixie Union) and its majority-owned European operating subsidiaries are Ferembal S.A. (Ferembal), Obalex A.S. (Obalex), Onena Bolsas de Papel, S.A. (Onena) and Industrias Gomariz, S.A. (Ingosa). Ferembal is a manufacturer of rigid packaging, primarily food cans, of which it is the second largest supplier in France. Obalex also manufactures rigid packaging, primarily food cans, in the Czech Republic. Dixie Union manufactures plastic films and packaging machines, primarily for the food and pharmaceutical industries. Onena manufactures film, and Onena and Ingosa laminate and print plastic, paper and foil packaging materials for the food and snack food industries primarily in Spain. The Company also owns Lockwood, Kessler & Bartlett, Inc. (LKB) which provides services principally in the northeastern United States in the fields of survey, civil, environmental and structural engineering, mechanical and electrical engineering, and construction administration and inspection. CPC - The Company's 50%-owned subsidiary, PCI, acquired CPC in November --- 1991. CPC, headquartered in Norwalk, Connecticut, develops, manufactures and sells a wide range of extrusion blow-molded plastic containers through its national network of fifteen manufacturing plants (including one in Puerto Rico). CPC supplies containers for household chemicals, food and beverages, automotive products and motor oil, industrial and agricultural chemicals and cosmetics and toiletries. CPC produces both single and multi-layer containers, manufactured primarily from high density polyethylene and polypropylene resins, ranging in size from two ounces to five gallons. Some of these multi-layer containers include a barrier layer to protect food products which are subject to spoilage or deterioration if exposed to oxygen. Besides being fully recyclable, in many instances, these containers can be, and are, produced using a significant amount of post-consumer recycled plastic. Its customers include some of the largest consumer products companies in the United States, such as Clorox Company, Coca- Cola Foods, Colgate-Palmolive Company, Mobil Oil Corporation, Pennzoil Products Company, Procter & Gamble Company, Quaker Oats Company and Quaker State Oil Refining Corporation. CPC, in many cases, manufactures substantially all of a customer's container requirements for specific product categories or for particular container sizes. CPC has long-standing relationships with most of its customers and has long-term contracts with customers representing approximately 70% of its dollar sales volume. FEREMBAL - The Company owns an 85% interest in Ferembal, the second -------- largest food can manufacturer in France and the fourth largest in Europe. Ferembal, headquartered in Paris, has five manufacturing plants located in each of the main agricultural regions of France. The most recent plant was built in 1991 and went into full production with both two and three-piece can lines by mid-1992. Besides food cans for such products as vegetables, mushrooms, fruits, prepared meals and pet foods, Ferembal also manufactures cans for industrial products such as paint, automotive products and motor oil. Ferembal's products include both two and three-piece cans for food, easy-open ends, stylized and "hi-white enamel" cans, and a large number of can products for industrial end uses, all in a number of different diameters. Ferembal's production for the food and pet food markets accounts for approximately 80% of its sales with remaining sales coming from cans produced for industrial products. Ferembal's customers include many leading French and European vegetable and prepared food processors, pet food processors, and paint and other industrial can users. OBALEX - The Company, through Ferembal, owns 51% of the outstanding stock ------ of Obalex. Obalex, located in the Czech Republic, manufacturers both two and three-piece cans for food which account for approximately 80% of its sales and a number of can products for industrial end users. DIXIE UNION - The Company, through its wholly-owned subsidiary, Viatech ----------- Holding GmbH, owns all of the outstanding stock of Dixie Union. Dixie Union is headquartered in Kempten, Germany and has subsidiary companies in France and the United Kingdom, which function as a sales, distribution and customer service network. Dixie Union manufactures three main product lines for the packaging industry: multi-layer shrink bags, composite plastic films and packaging machines and slicers. Dixie Union is one of a few companies in Europe which manufacture both packaging films and packaging equipment. Dixie Union's customers are primarily processors of meats, cheeses, poultry and fish products, although Dixie Union also produces packaging and machinery for suppliers of technical and medical products. Most of Dixie Union's sales are generated in Europe; however, a number of Dixie Union's packaging machines are sold in the United States through an exclusive distributor, and through agents and distributors on a worldwide basis. ONENA AND INGOSA - The Company also owns an 80% interest in Onena and a ---------------- 99.97% interest in Ingosa, which are located in Pamplona, Spain. Onena manufactures plastic film, and Onena and Ingosa laminate and print a variety of paper, foil and plastic film products. Their major customers are primarily in the food and snack food industries in Spain. During 1994, the Company intends to merge Onena and Ingosa and locate all of the operations at Ingosa's current manufacturing facility, which will be expanded. See Note 2(a) of the Notes to the Consolidated Financial Statements. SELECTED FINANCIAL DATA(1) (1) In thousands, except per share amounts and current ratio. (2) In 1993, includes sales of $10,682 and net income of $238 related to the purchase of Obalex. In 1991, includes sales of $17,030 and a net loss of $1,045 related to the purchase of PCI. In 1989, includes sales of $34,538 and net income of $150 related to the purchase of Ferembal. (3) Includes income for the cumulative effect of accounting change of $460 ($.15 per share primary and $.14 per share fully-diluted) and an extraordinary charge of $1,502 ($.49 per share primary and $.44 per share fully-diluted) in 1992. Includes income for an extraordinary item of $22 ($.01 per share both primary and fully-diluted), and $127 ($.10 per share primary and $.08 per share fully-diluted) in 1990 and 1989, respectively. (4) The 1991 weighted average shares outstanding include 1,020 shares and 255 warrants to purchase shares sold in June 1991 for net proceeds of $29,453. The 1990 weighted average shares outstanding include 460 shares sold in January 1990 for net proceeds of $6,756. (5) Earnings before interest, taxes, depreciation and amortization. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1993 VS. 1992 Sales declined 5.8% in 1993 to $481,842,000 as compared to $511,241,000 in 1992. The decrease resulted primarily from changes in foreign currency translation rates which reduced reported sales by $19.8 million as compared to the prior year. A reduction in vegetable can sales in France as a result of inventory reductions by Ferembal's customers (approximately $10 million) and an economic recession in Europe accounted for the remainder of the decline. Increased sales at PCI ($6.3 million) and sales of Obalex ($10.7 million) offset a portion of the decline. Management believes that currency translation rate differences and economic weakness in Europe will continue to negatively impact reported sales in 1994, although less severely than in 1993. Backlog amounted to approximately $19,868,000 at December 31, 1993 as compared to $19,149,000 at December 31, 1992. The increase in backlog is not expected to have a material effect on the Company's sales in 1994. Gross profit declined 10% to $87,164,000 as compared to $96,872,000 in 1992. Gross profit margin declined to 18.1% in 1993 from 18.9% in 1992. The decline in gross profit related primarily to the Company's European operations for the reasons noted above. Selling, general and administrative expenses remained at approximately 13% as a percentage of sales in both 1993 and 1992. As a result of these various factors, operating income was $24,871,000 in 1993 and $29,600,000 in 1992 while the operating income margin amounted to 5.2% in 1993 from 5.8% in 1992. Net interest expense declined during 1993 to $22,942,000 from $26,023,000 in 1992 as a result of changes in foreign currency translation rates, lower average outstanding debt balances and lower interest rates primarily in the Company's European operations. The Company's consolidated effective tax rate amounted to approximately 153% in 1993 compared to 87% in 1992. The higher effective tax rate reflects the low level of tax benefits accrued at the Company's loss operations offset by the provision for taxes applicable to the Company's profitable operations. Minority interest in each of 1993 and 1992 reflects the interests of other shareholders in PCI, Ferembal and Onena, and of Obalex in 1993. Net income amounted to $988,000 ($.33 per share) in 1993 as compared to $2,063,000 ($.67 per share) in 1992. Included in net income in 1992 was the cumulative effect of an accounting change relating to the adoption of FASB No. 109 amounting to $460,000 ($.15 per share) and an extraordinary loss related to the write-off of a deferred financing fee of $1,502,000 ($.49 per share). 1992 VS. 1991 Sales increased 65% in 1992 to $511,241,000 as compared to $310,654,000 in 1991. This increase resulted primarily from the acquisition of CPC in November 1991 ($183,712,000 in 1992 and $17,030,000 in 1991) and from an approximately 6% improvement in foreign currency translation rates over the prior year. Sales in 1992 were negatively impacted by a poor harvest in France for some crops because of adverse weather conditions and general economic weakness in both the United States and Europe. Management believes the negative impact of the poor harvest amounted to about $2,000,000 and about $3,000,000 related to weak economies. Gross profit increased by 40% or $27.5 million to $96.9 million in 1992. The increase in gross profit also related to the acquisition of CPC ($28,388,000 in 1992 and $1,568,000 in 1991) and foreign currency translation rates. Gross profit as a percentage of sales declined to 18.9% in 1992 from 22.3% in 1991. The percentage decline relates to a generally lower gross profit margin at CPC than at the Company's other operating subsidiaries primarily because of CPC's substantially higher depreciation charges relating to the write-up of its assets at acquisition. However, the Company's other operations also reported a decline in gross profit margin to 21.6% in 1992 from 23.1% in 1991. Other factors reducing gross profit margins were pricing pressures in the packaging machine business at Dixie Union which is expected to continue so long as Europe remains in a recession, and increased raw material costs at Ferembal which are not expected to continue to increase so long as Europe remains in a recession. Backlog declined approximately $7.9 million from December 31, 1991 to December 31, 1992. Of this amount approximately $1.7 million related to currency translation rates. Economic weakness, primarily in Europe, accounted for approximately $5.8 million while economic weakness in the United States accounted for approximately $.4 million. Approximately 80% of the decline related to Dixie Union with most of the remainder attributable to reduced backlog at Onena. The declining backlog could be expected to result in lower sales at Dixie Union and Onena during the first half of 1993 compared to the same period of 1992. Selling, general and administrative expenses remained at approximately 13% in each of 1992 and 1991. As a result of these factors operating income amounted to $29,600,000 in 1992 as compared to $27,356,000 in 1991. Operating income increased $2,883,000 in 1992 and declined $1,214,000 in 1991 as a result of the acquisition. The operating income margin declined from 8.8% in 1991 to 5.8% in 1992, again primarily resulting from a lower level of the operating income margin at PCI than at the remainder of the Company's operations. However, the operating profit margin in the remainder of the Company's operations also declined from 9.7% in 1991 to 9.0% in 1992. Net interest expense rose substantially in 1992 to $26,023,000. Besides the increase resulting from the acquisition of CPC ($10,095,000 in 1992 and $884,000 in 1991), European interest rates were higher during 1992 than 1991. Additionally, the Company earned substantial interest income during 1991 from the proceeds of a stock offering. Foreign currency exchange losses were also higher in 1992 than 1991 primarily as a result of the devaluation of the pound. The Company's consolidated effective tax rate in 1992 amounted to 87% as compared to 42% in 1991. The higher effective tax rate in 1992 reflects the effect of offsetting relatively low levels of tax benefits to pre-tax losses recognized by CPC against the provision for taxes applicable primarily to Ferembal's pre-tax income. Minority interest in each of 1992 and 1991 reflects the interest of other shareholders in PCI, Ferembal, and Onena, and of Dixie Union in 1991. The change in minority interests results principally because the minority shareholder of PCI absorbed 50% of PCI's losses, which were greater in 1992 than in 1991. Income before cumulative effect of accounting change and extraordinary item amounted to $3,105,000 ($1.01 per share) in 1992 as compared to $7,394,000 ($2.92 per share) in 1991. Cumulative effect of accounting change related to the adoption of FASB No. 109 on January 1, 1992 and amounted to $460,000 ($.15 per share) in 1992. The extraordinary loss related to the write-off of a deferred financing fee from the acquisition of CPC and amounted to $1,502,000 ($.49 per share) in 1992. As a result, net income amounted to $2,063,000 ($.67 per share) in 1992 and $7,394,000 ($2.92 per share) in 1991. FINANCIAL CONDITION Capital Requirements The packaging business utilizes relatively large amounts of specialized machinery and equipment which are periodically upgraded or replaced. Capital expenditures in 1993 amounted to $22,154,000 primarily for the purchase of machinery and equipment. During 1993, major capital expenditures included the purchase of extrusion blow-molding lines and line changes for barrier containers for food products and an easy-open end line for cans. Expenditures in 1994 are expected to amount to approximately $25,500,000 and be similar in character to those in 1993. Approximately $1 million is expected to be spent on a building addition at Ingosa during 1994. During 1993, Ferembal increased its ownership interest in Obalex to 51% through the issuance by Obalex of an additional 17% of its shares for a capital contribution by Ferembal of approximately $3,000,000. See Note 2(b). During 1993 the Company purchased substantially all of the shares of Ingosa for nominal consideration. The Company intends to merge the operations of Onena and Ingosa during 1994 and has entered into an agreement with the Spanish provincial government to capitalize certain amounts due it by Ingosa for 41% of the equity of the merged entity. The merger is expected to be completed by June 30, 1994 and to be legally effective as of January 1, 1994. See Note 2(a). The Company has actively pursued acquisition possibilities in 1993 and intends to continue to do so in 1994 and later years. It is presently the Company's intention to finance any acquisitions by leveraging the assets of the company to be acquired or, possibly, through the issuance of stock. There are no plans presently to utilize any substantial portion of the existing capital resources of the Company in an acquisition. The Company met its 1993 capital requirements with cash generated from operations, from existing funds, and through borrowings. It is anticipated that most expenditures in 1994 will be financed in a similar manner. LIQUIDITY The Company's liquidity position at December 31, 1993 remained essentially unchanged from the prior year end. Working capital decreased to $66.1 million at December 31, 1993 from $69.2 million at December 31, 1992. The current ratio was 1.67 at December 31, 1993 and 1.69 at December 31, 1992. The Company's cash position decreased by approximately $1.5 million between December 31, 1993 and 1992. Cash flows from operating activities provided $28.9 million for the Company in 1993 most of which related to depreciation and amortization. Of the cash provided by operating activities, the Company invested a substantial portion of such funds in capital expenditures amounting to $22.2 million. Additionally, the Company used a net amount of $9.0 million in financing activities primarily for the repayment of short and long-term borrowings. At December 31, 1993, the Company had available a credit line of $3,150,000 under a Revolving Credit Facility. The Company's packaging subsidiaries had available various credit facilities of $42.7 million at December 31, 1993. However, the Company's ability to draw upon these lines for other than certain subsidiary purposes is restricted. The Company expects that cash from operations and its existing banking facilities will be sufficient to meet its needs in 1994 and on a long-term basis. RECENT ACCOUNTING PRONOUNCEMENTS The Company and its subsidiaries account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS No. 109) issued in February 1992. This statement requires, among other things, recognition of future tax benefits, measured by enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and to tax net operating loss carryforwards, to the extent that realization of such benefits is more likely than not. As discussed in Note 10, PCI has tax net operating loss carryforwards (NOL's) totaling approximately $45,000,000 which expire between 2006 and 2008. FAS No. 109 requires that the tax benefit of such NOL's be recorded as an asset to the extent that management assesses the utilization of such NOL's to be "more likely than not". Management has determined, based on the Continental Plastic Container Company's history of prior operating earnings and its expectations for the future, that operating income of PCI will more likely than not be sufficient to utilize at least $28,500,000 of the $45,000,000 of NOL's prior to their ultimate expiration in the year 2008. The NOL's available for future utilization were generated principally by an operating loss in the short period following the November 1991 purchase and additional interest expense on debt incurred in connection with the purchase. Additionally, in the year ended December 31, 1992, an extraordinary loss was incurred due to the write-off of deferred financing costs relating to a short- term note which was refinanced. The operations of the Continental Plastic Container Companies have historically been profitable (excluding non-recurring items). In assessing the likelihood of utilization of existing NOL's, management considered the historical results of the Continental Plastic Container Companies' operations both prior to the purchase and as subsidiaries of PCI subsequent to the purchase, and the current operating environment. In 1992, PCI adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post-retirement Benefits Other than Pensions". There was no cumulative effect of the change in accounting for post-retirement benefits, as the accumulated post-retirement benefit obligation (APBO) existing at January 1, 1992 equaled the amount recorded in the prior year as part of the purchase accounting adjustments. PCI continues to fund benefit costs on a pay-as-you-go basis. See Note 13 for more information. NEW ACCOUNTING STANDARD NOT ADOPTED PCI provides certain post-employment benefits to former and inactive employees, their beneficiaries and covered dependents. These benefits include disability related benefits, continuation of health care benefits and life insurance coverage. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Post-Employment Benefits", which requires employers to recognize the obligation to provide post-employment benefits and an allocation of the cost of those benefits to the periods the employees render service. Implementation of SFAS No. 112 will be required of PCI in 1994. The effect of the implementation of this Statement has not been determined. However, management believes the impact will not be significant to the consolidated financial statements. INFLATION AND CHANGING PRICES Costs and revenues are subject to inflation and changing prices in the packaging business. Since all competitors are similarly affected, product selling prices generally reflect cost increases resulting from inflation. Inflation has not been a material factor in the Company's revenues and earnings in the past three-years. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) Accounting Policies and Other Matters (a) Principles of Consolidation The accompanying consolidated financial statements include the accounts of Continental Can Company, Inc. (the Company), its majority-owned foreign and domestic subsidiaries and, subsequent to acquisition on November 21, 1991, its 50% interest in Plastic Containers, Inc. (PCI). During 1992, the Company entered into an agreement which gave the Company a proxy to vote an additional 1% of the shares of PCI (see Note 2(c)). The proxy provides the Company with effective control over PCI and, accordingly, the Company's interest in PCI is reflected on a consolidated basis. At December 31, 1993, the Company owned the following packaging related businesses: 85% of Ferembal S.A. (Ferembal), located in France which in turn owns 51% of Obalex A.S. (Obalex) located in the Czech Republic; 100% of Viatech Holding GmbH (Holding), which in turn owns all of the outstanding shares of Dixie Union Verpackungen GmbH (Dixie Union), located in the Federal Republic of Germany; and 80% of Onena Bolsas de Papel, S.A. (Onena), and 99.97% of Industrias Gomariz, S.A. (Ingosa), both located in Spain. As mentioned above, the Company also owns 50% of PCI, which in turn owns 100% of Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively, CPC). In addition, the Company owns 100% of an engineering firm, Lockwood, Kessler & Bartlett, Inc. At December 31, 1992 the Company's then 34% interest in Obalex was reflected on the equity method of accounting. In 1993, the Company increased its interest in Obalex to 51% and accordingly the Company's interest is now reflected on a consolidated basis. Minority interests reflected in consolidation represent the portions of Ferembal, Holding, Onena, Ingosa and PCI not owned by the Company. See Note 2. All significant intercompany balances and transactions have been eliminated. (b) Inventories Inventories consist principally of packaging materials, repair parts and supplies. The manufacturing inventories of PCI are stated at the lower of cost applied on the last-in, first-out (LIFO) method, which is not in excess of market. Inventories of the Company's other subsidiaries and the repair parts and supplies inventories of PCI are stated at the lower of cost on a first-in, first-out (FIFO) basis or market. (c) Depreciation and Amortization Depreciation and amortization of property, plant and equipment are computed on a straight-line basis over the estimated useful lives of the assets, as follows: Leasehold improvements are amortized over their estimated useful lives or the term of the lease, whichever is less. Provision for amortization of intangible assets is based upon the estimated useful lives of the related assets and is computed using the straight-line method. Intangible assets resulting from the acquisitions of (a) PCI consist of (i) a non-compete agreement and acquisition and financing costs (amortized over five-years), and (ii) customer contracts (amortized over ten years); and (b) Ferembal consist of patents (amortized on a straight-line basis over their estimated useful lives) and goodwill (amortized on a straight line basis over forty years). (d) Income Taxes The Company files a consolidated tax return for U.S. purposes for itself and its domestic subsidiaries (to the extent it owns at least 80% of such subsidiaries). Separate returns are filed for all other subsidiaries. U.S. deferred income taxes have not been provided on the unremitted earnings of the Company's foreign subsidiaries to the extent that such earnings have been invested in the business, as any taxes on dividends would be substantially offset by foreign and other tax credits. Effective January 1, 1992, the Company implemented the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" (see Note 10). The cumulative effect of adopting SFAS No. 109 is reflected in the consolidated statement of earnings. SFAS No. 109 utilizes the liability method and deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of enacted tax laws. Prior to the implementation of SFAS No. 109, the Company accounted for income taxes using Accounting Principles Board Opinion No. 11. (e) Foreign Currency Translation The accounts of Ferembal and its subsidiary, Obalex, Holding and its subsidiary, Dixie Union, Onena and Ingosa have been converted to U.S. dollars utilizing SFAS No. 52, "Foreign Currency Translation", under which assets and liabilities are translated at the exchange rate in effect at the balance sheet date, while revenues, costs and expenses are translated at the average exchange rate for the reporting period. Resulting unrealized net gains or losses are recorded as a separate component of stockholders' equity. Realized foreign exchange gains or losses are reflected in operations. (f) Statement of Cash Flows The Company considers securities purchased within three months of their maturity date to be cash equivalents. Cash equivalents consist of short-term investments in government securities and bonds. Cash paid for interest and income taxes was as follows: As partial consideration for the purchase of CPC, PCI gave a secured promissory note for $100,000,000 effective November 22, 1991. See Note 2(c). (g) Research and Development Research and development costs are charged to expense as incurred. Such costs amounted to approximately $12,862,000, $14,603,000, and $4,194,000 in 1993, 1992, and 1991, respectively. (h) Accounting for Post-retirement Benefits Other Than Pensions In 1992, the Company adopted SFAS No. 106, "Employer's Accounting for Post- retirement Benefits Other Than Pensions", which requires a calculation of the actuarial present value of expected benefits to be paid to or for employees after their retirement and an allocation of the cost of those benefits to the periods the employees render service (see Note 13). (i) Insurance Prior to November 21, 1991, CPC was self-insured for the purposes of providing workers' compensation, general liability and property and casualty insurance coverages up to varying deductible amounts. CPC's former owner's risk management consulting services determined CPC's required reserves for asserted and unasserted claims based on actuarially determined loss experience. Subsequent to November 21, 1991, PCI purchased commercial insurance policies, but remained self-insured for coverages up to varying deductible amounts. PCI's self- insurance reserves are included in other liabilities in the consolidated balance sheets. Costs charged to operations for self-insurance for the years ended December 31, 1993 and 1992 were $2,268,000 and $2,078,000, respectively, and for the period from November 22, 1991 through December 31, 1991 were $222,000. (j) Plant Rationalization and Realignment PCI records an estimate of the liabilities associated with the closing of specific manufacturing facilities. Costs (income) charged to operations for these programs were $(135,000), and $159,000 for the years ended December 31, 1993 and 1992 respectively, and $32,000 for the period from November 22, 1991 through December 31, 1991. Net income was recognized in 1993 due to a sublease of the related facilities. Included in other current liabilities at December 31, 1993 is $472,000 ($1,734,000 at December 31, 1992) related to accruals for plant rationalization and realignment. (k) Earnings Per Share Earnings per common share is based on the weighted average number of common and common equivalent shares outstanding. Common equivalent shares include dilutive stock options (using the treasury stock method) exercisable under the Company's option plans and warrants. Weighted average shares outstanding in 1993, 1992, and 1991 were 3,023,062, 3,078,387, and 2,532,967, respectively. Earnings per common share, assuming full dilution, gives effect to the conversion of the Company's outstanding 10-3/4% Convertible Subordinated Debentures as if such Debentures had been converted, after elimination of related interest expense, net of income tax benefit. (l) Reclassifications Certain reclassifications have been made to conform prior year financial statements to the 1993 presentation. (2) Acquisitions (a) Ingosa On November 30, 1993, the Company purchased substantially all of the shares of Ingosa for nominal consideration. Ingosa, located in Pamplona, Spain, is a flexible packaging manufacturer which laminates and prints plastic, paper and foil materials primarily for the food industry in Spain. The acquisition is being accounted for under the purchase method. In connection with this transaction the excess of the fair value of the net assets acquired over the purchase price was allocated to property, plant and equipment. Such allocation has been based on preliminary estimates which may be revised at a later date. In addition, the Company entered into an agreement with the provincial government through SODENA, an economic development corporation owned by the government. The agreement, which was subsequently legislatively ratified in 1994, contemplates that Onena will be merged into Ingosa. SODENA will receive 41% of the equity in the combined entity in exchange for the elimination of $3,736,000 (534 million pesetas) in overdue local taxes owed by Ingosa. In addition, SODENA will provide the merged entity with a $2,100,000 (300 million pesetas) interest free loan for a period of up to 4 years secured by Onena's existing land and building and provide certain other incentives to the merged entity. The Company has agreed to invest $700,000 (100 million pesetas) in the merged entity as additional equity. The various transactions contemplated pursuant to this agreement are expected to be completed during the second quarter of 1994 and to be legally effective as of January 1, 1994. (b) Obalex On November 27, 1992, Ferembal acquired 34% of the stock of Obalex A.S., a producer of food cans in the Czech Republic, for approximately $3,021,000 and simultaneously entered into two agreements to provide Obalex with training, a technology license, and certain equipment, which approximates Ferembal's estimated cost of providing such training, technology and equipment. Ferembal paid approximately $1,086,000, with a balance of $1,935,000, paid in December 1993. In 1993, Ferembal, pursuant to a pre-emptive right, subscribed to a share issue which gave Ferembal an additional 17% interest in the common stock of Obalex for approximately $3,000,000. These transactions have been accounted for under the purchase method with the purchase price allocated to the fair value of the net assets acquired. (c) PCI During 1991, the Company and Merrywood, Inc. (Merrywood) each invested $30,000,000 for respective 50% interests in PCI. On November 21, 1991, PCI purchased all of the outstanding stock of CPC, manufacturer of a wide range of blow-molded plastic containers for the food, automotive, personal care and household, industrial and agricultural chemical markets. The purchase price of approximately $153,450,000 included $135,450,000 as the purchase price for the stock acquired, $15,000,000 as consideration for a non-competition agreement, and $3,000,000 as fees for providing financing. Of the total consideration, $53,450,000 was paid in cash and $100,000,000 was represented by a secured promissory note of PCI, guaranteed by CPC. PCI's results are reflected in the Company's consolidated financial statements after consideration of purchase accounting adjustments recorded by PCI. In 1992, PCI issued $110,000,000 in senior secured notes, the proceeds of which were used to retire the secured promissory note of PCI (see Note 9(c)). In connection with the retirement of the promissory note, PCI incurred an extraordinary loss of $3,005,000 on the write-off of capitalized financing costs. The Company has reflected this item in its consolidated statement of earnings, net of the portion attributable to the minority interest in PCI. In addition to the foregoing amounts to purchase CPC, PCI had agreed to pay the seller an amount equal to 30% of the amount by which CPC's sales (adjusted to reflect resin prices in effect on August 31, 1991) for 1992 and 1993 exceeded $218,000,000 and $224,000,000, respectively. No additional payments were required. During 1992, the Company entered into an agreement with Merrywood pursuant to which Merrywood granted the Company a proxy, irrevocable until August 6, 1998, to vote an additional 1% of the PCI common stock. The agreement also provides (i) that Merrywood has the right to require the Company to purchase its 50% interest in PCI for $30,000,000, plus interest at 1% over the prime rate from November 21, 1991, and (ii) that after July 1, 1994, Merrywood has the right to exchange its 50% interest in PCI for 887,500 shares of the Company's common stock (adjusted for any future stock split, stock combination or reclassification) representing approximately 31% of the total number of shares currently outstanding. In addition, pursuant to the agreement, the Company gave Merrywood three voting and one non-voting position on the Company's board of directors. If Merrywood has not elected to require the Company to purchase its interests in PCI for cash by August 7, 1998, then Merrywood's PCI shares are required to be exchanged for shares of the Company's Common Stock. (d) Minority Interest in Dixie Union In July 1991, the Company purchased the 49% minority interest in the equity of Viatech Holding GmbH owned by the Dow Chemical Company (Dow) for $5,804,000 in a transaction accounted for under the purchase method. In connection with this transaction, the excess of the fair value of the net assets acquired over the purchase price was allocated to property, plant and equipment. In addition, the Company entered into a new technology transfer agreement with Dow with regard to certain extrusion and polymer technology. The effective period is five-years, commencing 1991, and the annual royalty paid is $280,000. (e) Ferembal During the two-year period ended December 31, 1993, the Company purchased approximately 1% of the outstanding shares of Ferembal for $333,000. In August 1991, the Company purchased approximately 16% of the outstanding shares of Ferembal from Citicorp Capital Investors Europe Limited and certain of its affiliates for an aggregate consideration of $6,051,000. As a result of these transactions, the Company's equity interest in Ferembal increased from 68% (as acquired during 1989) to 85%. These transactions have been accounted for under the purchase method, with the excess of cost over the fair value of the net assets acquired (approximately $3.6 million) being amortized on a straight-line basis over forty years. As part of the 1989 purchase of Ferembal, goodwill of approximately $10.0 million (amortized over 40 years) was recorded and a junior subordinated convertible bond was issued which, if converted at December 31, 1993, would reduce the Company's percentage ownership of Ferembal to 64%. (See Note 9(d)). The accumulated amortization of goodwill relating to Ferembal amounted to $1,442,000 and $1,083,000 at December 31, 1993 and 1992, respectively. During the year ended December 31, 1991, Ferembal created Ferembal Investissement S.A. (Investissement) for the purpose of holding a subsidiary, Ferembal Sud Ouest S.A. (Sud Ouest). Investissement was capitalized with 150,000 shares of 100 francs par value. Ferembal holds 80,000 shares and two banks, Credit du Nord and Societe Generale, hold the remaining 70,000 shares. Ferembal has entered into an agreement with the banks whereby it has guaranteed to purchase the shares between the dates of May 1, 1995 and December 31, 1996. (3) Investments At December 31, 1993 and 1992, short-term investments consisted principally of U.S. treasury bills and government agency securities. All investments are recorded at cost, which approximates market. (4) Accounts Receivable and Business/Credit Concentrations Most of the Company's customers are located in the United States and Europe. Sales to two customers in 1993, two customers in 1992 and three customers in 1991 accounted for 15%, 15% and 24% of the Company's sales, respectively; accounts receivable from two customers at December 31, 1993 and from three customers at December 31, 1992 amounted to 19%, and 24%, respectively, of the Company's total stockholders' equity. Included in other accounts receivable at December 31, 1993 are $3,024,000 due from a customer for equipment purchases, engineering fees billed of $2,250,000 ($3,297,000 at December 31, 1992), recoverable value added taxes of $686,000 ($2,993,000 at December 31, 1992) related to Ferembal, and a loan aggregating $34,986 ($166,060 at December 31, 1992) to the Company's Chairman. The loan bears interest at prime + 1% and matures no later than December 31, 1994. (5) Inventories Inventories consist principally of packaging materials. The components of inventory at December 31 were as follows: (6) Prepaid Expenses and Other Current Assets The components of prepaid expenses and other current assets at December 31, were as follows: Ferembal entered into an agreement with a local municipality in France for the sale, at cost, of land and buildings under construction at December 31, 1991. Ferembal then agreed to lease the land and buildings from the municipality under a 20-year operating lease. Ferembal may terminate the lease at any time in the first six-years, without penalty, and upon agreement thereafter. Rental payments to the municipality will be determined on the cost of the land and buildings, less any government subsidies received, plus interest, and will be payable over the 20-year term. At December 31, 1992, the construction of the buildings was complete and the cost of such land and buildings were considered to be assets held for sale and were presented as other current assets in the amount of $1,560,000. The sale of the land and buildings occurred on January 11, 1993 at cost. Payment is due in the second quarter of 1994. (7) Other Assets The components of other assets at December 31 were as follows: (8) Short-term Borrowings At December 31, 1993 and 1992, approximately $6,378,000 and $3,986,000, respectively, were outstanding representing amounts drawn to cover bank overdrafts. Interest is to be paid at rates ranging from 7.14% to 14%. At December 31, 1993, Ferembal had short-term unsecured borrowing agreements of approximately $21,000,000, substantially all of which were unused. At December 31, 1993, Holding had total lines of credit available under short-term unsecured borrowing agreements of approximately $9,100,000. (9) Long-Term Debt, Capital Leases and Other Long-Term Liabilities Long-term debt and capital leases at December 31, 1993 and 1992 are summarized as follows: (a) In May 1987, the Company issued $1,612,875 of 10.75% Convertible Subordinated Debentures due in 1994. Interest payments are payable every six months. Each $15.00 face amount of Debenture, with the payment of an additional $15.00 in cash, is convertible into four shares of Common Stock. The Debentures are callable at the option of the Company. Shares issuable upon conversion of the Debentures amounted to 310,450 at December 31, 1993. (b) The Company's Revolving Credit Facility provides for borrowings of up to $4 million. A commitment fee of .75% is payable on the unused portion of the facility. There are provisions regarding the maintenance of minimum net worth and demand deposits averaging at least $400,000. The facility is secured by all of the Company's tangible and intangible assets. Subject to certain conditions precedent, the Revolving Credit Facility may be converted into a five-year term note when due. (c) PCI is required to make four annual sinking fund payments of $22 million each, commencing April 1, 1997 and continuing through April 1, 2000. The notes are redeemable, in whole or in part, at the option of PCI at prices decreasing from 105% of par at April 1, 1997 to par on April 1, 2000. In the event of a change of control of PCI as defined in the indenture, PCI is obligated to offer to purchase all outstanding Senior Secured Notes at a redemption price of 101% of the principal amount thereof, plus accrued interest. In addition, PCI is obligated in certain instances to offer to purchase Senior Secured Notes at a redemption price of 100% of the principal amount thereof, plus accrued interest with the net cash proceeds of certain sales or dispositions of PCI's assets. The indenture places certain restrictions on PCI concerning payment of dividends, additional liens, disposition of the proceeds from asset sales, sale-leaseback transactions and additional borrowings. At December 31, 1993, PCI was in compliance with these restrictions. (d) In 1989, Ferembal issued a subordinated bond convertible into 100,000 shares of capital stock at the option of the holders at any time prior to October 28, 1999. If exercised, the Company's ownership interest in Ferembal will decrease from the present 85% interest to a 64% interest. If the conversion right is not exercised, the bond becomes due in two equal annual installments beginning in 1999. (e) The capital lease obligations represent lease payments due through 2005 which are capitalized according to FASB Statement No. 13. The following is a schedule of future minimum lease payments under the capitalized leases together with the present value of the net minimum lease payments as of December 31, 1993: In January 1991, Ferembal entered into a sale and lease-back agreement relating to land and buildings at one of its manufacturing facilities with a net book value of approximately $2,394,000. The transaction resulted in a net gain of $284,000. The gain on this transaction was deferred and is being amortized over the lives of the leased assets. The proceeds were used to retire an equivalent amount of senior long-term debt. (f) In June 1988, Onena settled an outstanding dispute regarding the amount of turnover tax due to the Spanish provincial government. A mortgage on Onena's property, plant and equipment secures the obligation, which amounts to $822,000 (118 million pesetas) at December 31, 1993 and 1992 and is repayable in installments over a six-year term. Also included is $3,736,000 (534 million pesetas) at December 31, 1993 which is due to the Spanish provincial government by Ingosa and which is expected to be capitalized in 1994. See Note 2(a). (g) In 1992, Onena reached an agreement with regard to sums due to social security which amounts to $2,626,000 (375 million pesetas) at December 31, 1993 (385 million pesetas at December 31, 1992). The agreement provides for a five-year repayment schedule. Also included is $686,000 (98 million pesetas) at December 31, 1993 relating to amounts due to social security by Ingosa which will be repaid over a three-year period beginning in 1994. Maturities of long-term debt are as follows: During 1992, PCI obtained a $15 million credit facility with Citibank, N.A. ("Citibank") under which PCI is able to borrow, on a revolving basis, up to an amount representing specified percentages of PCI's eligible accounts receivable and eligible inventory, not to exceed $15 million outstanding at any time. The facility will mature on its fifth anniversary. The revolving credit loans bear interest at the rate, selected at PCI's option, of 1.5% per annum over the fluctuating alternative base rate of Citibank or 2.75% per annum over the London Inter Bank offering rate of Citibank. Borrowings under the revolving credit facility are guaranteed by CPC and secured by accounts receivable and inventories and a secondary lien on the outstanding stock of CPC. PCI is required to pay Citibank an annual commitment fee of 1/2% of the average daily unused portion of the revolving credit facility. Commitment fees totaled $72,000 and $43,000 for the years ended December 31, 1993 and 1992, respectively. There were no outstanding borrowings under this credit facility at December 31, 1993 and 1992. This revolving credit facility contains covenants covering, among other things, leverage, cash flow, minimum fixed charge coverage, minimum interest coverage and net worth, and restrictions on capital expenditures, additional indebtedness, sale-leaseback transactions, dividends and other corporate transactions of PCI and its subsidiaries. At December 31, 1993, PCI was in compliance with the covenants. PCI is required to have no outstanding borrowings under the revolving credit facility for at least 30 consecutive days during each 12-month period, other than borrowings used to finance permitted acquisitions, dividends and letters of credit. The agreement provides for the issuance of letters of credit by Citibank on PCI's behalf. At December 31, 1993, $1,084,000 of such letters of credit had been issued, guaranteeing obligations carried in the consolidated balance sheet. The revolving credit facility agreement also requires a reserve by PCI of $1,800,000 for automatic clearing house (ACH) float. The letter of credit and ACH reserve reduce the total amount available under the revolving credit facility. At December 31, 1993, no other funds had been drawn on the revolving credit facility. Additional letters of credit totaling $652,000 were obtained from another banking facility. The Company has a $625,000 unused standby letter of credit available, which expires on January 28, 1996, bears interest at 1.5% per annum and is secured by U.S. Treasury bills worth $510,000. Other long-term liabilities at December 31, 1993 primarily include pension and profit sharing amounts related to PCI and Ferembal of $17,447,000 ($16,275,000 at December 31, 1992), insurance reserves at PCI of $7,688,000 ($7,625,000 at December 31, 1992), and accrued post-retirement benefits at PCI of $6,008,000 ($5,832,000 at December 31, 1992). (10) Income Taxes As discussed in note 1(d), The Company adopted SFAS No. 109 as of January 1, 1992. The cumulative effect of this change in accounting for income taxes of $460,000, exclusive of the portion allocated to minority interest ($85,000), was determined as of January 1, 1992 and is reported separately in the consolidated statement of earnings for the year ended December 31, 1992. As a result of applying SFAS No. 109 in 1992, pre-tax income before minority interest, extraordinary item and cumulative effect of accounting change for the year ended December 31, 1992 increased by $884,000. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. The components of the provision for income taxes for the years ended December 31, 1993, 1992 and 1991 are as follows: The Company's total income tax provision differs from the provision that would result from applying the U.S. Federal statutory income tax rate to income before provision for income taxes, minority interest, extraordinary item and cumulative effect of accounting change due to the following: The significant components of deferred income tax benefit attributable to income from continuing operations for the years ended December 31, 1993 and 1992 are as follows: For the year ended December 31, 1991, deferred income tax expense of $53,000 results from timing differences in the recognition of income and expense reported in the financial statements and that reported for tax purposes. The source of the differences between income and expense for tax purposes as compared to related amounts reported in the financial statements and the tax effect of each is as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 are presented below: The valuation allowance for deferred tax assets as of January 1, 1992 was $2,211,000. The net change in the total valuation allowance for the years ended December 31, 1993 and 1992 was an increase of $1,671,000 and $2,409,000, respectively. Due to different tax jurisdictions of the Company's subsidiaries, net deferred tax liabilities of $32,000 at December 31, 1993, and $1,728,000 at December 31, 1992 shown above are reflected in the consolidated balance sheets as: At December 31, 1993, PCI has operating loss carry forwards for Federal income tax purposes of approximately $45,000,000 which are available to offset future Federal taxable income through 2008. (11) Common Stock (a) Sales of Common Stock In June 1991, the Company received net proceeds of $29,453,000 from the sale of 1,020,000 shares of its Common Stock and 255,000 Warrants to purchase its Common Stock. Each Warrant, for a period of two years, entitled the holder thereof to purchase one share of the Company's Common Stock for $30.875. At December 31, 1993, no Warrants remained outstanding. (b) Options The 1981 Incentive Stock Option Plan, as amended, (the Incentive Plan) provided for the issuance of up to 120,000 shares of the Company's Common Stock upon the exercise of options at prices not less than 100% of the fair market value of the shares. Options were exercisable for up to 10 years. During 1992, 3,000 options were exercised under the Plan. As of December 31, 1993, no options remained unexercised and no further options could be granted under the Incentive Plan. The 1988 Restricted Stock Option Plan, as amended, (the Restricted Plan) provides for the issuance of up to 500,000 shares of Common Stock upon the exercise of options at an exercise price determined by the Personnel Committee of the Board of Directors (the Committee), but no less than $1.00 per share. The Committee may determine the exercise period of the option up to a maximum of twenty years from the date of the grant and may determine a restricted period during which any portion of the option may not be exercised. On March 4, 1993, an employee was granted an option to purchase up to 5,000 shares of common stock at a price of $22.00 per share. The option expires five-years from its grant and had not been exercised as of December 31, 1993. As of December 31, 1993, the Chairman and the Executive Vice President had received (i) restricted options (granted in March 1992) to purchase 30,000 and 20,000 shares, respectively, vesting over a five- year period, at $26.75 per share, such price being the fair market value at date of grant; (ii) unrestricted options to purchase 140,000 and 60,000 shares, respectively, under the Restricted Plan at $8.625 to $17.00 per share, such prices being the fair market value of a share of the Company's Common Stock at the date of the grant; and (iii) restricted options (granted in April 1991) to purchase 10,000 and 6,000 shares, respectively, at an exercise price of $1.00 per share which vest at a rate of 20% per year subject to their continued employment. Concerning the 16,000 restricted options granted in April 1991, compensation to be recognized over the five-year vesting period will aggregate $520,000, of which $104,000, $104,000 and $78,000 was charged to expense in 1993, 1992 and 1991, respectively. As of December 31, 1993, 28,100 shares were reserved for future options under the Restricted Plan. The Chairman was granted, pursuant to a prior employment agreement, an option to purchase 40,000 shares of the Company's Common Stock at an exercise price of $2.94 per share being the fair market value of a share of the Company's stock on the date this option was approved by the Company's shareholders. This option is not under any of the Company's option plans, had not been exercised as of December 31, 1993 and expires on December 31, 1998. Pursuant to the 1988 Director Stock Option Plan (the Retainer Plan), directors may elect to receive a stock option in lieu of cash as an annual retainer. Each electing director will receive an option equal to the nearest number of whole shares determined by dividing the annual retainer by the fair market value of the stock less one dollar. The option price is one dollar per share and an option may not be exercised prior to the first anniversary of the date it was granted nor more than ten years after such date. During 1993, nine electing directors each received an option to purchase 316 shares of Common Stock under the Retainer Plan. During 1992 and 1991, nine and eight electing directors each received an option to purchase 241 and 100 shares of Common Stock, respectively, pursuant to the Retainer Plan. In 1993, 1992, and 1991, a total of $58,500, $41,250, and $24,000, respectively, was charged to compensation expense with respect to the Retainer Plan. In 1992, pursuant to an agreement (see Note 2(c)), each of three directors and an advisory director were granted options to purchase 10,000 shares of the Company's Common Stock at $25.75 per share, being its fair market value on the date of the grant. The options expire in 2002 and had not been exercised as of December 31, 1993. Pursuant to the 1992 Restricted Stock Plan for Non-Employee Directors (the "Stock Plan"), each non-employee director of the Company receives an award of 300 shares of Company Common Stock during each year of service beginning in 1992. Such shares are restricted from transfer while such recipient remains a member of the Board of Directors and the shares are subject to forfeiture under certain circumstances including resignation or failure to stand for reelection prior to age 70. The Company issued 8,400 shares under the Stock Plan in 1993 for the 1992 and 1993 plan years; the Company has expensed $103,425 in 1993 and $79,500 in 1992 for shares which were issued. In March 1990, a director received an option to purchase 10,000 shares of the Company's Common Stock at an exercise price of $17.00 per share, being the fair market value of a share of the Company's Common Stock on the date the option was granted. The option is not under any of the Company's option plans, had not been exercised as of December 31, 1993 and expires on March 13, 1995. The 1990 Stock Option Plan for Non-Employee Directors (the Director Plan) provides for the issuance of up to 200,000 shares of Common Stock to directors who are not employees of the Company or its subsidiaries. The Director Plan is administered by a Board Committee. The Director Plan provides for the grant to each non-employee director, at the commencement of his initial term, of an option to purchase up to 10,000 shares of Common Stock at a price equal to the fair market value of a share of Common Stock on the date of the grant. The options become exercisable as to one-tenth of the shares subject to option on the date of the grant and on the nine successive anniversaries of such date. The term of the options is 10 years provided that any option holder who ceases to be a member of the Board of Directors forfeits any part of the option grant which has not become exercisable as of such date. During 1990, each member of the Board of Directors who was not an employee (10 individuals) received an option to purchase 10,000 shares of Common Stock at prices ranging from $17.00 to $17.50 per share, being the fair market value of a share of Common Stock on the date of the grant. No options have been exercised pursuant to the Director Plan. There are currently 100,000 shares available for grant under the Director Plan. Additionally, on November 9, 1993, an individual was awarded an option to purchase up to 5,000 shares of Common Stock at an exercise price of $20.00 per share being the fair market value of a share of the Company's stock on such date. The option expires five-years from its grant and had not been exercised at December 31, 1993. (12) Pension and Profit Sharing Plan PCI provides a defined benefit pension plan for substantially all salaried employees (which was amended in 1993) and a noncontributory defined benefit pension plan for substantially all hourly workers who have attained 21 years of age. The following table sets forth the plans' funded status at December 31, 1993 and 1992 based primarily on January 1, 1993 participant data and plan assets: Net pension costs under the above mentioned PCI plans included the following components for the years ended December 31, 1993 and 1992 and the period from November 22, 1991 to December 31, 1991: During 1992, negotiated benefit increases were made for certain hourly plan participants and early retirement (window plan) was accepted by certain salaried plan participants. The effects of these changes were to increase the hourly plan's PBO by $576,000 and increase the salaried plan's PBO and total periodic pension expense by $814,000 and $581,000, respectively. Assumptions used in the accounting were: Ferembal provides retirement benefits pursuant to an industry-wide labor agreement. The plan is not funded. Amounts charged to expense amounted to $250,000 in 1993, $94,000 in 1992 and $35,000 in 1991. Other non-current liabilities at December 31, 1993 include $1,425,000 ($1,230,000 at December 31, 1992) for this plan. Ferembal also provides an employee profit-sharing plan, the annual contributions to which are determined by a prescribed formula. Amounts charged to expense amounted to $954,000 in 1993, $1,287,000 in 1992 and $1,450,000 in 1991. Amounts are paid to employees after five-years with accrued interest. Other non-current liabilities at December 31, 1993 include $5,951,000($4,557,000 at December 31, 1992) for the plan. Holding provides selected managers of a subsidiary company with pension and disability benefits. Amounts charged to expense amounted to $161,000 in 1993, $154,000 in 1992 and $326,000 in 1991. (13) Post-Retirement Benefits Other Than Pensions and Post-Employment Benefits PCI provides certain health care and life insurance benefits for retired PCI employees. Certain of PCI's hourly and salaried employees become eligible for these benefits when they become eligible for an immediate pension under a formal company pension plan. In 1993, the plan was amended to eliminate health care benefits for employees hired after January 1, 1993. Expenses for benefits provided to retired employees were $710,000, $490,000 and $132,000 for the years ended December 31, 1993 and 1992 and the period from November 22, 1991 through December 31, 1991, respectively. In 1992, PCI adopted SFAS No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions". There was no cumulative effect of the change in accounting for post-retirement benefits, as the accumulated post-retirement benefit obligation (APBO) existing at January 1, 1992 equaled the amount recorded in the prior year as part of the purchase accounting adjustments. PCI continues to fund benefit costs on a pay-as-you-go basis. Summary information on PCI's plan at December 31, 1993 and 1992 is as follows: As of December 31, 1993, the discount rate used in determining the APBO was 7.5%. The assumed health care cost trend rate used in measuring the accumulated post-retirement benefit obligation was 10.95% for 1993, declining gradually with each succeeding year on an ultimate rate of 5.0% beginning in calendar year 2002. As of December 31, 1992, the discount rate used in determining the APBO was 8.5%. The assumed health care cost trend rate used in measuring the accumulated post-retirement benefit obligation was 10% for 1992, declining gradually with each succeeding year on an ultimate rate of 6.2% beginning in calendar year 2020. The effect of a one percentage-point increase in the assumed health care cost trend rates in each year would increase the accumulated post- retirement benefit obligation as of December 31, 1993 by $851,000 and the aggregate of the service and interest cost components of net periodic post- retirement benefit cost for the year then ended by $90,000. PCI provides certain post-employment benefits to former and inactive employees, their beneficiaries and covered dependents. These benefits include disability related benefits, continuation of health care benefits and life insurance coverage. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Post-Employment Benefits", which requires employers to recognize the obligation to provide post-employment benefits and an allocation of the cost of those benefits to the periods the employees render service. Implementation of the Statement will be required of PCI in 1994. The effect of the implementation of the Statement has not been determined. However, management believes the impact will not be significant to the consolidated financial statements. (14) Executive Compensation The Company entered into employment agreements with its Chairman and former Vice-Chairman. The contract with the former Vice-Chairman, who died in January 1989, provided for compensation of $135,000 per annum and was to expire on December 31, 1998. Also, the contract provided that in the event of his death prior to December 31, 1998, his spouse will receive one-half of the amounts which would otherwise have been paid to him until her death or until December 31, 1998, whichever occurs first. The Company has included the present value of this obligation in accrued liabilities. At December 31, 1993, the contract with the Chairman, as amended, provides for base compensation of $400,000 per annum and expires on December 31, 1999. The contract also provides that, in the event of his death before December 31, 1999, his spouse will receive one-half of the amount paid to him annually as base compensation until her death, or until ten years after the date of his death, whichever occurs first. (15) Net Interest Expense The details of net interest expense were as follows: (16) Foreign and Domestic Operations The Company performs services principally in the packaging industry. Manufacturing operations are performed domestically through PCI, whereas manufacturing operations are performed overseas in Europe through Ferembal, Holding and Onena. Information about the Company's foreign and domestic operations follows. (17) Fair Value of Financial Instruments The carrying amounts of cash and cash equivalents, investments, accounts receivable, other current assets, accounts payable and short-term borrowings approximate fair value because of the short maturity of these instruments. The fair value of the Company's long-term debt is estimated, based on the quoted market prices for the same or similar issues, or on the current rates offered to the Company for debt of the same remaining maturities, and approximates the carrying amount as of December 31, 1993. (18) Commitments and Contingencies The Company and its subsidiaries occupy offices and use equipment under various lease arrangements. The rent expense under non-cancellable long- term operating leases for the years ended December 31, 1993, 1992 and 1991 was approximately $7,082,000, $4,968,000, and $758,000, respectively. Total commitments under such arrangements are payable in annual installments of $4,627,000 in 1994, $4,311,000 in 1995, $3,887,000 in 1996, $2,699,000 in 1997 and $1,435,000 in 1998 and $502,000 thereafter. The Company also rents certain equipment and facilities on a month-to-month basis or through short-term leases. The rent expense under such arrangements amounted to approximately $1,317,000 in 1993, $969,000 in 1992, and $711,000 in 1991. Ferembal is contingently liable for receivables sold with recourse of $9,859,000 at December 31, 1993. At December 31, 1993, Holding has commitments for the purchase or construction of capital assets amounting to $136,000. The Company's subsidiaries are defendants in several actions which arose in the normal course of business and, in the opinion of management, the eventual outcome of these actions will not have a material adverse effect on the Company's financial position. (19) Quarterly Financial Data (Unaudited) Summarized quarterly financial data for 1993 and 1992 (in thousands, except per share amounts) is as follows: INDEPENDENT AUDITORS' REPORT ---------------------------- THE BOARD OF DIRECTORS AND STOCKHOLDERS CONTINENTAL CAN COMPANY, INC. We have audited the consolidated balance sheets of Continental Can Company, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements present fairly, in all material respects, the financial position of Continental Can Company, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in notes 1 (h) and 13 and notes 1 (d) and 10 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Nos. 106, "Employer's Accounting for Post-Retirement Benefits Other Than Pensions" and 109, "Accounting for Income Taxes", respectively, on a prospective basis in 1992. /s/ KPMG PEAT MARWICK Jericho, New York March 9, 1994 GENERAL INFORMATION ANNUAL MEETING May 18, 1994 at 10:00 a.m. at The Union League Club, 38 East 37th Street, New York, New York. AVAILABILITY OF FORM 10-K Stockholders may receive, without charge, a copy of the Company's 1993 Annual Report filed with the Securities and Exchange Commission on Form 10-K, including the financial statements and schedules thereto, by directing their written inquiries to Abdo Yazgi, Secretary, Continental Can Company, Inc., One Aerial Way, Syosset, New York 11791. CONTINENTAL CAN COMPANY, INC. COMMON STOCK PRICES AND RELATED MATTERS The common stock of Continental Can Company, Inc. is traded on the New York Stock Exchange. The following table indicates the quarterly high and low sales prices for Continental Can Company, Inc. (CAN) common stock for the last two years. No dividends were paid to the holders of common stock for the years 1993, 1992 and 1991. The Company has no present intention to pay dividends on its common stock. There were 422 stockholders of record as of March 21, 1994. DIRECTORS PRINCIPAL OCCUPATION Donald J. Bainton Chairman of the Board and Chief Executive Officer of the Company Kenneth Bainton Registered Architect with the firm of Alexander Kouzmanoff in New York City Robert L. Bainton Former President of B & B Beverage Co. (Retired 1991) Nils E. Benson Former President of Penn Elastic Co. (Retired 1989) Rainer N. Greeven Partner, Greeven & Ercklentz (Attorneys) Ronald H. Hoenig President of Hoenig & Company, Inc. Charles H. Marquardt Former Chief Operating Officer of Plastic Containers, Inc. (Retired 1993) Ferdinand W. Metternich Managing partner in St. Gallen Consulting Group, a management consulting firm based in Switzerland V. Henry O'Neill Private investor in real estate Donald F. Othmer Distinguished Professor of Chemical Engineering Polytechnic University John J. Serrell President of Kinetic Development Inc. Robert A. Utting President of R.A. Utting & Associates, Inc. Abdo Yazgi Executive Vice President, Chief Administrative Officer, and Secretary of the Company Cayo Zapata Director of Tapas Tapones, a division of Taenza, S.A. DE C.V. Jose Luis Zapata Director of Corporate Finance of Taenza, S.A. DE C.V. OFFICERS PRINCIPAL OCCUPATION Donald J. Bainton Chairman of the Board & Chief Executive Officer Abdo Yazgi Executive Vice President, Chief Administrative Officer, and Secretary John Andreas Vice President - Manufacturing Marcial B. L'Hommedieu Treasurer Linda Driscoll Assistant Secretary CONTINENTAL CAN COMPANY, INC. General Offices: Syosset, New York SUBSIDIARIES AND OFFICERS: PLASTIC CONTAINERS, INC, Syosset, New York CONTINENTAL PLASTIC CONTAINERS, INC. Norwalk, Connecticut Charles DiGiovanna, Chief Executive Officer and President Jay Hereford, Chief Financial Officer Frank Kalisik, Vice President - Research & Development John E. Farrell, Vice President - Marketing CONTINENTAL CARIBBEAN CONTAINERS, INC. Caugus, Puerto Rico FEREMBAL S.A. Clichy, France Rene Faber, Managing Director Christian Bonnet, Financial Director Pierre Lichtenberger, Divisional Director Roland Montaclair, Purchasing Director Jean-Marie Desautard, Personnel Director OBALEX, A.S. Znojmo, Czech Republic Jiri Nekvasil, Chairman Lubos Kadlec, Managing Director VIATECH HOLDING GMBH Kempten, Federal Republic of Germany DIXIE UNION VERPACKUNGEN GMBH Kempten, Federal Republic of Germany Hans H. Schwaebe, Executive Director Peter Epp, Chief Financial Officer ONENA BOLSAS DE PAPEL S.A. INDUSTRIAS GOMARIZ S.A. Pamplona, Spain Carlos Paredes, Executive Director LOCKWOOD, KESSLER & BARTLETT, INC. Syosset, New York John A. Eaton, President Sylvester A. Celebrini, Vice President Ralph A. Cuomo, Vice President George Gross, Vice President Steven Hanuszek, Vice President John P. Lekstutis, Vice President Martin Solomon, Vice President TRANSFER AGENT AND REGISTRAR American Stock Transfer & Trust Company New York, New York AUDITORS KPMG Peat Marwick Jericho, New York GENERAL COUNSEL Carter, Ledyard & Milburn New York, New York

50548_1993.txt

50548

1993

ITEM 1. BUSINESS. Inland Steel Company (the "Company"), a Delaware corporation and a wholly owned subsidiary of Inland Steel Industries, Inc. ("Industries"), is a fully integrated domestic steel company. The Company produces and sells a wide range of steels, of which approximately 99% consists of carbon and high-strength low-alloy steel grades. It is also a participant in certain steel-finishing joint ventures. The Company has a single business segment, which is comprised of the operating companies and divisions involved in the manufacturing of basic steel products and in related raw materials operations. OPERATIONS General The Company is directly engaged in the production and sale of steel and related products and the transportation of iron ore, limestone and certain other commodities (primarily for its own use) on the Great Lakes. Certain subsidiaries and associated companies of the Company are engaged in the mining and pelletizing of iron ore and in the operation of a cold-rolling mill and two steel galvanizing lines. All raw steel made by the Company is produced at its Indiana Harbor Works located in East Chicago, Indiana, which also has facilities for converting the steel produced into semi-finished and finished steel products. In August 1988, the Company realigned its operations into two divisions -- the Inland Steel Flat Products Company division and the Inland Steel Bar Company division. The purpose of the realignment was to allow management to better focus on the distinctive competitive factors and customer requirements in the markets for the products manufactured by each division. The Flat Products division manages the Company's iron ore operations, conducts its ironmaking operations, and produces the major portion of its raw steel. This division also manufactures and sells steel sheet, strip and plate and certain related semi-finished products for the automotive, appliance, office furniture, steel service center and electrical motor markets. The Bar division manufactures and sells special quality bars and certain related semi-finished products for forgers, steel service centers, heavy equipment manufacturers, cold finishers and the transportation industry. The Bar division closed its 28-inch structural mill in early 1991, completing the Company's withdrawal from the structural steel manufacturing business. The Company and Nippon Steel Corporation ("NSC") are participants, through subsidiaries, in two joint ventures that operate steel-finishing facilities near New Carlisle, Indiana. The total cost of these two facilities was approximately $1.1 billion. I/N Tek, owned 60% by a wholly owned subsidiary of the Company and 40% by an indirect wholly owned subsidiary of NSC, operates a cold-rolling mill that began shipping commercial product in 1990 and reached its design capability in 1992. I/N Kote, owned equally by wholly owned subsidiaries of the Company and NSC (indirect in the case of NSC), operates two galvanizing lines which began start-up production in late 1991, became fully operational in the third quarter of 1992, and were operating near design capacity by August 1993. The Company is also a participant, through a subsidiary, in another galvanizing joint venture located near Walbridge, Ohio. Raw Steel Production and Mill Shipments The following table shows, for the five years indicated, the Company's production of raw steel and, based upon American Iron and Steel Institute data, its share of total domestic raw steel production: - --------------- * Net tons of 2,000 pounds. ** Based on preliminary data from the American Iron and Steel Institute. The annual raw steelmaking capacity of the Company was reduced to 6.0 million net tons from 6.5 million net tons effective September 1, 1991, as the Company ceased making ingots. The basic oxygen process accounted for 94% of raw steel production of the Company in 1993 and 1992. The remainder of such production was accounted for by electric furnaces. The total tonnage of steel mill products shipped by the Company for each of the five years 1989 through 1993 was 4.8 million tons in 1993; 4.3 million tons in 1992; 4.2 million tons in 1991; 4.7 million tons in 1990; and 4.9 million tons in 1989. In 1993, sheet, strip, plate and certain related semi-finished products accounted for 88% of the total tonnage of steel mill products shipped from the Indiana Harbor Works, and bar and certain related semi-finished products accounted for 12%. In 1993 and 1992, approximately 93% of the shipments of the Flat Products division and 92% of the shipments of the Bar division were to customers in 20 mid-American states. Approximately 75% of the shipments of the Flat Products division and 83% of the shipments of the Bar division in 1993 were to customers in a five-state area comprised of Illinois, Indiana, Ohio, Michigan and Wisconsin, compared to 72% and 83% in 1992. Both divisions compete in these geographical areas, principally on the basis of price, service and quality, with the nation's largest producers of raw steel as well as with foreign producers and with many smaller domestic mills. According to data from the American Iron and Steel Institute, steel imports to the United States in 1993 totaled an estimated 19.5 million tons, compared with 17.1 million tons imported in 1992. Steel imports constituted approximately 18.8% of apparent domestic supply in 1993, compared with approximately 17.9% of apparent domestic supply in 1992. During 1984, the peak year for steel imports into the U.S., such imports accounted for 26.4% of apparent domestic supply. In addition to the importation of steel mill products, the U.S. steel industry has faced indirect imports of steel. Data from the American Iron and Steel Institute show that imports of steel contained in manufactured goods exceeded exports by an estimated 16 million tons in 1993. Many foreign steel producers are owned, controlled or subsidized by their governments. In 1992, Industries and certain domestic steel producers filed unfair trade petitions against foreign producers of certain bar, rod and flat-rolled products. During 1993, the International Trade Commission ("ITC") upheld final subsidy and dumping margins on essentially all of the bar and rod products and about half of the flat-rolled products, in each case based on the tonnage of the products against which claims were brought. Industries and certain domestic producers have filed formal appeals of the adverse ITC decisions in the U.S. Court of International Trade or similar jurisdiction bodies, and foreign producers have appealed certain of the findings against them. These appeals are pending and decisions are not expected before September 1994 in the bar and rod product cases, and mid-1995 in the flat-rolled product cases. It is not certain how the ITC actions and the appeals will impact imports of steel products into the United States or the price of such steel products. On December 15, 1993, President Clinton notified the U.S. Congress of his intent to enter into agreements resulting from the Uruguay Round of multilateral trade negotiations under the General Agreement on Tariffs and Trade. The key provisions applicable to domestic steel producers include an agreement to eliminate steel tariffs in major industrial markets, including the United States, over a period of 10 years commencing July 1995, and agreements regarding various subsidy and dumping practices as well as dispute settlement procedures. Legislation must be enacted in order to implement the Uruguay Round agreements. Until that process is completed, it will not be possible to assess the extent to which existing U.S. laws against unfair trade practices may be weakened. Primarily as a result of the influx of foreign steel imports and the depressed demand for domestic steel products that began in the early 1980s, certain facilities at the Indiana Harbor Works were permanently closed during the second half of the 1980s and the early 1990s and others were shut down for temporary periods. The 28-inch structural mill was closed in early 1991, reflecting a decision to withdraw from the structural steel markets. In late 1991 the mold foundry, No. 8 Coke Oven Battery, and selected other facilities were closed either as part of a program to permanently reduce costs through the closure of uneconomic facilities or for environmental reasons. Provisions with respect to the shut-down of the structural mill were taken in 1987. Provisions for estimated costs incurred in connection with the closure of the mold foundry, No. 8 Coke Oven Battery, and selected other facilities were made in 1991. Included in such provisions were costs associated with Inland Steel Company's closure of its No. 11 Coke Oven Battery in June 1992. All remaining coke batteries were closed by year-end 1993, a year earlier than previously anticipated. An additional provision was required with respect to those closures. (See "Environment" below.) For the five years indicated, shipments by market classification of steel mill products produced by the Company at its Indiana Harbor Works, including shipments to affiliates of the Company, are set forth below. The table confirms that a substantial portion of shipments by the Flat Products division was to steel service centers and transportation-related markets. The Bar division shipped more than 70% of its products to the steel converters/processors market over the five-year period shown in the table. The increase in 1993 of sales to the automotive market and the decline in sales to the steel converters/processors market are indicative of the Company's efforts to maximize its sales of value-added and higher margin products. Some value-added steel processing operations that the Company does not have the capability to perform are performed by outside processors prior to shipment of certain products to the Company's customers. In 1993, approximately 16% of the products produced by the Company were processed further through value-added services such as electrogalvanizing, painting and slitting. Approximately 64% of the total tonnage of shipments by the Company during 1993 from the Indiana Harbor Works was transported by truck, with the remainder transported primarily by rail. A wholly owned truck transport subsidiary of the Company was responsible for shipment of approximately 15% of the total tonnage of products transported by truck from the Indiana Harbor Works in 1993. Substantially all of the steel mill products produced by the Flat Products division are marketed through its own selling organization, with offices located in Chicago; Southfield, Michigan; St. Louis; and Nashville, Tennessee. Substantially all of the steel mill products produced by the Bar division are marketed through its sales office in East Chicago, Indiana. See "Product Classes" below for information relating to the percentage of consolidated net sales accounted for by certain classes of similar products of integrated steel operations. Raw Materials The Company obtains iron ore pellets primarily from three iron ore properties, located in the United States and Canada, in which subsidiaries of the Company have varying interests -- the Empire Mine in Michigan, the Minorca Mine in Minnesota and the Wabush Mine in Labrador and Quebec, Canada. In recent years the Company has closed or terminated certain less cost-efficient iron ore mining operations. See "Properties Relating to Integrated Steel Segment -- Raw Materials Properties and Interests" in Item 2

ITEM 2. PROPERTIES. PROPERTIES RELATING TO OPERATIONS Steel Production All raw steel made by the Company is produced at its Indiana Harbor Works located in East Chicago, Indiana. The property on which this plant is located, consisting of approximately 1,900 acres, is held by the Company in fee. The basic production facilities of the Company at its Indiana Harbor Works consist of furnaces for making iron; basic oxygen and electric furnaces for making steel; a continuous billet caster, a continuous combination slab/bloom caster and two continuous slab casters; and a variety of rolling mills and processing lines which turn out finished steel mill products. Certain of these production facilities, including a continuous anneal line and the No. 2 BOF Shop Caster Facility ("Caster"), are held by the Company under leasing arrangements. The Company purchased the equity interest of the lessor of the Caster in March 1994 and currently intends to terminate the lease and prepay or formally assume the applicable debt in the first half of 1994. Substantially all of the remaining property, plant and equipment at the Indiana Harbor Works is subject to the lien of the First Mortgage of the Company dated April 1, 1928, as amended and supplemented. See "Operations -- Raw Steel Production and Mill Shipments" in Item 1 above for further information relating to capacity and utilization of the Company's properties. The Company's properties are adequate to serve its present and anticipated needs, taking into account those issues discussed in "Capital Expenditures and Investments in Joint Ventures" in Item 1 above. I/N Tek, a partnership in which a subsidiary of the Company owns a 60% interest, has constructed a 1,500,000-ton annual capacity cold-rolling mill on approximately 200 acres of land, which it owns in fee, located near New Carlisle, Indiana. Substantially all the property, plant and equipment owned by I/N Tek at this location is subject to a lien securing related indebtedness. The I/N Tek facility is adequate to serve the present and anticipated needs of the Company planned for such facility. I/N Kote, a partnership in which a subsidiary of the Company owns a 50% interest, has constructed a 900,000-ton annual capacity steel galvanizing facility on approximately 25 acres of land, which it owns in fee, located adjacent to the I/N Tek site. Substantially all the property, plant and equipment owned by I/N Kote is subject to a lien securing related indebtedness. The I/N Kote facility is adequate to serve the present and anticipated needs of the Company planned for such facility. PCI Associates, a partnership in which a subsidiary of the Company owns a 50% interest, has constructed a pulverized coal injection facility on land located within the Inland Harbor Works. The Company leases PCI Associates the land upon which the facility is located. Substantially all the property, plant and equipment owned by PCI Associates is subject to a lien securing related indebtedness. Upon achieving operation at design capacity, the PCI Associates facility will be adequate to serve the anticipated needs of the Company planned for such facility. The Company owns three vessels for the transportation of iron ore and limestone on the Great Lakes, and a subsidiary of the Company owns a fleet of 404 coal hopper cars (100-ton capacity each) used in unit trains to move coal to the Indiana Harbor Works. See "Operations -- Raw Materials" in Item 1 above for further information relating to utilization of the Company's transportation equipment. Such equipment is adequate, when combined with purchases of transportation services from independent sources, to meet the Company's present and anticipated transportation needs. The Company also owns and maintains research and development laboratories in East Chicago, Indiana, which facilities are adequate to serve its present and anticipated needs. Raw Materials Properties and Interests Certain information relating to raw materials properties and interests of the Company and its subsidiaries is set forth below. See "Operations -- Raw Materials" in Item 1 above for further information relating to capacity and utilization of such properties and interests. Iron Ore The operating iron ore properties of the Company's subsidiaries and of the iron ore ventures in which the Company has an interest are as follows: The Empire Mine is operated by the Empire Iron Mining Partnership, in which the Company has a 40% interest. The Company, through a subsidiary, is the sole owner and operator of the Minorca Mine. The Wabush Mine is a taconite project in which the Company owns a 13.75% interest. The Company also owns a 38% interest in the Butler Taconite project (permanently closed in 1985) in Nashwauk, Minnesota. The reserves at the Empire Mine, the Minorca Mine and the Wabush Mine are held under leases expiring, or expected at current production rates to expire, between 2012 and 2040. Substantially all of the reserves at Butler Taconite are held under leases. The Company's share of the production capacity of its interests in such iron ore properties is sufficient to provide the majority of its present and anticipated iron ore pellet requirements. Any remaining requirements have been and are expected to continue to be readily available from independent sources. During 1992, the Minorca Mine's original ore body was depleted and production shifted to a new major iron ore body, the Laurentian Reserve, acquired by lease in 1990. Limestone and Dolomite The limestone and dolomite properties of the Company located near the town of Gulliver in the Upper Peninsula of Michigan were permanently closed on December 29, 1989 and sold in 1990. Coal The Company's sole remaining coal property, the Lancashire No. 25 Property, located near Barnesboro, Pennsylvania, is permanently closed. All Company coal requirements for the past several years have been and are expected to continue to be met through contract purchases and other purchases from independent sources. OTHER PROPERTIES The Company and certain of its subsidiaries lease, under a long-term arrangement, approximately 12% of the space in the Inland Steel Building located at 30 West Monroe Street, Chicago, Illinois (where the Company's principal executive offices are located), which property interest is adequate to serve the Company's present and anticipated needs. Certain subsidiaries of the Company hold in fee at various locations an aggregate of approximately 355 acres of land, all of which is for sale. The Company also holds in fee approximately 300 acres of land adjacent to the I/N Tek and I/N Kote sites, which land is available for future development. Approximately 1,060 acres of rural land, which are held in fee at various locations in the north-central United States by various raw materials ventures, are also for sale. I R Construction Products Company, Inc. (formerly Inryco, Inc.), a subsidiary of the Company and the Company's former Construction Products business segment, owns, in fee, a combination office building and warehouse in Hoffman Estates (IL), which is for sale. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. On August 12, 1992, Inland Steel Administrative Service Company ("ISAS"), a wholly owned subsidiary of the Company, filed a lawsuit in the Court of Common Pleas in Lorain County, Ohio against Western Steel Group, Inc. ("Western") to collect the unpaid balance of its account for steel products sold to Western by the Company in the amount of $5.7 million. On October 15, 1992, Western filed a counterclaim against ISAS and a third-party complaint against the Company for $40 million actual damages and $100 million punitive damages, alleging, among other things, breach of contract and wrongful interference with contractual relations in connection with a refusal by the Company to continue selling steel products to Western and defamation of Western and a patent held by Western in connection with discussions with third parties. All claims were settled between the parties in February 1994 and the settlement was approved by the court. Under the terms of the settlement, ISAS has received $3.4 million and all counterclaims against the Company and ISAS have been released. On June 10, 1993, the U.S. District Court for the Northern District of Indiana entered a consent decree that resolved all matters raised by the lawsuit filed by the EPA in 1990. The consent decree includes a $3.5 million cash fine, environmentally beneficial projects at the Indiana Harbor Works through 1997 costing approximately $7 million, and sediment remediation of portions of the Indiana Harbor Ship Canal and Indiana Harbor Turning Basin estimated to cost approximately $19 million over the next several years. The fine and estimated remediation costs were provided for in 1991 and 1992. After payment of the fine, the Company's reserve for environmental liabilities totalled $19 million. The consent decree also defines procedures for corrective action at the Company's Indiana Harbor Works. The procedures defined establish essentially a three-step process, each step of which requires agreement of the EPA before progressing to the next step in the process, consisting of: assessment of the site, evaluation of corrective measures for remediating the site, and implementation of the remediation plan according to the agreed-upon procedures. The Company is presently assessing the extent of environmental contamination. The Company anticipates that this assessment will cost approximately $1 million to $2 million per year and take another three to five years to complete. Because neither the nature and extent of the contamination nor the corrective actions can be determined until the assessment of environmental contamination and evaluation of corrective measures is completed, the Company cannot presently reasonably estimate the costs of or the time required to complete such corrective actions. Such corrective actions may, however, require significant expenditures over the next several years that may be material to the results of operations or financial position of the Company. Insurance coverage with respect to such corrective actions is not significant. On March 22, 1985, the EPA issued an administrative order to the Company's former Inland Steel Container Company Division ("Division") naming the former Division and various other unrelated companies as responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") in connection with the cleanup of a waste disposal facility operated by Duane Marine Salvage Corporation at Perth Amboy, New Jersey. The administrative order alleged that certain of the former Division's wastes were transported to, and disposed of at, that facility and required the Company to join with other named parties in taking certain actions relating to the facility. The Company and the other administrative order recipients have completed the work required by the order. In unrelated matters, the EPA also advised the former Division and various other unrelated parties of other sites located in New Jersey at which the EPA expects to spend public funds on any investigative and corrective measures that may be necessary to control any releases or threatened releases of hazardous substances, pollutants and contaminants pursuant to the applicable provisions of CERCLA. The notice also indicated that the EPA believes the Company may be a responsible party under CERCLA. The extent of the Company's involvement and participation in these matters has not yet been determined. While it is not possible at this time to predict the amount of the Company's potential liability, none of these matters is expected to materially affect the Company's financial position. The EPA has adopted a national policy of seeking substantial civil penalties against owners and operators of sources for noncompliance with air and water pollution control statutes and regulations under certain circumstances. It is not possible to predict whether further proceedings will be instituted against the Company or any of its subsidiaries pursuant to such policy, nor is it possible to predict the amount of any such penalties that might be assessed in any such proceeding. The Indiana Department of Environmental Management ("IDEM") from time to time advises various parties of alleged violations of air pollution regulations by issuing Notices of Violation so as to initiate discussions concerning corrective measures. The Company has three currently outstanding unresolved Notices of Violation at its Indiana Harbor Works. The Company is presently in discussions with the staff of IDEM with respect to these matters and cannot currently estimate the time period within which these matters will be resolved. While it is not possible at this time to predict the amount of the Company's potential liability, none of these matters is expected to materially affect the Company's financial position. The Company received a Notice of Violation from IDEM dated March 3, 1989 alleging violations of the Company's National Pollution Discharge Elimination System permit regarding water discharges. The Company is presently in discussions with the staff of IDEM with respect to these matters and cannot currently estimate the time period within which these matters will be resolved. While it is not possible at this time to predict the amount of the Company's potential liability, this matter is not expected to materially affect the Company's financial position. The Company received a Special Notice of Potential Liability ("Special Notice") from IDEM on February 18, 1992 relating to the Four County Landfill Site, Fulton County, Indiana (the "Facility"). The Special Notice stated that IDEM has documented the release of hazardous substances, pollutants and contaminants at the Facility and was planning to spend public funds to undertake an investigation and control the release or threatened release at the Facility unless IDEM determined that a potentially responsible party ("PRP") will properly and promptly perform such action. The Special Notice further stated that the Company may be a PRP and that the Company, as a PRP, may have potential liability with respect to the Facility. In August 1993, the Company, along with other PRPs, entered into an Agreed Order with IDEM pursuant to which the PRPs agreed to perform a Remedial Investigation/Feasibility Study ("RI/FS") for the Facility and pay certain past and future IDEM costs. In addition, the PRPs agreed to provide funds for operation and maintenance necessary for stabilization of the Facility. The costs which the Company has agreed to assume under the Agreed Order are not currently anticipated to exceed $154,000. The cost of the final remedies which will be determined to be required with respect to the Facility cannot be reasonably estimated until, at a minimum, the RI/FS is completed. The Company is therefore unable to determine the extent of its potential liability, if any, relating to the Facility or whether this matter could materially affect the Company's financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company is a wholly owned subsidiary of Inland Steel Industries, Inc. thus, market, stockholder and dividend information otherwise called for by this Item is omitted. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The Company meets the conditions set forth in General Instruction J(2)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 7.

ITEM 7. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS. The Company's 1993 net loss of $59.7 million was significantly less than the 1992 net loss of $781.3 million. Included in the 1992 loss is $609.6 million related to one-time charges to recognize the cumulative effect of adopting the following new accounting standards: Financial Accounting Standards Board ("FASB") Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and FASB Statement No. 109, "Accounting for Income Taxes." Even excluding the one-time 1992 charges, 1993 results were significantly improved from the 1992 loss of $171.7 million. The following table summarizes selected earnings and other data: With I/N Tek and I/N Kote having reached the end of their learning curves and completion of major upgrades at the steelmaking operations, the Company's modernization program is complete. In addition, a new six-year labor contract at the Company is in place. These factors, coupled with the Company's turnaround strategy launched in 1991 to improve performance by increasing revenues, reducing costs and enhancing asset utilization, are anticipated to provide the basis for continued improvement in 1994 operating results. The 1993 financial results were negatively affected by approximately $30 million due to the unfavorable impact on steel operations of the scheduled outage of the largest blast furnace at the Indiana Harbor Works for a mini-reline. In addition, there was a $22.3 million charge taken for the early closure of the Company's remaining cokemaking facilities due to their inability to meet environmental regulations and deteriorating operating performance. Partially offsetting these unfavorable items was a $24 million LIFO profit recognition due to inventory reductions. Net sales increased 14 percent in 1993 to $2.17 billion due almost entirely to an increase in shipments to 4.8 million tons. The average selling price for 1993 was virtually unchanged from 1992. The Company operated at 83 percent of its raw steelmaking capability in 1993, compared with 79 percent in 1992. In 1992, a slower-than-expected shift in galvanized products to I/N Kote, as well as the initial recognition of interest and depreciation expense associated with the I/N Kote facility, added approximately $40 million to operating losses. Also, an outage of the No. 7 Blast Furnace reduced production by 140,000 tons, which increased the operating loss by nearly $30 million. These 1992 problems, coupled with an addition of $12 million to a reserve for environmental matters, more than offset the benefits of reduced costs and a $23 million gain on the sale of half of Inland's 25 percent interest in Walbridge Coatings. The Company embarked in 1991 on a three-year turnaround program to significantly reduce its underlying cost base by year-end 1994. The 1991 restructuring charge of $205 million provided for the write-off of facilities, an environmental reserve and the cost of an estimated 25 percent reduction in the workforce. Employment has been reduced by approximately 2,300 people from the end of 1991 through year-end 1993, and an additional 1,200 jobs are expected to be eliminated by the end of 1994. The 1993 effect of this program represents a savings of approximately $140 million in employment costs and $10 million in decreased depreciation expense. However, the savings from reduced employment was partially offset by increased wages under the Company's labor agreements and increased medical benefit costs as the Company began to accrue in 1992 for postretirement medical benefits. By year-end 1992 and throughout 1993, I/N Tek was operating near capacity and producing consistently high-quality steels. In August 1993, I/N Kote was operating near design capacity and, by year-end 1993, had achieved product qualification at all major customers. Under the I/N Kote partnership agreement, the Company supplies all of the steel for the joint venture and, with certain limited exceptions, is required to set the price of that steel to assure that I/N Kote's expenditures do not exceed its revenues. During 1993, the Company's sales price approximated its cost of production, but was still significantly less than the market value for cold-rolled steel. Beginning in 1993, I/N Kote expenditures included principal payments and provision for return on equity to the partners. Therefore, the Company's ability to realize a satisfactory price on its sales to I/N Kote depends on the facility achieving near capacity operations and obtaining appropriate pricing for its products. The Company's remaining cokemaking facilities were closed by year-end 1993. The Company determined that it was uneconomical to repair the coke batteries sufficiently to continue cost-effective operations that would comply with current environmental laws. To replace the Company-produced coke, the Company entered into a long-term contract and other arrangements to purchase coke. In addition, the Company and NIPSCO, a local utility, formed a joint venture which constructed and is operating a pulverized coal injection facility at the Indiana Harbor Works. This facility injects coal directly into the blast furnaces and is expected to reduce coke requirements by approximately 30 percent, or 600,000 tons a year, when fully operational. The joint venture commenced operations in the third quarter of 1993. FASB Statement No. 106 requires that the cost of retiree medical and life insurance benefits be accrued during the working years of each employee. Previously, retiree medical benefits were expensed as incurred after an employee's retirement. Adoption of this standard in 1992 did not and will not affect cash flow as liabilities for health care and life insurance benefits are not pre-funded and cash payments will continue to be made as claims are submitted. The net present value of the unfunded benefits liability as of December 31, 1993, calculated in accordance with that Statement was approximately $943 million. The expense provision for these benefits for 1993 was $86 million, which was $39 million more than the cash benefit payments for the year. The unfunded liability will continue to grow, since accrual-basis costs are expected to exceed cash benefit payments for several more years. The reported year-end benefits liability and postretirement benefits cost for the year reflect changes made during the year incorporating the favorable effects of the new United Steelworkers of America labor contract and revised actuarial assumptions incorporating more current information regarding claim costs and census data, partially offset by a reduction in the discount rate used to calculate the benefits liability. (See Note 6 to the consolidated financial statements for further details.) FASB Statement No. 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Without the change, the Company would not have been able to reduce its 1993 and 1992 losses by credits for deferred tax benefits of $30 million and $418 million, respectively. At December 31, 1993, the Company had a net deferred tax asset of $417 million of which $396 million relates to the temporary difference arising from the adoption of FASB Statement No. 106. While the Company believes it is more likely than not that taxable income generated through future profitable operations will be sufficient to realize all deferred tax assets, a secondary source of future taxable income could result from tax planning strategies, including the Company's option of changing from the LIFO method of accounting for inventories to the FIFO method (such change would have resulted in approximately $240 million of additional taxable income as of year-end 1993 which would serve to offset approximately $85 million of deferred tax assets) and selection of different tax depreciation methods. After assuming such change in accounting for inventories, the Company would need to recognize approximately $900 million of taxable income over the 15-year net operating loss carryforward period and the period in which the temporary difference related to the FASB Statement No. 106 obligation will reverse, in order to fully realize its net deferred tax asset. Additionally, in accordance with the Industries tax sharing agreement, if the Company is unable to use all of its allocated tax attributes (net operating loss carryforwards and tax credit carryforwards) in a given year but other companies in the Industries group are able to utilize them, then the Company will be paid for the use of its attributes. The Company believes that it is more likely than not that it will achieve such taxable income level. (See Note 7 to the consolidated financial statements for further details regarding this net deferred tax asset.) ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements (including the financial statement schedules listed under Item 14(a)2 of this report) of the Company called for by this Item, together with the Report of Independent Accountants dated February 23, 1994, are set forth on pages to, inclusive, of this Report on Form 10-K, and are hereby incorporated by reference into this Item. Financial statement schedules not included in this Report on Form 10-K have been omitted because they are not applicable or because the information called for is shown in the consolidated financial statements or notes thereto. Consolidated quarterly sales and earnings information for 1993 and 1992 is set forth in Note 13 of Notes to Consolidated Financial Statements (contained herein), which is hereby incorporated by reference into this Item. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) DOCUMENTS FILED AS A PART OF THIS REPORT. 1. CONSOLIDATED FINANCIAL STATEMENTS. The consolidated financial statements listed below are set forth on pages to, inclusive, of this Report and are incorporated by reference in Item 8 of this Annual Report on Form 10-K. Report of Independent Accountants. Consolidated Statements of Operations and Reinvested Earnings for the three years ended December 31, 1993. Consolidated Statement of Cash Flows for the three years ended December 31, 1993. Consolidated Balance Sheet at December 31, 1993 and 1992. Schedules to Consolidated Financial Statements at December 31, 1993 and 1992, relating to: Property, Plant and Equipment. Long-Term Debt. Statement of Accounting and Financial Policies. Notes to Consolidated Financial Statements. Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: Schedule V -- Property, Plant and Equipment. Schedule VI -- Reserve for Depreciation, Amortization and Depletion of Property, Plant and Equipment. Schedule VIII -- Reserves. Schedule IX -- Short-Term Borrowings. Schedule X -- Supplementary Profit and Loss Information. 2. EXHIBITS. The exhibits required to be filed by Item 601 of Regulation S-K are listed under the caption "Exhibits" below. (B) REPORTS ON FORM 8-K. No reports on Form 8-K were filed by the Company during the quarter ended December 31, 1993. (C) EXHIBITS. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INLAND STEEL COMPANY By: /S/ ROBERT J. DARNALL Robert J. Darnall Chairman and Chief Executive Officer Date: March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) REPORT OF INDEPENDENT ACCOUNTANTS TO THE BOARD OF DIRECTORS AND STOCKHOLDER OF INLAND STEEL COMPANY In our opinion, the consolidated financial statements listed in the index appearing on page present fairly, in all material respects, the financial position of Inland Steel Company (a wholly owned subsidiary of Inland Steel Industries, Inc.) and Subsidiary Companies at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes 6 and 7 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and for income taxes. PRICE WATERHOUSE Chicago, Illinois February 23, 1994 INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) CONSOLIDATED STATEMENTS OF OPERATIONS AND REINVESTED EARNINGS DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) CONSOLIDATED STATEMENT OF CASH FLOWS DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) CONSOLIDATED BALANCE SHEET DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULES TO CONSOLIDATED FINANCIAL STATEMENTS DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) STATEMENT OF ACCOUNTING AND FINANCIAL POLICIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The following briefly describes the Company's principal accounting and financial policies. ACCOUNTING FOR EQUITY INVESTMENTS The Company's investments in 20% or more but less than majority-owned companies, joint ventures and partnerships, and the Company's majority interest in the I/N Tek partnership, are accounted for under the equity method. INVENTORY VALUATION Inventories are valued at cost which is not in excess of market. Cost is determined by the last-in, first-out method except for supply inventories, which are determined by the average cost or first-in, first-out methods. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is depreciated for financial reporting purposes over the estimated useful lives of the assets. Steelmaking machinery and equipment, a significant class of assets, is depreciated on a production-variable method, which adjusts straight-line depreciation to reflect production levels at the steel plant. The adjustment is limited to not more than a 25% increase or decrease from straight-line depreciation. Blast furnace relining expenditures are capitalized and amortized on a unit-of-production method over the life of the lining. All other assets are depreciated on a straight-line method. Expenditures for normal repairs and maintenance are charged to income as incurred. Gains or losses from significant abnormal disposals or retirements of properties are credited or charged to income. The cost of other retired assets less any sales proceeds is charged to accumulated depreciation. BENEFITS FOR RETIRED EMPLOYEES Pension benefits are provided by the Company to substantially all employees under a trusteed non-contributory plan of Inland Steel Industries, Inc. Life insurance and certain medical benefits are provided for retired employees. The estimated costs of pension, medical, and life insurance benefits are determined annually by consulting actuaries. With the adoption of Financial Accounting Standards Board ("FASB") Statement No. 106, "Employers' Accounting For Postretirement Benefits Other Than Pensions," effective January 1, 1992, the cost of health care benefits for retirees, previously recognized as incurred, is now being accrued during their term of employment (see Note 6). Pensions are funded in accordance with ERISA requirements in a trust established under the plan. Costs for retired employee medical benefits and life insurance are funded when claims are submitted. CASH EQUIVALENTS Cash equivalents reflected in the Statement of Cash Flows are highly liquid, short-term investments with maturities of three months or less. Cash management activities are performed by the Company's parent, Inland Steel Industries, Inc., and periodic cash transfers are made, thereby minimizing the level of cash maintained by the Company. INCOME TAXES Effective January 1, 1992, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes" (see Note 7). - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTE 1/INVENTORIES Inventories were classified on December 31 as follows: During 1993, various inventory quantities were reduced, resulting in liquidations of LIFO inventory quantities carried at lower costs prevailing in prior years as compared with the current year costs. The effect of these liquidations on continuing operations was to decrease cost of goods sold by $24 million in 1993. The effect on cost of goods sold of LIFO liquidations in 1992 and 1991 was not material. Replacement costs for the LIFO inventories exceeded LIFO values by approximately $241 million and $280 million on December 31, 1993 and 1992, respectively. NOTE 2/BORROWING ARRANGEMENTS Inland Steel Administrative Service Company, a wholly owned subsidiary of the Company established to provide a supplemental source of short-term funds to the Company, has a $100 million revolving credit facility with a group of banks which extends to November 30, 1995. Under this arrangement the Company has agreed to sell substantially all of its receivables to Inland Steel Administrative Service Company to secure this facility. The facility requires the maintenance of various financial ratios including minimum net worth and leverage ratios. NOTE 3/LONG-TERM DEBT The outstanding First Mortgage Bonds of Inland Steel Company are the obligation solely of the Company and have not been guaranteed or assumed by, or otherwise become the obligation of, Inland Steel Industries, Inc. ("Industries") or any of its other subsidiaries. Each series of First Mortgage Bonds issued by the Company is limited to the principal amount outstanding and, with the exception of the Pollution Control Series 1982 Bonds, the Pollution Control Series 1993 Bonds, and the Series T First Mortgage Bonds described below, is subject to a sinking fund. Substantially all the property, plant and equipment owned by the Company at its Indiana Harbor Works is subject to the lien of the First Mortgage. This property had a net book value of approximately $1.0 billion on December 31, 1993. In June 1993, the Company refinanced $40 million of pollution control revenue bonds at an interest rate of 6.8 percent. The weighted average percentage rate of the refunded bonds was 9.9 percent. At year-end 1993 all remaining outstanding Series O, P, and Q First Mortgage Bonds were called to be redeemed on January 28, 1994. Accordingly, the outstanding principal amount of $75.1 million at December 31, 1993 has been classified as a current liability. Prior to the redemption of the Series O, P and Q First Mortgage Bonds, under terms of the First Mortgage, the Company was prohibited, when its reinvested earnings were less than - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- $187.1 million, from paying dividends on its common stock (other than stock dividends). At year-end 1993, the accumulated deficit of the Company was $1.0 billion. In December 1991, the Company issued $125 million principal amount of First Mortgage 12% Bonds, Series T, due December 1, 1998. Net proceeds of the offering were added to the general funds of the Company and used for general corporate purposes, allowing its special-purpose subsidiary to repay its short-term bank borrowing. The amended and supplemented Mortgage under which the Series T Bonds were issued contains covenants limiting, among other things, the creation of additional indebtedness; the declaration and payment of dividends and distributions on the Company's capital stock; and the acquisition or retirement of any debt of the Company that is subordinate to the Series T Bonds. Maturities of long-term debt and capitalized lease obligations due within five years are: $86.2 million in 1994, $15.9 million in 1995, $18.1 million in 1996, $18.2 million in 1997, and $145.4 million in 1998. See Note 10 regarding commitments and contingencies for other scheduled payments. Interest cost incurred by the Company totaled $63.3 million in 1993, $63.4 million in 1992, and $71.1 million in 1991. Included in these totals is capitalized interest of $2.9 million in 1993, $10.2 million in 1992, and $13.1 million in 1991. The estimated fair value of the Company's long-term debt (including current portions thereof) using quoted market prices of Company debt securities recently traded and market-based prices of similar securities for those securities not recently traded was $583 million, as compared with the carrying value of $562 million included in the balance sheet, at year-end 1993. NOTE 4/CAPITAL STOCK In December 1991, the Company sold 1,500,000 shares of Series C Preferred Stock to Industries for $150 million. Aside from this issuance, there were no changes in the Company's preferred or common stock during the year ended December 31, 1991. The Company's other preferred stock consisted of 295,094 shares of Series A Preferred Stock with a stated value of $.6 million and 1,497,500 shares of Series B Preferred Stock with a stated value of $74.9 million. In the fourth quarter of 1992, the Board of Directors authorized: (i) a reduction in the number of Company shares authorized, issued and outstanding and (ii) a change from no par to $1.00 par value stock. One share of $1.00 par value stock was issued for each 30,000 shares of the no par stock, rounded to the nearest whole share. As a result, capital in excess of par increased and corresponding capital accounts decreased by $674.5 million. Summarized below is the effect of these actions on the shares of Company stock: Information provided below for each preferred issue is presented on an after-change basis, which reflects the current status of each such issue. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Cash dividends on Series A Preferred Stock are cumulative and payable quarterly at an annual rate of $72,000 per share. The shares are convertible into common stock at the rate of one share of common stock for each share of Series A Preferred Stock and are redeemable, at the Company's option, for $1,320,000 per share plus any accrued and unpaid dividends. Cash dividends on Series B Preferred Stock are cumulative and payable quarterly at an annual rate of $142,500 per share. The shares are convertible into common stock at a conversion price of $1,128,750 per share, or 1.33 common shares for each preferred share, and have a liquidation value of $1,500,000 per share plus any accrued and unpaid dividends. The shares are redeemable at the Company's option, for $1,500,000 per share plus any accrued and unpaid dividends. Cash dividends on Series C Preferred Stock are cumulative and payable quarterly at an annual rate of $360,000 per share. The shares have a liquidation value of $3,000,000 per share plus any accrued and unpaid dividends. The shares are redeemable at the Company's option at a price (plus accrued and unpaid dividends) declining from $3,324,000 for the one-year period commencing December 1, 1993 to $3,000,000 beginning December 1, 2011. The Series C Preferred Stock is also exchangeable at the Company's option on any dividend payment date for the Company's 12% subordinated debentures due December 1, 2016, at a rate of $3,000,000 principal amount of debentures for each share of Series C Preferred Stock. NOTE 5/PROVISIONS FOR FACILITIES SHUTDOWN In 1993, the Company recorded a facility shutdown provision of $22.3 million which covered costs associated with the earlier than planned closure of the Company's cokemaking facilities. Of the amount provided, $7.7 million relates to the write-off of assets with the remainder provided for various expenditures associated with the shutdown of the facility, including personnel costs. In 1991, the Company recorded restructuring provisions aggregating $205 million which pertained to the Indiana Harbor steelmaking complex. The provisions cover writedowns of uneconomic facilities, principally cokemaking batteries, the ingot mold foundry, and selected older facilities expected to be shut down, as well as provisions for environmental matters and workforce reductions (consisting principally of added pension and other employee benefit costs). In 1992, as the specific identification of the continuing status of pension liabilities associated with the shutdown provisions is not feasible, these liabilities were transferred from the restructuring reserve to the general pension liabilities of the Company. At December 31, 1993, the Company had restructuring reserves, excluding pension-related liabilities, totaling $149.7 million. Comparable reserves at December 31, 1992 and 1991 were $140.7 million and $134.3 million, respectively. NOTE 6/RETIREMENT BENEFITS Pensions The Inland Steel Industries Pension Plan and Pension Trust, which covers certain employees of the Company, also covers certain employees of Industries and of certain of Industries' other subsidiaries. The plan is a non-contributory defined benefit plan with pensions based on final pay and years of service for all salaried employees and certain wage employees, and years of service and a fixed rate (in most instances based on frozen pay or on job class) for all other wage employees, including members of the United Steelworkers union. Because the fair value of pension plan assets pertains to all participants in the plan, no separate determination of the fair value of such assets is made solely with respect to the Company. At year-end 1993 and 1992, the - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- actuarial present value of benefits for service rendered to date and the fair value of plan assets available for benefits for the Industries consolidated group were as follows: In 1993, Industries recorded an additional minimum pension liability of $122.1 million representing the excess of the unfunded Accumulated Benefit Obligation over previously accrued pension costs. A corresponding intangible asset was recorded as an offset to this additional liability as prescribed. A weighted average discount (settlement) rate of 7.25% in 1993 and 8.6% in 1992 was used in the determination of the actuarial present value of benefits. Pension cost for the Company for 1993 was a credit of $5.6 million compared with a credit of $9.5 million in 1992 and an expense of $87.9 million in 1991. Included in the 1991 pension cost is a pension provision for workforce reductions of $106.3 million. Benefits Other Than Pension Substantially all of the Company's employees are covered under postretirement life insurance and medical benefit plans that involve deductible and co-insurance requirements. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on applicable annual earnings at retirement for salaried employees and specific amounts for hourly employees. The Company did not prefund any of these postretirement benefits in 1993. Effective January 1, 1994, a Voluntary Employee Benefit Association Trust was established for payment of health care benefits made to United Steelworkers of America ("USWA") retirees. Funding of the Trust will be made as claims are submitted for payment. The Company has adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective January 1, 1992. FASB Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. The Company must be fully accrued for these postretirement benefits by the date each employee attains full eligibility for such benefits. In conjunction with the adoption of FASB Statement No. 106, the Company elected to immediately recognize the accumulated postretirement benefit obligation for current and future retirees (the "transition obligation"). Prior to the adoption of FASB Statement No. 106, the cost of medical benefits for retired employees was expensed as incurred. For 1993 and 1992, the accrued expense for benefits other than pensions recorded in accordance with FASB Statement No. 106 exceeded the expense that would have been recorded under the prior accounting methods by $39 million ($25 million after tax) and $53 million ($33 million after tax), respectively. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The amount of net periodic postretirement benefit cost for 1993 and 1992 is composed of the following: The following table sets forth components of the accumulated postretirement benefit obligation: Any net gain or loss in excess of 10 percent of the accumulated post retirement benefit obligation will be amortized over the remaining service period of active plan participants. In 1993, in connection with the Company's new labor agreement with the USWA, the postretirement medical benefit plan covering union employees was amended, effective August 1, 1993, to provide for employee co-payments and increased deductibles. As a result of these plan amendments, the Company remeasured its postretirement benefit obligation under FASB Statement No. 106, as of August 1, 1993. This remeasurement incorporated the effect of the union contract changes as well as the effects of changes in actuarial assumptions to reflect more current information regarding claim costs, census data and interest rate factors. The assumptions used to determine the plan's accumulated postretirement benefit obligation are as follows: A one percentage point increase in the assumed health care cost trend rates for each future year increases annual net periodic postretirement benefit cost and the accumulated postretirement benefit obligation as of December 31, 1993 by $12 million and $118 million, respectively. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Postemployment Benefits In November 1992, the FASB issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." Adoption of the new Standard, which is required by the first quarter of 1994, is not anticipated to have a material impact on results of operations or the financial position of the Company. NOTE 7/INCOME TAXES The Company adopted FASB Statement No. 109, "Accounting for Income Taxes," effective January 1, 1992. As a result of adopting Statement No. 109, the Company recorded a $31.3 million charge reflecting the cumulative effect of the change on prior years. The Company is now required to record deferred tax assets and liabilities on its balance sheet as compared with the Company's past practice under APB Opinion No. 11 and Industries' former tax-sharing agreement under which no such recording was required. Pursuant to the former tax-sharing agreement with Industries, the Company paid Industries a charge in lieu of Federal income taxes only in those years in which the Company had regular taxable income or alternative minimum taxable income and the Industries group incurred a current Federal income tax liability. In addition, for purposes of determining the charge in lieu of Federal income taxes to the Company, the tax-sharing agreement recognized that the Company was entitled to utilize the full benefits of the NOL carryforwards and general business and other credit carryforwards that existed as of May 1, 1986 (the date of formation of Industries as a holding company for the Company and its subsidiaries). In 1991, the Company was credited $.3 million due entirely to its share of Industries' AMT liability. To comply with the provisions of FASB Statement No. 109, a new tax-sharing agreement was adopted under which current and deferred income tax provisions are determined for each company in the Industries group on a stand-alone basis. Companies with taxable losses record current income tax credits not to exceed current income tax charges recorded by profitable companies. NOL and tax credit carryforwards are allocated to each company in accordance with applicable tax regulations as if a company were to leave the consolidated group. The elements of the provisions for income taxes for each of the three years indicated below were as follows: - --------------- Cr. = Credit In accordance with FASB Statement No. 109, the Company adjusted its deferred tax assets and liabilities for the effect of the change in the corporate Federal income tax rate from 34 to 35 percent, effective January 1, 1993. A credit to income of $9 million, which includes the effect of the rate change on deferred tax asset and liability balances as of January 1, 1993 as well as the effect on 1993 tax benefits recorded by the Company prior to the enactment date of August 10, 1993, was recorded in the third quarter of 1993. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The components of the deferred income tax assets and liabilities arising under FASB Statement No. 109 were as follows: For tax purposes, the Company had available, at December 31, 1993, net operating loss ("NOL") carryforwards for regular Federal income tax purposes of approximately $837 million which will expire as follows: $72 million in year 2000, $114 million in year 2005, $288 million in year 2006, $258 million in year 2007, and $105 million in 2008. The Company also had investment tax credit and other general business credit carryforwards for tax purposes of approximately $18 million, which expire during the years 1994 through 2006. A valuation allowance of $9 million has been established for those tax credits which are not expected to be realized. Additionally, in conjunction with the Alternative Minimum Tax ("AMT") rules, the Company had available minimum tax credit carryforwards for tax purposes of approximately $13 million, which may be used indefinitely to reduce regular Federal income taxes. The Company believes that it is more likely than not that the $837 million of NOL carryforwards will be utilized prior to their expiration. This belief is based upon the factors discussed below. The NOL carryforwards and existing deductible temporary differences (excluding those relating to FASB Statement No. 106) are substantially offset by existing taxable temporary differences reversing within the carryforward period. Furthermore, any such recorded tax benefits which would not be so offset are expected to be realized by achieving future profitable operations based on the following: First, the Company launched a turnaround strategy to improve performance by implementing a cost reduction program and enhancing asset utilization. This resulted in a $205 million restructuring provision in 1991 to write off uneconomic facilities and provide for future workforce reductions at the Company. Second, in 1992 the Company completed a major plant and equipment investment program that amounted to approximately $1.3 billion since 1988. This included the joint ventures of I/N Tek and I/N Kote and major upgrades to facilities in the flat products and bar business. As expected, these facility upgrades - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- resulted in significant start-up costs and disruptions to operations that negatively impacted financial results. By year-end 1993, all facilities except the 12-inch Bar Mill reached their design capabilities. This major investment program also shifts the product mix to higher value-added products which historically have not experienced significant price volatility. Consequently, the Company is now positioned with modern facilities that will enhance its ability to generate taxable profits. Finally, the Company operates in a highly cyclical industry and consequently has had a history of generating and then fully utilizing significant amounts of NOL carryforwards. Subsequent to the adoption of FASB Statement No. 109, the Company adopted FASB Statement No. 106 and recognized the entire transition obligation at January 1, 1992 as a cumulative effect charge in 1992 (Note 6). This adoption resulted in a $366 million deferred tax asset at December 31, 1992, and future annual charges under FASB Statement No. 106 are expected to continue to exceed deductible amounts for many years. Thereafter, even if the Company should have a tax loss in any year in which the deductible amount would exceed the financial statement expense, the tax law provides for a 15-year carryforward period of that loss. Because of the extremely long period that is available to realize these future tax benefits, a valuation allowance for this deferred tax asset is not necessary. While not affecting the determination of deferred income taxes for financial reporting purposes, at December 31, 1993, the Company had available for AMT purposes approximately $270 million of NOL carryforwards which will expire as follows: $113 million in 2006 and $157 million in 2007. Total income taxes reflected in the Consolidated Statement of Operations differ from the amounts computed by applying the Federal corporate tax rate as follows: - --------------- Cr. = Credit Due to the existence of the former tax-sharing agreement, such reconciliation does not provide meaningful information for 1991 and has therefore been omitted. NOTE 8/TRANSACTIONS WITH NIPPON STEEL CORPORATION On December 18, 1989, Industries sold 185,000 shares of its Series F Exchangeable Preferred Stock to NS Finance III, Inc., an indirectly wholly owned subsidiary of Nippon Steel Corporation ("NSC"), for $1,000 per share. With respect to Industries stockholder voting, such preferred stock entitles the holder to - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 30.604 votes per share, which number may be adjusted from time to time upon the occurrence of certain events. The following is a summary of the Company's relationships with NSC. I/N Tek, a general partnership formed for a joint venture between the Company and NSC, owns and operates a cold-rolling facility that commenced operations in early 1990. I/N Tek is 60% owned by a wholly owned subsidiary of the Company and 40% owned by an indirect wholly owned subsidiary of NSC. The cost of the facility was $525 million, of which $111.6 million was contributed by the subsidiary of the Company and $74.4 million by the subsidiary of NSC, with the balance borrowed by I/N Tek from three Japanese trading companies. The Company has exclusive rights to the productive capacity of the facility, except in certain limited circumstances, and, under a tolling arrangement with I/N Tek, has an obligation to use the facility for the production of cold-rolled steel. Under the tolling arrangement, the Company was charged $141.2 million, $122.6 million and $95.0 million in 1993, 1992 and 1991, respectively, for such tolling services. NSC has the right to purchase up to 400,000 tons of cold-rolled steel from the Company in each year at market-based negotiated prices, up to half of which may be steel processed by I/N Tek. Purchases of Company products by a subsidiary of NSC aggregated $157.8 million, $123.0 million and $100.6 million during 1993, 1992 and 1991, respectively. At year-end 1993 and 1992, a subsidiary of NSC owed the Company $8.2 million and $7.1 million, respectively, related to these purchases. The Company and NSC also own and operate another joint venture which consists of a 400,000 ton electrogalvanizing line and a 500,000 ton hot-dip galvanizing line adjacent to the I/N Tek facility. I/N Kote, the general partnership formed for this joint venture, is owned 50% by a wholly owned subsidiary of the Company and 50% by an indirect wholly owned subsidiary of NSC. The facility commenced operations in the fourth quarter of 1991 and became fully operational in the third quarter of 1992, with the cost of the project being $554 million. Permanent financing for the project, as well as for capitalized interest and a portion of the working capital, was provided by third-party long-term financing, by capital contributions of the two partners of $60 million each and by subordinated partner loans of $30 million each. The Company and NSC each have guaranteed the share of long-term financing attributable to their respective subsidiary's interest in the partnership. I/N Kote had $516 million outstanding under its long-term financing agreement at December 31, 1993. Additional working capital requirements were met by partner loans and by third-party credit arrangements. I/N Kote is required to buy all of its cold-rolled steel from the Company, which is required to furnish such cold-rolled steel at a price that results in an annual return on equity to the partners of I/N Kote, depending upon operating levels, of up to 10 percent after operating and financing costs; this price is subject to an upward adjustment if the Company's return on sales is less than I/N Kote's return on sales. Purchases of Company cold-rolled steel by I/N Kote aggregated $191.7 million in 1993 and $99.3 million in 1992. At year-end 1993, I/N Kote owed the Company $35.5 million related to these purchases. Prices of cold-rolled steel sold by the Company to I/N Kote are determined pursuant to the terms of the joint venture agreement and are based, in part, on operating costs of the partnership. During 1993, the Company sold cold-rolled steel to I/N Kote at a price that approximated its cost of production compared with 1992 when such sales were at less than its cost of production. I/N Kote also provides tolling services to the Company for which it was charged $29.1 million in 1993. The Company sells all I/N Kote products that are distributed in North America. The Company and NSC have entered into various agreements pursuant to which NSC has provided technical services and licenses of proprietary steel technology with respect to specific Company research and engineering projects. Pursuant to such agreements, the Company incurred costs of $3.7 million, $4.1 million and $7.0 million for technical services and related administrative costs for services provided during 1993, 1992 and 1991, respectively. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTE 9/INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES The Company's investments in unconsolidated joint ventures accounted for by the equity method consist primarily of its 60% interest in I/N Tek, 50% interest in I/N Kote, 50% interest in PCI Associates, 40% interest in the Empire Iron Mining Partnership, 12 1/2% interest (25% interest in 1991) in Walbridge Electrogalvanizing Company and 13 3/4% interest in Wabush Mines. I/N Tek and I/N Kote are joint ventures with NSC (see Note 8). The Company does not exercise control over I/N Tek, as all significant management decisions of the joint venture require agreement by both of the partners. Due to this lack of control by the Company, the Company accounts for its investment in I/N Tek under the equity method. PCI Associates is a joint venture which operates a pulverized coal injection facility at the Indiana Harbor Works. Empire and Wabush are iron ore mining and pelletizing ventures owned in various percentages primarily by U.S. and Canadian steel companies. On June 30, 1992, the Company sold one-half of its interest in Walbridge, resulting in a $22.5 million pre-tax gain. Walbridge is a venture that coats cold-rolled steel in which Inland has the right to 25% of the productive capacity (50% at year-end 1991). Following is a summary of combined financial information of the Company's unconsolidated joint ventures: NOTE 10/COMMITMENTS AND CONTINGENCIES The Company guarantees payment of principal and interest on its 40% share of the long-term debt of Empire Iron Mining Partnership requiring principal payments of approximately $7.6 million annually through 1996. At year-end 1993, the Company also guaranteed $34.5 million of long-term debt attributable to a subsidiary's interest in PCI Associates. As part of the agreement covering the 1990 sale of the Inland Lime & Stone Company division assets, the Company agreed, subject to certain exceptions, to purchase, at prices which approximate market, the full amount of its annual limestone needs or one million gross tons minimum, whichever is greater, through 2002. The Company and its subsidiaries have various operating leases for which minimum lease payments are estimated to total $288.3 million through 2018, including approximately $45.0 million in 1994, $40.5 million in 1995, $37.4 million in 1996, $36.0 million in 1997, and $32.7 million in 1998. Included in the above amounts is a total of $154 million, approximately $20 million per year, related to the lease of a caster facility that the Company plans to buy-out in 1994. Upon completion of the transaction, the total and five year estimates provided should be reduced accordingly. The Company will also record additional long-term debt of - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- approximately $63 million as part of the transaction, the interest and principal of which will be paid on through 2001. It is anticipated that the Company will make expenditures of $20 million in 1994, $13 million in 1995, and $5 million to $10 million annually in each of the three years thereafter for the construction, and have ongoing annual expenditures of $40 million to $50 million for the operation, of air and water pollution control facilities to comply with current Federal, state and local laws and regulations. The Company is involved in various environmental and other administrative or judicial actions initiated by governmental agencies. While it is not possible to predict the results of these matters, the Company does not expect environmental expenditures, excluding amounts that may be required in connection with the consent decree in the 1990 EPA lawsuit, to materially affect the Company's results of operations or financial position. Corrective actions relating to the EPA consent decree may require significant expenditures over the next several years that may be material to the results of operations or financial position of the Company. At December 31, 1993, the Company's reserves for environmental liabilities totaled $19 million related to the sediment remediation under the 1993 EPA consent decree. The total amount of firm commitments of the Company and its subsidiaries to contractors and suppliers, primarily in connection with additions to property, plant and equipment, approximated $12 million at year-end 1993. NOTE 11/RELATED PARTY TRANSACTIONS Industries has established procedures for charging its administrative expenses to the operating companies owned by it. These charges are for management, financial and legal services provided to those companies. Charges from Industries for 1993, 1992 and 1991 totaled $24.2 million, $25.4 million and $25.2 million, respectively. There are also established procedures to charge interest on all intercompany loans within the Industries group of companies. Such loans currently bear interest at the prime rate. For 1993, 1992 and 1991, the Company's net interest expense to companies within the Industries group totaled $8.0 million, $5.1 million and $18.6 million, respectively. The Company sells to and purchases products from other companies within the Industries group of companies at prevailing market prices. These transactions for the indicated years are summarized as follows: NOTE 12/CONCENTRATION OF CREDIT RISK The Company produces and sells a wide range of steels, of which approximately 99% consists of carbon and high-strength low-alloy steel grades. Approximately 76% of the sales were to customers in five mid-American states, and 93% were to customers in 20 mid-American states. Over half the sales are to the steel service center and transportation (including automotive) markets. Sales to General Motors Corporation approximated 12% of consolidated net sales in 1993 and 1992, and 11% in 1991. No other customer accounted for more than 10% of the consolidated net sales of the Company during any of these years. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTE 13/CONSOLIDATED QUARTERLY SALES AND EARNINGS (UNAUDITED) - --------------- * Includes facility shutdown provision of $22.3 million, $14.7 million after tax. ** Includes cumulative effect of changes in accounting principles of $(609.6) million. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) Reflects the change in book value of rolls, annealing covers and convector plates. (B) Transfer between property, plant and equipment and other assets and other miscellaneous adjustments. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE VI - RESERVE FOR DEPRECIATION, AMORTIZATION AND DEPLETION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) Reclassification among indicated reserve accounts and other miscellaneous adjustments. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE VIII--RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) Bad debts written off during year. (B) Allowances granted during year. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE IX--SHORT-TERM BORROWINGS FOR YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) The average outstanding amount was computed by aggregating the daily balances of short-term debt outstanding and dividing the aggregate by the number of days in the year. (B) The weighted average interest rate during the year was computed by dividing interest expense on short-term debt by the average short-term debt outstanding during the year. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE X--SUPPLEMENTARY PROFIT AND LOSS INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INDEX TO EXHIBITS

101382_1993.txt

101382

1993

ITEM 1. BUSINESS GENERAL United Missouri Bancshares, Inc. (the "Company") was organized in 1967 under Missouri law for the purpose of becoming a bank holding company registered under the Bank Holding Company Act of 1956. The Company owns substantially all of the outstanding stock of 30 commercial banks, a consumer credit bank, a bank real estate corporation, a reinsurance company, a community development corporation and a discount brokerage company. The Company's 30 commercial banks are engaged in general commercial banking business entirely in domestic markets. The banks, 14 located in Missouri, 12 in Kansas, two in Illinois and two in Colorado, offer a full range of banking services to commercial, retail, government and correspondent bank customers. In addition to standard banking functions, the principal affiliate bank, United Missouri Bank, n.a., provides international banking services, investment and cash management services, data processing services for correspondent banks and a full range of trust activities for individuals, estates, business corporations, governmental bodies and public authorities. A table setting forth the names and locations of the Company's affiliate banks as well as their total assets, loans, deposits and shareholders' equity as of December 31, 1993, is included on page A-50 of the attached Appendix, and is incorporated herein by reference. United Missouri Bank, U.S.A. is a consumer credit bank chartered in Delaware. United Missouri Bank, U.S.A. services all incoming credit card requests, performs data entry services on new card requests and evaluates new and existing credit lines. Other subsidiaries of the Company are UMB Properties, Inc., United Missouri Insurance Company, United Missouri Brokerage Services, Inc., and UMB Community Development Corporation. UMB Properties, Inc. is a real estate company that leases facilities to certain subsidiaries and acquires and holds land and buildings for anticipated future facilities. United Missouri Insurance Company, an Arizona corporation, is a reinsurance company that reinsures credit life and disability insurance originated by affiliate banks. United Missouri Brokerage Services, Inc. provides transaction services in a variety of investment securities for the general public. This subsidiary offers brokerage and custodial services to its customers (including affiliate and correspondent banks) through the facilities of National Financial Services Corporation, a wholly-owned subsidiary of Fidelity Brokerage Services, Inc. UMB Community Development Corporation provides low-cost mortgage loans to low-to moderate-income families for acquiring or rehabing owner-occupied housing in Missouri, Kansas, Illinois and Colorado. The Company acquired eight Kansas bank holding companies during 1993. These acquisitions are discussed in detail on pages A-9 and A-10 of the attached Appendix, which is incorporated herein by reference. On a full-time equivalent basis at December 31, 1993, United Missouri Bancshares, Inc. and subsidiaries employed 3,718 persons. COMPETITION The commercial banking business is highly competitive. Affiliate banks compete with other commercial banks and with other financial institutions, including savings and loan associations, finance companies, money market mutual funds, mortgage banking companies and credit unions. In recent years, competition has also increased from institutions not subject to the same geographical and other regulatory restrictions as domestic banks and bank holding companies. MONETARY POLICY AND ECONOMIC CONDITIONS The operations of the Company's affiliate banks are affected by general economic conditions as well as the monetary policy of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") which affects the supply of money available to commercial banks. Monetary policy measures by the Federal Reserve Board are effected through open market operations in U.S. Government securities, changes in the discount rate on bank borrowings and changes in reserve requirements. SUPERVISION AND REGULATION As a bank holding company, the Company is subject to the Bank Holding Company Act of 1956, as amended (the "BHCA") and to regulation by the Federal Reserve Board. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may (i) acquire substantially all the assets of any bank, (ii) acquire more than 5% of the voting stock of a bank or bank holding company which is not already majority owned, or (iii) merge or consolidate with another bank holding company. Under the BHCA, a bank holding company is prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in business other than that of banking, managing and controlling banks or performing services for its banking subsidiaries. However, the BHCA authorizes the Federal Reserve Board to permit bank holding companies to engage in activities which are so closely related to banking or managing or controlling banks as to be a proper incident thereto. The BHCA prohibits the Federal Reserve Board from approving an application by a registered bank holding company to acquire shares of a bank located outside the state in which the operations of the holding company's banking subsidiaries are principally conducted unless the acquisition is specifically authorized by the laws of the state in which the bank to be acquired is located. In 1986, Missouri authorized bank holding companies domiciled in contiguous states to acquire Missouri banks and bank holding companies, provided their home states have similar laws. Colorado and all of the eight states contiguous to Missouri have passed similar legislation. There are various legal restrictions on the extent to which a bank holding company and certain of its non-bank subsidiaries can borrow or otherwise obtain credit from its bank subsidiaries. The Company and its subsidiaries are also subject to certain restrictions on issuance, underwriting and distribution of securities. Nine of the affiliate banks are national banks and are subject to supervision and examination by the Comptroller of the Currency. United Missouri Bank, U.S.A. is chartered under the state banking laws of Delaware and is subject to supervision and regular examination by the Office of the State Bank Commissioner of Delaware. One of the affiliate banks is chartered under the state banking laws of Illinois and is subject to supervision and regular examination by the Office of the Commissioner of Banks and Trust Companies of Illinois. One of the affiliate banks is chartered under the state banking laws of Colorado and is subject to supervision and regular examination by the Office of the State Bank Commissioner of Colorado. Seven of the affiliate banks are chartered under the state banking laws of Kansas and are subject to supervision and regular examination by the Kansas Banking Department. The remaining 12 banks are chartered under the state banking laws of Missouri and are subject to supervision and regular examination by the Office of the Commissioner of Finance of Missouri. In addition, the national banks and the one state bank that are members of the Federal Reserve System are subject to examination by that agency. All affiliate banks are members of the Federal Deposit Insurance Corporation, and as such, are subject to examination thereby. United Missouri Brokerage Services, Inc. is subject to supervision and regulation by the National Association of Securities Dealers. This subsidiary is also a member of the Securities Investor Protection Corporation. Information regarding capital adequacy standards of Federal banking regulators is included on pages A-28 through A-30 of the attached Appendix, and is incorporated herein by reference. Information regarding dividend restrictions is on pages A-12 and A-17 of the attached Appendix, incorporated herein by reference. STATISTICAL DISCLOSURE The information required by Guide 3, "Statistical Disclosure by Bank Holding Companies," has been integrated throughout pages A-26 through A-50 of the attached Appendix under the captions of "Five-Year Financial Summary" and "Financial Review," and such information is incorporated herein by reference. EXECUTIVE OFFICERS The following are the executive officers of the Company, each of whom is elected annually, and there are no arrangements or understandings between any of the persons so named and any other person pursuant to which such person was elected as an officer. ITEM 2.

ITEM 2. PROPERTIES The Company's headquarters building, the United Missouri Bank Building, is located at 1010 Grand Avenue in downtown Kansas City, Missouri, and was opened in July 1986. Of the total 250,000 square feet, the offices of the parent company and customer service functions of United Missouri Bank, n.a. comprise 175,000 square feet. The remaining 75,000 square feet are leased to the Company's principal law firm and principal accounting firm. The banking facility of United Missouri Bank, n.a. at 928 Grand Avenue principally houses that bank's operations, data processing and other support functions and is connected to the headquarters building by an enclosed pedestrian walkway. At December 31, 1993, the Company's affiliate banks operated a total of 30 main banking houses and 86 detached facilities, the majority of which are owned by them or a non-bank subsidiary of the Company and leased to the respective bank. The Company's affiliate bank in St. Louis leases 40,000 square feet of space in the Equitable Building in the heart of the downtown commercial sector. A full service banking center, operations and administrative offices are housed at this location. The St. Louis affiliate bank provides full service banking at 10 additional offices, which circle the metropolitan area. Additional information with respect to premises and equipment is presented on page A-16 of the attached Appendix, which is incorporated herein by reference. In the opinion of the management of the Company, the physical properties of the Company and its subsidiaries are suitable and adequate and are being fully utilized. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In the normal course of business, the Company and its subsidiaries had certain lawsuits pending against them at December 31, 1993. In the opinion of management, after consultation with legal counsel, none of these suits will have a significant effect on the financial condition of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to the shareholders for a vote during the fourth quarter ending December 31, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's stock is traded on the NASDAQ National Market System under the symbol "UMSB." As of December 31, 1993, the Company had 2,787 shareholders. Dividend and sale prices of stock information, by quarter, for the past two years is contained on page A-47 of the attached Appendix and is hereby incorporated by reference. Information concerning restrictions on the ability of Registrant to pay dividends and Registrant's subsidiaries to transfer funds to Registrant is contained on pages A-12 and A-17, respectively, of the attached Appendix and is hereby incorporated by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA See the "Five-Year Financial Summary" on page A-26 of the attached Appendix, which is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See the "Financial Review" on pages A-26 through A-50 of the attached Appendix, which is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements and supplementary data appearing on the indicated pages of the attached Appendix are incorporated herein by reference: Consolidated Financial Statements -- pages A-2 through A-24. Summary of Operating Results by Quarter -- page A-47. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors is included in the Company's 1994 Proxy Statement under the captions "Election of Directors" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" and is hereby incorporated by reference. Information regarding executive officers is included in Part I of this Form 10-K under the caption "Executive Officers." ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION This information is included in the Company's 1994 Proxy Statement under the captions "Executive Compensation", "Report of the Officers Salary and Stock Option Committee on Executive Compensation," "Director Compensation", "Salary Committee Interlocks and Insider Participation," and "Performance Graph" and is hereby incorporated by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS This information is included in the Company's 1994 Proxy Statement under the caption "Principal Shareholders" and is hereby incorporated by reference. SECURITY OWNERSHIP OF MANAGEMENT This information is included in the Company's 1994 Proxy Statement under the caption "Stock Beneficially Owned by Directors and Nominees and Executive Officers" and is hereby incorporated by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information is included in the Company's 1994 Proxy Statement under the caption "Certain Transactions" and is hereby incorporated by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Set forth below are the consolidated financial statements of the Company appearing on the indicated pages of the attached Appendix, which are hereby incorporated by reference. Condensed financial statements for parent company only may be found on page A-24. All other schedules have been omitted because the required information is presented in the financial statements or in the notes thereto, the amounts involved are not significant or the required subject matter is not applicable. REPORTS ON FORM 8-K The Company did not file a report on Form 8-K during the fourth quarter of 1993. EXHIBITS The following Exhibit Index lists the Exhibits to Form 10-K. - ------------------------- * Exhibit has heretofore been filed with the Securities and Exchange Commission and is incorporated herein as an exhibit by reference. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities on the date indicated. /s/ MALCOLM M. ASLIN ------------------------------ Director Malcolm M. Aslin ------------------------------ Director Paul D. Bartlett, Jr. THOMAS E. BEAL* ------------------------------ Director Thomas E. Beal H. ALAN BELL* ------------------------------ Director H. Alan Bell ------------------------------ Director David R. Bradley, Jr. NEWTON A. CAMPBELL* ------------------------------ Director Newton A. Campbell ------------------------------ Director Thom R. Cooper WILLIAM TERRY FULDNER* ------------------------------ Director William Terry Fuldner /s/ CHARLES A. GARNEY* ------------------------------ Director Charles A. Garney PETER J. GENOVESE* ------------------------------ Director Peter J. Genovese C.N. HOFFMAN, JR.* ------------------------------ Director C.N. Hoffman, Jr. ALEXANDER C. KEMPER* ------------------------------ Director Alexander C. Kemper R. CROSBY KEMPER* ------------------------------ Director R. Crosby Kemper R. CROSBY KEMPER III* ------------------------------ Director R. Crosby Kemper III DANIEL N. LEAGUE, JR.* ------------------------------- Director Daniel N. League, Jr. WILLIAM J. MCKENNA* ------------------------------- Director William J. McKenna ROY E. MAYES* ------------------------------ Director Roy E. Mayes JOHN H. MIZE, JR.* ------------------------------ Director John H. Mize, Jr. MARY LYNN OLIVER* ------------------------------ Director Mary Lynn Oliver W. L. ORSCHELN* ------------------------------ Director W. L. Orscheln ALAN W. ROLLEY* ----------------------------- Director Alan W. Rolley JOSEPH F. RUYSSER* ----------------------------- Director Joseph F. Ruysser ----------------------------- Director Thomas D. Sanders ----------------------------- Director Herman R. Sutherland E. JACK WEBSTER, JR.* ----------------------------- Director E. Jack Webster, Jr. JOHN E. WILLIAMS* ----------------------------- Director John E. Williams */s/ MALCOLM M. ASLIN ----------------------------- Malcolm M. Aslin Attorney-in-Fact for each director Date: March 18, 1994 UNITED MISSOURI BANCSHARES, INC. AND SUPPLEMENTARY DATA A-1 FINANCIAL STATEMENTS UNITED MISSOURI BANCSHARES, INC. CONSOLIDATED BALANCE SHEET See Notes to Financial Statements, pages A-6 to A-24. A-2 UNITED MISSOURI BANCSHARES, INC. CONSOLIDATED STATEMENT OF INCOME See Notes to Financial Statements, pages A-6 to A-24. A-3 UNITED MISSOURI BANCSHARES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS - ------------------------- Note: Certain noncash transactions regarding the adoption of SFAS No. 115 and common stock issued for acquisitions are disclosed in the accompanying financial statements and notes to financial statements. See Notes to Financial Statements, pages A-6 to A-24. A-4 UNITED MISSOURI BANCSHARES, INC. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY See Notes to Financial Statements, pages A-6 to A-24. A-5 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING POLICIES The accounting policies of United Missouri Bancshares, Inc. and its subsidiaries conform to generally accepted accounting principles applicable to the banking industry. Following is a summary of the more significant accounting policies to assist the reader in understanding the financial presentation. CONSOLIDATION -- All subsidiaries are included in the financial statements. Intercompany accounts and transactions have been eliminated where significant. ACQUISITIONS -- Banks acquired and recorded under the purchase method are recorded at the fair value of the net assets acquired at the acquisition date, and results of operations are included from that date. Excess of purchase price over the value of net assets acquired is recorded as premiums on purchased banks. Premiums on purchases prior to 1982 are being amortized ratably over 40 years. Premiums on purchases in 1982 and after are being amortized ratably over 15 years. Core deposit intangible assets are being amortized ratably over 10 years. LOANS -- Interest on discount loans is recorded on a method that approximates income at a level rate of return on the principal amount outstanding over the term of the loan. Interest on all other loans is recognized based on the rate times the principal amount outstanding. Interest accrual is discontinued when, in the opinion of management, the likelihood of collection becomes doubtful. Affiliate banks enter into lease financing transactions that are generally recorded under the financing method of accounting. Income is recognized on a basis that results in an approximately level rate of return over the life of the lease. Annual bankcard fees are recognized on a straight-line basis over the period that cardholders may use the card. The adequacy of the allowance is based on management's continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectability may not be assured and determination of the existence and realizable value of the collateral and guarantees securing such loans. The actual losses, notwithstanding such considerations, however, could differ significantly from the amounts estimated by management. SECURITIES AVAILABLE FOR SALE -- Prior to 1992, the Company acquired debt securities with the intent to hold to maturity. Accordingly, such securities were carried at amortized cost. Effective December 31, 1992, the company classified certain debt securities as securities available for sale. These securities are considered part of the company's asset/liability management program that may be sold in response to changes in interest rates, prepayments, or capital or liquidity needs. Debt securities available for sale include principally U.S. Treasury and agency securities and mortgage-backed securities. Until December 31, 1993, securities available for sale were carried at the lower of aggregate amortized cost or market value. Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, equity securities and debt securities available for sale are measured at fair value. Unrealized holding gains and losses are excluded from earnings and reported as a separate component of shareholders' equity until realized. Realized gains and losses on sales are computed by the specific identification method at the time of disposition and are shown separately as a component of noninterest income. Prior to the adoption of SFAS No. 115, marketable equity securities, owned primarily by the parent company, were carried at the lower of aggregate cost or market value. A-6 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED INVESTMENT SECURITIES -- Investment securities are carried at amortized historical cost based on management's intention, and the Company's ability, to hold them to maturity. The Company classifies securities of state and political subdivisions as investment securities. Certain significant unforeseeable changes in circumstances may cause a change in the intent to hold these securities to maturity. For example, such changes may include a deterioration in the issuer's creditworthiness that is expected to continue or a change in tax law that eliminates the tax-exempt status of interest on the security. Once a determination has been made that securities will be sold, such securities are classified as securities available for sale. Gains and losses on sales are computed by the specific identification method at the time of disposition and are shown separately as a component of noninterest income. TRADING SECURITIES -- Trading securities, generally acquired for subsequent sale to customers, are carried at market value. Market adjustments, fees and gains or losses on the sale of trading securities are considered to be a normal part of operations and are included in trading and investment banking income. Interest income on trading securities is included in income from earning assets. TAXES -- The Company recognizes certain income and expenses in different time periods for financial reporting and income tax purposes. The provision for deferred income taxes is based on the liability method and represents the change in the deferred income tax accounts during the year, including the effect of enacted tax rate changes. PER SHARE DATA -- Earnings per share are computed based on the weighted average number of shares of common stock outstanding during each period. The dilutive effect of shares issuable under stock options granted by the Company is immaterial. RECLASSIFICATIONS -- Certain reclassifications were made to the 1992 and 1991 financial statements to conform to the current year presentation. INDUSTRY SEGMENT REPORTING -- The Company operates principally in a single business segment offering general commercial banking services. ACCOUNTING CHANGES ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS -- The Financial Accounting Standards Board issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This Statement, effective for fiscal years beginning after December 15, 1992, requires accrual of postretirement benefits (such as health care benefits) during the years an employee provides services. The Company does not provide any such postretirement benefits and, consequently, adoption of this Statement did not affect its financial position or results of operations. ACCOUNTING FOR INCOME TAXES -- The Financial Accounting Standards Board issued SFAS No. 109, "Accounting for Income Taxes." This Statement superseded SFAS No. 96, by the same title, which the Company had adopted in 1989. SFAS No. 109 reduces the complexity of SFAS No. 96 and changes the criteria for recognition and measurement of deferred tax assets. SFAS No. 109 was adopted by the Company in 1993 and did not have a material effect on the Company's financial position or results of operations. EMPLOYERS' ACCOUNTING FOR POSTEMPLOYMENT BENEFITS -- The Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This Statement, which becomes effective for fiscal years beginning after December 15, 1993, establishes accounting standards for employers who provide certain benefits to former or inactive employees after employment but before retirement. The Company does not provide any such postemployment benefits and, consequently, adoption of this Statement will not affect its financial position or results of operations. ACCOUNTING BY CREDITORS FOR IMPAIRMENT OF A LOAN -- The Financial Accounting Standards Board issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." This Statement, which becomes A-7 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED effective for fiscal years beginning after December 15, 1994, will require that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, at the loan's observable market price or the fair value of collateral if the loan is collateral dependent. The impact of the Statement on the Company has not yet been determined, although the effects are not expected to be material in relation to the consolidated financial statements. ACQUISITIONS On May 1, 1991, the Company acquired Valley Bank Holding Company, the one-bank holding company of Valley Bank, Colorado Springs, Colorado (now UMB Bank Colorado). In exchange for all of the shares of the holding company, the Company paid $4.0 million in cash and other consideration. The acquisition of this $44 million bank was recorded as a purchase, with $1.3 million recorded as premium on purchased bank. On December 11, 1991, the Company acquired National Bank of the West, Colorado Springs, Colorado (renamed UMB Bank of the West). In exchange for all of the shares of the bank, the Company paid $1.9 million in cash and other consideration. The acquisition of this $17 million bank was recorded as a purchase, with $1.0 million recorded as premium on purchased bank. On April 30, 1993, UMB Bank of the West was merged into UMB Bank Colorado. On January 23, 1992, the Company acquired Columbine National Bank, Denver, Colorado (now UMB Columbine National Bank). The Company paid $9.1 million in cash for all the shares of the bank's holding company, The Village Corporation, as well as the minority holdings of bank stock. The acquisition of this $62 million bank was recorded as a purchase, with $2.0 million recorded as premium on purchased bank. These acquisitions are not deemed to be material in relation to the consolidated results of the Company. A-8 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED As of June 25, 1993, the Company had consummated the acquisitions of eight Kansas bank holding companies (the "Kansas banks"). The eight companies, their subsidiary banks and the ownership percentage in the subsidiary banks are presented below: The cash portion of the purchase prices was obtained principally through the issuance of debt by the Company. On February 24, 1993, the Company issued $10,000,000 in medium-term notes due 2000 at 6.81% and $15,000,000 in medium-term notes due 2003 at 7.30%. The acquisitions of the Kansas banks have been accounted for by the Company under the purchase method of accounting in accordance with Accounting Principles Board Opinion No. 16, "Business Combina- A-9 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED tions," as amended. Under this method of accounting, the purchase prices have been allocated to assets acquired and liabilities assumed based on their estimated fair values, including applicable income tax effects, at the effective dates of the acquisitions. Income of the combined company does not include income of the acquired companies prior to the effective dates of the acquisitions. The following table presents supplementary information regarding the acquisitions of the Kansas banks (dollars in thousands): The following unaudited pro forma consolidated financial information gives effect to the Kansas banks as if they were all acquired on January 1, 1992. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which actually would have resulted had the combinations been in effect on the dates indicated, or which may result in the future. COMMITMENTS AND CONTINGENCIES The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest A-10 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED rates. These financial instruments include commitments to extend credit, commercial letters of credit, standby letters of credit, interest rate caps and floors written, and forward and futures contracts. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, commercial letters of credit and standby letters of credit is represented by the contract or notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. For interest rate caps, floors, and forward and futures contracts, the contract or notional amounts do not represent exposure to credit loss. The Company controls the credit risk of its forward and futures contracts through credit approvals, limits and monitoring procedures. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. These conditions generally include, but are not limited to, each customer being current as to repayment terms of existing loans and no deterioration in the customer's financial condition. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The interest rate is generally a variable, or floating, interest rate. If the commitment has a fixed interest rate, the rate is generally not set until such time as credit is extended. For its credit card customers, the Company has the right to change or terminate any terms or conditions of the credit card account at any time. Since some of the commitments and unused credit card lines are never actually drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on an individual basis. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management's credit evaluation. Collateral held varies but may include accounts receivable, inventory, real estate, plant and equipment, stock, securities and certificates of deposit. Commercial letters of credit are issued specifically to facilitate trade or commerce. Under the terms of a commercial letter of credit, as a general rule, drafts will be drawn when the underlying transaction is consummated as intended. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds collateral supporting those commitments when deemed necessary. Collateral varies but may include such items as those described for commitments to extend credit. Forward and futures contracts are contracts for delayed delivery of securities or money market instruments in which the seller agrees to make delivery at a specified future date of a specified instrument at a specified yield. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from movements in securities values and interest rates. Instruments used in trading activities are carried at market value. Any changes in the market value are recognized in trading and investment banking income. Interest rate caps and floors written by the Company enable customers to transfer, modify or reduce their interest rate risk. With respect to group concentrations of credit risk, most of the Company's business activity is with customers in the states of Missouri, Kansas, Colorado and Illinois. At December 31, 1993, the Company did not have any significant credit concentrations in any particular industry. A-11 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED In the normal course of business, the Company and its subsidiaries are named defendants in various lawsuits and counterclaims. In the opinion of management, after consultation with legal counsel, none of these lawsuits will have a materially adverse effect on the financial position or results of operations of the Company. REGULATORY REQUIREMENTS Payment of dividends by the affiliate banks to the parent company is subject to various regulatory restrictions. For national banks, state banks that are Federal Reserve members and state banks in Colorado, the governing regulatory agency must approve the declaration of any dividends generally in excess of the sum of net income for that year and retained net income for the preceding two years. The state banks in Missouri, Kansas and Illinois are subject to state laws permitting dividends to be declared from retained earnings, provided certain specified capital requirements are met. At December 31, 1993, approximately $38,892,000 of the equity of the affiliate banks was available for distribution as dividends to the parent company without prior regulatory approval or without reducing the capital of the respective affiliate banks below prudent levels. The Company is required to maintain minimum amounts of capital to total risk weighted assets, as defined by the banking regulators. At December 31, 1993, the Company is required to have minimum Tier 1 and Total capital ratios of 4.00% and 8.00%, respectively. The Company's actual ratios at that date were 17.09% and 18.50%, respectively. The Company's leverage ratio at December 31, 1993, was 7.59%. Certain affiliate banks maintain reserve balances with the Federal Reserve Bank as required by law. During 1993, this amount averaged $94,577,000. LOANS TO MANAGEMENT Certain Company and principal affiliate bank executive officers and directors, including companies in which those persons are principal holders of equity securities or are general partners, borrow in the normal course of business from affiliate banks of the Company. All such loans have been made on the same terms, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other persons. In addition, all such loans are current as to repayment terms. For the years 1993, 1992 and A-12 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED 1991, an analysis of activity with respect to such aggregate loans to related parties appears below (in thousands): ALLOWANCE FOR LOAN LOSSES The table below provides an analysis of the allowance for loan losses for the three years ended December 31, 1993 (in thousands): A-13 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED SECURITIES AVAILABLE FOR SALE The table below provides detailed information for securities available for sale at December 31, 1993 and 1992: The following table presents contractual maturity information for securities available for sale at December 31, 1993. Securities may be disposed of before contractual maturities due to sales by the Company or because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities available for sale with a market value of $1,554,257,000 at December 31, 1993, and $858,175,000 at December 31, 1992, were pledged to secure U.S. Government deposits, other public deposits and certain trust deposits as required by law. During 1993, proceeds from the sales of securities available for sale were $225,587,000 and securities transactions resulted in gross realized gains of $1,598,000 and gross realized losses of $8,000. A-14 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED The net unrealized holding loss on trading securities at December 31, 1993, was $130,000, and was included in trading and investment banking income. INVESTMENT SECURITIES The table below provides detailed information for investment securities at December 31, 1993, 1992 and 1991 (in thousands): The following table presents contractual maturity information for investment securities at December 31, 1993. Expected maturities will differ from contractual maturities because borrowers may have the rights to call or prepay obligations with or without call or prepayment penalties. A-15 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED Proceeds from sales of investment securities and gross realized gains and gross realized losses on such sales for the three years ended December 31, 1993, were (in thousands): During 1993, certain investment securities with a total amortized cost amount of $680,000 were sold due to significant deterioration in the creditworthiness of the related issuers. Investment securities with a market value of $5,356,000 at December 31, 1993, $3,139,000 at December 31, 1992, and $990,094,000 at December 31, 1991, were pledged to secure U.S. Government deposits, other public deposits and certain trust deposits as required by law. BANK PREMISES AND EQUIPMENT Bank premises and equipment are stated at cost less accumulated depreciation, which is computed primarily on an accelerated method. Bank premises are depreciated over a 20-to 40-year life span, while equipment is depreciated over a life span of 3 to 20 years. Bank premises and equipment consisted of the following (in thousands): Consolidated rental and operating lease expenses were $2,932,000 in 1993, $2,422,000 in 1992 and $2,144,000 in 1991. Minimum rental commitments as of December 31, 1993, for all noncancelable operating leases are: 1994 -- $2,045,000; 1995 -- $2,089,000; 1996 -- $1,937,000; 1997 -- $1,700,000; 1998 -- $1,679,000; and thereafter -- $6,892,000. A-16 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED BORROWED FUNDS The components of the Company's short-term and long-term debt were as follows (in thousands): The long-term debt represents direct, unsecured obligations of the parent company. The senior notes due 2000 and 2003 cannot be redeemed prior to stated maturity. The senior notes due 1996 require annual redemptions of $3,572,000. Optional prepayments without premiums were made on the senior notes due 1996 of $2,678,000 in 1993 and $3,572,000 in 1992. The senior notes due 1999 require annual redemptions of $3,000,000 beginning in 1995. The 7.50% notes that mature in 1997 require annual principal payments of $1,546,000. The senior notes contain financial covenants relating to the issuance of additional debt, payment of dividends, reacquisition of common stock and maintenance of minimum tangible capital. Under the most restrictive covenant, approximately $80,113,000 was available for the payment of dividends at December 31, 1993. The Company enters into sales of securities with simultaneous agreements to repurchase ("repurchase agreements"). The amounts received under these agreements represent short-term borrowings and are reflected as a separate item in the consolidated balance sheet. The amount outstanding at December 31, 1993, was $598,872,000 (with accrued interest payable of $1,654,000). Of that amount, $119,785,000 represented sales of securities in which the securities were obtained under reverse repurchase agreements ("resell agreements"). The remainder of $479,087,000 represented sales of U.S. Treasury securities obtained from the Company's securities portfolio. The carrying amounts and market values of the securities and the related repurchase liabilities and weighted average interest rates of the repurchase liabilities (grouped by maturity of the repurchase agreements) were as follows (amounts in thousands): A-17 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED COMMON STOCK The following table summarizes the share transactions for the three years ended December 31, 1993: EMPLOYEE BENEFITS The Company has a noncontributory profit sharing plan, which features an employee stock ownership plan. These plans are for the benefit of substantially all officers and employees of the Company and its subsidiaries. Contributions to these plans for the years 1993, 1992 and 1991 were $3,542,000, $3,317,000 and $2,972,000, respectively. The Company has a qualified 401(k) profit sharing plan that permits participants to make contributions by salary reduction. The Company does not make contributions to this plan. Substantially all officers and employees are covered by a noncontributory defined benefit pension plan. Under the plan, retirement benefits are based on years of service and the average of the employee's highest 120 consecutive months of compensation. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. To the extent that these requirements are fully covered by assets in the plan, a contribution may not be made in a particular year. The following items are components of the net periodic pension income for the three years ended December 31, 1993 (in thousands): A-18 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED Assumptions used in accounting for the plan were as follows: The following table sets forth the pension plan's funded status, using valuation dates of September 30, 1993, 1992 and 1991 (in thousands): On April 16, 1992, the shareholders of the Company approved the 1992 Incentive Stock Option Plan ("the 1992 Plan"), which provides incentive options to certain key employees for up to 500,000 common shares of the Company. The options are not exercisable for two years from the date of the grant and are thereafter exercisable for such periods as the Board of Directors, or a committee thereof, specify (which may not exceed 10 years), provided that the optionee has remained in the employment of the Company or its subsidiaries. The Board or the committee may accelerate the exercise period for an option upon the optionee's disability, retirement or death. All options expire at the end of the exercise period. The Company makes no recognition in the balance sheet of the options until such options are exercised and no amounts applicable thereto are reflected in net income. Options are granted at not less than 100% of fair market value at date of grant. A-19 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED Activity in the 1992 Plan for the two years ended December 31, 1993, is summarized in the following table: The 1981 Incentive Stock Option Plan ("the 1981 Plan") was adopted by the Company on October 22, 1981, and amended November 27, 1985, and October 10, 1989. No further options may be granted under the 1981 Plan. Provisions of the 1981 Plan regarding option price, term and exercisability are generally the same as that described for the 1992 Plan. Activity in the 1981 Plan for the three years ended December 31, 1993, is summarized in the following table: A-20 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED INCOME TAXES Income taxes as set forth below produce effective federal income tax rates of 30.17% in 1993, 26.67% in 1992 and 23.22% in 1991. These percentages are computed by dividing total federal income tax by the sum of such tax and net income. Income taxes include the following components (in thousands): The reconciliation between the income tax provision and the amount computed by applying the statutory federal tax rate of 35% in 1993 and 34% in 1992 and 1991 to income before income taxes is as follows (in thousands): Deferred taxes are recorded based upon differences between the financial statement and tax bases of assets and liabilities. Net deferred tax assets included in the consolidated balance sheet at December 31, 1992 and 1991, were $2,273,000 and $5,054,000, respectively. A-21 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED Temporary differences which comprise a significant portion of deferred tax assets and liabilities at December 31, 1993, were as follows (in thousands): DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosure about Fair Value of Financial Instruments," requires disclosures about the fair value of all financial instruments, whether or not recognized in the balance sheet. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND SHORT-TERM INVESTMENTS -- The carrying amounts of cash and due from banks, federal funds sold and resell agreements are reasonable estimates of their fair values. SECURITIES AVAILABLE FOR SALE AND INVESTMENT SECURITIES -- Fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. TRADING SECURITIES -- Fair values for trading securities (including off-balance-sheet instruments), which also are the amounts recognized in the balance sheet, are based on quoted market prices where available. If quoted market prices are not available, fair values are based on quoted market prices for similar securities. LOANS -- Fair values are estimated for portfolios with similar financial characteristics. Loans are segregated by type, such as commercial, real estate, consumer, and credit card. Each loan category is further segmented into fixed and variable interest rate categories. The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. DEPOSIT LIABILITIES -- The fair value of demand deposits and savings accounts is the amount payable on demand at December 31, 1993 and 1992. The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities. SHORT-TERM DEBT -- The carrying amounts of federal funds purchased, repurchase agreements and other short-term debt are reasonable estimates of their fair values. LONG-TERM DEBT -- Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. A-22 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED OFF-BALANCE-SHEET INSTRUMENTS -- The fair value of a loan commitment and a letter of credit is determined based on the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counterparties. Neither the fees earned during the year or these instruments or their fair value at year-end are significant to the Company's consolidated financial position. The estimated fair values of the Company's financial instruments at December 31, 1993 and 1992, are as follows (in thousands): The fair value estimates presented herein are based on pertinent information available to management as of December 31, 1993 and 1992. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein. A-23 UNITED MISSOURI BANCSHARES, INC. NOTES TO FINANCIAL STATEMENTS -- CONTINUED PARENT COMPANY FINANCIAL INFORMATION A-24 INDEPENDENT AUDITORS' REPORT To the Shareholders and the Board of Directors of United Missouri Bancshares, Inc.: We have audited the accompanying consolidated balance sheets of United Missouri Bancshares, Inc. and subsidiaries as of December 31, 1993, 1992 and 1991, and the related consolidated statements of income, shareholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of United Missouri Bancshares, Inc. and subsidiaries as of December 31, 1993, 1992 and 1991, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. As discussed in the Accounting Policies note to the financial statements, the Company changed its method of accounting for certain investments in debt and equity securities effective December 31, 1993, to conform with Statement of Financial Accounting Standards No. 115. /s/ DELOITTE & TOUCHE Kansas City, Missouri February 23, 1994 A-25 FINANCIAL REVIEW FIVE-YEAR FINANCIAL SUMMARY - ------------------------- * Securities include investment securities and securities available for sale. ** For purposes of computing these ratios, earnings represent pretax income plus fixed charges. Fixed charges include all interest (except interest on deposits as indicated above), the portion of rental expense deemed representative of an interest factor and amortization of debt expense. A-26 OVERVIEW Financial highlights for United Missouri Bancshares, Inc. (the "Company") for 1993 included: - net income of $41.1 million, up 4.5% from 1992; - assets exceeded $6.5 billion at December 31, 1993, an increase of 30.5% from one year earlier, attributable to the Company's expansion into Kansas; - excellent credit quality, with only 0.3% of the loan portfolio classified as nonperforming at year-end 1993; - strong capital adequacy, with a total risk-based capital ratio of 18.5% at December 31, 1993, compared to a regulatory minimum of 8%; and - fee-based services contributed 43.4% of net revenues for 1993, reflecting the Company's diverse financial services, which include trust, securities processing, bond trading, cash management and credit cards. EXPANSION INTO KANSAS During 1993, the Company expanded significantly into Kansas. Twelve banks were added to the UMB family between March 26, 1993 and June 25, 1993 (the "Kansas banks"). The Kansas banks added assets of $1.3 billion, helping increase the size of the Company by 30.5%. The Kansas banks are strategically located around Interstate 70. This complements our "I-70 corridor" of affiliates, stretching from Denver in the West across Kansas and Missouri to the Metro East St. Louis area in Illinois. Additionally, two of the larger Kansas bank acquisitions, UMB Overland Park Bank and UMB Commercial National Bank give us a meaningful presence in Johnson County. Johnson County is one of the highest per capita income counties in the country and lies just over the state line from the Company's headquarters in Kansas City, Missouri. The state of Kansas opened its doors to regional interstate banking effective on July 1, 1992. Even in advance of that date, the Company was either approaching, or being approached by, several good performing Kansas banks about possible affiliations. Cross-ownership already existed with UMB Overland Park Bank and the CNB Financial Corporation group of banks. Management of the Company made the decision to reach critical mass in Kansas as quickly as possible. Meaningful market share was felt to be desirable to achieve long-term profitability. The total purchase price of the Kansas bank acquisitions was $178.0 million. The consideration given in acquiring these banks consisted of approximately 3.9 million shares of Company common stock and $26.6 million in cash. Generally, stock was required in all but one of the acquisitions to meet sellers' demands for largely tax-free transactions. The source of the cash was a $25 million public debt offering of seven and ten year notes at a blended rate of approximately 7.1%. Each of the acquisitions was accounted for under the purchase method of accounting, in which the earnings of the acquired bank were added into the consolidated results of operations from the respective date of acquisition. Additionally, the purchase price for each bank was allocated to assets acquired and liabilities assumed based on their fair market values at date of acquisition. An intangible asset of $12.8 million for the value of the core deposits was recorded and the remaining excess of the purchase prices over the fair value of net assets acquired was recorded as goodwill in the amount of $51.9 million. These intangible assets are being amortized over periods of 10 and 15 years, respectively. The amortization expense associated with the intangible assets has impacted the earnings of the Kansas banks and their contribution to the Company's results of operations. Earnings per share were further diluted by the shares issued to effect these transactions. The dilution in the Company's earnings per share for 1993 as a result of the Kansas bank acquisitions is estimated to be $0.28 per share, or 9.8%. The Company is actively pursuing a variety of strategies to eliminate the earnings dilution as quickly as possible. These strategies include converting the Kansas banks to the Company's data processing systems; merging the 12 banks into two banks (Salina and Kansas City, Kansas); consolidating bookkeeping and other A-27 back room operations; and eliminating redundant functions, such as trust services, credit card processing and bond portfolio administration. ROA ANALYSIS Return on average assets (ROA) was 0.71% for 1993, compared to 0.85% for 1992. The Company's ROA has benefited from relatively low loan loss provisions as well as the noninterest income generated by fee services. Offsetting these factors are the Company's overhead and net interest margin. TABLE 1: ANALYSIS OF RETURN ON ASSETS The table below expresses each component of net income as a percentage of average assets. Noninterest expense, or overhead, was 4.0% of average assets in 1993 and 1992. The staffing and automation to support the Company's fee services contribute to overhead. Plans currently under way to reduce noninterest expenses in the Kansas banks should have a favorable impact on ROA in 1994 and subsequent years. Net interest income (tax-equivalent) as a percent of average assets leveled off at 2.95% in 1993 compared to 1992, after following a downward trend the three previous years. Relative to other banks, the Company has a more liquid balance sheet and a higher percentage of its earning assets represented by securities. Through much of the five-year period 1989 through 1993, market interest rates steadily declined and loan demand was sluggish. The Company was investing the monies from maturing securities and deposit growth into new securities at lower yields. As a consequence, net interest income contributed less and less to earnings and the Company's ROA. Beginning in the fourth quarter of 1992, the effects of the Company's emphasis on business development and loan generation could be seen. These efforts, coupled with a strengthening economy, produced loan growth in 1993. A second step to stabilize and improve net interest income was a repositioning of the securities portfolio in December 1992. At that time, the Company's affiliate banks sold approximately $906.3 million of short-term securities prior to scheduled maturity dates. Securities sold were short-term U.S. Treasury obligations, most of which were scheduled to mature in 1993. The proceeds of these sales were reinvested in other securities with similar characteristics, with maturities in 1994, 1995 and 1996. These transactions resulted in net realized securities gains of $4.2 million. At December 31, 1992, the average maturity of the securities portfolio, reflective of the repositioning, was 1 year and 10 months, compared to only 11 months at December 31, 1991. At December 31, 1993, the average maturity of the securities portfolio had lengthened slightly to about 2 years, due to relatively longer-term mortgage-backed securities included in the portfolios of the Kansas banks. Some additional repositioning of the securities portfolio by management is anticipated in 1994, as the Company continues to actively manage its securities portfolio to improve its yield and contribution to earnings. CAPITAL MANAGEMENT Management of the Company has consistently maintained a strong capital position, believing it essential for operating a safe and sound financial institution and safeguarding the funds entrusted to it by customers and shareholders. At December 31, 1993, shareholders' equity was $586.6 million, up $186.9 million or 46.8% from A-28 $399.7 million at year-end 1992. The net increase in shareholders' equity as a result of the stock issued in acquiring the Kansas banks was $148.9 million. The equity to asset ratio was 9.0% and 8.0% at December 31, 1993 and 1992, respectively. Risk-based capital guidelines established by regulatory agencies set minimum capital standards based on the level of risk associated with a financial institution's assets. A financial institution's total capital is required to equal 8% of risk-weighted assets. At least half of that 8% must consist of Tier 1 core capital, and the remainder may be Tier 2 supplementary capital. The risk-based capital guidelines indicate the specific risk weightings by type of asset. Certain off-balance sheet items (such as standby letters of credit and binding loan commitments) are multiplied by "credit conversion factors" to translate them into balance sheet equivalents before assigning them specific risk weightings. Due to the Company's high level of core capital and substantial portion of earning assets invested in riskless government securities, the Tier 1 capital ratio of 17.1% and Total capital ratio of 18.5% substantially exceed the regulatory minimums. A-29 TABLE 2: RISK-BASED CAPITAL The table below computes risk-based capital in accordance with current regulatory guidelines. These guidelines as of December 31, 1993, excluded net unrealized gains on securities available for sale from the computation of regulatory capital and the related risk-based capital ratios. - ------------------------- * Qualifying amounts. ASSET QUALITY LOANS The quality of the Company's loan portfolio remains strong. A primary measure of the effectiveness of credit risk management is the percentage of the loan portfolio that is classified as nonperforming. Nonperforming loans include nonaccrual loans and restructured loans. The Company's nonperforming loans A-30 totaled $7.2 million at December 31, 1993, representing only 0.3% of the loan portfolio, compared to $3.1 million and 0.2% one year earlier. At year-end 1993, the Kansas banks held $5.7 million in nonperforming loans, or 1.2% of the loans in their combined loan portfolio. The Company's nonperforming loans have not exceeded 0.5% of total loans in each of the last five years. TABLE 3: LOAN QUALITY - ------------------------- * Includes in-substance foreclosures. Nonperforming assets include foreclosed real estate with the nonaccrual and restructured loans. The Company's nonperforming asset ratio (nonperforming assets divided by loans plus foreclosed real estate) was 0.7% at December 31, 1993 and December 31, 1992. Key factors of the Company's loan quality program are a sound credit policy combined with periodic and independent credit reviews. All affiliate banks operate under written loan policies. Credit decisions continue to be based on the borrower's cash flow position and the value of underlying collateral, as well as other relevant factors. Each bank is responsible for evaluating its loans by using a ranking system. In addition, the Company has an internal loan review staff that operates independent of the affiliate banks. This review team performs periodic examinations of each bank's loans for credit quality, documentation and loan administration. Another means of ensuring loan quality is diversification. By keeping its loan portfolio diversified, the Company has avoided problems associated with undue concentrations of loans within particular industries. Commercial real estate loans comprise 12.9% of total loans, with a history of no significant losses. The Company has no significant exposure to highly leveraged transactions and has no foreign credits in its loan portfolio. A loan is generally placed on nonaccrual status when payments are past due 90 days or more and when management has considerable doubt about the borrower's ability to repay on the terms originally contracted. The accrual of interest is discontinued and recorded thereafter only when actually received in cash. At year-end 1993, $210,000 of interest due was not recorded as earned, compared to $168,000 for the prior year. Certain loans are restructured to provide a reduction or deferral of interest or principal because of deterioration in the financial condition of the respective borrowers. Management estimates that approximately $35,000 of additional interest would have been earned in 1993 if the terms of these loans were similar to other comparable loans. In certain instances, the Company continues to accrue interest on loans past due 90 days or more. Though the loan payments are delinquent, collection of interest and principal is expected to resume and sufficient collateral is believed to exist to protect the Company from significant loss. Consequently, management A-31 considers the ultimate collection of these loans to be reasonable and has recorded $214,000 of interest due as earned for 1993. The comparative figure for 1992 was $123,000. In addition to the loans discussed above, management has identified through its loan ranking system $1,781,000 of potential problem loans. Though the loan payments are current, the borrowers' abilities to comply with the stated terms are questioned. Each of these loans is subject to constant management attention, and its classification is reviewed periodically. Other real estate that has been acquired through or in lieu of foreclosure and certain "in-substance" foreclosures have a total carrying value of $7.2 million, which approximates market value, at year-end 1993. The largest real estate parcel is in Kansas City and represents an in-substance foreclosure of $5.2 million recorded in the fourth quarter of 1992. Of the remaining 22 parcels, 19 are in Kansas and total $1.3 million. ALLOWANCE AND PROVISION FOR LOAN LOSSES The allowance for loan losses is maintained to absorb potential losses in the loan portfolio. The allowance is increased by provisions charged to expense and is reduced by loan charge-offs, net of recoveries. The Company's allowance for loan losses at December 31, 1993, was $35.6 million, 1.7% of total loans, compared to $24.5 million, 1.7% of total loans, one year earlier. The allowance at year-end 1993 was 4.9 times the total of nonperforming loans, exceeding the dollar amount of those loans by $28.4 million. Included in the Company's allowance figure at December 31, 1993, was an allowance of $11.4 million recorded by the Kansas banks representing 2.3% of their combined loans and 2.0 times the total of their nonperforming loans. Net loan charge-offs decreased to $4.3 million in 1993 from $5.0 million in 1992. The 1992 net charge-off figure included principal of $506,000 and interest of $373,000 charged against the allowance in recording an in-substance foreclosure of $5.2 million. The net charge-off ratio was 0.24% for 1993 and 0.37% for 1992. The provision for loan losses was $3.3 million in 1993 and $3.0 million in 1992. During the past five years, due to the consistency in the quality of the Company's loan portfolio, management has been able to record provisions less than the amount of actual net charge-offs and still maintain the allowance at adequate levels. Absent any significant deterioration in the loan portfolio, management anticipates that the loan loss provision for 1994 should not materially exceed the provision recorded in 1993. The adequacy of the allowance is based on management's continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectability may not be assured and determination of the existence and realizable value of the collateral and guarantees securing such loans. The actual losses, notwithstanding such considerations, however, could differ significantly from the amounts estimated by management. A-32 TABLE 4: ANALYSIS OF ALLOWANCE FOR LOAN LOSSES A-33 TABLE 5: ALLOCATION OF ALLOWANCE FOR LOAN LOSSES This table presents an allocation of the allowance for loan losses by loan categories; however, the breakdown is based on a number of qualitative factors, and the amounts presented are not necessarily indicative of actual future charge-offs in any particular category. The percent of loans in each category to total loans is provided in Table 13. SECURITIES During 1993, the Company's securities portfolio comprised 55.8% of total average earning assets. As discussed previously, the average maturity of the securities portfolio was about 2 years at December 31, 1993, compared to 1 year and 10 months at December 31, 1992, and 11 months at December 31, 1991. The Financial Accounting Standards Board issued a new accounting standard in 1993 that requires companies to value securities available for sale at current market prices, with unrealized holding gains and losses reported as a net amount in a separate component of shareholders' equity (net of a deferred tax liability). The Company elected to adopt this accounting standard early, effective December 31, 1993. Securities available for sale include securities considered part of the Company's asset/liability management that may be sold in response to changes in interest rates, prepayments, or capital or liquidity needs. This category includes principally U.S. Treasury and agency securities and mortgage-backed securities. At December 31, 1993, securities available for sale had an aggregate amortized cost of $2.68 billion and fair value of $2.70 billion. The amount of the related net unrealized holding gain reported in equity at year-end 1993 was $14.3 million. TABLE 6: SECURITIES AVAILABLE FOR SALE A-34 Investment securities are carried at amortized historical cost based on management's intention and the Company's ability to hold them to maturity. Generally, the Company classifies securities of state and political subdivisions as investment securities. At December 31, 1993, investment securities had a total carrying value of $278.9 million and fair value of $282.3 million. TABLE 7: INVESTMENT SECURITIES EARNINGS PERFORMANCE NET INTEREST INCOME Net interest income, the principal source of earnings, is the difference between the interest income generated by earning assets and the total interest cost of the liabilities obtained to fund them. Net interest income in 1993 was $163.5 million, compared to $129.6 million in 1992. However, to provide comparability among the types of interest earned, the following discussion of net interest income is on a fully tax-equivalent (FTE) basis, which adjusts for the tax-exempt status of certain municipal securities and loans. The reported interest income for these tax-free assets is increased by the amount of the income tax savings, less the additional taxes for the nondeductible portion of interest expense incurred to acquire the tax-free assets. Measured on a tax-equivalent basis, net interest income in 1993 increased $33.8 million to $170.3 million, an increase of 24.7% from 1992. The Kansas banks contributed $25.0 million in tax-equivalent net interest income. Net interest margin measures the Company's ability to generate net interest income. It is defined as net interest income (FTE) as a percent of earning assets. The behavior of the margin depends on the interaction of three factors: 1) net interest spread (defined as the difference between the yield on earning assets and the rate paid on interest-bearing liabilities); 2) yield earned on assets funded by interest-free funding sources (primarily noninterest-bearing demand deposits and equity capital); and 3) percentage of earning assets funded by interest-free funding sources. During 1993, the economy continued to strengthen modestly. Certain monetary actions of the Federal Reserve Board over the last four years had cut short-term rates (as measured by the federal funds rate) from 10% to the current level of 3%, a level that was steady throughout much of 1993. The actions of the Federal Reserve did not impact long-term rates until 1993, when these rates fell throughout the year. A-35 The Company's cost of funds decreased from 3.82% in 1992 to 3.05% in 1993, a reduction of 77 basis points. However, the Company's yield on earning assets also decreased, from 6.63% in 1992 to 5.92% in 1993, a decrease of 71 basis points. As a consequence, the Company's net interest spread improved from 2.81% in 1992 to 2.87% in 1993. However, net interest margin remained level at 3.48%, as interest-free funds were invested at lower market rates in 1993 compared to 1992. Management believes the repositioning of the securities portfolio in December 1992 helped stabilize the margin and improve the spread. Additionally, loan growth has resulted in loans constituting a higher percentage of average earning assets, 36.5% in 1993 compared to 34.1% in 1992. The Company expects its spread and margin to improve in 1994 as a result of the active management of the securities portfolio and a noted increase in quality loan demand. TABLE 8: ANALYSIS OF NET INTEREST MARGIN A-36 TABLE 9: TAX-EQUIVALENT RATE-VOLUME ANALYSIS This analysis attributes changes in net interest income on a tax-equivalent basis either to changes in average balances or to changes in average rates for earning assets and interest-bearing liabilities. The change in interest due jointly to volume and rate has been allocated to volume and rate in proportion to the relationship of the absolute dollar amount of change in each. All information is presented on a tax-equivalent basis and gives effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax-free assets. NONINTEREST INCOME Management has stressed the importance of growth of noninterest income to enhance the Company's profitability. Fee-based services, being non-credit related, provide generally steady income and are not affected by the rise and fall in interest rates. These activities are also relatively low-risk and do not impact the Company's regulatory capital needs. Fee-based services that have been emphasized include trust and securities processing, securities trading, cash management and credit cards. Fee income (exclusive of net A-37 security gains) as a percent of adjusted operating revenues has increased from 38.4% in 1989 to 43.4% in 1993. Adjusted operating revenues is defined as tax-equivalent net interest income plus noninterest income, excluding net security gains. Noninterest income, exclusive of net security gains, increased to $130.5 million in 1993 from $108.2 million in 1992, an increase of 20.6%. The Kansas banks contributed $9.0 million in noninterest income, which included $3.7 million in service charges and other fees, $2.5 million in trust fees and $1.6 million in data processing fees. Trust income is the largest component of noninterest income and increased 17.2% to $32.0 million in 1993 from $27.3 million in 1992. The continuing improvement in trust income is evidence of increased business activity and marketing efforts. The aggregate value of managed trust assets at December 31, 1993, was $8.7 billion, compared to $7.5 billion for December 31, 1992. The managed trust assets of the Kansas banks approximated $800 million. The Company's custodial trust business, principally from the mutual funds industry, continued to grow in 1993. Total trust assets under custody at December 31, 1993, were $178.4 billion, up from $150.6 billion one year earlier, due to both new customers and increases in the funds of existing customers. The custodial trust assets of the Kansas banks approximated $300 million. Securities processing income, which is derived from the custodial business, was $13.3 million for 1993, compared to $13.7 million for 1992. The variance between years reflects some mutual fund customers maintaining deposit balances in lieu of paying fees and some adjustments in pricing to meet competition. Trading and investment banking income increased 9.0% to $13.6 million in 1993. The increase was generated through increased business development efforts in new markets and increased sales of mortgage-backed and tax-exempt securities to correspondent bank customers and retail investors. Service charges on deposits for 1993 were $30.2 million, an increase of 25.4% from 1992, reflecting the contribution of $3.2 million by the Kansas banks, higher transaction volumes and higher occurrences of fees paid in lieu of compensating balances. Additionally, adjustments to fee schedules were made mid-year 1993 in conjunction with modifications to our deposit products to meet the requirements of consumer banking legislation that became effective at that time. Other service charges and fees grew 44.7% to $14.1 million, resulting from increased sales of cash management services to mutual fund and corporate customers. In October 1992, the Company began providing check processing and related cash management services for the Fidelity mutual funds. Bankcard fees for 1993 were $22.4 million, compared to $18.3 million for 1992, an increase of 22.9%. The increase in bankcard fees was due to a higher volume of credit card transactions processed for merchants. Other noninterest income increased in 1993 to $4.7 million from $2.5 million in 1992. The increase was principally due to $1.6 million in data processing fees generated by two of the Kansas banks. Realized net security gains were $1.6 million in 1993 and $5.3 million in 1992. In 1992, $4.2 million of the net security gains were attributable to the repositioning of the Company's securities portfolio, as discussed earlier. In 1993, approximately $714,000 of security gains were recognized in the fourth quarter from the sales of U.S. Treasury securities with maturities occurring in the first three months of 1994. The remaining 1993 gains resulted from the sales of various equity securities. NONINTEREST EXPENSE Noninterest expense rose to $231.0 million in 1993, a 24.9% increase from 1992. Without the Kansas banks, the increase in noninterest expense was 9.2% between years. Principally due to the Kansas bank acquisitions, the net overhead ratio increased to 33.4% in 1993, up from 31.4% in 1992. Without the Kansas banks, the net overhead ratio was 30.2% for 1993. The net overhead ratio is defined as the difference between noninterest expense and noninterest income (excluding net security gains) as a percent of adjusted operating revenues. During 1994, the Company will continue to work toward consolidating certain operations and eliminating redundant costs as the Kansas banks are assimilated into the Company. A-38 TABLE 10: ANALYSIS OF NONINTEREST EXPENSE Salaries and employee benefits expense, the largest component of noninterest expense, increased $18.5 million, or 21.0%, to $106.3 million. Approximately $13.1 million of the increase was due to the Kansas banks. The balance of the increase was attributable to merit increases and increased hospitalization and medical expenses. Equipment expense increased 29.0% in 1993 to $20.3 million. The increase without the Kansas banks was 11.6% and was due to a full year's depreciation on 1992 investments in a new computer mainframe and other data processing equipment, and a new check imaging system. In 1993, a new bond trading system was implemented at the principal affiliate bank in Kansas City. Additionally, the data processing equipment used by the Salina bank affiliate in serving its correspondent bank customers was upgraded. Supplies and services expense increased 20.4% to $17.4 million, reflecting more customer mailings and form revisions in conjunction with the bank acquisitions. Bankcard processing expense increased 16.7% to $18.7 million in 1993 from $16.0 million in 1992. This increase was attributed to higher merchant authorization expenses from processing a greater volume of transactions. Marketing and business development expenses were $13.6 million in 1993, compared to $10.6 million in 1992. These expenses increased in 1993 due to the Kansas bank acquisitions, a campaign for new loans as well as deposit product modifications resulting from new consumer banking regulations. Other noninterest expense in 1993 was $23.6 million, compared to $17.3 million in 1992, an increase of $6.3 million, or 36.4%. Approximately $3.2 million of the increase relates to the Kansas banks. The remaining increase was primarily attributable to higher outside data processing fees paid by the Company to service its mutual fund customers and higher check processing and wire transfer fees resulting from increased business. INCOME TAXES The increase in the corporate tax rate from 34% to 35% was effective January 1, 1993. The Company's effective federal tax rate on income was 30.2% in 1993, 26.7% in 1992 and 23.2% in 1991. The Company's tax-exempt income as a percent of pre-tax income was 23.2% in 1993, 28.3% in 1992 and 40.8% in 1991. The major difference between the effective federal tax rates and the federal statutory rate of 35% in 1993 and 34% in 1992 and 1991 results from tax-exempt interest income on state and political subdivision securities. Since this interest is not subject to federal income tax, the states and political subdivisions are able to issue these obligations at lower interest rates. Accordingly, the Company and other holders of such securities give up additional interest income that could have been earned on similar taxable investments. Management A-39 estimates that tax-exempt interest decreased the Company's effective tax rates for 1993, 1992 and 1991 by 7.2%, 8.6% and 11.9%, respectively. ASSET/LIABILITY MANAGEMENT LIQUIDITY Liquidity represents the ability of the Company to provide a continuing flow of funds to meet its financial commitments and the borrowing needs and deposit withdrawal requirements of its customers. Liquidity is primarily provided through the regularly scheduled maturities of assets and $2.7 billion of high-quality securities available for sale. Maturities in the loan portfolio also provide a steady flow of funds, and strict adherence to credit standards helps ensure the collection of those loans. At December 31, 1993, loans of $1.08 billion, representing 49.9% of total loans, were due to mature in one year or less. The overall liquidity of the Company is also enhanced by its net federal funds sold position and significant amount of core deposits. TABLE 11: RATE SENSITIVITY AND MATURITY OF LOANS The following table presents the rate sensitivity of certain loans maturing after 1994 compared with the total loan portfolio as of December 31, 1993. Of the $1,082,723,000 of loans due after 1994, $615,417,000 are to individuals for the purchase of residential dwellings and other consumer goods. The remaining $467,306,000 is for all other purposes and reflects maturities of $380,524,000 in 1995 through 1998 and $86,782,000 after 1998. The parent company's cash requirements consist primarily of dividends to shareholders and principal and interest payments on debt. These cash needs are routinely satisfied by dividends and management fees collected from the affiliate banks. The parent company's long-term debt position is modest and compares favorably with its peer group. Principal and interest payments on this debt total approximately $9.1 million for 1994. Projected cash flows are adequate to service the debt, given the strong capital levels and continued profitable operations of the affiliate banks. INTEREST RATE SENSITIVITY Interest rate sensitivity indicates a financial institution's potential earnings exposure to fluctuating interest rates. It is related to liquidity because each is affected by maturing assets and liabilities. However, interest rate sensitivity also takes into consideration those assets and liabilities with interest rates that are subject to change prior to maturity. Interest rate sensitivity is measured by "gaps," defined as the difference between interest- earning assets and interest-bearing liabilities within specified time frames. When the gap is positive, with earning assets in excess of interest-bearing liabilities, net interest income generally improves if interest rates rise. The opposite effect occurs in the case of a negative gap. A-40 The Company structures the balance sheet to provide for the repricing of approximately equal amounts of assets and liabilities at the same time. This strategy helps maintain relative stability in net interest income despite unpredictable fluctuations in interest rates. Table 12 is a summary statement that reflects the repricing dates for various assets and liabilities at December 31, 1993. As depicted in Table 12, the cumulative ratio of earning assets to funding sources for the one year time period was 1.02 at December 31, 1993, compared to 0.90 at December 31, 1992. Securities available for sale are included in Table 12 based on scheduled maturity dates. However, these securities, as described, may be sold as management determines in accordance with the Company's asset/liability management program. TABLE 12: INTEREST RATE SENSITIVITY ANALYSIS - ------------------------- * Includes securities available for sale based on scheduled maturity dates. EARNING ASSETS Average earning assets in 1993 were $4.9 billion, a 24.8% increase over 1992. Average loans in 1993 were $1.8 billion, up 33.6% from 1992, and accounted for 36.5% of average earning assets compared to 34.1% for the prior year. Average securities of $2.7 billion, 29.4% higher than 1992, represented 55.8% of average earning assets in 1993. At year-end 1993, loans net of unearned interest were $2.2 billion, compared to $1.5 billion one year earlier, an increase of 45.6%. The Kansas banks contributed $508.6 million in loans, distributed as follows: commercial -- $139.5 million; agricultural -- $43.7 million; consumer -- $105.6 million; bankcard -- $19.9 A-41 million; residential real estate -- $80.4 million; and commercial real estate -- $119.5 million. The remainder of the increase in the Company's loans was largely attributable to growth in the volume of commercial and commercial real estate loans, as credit demands rose with the strengthening of the economy and from continued emphasis on business development efforts. The increase was broad-based and not concentrated by either industry or borrower. TABLE 13: ANALYSIS OF LOANS BY TYPE Commercial real estate loans constituted about 12.9% of the loan portfolio and were $280.1 million at December 31, 1993, compared to $140.3 million at December 31, 1992. The commercial real estate loan portfolio includes loans secured by: farmland of $33.3 million; multifamily residential properties of $15.7 million; construction loans of $19.8 million; and commercial properties of $211.3 million. The percentage distribution by area of the loans secured by commercial properties is as follows: 42% in the Kansas City area; 22% in outstate Kansas; 19% in St. Louis; 10% in outstate Missouri; 5% in Colorado; and 2% in Illinois. The Company's commercial real estate loans generally do not exceed a maximum loan-to-value ratio of 80% and the properties are essentially owner-occupied. Borrower experience and financial capacity are critical factors in underwriting and approving loan requests. Loan officers remain in close contact with the borrowers, monitoring the credits and tracking market conditions. Consumer-related loans at year-end 1993 were $777.5 million, an increase of $239.5 million or 44.5% from one year earlier. The increase without the Kansas banks was $33.6 million or 6.2%. In addition to the A-42 Kansas banks, $15.2 million was added in bankcard loans due to increased business development efforts. Approximately $22.7 million was added in other installment loans due to increased demand and additional indirect loans from automobile dealers and home improvement dealers. Federal funds transactions essentially are overnight loans between financial institutions. During the last five years, the Company's banks have been net sellers of federal funds. The average net sold position for 1993 was $36.3 million, compared to $153.9 million for 1992. The Investment Banking Division of the Company's principal affiliate bank buys and sells federal funds as agent for nonaffiliated banks. Due to the agency arrangement, these transactions do not appear on the balance sheet and averaged $776.8 million in 1993 and $764.2 million in 1992. The Investment Banking Division also maintains an active securities trading inventory. The average holdings in the securities trading inventory in 1993 were $58.1 million, compared to $70.5 million in 1992, and were recorded at market value. FUNDING SOURCES Average interest-bearing liabilities in 1993 were $3.9 billion, an increase of 21.1% over 1992. Interest-bearing deposits accounted for 83.8% of average interest-bearing liabilities in 1993. Repurchase agreements and noninterest-bearing demand deposits are the other principal funding sources. Total deposits averaged $4.6 billion in 1993, up $963.9 million or 26.8% from 1992. Average deposits for the Kansas banks were approximately $658.2 million and were distributed as follows: noninterest-bearing demand -- $115.9 million; interest bearing demand and savings -- $290.1 million; time deposits under $100,000 -- $185.2 million; and time deposits of $100,000 or more -- $67.0 million. TABLE 14: ANALYSIS OF AVERAGE DEPOSITS Interest-bearing demand and savings deposits represent the largest component of the Company's total deposits and increased $533.0 million, or 34.2%, to $2.1 billion in 1993 over 1992. During 1993, customers remained wary of tying up their funds in long-term products at relatively low yields. Consequently, interest-bearing demand and savings deposits grew while the time deposits under $100,000 category, without the Kansas bank deposits, decreased from 1992. Average noninterest-bearing demand deposits comprised approximately 27.9% of the deposit base in 1993, up from 26.1% in 1992. This increase reflects increased balances from both correspondent banks and corporate accounts, including some compensating balances derived from mutual fund customers. A-43 Average time deposits of $100,000 or more in 1993 were $236.2 million, or 5.2% of average deposits, compared to $193.3 million and 5.4% in 1992. This category, exclusive of the Kansas bank deposits, decreased from the prior year as a result of the Company promoting repurchase agreements in lieu of large time deposits. TABLE 15: SHORT-TERM DEBT Repurchase agreements amounted to $598.9 million at December 31, 1993, compared to $529.8 million one year earlier. Repurchase agreements are transactions involving investment funds that are exchanged for securities with a commitment by the seller of the securities to repurchase the same or similar issues at an agreed-upon price and date. The Investment Banking Division buys and sells repurchase agreements as principal for nonaffiliated banks. These agreements are reflected on the balance sheet as both an asset (resell agreement) and a corresponding liability (repurchase agreement), since such funds are purchased and then sold to approved dealer banks and primary dealers. The amount of repurchase agreements handled in this manner was $263.2 million at December 31, 1993, compared to $222.7 million one year earlier. At year-end 1993, the Company had repurchase agreements of $335.7 million for its own funding needs, compared to $307.1 million at December 31, 1992. The Company's other short-term borrowings consist primarily of U.S. Treasury demand notes. These demand notes represent treasury tax deposits remitted to the Federal Reserve Bank other than daily. The rate paid on these funds is 0.25% below the weekly average federal funds rate. The Company's long-term borrowings consist of four senior note issues and some installment notes. The Company's ratio of long-term debt to total capital, a measure of debt capacity, was 8.8% at December 31, 1993, which compares very favorably with its peer group. The Company borrowed $25.0 million in 1993 under a medium-term note program to fund the cash portions of the Kansas bank acquisitions. Of the total, $10.0 million of notes were issued with a seven-year maturity at 6.81% and $15.0 million of notes were issued with a 10-year maturity at 7.30%. A-44 TABLE 16: MATURITIES OF TIME DEPOSITS OF $100,000 OR MORE COMPARISON OF 1992 VERSUS 1991 Net income for 1992 was $39.4 million, relatively unchanged from 1991. Measured on a tax-equivalent basis, net interest income in 1992 was $136.5 million, an increase of 0.4% from 1991. During 1992, as short-term market rates went down, the rates on interest-bearing funds fell 190 basis points. However, the yields on earning assets fell 201 basis points due to the lack of quality loan demand and the reinvestment of funds from maturing securities into similar securities at yields lower than the preceding year. Consequently, the net interest spread narrowed to 2.81% in 1992 from 2.92% in 1991. Lower market interest rates also meant that interest-free funds were invested at lower yields during 1992. These factors resulted in a decrease in the net interest margin from 3.82% in 1991 to 3.48% in 1992. The provision for loan losses was $3.0 million in 1992, compared to $6.0 million in 1991. With average loan volume level in 1992, management was able to record a provision less than the amount of actual net charge-offs and still maintain the allowance at an adequate level. Noninterest income, exclusive of net security gains, increased to $108.2 million in 1992 from $98.6 million in 1991, an increase of 9.7%. Trust fees increased 10.3% to $27.3 million. Trust assets under management increased to $7.5 billion at December 31, 1992, from $6.8 billion one year earlier. Securities processing income was $13.7 million in 1992 and $10.5 million in 1991. The Company's custodial assets increased to $150.6 billion at December 31, 1992, from $119.6 billion at December 31, 1991, due to both new customers and increases in the funds of existing customers. Trading and investment banking income increased 2.8% to $12.5 million in 1992, from increased business development efforts in new markets, partially offset by a decrease in trading volumes resulting from lower interest rates. Service charges on deposit accounts increased 13.0% to $24.1 million in 1992 from $21.3 million in 1991. This increase reflected higher transaction volumes and higher occurrences of fees paid in lieu of compensating balances. Cash management and other service charges and fees increased to $9.7 million in 1992 from $7.1 million in 1991, due to increased sales of cash management services to mutual fund and corporate customers. In October 1992, the Company began providing check processing and related cash management services for the Fidelity mutual funds. Bankcard fees for 1992 were $18.3 million, compared to $19.4 million for 1991. The decrease was due to reducing annual fees for consumers and a reduction in discounts charged to merchants to meet competition. Other noninterest income decreased in 1992 due to gains realized in 1991 on the sales of assets previously held under lease financing transactions with customers. Realized net investment security gains were $5.3 million in 1992, compared to $116,000 in 1991. Of the 1992 gains, $4.2 million were attributable to the repositioning of the Company's securities portfolio. Noninterest expense rose to $184.9 million in 1992, 11.6% higher than 1991. Salaries and employee benefits expense increased $7.1 million, or 8.8%, to $87.9 million. The increase was attributable to Colorado banking offices opened since May 1991, a higher staffing level from increased business at other existing locations as well as merit increases. A-45 Net occupancy expense in 1992 of $12.2 million was 11.6% higher than 1991 because of locations added by acquisitions or new branches constructed since May 1991 and renovations of the operations facility in Kansas City. Equipment expense increased 11.0% in 1992 to $15.8 million due to investments in a new computer mainframe and other data processing equipment, a new check imaging system, and additional furniture and equipment expense from the new banking locations. Supplies and services expense increased 7.0% to $14.5 million, reflecting more customer mailings and form revisions in conjunction with the bank mergers and acquisitions. Bankcard processing expense increased slightly to $16.0 million in 1992 from $15.8 million in 1991 because of a higher volume of merchant transactions and costs associated with marketing a new variable rate credit card. Marketing and business development expense was $10.6 million in 1992, compared to $8.4 million in 1991. There were advertising expenses in 1992 associated with the new Colorado locations and a Company reidentification program. Additionally, marketing programs had been curtailed in 1991, resulting in lower expense. FDIC insurance and regulatory fees increased 18.4% to $8.6 million in 1992 from $7.2 million in 1991. The FDIC rate for 1992 was 0.23% of domestic deposits, having been increased from 0.195% effective July 1, 1991. Other noninterest expense in 1992 was $17.3 million, compared to $12.9 million in 1991, an increase of $4.4 million, or 34.1%. Approximately $1.7 million of the increase relates to outside data processing fees paid by the Company to service its mutual fund customers. Other factors contributing to this increase included higher Federal Reserve Bank check processing charges, expenses associated with foreclosed real estate and an increase in legal and consulting fees. A-46 TABLE 17: SUMMARY OF OPERATING RESULTS BY QUARTER (UNAUDITED) - ------------------------- * Net investment security gains of $4,220,000 were recorded for the three months ended December 31, 1992. A-47 UNITED MISSOURI BANCSHARES, INC. FINANCIAL STATISTICS FIVE-YEAR AVERAGE BALANCE SHEETS/YIELDS AND RATES - ------------------------- (1) Interest income and yields are stated on a fully tax-equivalent (FTE) basis, using a rate of 34% for 1989 through 1992 and 35% for 1993. The tax-equivalent interest income and yields give effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax-free assets. Rates earned/paid may not compute to the rates shown due to presentation in millions. (2) Loan fees and income from loans on nonaccrual status are included in loan income. A-48 A-49 UNITED MISSOURI BANCSHARES, INC. FINANCIAL STATISTICS SELECTED FINANCIAL DATA OF AFFILIATE BANKS A-50

840216_1993.txt

840216

1993

ITEM 1. BUSINESS Koll Real Estate Group, Inc., a Delaware corporation, formerly known as The Bolsa Chica Company (from July 16, 1992 to September 30, 1993) and as Henley Properties Inc. (from December 1989 to July 16, 1992), is a real estate development company with properties principally in Southern California, as well as New Hampshire. The principal activity of Koll Real Estate Group, Inc. and its consolidated subsidiaries (the "Company") has been to obtain zoning and other entitlements for land it owns and to improve the land principally for residential development. Once the land is entitled, the Company may sell unimproved land to other developers or investors; sell improved land to home builders; or participate in joint ventures with other developers, investors or home builders to finance and construct infrastructure and homes. With the acquisition of the domestic real estate development business of The Koll Company on September 30, 1993, the Company's principal activities have been expanded to include providing commercial, industrial, retail and residential real estate development services to third parties, including feasibility studies, entitlement coordination, project planning, construction management, financing, marketing, acquisition, disposition and asset management services on a national basis, through its current offices throughout California, and in Seattle, Dallas and Denver. The Company intends to consider additional real estate acquisition opportunities; however, over the next two years the Company's principal objective is to maintain adequate liquidity to fully support the Bolsa Chica project entitlement efforts. The Company's executive offices are located at 4343 Von Karman Avenue, Newport Beach, California 92660 (telephone: (714) 833-3030). PRINCIPAL PROPERTIES The following sections describe the Company's principal properties. BOLSA CHICA. The Bolsa Chica property is the principal property in the Company's portfolio. The Company owns approximately 1,200 acres of the 1,700 acres of undeveloped Bolsa Chica land located on the Pacific Ocean in northwestern Orange County, California. Bolsa Chica is bordered on the north and east by residential development, to the south by open space and residential development, and to the west by the Pacific Coast Highway and the Bolsa Chica State Beach. Bolsa Chica is one of the last large undeveloped coastal properties in Southern California, approximately 35 miles south of downtown Los Angeles. In 1986, the California State Coastal Commission certified a local coastal program/land use plan for the Bolsa Chica property, which was subject to the satisfaction of certain conditions, including presentation of favorable economic, environmental and physical feasibility studies. The proposed development of the Bolsa Chica property as a marina/residential development provoked substantial controversy and highlighted public awareness of an earlier lawsuit related to the potential impact of development on the environmentally sensitive wetland areas, among other issues. In order to achieve a public consensus on the plans for Bolsa Chica's development and to expedite development of the property, in November 1988 the Company helped organize the Bolsa Chica Planning Coalition (the "Coalition"), consisting of representatives of the Company, city, county and state officials, and the Amigos de Bolsa Chica, a local environmental organization which had previously opposed the project and was a party to the earlier lawsuit. The objective of the Coalition was to consider alternative land use plans for Bolsa Chica. In 1989, the Coalition reached an agreement in principle on a concept plan permitting the development of an oceanfront residential community featuring protected wetlands (the "Coalition Plan"). The parties to the litigation also dismissed the litigation which had halted development of Bolsa Chica. In November 1991, in accordance with the Coalition Plan, the Company announced its plan to develop a master planned community of approximately 4,900 homes at Bolsa Chica, including approximately 4,300 units on the Company's land. The planned community at Bolsa Chica is expected to offer a broad mix of home choices, including single-family homes, townhomes and condominiums at a wide range of prices. In September 1992, environmental impact documents for the Bolsa Chica project's master planned community were released by the City of Huntington Beach, California, and the U.S. Army Corps of Engineers for a ninety-day public comment period which concluded in December 1992. In March 1993, the Company transferred local processing of the Coalition Plan to the County of Orange in order to integrate the Bolsa Chica regional park and wetlands restoration with the rest of the land use planning. Given the extent of comments received from the public, including a variety of state and federal agencies, the County of Orange recirculated a revised draft of the environmental impact report in December 1993, for public omment which concluded on February 18, 1994. The revised draft contains an in-depth analysis of an alternative plan which includes 3,500 homes, in addition to the in-depth analysis of the Coalition Plan. Despite efforts to date in the Bolsa Chica entitlement process, the Company has not yet obtained any of the final approvals from local, state or federal governmental entities that are required for development of the project. Due to a number of factors beyond the Company's control, including possible objections to the Coalition Plan by various environmental and so-called public interest groups that may be made in legislative, administrative or judicial forums, such approvals could be delayed substantially. Subject to these and other uncertainties inherent in the entitlement process, the Company's goal is to obtain all material governmental approvals in the first half of 1995 and to begin infrastructure construction in the second half of 1995, depending on economic and market conditions. Realization of the Company's investment in Bolsa Chica will also depend upon various economic factors, including the demand for residential housing in the Southern California market and the availability of credit to the Company and to the housing industry. EAGLE CREST. In the City of Escondido in San Diego County, approximately 30 miles north of downtown San Diego, the Company is developing an 860-acre, gated community consisting of 580 residential lots surrounding an 18-hole championship golf course. The golf course opened during May 1993. Construction of the remaining infrastructure and the permanent clubhouse has been deferred until the residential market for trade-up homes improves and financing for such infrastructure construction becomes available. FAIRBANKS HIGHLANDS. This property consists of approximately 390 acres near the communities of Fairbanks Ranch and Rancho Santa Fe in the northern part of the City of San Diego. The property is located within an area designated by the City of San Diego as the "Future Urbanizing Area." The City of San Diego recently approved a "Framework Plan" which generally defines land use, locations and densities for the Future Urbanizing Area, subject to voter approval. The Framework Plan could allow development of significantly greater density (up to 800 residential units) on the Company's Fairbanks Highlands property if ultimately approved by the voters in June 1994, along with approximately 12,000 acres to be developed by neighboring landowners. WENTWORTH BY THE SEA. This project is currently being managed, at the direction of the Company, by a local real estate management and development company, with the objective of developing 130 new residential and vacation homes in New Hampshire, approximately 60 miles north of Boston. The project currently includes an 18-hole golf course, a 170-slip marina, 21 single-family detached condominium homes built by the previous owner and related commercial development. The Company began marketing the 21 existing homes in September 1993, and since then four homes have been sold and nine additional homes are in escrow. The Company is continuing to hold discussions with a community group interested in purchasing and restoring the original Wentworth Hotel, which closed in 1981. OTHER PROPERTIES. The Company owns various other commercial and industrial properties in Southern California, including land zoned for commercial/industrial use in Coronado, Rancho Murrieta and Signal Hill, California. All of these properties are currently held for sale, subject to market conditions. PROPERTY DISPOSITIONS. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a description of the Company's property dispositions during 1992 and 1993. ENVIRONMENTAL AND REGULATORY MATTERS Before the Company can develop a property, it must obtain a variety of discretionary approvals from local and state governments, as well as the federal government in certain circumstances, with respect to such matters as zoning, subdivision, grading, architecture and environmental matters. The entitlement approval process is often a lengthy and complex procedure requiring, among other things, the submission of development plans and reports and presentations at public hearings. Because of the provisional nature of these approvals and the concerns of various environmental and public interest groups, the approval process can be delayed by withdrawals or modifications of preliminary approvals and by litigation and appeals challenging development rights. Accordingly, the ability of the Company to develop properties and realize income from such projects could be delayed or prevented due to difficulties in obtaining necessary governmental approvals. As more fully described above, the Company is in the process of seeking the necessary local, state and federal approvals and permits to begin development of its Bolsa Chica property. The Company reached an agreement in 1989 on the Coalition Plan, and the Company's goal is to obtain the necessary approvals in the first half of 1995. Nevertheless, the approval process for the Bolsa Chica property remains subject to the uncertainties described above, and there is no assurance that such approvals will ultimately be obtained or will not be substantially delayed. Failure to obtain such approvals would have, and a substantial delay in obtaining such approvals could have, a material adverse effect on the Company. The Company has expended and will continue to expend significant financial and managerial resources to comply with environmental regulations and local permitting requirements. Although the Company believes that its operations are in general compliance with applicable environmental regulations, certain risks of unknown costs and liabilities are inherent in developing and owning real estate. However, the Company does not believe that such costs will have a material adverse effect on its business or financial condition, including current environmental litigation discussed in Part I, Item 3 -- "Legal Proceedings" and the potential remediation expenditures required in connection with certain indemnity obligations discussed below in "Corporate Indemnification Matters." CORPORATE INDEMNIFICATION MATTERS The Company and its predecessors have, through a variety of transactions effected since 1986, disposed of several assets and businesses, many of which are unrelated to the Company's current operations. By operation of law or contractual indemnity provisions, the Company has retained liabilities relating to certain of these assets and businesses, including certain tax liabilities. See Note 9 "Income Taxes -- Tax Sharing Agreements" in Notes to Financial Statements on pages to of this Annual Report. Many of such liabilities are supported by insurance or by indemnities from certain of the Company's predecessor and currently or previously affiliated companies. The Company believes its balance sheet reflects adequate reserves for these matters. Abex Inc. ("Abex") and the Company have agreed that, following the Company's 1992 merger with The Henley Group, Inc., each company will be responsible for environmental liabilities relating to its existing, past and future assets and businesses and will indemnify the other in respect thereof. The United States Environmental Protection Agency ("EPA") has designated Universal Oil Products ("UOP"), among others, as a Potentially Responsible Party ("PRP") with respect to an area of the Upper Peninsula of Michigan (the "Torch Lake Site") under the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"). UOP is allegedly the successor in interest to one of the companies that conducted mining operations in the Torch Lake area and an affiliate of Allied-Signal Inc., a predecessor of the Company. The Company has not been named as a PRP at the site. However, Allied-Signal has, through UOP, asserted a contractual indemnification claim against the Company for claims that may be asserted against UOP by EPA or other parties with respect to the site. EPA has proposed a cleanup plan which would involve covering certain real property both contiguous and non-contiguous to Torch Lake with soil and vegetation in order to address alleged risks posed by copper tailings and slag at an estimated cost of approximately $7.2 million. EPA estimates that it has spent in excess of $2 million to date in performing studies of the site. Under CERCLA, EPA could assert claims against the Torch Lake PRPs, including UOP, to recover the cost of these studies, the cost of all remedial action required at the site, and natural resources damages. An earlier settlement in principle with EPA staff pursuant to which UOP would pay $1.7 million in exchange for a release similar to those normally granted by EPA in such circumstances was rejected by certain other governmental authorities in July 1993. Settlement negotiations between the Company, on behalf of UOP, and EPA resumed shortly thereafter and are ongoing. EMPLOYEES As of March 1, 1994, the Company and its subsidiaries had approximately 92 employees. EXECUTIVE OFFICERS OF THE COMPANY Certain of the executive officers of the Company are also executive officers of The Koll Company ("Koll") and its affiliates. Accordingly, they will devote less than all of their working time to the businesses of the Company. Set forth below is information with respect to each executive officer. ITEM 2.

ITEM 2. PROPERTIES The Company's principal executive offices are located in Newport Beach, California. The Company and each of its subsidiaries believe that their properties are generally well maintained, in good condition and adequate for their present and proposed uses. The inability to renew any short-term real property lease would not be expected to have a material adverse effect on the Company's results of operations. The principal properties of the Company and its subsidiaries, which are owned in fee unless otherwise indicated, are as follows: ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The owners of undeveloped real property located in San Diego County sued Signal Landmark, a subsidiary of the Company ("Signal"), in San Diego Superior Court, in May 1990, alleging that Signal had deposited contaminated soils on their property and was liable under theories of nuisance, negligence, trespass and strict liability. The plaintiffs sought general damages in the amount of approximately $40 million and, additionally, punitive damages in an unspecified amount, plus prejudgment interest and costs. On August 5, 1991, the plaintiffs filed a complaint in federal court against Signal, the Company and several other parties asserting claims under CERCLA seeking essentially the same relief sought in the state action. In April 1992, a jury awarded the plaintiffs damages in the amount of $2.5 million following a trial in the state action. Signal appealed the verdict in the state action and posted a bond and cash collateral of $3.75 million in August 1992. On March 5, 1993, Signal reached an agreement in principle with the plaintiffs in such litigation to settle both the federal and state actions. On July 2, 1993, the Federal Court for The Southern District of California approved the settlement under the terms of which funds from such cash collateral account were disbursed approximately as follows: 1) $1.3 million deposited in trust for remediation expenditures, 2) $1.3 million disbursed to the plaintiffs, and 3) $1.1 million returned to Signal. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The following tables set forth information with respect to bid quotations for the Class A Common Stock of the Company for the periods indicated as reported by NASDAQ. These quotations are interdealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. The number of holders of record of the Company's Class A Common Stock as of March 1, 1994 was approximately 28,000. The Company has not paid any cash dividends on its Class A Common Stock to date, nor does the Company currently intend to pay regular cash dividends on the Class A Common Stock. Such dividend policy is and will continue to be subject to prohibitions on the declaration or payment of dividends contained in debt agreements of the Company. See Note 7 -- Notes to Financial Statements on pages to of this Annual Report, which Note is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data with respect to the Company and its subsidiaries are set forth on pages to of this Annual Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations is set forth on pages to of this Annual Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial statements, schedules and supplementary data of the Company and its subsidiaries, listed under Item 14, are submitted as a separate section of this Annual Report, commencing on page. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS. The information appearing under the caption "Election of Directors" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders is incorporated herein by reference in this Annual Report. EXECUTIVE OFFICERS. Information with respect to executive officers appears under the caption "Executive Officers of the Company" in Item 1 of this Annual Report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information in answer to this Item appears under the caption "Compensation of Directors and Executive Officers" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, and is incorporated herein by reference in this Annual Report. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in answer to this Item appears under the captions "Voting Securities and Principal Holders Thereof" and "Election of Directors" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, and is incorporated herein by reference in this Annual Report. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in answer to this Item appears under the captions "Certain Transactions" and "Compensation of Directors and Executive Officers" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, and is incorporated herein by reference in this Annual Report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Financial Statements: The following financial statements and supplementary data of the Company are included in a separate section of this Annual Report on Form 10-K commencing on the page numbers specified below: (2) Financial Statement Schedules: All schedules have been omitted since they are not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Listing of Exhibits: - ------------------------ * Filed herewith. (b) Reports on Form 8-K: Report on Form 8-K dated December 17, 1993, reporting under Item 5 Other Events, regarding (i) the disposition of Lake Superior Land Company to Libra Invest & Trade Ltd. ("Libra"), and; (ii) the issuance of common stock to Libra in exchange for Libra's subordinated debentures of the Company. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 30, 1994 KOLL REAL ESTATE GROUP, INC. By: /s/ RAYMOND J. PACINI ------------------------------------ Raymond J. Pacini Executive Vice President -- Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. KOLL REAL ESTATE GROUP, INC. SELECTED FINANCIAL DATA The following selected financial data of Koll Real Estate Group, Inc. and its consolidated subsidiaries (the "Company") should be read in conjunction with the financial statements included elsewhere herein. The financial statements for the year ended December 31, 1989 do not necessarily reflect the results of operations of the Company had it been a separate, stand-alone company. For further discussion of the formation of the Company and the basis of presentation see the Notes to Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The principal activity of the Company has been to obtain zoning and other entitlements for land it owns and to improve the land for residential development. Once the land is entitled, the Company may sell unimproved land to other developers or investors; sell improved land to home builders; or participate in joint ventures with other developers, investors or home builders to finance and construct infrastructure and homes. With the acquisition of the domestic real estate development business of The Koll Company on September 30, 1993, the Company's principal activities have been expanded to include providing commercial, industrial, retail and residential development services to third parties, including feasibility studies, entitlement coordination, project planning, construction management, financing, marketing, acquisition, disposition and asset management services on a national basis, through its current offices throughout California, and in Seattle, Dallas and Denver. The Company intends to consider additional real estate acquisition opportunities; however, over the next two years the Company's principal objective is to maintain adequate liquidity to fully support the Bolsa Chica project entitlement efforts. Real estate held for development or sale and land held for development (real estate properties) are carried at the lower of cost or estimated net realizable value (Note 2). The Company's real estate properties are subject to a number of uncertainties which can affect the future values of those assets. These uncertainties include delays in obtaining zoning and regulatory approvals, withdrawals or appeals of regulatory approvals and availability of adequate capital, financing and cash flow. In addition, future values may be adversely affected by heightened environmental scrutiny, limitations on the availability of water in Southern California, increases in property taxes, increases in the costs of labor and materials and other development risks, changes in general economic conditions, including higher mortgage interest rates, and other real estate risks such as the demand for housing generally and the supply of competitive products. Real estate properties do not constitute liquid assets and, at any given time, it may be difficult to sell a particular property for an appropriate price. The state of the nation's economy, and California's economy in particular, has had a negative impact on the real estate market generally, on the availability of potential purchasers for such properties and upon the availability of sources of financing for carrying and developing such properties. LIQUIDITY AND CAPITAL RESOURCES The principal assets remaining in the Company's portfolio are residential land which must be held over an extended period of time in order to be developed to a condition that, in management's opinion, will ultimately maximize the return to the Company. Consequently, the Company requires significant capital to finance its real estate development operations. Sales of the Company's non-strategic assets, such as its 44% interest in Deltec Panamerica S.A. ("Deltec"), the LaJolla, California office buildings and Lake Superior Land Company (Note 4) have been pursued as a source of capital. During 1993, the Company generated an aggregate of approximately $97 million through the Lake Superior Land Company financing, the disposition of the Company's investment in Deltec and the sale of its LaJolla office buildings, and utilized $58.4 million of such proceeds to reduce outstanding senior bank debt. At December 31, 1993 the Company's cash, cash equivalents and short-term investments aggregated $43.5 million. Historically, sources of capital have included bank lines of credit, specific property financings, asset sales and available internal funds. Although the Company reported income in 1993 as a result of gains on dispositions and extinguishment of debt, it reported losses in 1991 and 1992, and expects to report losses in the foreseeable future. While a significant portion of such losses is attributable to noncash interest expense on the Company's subordinated debentures, the Company's capital expenditures for project development are significant. In addition, the Company was notified in March 1994 that a Stipulation of Settlement has been entered into between a predecessor company and the Internal Revenue Service regarding the settlement of an alleged tax deficiency that is the subject of certain tax sharing agreements (Note 9). The Company has been informed by the other parties to these tax sharing agreements that it is being charged with a net obligation of approximately $21 million under this settlement, which the Company accrued for in December 1989. The Company is currently evaluating the scope of this claimed obligation under the settlement and potential sources of financing for such amount that the Company may ultimately be obligated to pay. However, there can be no assurance that any financing will be available, or that if available, it can be obtained on terms that are favorable to the Company and its stockholders. Given the limited availability of capital for real estate development under current conditions in the financial markets, the Company will be dependent primarily on cash and short-term investments on hand to fund project investments, and general and administrative costs during 1994 and 1995. However, if the Company is required to pay all or a significant portion of the $21 million claimed under the tax sharing agreements as discussed above, and any such amount is not financed, the Company will need to obtain other sources of financing or sell additional assets in order to meet projected cash requirements for the first quarter of 1995. In January 1993, Lake Superior Land Company, which was a wholly owned subsidiary of the Company at that time, sold $45 million of secured notes due May 1, 2012 to certain pension funds of the State of Michigan. The obligations under the note agreement are secured by all of the assets of Lake Superior Land Company, which principally consist of approximately 300,000 acres of timberlands and shorefront property on Lake Superior in Michigan and Wisconsin. Lake Superior Land Company dividended the proceeds to the Company, which used $21 million of the financing proceeds to make a principal prepayment in accordance with a term loan agreement with Bank of America. At December 31, 1993, the Company's only outstanding senior bank debt is due to the Bank of Boston in the principal amount of $7.0 million, under a term note due on July 31, 1995. The term note agreement with Bank of Boston requires additional principal prepayments to be made from the net proceeds from the sales of Wentworth and other assets. The term note agreement also requires additional principal repayments of $.2 million in the second half of 1994 and $.4 million in the first half of 1995, with any remaining balance due at maturity on July 31, 1995. Amounts outstanding under the term note bear interest at prime plus 1%. The term note agreement with Bank of Boston is secured by a first mortgage on the Wentworth property, stock pledge agreements of substantially all significant subsidiaries of the Company and first mortgages on certain other properties. The term note agreement contains certain restrictive covenants that prohibit the declaration or payment of dividends and limit, among other things, (i) the incurrence of indebtedness, (ii) the making of investments, loans and advances, (iii) the creation or incurrence of liens on existing and future assets of Wentworth or its subsidiaries, (iv) stock repurchases, and (v) project development spending in excess of certain planned levels. The term note agreement also contains various financial covenants and events of default customary for such agreements. FINANCIAL CONDITION DECEMBER 31, 1993 COMPARED WITH DECEMBER 31, 1992 Cash, cash equivalents and short-term investments aggregated $43.5 million at December 31, 1993 compared with $41.6 million at December 31, 1992. The change in cash and cash equivalents reflects the activity presented in the Statements of Cash Flows and described below. The $15.9 million decrease in real estate held for development or sale is primarily due to the November 1993 sale of the Company's office properties in LaJolla, California, as well as the placement into service in May 1993 of the Eagle Crest golf course and its related reclassification to operating properties. The $25.0 million decrease in other assets primarily reflects the sale of the Company's investment in Deltec, partially offset by the acquisition of the domestic real estate development business of The Koll Company (Note 4). The $9.5 million increase in accounts payable and accrued liabilities primarily reflects reclassification of approximately $21 million in taxes payable from other liabilities in 1993 (Notes 8 and 9), partially offset by the 1993 payments of $7.6 million in income taxes (Note 9) and $3.2 million to settle shareholder litigation related to the July 1992 merger with The Henley Group, Inc. (the "Merger") (Note 1). The $58.4 million decrease in senior bank debt reflects principal prepayments to Bank of America and Bank of Boston in connection with Lake Superior Land Company's financing, the disposition of the Company's investment in Deltec (Note 4) and the sale of the Company's office properties in LaJolla, California. The $30.2 million decrease in subordinated debentures reflects the exchange of approximately $42.4 million in aggregate face amount of senior subordinated debentures held by Libra Invest & Trade Ltd. ("Libra") for the Company's Lake Superior Land Company subsidiary, and the exchange of approximately $10.6 million in aggregate face amount of subordinated debentures held by Libra for approximately 3.4 million shares of the Company's Class A Common stock (Notes 4 and 7), offset by payments of interest through the issuance of additional pay-in-kind debentures on March 15 and September 15, 1993 and the accrual of interest since September 15, 1993. The $25.4 million increase in other liabilities is principally due to the adoption of FAS 109 (Note 9), as well as the tax effect of the extraordinary gain on extinguishment of debt, partially offset by the reclassification of approximately $21 million in taxes payable to accounts payable and accrued liabilities. DECEMBER 31, 1992 COMPARED WITH DECEMBER 31, 1991 Cash aggregated $41.6 million at December 31, 1992 compared with $7.8 million at December 31, 1991. The increase in cash principally reflects the Merger, along with the activity presented in the Statement of Cash Flows and described below. The Company received $58.3 million of cash in connection with the Merger, $15 million of which was used to repay senior bank debt on July 16, 1992 (Note 7). The $7.7 million decrease in real estate held for development or sale primarily reflects the sale of the Company's Ontario, California property for net cash proceeds of approximately $6.1 million and a $1.7 million note. The $35.2 million increase in other assets primarily reflects the Company's investment in Deltec as a result of the Merger (Note 1). On February 4, 1993, the Long Beach Airport Marriott Hotel (the "Hotel") was transferred to California Federal Bank ("CalFed") in a foreclosure sale. The foreclosure process was initiated as a result of the Hotel's inability to make its July 1992 interim interest payment deposits under a letter of credit reimbursement agreement with CalFed, which secured $25 million in principal amount of Industrial Revenue Bonds (the "Bonds") issued by the City of Long Beach on September 1, 1985 for construction of the Hotel. The Bonds and letter of credit were nonrecourse to an indirect subsidiary of the Company that previously owned the Hotel, and neither the Company nor any of its other subsidiaries was a party to, or a guarantor with respect to, these obligations. On September 15, 1992, the Company stipulated to the appointment of a receiver to control and manage the assets of the Hotel, and the receiver took control of the Hotel on September 16, 1992. Accordingly, the December 31, 1992 balance sheet reflects the elimination of $24.9 million in nonrecourse project debt of the Hotel, $.9 million of related Hotel liabilities, and a corresponding reduction in assets of $24.3 million, with the difference of $1.5 million reflected in other income in the 1992 statement of operations. The $30.7 million decrease in operating properties in 1992 principally reflects the elimination from the Company's balance sheet of the Hotel's assets as discussed above, along with the sale of the Company's Long Beach, California office building for approximately $6 million. The $8.4 million increase in accounts payable and accrued liabilities primarily reflects the classification of $7.6 million of obligations paid in January 1993 under the tax sharing agreement with a predecessor company, Wheelabrator Technologies Inc. ("WTI") (Note 9), as current at December 31, 1992. The $41.0 million increase in other liabilities primarily reflects liabilities received in connection with the Merger (Note 1), partially offset by the reclassification of certain tax liabilities as discussed above. The $17.0 million decrease in senior bank debt primarily reflects a $15.0 million principal prepayment in connection with the Merger (Note 7). The $19.6 million decrease in subordinated debentures reflects the $42.5 million book value reduction in connection with the Merger (Notes 1 and 7), partially offset by a $22.9 million increase related to pay-in-kind interest. The changes in stockholders' equity primarily reflect the issuance by the Company of preferred and common stock in connection with the Merger (Notes 2 and 13), partially offset by the net loss for the year. RESULTS OF OPERATIONS The nature of the Company's business is such that individual transactions often cause significant fluctuations in operating results from year to year. 1993 COMPARED WITH 1992 The $11.6 million decrease in revenues from $28.3 million in 1992 to $16.7 million in 1993 and the decrease in cost of sales from $26.5 million in 1992 to $16.3 million in 1993 were both principally related to the Company's 1992 sale of California properties in Ontario, Long Beach and Coronado, along with the February 1993 foreclosure sale of the Hotel, offset by the Company's sale in November 1993 of two office buildings located in LaJolla, California and revenues from golf operations and the domestic real estate development business acquired from The Koll Company (Note 4). The pro forma impact of this acquisition assuming it had occurred on January 1, 1993, would have been to increase the Company's revenues and income from continuing operations before income taxes and amortization of goodwill by $10.0 million and $2.4 million, respectively. The $1.8 million decrease in general and administrative expenses for 1993 as compared with 1992 was primarily attributed to reduced personnel and occupancy costs. The decrease in interest expense from $31.2 million in 1992 to $24.4 million in 1993 primarily reflects the reduction in outstanding subordinated debentures and senior bank debt in connection with the July 1992 Merger and the 1993 prepayments of senior bank debt (Note 7). The improvement in other expense (income), net from $2.9 million of expense for 1992 to $2.4 million of income for 1993 primarily reflects $3.0 million received in 1993 in connection with the termination of a put option agreement with Abex Inc. ("Abex"), a former subsidiary of The Henley Group, Inc., and a $2.0 million insurance reimbursement received in 1993 related to prior year environmental litigation costs. The Company adopted Financial Accounting Standard No. 109 "Accounting for Income Taxes," in the first quarter of 1993, resulting in an increase in its deferred tax liability of $36.0 million through a charge to income at the time of adoption (Notes 2 and 9). Under this new accounting standard, the Company also recognized $10.4 million of tax benefits on continuing operations for the year ended December 31, 1993. 1992 COMPARED WITH 1991 The decrease in revenues from $34.7 million in 1991 to $28.3 million in 1992 and the decrease in cost of sales from $28.8 million in 1991 to $26.5 million in 1992 were both principally due to the commencement of foreclosure proceedings against the Hotel in September 1992, and lower Hotel operating revenues prior to that date. The decrease in gross operating margin from $5.9 million in 1991 to $1.8 million in 1992 is primarily attributable to lower margins on asset sales and lower Hotel operating margins in 1992 discussed above. The $3.3 million decrease in interest expense from 1991 to 1992 is primarily due to the reduction in outstanding subordinated debentures and senior bank debt in connection with the Merger, as well as lower interest rates on the senior bank debt. The change in other expense (income), net from $65.5 million of expense for 1991 to $2.9 million of expense for 1992 primarily reflects approximately $65 million of charges in 1991 related to asset revaluations. 1991 COMPARED WITH 1990 The decrease in revenues from $97.0 million in 1990 to $34.7 million in 1991, the decrease in cost of sales from $78.9 million in 1990 to $28.8 million in 1991, and the decrease in gross operating margin from $18.1 million in 1990 to $5.9 million in 1991, principally reflect the $42 million sale in 1990 of a 90% interest in approximately 3,500 acres of land on the island of Hawaii, along with the substantial completion of residential sales at Coronado Cays in 1990. The change in other expense (income), net from $97.5 million of income for 1990 to $65.5 million of expense in 1991 primarily reflects the gain on sale of the Company's interest in two trash-to-energy facilities to WTI in 1990 and asset revaluations in 1991. INDEPENDENT AUDITORS' REPORT To The Board of Directors and Stockholders of Koll Real Estate Group, Inc.: We have audited the accompanying balance sheets of Koll Real Estate Group, Inc. (formerly The Bolsa Chica Company) as of December 31, 1993 and 1992 and the related statements of operations, cash flows and changes in stockholders' equity for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of the Company for the year ended December 31, 1991 were audited by other auditors whose report, dated February 3, 1992, expressed an unqualified opinion on those statements and included explanatory paragraphs that described the uncertainties associated with the Company's ability to continue as a going concern and the inherent uncertainty involved in the process of estimating the net realizable value of its real estate properties. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such 1993 and 1992 financial statements present fairly, in all material respects, the financial position of Koll Real Estate Group, Inc. at December 31, 1993 and 1992 and the results of its operations and its cash flows for the years ended December 31, 1993 and 1992 in conformity with generally accepted accounting principles. The Company carries its real estate properties at the lower of cost or estimated net realizable value. As discussed in Note 2, the estimation process is inherently uncertain and relies to a considerable extent on future events and market conditions. As discussed in Note 6, the development of the Company's Bolsa Chica project is dependent upon obtaining various governmental approvals and various economic factors. Accordingly, the amount ultimately realized from such project may differ materially from the current estimate of net realizable value. As discussed in Note 9, the Company changed its method of accounting for income taxes in 1993. Also as discussed in Note 9, the Company was notified in March 1994 that a Stipulation of Settlement has been entered into between a predecessor company and the Internal Revenue Service regarding the settlement of an alleged tax deficiency that is the subject of certain tax sharing agreements. The Company has been informed by the other parties to these tax sharing agreements that it is being charged with a net obligation of approximately $21 million under this settlement, which has been accrued in the Company's financial statements since December 1989. DELOITTE & TOUCHE San Diego, California February 15, 1994 (March 28, 1994 as to the last paragraph of Note 9) INDEPENDENT AUDITORS' REPORT To The Board of Directors and Stockholders of Koll Real Estate Group, Inc.: We have audited the accompanying statements of operations, changes in stockholders' equity and cash flows of Koll Real Estate Group, Inc. (formerly The Bolsa Chica Company and Henley Properties Inc.) for the year ended December 31, 1991. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects the results of operations and cash flows of Koll Real Estate Group, Inc. for the year ended December 31, 1991 in conformity with generally accepted accounting principles. The financial statements referred to above have been prepared assuming that the Company will continue as a going concern. The Company has suffered losses from operations and must obtain significant capital for financing its real estate development activities and scheduled repayments of debt obligations during 1992. The uncertainties associated with the Company's ability to obtain sufficient capital, restructure its debt agreements and return to profitable operations raise substantial doubt about the Company's ability to continue as a going concern. The Company has announced a recapitalization and merger plan to deal with these matters. The financial statements referred to above do not include any adjustments that might result from the outcome of these uncertainties. The Company carries its real estate held for development or sale and land held for development at the lower of cost or estimated net realizable value. As discussed in Note 2, the estimation process is inherently uncertain and relies to a considerable extent on future events and market conditions, the ability to achieve financing for its real estate development activities and the resolution of political, environmental and other related issues. Accordingly, ultimate realization of asset values may differ materially from amounts presently estimated. KENNETH LEVENTHAL & COMPANY Orange County, California February 3, 1992 KOLL REAL ESTATE GROUP, INC. BALANCE SHEETS See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. STATEMENTS OF OPERATIONS See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. STATEMENTS OF CASH FLOWS See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1 -- FORMATION AND BASIS OF PRESENTATION On December 31, 1989, The Henley Group, Inc. separated its business into two public companies through a distribution to its Class A and Class B common stockholders of all of the common stock of a newly formed Delaware corporation to which The Henley Group, Inc. had contributed its non-real estate development operations, assets and related liabilities. The new company was named The Henley Group, Inc. ("Henley Group") immediately following the distribution. The remaining company was renamed Henley Properties Inc. ("Henley Properties") and consisted of the real estate development business and assets of Henley Group. On July 16, 1992, a subsidiary of Henley Properties merged with and into Henley Group (the "Merger") and Henley Group became a wholly owned subsidiary of Henley Properties. Henley Properties, through its Henley Group subsidiary, received in the Merger net assets having a book value as of July 16, 1992 of approximately $45.3 million, consisting of approximately $103.6 million of assets, including $58.3 million of cash and a 44% interest in Deltec Panamerica S.A. ("Deltec"), and $58.3 million of liabilities. In connection with the Merger, Henley Properties was renamed The Bolsa Chica Company. On September 30, 1993, a subsidiary of The Bolsa Chica Company acquired the domestic real estate development business and related assets of The Koll Company (Note 4). In connection with this acquisition, The Bolsa Chica Company was renamed Koll Real Estate Group, Inc. (the "Company"). Immediately prior to the July 1992 Merger, Henley Group distributed to its stockholders among other consideration (the "Distribution"), in respect of each share of its outstanding common stock (the "Henley Group Common Stock"): (i) $6.00 aggregate principal amount of the 12% Senior Subordinated Pay-In-Kind Debentures due March 15, 2002 of the Company (the "Senior Subordinated Debentures"); and (ii) $1.50 aggregate principal amount of the 12% Subordinated Pay-In-Kind Debentures due March 15, 2002 of the Company (the "Subordinated Debentures", and, together with the Senior Subordinated Debentures, the "Debentures"). Approximately $159.4 million aggregate principal amount of the Debentures were distributed in the Distribution and approximately $43.8 million aggregate principal amount of the Debentures were retained by the Company's Henley Group subsidiary in the Merger. In the Merger, Henley Group stockholders also received, in respect of each share of Henley Group Common Stock, the following securities of the Company: (i) two shares of Series A Convertible Redeemable Preferred Stock (the "Series A Preferred Stock"); and (ii) one share of Class A Common Stock (the "Class A Common Stock"). Certain prior-period amounts have been reclassified to conform with the current presentation. NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES The accompanying financial statements include the accounts of the Company and all majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. STATEMENTS OF CASH FLOWS For purposes of the Statements of Cash Flows, all highly liquid instruments purchased with a maturity of three months or less are considered to be cash equivalents. EARNINGS PER COMMON SHARE In connection with the Merger, on July 16, 1992, the Company issued approximately 19.7 million shares of its Class A Common Stock and 42.5 million shares of its Series A Preferred Stock. On December 17, 1993, the Company issued 3.4 million shares of its Class A Common Stock to Libra Invest & Trade Ltd. ("Libra") in exchange for all of Libra's approximately $10.6 million in aggregate principal amount of Subordinated Debentures plus accrued interest. The weighted average numbers of common shares outstanding for the years ended December 31, 1991, 1992, and 1993 were 20.0 million, 29.0 million, and 83.0 million, respectively. The Series A Preferred Stock is KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) not included in the loss per share calculation for 1991 and 1992 because the effect is antidilutive. The 1993 earnings per share calculation includes the Series A Preferred Stock and the effect of 5.7 million shares of common and preferred stock granted under the 1988 Stock Option Plan (Note 14). SHORT-TERM INVESTMENTS The Company accounts for short-term investments at the lower of cost or market value. REAL ESTATE Real estate held for development or sale and land held for development (real estate properties) are carried at the lower of cost or estimated net realizable value. The estimation process involved in the determination of net realizable value is inherently uncertain since it requires estimates as to future events and market conditions. Such estimation process assumes the Company's ability to complete development and dispose of its real estate properties in the ordinary course of business based on management's present plans and intentions. Economic, market, environmental and political conditions may affect management's development and marketing plans. In addition, the implementation of such development and marketing plans could be affected by the availability of future financing for development and construction activities. Accordingly, the ultimate net realizable values of the Company's real estate properties are dependent upon future economic and market conditions, the availability of financing, and the resolution of political, environmental and other related issues. The cost of sales of multi-unit projects is computed using the relative sales value method. Direct construction costs are accumulated by phase, using the specific identification method; land and all other common costs are allocated between phases benefited, using area or unit methods. These methods do not differ significantly from the relative sales value method. Interest, carrying costs, indirect general and administrative costs that relate to several real estate projects and property taxes are capitalized to projects during their development period. No interest expense incurred during the years ended December 31, 1991, 1992, and 1993 was capitalized. Operating properties are generally depreciated using estimated lives that range principally from 5 to 30 years. For financial statement purposes, depreciation is computed utilizing the straight-line method. For tax purposes, depreciation is generally computed by accelerated methods based on allowable useful lives. Accumulated depreciation amounted to $12.6 million and $9.7 million at December 31, 1992 and 1993, respectively. The Company's rental operations consist primarily of the leasing of office and marina space and all of the Company's leases are classified as operating leases. Such leases are generally for periods of up to 5 years. INTANGIBLE ASSETS Goodwill, which represents the difference between the purchase price of a business acquired in 1993 (Note 4) and the related fair value of net assets acquired, is amortized on a straight-line basis over 15 years. Goodwill of $8.7 million as of December 31, 1993 is included in other assets. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," ("FAS 106") was implemented by the Company on the immediate recognition basis effective January 1, 1991 resulting in a $2 million charge to earnings. This standard requires that the cost of these benefits, which are primarily health care related, be recognized in the financial statements during each employee's active working career. The Company's previous practice was to charge these costs to expense as they were paid. As of December 31, 1993 the accrued unfunded costs totalled $1.5 million. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 supersedes both APB Opinion No. 11 and FAS No. 96, "Accounting for Income Taxes." With the adoption of FAS 109 in the first quarter of 1993, the Company changed to the liability method of accounting for income taxes, which resulted in an increase in its deferred tax liability of approximately $36 million, through a charge to income (Note 9). Also see Note 9 for a discussion of the tax sharing agreements with Abex Inc.("Abex") and Wheelabrator Technologies Inc. ("WTI"). RECOGNITION OF REVENUES Sales are recorded using the full accrual method when title to the real estate sold is passed to the buyer and the buyer has made an adequate financial commitment. When it is determined that the earning process is not complete, income is deferred using the installment, cost recovery or percentage of completion methods of accounting. NOTE 3 -- ASSET REVALUATIONS During the fourth quarter of 1991, the Company recorded approximately $65 million of charges for the revaluation of certain assets, including goodwill. Management believes that these revalued amounts better reflected market values based on real estate market conditions and the Company's plan to sell certain non-strategic assets. NOTE 4 -- ACQUISITIONS AND DISPOSITIONS On August 27, 1993 the Company disposed of its entire 44% interest in Deltec for $43.7 million in net cash proceeds, resulting in a gain of $1.9 million. Discontinued operations for the years ended December 31, 1992 and 1993 also includes $.9 million and $4.2 million of net income through the date of disposition. The Company used $23.8 million of the proceeds to make principal prepayments in accordance with term loan agreements with Bank of America and Bank of Boston. The Company also terminated its put option agreement with Abex (Note 10) on August 27, 1993 and received $3 million in cash from Abex which was used to prepay senior bank debt. On September 30, 1993, the Company acquired the domestic real estate development business and related assets of The Koll Company ("Koll"). The principal activity of the acquired business is to provide commercial, industrial, retail and residential real estate development services, including feasibility studies, entitlement coordination, project planning, construction management, financing, marketing, acquisition, disposition and asset management services throughout the nation. The acquired business generates income principally through fees and participating interests in equity partnerships. No real property was involved in the transaction. In connection with the acquisition, the Company paid $4.75 million in cash, approximately $1 million in reimbursement of investments in transferred development projects, and agreed to pay an earn-out over the next four and one-quarter years based on the future profitability of the business acquired. On December 29, 1993 the Company amended its agreement with Koll, under which the Company paid $4.25 million in cash to Koll in exchange for the immediate termination of the earn-out payments with retroactive effect to the initial date of the acquisition agreement. Under the earn-out, the Company was entitled to a 20% preferred return on its original $4.75 million investment, Koll was then entitled to a matching return subject to available profits, with all remaining profits split equally between the Company and Koll. In addition, on September 30, 1993, Koll and Mr. Donald M. Koll (an officer and director of the Company and owner of Koll) entered into covenants not to compete with the Company with respect to domestic real estate development, subject to certain limited exceptions. The Koll covenant is perpetual in duration while the covenant of Mr. Koll is limited to the five-year period following his ceasing to be either an officer, director or stockholder of the Company. In connection with the acquisition, the Company also paid KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 4 -- ACQUISITIONS AND DISPOSITIONS (CONTINUED) Koll $325,000 to terminate its June 11, 1990 management agreement in lieu of continuing to receive and pay for duplicative services during the 90-day notice period which would otherwise have been required under the management agreement. On September 30, 1993, the Company and Koll also entered into various other agreements regarding services they provide to one another (Note 11). On December 17, 1993, the Company completed a transaction with Libra whereby it exchanged the Company's Lake Superior Land Company subsidiary for (1) approximately $42.4 million in aggregate face amount of Senior Subordinated Debentures held by Libra; (2) net cash proceeds to be generated by Libra's periodic sale of up to approximately 3.4 million shares of the Company's Class A Common Stock held by Libra through a series of transactions to be effected in an orderly manner within a three-year period; and (3) the right of the Company to receive a contingent payment if the proceeds from any disposition by Libra of Lake Superior Land Company during the 15 year period following the closing of the transaction exceed a 20% preferred return on the negotiated value of Libra's investment. Accordingly, the financial information included in the statements of operations for all periods has been reclassified to present Lake Superior Land Company as a discontinued operation. Lake Superior Land Company owns and manages a commercial hardwood timber business on approximately 300,000 acres of forest lands and shoreline property on Lake Superior in Michigan and Wisconsin. Revenues related to the discontinued operation were $6.2 million and $8.9 million for the years ended December 31, 1991 and 1992, respectively and $10.6 million for 1993 through the date of the disposition. Net income from the discontinued operation for 1991 , 1992 and 1993 through the date of disposition was $.8 million, $2.6 million and $1.6 million, respectively. The accumulated deficit of Lake Superior Land Company at the date of the disposition was approximately $24.8 million. The Company also completed a separate transaction with Libra in December 1993, whereby the Company exchanged approximately 3.4 million newly issued shares of its Class A Common Stock for approximately $10.6 million in aggregate face amount of Subordinated Debentures held by Libra. In connection with these transactions, the Company recorded an after-tax gain of $39.1 million on the disposition of Lake Superior Land Company and an after-tax extraordinary gain on extinguishment of the Debentures of $23.6 million (Note 7). After these transactions, Libra and affiliates presently hold approximately 7.4 million shares, or 17%, of the Company's Class A Common Stock, including approximately 3.4 million shares which have been deposited in a custodial account for periodic sale in accordance with instructions from the Company, and approximately 11.9 million shares, or 28%, of the Company's preferred stock. In February 1994, the Company received $1 million in cash from Libra in exchange for the immediate termination of the contingent payment provision described above. NOTE 5 -- REAL ESTATE HELD FOR DEVELOPMENT OR SALE Real estate held for development or sale consists of the following at December 31 (in millions): The decrease in real estate held for development or sale during 1993 relates primarily to the sale of the Company's LaJolla, California office property for $10.0 million in cash, as well as the placement into service of the Eagle Crest golf course and its related reclassification to operating properties. NOTE 6 -- LAND HELD FOR DEVELOPMENT Land held for development consists of approximately 1,200 acres known as Bolsa Chica located in Orange County, California, surrounded by the City of Huntington Beach and approximately 35 miles south of downtown Los Angeles ("Bolsa Chica"). The Company is currently seeking approvals from local, state and federal governmental entities for a 4,900 unit (approximately 4,300 units on Company-owned land) KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 6 -- LAND HELD FOR DEVELOPMENT (CONTINUED) residential project on this site. A revised environmental impact report was released for public comments in December 1993 for a 60-day period ending February 18, 1994. The County of Orange requested that this document contain an in-depth analysis of an alternative plan which includes 3,500 homes, in addition to the in-depth analysis of the Company's plan. Due to a number of factors beyond the Company's control, including possible objections of various environmental and so-called public interest groups that may be made in legislative, administrative or judicial forums, the required approvals could be delayed substantially. Subject to these and other uncertainties inherent in the entitlement process, the Company's goal is to obtain all material governmental approvals in the first half of 1995 and to begin construction in the second half of 1995, depending on economic and market conditions. Realization of the Company's investment in Bolsa Chica will also depend upon various economic factors, including the demand for residential housing in the Southern California market and the availability of credit to the Company and to the housing industry. NOTE 7 -- DEBT SENIOR BANK DEBT TERM LOAN During 1993, the Company retired the entire balance of senior bank debt owed to Bank of America with proceeds from the January 1993 Lake Superior Land Company financing, the August Deltec disposition and termination of the Abex put option agreement (see Note 4), and the November sale of two office buildings located in La Jolla, California. TERM NOTE On July 16, 1992, in connection with the Merger, the Company entered into a $13.8 million term note agreement due on July 31, 1995 with the Bank of Boston, principally secured by resort and residential property in New Hampshire ("Wentworth"). Approximately $6.4 million of the proceeds from the August 1993 Deltec disposition and termination of the Abex put option agreement (Note 4) were used to make principal prepayments to Bank of Boston. The term note agreement with Bank of Boston requires additional principal prepayments to be made from the net proceeds from the sale of Wentworth and other assets. The term note agreement also requires additional principal repayments of $.2 million in the second half of 1994 and $.4 million in the first half of 1995, with any remaining balance due at maturity on July 31, 1995. Amounts outstanding under the term note bear interest at prime plus 1%. The term note agreement with Bank of Boston is secured by a first mortgage on the Wentworth property, stock pledge agreements of substantially all significant subsidiaries of the Company and first mortgages on certain other properties. The term note agreement contains certain restrictive covenants that prohibit the declaration or payment of dividends and limit, among other things, (i) the incurrence of indebtedness, (ii) the making of investments, loans and advances, (iii) the creation or incurrence of liens on existing and future assets of Wentworth or its subsidiaries, (iv) stock repurchases, and (v) project development spending in excess of certain planned levels. The term note agreement also contains various financial covenants and events of default customary for such agreements. SUBORDINATED DEBENTURES The Debentures were comprised of the following as of December 31 (in millions): KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 7 -- DEBT (CONTINUED) The Debentures give the Company the right to pay interest in-kind, in cash or, subject to certain conditions, in the Company's common stock. It is currently anticipated that interest on the Debentures will be paid in-kind. The Debentures, which are due March 15, 2002, do not require any sinking fund payments and may be redeemed by the Company at any time in cash only, or at maturity in cash or stock, subject to certain conditions. The Debentures prohibit the payment of any dividends or other distributions on the Company's equity securities. As a result of the Distribution and the Merger on July 16, 1992 (Note 1), approximately $159.4 million aggregate principal amount of the Debentures were distributed to stockholders of Henley Group and approximately $43.8 million aggregate principal amount of the Debentures were retained by Henley Group, which is now a wholly owned subsidiary of the Company. As a result of the transactions with Libra (Note 4) in which approximately $42.4 million in aggregate principal amount of Senior Subordinated Debentures and $10.6 million in aggregate principal amount of Subordinated Debentures held by Libra were retired, the Company recorded on extraordinary gain of $36.1 million, less an applicable income tax provision of $12.5 million, in the accompanying consolidated financial statements. At December 31, 1993 the estimated fair value of the Company's Debentures was within a range of approximately $40 million to $60 million. The fair value of the Debentures is estimated based on the negotiated values in the Libra transactions (lower end of range) and current quotes from certain bond traders making a market in the Debentures (upper end of range). However, due to the low trading volume and illiquid market for the Debentures, current quotes from bond traders may not be meaningful indications of value. The carrying amount for all other debt of the Company approximates market primarily as a result of floating interest rates. INTEREST The Company made cash payments of interest of $10.6 million, $7.4 million and $2.5 million for the years ended December 31, 1991, 1992 and 1993, respectively. NOTE 8 -- OTHER LIABILITIES Other liabilities were comprised of the following as of December 31 (in millions): NOTE 9 -- INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 requires a change from the deferred method of accounting for income taxes under APB Opinion No. 11 to the asset and liability method of accounting for income taxes. Under FAS 109, deferred income taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect in the years in which these differences are expected to reverse. At January 1, 1993, the Company recorded the cumulative effect of this change in accounting for income taxes as a $36 million charge to earnings in the consolidated statement of operations. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 -- INCOME TAXES (CONTINUED) The tax effects of items that gave rise to significant portions of the deferred tax accounts as of December 31, 1993 are as follows: At December 31, 1993, the Company had available tax net operating loss carryforwards of approximately $106 million which expire in the years 2003 through 2008 if not utilized. The Internal Revenue Code (the "Code") imposes an annual limitation on the use of loss carryforwards upon the occurrence of an "ownership change" (as defined in Section 382 of the Code). Such an ownership change occurred in connection with the Merger. As a result, approximately $25 million of the Company's net operating loss carryforwards will generally be limited to the extent that Henley Properties and its subsidiaries recognize certain gains in the five-year period following the ownership change (ending July 16, 1997). The following is a summary of the income tax provision (benefit) on continuing operations for the years ended December 31 (in millions): Cash payments for federal, state and local income taxes were approximately $1.6 million, $1.3 million and $7.8 million for the years ended December 31, 1991, 1992 and 1993, respectively. Tax refunds received in 1993 were approximately $5.1 million. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 -- INCOME TAXES (CONTINUED) The principal items accounting for the difference in taxes on income computed at the statutory rate and as recorded are as follows for the years ended December 31 (in millions): TAX SHARING AGREEMENTS Henley Group and Abex, a former subsidiary of Henley Group whose stock was distributed to stockholders of Henley Group, entered into a tax sharing agreement in 1992 prior to the Distribution to provide for the payment of taxes for periods during which Henley Group and Abex were included in the same consolidated group for federal income tax purposes, the allocation of responsibility for the filing of tax returns, the cooperation of the parties in realizing certain tax benefits, the conduct of tax audits and various related matters. 1989-1992 INCOME TAXES. The Company is generally charged with responsibility for all of its federal, state, local or foreign income taxes for this period and, pursuant to the tax sharing agreement with Abex, all such taxes attributable to Henley Group and their consolidated subsidiaries, including any additional liability resulting from adjustments on audit (and any interest or penalties payable with respect thereto), except that Abex is generally charged with responsibility for all such taxes attributable to it and its subsidiaries for 1990-1992. In addition, under a separate tax sharing agreement between Henley Group and a former subsidiary of Henley Group, Fisher Scientific International Inc. ("Fisher"), Fisher is generally charged with responsibility for its own income tax liabilities for this period. PRE-1989 INCOME TAXES. Under tax sharing agreements with WTI and Abex, the parties are charged with sharing responsibility for paying any increase in the federal, state or local income tax liabilities (including any interest or penalties payable with respect thereto) for any consolidated, combined or unitary tax group which included WTI, Henley Group or any of their subsidiaries for tax periods ending on or before December 31, 1988. WTI is charged with responsibility for paying the first $51 million of such increased taxes, interest and penalties, plus any amounts payable with respect to such liabilities by certain former affiliates of WTI under their tax sharing agreements with WTI. Should the amounts payable exceed $51 million, the Company is charged with responsibility for paying the next $25 million, plus amounts payable with respect to liabilities which are attributable to certain of the Company's subsidiaries. Liabilities in excess of amounts payable by WTI and the Company, as described above, will generally be assumed by Abex (the "Abex Indemnification"). In the first quarter of 1993, the Company paid approximately $7.6 million related to the tax sharing agreements. Of this amount, approximately $4.5 million will be applied against the Company's $25 million limitation (as discussed above). The remaining $3.1 million relates to liabilities which are attributable to certain of the Company's subsidiaries. Therefore the Company's potential liability for additional payments under these tax sharing agreements is approximately $21 million, which has been accrued in the Company's financial statements since December 1989 and is included in accounts payable and accrued liabilities as of December 31, 1993. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 -- INCOME TAXES (CONTINUED) In January 1993, the Internal Revenue Service completed its examination of the Federal tax returns of WTI for the periods May 27, 1986 through December 31, 1988 and asserted a material deficiency relating to the tax basis of a former subsidiary of WTI. WTI, Abex and the Company disagreed with the position taken by the IRS and WTI filed a petition with the U.S. Tax Court. A trial date had been scheduled for June 1994; however, in March 1994, WTI and the IRS entered into a Stipulation of Settlement that will result in a tax payable together with interest of approximately $72 million which is due in April 1994. The Company has been informed by the other parties to these tax sharing agreements that it is being charged with a net obligation of approximately $21 million under this settlement. The Company is currently evaluating the scope of this claimed obligation under the settlement and potential sources of financing for such amount that the Company may ultimately be obligated to pay. However, there can be no assurance that any financing will be available, or that if available, it can be obtained on terms that are favorable to the Company and its stockholders. NOTE 10 -- COMMITMENTS AND CONTINGENCIES TRANSITION AGREEMENTS Pursuant to a 1989 transition agreement, Henley Group provided to the Company and its subsidiaries certain services, including management, strategic planning and advice, legal, tax, accounting, data processing, cash management, employee benefits, operational, corporate secretarial, insurance purchasing and claims administration consulting services for a quarterly fee of $750,000, commencing on the date of the 1989 distribution, plus an amount for the use of office space in Henley Group's Hampton, New Hampshire offices for such period. This rent amounted to approximately $.8 million for the year ended December 31, 1991, and $.4 million for the first half of 1992. The 1989 Transition Agreement was cancelled in July 1992 in connection with the Merger. Pursuant to a 1992 transition agreement, each of Abex and the Company provides to the other certain administrative support services until the first anniversary of the Merger, and thereafter until 60 days' prior written notice of termination is given by one company to the other and each company reimburses the other for its out-of-pocket expenses. Effective March 16, 1993, the 1992 transition agreement was amended to provide that all transitional services would be provided by Abex to the Company for a period ending on March 31, 1994, and that the Company would pay $.5 million quarterly for such services. Accordingly, the Company reimbursed Abex approximately $1.0 million and $1.8 million for the years ended December 31, 1992 and 1993. The amendment also provided for the termination of the New Hampshire facilities lease on March 31, 1993. In connection with the Merger, the Company entered into a put option agreement with Abex, through December 31, 1995, which provided the Company the right to require Abex to purchase certain assets of the Company at 85% of appraised value, subject to an annual limitation of no more than $50 million and an aggregate limitation of $75 million for such assets. On August 27, 1993, the Company received $3.0 million from Abex in exchange for the termination of this agreement (Note 4). LEGAL PROCEEDINGS The owners of undeveloped real property located in San Diego County sued Signal Landmark, a subsidiary of the Company ("Signal"), in San Diego Superior Court, in May 1990, alleging that Signal had deposited contaminated soils on their property and was liable under theories of nuisance, negligence, trespass and strict liability. The plaintiffs sought general damages in the amount of approximately $40 million and additionally, punitive damages in an unspecified amount, plus prejudgment interest and costs. On August 5, 1991, the plaintiffs filed a complaint in Federal court against Signal and several other parties asserting claims under the Federal Comprehensive Environmental Response, Compensation and Liability Act, seeking essentially the same relief sought in the state action. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 10 -- COMMITMENTS AND CONTINGENCIES (CONTINUED) In April 1992, a jury awarded the plaintiffs damages in the amount of $2.5 million following a trial in the state action. Signal appealed the verdict in the state action and posted a bond and cash collateral of $3.75 million in August 1992. On March 5, 1993, Signal reached an agreement in principle with the plaintiffs in such litigation to settle both the federal and state actions. On July 2, 1993, the Federal Court for the Southern District of California approved the settlement agreement under the terms of which funds from such cash collateral account were disbursed approximately as follows: 1) $1.3 million was deposited in trust for remediation expenditures; 2) $1.3 million was disbursed to the plaintiffs; and 3) $1.1 million was returned to Signal. There are various other lawsuits and claims pending against the Company and certain subsidiaries. In the opinion of the Company's management, ultimate liability, if any, will not have a material adverse effect on the Company's liquidity or financial condition. CORPORATE INDEMNIFICATION MATTERS The Company and its predecessors have, through a variety of transactions effected since 1986, disposed of several assets and businesses, many of which are unrelated to the Company's current operations. By operation of law or contractual indemnity provisions, the Company has retained liabilities relating to certain of these assets and businesses. Many of such liabilities are supported by insurance or by indemnities from certain of the Company's predecessor and currently or previously affiliated companies. The Company believes its balance sheet reflects adequate reserves for these matters. Abex and the Company agreed that, following the Distribution and the Merger, each company will be responsible for environmental liabilities relating to its existing, past and future assets and businesses and will indemnify the other in respect thereof. The United States Environmental Protection Agency ("EPA") has designated Universal Oil Products ("UOP"), among others, as a Potentially Responsible Party ("PRP") with respect to an area of the Upper Peninsula of Michigan (the "Torch Lake Site") under the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"). UOP is allegedly the successor in interest to one of the companies that conducted mining operations in the Torch Lake area and an affiliate of Allied-Signal Inc., a predecessor of the Company. The Company has not been named as a PRP at the site. However, Allied-Signal has, through UOP, asserted a contractual indemnification claim against the Company for claims that may be asserted against UOP by EPA or other parties with respect to the site. EPA has proposed a cleanup plan which would involve covering certain real property both contiguous and non-contiguous to Torch Lake with soil and vegetation in order to address alleged risks posed by copper tailings and slag at an estimated cost of approximately $7.2 million. EPA estimates that it has spent in excess of $2 million to date in performing studies of the site. Under CERCLA, EPA could assert claims against the Torch Lake PRPs, including UOP, to recover the cost of these studies, the cost of all remedial action required at the site, and natural resources damages. An earlier settlement in principle with EPA staff pursuant to which UOP would pay $1.7 million in exchange for a release similar to those normally granted by EPA in such circumstances was rejected by certain other governmental authorities in July 1993. Settlement negotiations between the Company, on behalf of UOP, and EPA resumed shortly thereafter and are ongoing. NOTE 11 -- RELATED PARTY TRANSACTIONS MANAGEMENT AGREEMENT In June 1990 the Company entered into a management agreement with Koll. On September 30, 1993, in connection with the Company's acquisition of the domestic real estate development business and related assets of Koll, the Company paid Koll $325,000 to terminate the management agreement in lieu of continuing to receive and pay for duplicative services during the 90-day notice period which would otherwise have been required under the management agreement. Under the terms of the management agreement, the KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 11 -- RELATED PARTY TRANSACTIONS (CONTINUED) Company was obligated to pay a quarterly management fee equal to .125% of the average book value of its assets managed by Koll. Additionally, the Company was obligated to reimburse Koll for certain personnel costs and other expenses and Koll was generally entitled to a disposition fee of 1% of the net sale proceeds (as defined) upon the sale of any real estate property (other than the Bolsa Chica and Wentworth properties) managed by Koll. During 1991, 1992 and 1993 the Company incurred management fees of $2.5 million, $2.0 million and $1.4 million through September 30, 1993, respectively, and reimbursable personnel costs and other expenses of $1.6 million, $.9 million and $.1 million, respectively, under this management agreement. In 1990, the Company also entered into construction management agreements with Koll Construction, a wholly owned subsidiary of Koll, with respect to the Eagle Crest and Murrieta projects. In 1993, the Company entered into a construction management agreement with Koll Construction for demolition of bunkers at the Bolsa Chica project. During 1991, 1992 and 1993 the Company incurred fees aggregating approximately $.5 million, $.2 million and $.1 million, respectively, to Koll Construction in consideration of these services and related reimbursements. SERVICE AGREEMENTS On September 30, 1993, the Company entered into a Financing and Accounting Services Agreement to provide Koll with financing, accounting, billing, collections and other related services until 30 days' prior written notice of termination is given by one company to the other. Fees earned for the year ended December 31, 1993 were approximately $.1 million. The Company also entered into a Management Information Systems and Human Resources Services Agreement on September 30, 1993 with Koll Management Services, Inc. ("KMS"), a public company majority owned by Koll. Under this agreement, KMS provides computer programming, data organization and retention, record keeping, payroll and other related services until 30 days' prior written notice of termination is given by one company to the other. Fees and related reimbursements accrued during the year ended December 31, 1993 were approximately $.1 million. SUBLEASE AGREEMENTS On September 30, 1993, the Company entered into a month-to-month Sublease Agreement with Koll to sublease a portion of a Koll affiliate's office building located in Newport Beach, California. The Company also entered into lease agreements on a month-to-month basis for office space in Northern California and San Diego, California with KMS and Koll Construction, respectively. Combined annual lease costs on these month-to-month leases during the year ended December 31, 1993 were approximately $.1 million. DEVELOPMENT FEES For the year ended December 31, 1993, the Company earned fees of approximately $.7 million for real estate development services provided to partnerships in which Koll and certain directors and officers of the Company have an ownership interest. LOAN RECEIVABLE In December 1993, the Company purchased a nonrecourse construction loan, secured by a first trust deed on four multi-tenant industrial buildings, for which the borrower is a partnership in which Koll and certain directors and officers of the Company have an ownership interest. The loan balance of $.8 million as of December 31, 1993 is included in other assets. OTHER TRANSACTIONS See Notes 4, 9 and 10 for descriptions of other transactions and agreements with Koll, Libra, Abex and WTI. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 12 -- RETIREMENT PLANS The Company has noncontributory defined benefit retirement plans covering substantially all employees of the Company prior to September 30, 1993 who had completed one year of continuous employment. Net periodic pension cost for the years ended December 31, consisted of the following (in millions): The curtailment loss in 1993 resulted from the freeze of benefit accruals for former participants in April 1993. The funded status and accrued pension cost at December 31, 1992 and 1993 for defined benefit plans were as follows (in millions): The development of the projected benefit obligation for the plans at December 31, 1991, 1992 and 1993 are based on the following assumptions: discount rates of 8.5%, 8% and 7%, respectively, rates of increase in employee compensation of 5.5%, 4% and 0%, respectively, and expected long-term rates of return on assets of 9%. The date used to measure plan assets and liabilities was October 31 in each year. Assets of the plans are invested primarily in stocks, bonds, short-term securities and cash equivalents. NOTE 13 -- CAPITAL STOCK COMMON STOCK Under its restated certificate of incorporation, the Company has authority to issue up to 750 million shares of common stock, par value $.05 per share, subject to approval of the Board of Directors (the "Board"), of which 625 million shares of Class A Common Stock and 25 million shares of Class B Common Stock are initially authorized for issuance and an additional 100 million shares may be issued in one or more series, and have such voting powers or other rights and limitations as the Board may authorize. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 13 -- CAPITAL STOCK (CONTINUED) On June 11, 1992, all shares of Class B Common Stock (convertible nonvoting) were converted into an equal number of shares of Class A Common Stock (voting). On July 16, 1992, in connection with the Merger, the Company issued approximately 19.7 million shares of its Class A Common Stock (Notes 1 and 2). On December 17, 1993, the Company issued 3.4 million shares of its Class A Common Stock in exchange for all of Libra's approximately $10.6 million in aggregate principal amount of Subordinated Debentures plus accrued interest. In connection with the Company's sale of Lake Superior Land Company to Libra, the net cash proceeds from the sale of 3.4 million shares of Class A Common Stock held by Libra will be forwarded to the Company. The estimated amount of proceeds to be received from such sale is reflected in the equity section of the balance sheet as deferred proceeds from stock issuance. Under the Company's term loan agreement with Bank of Boston and Indentures for the Debentures (Note 7), the Company is prohibited from purchasing shares of its common stock. PREFERRED STOCK Under its restated certificate of incorporation, the Company has authority to issue 150 million shares of preferred stock, par value $.01 per share, in one or more series, with such voting powers and other rights as authorized by the Board. Effective July 16, 1992, in connection with the Merger, the Board authorized approximately 42.5 million shares of Series A Preferred Stock, which have a liquidation preference of $.75 per share, participate in any dividend or distribution paid on the Class A Common Stock on a share for share basis, and have no voting rights, except as required by law (Notes 1 and 2). The Series A Preferred Stock is redeemable at the Company's option, on 30 days' notice given at any time after the second anniversary of issuance, at the liquidation preference of $.75 per share, in cash or generally in shares of Class A Common Stock. Each share of the Series A Preferred Stock is convertible at the holder's option, at any time after the second anniversary of issuance, generally into one share of Class A Common Stock. NOTE 14 -- STOCK PLANS The Company has various plans which are described below: 1993 STOCK OPTION/STOCK ISSUANCE PLAN The 1993 Stock Option/Stock Issuance Plan ("1993 Plan"), was adopted by the Board on November 29, 1993, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, as the successor equity incentive program to the Company's 1988 Stock Plan. Outstanding options under the 1988 Stock Plan will be incorporated into the 1993 Plan upon its approval. Under the 1993 Plan 7,500,000 shares each (including 3,000,000 shares each authorized under the 1988 Stock Plan) of Series A Preferred Stock and Class A Common Stock have been reserved for issuance to officers, key employees and consultants of the Company and its subsidiaries and the non-employee members of the Board. Options generally become exercisable for 40% of the option shares upon completion of one year of service and become exercisable for the balance in two equal annual installments thereafter. The 1993 Plan includes an automatic option grant program, pursuant to which each individual serving as a non-employee Board member on the November 29, 1993 effective date of the 1993 Plan received an option grant for 125,000 shares each of Series A Preferred Stock and Class A Common Stock with an exercise price of $.4063 per share, equal to the fair market value of the underlying securities on the grant date. Each individual who first joins the Board as a non-employee director after such effective date will receive a similar option grant. Of the shares subject to each option, 40% will vest upon completion of one year of Board service measured from the grant date, and the balance will vest in two equal annual installments thereafter. Each automatic grant will have a maximum term of 10 years, subject to earlier termination upon the optionee's cessation of Board service. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 14 -- STOCK PLANS (CONTINUED) Each non-employee Board member may also elect to apply all or any portion of his or her annual retainer fee to the acquisition of shares of Series A Preferred Stock or Class A Common Stock which will vest incrementally over the individual's period of Board service during the year for which the election is in effect. During the fiscal year ended December 31, 1993, options for 3,520,000 shares each of Series A Preferred Stock and Class A Common Stock were granted under the 1993 Plan, including options for an aggregate of 500,000 shares of each class to non-employee directors, subject to stockholder approval at the 1994 Annual Meeting. The exercise price for these options is $.4063 per share, equal to the fair market value of the underlying securities as of the grant date. 1988 STOCK PLAN The 1988 Stock Plan will be replaced by the 1993 Plan, subject to stockholder approval at the 1994 Annual Meeting of Stockholders. The 1988 Stock Plan of the Company provides for the grant of awards covering a maximum of 3,000,000 shares each of Class A Common Stock and Series A Preferred Stock to officers and other executive employees of the Company and to persons who provide management services to the Company. Awards under the 1988 Stock Plan may be granted in the form of: (i) incentive stock options, (ii) non-qualified stock options, (iii) restricted shares, (iv) restricted units to acquire shares, (v) stock appreciation rights or (vi) limited stock appreciation rights. No incentive stock options grants may be made thereunder after December 14, 1999. Options may be accompanied by stock appreciation rights or limited stock appreciation rights. During the year ended December 31, 1993, options for 1,860,000 shares each of Class A Common Stock and Series A Preferred Stock were cancelled and options for 2,630,000 shares of each class were granted at an exercise price of $.25 and $.2813, respectively. No Class A Common Stock options were granted during 1991 and no Series A Preferred Stock options were granted prior to 1992. Options vest 40%, 70%, and 100% at the first, second, and third anniversaries, respectively, from the grant date. RESTRICTED STOCK PLAN Under the Restricted Stock Plan, each individual joining the Company as an non-employee Board member received an immediate one-time grant of 2,000 shares of Class A Common Stock. The shares are subject to certain transfer restrictions for a specified period, during which the director has the right to receive dividends and the right to vote the shares. After the restricted period expires, the shares will vest based upon certain terms related to service. The shares are forfeited if the director ceases to be a nonemployee director prior to the end of the restricted period. During 1993, 8,000 shares were granted and 3,600 shares were forfeited under such Restricted Stock Plan. No shares were granted during 1991 or 1992. The Restricted Stock Plan was terminated in November 1993 in connection with the implementation of the 1993 Plan. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 15 -- UNAUDITED QUARTERLY FINANCIAL INFORMATION The following is a summary of quarterly financial information for 1992 and 1993 (in millions, except per share amounts):

107832_1993.txt

107832

1993

ITEM 1. BUSINESS THE COMPANY On March 1, 1988, after obtaining shareowner and all the necessary regulatory approvals, Wisconsin Power and Light Company (the "Company" or "WP&L") effected a corporate restructuring which included the formation of a holding company, WPL Holdings, Inc. WPL Holdings, Inc. is the parent company of WP&L and its utility subsidiaries and of Heartland Development Corporation, the parent corporation for nonregulated businesses. The Company, incorporated in Wisconsin on February 21, 1917, as the Eastern Wisconsin Electric Company, is a public utility predominately engaged in the transmission and distribution of electric energy and the generation and bulk purchase of electric energy for sale. The Company also transports, distributes and sells natural gas purchased from gas suppliers. Nearly all of the Company's customers are located in south and central Wisconsin. The Company operates in municipalities pursuant to permits of indefinite duration which are regulated by Wisconsin law. The Company does not derive a material portion of its revenues from any one customer. The Company owns all of the outstanding capital stock of South Beloit Water, Gas and Electric Company ("South Beloit"), a public utility supplying electric, gas and water service, principally in Winnebago County, Illinois, which was incorporated on July 23, 1908. The Company also owns varying interests in several other subsidiaries and investments which are not material to the Company's operations. REGULATION The Company is subject to regulation by the PSCW as to retail utility rates and service, accounts, issuance and use of proceeds of securities, certain additions and extensions to facilities, and in other respects. South Beloit is subject to regulation by the Illinois Commerce Commission ("ICC") for similar items. The Federal Energy Regulatory Commission ("FERC") has jurisdiction under the Federal Power Act over certain of the electric utility facilities and operations, wholesale rates and accounting practices of the Company and in certain other respects. Certain of the Company's natural gas facilities and operations are subject to the jurisdiction of the FERC under the Natural Gas Act. The Company is presently exempt from all provisions of the Public Utility Holding Company Act of 1935, except provisions relating to the acquisition of securities of other public utility companies. An anticipated change in the regulatory environment is the movement towards the deregulation of certain aspects of utility operations. The Company is in the process of evaluating the impacts of such deregulation. With respect to environmental matters, the United States Environmental Protection Agency administers certain federal statutes; others are delegated to the Wisconsin Department of Natural Resources ("DNR"). In addition, the DNR has jurisdiction over air and water quality standards associated with fossil fuel fired electric generation and the level and flow of water, safety and other matters pertaining to hydroelectric generation. The Company is subject to the jurisdiction of the Nuclear Regulatory Commission ("NRC") with respect to the Kewaunee nuclear plant and to the jurisdiction of the United States Department of Energy ("DOE") with respect to the disposal of nuclear fuel and other radioactive wastes from the Kewaunee Nuclear Power Plant ("Kewaunee"). EMPLOYEES At year-end 1993, the Company employed 2,673 persons, of whom 2,136 were considered electric utility employees, 387 were considered gas utility employees and 150 were considered other utility employees. The Company has a three-year contract with members of the International Brotherhood of Electrical Workers, Local 965, that is in effect until June 1, 1996. The contract covers 1,742 of the Company's employees. ELECTRIC OPERATIONS General The Company provides electricity in a service territory of approximately 16,000 square miles in 35 counties in southern and central Wisconsin and four counties in northern Illinois. As of December 31, 1993, the Company provided retail electric service to approximately 360,000 customers in 609 cities, villages and towns, and wholesale service to 25 municipal utilities, 1 privately owned utility, three rural electric cooperatives and to Wisconsin Public Power, Inc. System, which provides retail service to nine communities. The Company owns 21,579 miles of electric transmission and distribution lines and 351 substations located adjacent to the communities served. The Company's electric sales are seasonal to some extent with the yearly peak normally occurring in July or August. The Company also experiences a smaller winter peak in December or January. Fuel In 1993, approximately 80 percent of the Company's net kilowatthour generation of electricity was fueled by coal and 17 percent by nuclear fuel (provided by the Company's 41 percent ownership interest in Kewaunee). The remaining electricity generated was produced by hydroelectric, oil-fired and natural gas generation. Coal The Company anticipates that its average fuel costs will increase in the future, due to cost escalation provisions in existing coal and transportation contracts and increases in the costs of new coal contracts due to emission requirements under federal and state laws. The estimated coal requirements of the Company's generating units (including jointly-owned facilities) for the years 1994 through 2013 total about 166 million tons. Present coal supply contracts and transportation contracts (excluding extension options) cover approximately 25 percent and 24 percent, respectively, of this estimated requirement. The Company will seek renewals of existing contracts or additional sources of supply and negotiate new or additional transportation contracts to satisfy the requirements of approved environmental regulations. Nuclear Kewaunee is jointly owned by the Company (41%), Wisconsin Public Service Corporation (41.2%) and Madison Gas & Electric Company (17.8%). Wisconsin Public Service Corporation is the operating partner. The plant began commercial operation in 1974. The supply of fuel for Kewaunee involves the mining and milling of uranium ore to uranium concentrates, the conversion of uranium concentrates to uranium hexafluoride, enrichment of the uranium hexafluoride and fabrication of the enriched uranium into usable fuel assemblies. The following narrative discusses the nuclear fuel supplies for Kewaunee which requires approximately 250,000 pounds of uranium concentrates per year. Additionally, the Company and the other Kewaunee co-owners formed a limited partnership of subsidiaries in the mid-1970's to secure uranium reserves and maintain a long-term uranium concentrates supply capability. (a) Requirements for uranium are met through spot market purchases of uranium. In general a four-year supply of uranium is maintained. (b) Uranium hexafluoride, from inventory and from spot market purchases, was used to satisfy converted material requirements in 1993. Such conversion services will be purchased on the spot market in the future. (c) In 1993, enriched uranium was procured from COGEMA, Inc. pursuant to a contract executed in 1983 and last amended in 1991. The partnership is obligated to take delivery of additional enriched uranium contracted from COGEMA in 1993 and 1994. The partnership also purchased enriched uranium on the spot market in 1993. Enrichment services were purchased from the DOE under the terms of the utility services contract. This contract is in effect for the life of Kewaunee. The partnership is committed to take 70 percent of its annual requirements in 1994 and 1995, and in alternate years thereafter from the DOE. (d) Fuel fabrication requirements through 1995 are covered by contract. This contract contains an option to allow the partnership to extend the contract through 1998. (e) Beyond the stated periods for Kewaunee, additional contracts for uranium concentrates, conversion to uranium hexafluoride, fabrication and spent fuel storage will have to be procured. The prices for the foregoing are expected to increase. The National Energy Policy Act of 1992 provides that both the Federal government and the nuclear utilities fund the decontamination and decommissioning of the three federal gaseous diffusion plants in the United States. This will require the owners of the Kewaunee to pay approximately $15 million, in current dollars over a period of 15 years. The Company's share amounts to an annual payment of approximately $410,000. The steam generator tubes at Kewaunee are susceptible to corrosion characteristics seen throughout the nuclear industry. Annual inspections are performed to identify degraded tubes. Degraded tubes are either repaired by sleeving or are plugged with approximately 15 percent heat transfer margin, meaning that full power should be sustainable with the equivalent of 15 percent of the steam generator tubes plugged. Currently, the equivalent of 10 percent of the tubes in the steam generators are plugged. The Company and the other joint owners continue to evaluate appropriate strategies, including replacement, as well as continued operation of the steam generators without replacement. The Company and the joint owners intend to operate Kewaunee until at least 2013, the expiration of the present operating license. The Company and the joint owners are also evaluating initiatives to improve the performance of Kewaunee. These initiatives include funding of the development of welded repair technology for steam generator tubes and numerous cost reduction measures such as the conversion from a 12-month to an 18-month fuel cycle. If the steam generators are not replaced, and excluding the possible affect of the aforementioned repair strategies, a gradual power reduction of approximately 1 percent per year may begin as soon as 1995. Physical decommissioning is expected to occur during the period 2014 to 2021 with additional expenditures being incurred during the period 2022 to 2050 related to the storage of spent nuclear fuel at the site. The Company's share of the decommissioning costs of this plant is estimated to be $149 million (in 1993 dollars) based on a site specific study, performed in 1992, using immediate dismantlement as the method of decommissioning. Wisconsin utilities operating nuclear generating plants are required by the PSCW to establish external trust funds to provide for the decommissioning of such plants. The market value of the investments in the funds established by the Company at December 31, 1993 totaled $45.1 million. Pursuant to the Nuclear Waste Policy Act of 1982, the DOE has entered into a contract with the Company to accept, transport and dispose of spent nuclear fuel beginning not later than January 31, 1998. It is likely that the DOE will delay the acceptance of spent nuclear fuel beyond 1998. A fee to offset the costs of the DOE's disposal for all spent fuel used since April 7, 1983 has been assessed by the DOE at one mill per net kilowatthour of electricity generated and sold by the Kewaunee nuclear power plant. An additional one-time fee was paid for the disposal of spent nuclear fuel used to generate electricity prior to April 7, 1983. Spent fuel is currently stored at Kewaunee. The existing capacity of the spent fuel storage facility will enable storage of the projected quantities of spent fuel through April 2001. The Company is currently evaluating options for the storage of additional quantities beyond 2001. Several technologies are available. It is expected that the larger capacity requirements for spent nuclear fuel storage will require a capital investment in the late 2000's. The Low-Level Radioactive Waste Policy Act of 1980 as amended in 1985 provides that states may enter into compacts to provide for regional low-level waste disposal facilities. The amended Act provides that after January 1, 1993, compact members may restrict the use of regional disposal facilities to waste generated within the region. Wisconsin is a member of the Midwest Interstate Low-Level Radioactive Waste Compact which includes six Midwestern states and was ratified by Congress. A Midwest disposal facility is not expected to be operational until the late 1990's. Presently, the state of Ohio has been selected as the host state for the Midwest Compact and is proceeding with the preliminary phases of site selection. In the meantime, the Company has access to an existing low level waste storage space to temporarily store low level waste generated. Recovery of Electric Fuel Costs The Company does not automatically pass changes in electric fuel cost through to its Wisconsin retail electric customers. Instead, rates are based on estimated per unit fuel costs established during rate proceedings and are not subject to change by fuel cost fluctuations unless actual costs are outside specified limits. If actual fuel costs vary from the estimated costs by more than +10 percent in a month or by more than +3 percent for the test year to date, projected annual variances are then estimated. If the projected annual variance is more than +3 percent, rates are subject to hearings and increase or decrease by the PSCW. The Company's wholesale rates and South Beloit's retail rates contain fuel adjustment clauses pursuant to which rates are adjusted monthly to reflect changes in the costs of fuel. Environmental Matters The Company cannot precisely forecast the effect of future environmental regulations by federal, state and local authorities upon its generating, transmission and other facilities, or its operations, but has taken steps to anticipate the future while meeting the requirements of approved environmental regulations of today. The Clean Air Act Amendments of 1977 and subsequent amendments to the Clean Air Act, as well as the new laws affecting the handling and disposal of solid and hazardous wastes along with clean air legislation passed in 1990 by Congress, could affect the siting, construction and operating costs of both present and future generating units (see "Item 3. Legal Proceedings"). Under the Federal Clean Water Act, National Pollutant Discharge Elimination System permits for generating station discharge into water ways are required to be obtained from the DNR, to which the permit program has been delegated. These permits must be periodically renewed. The Company has obtained such permits for all of its generating stations or has filed timely applications for renewals of such permits. Air quality regulations promulgated by the DNR in accordance with Federal standards impose statewide restrictions on the emission of particulates, sulfur dioxide, nitrogen oxides and other air pollutants and require permits from the DNR for the operation of emission sources. The Company currently has the necessary permits to operate its fossil-fueled generating facilities. Pursuant to Wisconsin statutes 144.386(2), the Company has submitted data and plans for 1993 sulfur dioxide emissions compliance. The Company will make any necessary operational changes in fuel types and power plant dispatch to comply with the Plan. The Company's compliance strategy for Wisconsin's 1993 sulfur dioxide law and the Federal Clean Air Act Amendments required plant upgrades at its generating facilities. The majority of these projects were completed in 1992. The Company will be installing continuous emissions monitoring systems at all of its coal fired boilers 1994. Coal handling equipment upgrades will also be made at the Edgewater facility in 1994. Total expenditures for these projects are expected to be $3.5 million. No additional costs for compliance with these acid rain requirements are anticipated at this time. The Company maintains licenses for all its ash disposal facilities and regularly reports to the DNR groundwater data and quantities of ash landfilled or reused. The landfills are operated according to a Plan of Operation approved by the DNR. The Company's accumulated pollution abatement expenditures through December 31, 1993, totaled approximately $122 million. The major expenditures consist of about $60 million for the installation of electrostatic precipitators for the purpose of reducing particulate emissions from the Company's coal-fired generating stations and approximately $62 million for other pollution abatement equipment at the Columbia, Edgewater, Kewaunee, Nelson Dewey, Rock River and Blackhawk plants. Expenditures during 1993 totaled approximately $6 million. Estimated pollution abatement expenditures total $.7 million through 1995. The Company's estimated pollution abatement expenditures are subject to continuing review and are revised from time to time due to escalation of construction costs, changes in construction plans and changes in environmental regulations. See "Electric Operations - Fuel" for information concerning the disposal of spent nuclear fuel and high level nuclear waste. GAS OPERATIONS General As of December 31, 1993, the Company provided retail natural gas service to approximately 136,000 customers in 217 cities, villages and towns in 22 counties in southern and central Wisconsin and one county in northern Illinois. The Company's gas sales follow a seasonal pattern. There is an annual base load of gas used for heating, cooking, water heating and other purposes, with a large peak occurring during the heating season. In 1993, the Company purchased significant volumes of lower cost gas directly from producers and marketers and transported those volumes over its two major pipeline supplier's systems. This replaced higher cost gas historically purchased directly from the major pipeline systems. The Company transported gas for 85 end users at year-end 1993. Gas Supplies In 1992 the FERC issued Order No. 636 and 636-A which requires interstate pipelines to restructure their services. Under these orders, existing pipeline sales service would be "unbundled" such that gas supplies would be sold separately from interstate transportation services. Both of the interstate pipelines which serve the Company, ANR Pipeline and Northern Natural Pipeline, completed their transition to unbundled services as mandated by the FERC in its Order 636 during 1993. As a result, the Company now contracts with these two parties for various unbundled services such as firm and interruptible transportation, firm and interruptible storage service and "no-notice" service. The Company has benefited from enhanced access to competitively priced gas supplies, and from more flexible transportation services. Pipelines are, however, seeking to recover from their customers certain transition costs associated with restructuring. Any such recovery is subject to prudence hearings at the FERC and state regulatory commissions. With the pipelines exiting their historic role of selling gas to the Company, the utility has increased its contracting activity with producers and marketers of natural gas correspondingly. The Company's portfolio of gas supply contracts are designed to meet the needs of gas customers and extend from one month to 10 years in term. The most significant change in the Company's mix of gas contracts for 1993 are: 1) a significant increase in the volume of Canadian gas contracted for, and 2) a large increase in firm storage service from the pipelines. The new Canadian contract commitments represent the Company's successful negotiations to minimize the "transition costs" of moving to the unbundled, post-Order 636 environment. In mid 1993, the Company was faced with the decision of whether to negotiate with the Canadians to reform the terms of long-term contracts which were in place with the two pipelines and assume the contracts on the renegotiated terms, or pay the pipelines to buy out of these contract commitments with the Canadians. The Company opted for the latter approach at an estimated savings of over $16 million to the Company's customers. In 1993, the Company increased its peak-day entitlements on ANR pipeline by 16,000 dekatherms per day reflecting the need for additional firm capacity in order to meet the load growth of firm customers. The Company maintains gas storage agreements with ANR Pipeline and a third party storage service provider. The storage agreements allow the Company to purchase a portion of its gas supply between April and October, when natural gas costs usually are lower. The less expensive gas is stored in the storage fields and is withdrawn between November and March when gas costs typically are higher. The agreements have terms extending through March 31, 1995 and March 31, 1997. The Company's current portfolio of contracts is as follows: ANR Pipeline Contract year 1989-90 1990-91 1991-92 1992-93 1993-94 Maximum daily entitlement: (000 Dt per day) Contract demand 120.0 81.5 81.5 81.5 0 Firm transportation 25.5 25.9 25.9 25.9 80.0 Firm storage - 40.1 40.1 40.1 83.5 ------ ------ ------ ------ ------ Total 145.5 147.5 147.5 147.5 163.5 ====== ====== ====== ====== ====== Maximum annual entitlement (000 Dt) 11,400 11,680 11,680 N/A N/A Northern Natural Pipeline Contract year 1989-90 1990-91 1991-92 1992-93 1993-94 (a) (a) Maximum daily entitlement: (000 Dt per day) Contract demand 19.9 19.9 16.9 -- -- Firm transportation 13.7 13.7 26.5 53.6 53.6 Firm storage - - 2.2 1.5 8.5 "Unbundled" sales - - - 16.9 1.4 ------ ------ ------ ------ ------ Total 33.6 33.6 45.6 53.6 53.6 ====== ====== ====== ====== ====== Maximum annual entitlement (000 Dt) 5,815 5,815 N/A N/A N/A (a) Total no longer equals sum of components. Currently, Northern Natural requires that the Company hold firm transportation equal to its total peak-day requirements. Firm storage, "unbundled" sales from Northern Natural, and third party gas supply (not shown) are all eligible gas sources to be moved to the Company's city gates via this firm transportation. Contract demand services from Northern Natural in its previous form, has been eliminated. The future cost of natural gas is expected to be market sensitive. The Company's rate schedules applicable to all retail gas customers provide for adjustments of its rates, upon notice by the Company to the PSCW, to reflect all increases or decreases in the cost of gas purchased for resale. Increases or decreases in such costs are reflected automatically by adjustments to customers' bills commencing with meters read following the effective date of any changes in such costs. One of the biggest changes which the Company faces in the post-Order 636 environment is dealing with the heightened emphasis placed upon daily balancing of the economic utilization of the Company's two pipelines. As the natural gas market continues to evolve, The Company continuously evaluates products and services provided by pipelines and gas suppliers to meet the changing needs of its firm and interruptible gas customers. Environmental Matters Manufactured Gas Plant Sites. Historically, the Company has owned 11 properties that have been associated with the production of manufactured gas. Currently, the Company owns five of these sites, three are owned by municipalities, and the remaining three are owned by private companies. In 1989, the Company initiated investigation of these manufactured gas plant sites. The Wisconsin Department of Natural Resources ("DNR") has been involved in reviewing preliminary investigation plans and has received reports regarding these investigations. Based on the results of the Company's preliminary investigations, the Company recorded an estimated liability and corresponding deferred charge of approximately $15 million as of December 31, 1991. In 1992, and into the beginning of 1993, the Company continued its investigations and studies. The Company confirmed that there was no contamination at two of the sites and received a close out letter from the DNR related to one of those sites and requested a close out letter for the other site. Additionally, the investigation of historical records at a third site indicated a minimal likelihood of any significant environmental impacts. In February 1993, the Company completed more current cost estimates for the environmental remediation of the eight remaining sites. The results of this more current analysis indicated that during the next 35 years, the Company will expend approximately $81 million for feasibility studies, data collection, soil remediation activities, groundwater research and groundwater remediation activities, including construction of slurry containment walls and the installation of groundwater pump and treatment facilities. This estimate was based on various assumptions, and is subject to continuous review and revision by management. Based on the cost estimate set forth above, which assumes a 4 percent average inflation over the 35 year period, the Company will spend approximately $4.2 million, $1.5 million, $2.1 million, $4.4 million and $4.2 million in 1994 through 1998, respectively. The cost estimate also contemplates that primarily groundwater pump and treatment activities will take place after 1998 through and including 2027. During this time, the Company estimates that it will incur average annual costs of $2.0 million to complete the planned groundwater remediation activities. With respect to rate recovery of these costs, the PSCW has approved a five year amortization of the unamortized balance of incurred environmental costs deferred to date. Based on the present regulatory record at the PSCW, management believes that future costs of remediating these manufactured gas plant sites will be recovered in rates. ITEM 2.

ITEM 2. PROPERTIES GENERAL The following table gives information with respect to electric generating facilities of the Company (including the Company's portion of those facilities jointly owned). The maximum net hourly peak load on the Company's electric system was 1,971,000 kwh's and occurred on August 26, 1993. At the time of such peak load, 2,310,000 kwh's were produced by generating facilities operated by the Company (including other Company shared jointly owned facilities) and the Company delivered 812,000 kwh's of power and received 473,000 kwh's of power from external sources. During the year ended December 31, 1993, about 86.4 percent of the Company's total kilowatthour requirements was generated by Company-owned and jointly-owned facilities and the remaining 13.6 percent was purchased. Substantially all of the Company's facilities are subject to the lien of its first mortgage bond indenture. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries is a party or to which any of their property is subject. ENVIRONMENTAL MATTERS The information required by Item 3 is included in this Form 10-K as Item 8 - Notes to Consolidated Financial Statements, Note 10c, incorporated herein by reference. RATE MATTERS The information required by Item 3 is included in Item 7 of this Form 10-K within the Management's Discussion and Analysis of Financial Condition and Results of Operations narrative under the caption "Rates and Regulatory Matters." ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Erroll B. Davis, Jr, 49, was elected President and Chief Executive Officer, effective August 1, 1988 and has been a board member since April 1984. He had been Executive Vice President since May 1984, Vice President - Finance and Public Affairs since November 1982 and Vice President - Finance since August 1978. Mr. Davis was elected President of WPL Holdings, Inc. on January 17, 1990 and Chief Executive Officer of WPL Holdings, Inc. effective July 1, 1990. He has served as a director of WPL Holdings, Inc. since March 1988. A. J. (Nino) Amato, 42, was appointed Senior Vice President effective October 3, 1993. He previously served as Vice President - Marketing and Strategic Planning since December 1992, Vice President - Marketing and Communications since January 1989 and Director of Electric Marketing and Customer Service since October 1988. He had been President of Forward Wisconsin, Inc. from 1987 to 1988. Norman E. Boys, 49, was elected Vice President of Power Production effective January 1, 1989. He previously served as the Director of Power Production since October 1987 and Generating Station Manager at the Edgewater Generating Station since August 1984. Thomas L. Consigny, 59, has been Assistant Vice President - Public Affairs since October 1976. Daniel A. Doyle, 35, was appointed controller and treasurer effective October 3, 1993. He previously served as controller since July 1992. Prior to joining the Company, he was Controller of Central Vermont Public Service Corporation since December 1988. During the period 1981 to 1988, he was employed by Arthur Andersen & Co. as an Audit Staff Assistant, Audit Senior and Audit Manager with primary responsibilities of auditing and providing financial consulting services to large publicly held corporations. David E. Ellestad, 53 was appointed Vice President-Electrical Engineering and Operations on August 1, 1992. He previously served as Vice President-Engineering and Operations since 1988; Vice President of Electrical Engineering and Procurement since January 1, 1986; Director of Electrical Engineering & Procurement since May 1985 and Director of Electrical Engineering since November 1979. Thomas L. Hanson, 40, was elected Assistant Treasurer on May 17, 1989. He had been Financial Relations Supervisor in the Treasury Department since October 1987. Thomas J. Handziak, 30, was elected Assistant Controller on September 20, 1993. Prior to joining the Company, he was employed by Arthur Andersen & Co. as an Audit Staff Assistant, Audit Senior and Audit Manager with primary responsibilities of auditing and providing financial consulting services to large publicly held corporations. William D. Harvey, 44, was appointed Senior Vice President effective October 3, 1993. He previously served as Vice President-Natural Gas and General Counsel since August 1992, Vice President-General Counsel since October 1, 1990 and Vice President-Associate General Counsel since July 1986. Prior to joining the Company, he was a member of the law firm of Wheeler, Van Sickle, Anderson, Norman and Harvey. Steve F. Price, 41, was appointed Assistant Corporate Secretary on April 15, 1992. He had been Cash Management Supervisor since December 1987. He was also appointed Assistant Corporate Secretary and Assistant Treasurer of WPL Holdings, Inc. on April 15, 1992. Eliot G. Protsch, 40, was appointed Senior Vice President effective October 3, 1993. He previously served as Vice President-Customer Services and Sales since August 1992, Vice President and General Manager-Energy Services since January 1989 and District Manager, Dane County, since October 1986. Pamela J. Wegner, 46 was elected Vice President-Information Services and Administration on October 13, 1994. Prior to joining the Company, she was the Administrator of the Division of Finance and Program Management in the Wisconsin Department of Administration since 1987. She served as administrator of the Division of Administrative Services in the Wisconsin Department of Revenue from 1983 to 1987. Kim K. Zuhlke, 40 was elected Vice President - Customer Services and Sales effective October 3, 1993. He previously served as Director of Marketing and Sales Services since 1991, Director of Market Research, Planning and Development since February 1990, Director of Customer Services since 1988 and District Manager at Beaver Dam since April 1984. NOTE: All ages are as of December 31, 1993. None of the executive officers listed above is related to any director of the Board or nominee for director of the Company. Executive officers of the Company have no definite terms of office and serve at the pleasure of the Board of Directors. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Effective with the formation of the holding company, all $5 par value common stock of the Company was owned and converted by WPL Holdings, Inc. to $.01 par value common stock of WPL Holdings, Inc. WPL Holdings is now the sole common shareowner of the Company. The Company's dividend payments for administrative allowance and other costs throughout 1993 and 1992 totaled $1,000,000. Regular cash dividends paid per share of common stock during 1993 and 1992 to WPL Holdings, Inc. were 95 cents and 94 cents, respectively for each quarter. ITEMS 6 and 7. SELECTED FINANCIAL DATA AND MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION WISCONSIN POWER AND LIGHT COMPANY Management's Discussion and Analysis of Financial Condition and Results of Operations 1993 COMPARED WITH 1992 OVERVIEW Wisconsin Power and Light Company's (the "Company") 1993 net income increased 9 percent to $60.2 million compared with $55.4 million in 1992. The principle factors leading to increased earnings include warmer summer weather and lower electric fuel costs per kilowatthour ("kWh") which yielded higher electric gross margins for the Company. These increases were somewhat offset by increased depreciation expense resulting from additional investment in utility plant, a change in the mix of gas sales from higher margin sales to lower margin sales, the increase in the Federal corporate tax rate from 34% to 35% and a one-time 4-cent-per- share charge associated with a voluntary separation program for the executive management group. The Company's electric margin, in dollars, increased during 1993 compared with 1992 due to increased demand for electricity brought on by warmer summer weather. Residential customers, being the most weather sensitive, experienced the most significant increases. Wisconsin's strong economy kept the Commercial and Industrial classes growing steadily. These increases were coupled with declining electric production fuel costs per kWh. The decrease in electric production fuels is due to the Company's aggressive pursuit of additional spot coal purchase opportunities as its longer term contracts begin to expire. Additionally, a highly competitive rail transportation environment has significantly reduced the cost of transporting the coal. Also, lower cost purchased power became available due to excess capacity in the bulk power market. The Company's gas revenues for 1992 were affected by the recognition of a $4.9 million, before-tax refund to its natural gas customers resulting from an adjustment in the calculation of the purchased gas adjustment clause. Without the impact of this revenue adjustment, comparative gas margins would have declined for 1993 compared with 1992. The overall increases in gas revenues and purchased gas expense between years resulted primarily from increased volumes procured on behalf of transportation customers. This had the impact of decreasing margins as a percentage of total revenues. A change in the mix of gas sales from higher margin residential sales to lower margin sales also moved margins downward. Offsetting this decline, Wisconsin's strong economy enabled growth in the Commercial and Industrial classes, and there was also some overall increase in the demand for natural gas due to colder weather. Other Operation Expense Other operation expense increased as a result of higher employee benefit expenses (See Notes to Consolidated Financial Statements, Note 8). These increases were offset somewhat by decreases in the Company's conservation program expenditures and decreases in fees associated with the sale of the Company's accounts receivable due to a decline in interest rates. Additionally, the Company's cost management efforts have helped control annual inflationary pressures on general and administrative costs. Maintenance and Depreciation and Amortization Maintenance expense increased for 1993 compared with 1992, primarily due to service restoration expenses related to a severe storm in the summer of 1993. Depreciation and amortization expense increased, principally reflecting increased property additions and the commencement of deferred charge amortizations approved in the Company's last two rate orders received in December 1992 and October 1993. The most significant amortizations include the amortization related to an acquisition adjustment which resulted from the purchase of transmission facilities and the amortization of costs incurred related to the remediation of former manufactured gas plant sites (See Notes to the Consolidated Financial Statements, Note 10). Allowance for Funds Used During Construction ("AFUDC") Total AFUDC increased in 1993 compared with 1992, reflecting the greater amounts of construction work in progress including the costs associated with the Company's construction of two 86-megawatt combustion-turbine generators. 1992 COMPARED WITH 1991 Company Overview The Company's 1992 net income decreased 13 percent to $59.2 million compared with $67.9 million in 1991. A combination of an electric rate decrease in March 1992 and significantly cooler summer weather led to lower electric revenues, gross margins and earnings at the Company. The Company's earnings were also affected by the recognition of a $4.9 million, before-tax refund to natural gas customers noted previously. The Company's electric margin decreased during 1992 compared with 1991 due to decreased demand for electricity brought on by cooler summer weather. Residential customers, being the most weather sensitive, experienced the most significant decreases. However, improved economic conditions in 1992 kept the Industrial customer class growing steadily. Sales to commercial customers remained flat despite the negative weather impact due to increased customer growth in this sector and the improving economy. As a result of significantly lower weather-related peak demands, sales and revenues to other Class A utilities decreased. Electric production fuels expense decreased in response to reduced kWh sales, lower fuel costs and a greater reliance on purchased power. Purchased power expense increased in 1992 due to the greater availability of purchased power at competitive prices. After adjusting 1992 gas revenues for the customer refund noted previously, both gas revenues and gas margins increased during 1992 compared with 1991. Overall increases in gas revenues between years resulted primarily from the recovery of increased purchased gas costs through the purchased gas adjustment clause. Gas margins benefited from an increase in gas customers. The impacts of weather were comparable between years. Other Operation Expense Contributing to the decrease in other operation expense at the Company was a decrease in the Company's conservation program expenditures, a decrease in fees associated with the sale of the Company's accounts receivable due to a decline in interest rates, and reduced employee benefit expenses. Additionally, the Company's cost management efforts have helped control annual inflationary pressures on general and administrative costs. Maintenance and Depreciation and Amortization Expense Maintenance expense increased for 1992 compared with 1991, primarily due to an increased tree trimming program, increased costs associated with scheduled overhauls at generating units and major service restoration expenses related to three tornados which caused extensive damage to the Company's service territory during the summer of 1992. Depreciation expense increased, principally reflecting increased property additions. Allowance for Funds Used During Construction ("AFUDC") and Other, net Total AFUDC increased in 1992 compared with 1991, reflecting the greater amounts of construction work in progress which includes the costs associated with the Company's construction of two 86-megawatt combustion- turbine generators. Interest Expense Interest expense on bonds decreased between years, primarily due to increased debt outstanding to fund construction activity. This increase was somewhat offset by the Company's refinancing activities during 1992. To take advantage of recent low interest rates, the Company issued $279 million principal amount of first mortgage bonds, of which $235 million was used to refinance the aggregate principal amount of existing series. The bonds, which had coupon payments ranging from 8 to 10 percent, were replaced with issues having coupons of 6.125 percent to 8.6 percent. Income Taxes Income taxes decreased between years, primarily due to lower taxable income and an increase in tax credits associated with affordable housing investments in 1992 compared with 1991. LIQUIDITY AND CAPITAL RESOURCES Rates and Regulatory Matters On September 30, 1993, the Company received final decisions from the PSCW on its retail rate application filed in early 1993. The final order authorized an annual retail electric rate increase of $15.6 million, or 3.8 percent; a natural gas rate increase of $1.8 million, or 1.4 percent; and a nominal water rate increase. The new rates became effective October 1, 1993 and will remain effective until January 1, 1995. The regulatory return on common equity for the Company was reduced from 12.4 percent to 11.6 percent. The allowed rates of return authorized by the Company's regulators have decreased due to declines in debt capital costs and equity investor rate of return expectations. On August 6, 1993 the Federal Energy Regulatory Commission ("FERC") approved the Company's request for a $2.1 million, or 2.9 percent increase in wholesale rates. The rates became effective October 1, 1993. Electric and Gas Sales Outlook To deal with competitive pressures arising from regulatory changes, the Company is forecasting to hold retail rates flat through 1996. The National Energy Policy Act contains a provision calling for "open transmission access". The Company anticipates that retail wheeling will become a reality within a few years. In order to meet these new competitive challenges and maintain a low cost pricing advantage, the Company's objective is to manage costs to maintain profitability while limiting any rate changes until 1997. These forecasts are subject to a number of assumptions, including the economy and weather. The Company anticipates that its customer base will remain strong in the electric sectors and that favorable gas prices over alternative fuels prices should result in sales growth in gas sectors. Growth in customers' demand for electric service will require capacity additions. Capacity requirements will be met through increased generating capacity (two combustion-turbines in mid-1994), continuation of existing long-term contracts for purchase of capacity, increased efficiency at existing power plants from capital improvements and continued emphasis on cost effective demand-side management programs such as direct load control rate options including interruptible rates and conservation programs. Financing and Capital Structure The level of short-term borrowings fluctuates based on seasonal corporate needs, the timing of long-term financing and capital market conditions. To maintain flexibility in its capital structure and to take advantage of favorable short-term rates, the Company also uses proceeds from the sales of accounts receivable and unbilled revenues to finance a portion of its long-term cash needs. The Company also anticipates that short-term debt funds will continue to be available at reasonable costs due to strong ratings by independent utility analysts and rating services. Commercial paper has been rated A-1+ by Standard & Poor's Corp. (S&P) and P-1 by Moody's Investors Service (Moody's). Bank lines of credit of $70 million at December 31, 1993 are available to support these borrowings (see "Notes to Consolidated Financial Statements," Note 11). The Company's capitalization at December 31, 1993, including the current maturities of long-term debt, variable rate demand bonds and short-term debt, consisted of 50.5 percent common equity, 5.8 percent preferred stock and 43.7 percent long-term debt. The common equity to total capitalization ratio at December 31, 1993 increased to 50.5 percent from 44.2 percent at December 31, 1992 due to the receipt of $61 million of capital contributions from WPL Holdings, Inc. during 1993. A retail rate order effective October 1, 1993, requires the Company to maintain a utility common equity level of 50.31 percent of total utility capitalization during the test year August 1, 1993 to July 31, 1994. In addition, the PSCW ordered that it must approve the payment of dividends by the Company to WPL Holdings, Inc. that are in excess of the level forecasted in the projected test year ($56.8 million), if such dividends would reduce the Company's average common equity ratio below 50.31 percent. Capital Requirements The Company is capital-intensive and requires large investments in long-lived assets. Therefore, the Company's most significant capital requirements relate to construction expenditures. Estimated capital requirements of the Company for the next five years are as follows: Included in the construction expenditure estimates, in addition to the recurring additions and improvements to the distribution and transmission systems, are the following: expenditures for managing and controlling electric line losses and for the electric delivery system which will save electric line losses and enhance the Company's interconnection capability with other utilities; expenditures related to environmental compliance issues including the installation of additional emissions monitoring equipment and coal handling equipment; and expenditures associated with the construction of two 86-megawatt combustion-turbine generators expected to become operational in 1994 through 1996. In addition, the steam generator tubes at the Kewaunee Nuclear Power Plant ("Kewaunee") are susceptible to corrosion characteristics seen throughout the nuclear industry. Annual inspections are performed to identify degraded tubes. Degraded tubes are either repaired by sleeving or are removed with approximately 15 percent heat transfer margin, meaning that full power should be sustainable with the equivalent of 15 percent of the steam generator tubes plugged. Currently, the equivalent of 10 percent of the tubes in the steam generators are plugged. The Company and the other joint owners continue to evaluate appropriate strategies, including replacement, as well as continued operation of the steam generators without replacement. The Company and the joint owners intend to operate Kewaunee until at least 2013, the expiration of the present operating license. The Company and the joint owners are also evaluating initiatives to improve the performance of Kewaunee. These initiatives include funding of the development of welded repair technology for steam generator tubes and numerous cost reduction measures such as the conversion from a 12-month to an 18-month fuel cycle. If the steam generators are not replaced, and excluding the possible affect of the aforementioned repair strategies, a gradual power reduction of approximately 1 percent per year may begin as soon as 1995. Capital Resources One of the Company's objectives is to finance construction expenditures through internally generated funds supplemented, when required, by outside financing. With this objective in place, the Company has financed an average of 71 percent of its construction expenditures during the last five years from internal sources. However, during the next five years, the Company expects this percentage to be reduced primarily due to the continuation of major construction expenditures and due to the maturity of $64 million of first mortgage bonds. External financing sources such as the issuance of long-term debt and short-term borrowings and equity investments from its parent company, WPL Holdings, Inc., will considered by the Company to finance the remaining construction expenditure requirements for this period. Current forecasts are that $71 million of additional equity and $60 million of long-term debt will be issued over the next three years. The Company's financial condition has enabled it to pay interest charges, preferred stock dividends and common stock dividends out of current earnings. Return on equity for 1993 was 12.4 percent and has averaged 13.6 percent over the last five years. INFLATION Under current ratemaking methodologies prescribed by the various commissions that regulate the Company, projected or forecasted operating costs, including the impacts of inflation, are incorporated into the Company's revenue requirements. Accordingly, the impacts of inflation on the Company are currently mitigated. FINANCIAL ACCOUNTING STANDARDS BOARD (the "FASB") ACCOUNTING STANDARDS ISSUED BUT NOT YET EFFECTIVE In November 1992, the FASB issued Statement of Financial Accounting Standards No.112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 requires adoption of the new accounting and disclosure rules effective January 1, 1994. The impact on earnings will not be material. OTHER EVENTS In November 1989, the PSCW concluded that the Company did not properly administer a coal contract, resulting in an assessment to compensate ratepayers for excess fuel costs having been incurred. As a result, the Company recorded a reserve in 1989 which had an after-tax affect of reducing 1989 net income by $4.9 million. The PSCW decision was found to represent unlawful retroactive ratemaking by both the Dane County Circuit Court and the Wisconsin Court of Appeals. The case was then appealed to the Wisconsin Supreme Court. Subsequent to December 31, 1993, the Wisconsin Supreme Court affirmed the decisions of the Dane County Circuit Court and Wisconsin Court of Appeals. Given the continued uncertainty related to the ultimate method of collection of the assessment from ratepayers to be approved by the PSCW, it is management's opinion that the financial impact of the Wisconsin Supreme Court's decision on the Company cannot currently be determined and will require further evaluation. As a result the Company will not adjust the reserve. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Wisconsin Power and Light Company: We have audited the accompanying consolidated balance sheets and statements of capitalization of WISCONSIN POWER AND LIGHT COMPANY (a Wisconsin corporation and a wholly owned subsidiary of WPL Holdings, Inc.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common shareowner's investment and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Wisconsin Power and Light Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Milwaukee, Wisconsin, ARTHUR ANDERSEN & CO. January 28, 1994. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. WISCONSIN POWER AND LIGHT COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES: a. Business and Consolidation: The consolidated financial statements include Wisconsin Power and Light Company (the "Company") and its wholly owned consolidated subsidiaries, the principal of which is South Beloit Water, Gas and Electric Company. All significant intercompany transactions have been eliminated in consolidation. Certain amounts from prior years have been reclassified to conform with the current year presentation. The Company is a public utility predominantly engaged in the transmission and distribution of electric energy and the generation and bulk purchase of electric energy for sale. The Company also transports, distributes and sells natural gas purchased from gas suppliers. Nearly all of the Company's customers are located in south and central Wisconsin. b. Regulation: The Company's financial records are maintained in accordance with the uniform system of accounts prescribed by its regulators. The Public Service Commission of Wisconsin ("PSCW") and the Illinois Commerce Commission have jurisdiction over retail rates, which represent approximately 86 percent of electric revenues plus all gas revenues. The Federal Energy Regulatory Commission ("FERC") has jurisdiction over wholesale electric rates representing the balance of electric revenues. Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" provides that rate-regulated public utilities such as the Company record certain costs and credits allowed in the ratemaking process in different periods than for the unregulated entities. These are deferred as regulatory assets or regulatory liabilities and are recognized in the Consolidated Statements of Income at the time they are reflected in rates. c. Utility Plant: Utility plant is recorded at original cost. Utility plant costs include financing costs which are capitalized through the PSCW- approved allowance for funds used during construction ("AFUDC"). The AFUDC capitalization rates approximate the Company's cost of capital. These capitalized costs are recovered in rates as the cost of the utility plant is depreciated. Normal repairs and maintenance and minor items of utility plant and other property and equipment are expensed. Ordinary utility plant retirements, including removal costs less salvage value, are charged to accumulated depreciation upon removal from utility plant accounts, and no gain or loss is recognized. Upon retirement or sale of other property and equipment, the cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in other income and deductions. d. Nuclear Fuel: Nuclear fuel is recorded at its original cost and is amortized to expense based upon the quantity of heat produced for the generation of electricity. This accumulated amortization assumes spent nuclear fuel will have no residual value. Estimated future disposal costs of such fuel are expensed based on kilowatthours ("Kwh") generated. e. Revenue: The Company accrues utility revenues for services provided but not yet billed. f. Fuel and Purchased Gas: An automatic fuel adjustment clause for the FERC wholesale portion of the Company's electric business operates to increase or decrease monthly rates based on changes in fuel costs. The PSCW retail electric rates provide a range from which actual fuel costs may vary in relation to costs forecasted and used in rates. If actual fuel costs fall outside this range, a hearing may be held to determine if a rate change is necessary, and a rate increase or decrease can result. The Company's base gas cost recovery rates permit the recovery of or refund to all customers for any increases or decreases in the cost of gas purchased from the Company's suppliers through a monthly purchased gas adjustment clause. g. Cash and Equivalents: The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The carrying amount approximates fair value because of the short maturity of these items. h. Income Taxes: The Company is included in the consolidated federal income tax return of its parent, WPL Holdings, Inc. ("WPLH"), and calculates its federal tax provision and makes tax payments to WPLH as if the Company were a separate taxable entity. Beginning in 1993, the Company fully provides deferred income taxes in accordance with Statement of Financial Accounting Standards No.109, "Accounting for Income Taxes" ("SFAS 109"), to reflect tax effects of reporting book and tax items in different periods. NOTE 2. DEPRECIATION: The Company uses the straight-line method of depreciation. For utility plant, straight-line depreciation is computed on the average balance of depreciable property at individual straight-line PSCW approved rates as follows: Electric Gas Water Common -------- --- ----- ------ 1993 3.6% 3.7% 2.5% 7.3% 1992 3.4 3.7 2.6 7.1 1991 3.4 3.7 2.6 6.9 NOTE 3. NUCLEAR OPERATIONS: Depreciation expense related to the jointly-owned Kewaunee Nuclear Power Plant includes a provision for the decommissioning of the plant which totaled $6.1 million, $3.9 million and $4.1 million in 1993, 1992 and 1991, respectively. Wisconsin utilities with ownership of nuclear generating plants are required by the PSCW to establish external trust funds to provide for plant decommissioning. The market value of the investments in the funds established by the Company at December 31, 1993 and 1992, totaled $45.1 million and $42.8 million, respectively. The Company's share of the decommissioning costs is estimated to be $149 million (in 1993 dollars, assuming the plant is operating through 2013) based on a 1992 study, using the immediate dismantlement method of decommissioning. Under the Nuclear Waste Policy Act of 1982, the U.S. Department of Energy ("DOE") is responsible for the ultimate storage and disposal of spent nuclear fuel removed from nuclear reactors. Interim storage space for spent nuclear fuel is currently provided at the Kewaunee Nuclear Power Plant. Currently there is on-site storage capacity for spent fuel through the year 1999. Nuclear fuel, net, at December 31, 1993 and 1992 consists of (In Thousands of Dollars): 1993 1992 ---- ---- Original cost of nuclear fuel $147,325 $140,652 Less--Accumulated amortization 129,325 123,729 -------- -------- Nuclear fuel, net $ 18,000 $ 16,923 ======== ======== The Price Anderson Act provides for the payment of funds for public liability claims arising from a nuclear incident. Accordingly, in the event of a nuclear incident, the Company, as a 41 percent owner of the Kewaunee Nuclear Power Plant, is subject to an overall assessment of approximately $32.5 million per incident for its ownership share of this reactor, not to exceed $4.1 million payable in any given year. Through its membership in Nuclear Electric Insurance Limited, the Company has obtained property damage and decontamination insurance totaling $1.4 billion for loss from damage at the Kewaunee Nuclear Power Plant. In addition, the Company maintains outage and replacement power insurance coverage totalling $99 million in the event an outage exceeds 21 weeks. NOTE 4. PROPERTY: a. Jointly Owned Utility Plants: The Company participates with other Wisconsin utilities in the construction and operation of several jointly owned utility generating plants. The chart below represents the Company's proportionate share of such plants as reflected in the Consolidated Balance Sheets at December 31, 1993 and 1992 (In Thousands of Dollars): Each of the respective joint owners finances its portion of construction costs. The Company's share of operations and maintenance expenses is included in the Consolidated Statements of Income. b. Capital Expenditures: The Company's capital expenditures for 1994 are estimated to total $142.6 million. Substantial commitments have been incurred for such expenditures. NOTE 5. NET ACCOUNTS RECEIVABLE: The Company has a contract with a financial organization to sell, with limited recourse, certain accounts receivable. These receivables include customer receivables resulting from sales to other public utilities as well as from billings to the co-owners of the jointly owned electric generating plants that the Company operates. The contract allows the Company to sell up to $100 million of receivables at any time. Consideration paid to the financial organization under this contract includes, along with various other fees, a monthly discount charge on the outstanding balance of receivables sold that approximated a 4.14 percent annual rate during 1993. These costs are recovered in retail utility rates as an operating expense. All billing and collection functions remain the responsibility of the Company. The contract expires August 19, 1995, unless extended by mutual agreement. As of December 31, 1993 and 1992, proceeds from the sale of accounts receivable totaled $74 million and $69 million, respectively. During 1993, the Company sold an average of $75.9 million of accounts receivable per month, compared with $68.8 million in 1992. As a result of its diversified customer base and the Company's sale of receivables, the Company does not have any significant concentrations of credit risk in the December 31, 1993 net accounts receivable balance. NOTE 6. DEFERRED CHARGES AND OTHER: Certain costs are deferred and amortized in accordance with authorized or expected rate-making treatment. As of December 31, 1993 and 1992, deferred charges and other include regulatory created assets and other noncurrent items representing the following (In Thousands of Dollars): 1993 1992 ---- ---- Unamortized debt redemption expense $13,178 $15,384 Decontamination and decommissioning costs of Federal enrichment facilities 6,181 6,150 Prepaid pension costs 26,128 21,226 Conservation loans to the Companys' customers (at cost which approximates market) 12,236 12,257 Tax related (see Note 7) 28,608 - Emission allowance credits receivable 5,335 5,335 Other 35,919 20,024 -------- ------- $127,585 $80,376 ======== ======= NOTE 7. INCOME TAXES: The following table reconciles the statutory Federal income tax rate to the effective income tax rate: 1993 1992 1991 ---- ---- ---- Statutory Federal income tax rate 35.0% 34.0% 34.0% State income taxes, net of federal benefit 6.1 6.0 4.7 Investment tax credits restored (2.0) (2.4) (2.1) Amortization of excess deferred taxes (1.5) (1.6) (1.5) Other differences, net (1.9) (2.0) (2.3) ---- ---- ---- Effective income tax rate 35.7% 34.0% 32.8% ==== ==== ==== Items which resulted in deferred income tax expense are as follows (In Thousands of Dollars): 1991 1992 ---- ---- Utility plant timing differences $4,104 $4,317 Qualified nuclear decommissioning trust contribution 709 709 Employee benefits 2,081 2,105 Other, net (755) (3,292) ------ ------ $6,139 $3,839 ====== ====== The temporary differences that resulted in accumulated deferred income tax assets and liabilities as of December 31, 1993 are as follows (In Thousands of Dollars): Deferred Tax (Assets) Liabilities ------------ Accelerated depreciation and other plant related $171,993 Excess deferred taxes 22,744 Unamortized investment tax credits (22,812) Allowance for equity funds used during construction 13,518 Regulatory liability 19,179 Other 6,140 -------- $210,762 ======== Changes in the Company's deferred income taxes arising from the adoption of SFAS 109 represent amounts recoverable or refundable through future rates and have been recorded as net regulatory assets totalling approximately $29 million on the Consolidated Balance Sheets. These net regulatory assets are being recovered in rates over the estimated remaining useful lives of the assets to which they pertain. NOTE 8. EMPLOYEE BENEFIT PLANS: a. Pension Plans: The Company has noncontributory, defined benefit retirement plans covering substantially all employees. The benefits are based upon years of service and levels of compensation. The Company's funding policy is to contribute at least the statutory minimum to a trust. The projected unit credit actuarial cost method was used to compute net pension costs and the accumulated and projected benefit obligations. The discount rate used in determining those benefit obligations was 7.25 percent for 1993, and 8 percent for 1992 and 1991. The long-term rate of return on assets used in determining those benefit obligations was 9.75 percent for 1993 and 10 percent for 1992 and 1991. The following table sets forth the funded status of the Companys' plans and amounts recognized in the Consolidated Balance Sheets at December 31, 1993 and 1992 (In Thousands of Dollars): 1993 1992 ---- ---- Accumulated benefit obligation-- Vested benefits $(135,303) $(119,883) Nonvested benefits (2,962) (869) --------- --------- $(138,265) $(120,752) ========= ========= Projected benefit obligation $(164,271) $(144,760) Plan assets at fair value, primarily common stocks and fixed income securities 183,881 164,771 --------- --------- Plan assets in excess of projected benefit obligation 19,610 20,011 Unrecognized net transition asset (21,823) (24,270) Unrecognized prior service cost 7,691 9,510 Unrecognized net loss 20,650 15,975 --------- --------- Prepaid pension costs, included in deferred charges and other $ 26,128 $ 21,226 ========= ========= The net pension (benefit) recognized in the Consolidated Statements of Income for 1993, 1992 and 1991 included the following components (In Thousands of Dollars): 1993 1992 1991 ---- ---- ---- Service cost $ 4,263 $ 3,912 $ 3,167 Interest cost on projected benefit obligation 11,614 10,615 9,469 Actual return on assets (24,759) (12,143) (30,035) Amortization and deferral 8,430 (5,317) 14,603 -------- -------- -------- Net pension (benefit) $ (452) $ (2,933) $ (2,796) ======== ======== ======== b. Postretirement Health-care and Life Insurance: Effective January 1, 1993, the Company prospectively adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"). SFAS 106 establishes standards of financial accounting and reporting for the Company's postretirement health-care and life insurance benefits. SFAS 106 requires the accrual of the expected cost of such benefits during the employees' years of service based on actuarial methodologies that closely parallel pension accounting requirements. The Company has elected delayed recognition of the transition obligation and is amortizing the discounted present value of the transition obligation to expense over 20 years. The cost of providing postretirement benefits, including the transition obligation, is being recovered in retail rates and wholesale rates under current regulatory practices. For 1993, the annual net postretirement benefits costs recognized in the Consolidated Statements of Income consist of the following components (In Thousands of Dollars): Service cost $ 1,463 Interest cost on projected benefit obligation 3,151 Actual return on plan assets (696) Amortization of transition obligation 1,560 Amortization and deferral (27) ------- Net postretirement benefits cost $ 5,451 ======= The following table sets forth the plans' funded status recognized in the Consolidated Balance Sheets (In Thousands of Dollars): ---- Accumulated postretirement benefit obligation-- Retirees $ (27,358) Fully eligible active plan participants (5,429) Other active plan participants (9,980) --------- Accumulated benefit obligation (42,767) Plan assets at fair value 7,073 --------- Accumulated benefit obligation in excess of plan assets (35,694) Unrecognized transition obligation 29,638 Unrecognized loss 2,025 --------- Accrued postretirement benefit liability $ (4,031) ========= The postretirement benefits cost components for 1993 were calculated assuming health care cost trend rates ranging from 12.5 percent for 1993 and decreasing to 5 percent by the year 2002. The health care cost trend rate considers estimates of health care inflation, changes in utilization or delivery, technological advances, and changes in the health status of the plan participants. Increasing the health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $2.54 million and the aggregate of the service and interest cost components of postretirement expense by $.4 million. The assumed discount rate used in determining the accumulated postretirement obligation was 7.25 percent. The long-term rate of return on assets was 9.50 percent. Plan assets are primarily invested in common stock, bonds and fixed income securities. The Company's funding policy is to contribute the tax advantaged maximum to a trust. The costs for the postretirement health-care and life insurance benefits, based on an actuarial determination, were $1,335,000 and $1,078,000, respectively, for 1992 and 1991. c. Other Postemployment Benefits: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 establishes standards of financial accounting and reporting for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. The effect of adopting SFAS 112, which must be adopted January 1, 1994, will not be material. NOTE 9. CAPITALIZATION: a. Common Shareowner's Investment: A retail rate order effective October 1, 1993, requires the Company to maintain a utility common equity level of 50.31 percent of total utility capitalization during the projected test year August 1, 1993 to July 31, 1994. In addition, the PSCW ordered that it must approve the payment of dividends by the Company that are in excess of the level forecasted in the projected test year ($56.8 million), if such dividends would reduce the Company's average common equity ratio below 50.31 percent. b. Preferred Stock: On October 27, 1993, the Company issued two new series of preferred stock through two separate public offerings. The 6.2 percent Series is non-redeemable for ten years and the 6.5 percent Series is non- redeemable for five years. The proceeds from the sale were used to retire 150,000 shares of 7.56 percent Series and 149,865 shares of 8.48 percent Series preferred stock. c. First Mortgage Bonds: During 1992, the Company issued $279 million of first mortgage bonds, of which $235 million was used to refinance the principal amount of existing series in order to take advantage of lower interest rates. The remaining proceeds were used for the payment of short-term debt and general corporate purposes. Substanitially all of the Company's utility plant is secured by its first mortgage bonds. Current maturities on first mortgage bond issues outstanding are as follows: none in 1994 through 1996, $55 million in 1997 and $8.9 million in 1998. The fair value of the Company's first mortgage bonds is estimated at $428,841,000 and $406,281,000 as of December 31, 1993 and 1992, respectively, and is based on the quoted market prices for similar issues or on the current rates offered to the Company for similar debt. NOTE 10. COMMITMENTS AND CONTINGENCIES: a. Coal Contract Commitments: To ensure an adequate supply of coal, the Company has entered into certain long-term coal contracts. These contracts include a demand or take-or-pay clause under which payments are required if contracted quantities are not purchased. Purchase obligations on these coal and related rail contracts total approximately $263 million through December 31, 2004. The Company's management believes it will meet minimum coal and rail purchase obligations under the contracts or recover in rates any demand or take-or-pay costs if minimum purchase obligations are not met. Minimum purchase obligations on these contracts over the next five years are estimated to be $67 million in 1994 and $27 million in 1995, 1996, 1997 and 1998, respectively. b. Purchased Power: Under firm purchase power contracts, the Company is obligated to pay $11 million, $8 million, $5 million, $7 million and $14 million in 1994, 1995, 1996, 1997 and 1998, respectively. For 1994, this represents 2,515 megawatts of capacity. Purchase obligations on these purchase power contracts total approximately $169 million through December 31, 2007. c. Manufactured Gas Plant Sites: Historically, the Company has owned 11 properties that have been associated with the production of manufactured gas. Currently, the Company owns five of these sites, three are owned by municipalities, and the remaining three are owned by private companies. In 1989, the Company initiated investigation of these manufactured gas plant sites. The Wisconsin Department of Natural Resources ("DNR") has been involved in reviewing preliminary investigation plans and has received reports regarding these investigations. Based on the results of the Company's preliminary investigations, the Company recorded an estimated liability and corresponding deferred charge of approximately $15 million as of December 31, 1991. In 1992, and into the beginning of 1993, the Company continued its investigations and studies. The Company confirmed that there was no contamination at two of the sites and received a close out letter from the DNR related to one of those sites and requested a close out letter for the other site. Additionally, the investigation of historical records at a third site indicated a minimal likelihood of any significant environmental impacts. In February 1993, the Company completed more current cost estimates for the environmental remediation of the eight remaining sites. The results of this more current analysis indicated that during the next 35 years, the Company will expend approximately $81 million for feasibility studies, data collection, soil remediation activities, groundwater research and groundwater remediation activities, including construction of slurry containment walls and the installation of groundwater pump and treatment facilities. This estimate was based on various assumptions, and is subject to continuous review and revision by management. Based on the cost estimate set forth above, which assumes a 4 percent average inflation over the 35 year period, the Company will spend approximately $4.2 million, $1.5 million, $2.1 million, $4.4 million and $4.2 million in 1994 through 1998, respectively. The cost estimate also contemplates that primarily groundwater pump and treatment activities will take place after 1998 through and including 2027. During this time, the Company estimates that it will incur average annual costs of $2.0 million to complete the planned groundwater remediation activities. With respect to rate recovery of these costs, the PSCW has approved a five year amortization of the unamortized balance of incurred environmental costs deferred to date. Based on the present regulatory record at the PSCW, management believes that future costs of remediating these manufactured gas plant sites will be recovered in rates. d. FERC Order No. 636: In 1992 the FERC issued Order No. 636 and 636-A which requires interstate pipelines to restructure their services. Under these orders, existing pipeline sales service would be "unbundled" such that gas supplies would be sold separately from interstate transportation services (pipelines serving the Company implemented new services November 1, 1993). Pipelines will, however, seek to recover from their customers certain transition costs associated with restructuring. Any such recovery would be subject to prudence hearings at the FERC and state regulatory commissions. NOTE 11. SHORT-TERM DEBT AND LINES OF CREDIT: The Company maintains bank lines of credit, most of which are at the bank prime rates, to obtain short-term borrowing flexibility, including pledging lines of credit as security for any commercial paper outstanding. The carrying amount approximates fair value because of the short maturity of these items. Amounts available under these lines of credit totaled $70 million at December 31, 1993 and 1992 and $52.5 million at December 31, 1991. Information regarding short-term debt and lines of credit is as follows (In Thousands of Dollars): NOTE 12. SEGMENT INFORMATION: The following table sets forth certain information relating to the Company's consolidated operations (In Thousands of Dollars). NOTE 13. CONSOLIDATED QUARTERLY FINANCIAL DATA (Unaudited): Seasonal factors significantly affect the Company and, therefore, the data presented below should not be expected to be comparable between quarters nor necessarily indicative of the results to be expected for an annual period. The amounts below were not audited by independent public accountants, but reflect all adjustments necessary, in the opinion of the Company, for a fair presentation of the data (In Thousands of Dollars). Operating Net Operating Quarter Ended Revenues Income Net Income ------------- --------- ------------- ---------- 1993: March 31 $182,023 $26,405 $17,740 June 30 141,049 16,936 8,237 September 30 144,440 21,045 13,096 December 31 177,986 31,091 21,104 1992: March 31 $169,015 $26,415 $18,001 June 30 129,038 14,731 6,445 September 30 137,530 19,359 11,917 December 31 165,236 27,730 19,045 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 relating to directors and nominees for election as directors at the Company's 1994 Annual Meeting of Shareowners is incorporated herein by reference to the information under the caption "Election of Directors" in the Company's Proxy Statement (the "1994 Proxy Statement") filed with the Securities and Exchange Commission. The information required by Item 10 relating to executive officers is set forth in Part I of this Annual Report on Form 10-K. The information required by Item 10 relating to delinquent filers is incorporated herein by reference to the information under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the 1994 Proxy Statement. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to the information under the caption "Compensation of Executive Officers" in the 1994 Proxy Statement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to the information under the caption "Ownership of Voting Securities" in the 1994 Proxy Statement. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated herein by reference to the information under the caption "Election of Directors" in the 1994 Proxy Statement. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Consolidated Financial Statements Included in Part II of this report: Report of Independent Public Accountants on Schedules Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization, December 31, 1993 and Consolidated Statements of Common Shareowner's Investment Notes to Consolidated Financial Statements (a) (2) Financial Statement Schedules For each of the years ended December 31, 1993, 1992 and 1991 Schedule V. Property Plant and Equipment Schedule VI. Accumulated Provision for Depreciation and Accumulated Amortization of Nuclear Fuel Schedule VIII. Valuation and Qualifying Accounts and Reserves Schedule X. Supplementary Income Statement Information All other schedules are omitted because they are not applicable or not required, or because that required information is shown either in the consolidated financial statements or in the notes thereto. (a)(3) Exhibits Required by Securities and Exchange Commission Regulation S-K The following Exhibits are filed herewith or incorporated herein by reference. Documents indicated by an asterisk (*) are incorporated herein by reference. 3A* Restated Articles of Organization, as amended, of the Company (including the Articles of Amendment to the Company's Restated Articles of Organization creating the New Preferred Stock) (Exhibit 4.1 to the Company's Form 8-K/A, Amendment No.1 to Current Report, dated October 20, 1993) 3B* By-Laws of the Company as revised to January 1, 1993 4A* Indenture of Mortgage or Deed of Trust dated August 1, 1941, between the Company and First Wisconsin Trust Company and George B. Luhman, as Trustees, filed as Exhibit 7(a) in File No. 2-6409, and the indentures supplemental thereto dated, respectively, January 1, 1948, September 1, 1948, June 1, 1950, April 1, 1951, April 1, 1952, September 1, 1953, October 1, 1954, March 1, 1959, May 1, 1962, August 1, 1968, June 1, 1969, October 1, 1970, July 1, 1971, April 1, 1974, December 1, 1975, May 1, 1976, May 15, 1978, August 1, 1980, January 15, 1981, August 1, 1984, January 15, 1986, June 1, 1986, August 1, 1988, December 1, 1990, September 1, 1991, October 1, 1991, March 1, 1992, May 1, 1992, June 1, 1992 and July 1, 1992 (Second Amended Exhibit 7(b) in File No. 2-7361; Amended Exhibit 7(c) in File No. 2-7628; Amended Exhibit 7.02 in File No. 2-8462; Amended Exhibit 7.02 in File No. 2-8882; Second Amendment Exhibit 4.03 in File No. 2-9526; Amended Exhibit 4.03 in File No. 2-10406; Amended Exhibit 2.02 in File No. 2-11130; Amended Exhibit 2.02 in File No. 2-14816; Amended Exhibit 2.02 in File No. 2-20372; Amended Exhibit 2.02 in File No. 2-29738; Amended Exhibit 2.02 in File No. 2-32947; Amended Exhibit 2.02 in File No. 2-38304; Amended Exhibit 2.02 in File No. 2-40802; Amended Exhibit 2.02 in File No. 2-50308; Exhibit 2.01(a) in File No. 2-57775; Amended Exhibit 2.02 in File No. 2-56036; Amended Exhibit 2.02 in File No. 2-61439; Exhibit 4.02 in File No. 2-70534; Amended Exhibit 4.03 File No. 2-70534; Exhibit 4.02 in File No. 33-2579; Amended Exhibit 4.03 in File No. 33-2579; Amended Exhibit 4.02 in File No. 33-4961; Exhibit 4B to the Company's Form 10-K for the year ended December 31, 1988, Exhibit 4.1 to the Company's Form 8-K dated December 10, 1990, Amended Exhibit 4.26 in File No. 33-45726, Amended Exhibit 4.27 in File No.33-45726, Exhibit 4.1 to the Company's Form 8-K dated March 9, 1992, Exhibit 4.1 to the Company's Form 8-K dated May 12, 1992, Exhibit 4.1 to the Company's Form 8-K dated June 29, 1992 and Exhibit 4.1 to the Company's Form 8-K dated July 20, 1992) 10A*# Executive Tenure Compensation Plan as revised November 1992 10B*# Form of Supplemental Retirement Plan, as revised November 1992 10C*# Forms of Deferred Compensation Plans, as amended June, 1990 (Exhibit 10C to the Company's Form 10-K for the year ended December 31, 1990) 10C.1*# Officer's Deferred Compensation Plan II, as adopted September 1992 10C.2*# Officer's Deferred Compensation Plan III, as adopted January 1993 10F*# Pre-Retirement Survivor's Income Supplemental Plan, as revised November 1992 10H*# Management Incentive Plan 10I*# Deferred Compensation Plan for Directors, as adopted June 27, 12 Computation of ratio of earnings to fixed charges and preferred dividend requirements after taxes 21 Subsidiaries of the Company 99 1994 Proxy Statement for the Annual Meeting of Shareowners to be held May 18, 1994 Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the Company hereby agrees to furnish to the Securities and Exchange Commission, upon request, any instrument defining the rights of holders of unregistered long-term debt not filed as an exhibit to this Form 10-K. No such instrument authorizes securities in excess of 10 percent of the total assets of the Company. # - A management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. 1. The Company filed a report on Form 8-K dated October 20, 1994, which reported, under "Item 5. Other Events", the agreement to sell: (i) 150,000 shares of its 6.2% Preferred Stock, with a stated value of $100, in a public offering through Goldman, Sachs & Co.; and (ii) 599,460 shares of its 6.5% Preferred Stock, with a stated value of $25 in a public offering through Robert W. Baird & Co. Incorporated. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 23rd day of February 1994. WISCONSIN POWER AND LIGHT COMPANY By: /s/ Erroll B. Davis, Jr. Erroll B. Davis, Jr. President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 23rd day of February 1994. /s/ Erroll B. Davis, Jr. President, Chief Executive Officer Erroll B. Davis, Jr. and Director (principal executive officer) /s/ Daniel A. Doyle Controller and Treasurer Daniel A. Doyle (principal financial and accounting officer) /s/ L. David Carley Director /s/ Milton E. Neshek Director L. David Carley Milton E. Neshek /s/ Rockne G. Flowers Director /s/ Henry C. Prange Director Rockne G. Flowers Henry C. Prange /s/ Donald R. Haldeman Director /s/ Henry F. Scheig Director Donald R. Haldeman Henry F. Scheig /s/ Katharine C. Lyall Director /s/ Carol T. Toussaint Director Katharine C. Lyall Carol T. Toussaint /s/ Arnold M. Nemirow Director Arnold M. Nemirow REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To Wisconsin Power and Light Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Wisconsin Power and Light Company's annual report to shareowners incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. Supplemental Schedules V, VI, VIII and X are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Milwaukee, Wisconsin, ARTHUR ANDERSEN & CO. January 28, 1994. INDEX TO SCHEDULES WISCONSIN POWER AND LIGHT COMPANY INDEX TO FINANCIAL STATEMENT SCHEDULES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 FINANCIAL STATEMENT SCHEDULES: V. Property Plant and Equipment VI. Accumulated Provision for Depreciation and Accumulated Amortization of Nuclear Fuel VIII. Valuation and Qualifying Accounts and Reserves X. Supplementary Income Statement Information NOTE: All other schedules are omitted because they are not applicable or not required, or because that required information is shown either in the financial statements or in the notes thereto. SCHEDULE X WISCONSIN POWER AND LIGHT COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993 1992 1991 Real estate and personal property. $16,316 $16,685 $15,488 Payroll............. 8,680 8,440 7,733 Other............... 1,149 1,045 1,160 ------- ------ ------ $26,145 $26,170 $24,381 ======= ======= ======= The amounts of maintenance and repairs, depreciation and taxes charged to other expense accounts are not significant. The amounts charged to the respective accounts for advertising aggregated less than one percent of total consolidated revenues, and no royalty expenses were incurred. WISCONSIN POWER AND LIGHT COMPANY Exhibit Index for the Year Ended December 31, 1993 Item Description 12 Computation of ratio of earnings to fixed charges and preferred dividend requirements after taxes 21 Subsidiaries of the Company 99 1994 Proxy Statement for the Annual Meeting of Shareowners to be held May 18, 1994 (To be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of the Company's fiscal year)

714655_1993.txt

714655

1993

Item 1. Business Biogen, Inc. ("Biogen" or the "Company") is a biopharmaceutical company principally engaged in the business of developing and manufacturing drugs for human health care through genetic engineering. Biogen currently derives revenues from five products sold by licensees around the world. During 1993, Biogen's licensees generated total sales of approximately $1.5 billion from these products. In the future, Biogen expects to derive additional revenues from sales of proprietary products which Biogen will market. One of Biogen's two leading product candidates, its Hirulog(TM) thrombin inhibitor, is in Phase III clinical trials for two indications and in Phase II trials for certain other indications. Hirulog(TM) is a rationally designed antithrombotic being tested for use in the treatment of a number of arterial cardiovascular conditions. Biogen's other leading product candidate, recombinant beta interferon, is in Phase III clinical trials for one indication and in Phase II clinical trials for certain other indications. Recombinant beta interferon is a protein being tested for use as a therapy for multiple sclerosis and certain viruses and cancers. Biogen focuses its research and development efforts on areas where it has particular scientific and competitive strengths: cardiovascular disease, inflammatory diseases, AIDS and certain cancers and viruses. Biogen is conducting preclinical tests on three anti-inflammatory product candidates from its T-cell activation, T-cell/B-cell interaction and cell adhesion programs. These product candidates are being tested for therapeutic uses in a broad range of acute and chronic inflammatory and autoimmune diseases. Biogen is also conducting preclinical tests on an antimucolytic agent for treatment in cystic fibrosis and several other pulmonary diseases. In addition, Biogen has earlier-stage research programs directed toward new immune system modulators, antithrombotic agents, virus inhibitors and drug delivery agents. Biogen Proprietary Products and Major Research Programs Biogen's research is focused on biological systems and processes where its scientific expertise in molecular biology, cell biology, immunology and protein chemistry can lead to a greater understanding of disease processes and, as a result, to the creation of new pharmaceuticals. Biogen selects product candidates from its research programs to test in clinical trials, focusing its efforts on those agents with the greatest potential competitive advantages and large commercial markets. Described below are Biogen's proprietary products in clinical trials and its major research programs. Products in Clinical Trials Hirulog(TM) Thrombin Inhibitor Hirulog(TM) is a rationally designed antithrombotic which directly inhibits thrombin, a central component in the cascade that leads to clot formation in arteries and veins. Biogen believes that Hirulog(TM) may have broad therapeutic applications and is focusing its initial clinical efforts on the use of Hirulog(TM) during coronary balloon angioplasty, for the treatment of unstable angina and as an adjunctive with thrombolytic agents for treating myocardial infarction (heart attack). Each of these indications often requires expensive and invasive surgical procedures, and Biogen believes there is a significant need for better treatments which is not met by currently available medications. To date, Hirulog(TM) has been administered to more than 2,500 patients in Phase I, Phase II and Phase III clinical trials conducted in North America and Europe. The results of Phase I and Phase II clinical trials to date have shown that Hirulog(TM) is well tolerated and has a dose-related antithrombotic effect in humans. A clinical trial of Hirulog(TM) in the treatment of unstable angina conducted by the Thrombolysis in Myocardial Infarction (TIMI) group at the Brigham and Women's Hospital has been completed. A second, larger Phase III clinical trial of Hirulog(TM) in unstable angina recently began. A Phase III clinical trial of Hirulog(TM) in angioplasty and additional Phase II trials are ongoing. Biogen presently expects the Phase III trials of Hirulog(TM)in angioplasty to be completed in 1994. Because of the mechanism of action and results of in vitro, in vivo and clinical testing of Hirulog(TM), Biogen believes Hirulog(TM) has the potential for use in many situations where an anticoagulant is needed. Hirulog(TM) is the product of Biogen research which began on hirudin, the anticoagulant protein found in the saliva of the medicinal leech. Based on their knowledge of the structure and function of hirudin and thrombin, Biogen's scientists designed a smaller molecule which may have different therapeutic effects from those of hirudin. Hirulog(TM) is a chemically synthesized, twenty amino acid peptide. Biogen has contracted with a major chemical company to provide Biogen with the quantities of Hirulog(TM) necessary to meet its anticipated needs for clinical trials and commercial sale. Biogen is developing Hirulog(TM) as a proprietary therapeutic product which it intends to market itself, assuming the successful completion of clinical studies and receipt of applicable regulatory approvals. In 1991, Biogen licensed to Commonwealth Serum Laboratories Limited, Australia's largest domestic pharmaceutical company, the rights to market Hirulog(TM) as a therapeutic in Australia and New Zealand. Recombinant Beta Interferon Natural beta interferon is a protein produced by fibroblast cells in response to viral infection. Biogen is investigating recombinant beta interferon for use as an antiviral and anticancer agent and for the treatment of multiple sclerosis. Dosing in a Phase III clinical trial in the United States of recombinant beta interferon for the treatment of multiple sclerosis, sponsored by the National Institutes of Health, ended in February 1994. The Company is currently collecting and analyzing data and information from the trial. Biogen is also conducting and sponsoring clinical investigations for the use of recombinant beta interferon in treating hepatitis B, hepatitis C, and other diseases. Phase II clinical trials of beta interferon are ongoing in Europe and the United States for several indications. Compared to natural beta interferon, beta interferon produced through recombinant technology is believed to be a purer and more consistent product, and can be produced in recombinant form in large quantities. Biogen's recombinant beta interferon is produced in mammalian cells. Biogen believes that recombinant beta interferon has greater activity in vivo than natural beta interferon. In addition, Biogen believes that recombinant beta interferon can be administered by routes, such as subcutaneous and intramuscular, which are limited for natural beta interferon. Biogen is developing recombinant beta interferon as a proprietary product and, assuming the successful completion of clinical studies and receipt of applicable regulatory approvals, intends to market the drug in North America and Europe. In 1993, Bioferon Biochemische Substanzen GmbH & Co. ("Bioferon"), a pharmaceutical company owned jointly by Biogen and Dr. Rentschler Arzneimittal GmbH & Co. ("Rentschler"), was liquidated and its assets sold to Rentschler. As a result, Biogen's agreements with Bioferon and Asta Pharma AG relating to beta interferon and the participation of Bioferon and Asta in the development of Biogen's recombinant beta interferon have terminated. Major Research Programs Inflammation Program Biogen scientists have been working to understand the activities of white blood cells involved in the inflammation process. Biogen has focused on two events central to inflammation: (1) the activation of T-cells, specialized white blood cells which initiate and control the immune response; and (2) the adhesion of white blood cells to the endothelium (blood vessel walls) and their migration through the endothelium into surrounding tissues where they cause inflammation. Activation and adhesion of white blood cells depend upon the binding of pairs of receptor molecules which appear on the surface of white blood cells and endothelial cells. When these pairs of receptors bind together their interactions create cellular "pathways" for activation and adhesion events. Biogen has investigated several of these cellular pathways and identified new receptors in certain of these pathways. Based on its research, Biogen has selected three cellular pathways as the best points of therapeutic intervention to prevent inflammation: (1) the LFA-3/CD2 pathway, which activates T-cells, (2) the VCAM-1/VLA-4 pathway, which is necessary for the adhesion of several types of white blood cells to endothelial cells, and (3) the TBAM/CD40 pathway which activates B-cells which produce antibodies. Biogen believes that products which interrupt these pathways will block the inflammation process at an early stage, thus preventing tissue damage more effectively than currently available therapies. Moreover, such products should result in selective inhibition of the immune system, rather than the broad suppression associated with most therapies currently available or under development. In in vitro and in vivo experiments the product candidates from the inflammation program have shown promising inhibitory effects. The Company has delayed commencing Phase I clinical trials of product candidates from the inflammation program while resources are devoted to development of Hirulog* and beta interferon. Gelsolin Thick viscid secretions in the airways of cystic fibrosis ("CF") patients are believed to cause progressive pulmonary destruction. A major contributor to the viscosity of CF mucus is the release of a large amount of filamentous actin by degenerating inflammatory cells which migrate in large numbers to the airways of CF patients. Biogen and its collaborators believe that severing actin filaments contaminating the CF airway mucus may lead to clinical improvement in CF patients. Biogen is developing a recombinant form of an actin severing agent, human r-P gelsolin, for reducing airway obstruction in CF and several other pulmonary diseases. The Company is presently conducting preclinical studies of gelsolin product candidates. Other Research Programs As part of its further research efforts, Biogen is investigating a number of different approaches for intervening in thrombotic processes, targeting new approaches to the treatment of certain persistent viral diseases, such as human papillomavirus infections, and developing methods for delivering drug products directly to the inside of cells. Additional efforts are being directed towards new strategies for intervening in diseases where the normal pattern of growth regulation has been disturbed. Abnormal growth is implicated in diseases as diverse as cancer, which is characterized by the uncontrolled growth of abnormal cells, and restenosis, in which the reclosure of blood vessels may be associated with the growth of scar tissue. Biogen is also exploring various avenues of therapeutic intervention in AIDS. One of these avenues is a therapy that blocks entry of HIV into cells via CD4. Biogen has identified a monoclonal antibody, known as 5A8, directed against CD4, which has the potential to block HIV infection and HIV- induced cell fusion or HIV/CD4 cell fusion. Research Costs During 1993, 1992 and 1991, Biogen's research and development costs were approximately $79.3 million, $60.4 million and $44.3 million, respectively. There can be no assurance that any of the products described above or resulting from Biogen's research programs will be successfully developed, prove to be safe and efficacious at each stage of clinical trials, meet applicable regulatory standards, be capable of being produced in commercial quantities at reasonable costs or be successfully marketed. Products Being Marketed or Developed by Biogen Licensees Intron(R) A Alpha Interferon Alpha interferon is a naturally occurring protein produced by normal white blood cells. Biogen has been granted patents in the United States and in Europe covering the production of alpha interferons through recombinant DNA techniques and has applications pending in numerous other countries. See "Patents and Other Proprietary Rights." Biogen's worldwide licensee for recombinant alpha interferon, Schering-Plough Corporation ("Schering-Plough"), first began commercial sales of its Intron(R) A brand of alpha interferon in the United States in 1986 for hairy-cell leukemia. Schering-Plough now sells Intron(R) A in more than 60 countries for more than 16 indications, including hepatitis B, hepatitis C, genital warts and Kaposi's sarcoma. Sales of Intron(R) A by Schering-Plough were $572 million in 1993, the majority of which were generated outside the United States. Currently the largest market for Intron(R) A is in Japan for the treatment of hepatitis C. The United States Food and Drug Administration ("FDA") has approved Intron(R) A for the treatment of hepatitis B and hepatitis C in the United States. Schering-Plough has undertaken studies using Intron(R) A for a number of additional indications. These studies include Phase III trials of Intron(R) A for the treatment of chronic myelogenous leukemia, bladder cancer, non- Hodgkin's lymphoma, malignant melanoma, renal cell carcinoma, multiple myeloma and head and neck cancer, and earlier phase trials for Crohn's disease and, in combination with AZT or ddI, as a treatment for AIDS. Royalties from Schering-Plough accounted for approximately 57% of Biogen's revenues (excluding interest) in 1993. Hepatitis B Vaccines and Diagnostics Hepatitis B is a blood-borne disease which causes a serious infection of the liver and substantially increases the risk of liver cancer. More than 250 million people worldwide have chronic hepatitis B virus infections. Biogen holds several important patents related to hepatitis B antigens produced by genetic engineering techniques. See "Patents and Other Proprietary Rights." These antigens are used in recombinant hepatitis B vaccines and in diagnostic test kits used to detect hepatitis B infection. In total, sales of hepatitis B vaccines and diagnostic products by Biogen licensees exceeded $900 million in 1993. Hepatitis B Vaccines The American Academy of Pediatrics and the United States Centers for Disease Control and Prevention ("CDCP") have recommended that all infants born in the United States receive inoculation against hepatitis B as part of a universal vaccination program. At least 20 countries around the world already recommend vaccination for all infants. CDCP and the American Academy of Pediatrics have also recommended universal immunization of ten-year-old children and at-risk adolescents. In addition, the United States Occupational Safety and Health Administration ("OSHA") has recommended that all persons with an occupational exposure to blood and other infectious material receive the hepatitis B vaccine. In 1992, OSHA instituted a program requiring certain employers to offer the vaccine at no cost to all employees at risk. SmithKline Beecham Biologicals s.a. ("SmithKline") and Merck & Co., Inc. ("Merck") are the two major worldwide marketers of hepatitis B vaccines. Biogen has licensed to SmithKline exclusive rights under Biogen's hepatitis B patents to market hepatitis B vaccines in the major countries of the world, excluding Japan. SmithKline's vaccine is approved in the United States and in over 60 other countries. In 1990, SmithKline and Biogen entered into a sublicense arrangement with Merck under which Biogen currently receives royalties. Royalties from SmithKline and Merck together accounted for approximately 34% of Biogen's revenues (excluding interest) in 1993. Biogen has also licensed rights under its hepatitis B patents to Merck and The Green Cross Corporation non-exclusively in Japan. In 1993, SmithKline initiated arbitration in the United States regarding the rate of royalties payable on sales of hepatitis B vaccines by SmithKline in the United States. In the fourth quarter of 1992, SmithKline received a favorable decision against Biogen in a foreign arbitration regarding similar royalty provisions in a separate agreement governing international sales of hepatitis B vaccines by SmithKline. Biogen has received leave to appeal the foreign arbitration decision from the English Chancery Court. The Company believes that a decision in the United States similar to the foreign arbitration decision is not probable. Hepatitis B Diagnostics Biogen has licensed its proprietary hepatitis B rights non-exclusively, on an antigen-by-antigen basis, to diagnostic kit manufacturers. Biogen currently has hepatitis B license or supply agreements for diagnostic use with more than a dozen companies, including Abbott Laboratories, the major worldwide marketer of hepatitis B diagnostic kits, Ortho Diagnostic Systems, Inc., Roche Diagnostic Systems, Inc. and Organon Teknika B.V. Other Products Gamma Interferon Gamma interferon is a protein produced by cells of the immune system. Biogen has developed a recombinant gamma interferon for Biogen Medical Products Limited Partnership ("BMPLP"). In 1993, BMPLP terminated its agreements with Bioferon under which Bioferon developed gamma interferon and, under a distribution agreement with Rentschler, marketed gamma interferon in Germany for the treatment of rheumatoid arthritis as a second line therapy for patients who no longer benefit from nonsteroidal anti-inflammatory drugs. See "Patents and Other Proprietary Rights." In Japan, Biogen's licensee, Shionogi & Co., Ltd. ("Shionogi"), markets recombinant gamma interferon under the trademark Imunomax(R)-Gamma for renal cell carcinoma. Biogen supplies Shionogi with its clinical and commercial needs for recombinant gamma interferon. In general, gamma interferon has experienced disappointing results in clinical trials for tested indications. Porcine Somatotropin Porcine somatotropin ("PST") is a protein normally produced in young pigs which promotes their growth and development into adult animals. Biogen believes that PST significantly increases feed conversion efficiency and daily weight gain and improves the quality of the meat product in pigs by reducing fat content. Biogen has been granted a patent in the European Patent Office and has applications pending in certain other countries, including the United States, covering the production of PST through recombinant DNA techniques. Until 1993, recombinant PST was being developed by Pitman-Moore, Inc., a subsidiary of the IMCERA Group, under an agreement with Biogen. In 1993, Pitman-Moore terminated its development agreement with Biogen and the license to recombinant PST patent rights, citing changing market conditions. Patents and Other Proprietary Rights Biogen has filed numerous patent applications in the United States and various other countries seeking protection of a number of its processes and products, and patents have issued on a number of these applications. Issues remain as to the ultimate degree of protection that will be afforded to Biogen by such patents. There is no certainty that these patents or others, if obtained, will be of substantial protection or commercial benefit to Biogen. Furthermore, it is not known to what extent Biogen's other pending patent applications will ultimately be granted as patents or whether those patents that have been issued will prevail if they are challenged in litigation. Trade secrets and confidential know-how are important to Biogen's scientific and commercial success. Although Biogen seeks to protect its proprietary information, there can be no assurance that others will not either develop independently the same or similar information or obtain access to Biogen's proprietary information. Recombinant Alpha Interferon Biogen has more than 30 patents in countries around the world, including the United States and countries of the European Patent Office, covering the production of recombinant alpha interferons. Biogen continues to seek related patents in the United States and other countries. Three infringement suits have been filed in Biogen's name to enforce its European alpha interferon patent. The first suit was filed in Vienna, Austria against Boehringer Ingelheim Zentrale GmbH ("BI") and two of its subsidiaries. The Austrian Court has stayed Biogen's infringement case pending a decision by the Austrian Patent Office on BI's petition to revoke Biogen's European (Austrian) patent on grounds peculiar to Austrian law. The second suit was filed in Dusseldorf, Germany against Dr. Karl Thomae GmbH and two other BI companies. The German trial and appeal courts ruled in favor of Biogen and have enjoined Thomae from the further manufacture, use or sale of recombinant alpha-2(c) interferon. The third suit was filed in Warsaw, Poland against Boehringer Ingelheim Pharma GmbH ("BI Pharma"). The Polish court preliminarily enjoined BI Pharma from further infringement of Biogen's patent. The court then stayed the injunction pending a decision on BI Pharma's appeal. Recombinant Hepatitis B Antigens Biogen has more than 50 granted patents in countries around the world, including three in the United States and two in countries of the European Patent Office, and several patent applications, covering the recombinant production of hepatitis B surface, core and "e" antigens. Biogen continues to seek related patents in the United States and other countries. Biogen's first European hepatitis B patent was opposed by five companies. The Opposition Division of the European Patent Office maintained the patent over those oppositions. Two of the opponents appealed the Opposition Division's decision to the Technical Board of Appeal which is the final arbiter. Biogen expects an oral hearing on this appeal in June 1994. Biogen's second European hepatitis B patent was opposed by four companies. In 1992, the Opposition Division decided to revoke Biogen's second European hepatitis B patent alleging that it lacked inventive step. Biogen has appealed this decision to the European Patent Office Technical Board of Appeal. The patent will remain in force during the appeal process. Although such matters can never be free from doubt, Biogen believes that the decision of the Opposition Division will be reversed on appeal. Biogen has filed three infringement suits to enforce its hepatitis B patents, in England against Medeva plc ("Medeva"), in Israel against Bio-Technology General (Israel) Ltd. ("BTG"), and in Singapore against Scitech Medical Products Pte Ltd. and Scitech Genetics Pte Ltd. The action against Medeva seeks to enjoin Medeva's planned production and distribution of hepatitis B vaccine. In November 1993, the United Kingdom High Court of Justice ruled in favor of Biogen and enjoined Medeva from further infringement of one of Biogen's European (UK) patents. The Court then stayed the injunction pending decision on Medeva's appeal. The appeal is expected to be heard in mid-1994. In 1992, BTG brought an action against Biogen seeking a compulsory license under Biogen's Israeli hepatitis B patent and Biogen filed an infringement suit against BTG, seeking to enjoin BTG's production, sale and distribution of hepatitis B vaccine. Both cases are continuing in Israel. In 1993, Biogen sued Scitech Products and Scitech Genetics in Singapore. The case is continuing in Singapore. Recombinant Beta Interferon The European Patent Office and certain countries have granted patents to Biogen covering the recombinant production of beta interferon. In other countries, including the United States, Biogen has filed patent applications and continues to seek patents covering the recombinant production of beta interferon and related technology. Biogen's European patent was opposed by one company. In December 1993, the European Patent Office's Opposition Division dismissed the opposition and maintained Biogen's patent. Biogen expects the opponent to appeal this decision. In the United States, Biogen's claims to key intermediates in the recombinant production of beta interferon were involved in an interference to determine who was the first to invent those intermediates in the United States. Priority of invention was awarded to another party in the interference. Biogen's pending United States claims to the production of recombinant beta interferon were not part of that interference. Other parties have also filed patent applications in various countries covering the recombinant production of beta interferon, and, in particular, key intermediates in that production, as well as beta interferon itself. One such party has been granted several patents in the European Patent Office and in certain countries on the key intermediates. The same party was awarded priority to those intermediates in the United States interference. Biogen has obtained non-exclusive rights to manufacture, use and sell recombinant beta interferon under these patents in various countries of the world, including the United States, Japan and most European countries. Another party has been granted various patents in the United States and in other countries on beta interferon itself. Biogen has obtained worldwide, non-exclusive rights under these patents to make, use and sell recombinant beta interferon. Hirulog(TM) Thrombin Inhibitor In 1993, the United States Patent Office issued to Biogen a patent covering Biogen's Hirulog(TM) thrombin inhibitor. Biogen has several patent applications pending on Hirulog(TM) and continues to seek patents covering Hirulog(TM) in the United States and other countries. Recombinant Gamma Interferon In 1988 and 1990, Genentech, Inc. ("Genentech") was granted several patents in the United States and Europe claiming recombinant gamma interferon and intermediates and methods for the production of recombinant gamma interferon. In January 1990, Genentech and Biogen and BMPLP entered into a cross-license agreement under which Genentech and Biogen/BMPLP each licensed to the other its United States patent rights relating to certain gamma interferons and their intermediates and processes of production for certain fields of use. At the same time, Biogen granted Genentech a non-exclusive worldwide sublicense for certain proteins under certain of its licensed process patents relating to the secretion of proteins. Biogen opposed the Genentech European gamma interferon patent in the European Patent Office. The European Patent Office has maintained the Genentech patent in a decision that cannot be appealed. If Genentech's European gamma interferon patents continue in force in Europe with their present scope and Biogen does not obtain a license under such patents, Biogen will likely be prevented from selling recombinant gamma interferon in Europe. Other Patents In January 1994, Biogen filed suit in the District Court in Osaka, Japan, against Sumitomo Pharmaceutical Co., Ltd. ("Sumitomo"). The suit seeks to enjoin Sumitomo from importing and selling its recombinant human growth hormone products in Japan. Biogen believes that these products are made by a process that infringes certain of its licensed patents relating to the secretion of proteins. In January 1994, Biogen granted Eli Lilly and Company ("Lilly") a non-exclusive license under certain of Biogen's patents for gene expression. Lilly uses the patented vectors and methods in several products that are on the market or in development. Third Party Patents Biogen is aware that others, including various universities and companies working in biotechnology, have also filed patent applications and have been granted patents in the United States and in other countries claiming subject matter potentially useful or necessary to Biogen's business. Some of those patents and applications claim only specific products or methods of making such products, while others claim more general processes or techniques useful or now used in the biotechnology industry. Genentech has been granted patents and is prosecuting other patent applications in the United States and certain other countries which it may allege are currently used by Biogen and the rest of the biotechnology industry to produce recombinant proteins in microbial hosts. Genentech has offered to Biogen and others in the industry non-exclusive licenses under those patents and patent applications for various proteins and in various fields of use, but not for others. Schering-Plough, Biogen's exclusive licensee for recombinant alpha interferon, is licensed under certain of these patents for the manufacture, use and sale of recombinant alpha interferon. The ultimate scope and validity of Genentech's patents, of other existing patents, or of patents which may be granted to third parties in the future, the extent to which Biogen may wish or be required to acquire rights under such patents, and the availability and cost of acquiring such rights currently cannot be determined by Biogen. There has been, and Biogen expects that there may continue to be, significant litigation in the industry regarding patents and other intellectual property rights. Such litigation could create uncertainty and consume substantial resources. Competition and Marketing Competition in the biotechnology and pharmaceutical industries is intense and comes from many and varied sources. Biogen does not believe that it or any of the other industry leaders can be considered dominant in view of the rapid technological change in the industry. Biogen experiences significant competition from specialized biotechnology firms in the United States, Europe and elsewhere and from many large pharmaceutical, chemical and other companies. Certain of these companies have substantially greater financial, marketing and human resources than Biogen. The pharmaceutical companies have considerable experience in undertaking clinical trials and in obtaining regulatory approval to market pharmaceutical products. In addition, certain of Biogen's products may be subject to competition from products developed using alternatives to biotechnology techniques. Much competition is directed towards establishing proprietary positions through research and development. A key aspect of such competition is recruiting and retaining qualified scientists and technicians. Biogen believes that it has been successful in attracting skilled and experienced scientific personnel. Biogen believes that leadership in the industry will be based on managerial and technological superiority and may be influenced significantly by patents and other forms of protection of proprietary information. The achievement of such a position depends upon Biogen's ability to attract and retain skilled and experienced personnel, its ability to identify and exploit commercially the products resulting from biotechnology and the availability of adequate financial resources to fund facilities, equipment, personnel, clinical testing, manufacturing and marketing. Many of Biogen's competitors are working to develop products similar to those under development and testing by Biogen. The timing of the entry of a new pharmaceutical product into the market can be an important factor in determining the product's eventual success and profitability. Early entry may have important advantages in gaining product acceptance and market share. Moreover, for certain diseases with limited patient populations, the FDA is prevented under the Orphan Drug Act, for a period of seven years, from approving more than one application for the "same" product for a single orphan drug designation, unless a later product is considered clinically superior. Accordingly, the relative speed with which Biogen can develop products, complete the testing and approval process and supply commercial quantities of the product to the market is expected to have an important impact on Biogen's competitive position. In addition, competition among products approved for sale may be based, among other things, on patent position, product efficacy, safety, reliability, availability and price. Regulation Biogen's current and contemplated activities and the products and processes that will result from such activities are and will be subject to substantial government regulation. Before pharmaceutical products may be sold in the United States and other countries, clinical trials of the products must be conducted and the results submitted to appropriate regulatory agencies for approval. These clinical trial programs generally involve a three-phase process. Typically, in Phase I, trials are conducted in volunteers or patients to determine the early side effect profile and, perhaps, the pattern of drug distribution and metabolism. In Phase II, trials are conducted in groups of patients with a specific disease in order to determine appropriate dosages, expand evidence of the safety profile and, perhaps, determine preliminary efficacy. In Phase III, large scale, comparative trials are conducted on patients with a target disease in order to generate enough data to provide the statistical proof of efficacy and safety required by national regulatory agencies. The receipt of regulatory approvals often takes a number of years, involving the expenditure of substantial resources and depends on a number of factors, including the severity of the disease in question, the availability of alternative treatments and the risks and benefits demonstrated in clinical trials. On occasion, regulatory authorities may require larger or additional studies, leading to unanticipated delay or expense. In connection with the commercialization of products resulting from Biogen's projects, it is necessary, in a number of countries, to comply with certain regulations relating to the manufacturing and marketing of such products and to the products themselves. For example, the commercial manufacturing, marketing and exporting of pharmaceutical products require the approval of the FDA in the United States and of comparable agencies in other countries. The FDA has established mandatory procedures and safety standards which apply to the manufacture, clinical testing and marketing of pharmaceutical products in the United States. The process of seeking and obtaining FDA approval for a new product and the facilities in which it can be produced is likely to take a number of years and involve the expenditure of substantial resources. The commercial manufacture and marketing of pharmaceutical products for animal use require approval of either the FDA or the USDA and of comparable agencies in other countries. In addition, the regulatory approval processes for products in the United States, Canada and Europe are undergoing or may undergo changes. Biogen cannot determine what effect any changes in regulatory approval processes may have on its business. In the United States, the federal government is currently undertaking a complete review and reformation of health care coverage and costs. Resulting legislation or regulatory actions may have a significant effect on the Company's business. Biogen's ability to commercialize successfully human pharmaceutical products also may depend in part on the extent to which reimbursement for the costs of such products and related treatments will be available from government health administration authorities, private health insurers and other organizations. Currently, substantial uncertainty exists as to the reimbursement status of newly approved health care products by third-party payors. Biogen's policy is to conduct relevant research in compliance with the current United States National Institutes of Health Guidelines for Research Involving Recombinant DNA Molecules (the "NIH Guidelines") and all other federal and state regulations. By local ordinance, Biogen is required, among other things, to comply with the NIH Guidelines in relation to its facilities in Cambridge, Massachusetts, and is required to operate pursuant to certain permits. Various laws, regulations and recommendations relating to safe working conditions, laboratory practices, the experimental use of animals and the purchase, storage, movement, import and export and use and disposal of hazardous or potentially hazardous substances, including radioactive compounds and infectious disease agents, used in connection with Biogen's research work are or may be applicable to its activities. These include, among others, the United States Atomic Energy Act, the Clean Air Act, the Clean Water Act, the Occupational Safety and Health Act, the National Environmental Policy Act, the Toxic Substances Control Act and the Resource Conservation and Recovery Act, national restrictions on technology transfer and import, export and customs regulations. The extent of government regulation which might result from future legislation or administrative action cannot accurately be predicted. Certain agreements entered into by Biogen involving exclusive license rights may be subject to national or supranational antitrust regulatory control, the effect of which also cannot be predicted. Employees At January 1, 1994, Biogen employed 380 full-time employees, of whom 55 held Ph.D. and/or M.D. degrees. Of the 380 employees, 167 were engaged in, or directly supported, research and process development and 111 were involved in, or directly supported, manufacturing, quality assurance/quality control, regulatory, medical operations and preclinical and clinical development. Biogen maintains consulting arrangements with a number of scientists at various universities and other research institutions in Europe and the United States, including the six outside members of its Scientific Board. Item 2.

Item 2. Properties Substantially all of Biogen's facilities are located in Cambridge, Massachusetts, where the Company leases all or part of five buildings containing a total of approximately 220,000 square feet of office and research and development space. Most of the Company's operations are contained in a 67,000 square foot building housing a pilot production plant, laboratories and office space, in a building with a combined 64,000 square feet of space containing laboratories, purification and aseptic bottling facilities and office space, in a multitenant building where the Company occupies approximately 54,000 square feet of office space and in a 17,000 square foot building designed for specialized research laboratories. The leases for these sites terminate in 1998 (with the right to renew), 2004, 1998 (with the right to renew) and 2004, respectively. In 1993, the Company began construction of a 150,000 square foot building in Cambridge, Massachusetts which will house laboratories and office space. The anticipated cost of construction, including the land, is approximately $40 million. Upon completion of the building, the Company has the option, subject to certain conditions, to obtain a secured term loan with a bank for up to $25 million for a period of up to ten years. The building is scheduled for completion in 1995. The Company believes that its pilot production plant in Cambridge, Massachusetts and existing outside sources will allow it to meet its production needs for clinical trials and its initial commercial production needs for its Hirulog(TM) thrombin inhibitor and beta interferon product. Biogen believes that the facilities are in compliance with appropriate regulatory standards. The Company expects that additional facilities and outside sources will be required to meet the Company's future research and production needs. Item 3.

Item 3. Legal Proceedings For a description of legal proceedings relating to patent rights, see Item 1, "Business-Patents and Other Proprietary Rights." Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None Executive Officers The following is a list of the executive officers of the Company and their principal positions with the Company. Each individual officer serves at the pleasure of the Board of Directors. Name Age Positions James L. Vincent . 54 Chairman of the Board of Directors, Chief Executive Officer James R. Tobin . . 49 President and Chief Operating Officer Michael J. Astrue. 37 Vice President - General Counsel, Secretary and Clerk Kenneth M. Bate. . 43 Vice President - Marketing and Sales Frank A. Burke, Jr. 50 Vice President - Human Resources Lawrence S. Daniels 51 Vice President - Strategic Planning Joseph M. Davie. . 54 Vice President - Research Irving H. Fox. . . 50 Vice President - Medical Affairs Timothy M. Kish . 42 Vice President - Finance, Chief Financial Officer and Treasurer James C. Mullen. . 35 Vice President - Operations Michael R. Slater. 47 Vice President - Regulatory Affairs Irvin D. Smith.... 61 Vice President - QA/QC and Drug Development The background of these officers is as follows: James L. Vincent joined the Company as its Chief Executive Officer in October 1985. He also served as Chief Operating Officer and President from April 1988 until February 1994. He is also Chairman of the Board of Directors of the Company. Before joining Biogen, Mr. Vincent served as Group Vice President, Allied Corporation and as President, Allied Health & Scientific Products Company, a subsidiary of Allied Corporation. Before joining Allied Corporation, Mr. Vincent was with Abbott Laboratories, Inc. where he served in various capacities, including Executive Vice President, Chief Operating Officer and Director of the parent corporation. Mr. Vincent is, in addition, Chairman of the Executive Board of Wharton Graduate School of the University of Pennsylvania and is a member of the Board of Directors of Continental Bank, Continental Corporation and Millipore Corporation. James R. Tobin joined the Company as its President and Chief Operating Officer in February 1994. Prior to joining the Company, Mr. Tobin served in various capacities at Baxter International, including Executive Vice President from 1988 until 1992 and President and Chief Operating Officer from 1992 until 1993. Michael J. Astrue was appointed Vice President - General Counsel, Secretary and Clerk of the Company in June 1993. Prior to joining the Company, Mr. Astrue was a partner in the Boston law firm of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. and a managing director of its wholly-owned consulting firm, ML Strategies, from November 1992 to June 1993. From June 1989 through November 1992, Mr. Astrue served as General Counsel of the United States Department of Health and Human Services. From April 1988 through June 1989, Mr. Astrue served as Associate Counsel to the President of the United States. Kenneth M. Bate was appointed Vice President - Marketing and Sales in August 1993 after serving as Vice President - Finance and Chief Financial Officer since August 1990 and as Treasurer of the Company since December 1991. From 1978 until 1990, Mr. Bate was employed by Peter Kiewit & Sons, Inc. and its subsidiaries in various financial capacities, most recently as Vice President - Treasurer. Frank A. Burke, Jr., was appointed Vice President - Human Resources in May 1986 after serving for 12 years in various human resource management positions at Allied-Signal, Inc., most recently as Director of Compensation and Employee Benefits of the Engineered Materials Sector. Lawrence S. Daniels was appointed Vice President - Strategic Planning of the Company in August 1993 after serving as Vice President - Marketing and Business Development since November 1991. Prior to joining the Company, Mr. Daniels served for nine years in planning and administrative functions for Allied-Signal, Inc., most recently as Vice President, Corporate Strategy Development. Joseph M. Davie, Ph.D. was appointed Vice President - Research of the Company in April 1993. Prior to joining the Company, Dr. Davie was employed by Searle Corporation where he served as Senior Vice President - Science and Technology from January 1993 to April 1993, President - Research and Development from July 1987 to January 1993 and Senior Vice President - Discovery Research from January 1987 to July 1987. Irving H. Fox, M.D. was appointed Vice President - Medical Affairs in February 1990. Dr. Fox joined Biogen following a 14-year career at the University of Michigan, where he held professorships in internal medicine and biological chemistry, and from 1978 to 1990, was program director of the Clinical Research Center at the University of Michigan Hospital. Timothy M. Kish was appointed Vice President - Finance, Treasurer and Chief Financial Officer of the Company in August 1993 after serving as Corporate Controller of the Company since 1986. Prior to joining Biogen, Mr. Kish was Director of Finance for Allied Health & Scientific Products Company, a subsidiary of Allied Corporation. Before joining Allied, Mr. Kish served in various capacities at Bendix Corp., most recently as Executive Assistant to the President. James C. Mullen became Biogen's Vice President - Operations in December 1991 after serving as Senior Director - Operations since February 1991. Mr. Mullen joined the Company in 1989 as Director - Facilities and Engineering and then served as Acting Director - Manufacturing and Engineering. Before coming to Biogen, Mr. Mullen held various positions of responsibility from 1984 through 1988 at SmithKline-Beckman Corporation, most recently as Director, Engineering - - SmithKline and French Laboratories, Worldwide. Michael R. Slater was appointed Vice President - Regulatory Affairs in 1991. Mr. Slater has been with Biogen since 1983, serving first as Head of Regulatory Affairs and then as Director of Regulatory Affairs of Biogen, S.A., the Company's former Swiss subsidiary. From 1985 to 1988, Mr. Slater served as Director of Corporate Regulatory Affairs of Biogen Research Corp. From 1988 to 1991, Mr. Slater served as Vice President - Quality Assurance and Regulatory Affairs of the Company. Irvin D. Smith, Ph.D. was appointed Vice President - Quality Assurance/Quality Control and Drug Development in August 1993 after serving as General Manager of Bioferon, Biogen's former joint venture in Germany, since July 1991. Dr. Smith was a private consultant from March 1990 to July 1991 and President and Chief Executive Officer of Applied BioSystems from October 1987 to March 1990. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The section entitled "Market for Securities" in the Company's 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 6.

Item 6. Selected Financial Data The section entitled "Selected Financial Data" in the Company's 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 8.

Item 8. Financial Statements and Supplementary Data The sections entitled "Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Cash Flows," "Consolidated Statements of Shareholders' Equity," "Notes to Consolidated Financial Statements" and "Report of Independent Accountants" in the Company's 1993 Annual Report to Shareholders are hereby incorporated by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not Applicable PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant, Promoters and Control Persons Directors The sections entitled "Election of Directors" and "Other Matters" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, are hereby incorporated by reference. Executive Officers Information concerning the Company's Executive Officers is set forth in Part I of this Annual Report on Form 10-K. Item 11.

Item 11. Executive Compensation The sections entitled "Executive Compensation", "Board of Directors and Committees", "Employment Arrangements", "Statement of Compensation Philosophy" and "Performance Graph" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, are hereby incorporated by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The section entitled "Share Ownership" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, is hereby incorporated by reference. Item 13.

Item 13. Certain Relationships and Related Transactions The section entitled "Certain Transactions" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, is hereby incorporated by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Financial Statements and Financial Statement Schedules. The following documents are filed as a part of this report: 1. Financial Statements, as required by Item 8 of this Form, incorporated by reference herein from the 1993 Annual Report to Shareholders attached hereto as Exhibit 13: Item Location Consolidated Balance Sheets Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Balance Sheets." Consolidated Statements of Income Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Statements of Income." Consolidated Statements of Cash Flows Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Statements of Cash Flows." Consolidated Statements of Shareholders' Equity Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Statements of Shareholders' Equity." Notes to Consolidated Financial Statements Annual Report under the caption "Biogen, Inc. and Subsidiaries Notes to Consolidated Financial Statements." Reports of Independent Accountants Page 25 of this Report; Annual Report under the caption "Report of Independent Accountants." With the exception of the portions of the 1993 Annual Report to Shareholders specifically incorporated herein by reference, such report shall not be deemed filed as part of this Annual Report on Form 10-K. (2) Financial Statement Schedules: Item Location Report of Independent Accountants Page 25 of this Report Consent of Independent Accountants Page 26 of this Report Schedule I, Marketable Securities Page 27 of this Report Schedule X, Supplementary Income Page 28 of this Report Statement Information Schedules not included herein are omitted because they are not applicable or the required information appears in the Consolidated Financial Statements or Notes thereto. (3) Exhibits Exhibit No. Description (3.1) Articles of Organization, as amended (k) (3.2) By-Laws, as amended (o) (4.1) Form of Common Stock Share Certificate (q) (4.2) Form of Warrant Certificate (f) (4.3) Certificate of Designation of Series A Junior Participating Preferred Stock (j) (4.4) Rights Agreement dated as of May 8, 1989 between Registrant and The First National Bank of Boston, as Rights Agent (j) (10.1) Independent Consulting and Project Agreement dated as of June 29, 1979 between Registrant and Kenneth Murray (a)** (10.2) Letter Agreement dated March 12, 1993 with Dr. Kenneth Murray relating to renewal of Independent Consulting Agreement (o)** (10.3) Minute of Agreement dated February 5, 1981 among Registrant, The University Court of the University of Edinburgh and Kenneth Murray (a)** (10.4) Independent Consulting Agreement dated as of June 29, 1979 between Registrant and Phillip A. Sharp (a)** (10.5) Letter Agreement dated December 10, 1992 with Phillip Sharp relating to chairmanship of Scientific Board and renewal of Independent Consulting Agreement (o)** (10.6) Project Agreement dated as of December 14, 1979 between Registrant and Phillip A. Sharp (a)** (10.7) Share Restriction and Repurchase Agreement dated as of December 15, 1979 between Registrant and Phillip A. Sharp (a)** (10.8) Consulting Agreement dated as of April 1, 1991, as amended, between Registrant and Alexander G. Bearn (m)** (10.9) Form of Amendment dated July 1, 1988 to Independent Consulting Agreement between Registrant and Scientific Board Members (h)** (10.10) Form of Extension of Independent Consulting Agreement between Registrant and Scientific Board Members (k)** (10.11) Form of Share Purchase Agreement between Registrant and Scientific Board Members (a)** (10.12) Form of Stock Option Agreement between Registrant and each of Alan Belzer, Harold W. Buirkle, James W. Stevens and Roger H. Morley (d)** (10.13) Letter regarding employment of James L. Vincent dated September 23, 1985 (c)** (10.14) Form of Stock Option Agreement with James L. Vincent under 1985 Non-Qualified Stock Option Plan (o)** (10.15) Letter dated December 13, 1989 regarding employment of Dr. Irving H. Fox (l)** (10.16) Letter dated August 13, 1990 regarding employment of Mr. Kenneth M. Bate (m)** (10.17) Letter dated October 23, 1991 regarding employment of Mr. Lawrence S. Daniels (o)** (10.18) Letter dated April 7, 1993 regarding employment of Dr. Joseph M. Davie (p)** (10.19) Letter dated January 12, 1994 regarding employment of James R. Tobin *,** (10.20) Letter dated August 30, 1993 regarding employment of Irvin D. Smith, Ph.D.*,** (10.21) Form of Indemnification Agreement between Registrant and each Director and Executive Officer (h)** (10.22) Second Amended and Restated Agreement and Certificate of Limited Partnership dated as of May 15, 1984 among Biogen Medical Products, Inc. as General Partner and certain limited partners (k) (10.23) First Amendment dated December 22, 1986 to Agreement and Certificate of Limited Partnership (d) (10.24) Technology License Agreement dated May 15, 1984 between Biogen B.V. and Biogen Medical Products Limited Partnership (k) (10.25) Development Contract dated May 15, 1984 between Biogen B.V. and Biogen Medical Products Limited Partnership (k) (10.26) Amendment dated December 22, 1986 to Development Contract (d) (10.27) Amendment dated January 1, 1987 to Development Contract (g) (10.28) Extension Agreement dated October 10, 1989 relating to Development Contract (k) (10.29) Extension Agreement dated December 31, 1993 relating to Development Contract * (10.30) Joint Venture Option Agreement dated May 15, 1984 between Biogen Inc. and Biogen Medical Products Limited Partnership (k) (10.31) Purchase Option Agreement dated May 15, 1984 between Biogen B.V. and the limited partners of Biogen Medical Products Limited Partnership (k) (10.32) Guaranty dated May 15, 1984 to Biogen Medical Products Limited Partnership by Registrant guaranteeing certain obligations of Biogen Medical Products, Inc., Biogen B.V. and Biogen Inc. to the Partnership (k) (10.33) Demand Loan Agreement dated October 1, 1989 between Biogen Medical Products Limited Partnership and Biogen Medical Products, Inc. (k) (10.34) Standard Form Commercial Lease dated January 29, 1981 between Ira C. Foss and Ira C. Foss, Jr., as Trustees of Eastern Realty Trust, and B. Leasing, Inc. (k) (10.35) Letter of May 24, 1989 exercising option under Standard Form Commercial Lease dated January 29, 1981 (k) (10.36) Lease Extension Agreement dated February 20, 1990 between Eastern Realty Trust and Registrant (k) (10.37) Standard Form Commercial Lease dated June 1, 1989 between Eastern Realty Trust and Registrant (k) (10.38) Cambridge Center Lease dated October 4, 1982 between Mortimer Zuckerman, Edward H. Linde and David Barrett, as Trustees of Fourteen Cambridge Center Trust, and B. Leasing, Inc. (a) (10.39) First Amendment to Lease dated January 19, 1989 amending Cambridge Center Lease dated October 4, 1982 (o) (10.40) Second Amendment to Lease dated March 8, 1990 amending Cambridge Center Lease dated October 4, 1982 (o) (10.41) Third Amendment to Lease dated September 25, 1991 amending Cambridge Center Lease dated October 4, 1982 (o) (10.42) Lease dated October 6, 1993 between North Parcel Limited Partnership and Biogen Realty Limited Partnership*. (10.43) 1983 Employee Stock Purchase Plan as amended through April 3, 1992 and restated (n)** (10.44) 1982 Incentive Stock Option Plan as amended through March 25, 1993 and restated with form of Option Agreement (p)** (10.45) 1985 Non-Qualified Stock Option Plan as amended through March 25, 1993 and restated with form of Option Agreement (p)** (10.46) 1987 Scientific Board Stock Option Plan as amended through April 3, 1992 and restated with form of Option Agreement (n)** (10.47) Exclusive License and Development Agreement dated December 8, 1979 between Registrant and Schering Corporation (a) (10.48) Amendatory Agreement dated May 14, 1985 to Exclusive License and Development Agreement dated December 8, 1979 (c) (10.49) Amendment and Settlement Agreement dated September 29, 1988 to Exclusive License and Development Agreement dated December 8, 1979 (o) (10.50) Amendment dated March 20, 1989 to Exclusive License and Development Agreement dated December 8, 1979 (o ) (10.51) License Agreement (United States) dated March 28, 1988 between Registrant and SmithKline Beecham Biologicals, s.a. (as successor to Smith Kline-R.I.T, s.a.) (o) (10.52) License Agreement (International) dated March 28, 1988 between Registrant and SmithKline Beecham Biologicals, s.a. (as successor to Smith Kline-R.I.T., s.a.) (o) (10.53) Sublicense Agreement dated as of February 15, 1990 among Registrant, SmithKline Beecham Biologicals, s.a (as successor to SmithKline Biologicals, s.a.) and Merck and Co., Inc. (o) (11) Computation of Earnings per Share * (12) None (13) Incorporated portions from Biogen, Inc. 1993 Annual Report to Shareholders * (22) Subsidiaries of the Registrant * (24.1) Consent of Price Waterhouse (Included in Part IV hereof) (29) None (a) Previously filed with the Commission as an exhibit to Registration Statement on Form S-1, File No. 2-81689 and incorporated herein by reference. (b) Previously filed with the Commission as an exhibit to Registration Statement on Form S-8, File No. 2-87550 and incorporated herein by reference. (c) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, as amended, File No. 0-12042 and incorporated herein by reference. (d) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986, as amended, File No. 0-12042 and incorporated herein by reference. (e) Previously filed with the Commission as an exhibit to Report on Form 8-K, File No. 0-12042, dated September 30, 1988 and incorporated herein by reference. (f) Previously filed with the Commission as an exhibit to Registration Statement on Form 8-B, File No. 0-12042, dated December 12, 1988 and incorporated herein by reference. (g) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987, File No. 0-12042 and incorporated herein by reference. (h) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, File No. 0-12042 and incorporated herein by reference. (i) Previously filed with the Commission as an exhibit to Registration Statement on Form S-3, File No. 33-28612 and incorporated herein by reference. (j) Previously filed with the Commission as an exhibit to Registration Statement on Form 8-A, File No. 0-12042, filed May 26, 1989 and incorporated herein by reference. (k) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, File No. 0-12042, and incorporated herein by reference. (l) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 0-12042, and incorporated herein by reference. (m) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, File No. 0-12042, and incorporated herein by reference. (n) Previously filed with the Commission as an exhibit to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 0-12042, and incorporated herein by reference. (o) Previously filed with the Commission as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, File No. 0-12042, and incorporated herein by reference. (p) Previously filed with the Commission as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, File No. 0-12042, and incorporated herein by reference. (q) Previously filed with the Commission as an exhibit to Registration Statement on Form S-3, File No. 33-51639, and incorporated herein by reference. * Filed herewith ** Management contract or compensatory plan or arrangement (b) Reports on Form 8-K None. Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BIOGEN, INC. By:/s/ James L. Vincent James L. Vincent, Chairman of the Board and Chief Executive Officer Dated March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signatures Title Date /s/ James L. Vincent Chairman, Board of DirectorsMarch 18, 1994 James L. Vincent (principal executive officer) /s/ Timothy M. Kish Vice President - Finance March 18, 1994 (principal Timothy M. Kish financial and accounting officer) /s/ Alexander Bearn Director March 18, 1994 Alexander Bearn /s/ Harold W. Buirkle Director March 18, 1994 Harold W. Buirkle /s/ Alan Belzer Director March 18, 1994 Alan Belzer /s/ Roger H. Morley Director March 18, 1994 Roger H. Morley /s/ Kenneth Murray Director March 18, 1994 Kenneth Murray /s/ Phillip A. Sharp Director March 18, 1994 Phillip A. Sharp /s/ James W. Stevens Director March 18, 1994 James W. Stevens Report of Independent Accountants on Financial Statement Schedules To the Board of Directors of Biogen, Inc. Our audits of the consolidated financial statements referred to in our report dated January 20, 1994 appearing on page 32 of the 1993 Annual Report to Shareholders of Biogen, Inc. and its subsidiaries (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10- K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Price Waterhouse Boston, Massachusetts January 20, 1994 Consent of Independent Accountants We hereby consent to the incorporation by reference in the Prospectus constituting part of its Registration Statements on Form S-8, as amended (Nos. 2-87550, 2-96157, 33-9827, 33-14742, 33-37312, 33-22378, 33-41077 and as filed on September 21, 1993) and on Form S-3, as amended (Nos. 33-14741, 33-14743, 33-20183, and 33-51639) of Biogen, Inc. and its subsidiaries of our report dated January 20, 1994 appearing on page 32 of the 1993 Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears in this Form 10-K. Price Waterhouse Boston, Massachusetts March 28, 1994 SCHEDULE I BIOGEN, INC. AND SUBSIDIARIES MARKETABLE SECURITIES AT DECEMBER 31, 1993 (in thousands) PRINCIPAL MARKET VALUE BALANCE NAME OF ISSUER AND AMOUNTS OF AT BALANCE SHEET TITLE OF EACH ISSUE BONDS & NOTES COST SHEET DATE AMOUNT Corporate Bonds and Notes: Aluminum Co America $ 300 $ 300 $ 296 $ 300 American Brands Inc. 2,000 2,029 2,017 2,023 Associates Corp of NA 2,840 2,855 2,927 2,852 Bank America Corp 1,300 1,373 1,369 1,359 Bankers TR NY Corp 2,675 2,668 2,670 2,669 Beneficial Corp 1,500 1,696 1,686 1,668 BNY Master CR Card TR 2,500 2,555 2,560 2,543 Boeing Co 300 301 301 301 Chase Manhattan CR Corp 1,250 1,277 1,275 1,272 Commercial CR Group Inc 300 296 297 296 Discover Card TR 6,583 6,876 6,862 6,865 Discover Card TR 625 635 631 632 First Chicago Master TR 2,833 2,890 2,906 2,879 Fleet MTG Secs Inc. 2,000 2,040 2,046 2,036 Ford Motor CR CO 6,500 6,915 6,875 6,772 Ford Motor CR CO 554 579 575 577 General Motors Accep Corp 3,964 3,989 4,013 3,980 Gillette Co 300 300 298 300 Golden West Finl Corp DEl 900 1,029 998 1,021 Household Fin Corp 2,752 2,935 2,921 2,914 Korea Dev BK 2,000 2,184 2,134 2,168 MMCA Auto Grantor TR 1,862 1,859 1,849 1,859 Nissan Auto Receivables 799 798 804 798 Norwest Corp 1,925 1,908 1,916 1,915 Premier Auto TR 4,190 4,179 4,187 4,179 Reebok INTL LTD 1,082 1,196 1,161 1,183 Republic NATL BK New York 2,000 2,000 2,050 2,000 Ryland MTG Secs Corp 5,516 5,517 5,566 5,517 Saxon MTG Secs Corp 1,890 1,952 1,952 1,951 Security Pac Corp 1,000 1,051 1,092 1,040 Shawmut Natl Remic TR 241 248 246 248 Smith Barney Shearson HLDGS IN 1,000 1,000 1,009 1,000 Standard CR Card Master TR 1 1,250 1,266 1,275 1,260 Structured Asset Secs Corp 926 924 945 924 Syntex USA Inc. 1,000 995 996 996 Tennessee Valley Auth 300 296 299 296 TMS Home Equity LN TR 1,529 1,572 1,548 1,572 WMX Technologies 2,000 2,010 2,002 2,009 Computer Industry Bonds 530 528 552 528 Retail Industry Bonds 2,600 2,602 2,600 2,602 Utility Industry Bonds 5,605 5,920 5,912 5,843 U.S. Government Securities 115,548 112,633 113,886 112,658 TOTAL MARKETABLE SECURITIES $ 195,805 SCHEDULE X BIOGEN, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (in thousands) The amounts shown below are included in costs and expenses in the consolidated statements of income. 1993 1992 1991 Maintenance and repairs. . . . . . . . . . 1,883 1,4531,410 Patent amortization. . . . . . . . . . . . 2,258 3,6601,689 Royalties. . . . . . . . . . . . . . . . . 11,588 9,3843,768 There were no material charges for advertising and taxes, other than payroll and income taxes, for the periods noted above. EXHIBIT INDEX Exhibit No. Description (10.19) Letter dated January 12, 1994 regarding employment of James R. Tobin (10.20) Letter dated August 30, 1993 regarding employment of Irvin D. Smith, Ph.D. (10.29) Extension Agreement dated December 31, 1993 relating to Development Contract. (10.42) Lease dated October 6, 1993 between North Parcel Limited Partnership and Biogen Realty Limited Partnership. (11) Computation of Earnings per Share (13) Incorporated portions from Biogen, Inc. 1993 Annual Report to Shareholders. (22) Subsidiaries of the Registrant. (24.1) Consent of Price Waterhouse (included in Part IV hereof).

36995_1993.txt

36995

1993

ITEM 1. BUSINESS. GENERAL First Union Corporation (the Corporation or FUNC) was incorporated under the laws of North Carolina in 1967 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the BHCA). In 1968, the Corporation became the sole stockholder of First Union National Bank of North Carolina (FUNB-NC ) and First Union Mortgage Corporation, a mortgage banking firm acquired by FUNB-NC in 1964. In addition to FUNB-NC, the Corporation also operates banking subsidiaries in Florida (since November 1985), South Carolina (since March 1986), Georgia (since March 1986), Tennessee (since December 1987), Maryland (since December 1992), Virginia (since December 1992) and Washington, D.C. (since December 1992). In addition to providing a wide range of commercial and retail banking and trust services through its banking subsidiaries, the Corporation also provides various other financial services, including mortgage banking, home equity lending, consumer lending, asset-based financing, insurance and securities brokerage services, through other subsidiaries. The Corporation's principal executive offices are located at One First Union Center, Charlotte, North Carolina 28288-0013 (telephone number (704)374-6565). Since the 1985 Supreme Court decision upholding regional interstate banking legislation, the Corporation has concentrated its efforts on building a large regional banking organization in the southeastern United States. Since November 1985, the Corporation has completed 38 banking related acquisitions, including the more significant acquisitions set forth in the following table, in addition to the currently pending acquisitions set forth in such table. (1) Additional information relating to certain of the foregoing acquisitions is set forth in the Annual Report in Note 2 on pages 59 through 60. (2) The dollar amounts indicated represent assets of the related organization as of the last reporting period prior to acquisition, except for (i) the dollar amount relating to RTC acquisitions, which represents deposits acquired from the Resolution Trust Corporation, (ii) the dollar amount relating to Southeast banks, which represents assets of the two banking subsidiaries of Southeast Banking Corporation acquired from the Federal Deposit Insurance Corporation (the FDIC), and (iii) the dollar amount relating to the pending acquisition of Lieber, which represents assets under management by Lieber as of December 31, 1993. Since such assets are not owned by Lieber, they will not be reflected on the Corporation's balance sheet upon consummation of the acquisition. Lieber serves as investment adviser to the Evergreen family of mutual funds. The acquisition agreement provides for issuance of approximately 3.1 million shares of Common Stock to acquire Lieber. (3) On January 17, 1994, FUNC entered into an agreement to acquire BancFlorida, which provides for the exchange of FUNC Common Stock for each share of BancFlorida common stock and BancFlorida convertible preferred stock. The exchange ratio will be used upon the average closing price of FUNC Common Stock prior to consummation of the acquisition. Based on the closing price of FUNC Common Stock on March 1, 1994 ($40.50), approximately 4.2 million shares of FUNC Common Stock would be issued in connection with the acquisition. FUNC currently expects to account for the acquisition as a purchase and to purchase in the open market up to one-half of the shares of FUNC Common Stock issued in the acquisition, depending on market conditions and other factors. Interstate banking legislation has greatly impacted the Corporation and the banking industry in general. North Carolina's regional interstate banking bill includes the states of Alabama, Arkansas, Florida, Georgia, Kentucky, Louisiana, Maryland, Mississippi, South Carolina, Tennessee, Texas, Virginia and West Virginia and Washington, D.C., each of which has passed interstate banking legislation, either on a regional or national basis. In addition, various other states not named in the North Carolina legislation have also adopted interstate banking legislation, which, subject to certain conditions and limitations, would permit the Corporation to acquire banks in such states. The Corporation is continually evaluating acquisition opportunities and frequently conducts due diligence activities in connection with possible acquisitions. As a result, acquisition discussions and, in some cases, negotiations frequently take place and future acquisitions involving cash, debt or equity securities can be expected. Acquisitions typically involve the payment of a premium over book and market values, and therefore some dilution of the Corporation's book value and net income per common share may occur in connection with any future transactions. Additional information relating to the business of the Corporation and its subsidiaries is set forth on pages 6 through 8 in the Annual Report and incorporated herein by reference. Information relating to the Corporation only is set forth in Note 16 on pages 77 through 80 in the Annual Report and incorporated herein by reference. COMPETITION The Corporation's subsidiaries face substantial competition in their operations from banking and nonbanking institutions, including savings and loan associations, credit unions, money market funds and other investment vehicles, brokerage firms, insurance companies, leasing companies, credit card issuers, mortgage banking companies, finance companies and other types of financial institutions. Based on the volume of permanent mortgages serviced on September 30, 1993, the Corporation's mortgage banking subsidiary, First Union Mortgage Corporation, was the 11th largest mortgage banking company in the United States. SUPERVISION AND REGULATION GENERAL As a bank holding company, the Corporation is subject to regulation under the BHCA and its examination and reporting requirements. Under the BHCA, bank holding companies may not directly or indirectly acquire the ownership or control of more than five percent of the voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Board of Governors of the Federal Reserve System (the Federal Reserve Board). In addition, bank holding companies are generally prohibited under the BHCA from engaging in nonbanking activities, subject to certain exceptions. The earnings of the Corporation's subsidiaries, and therefore the earnings of the Corporation, are affected by general economic conditions, management policies and the legislative and governmental actions of various regulatory authorities, including the Federal Reserve Board and the Comptroller of the Currency (the Comptroller). In addition, there are numerous governmental requirements and regulations which affect the activities of the Corporation and its subsidiaries. PAYMENT OF DIVIDENDS The Corporation is a legal entity separate and distinct from its banking and other subsidiaries. A major portion of the revenues of the Corporation result from amounts paid as dividends to the Corporation by its national bank subsidiaries. The Corporation's banking subsidiaries are subject to legal limitations on the amount of dividends they can pay. The prior approval of the Comptroller is required if the total of all dividends declared by a national bank in any calendar year will exceed the sum of such bank's net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits national banks from paying dividends which would be greater than the bank's undivided profits after deducting statutory bad debt in excess of the bank's allowance for loan losses. Under the foregoing dividend restrictions and certain restrictions applicable to certain of the Corporation's nonbanking subsidiaries, as of December 31, 1993, the Corporation's subsidiaries, without obtaining affirmative governmental approvals, could pay aggregate dividends of $510 million to FUNC during 1994. During 1993, the Corporation's subsidiaries paid $407 million in cash dividends to FUNC. In addition, both the Corporation and its national bank subsidiaries are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a national bank or bank holding company that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The Comptroller has indicated that paying dividends that deplete a national bank's capital base to an inadequate level would be an unsound and unsafe banking practice. The Comptroller and the Federal Reserve Board have each indicated that banking organizations should generally pay dividends only out of current operating earnings. BORROWINGS BY THE CORPORATION There are also various legal restrictions on the extent to which the Corporation and its nonbank subsidiaries can borrow or otherwise obtain credit from its bank subsidiaries. In general, these restrictions require that any such extensions of credit must be secured by designated amounts of specified collateral and are limited, as to any one of the Corporation or such nonbank subsidiaries, to ten percent of the lending bank's capital stock and surplus, and as to the Corporation and all such nonbank subsidiaries in the aggregate, to 20 percent of such lending bank's capital stock and surplus. CAPITAL Under the risk-based capital requirements for bank holding companies, the minimum requirement for the ratio of capital to risk-weighted assets (including certain off-balance-sheet activities, such as standby letters of credit) is eight percent. At least half of the total capital is to be composed of common equity, retained earnings and qualifying perpetual preferred stock, less goodwill (tier 1 capital and together with tier 2 capital total capital). The remainder may consist of subordinated debt, non-qualifying preferred stock and a limited amount of the loan loss allowance (tier 2 capital). At December 31, 1993, the Corporation's tier 1 capital and total capital ratios were 9.14 percent and 14.64 percent, respectively. In addition, the Federal Reserve Board has established minimum leverage ratio requirements for bank holding companies. These requirements provide for a minimum leverage ratio of tier 1 capital to adjusted average quarterly assets (leverage ratio) equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a leverage ratio of from at least four to five percent. The Corporation's leverage ratio at December 31, 1993, was 6.13 percent. The requirements also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the requirements indicate that the Federal Reserve Board will continue to consider a tangible tier 1 leverage ratio (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve Board has not advised the Corporation of any specific minimum tier 1 leverage ratio applicable to it. Each of the Corporation's subsidiary national banks is subject to similar capital requirements adopted by the Comptroller. As of December 31, 1993, the capital ratios of the bank subsidiaries of the Corporation, FUNB-NC, First Union National Bank of South Carolina (FUNB-SC), First Union National Bank of Georgia (FUNB-GA), First Union National Bank of Florida (FUNB-FL), First Union National Bank of Tennessee (FUNB-TN ), First Union National Bank of Maryland (FUNB-MD), First Union National Bank of Virginia (FUNB-VA) and First Union National Bank of Washington, D.C. (FUNB-DC), were as follows: Banking regulators continue to indicate their desire to raise capital requirements applicable to banking organizations, including a proposal to add an interest rate risk component to risk-based capital requirements. FIRREA; SUPPORT OF SUBSIDIARY BANKS The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), among other things, imposes liability on an institution the deposits of which are insured by the FDIC, such as the Corporation's subsidiary national banks, for certain potential obligations to the FDIC incurred in connection with other FDIC-insured institutions under common control with such institution. Under the National Bank Act, if the capital stock of a national bank is impaired by losses or otherwise, the Comptroller is authorized to require payment of the deficiency by assessment upon the bank's stockholders, pro rata, and to the extent necessary, if any such assessment is not paid by any stockholder after three months notice, to sell the stock of such stockholder to make good the deficiency. Under Federal Reserve Board policy, the Corporation is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support each of such subsidiaries. This support may be required at times when, absent such Federal Reserve Board policy, the Corporation may not find itself able to provide it. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. FDICIA In December 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was enacted, which substantially revises the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking agencies to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. A depository institution's capital tier will depend upon where its capital levels compare to various relevant capital measures and certain other factors, as established by regulation. The federal regulatory authorities have adopted regulations establishing relevant capital measures and relevant capital levels. The relevant capital measures are the total capital ratio, tier 1 capital ratio and the leverage ratio. Under the regulations, a bank will be: (i) well capitalized if it has a total capital ratio of ten percent or greater, a tier 1 capital ratio of six percent or greater and a leverage ratio of five percent or greater and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) adequately capitalized if it has a total capital ratio of eight percent or greater, a tier 1 capital ratio of four percent or greater and a leverage ratio of four percent or greater (three percent in certain circumstances) and is not well capitalized; (iii) undercapitalized if it has a total capital ratio of less than eight percent, a tier 1 capital ratio of less than four percent or a leverage ratio of less than four percent (three percent in certain circumstances); (iv) significantly undercapitalized if it has a total capital ratio of less than six percent, a tier 1 capital ratio of less than three percent or a leverage ratio of less than three percent; and (v) critically undercapitalized if its tangible equity is equal to or less than two percent of average quarterly tangible assets. As of December 31, 1993, all of the Corporation's subsidiary banks had capital levels that qualify them as being well capitalized under such regulations. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit a capital restoration plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to five percent of the depository institution's total assets at the time it became undercapitalized, and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator. FDICIA directs that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares and such other standards as the agency deems appropriate. The ultimate effect of these standards cannot be ascertained until final regulations are adopted. FDICIA also contains a variety of other provisions that may affect the operations of the Corporation, including new reporting requirements, regulatory standards for real estate lending, truth in savings provisions, the requirement that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch, and a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not well capitalized or are adequately capitalized and have not received a waiver from the FDIC. Under regulations relating to the brokered deposit prohibition, all of the Corporation's subsidiary banks are well capitalized and not subject to the prohibition. FDIC INSURANCE ASSESSMENTS FUNC's subsidiary banks are subject to FDIC deposit insurance assessments. The FDIC assessment rates for the Bank Insurance Fund (BIF) range from $.23 to $.31 for every $100 of deposits. Each financial institution is assigned to one of three capital groups -- well capitalized, adequately capitalized or undercapitalized -- and further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution's primary federal and, if applicable, state supervisors and other information relevant to the institution's financial condition and the risk posed to the applicable insurance fund. The actual assessment rate applicable to a particular institution, therefore, depends in part upon the risk assessment classification so assigned to the institution by the FDIC. For the assessment due on January 31, 1994, the rate for each of the Corporation's subsidiary banks was $.23, except for FUNB-VA, FUNB-MD and FUNB-DC, each whose rate was $.26. ADDITIONAL INFORMATION Additional information related to certain regulatory and accounting matters is set forth on pages 19 and 20 in the Annual Report and incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES. As of December 31, 1993, the Corporation and its subsidiaries owned or leased 1,525 locations in 39 states and one foreign country from which their business is conducted, including a multi-story office complex in Charlotte, North Carolina, which serves as the administrative headquarters of the Corporation, FUNB-NC and most of the Corporation's nonbanking subsidiaries. Listed below are the number of banking and nonbanking locations of the Corporation that are leased or owned, as of December 31, 1993: The principal offices of each of the Corporation's subsidiary banks in Jacksonville, Florida; Atlanta, Georgia; Greenville, South Carolina; Nashville, Tennessee; Roanoke, Virginia; Rockville, Maryland; and Washington, D.C., are all leased. Additional information relating to the Corporation's lease commitments is set forth in Note 17 on page 83 in the Annual Report and incorporated herein by reference. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Corporation and certain of its subsidiaries have been named as defendants in various legal actions arising from their normal business activities in which varying amounts are claimed. Although the amount of any ultimate liability with respect to such matters cannot be determined, in the opinion of management, based upon the opinions of counsel, any such liability will not have a material effect on the consolidated financial position of the Corporation and its subsidiaries. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Corporation's Common Stock, $3.33 1/3 par value per share (the Common Stock), is listed on the New York Stock Exchange. Table 6 on page 28 in the Annual Report sets forth information relating to the quarterly prices of, and quarterly dividends paid on, the Common Stock for the two-year period ended December 31, 1993, and is incorporated herein by reference. Prices shown represent the high and low last sale prices of the Common Stock as reported on the New York Stock Exchange, Inc. Composite Transactions Tape. As of December 31, 1993, there were 58,670 holders of record of the Common Stock. In December 1990, the Board of Directors of the Corporation adopted a Shareholder Protection Rights Plan (the Plan) designed to enhance the ability of the Board to protect stockholders against attempts to acquire control of the Corporation by means of unfair or abusive tactics. The Plan provides, among other things, that the rights granted under the Plan to the holders of shares of Common Stock (one right for each share of Common Stock) will become exercisable (after a specified period) if any person or group announces a tender or exchange offer for, or acquires, 15 percent or more of the Common Stock. At that time each right will enable the holders of the rights (other than such person or group, whose rights become void) to purchase additional shares of Common Stock (or at the option of the Board of Directors, shares of junior participating Class A Preferred Stock) having a market value of twice the $110 exercise price of the right, subject to adjustment in certain events. If any person or group acquires beneficial ownership of between 15 percent and 50 percent of the Corporation's Common Stock, the Corporation's Board of Directors may, at its option, exchange for each outstanding and not voided right either two shares of Common Stock or junior participating Class A Preferred Stock having economic and voting terms similar to two shares of Common Stock, subject to adjustment in certain events. The rights are redeemable by the Corporation at $0.01 per right (subject to adjustment in certain events) prior to becoming exercisable and, in certain events, may be cancelled and terminated without any payment to holders. The rights have no voting rights and are not entitled to dividends. The rights will expire on December 28, 2000, unless sooner redeemed or terminated. Each share of Common Stock has attached to it one right, and the rights will not trade separately from the Common Stock unless they become exercisable. Subject to the prior rights of the holders of the Series 1990 Cumulative Perpetual Adjustable Rate Preferred Stock (Series 1990 Preferred Stock) issued in connection with the acquisition of Florida National in January 1990, holders of the Common Stock are entitled to receive such dividends as may be legally declared by the Board of Directors and, in the event of dissolution and liquidation, to receive the net assets of the Corporation remaining after payment of all liabilities, in proportion to their respective holdings. Additional information concerning certain limitations on the payment of dividends by the Corporation and its subsidiaries is set forth above under Business -- Supervision and Regulation; Payment of Dividends and in Note 16 on page 77 in the Annual Report and incorporated herein by reference. Additional information relating to the Series 1990 Preferred Stock and Common Stock is set forth in Note 12 on page 71 in the Annual Report and incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. In response to this Item the information set forth in Table 2 on page 24 in the Annual Report is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. In response to this Item the information set forth on pages 10 through 51 in the Annual Report is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. In response to this Item the information set forth on page 28 and on pages 53 through 85 in the Annual Report is incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The executive officers of the Corporation are elected to their offices for one year terms at the meeting of the Board of Directors in April of each year. The terms of any executive officers elected after such date expire at the same time as the terms of the executive officers elected on such date. The names of each of the current executive officers of the Corporation, their ages, their current positions with the Corporation and certain subsidiaries and, if different, their business experience during the past five years, are as follows: Edward E. Crutchfield, Jr. (52). Chairman and Chief Executive Officer, the Corporation. Also, President, the Corporation, October 1988 to June 1990. John R. Georgius (49). President, the Corporation, since June 1990. Chairman and Chief Executive Officer, FUNB-NC, from October 1988 to February 1993. Vice Chairman, the Corporation, August 1987 to June 1990. President, FUNB-NC, prior to October 1988. B. J. Walker (63). Vice Chairman, the Corporation. Also, Chairman and Chief Executive Officer, FUNB-FL, prior to March 1991. Robert T. Atwood (53). Executive Vice President and Chief Financial Officer, the Corporation, since March 1991. Prior to that time, Mr. Atwood was a partner with the accounting firm of Deloitte & Touche. Marion A. Cowell, Jr. (59). Executive Vice President, Secretary, and General Counsel, the Corporation. Mr. Cowell served as Senior Vice President, Secretary and General Counsel of the Corporation prior to December 1991. In addition to the foregoing, the information set forth in the Proxy Statement under the heading General Information and Nominees, and in the last paragraph under the heading Other Matters Relating to Executive Officers and Directors is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. In response to this Item the information set forth in the Proxy Statement under the heading Executive Compensation, excluding the information under the subheadings HR Committee Report on Executive Compensation and Performance Graph, is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. In response to this Item the information set forth in the Proxy Statement relating to the ownership of Common Stock and Series 1990 Preferred Stock by the directors and executive officers of the Corporation under the heading General Information and Nominees is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. In response to this Item the information set forth in the Proxy Statement in the first two paragraphs under the heading Other Matters Relating to Executive Officers and Directors is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The consolidated financial statements of the Corporation, including the notes thereto and independent auditors' report thereon, are set forth on pages 53 through 85 of the Annual Report. All financial statement schedules are omitted since the required information is either not applicable, is immaterial or is included in the consolidated financial statements of the Corporation and notes thereto. A list of the exhibits to this Form 10-K is set forth on the Exhibit Index immediately preceding such exhibits and is incorporated herein by reference. (b) During the quarter ended December 31, 1993, no current reports on Form 8-K were filed by the Corporation with the Securities and Exchange Commission. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST UNION CORPORATION Date: March 8, 1994 By: MARION A. COWELL, JR. MARION A. COWELL, JR. EXECUTIVE VICE PRESIDENT, SECRETARY AND GENERAL COUNSEL Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated and on the date indicated. Date: March 8, 1994 EXHIBIT INDEX * The Corporation agrees to furnish to the Securities and Exchange Commission upon request, copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its subsidiaries. * Except for those portions of the Annual Report which are expressly incorporated by reference in this Form 10-K, the Annual Report is furnished for the information of the Securities and Exchange Commission only and is not to be deemed filed as part of such Form 10-K.

740694_1993.txt

740694

1993

Item 1. BUSINESS a. General Development of Business Kaydon Corporation (the "Company" or "Kaydon") was formed in October 1983, as a wholly owned subsidiary of Bairnco Corporation ("Bairnco" or "former parent"), when it acquired all of the assets and assumed certain liabilities, other than amounts due from affiliates, from a subsidiary of Keene Corporation, another wholly owned subsidiary of Bairnco, which was then known as Kaydon Corporation and is now inactive. The Company was spun off from Bairnco in April 1984 and is no longer a member of its consolidated group. This spinoff was effected in the form of a 100 percent stock dividend to stockholders of the former parent's common stock. On June 30, 1986, Kaydon Ring and Seal, Inc., a wholly owned subsidiary of Kaydon, acquired for $29,600,000 certain assets and liabilities of the Piston Ring and Seal Division of Koppers Company, Inc., a manufacturer of piston rings and shaft seals. This acquisition was consummated by Kaydon Ring and Seal, Inc. with loaned funds from Kaydon. On July 17, 1987, Kaydon acquired for $5,100,000 certain assets and liabilities of the Spirolox operation of TRW, Inc., a manufacturer of specialty retaining rings. This acquisition was consummated with funds acquired through bank credit obtained in the normal course of business. On June 23, 1989, Kaydon Corporation, through its newly formed, wholly owned subsidiaries, Kaydon Acquisition Corp. III and Kaydon Acquisition Corp. IV, acquired for $22,710,000 all of the stock of I.D.M. Electronics Ltd., a United Kingdom corporation, and KDI Electro-Tec Corp., a Delaware corporation, from KDI Corporation. I.D.M. Electronics Ltd. and Electro-Tec Corp. manufacture high-performance, precision slip-rings, slip-ring capsules and slip-ring assemblies. Slip-rings are complex, electromechanical devices used to transmit electric signals or electrical power between the rotating and stationary members of an assembly, such as a gyro and its housing. The purchase price was financed by credit obtained in the normal course of business. On December 16, 1991, Kaydon Corporation, through its wholly owned subsidiaries, Kaydon Acquisition Corp. III and Kaydon Acquisition Corp. U.K. Ltd., acquired for L.24,000,000 (approximately $43,440,000 when translated at the exchange rate in effect at the time of purchase) all of the capital stock of Prizerandom Limited, a United Kingdom corporation, from Clairmont PLC, a Scotland corporation. Prizerandom Limited is a wholly owned subsidiary of Clairmont PLC and is the holding company for Cooper Bearings Limited, a United Kingdom corporation, which was the primary subject of the acquisition. Cooper Bearings Ltd. is a holding company consisting of the following operating subsidiaries, all of which are manufacturers or distributors of complete bearings and related components parts: Cooper U.K. is a manufacturing operation located in King's Lynn, Norfolk - U.K. that produces a range of split roller bearings including both a standard line and custom-designed product. Split bearings are designed specifically to aid the customer in solving problems where the application of full round bearings would be impractical. Cooper U.S. and Cooper Germany are distribution operations located in Virginia Beach, VA - U.S. and Krefeld, Germany, respectively. The purchase price was financed through Kaydon Corporation cash plus bank loans from the National Bank of Detroit and Continental Bank, U.K. b. and c. Financial Information About Industry Segments and Narrative Description of Business The Company designs, manufactures and sells custom-engineered products for a broad and diverse customer base. The Company's principal products include antifriction bearings, bearing systems, filters, filter housings, high-performance rings, sealing rings, specialty retaining rings, shaft seals and slip-rings. These products are used by customers in a variety of medical, instrumentation, material handling, machine tool positioning, aerospace, defense, construction and other industrial applications. Products Kaydon works closely with its customers to engineer the required solutions to their design problems. Design solutions are frequently unique to a single customer or application. Depending upon the nature of the application, the design may be used over a protracted time period and in large numbers, or it may be for a single use. The antifriction bearing products of Kaydon incorporate various types of rolling elements. The ball, tapered roller, cylindrical roller and needle roller bearings manufactured by Kaydon are made in sizes ranging from needle bearings with a 1/2-inch outside diameter to heavy-duty ball bearings with an outside diameter of 180 inches. These antifriction products are fabricated from aluminum, bearing-quality steel, stainless steel or special tool steels. They often incorporate a broad range of features such as gearing, special sealing systems and mounting arrangements in combination with other mechanical components. As a custom manufacturer, many diverse applications are served. Typical applications include large-diameter ball bearings for hydraulic cranes and excavators; thin-section ball bearings for rotating joints of industrial robots; lightweight airborne radar bearings; large-diameter aluminum roller bearings for military vehicle turret systems; needle roller bearings for passenger car transmissions; loose needle rollers for universal joints utilized in light trucks, agricultural tractors and passenger cars; special coalescing elements and filter housings for diesel fuel filtration on both commercial and military vehicles; hydraulic filter elements for tractor-mounted farm implement units; and ultra high-precision roller bearings for gear box applications. Kaydon's subsidiary, Kaydon Ring and Seal, Inc., manufactures metallic medium and large bore-size rings for low and medium-speed internal combustion engines, steam engines, pumps and reciprocating compressors. Sealing rings are engineered with metallic and nonmetallic products used to limit the leakage of fluids and gases within engines and a wide variety of other mechanical products. Sealing rings are used in industrial applications, such as: compressors, transmissions, hydraulic and pneumatic cylinders, and commercial and military aircraft, jet engines and control apparatus applications. Shaft seals are used to seal gases or liquids usually under extreme conditions of speed, pressure or temperature. Shaft seals are fabricated from a variety of materials depending on the application. Electro-Tec Corp. and I.D.M. Electronics Ltd., wholly owned subsidiaries of Kaydon Corporation, design and manufacture precision, high-performance slip-rings, slip-ring assemblies, capsules and related electromechanical devices to meet customers' exact needs and specifications. Slip-rings are manufactured from injection and transfer-molded plastics, aluminum and stainless steel castings, bearings and electronic components and connectors, and are sometimes subjected to an electro-deposition process. They are used to transmit electrical signals or power between the rotating and stationary members of an assembly and can be found in combat vehicles, aircraft inertial guidance systems, telecommunications satellites, aircraft targeting systems and medical diagnostic equipment. Cooper Bearings Ltd., a wholly owned subsidiary of Kaydon Corporation, designs and manufactures a range of split roller bearings, which include both standard and custom-designed lines. Split bearings are designed specifically to aid the customer in solving problems where the application of full round bearings would be less desirable. The product is used in a wide range of applications but particularly those where space and ease of change are important selection criteria. Approximately 69 percent of Kaydon's sales are to original equipment manufacturers, which incorporate the Kaydon products in the products they sell. Many of the applications for the Company's products also provide the opportunity for participation in the replacement or spare parts markets. New Product and Industry Segment Information On December 4, 1993 the Company acquired, for approximately $716,000, the assets of Kenyon Power Transmission Ltd. of Manchester, England. Kenyon manufactures pulleys and drive components which are complementary to the product offering of the Company's subsidiary, Cooper U.K., into which it will be absorbed. Subsequent to year end, on January 28, 1994 the Company acquired, for approximately $7,500,000, the assets of Industrial Tectonics Inc located in Dexter, Michigan. This company has been in existence since 1946 and is noted for the production of balls made of alloyed steel, plastic, tungsten carbide, glass and an assortment of other materials which are used in gauges, floats, measuring instruments, ball point pens and antifriction bearings. The Company has not made any other public announcement of, or otherwise made public information about, a new product or a new industry segment which would require the investment of a material amount of the Company's assets or which would otherwise result in a material cost. Patents, Trademarks, Licenses, Etc. The Company does not believe that any material part of its business is dependent on the continued availability of any one or all of its patents or trademarks. Seasonal Nature of Business The Company does not consider its business to be seasonal in nature. Working Capital Practices The Company does not believe that it or the industry in general has any special practices or special conditions affecting working capital items that are significant for an understanding of the Company's business. Customers Kaydon sells its products to over 1,000 companies throughout the world. The principal customers are generally large manufacturing corporations. During 1993, 1992 and 1991, sales to no single customer exceeded 10% of total sales. Customers can generally be divided into four major market groups: Aerospace and Military, Replacement Parts and Exports, Special Industrial Machinery and Heavy Industrial Equipment. Sales to these customer groups for 1993, 1992 and 1991 are set forth in the following table: Replacement parts are sold mainly through specialized distributors. Kaydon had export sales of $10,979,000 in 1993, $9,102,000 in 1992, and $10,762,000 in 1991, with most of such sales concentrated in Canada, Europe and Japan. Marketing Kaydon's sales organization consists of salespersons and representatives located throughout the United States, Canada, Europe and Asia. Salespersons are trained to provide technical assistance to customers, as well as to provide liaison with factory engineering staffs. A nationwide network of specialized distributors and agents provides local availability of Kaydon products to serve the requirements of the replacement market and small original equipment manufacturers. Manufacturing Kaydon manufactures virtually all of the products it sells and utilizes subcontractors only for occasional specialized services. Kaydon's products require sophisticated processes and equipment, and many of its products incorporate unique Kaydon-developed production techniques. Certain satellite and aircraft-type bearing products must meet extraordinary mechanical tolerances (for example, within 20 millionths of an inch) and many bearings and slip-rings are assembled in quality-controlled "white room" conditions. Nearly all of Kaydon's products require high levels of incoming quality control and process quality control. The manufacturing equipment required for Kaydon's operations entails a very high level of capital investment for any given level of sales. Suppliers Kaydon and its subsidiaries purchase large quantities of raw materials, mainly bearing-quality steel, special alloy steel, high-grade carbon and filter media, aluminum alloy and stainless steel castings, plastics, wire and electrical connectors, from multiple sources. Kaydon purchases large amounts of certain types of bearing-quality steel from a number of foreign suppliers. No significant supply problems have been encountered in recent years as relationships with suppliers have generally been good. Environmental Matters Reference is made to "Management's Discussion and Analysis" on pages 15 and 16 of Kaydon's 1993 Annual Report to Stockholders which is incorporated herein by reference. Employees On December 31, 1993, Kaydon employed 1,671 employees. Hourly employees at the Muskegon facilities (including Norton Shores) are represented by the International Association of Machinists and Aerospace Workers. The current collective bargaining agreement is effective until December 3, 1994. The Baltimore hourly employees are also represented by the International Association of Machinists and Aerospace Workers. The current collective bargaining agreement is effective until November 5, 1995. Greeneville hourly employees are represented by the United Steelworkers of America, with the current collective bargaining agreement effective until February 2, 1996. The remaining domestic factory employees, as well as all office employees, are non-union. Kaydon provides its employees with a full range of insurance, pension and deferred compensation benefits. The Company believes its levels of total compensation are equal to or better than comparable companies in communities adjacent to each facility. Backlog Kaydon sells certain products on a build-to-order basis that requires substantial order lead time. This results in a backlog of unshipped, scheduled orders. Other products are manufactured on the basis of sales projections or annual blanket purchase orders. Orders for such products are not entered into backlog until explicit shipping releases are received. Kaydon's backlog was $84,385,000 at December 31, 1993 and $83,296,000 at December 31, 1992. Based on experience, management would expect to ship over the following twelve months about 90 percent of the year-end backlog. The backlog increase reversed a downward trend over the last several years. Backlog has become less indicative of future results as the Company has made efforts to shorten manufacturing lead times, creating a faster response to customer orders. Competition Kaydon competes with divisions of SKF Industries, Timken Corporation, Torrington/Fafnir, Rotek, FAG, EG&G Inc., Litton Poly-Scientific and numerous other smaller companies. The markets served by Kaydon are large and extremely competitive. The major domestic competitors generally produce a wide line of standard products and do not specialize in custom products. The major domestic bearing manufacturers nonetheless do offer special-engineered bearings. The markets for Kaydon's special-machined components, fabricated products, filters, rings and seals are very diverse. Consequently, management feels that the size of the total market for such products cannot be meaningfully estimated. In all of the markets served by Kaydon, the principal methods of competition involve price, product performance, engineering support and timely delivery. Many of Kaydon's domestic competitors are part of large, worldwide manufacturing concerns and have significantly greater financial resources. While foreign competition is intense and growing for all industrial components, the special nature of Kaydon's products and the close working relationship with its customers have somewhat limited the impact of foreign competition on domestic business. Government Contracts and Renegotiation Various provisions of federal law and regulations require, under certain circumstances, the renegotiation of military procurement contracts or the refund of profits determined to be excessive. Based on Kaydon's experience under such provisions, management believes that no material renegotiation or refunds (if any) will be required. d. Information About International Operations Information with respect to operations by geographic area appears in Note 15, "Business Segment Information" of the Notes to Consolidated Financial Statements set forth on page 28 of the Annual Report to Stockholders, which is incorporated herein by reference. Fluctuating exchange rates and factors beyond the control of the Company, such as tariffs and foreign economic policies, may affect future results of foreign operations. Item 2.

Item 2. PROPERTIES The following chart lists the principal locations, activity (use) and square footage of Kaydon's most significant facilities as of December 31, 1993 and indicates whether the property is owned or leased: Kaydon owns the two manufacturing facilities located in Muskegon (Norton Shores), the assembly facility located in Newaygo, the manufacturing facilities located in Sumter, Greeneville, LaGrange (lease option to purchase exercised June 1, 1993), Baltimore, Blacksburg, Monterrey, Mexico, and King's Lynn, England and the warehouse facility in Virginia Beach. The other property in Muskegon was leased (under a capitalized lease) in connection with a $10,000,000 Industrial Revenue Bond (IRB) financing for a term expiring January 15, 2009, with an option to purchase the property during the pendency of the lease and an obligation to purchase the property for nominal consideration upon its expiration. The IRB's were paid off on January 4, 1993, the lease was terminated, and the Company took title to the land. Due to the continuing shrinkage of the military and aerospace markets, Kaydon consolidated its three Muskegon, Michigan plants into two buildings and closed this plant which is located within a modern industrial park during the year. Management does not anticipate a material impact, if any, on earnings relating to the sale of this facility and anticipates that the desirable location will allow the plant facility to be sold for at least book value. Kaydon operates at two sites in Sumter, one site is owned and the other is leased (under a capitalized lease) in connection with a $4,000,000 Industrial Revenue Bond financing for a term expiring April 1, 1997, with an option to purchase the property during the pendency of the lease and an obligation to purchase the property for nominal consideration upon its expiration. The St. Louis property is leased for a term expiring July 31, 1997. The property in Reading, England, is leased for a term expiring May 1, 2009. The Krefeld, Germany property is leased for a term expiring September 30, 1994. The Corporate office located in Clearwater, Florida is leased for a term expiring January 31, 1999. Kaydon Corporation is the sole shareholder of the following operating subsidiaries: Item 3.

Item 3. LEGAL PROCEEDINGS The Company, together with other companies, certain former officers, and certain current and former directors, has been named as a co-defendant in lawsuits filed in the federal court in New York. The suits purport to be class actions on behalf of all persons who have unsatisfied personal injury and property damage claims against Keene Corporation. The premise of the suits is that assets of Keene were transferred to Bairnco subsidiaries, of which Kaydon was one in 1983, at less than fair value. The suits also allege that the Company, among other named defendants, was a successor to and alter ego of Keene. While the ultimate outcome of this litigation is unknown at the present time, management believes that it has meritorious defenses to the asserted claims. Accordingly, no provision has been reflected in the financial statements for any alleged damages. Management believes that the outcome of this litigation will not have a materially adverse effect on the Company's financial position. Various other claims, lawsuits and environmental matters arising in the normal course of business are pending against the Company. Management believes that the outcome of these matters will not have a materially adverse effect on the Company's financial position or results of operations. Item 4.

Item 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1993. PART II Item 5.

Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY & RELATED STOCKHOLDER MATTERS a. and c. Market Information and Dividends Information regarding the market price of Kaydon's common stock appears in Note 14, "Quarterly Results of Operations" of the Notes to Consolidated Financial Statements on page 27 of Kaydon's 1993 Annual Report to Stockholders, which is incorporated herein by reference. During 1992, the Company effected a two-for-one stock split; accordingly, all applicable financial data has been restated to reflect the split. Kaydon's common stock is listed on NASDAQ (over the counter) under the symbol KDON. Kaydon declared cash dividends during 1991, 1992 and 1993 as follows (on a per-share basis): Effective with the cash dividend declared in December 1993 and paid in January 1994, Kaydon adopted a plan which calls for quarterly cash dividends of $0.10 per share. This recent increase in the dividend amount reflects Kaydon management's continuing confidence in the growing financial strength of the Company and their expectation of continued earnings growth. b. Holders The number of common equity security holders is as follows: Item 6.

Item 6. SELECTED FINANCIAL DATA Reference is made to "Financial History" on page 14 and "Management's Discussion and Analysis" on pages 15 and 16 of Kaydon's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to "To Our Stockholders" on pages 2 through 4 and "Management's Discussion and Analysis" on pages 15 and 16 of Kaydon's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the financial statements and related notes included on pages 18 through 28 and "Quarterly Results of Operations" on page 27 of Kaydon's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Financial statement schedules are included in Part IV of this filing. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required with respect to directors of Kaydon is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and is incorporated herein by reference. The information required with respect to executive officers of the company is as follows: Item 11.

Item 11. EXECUTIVE COMPENSATION The information required by Item 11 is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and is incorporated herein by reference. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and is incorporated herein by reference. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is included in the Proxy Statement for the 1994 Annual Meeting of Stockholders of Kaydon, which has been filed with the Securities and Exchange Commission and is incorporated herein by reference. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a. 1. Financial Statements The following consolidated financial statements of the Company are included in the Annual Report of the registrant to its stockholders for the year ended December 31, 1993 which is incorporated herein by reference in Part II, Item 8 of this report. 2. Financial Statement Schedules The following financial statement schedules and related Report of Independent Public Accountants on Financial Statement Schedules are included in this Form 10-K on the pages noted: All other schedules required by Form 10-K Annual Report have been omitted because they were inapplicable, the required information is included in the notes to the consolidated financial statements or otherwise is not required under instructions contained in Regulation S-X. Financial statements of the Company have been omitted since the Company is primarily an operating company and all subsidiaries included in the consolidated financial statements filed are wholly owned subsidiaries. 3. Reference to Exhibits Reference is made to the Exhibit Index which is found on pages 27 through 34 of this Form 10-K. b. Reports on Form 8-K No reports on Form 8-K have been filed during the fourth quarter of 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and Board of Directors of Kaydon Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Kaydon Corporation and Subsidiaries' annual report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 20, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed at Item 14.a.2. above are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. - - ------------------------- ARTHUR ANDERSEN & CO. Grand Rapids, Michigan January 20, 1994 (a) Plant and equipment of businesses acquired at date of acquisition. (b) Reclassification of plant and equipment. (c) Adjustment for change in foreign currency exchange rate. (a) Adjustment for change in foreign currency exchange rate. (1) Calculated based on daily balances. (2) Calculated based on daily rates. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Kaydon has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of Kaydon and in the capacities and on the dates indicated. c. 1. Exhibits Index

35527_1993.txt

35527

1993

ITEM 1. BUSINESS FIFTH THIRD BANCORP ORGANIZATION Registrant was organized in 1974 under the laws of the State of Ohio. It began operations in 1975 upon reorganization of its principal subsidiary The Fifth Third Bank. The executive offices of the Registrant are located in Cincinnati, Ohio. The Registrant is a multi-bank holding company as defined in the Bank Holding Company Act of 1956, as amended, and is registered as such with the Board of Governors of the Federal Reserve System. Registrant is also a unitary savings and loan holding company and is registered with the Office of Thrift Supervision. Registrant has thirteen wholly-owned subsidiaries: The Fifth Third Bank; The Fifth Third Bank of Columbus; The Fifth Third Bank of Northwestern Ohio, National Association; The Fifth Third Bank of Southern Ohio; The Fifth Third Bank of Western Ohio, National Association; Fifth Third Community Development Company; Fifth Third Trust Co. & Savings Bank, FSB; Fountain Square Management Co.; Fifth Third Bank of Central Kentucky, Inc.; Fifth Third Bank of Northern Kentucky, Inc.; The Fifth Third Bank of Central Indiana; The Fifth Third Bank of Southeastern Indiana; and Fountain Square Insurance Company. Unless the context otherwise indicates the term "Company" as used herein means the Registrant and the term "Bank" means its wholly-owned subsidiary, The Fifth Third Bank. As of December 31, 1993, the Company's consolidated total assets were $11,966,000,000 and capital accounts totalled $1,197,646,000. The Bank has four wholly-owned subsidiaries: Midwest Payment Systems, Inc.; Fifth Third Securities, Inc.; The Fifth Third Company; and The Fifth Third Leasing Company. PRIOR ACQUISITIONS The Company is the result of mergers and acquisitions over the years involving 25 financial institutions throughout Ohio, Indiana, Kentucky, and Florida. The Company during 1993 made the following acquisitions: On January 22, 1993, the Company purchased $54 million in deposits from Home Savings of America. The three offices were located in Oxford, Fremont, and Chillicothe Ohio and were acquired by The Bank, The Fifth Third Bank of Northwestern Ohio, National Association and the Fifth Third Bank of Southern Ohio, respectively. On February 26, 1993, the Company purchased $106 million in deposits of six Cincinnati banking offices of First National Bank of Dayton which were acquired by the Bank. On October 18, 1993, the Company purchased $131 million in deposits from World Savings and Loan Association. The two branches located in Norwalk and Sandusky, Ohio were acquired by The Fifth Third Bank of Northwestern Ohio, National Association and the three branches located in Piqua and Sidney, Ohio were acquired by The Fifth Third Bank of Western Ohio, National Association. Page 3 On December 23, 1993, the Company acquired The TriState Bancorp with consolidated assets of approximately $342 million. TriState's subsidiary, First Financial Savings Association, F.A., which had six branches in Cincinnati, was merged with the Bank. OTHER OPERATIONS The Company has other operations conducted through non-bank entities as follows: Fountain Square Insurance Company, a wholly-owned subsidiary of the Company, was formed for the purpose of engaging in credit life, accident and health insurance underwriting and reinsurance activities. Fifth Third Community Development Company, a wholly-owned subsidiary of the Company, was formed for the purpose of engaging in development and rehabilitation of real estate, investment in business ventures, and related activities specifically designed to address the needs in housing, employment, and public facilities of low and moderate income persons and communities. Fountain Square Management Co., a wholly-owned subsidiary of the Company, was formed for the purpose of engaging in real estate management of the Fifth Third Center and other Company owned properties. Fifth Third Company, a wholly-owned subsidiary of the Bank, owns a 32-story office tower and 5-story office building and parking garage known as the Fifth Third Center and the William S. Rowe Building, respectively. The Company occupies 70% of the buildings and leases the remainder to commercial and retail tenants. Fifth Third Securities, Inc., a wholly-owned subsidiary of the Bank, is a registered broker-dealer, through which the Company operates its securities brokerage business. Fifth Third Leasing Company, a wholly-owned subsidiary of the Bank, is engaged in the business of leasing personal property. Midwest Payment Systems, Inc., a wholly-owned subsidiary of the Bank, engages in providing merchant processing, electronic funds transfers and other data processing services. THE FIFTH THIRD BANK ORGANIZATION The present Bank is the result of mergers and acquisitions over the years involving thirty-one Cincinnati financial institutions, the oldest of which was The Bank of Ohio Valley, organized June 17, 1858. Other major banks involved in the mergers were The Fifth National Bank, The Third National Bank and The Union Trust Company. Sixty-three of the Bank's banking centers are located in Hamilton County, Ohio; with its other banking centers in the following counties: Butler County - 12; Clermont County - 5; Cuyahoga Co 3; Lake County - 5; Montgomery County - 12; and Warren County - 7. Page 4 As of December 31, 1993, the Bank's total assets were $6,875,027,000 including total loans and leases of $4,847,723,000. On that date, total deposits were $4,605,082,000 and capital accounts totalled $518,088,000. The Bank in 1993 opened 10 new banking centers, purchased or acquired through merger 12 banking centers, transferred 2 banking centers to an affiliate and closed 3 banking centers. The Bank has 34 Bank Marts(R), non-traditional centers located in select grocery stores, which combine location accessibility with extended hours on Saturday and Sunday afternoons. The Bank provides full service banking to individuals, industry and governmental agencies through each of its 118 banking centers. The Company, through its Affiliates and the Bank, provides a full line of banking services including Retail, Commercial, Trust & Investment, and Data Processing. RETAIL BANKING Retail Banking is responsible for operating the 102 banking centers in southwestern Ohio. The Affiliate Division is responsible for the operations of the Company's other nine banks throughout Ohio, Kentucky, Indiana and Florida. The banking centers offer full service banking to individuals, industry and governmental agencies providing customers with easy accessibility to banking services. The Bank operates banking centers which are open seven days a week (which are referred to under the federally registered trademark as "Bank Marts") in select Kroger, FINAST and Marsh Supermarkets and retirement centers, providing the ultimate in convenience for the busy consumer of the '90s. Convenience and personal service, delivered along with a comprehensive package of banking products continue to reinforce the Company's marketing position. The Bank makes a strong impact on the southwestern Ohio retail banking market through a great variety of services, including personal checking accounts and savings programs, certificates of deposit, money market accounts, individual retirement accounts and Keogh plans. Consumer Banking includes the Bankcard, Installment Loan, Leasing and Residential Mortgage Loan Departments, services individual as well as corporate customers, offering a broad range of credit programs for all retail customers including credit card banking under the VISA and MasterCard designation, as well as private label cards, installment loans, student loans, and secured and unsecured personal loans. The Residential Mortgage Loan Department provides FHA, VA and conventional as well as adjustable rate mortgage loans to individuals, and is active in originating mortgages for sale in the secondary market. The Affiliate banks are headquartered in major geographic areas and make a strong impact on the banking market in the region. These banks provide full service banking including consumer lending, commercial lending, and trust and investment services making a major contribution to the Company's strong growth. Twenty-three of the Company's new banking centers were opened or purchased by the Affiliate banks bringing the total to 171 banking centers. The Affiliate banks had a strong year with 1993 net income increasing 24.4 percent over 1992. The Affiliates Division is also responsible for identifying acquisition candidates and for coordinating the merging of the acquired institutions and branches into the Company. The Company's Annual Report has a full discussion of announced acquisitions expected to occur in 1994. Page 5 COMMERCIAL BANKING Commercial Banking experienced solid growth in commercial loan and lease outstandings during 1994 with significant improvement in credit quality. The Company's strong capital base and consistent earnings performance allow flexibility to work with its borrowers. A sound lending philosophy, aggressive calling, cross-selling techniques and a strong focus on customer service allowed Commercial Banking to experience strong growth. Commercial Banking provides a variety of services to meet the needs of the Bank's corporate customers. Available are all types of commercial loans, including lines of credit, revolving credits, term loans, real estate mortgage loans and other specialized loans including asset-based financing as well as various types of commercial leases. The Company further serves the requirements of large and small industrial and commercial enterprises by providing cash management services including freight payment, payroll programs, merchant banking services, cashiering, lockbox and other automated services. Relationship banking continues to be the focus, with emphasis on product packages and cross-selling to produce outstanding results. The Bank through its Financial Institutions Department, serves as correspondent for numerous banks principally located in the four state area of Ohio, Kentucky, Indiana and West Virginia. The Bank offers a wide variety of services to its correspondent banks, including check clearance, loan participation, automated data processing services as well as investment, trust, pension and profit sharing services. The Bank through the International Department, assists local businesses and customers in carrying out their import-export activities and provides letters of credit, foreign exchange, banker's acceptance financing and other related international banking services. TRUST & INVESTMENT SERVICES The Trust & Investment Group is customer driven offering a full range of trust and investment services for individuals, corporations and not-for-profit organizations. The Company offers investment management to all its customers. For those who prefer to choose their own investment options, Fifth Third Securities, Inc., the Bank's brokerage subsidiary, offers full-service brokerage to both institutional and retail customers. For the year ended December 31, 1993, the Trust & Investment Services, primarily within the Bank, had over $38 billion in assets under care, of which approximately $7 billion is under management. The Personal Trust Department offers a diverse range of investment and financial services, including Investment Management, Private Banking, Tax and Real Estate Services, Trust Services, Estate Planning and a Foundation Office. These services are tailored to suit any individual's needs. Corporations and non-profit organizations also benefit from the Bank's wide range of services, including Investment Management, Employee Benefits, Corporate Trust, Stock Transfer, Securities Custody, Mutual Funds, Custody and Endowments. Page 6 The Bank is the Investment Advisor of the Fountain Square Funds. The Fountain Square Funds is a family of mutual funds consisting of three money market funds and six stock and bond funds. At December 31, 1993 the Fountain Square Funds' assets were approximately $1 billion. DATA PROCESSING Midwest Payment Systems, Inc. ("MPS") a subsidiary of the Bank, provides computer services and electronic funds transfer services for the Bank as well as for other retail and financial institutions. MPS is one of the nation's leading providers of electronic funds transfer (EFT) services, servicing customers nationwide and a source of substantial fee income. MPS is active in the Point of Sale (POS) business, where it has become a national force in credit card authorization and data capture. MPS is committed to growth as a single- source solution for financial institutions, retail businesses and governmental entities. MPS offers an online automated teller machine (ATM) network, known as the JEANIE(R) network, and serves as the transaction switch processor for several regional ATM Networks including MONEY(SM) Station of Ohio located principally in Ohio where the JEANIE network members participate, the Kentucky regional ATM Network called the QUEST Network, and a shared ATM Network operating in Chicago, Illinois called CASH(SM) Station. It also provides other electronic banking services to financial institutions throughout the United States and online credit card authorization and data capture for retail merchants at the point of sale. ____________________ (R) Registered Trademark with U.S. Pat. & T.M. Office (SM) Service Mark owned by Money Station, Inc. (SM) Service Mark owned by Cash Station, Inc. FINANCE The Finance Group consists of the Treasury and Accounting Groups. The Treasury Group's responsibilities primarily include monitoring and managing the Company's net interest income in response to changes in economic conditions and interest rate movements. The Treasury Group monitors changes in the Company's financial risk exposures and coordinates strategies with various business units, and manages and monitors the Bank's and the Company's money market funding, asset liability management, institutional security dealer sales, investor relations areas, and monitors the affiliate banks' investment portfolios. COMPETITION There are hundreds of commercial banks, savings and loans and other financial service providers in Ohio, Kentucky, Indiana and Florida, and adjoining states, thus providing strong competition to the Company's subsidiaries. With respect to correspondent banking, the Bank's area of competition includes most of Kentucky and southern Ohio and parts of Indiana and West Virginia. The Company's subsidiaries compete for deposits with commercial banks, savings and loan associations and other competitors such as brokerage houses and for retail and commercial business with banks in other areas of the country, many of which possess greater financial resources. With respect to the data processing services, the Bank competes with other third party service providers such as Deluxe Data Services, EDS and Electronic Payment Systems. Page 7 The earnings of the Company are affected by general economic conditions as well as by the monetary policies of the Federal Reserve Board. Such policies, which include regulating the national supply of bank reserves and bank credit, can have a major effect upon the source and cost of funds and the rates of return earned on loans and investments. The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits. REGULATION AND SUPERVISION The Company, as a bank holding company, is subject to the restrictions of the Bank Holding Company act of 1956, as amended. This Act provides that the acquisition of control of a bank is subject to the prior approval of the Board of Governors of the Federal Reserve System. The Company is required to obtain the prior approval of the Federal Reserve Board before it can acquire control of more than 5% of the voting shares of another bank. The Act does not permit the Federal Reserve Board to approve an acquisition by the Company, or any of its subsidiaries, of any bank located in a state other than Ohio, unless the acquisition is specifically authorized by the law of the state in which such bank is located. The Bank, as a state member bank, is subject to regulation by the Superintendent of Banks of the State of Ohio, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation. The Company and any other subsidiaries which it now owns or may hereafter acquire are considered affiliates of the Bank as that term is defined in the Securities Act of 1933, as amended. The Company's other affiliate state banks are primarily subject to the laws of the state in which each is located, the Board of Governors of the Federal Reserve System and/or the Federal Deposit Insurance Corporation. The affiliate banks which are organized under the laws of the United States are primarily subject to regulation by the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Company and its banking affiliates are subject to certain restrictions on loans by the Bank, on investments by the Bank in their stock and on its taking such stock and securities as collateral for loans to any borrower. The Company and affiliates of the Bank are also subject to certain restrictions with respect to engaging in the underwriting and public sale and distribution of securities. In addition, any such affiliates of the Bank will be subject to examination at the discretion of supervisory authorities. The Company as a saving and loan holding company and its savings and loan subsidiary is subject to examination and regulation by the Office of Thrift Supervision. The Bank Holding Company Act limits the activities which may be engaged in by the Company and its subsidiaries to ownership of banks and those activities which the Federal Reserve Board has deemed or may in the future find to be so closely related to banking as to be a proper incident thereto. Page 8 Those activities presently authorized by the Federal Reserve Board include the following general activities: (1) the making or servicing of loans or other extensions of credit; (2) operating as an industrial bank, Morris Plan Bank, or industrial loan company according to state law without the accepting of demand deposits and without the making of commercial loans; (3) performing the functions and activities of a trust company; (4) acting with certain limitations as investment or financial advisor; (5) leasing personal property and equipment; (6) the making of equity and debt investments in projects or corporations designated primarily to promote community welfare; (7) providing bookkeeping and data processing services for the internal operations of the bank holding company and its subsidiaries; and providing to others data processing and transmission services and facilities for banking, financial or related economic data; (8) acting as insurance agent or broker under certain circumstances and with respect to certain types of insurance, including underwriter for credit life insurance, credit accident insurance and health insurance which is directly related to extensions of credit by the bank holding company system; (9) providing limited courier services for the internal operations of the holding company, for checks exchanged among banking institutions, and for audit and accounting media of a banking or financial nature used in processing such media; (10) providing management consulting advice to non-affiliate banks under certain limitations; (11) the retail sale of money orders with a face value of $1,000 or less, of travelers checks and of U.S. Savings Bonds; (12) performing appraisals of real estate; (13) acting as intermediary in arranging financing of commercial or industrial income-producing real estate; (14) providing securities brokerage services, (restricted to buying and selling securities solely as agent for customers), related securities activities and incidental activities; (15) underwriting and dealing in government obligations and money market instruments; (16) foreign exchange advisory and transactional services; (17) acting as futures commission merchant; (18) providing investment advice on financial futures and options on futures; (19) providing consumer financial counseling; (20) providing tax planning and preparation; (21) providing check guaranty services; (22) operating a collection agency; and (23) operating a credit bureau. For details and limitations on these activities, reference should be made to Regulation Y of the Federal Reserve Board, as amended. Further, under the 1970 amendment of this Act and the regulations of the Federal Reserve Board, the Company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provisions of any property or service. EMPLOYEES As of December 31, 1993, there were no full time employees of the Company. Affiliates of the Company employed 5,294 employees of whom 860 were officers and 1,162 were part-time employees. STATISTICAL INFORMATION Pages 10 to 17 contain statistical information on the Company and its subsidiaries. Page 9 SECURITIES PORTFOLIO The securities portfolio as of December 31 for each of the last five years, and the maturity distribution and weighted average yield of securities as of December 31, 1993, are incorporated herein by reference to the securities tables on page 30 of the Company's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. The weighted average yields for the securities portfolio are yields to maturity weighted by the par values of the securities. The weighted average yields on securities exempt from income taxes are computed on a taxable equivalent basis. The taxable equivalent yields are net after-tax yields to maturity divided by the complement of the full corporate tax rate (35%). In order to express yields on a taxable equivalent basis, yields on obligations of states and political subdivisions have been increased as follows: Under 1 year 2.43% 1 - 5 years 2.73% 6 - 10 years 2.65% Over 10 years 3.09% Total securities 2.64% The Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Debt and Equity Securities," effective December 31, 1993. This Statement requires securities to be classified as held to maturity, available for sale or trading. Only those securities classified as held to maturity are reported at amortized cost, with those available for sale and trading reported at fair value with unrealized gains and losses included in stockholders' equity or income, respectively. Refer to pages 19 and 20 in the Company's 1993 Annual Report to Stockholders for a summary of the investment portfolio classifications at December 31, 1993. The investment portfolio has increased in size during the past year due in part to the securitization and transfer to securities of $291,586,000 in residential mortgage loans. The investment portfolio is comprised largely of fixed and variable rate mortgage-backed securities. These AAA rated securities are backed by first mortgages on single-family homes predominately underwritten to the standards of and guaranteed by the government sponsored agencies of GNMA, FNMA and FHLMC. They differ from traditional debt securities primarily in that they have uncertain maturity dates, and are priced based on estimated prepayment rates on the underlying mortgages. The estimated average life of the portfolio is three years and six months, which is very short by industry standards and minimizes our exposure to the risk of rising interest rates. The Company holds no securities which would be classified as high risk under the new FFIEC guidelines on mortgage-backed securities. The Company had sales of securities available for sale of approximately $230 million during 1993. This activity resulted in $6.5 million in realized securities gains, less than 2.2% of income before income taxes, and represented 12.2% of total security gains, realized and unrealized, as of December 31, 1993. AVERAGE BALANCE SHEETS The average balance sheets are incorporated herein by reference to Table 1 on pages 26 and 27 of the Company's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ANALYSIS OF NET INTEREST INCOME AND NET INTEREST INCOME CHANGES The analysis of net interest income and the analysis of net interest income changes are incorporated herein by reference to Table 1 and Table 2 and the related discussion on pages 26 through 28 of the Company's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. Reserve for Credit Losses - ------------------------- The reserve for credit losses is established through charges to operations by a provision for credit losses. Loans and leases which are determined to be uncollectible are charged against the reserve and any subsequent recoveries are credited to the reserve. The amount charged to operations is based on several factors. These include the following: 1. Analytical reviews of the credit loss experience in relationship to outstanding loans and leases to determine an adequate reserve for credit losses required for loans and leases at risk. 2. A continuing review of problem or at risk loans and leases and the overall portfolio quality. 3. Regular examinations and appraisals of the loan and lease portfolio conducted by the Bank's examination staff and the banking supervisory authorities. 4. Management's judgement with respect to the current and expected economic conditions and their impact on the existing loan and lease portfolio. The amount provided for credit losses exceeded actual net charge-offs by $18,224,000 in 1993, $20,629,000 in 1992 and $5,001,000 in 1991. Management reviews the reserve on a quarterly basis to determine whether additional provisions should be made after considering the factors noted above. Based on these procedures, management is of the opinion that the reserve at December 31, 1993 of $135,097,000 is adequate. Maturity Distribution of Domestic Certificates of Deposit of $100,000 and Over - ------------------------------------------------------------------------------ at December 31, 1993 ($000's) ----------------------------- Under 3 months $174,719 3 to 6 months 70,717 7 to 12 months 45,625 Over 12 months 14,469 -------- Total certificates - $100,000 and over $305,530 ======== Note: Foreign office deposits are denominated in amounts greater than $100,000. Purchase of Deposits - -------------------- On January 22, 1993, the Company purchased $54 million of deposits as well as the facilities of three Home Savings of America offices in Oxford, Chillicothe and Fremont, Ohio. On February 26, 1993, the Company purchased $106 million in deposits and the facilities of six First National Bank of Dayton locations in Cincinnati. On October 18, 1993, the Company purchased $131 million in deposits and the facilities of five World Savings and Loan Association branches in western and northwestern Ohio. Funds Borrowed - -------------- Funds borrowed is comprised of various short-term sources of funds. A summary of the average outstanding, maximum month-end balance and weighted average interest rate for the years ended December 31 follows ($000's): 1993 1992 1991 ---- ---- ---- Average outstanding $1,275,568 1,173,253 766,860 Maximum month-end balance $1,602,217 1,436,203 1,042,566 Weighted average interest rate 3.00% 3.47 5.59 Return on Equity and Assets - --------------------------- The following table presents certain operating ratios: 1993 1992 1991 ------ ------ ------ Return on assets (A) 1.80% 1.74 1.68 Return on equity (B) 18.2% 17.3 16.6 Dividend payout ratio (C) 31.8% 33.0 33.7 Equity to assets ratio (D) 9.92% 10.07 10.11 - ----------------------------------------- (A) net income divided by average assets (B) net income divided by average equity (C) dividends declared per share divided by fully diluted net income per share (D) average equity divided by average assets ITEM 2.

ITEM 2. PROPERTIES The Company's executive offices and the main office of the Bank are located on Fountain Square Plaza in downtown Cincinnati, Ohio. On August 17, 1983, these facilities, located in a 32-story office tower and a 5-story office building and parking garage known as the Fifth Third Center and the William S. Rowe Building, respectively, were purchased by a subsidiary of the Bank, as a 65% partner in a partnership with two other partners. The Bank's subsidiary has acquired the interest of the other two partners and now owns 100% of the Fifth Third Center and the William S. Rowe Building. The Bank operates 118 banking centers, of which 53 are owned and 65 are leased. These leases have various expiration dates to the year 2013. Properties owned by the Bank are free from mortgages and encumbrances. The Company has nine other affiliate banks, four located in Ohio, two in Kentucky, two in Indiana, and one in Florida. The affiliate banks operate 171 banking centers, of which 99 are owned and 72 are leased. OHIO BANKS The Fifth Third Bank of Columbus opened 7 new banking centers, 3 of which were Bank Marts. The Fifth Third Bank of Columbus, with its main office in the Fifth Third Center, Columbus, Ohio, now has 35 locations. The Fifth Third Bank of Northwestern Ohio, National Association, opened 1 new banking center and purchased 3 banking centers. The Fifth Third Bank of Northwestern Ohio, National Association, with its main office located in Toledo, Ohio, now has 49 locations. The Fifth Third Bank of Western Ohio, National Association, purchased 3 banking centers (2 of which were later closed), and closed 1 banking center. The Fifth Third Bank of Western Ohio, National Association, with its main office located in Piqua, Ohio, now has 28 locations. The Fifth Third Bank of Southern Ohio purchased 1 banking center, and had 2 banking centers transferred from the Bank. The Fifth Third Bank of Southern Ohio, with its main office located in Hillsboro, Ohio, now has 13 locations. KENTUCKY BANKS Fifth Third Bank of Northern Kentucky, Inc., opened 3 new banking centers. The Fifth Third Bank of Northern Kentucky, with its main office located in Covington, Kentucky, now has 18 locations. Fifth Third Bank of Central Kentucky, Inc., opened 2 new banking centers. The Fifth Third Bank of Central Kentucky, Inc., with its main office in Lexington, Kentucky, now has 6 locations. INDIANA BANKS The Fifth Third Bank of Central Indiana opened 4 new banking centers, 2 of which were Bank Marts. The Fifth Bank of Central Indiana, with its main office in Indianapolis, Indiana, now has 15 locations. The Fifth Third Bank of Southeastern Indiana did not open or close any banking centers in 1993. The Fifth Third Bank of Southeastern Indiana, with its main office located in Greensburg, Indiana, has 6 locations. FLORIDA SAVINGS BANK Fifth Third Trust Co. & Savings Bank, FSB, relocated its banking center to a new full-service location in 1993. The Fifth Third Trust Co. & Savings Bank, FSB, has its main office and banking center located in Naples, Florida. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are not parties to any material legal proceedings other than routine litigation incidental to its business. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None EXECUTIVE OFFICERS The names, ages and positions of the Executive Officers of the Company as of January 31, 1994 are listed below along with their business experience during the past 5 years. Officers are appointed annually by the Board of Directors at the meeting of Directors immediately following the Annual Meeting of Stockholders. CURRENT POSITION and Name and Age Business Experience During Past 5 Years George A. Schaefer, Jr., 48 PRESIDENT AND CEO. President and Chief Executive Officer of the Company and the Bank since January, 1991. Previously, Mr. Schaefer was President and COO of the Company and Bank since April, 1989. Formerly, Mr. Schaefer had been Executive Vice President of the Company and the Bank. George W. Landry, 53 EXECUTIVE VICE PRESIDENT. Executive Vice President of the Company and Bank since November, 1989. Previously, Mr. Landry was Group Vice President of the Bank. Stephen J. Schrantz, 45 EXECUTIVE VICE PRESIDENT. Executive Vice President of the Company and Bank since November, 1989. Previously, Mr. Schrantz was Senior Vice President of the Bank. Michael D. Baker, 43 SENIOR VICE PRESIDENT. Senior Vice President of the Company since March, 1993, and of the Bank since July, 1987. P. Michael Brumm, 46 SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER. CFO of the Company and Bank since June, 1990, and Senior Vice President of the Bank. Robert P. Niehaus, 47 SENIOR VICE PRESIDENT. Senior Vice President of the Company since March 1993, and Senior Vice President of the Bank. Previously, Mr. Niehaus was Vice President of the Company. Michael K. Keating, 38 SENIOR VICE PRESIDENT, GENERAL COUNSEL AND SECRETARY. Senior Vice President and General Counsel of the Company since March, 1993 and Senior Vice President and Counsel of the Bank since November, 1989, and Secretary of the Company and the Bank since January, 1994. Previously, Mr. Keating was Vice President, Counsel and Assistant Secretary of the Bank and Counsel of the Company. Mr. Keating is a son of Mr. William J. Keating, Director. Neal E. Arnold, 33 TREASURER. Treasurer of the Company and the Bank since October, 1990 and Senior Vice President of the Bank since April, 1993. Previously, Mr. Arnold was Vice President of the Bank since October, 1990. Previously, Mr. Arnold was CFO and Senior Vice President with First National Bank of Grand Forks, North Dakota. Gerald L. Wissel, 37 AUDITOR. Auditor of the Company and the Bank since March 1990 and Senior Vice President of the Bank since November 1991. Previously, Mr. Wissel was Vice President of the Bank since March 1990. Mr. Wissel was formerly with Deloitte and Touche, independent public accountants. Roger W. Dean, 31 CONTROLLER. Controller of the Company and Vice President of the Bank since June, 1993. Previously, Mr. Dean was with Deloitte & Touche, independent public accountants. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item is incorporated herein by reference to Page 1 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The information required by this item is incorporated herein by reference to page 35 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is incorporated herein by reference to pages 26 through 34 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated herein by reference to pages 15 through 25 and page 35 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item concerning Directors is incorporated herein by reference under the caption "ELECTION OF DIRECTORS" of the Registrant's 1994 Proxy Statement. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated herein by reference under the caption "EXECUTIVE COMPENSATION" of the Registrant's 1994 Proxy Statement. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated herein by reference under the captions "CERTAIN BENEFICIAL OWNERS, ELECTION OF DIRECTORS, AND EXECUTIVE COMPENSATION" of the Registrant's 1994 Proxy Statement. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated herein by reference under the caption "CERTAIN TRANSACTIONS" of the Registrant's 1994 Proxy Statement. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) Documents Filed as Part of the Report PAGE 1. Index to Financial Statements Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 * Consolidated Balance Sheets, December 31, 1993 and 1992 * Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 * Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 * Notes to Consolidated Financial Statements * * Incorporated by reference to pages 15 through 25 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. 2. Financial Statement Schedules The schedules for Registrant and its subsidiaries are omitted because of the absence of conditions under which they are required, or because the information is set forth in the consolidated financial statements or the notes thereto. 3. Exhibits EXHIBIT NO. 3- Amended Articles of Incorporation and Code of Regulations ** 10(a)- Fifth Third Bancorp Unfunded Deferred Compensation Plan for Non-Employee Directors *** 10(b)- Fifth Third Bancorp 1990 Stock Option Plan **** 10(c)- Fifth Third Bancorp 1987 Stock Option Plan ***** 10(d)- Fifth Third Bancorp 1982 Stock Option Plan ****** 10(e)- Fifth Third Bancorp Stock Option Plan for Employees of The Fifth Third Bank of Miami Valley, National Association ******* 10(f)- Fifth Third Bancorp Stock Option Plan for Employees of The Fifth Third Bank of Eastern Indiana ******** 10(g)- Indenture effective November 19, 1992 between Fifth Third Bancorp, Issuer and NBD Bank, N.A., Trustee ********* 10(h)- Fifth Third Bancorp Amended and Restated Stock Option Plan for Employees and Directors of The TriState Bancorp ********** 10(i)- Fifth Third Bancorp 1993 Discount Stock Purchase Plan *********** 11- Computation of Consolidated Net Income Per Share for the Years Ended December 31, 1993, 1992, 1991, 1990 and 1989 13- Fifth Third Bancorp 1993 Annual Report to Stockholders 21- Fifth Third Bancorp Subsidiaries 23- Independent Auditors' Consent b) Reports on Form 8-K NONE. ____________________ ** Incorporated by reference to Registrant's Registration Statement, Exhibits 3.1 and 3.2, on Form S-4, Registration No. 33-19965 which is effective. *** Incorporated in this Form 10-K Annual Report by reference to Form 10-K filed for fiscal year ended December 31, 1985. **** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 34075, which is effective. ***** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 13252, which is effective. ****** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 2-98550, which is effective. ******* Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 20888, which is effective. ******** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission on November 18, 1992 a Form 8-K Current Report as an exhibit to a Registration Statement on Form S-8, Registration No. 33-30690, which is effective. ********* Incorporated by reference to Registrant's filing with the Securities and Exchange Commission on November 18, 1992 a Form 8-K Current Report dated November 16, 1992 and as Exhibit 4.1 to a Registration Statement on Form S-3, Registration No. 33-54134, which is effective. ********** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 51679, which is effective. *********** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 60474, which is effective. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIFTH THIRD BANCORP (Registrant) /s/George A. Schaefer, Jr. February 15, 1994 George A. Schaefer, Jr. President and CEO (Principal Executive Officer) Pursuant to requirements of the Securities Exchange Act of 1934, this report has been signed on February 15, 1994 by the following persons on behalf of the Registrant and in the capacities indicated. /s/P. Michael Brumm /s/Roger W. Dean P. Michael Brumm Roger W. Dean Senior Vice President and CFO Controller (Chief Financial Officer) (Principal Accounting Officer) /s/John F. Barrett /s/Richard T. Farmer /s/Robert B. Morgan John F. Barrett Richard T. Farmer Robert B. Morgan Director Director Director /s/John D. Geary /s/Michael H. Norris J. Kenneth Blackwell John D. Geary Michael H. Norris Director Director Director Milton C. Boesel, Jr.Ivan W. Gorr Brian H. Rowe Director Director Director /s/Clement L. Buenger/s/Joseph H. Head, Jr. /s/George A. Schaefer, Jr. Clement L. Buenger Joseph H. Head, Jr. George A. Schaefer, Jr. Director Director Director /s/Nolan W. Carson /s/Joan R. Herschede /s/John J. Schiff, Jr. Nolan W. Carson Joan R. Herschede John J. Schiff, Jr. Director Director Director /s/Thomas L. Dahl /s/William G. Kagler Thomas L. Dahl William G. Kagler Stephen Stranahan Director Director Director /s/Gerald V. Dirvin /s/William J. Keating /s/Dennis J. Sullivan, Jr. Gerald V. Dirvin William J. Keating Dennis J. Sullivan, Jr. Director Director Director /s/James D. Kiggen /s/Dudley S. Taft Thomas B. Donnell James D. Kiggen Dudley S. Taft Director Director Director

814677_1993.txt

814677

1993

ITEM 1. BUSINESS. A. Introduction (i) Background. PLM International, Inc. ("PLM International" or the "Company" or "PLMI"), a Delaware corporation, is a transportation equipment leasing company specializing in the management of equipment on operating leases domestically and internationally. The Company is also the leading sponsor of syndicated investment programs organized to invest primarily in transportation equipment. The Company operates and manages approximately $1.4 billion of transportation equipment and related assets for its account and various investment partnerships and third party accounts. An organization chart for PLM International indicating the relationships of active legal entities is shown in Table I: TABLE 1 ORGANIZATION CHART PLM International, Inc., a Delaware corporation, the parent corporation. Subsidiaries of PLM International, Inc.: PLM Financial Services, Inc., a Delaware corporation; PLM Railcar Management Services, Inc., a Delaware corporation; and Transportation Equipment Indemnity Company, Ltd., a Bermuda corporation. Subsidiaries of PLM Financial Services, Inc.: PLM Investment Management, Inc., a California corporation; PLM Transportation Equipment Corporation, a California corporation; PLM Securities Corp., a California corporation. A Subsidiary of PLM Transportation Equipment Corporation is PLM Rental, Inc., a Delaware corporation. A Subsidiary of PLM Railcar Management Services, Inc. is PLM Railcar Management Services Canada, Ltd., an Alberta corporation. Note: All entities are 100% owned PAGE (ii) Description of Business PLM International owns and manages a portfolio of transportation equipment consisting of approximately 50,000 individual items with an original cost of approximately $1.4 billion (shown in Table 2). The Company manages equipment and related assets for approximately 71,000 investors in various limited partnerships or investment programs. (iii) Equipment Owned. The Company leases its own equipment to a wide variety of lessees. In general, the equipment leasing industry is an alternative to direct equipment ownership. It is a highly competitive industry that offers varying lease terms that range from day-to-day to a term equal to the economic life of the equipment ("Full Payout"). Generally, leases that are for a term less than the economic life of the equipment are known as operating leases because the aggregate lease rentals accruing over the initial lease period are less than the cost of the leased equipment. PLM International's focus is on providing equipment under operating leases. This type of lease generally commands a higher lease rate for the equipment than Full Payout leases. This emphasis on operating leases requires highly experienced management and support staff, as the equipment must be periodically re-leased to continue generating rental income, and thus, to maximize the long-term return on investment in the equipment. In appropriate circumstances, certain equipment, mainly marine containers, is leased to utilization-type pools which pools include equipment owned by unaffiliated parties. In such instances, revenues received by the Company consist of a specified percentage of the pro-rata share of lease revenues generated by the pool operator from leasing the pooled equipment to its customers, after deducting certain direct operating expenses of the pooled equipment. With respect to trailer leasing activities, the Company has refocused its direction by marketing over-the-road trailers through its subsidiary PLM Rental, Inc. ("PLM Rental") on short-term leases through rental yards located in ten major U.S. cities. In addition, the Company markets its intermodal trailers on short-term arrangements through a licensing agreement with a short line railroad. In 1991, the Company expanded its short-term trailer rental operations by purchasing seven existing rental yards, transferring portions of its existing fleet to rental yard operations and purchasing additional trailers at attractive prices. In addition, the Company markets on-site storage units protected by a patented security system through both existing facilities and PLM Rental's facilities. Over the past five years, approximately 95% of all equipment (owned and managed) on average, was on lease. (See Table 3.) Set forth below in Table 3 are details of the development of the Company's managed equipment portfolio and off-lease performance over the past five years. (iv) Subsidiary Business Segments: (A) PLM Financial Services, Inc. The Company's financial services activities, as conducted by PLM Financial Services, Inc. ("FSI") along with its primary subsidiaries: PLM Transportation Equipment Corporation ("TEC"); PLM Securities Corp. ("PLM Securities"); and PLM Investment Management, Inc. ("IMI"), center on the development, syndication and management of investment programs, principally limited partnerships, which acquire and lease transportation equipment. Depending on the objectives of the particular program, the programs feature various combinations of current cash flow and income tax benefits through investments in long-lived, low obsolescence transportation and related equipment. Programs sponsored by FSI are offered nationwide through a network of unaffiliated national and regional broker-dealers and financial planning firms. FSI has completed the offering of fourteen public programs which have invested in diversified portfolios of transportation and related equipment. In 1986, FSI introduced the PLM Equipment Growth Fund ("EGFs") investment series. The EGFs are limited partnerships designed to invest primarily in used transportation equipment for lease in order to generate current operating cash flow for (i) distribution to investors and (ii) reinvestment into additional used transportation equipment. An objective of the EGFs is to maximize the value in the equipment portfolio and provide cash distributions to investors by acquiring and selling items of equipment at times when prices are most advantageous to the investor. The cumulative equity raised by PLM International for its affiliated investment limited partnerships now stands at $1.5 billion. The Company has raised more syndicated equity for equipment leasing programs than any other syndicator in United States history. Annually, since 1983, PLM International has been one of the top three equipment leasing syndicators in the United States. Annually, from 1990 through 1993, the Company has ranked as the number one diversified transportation equipment leasing syndicator in the United States. PLMI's market share for all syndicated equipment leasing programs rose to 22% in 1993 from 18% in 1992. In 1993 the Company was the number one overall equipment leasing syndicator. Since 1983, the Company is the only syndicator of equipment leasing programs to raise on average over $100,000,000 annually. EGFI, EGFII and EGFIII are listed for trading on the American Stock Exchange. Changes in the federal tax laws which could cause a partnership such as an EGF to be taxed as a corporation rather than treated as a nontaxable entity in the event its partnership interests become publicly traded prompted management of PLM International to structure EGF IV, EGF V, EGF VI and EGF VII so that they will not be publicly traded. These tax law changes do not currently apply to EGF I, EGF II or EGF III. In general, investment programs that acquire assets on an all-cash basis with the primary goal of maximizing cash flow for distribution to investors are known as income funds. The EGFs, as growth funds, may, if it is deemed advantageous to the overall program, obtain limited leverage and typically reinvest a portion of their current cash flow to acquire additional equipment to grow the equipment [FN] The Stanger Review, Partnership Sales Summary portfolio. Each of EGF I, EGF II, EGF III, EGF IV, EGF V and EGF VI have entered into long-term debt agreements with independent banks and financial institutions permitting each partnership to borrow an amount equal to approximately 20% of the original cost of equipment in the respective EGF's portfolio. The loans are non- recourse except to the assets of the respective partnerships. FSI's revenues are derived from services performed in connection with the organization, marketing and management of its investor programs. These services include acquiring and leasing equipment and a variety of management services for which the following fees are received: (1) placement fees earned from the sale of equity in the investment programs; (2) acquisition and lease negotiation fees earned for arranging delivery of equipment and the negotiation of initial use of equipment; (3) debt placement fees, as applicable, earned at the time loans (other than loans associated with the refinancing of existing indebtedness) are funded; (4) management fees earned on revenues or cash flows generated from equipment portfolios; and (5) commissions and subordinated incentive fees earned upon sale of the equipment during the liquidation stage of the program. FSI serves as the general partner for most of the partnerships offered by PLM Securities Corp. As general partner, FSI retains a 1% to 5% equity interest. FSI recognizes as other income its equity interest in the earnings or cash distributions of partnerships for which it serves as general partner. (B) PLM Transportation Equipment Corporation PLM Transportation Equipment Corporation ("TEC") is responsible for selection of equipment; negotiation and purchase of equipment; initial use and re-lease of equipment; and financing of equipment. This process includes identification of prospective lessees, analyses of lessees' credit worthiness, negotiation of lease terms, negotiations with equipment owners, manufacturers or dealers for the purchase, delivery and inspection of equipment, preparation of debt offering materials and negotiation of loans. TEC purchases transportation equipment for PLM International's own portfolio and on an interim basis for resale to various affiliated limited partnerships at cost, or to third parties. (C) PLM Securities Corp. PLM Securities Corp. ("PLM Securities") markets the investment programs through unaffiliated broker/dealers and financial planning firms throughout the United States. Sales of investment programs are not made directly to the public by PLM Securities. During 1993, approximately 200 selected broker/dealer firms with over 20,000 agents sold investment units in EGFVI and EGFVII. During 1993, Wheat First Butcher Singer and Equico Securities, Inc. accounted for approximately 16% and 12%, respectively, of the equity sales. In 1992, Equico Securities, Inc. and J.C. Bradford and Co. sold approximately 18% and 13%, respectively, of the limited partnership units offered by PLM Securities. Approximately 17.0% of the investment program units sold in 1991 were placed by Equico Securities, Inc. No other selected agent has accounted for the sale of more than 10% of the investment programs during these periods. The marketing of the investment programs is supported by PLM Securities representatives who deal directly with account executives of participating broker/dealers. PLM Securities earns a placement fee for the sale of the aforementioned investment units of which a significant portion is reallowed to the originating broker/dealer. Placement fees may vary from program to program, but in the EGF VII program, PLM Securities receives a fee of up to 9% of the capital contributions to the partnership, of which commissions of up to 8% are reallowed to the unaffiliated selling entity with the difference being retained by PLM Securities. For the year ended December 31, 1993, the Company raised investor equity totalling approximately $92,500,000 for its EGF VI and EGF VII programs. FSI continues to sponsor syndicated investor offerings involving diversified equipment types. (D) PLM Investment Management, Inc. PLM Investment Management, Inc. ("IMI") manages equipment owned by the Company and by investors in the various investment programs. The equipment consists of the following: aircraft (commercial, commuter, corporate and emergency medical services); aircraft engines; railcars and locomotives; tractors (highway); trailers (highway and intermodal, refrigerated and non- refrigerated); marine containers (refrigerated and non-refrigerated), marine vessels (dry bulk carriers and product tankers) and mobile off-shore drilling units ("MODUs"). IMI is obligated to invoice and collect rents, arrange for maintenance and repair of the equipment, pay operating expenses, debt service and certain taxes, determine that the equipment is used in accordance with all operative contractual arrangements, arrange insurance, correspond with program investors, provide or arrange clerical and administrative services necessary to the operation of the equipment, prepare financial statements and tax information materials and make distributions to investors. IMI also monitors equipment regulatory requirements and application of investor program debt covenants. (E) PLM Railcar Management Services, Inc. PLM Railcar Management Services, Inc. ("RMSI") markets and manages railcar fleets which are owned by the Company and the various investment programs. RMSI is also involved in negotiating the purchase and sale of railcars. Much of the historical responsibilities of RMSI are now being conducted by TEC. PLM Railcar Management Services Canada Limited, a wholly-owned subsidiary of RMSI and headquartered in Calgary, Alberta, Canada, provides fleet management services to the owned and managed railcars operating in Canada. (F) Transportation Equipment Indemnity Company Ltd. Transportation Equipment Indemnity Company Ltd. ("TEI") is a Bermuda-based insurance company licensed to underwrite a full range of insurance products including property and casualty risk. TEI's primary objective is to minimize the long term cost of insurance coverages for all owned and managed equipment. A substantial portion of the risks underwritten by TEI are reinsured with unaffiliated underwriters. (G) PLM Rental, Inc. PLM Rental markets trailers and storage units owned by the Company and its affiliated investor programs on short term leases through a network of rental facilities. Presently, facilities are located in Atlanta, Chicago, Dallas, Detroit, Indianapolis, Kansas City, Miami, Newark, Orlando and Tampa. All subsidiaries are 100% owned directly or indirectly by PLM International. (v) Equipment Leasing Markets Within the equipment leasing industry, there are essentially three leasing markets: the Full Payout lease, short-term rentals and the mid-term operating lease. The Full Payout lease, in which the combined rental payments are sufficient to cover the lessor's investment and to provide a return on the investment, is the most common form of leasing. This type of lease is sometimes referred to as a finance lease. Under United States generally accepted accounting principles a finance lease is accounted for as a purchase of the underlying asset. From the lessee's perspective, the election to enter into a Full Payout lease is usually made on the basis of a lease versus purchase analysis which will take into account the lessee's ability to utilize the depreciation tax benefits of ownership, its liquidity and cost of capital, and financial reporting considerations. Short-term rental lessors direct their services to a user's short-term equipment needs. This business requires a more extensive overhead commitment in the form of marketing and operating personnel by the lessor/owner. There is normally less than full utilization in the lessor's equipment fleet as lessee turnover is frequent. Lessors usually charge a premium for the additional flexibility provided through short-term rentals. To satisfy lessee short-term needs, certain equipment is leased through pooling arrangements or utilization leases. For lessees these arrangements can work effectively with respect to interchangeable equipment such as marine containers, trailers and marine vessels. From the lessor's perspective these arrangements diversify risk. Operating leases for transportation equipment generally run for a period of one to six years. Operating lease rates are usually higher than Full Payout lease rates, but lower than short-term rental rates. From a lessee's perspective, the advantages of a mid-term operating lease compared to a Full Payout lease are flexibility in its equipment commitment and the fact that the rental obligation under the lease need not be capitalized on its balance sheet. The advantage from the lessee's perspective of a mid-term operating lease compared to a short-term rental, apart from the lower monthly cost, is greater control over future costs and the ability to balance equipment requirements over a specific period of time. Disadvantages of the mid-term operating lease from the lessee's perspective are that the equipment may be subject to significant changes in lease rates for future periods or may even be required to be returned to the lessor at the expiration of the initial lease. A disadvantage from the lessor's perspective of the mid-term operating lease (as well as the short-term rental) compared to the Full Payout lease is that the equipment generally must be re-leased at the expiration of the initial lease term in order for the lessor to recover its investment. PLM International, its subsidiaries and affiliated investment programs lease their equipment primarily on mid-term operating leases and short-term rentals. Many of its leases are "net" operating leases. In a net operating lease, expenses such as insurance and maintenance are the responsibility of the lessee. The effect of entering into net operating leases is to reduce the lease rates as compared to non-net lease rates for comparable lease terms. However, the overall profitability of net operating leases is more predictable and less risk is assumed over time as the lessees absorb maintenance costs that generally increase as equipment ages. Per diem rental agreements are used mainly on equipment in the Company's trailer, marine container, and storage unit rental operations. Per diem rentals for the most part require the Company to absorb maintenance costs which again tend to increase as the equipment ages. (vi) Management Programs FSI also has sponsored programs in which the equipment is individually owned by the program investors. Management agreements, with initial terms ranging from 3 to 10 years, are typically employed to provide for the management of this equipment. These agreements require that the Company or one of its subsidiaries use its best efforts to lease the equipment, and to otherwise perform all managerial functions necessary for the operation of the equipment, including arranging for maintenance and repair, collection of lease revenues and disbursement of operating expenses. Management agreements also require that the Company correspond with program investors, prepare financial statements and tax information materials and make distributions to investors. Operating revenues and expense for equipment under management agreements are generally pooled in each program and shared prorata by the participants. Management fees are received by IMI for these services based on a flat fee per unit of equipment per month. (vii) Lessees Lessees of equipment range from Fortune 500 companies to small, privately-held corporations and entities. All (i) equipment acquisitions, (ii) equipment sales, and (iii) lease renewals relating to equipment having an original cost basis in excess of $1 million must be approved by a credit committee consisting of senior executives of PLM International. PLM Rental, which leases equipment primarily on short-term rentals, follows guidelines set by the credit committee in determining the credit worthiness of its respective lessees. Deposits, prepaid rents, corporate and personal guarantees and letters of credit are utilized, when necessary, to provide credit support for lessees which alone do not have a financial condition satisfactory to the credit committee. No single lessee of the Company's equipment accounted for more than 10% of revenues for the year ended December 31, 1993. (viii) Competition In the distribution of investment programs, FSI competes with numerous organizations engaged in limited partnership syndications. While management of the Company does not believe that any sponsor dominates the offering of similar investment programs, there are other sponsors of such programs which may have greater assets and financial resources or may have the ability to borrow on more favorable terms, or may have other significant competitive advantages. The principal competitive factors in the organization and distribution of investment programs are: the ability to reach investors through an experienced marketing force, the performance of prior investment programs, the particular terms of the investment program, and the development of a client base which is willing to consider periodic investments in such programs. Competition for investors' funds also exists with other financial instruments and intermediaries such as: certificates of deposits, money market funds, stocks, bonds, mutual funds, investment trusts, real estate, brokerage houses, banks and insurance companies. FSI believes that the structure of its current partnership programs permits it to compete with other equipment leasing programs as well as with oil and gas and real estate programs. FSI's investment programs compete directly with numerous other entities for equipment acquisition and leasing opportunities and for debt financing. The $93,100,000 invested in the Company's public-sponsored partnerships in 1991 ranked it the number one syndicator of transportation equipment leasing programs in 1991. In 1992, the $111,100,000 invested in EGF VI ranked the Company as the number two syndicator of transportation equipment leasing programs. The $92,500,000 invested in the Company's public- sponsored equity programs in 1993 ranked PLM Securities the number one syndicator of equipment leasing programs for the year. Since 1983, the Company is the only syndicator of transportation equipment programs to raise on average more than $100,000,000 annually. In connection with operating leases, the Company encounters considerable competition from lessors offering Full Payout leases on new equipment. In comparing lease terms for the same equipment, Full Payout leases provide longer lease periods and lower monthly rent than the Company offers. However, lower lease rates can generally be offered for used equipment under operating leases than can be offered on similar new equipment under a Full Payout lease. For the most part, long lived, low-obsolescence equipment such as used transportation equipment can be utilized by a lessee to the same extent as new equipment. The shorter length of operating leases also provides lessees with flexibility in their equipment commitments. The Company also competes with equipment manufacturers who offer operating leases and Full Payout leases. Manufacturers may provide ancillary services which the Company cannot offer such as specialized maintenance services (including possible substitution of equipment), warranty services, spare parts, training and trade-in privileges. The Company competes with many equipment lessors, including ACF Industries, Inc. (Shippers Car Line Division), American Finance Group, Chancellor Corporation, General Electric Railcar Services Corporation, Greenbrier Leasing Company, Polaris Aircraft Leasing Corp., G.P.A. Group Plc., and certain limited partnerships, some of which engage in syndications, and which lease the same type of equipment. (ix) Government Regulations PLM Securities is registered with the Securities and Exchange Commission ("SEC") as a broker-dealer. As such, it is subject to supervision by the SEC and securities authorities in each of the states. In addition, it is a member of the National Association of Securities Dealers, Inc. and is subject to that entity's rules and regulations. These rules and regulations govern such matters as program structure, sales methods, net capital requirements, record keeping requirements, trade practices among broker-dealers and dealings with investors. Sales of investment programs must be made in compliance with various complex federal and state securities laws. Failure to comply with provisions of these laws, even though inadvertent, could result in investors having rights of rescission or claims for damages. [FN] The Stanger Review, Partnership Sales Summary. The transportation industry, in which a substantial majority of the equipment owned and managed by the Company operates, has been subject to substantial regulation by various federal, state, local and foreign governmental authorities. For example, the United States Oil Pollution Act of 1990 ("O.P.A.") requires that all newly constructed oil tankers and oceangoing barges operating in United States waters have double hulls. Additionally, under O.P.A. owners are required to either retrofit existing single hulled vessels with double hulls or remove them from service in United States waters in accordance with a statutory timetable before the year 2015. Also, the Airport Noise and Capacity Act of 1990 generally prohibits the operation of commercial jets which do not comply with Stage 3 noise level restrictions at United States airports after December 1999. Both of these enactments could affect the performance of marine vessels and aircraft owned and managed by the Company. It is not possible to predict the positive or negative effect of future regulatory changes in the transportation industry. (x) Employees As of March 15, 1994, the Company and its subsidiaries had 215 employees. None of the Company's employees are subject to collective bargaining arrangements. On August 21, 1989, PLM International sold 4,923,077 shares of Series A Convertible Preferred Stock (the "Preferred Stock") to the PLM International Employee Stock Ownership Plan Trust (the "ESOP Trust") for $13.00 per share. The Preferred Stock is a voting security, representing approximately 32% of the voting shares of PLM International. The Company believes employee relations are good. ITEM 2.

ITEM 2. PROPERTIES At December 31, 1993, the Company owned transportation equipment and related assets originally costing approximately $221 million. The Company leases approximately 46,000 square feet as its principal office at One Market, Steuart Street Tower, San Francisco, California. The Company leases business offices in Chicago, Illinois; Hurst, Texas; and Calgary, Alberta, Canada. In addition, the Company leases trailer rental yard facilities in Atlanta, Georgia; Chicago, Illinois; Dallas, Texas; Detroit, Michigan; Indianapolis, Indiana; Kansas City, Kansas; Miami, Florida; Newark, New Jersey; Orlando, Florida and Tampa, Florida. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Company is involved as plaintiff or defendant in various legal actions incident to its business. Except as described below, management does not believe that any of these actions will be material to the financial condition of the Company. Five current members of the Board of Directors of PLM International (the "Individual Defendants") were named as defendants in an amended complaint that was filed on October 4, 1993, in the Superior Court of the State of California in and for the County of San Francisco, Case No. 953005, by purported PLMI shareholder Robert D. Hass on behalf of himself and derivatively on behalf of PLMI. The action alleges intentional breaches of fiduciary duties, abuse of control, waste of corporate assets, gross mismanagement, and unjust enrichment, and seeks injunctive relief and damages. Specifically, the plaintiff alleges that certain or all of the individual defendants breached their duties by (i) establishing and maintaining the Company's Employee Stock Ownership Plan, (ii) amending on January 25, 1993 the Company's Shareholder Rights Agreement and (iii) granting to each other excessive and unjustified compensation. The Individual Defendants have denied and continue to deny all of the claims and contentions of alleged wrongdoing or liability. On February 14, 1994, the Individual Defendants, Mr. Hass and the Company entered into a Stipulation of Settlement (the "Stipulation"), wherein they agreed to settle the lawsuit, subject to court approval. The Stipulation provides, in part, that the Company Board of Directors will take certain actions with respect to the compensation and make-up of such Board of Directors. The Stipulation also provides that the Company will pay up to $160,000 to plaintiffs' attorneys for fees and costs. On March 11, 1994, the court approved the Stipulation and entered its Final Order and Judgment. The settlement was reached after all of the parties concluded that such settlement was desirable in order to avoid the expense, inconvenience, uncertainty and distraction of further legal proceedings. The Company believes that the settlement is fair, reasonable and adequate and in the best interests of PLM and its shareholders. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS. At the Annual Meeting of Stockholders of PLM International held on Thursday, May 12, 1993, one proposal was submitted to a vote of the Company's security holders. Allen V. Hirsch was re- elected as a Class III director of the Company. PART II ITEM 5.

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. Common Stock: The Company's Common Stock trades (under the ticker symbol "PLM") on the American Stock Exchange ("AMEX"). As of the date of this Annual Report, there are 10,486,782 common shares outstanding and approximately 13,000 shareholders of record. Table 4, below, sets forth the high and low prices of the Company's common stock for 1992 and 1993 as reported by the AMEX: Four hundred thousand shares of the Company's common stock were held in escrow on behalf of Transcisco Industries, Inc. ("Transcisco"), holder of approximately 32% of the common stock of the Company, which were to be released to Transcisco only if the Company met certain tests based on achievement of predetermined target stock prices and target earnings per share levels at any point prior to January 1, 1993. The Company did not meet any of the applicable tests and the 400,000 shares were transferred to treasury. Historically, these shares have been treated as contingent recallable shares for all calculations of earnings (loss) per share. On March 2, 1989, Transcisco amended its Schedule 13D filed in connection with its investment in the Company indicating an intention to dispose of its entire holdings of the Company. In July, 1991, Transcisco filed a petition for reorganization in the United States Bankruptcy Court. On October 20, 1993, the Bankruptcy Court issued an order confirming a joint plan of reorganization (the "Plan") in Transcisco's Chapter 11 bankruptcy case. Under the Plan, in consideration for a release by Transcisco's bondholders of all claims against Transcisco, Transcisco will transfer to Securities Holding, L.P., a California limited partnership that will act as the bondholders' representative, the 3,367,367 shares of the Company's Common Stock and a $5 million subordinated note from the Company (the "PLMI Note"). Transcisco will retain a 40% interest in the PLMI Note. As of the date of this report, the foregoing transactions had not been completed. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA SUMMARY OF SELECTED FINANCIAL DATA (In thousands except per share amounts) ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Comparison of the Company's Operating Results for the Years Ended December 31, 1993 and 1992 The Company owns a diversified portfolio of transportation equipment from which it earns operating lease revenue and incurs operating expenses. The Company also raises investor equity through syndicated partnerships and invests the equity raised in transportation equipment which it manages on behalf of its investors. The Company earns various fees and equity interest from syndication and investor equipment management activities. The Company's transportation equipment held for operating leases is mainly equipment built prior to 1988. As trailer equipment ages, the Company is generally replacing it with newer equipment. However, aged equipment for other equipment types may not be replaced. Rather, proceeds from the liquidation of other equipment types may be invested in trailers or in other Company investment opportunities. Failure to replace equipment may result in shorter lease terms and higher costs of maintaining and operating aged equipment and in certain instances, limited remarketability. During 1992 the Company embarked on a strategic restructuring plan designed to identify underperforming assets in its own transportation equipment portfolio for both valuation adjustments and sale opportunities, to reduce senior indebtedness primarily from the proceeds of such sales and associated interest costs, and to reduce the operational cost structure. During 1993, the Company continued to execute on this strategy and realized significant progress in the restructuring plan. Below is an analysis of the impact the restructuring plan had on operations for the year. Following is an analysis of other operational factors that impacted the financial results for 1993. Restructuring Plan: Impact on Operating Results Results from sales of equipment that were designated in 1992 as assets held for sale demonstrated the intended purpose of the asset sale strategy. Assets with a net book value of approximately $24.9 million were sold at a gain of $2.4 millon in 1993. During 1992 there were sales having a net book value of $14.6 million and corresponding gains of $2.0 million. The Company had $9.3 million in equipment held for sale at December 31, 1993 versus $29.9 million at December 31, 1992. The proceeds generated by sales of equipment, combined with excess operating cash flow, have been used to reduce senior indebtedness from $100 million as of July 1992 to $45 million as of December 31, 1993. Outstanding senior and other secured debt was reduced by $37.2 million in 1993. This reduction in outstanding debt resulted in a decrease in interest expense of $1.5 million in 1993. Sales of equipment impacted operational results in several other areas as well. Operating lease revenues decreased by $6.2 million versus 1992 due to the reduced asset base. This included sale of most of the railcar fleet, an 18% reduction in the aircraft fleet, and a 13% reduction in both trailers and marine containers. The reduction in the lease fleet also accounted for a $1.7 million decrease in depreciation expense versus 1992. Review of the Company's equipment portfolio and identification of underperforming assets led to valuation adjustments charged to operations for reductions in carrying values of assets. These adjustments amounted to $2.2 million in 1993 as compared to $36.2 million in 1992. Equipment types that were subject to valuation adjustments in 1993 were primarily containers, trailers and railcars. Equipment types that were subject to valuation adjustments in 1992 were primarily commuter aircraft and trailers. The Company continues to review the performance and carrying values of its transportation equipment portfolio in relation to expected net realizable values. Future adjustments to the carrying value of the Company's equipment may occur if permanent impairments are identified. The strategic restructuring of operations led to a reduction in operations support costs of approximately $4.0 million for 1993. These decreases result from the reduction in the Company's portfolio of assets, efficiencies gained in accounting functions as well as the closing of the PLM Rental headquarters office and subsequent consolidation of its functions in San Francisco. The Company's sales office in London was closed in 1993 and other cost savings measures were implemented. Employee count was reduced from 247 at December 31, 1992 to 209 at December 31, 1993. During 1992 and 1993, the Company settled its long-standing class action litigation and other material litigation resulting in a reduction of litigation costs. The Company also charged to expense in 1992 certain capitalized costs as a result of restructuring of the Company's senior loan agreement. Litigation and other charges amounted to $7.6 million in 1992. Other Operational Factors: Impact on Operating Results Revenue: The Company's total revenue for the years ended December 31, 1993 and 1992 were $69.7 million and $75.0 million, respectively. The above analysis of the restructuring plan explains a $6.2 million negative variance in lease revenue. Various other factors impacting revenues in 1993 are explained below: Operating lease revenue was unfavorably impacted by lower utilization of interim bridge financing to acquire equipment for resale to one or more of the Company's affiliated partnerships or to independent parties. In 1993, the bridge financing was shared with either EGF VI or EGF VII. During the period that equipment is acquired by use of the bridge facility, the lease revenue generated by this equipment is earned by the Company. This revenue is offset by corresponding equipment operating costs as well as by the interest accruing on the interim debt. There was a decrease of $1.3 million in leasing revenue resulting from lower utilization of the bridge facility in 1993 versus 1992. Management fees remained relatively constant at $10.8 million between 1993 and 1992. These fees are, for the most part, based on the revenues generated by equipment under management. The managed equipment portfolio grows correspondingly with new syndication activity. Affiliated partnership and investment program surplus operating cash flows and loan proceeds invested in additional equipment favorably influence management fees. While equipment under management increased from 1992 to 1993, lease rates for affiliated partnerships and investment programs fell so that gross revenues, which give rise to the management fees, remained relatively constant. Equipment managed at year end 1993 and 1992 (measured at acquisition cost) amounted to $1,141,000,000 and $1,082,000,000, respectively. Commission revenue and other fees are derived from raising syndicated equity and acquiring and leasing equipment for Company sponsored investment programs. Commission revenue consists of placement fees which are earned on the amount of equity raised. Acquisition and lease negotiation fees are earned on the amount of equipment purchased and leased on behalf of syndicated investment programs. These fees are governed by applicable program agreements and securities regulations. The Company also receives a residual interest in additional equipment acquired by affiliated partnerships. Income is recognized on residual interests based upon the general partner's share of the present value of the estimated disposition proceeds of the equipment portfolios of the affiliated partnerships. Placement fees in 1993 decreased $1.7 million (18%) from 1992 as a result of less syndicated equity being raised. Equity raised in 1993 decreased to $92,462,000 from $111,123,000 in 1992. Acquisition and lease negotiation fees and other fees increased $5.0 million in 1993 from the 1992 levels. Equipment placed in service, or remarketed, totalled $186,606,000 in 1993 and $93,185,000 in 1992. At December 31, 1993 cash resources available to certain investment programs would permit additional equipment acquisitions of approximately $19 million. These cash resources are expected to be used by the programs to acquire additional equipment in 1994. In 1993, the Company ranked as the number one equipment leasing syndicator in the United States, as reported by Stanger, an industry trade publication. Costs and Expenses: Certain costs and expense reductions related to the effects of the restructuring plan, as detailed above resulted in specific expense reductions in 1993 versus 1992 totalling $39.7 million as follows: equipment valuation adjustments of $34.0 million, depreciation of $1.7 million and operation support costs of $4.0 million. Various other factors impacting 1993 expenses are explained below: Commission expenses are primarily incurred by the Company in connection with the syndication of investment partnerships. Commissions are also paid to certain of the Company's employees directly involved in leasing activities. The 1993 commission expenses decreased $2.3 million (21%) from 1992 levels reflecting the decrease in syndicated equity raised in 1993 versus 1992. General and administrative expenses increased $2.6 million (32%) during 1993. A portion of the increase relates to reclassification of certain activities previously classified as operations support. While headcount has decreased as discussed above, there have been certain severance related costs that reduce the favorable cost comparison for the periods reported. Additionally, professional service costs were $1.0 million higher in 1993. Interest income decreased $0.6 million (11%) in 1993 primarily due to the decrease in the interest rates applicable to restricted cash deposits and marketable securities. Other income (expense) was an expense of a $0.3 million in 1993 versus income of $0.5 million in 1992. Included is a charge of $0.7 million in 1993 resulting from accelerating certain expenses related to the Company interest rate swap agreement required by its senior loan agreement. The Company's income taxes include foreign, state and federal elements and reflect a provision of 19% in 1993 and a benefit of 46% in 1992. The effective tax rate varies from the statutory rate in 1993 due to non-recurring tax credits and the change in the effect of the ESOP dividend due to implementation of FASB 109. The 1992 benefit of 46% differs from the statutory rate due primarily to the effect of the ESOP dividend as prescribed under FASB 96. As a result of all the foregoing, net income to common shares for the year ended December 31, 1993 was $1,432,000 compared to net loss to common shares of $25,271,000 in 1992. Comparison of Company's Operating Results for the Years ended December 31, 1992 and 1991 Restructuring Plan: Impact of Operating Results Revenues: Sales of equipment, pursuant to the restructuring plan announced in the third quarter of 1992, had a negative impact on lease revenue during 1992. Rail and aircraft revenue declined by $3.4 million in 1992 due to the Company's reduction in the aircraft fleet from 50 aircraft on December 31, 1991 to 39 aircraft as of December 31, 1992 and its railcar fleet from 614 railcars on December 31, 1991 to 407 railcars on December 31, 1992. As part of the restructuring plan the Company sold certain underperforming assets having a net book value of $14.6 million for a gain of $2.0 million. This compared to a gain on the sale of transportation equipment in 1991 of $0.1 million. Costs and Expenses The restructuring plan had a negative impact on the expenses of the Company. In 1992, the Company reduced the carrying value of certain assets, primarily aircraft and trailers, by $36.2 million. This resulted from the Company's decision to exit certain market niches and from permanent declines in the net realizable value of equipment. During 1991 the Company reduced the carrying value of one aircraft by $0.4 million. The Company also recorded a nonrecurring charge in 1992 of $7.6 million for litigation and other costs. This related to settlement of litigation as well as expenses incurred in the course of addressing lawsuits arising in the normal course of business operations. The Company also charged to expense certain capitalized costs as a result of restructuring the Company's senior loan agreement. The sale of equipment in 1992 caused a reduction in depreciation expenses of $0.8 million. Other Operational Factors: Impact on Operating Results The Company's total revenue for the years ended December 31, 1992 and 1991 were $75.0 million and $72.8 million, respectively. The results of the restructuring plan account for a negative impact on revenues of $3.4 million. Various other factors affected revenues in 1992 and are explained below: Operating lease revenue increased $2.5 million in 1992 compared to 1991. Trailer revenues increased $4.4 million in 1992 due to the Company's decision to acquire more trailers for its per diem rental operations, increased utilization of trailers, and increased revenue from its new storage unit division. During 1992, there was an increase of $0.8 million in leasing revenue resulting from equipment being held on an interim basis for resale to its sponsored programs. Management fees and partnership interests. Management fees decreased $0.4 million (3%) in 1992 over the fees earned in 1991. While equipment under management increased from 1991 to 1992, lease revenues of affiliated partnerships and investment programs fell slightly. Equipment oversupply, weaker demand and lower interest rates all contributed to lower lease rates in commercial aircraft and marine vessels in 1992. Equipment managed at year end 1992 and 1991 (measured at acquisition cost) amounted to $1,082,000,000 and $1,036,000,000, respectively. Income from partnership interests decreased $1.1 million (22%) primarily due to a retroactive special allocation of income in 1991. Commission revenue and other fees. Placement fees in 1992 increased $1.6 million (20%) from 1991 as a result of more syndicated equity being raised. Equity raised in 1992 increased to $111,123,000 from $93,092,000 in 1991. In 1992, the Company ranked as the number one diversified transportation equipment syndicator and number two overall equipment syndicator in the United States. Acquisition and lease negotiation fees and other fees decreased 31% in 1992 from 1991 levels. Equipment placed in service by the Company's affiliated partnerships totalled $93,185,000 in 1992 and $120,699,000 in 1991. At December 31, 1992, cash resources available to certain investment programs would permit additional equipment acquisitions of approximately $25 million. These cash resources were used by the investment programs to acquire additional equipment in 1993. Costs and Expenses: Certain cost and expense variances relating to the restructuring plan, as detailed above, resulted in specific variations as follows: increase in equipment valuation adjustments of $35.8 million and a decrease in depreciation expense of $0.8 million. Various other factors impacting 1992 expenses are explained below: Operations support expense increased $2.4 million (11%) in 1992 from 1991 levels. The change for 1992 is due principally to (i) a one-time favorable bad debt settlement received in 1991; (ii) expense incurred in the expansion of storage equipment operations; (iii) increased utilization of trailer equipment and (iv) expansion of PLM Rental operations (Company-owned trailers in daily rental operations increased to 5,000 units in 1992 from approximately 4,700 in 1991). Commission expenses increased in 1992 $2.0 million (22%) from 1991 levels reflecting the increased in syndicated equity raised in 1992 versus 1991. General and administrative expenses decreased $0.6 million (7%) during 1992. This expense reduction resulted primarily from the loss incurred on the sublease of the Company's former principal offices totaling $0.3 million in 1992 compared to $1.25 million in 1991. This was offset in 1992 by an increase in professional fees of $0.4 million. Other Items: Interest expense decreased $1.6 million (10%) in 1992 from that incurred in 1991. The decrease reflects the effect of reduced interest rates in 1992 versus 1991 which more than offset the increase in average borrowings during 1992. Interest income decreased $1.9 million (24%) in 1992 primarily due to the decrease in the interest rates for restricted cash deposits and marketable securities. Income taxes. The Company's income taxes include foreign, state, and federal elements and reflect a benefit of 46% in 1992 and a provision of 1% in 1991. The effective tax rate varies from the statutory rate principally due to the tax effect of the ESOP dividend. As a result of all the foregoing, net loss to common shares for the year ended December 31, 1992 was $25,271,000 compared to net income available to common shares of $3,063,000 in 1991. This decline was primarily attributable to restructuring adjustments and litigation and other costs. Liquidity and Capital Resources Cash requirements have been historically satisfied through cash flow from operations, borrowings or sales of transportation equipment. During 1993 cash flow from operations was significantly impacted by the Company's restructuring plan, announced in August 1992, which plan includes the sale of equipment to pay down senior indebtedness. Equipment sales generated $16.6 million in 1992 and $27.3 million in 1993. At July 1, 1992, the outstanding principal balance on the senior secured loan totalled $100 million. At December 31, 1993, the principal balance of the senior loan was $45 million. Reduced lease revenues resulting from a smaller transportation equipment portfolio have been offset by the lower interest expense exposure resulting from the reduction in senior indebtedness, as well as operational cost reductions implemented by the Company also as part of the restructuring plan. As a result, cash and cash equivalents are at a historical high for the Company. Liquidity beyond 1993 will depend in part on continued remarketing of the remaining equipment portfolio at similar lease rates, continued success in raising syndicated equity for the sponsored programs, effectiveness of cost control programs, ability of the Company to secure new financings and possible additional equipment sales. Specifically, future liquidity will be influenced by the following: (a) Debt Financing: Senior and Subordinated Debt: On October 28, 1992, the Company's senior secured term loan agreement was amended to provide an accelerated principal amortization schedule. The amended agreement provides for the net proceeds from the sale of transportation equipment to be placed into collateral accounts to be used for principal reductions. Cash proceeds received from equipment sales totaling $43.9 million in 1992 and 1993 have contributed substantially to the $55 million reduction of this loan to $45.0 million. The Company will make an additional principal payment in the amount of $8.2 million on March 31, 1994. Final maturity of the senior secured indebtedness is June 30, 1994. The Company is presently marketing replacement financing for the senior secured indebtedness and a portion of its subordinated debt. Management of the Company believes this replacement financing will be completed prior to maturity of the senior secured debt facility. The Company also negotiated an amendment to the Senior Subordinated Notes agreement in October 1992 adjusting certain covenants to accommodate the Company's restructuring plan. Bridge Financing: Assets held on an interim basis for placement with affiliated partnerships have, from time to time, been partially funded by a $25.0 million short-term equipment acquisition loan facility. This facility, made available to the Company effective June 30, 1993, provides 80 percent financing, and the Company uses working capital for the non-financed costs of these transactions. The commitment for this facility expires on July 13, 1994. This facility, which is shared with a PLM Equipment Growth Fund, allows the Company to purchase equipment prior to the designated program or partnership being identified or prior to having raised sufficient resources to purchase the equipment. During 1993 the Company bought and sold, at its cost, $18.1 million of these interim held assets to affiliated partnerships. The Company usually enjoys a spread between the net lease revenue earned and the interest expense during the interim holding period. Decreased utilization of this facility versus use of a similar facility available to the Company in 1992 resulted in lower lease revenues of $1.3 million in 1993. (b) Equity Financing: On August 21, 1989 the Company established a leveraged employee stock ownership plan ("ESOP"). PLM International issued 4,923,077 shares of Preferred Stock to the ESOP for $13.00 per share, for an aggregate purchase price of $64,000,001. The sale was originally financed, in part, with the proceeds of a loan (the "Bank Loan") from a commercial bank (the "Bank") which proceeds were lent on to the ESOP the ("ESOP Debt") on terms substantially the same as those in the Bank Loan agreement. The ESOP Debt is secured, in part, by the shares of Preferred Stock while the Bank Loan is secured with cash equivalents and marketable securities. Preferred dividends are payable semi-annually on February 21 and August 21, which corresponds to the ESOP Debt payment dates. Bank Loan debt service is covered through release of the restricted cash security. While the annual ESOP dividend is fixed at $1.43 per share the interest rate on the ESOP debt varies resulting in uneven debt service requirements. With declining interest rates, the ESOP dividends for 1993 exceeded required ESOP Debt service and the excess was used for additional principal payments totalling $2.4 million in 1993. If interest rates continue at current levels it is expected that ESOP dividends during 1994 will again exceed the required ESOP Debt service. Management, as part of its overall strategic planning process, is evaluating the effectiveness of the ESOP and the Company's other qualified benefit plan. On January 20, 1992, the Company's Board of Directors voted to suspend the $0.10 per share quarterly dividend on its common shares. This reduced cash requirements for dividend payments in 1992 by approximately $4.0 million. The amended and restated senior secured term loan agreement restricts dividend payments until its principal balance is reduced below $30 million. (c) Portfolio Activities: During 1993, the Company continued to execute on the restructuring plan announced effective for the second quarter of 1992. The restructuring plan was designed to identify under performing assets in the Company's own transportation equipment portfolio for both valuation and sale opportunities, reduce senior indebtedness primarily from the proceeds of such sales and associated interest costs, and reduce operational cost structures. The overall effect of this Plan will be to reduce future lease revenues and related interest, depreciation and operations support expenses allocable to the sold equipment and position the Company for future improved profitability. The Company generated proceeds of $27.3 million from the sale of equipment during 1993. The assets sold during the year consisted primarily of aircraft, railcars, trailers and containers. The Company believes the remaining fleet of leased assets has higher earnings potential and more stable residual values than the disposed equipment. As stated last year, the Company did not expect to commit substantial capital resources for acquisition of new transportation equipment in 1993. Accordingly, $1.5 million of transportation equipment was acquired in 1993, compared to $9.8 million in 1992. These purchases are in market niches targeted by the Company as profitable with long term growth potential. As of the date of this report, there were commitments in place totaling approximately $9.4 million to acquire transportation equipment that is intended to be assigned to one or more of the investment programs sponsored by the Company. The purchase of this equipment will be funded by the assigned program. (d) Syndication Activities: The Company earns fees generated from syndication activities which enhances cash flow. In May 1993, PLM Equipment Growth and Income Fund VII ("EGF VII") became effective and selling activities commenced. Through March 25, 1994 a total of $53 million syndicated equity had been raised for this investment program of the maximum of $150 million which was registered. The Company will likely continue to offer units in EGF VII through the end of 1994. Inflation did not have a material impact on the financial performance of the Company. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA The response to this item is submitted as a separate section of this report. See Item 14. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NONE PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. ITEM 12.

ITEM 12. SECURITY OWNERSHIPS OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. A definitive proxy statement of the Company will be filed not later than 120 days after the end of the fiscal year with the Securities and Exchange Commission. The information set forth under "Identification of Directors and Officers," "Compensation of Executive Officers," "Employee Stock Ownership Plan," and "Certain Business Relationships" and "Security Ownership of Certain Beneficial Owners and Management" in such proxy statement is incorporated herein by reference for Items 10, 11, 12 and 13, above. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Financial Statements and Schedules (1) The consolidated financial statements listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. (2) The consolidated financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. (3) Exhibits are listed at item (c), below. (b) Reports on Form 8-K Filed in Last Quarter of 1993 None. (c) Exhibits 3.1 Certificate of Incorporation, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 3.2 Bylaws, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 10.1 Third Amended and Restated Loan Agreement, dated as of October 28, 1992, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.2 $23,000,000 Note Agreement, dated as of January 15, 1989, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 10.3 Second Amended and Restated Loan Agreement, dated as of December 9, 1991, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 30, 1992. 10.4 Warehousing Credit Agreement, dated as of June 30, 1993, as amended. 10.5 Form of Employment contracts for executive officers, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.6 Rights Agreement, as amended, filed with Forms 8-K, March 12, 1989, August 12, 1991 and January 23, 1993 and incorporated herein by reference 10.7 PLM International Employee Stock Ownership Plan filed with Form 8-K, August 21, 1989 and incorporated herein by reference. 10.8 PLM International Employee Stock Ownership Plan Trust filed with Form 8-K, August 21, 1989 and incorporated herein by reference. 10.9 PLM International Employee Stock Ownership Plan Certificate of Designation filed with Form 8-K, August 21, 1989 and incorporated herein by reference. 10.10 Directors' 1992 Non Qualified Stock Option Plan, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.11 Form of Company Non Qualified Stock Option Agreement, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.12 Form of Executive Deferred Compensation Agreement, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.13 Lease Agreement for premises at 655 Montgomery Street, San Francisco, California, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 10.14 Office Lease for premises at One Market, San Francisco, California, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 1, 1991. 11.1 Statement regarding computation of per share earnings. 22.1 Subsidiaries of the Company. 24.1 Consents of Independent Auditors 25.1 Powers of Attorney. (d) Financial Statement Schedules The consolidated financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. Date: March 25, 1994 PLM International, Inc. By: /s/ J. Michael Allgood J. Michael Allgood Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. Signature Title Date /s/J. Michael Allgood Vice President and March 25, 1994 J. Michael Allgood Chief Financial Officer * _____________________ Director, Executive March 25, 1994 Allen V. Hirsch Vice President * _____________________ Director March 25, 1994 Walter E. Hoadley * _____________________ Director March 25, 1994 J. Alec Merriam * _____________________ Director March 25, 1994 Robert L. Pagel * _____________________ Director, President March 25, 1994 Robert N. Tidball * Stephen Peary, by signing his name hereto, does sign this document on behalf of the persons indicated above pursuant to powers of attorney duly executed by such persons and filed with the Securities and Exchange Commission. /s/ Stephen Peary Stephen Peary Attorney-in-Fact PAGE INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (Item 14(a)(1)(2)) Description Page Independent Auditors' Report 27 Consolidated Statements of Operations for years ended December 31, 1993, 1992, and 1993 28 Consolidated Balance Sheets at December 31, 1993 and 1992 29 Consolidated Statements of Changes in Shareholders' Equity for years ended December 31, 1991, 1992, and 1993 30 Consolidated Statements of Cash Flows for years ended December 31, 1993, 1992, and 1991 31 Notes to Consolidated Financial Statements 33 Schedule I - Schedule of Marketable Securities 50 Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other than Related Parties 51 Schedules V and VI - Schedule of Equipment and Accumulated Depreciation 52 Schedule IX - Short Term Borrowings 55 Exhibit XI - Computation of Earnings (Loss) Per Common Share 56 All other schedules are omitted since the required information is not pertinent or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. PAGE INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders PLM International, Inc. We have audited the consolidated financial statements of PLM International, Inc. and subsidiaries as listed in the accompanying index to financial statements (Item 14 (a)) for the years ended December 31, 1993, 1992, and 1991. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules for the years ended December 31, 1993, 1992, and 1991, as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PLM International, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/KPMG PEAT MARWICK KPMG PEAT MARWICK SAN FRANCISCO, CALIFORNIA MARCH 25, 1994 PAGE PAGE PAGE PAGE Supplemental schedule of noncash financing activities: In December 1991, the Company issued 343,291 shares of its common stock as partial consideration for the purchase of all remaining shares of the common stock of Rent-A-Vault, Inc. not previously held. In 1992, there was a net credit to Paid in Capital resulting from a $2.0 million Consolidation (see Note 1) settlement offset by related tax effect and adjustment of deferred taxes for the effect of the taxable premium paid from the 1988 Consolidation transaction. In 1993, the Company recalled 400,000 contingently issued shares from Transcisco due to certain earnings per share and market price amounts not being met by the Company. Of the recalled shares, the Company has issued 29,530 to former participants in the Company's Employee Stock Ownership Plan and is holding the remaining 370,470 shares as treasury stock. See accompanying notes to these financial statements PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying consolidated financial statements present the financial position, changes in equity, results of operations and cash flows of PLM International, Inc. and its wholly owned subsidiaries ("PLM International" or the "Company"). PLM International began operations on February 1, 1988 through an exchange of 10,554,033 shares of its common stock and other consideration for the assets, subject to related liabilities, of 21 limited partnerships (the "Partnerships") and for the common stock of PLM Financial Services, Inc. and its wholly owned subsidiaries and certain of its affiliates (collectively referred to as "FSI"). Transcisco Industries, Inc.("Transcisco"), the former parent of FSI, received 3,766,667 shares of the Company's common stock, which included 400,000 contingent shares which were recalled on January 1, 1993 as certain earnings per common share and market price amounts were not met. The entire transaction is referred to as the "Consolidation." All significant intercompany transactions among the consolidated group were eliminated. FSI was the general partner of the Partnerships and due to the existing affiliation prior to the Consolidation, PLM International accounted for the exchange as a reorganization of entities under common control, with the historical account balances carried forward from those of the predecessor exchanging entities to the new organization. Accounting for Leases PLM International's leasing operations generally consist of operating leases. Under the operating lease method of accounting, the leased asset is recorded at cost and depreciated over its estimated useful life. Rental payments are recorded as revenue over the lease term. Lease origination costs are capitalized and amortized over the terms of the lease. Transportation Equipment Transportation equipment held for operating leases is stated at the lower of depreciated cost or estimated net realizable value. Depreciation is computed on the straight line method down to its estimated salvage value utilizing the following estimated useful lives (in years): Aircraft 8-20; Trailers 8-18; Marine containers 10-15; Marine vessels 15; and Storage vaults 15. Salvage value is 15% of original equipment cost. If projected future lease revenue plus residual values are less than the net book value of the equipment a valuation allowance is recorded. Transportation equipment held for sale is valued at the lower of depreciated cost or estimated net realizable value. Lease rentals earned prior to sale are recorded as operating lease revenues with an offsetting charge to depreciation and amortization expense. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Except for trailers and storage units at the Company's per-diem rental yards, maintenance costs are usually the obligation of the lessee. If they are not covered by the lessee they are charged against operations as incurred except for dry docking costs on marine vessels which are estimated and reserved for prior to dry docking. To meet the maintenance obligations of certain aircraft engines, escrow accounts are prefunded by the lessees. The escrow accounts are included in the consolidated balance sheet as restricted cash and other liabilities. Certain railcars and trailers are maintained under fixed price maintenance contracts with third parties. Repairs and maintenance expense was $4,380,858, $5,587,000, and $5,151,000 for 1993, 1992, and 1991, respectively. Commissions and Fees PLM International engages in the organization, sale and management of transportation equipment leasing investment programs, which are mainly limited partnerships, and receives for its services an equity interest in the partnership and equity placement, equipment acquisition, lease negotiation, debt placement, and equipment management fees from these affiliated investment programs and limited partnerships. Fees are recognized as revenue at the time the related services have been performed. Placement fees, generally 9% of equity raised, are earned upon the purchase by investors of partnership units. Equipment acquisition, lease negotiation and debt placement fees are earned through the purchase, initial lease and financing of equipment, and are generally recognized as revenue when the Company has completed substantially all of the services required to earn the fee, generally when binding commitment agreements are signed. Management fees are earned for managing the equipment portfolio and administering investor programs as provided for in various agreements and are recognized as revenue over time as they are earned. As compensation for organizing a partnership, FSI is generally granted an interest (ranging between 1% and 5%) in the earnings and cash distributions of the partnership for which FSI is the general partner. The Company recognizes as management fees and partnership interests its equity interest in the earnings of the partnership after adjusting such earnings to reflect the use of straight-line depreciation and the effect of special allocations of the partnership's gross income allowed under the respective partnership agreements. The Company also recognizes as income its interest in the estimated net residual interest in the assets of the partnership as they are being purchased. The amounts recorded are based on management's estimate of the net proceeds to be distributed upon disposition of the partnership equipment at the end of the partnerships. These residual value interests are recorded in commissions and other fees at the present value of the Company's share of estimated disposition proceeds as assets are purchased by the partnerships. As required by FASB Technical Bulletin 1986-2, the discount on the Company's residual value interests is not accreted over the holding period. The Company reviews the carrying value of its residual interests at least annually in relation to expected future market values for the underlying equipment for the purpose of assessing recoverability of recorded amounts. When a limited partnership is in the liquidation phase, distributions received by the Company will initially be treated as recoveries of its equity interest in the partnership. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Commission expense includes placement commissions of approximately 8% of equity raised which is paid to outside brokers and up to 1.6% paid to the Company's wholesalers. The expense is recognized on the same basis as placement fees earned. Marketable Securities In May 1993, the Financial Accounting Standards Board issued statement No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). SFAS 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair value and for all investments in debt securities. SFAS 115 is effective for fiscal years beginning after December 15, 1993. Initial adoption must be at the beginning of the fiscal year, and retroactive adoption is not allowed. The Company intends to adopt SFAS 115 when required, and does not believe that such adoption will have a material impact on its consolidated financial statements. Earnings (Loss) Per Common Share Primary earnings (loss) per common share is calculated using the weighted average number of shares outstanding during each period (less 400,000 contingent shares held in escrow for 1992 and 1991 considered common stock subject to recall). These recallable shares and the outstanding stock options (see Note 11) are treated as common stock equivalents. Fully diluted earnings (loss) per common share is anti-dilutive or substantially the same as primary earnings (loss) per common share for each period reported on and, therefore, is not reported separately. Income Taxes As of January 1, 1993, the Company has adopted Statement of Financial Accounting Standards No. 109 ("Accounting for Income Taxes")("SFAS No. 109"). SFAS No. 109 continues to require the liability method of accounting for income taxes as under SFAS No. 96. No additional tax assets were recorded and no valuation allowances or additional liability was required upon adoption of SFAS No. 109. As permitted under adoption of SFAS 109, the Company has elected not to restate prior years' financial statements. The consolidated statement of operation for 1993 reflect the required changes in the presentation of the tax benefit from the dividend payable on the preferred shares held by the Company Employee Stock Ownership Plan. Under the liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Deferred income taxes arise primarily because of differences in the timing of reporting transportation equipment depreciation, partnership income, and certain reserves for financial statement and income tax reporting purposes. Deferred income taxes were established at the Consolidation to account for differences between the net book value and tax bases of transportation equipment and other items received from the Partnerships. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Intangibles Intangibles are included in other assets on the balance sheet and consist primarily of goodwill related to acquisitions. The goodwill is being amortized over 15 years from the acquisition date. Cash, Cash Equivalents and Marketable Securities The Company considers highly liquid investments that are readily convertible into known amounts of cash with original maturities of ninety days or less to be cash equivalents. Marketable securities are valued at the lower of cost or market. Financial Instruments Financial instruments are used to hedge financial risk caused by fluctuating interest rates. The amounts to be paid or received on interest-rate swap agreements accrue and are recognized over the lives of the related debt agreements. Reclassification Certain prior year amounts have been reclassified in order to conform to the current year's presentation. 2. VALUATION ADJUSTMENTS In 1993, as part of the Company's ongoing strategic planning process, the Company reviewed its transportation equipment portfolio resulting in the reduction of the carrying value of certain equipment to its net realizable value by $2.2 million. The valuation adjustments included containers ($0.9 million), trailers ($0.7 million), railcars ($0.4 million), and aircraft ($0.2 million). In 1992, as part of this process, the Company took valuation adjustments totalling $36.2 million, consisting of revaluations of the carrying value of certain aircraft ($13.8 million), trailers ($18.6 million), and other related assets and equipment ($3.8 million). Of these adjustments, $19.6 million resulted from the Company reassessing its investment in certain equipment for which projected earnings potential had declined and decided to exit certain equipment niches and to sell the related equipment. In addition, certain other transportation equipment was put up for sale because of marketing limitations resulting from its physical condition or unique configurations. Of the $29.9 million in net book value of these assets held for sale at the end of 1992, $18.3 million in net book value were sold during 1993 at a net gain of $2.4 million. In addition, the valuation adjustments included a $7.0 million adjustment on its refrigerated over-the-road trailers as they were transitioned from fixed-term leases to per diem rental yard operations as a result of increased maintenance and other operating costs associated with operating refrigerated trailers in per diem rental service. These revaluations also included adjustments to the carrying value of aircraft of $4.1 million resulting from reduced demand and increased availability of such aircraft due to the weak performance in the airline industry. Other valuation adjustments totaling $5.5 million were taken on various equipment to reduce the carrying value to its estimated net realizable value. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 During 1991, the Company took a $0.4 million charge to reduce the carrying value of an aircraft to its estimated net realizable value. 3. ASSETS HELD FOR SALE Assets held for sale include assets acquired with the intent to resell them to unrelated parties or to affiliated partnerships, certain transportation equipment that the Company intends to sell rather than re-lease, and participation interests in equipment residual values. At December 31, 1993 the components of assets held for sale were: airplanes $4,801,000; trailers $2,341,000; residual option contracts on equipment $1,824,000; and marine containers $90,000. The components of assets held for sale at December 31, 1992 were: airplanes $13,638,000; railcars $10,464,000; trailers $3,680,000; residual option contracts on equipment $1,960,000; and marine containers $200,000. 4. EQUITY INTEREST IN AFFILIATES PLM International, through subsidiaries, is the general partner in 23 limited partnerships (not included in the Consolidation), and generally holds an equity interest in each ranging from 1% to 5%. Summarized combined financial data for these affiliated partnerships, reflecting straight line depreciation, is as follows (in thousands and unaudited): PAGE PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Operating results for the years ended December 31,: During 1991 certain limited partnership agreements were amended to accelerate the timing of special allocations of gross income to the general partner from the liquidation stage of the partnership to the present. Current income allocated to the general partner increased retroactively by an amount equal to the difference between cumulative cash distributions paid to the general partner and the general partner's equity in earnings of the partnership before special allocations. Taxable income allocated to the limited partners was reduced by a similar amount. Cash distributions to the partners was not effected as a result of the change. During the fourth quarter of 1991 the Company recognized $1.2 million of additional equity in earnings of the managed affiliated partnerships to record the special allocations of income resulting from these amendments. While none of the partners are directly liable for partnership borrowings and while the general partner maintains insurance against liability for bodily injury, death and property damage for which a partnership may be liable, the general partner may be contingently liable for claims against the partnership that exceed asset values. 5. TRANSPORTATION EQUIPMENT HELD FOR OPERATING LEASE Transportation equipment, at cost, held for operating lease at December 31, 1993 is represented by the following types: Aircraft 42%; Trailers 37%; Marine vessels and Marine cargo containers 17%; other 4%. Future minimum rentals receivables under non-cancelable leases at December 31, 1993 are approximately $11,219,000 in 1994; $5,215,000 in 1995; $4,540,000 in 1995; $2,226,000 in 1997; $1,627,000 in 1998; and $1,279,000 thereafter. In addition, per diem and contingent rentals consisting of utilization rate lease payments included in revenue for 1993 amounted to approximately $15,957,000. At December 31, 1993, the Company had committed approximately 83% of its trailer equipment to rental yard and per diem operations. 6. RESTRICTED CASH AND RESTRICTED MARKETABLE SECURITIES Restricted cash consists of bank accounts and short term investments that are subject to withdrawal restrictions as per lease agreements or loan agreements. Certain lease agreements, primarily on aircraft, require prepayments to the Company for periodic engine maintenance. Certain debt agreements require proceeds from the sale of particular assets to be deposited into a collateral bank account and the funds used to reduce the outstanding balance. Restricted marketable securities are valued at the lower of amortized cost or market and consist of investments subject to withdrawal restrictions imposed by the Employee Stock Ownership Plan loan agreement (See Note 7). At December 31, 1993 the fair value of these securities approximated the original acquisition cost. 7. SECURED DEBT (in thousands): Secured debt consists of the following at December 31: The institutional debt agreement contains financial covenants related to tangible net worth, ratios for leverage, interest coverage ratios and collateral coverage all of which were met at December 31, 1993. The Company is also restricted from paying dividends on its common stock until the senior secured debt is reduced to approximately $30,000. In addition, there are the restrictions based on computation of tangible net worth, financial ratios and cash flows, as defined. The Company is presently marketing replacement financing for the senior secured debt and a portion of its subordinated debt. Management of the Company believes this replacement financing will be completed prior to maturity of the senior secured debt. Principal payments on long term secured debt are approximately $48,386 in 1994; $3,100 in 1995; $3,396 in 1996; $3,957 in 1997; $4,076 in 1998, and $35,204 thereafter. The book value of the senior secured debt and ESOP debt approximates fair value due to the variable interest rates on the debt. The Company estimates,based on recent transactions, that the fair value of the other secured debt is approximately equal to its book value. In the fourth quarter of 1991 the Company entered into interest rate swap agreements expiring in 1994 and 1996 that effectively convert $20 million of its variable rate institutional debt into fixed obligations at rates ranging from 5.538% to 7.23%. Under the terms of these agreements, the Company makes payments at fixed rates and receives payments on variable rates based on LIBOR. The net interest paid or received is included in interest expense. The Company estimates, based on quoted market prices for similar swaps, that the fair value to release the Company of its obligation thereunder would be approximately $882 at December 31, 1993, which has been accrued. 8. SUBORDINATED DEBT (in thousands) Subordinated debt consists of the following at December 31: The senior subordinated debt agreement contains certain financial covenants and other provisions, including an acceleration provision in the event that, under certain circumstances, a person or group obtains certain percentages of the voting stock of the Company or seeks to influence the voting on certain matters at a meeting of shareholders. In addition, extensions to the senior secured debt may cause payment of this debt to be delayed. Absent the aforementioned, principal payments due on subordinated debt in the next five years are $8,000 in 1995, $5,750 in 1996, $5,750 in 1997, $5,750 in 1998 and $5,750 thereafter. The subordinated $8,000 notes maturity dates may be extended under certain circumstances. Therefore, the Company is not able to estimate the fair market value of this debt. Based on the borrowing rates estimated to be available to the Company, if the Company's subordinated debt could be replaced in the current market, the Company estimates the fair value of this debt to be $1,000 higher than its face value as of December 31, 1993. 9. INCOME TAXES (in thousands) As discussed in Note 1, the Company adopted SFAS 109 as of January 1, 1993. No additional tax assets were recorded and no valuation allowances or additional liability was required upon the adoption of SFAS 109. As permitted under the adoption of SFAS 109, the Company has elected not to restate prior year's financial statements. Total income tax benefit of $976,000 for the year ended December 31, 1993 was allocated as follows: Income from operations $ 1,455 Tax benefit of ESOP dividend charged to shareholders equity (2,182) Tax benefit of net operating losses from merged subsidiary reducing goodwill (249) Total tax benefit $ (976) The provisions for (benefit from) income taxes attributable to income from operations consist of the following: Amounts for the current year are based upon estimates and assumptions as of the date of this report and could vary significantly from amounts shown on the tax returns ultimately filed. Accordingly, the variances from the amounts previously reported for prior years are primarily the result of adjustments to conform to the tax returns as filed. PAGE PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 The difference between the effective rate and the expected Federal statutory rate is reconciled below: During 1993 the Company recorded a tax benefit of $716,000 relating to federal tax credits allocated from its prior affiliated group and a net state tax benefit of $294,000 relating to California solar energy credits with a reduction of the deferred income tax liability. During 1991 the Company resolved audit issues with federal and state tax authorities related to deductibility of depreciation and allowability of investment and energy tax credits associated with FSI's investment in alternative energy programs prior to the Consolidation. Approximately $220,000 paid to resolve the State audit issues was charged against deferred income taxes. In addition, the provision for income tax expense for 1991 has been reduced by $680,000 with a corresponding reduction in the deferred income tax liability retained at the end of 1990 to provide for exposure related to this uncertainty. Components of the deferred tax provision are as follows for the years ending December 31, (in thousands): Net operating loss carryforwards for federal income tax purposes amounted to $20,744 and $41,478 at December 31, 1993 and 1992, respectively. These net operating losses have a 15 year carryforward period. The net operating losses at December 31, 1993, will expire as follows: $9,358 in 2004; $3,475 in 2005; $7,149 in 2006 and $762 in 2007. Alternative minimum tax credit carryforwards at December 31, 1993 are $7,022. For financial statement purposes, there are no operating loss or alternative minimum tax credit carryforwards. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities at December 31, 1993 are presented below: Deferred Tax Assets: Tax credits carryforwards $ 7,782 Net operating loss carryforwards 7,921 Federal benefit of state taxes 1,090 Other 473 Total deferred tax assets 17,266 Deferred Tax Liabilities: Transportation equipment, principally differences in depreciation 28,376 Partnership Interests 8,276 Total deferred tax liabilities 36,652 Net deferred tax liabilities $ 19,386 10. COMMITMENTS AND CONTINGENCIES Litigation The Company is involved as plaintiff or defendant in various legal actions incidental to its business. Management does not believe that any of these actions will be material to the financial condition of the Company. Five current members of the Board of Directors of PLM International, Inc. (the "Individual Defendants") were named as defendants in an amended complaint that was filed on October 4, 1993, in the Superior Court of the State of California in and for the County of San Francisco, Case No. 953005, by purported PLMI shareholder Robert D. Hass on behalf of himself and derivatively on behalf of PLMI. The action alleges intentional breaches of fiduciary duties, abuse of control, waste of corporate assets, gross mismanagement, and unjust enrichment, and seeks injunctive relief and damages. Specifically, the plaintiff alleges that certain or all of the individual defendants breached their duties by (i) establishing and maintaining the Company's ESOP, (ii) amending on January 25, 1993 the Company's Shareholder Rights Agreement and (iii) granting to each other excessive and unjustified compensation. The Individual Defendants have denied and continue to deny all of the claims and contentions of alleged wrongdoing or liability. On February 14, 1994, the Individual Defendants, Mr. Hass and the Company entered into a Stipulation of Settlement (the "Stipulation"), wherein they agreed to settle the lawsuit, subject to court approval. The Stipulation provides, in part, that the PLM International Board of Directors will take certain actions with respect to the compensation and make-up of such Board of Directors. The Stipulation also provides that the Company will pay up to $160,000 to plaintiffs' attorneys for fees and costs. On March 11, 1994, the court approved the Stipulation and entered its Final Order and Judgment. The settlement was reached after all of the parties concluded that such settlement was desirable in order to avoid the expense, inconvenience, uncertainty and distraction of further legal proceedings. The Company believes that the settlement is fair, reasonable and adequate and in the best interests of PLM and its shareholders. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Lease Agreements The Company's net rent expense was $2,353,000, $2,351,000, and $2,133,000 in 1993, 1992 and 1991, respectively. In December 1990, the Company negotiated a lease for new office space and moved into this space in June 1991. The new office space is leased through May 2001 with annual rentals of $1,329,000 through May 1996 and annual rentals of $1,535,000 in 1997 and $1,649,000 through May 2001. A rent abatement existed for the first year. Rental expense averages $1,350,000 per year under this lease. The Company is obligated under the lease for approximately $400,000 of leasehold improvements which is being paid over the term of the lease with interest at 10.5%. The lease agreement also provided for a loan of $750,000 to fund the sub-leasing deficit on the Company's former space, which is being repaid over the term of the lease with interest at 10.5%. The Company is obligated under a lease for its former office space through April 1994. The rental payments on the former office space are $167,000 for 1994. The Company's contracted rentals from subleasing its former space are less than its obligations, and consequently the Company recorded an expense of $149,000 in 1993, $300,000 in 1992, and $1,250,000 in 1991. The Company also has leases for other office space and for rental yard operations. The applicable rent expense recorded in 1993 was $1,003,000; $1,048,000 in 1992; and $848,000 in 1991. Annual lease rental commitments for these locations total $826,000, $572,000, $411,000, $181,000, and $39,000 for years 1994 through 1998, respectively. Letter of Credit At December 31, 1993 the Company had a $500,000 open letter of credit to cover its guarantee of the payment of the outstanding debt of a Canadian railcar repair facility, in which the Company has a 10% equity interest. This letter of credit must be extended or replaced under the terms of the guarantee. Other The Company provides employment contracts to certain officers for periods of up to three years which provide for certain payments in the event of a change of control and termination of employment. The Company has agreed to provide supplemental retirement benefits to twelve current or former members of management. The benefits accrue over a maximum of 15 years and will result in payments over five years based on the average base rate of pay during the 60 month period prior to retirement as adjusted for length of participation in the plan. Expense for the plan was $429,000 for 1993, $80,000 for 1992 and $38,000 for 1991. As of December 1993, the total estimated future obligation relating to the current participants is $9,031,000 including vested benefits of $1,123,000. In connection with this plan, whole life insurance contracts were purchased on the participants. Insurance premiums of $122,000 and $238,000 were paid during 1993 and 1992, respectively, of which $229,000 has been capitalized to reflect the cash surrender value of these contracts as of December 31, 1993. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 11. SHAREHOLDERS' EQUITY Common Stock PLM International has authorized 50,000,000 shares of common stock at $.01 par value; 10,554,033 shares were issued on February 1, 1988 in connection with the Consolidation which remain outstanding. Common shares have been reserved for the conversion of preferred stock and the exercise of stock options. On December 13, 1991, 343,291 shares of common stock were issued as payment under an acquisition agreement. Of Transcisco's 3,766,667 shares issued in the Consolidation (See Note 1) 400,000 shares were recallable if certain earnings per common share and market price amounts were not met by January 1, 1993. These conditions were not met and the shares were recalled in January 1993. Of the shares recalled from Transcisco, the Company has issued 29,530 of these shares to former participants in the Company's Employee Stock Ownership Plan and is holding the remaining 370,470 shares as treasury stock. In December 1993 as part of a lawsuit settled earlier, the Company reclassified 61,548 shares as treasury stock. Consequently, the total shares outstanding at December 31, 1993, decreased to 10,465,306 from 10,897,324 outstanding at December 31, 1992. Transcisco has emerged from Chapter 11 bankruptcy proceedings and as part of its plan of reorginization will be transfering its shares of PLM International to certain creditors of Trancisco. Preferred Stock PLM International has authorized 10,000,000 shares of preferred stock at $.01 par value; 4,923,077 Series A Cumulative Convertible preferred shares (the "Preferred Stock") were issued on August 21, 1989 to the ESOP for $13.00 per share; as of December 31, 1993, 4,916,301 were outstanding. Each share is entitled to receive a fixed annual dividend of $1.43 and is convertible into and carries voting rights equivalent to a common share (subject to adjustment). The Preferred Stock is redeemable at the option of the Company at anytime after August 21, 1992 at $14.43 per share, decreasing ratably to $13.00 per share anytime after August 21, 1999. In addition, the Preferred Stock is redeemable by the Company at the liquidating value should the ESOP cease to be a "qualified plan" as defined in the Internal Revenue Code or in the event of certain tax law changes. In 1993, 5,831 shares and in 1992, 509 shares were redeemed in accordance with the ESOP. Dividend Restrictions Pursuant to certain credit agreements (see Note 7), at December 31, 1993, the Company is restricted from paying dividends on its common stock until current senior debt levels have been reduced by approximately $15 million to an outstanding principal balance of $30 million. Stock Options The granting of non-qualified stock options to key employees and directors is provided for in plans that reserve up to 660,000 shares of the Company's common stock. The price of the shares issued under option must be at least 85% of the fair market value of the common stock at the date of grant. Vesting of options granted generally occurs in three equal installments of 33 1/3% per year, initiating from the date of grant. In 1992, the previously issued and outstanding stock options were cancelled and replaced with new stock options with a lower per share price which approximated the current market price. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Stock option transactions during 1993 and 1992 are summarized as follows: At December 31, 1993, 193,767 of these options were exercisable. Shareholder Rights On March 12, 1989, the Company adopted a Shareholder Right's Plan ("Plan") under which one common stock purchase right (a "Right") was distributed as a dividend on each outstanding share of common stock. The Plan, which was amended on August 12, 1991 and on January 18, 1993, is designed to protect against unsolicited and coercive attempts to acquire control of PLM International and other abusive tactics. The Plan is not intended to preclude an acquisition of PLM International which is determined to be fair to, and in the best interest of, its shareholders. Upon the occurrence of certain events which may be characterized as unsolicited or abusive attempts to acquire control of the Company, each Right will entitle its holder (other than holders and their affiliates participating in such attempts), to purchase, for the exercise price, shares of the Company's common stock (or in certain circumstances, other securities, cash, or properties) having a fair market value equal to twice the exercise price. In addition, in certain other events involving the sale of the Company or a significant portion of its assets, each Right not owned by the acquiring entity and its affiliates will entitle the holder to purchase, at the Right's exercise price, equity securities of such acquiring entity having a market value equal to twice the exercise price. Previously, the Plan did not provide for the issuance of rights to the holder of preferred stock except upon conversion of the preferred stock into common stock. On January 18, 1993 the Plan was amended to distribute additional rights as a dividend on each outstanding share of the Company's Series A Cumulative Preferred Stock held at the close of business on February 1, 1993. PLM International generally will be entitled to redeem the Rights in whole at a price of one cent per Right at any time prior to the Rights becoming exercisable. The Rights will expire on March 31, 1999 and carry no voting privileges. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Employee Stock Ownership Plan On August 21, 1989 the Company established a leveraged Employee Stock Ownership Plan ("ESOP"). PLM International issued 4,923,077 shares of Series A Cumulative Convertible Preferred Stock to the ESOP for $13.00 per share, for an aggregate purchase price of $64,000,001. The sale was financed, in part, with the proceeds of a bank loan which proceeds were loaned to the ESOP on terms substantially the same as those in the bank loan agreement (see Note 7). The ESOP debt is secured, in part by preferred shares. As the ESOP makes payments to the Company, it releases shares to be allocated to employee accounts. Interest income earned on the loan to the ESOP by the Company and interest expense due on the bank note each amounted to approximately $1,726,000 for 1993 compared to $2,153,000 for 1992. The ESOP covers substantially all U.S. employees. Cash contributions and total costs are determined by the amount of principal and interest payments required to service the ESOP debt. The primary source for these payments is the dividend on the preferred shares which may be supplemented by Company cash contributions. In 1993 and 1992 there were no cash contributions and no contribution expense. During 1993 and 1992, the reductions in interest rates resulted in the preferred dividend being greater than required to service the interest and principal on the ESOP debt. ESOP cash not required to service the debt was used to reimburse the Company for, or directly pay for, trustee fees and other expenses applicable to the operation of the ESOP and for prepayment of additional principal on the ESOP debt in 1993 and 1992. Preferred dividends are payable semi-annually on February 21 and August 21, which corresponds to the ESOP debt service dates. As of December 31, 1993 and 1992, 1,312,487 and 956,547 preferred shares were allocated to employee accounts, respectively. The ESOP is administered by a trustee. In the event the trustee were to convert Preferred Stock owned by the ESOP trust to Common Stock, the Company would need to make additional contributions to the ESOP trust in an amount equal to the difference between any actual dividends paid on the Company's Common Stock and the principal and interest amounts due in order for the ESOP trust to be able to meet its obligations to the Company under the ESOP note receivable. Conversion of a substantial portion of the Preferred Stock could have a material impact on earnings (loss) per common share for future periods and on the current calculation of fully- diluted earnings (loss) per common share. Certain participants in the Company's incentive compensation plans have agreed to forego incentive compensation up to the amount of any additional contributions to the ESOP trust necessitated by a conversion of all of the ESOP's Preferred Stock in order to reduce the impact on calculations of earnings per common share of such a conversion. 12. TRANSACTIONS WITH AFFILIATES In addition to various fees payable to the Company or its subsidiaries (see Notes 1 and 4), the affiliated partnerships reimburse the Company for certain expenses as allowed in the partnership agreements. Reimbursed expenses totaling approximately $10,000,000 in 1993 and 1992 have been recorded as reductions of expense. Outstanding amounts are paid within normal business terms or treated as a capital contribution if excess organization and offering costs exceed the partnership agreement limitations. The Company amortizes such capital contributions over the estimated life of the partnership. PLM INTERNTIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 13. OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK Off-Balance-Sheet Risk: The Company has entered into interest rate swap agreements to exchange fixed and variable rate interest payment obligations without the exchange of the underlying principal amounts in order to manage interest rate exposures. The agreements have been used to adjust interest on the Company's senior secured debt (see Note 7). Concentrations of Credit Risk: Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments, marketable securities and trade receivables. The Company places its temporary cash investments and marketable securities with financial institutions and other credit worthy issuers and limits the amount of credit exposure to any one party. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base, and their dispersion across different businesses and geographic areas. As of December 31, 1993 and 1992, management believes the Company had no significant concentrations of credit risk. 14. QUARTERLY RESULTS OF OPERATIONS (unaudited) The following is a summary of the quarterly results of operations for the years ended December 31, 1993 and 1992 (in thousands, except per share amounts): In the second quarter of 1992 the Company recorded a restructuring adjustment of $36,000 of which $33,300 was related to revaluation of equipment and related assets. The restructuring adjustment net of its tax benefits decreased net income by $22,300 or $2.13 per common share. PLM INTERNTIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 In the fourth quarter of 1992, the Company added $2,900 to the restructuring adjustment reflecting lower performance expectations in the aircraft market ($2,300) and the anticipated sale of certain railcars ($600). The Company also recorded $800 of bonus expense. The effect of these adjustments was to reduce fourth quarter net income to common shares by $2,300 or $0.22 per common share. In the fourth quarter of 1993, the Company reduced the carrying value of certain equipment by $1.3 million. This was partially offset by tax credits of $0.2 million and by the revenue generated by the purchase of $61 million for the managed programs. 15. THE COMPANY'S 401(k) SAVINGS PLAN The Company adopted the PLM International Employers Profit Sharing and Tax-Advantaged Savings Plan effective as of February 1, 1988. The plan provides for a deferred compensation arrangement as described in 401(k) of the Internal Revenue Code. The 401(k) Plan is a non-contributing plan and is available to substantially all full-time employees of the Company. In 1993, employees of the Company who participated in the 401(k) Plan could elect to defer and contribute to the trust established under the 401(k) Plan up to $8,999 of pre-tax salary or wages. The Company makes no contributions to the 401(k) Plan. PAGE SCHEDULE I PLM INTERNATIONAL, INC. December 31, 1993 Schedule of Marketable Securities (in thousands) PAGE SCHEDULES V AND VI PLM INTERNATIONAL, INC. Year Ended December 31, 1993 Schedule of Equipment and Accumulated Depreciation (in thousands) PLM INTERNATIONAL, INC. Year Ended December 31, 1992 Schedule of Equipment and Accumulated Depreciation (in thousands) SCHEDULES V AND VI PLM INTERNATIONAL, INC. Year Ended December 31, 1991 Schedule of Equipment and Accumulated Depreciation (in thousands) PAGE SCHEDULE IX PLM INTERNATIONAL, INC. December 31, 1993, 1992 and 1991 SHORT-TERM BORROWINGS (in thousands) PAGE EXHIBIT XI PLM INTERNATIONAL, INC. COMPUTATION OF EARNINGS (LOSS) PER COMMON SHARE (a) Years ended December 31, PAGE EXHIBIT XI, Page 2 PLM INTERNATIONAL, INC. COMPUTATION OF EARNINGS (LOSS) PER COMMON SHARE Years ended December 31,

100923_1993.txt

100923

1993

ITEM 1. BUSINESS General UNION TANK CAR COMPANY, with its wholly-owned subsidiaries (herein collectively referred to, unless the context otherwise requires, as the "Company") was organized under the laws of Delaware on September 23, 1980 and is the successor to a business which was originally incorporated in New Jersey in 1891. The Company is a wholly-owned subsidiary of Marmon Industrial Corporation, an indirect wholly-owned subsidiary of Marmon Holdings, Inc. ("Holdings"). Substantially all of the stock of Holdings is owned, directly or indirectly, by trusts for the benefit of certain members of the Pritzker family. As used herein, "Pritzker family" refers to the lineal descendants of Nicholas J. Pritzker, deceased. Railcar Leasing, Services and Sales The principal activity of the Company is the leasing of railway tank cars and other railcars to United States, Canadian and Mexican manufacturers and other shippers of chemicals products, including liquid fertilizers, petroleum products, including liquefied petroleum gas, food products and bulk plastics. The Company owns and operates one of the largest fleets of privately-owned railway tank cars in the world. As of December 31, 1993, the Company's fleet was comprised of approximately 51,000 tank cars and 13,500 railway cars of other types. Approximately 22,260 cars were added to the lease fleet during the ten years ended December 31, 1993. These cars accounted for approximately 38% of total lease revenues during 1993. Most of the Company's cars were built by the Company or to its specifications and the balance were purchased from other sources. The Company added approximately 2,630 new cars to its lease fleet during 1993, including approximately 2,290 tank cars with an average capacity of approximately 23,560 gallons, and approximately 2,100 new cars during 1992, including approximately 1,900 tank cars with an average capacity of approximately 23,850 gallons. During 1993 the Company sold or retired approximately 1,310 cars, including approximately 850 tank cars with an average capacity of approximately 14,940 gallons, and during 1992 the Company sold or retired approximately 2,660 cars, including approximately 1,200 tank cars with an average capacity of approximately 13,650 gallons. Management estimates that tank cars carrying chemicals and acids account for the greatest portion of total leasing revenues, followed in order by compressed gases (particularly liquefied petroleum gas and anhydrous ammonia), refined petroleum products (such as gasoline, fuel oils and asphalt), food products and liquid fertilizers. A significant portion of the revenues from the Company's non-tank car fleet derives from hopper cars carrying bulk plastics. The remaining non-tank car revenues are attributable to cars which serve the lumber, dry bulk chemical, coal and sulphur industries. The Company builds tank cars primarily for use in its leasing business. In addition, the Company builds cars for sale to others. Generally, the Company only manufactures a car following the receipt of a firm order for the lease or sale of such car. During 1993, 1992 and 1991, the Company manufactured an aggregate of approximately 2,450, 2,260 and 2,110 tank cars, respectively, of which approximately one-third were sold to third parties. Substantially all of the Company's cars are leased directly to several hundred manufacturers and other shippers under leases covering from one to several thousand cars and for periods ranging from one to twenty years. The average term of leases entered into during 1993 for newly-manufactured cars was approximately seven years. The average term of leases entered into during 1993 for other cars was approximately four years. Under the terms of most leases the Company agrees to provide a full range of services, including car repair and maintenance. The Company supplies relatively few cars directly to railroads. The Company markets its cars through regional sales offices located throughout the United States and Canada and through a sales agent in Mexico. To insure optimum utilization of the U.S., Canadian and Mexican lease fleets, the Company maintains fleet data processing systems which contain information relative to each car, including its mechanical specifications, maintenance and repair data and lease terms. The Company has generally followed the practice of financing additions to its fleet by borrowing 75% to 80% of the funds required through the issuance of equipment obligations. The Company's long-term equipment obligations are generally payable over a period of fifteen to twenty years, which is considerably less than the estimated useful life of the equipment. In addition, in 1992 the Company entered into ten separate sale-leaseback transactions pursuant to which it sold and leased back (under operating leases) an aggregate of approximately 2,100 railcars. The average term of the Company's leases (as lessor) is substantially less than the average maturity of the equipment obligations and the average terms of the operating leases (as lessee); however, the aggregate rentals to be received in the future under existing leases are substantial and exceed the total of the principal payments due under the equipment obligations and the minimum lease payments due (as lessee) under the operating leases. The following table sets forth the minimum rentals to be received in relation to the debt maturities under outstanding equipment obligations, the minimum lease payments due (as lessee) under all operating leases and the cost of the fleet. The table excludes outstanding commercial paper and, for periods prior to January, 1990, excludes reductions in the Company's advances to its parent, both of which were used as interim financing for additions to the Company's railcar fleet. The figures shown are the minimum future rentals under leases in effect at the dates indicated. Based upon its historical experience, the Company expects that the cars (other than those which are retired in the ordinary course of business) will be re-leased at the expiration of such leases. The rentals under such future leases and related interest and other expenses to be incurred in the future cannot be ascertained and therefore are not reflected in this table. (1) Includes $143.0 million principal amount of unsecured senior notes issued by the Company in 1990, the proceeds of which were used to retire certain higher coupon railcar obligations. Approximately 62% of the Company-owned fleet of railcars is pledged to secure equipment obligations. The remaining cars are free of liens. The Company maintains repair facilities located at strategic points throughout the United States and Canada. In addition to the work performed by the Company, certain maintenance and repair work is performed for the Company's account by railroads, when railroad inspection determines the need for such work under the code of the Association of American Railroads ("AAR"). The Company is not a common carrier and is not subject to regulation or supervision by the Interstate Commerce Commission. The Company's railcars are subject to regulations governing construction, safety and maintenance promulgated by the Department of Transportation ("DOT") and various other government agencies and by the AAR. These regulations have required and may in the future require the Company to make significant modifications to certain of its cars from time to time. The Company's principal facilities for manufacturing and assembling tank cars are located in East Chicago, Indiana and Oakville, Ontario, Canada. The Company also operates a network of shops for repairing and servicing railcars, with the principal shops located in Valdosta, Georgia; Muscatine, Iowa; El Dorado, Kansas; Ville Platte, Louisiana; Marion, Ohio; Altoona, Pennsylvania; Cleveland and Longview, Texas; Edmonton, Alberta; Sarnia and Oakville, Ontario; Montreal, Quebec; and Regina, Saskatchewan. In addition, on January 13, 1994, the Company purchased certain assets, located in Sheldon, Texas, that were used in the repair of railcars and other assets that were in the past used to manufacture railcars. Other Activities The Company is engaged in several other activities, as described below. Fasteners The Company's fastener business, which is conducted through several wholly-owned subsidiaries, consists of manufacturing and distributing a wide range of fasteners in the United States and Canada to the construction industry and manufacturers of furniture, household appliances, industrial and agricultural equipment. Sulphur Processing A subsidiary of the Company provides sulphur producers in Canada with various services, including the processing of liquefied sulphur into crystalline slates and granules and the storage and shipping of the product. The subsidiary also designs, manufactures and sells sulphur processing plants worldwide. Liquefied Petroleum Gas Storage A subsidiary of the Company operates several underground liquefied petroleum gas storage caverns in Canada as a service to producers and sellers of liquefied petroleum gas. Segment Data The principal activity of the Company's primary industry segment is railcar leasing, services and sales. Information with regard to the Company's industry and geographic segments is as follows (dollars in millions): Intersegment sales are immaterial. Segment operating income includes segment revenue less operating expenses directly traceable to the segment and an allocation of common expenses benefiting more than one segment. Major Customers Revenues from any one customer did not exceed 4% of consolidated or industry segment revenues. Raw Materials The Company purchases raw materials from a variety of suppliers, with no one supplier in any industry segment being significant. In the opinion of management the Company will have adequate availability of applicable raw materials in the future. Foreign Operations The Company does not believe that there are unusual risks attendant to its foreign operations. Competition All the activities of the Company are in competition with similar activities carried on by other companies. In particular, there are several companies engaged in the business of leasing tank cars in the United States and Canada. The largest competitor is General American Transportation Corporation (including its Canadian affiliate, Canadian General Transit Company, Limited). The other principal competitors in the tank car business are ACF Industries, Incorporated, and General Electric Railcar Services Corporation. The principal competitive factors are price, service and product design. Manufacturing Backlog The Company builds tank cars primarily for use in its leasing business and the number of cars added in any one year is a small fraction of the Company's total fleet. Additionally, for tank cars built for sale to customers, the Company delivers against orders within a relatively brief period of time. Therefore, backlog is not material to the Company's business or an understanding thereof. Employees As of December 31, 1993, the Company had approximately 3,570 employees. Environmental Matters The Company believes that all of its facilities are in substantial compliance with applicable laws and regulations relating to environmental protection. Over the past several years the Company has attempted to identify and remediate potential problem areas. In 1993 the Company spent approximately $4.7 million on remediation and related matters, compared with $3.7 and $2.8 million in 1992 and 1991, respectively. The Company expects to spend approximately $8 million in 1994 on similar activities, including approximately $3 million for capital expenditures. The Company has approximately $2.5 million accrued for environmental liabilities at December 31, 1993, and management currently believes this accrual is adequate. In October, 1990, the Pennsylvania Office of Attorney General and the Pennsylvania Department of Environmental Resources ("DER") commenced an investigation of alleged violations of the Pennsylvania Solid Waste Management Act with respect to the handling of solid and hazardous waste material at the Company's railcar repair facility in Altoona, Pennsylvania. The Board of Directors of the Company authorized special counsel to conduct an internal investigation of the allegations made against the Altoona facility. The Company is satisfied with current operations at the facility. The Pennsylvania DER has requested that the Company cooperate voluntarily in a site assessment of areas of potential environmental contamination at the facility. The Pennsylvania Attorney General's office has advised the Company's counsel that it would like to discuss an amicable resolution of the criminal investigation. The Company is unable to predict whether satisfactory settlement of the allegations will occur, whether the Pennsylvania authorities will go forward with their investigations, or whether any civil or criminal proceedings will be initiated against it. In March, 1993, the EPA filed an administrative complaint alleging the Company violated certain inspection, recordkeeping, and other requirements of the Toxic Substances Control Act with respect to electrical transformers containing PCB fluids at the Company's East Chicago, Indiana facility. The EPA proposed a penalty of $103,400 with respect to the alleged violations. The Company has answered the complaint and raised certain defenses. The Company has been engaged in informal settlement negotiations. The matter is still under discussion. In June, 1993, the EPA filed an administrative complaint alleging the Company violated (S)313 of the Emergency Planning and Community Right-to-Know Act of 1986 by failing to submit Toxic Chemical Release Inventory Reporting Forms relating to its use of certain chemicals in manufacturing operations at its East Chicago, Indiana facility during calendar years 1987-1990. The EPA proposed a civil penalty in the amount of $524,000. The Company has denied the allegations of the complaint and has requested a formal hearing to contest the EPA's allegations and the proposed penalty. The Company is engaging in informal settlement negotiations with the EPA. In August, 1992, the EPA issued an administrative order alleging that the Company discharged waste waters containing pollutants in excess of permissible amounts in violation of the Clean Water Act and the terms of three industrial waste water discharge permits held by the Company at its East Chicago, Indiana facility. In July, 1993, the EPA issued a new administrative order which, in part, extended the pretreatment standards compliance deadline to February, 1994 and set forth a compliance schedule for the completion of a new pretreatment system at this facility. Other reporting and monitoring requirements of the prior administrative order were retained. The Company is complying with the terms of the new administrative order. The Company has been designated as a Potentially Responsible Party by the EPA at five sites: American Chemical Services, Inc., Griffith, IN; Auto Ion Chemical Company, Kalamazoo, MI; Douglassville Disposal Site, Union Township, PA; Whitehouse Waste Oil Pits Site, Jacksonville, FL; and Grandville Solvents Site, Grandville, OH. Costs incurred to date have not been material, either individually or in the aggregate. Because of the Company's minimal involvement at these sites, management of the Company believes that future costs related to these sites will not be material, either individually or in the aggregate. Management of the Company does not anticipate that the resolution of any of the matters discussed above will have a material adverse affect on the Company's results of operations, financial condition or business. ITEM 2.

ITEM 2. PROPERTIES In the opinion of management, the Company's properties are substantially adequate and suitable for their intended use. Railcars The Company owns approximately 95 percent of its total lease fleet of 64,500 railcars, of which 51,000 are tank cars and 13,500 are other railway freight cars. Of the approximately 61,360 owned cars, 23,500 are free of liens. Cars which are not owned are leased from others under long-term net leases. Car Servicing and Repair Shops The Company operates a network of shops for repairing and servicing railcars. The principal shops owned by the Company are located at Valdosta, Georgia; Muscatine, Iowa; El Dorado, Kansas; Ville Platte, Louisiana; Marion, Ohio; Altoona, Pennsylvania; Cleveland, Sheldon and Longview, Texas; Edmonton, Alberta; and Oakville, Ontario. Several other repair shops and small repair points are strategically located throughout the United States and Canada. At any one time, less than 3.0% of the cars in the lease fleet are normally in the Company's shops for repair and maintenance. Railcar Manufacturing and Assembling Facilities The Company's plants for the manufacturing and assembling of tank cars are located at East Chicago, Indiana and Oakville, Ontario, together occupying approximately 130 acres. Liquefied Petroleum Gas Storage Facilities A subsidiary of the Company owns several underground liquefied petroleum gas storage caverns in Canada. Other Properties In connection with its other business activities, the Company owns (either directly or through its subsidiaries) fastener manufacturing facilities in Ashland, Ohio; Milton, Ontario; and Montreal, Quebec. In addition, subsidiaries of the Company which manufacture fasteners lease several small plants in the United States and Canada. The Company and its subsidiaries maintain numerous sales and business offices and warehouses, most of which are leased, throughout the United States and Canada. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries have been named as defendants in a number of lawsuits and certain claims are pending. The Company has accrued what it reasonably expects to pay to resolve such claims (including legal fees), and, in the opinion of management, ultimate resolution of these matters will not have a material effect on the Company's consolidated financial position or results of operations. See discussion of Environmental Matters in ITEM 1. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Not applicable. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA See Item 7

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1993 versus 1992 Results of Operations - --------------------- Service revenues increased $19.4 million primarily due to the effect of cars added to the railcar lease fleet since 1992 and higher repair revenues offset slightly by lower revenues from sulphur service operations. Gross profit was relatively unchanged from 1992. In June, 1992, the Company entered into ten separate sale-leaseback transactions in which it sold for $124.9 million an aggregate of 2,073 railcars. Excluding these 1992 sale-leaseback transactions, net sales revenues in 1993 decreased approximately $7.7 million due to lower railcar and sulphur plant sales. Other income decreased $4.4 million due to reduced interest income resulting from lower interest rates as well as lower average outstanding balance on advances to the Company's parent. Interest expense decreased $8.8 million primarily due to a decline in the average outstanding commercial paper balance as well as a lower average effective interest rate on debt outstanding. Provision for income taxes increased due to the effect of the increase in the federal statutory tax rate. Net income in 1993 included an $80.0 million credit to earnings for the cumulative effect of a change in accounting principle related to accounting for income taxes. See further discussion under "Change in Accounting Principles" below. Financial Condition - ------------------- Operating activities provided $183.8 million of cash in 1993. These funds, along with the commercial paper borrowings, net of amounts advanced to parent, were used to provide interim financing for railcar additions, service long-term debt and pay dividends to the Company's stockholder. It is the Company's policy to pay a quarterly dividend to its stockholder equal to 70% of net income. To the extent that the Company generates cash in excess of its operating needs, such funds are advanced to its parent and bear interest at commercial rates. Conversely, when the Company requires additional funds to support its operations, prior advances are repaid by its parent. No restrictions exist regarding the amount of dividends which may be paid or advances which may be made by the Company to its parent. Management expects future cash to be provided by operating activities, commercial paper borrowings and long-term railcar financings will be adequate to provide for the continued expansion of the Company's business and enable it to meet its debt service obligations. The Company also has a $150.0 million liquidity back-up revolving credit facility supporting the commercial paper programs. However, no borrowings have occurred under this facility and none are currently anticipated. In 1993, the Company spent $175.8 million for the construction and purchase of railcars and other fixed assets. The Company received $15.1 million in proceeds from disposals of railcars and other fixed assets. The Company also decreased its advance to its parent company by $89.2 million. Overall, net cash used in investing activities was $72.8 million. In May, 1993, the Company issued $100.0 million in long-term equipment trust pass through certificates to finance additions to its railcar fleet at an annual interest rate of 6.5%. Other financing activities of the Company included $8.4 million for the repayment of commercial paper obligations, $78.8 million for principal repayments on debt, $17.7 million to repay an advance to an affiliate and $90.0 million for dividends. Net cash used in financing activities was $94.9 million. As more fully discussed in note 21 to the consolidated financial statements, on January 13, 1994, the Company acquired certain assets located in Sheldon, Texas for approximately $24.3 million. In addition, on March 2, 1994, the Company issued $100.0 million in long-term equipment trust certificates to finance additions to its railcar fleet at an annual interest rate of 6.6%. The Company has not experienced any significant impact of inflation and changing prices on its financial position or results of operations over the last several years. 1992 versus 1991 Results of Operations - --------------------- Revenues from railcar services increased $15.0 million from 1991 primarily due to the impact of cars added to the railcar lease fleet during 1991 and 1992. Other service revenues, primarily sulphur processing, decreased $4.8 million. On June 30, 1992, the Company entered into ten separate sale-leaseback transactions with trusts for the benefit of certain institutional investors pursuant to which it sold (at approximately book value) an aggregate of 2,073 railcars, including 1,570 tank cars. As a result of these transactions, the Company recorded sales revenue of $124.9 million. The sale-leaseback transactions therefore account for the $124.4 million increase in consolidated net sales revenues in 1992 as compared to 1991. Other income decreased $14.7 million primarily due to lower interest income resulting from lower interest rates on advances to the Company's parent. Income taxes as a percentage of income before taxes decreased due to reduced effective tax rates on foreign income. Financial Condition - ------------------- Operating activities provided $175.6 million of cash. These funds, along with the commercial paper borrowings, net of amounts advanced to parent, were used to provide interim financing for railcar additions, service long-term debt and pay dividends to the Company's stockholder. As discussed above, the Company entered into ten separate sale-leaseback transactions that provided aggregate sales revenue of $124.9 million. Net of $145.9 million spent for the construction and purchase of railcars and other fixed assets, and $71.1 million provided by other investing activities, net cash provided by investing activities was $50.1 million. The Company did not enter into any new railcar debt financing in 1992. The Company spent $104.3 million for the repayment of commercial paper obligations, $72.3 million for principal repayments on debt and $33.0 million for dividends. Changes in Accounting Principles - -------------------------------- As more fully discussed in note 9 to the consolidated financial statements, effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." The cumulative effect of the adoption of this new standard resulted in a $80.0 million credit to earnings in 1993. The new standard, however, had no effect on the Company's cash flow. The Financial Accounting Standards Board has issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This statement will have no material impact on the Company's financial position or results of operations since the Company's employee benefit programs do not include significant postemployment benefits. The Financial Accounting Standards Board has also issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." However, since the Company does not currently have investments in these types of securities, there will be no impact on the Company's consolidated financial statements. Other Matters - ------------- The Company has certain environmental matters currently outstanding, none of which are significant to the Company's results of operations or financial condition, either individually or in the aggregate. See further discussion of such matters under the "Environmental Matters" caption of Item 1 of this Form 10-K. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements And Supplemental Schedules REPORT OF INDEPENDENT AUDITORS TO UNION TANK CAR COMPANY We have audited the accompanying consolidated balance sheet of Union Tank Car Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholder's equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14 (a)(2). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Union Tank Car Company and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 9 to the consolidated financial statements, the Company changed its method of accounting for income taxes in the year ended December 31, 1993. ERNST & YOUNG Chicago, Illinois March 9, 1994. UNION TANK CAR COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME (Dollars in Thousands) See Notes to Consolidated Financial Statements. UNION TANK CAR COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in Thousands) ASSETS See Notes to Consolidated Financial Statements. UNION TANK CAR COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) See Notes to Consolidated Financial Statements. UNION TANK CAR COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in Thousands) See Notes to Consolidated Financial Statements. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) 1. Ownership UNION TANK CAR COMPANY, with its wholly-owned subsidiaries (herein collectively referred to, unless the context otherwise requires, as the "Company") is a wholly-owned subsidiary of Marmon Industrial Corporation ("MIC") and an indirect subsidiary of Marmon Holdings, Inc. ("Holdings"). Substantially all of the stock of Holdings is owned, directly or indirectly, by trusts for the benefit of certain members of the Pritzker family. As used herein, "Pritzker family" refers to the lineal descendants of Nicholas J. Pritzker, deceased. 2. Summary of Accounting Principles and Practices Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and all subsidiaries. All significant intercompany accounts and transactions have been eliminated. Lessor Accounting Operating Leases - Most of the Company's railcar leases are classified as operating leases. Aggregate rentals from operating leases are reported as revenue ratably over the life of the lease. Expenses, including depreciation and maintenance, are charged against such revenues as incurred. Direct Financing Leases - Some of the Company's railcar leases and other rental equipment are classified as direct financing leases. Gross investment in leases (minimum lease payments plus estimated residual values) less the cost of the equipment is designated as unearned income. This unearned income is recognized over the life of the lease based upon the "constant yield method" or similar methods which generally result in an approximate level rate of return on the investment. Depreciation and Fixed Assets Accounting Railcars and fixed assets are recorded at cost less accumulated depreciation. These assets are depreciated to salvage value over their estimated useful lives on the straight-line method. The estimated useful lives are principally: railcars, 20-30 years; buildings and improvements, 20-30 years; and machinery and equipment, 4-25 years. The cost of major conversions and betterments are capitalized and depreciated over their estimated useful life or, if shorter, the remaining useful life of the related asset. Maintenance and repairs are charged to expense when incurred. Gain or loss on disposals is included in other income, except for railcar disposals which are included in cost of services. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Deferred Income Taxes The Company provides deferred taxes for temporary differences between pre-tax accounting income and taxable income (principally related to railcar depreciation). Deferred Investment Tax Credits United States investment tax credits (as generated through 1986 and to the extent not transferred to lessees) and Canadian investment tax credits result in a reduction of current or deferred income taxes and are due primarily to investments in certain new railcars. Investment tax credits retained are deferred and amortized over the estimated useful lives of the related assets. Foreign Currency Translation All assets and liabilities are translated at exchange rates in effect at the date of translation. Average exchange rates are used for revenues, costs and expenses and income taxes. Translation adjustments and transaction gains and losses are assumed by the Company's parent. For the years ended December 31, 1993 and 1992, MIC absorbed gains of $57 and $140, respectively. For the year ended December 31, 1991, MIC absorbed a loss of $79. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market. Statement of Cash Flows For purposes of reporting cash flows, cash and cash equivalents includes all highly liquid debt instruments purchased with an original maturity of three months or less. Fair Value of Financial Instruments All book value amounts for financial instruments approximate the instruments' fair value except for the borrowed debt discussed in Note 8. Reclassification Certain prior year amounts have been reclassified to conform to the current year's presentation. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 3. Railcar Lease Data Railcars are leased directly to several hundred shippers, located throughout the United States, Canada and Mexico. The Company leases to a wide variety of customers, and no customer accounted for more than 4% of consolidated lease revenues. The leases involve one to several thousand cars, normally for periods ranging from one to twenty years. The average term of leases entered into during 1993 for newly-manufactured cars was approximately seven years. The average term of leases entered into during 1993 for other cars was approximately four years. Under the terms of most of the leases the Company agrees to provide a full range of services including car repair and maintenance. Minimum future rentals to be received on railcar leases at December 31, 1993, are as follows: The investment in railcars on direct financing leases is recoverable from future lease payments and estimated residual values. Details of this investment, which is classified in the accompanying consolidated balance sheet under railcar lease fleet, are as follows: UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 4. Railcar Lease Fleet and Fixed Assets 5. Investment in Direct Financing Lease In 1987 one of the Company's Canadian subsidiaries entered into a Canadian dollar denominated lease of a passenger airplane to a scheduled commercial air carrier for an 18 year period. Minimum future rentals to be received on the lease as of December 31, 1993 are as follows (at December 31, 1993 exchange rate): UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The investment is recoverable from future lease payments and estimated residual value, as follows (at year-end exchange rates): 6. Lease Commitments The Company, as lessee, has entered into long-term leases for railcars and various manufacturing, office and warehouse facilities. The railcar lease fleet includes the following capitalized leases: On June 30, 1992, the Company entered into ten separate sale-leaseback transactions with trusts for the benefit of certain institutional investors pursuant to which it sold (at approximately book value) and leased back an aggregate of 2,073 railcars, including 1,570 tank cars. The Company may reacquire the railcars subject to one or more of the leases by purchasing the beneficial interests in the related trusts at fair value on January 2, 2009 in the case of four leases and January 2, 2010 in the case of the other six leases. Each lease expires on January 2, 2014. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) At December 31, 1993, future minimum rental commitments for all noncancellable leases are as follows: 7. Accrued Liabilities UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 8. Borrowed Debt Equipment obligations above include $7,667 and $9,081 of capitalized leases and are secured by railcars with an original cost of $1,597,476 and $1,497,439 at December 31, 1993 and 1992, respectively. The senior notes contain certain provisions regarding asset sales and sale-leaseback restrictions. As of December 31, 1993, the Company is in compliance with all debt covenants. In January, 1990, the Company began issuing commercial paper. As a liquidity back-up to the issuance of commercial paper, the Company and MIC entered into a revolving credit agreement, as amended, with several banks that provides aggregate short-term commitments of up to $150 million. Under the credit agreement, loans with maturities of up to six months may be issued. Under the terms of the credit agreement the Company must maintain available unused credit thereunder equal to 100% of the commercial paper outstanding at any time. The restrictive covenants under the credit agreement require MIC, among other things, to maintain consolidated net worth at specified minimum levels and achieve defined levels of cash flow from operations. The Company is not separately subject to these covenants. The Company's debt under the credit agreement is guaranteed by MIC but the Company does not guarantee MIC's debt under the credit agreement. MIC does not guarantee payment of the Company's commercial paper indebtedness. Interest rates on the commercial paper and on the debt under the credit agreement are based on rates in effect at the time the commercial paper is placed or the debt is incurred. Expenses associated with the credit agreement (approximately $370 in 1993 and $300 in 1992) are included in interest expense. The credit agreement expires in May, 1995. The Company has no amounts outstanding under the credit agreement at December 31, 1993. The Company's Canadian subsidiaries have approximately $13,817 of credit lines available on a no-charge basis. No amounts were outstanding as of December 31, 1993. Maturities of debt obligations for the years 1994 - 1998 are $577,690, as follows: $81,591 in 1994, $125,843 in 1995, $74,570 in 1996, $218,599 in 1997 and $77,087 in 1998. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The estimated fair value of borrowed debt is as follows: The current fair value of the Company's borrowed debt is estimated by discounting the future interest and principal cash flows at the Company's estimated incremental borrowing rate at the respective year-end for debt with similar maturities. The Company currently anticipates holding all borrowed debt obligations until maturity. 9. Income Taxes The Company is included in the consolidated U.S. federal income tax return of Holdings. Under an arrangement with MIC, federal income taxes, before consideration of investment tax credits, are computed as if the Company files a separate consolidated return. For this computation, the Company generally uses tax accounting methods which minimize the current tax liability (these methods may differ from those used in the consolidated tax return). Tax liabilities are remitted to, and refunds are obtained from, MIC on this basis. If deductions and credits available to Holdings' entire consolidated group exceed those which can be used on the return, allocation of the related benefits between the Company and others will be at the sole discretion of Holdings. As a member of a consolidated federal income tax group, the Company is contingently liable for the federal income taxes of the other members of the group. Effective January 1, 1993, the Company prospectively adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (SFAS 109) and, accordingly, changed from the deferred method to the asset and liability approach to accounting for income taxes. The cumulative effect of this accounting change as of that date is reflected in the accompanying consolidated statement of income as an $80,000 credit to earnings for the cumulative effect of a change in accounting principle. This item represents a non-cash credit to earnings, as it merely reflects the new, lower net deferred income tax liability calculated under the new accounting method as compared to the net liability recorded under the former income tax accounting method. Adoption of the new accounting method did not change the tax arrangement with MIC, had no effect on income before taxes and cumulative effect of a change in accounting principle and has no past or future impact on the cash flows related to income taxes. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Under the provisions of the Revenue Reconciliation Act of 1993 (enacted on August 10, 1993) the corporate federal income tax rate increased from 34% to 35%, effective January 1, 1993. The rate change increased the 1993 provision for income taxes $7,300 due to the effect of the increased tax rate on the net deferred income tax liability which existed as of the enactment date of the law. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The December 31, 1993 net deferred income tax liability of $451,812 shown in the accompanying consolidated balance sheet is composed of $492,225 in deferred tax liabilities, partially offset by $40,413 in deferred tax assets. These deferred income tax assets and (liabilities) result from the following temporary differences: The above assets exclude certain state deferred income tax assets related to loss carryforwards (which expire over the next fifteen years) in the gross amount of $14,000. These assets have been assigned a 100% valuation reserve due to significant uncertainty as to ultimate realizability. There have been no changes in any asset valuation reserves for the year ended December 31, 1993. Undistributed earnings of the Company's non-U.S. subsidiaries reflect full provision for non-U.S. income taxes. However, since the earnings are indefinitely reinvested in non-U.S. operations, no provision has been made for taxes that might be payable upon remittance of such earnings nor is it practicable to determine the amount of any such liability. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following summarizes the provision for income taxes on income before the cumulative effect of a change in accounting principle: In 1990 and 1991, the Company provided for U.S. alternative minimum tax, $9,280 and $3,859 of which has been credited to regular income tax liabilities in 1993 and 1992, respectively. In 1993, 1992 and 1991 the Company paid foreign withholding taxes of $627, $2,651 and $4,606, respectively. Income tax expense is based upon domestic and foreign income before taxes and the cumulative effect of a change in accounting principle as follows: UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Income tax effects of significant items which resulted in effective tax rates of 45.0% in 1993, 40.4% in 1992, and 44.6% in 1991 follow: The excess tax on foreign income represents differences due to higher foreign tax rates and foreign tax credits not benefitted. The components of the provision for deferred taxes for the years ended December 31, 1992 and 1991 (calculated under the deferred method) are as follows: 10. Contingencies The Company and its subsidiaries have been named as defendants in a number of lawsuits and certain claims are pending. The Company has accrued what it reasonably expects to pay to resolve such claims, and, in the opinion of management, their ultimate resolution will not have a material effect on the Company's consolidated financial position or results of operations. The Company self-insures certain exposures in its risk management plan. The Company has accrued for the estimated costs of reported, as well as incurred but not reported, self-insured claims. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The company has certain environmental matters currently outstanding, none of which are significant to the Company's results of operations or financial condition, either individually or in the aggregate. See further discussion of such matters under the "Environmental Matters" caption of Item 1 of this Form 10-K. 11. Pension Benefits Substantially all of the Company's employees are covered by discretionary contribution or defined benefit retirement plans. Costs of the discretionary contribution pension plans are accrued in amounts determined on the basis of percentages, generally established annually by the Company, of employee compensation of the various units covered by such plans. The contributions are funded as accrued. Discretionary and defined contribution plan expense for 1993, 1992 and 1991 was $5,164, $4,963 and $5,200, respectively. As of December 31, 1993, the Company's domestic defined benefit plans were either in the process of being terminated (and their benefits frozen) or were completely terminated. The benefits are based on payment of a specific amount, which varies by plan, for each year of service. The Company's funding policy is to contribute the minimum amount required either by law or union agreement. Contributions are intended to provide not only for benefits attributed to service through the plans' termination dates, but also for those expected to be earned in the future. Certain foreign subsidiaries sponsor unfunded defined benefit plans which cover substantially all of their regular, full-time employees. Benefits are based on both years of service and compensation. Defined benefit pension plan expense was $371, $291 and $462 for 1993, 1992 and 1991, respectively. Accrued defined benefit pension liability recognized in the consolidated balance sheet was $7,167 and $7,367 at December 31, 1993 and 1992. 12. Retirement Health Care and Life Insurance Benefits The Company provides limited health care and life insurance benefits for certain retired employees. These benefits are subject to deductible and copayment provisions, medicare supplements and other limitations. In 1990, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and recorded a liability for the present value of the estimated future costs of vested health care and life insurance benefits. The new accounting method has no impact on the Company's cash funding for retiree benefits. At December 31, 1993 and 1992, the liability for postretirement health care and life insurance benefits was $4,294 and $4,000, respectively, and was included in accrued liabilities in the consolidated balance sheet. Expense related to these benefits was $590, $546 and $506 in 1993, 1992 and 1991, respectively. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 13. Other Income Interest income presented above includes interest earned on advances to MIC as described in Note 17. 14. Supplementary Profit and Loss Information Royalties, advertising and research and development costs are less than 1% of consolidated revenues. 15. Ratio of Earnings to Fixed Charges The ratio of earnings to fixed charges represents the number of times that interest expense, amortization of debt discount and the interest component of rent expense were covered by income before income taxes and cumulative effect of a change in accounting principle and such interest, amortization and the interest component of rentals. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 16. Summarized Financial Information of Procor Limited Summarized consolidated financial information for the Company's wholly-owned subsidiary, Procor Limited, is as follows: Services and net sales in 1993 and 1991 include $16,168 and $13,050, respectively, representing the sale of railcars to UTLX International, Inc., a wholly-owned subsidiary of the Company. 17. Related Party Transactions The following table sets forth the major related party transaction amounts included in the consolidated financial statements. The Company leases 486 box cars under net long-term leases of 15 to 20 years to WCTU Railway Company, an affiliated company. Revenues from these leases are classified in the preceding table as service revenues. The Company from time to time advances funds in excess of its current cash requirements for domestic operations to MIC or MIC's subsidiaries on an unsecured demand basis. Such advances, which bear interest principally at LIBOR plus 1%, amounted to $202,393 and $284,030 at December 31, 1993 and 1992, respectively. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Certain of the Company's Canadian operations and its affiliates enter into intercompany loans utilizing their respective excess cash balances. These advances between the Company and subsidiaries of MIC amounting to a payable of $138 and $977 at December 31, 1993 and 1992, respectively, have been included in Advances to Parent Company. Management fees are paid to The Marmon Group, Inc. ("Marmon"), an indirect subsidiary of Holdings and an affiliate of MIC, for certain services provided by Marmon's officers and employees including services with respect to accounting, tax, finance, legal and related matters which Marmon provides to certain of Holdings' divisions, subsidiaries and affiliates. Marmon provides these services to the Company because it is considered more cost efficient to provide such services in this manner. The management fee which Marmon charges to the Company and other entities that it manages is determined in the following manner. First, budgeted administrative expenses of Marmon for the twelve month period following the date of computation (including wages, salaries and related expenses, rent, utilities, travel expenses and other similar expenses, but excluding extraordinary and non- recurring items) are multiplied by the average of the following three percentages (each of which is given equal weight): (1) the percent of the sales and services revenues of the Company to the total sales and services revenues of all managed entities, including the Company; (2) the percent of the assets of the Company to the assets of all managed entities, including the Company; and (3) the percent of the net income of the Company to the net income of all managed entities, including the Company. In making this computation, Marmon uses sales and services revenues and net income from the beginning of the year to the approximate date of computation and assets at that date. Marmon's management takes the amount derived from this formula and applies discretion to determine the final management fee to be charged. The factors which are considered include matters such as the following: any known operating problems and risks that require or may require additional time to be devoted to the Company by Marmon's management; significant expansion programs; significant contracts; unusual tax or accounting matters; and the experience and length of service of the Company's management. Included in the preceding table as insurance billed are $159 in 1993, $879 in 1992 and $1,064 in 1991 for insurance premiums for coverage that was insured or reinsured with an insurance company which the Company has been advised is controlled by trusts for the benefit of an individual related by marriage to a member of the Pritzker family. In 1986, the Company entered into a partnership with an affiliate for the purpose of purchasing used railcars. The Company's investment as of December 31, 1993 and 1992 was $40,070 and $37,254, respectively, which represents 80% ownership in this partnership. The minority partner's interest in the partnership at December 31, 1993 and 1992 is $10,018 and $9,314, respectively, which is included in accrued liabilities. The minority interest in income, $704, $668 and $588 for the years ended December 31, 1993, 1992 and 1991, respectively, is reflected in other income. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 18. Quarterly Data (Unaudited) In the first quarter of 1993, the Company recorded an $80,000 credit to earnings to reflect the adoption of SFAS 109. In the third quarter, the Company recorded a $7,300 charge to earnings to reflect the effect of the statutory tax rate increase on deferred taxes. See Note 9. In the second quarter of 1992, included in net sales and service revenues and cost of sales and services is $124,886 related to sale-leaseback transactions. See Note 6. In the fourth quarter of 1991, the Company recorded a $4,238 charge for the writedown of the carrying value of box cars leased to an affiliated entity. The substantial decrease in the fourth quarter of 1992 and 1991 earnings was primarily attributed to the Company's inability to benefit from certain foreign tax credits. Net sales and service revenues in 1991 and 1992 have been restated above to reflect the reclassification of certain lease revenues to conform with the 1993 presentation. UNION TANK CAR COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 19. Supplementary Disclosures of Cash Flow Information Unrealized foreign currency translation gains and losses, which are non-cash items, are excluded from the decrease in advance to parent. 20. Industry Segment Information The Company's industry and geographic data are found under the "Segment Data" caption of Item 1 of this Form 10-K. The aforementioned data are an integral part of the Notes to Consolidated Financial Statements. 21. Subsequent Events On January 13, 1994, the Company purchased certain assets, located in Sheldon, Texas, that were used in the repair of railcars, assets that were in the past used to manufacture railcars and other assets used in the manufacture of heads for metal containers. On March 2, 1994, the Company issued $100,000 in long-term equipment trust certificates to finance additions to its railcar fleet. Principal will be due annually through 2009, beginning February, 1995. The certificates bear interest at a rate of 6.6% per annum. Maturities of this obligation are as follows: $6,666 in 1995, $6,666 in 1996, $6,666 in 1997, $6,666 in 1998, $6,666 in 1999 and $66,670 thereafter. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Sidney H. Bonser Mr. Bonser is also Executive Vice President of each of The Marmon Corporation ("TMC"), MIC and The Marmon Group, Inc. ("Marmon"). TMC, MIC and Marmon are affiliates of the Company. Kenneth P. Fischl Mr. Fischl was appointed President of the Tank Car Division in February, 1993. He was appointed a Vice President of the Company and Executive Vice President and General Manager of the Tank Car Division in July, 1992. He joined the Company in 1977 as a Market Analyst. Mr. Fischl was promoted to Manager - Tank Car Marketing and Administration in 1979 and became Vice President of Fleet Management in 1981. He held this position until assuming his current responsibilities. Stephen G. Dinsmore Mr. Dinsmore was elected a Vice President of the Company in January, 1982. He joined the Tank Car Division in 1961 as an Internal Auditor and became an Audit Supervisor in 1964. He became Assistant Controller in 1966, Vice President- Controller in 1970 and Senior Vice President of the division in February, 1976. Robert C. Gluth Mr. Gluth is Executive Vice President and a Director of MIC, Vice President, Treasurer and a Director of Holdings, Executive Vice President and Director of TMC, and Executive Vice President and a Director of Marmon. Mr. Gluth is also Treasurer of each of TMC, MIC and Marmon. Jay A. Pritzker Mr. Jay A. Pritzker is Chairman of the Board of each of MIC, Holdings, TMC and Marmon. Mr. Pritzker is also a partner in the law firm of Pritzker & Pritzker, and Chairman of the Board of Hyatt Corporation. Robert A. Pritzker Mr. Robert A. Pritzker is President and a Director of each of MIC, Holdings, TMC and Marmon. Mr. Pritzker is also a director of Hyatt Corporation. Robert W. Webb Mr. Webb is Secretary and a Vice President of each of MIC, Holdings, TMC and Marmon. Messrs. Jay A. Pritzker and Robert A. Pritzker are brothers. There are no other family relationships among the directors and executive officers of the Company. Directors and executive officers are elected for a term of one year, or until a successor is appointed. Other Directorships Mr. Robert A. Pritzker and Mr. Gluth are Directors of TIE/communications, Inc. Other than that, none of the members of the Company's Board of Directors are members of the board of directors of companies with a class of securities registered pursuant to Section 12 of the Securities Exchange Act of 1934 or subject to the requirements of Section 15(d) of that Act or of a company registered as an investment company under the Investment Company Act of 1940. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Sidney H. Bonser, Senior Vice President; Kenneth P. Fischl, Vice President; and Stephen G. Dinsmore, Vice President, were the only executive officers of the Company who in the year ended December 31, 1993, received salary and bonus in excess of $100,000 from the Company and its subsidiaries for services in all capacities to the Company. All other officers of the Company received their 1993 compensation from Marmon and are primarily involved in the management of MIC and Marmon. The Company, together with the other subsidiaries of MIC, have been required to pay Marmon a portion of such compensation which is encompassed in the charge for certain common services provided by Marmon to the Company and such other subsidiaries. The amount of such charge has been determined pursuant to a formula based upon the dollar value of revenues, earnings and assets. See Note 17. Directors of the Company do not receive any compensation in such capacity. Shown below is the aggregate of all forms of compensation paid by the Company to Mr. Bonser, Mr. Fischl and Mr. Dinsmore: Summary Compensation Table * Represents the aggregate amounts of Company contributions to defined contribution plans on behalf of each of the named individuals. ** Prior to 1992, Mr. Fischl was not an executive officer of the Company. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT MIC, a Delaware corporation having its principal executive offices at 225 West Washington Street, Chicago, Illinois, owns 1,000 shares, or 100% of the Company's issued and outstanding common stock. MIC is an indirect subsidiary of Holdings. Substantially all of the stock of Holdings is owned, directly or indirectly, by trusts for the benefit of certain members of the Pritzker family. As used herein, "Pritzker family" refers to the lineal descendants of Nicholas J. Pritzker, deceased. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Related Party Transactions See "Notes to Consolidated Financial Statements," Note 17. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Page ---- a) 1. Financial Statements - Consolidated statement of income for each of the three years in the period ended December 31, 1993...................... 16 Consolidated balance sheet - December 31, 1993 and 1992.... 17 Consolidated statement of stockholder's equity for each of the three years in the period ended December 31, 1993...... 18 Consolidated statement of cash flows for each of the three years in the period ended December 31, 1993................ 19 Notes to consolidated financial statements.................. 20 2. Financial Statement Schedules - V - Property.............................................. 43 VI - Accumulated Depreciation.............................. 44 3. Index to Exhibits........................................... 45 b) Reports on Form 8-K There were no reports on Form 8-K for the three months ended December 31, 1993. All other schedules are not submitted because they are not applicable or because the required information is included in the financial statements or notes thereto. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized: UNION TANK CAR COMPANY (Registrant) By: /s/ R.C. GLUTH ------------------------ R.C. Gluth Executive Vice President Dated: March 9, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Signature Title Date - --------- ----- ---- /s/ Jay A. Pritzker Chairman of the Board March 9, 1994 - ------------------------- and Director Jay A. Pritzker /s/ Robert A. Pritzker President and Director March 9, 1994 - ------------------------- (principal executive officer) Robert A. Pritzker /s/ R.C. Gluth Executive Vice President March 9, 1994 - ------------------------- and Director and Treasurer R.C. Gluth (principal financial officer and principal accounting officer) /s/ Sidney H. Bonser Senior Vice President March 9, 1994 - ------------------------- and Director Sidney H. Bonser Schedule V UNION TANK CAR COMPANY AND SUBSIDIARIES PROPERTY (Dollars in Thousands) Schedule VI UNION TANK CAR COMPANY AND SUBSIDIARIES ACCUMULATED DEPRECIATION (Dollars in Thousands) Railcars and fixed assets are depreciated to estimated salvage value over their estimated useful lives on the straight line method. For railcars, the salvage value is the estimated scrap value of their steel content. The estimated useful lives are principally: railcars, 20-30 years; buildings and improvements 20-30 years; and machinery and equipment, 4-25 years. UNION TANK CAR COMPANY AND SUBSIDIARIES INDEX TO EXHIBITS ITEM 14 (a)(3) Exhibit 3 Articles of incorporation and by-laws 3(a) Restated Certificate of Incorporation of the Company, as filed with the Secretary of State of Delaware on September 2, 1982 (which was filed as Exhibit 3(a) to the Annual Report on Form 10-K for the fiscal year ended December 31, 1982, and is incorporated herein by reference) 3(b) By-Laws of the Company, as adopted November 25, 1987 (which was filed as Exhibit 3(b) to the Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and is incorporated herein by reference) Exhibit 12 Statements re computation of ratios The computation of the Ratio of Earnings to Fixed Charges (summarized in Note 15 to the consolidated financial statements)............................................... 46 Exhibit 22 Subsidiaries of the registrant.............................. 47 Instruments defining the rights of holders of long-term debt are not being filed herewith pursuant to the provisions of paragraph 4(iii) of Item 601(b) of Regulation S-K. The Company agrees to furnish a copy of any such instrument to the Commission upon request.

66740_1993.txt

66740

1993

Item 1. Business. Minnesota Mining and Manufacturing Company was incorporated in 1929 under the laws of the State of Delaware to continue operations, begun in 1902, of a Minnesota corporation of the same name. As used herein, the term "3M" includes Minnesota Mining and Manufacturing Company and subsidiaries unless the context otherwise indicates. 3M employs 86,168 persons. 3M is an integrated enterprise characterized by substantial interdivision and intersector cooperation in research, manufacturing and marketing of products incorporating similar component materials manufactured at common internal sources. Its business has developed from its research and technology in coating and bonding for coated abrasives, its only product in its early years. Coating and bonding is the process of applying one material to another, such as adhesives to a backing (pressure-sensitive tapes), abrasive granules to paper or cloth (coated abrasives), ceramic coating to granular mineral (roofing granules), heat- or light- sensitive materials to paper, film and metal (dry silver paper, photographic film and lithographic plates), iron oxide to plastic backing (magnetic recording tape), glass beads to plastic backing (reflective sheeting), and low tack adhesives to paper (repositionable notes). 3M believes that it is among the leading producers of products for many of the markets it serves. In all cases, 3M products are subject to direct or indirect competition. Generally speaking, most 3M products involve technical competence in development, manufacturing and marketing and are subject to competition with products manufactured and sold by other technically-oriented companies. 3M's three business sectors are: Industrial and Consumer; Information, Imaging and Electronic; and Life Sciences. Each sector brings together common or related 3M technologies and thus provides greater opportunity for the future development of products and services and a more efficient sharing of business strengths. The notes to the financial statements on page 25 and 26 of this Form 10-K provide financial information concerning 3M's three industry segments and 3M's operations in various geographic areas of the world. Industry Segments 3M's operations are organized into three business sectors. These sectors have worldwide responsibility for virtually all 3M product lines. A few miscellaneous and staff-sponsored new products, still in development, are not assigned to the sectors. Industrial and Consumer Sector: This sector is a leader in developing the technologies for pressure-sensitive adhesives, specialty tapes, coated and nonwoven abrasives, and specialty chemicals. These core technologies provide a strong basis for the development of new products. The sector also has strong distribution channels and logistics expertise. The sector is organized into five groups: Abrasive, Chemical and Film Products Group; Automotive Systems Group; Consumer Markets; Office Markets; and Tape Group. Major products in the Abrasive, Chemical and Film Products Group include coated abrasives (such as sandpaper) for grinding, conditioning and finishing a wide range of surfaces; natural and color-coated mineral granules for asphalt shingles; finishing compounds; and flame-retardant materials. This group also markets products for maintaining and repairing vehicles. Major chemical products include protective chemicals for furniture, fabrics and paper products; fire-fighting agents; fluoroelastomers for seals, tubes and gaskets in engines; engineering fluids; and high performance fluids used in the manufacture of computer chips and for electronic cooling and lubricating of computer hard disk drives. This group also serves as a major resource for other 3M divisions, supplying specialty chemicals, adhesives and films used in the manufacture of many 3M products. Major products in the Automotive Systems Group include body side-molding and trim; functional and decorative graphics; corrosion- and abrasion- resistant films; tapes for attaching nameplates, trim and moldings; and fasteners for attaching interior panels and carpeting. Major products in the Consumer and Office Market businesses include Scotch brand tapes; Post-it brand note products including memo pads, labels, stickers, pop-up notes and dispensers; home cleaning products including Scotch-Brite brand scouring products, O-Cel-O brand sponges and Scotchgard brand fabric protectors; energy control products such as window insulation kits; nonwoven abrasive materials for floor maintenance and commercial cleaning; floor matting; and a full range of do-it-yourself products including surface preparation and wood finishing materials, and filters for furnaces and air conditioners. The Tape Group manufactures and markets a wide variety of high- performance and general-use pressure-sensitive tapes and specialty products. Major product categories include industrial application tapes made from a wide variety of materials such as foil, film, vinyl and polyester; specialty tapes and adhesives for industrial applications including Scotch brand VHB brand tapes, lithographic tapes, joining systems, specialty additives, vibration control materials, liquid adhesives, and reclosable fasteners; general-use tapes such as masking, box-sealing and filament; and labels and other materials for identifying and marking durable goods. Information, Imaging and Electronic Sector: This sector serves rapidly changing markets in audio, video and data recording; graphic communications; information storage, output and transfer; telecommunications; electronics and electrical products. The sector has the leading technologies for certain electrical, electronic and fiber-optic applications and a wide variety of graphic imaging technologies. Having these related areas in one operating unit fosters efficient product development and innovation. The sector is also strong in worldwide distribution and service. The sector is organized into three groups: Electro and Communications Systems; Imaging Systems; and Memory Technologies. The Electro and Communication Systems Group includes products in the electronic, electrical, telecommunication and visual communication fields. The electronic and electrical products include packaging and inter-connection devices; insulating materials, including pressure-sensitive tapes and resins; and other related equipment. These products are used extensively by manufacturers of electronic and electrical equipment, as well as the construction and maintenance segments of the electric utility, telephone and other industries. The telecommunication products serve the world's telephone companies with a wide array of products for fiber-optic and copper-based telephone systems. These include many innovative connecting, closure and splicing systems, maintenance products and test equipment. The visual communication products serve the world's office and education markets with overhead projectors and transparency films and materials plus equipment and accessories for computer-based presentations. The Imaging Systems Group offers a complete line of products for printers and graphic arts firms, from the largest commercial printer to the smallest instant printer or in-house facility. These products include a broad line of presensitized lithographic plates and related supplies; a complete line of duplicator press plates and automated imaging systems and related supplies; copy and art preparation materials; pre-press proofing systems; carbonless paper sheets for multiple-part business forms; and a line of light-sensitive dry silver papers and films for electronically recorded images. This group's imaging technologies are used in producing photographic products, including medical X-ray films, graphic arts films and amateur color films. It also is a major supplier of laser imagers and supplies and computerized medical diagnostic systems. This group also offers an array of micrographic systems including readers and printers for engineering graphics and office applications. Related products include dry silver imaging papers and microfilm in aperture card and roll formats. The Memory Technologies Group manufactures and markets a complete line of magnetic and optical recording products for many applications that meet the requirements for complex applications in computers, instrumentation, automation and other fields. Memory Technologies is the world's largest supplier of removable memory media for computers. Products range from computer diskettes, cartridges and tapes to CD-ROM and rewritable optical media. The group markets a wide array of recording products which are used for home video recording, in professional radio and television markets, as well as for commercial and industrial uses. These include reel-to-reel, cartridge and cassette tapes for audio and video recording. Life Sciences Sector: This sector contributes to better health and safety for people around the world. The Life Sciences Sector's major technologies include pressure-sensitive adhesives, substrates, extrusion/coating, nonwoven materials, specialty polymers and resins, optical systems, drug delivery, and electro-mechanical devices. The sector has strong distribution channels in all its major markets. The sector is organized into three groups: Medical Products; Pharmaceuticals, Dental and Disposable Products; and Traffic and Personal Safety Products. The Medical Products Group produces a broad range of medical supplies, devices and equipment. Medical supplies include tapes, dressings, surgical drapes and masks, biological indicators, orthopedic casting materials and electrodes. Medical devices and equipment include stethoscopes, heart-lung machines, sterilization equipment, blood gas monitors, powered orthopedic instruments, skin staplers, and intravenous infusion pumps. The Medical Products Group also develops hospital information systems. The Pharmaceuticals, Dental and Disposable Products Group serves pharmaceutical and dental markets, as well as manufacturers of disposable diapers. Pharmaceuticals include ethical drugs and drug-delivery systems. Among ethical pharmaceuticals are analgesics, anti-inflammatories and cardiovascular and respiratory products. Drug-delivery systems include metered-dose inhalers, as well as transdermal skin patches and related components. Dental products include dental restoratives, adhesives, impression materials, temporary crowns, infection control products and orthodontic brackets and wires. This group also produces a broad line of tape closures for disposable diapers. The Traffic and Personal Safety Products Group is a leader in the following markets: traffic control materials, commercial graphics, occupational health and safety, and out-of-home advertising. In traffic control materials, 3M is the worldwide leader in reflective sheetings. These materials are used on highway signs, vehicle license plates, construction workzone devices, and trucks and other vehicles. In commercial graphics, 3M supplies a broad line of films, inks and related products used to produce graphics for trucks and signs. Major occupational health and safety products include maintenance-free and reusable respirators plus personal monitoring systems. Out-of-home advertising includes outdoor advertising, advertising displays in shopping centers and local advertising in national magazines. This product group also markets a variety of other products. These include spill-control sorbents, Thinsulate brand and Lite Loft brand insulations, traffic control devices, filtration products, electronic surveillance products, reflective sheetings for personal safety, and films for protection against counterfeiting. Distribution 3M products are sold directly to users and through numerous wholesalers, retailers, jobbers, distributors and dealers in a wide variety of trades in many countries of the world. Management believes that the confidence of wholesalers, retailers, jobbers, distributors and dealers in 3M and its products, developed through long association with trained marketing and sales representatives, has contributed significantly to 3M's position in the marketplace and to its growth. 3M has 322 sales offices and distribution centers worldwide, including 9 major branch offices and warehouses that are located in principal cities throughout the United States. There are 99 sales offices and distribution centers located in the United States. The remaining 223 sales offices and distribution centers are located in 52 countries outside the United States. Research, Patents and Raw Materials Research and product development constitute an important part of 3M's activities, and products resulting from such research and product development have contributed in large measure to its growth. The total amount spent for all research and development activities was $1.030 billion, $1.007 billion, and $914 million in 1993, 1992 and 1991, respectively. The corporate research laboratories are engaged in research which does not relate directly to 3M's existing product lines. They also support the research efforts of division and sector laboratories. Most major operating divisions and domestic subsidiaries, as well as several international subsidiaries, have their own laboratories for improvement of existing products and development of related new products. Engineering research staff groups provide specialized services in instrumentation, engineering and process development. An organization is maintained for technological development not sponsored by other units of the company. 3M is the owner of many domestic and foreign patents derived primarily from its own research activities. 3M does not consider that its business as a whole is materially dependent upon any one patent, license or trade secret or any group of related patents, licenses or trade secrets. The company experienced no significant or unusual problems in the purchase of raw materials during 1993. While 3M has successfully met its demands to date, it is impossible to predict future shortages or their impact. Executive Officers The following is a list of the executive officers of 3M as of March 1, 1994, their present position, their current age, the year first elected to their position and other positions held within 3M during the previous five years. All of these persons have been employed full time by 3M or a subsidiary of 3M for more than five years. All officers are elected by the Board of Directors at its annual meeting, with vacancies and new positions being filled at interim meetings. There are no family relationships between any of the executive officers named, nor is there any arrangement or understanding pursuant to which any person was selected as an officer. Item 2.

Item 2. Properties. 3M's general offices, corporate research laboratories, most division laboratories and certain manufacturing facilities are located in St. Paul, Minnesota. Within the United States, 3M operates 82 plants in 28 states and has 99 sales offices and distribution centers located in 24 states. Internationally, 3M operates 109 manufacturing and converting facilities in 44 countries. 3M owns substantially all of its physical properties. 3M leases certain facilities that were financed through the issuance of industrial development bonds in the original principal amount of $30 million. 3M has capitalized the construction costs related to these facilities and recorded the related liabilities. Management believes 3M's existing physical facilities are highly suitable for the purposes for which they were designed. Item 3.

Item 3. Legal Proceedings. The company and certain of its subsidiaries are named defendants in a number of actions, governmental proceedings and claims, including product liability claims involving products now or formerly manufactured and sold by the company, many of which relate to silicone gel mammary implants, and some of which claims are purported or tentatively certified class actions. Mammary implant cases and claims are discussed separately below. In some actions, the claimants seek damages as well as other relief which, if granted, would require substantial expenditures. The company is involved in a number of environmental proceedings by governmental agencies asserting liability for past waste disposal and other alleged environmental damage. The company conducts ongoing investigations, assisted by environmental consultants, to determine accruals for the probable, estimable costs of remediation. The remediation accruals are reviewed each quarter and changes are made as appropriate. Some of these matters raise difficult and complex factual and legal issues and are subject to many uncertainties, including, but not limited to, the facts and circumstances of each particular action, the jurisdiction and forum in which each action is proceeding, and differences in applicable law. Accordingly, the company is not able to estimate the nature and amount of any future liability with respect to such matters. Mammary Implant Litigation As of December 31, 1993, the company had been named as a defendant, often with multiple co-defendants, in 3,054 claims and lawsuits in various courts, all seeking damages for personal injuries from allegedly defective breast implants. These claims and lawsuits, including class actions, purport to represent 8,842 individual claimants. These claims and lawsuits are generally in very preliminary stages, and it is not yet certain how many of these lawsuits and claims involve products manufactured and sold by the company, as opposed to other manufacturers. The company entered the business in 1977 by purchasing McGhan Medical and subsequently sold that business in 1984. The company's sales of implants, during the time that it engaged in this business, represent approximately seven percent of the total cumulative mammary implant sales. The company is vigorously defending the individual claims and lawsuits. Given the preliminary state of the proceedings, company's counsel has not yet reached a conclusion on the probability of company liability. Discussions regarding a possible "global settlement" have taken place during the last several months, with the facilitation of a panel of federal judges acting as mediators, between a plaintiffs' steering committee, various plaintiff groups, the mediators, and key defendants. The company was a participant in these mediation efforts. On February 14, 1994, Dow Corning, Bristol-Myers Squibb, and Baxter Healthcare Corp., together with several other defendants, announced an agreement with representatives from the plaintiffs' steering committee on financial terms for a global settlement. The company was not included by the parties in this arrangement. Discussions are now being conducted between the company and representatives of the plaintiffs' steering committee. The company does not know at this time whether these discussions will lead to resolution of all or any portion of the suits and claims against it or whether it will be a participant in such a settlement. With respect to these silicone gel mammary implant claims and lawsuits, the company's general counsel has opined that, based solely on the facts known as of February 25, 1994, date of the opinion and subject to future developments, there is sufficient insurance coverage to recover all liability and costs arising out of these matters. No insurers have denied coverage. Therefore, the company believes that such matters will not pose a material risk to the financial position of the company or its results of operations. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. None in the quarter ended December 31, 1993. Part II Item 5.

Item 5. Market Price of 3M's Common Stock and Related Security Holder Matters. At January 31, 1994, there were 117,343 shareholders of record. 3M's stock is listed on the following stock exchanges: New York Stock Exchange, Pacific Stock Exchange, Chicago Stock Exchange, Amsterdam Stock Exchange, German stock exchanges, Swiss stock exchanges, Paris Stock Exchange, and Tokyo Stock Exchange. Stock price comparison information (New York Stock Exchange Composite Transactions) is as follows: Quarter First Second Third Fourth Year 1993 High $111.75 $117.00 $111.25 $113.50 $117.00 Low 97.25 104.88 102.25 101.50 97.25 1992 High 98.75 97.38 103.75 107.00 107.00 Low 87.38 85.50 95.75 97.00 85.50 [TEXT] Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Operating Results 1993 was a challenging year in several respects. The company faced recessions in Europe and Japan, negative currency effects, a soft U.S. health care market and a highly competitive pricing environment. Worldwide net sales rose 1.0 percent to $14.020 billion. This followed increases of 4.1 percent in 1992 and 2.5 percent in 1991. Sales in the United States were $7.126 billion, up about 3 percent from 1992. Internationally, sales totaled $6.894 billion, a decrease of about 1 percent from 1992. Estimatedcomponents ofsales changefrom prioryears wereasfollows (percents): 1993 1992 ______________________________________________________________________________ U.S. Int'l Worldwide U.S. Int'l Worldwide ______________________________________________________________________________ Volume 5 7 6 3 5 4 Price (2) (2) (2) --- (1) (1) Translation --- (6) (3) --- 1 1 ______________________________________________________________________________ Total 3 (1) 1 3 5 4 ______________________________________________________________________________ In the United States volume growth accelerated in 1993, helped by a slight improvement in the domestic economy; however, pricing pressures also increased, mainly in memory technologies product lines. Internationally, sales growth in local currencies was slightly better than in 1992. However, currency fluctuations, which added to international sales in 1992, reduced those sales by about 6 percent in 1993. Cost of goods sold was 60.8 percent of sales, up from 60.1 percent in 1992. The negative impact of lower selling prices and currency was partially offset by improvements due to productivity gains and lower raw material costs. In 1992, cost of goods sold decreased as a percent of sales compared to 1991 due to productivity gains and lower raw material costs which were partially offset by higher R&D spending and lower selling prices. Cost of goods sold includes manufacturing, research and development, and engineering expenses. Selling, general and administrative expenses decreased to 25.2 percent of sales as the result of several cost-reduction programs. This compares with 25.6 percent in 1992 and 24.9 percent in 1991. The 1992 increase was magnified by costs for voluntary separations, higher sales costs and modest volume growth. Worldwide employment decreased by over 1,000 in 1993, even though about 600 people were added to support continued rapid growth in developing countries. This net reduction in employment occurred with little disruption to the company. (Percent of sales) 1993 1992 1991 ______________________________________________________________________________ Cost of goods sold 60.8 60.1 60.4 ______________________________________________________________________________ Selling, general and administrative expenses 25.2 25.6 24.9 ______________________________________________________________________________ In December 1992, 3M recognized $129 million in settlement of a patent lawsuit involving 3M orthopedic casting materials. Operating income in 1992 includes this amount, which is shown on a separate line of the Income Statement titled "legal settlement." Also in 1992, 3M recorded $115 million of special charges to enhance its competitiveness and productivity. These charges relate primarily to asset write-downs, including rationalization of manufacturing operations. Operating income in 1992 includes this amount, which is shown on a separate Income Statement line titled "special charges". Worldwide operating income in 1993 decreased 1.9 percent to $1.956 billion. The positive impact of increased sales volume and cost control was more than offset by negative currency and pricing. Operating income in 1993 included about $53 million for manufacturing rationalizations and voluntary separations. This compared to 1992 costs of about $80 million for voluntary separation programs, in addition to the $115 million of special charges. In 1992, operating income increased 1.7 percent, following a decrease of 10.6 percent in 1991. (Percent of sales) 1993 1992 1991 ______________________________________________________________________________ Operating Income 14.0 14.4 14.7 ______________________________________________________________________________ Interest expense was $50 million, down from $76 million in 1992 and $97 million in 1991. The declines in both 1993 and 1992 were mainly due to lower interest rates. Investment and other income totaled $96 million in 1993, which includes a $36 million benefit from tax settlements, improved investment results, and other items, many of which were of a non-recurring nature. This compared with investment and other income of $29 million in 1992 and $15 million in 1991. The company's effective tax rate was 35.3 percent of pre-tax income, the same as in 1992 and down from 36.8 percent in 1991. The 1 percent increase in the 1993 U.S. statutory corporate tax rate was offset by lower taxes on 3M International Operations, the extension of the U.S. R&D tax credit and the positive effect of revaluing deferred tax assets. The company's deferred tax assets will reverse over an extended period of time. Net income increased 2.5 percent to $1.263 billion, or $5.82 per share. In 1992, net income increased 6.8 percent to $1.233 billion, or $5.63 per share, compared with $1.154 billion, or $5.26 per share, in 1991. The company estimates that changes in the value of the U.S. dollar decreased 1993 net income by about $62 million, or 29 cents per share. Currency changes increased net income by about $1 million, or 1 cent per share, in 1992, and by $23 million, or 11 cents per share, in 1991. These estimates include the effect of translating profits from local currencies into U.S. dollars, the costs in local currencies of transferring goods between the parent company in the U.S. and international companies, and transaction gains and losses in countries not considered to be highly inflationary. Over the long term, 3M expects to meet its aggressive financial goals. These include a growth in earnings per share averaging 10 percent a year or better; return on stockholders' equity of 20 to 25 percent; return on capital employed of 27 percent or better; and 30 percent of sales from products introduced in the last four years. Earnings per share increased 3.4 percent in 1993. Currency effects reduced earnings by about 5 percent. Return on average stockholders' equity was 19.1 percent, up from 18.8 percent in 1992. This return has averaged 20.5 percent over the past 5 years. Return on capital employed was 19.1 percent, down from 19.7 percent in 1992. This return has averaged 22.1 percent over the past 5 years. In 1993 more than 25 percent of sales came from products introduced within the last 4 years. Performance by Business Sector Industrial and Consumer Sector: In 1993, sales were up 2.6 percent to $5.4 billion. Operating income rose 2.8 percent to $849 million. Excluding special charges of $13 million in 1992, operating income rose 1.2 percent in 1993. Sales and profits showed strong growth in the Asia Pacific area and in Latin America. However, results in Europe were adversely affected by weak economies and the stronger U.S. dollar. This sector expects continued growth in the United States, Asia Pacific area and in Latin America. Information, Imaging and Electronic Sector: In 1993, sales were down 1.7 percent to $4.5 billion. A solid increase in unit volume was more than offset by continued price competition and negative currency translation. Operating income increased 14.0 percent to $271 million. Excluding special charges of $81 million in 1992, operating income decreased 15.0 percent. Operating profit margins were affected by price competition and currency effects, as well as by large investments in new products and efforts to streamline operations. This sector will continue to face significant price pressure in 1994. Life Sciences Sector: In 1993, sales increased 2.6 percent to $4.1 billion. Sales growth was constrained by the stronger U.S. dollar and by the slowdown in the U.S. health care market due to uncertainty over health care reform. Operating income decreased 8.6 percent to $846 million. Excluding a net benefit of $108 million from a legal settlement and special charges, operating income increased by 3.4 percent. This sector will continue to be impacted by the uncertainty over U.S. health care reform. Financial Position 3M's financial condition remained strong in 1993, despite a sluggish worldwide economy. Balance sheet amounts did not vary significantly from 1992. Various items, such as cash and short-term debt, can fluctuate significantly from month to month depending on short-term liquidity needs. Substantially all of the vested and earned benefits under 3M's employee retirement plans, and about half of the other postretirement benefit obligations, were funded as of December 31, 1993. The company's key inventory index, which represents the number of months of inventory, was 4.0 months, up from 3.8 months in 1992. Accounts receivable days' sales outstanding were 66 days, up one day from 1992. The company's current ratio was 1.9, unchanged from the end of 1992. Of the long-term debt outstanding at the end of 1993, $469 million was a guarantee of debt of the 3M Employee Stock Ownership Plan. Total debt was 23 percent of stockholders' equity at the end of 1993. This compared with 22 percent at year-end 1992. The company's borrowings continued to maintain AAA long-term ratings. Legal proceedings, including the silicone gel mammory prosthesis situation and environmental liabilities, are discussed in the legal proceedings section on page 8. The company believes that such matters will not pose a material risk to the financial position of the company. Liquidity Due to a change in the financial reporting period for 3M's international companies, the 1992 Consolidated Statement of Cash Flows includes the cash provided or used by 3M's international companies for a 14-month period (November 1, 1991, to December 31, 1992). The following table is presented on a comparative basis, whereby 1992 excludes the November 1 to December 31, 1991, period for our international companies. (Millions) 1993 1992 1991 ______________________________________________________________________________ Net cash provided by operating activities $2,091 $2,218 $1,909 Net cash used in investing activities (1,092) (1,139) (1,197) Net cash used in financing activities (1,128) (1,027) (686) Effect of exchange rate changes on cash 21 (20) (62) ______________________________________________________________________________ Net increase (decrease) in cash and cash equivalents $ (108) $ 32 $ (36) ______________________________________________________________________________ Capital expenditures $1,112 $1,225 $1,326 Depreciation 976 950 884 ______________________________________________________________________________ The company met its cash requirements primarily from operating activities. During 1993, cash flows provided by operating activities totaled $2.091 billion. This more than covered capital expenditures and dividend payments of $1.833 billion. The company's superior credit rating provides easy and ample access to global capital markets. As part of our efforts to control overall spending, capital expenditures declined 9.3 percent to $1.112 billion in 1993. This followed a decline of 7.5 percent in calendar year 1992. Stockholder dividends increased 3.8 percent to $3.32 per share in 1993. Cash dividend payments totaled $721 million. 3M has paid dividends for 78 consecutive years. On February 14, 1994 the 3M Board of Directors boosted the quarterly dividend on 3M common stock 6 percent to 88 cents a share, declared a two-for-one stock split to shareholders of record on March 15, 1994 and authorized the repurchase of up to 12 million of the company's (pre-split) shares. This share-repurchase authorization runs through February 10, 1995. The company repurchased all of the six million shares available under a previous authorization. Repurchases of 3M common stock totaled $706 million in 1993, compared with $247 million in 1992 and $240 million in 1991. Increased share repurchases in 1993 reduced the total number of shares outstanding by more than 4 million. Repurchases were made to support employee stock purchase plans and for other corporate purposes. Future Outlook Most economists expect slightly better global economic growth this year, with the improvement coming in the second half. This combined with continued emphasis on productivity improvement and new products should help our results; however, the pricing environment is likely to remain quite competitive and currency fluctuations could have a significant, negative effect on our results again this year. Spending on research and development and capital equipment is expected to remain around 1993 levels. Employment levels should continue to decline slightly in 1994. In 1992, the Financial Accounting Standards Board issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." Postemployment benefits include, but are not limited to, disability, severance and health care benefits. 3M will adopt this standard in the first quarter of 1994. This adoption will have a diminimus effect on the company's results of operations. Item 8.

Item 8. Financial Statements and Supplementary Data. Reference (pages) Form 10-K Data submitted herewith: Report of Independent Accountants............... 15 Consolidated statements of income for the years ended December 31, 1993, 1992 and 1991 ............. 16 Consolidated balance sheets as of December 31, 1993 and 1992 ........................................... 17 Consolidated statements of cash flows for the years ended December 31, 1993, 1992 and 1991........................... 18 Notes to financial statements .................. 19-30 Report of Independent Accountants We have audited the consolidated financial statements and the financial statement schedules of Minnesota Mining and Manufacturing Company and subsidiaries (the company) as listed in Item 8 and Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Minnesota Mining and Manufacturing Company and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in the Notes to the Financial Statements, the company changed the fiscal year-end of its international companies in 1992. The company also adopted in 1992 Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and No. 109, "Accounting for Income Taxes." /s/COOPERS & LYBRAND COOPERS & LYBRAND St. Paul, Minnesota February 14, 1994 Notes to Financial Statements Accounting Policies Consolidation: All significant subsidiaries are consolidated. Unconsolidated subsidiaries and affiliates are included on the equity basis. Cash and Cash Equivalents: Cash and cash equivalents consist of cash and temporary investments with maturities of three months or less when purchased. Other Securities: Other securities consist of marketable securities and interest-bearing bank deposits with varied maturity dates. These securities are employed in the company's banking, captive insurance and cash management operations. The securities are stated at cost, which approximates fair value. Inventories: Inventories are stated at lower of cost or market, with cost generally determined on a first-in, first-out basis. Investments: Investments primarily include assets from captive insurance and banking operations and from venture capital investments. These investments are stated at cost, which approximates fair value. Other Assets: Other assets include goodwill, patents, other intangibles, deferred taxes and other noncurrent assets. Other assets are periodically reviewed for impairment to ensure that they are appropriately valued. Goodwill is generally amortized on a straight-line basis over 10 years. Other intangible items are amortized on a straight-line basis over their estimated economic lives. Deferred Income Taxes: Deferred income taxes arise from differences in basis for tax and financial-reporting purposes. Revenue Recognition: Revenue is recognized upon shipment of goods to customers and upon performance of services. Depreciation: Depreciation of property, plant and equipment is generally computed on a straight-line basis over the estimated useful lives of these assets. Research and Development: Research and development costs are charged to operations as incurred and totaled $1.030 billion in 1993, $1.007 billion in 1992 and $914 million in 1991. Foreign Currency Translation: Local currencies are generally considered the functional currencies outside the United States, except in countries with highly inflationary economies. Assets and liabilities are translated at year- end exchange rates for operations in local currency environments. Income and expense items are translated at average rates of exchange prevailing during the year. Translation adjustments are recorded as a component of stockholders' equity. For operations in countries with highly inflationary economies, certain financial statement amounts are translated at historical exchange rates, with all other assets and liabilities translated at year-end exchange rates. These translation adjustments are reflected in the results of operations. They decreased net income by $12 million in 1993, increased net income by $10 million in 1992 and decreased net income by $6 million in 1991. Accounting Changes Effective January 1, 1992, 3M's international companies changed their reporting period from a fiscal year ending October 31 to a calendar year ending December 31. The change was made to aid worldwide business planning, increase efficiency and reflect the global nature of the company's business. The international companies' results of operations for the period November 1 to December 31, 1991, are shown in the 1992 Consolidated Statement of Income as a cumulative effect of an accounting change. The cash flows of the international companies for the 14-month period November 1, 1991, to December 31, 1992, are reflected in the 1992 Consolidated Statement of Cash Flows. Effective January 1, 1992, the company adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires that the cost of providing postretirement benefits be accrued over an employee's service period. In implementing this standard, the company was required to accrue the unfunded obligation. The company had accrued and funded - under a different actuarial methodology - a substantial amount of these benefits since 1977. In implementing this standard, the company elected to record the transition obligation using the immediate recognition option. Also effective January 1, 1992, the company adopted SFAS No. 109, "Accounting for Income Taxes." This statement requires an asset and liability approach for financial accounting and reporting of income taxes. Under this approach, deferred taxes are recognized for the estimated taxes ultimately payable or recoverable based on enacted tax law. Changes in enacted tax rates will be reflected in the tax provision as they occur. Adoption of these accounting changes, in aggregate, did not have a material impact on 1992 results of operations. The table below shows the components of the cumulative effect of accounting changes. ______________________________________________________________________________ (Millions, except per-share data) 1992 ______________________________________________________________________________ Amount Per Share ______________________________________________________________________________ Cumulative effect of change in: Reporting period for international companies, net of $25 million in taxes (including tax benefits from revaluation of certain fixed assets in Italy) $ 100 $ 0.46 Accounting for other postretirement benefits, net of $107 million in taxes (183) (0.84) Accounting for income taxes 80 0.36 ______________________________________________________________________________ Total $ (3) $(0.02) ______________________________________________________________________________ Legal Settlement and Special Charges In December 1992, Johnson & Johnson agreed to pay 3M $129 million in settlement of a patent lawsuit involving 3M orthopedic casting materials. 3M received payment in January 1993. In 1992, 3M recorded $115 million of special charges designed to enhance competitiveness and productivity. About 75 percent of these charges related to asset write-downs, including rationalization of manufacturing operations. Supplemental Balance Sheet Information ______________________________________________________________________________ (Millions) 1993 1992 ______________________________________________________________________________ Accounts receivable ______________________________________________________________________________ Accounts receivable $ 2,730 $ 2,506 Less allowances 120 112 ______________________________________________________________________________ Accounts receivable - net $ 2,610 $ 2,394 ______________________________________________________________________________ Inventories ______________________________________________________________________________ Finished goods $ 1,246 $ 1,224 Work in process 604 586 Raw materials and supplies 551 505 ______________________________________________________________________________ Total inventories $ 2,401 $ 2,315 ______________________________________________________________________________ Property, plant and equipment - at cost ______________________________________________________________________________ Land $ 258 $ 241 Buildings and leasehold improvements 2,572 2,463 Machinery and equipment 8,305 7,732 Construction in progress 353 392 ______________________________________________________________________________ $11,488 $10,828 Less accumulated depreciation 6,658 6,036 ______________________________________________________________________________ Property, plant and equipment - net $ 4,830 $ 4,792 ______________________________________________________________________________ Short-term debt ______________________________________________________________________________ Commercial paper $ 193 $ 165 Long-term debt - current portion 79 148 Other borrowings 425 426 ______________________________________________________________________________ Total short-term debt $ 697 $ 739 ______________________________________________________________________________ Other current liabilities ______________________________________________________________________________ Deposits - banking operations $ 291 $ 259 Other current liabilities 795 798 ______________________________________________________________________________ Total other current liabilities $ 1,086 $ 1,057 ______________________________________________________________________________ Other liabilities ______________________________________________________________________________ Minority interest in subsidiaries $ 376 $ 314 Nonpension postretirement benefits 386 366 Other liabilities 845 748 ______________________________________________________________________________ Total other liabilities $ 1,607 $ 1,428 ______________________________________________________________________________ The carrying amount of short-term debt approximates fair value. Deposits - banking operations - are primarily demand deposits and, as such, the carrying amount approximates fair value. Leases Rental expense under operating leases was $141 million in 1993, $140 million in 1992 and $141 million in 1991. The table below sets forth minimum payments under operating leases with noncancelable terms in excess of one year as of year-end 1993. _______________________________________________________________________________ After (Millions) 1994 1995 1996 1997 1998 1998 Total _______________________________________________________________________________ Minimum lease payments $70 $53 $39 $21 $16 $88 $287 _______________________________________________________________________________ Long-Term Debt Employee Stock Ownership Plan: In 1989, the company established an Employee Stock Ownership Plan (ESOP). The ESOP borrowed $548 million. Because the company has guaranteed repayment of the ESOP debt, the debt and related unearned compensation are recorded on the Consolidated Balance Sheet. Medium-Term Notes: 3M maintains a shelf registration with the Securities and Exchange Commission that provides the means to offer medium-term notes not to exceed $601 million. As of December 31, 1993, $502 million was available for future financial needs. The company entered into interest rate swap agreements to achieve variable interest rates below U.S. commercial paper rates for notes outstanding. The effective rate of these agreements approximated 2.5 percent at year-end 1993. Other Borrowings: These are primarily borrowings of 3M's international companies and municipal bond issues in the United States. Interest rates range mainly from 2.3 to 11.0 percent. ______________________________________________________________________________ (Millions) 1993 1992 ______________________________________________________________________________ ESOP debt guarantee, 8.13-8.27%, due 1995-2004 $469 $490 Eurobond, 4.81%, due 1998 114 --- Medium-term notes, due 1995 75 115 Other borrowings, due 1995-2025 138 82 ______________________________________________________________________________ Total long-term debt $796 $687 ______________________________________________________________________________ Maturities of long-term debt for the next five years are as follows: 1994, $79 million; 1995, $168 million; 1996, $44 million; 1997, $41 million; and 1998, $159 million. Interest payments included in the Consolidated Statement of Cash Flows totaled $53 million in 1993, $88 million in 1992 and $118 million in 1991. For the calendar year 1992, interest payments were $79 million. The company estimates that the fair value of long-term debt is not materially different than the carrying amount of this debt. Other Financial Instruments The company has entered into interest rate and currency swaps, as well as forward interest rate agreements, with face amounts of $605 million and $308 million, respectively, as of December 31, 1993, and 1992. The company uses these instruments to manage risk from interest rate and currency fluctuations and to lower its cost of borrowing. The unrealized gains and losses are deferred until the underlying transactions are realized. As of December 31, 1993, the unrealized gains and losses were not material. The company also had foreign exchange forward and option contracts with face amounts of $704 million and $785 million, respectively, at December 31, 1993, and 1992. The company uses these financial instruments primarily to hedge transactions denominated in foreign currencies, thereby reducing risk from exchange rate fluctuations in the regular course of its global business. The net unrealized gain on these contracts as of December 31, 1993, was not material. Income Taxes _______________________________________________________________________________ Income Before Income Taxes _______________________________________________________________________________ (Millions) 1993 1992 1991 _______________________________________________________________________________ U.S. $1,390 $1,301 $1,136 International 612 646 741 _______________________________________________________________________________ Total $2,002 $1,947 $1,877 _______________________________________________________________________________ Provision for Income Taxes _______________________________________________________________________________ (Millions) 1993 1992 1991 _______________________________________________________________________________ Currently payable Federal $430 $371 $396 State 74 78 74 International 292 339 343 Deferred Federal (66) (63) (110) State (5) (6) (9) International (18) (32) (3) _______________________________________________________________________________ Total $707 $687 $691 _______________________________________________________________________________ Net deferred tax assets totaled $439 million ($293 million current) and net deferred tax liabilities totaled $98 million ($6 million current) at year-end 1993. The major components of deferred taxes include benefit costs not currently deductible of $336 million and accelerated depreciation for tax purposes of $362 million. Income tax payments included in the Consolidated Statement of Cash Flows totaled $802 million in 1993, $743 million in 1992 and $867 million in 1991. For calendar year 1992, income tax payments were $714 million. At December 31, 1993, there were approximately $2.850 billion of retained earnings attributable to our international companies that are considered to be permanently invested. No provision has been made for taxes that might be payable if these earnings were remitted to the United States. It is not practical to determine the amount of incremental tax that might arise should these earnings be remitted. Retirement Plans 3M has various company-sponsored retirement plans covering substantially all U.S. employees and many employees outside the United States. Pension benefits are based principally on an employee's years of service and compensation near retirement. Plan assets are invested in common stocks, fixed-income securities, real estate and other investments. The company's funding policy is to deposit with an independent trustee amounts at least equal to those required by law. A trust fund is maintained to provide pension benefits to plan participants and their beneficiaries. In addition, a number of plans are maintained by deposits with insurance companies. The charge to income relating to these plans was $203 million in 1993, $178 million in 1992 and $133 million in 1991. Other Postretirement Benefits The company provides health care and life insurance benefits for substantially all of its U.S. employees who reach retirement age while employed by the company. The company has set aside funds with an independent trustee for these postretirement benefits and makes periodic contributions to the plan. The assets held by the trustee are invested in common stocks and fixed-income securities. Employees outside the United States are covered principally by government-sponsored plans and the cost of company-provided plans for these employees is not material. The table below sets forth the components of the net periodic postretirement benefit cost and a reconciliation of the funded status of the postretirement benefit plan for U.S. employees. Net Periodic Postretirement Benefit Cost ______________________________________________________________________________ (Millions) 1993 1992 ______________________________________________________________________________ Service cost $ 23 $ 21 Interest cost 53 49 Return on plan assets - actual (23) (20) Net amortization and deferral 1 --- ______________________________________________________________________________ Total $ 54 $ 50 ______________________________________________________________________________ Funded Status of Postretirement Benefits Plan ______________________________________________________________________________ (Millions) 1993 1992 ______________________________________________________________________________ Fair value of plan assets $335 $314 ______________________________________________________________________________ Accumulated postretirement benefit obligation: Retirees 248 193 Fully eligible active plan participants 153 139 Other active plan participants 378 348 ______________________________________________________________________________ Benefit obligation 779 680 ______________________________________________________________________________ Plan assets less benefit obligation (444) (366) Adjustments and unrecognized items 58 --- Accrued postretirement expense recognized in the Consolidated Balance Sheet $(386) $(366) The accumulated postretirement benefit obligation and related benefit cost are determined through the application of relevant actuarial assumptions. The company anticipates its health care cost trend rate to slow from 7.5 percent in 1994 to 5.0 percent in 2003, after which the trend rate is expected to stabilize. The effect of a one percentage point increase in the assumed health care cost trend rate for each future year would increase the benefit obligation by $57 million and the current year benefit expense by $4 million. Other actuarial assumptions include an expected long-term rate of return on plan assets of 9.0 percent (before taxes applicable to a portion of the return on plan assets), and a discount rate of 7.25 percent. The charge to income relating to these plans was $54 million in 1993, $50 million in 1992 and $51 million in 1991. Other Postemployment Benefits In 1992, the Financial Accounting Standards Board issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." Postemployment benefits include, but are not limited to, disability, severance and health care benefits. 3M will adopt this standard in the first quarter of 1994. This adoption will have a diminimus effect on the company's results of operations. Employee Stock Ownership Plan The company maintains an Employee Stock Ownership Plan (ESOP) for substantially all full-time U.S. employees. This plan was established in 1989 as a cost-effective way of funding certain employee retirement savings benefits, including the company's matching contributions under its 401(k) employee savings plan. The ESOP borrowed $548 million and used the proceeds to purchase 7.7 million shares of the company's common stock, previously held in treasury. The debt is being serviced by dividends on stock held by the ESOP and by company contributions. These contributions are reported as a benefit expense. Employee Savings Plan The company sponsors an employee savings plan under Section 401(k) of the Internal Revenue Code. This plan covers substantially all full-time U.S. employees. The company matches employee contributions of up to 6 percent of compensation at rates ranging from 35 to 85 percent, depending upon company performance. Amounts charged against income were $29 million in 1993 and 1992, and $28 million in 1991. General Employees' Stock Purchase Plan Participants in the General Employees' Stock Purchase Plan are granted options at 85 percent of market value at the date of grant. At December 31, 1993, there were 23,216 participants in the plan, with 58,058 employees eligible to participate. Options must be exercised within 27 months from date of grant. Shares Price Range ______________________________________________________________________________ Under Option- January 1, 1993 223,179 $66.94-88.30 Granted 818,005 83.57-96.59 Exercised (777,102) 66.94-96.59 Cancelled (27,633) 66.94-96.59 ______________________________________________________________________________ Under Option- December 31, 1993 236,449 $73.90-96.59 ______________________________________________________________________________ Shares available for grant- December 31, 1993 8,803,215 ______________________________________________________________________________ Management Stock Ownership Program Management stock options are granted at market value at the date of grant. At December 31, 1993, there were 4,238 participants in the plan. All outstanding options expire between May 1994 and May 2003. Shares Price Range ______________________________________________________________________________ Under Option- January 1, 1993 9,400,910 $38.73-103.60 Granted 2,138,014 97.85-116.15 Exercised (1,361,733) 38.73-103.60 Cancelled (85,844) 38.73-113.25 ______________________________________________________________________________ Under Option- December 31, 1993 10,091,347 $38.73-116.15 ______________________________________________________________________________ Options Exercisable- December 31, 1993 8,133,231 $38.73-115.45 ______________________________________________________________________________ Shares available for grant- December 31, 1993 10,869,705 ______________________________________________________________________________ Quarterly Data (Unaudited) ___________________________________________________________________________ (Millions, except per-share data) First Second Third Fourth Year __________________________________________________________________________ Net Sales 1993 $3,517 $3,540 $3,481 $3,482 $14,020 1992 3,438 3,519 3,551 3,375 13,883 __________________________________________________________________________ Cost of Goods Sold 1993 $2,112 $2,131 $2,167 $2,119 $8,529 1992 2,058 2,115 2,134 2,039 8,346 __________________________________________________________________________ Income Before Cumulative Effect of Accounting Changes 1993 $330 $331 $316 $286 $1,263 1992 306 317 324 289 1,236 Per Share 1993 $1.51 $1.51 $1.47 $1.33 $5.82 1992 1.40 1.45 1.48 1.32 5.65 __________________________________________________________________________ Net Income 1993 $330 $331 $316 $286 $1,263 1992 303 317 324 289 1,233 Per Share 1993 $1.51 $1.51 $1.47 $1.33 $5.82 1992 1.38 1.45 1.48 1.32 5.63 __________________________________________________________________________ Stock Price Comparisons (New York Stock Exchange Composite Transactions) 1993 High $111.75 $117.00 $111.25 $113.50 $117.00 Low 97.25 104.88 102.25 101.50 97.25 1992 High 98.75 97.38 103.75 107.00 107.00 Low 87.38 85.50 95.75 97.00 85.50 __________________________________________________________________________ [FN] 1 Includes a legal settlement and special charges, which together added $9 million, or 4 cents a share, to net income. Item 9.

Item 9. Disagreements on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. Item 11.

Item 11. Executive Compensation. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. Item 13.

Item 13. Certain Relationships and Related Transactions. The information called for by Items 10 through 13 are omitted pursuant to general instruction G(3). The registrant will file with the Commission a definitive proxy statement pursuant to Regulation 14A before April 30, 1994. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The financial statements filed as part of this report are listed in the index to financial statements on page 14. Index to Financial Statement Schedules Reference(pages) Form 10-K ________________ Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: V Property, Plant and Equipment.......................33 VI Accumulated Depreciation of Property, Plant and Equipment ......................................34 IX Short-Term Borrowings .............................35 X Supplementary Income Statement Information ..........................................35 All other schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements or the notes thereto. (b) Reports on Form 8-K: 3M was not required to file any reports on Form 8-K for the quarter ended December 31, 1993. (c) Exhibits: Incorporated by Reference: Incorporated by Reference in the Report From (3) Restated certificate of incorporation Exhibit (3) to and bylaws, amended to and Report Form 10-Q including amendments of for period ended May 12, 1987. June 30, 1987. (4) Instruments defining the rights of security holders, including debentures: (a) common stock. Exhibit (3) above (b) medium term notes. Registration Nos. 33-29329 and 33-48089 on Form S-3. (10) Management contracts, management remuneration: (a) management stock ownership program. Exhibit 4 of Registration No. 33-49842 on Form S-8 (b) profit sharing plan, performance Written description unit plan and other compensation contained in issuer's arrangements. proxy statement for the 1994 annual shareholders meeting. Reference (pages) Form 10-K Submitted herewith: (11) Computation of per share earnings. 36 (12) Calculation of ratio of earnings to fixed charges. 37 (22) Subsidiaries of the registrant. 38 (24) Consent of experts. 39 (25) Power of attorney. 40 [TEXT] SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION COLUMN A COLUMN B _____________________________________________________________________ CHARGED TO COSTS AND EXPENSES ITEM 1993 1992* 1991 __________________________________ ____ ____ ____ Maintenance and Repairs ................ $463 $456 $420 Advertising Costs ...................... $161 $172 $152 * Includes expenses for the 12-month period ending December 31, 1992.